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Building on the Rock The Taxation Institute of Australia responds to A Strong Foundation December 24 1998 Level 7 64 Castlereagh Street Sydney NSW 2000 TABLE OF CONTENTS NO 1 DESCRIPTION INTRODUCTION AND BACKGROUND 1.1 1.2 1.3 1.4 2 Scope Consultation on Preliminary matters Complexity and Verbage Need for Bipartisan Support PAGE 1-1 1-2 1-2 1-2 1-2 1-3 2-5 2-5 2-9 2-17 3-18 3-19 3-19 3-21 3-23 3-24 3-24 3-25 3-27 3-28 4-30 4-30 4-30 4-32 4-32 5-34 EXECUTIVE SUMMARY THE DESIGN FRAMEWORK OF NATIONAL OBJECTIVES AND SUPPORTING PRINCIPLES 2.1 2.2 2.3 National Objectives of Taxation Design Principles to apply in achieving the National Objectives of Taxation Strategy for implementation of National Objectives, aligned to Principles Policy Formulation Reforms to the Processes of Policy Formulation The Appointment of Two Taxation Boards: Legislative Design Principles Matters flowing out of the objective determination of taxation policy and the proper legislative response to that policy Limiting Legislation By Press Release Legislative Gap Filling by Public Rulings The Desire for Private Rulings to attain Certainty Reasonable Expectation Taxation dispute resolution Interaction of Income tax with other taxes Integration of Taxpayer Compliance with other taxes, including GST Preservation of Taxpayer Rights 3 REFORMS TO LEGISLATIVE DESIGN PROCESSES 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 4 OTHER ADMINISTRATIVE ISSUES 4.1 4.2 4.3 4.4 5 CONCLUSION APPENDIX A APPENDIX B APPENDIX C 1-1 EXECUTIVE SUMMARY The Taxation Institute of Australia applauds the release of A Strong Foundation and is pleased to respond to it. Business taxation touches most Australians, be they small farmers or shareholders in mighty companies. The engraving of National Objectives for Business Taxation, and Principles by which these are to be attained, in a Charter can bring lasting benefits. But this will occur only if the Objectives and Principles are both soundly based and have bipartisan acceptance. The Taxation Institute sees certainty as a critical objective of business taxation, out weighing such issues as the bulk of the legislation. The Taxation Institute also firmly believes that the principles expounded must be realistic if they are to gain acceptance. In particular, accounting concepts are favoured as the income base. The Taxation Institute does not support the idea of "income" that taxes unrealised gains not recognised in accounting. The volume of items to be added back because the law departs from accounting criteria, only to be replaced by comparable amounts derived from statutory fictions, must be minimised in order to reduce compliance costs now estimated to be 18% of taxes collected. A Strong Foundation also challenges the existing models for taxation policy formulation and development. Such ventilation is long over due. Much work would have been saved had the advice of experts outside of the Public Service been sought in the past, or had it been heeded when offered, either without invitation or in some process of token consultation. The plans to build such advice into the formulation of taxation policy and its implementation in legislation though an independent Advisory Board are most refreshing – this Institute has been pressing for such measures for some time. But the Board must be adequately funded and its freedom to act on its own account guaranteed. But difficulties remain, particularly in the uncertainties now found in public rulings and the delays of the Australian Taxation Office in the giving private rulings. Further uncertainty flows from the continuing practice of legislating by press release, in poor substitution for prospective legislation. And work remains to be done to improve taxpayers' rights in disputation with the Australian Taxation Office, and to resist attacks upon those rights. The Review is to be commended for its work to date, but its efforts would bring acclamation if business taxation were to be simplified by the abandonment of Fringe Benefits Tax, now that a way has been found of quantifying these benefits on employees group certificates. This, beyond any other measure, would show business that the Review means business. 1-2 1 1.1 INTRODUCTION AND BACKGROUND Scope The Review of Business Taxation (the Review) is charged in its terms of reference with obtaining certain objectives. These include making recommendations on: The fundamental design of the business tax system; The processes of ongoing policy making; Drafting of legislation; and The administration of business taxation.1 The Review is to be commended in taking a broad approach in arriving at its recommendations, for business taxation is a concern of taxpayers in Australia ranging from the humblest farmer to the largest of corporations and their shareholders. The Review has rightly decided that the imposts falling on business and the resulting compliance cost is not limited to income tax alone but extends to other regimes, notably Fringe Benefits Tax. Because of the breath of the impact of business taxation, it is neither desirable or even constructive to attempt to place a ring fence around "business taxation" so as to set up an escalation of complexity arising in steps from salary and wage earners to business taxpayers to international investors and other specialised taxpayers – the clear, sound principles that will emerge from the Review will have equal applicability to all taxpayers although, in due course, the actual impact on the taxing statutes and on various taxpayers will differ. 1.2 Consultation on Preliminary matters The Discussion Paper "A Strong Foundation" released on 23 November 1998 invites consultation by the Review on preliminary matters2. These are: a suggested design framework of national objectives and supporting principles; and the proposed reforms to the design processes for policy, legislation and administration. The first part of this response addresses the design framework. 1.3 Complexity and Verbiage A recurrent theme in the context of taxation reform in recent years has been the length of the Australian tax legislation. Various targets have been set by those engaged in legislative reform to reduce the number of pages in the Income Tax Assessment Act 1936. The Taxation Institute does not see the reduction in bulk as an end in itself: what is required is accessible and clear law, capable of predictable interpretation. If the commitment to clear objectives and principles to attain those 1 2 Terms of Reference to Review of Business Taxation – Appendix A to A Strong Foundation. A Strong Foundation para 23. 1-3 objectives results in a more straight forward taxation system, then it may be expected that a reduction in the bulk of the document itself may follow.3 It is this realisation of the complexities of the system for ordinary Australians that has lead, as much as anything, to a ground swell for tax reform. The difficulties with the system (admittedly reflected in the legislation) may be seen in the bulk of TaxPack. It is now a document of 124 pages, with the supplement of a further 60 pages, and which, despite the intimidating bulk, does not allow a taxpayer to work out the amount of tax payable in all cases.4 The extraordinary complexity of the Australian taxation system as it affects businesses, large and small, is due to the failure of successive administrations to aim for constant objectives and to adhere to recognised principles. 