Australia's Future Tax System

Final Report: Detailed Analysis

Chapter B: Investment and entity taxation

B1. Company and other investment taxes

B1–4 Refining the business income tax base

To avoid a misallocation of resources that can reduce productivity, the business income tax base — for both companies and other entities — should be as broad as possible with few exemptions and concessions. Where income is measured incorrectly for tax purposes, investment may be directed towards less productive assets that would not be viable in the absence of the tax bias. There are also likely to be benefits from minimising biases around other business choices, such as the choice of business entity (see Section B2 The treatment of business entities and their owners), risk taking and financing choices.

However, the uniform taxation of all investments and business choices may not always be efficient. It may be more efficient to tax some investments more highly, such as those that earn economic rents that are specific to Australia, while other specific investments could be taxed more lightly if they generate spillover benefits that improve the wellbeing of Australian society more generally.

Furthermore, given the difficulties in calculating real income the administration and compliance costs of trying to tax business income uniformly may exceed the benefits.

Taxing investments more consistently

Measuring income correctly can be difficult

If the tax system measures income incorrectly, this can bias the level and pattern of investment. Difficulties include adjusting for inflation and measuring changes in real asset values (depreciation, capital gains and stock valuation). All of these issues can result in biases to firms' investment decisions.

Inflation aside, incorrectly measuring the rate of economic depreciation for tax purposes may favour investment in less productive assets. This reduces productivity and economic growth. However, it is hard to measure economic depreciation accurately.

Rates of economic depreciation will depend on a number of factors including the type of asset, how it is used and where it is used. At best, capital allowance provisions provide an approximation of economic depreciation measured as the change in value of a machine or building over an accounting period. The practical problem is how to reduce biases given real-world uncertainties.

Some deviations from economic income may correct market failures

In some circumstances deviations from economic income may have some merit, where this can correct for market failures.

Innovation and technological progress by businesses can take the form of product innovation or process innovation to increase efficiency and productivity. Such progress therefore encompasses a vast array of factors in the economy, including workforce skills, management, venture capital, technology uptake, work reorganisation, and research and development.

Where the research and development of a firm generates spillover benefits for others, the social returns from research and development may be greater than the private returns. A tax-preference or government expenditure that appropriately targets such spillovers may therefore be beneficial and improve overall productivity.

But where a subsidy is inappropriately targeted, such incentives can bias the allocation of resources in the economy and actually reduce productivity.

As innovation policies have recently been the subject of review, detailed consideration has not been given by the review to the arguments and evidence for encouraging research and development. While contestable, there is some evidence to support the use of subsidies or concessions to encourage research and development. For example, research and development expenditure has been found to be highly sensitive to tax incentives (Johansson et al. 2008).

Principle

The business income tax base should be as comprehensive as possible to ensure investment is allocated to its most productive uses. This must be balanced against the benefits of correcting market failures and the practical difficulties in achieving a completely uniform treatment of different investments.

Current depreciation arrangements are distortionary

The tax treatment of assets varies considerably under the current tax system. Differences arise from difficulties in determining economic income and from a history of discrete government decisions.

The overall impact of the income tax system on resource allocation and investment decisions is unclear. Tax concessions arise from tax exemptions and concessional rates, tax offsets or the deferral of tax liabilities. There are also tax arrangements that effectively impose an additional charge on the taxpayer, such as limitations on the use of losses, while special provisions, such as income averaging, are needed to minimise other adverse affects of the tax system.

Many of these arrangements interact with each other. For example, there are a number of special provisions that apply to different uses of agricultural land. These include special tax arrangements for investors in forestry managed investment schemes and agricultural managed investment schemes and accelerated write-off for establishment costs of carbon sink forests. In these cases the inconsistent treatment adds to the complexity of the tax system and is also likely to distort land use allocation.

One way to examine the potential impacts is to compare effective tax rates across different sectors. Markle and Shackelford (2009) estimate effective tax rates by industry using financial statement information for a number of countries. Their country-specific estimates show significant variation in effective tax rates across sectors. For example, for Australia they find the highest effective tax rate is in the financial services and retail trade sectors (27 per cent) and the lowest in the information and mining sectors (14 and 17 per cent respectively). As shown in Table B1–2, the results for Australia are typical of those across the other countries surveyed.

Table B1–2: Effective tax rates by industry, selected countries (domestic)

  Australia Canada Japan United Kingdon United States
All industries 24 24 39 26 26
Construction 23   36 21 25
Financials 27 13 36 26 15
Information 14 19 35 21 19
Manufacturing 25 24 38 25 28
Mining 17 17     22
Other 24 23 41 26 30
Professional 19   36 24 21
Real estate 23   40 26 24
Retail trade 27   44 27 34
Transportation 22   39 25 24

Source: Markle and Shackelford (2009), Table 4.

