Australia's Future Tax System

Consultation Paper

Appendix E: Business level expenditure tax designs

This appendix outlines and illustrates some of the main design, administrative, and transitional issues associated with commonly proposed business level expenditure tax options: the allowance for corporate equity (ACE) and cash-flow taxes.

It does not discuss issues in relation to business-shareholder interactions. Both the ACE and cash-flow taxes can be designed to accommodate different levels and forms of integration, including classical and dividend imputation systems.

Allowance for corporate equity

An ACE levies tax on business income as conventionally measured, but provides an additional deduction (allowance) equal to a return calculated on the equity invested in the business. This deduction parallels the deduction allowed for interest paid on a business' debt capital.

Under an ACE, the equity of the company is not calculated with reference to the market value of the equity but rather the book value (at historic cost) of accumulated equity as calculated for tax purposes. At each year end, the closing book value of equity could be calculated as follows (for a business operating solely domestically):

Opening value of equity
Add: Taxable profits in the previous period
Add: Dividends from other companies
Add: New equity issues
Less: Tax payable on taxable profits in the previous period
Less: Dividends paid and returns of equity
Less: Net new acquisitions of other companies


Closing value of equity = Opening value of equity for next year


The ACE allowance is calculated by multiplying the opening value of equity (for the relevant income year) by an imputed rate of return. Setting the imputed rate is one of the most challenging aspects of the ACE. The academic consensus is that where full loss offsets are available an appropriate imputed rate is the risk-free nominal interest rate, which can be approximated by the rate on government bonds.17

As for expenditure taxes generally, under an ACE the tax system should not affect the cost of capital of a firm, as the effective marginal tax rate (EMTR) is zero for an investment generating returns that just cover the cost of capital (that is, one that provides 'normal returns').

The design of the ACE is such that if too much (little) tax is paid in any one year — taxable income exceeds (is less than) economic income — it is compensated by a higher (reduced) allowance in future years. This approach automatically taxes real rather than nominal income (it does not tax the inflation component of returns) and causes deviations from accrual-based capital gains or economic depreciation, and other valuation or timing misalignments, to be less material other than for the timing of revenues. The ability of the ACE to accommodate the existing income tax framework (including associated income recognition rules) makes it relatively easy to introduce (compared to cash-flow taxes) though requiring an additional set of provisions.

For investments by a business in another country, where income generated by the foreign investment is exempt in principle, there should be a reduction in the book value of equity. This is on the basis that an allowance should not be provided against income that is exempt. Complications can arise where the foreign income is partially exempt (for example, it does not entirely consist of 'active' foreign income of a company) or where the investment occurs through a branch.

In the case of inbound investments by foreign businesses, under an ACE a domestic subsidiary or branch of a foreign firm would be treated in the same way as a domestic business. Based on the experiences of the ACE in Belgium and Croatia, it can reasonably be expected that domestic taxes paid under an ACE would be eligible for a foreign tax credit in the foreign firm's home jurisdiction.

The more symmetric treatment of debt and equity under an ACE mean that thin capitalisation rules (which guard against excess debt financing) should no longer be required. However, transfer pricing rules would still be required.

Cash-flow tax

A cash-flow tax taxes the difference between cash receipts and cash outgoings. Unlike income tax, there is no revenue/capital distinction and, hence, both current and capital expenditure receive the same treatment.

The nature of transactions included in the tax base depends on which variant of the cash-flow tax is implemented. Three variants include the following.

  • The 'R' (real) base cash-flow tax: only real (not financial) cash flows are included in the base. Interest is neither taxable nor deductible. The petroleum resource rent tax is an example of an 'R' base cash-flow tax. Separate rules would be required if applied to financial service providers.
  • The 'R+F' (real plus financial) base cash-flow tax: both real and non-equity financial cash flows (borrowing, lending and repayments of debt) are included in the tax base. Where an amount is borrowed, it will result in an increase in the tax base. Repayments of both principal and interest are deductible from the tax base.
  • The 'S' (share) base cash-flow tax: the firm's net flows on equity is taxed (dividends paid plus purchases of shares less issues of new shares and receipt of dividends). It is essentially equivalent to an 'R+F' tax.

Like an ACE, the cash-flow tax gives rise to a zero effective tax rate on marginal investments. The immediate deduction for all expenditure means a cash-flow tax potentially: does not distort asset choices; taxes real returns only; and, as transactions are recognised at the time cash flows in or out of the business, does not require timing and valuation rules (for example, for depreciation). This offers significant simplification benefits.