1.4 Need for Bipartisan Support The form of the Australian tax system as it impacts on business will only be sensibly achieved if the effort of designing and implementing that reform has lasting effect. The aim should be that the tax base remains fundamentally static. The demands of revenue raising could then be satisfied by variations in the rates of taxation (and because of the transparency of income flows through business entities, this should be at the individual taxpayer level). This process must be approached with care and deliberation. The Tax Law Improvement Project (TLIP) stands as a dreadful example of what can happen if legislation is introduced before the whole task is completed.5 In that case the task involved the rewriting of the legislation without any policy change. The need to have the destination and the legislative path to it clearly planned and realised before implementation is much more important where sweeping policy changes are undertaken. Accordingly, a bipartisan approach is essential if there is to be lasting benefit. Bipartisan in the sense of agreement between major political parties, as well as agreement between the agencies of government and the business sector, lead by those with particular interests in taxation, such the Taxation Institute. It follows that there must be unanimity of agreement as to what the objectives of the taxation system in Australia should be and what principles are to be strived for in attaining these objectives. The embedding of these objectives and principles in a "Charter" is an appropriate means of directing focus and bringing commitment to consensus. Methods must also be found of ensuring adherence to the agreed Charter by agencies of change, particularly by government and its agencies. The Discussion Paper is correct in beginning with these fundamental building blocks. Unless consensus is attained on these matters, the risk of continuance of ad hoc measures will remain, with waste of effort and continuing re-invention of the wheel. 3 An example might be Subdivision 20-B of the Income Tax Assessment Act 1997 (sections 20-100 to 20-160) which, even after rewriting in plain English amounts to some extraordinarily complicated provisions dealing with the outcomes where a leased car is traded in. This whole subdivision would not be necessary if motor vehicles were treated as any other asset for capital gains tax purposes. 4 See for example the calculation of foreign tax credits at "Part D" on page S24 of TaxPack 98 Supplement. 5 See Joint Submission on the Income Tax Assessment Bill 1996 and Associated Bills by the ASCPA, ICAA, LCA, and the Taxation Institute dated July 1996. 1-4 We agree that this reform must be addressed as a matter of urgency – but that does not mean that pressing ahead to meet artificially imposed deadlines without consensus is acceptable. 2-5 2 2.1 THE DESIGN FRAMEWORK OF NATIONAL OBJECTIVES AND SUPPORTING PRINCIPLES National Objectives of Taxation Three National Objectives of Taxation in meeting the Commonwealth its revenue targets are discussed in Chapter 6 of the Discussion Paper.6 These objectives are: Optimising economic growth; Ensuring equity; and Facilitating simplification.7 There can be no debate about the inclusion among the objectives of economic growth, equity and simplicity. These heads broadly accord with those found in the 1985 draft White Review paper Reform of the Australian Tax System. 8 But the RATS paper included as "Other Considerations" the need to prevent tax avoidance and evasion, the need to recognise the impact of inflation on the tax system, the need to review tax expenditures and the harmonisation of Federal and other taxes. Even these expanded heads do not wholly reconcile with the traditional (well tested rather than old fashioned) principles of taxation expounded by Adam Smith. In The Wealth of Nations, Smith set out the following canons for the design of a tax: Equity Certainty Convenience in payment Efficiency In particular, in the Discussion Paper, questions of certainty and efficiency are not separately addressed. These are important issues in their own right and should not be submerged under the head of economic growth. The Taxation Institute therefore seeks to add to the listed objectives in the discussion below. 2.1.1 Economic Growth as an Objective of Business Taxation – the impact of compliance costs There can be little argument that economic growth will be optimised if market forces are allowed as much free rein as can be attained. In the context of business taxation, this implies that the uniformity of the imposition of taxation over various heads of income, over various activities, and over various structures, avoids distortion and misallocation of resources. However, the taxation system impacts on economic growth in more direct ways at the present time. 6 7 8 A Strong Foundation, paras 6.1 to 6.40 A Strong Foundation, Box 6.1, para 6.7 Reform of the Australian Tax System (Draft White Paper) p.14 2-6 It has been argued that the costs of administration and compliance in Australia are particularly high by international standards.9 It is also evident that those costs are more severe in the case of some events or taxpayers than others. It is pleasing to see then, that the Review recognises that these costs need to be kept within bounds. There are a number of aspects to this issue that may be emphasised. Any saving in the cost of compliance (now estimated at 18% of the revenue raised) contributes directly to gross domestic product and eventually to an increase in the revenues imposed upon it. There are two aspects to this issue that may be emphasised. One is the unnecessary duplication (or worse) of tasks in order to satisfy particular rules established in the taxation context. The law mandates this even where similar rules established for other purposes (and notably the determination of the annual profit and loss) may either be substituted or used as a basis from which the tax response may be derived. Common definitions are an obvious example. The need to "do it once and get it right" is desirable in the interests of both the taxpayer and the economy as a whole. Another benefit would be the introduction of some concept of materiality in the determination of the basis of business taxation. For example, the existing law contemplates endless apportionment. 10 Whilst common sense suggests that these unimaginative requirements are ignored in the real world, there is a need to balance the risk to revenue against the cost pressures of exacting tax accounting on the taxpaying community and to formally set safe harbours for taxpayer compliance accordingly. 2.1.2 Equity as an Objective of Business Taxation – a guiding principle The maintenance of equity, and particularly horizontal equity, is important in attaining the objectives of economic growth referred to previously. In this, the Taxation Institute recognises as a guiding principle that there should be a single layer of Australian taxation for business tax purposes, so that various entities should be considered, as far as possible, as extensions of the relevant owners. This means that those elements that result in the contemporaneous taxing of income earned by business entities in the hands of their owners is to be preferred over systems that entail the imposition of tax on those entities with complicated systems for eliminating the second tier of taxation. 2.1.3 Continuing Simplification of the Australian Taxation System – an emphasis on policy not words No matter from what viewpoint the subject is approached, all agree that the Australian taxation system, and the income tax falling on business income in particular, is complex. It is complex in its policy drivers, it is complex in its structure, it is complex in its legislative implementation, it is complex in its compliance requirements, and it is 9 A Strong Foundation para 6.135 et seq. Strictly, for example, it even requires that the usage of the boardroom refrigerator be apportioned between employees and other persons "entertained" in order that depreciation deductions may be accurately calculated. 