While other factors have an important influence on the allocation of investment in Australia, tax disparities tend, at the margin, to cause resources to move into less-productive investments in tax-favoured industries at the expense of more-productive investments in less-favoured industries. Overall productivity performance will be held back if there is over-investment in one tax-favoured sector at the expense of investment in other sectors that may be potentially more productive.

Tax disparities could also influence the way in which the economy may respond to a lowering of the company income tax rate. Industries with an already low effective tax rate could be expected to be less responsive than those with relatively high effective rates, all other things being equal.

Some assets are concessionally taxed

Following the recommendations of the Review of Business Taxation, Australia's capital allowance regime moved to a system based on the effective life of the asset (uniform capital allowances). The aim of effective life depreciation is to provide a neutral treatment across depreciating assets, aligning the rate of depreciation for tax purposes more closely with economic depreciation. This should reduce the distortions induced by tax across different assets, but a number of distortionary arrangements still remain.

For a small number of assets the effective life is capped or alternative capital allowance provisions apply. Statutory effective life caps currently apply to tractors, harvesters, trucks, buses, aircraft, helicopters and gas transmission and production assets.

These accelerated capital allowance provisions may result in significantly lower effective marginal tax rates for eligible investments relative to assets whose capital allowances are based on effective life. However, in some cases the statutory effective life cap may offset the impact arising from the fixed declining balance parameter being too low.

Another area of departure is the capital allowance rate for capital works, such as buildings and structural improvements. Taxpayers can claim a deduction for capital works at either 2.5 per cent (over 40 years) or 4 per cent (over 25 years) of the construction expenditure.

The rate depends on when construction started and how the capital works are used. The United Kingdom is phasing down allowances for industrial buildings, on the grounds that its tax system already recognises the depreciation of buildings and structures in other ways — through tax relief for the costs of repairs and insurance, and by directly recognising any actual depreciation (or appreciation) through the capital gains tax system (HM Treasury 2007).

Certain expenditure can be written-off immediately, even though it should be capitalised into an asset and depreciated over its effective life. For example, expenditures relating to the creation of intangibles like goodwill (discussed further below), certain repairs and maintenance and exploration expenditure (which can be immediately written-off even when exploration activity is successful or may still prove successful).

A number of submissions also suggest that longer-life assets should be written off at faster rates. However, under the current arrangements, where capital allowance deductions are based on historical cost, the system will favour more durable assets in the presence of inflation (Auerbach 1979). That said, the actual impact is less clear when other elements of the tax system are also considered. For example, to the extent longer-life assets are more risky, the current imperfect loss offset provisions (discussed below) may discourage investment in them.

Investment in intangibles is generally favoured

Investment in creating goodwill and other intangibles is currently taxed more generously than investment in many tangible assets. Expenditures incurred to create 'new' goodwill, such as marketing costs, are immediately deductible for tax and accounting purposes even though the economic benefits persist over time.

In contrast, acquired goodwill and other intangibles are taxed under the capital gains tax provisions. They cannot be depreciated for tax purposes, and gains (or losses) are taxed only when the asset is sold and the gain or loss realised. This treatment applies because of the practical difficulties under an income tax system in estimating the value of goodwill when it is acquired and the annual change in value.8 While acquired goodwill cannot be written-down for tax purposes, where it declines in value, any expenditure incurred in maintaining its value is immediately deductible. In many cases, this will approximate economic depreciation.

Under the capital gains tax provisions, any reduction in the value of previously acquired goodwill is effectively deducted when a business is sold. This is because the value of acquired goodwill is included in the cost base for measuring any capital gain or loss.9 If acquired goodwill were amortised, it would be deductible earlier, whereas gains from the creation of goodwill or any increase in the value of acquired goodwill would not be recognised until realisation. Allowing acquired goodwill to be written-off would therefore increase the overall tax preference in favour of intangibles.

The current arrangements are complex

A number of submissions also highlighted the complexity of the current capital allowance arrangements and the record keeping requirements associated with them.

The complexity of the existing system largely reflects the fact that Australian businesses use many different types of assets in their operations, each of which has its own effective life. Under the uniform capital allowances rules there are 40 different effective lives based on the Commissioner's current determination. Effective lives are provided for over 3,700 assets, of which around 400 are general use assets not specific to any particular industry or sector.

Complexity is also increased because special or preferential arrangements apply to certain assets or types of taxpayer. As discussed, buildings have their own specific arrangements, falling outside the uniform capital allowance system, while low-value assets, with a value of $1,000 or less, can be pooled together and depreciated at 37.5 per cent per year, and certain assets costing $300 or less are immediately deductible. Separate capital allowance arrangements are also available for small business.

Findings

While previous reforms to Australia's capital allowance arrangements have reduced distortions to investment decisions and some aspects of complexity, there remain a number of distortions that may encourage investment in less productive assets and the system remains complex.

