Australia's Future Tax System

Architecture of Australia's tax and transfer system

8.3 The treatment of different holding entities

This section covers another element of Chart 8.1 — how holding assets through different entities can affect incentives. Apart from investments in housing, personal use assets and bank accounts, individuals predominantly invest in businesses and assets through entities such as superannuation funds (including through compulsory superannuation guarantee payments), ordinary life insurance companies and other companies (through share purchases), trusts and partnerships. In turn, superannuation funds and life insurance companies predominantly invest through other companies and trusts.

Of the various types of business entities, companies are the most common and most significant in terms of net income (Chart 8.5). They differ from partnerships and trusts in that significant tax is collected at the entity level ($57.1 billion in 2006‑07, measured on a cash basis).

Chart 8.5: Numbers and net income of companies, trusts, superannuation funds
and partnerships(a)

Number of entities

Number of entities

Net income(b)

Net income(b)
  1. The final year of figures does not include all returns.
  2. Net income excludes distributions received from an entity of the same type (for example, net income of companies does not include dividends received).

Source: Australian Taxation Office (2008).

The treatment of partnerships represents a fully integrated 'flow‑though' approach to taxing an entity, with partners taxed directly on partnership income and also able to use the losses of the entity against other income they might have. In contrast, superannuation funds are taxed separately from their members. The treatment of companies and trusts falls between these two points. Company income tax is partially integrated with shareholders' personal income tax through dividend imputation. Beneficiaries of trusts are generally taxed on the taxable income of trusts. As with superannuation funds, losses of these entities are retained at the entity level and may only be offset against income of the entity. (See Table 2.15 and Table 2.16 in Section 2 for a more detailed comparison.)

The different treatments of companies, trusts and partnerships can result in different effective tax rates for a given investment of an individual taxpayer (Chart 8.6).

Chart 8.6: Nominal EMTRs for an individual taxpayer investing in assets,
directly or through a business entity

Chart 8.6: Nominal EMTRs for an individual taxpayer investing in assets,directly or through a business entity

Assumptions: As for Chart 8.3, except that: at the end of the seven years the company sells the underlying asset and distributes all current and retained earnings. The trust distributes income annually. 'R&D equipment' has an effective life of eight years and the company is eligible for a 125 per cent R&D tax concession.

Source: Australian Treasury estimates.

For higher income individuals, investing in bank accounts and bonds through companies is marginally preferred over other entities or investing directly. This reflects the tax deferral benefit that arises because the company tax rate is lower than the assumed marginal personal tax rate. For investment in equipment for research and development (R&D), companies benefit from a tax concession not available to non‑corporate businesses. However, when dividends are paid to shareholders and taxed in their hands, the benefit of the company level concession is partially clawed back.

For rental property held by a company, stamp duty, land tax and rates result in estimated EMTRs above an investor's personal tax rate. For investors in rental properties and CGT assets, a company is not the preferred entity as no CGT discount is available when the company sells the asset. In contrast, individuals can obtain a 50 per cent CGT discount on assets held for at least 12 months, either directly or through a trust. If, however, the shareholder sold his or her shares (so receiving the 50 per cent CGT discount) instead of the company selling the rental property or asset and distributing the proceeds to the shareholder as a dividend, the EMTR for a rental property would fall to 40 per cent, and for a CGT asset, to 20 per cent, depending on the market valuation of the shares.

In practice, both small and large businesses will often own assets and operate businesses using a combination of entities for both tax and non‑tax reasons, and will choose distribution and asset disposal strategies that best suit the particular entity or entities used. Box 8.2 discusses some of these issues from a small business perspective.

Box 8.2: Multiple business entity structures for a small business

In deciding on a business structure, small businesses will consider a range of issues, both non-tax (protecting valuable assets from business risk, succession planning, and allowing outside equity investments) and tax (income splitting and access to various tax concessions, including CGT concessions). Different businesses will attach varying importance to different factors based on the nature of the business and the circumstances of the owners. Where no single entity alone meets all requirements, small businesses generally use a combination of entities to achieve a desired outcome (Chart 8.7).

Chart 8.7: Illustrative small business structure

Chart 8.7: Illustrative small business structure

For example, a business may operate through a partnership to allow for outside investment, business succession, and losses to flow through to partner level. Partnership interests may be held by non‑fixed trusts (such as discretionary trusts) to allow for income splitting, with a company among the trust beneficiaries to allow income to be retained in a company when advantageous. Another non-fixed trust may own the partnership business assets to protect them from business risks and maximise access to the CGT concessions. In addition, trustees may themselves be companies to limit the trustee's liability.

The above EMTR calculations also do not incorporate a range of special treatments for small businesses, summarised in Box 8.3.

Box 8.3: Small business tax concessions

Targeted concessions for small business are a relatively common feature in tax systems, and those in Australia are described briefly below. The principal reasons given for special concessions are that small businesses are important to the economy in creating wealth, stimulating competition and creating jobs. Other reasons commonly given are:

  • the need to counteract market failures;
  • the desirability of countering inherent disadvantages of being small, such as the regressivity of compliance costs (compliance costs as a proportion of total turnover are greatest for small business) and the asymmetry of taxable profits and losses; and
  • the need to ensure that small businesses can survive family and other events which might threaten to break them up.