10 2-7 complex in the response it produces from taxpayers, in turn calling for anti avoidance measures on top of all that has gone before. Improvements can and must be made in all of these areas. It must also be agreed that tax reform directed towards the broadening of the tax base has resulted in "increased complexity of the tax law".11 The "myriad trade offs" that are said to contribute to this complexity are a function of the inability or reluctance of governments and bureaucrats to establish consensus as to what should be the objectives of the taxation system and by which principles those objectives are to be attained. As noted in paragraph 1.4 above, if such consensus can be reached and embodied in a Charter setting out these objectives and principles, the temptation to offer trade offs will lessen, and, to that extent, so will complexity. The Taxation Institute notes, however, that simplification does not merely involve a reduction in the words of a piece of legislation – see our earlier observations in paragraph 1.3 above. In particular, whilst we would endorse the use of statements of principle as an introduction to various parts of the income tax legislation, we believe it is inappropriate to either embody these principles as substantive law, or, worse, to provide statements of principle without amplification. This distinction between guides to the legislation, examples and other non-operative material and the substantive, operative provisions is well used in the "plain English" style adopted in recent tax legislation. Needless to say, such statements of principle and examples should not conflict with the operative provisions in their effect. But these guides should only be resorted to where there is residual uncertainty in the operative provisions, which should be drawn so as to minimise this likelihood so far as possible. Statements of policy or of principle should not stand alone. We are strongly of the view that simplification is not enhanced by merely enacting broad principles and leaving the taxpayer either to flounder in uncertainty or, worse, to have to work through a labyrinth of regulations or rulings in order to determine the amount of tax payable. The taxation legislation in the United States is a good example of how broad statements of principle embodied in the actual legislation can become overwhelmed by the massive detail called into existence by regulation or by ruling. As such detailed Statutory Rules (or worse) do not have the direct endorsement of passage through Parliament, they are to be despised as a poor substitute for legislation in a democratic system. 2.1.4 Certainty – a fundamental objective for business A discrete objective In one sense, certainty is a function of simplicity. But the need for certainty is wider than mere simplicity in system design. Crude taxes, mollified by Executive or Administrative discretion may be simple but they lack the certainty of law. Certainty is an implicit requirement of business taxation because of the need for entrepreneurs to plan their business activities so as to be able to meet the taxes properly due and payable by them. The absence of certainty as a pre-requisite for such planning is in the interests of neither the business taxpayer nor the government administration. Certainty is a prime issue for all 11 A Strong Foundation, para 3.23. 2-8 taxpayers but is of particular concern to business taxpayers, where collateral impacts ranging from stock exchange reporting to adverse reactions from bank managers loom as more immediate problems than even the response of the Australian Taxation Office. In providing certainty the private rulings system has a part to play. Unfortunately, that system is proving inadequate. The deficiencies of the private rulings system and possible responses are addressed later in this Submission. The foregoing does not mean that certainty has to be absolute – neither death nor taxation is that predictable – but reasonable expectations must be capable of being met. The framing of the principles of the Australian taxation system for business will be impacted depending upon the amount of weight that is given to the objective of certainty. In particular, establishing outcomes by reference to behavioural impacts rather than formal or legal impacts, by subjective rather than objective criteria and by reference to economic substance are all factors that lessen the certainty of the taxation system for the taxpayer. Any steps to introduce these approaches seem likely to increase disputation between the Australian Taxation Office and taxpayers and to drastically reduce certainty in favour of administrative colouration. The curtailing or curbing of tax avoidance is made easy by discretionary legislation but the resulting uncertainty for all taxpayers is unacceptable (and has been for at least 370 years12). The need to prevent tax avoidance There is no serious argument that tax avoidance should not be negated by the tax laws. But at least two issues require discussion. Firstly, the extent to which activities of business taxpayers in pursuing advantageous options under the tax law should be penalised because they have found the law more accommodating than Treasury expected. A second issue addressed above, is whether, in the attempt to embrace all possible prospects within a general anti avoidance measure, the law is deliberately destroying certainty.13 It has been argued that a great deal of simplification can be achieved if specific anti-avoidance provisions were deleted from the tax legislation, relying instead on the broad general anti-avoidance provision found in Part IVA of the Income Tax Assessment Act 1936. This statement requires a cautious approach. There are some situations where a specific anti-avoidance provision does provide desirable certainty in contrast to the sometimes imponderable responses of the Australian Taxation Office under Part IVA. For example, section 82KZM addresses the question of the tax deductibility of pre-paid expenditure incurred for services etc extending beyond 13 months. This section provides a clear rule as well as a save haven. Comparable certainty would not be attained by simply relying on the general anti-avoidance provision. In contrast, the inordinate complications arising where private companies make advances to their shareholders or associates of shareholders is an example of the great confusion and uncertainty being placed upon business taxpayers through complex legislation. No greater uncertainty would have arisen had Part IVA being relied upon to strike down abusive loans to shareholders having the character of dividends. 12 13 The Petition of Right (1628) See, for example, Section 177EA 2-9 2.2 Design Principles to apply in achieving the National Objectives of Taxation Whilst the National objectives of taxation are a matter of common accord, (subject to an expanded and focused emphasis on the objective of certainty discussed in paragraph 2.1 above), the same cannot be said of the principles that are to be applied in attaining these national objectives. Whilst the Discussion Paper recognises that differing governments may give different weight to particular objectives, and in particular to the specific principles to be applied in achieving those objectives, the Taxation Institute asserts that some of the principles directed to definition of the income tax base are impractical and that other principles will prove, not merely more conducive to consensus, but also more effective. The primary concerns of the Taxation Institute are with the suggestion that "comprehensive income", as defined, should be the basis of income taxation. These concerns are discussed below. The following commentary adopts the order of the headings in Box 6.2 of the Discussion Paper. 