Investment in creating intangibles is currently taxed more generously than investment in many tangible assets, reflecting the inherent difficulties in valuing intangibles.

Enhancing productivity and simplifying the capital allowance arrangements

The current capital allowance arrangements could be enhanced and simplified without significant adverse implications for resource allocation. A simplified system should be designed in such a way as to provide broadly the same capital allowance deductions as under the current law, but under a simpler, more streamlined arrangement.

Any simplification of the current regime risks biasing investment decisions by providing capital allowances that are less closely matched to economic depreciation. But given the difficulties in measuring the true decline in the value of an asset, it is unclear how significant any biases would be relative to the current arrangements.

In particular, the existing low-value pool should be abolished, and instead all assets with a value of less than $1,000 should be immediately deductible for all taxpayers — apart from those eligible for the small business concessions, who can already write off assets with a value of less than $1,000 and for whom an increase in this threshold is recommended (see 'Arrangements for small business (including sole traders)' below). This would reduce record keeping requirements by removing the need to maintain a low-value pool.

Consideration could separately be given to grouping assets with a related purpose or use, and having a single capital allowance rate for all assets in the group, based broadly on the effective life of assets within that group. For example, all information technology equipment could be grouped together.

To improve overall productivity, existing concessional arrangements should also be reconsidered, including statutory effective life caps, capital works (including buildings), exploration expenses and the taxation of agriculture and forestry more generally. But any review of the existing concessional arrangements, including effective life caps, would need to be mindful of the effective depreciation rate for tax purposes relative to the actual rate of economic depreciation and other related elements of the tax system.

Recommendation 28:

The capital allowance arrangements should be enhanced and streamlined to ensure effective rates more closely match rates of economic depreciation, and to reduce administration and compliance costs overall. This should include:

  1. allowing low-value assets (assets costing less than $1,000) to be immediately written-off; and
  2. reviewing the impact of special provisions applying to different investments in agriculture and statutory effective life caps and other concessional write-off provisions.
Arrangements for small businesses (including sole traders)

To simplify and provide more certainty over the taxation arrangements for small business entities (including sole traders) in particular (and to provide a cash-flow benefit to such businesses), the threshold for determining a low-value asset for small businesses should be increased to $10,000. This would allow small businesses to immediately write-off most of their asset purchases.

Arrangements for small business should be simplified further by allowing any remaining depreciating assets (other than buildings) that are not immediately written-off to be grouped in a single pool (rather than the two existing pools), with the entire pool written off at a single declining balance rate.

In addition, the operation of the pool could be further simplified by removing the requirement for small businesses to calculate a balancing adjustment on sale or disposal of an asset. This would remove the requirement for small businesses to keep track of individual non-immediately deductible assets. Instead, capital allowances would continue for the asset pool, but any proceeds from the sale of an asset would be included in the taxpayer's income.

Combined with the recommendation to streamline and improve access to the small business capital gains tax concessions (Recommendation 17), and the Standard Business Reporting program, these measures would result in a significant simplification for small businesses.

Access to these small business tax concessions, and others under the small business tax framework, should also be extended by increasing the current $2 million turnover 'small business entity test' to $5 million.

Recommendation 29:

The capital allowance arrangements for small business should be streamlined and simplified, by:

  1. allowing depreciating assets costing less than $10,000 to be immediately written-off; and
  2. allowing all other depreciating assets (except buildings) to be pooled together, with the value of the pool depreciated at a single declining balance rate.

Recommendation 30

The small business entity turnover threshold should be increased from $2 million to $5 million, and adjustments to the $6 million net asset value test should be considered.

Supporting an appropriate level of risk-taking

Risk-taking can be discouraged by the treatment of losses

The tax system treats gains and losses differently. The current tax system limits the refundability of losses, while all gains are taxed as they are realised. This reduces incentives to undertake risky investments, as denying full loss offset reduces the expected return from, and therefore increases effective tax rates on, risky investments.

Where losses are not fully refunded or where gains and losses are taxed at different rates, as under a progressive tax rate scale, these asymmetries will tend to discourage risk taking including entrepreneurial activity. Restrictions on loss utilisation may also lead to pressure for concessions to attract investors to investments that are disadvantaged as a result of the restrictions. If such concessions are targeted towards specific types of investments, they risk further biasing investment allocation.

Limitations on the use of losses may in particular disadvantage small businesses and firms engaged in risky investments, with start-up or closing down expenditure and without other income to offset losses against. In 2006–07, small businesses accounted for almost half of all carried forward tax losses in Australia.

This bias against small business may lead to greater market concentration, because larger more diversified businesses may have a higher expected post-tax return when they have other income to use against a loss against. It may also result in inefficient takeover activity, where entities carrying losses forward are valued more highly by entities that can utilise those losses.

