Australia's Future Tax System

Final Report: Detailed Analysis

Chapter B: Investment and entity taxation

B2. The treatment of business entities and their owners

B2–1 Approaches to taxing the income of business entities and their owners

The organisational forms or entities used for business activities depend on a country's legal arrangements and commercial practices. In Australia, businesses operate through companies, general and limited partnerships, and different types of trusts, as well as directly by individuals as sole traders.

Each of these entity types has advantages and disadvantages. For example, the limited liability of companies and their governance arrangements may make them better suited to conducting risky activities. Trusts, which separate legal and beneficial ownership, offer the benefits of asset protection. Operating as a sole trader is simpler than operating through a separate entity, reducing legal and accounting costs.

Income tax can apply to both the owners of a business and the business entity itself (except in the case of sole traders). This raises the prospect of double taxation, which may give rise to high effective rates of tax. However, in some cases, even where income tax is paid at the owner and business levels, the total income tax paid may be less than if the business was operated by a sole proprietor subject to personal income tax only.

Where double taxation is seen to be undesirable, it can be dealt with in a number of ways, including by flow-through treatment (where the income of the entity is attributed annually to the owners), taxing the owners only on distributions received and on changes in the value of the business, and taxing both the owners and the business separately but in an integrated way. These approaches can also be combined; for example, a flow-through approach can be combined with entity taxation in certain circumstances.

If tax outcomes were the same regardless of the choice of business entity, the tax system would allow businesses to adopt organisational forms that are commercially preferred. While estimating the economic cost of inconsistent tax treatments of business entities is difficult, Gordon and MacKie-Mason (1997) found that taxes do affect the choice of organisational form, though non-tax factors dominate. There is also evidence that reductions in company income tax rates cause income to shift to the corporate sector (de Mooij & Ederveen 2008).

Flow-through treatment has considerable advantages in achieving outcomes consistent with a personal income tax system based on a progressive rate scale. However, there are situations where separate entity treatment may be more practical — in particular, for large businesses where ownership rights are frequently traded. Also, where such businesses are conducted through a company owned by non-residents, there are constraints on Australia's ability to tax the profits of the company other than on a separate entity basis.

Other features of the tax system may also affect how different entities should be taxed. For example, concerns over tax losses arising from mismeasurement of business income (which may occur where capital expenditures are immediately deducted) may justify imposing limits on loss flow through (see Section B1 Company and other investment taxes).

Commercial practice and needs, along with the non-tax legal and regulatory environments, are also relevant in considering the appropriate tax arrangements for different entity types. For example, in Australia, unit trusts have been the entity type most commonly used for managed investment vehicles, whereas in other countries companies may also be used. The nature of managed investment vehicles, which invest the savings of investors with very different tax profiles into domestic and foreign assets, places a premium on certain tax features, such as a flow-through treatment and certainty in tax outcomes.

Principles

Income tax arrangements for different types of business entity and their owners should be broadly consistent to limit biases in choice of business structure, while taking account of diverse circumstances and requirements.

Relationship between company and personal income tax

The difficulties associated with taxing large and complex companies under a flow-through approach mean that companies are typically taxed separately from their owners (shareholders). As shareholders are also taxed on company profits when received as dividends (or as capital gains), an issue arises as to how the company and personal income tax systems interact.

Where the income taxation of companies and shareholders is not integrated (often referred to as a 'classical' company income tax), company profits are taxed once at the company level and then again in the hands of shareholders through personal income tax.

A classical company income tax system, by favouring unincorporated businesses, can bias individual choices around how a business is structured. It can also affect the allocation of activity between the corporate and unincorporated sectors, in turn potentially affecting overall investment allocation. And it can affect choices by individuals about investing their savings in shares. Classical company income tax systems may also distort company level financing and distribution decisions, encouraging the use of debt over equity and the retention rather than distribution of company profits.

The use of debt can give rise to a tax-induced bias in financing decisions because profits taken as interest are not taxed at the company level. This bias can give rise to non-tax costs, although this may not always be the case. For example, if the owner of a company — whether an individual owner of a small company or a multinational company with its subsidiary — is the sole provider of capital, a degree of integration can be achieved through contributing capital to the business primarily as debt, with few non-tax costs. However, for companies with more diversified sources of capital, the tax bias towards debt may result in excessive leverage, which can give rise to significant non-tax costs such as the increased risk of financial distress.