2.2.1 Income tax base Business tax arrangements reflect an income tax base. Response: The willingness of the Review to address FBT is a welcome recognition that business taxation is not confined to the taxation of business income. Other taxes to consider might include Petroleum Resource Rent Tax, which is not based on income but is indeed a modification of a simple taxation of cash flows. The cost of compliance to business of administrative functions on behalf of other taxpayers under various withholding tax obligations is not directly addressed in the Discussion Paper other than as an example of the need for one system rather than a rag-bag. Assuming the Review does come to consider these matters, they must do so from the perspective of the taxpayer primarily and not the Treasury – eg payments of instalments by large taxpayers are to be made earlier than by others, but for whose convenience is this suggestion made? 2.2.2 Taxation of comprehensive income Comprehensive income is defined as the sum, over an annual period, of the taxpayer"s current revenue less current costs, plus the net change in the value of the taxpayer"s assets and liabilities. Response: Sixty years ago Henry Simons proposed an economic definition of income. He defined it as "the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and end of the period in question."14 14 Personal Income Taxation: the definition of income as a problem of fiscal policy (1938). It may be noted that Simons definition does not accord with the definition of comprehensive income cited in the Discussion Paper. On its face, the definition of comprehensive income would appear to include in income amounts 2-10 The Taxation Institute rejects the proposition that either the notion of comprehensive income or the Henry Simons model is appropriate as a principle to be aimed at in Australia in the attaining of taxation objectives. It is essentially an economist"s model, which, as we understand it, is based on presumptions of unimpeded access to funds for the payment of taxation which, we believe, is unrealistic and unattainable. These concerns revolve primarily around the proposition that income should include unrealised gains – that is the net change in the value of the taxpayers assets and liabilities. It is apparent that the payment of tax by a farmer on the growth in value of his property (or conversely the refund of tax to the farmer as a consequence of the fall in the value of his property at a time of drought) is unpallatable for both taxpayer and Revenue. Yet it is only by this mechanisim, it is argued, that the "lock in" effect of accrued capital gains tax on unrealised investments is be avoided. We recognise that the realisation basis in handling the taxation of capital gains produces a distortion to the "free market". But the practicalities and the realities dictate that here theory must stand aside. (In our discussion below, we accept the taxation of unrealised gains or losses on a "mark to market" basis, but only where that basis is adopted by the taxpayer in arriving at their accounting profit). Other difficulties present themselves when consideration is given to the taxation of unrealised gains. The first of these is the scope of assets that are subject to this valuation basis. Does it, for example, include the goodwill of a business; does it include "trade secrets"; does it include "personal capital" in the form of schooling and talents attributible to the individual entreprenuer? Likewise, the concept of value or "market value" is far from straight forward. Does it mean for example that a retailer is to pay tax on the markup in his unsold stock or is the notion of "market value" in that case better related to the price that the inventory would raise if sold as a whole (which accords with its wholesale value or cost to the retailer)? Similarly, the valuation of liabilities presumably has to take into account some recognition of the net present value of long term obligations. The complexity of this, applied generally, would alone outweigh any benefits to Revenue. But these are technical issues which are insignfiicant compared to the cash flow penalties implicit in the taxation of unrealised gains. Nevertheless, settling aside of the inclusion of unrealised gains within the tax base through notion of comprehensive income, the Taxation Institute recognises that the traditionally sharp distinction between capital receipts and income receipts has become blurred in recent years, as has the revenue response as a consequence of the inclusion of capital gains within the tax base. So if there is to be acceptance that real capital gains are a proper object of income tax, then it must follow that capital losses are similarly to be recognised as a deduction in arriving at taxable income generally and should not be quarantined against capital gains. This is all the more apparent when there is no system for refund of taxes where a loss is incurred. saved from current revenue, which are also reflected in the "net change in the value of the taxpayer"s assets and liabilities". Some adjustment to the terms of the definition of comprehensive income is required to avoid this duplication. 2-11 Recommendation: Adoption of Accounting Profits as the income tax base It follows from the foregoing that the Taxation Institute believes that the present determination of net profit under Generally Accepted Accounting Principles is a more satisfactory base to aim for as a matter of principle than any notion of "comprehensive income". Profits arrived at under GAAP are the fundamental commercial reflex of business income, have acceptance throughout Australia and are generally in line with comparable principles internationally. The cost of compliance with taxation requirements would be slashed from its present 18% of revenue raised 15 to a markedly lesser percentage, we believe, if accounting profits could be installed as the tax base. Nevertheless, we recognise that Government and Treasury is unlikely to be willing to relinquish exacting control over the income tax base for businesses in favour of any independent accounting principles board. However, the principle should be asserted and every step taken that is possible to eliminate those items that must be "added back" out of the accounting profit on the premise that these items do not accord with the requirements of income tax legislation and the substitution therefore of other amounts derived artificially from the Income Tax Assessment Act.16 As is broadly demonstrated in figure 2.2 of the Discussion Paper,(taxable income and accounting profits 1995-96), it is ludicrous to have a situation where the dollar outcomes of so much compliance effort is directed to such a small amount of net change in the tax base. The Discussion Paper notes the ways in which the existing law departs from the theoretical outcomes17. These may be summarised as: entity taxation; the taxation of realised profits (in most cases); the capital/income distinction; the carry forward of losses rather than refunds; and the departure "systematically" from the "comprehensive real income base". It follows from the foregoing, that the Taxation Institute believes that the principle from which the income tax base is derived should be changed to the profits arising from business activities and that if this was done, the departures outlined in these paragraphs would be less important. 