Restrictions on loss utilisation also limit the ability of the tax system to serve as an automatic stabiliser during a downturn. This is because the tax value of deductions is not recouped by companies until they have income to offset losses against.

However, despite its theoretical benefit, full loss offset is rarely seen in practice.

In the same way that profits are highly mobile and can be shifted between countries in response to high statutory tax rates, full refundability could attract losses into a country at a substantial cost to revenue — without necessarily improving the climate for investment. While loss restrictions are an imperfect substitute for effective integrity provisions, they limit the benefits of tax avoidance schemes. They also limit the benefits arising from any income mismeasurements, such as immediate deductions for capital expenditure and accelerated capital allowance arrangements.

Loss restrictions, such as continuity of ownership tests, also prevent losses from being transferred to new investors who may value them more highly because of differences in tax rates. Further, loss restrictions may limit the extent of a bias in favour of debt financing by companies and, in respect of trusts, may reduce the scope to exploit differences in the tax rates of trust beneficiaries.

Principle

The treatment of business losses should reduce biases against risk taking by treating income and losses symmetrically. This must be balanced against problems arising from the mismeasurement of losses from difficulties in measuring economic income, artificial loss creation schemes or from other forms of tax avoidance.

The current tax system treats gains and losses asymmetrically. Gains are taxed as they accrue while losses are not refunded but can be carried forward and used against future income, subject to certain tests. There are two main tests to determine whether or not a loss can be utilised: the continuity of ownership test and the same business test.

Despite these tests, a considerable degree of loss utilisation is in effect permitted other than through the loss carry-forward provisions. For example, sole traders and partnerships are able to flow through their losses to owners, and wholly-owned corporate groups are allowed to offset losses in one subsidiary against income from others under the consolidation regime.10 Recent changes to research and development tax arrangements will also improve loss utilisation.11

A number of submissions to the Review have also noted that the current loss utilisation rules add significant complexity and uncertainty to the tax system.

Finding

The current tax system treats gains and losses asymmetrically. This treatment may have an adverse effect on risk taking and entrepreneurship.

Limiting biases against risk taking

The benefits from reducing the existing tax bias against risk-taking, and at the same time increasing the degree to which business income tax arrangements act as an automatic stabiliser, emphasise the value of improving the current income tax treatment of losses.

The Review has not attempted to evaluate fully all options for improving loss arrangements, given that careful account also needs to be taken of the risks associated with the mismeasurement of losses. Given that the latter depends on other policy choices, including further reforms to enhance the comprehensiveness of the business income tax base (see Recommendation 28), taxpayer behavior and the effectiveness of the tax administration, the right balance between these competing considerations may vary over time and sometimes require reassessment.

Companies should be able to offset losses made in a particular income year against taxable income from the preceding year. This would allow companies to receive an immediate tax refund to the extent the company paid tax in the previous year. Without this, the timing of the income year can lead to over-taxation as it does not consider expenditure that falls narrowly outside the income year. While there would be some increase in complexity, the change would also improve the ability of the tax system to serve as an automatic stabiliser, particularly for small companies, and reduce reliance on ad hoc relief for businesses under stress (Abhayaratna & Johnson 2009).

As taxpayers can time the realisation of capital losses, it is recommended that this proposed loss carry-back be restricted to revenue losses. Further, due to Australia's imputation system, provisions would also be required to prevent losses from being offset against prior year tax payments that have been distributed to shareholders as imputation credits. To address this, it is recommended that the carry-back arrangements be limited to the amount of franking credits retained in the company.

Loss carry-back provides limited benefits to start-up businesses, small businesses and businesses engaging in high risk activities. There is no single solution for providing a better loss treatment for these businesses and activities. Recommendation 32 represents a targeted approach in regard to exploration, an activity that involves relatively small start-ups undertaking high risk investments. Other such opportunities could be further considered. There may also be merit in reviewing the continuity of ownership and same business tests to give greater weight to simplicity and certainty objectives.

Recommendation 31

Companies should be allowed to carry back a revenue loss to offset it against the prior year's taxable income, with the amount of any refund limited to a company's franking account balance.

Flow-through treatment for exploration

The Australian Government asked the Review to consider a proposal to promote exploration investment by adopting flow-through share schemes for smaller operators in the gas, oil and mineral exploration industries. The issues raised by the proposal illustrate some of the issues associated with the treatment of losses and, related to that, the measurement of income.

The current treatment of tax losses puts small exploration companies at a competitive disadvantage relative to larger, more diversified companies and to business investments in other sectors. This is because losses generated by exploration companies often cannot be used to offset other taxable income. At the same time, the immediate deduction for exploration expenses generates non-economic tax losses when exploration is successful.

