Australia's Future Tax System

Final Report: Detailed Analysis

Chapter B: Investment and entity taxation

B2. The treatment of business entities and their owners

B2–2 Current entity arrangements have strengths and weaknesses

A high level of tax integration between entities and their owners

In Australia, companies are the most significant type of business entity in terms of net assets and net income. For the 2006–07 income year, there were 750,275 companies (of which 1 per cent were public companies); 355,345 partnerships and 272,535 trusts identified for income tax purposes. Just over one million individuals reported net business income in their tax returns, reflecting sole traders (ATO 2009).

Partnerships are generally taxed on a flow-through basis, so that each partner is taxed similarly to a sole trader. Generally, the income and losses of a partnership flow through to the partners in proportion to their interests in the partnership. Where a partner leaves a partnership, they are taken to dispose of their share in the underlying partnership assets. This can create some complexity due to the interaction of the capital gains tax and partnership rules.

Trusts can be used as an alternative structure for conducting business activities. Trusts are largely taxed on a flow-through basis, with the income of a trust allocated to its beneficiaries based on their 'present entitlements'. However, losses do not flow through to beneficiaries. Where there is income of the trust to which no beneficiary is presently entitled, it is taxed in the hands of the trustee at the top personal income tax rate plus the Medicare levy.

In contrast to the treatment of partnerships and trusts, companies are taxed separately from their shareholders.13 Under the dividend imputation system introduced in 1987, resident companies are able to attach (frank) imputation credits to dividends paid to shareholders. The imputation credits represent tax paid by the company on behalf of the shareholders. Resident shareholders receiving franked dividends are taxed on the dividend and the attached credit, but their liability is reduced by the amount of the credit. From 1 July 2000, excess imputation credits have been refundable for individuals, superannuation funds and charities.

Some variation in tax outcomes according to type of entity

While the tax treatment of the entity and its owners is highly or fully integrated for all types of entity, in practice there is some variation in: how business income is taxed (with a more favourable treatment of capital gains and foreign source income for unincorporated entities), access to losses, and potential tax deferral benefits from retaining income in a company (see Table B2–2).

These variations can distort business choices, and encourage more complex structures than would otherwise be used.

Table B2–2: Tax treatment of income attributable to individual resident owner

  Sole trader, partnership Trust Company
Taxable income Taxed at individual's personal rate. Taxed at individual's personal rate.(a) Taxed at individual's personal rate.(b)
Tax-preferred income Tax preference retained. Partial claw back as a capital gain (unless non-fixed trust). Claw back occurs when taxed as an unfranked dividend.
Capital gains of entity 50 per cent of gain is taxed at individual's personal rate. 50 per cent of gain is taxed at individual's personal rate. Taxed at individual's personal rate.(c)
Foreign source income Taxed at individual's personal tax rate with a credit for foreign tax. Taxed at individual's personal tax rate with a credit for foreign tax. After foreign tax income taxed at individual's personal tax rate.
Losses Can be used against other income.(d) Quarantined in trust to be carried forward. Quarantined in company to be carried forward.
  1. If there is trust income to which no beneficiary is presently entitled, it is taxed to the trustee at the top personal tax rate plus the Medicare levy.
  2. Retained profits taxed at 30 per cent, but taxed at individual's personal tax rate when distributed, with credit for company income tax paid.
  3. A tax concession broadly equivalent to the capital gains tax discount is provided to investors in listed investment companies.
  4. Subject to non-commercial loss provisions being satisfied.

Source: Treasury (2008).

Trust tax rules are complex, uncertain and result in inappropriate outcomes

The general rules governing the taxation of trusts rely on a mix of trust law concepts (which mostly derive from case law) and tax law concepts (which derive from case law and statute). Differing views on key concepts, such as 'present entitlement', 'income of the trust estate' and 'share', create uncertain tax outcomes for taxpayers, increasing compliance and administration costs.

For example, there are differing views as to whether the income of the trust estate refers to net accounting profit, distributable or gross ordinary income, or whether it can vary according to the terms of the trust deed. In addition, the interaction between the income of the trust estate (which relates to present entitlement) and the net income of the trust (the basis for a beneficiary's tax liability) can be problematic; for example, when it comes to the treatment of capital gains derived through a trust. Recent court cases have also given rise to uncertainty around whether income retains its character as it flows through a trust.

Findings

Partnerships and, to a significant degree, trusts are taxed on a flow-through basis, which can achieve a high degree of integration. Although companies are taxed on a separate entity basis, a similar degree of integration is achieved through the imputation system. There is, however, variation in how some types of income are taxed through different entities.

Current income tax rules applying to trusts are complex and uncertain.

Ways of improving trust rules

To reduce complexity and uncertainty around their application, the general trust tax rules should be updated and rewritten. While the trust tax rules have been examined recently by the Board of Taxation, that review focused specifically on how the rules applied to managed investment trusts rather than trusts in general (Board of Taxation 2010).

Recommendation 36:

The current trust rules should be updated and rewritten to reduce complexity and uncertainty around their application.


13 Limited partnerships, public trading trusts, widely held unit trusts that do not limit their activities to eligible investment businesses, and corporate unit trusts are also taxed like companies.