2.2.3 Real or nominal taxation Comprehensive income is conceptually measured as real income (i.e. income comprehensively adjusted for uniform inflation) but for practical reasons comprehensive nominal income (i.e. income not comprehensively adjusted for inflation) may be an unavoidable compromise. Response: The Taxation Institute believes that recognition of inflationary effects in the 15 16 17 A Strong Foundation, paragraph 6-135 et seq. See figure 2.2 and subsequent discussion in A Strong Foundation paras 2.24 to 2.28. A Strong Foundation paras 6.55, 6.56. 2-12 taxation system is a fundamental principle. However The Taxation Institute does not believe that abandonment of indexation is "an unavoidable compromise". The taxation of nominal income is the antithesis of the Matthews Committee approach18. Taxation of nominal cash is inherently unjust and skews the funding choice in the direction of debt with consequential impacts on interest rates. Concerns about inflation and its effects remain valid, for we will not always be in a low inflationary cycle. Indexation is a fair approach to those situations where it can be applied, (although the recent changes in the CPI base suggest that one index is not necessarily appropriate for all things - at least the basis should be kept constant, or if there is a change, the old index values should be adjusted). The idea of a "fully nominal" income tax system would abandon the indexation of cost bases in the calculation of capital gains. Whilst full indexation of all components of the tax framework may be impractical, at least until driven by excessive inflation, the effects of inflation need to be recognised where long-term outcomes are distorted, as in the calculation of capital gains. In this regard, it might be noted that a cap of 30% on the taxation of capital gains for individuals is not a trade off for indexation, as indexation currently would benefits all taxpayers, irrespective of the rate of tax they pay. Further, the Taxation Institute would assert that in the determination of the quantum of capital losses, the cost base of the asset sold or otherwise disposed of should be indexed just as it is when the asset is sold for a gain. The experience of the inflationary impact on the cost base (particularly when regard is had to the enhanced cost of replacement) is equally deleterious whether a gain or loss results from disposal. 2.2.4 Integration of ownership interests For business tax — as distinguished from commercial or legal — purposes, entities should be considered as extensions of their ultimate owners. Response: Desirably, the current income of investors and other entrepreneurs should reflect their share of the profits of their activities, irrespective of the entity chosen for the conduct of those activities. This is done, for example, in the taxation of partnerships. This should be the standard by which entity taxation is judged. The proposals for consolidated or group taxation of entities under common control is a step towards this principle of integration, which we endorse in principle. Many severe complications in existing arrangements could be lessened if a sensible consolidation approach was adopted, drawing so far as possible on group accounting concepts already used by companies. Here is an opportunity to build on an existing base and to avoid creating a special regime. In the case of companies, until company and personal tax rates are aligned, the retention of income in a company or group has presented the designers of the Australian taxation system with problems, which are not yet solved. But in the case of closely held companies, there seems to be no reason why they should not be able to elect out of the two tier taxation system so that the income of the company may be directly attributed to the shareholders in the company 18 Report of Committee of Inquiry into Inflation and Taxation (1975) 2-13 as if the company were a partnership. The United States income tax system accommodates such an election and it was recommended by the Asprey committee in its findings19. In addition, the mechanisms for the calculation of capital gains attributable to either the accumulation within the company of taxed profits or unrealised gains in the company"s assets demands consideration and relief. Again, this is an issue that is substantially avoided if a partnership model for the taxation of entities can be adopted wherever possible. The "full imputation system" is not an adequate response to these concerns. A critique of the proposed changes will be made when the further Discussion Paper on A New Tax System issues. So far as the taxation of other entities is concerned, the focus of excitement at the present time is with respect to trusts. The appalling legislative response to the question of trust losses discussed in Appendix A suggests that nothing but confusion will come from the proposal to tax trusts as companies. Unfortunately, like companies, trusts come in all types of varieties and come into being for all manner of reasons. But it is understood that not all trusts will be subjected to entity taxation. Examples given include constructive trusts and "trusts arising from a range of circumstances where the sole beneficiary is subject to a legal disability or is legally incapacitated". When it is considered that a trust relationship subject to separate taxation has already been held to exist where monies are paid to a stakeholder by a builder and his client pending the resolution of a dispute, the expansion of the base of taxable entities is very great indeed. All of this is unnecessary, or at least is contrary to principle, as the present mechanism for taxation of trusts seems closer to the principle of integration annunciated in the Discussion Paper than otherwise. The solution must be to better address the contemporaneous taxation of the income of trusts in the hands of beneficiaries rather than impose a separate tier of taxation and complication upon some trusts, (but not all trusts). It is ironic that one of the few imaginative undertakings of the TLIP processes was to develop a seemingly workable regime for the taxation of trust income. The purported difficulties with trust losses could continue to be addressed separately, but the difficulties would be much modified if the more equitable alignment with the principle of refunding tax on losses was recognised by means of allowing a carry back of losses. It follows that the extension of the full imputation system to other entities such as trusts is a poor substitute for the attribution to each individual investor of his or her share of the entity's income. It is true that in the case of some corporate structures and public companies in particular, there are significant obstacles to a full integration approach. But that is no reason why it should not be adopted in simpler environments, and in particular where the individual entrepreneurs request that treatment. 19 The "Subchapter S" election and the report of the Asprey Committee (Taxation Review Committee) Full report 1975. 2-14 2.2.5 Single layer of domestic taxation Business income should not bear more than a single layer of Australian taxation. Response: It follows from notions of equity and of integration (referred to immediately above) that income tax should not be imposed on income flowing through multiple entities to the ultimate investor or entrepreneur at more than one level, or, if such taxation does fall on the income streams, full credit should be allowed for prior taxes paid. The Discussion Paper limits this concept to "domestic taxation". But there is no reason why this premise should be so limited. It is a demonstrable fact that the existing tax system in Australia actively discourages Australian business from earning its income abroad. This would seem to be diametrically opposed to the Nation"s economic objectives, particularly given our balance of trade position. Under the existing system, an entrepreneur trading in the United States, for example, will pay some 71% of gross income in tax, as compared to a maximum of 49.5% if no activities outside Australia were attempted. This comparative disadvantage will not improve under the full imputation system proposed in A New Tax System but will fall wholly on the company. The simple message is that these credits must be allowed through to the shareholder level under the Australian tax system. If this cannot be acheived universally, then at least some reciprocal allowance of credits should be considered between Australia and those countries in which ex-Australian activities are most likely to occur (where there are compatible tax systems). 