The impact of providing special arrangements for losses incurred as a result of exploration activity has not been fully evaluated by the Review. While the current treatment of losses may disadvantage exploration relative to other investments, targeted provisions for expenditure on resource exploration could reverse that bias and favour investment in exploration at the expense of other, potently more profitable, investment opportunities.

Canada has adopted a flow-through share scheme arrangement under which income tax deductions associated with exploration are, in effect, made available to shareholders. Other tax credits, at the federal and provincial levels, are also available for qualifying investors, including a 15 per cent credit for expenditure associated with new resources or fields.

Submissions to the Review have proposed the following features for a flow-through share scheme:

  • An exploration tax credit would be allowed to resident shareholders of Australian companies for Australian exploration expenditure incurred by those companies.
  • The credit would be available at the company income tax rate (currently 30 per cent), possibly with an uplift and would be refundable.
  • Credits could not be distributed to shareholders where the company itself pays company income tax (effectively limiting the scheme's availability to small companies).
  • Dividend imputation rules would be drawn on where possible (including anti-streaming and anti-credit trading rules).

While the current tax treatment of losses creates a tax bias against small explorers, the flow-through share proposal, as described, may over-correct the bias. Even without an uplift, a 25 or 30 per cent credit would provide a significant tax incentive for superannuation funds to invest in a sector when any returns would only be taxed at 7.5 per cent (see Recommendation 19).

There are no strong grounds to believe that exploration generates unusually large positive spillovers that would justify a subsidy. Exploration does produce information of public value, and explorers are required to make such information publicly available. However, nearly all activities generate information that is of benefit to others; for example, that a particular business model does or does not work.

Further, as the flow-through share design is targeted at resident shareholders (to improve marketability) rather than at the company level, it makes the design of a flow-through scheme more complicated and therefore is likely to result in higher administration and compliance costs. It would also not assist in attracting investment from non-resident investors.

The existing tax bias arising from the treatment of losses could be addressed by using a targeted, company-level approach to increase loss utilisation. For example, it would be possible to allow the company to choose to defer taking a deduction in respect of exploration expenditure (effectively allowing loss transfers) or, preferably, to provide a refundable tax offset for designated expenditure set by reference to the company income tax rate and with appropriate adjustment to franking account rules. The detailed design of the rules would need to be the subject of further consideration and consultation.

Recommendation 32

If earlier access to tax benefits from exploration expenses (relative to other expenses) is to be provided, it should take the form of a refundable tax offset at the company level for exploration expenses incurred by Australian small listed exploration companies, with the offset set at the company income tax rate.

Reducing financing distortions

Financing choices of business can be distorted

Most company income tax systems, including Australia's, tax the full return to equity only, with interest payments deductible from the company income tax base. This provides companies with a tax incentive to finance investment with debt rather than equity capital. The debt-equity distortion may, however, be reduced where companies are unable to use deductions for interest payments, such as where a company is in a loss situation.

Over reliance on debt makes companies more vulnerable to insolvency and to economic shocks, and may have implications for macroeconomic stability. Providing a deduction for debt and not for equity financing may also discriminate against smaller businesses, and knowledge-based industries that invest more heavily in intangibles. Such businesses may have more difficulty borrowing.

The treatment of debt and equity for tax purposes is complex and creates opportunities for tax avoidance. This has been compounded over recent years with the increased innovation in financial products, often devised to exploit the difference in the tax treatment of debt and equity. As a result of this innovation, the traditional distinction between debt and equity has become even less clear. Increased globalisation has also increased opportunities for tax arbitrage, particularly where countries take different views as to whether a particular instrument qualifies as debt or equity.

The implications of the tax treatment of debt and equity depend in part on the source of finance for specific businesses. The following sections consider the implications for businesses with and without direct access to foreign capital.

Businesses that rely on domestic finance

To the extent that capital is not perfectly mobile, as may be the case particularly for small unlisted domestic firms, financing decisions may be influenced by taxes on capital income (dividends, capital gains, interest) at the personal level.

Where businesses do not have access to international capital — that is, they may effectively operate in a closed economy — the tax preference in favour of debt relative to equity at the company level may be offset by Australia's dividend imputation system. However, even with dividend imputation and with a closed economy assumption, investments financed by retained earnings are likely to be favoured over new equity, because of the concessional taxation of capital gains.

When earnings that would otherwise have been used to pay dividends (and been taxed in the hands of the recipient) are retained in the company, the value of equity increases and shareholders are rewarded with an accrued capital gain which is taxed preferentially on realisation at reduced rates. The shareholder can therefore delay paying tax until the share is sold and the gain realised.

As dividends and interest income are taxed at full marginal rates for domestic savers, investments financed by new equity and debt need to earn a higher return relative to investments funded by retained earnings. This higher return is required to compensate for the tax penalty they face relative to concessionally taxed capital gains.