It is the potential biases arising from classical company income tax systems that make a case for shareholder tax relief. That relief can be implemented at either the company or shareholder level, or both (see Table B2–1).

Table B2–1: Types of shareholder tax relief

Company level Shareholder level
Type of relief Description Type of relief Description
Dividend deduction A full or partial deduction for distributed profits.
(Akin to the approach taken with interest.)
Dividend exclusion Proportion of dividend is excluded from taxation.
Credit A full or partial credit to the company for distributed profits. Credit A full or partial credit for dividends received.
Reduced rate Company income tax rate reduced. Dividend imputation A full or partial credit for dividends received to the extent company income tax was paid.
Expenditure tax Deduction for normal return to capital.
(Akin to the approach taken with interest.)
Reduced rate Reduced tax rate for dividends received.
    Allowance for
shareholder equity
Deemed normal return on shareholding excluded from taxation.

A high degree of integration can be achieved by providing shareholders with a credit (in full or part) for company income tax paid, as under dividend imputation. A semi-integrated or semi-classical approach would see tax relief provided to shareholders through other means; for example, through providing a tax credit not related to actual company income tax paid, taxing dividends at a low rate, or having partial or full exemption of dividends from tax. Alternatively, relief could be provided at the company level by reducing company income tax in a number of ways.

More radically, expenditure tax approaches at either the company level (such as an allowance for corporate equity) or the shareholder level (an allowance for shareholder equity) could be adopted.12

The effects of providing shareholder-level tax relief

There are three broad views about the effects of providing shareholder-level tax relief, and the extent of relief that is appropriate: the 'new view', the 'traditional view' and an 'open economy view'. These views are not mutually exclusive, and each can be relevant for some firms and may vary over time with changes in economic conditions. A wide range of largely non-Australian empirical studies has provided mixed support for all three views.

The new view holds that in certain circumstances, and even in a closed economy, taxes on dividends may be irrelevant to a firm's investment decisions and to the choice between funding investments from retained earnings or debt. Under this view, the value of a company is equal to the present value of post-tax dividends. Shareholders are therefore indifferent as to whether they retain their earnings in a company or receive dividends. Introducing shareholder level tax relief may simply result in an increase in the market value of companies, providing windfall gains to existing shareholders, and have no impact on a company's cost of capital and, hence, its investment decisions.

The traditional view holds that dividend taxation does affect business choices. This can occur because newly established companies do not have retained earnings and have more difficulties accessing debt. A tax bias against raising new shareholder equity therefore creates a bias against start-ups. Shareholders may also have a preference for receiving company profits as dividends rather than capital gains, as regular dividend distributions may indicate the health of the company and can counteract suboptimal reinvestment of profits by company managers.

The open economy view takes account of the openness of the economy to international investment and capital, and the trend over time to more integrated international capital markets. As discussed in Section B1 Company and other investment taxes, for a small open economy where capital is perfectly mobile, the cost of capital for domestic companies is determined internationally. A source-based tax, such as the company income tax, increases the pre-tax return demanded by international investors and so increases a company's cost of capital.

In contrast, resident shareholder taxes do not increase or decrease the pre-tax return demanded by non-resident savers and therefore do not affect a company's cost of capital or its investment decisions. Shareholder tax relief would likewise not affect a company's cost of capital. However, taxes on dividends and capital gains could still affect residents' decisions about where to invest their savings.

As noted in Section B1, despite the trend towards increased openness in trade and international capital mobility, Australia will continue to exhibit some characteristics of a closed economy. Thus insights about how taxes affect economic outcomes in both open and closed economies need to be taken into account.

While this discussion assumes that company profits arise from the investment of capital, profits may also represent a return to the efforts of the owners, for smaller companies in particular. For these profits, it is the combined company and shareholder level taxes that represent the tax on that return to labour. This must be taken into account when integrating the taxation of such companies and their owners.

Principles

The interaction of the company and personal income tax systems should avoid introducing biases to company financing arrangements, other business decisions and the allocation of household savings. In doing so, an important consideration is the openness of the economy.


12 These approaches are outlined in Australia's Future Tax System conference paper by Sørensen and Johnson (2010).