2.2.6 Horizontal and transitional equity Under the integration principle, ability to bear tax ultimately refers only to natural persons, not entities, so that for tax purposes all income — e.g. entity profits, interest, royalties, rental and wage income — should be taxed comparably. Changes affecting existing taxpayer arrangements should also be designed and implemented fairly. Response: The Taxation Institute supports this principle but notes that it simply means that entity profits, flowing through companies as dividends should be taxed comparably with those profits had they been derived directly by the entrepreneur. As is noted, this is yet another aspect of the integration principle. It follows that tax preferred income when distributed to an investor should remain tax preferred and not subjected to a new full imputation system designed to penalise it. Conversely, "capital gain income" after adjustment from nominal gains to real gains by indexation, would be taxed comparably with any other income. This would mean that the 30% cap on the taxation of capital gains and other favoured treatment of this "income" would have to be abandoned if the system is fully to adhere to this principle. 2.2.7 Investment neutrality In order not to distort the cost of capital used to evaluate alternative investments, business tax arrangements should avoid differentially taxing: 2-15 the type of investment; the type of entity (companies, trusts, partnerships, direct investment etc); entity financing alternatives (retentions, capital issues, debt issue, dividend reinvestment, reductions in share buy-backs); the type of income distribution (dividends and the income component of share buy-backs or liquidations); or distributions relative to retentions. To achieve neutrality, the tax base adopted should be as close as possible to comprehensive income. Response: In the responses above, these issues have been addressed (or will be addressed in a response to the next Discussion Paper). In particular, however, it is evident that Australia"s capacity to retain existing foreign investments here, much less to attract additional foreign investment, will be influenced by the Australian corporate tax rate, among other things. The proposed reduction to a 30% corporate tax rate is a welcome recognition of these pressures. That step should not be negated by other strategies, particularly those affecting the retention of taxed earnings by Australian companies. 2.2.8 Risk neutrality Since capital markets must compensate investors for bearing undiversible risk, business tax arrangements should seek to minimise distortions to the pattern of such risk bearing by adopting a tax base as close as possible to comprehensive income. Response: The Discussion Paper raises two issues under this heading, the first of which is the non neutral treatment of carry forward losses. The Discussion Paper suggests that loss refunds cannot be considered because of "the need to protect the revenue-raising function of the business tax system". This argument is fallacious a loss in this context is no more than an excess of allowable deductions over assessable income. If allowable deductions can be artificially generated so as to create a loss, so they can be artificially generated to reduce the taxable income. The fact is that they cannot be so generated without having other economic or legal impacts. The question of the non-neutrality of the treatment of carry forward losses was considered in the Asprey report20. Its recommendations on the carry back of losses awaits adoption. Appendix B refers to this matter in greater detail. As the second proposition concerning the "non-neutral taxation of risk" it is perhaps a sufficient response here to say that we have severe reservations above the universal application (or indeed any application outside of banks) of proposals for changes in the taxation of financial instruments. Apart from other considerations, 20 The "Subchapter S" election and the report of the Asprey Committee (Taxation Review Committee) Full report 1975. 2-16 it is the view of the Taxation Institute that efficiencies in financial markets through the development of hybrid and synthetic instruments through the more efficient placement of debt or equity among the various factors in the business system outweighs the detriment alleged to be done to the taxation system. 2.2.9 Balanced taxation of international investment Taxation of inbound and outbound investment and other cross-border business activities should be consistent with Australia"s national interests, including its competitiveness, while respecting Australia"s international obligations. Response: As has been indicated above, the burden of taxation borne by the entrepreneur earning income off shore is a major issue to be addressed in the reform of business taxation. This matter is expounded upon further in our response to the Gibson Committee. There is no reason why principles should be distorted in this area – considerations of horizontal equity are as important here as elsewhere. Further, not only is an Australian investing aboard burdened with additional taxation, the Australian taxation system imposes on that person extraordinary demands in terms of information reporting, some of which may be unobtainable given the degree of control commanded by the Australian investor. A sense of reality needs to be introduced into the law in this area 2.2.10 Tax Incentive Provisions Business tax incentives should be provided only following a formal assessment of their net impact on the national taxation objectives, and only where assessed to be an essential or superior form of government intervention. Response: The introduction of taxation incentives will, as has been noted, move the tax base away from the taxation of comprehensive income. To that extent, such tax expenditures might better be satisfied by a direct subsidy. In those cases where a tax incentive is thought to be desirable, experience shows that there must be a complete coincidence of aspirations and expectations of the industry policy and the tax policy. There frequently appears to be a reluctance on the part of the Australian Taxation Office and of Treasury to give full weight to initiatives for tax incentives. This may have come about because these incentives frequently become the target of aggressive planning. Improvements in the legislative drafting processes should correct this problem of language not matching intent.21 2.2.11 Effective tax incidence Business taxation measures should be designed on the basis of an assessment of their actual behavioural impacts — not simply their formal or legal impacts. 21 It might also be said that the reluctance of Treasury and the Australian Taxation Office to give full effect to various initiatives is not limited to industry policy issues. The small business task force, for example, recommended liberalisation of record keeping requirements by small business. That recommendation was implemented merely in the context of direct penalties for failure to keep proper records and did not extend to the obligation of the small business proprietor to maintain those records in order to support positions adopted in the income tax returns lodged, thus effectively negating the initiative. 