However, while smaller companies and businesses may not have direct access to foreign capital, much foreign debt capital is raised by Australian banks or financial institutions who then on-lend to the business sector generally. The cost of equity capital for larger firms, to the extent that it is set by access to international equity, will also influence the cost of equity for smaller firms. Hence, even for this sector or group of businesses, the biases outlined for businesses with access to international finance will still be relevant.

Businesses with access to international finance

Where the marginal source of finance is the international capital market, the deductibility of interest from the business income tax base would appear to favour higher levels of debt, driven by the company or relevant income tax rate.

Interest deductibility biases the capital structure of a business towards higher levels of debt — increasing its risk exposure. Distorting these choices may discourage businesses from adopting the best approach to managing other factors associated with their capital structure. To the extent that interest withholding tax applies on the payment of interest to the non-resident investor, it may moderate the bias against equity.

For a multinational company investing in Australia through an Australian subsidiary, the allocation of debt or equity capital to that subsidiary may be motivated in part by tax planning considerations, and not directly affect risk exposure given parent guarantees over any debts of the subsidiary.

Australia's thin capitalisation and transfer pricing rules aim to safeguard against excessive interest charges being allocated to the Australian subsidiary, either by restricting deductibility for businesses that operate at above a specified level of gearing or by policing the interest rate. In this regard, the thin capitalisation rules can be seen as placing a limit on the degree to which the normal, risk-adjusted, return from an investment in Australia can be excluded from Australian tax (by being characterised as a return on debt) and the extent to which it is taxable (as the return on equity). The transfer pricing rules can be seen as a means of restricting the ability of firms to avoid tax on supernormal returns. Together, these rules play a role in ensuring what is judged to be the appropriate level of tax is collected from investment in Australia.

At an economy wide level, the overall bias in favour of debt — together with the incentive provided by dividend imputation and the capital gains tax discounting rules for domestic residents to hold domestic equity — might be reflected in a relatively high share of debt finance in the capital account of the balance of payments. For an individual firm, debt financing can exacerbate vulnerability in the profit and loss statement when revenue falls, as the debt servicing costs are essentially unavoidable, short of default — unlike dividend payments. The increased vulnerability of firms would be expected to magnify the impact of financial shocks and other sources of macroeconomic instability.

Tax-induced distortions to financing decisions should be reduced to avoid encouraging firms to rely excessively on debt finance and to avoid biasing other financial decisions, such as dividend payouts. However, outside of the business level expenditure taxes outlined previously, it is difficult to reduce distortions to financing decisions.

Principle

Thin capitalisation and transfer pricing rules should continue to be used as mechanisms to ensure that what is judged to be the appropriate level of tax is collected from investments in Australia.

The current treatment of foreign debt is complex and distortionary

Interest paid on foreign debt is deductible against the company income tax base (subject to the thin capitalisation rules) but the non-resident lender may be subject to interest withholding tax. While interest withholding tax is applied notionally at a rate of 10 per cent, in aggregate the effective tax rate is around 3.5 per cent given the wide range of available exemptions (see Table B1–3).

Table B1–3: Interest withholding tax rates and exemptions

Foreign debt Interest withholding tax rate (IWT)
Exemption dependent on borrower  
Australian investor borrows from non-resident lenders through a publicly offered debenture issue, non-equity share or syndicated loan Exempt
Australian branch of foreign bank borrows from its parent 5% IWT on notional interest (based on LIBOR)(a)
Australian bank borrows from non-resident retail investors (retail deposits, in Australian parent) 10% IWT
Offshore banking unit (borrows offshore and on-lends offshore) Exempt
Australian Government bonds Exempt
State government bonds Exempt
Exemption dependent on lender  
Australian investor borrows from foreign financial institution Exempt for institutions located in US, UK, Norway, France, Finland, Japan, South Africa and New Zealand (cf. tax treaties) (b). Otherwise, 10% IWT
Australian investor borrows from sovereign wealth fund Exempt (exemption administered by ATO)
Australian investor borrows from foreign superannuation fund that is tax-exempt in its country of residence Exempt
No exemption available  
Other related party borrowings 10% IWT
  1. London Interbank Offered Rate.
  2. This exemption is being extended to other countries over time.

Although interest withholding tax is imposed on the non-resident lender, it is likely to be passed onto Australian borrowers by way of higher interest rates on their borrowings — increasing their cost of capital and reducing domestic investment. In large part this is likely to depend on whether the non-resident lender is able to receive a credit for the interest withholding tax paid in their home jurisdiction.

The extent to which interest withholding tax is a creditable tax is unknown. As most countries tax interest income on a residence basis, the formal creditability of interest withholding tax would be expected to be relatively high. But, there are a number of situations where it may not be creditable, or, even where credits are available, they may not be valued in whole or part by the lender.