Payroll tax

All the States provide an exemption from payroll tax for annual gross wages below a given threshold. The threshold varies significantly between States, ranging from $550,000 to $1,500,000. For example, in NSW where the payroll tax rate is 6 per cent and the exemption threshold $623,000, a small business with an annual wages bill of $500,000 would receive an annual payroll tax concession of $30,000.

Income tax

Small businesses with an annual turnover less than $2 million may qualify for a range of tax concessions. A small business unable to satisfy the turnover test in an income year may still be able to access available CGT concessions if the business meets a $6 million maximum net asset value test.

Small business CGT concessions

15 year exemption: a capital gain on a business asset is exempt if the taxpayer has owned the asset continuously for at least 15 years and is at least 55 years old and retiring, or is permanently incapacitated.

50 per cent active asset reduction: the taxable value of capital gains on active assets is reduced by 50 per cent. This concession applies in addition to the generally available 50 per cent CGT discount for assets owned for at least 12 months by individuals or trusts.

Retirement exemption: a capital gain on a business asset is exempt, up to a lifetime limit of $500,000, if the individual is 55 or over, or, if under 55, the money from the sale of the asset is paid into a complying superannuation fund, an approved deposit fund or a retirement savings account.

Roll-over relief: if a small business sells an asset and buys a replacement, the CGT liability is rolled over until disposal of the replacement asset.

Depreciation rules

Asset pooling is available with generally concessional depreciation rates and an immediate deduction is available for most depreciating assets costing less than $1,000.

Trading stock valuation

If the difference between the value of opening stock and a reasonable estimate of closing stock is $5,000 or less, a small business does not have to account for changes in the value of trading stock, or do stocktakes for tax purposes.

Immediate deduction for certain prepaid business expenses

A small business can claim an immediate deduction for prepaid business expenses where the payment covers a period of 12 months or less that ends in the next income year.

Entrepreneurs' tax offset

The entrepreneurs' tax offset can reduce tax payable by up to 25 per cent where the business has a turnover of less than $75,000. The 2008‑09 Budget announced that a family income test will be applied to the entrepreneurs' tax offset from 1 July 2008.

Goods and services tax

Registering and collecting goods and services tax is optional for businesses with an annual turnover of up to $75,000. A number of compliance cost saving arrangements are also available.

As well as affecting the effective tax rate on the underlying investments, the various tax treatments of different entities affect other choices made by individuals and business — most obviously, the choice of holding entity or entities, but also entity financing decisions, individuals' investment portfolio choices and whether to invest in Australia or overseas.

Given the importance of companies relative to other business entities, and their importance as the principal means by which non‑residents make equity investments in Australia, they merit further consideration in their own right.

Companies — the role and purpose of company income tax

Company income tax has two basic roles:

  • as a withholding tax on income earned by Australian residents, through shares in a resident (Australian) company; and
  • as a final tax on (generally Australian source) income earned by non‑residents, through shares in an Australian company or a non‑resident company's branch in Australia.

The design of Australia's company income tax system has historically taken account of both these roles. This has influenced decisions about the company income tax rate, base and other rules, and the interaction of company income tax with the taxation of resident and non‑resident shareholders.

A withholding tax on residents

Company income tax reduces or removes potential tax advantages for residents from earning income through a company and deferring personal income tax until such time as company profits are paid out as a dividend, or the shares are sold. The income potentially sheltered from personal income tax can be either income from investments or labour income from the labour of owner‑managers, subject to personal services income rules.

Where a shareholder's personal tax rate (including consideration of income support payments) exceeds the company income tax rate, there can be tax deferral advantages from earning income through a company and retaining it there.

The net benefit from deferring tax is, however, smaller than the gross amount of tax deferred. An indicative estimate of the net benefit would be a return of around 3 per cent per annum on the amount of deferred tax. The potential value of the tax deferral benefit is also only one part of a more complex story. For example, the cash‑flow needs of an individual or family may preclude significant deferral, and the costs of creating and maintaining a company also need to be considered.

By providing a credit to shareholders for company tax paid on the profits from which dividends are paid, dividend imputation is the mechanism that converts company income tax into (in effect) a withholding tax rather than a separate (final) tax. Australia is one of only a few countries that still has a dividend imputation system but many other countries provide some form of relief to resident shareholders (for example, by exempting all or part of the dividend, or taxing dividends at reduced rates).

As discussed below, dividend imputation may also impact on company financing and overseas investment decisions. The relevance of resident shareholder tax arrangements for the decisions of many companies may be declining as non‑residents become a more important source of capital.

A final tax on non‑residents

Non‑residents own around 32 per cent of the shares in Australian companies. Company income tax is the primary means by which the returns to non‑residents from their equity investments in Australia are taxed. Collecting tax from non‑residents is of direct benefit to Australia but has the potential to reduce total investment and so reduce the productivity of Australian workers and, in turn, their real wages.