2-17 Response: The Discussion Paper properly recognises that the formal incidence of taxation is likely to be diffused in practice by the transfer of the burdens or the sharing of the benefits of elements of the tax equation. The Discussion Paper appears to focus primarily on the diffusion of the impact of corporation tax, and, inferentially argues that the impact of the corporate tax rate on the entrepreneur is not as severe as it might otherwise be. The existing legislation and, to a greater extent, Australian Taxation Office administration, finds tax benefit transfer abhorrent. Greater simplicity and efficiency would be obtained by permitting tax benefit transfer to occur in accordance with market forces, whilst recognising its economic impact in the structuring of the taxation system. 2.2.12 Economic substance over form Economic transactions having the same economic substance should be taxed similarly, irrespective of their form. Response: The Taxation Institute cannot accept this bald principle. How this principle can be applied or contained is impossible to say. It would appear to extend to imposing tax on a saving of expense by personal work as if it were the derivation of income. A farmer, helping a neighbour erect a boundary fence, who derive income matched by depreciation of the deemed cost of the fences over years. Attempting to legislate on a case by case basis to tax the "economic substance" rather than the form does nothing for the simplicity of the tax system. In the Discussion Paper, the example is quoted of the taxation of trusts on the same basis as companies. This, it is said, is an illustration of the principle but appears to proceed from the proposition that trusts should be subjected to company tax, rather than shareholders being permitted to pay tax on the current income earned by the company. 2.3 Strategy for implementation of National Objectives, Aligned to Principles Once consensus is reached as to the national objective of taxation and the principles that are to be applied in attaining those objective, the outcomes are to be embedded, it is proposed, in a Charter of Business Taxation22. We have previously stated the need for bipartisan support for this Charter and for mechanisms to ensure that it remains operative. Given that this can be done, the Review should specifically address those strategies that it sees as being appropriate for the implementation of the national objectives as expressed in the Charter. We see this as going beyond merely referring to the reformed consultative and oversight arrangements that the Taxation Institute"s hopes will emerge from the recommendations of the Review. The Taxation Institute believes that it would be desirable for the Review to set specific strategic program for the conversion of the existing provisions of the Income Tax Assessment Act and the Fringe Benefits Tax Assessment Act to conform with its recommendations and to set milestones against which progress towards this end may be gauged. 22 See A Strong Foundation paras 7.93 to 7.97. 3-18 3 REFORMS TO LEGISLATIVE DESIGN PROCESSES The terms of reference for the Review require the Review to make recommendations on "consultative input from the business community into the ongoing processes of policy design, drafting of legislation and the administration of taxation.". The existing Legislative Development Processes in the context of the business tax system are well summarised in Chapter 4 of A Strong Foundation. In paragraph 4.28, the Review identifies four fundamental reasons for the wide spread dissatisfaction and frustration with the current business tax system and with its legislative implementation. These are: the lack of a coherent framework of objectives and principles to guide the operation of the business tax system; the largely "fragmented" approach which is usually taken to make changes; the lack of accountability for, and the review of, the results the system produces; and ineffective consultation with the ultimate users of the business tax system, the private sector, when changes are being developed. The Taxation Institute fundamentally endorses this analysis, but would add an emphasis to the need for ultimate accountability. It has been the experience of the Institute that the Parliament, even when specific committees engage in the task, are reluctant to come to grips with the detail of policy and the resulting legislative design outputs. Further, even when this is done by such bodies as a Joint Committee of Public Accounts and Audit, the attention of the Government seems hard to attract. Numerous recommendations emanating from the examination of the Tax Law Improvement Project remain unaddressed, despite the unanimous and bipartisan support for various initiatives by the JCPAA. This seeming reluctance of the Parliament to address the detail of the taxation laws imposed on Australians is regrettable, and can only be explained by the extraordinary complexity of the legislation overall and the dominance of views emanating from policy formulators within Treasury and Government. The Taxation Institute has been frustrated in recent years by the unwillingness of the bureaucracy to listen with an open mind to advice on taxation matters from the tax profession and business interests. Whilst we can understand that such advice would have to be weighed up carefully, and that our advice might not necessarily be accepted, many embarrassing errors (for the authorities) could have been avoided had that advice been given due weight. Similarly, many taxpayers could have been spared very significant unwarranted compliance costs had basic deficiencies in draft legislation – which had been pointed out to the bureaucrats by tax experts – been considered properly. Even where special advisory committees are formed for obtaining private sector input to tax issues, the advice is not always given the consideration it deserves. It is our view that a highly skilled and currently cost-free resource is being greatly under-utilised by the public sector 3-19 in relation to taxation matters. In fact, these resources are being actively alienated at present. It is hoped that independent advisory boards may be able to intercede in this process, but ultimately the remedy lies, we believe, with dedicated standing committees of Parliament reviewing tax legislation in some detail prior to its implementation and overtly accepting responsibility for it. This process would be assisted if, as in the UK, all amending tax legislation could be introduced in an annual Tax Act (after meaningful consultation and with prospective effect). This would also remove the confusion for all of leap-frogging amending legislation. 