A potential benefit of interest withholding tax is reducing the tax bias, in respect of international capital, in favour of debt over equity. However, the extent and nature of the exemptions available mean that in practice this benefit is likely to be minor.

In turn, those exemptions generate distortions of their own that appear more significant. In particular, the current arrangements are likely to influence how Australian businesses and households access foreign debt capital, potentially distorting competition between financial service providers and reducing the stability of the financial system, and leading to a misallocation of that capital away from its most productive uses in favour of less productive investments that have better access to debt.

While it is difficult to estimate how large these potential costs may be, the current rules potentially favour domestic financial institutions raising funds offshore through wholesale markets rather than retail deposits, increasing their vulnerability in periods of financial turmoil. They also favour borrowing directly from banks in certain countries, over banks in other countries or the Australian branches or subsidiaries of foreign banks generally, favouring less commercially competitive forms of intermediation.

An important benefit of the current interest withholding tax arrangements is that they act as a brake on tax avoidance schemes by residents, such as the routing of income through offshore structures with the income then returned in a tax exempt form (such as a foreign non-portfolio dividend received by an Australian company). Interest withholding tax can reduce the tax benefit of such schemes, and also generate information for use by tax authorities.

Interest withholding tax also limits the tax advantage to multinationals from thinly capitalising their Australian subsidiaries or branches or paying interest at excessive rates. In this respect, interest withholding tax supports the thin capitalisation and transfer pricing rules.

Finding

Foreign capital invested in Australia in the form of debt is subject to low effective tax rates, primarily through interest withholding tax. That tax currently helps safeguard the taxation of foreign equity and of resident savings. But it may negatively affect the financial sector by distorting the way foreign debt is accessed.

Reducing distortions in how foreign debt is accessed

Distortions in the access to and intermediation of foreign debt could be reduced by generally not applying interest withholding tax to interest paid to non-residents by financial institutions operating in Australia.

While the precise boundaries of the exemption require separate consideration, it is expected that this targeted interest withholding tax exemption would cover authorised deposit-taking institutions such as banks, building societies and credit unions, as well as other financial institutions (such as money market corporations).

The exemption would not, however, extend to debt accessed through the corporate treasury of a multinational group. This would ensure that interest withholding tax would remain payable on the related party debt of Australian businesses other than financial institutions. The exemption would also not apply to insurers or fund managers, who are engaged in investing in financial instruments rather than being a source of debt capital for Australian businesses.

For non-resident retail deposits in Australia, the compliance and integrity issues arising from this recommended exemption would need to be further considered. For example, retaining interest withholding tax on such deposits would avoid increasing incentives for resident savers to claim non-resident status. While some compliance costs are imposed by requiring Australian financial institutions to withhold tax from interest paid on retail deposits, financial institutions are already required to operate tax file number withholding.

Australian businesses that are not financial institutions would continue to be able to access the existing exemptions for publicly offered debentures and certain debt interests. But consideration should be given to streamlining these rules.

There may also be scope to remove interest withholding tax on a bilateral basis in tax treaties, as recently agreed between the United States and Canada. Tax treaties, by providing scope for the effective exchange of information, may guard against the risks of potential tax avoidance by resident savers which could arise where unilateral abolition is pursued.

Recommendation 33

Financial institutions operating in Australia should generally not be subject to interest withholding tax on interest paid to non-residents.

Recommendation 34

Consideration should be given to negotiating, in future tax treaties or amendments to treaties, a reduction in interest withholding tax to zero so long as there are appropriate safeguards to limit tax avoidance.

Managing the investment of foreign savings

Tax can affect the ability of Australian business to manage foreign savings

Multinational companies, managed funds and related corporate and investment management services can be seen as providing a service to manage domestic and foreign savings by investing it domestically and overseas.

For such entities in Australia, taxing their foreign source income (whether by company income tax or withholding taxes) as it flows to non-resident investors could effectively act as a toll on non-residents using Australian rather than foreign managers. The toll would be on top of any general source-based tax on the profits from the service of managing capital. It would create a bias against the Australian provision of such services, potentially allocating resources away from their most productive use.

The location of managed funds and related services is particularly likely to be sensitive to such taxes. Given the ease with which savings can be reallocated between different funds, any tax on the income flows to the underlying investors can significantly affect the ability of Australian-based operations to compete. A small amount of Australian tax on the underlying conduit income, or the risk of such tax, can give rise to a very high effective tax rate on the value added by the Australian based activity.

Conceivably, aspects of Australia's commercial environment, including political stability, effective legal system, governance arrangements and a reasonably well-developed and sophisticated financial services sector, could generate location-specific rents for such business services. However, other factors, such as the relatively small size of Australian financial markets and geographical isolation, are likely to mean that these rents are low.