A simple, commonly used measure of Australia's international tax competitiveness is the statutory company income tax rate. While Australia's company income tax rate has fallen in recent decades, this has largely mirrored a world‑wide trend and, in recent years, Australia's relative position in the OECD has slipped (Chart 8.8 and see also Chart 5.10).

Chart 8.8: Statutory corporate income tax rates of OECD countries

Chart 8.8: Statutory corporate income tax rates of OECD countries

Note: Rates are top national statutory corporate tax rates until 2000 (that is, they exclude local and state company taxes imposed in some countries) and full corporate tax rates thereafter (that is, they include company taxes from all levels of government). Averages are unweighted.

Source: Australian Treasury estimates, OECD Tax Database; KPMG (various years); OECD (2006b); Deloitte (2006); national governments.

The company income tax rate is, however, only part of a more complex set of tax arrangements that together determine the effective rates of tax on investments into and out of Australia. Issues regarding cross‑border investments are discussed further below.

Company financing decisions and the debt/equity distinction

Companies can finance an investment by using retained earnings (taxed or untaxed profits that have not been distributed to shareholders), raising new equity capital (for example, by issuing new shares) or by borrowing (debt). As at March 2008, the debt to equity ratio for Australian non‑financial corporations was 0.78. This reflects liabilities, other than accounts payable, of $935.3 billion and equity, including retained earnings, of $1,199 billion (ABS 2008c). The method of financing investment will be influenced by a company's profit distribution policy. That is, whether it retains profits and invests them, or distributes them as dividends or by other means to shareholders.

From the perspective of residents investing in an Australian company (particularly start‑ups and fast‑growing companies that rely on raising new equity), dividend imputation provides a tax treatment of returns on equity investment that is generally comparable to returns on debt. This neutrality between debt and equity is recognised as a significant advantage of Australia's shift to an imputation system in 1987. Some biases in the choice of financing new investment still remain, driven by differences between the company income tax rate and the tax rates applying to individual and superannuation fund investors, and the operation of CGT, which in effect acts as a tax on retained earnings. Other countries have explored different systems that improve the neutrality between debt and equity treatments, or at least reduce their differential impacts. These are discussed in Box 8.4.

Box 8.4: Other countries' approaches to taxing capital income

Under a dual income tax, or schedular, approach, as adopted to varying degrees by countries such as Sweden, Norway and the Netherlands, capital income is taxed at a (low) flat rate, while returns to labour are subject to progressive rates of tax. Given the lower rate of tax applying to capital income, efforts are also made to tax company or business income that is attributable to the labour of owner-managers at the progressive rates of tax applying to labour income.

A few other countries have moved to not tax the normal required return on equity, particularly at the company level. Doing so has moved their systems closer to a post-paid expenditure tax treatment of capital (see Box 6.1) and provides for a more consistent treatment of equity and debt financing. A range of methods to achieve these outcomes have been developed, including the following.

  • Allowance for corporate equity (ACE): under an ACE, a deduction is provided for the deemed normal return on equity, equivalent to that provided for interest on debt. As measured equity is reduced by the depreciation allowed for tax purposes, changes to depreciation rates produce offsetting changes to the deduction allowed for equity. Hence, debt and equity are treated equally, and the tax depreciation schedules rendered irrelevant. Belgium and Brazil have adopted such arrangements.
  • Cash-flow type taxes: in its simplest form, a cash-flow tax applies to the sales of goods and services net of purchases, including an immediate deduction for all capital expenditure. No deduction for interest expense is provided. Rather, the immediate deduction of capital expenditures provides a tax benefit equivalent to interest deductibility and also provides an equivalent deduction for equity. More complicated cash-flow tax variants adjust for, or rely on, certain cash-flows associated with financial assets and liabilities. Australia's petroleum resource rent tax (PRRT) is a variant on a cash-flow tax, and Estonia's corporate tax can also be seen as an example.

An opposite approach to equalising the treatment of debt and equity, not yet adopted by any country, is a 'comprehensive business income tax' (or CBIT). The CBIT was developed by the United States Treasury in the early 1990s, and is otherwise like a normal company income tax base but with no deduction provided for interest paid. By not providing a deduction for debt, a CBIT ensures that the full return for debt, as well as equity, is taxed. Unlike the ACE, the CBIT represents a significant broadening of the tax base. This broader base means a lower tax rate can be applied to generate the same level of revenue.

Unlike resident investors, non‑resident investors in Australian companies receive only a limited benefit from imputation credits — an exemption from any dividend withholding tax. Dividend imputation is therefore less relevant to the financing and investment decisions of Australian companies for which non‑residents are a major source of finance — in particular, the Australian subsidiaries of foreign companies or internationally traded Australian multinationals.

The different treatment of non‑resident shareholders also creates incentives to pay franked dividends to resident shareholders and dividends that are not franked to non‑resident shareholders (dividend streaming), or otherwise transfer imputation credits to residents (franking credit trading). Guarding against these practices involves significant complexity in the tax law and compliance costs.