International tax considerations raise similar issues as for an ACE. However, in the case of inbound investments there is a more open question as to whether other countries would be willing to provide a foreign tax credit for a cash-flow tax, given it is more radically different to an income tax than an ACE.18 As is the case with the ACE, thin capitalisation rules should be unnecessary as a bias towards debt financing should no longer exist.

The transition to a cash-flow tax is potentially complex given that existing assets and debts of firms would straddle the operation of both the original income tax and a replacement cash-flow tax.

It is also likely that revenue from a cash-flow tax would be pro-cyclical (as investment expenditure is typically pro-cyclical). This is in contrast to an ACE, which provides for 'smoother' revenue collections. This difference in the timing of revenues is reflected in the illustrative comparisons of income tax, ACE and cash-flow taxes below.

Comparison of corporate income tax, a business level cash-flow tax and an allowance for corporate equity

In each hypothetical case, a firm has initial capital of $120. Its cost of capital is 10 per cent, which is equal to the return generated by the investment (a marginal investment). The tax rate is 30 per cent. Capital depreciates at a rate of $40 per annum, which is assumed to be equal to depreciation for income tax purposes. The firm does not reinvest its gross returns, distributing these annually to shareholders.

Investment generates normal returns

Income tax

  Year 0 Year 1 Year 2 Year 3
Revenues   52 48 44
Less: tax depreciation   (40) (40) (40)
Taxable income   12 8 4
Tax   3.60 2.40 1.20
Effective average tax rate   30%    
Effective average tax rate   30%    

The income tax gives rise to a 'tax wedge' of 30 per cent, distorting the marginal investment decision.

Allowance for corporate equity

  Year 0 Year 1 Year 2 Year 3
Revenues   52 48 44
Less: tax depreciation   (40) (40) (40)
Less: ACE(a)   (12) (8) (4)
Taxable income   0 0 0
Tax   0 0 0
Opening book value   120 80 40
EATR   0%    
EATR   0%    
  1. Equal to 10 per cent of opening book value of equity for that year.

Under the ACE, where the correct imputed rate of return is selected (one that is equal to the normal return), no tax is payable on a marginal investment.

Cash-flow tax — 'R' and 'R+F' base

  Year 0 Year 1 Year 2 Year 3
Cash outlays -120 0 0 0
Cash receipts 0 52 48 44
Tax -36 15.6 14.4 13.2
EATR   0%    
EATR   0%    

Under the 'R' and 'R+F' base cash-flow taxes, the present value of future tax payments is equal to the tax credit received in respect of the new capital expenditure. As with an ACE, the cash-flow tax does not distort the marginal investment. However, unlike an ACE it potentially requires the government to fund the tax credit in the first year (which would be subsequently recouped over later years).

Under an 'S' base cash-flow tax, a similar outcome is achieved, but the tax calculations instead focus on cash flows relating to the raising and return of shareholder equity and dividend payments.

Investment generating economic rents

In this case, the investment generates above-normal returns of 20 per cent. All other circumstances remain the same.

Income tax

  Year 0 Year 1 Year 2 Year 3
Revenues   64 56 48
Less: tax depreciation   (40) (40) (40)
Taxable income   24 16 8
Tax   7.20 4.80 2.40
EATR   30%    

Allowance for corporate equity

  Year 0 Year 1 Year 2 Year 3
Revenues   64 56 48
Less: tax depreciation   (40) (40) (40)
Less: ACE   (12) (8) (4)
Taxable income   12 8 4
Tax   3.60 2.40 1.20
Opening book value   120 80 40
EATR   15%    

Cash-flow tax — 'R' and 'R+F' base

  Year 0 Year 1 Year 2 Year 3
Cash outlays -120 0 0 0
Cash receipts 0 64 56 48
Tax -36 19.20 16.80 14.40
EATR   15%    

17 Belgium's imputed rate is calculated by taking an average of the monthly government bond rate of the year preceding the fiscal year by two years. The rate is capped at 6.5 per cent and cannot change by more than 1 percentage point from year to year (a separate higher rate applies to small and medium enterprises).

18 It should be noted that the petroleum resource rent tax is recognised as a general income tax in some of Australia's tax treaties, while other treaties require it to be specifically identified in order to be creditable.