Many of these features are also found in other countries, and funds management and related services, in particular, are likely to be highly mobile and operate in highly competitive environments. There is therefore a case for not taxing the foreign source income of Australian entities, companies or funds, as it flows to or is realised by non-resident investors, while still taxing the Australian source income arising from the management activity in Australia.

While there is an in-principle case to generally exempt such conduit income, there are a number of competing considerations that also need to be taken into account. Conduit income tax relief may not be appropriate where, for example, it disproportionately increases administration or compliance costs, or compromises the ability to appropriately tax resident savings or (to the extent it is desirable) the Australian source income of non-residents, or is inconsistent with international tax coordination objectives or norms.

The highly mobile nature of some financial services also provides, in theory, a case, not only for not taxing conduit income, but also reducing the source-based taxation of the highly mobile activities undertaken by Australian intermediaries. Australia's offshore banking unit regime is an example of this approach. However, reducing the source-based taxation of highly mobile activities gives rise to the potential misallocation of domestic investment and practical difficulties, including problems with targeting any concessions. Preference should therefore be given to broader structural responses such as minimising taxes on conduit income.

Principle

To avoid penalising the management of foreign savings in Australia, investment taxes should not apply to the conduit income of Australian companies and managed funds. This needs to be balanced against practicality, international constraints and ensuring the taxation of resident savings or source-based investment taxes are not compromised.

The treatment of conduit income is mixed, particularly for managed funds

The conduit income of Australian multinationals is largely exempt from Australian investment taxes. This is achieved by the exemption provided to dividends received by an Australian company from a foreign company in which it has a significant (non-portfolio) holding, and the capital gains tax exemption that can also apply to the sale of such interests. These arrangements are consistent with an international trend to exempt non-portfolio dividends received from foreign companies from company income tax.

Further, dividends paid to foreign shareholders out of conduit foreign income are expressly excluded from dividend withholding taxes, and capital gains tax does not generally apply to sale by non-residents of shares in Australian companies. The trend in Australia's tax treaties of reducing withholding taxes has also acted to reduce tax on conduit income.

Exceptions to the non-taxation of the conduit income of Australian companies arise from the taxation of foreign source interest, royalties and portfolio dividends, and controlled foreign companies rules that in effect tax returns from the non-business investments of offshore subsidiaries. These exceptions limit opportunities for residents to defer taxation of the returns to their savings.

For Australian managed funds, though, the situation is less satisfactory. Managed funds established as trusts are currently treated on a flow-through basis for tax purposes, with some exceptions. As a consequence, the tax system should be largely neutral in its treatment of savings invested directly or indirectly through an Australian managed fund.

However, in practice, the taxation of Australian managed funds is more complex. Firstly, it is governed by a mix of trust law and tax law concepts. Secondly, there is a reliance on both case law and statutory rules. These complicating factors have given rise to uncertain tax outcomes.

In particular, considerable uncertainty remains around the treatment of investments offshore or cross-border dealings. As submissions indicate, this largely arises from ambiguity around the meaning of 'Australian source'. For example, reliance on common law can result in income being given an Australian source merely because a contract is executed in Australia, notwithstanding that the contract concerns non-Australian assets and non-resident owners. In some cases, issues also arise around whether having fund-related services performed in Australia gives rise to Australian residency or a permanent establishment in Australia.

Finding

Current taxation arrangements for Australian managed funds create uncertainty around the treatment of conduit income, reducing the competitiveness of Australian managers of global savings.

Improving the treatment of foreign income

Source and residence can be nebulous concepts, which make improving existing arrangements challenging. There is also a risk that any reforms to current arrangements may reduce the taxation of resident savings or profits of non-residents from Australian operations (where it is desirable that those profits be taxed).

These difficulties notwithstanding, the existing tax treatment of managed funds and related entities should be improved to provide greater certainty and minimise the risk of conduit income being taxed. As reforms will raise complex and technical issues, the details of these reforms require separate consideration.

Recommendation 35

Taxation arrangements applying to Australian managed funds and related services should be improved to provide greater certainty that conduit income will not be subject to Australian tax.


8 Difficulties in measuring the acquisition cost of goodwill arise because goodwill is typically measured as the residual amount remaining after values have been allocated to other assets. In some circumstances this can create an incentive to manipulate value allocations to provide the most favourable tax treatment.

9 Where goodwill is sold at a loss, as with all capital losses, it can only be used to offset a capital gain.

10 The Government has recently announced measures to further restrict the deductibility of business losses for high-income individuals.

11 A key aspect of the announced changes is the move away from accelerated deductions to a system of tax credits (offsets). This neutralises the existing bias in the tax system associated with the treatment of losses. In effect, the offset to be provided consists of two parts: a loss offset (at 30 cents in the dollar) and a subsidy to encourage innovation (at 10 or 15 cents in the dollar).