3.1 Policy Formulation The Discussion Paper, in Chapter 4, implies that most, if not all taxation initiatives are subjected to a common legislative development process. Whilst it is no doubt true that broad policy initiatives – such as those Discussion Paper itself – are frequently initiatives of Treasury supported by the Australian Taxation Office, it is our perception that much of the remaining tax legislation brought before Parliament has its genesis in the Australian Taxation Office, rather than in Treasury. This continual tinkering by the Australian Taxation Office is perceived to be often done to remedy defects arising from an imperfect development of or understanding of the relevant policy, and certainly without any reference to the policy perceptions of the business community. Frequently, the result is the pressure being placed upon Government to take immediate action to counter a loss of revenue, which in turn brings forth a knee jerk reaction in the form of a press release announcing impending legislation. It is only at this point that there is any interaction with the wider business community. By that time the capacity of the business sector to have any meaningful input in designing the initiative has effectively passed. The experience of the Taxation Institute is that, once policy initiatives are the subject of Government announcements, or worse, are reduced to draft legislation, the effort and commitment of the formulator of these initiatives in their work produces a natural impediment to change, no matter how sensible that change may be. Examples abound. The outcome is that when these concerns are ultimately voiced when the legislation is being debated in Parliament, the impending legislation is delayed, amendments to the legislation are put in place, not infrequently in haste, and or the legislation passes in an unsatisfactory form only to require subsequent amendment at a later date. And all this, not infrequently, is back dated to the date of a press release. 3.2 Reforms to the Processes of Policy Formulation It is apparent from the foregoing that we agree with the views expressed in the Discussion Paper that an integrated approach to policy development is imperative as a starting point. It is only in this way that a clearly articulated and thoroughly thought through policy can be developed on any taxation issue. This process will serve a number of purposes, including the more straight-forward communication of these policy objectives to Parliament and to the taxpayer community generally. It follows that we support wholly the Review"s proposals for reform of policy formulation processes. These are summarised as follows: adopting a more open approach to planning the business tax policy agenda, subject to the Treasurer"s direction; 3-20 strengthening the effectiveness of consultation in designing and implementing business tax arrangements; applying an integrated, team-based design process; specifying accountabilities for design; establishing an advisory board with a focus on the overall performance of the business tax system and significant private sector representation to support the reformed framework and processes; reinforcing business tax simplification as an ongoing requirement; and consolidating a Charter of Business Taxation as a consensus statement on design framework and process. Integral with the attainment of these proposals is, we believe, the development of the confidence to formulate a policy in an open way, accepting input to that process from outside Treasury and the Australian Taxation Office. Whilst the open policy formulation mechanisms arising from the development of revenue bills by the committee system of Congress in the United States is an extraordinarily open and interactive process, its adoption in Australia seems hard to replicate. However as this is pointed out in paragraph 7.8 of the Discussion Paper, the formal process adopted in New Zealand of the Generic Taxation Policy Process has attributes that warrant careful consideration in the formulation of equivalent processes in Australia. The Richardson Report 23 , states in paragraph 12.3 a catalogue of issues broadly comparable to those raised by the Discussion Paper. These are: Key strategic issues should be resolved early in the policy development process. This includes ensuring an effective link between economic and revenue strategies, and settling issues of principle at a broad level. The fundamental intentions of tax policy should be thoroughly debated to ensure a wide exchange of views and understanding, and consistency with other Government policies. Once agreed, the intentions should be communicated as soon as practicable to all people involved. The roles and responsibilities of all participants in the tax policy process should be clear. The policy development process should specify trade-offs relevant to the policy (such as revenue impact, compliance and administration costs, economic objectives, social objectives and implementation). Appropriate external people and/or other government departments should be consulted at all stages of the policy development process, and particularly at the early stages, unless there are specific reasons for excluding them. The results of implementing tax policy, and the policy process itself, should be reviewed regularly for adherence to the intended direction and potential improvements. Remedial action should be taken as soon as practicable. The management of tax policy, and the drafting of any subsequent legislation should reflect best practices, including clear accountability, specification and 23 Report of an Enquiry into the Inland Revenue Department. 3-21 monitoring of performance, the provision of free and frank advice form officials, and optimum use of resources. An important aspect of the Generic Tax Policy Process is the allowance of adequate time for the development of policy in an open and interactive fashion. The institution of a three year rolling work program, during which input from the private sector is considered, is an element that could well be adopted in Australia given by bipartisan support of the principles to which tax reform is directed. A diagrammatic representation of GTPP is attached as Appendix C. With such meaningful consultative arrangements in place, the Government could be assured of the professional co-operation and commitment of taxpayers generally and of the Taxation Institute in particular. We believe it is evident that the benefits of participative arrangements in the reduction of complexity and duplication of effort would prevail. 3.3 The Appointment of Two Taxation Boards The Taxation Institute has recommended in its Submission to the Gibson Committee that two separate Advisory Boards, be formed, as there are two quite distinct roles to be performed. Each Board would have a different focus, different responsibilities and different members. There would be representatives of the taxpaying community on each Board, as well as representatives of other Government Departments besides Treasury and the Australian Taxation Office. We have called these two boards: The Taxation Policy Review Board, being the Advisory Board contemplated in paragraph 7.6 and following a Strong Foundation. The Taxation Administration Review Board, primarily focussed on improving the administration of the tax law. 3.3.1 Taxation Policy Review Board We welcome the support of the Review in recommending the establishment of an advisory Board with a role in consultation on an approved "work program". This seems to the Taxation Institute to be harmonious with the adoption of a process similar to that of the "generic tax policy process" referred to in 3.2 above and illustrated in Appendix C. It seems clear to us that the whole process of developing a proper balanced oversight of business tax design can only follow if the Board has consulting input into the process. Therefore, the Board should adopt a consultative role from the outset, as is envisaged in paragraph 7.69 of A Strong Foundation. But the Board should not be subject to the effective control by Treasury through starvation of funds or by dictation as to what form enquiries might take, or from whom they might be made or by the imposition of an overly rigid timetable. The adverse experience of the TLIP Consultative Committee shows that resort by the Board to advisers independent of the public sector is essential if the Board is to make an informed and timely contribution that will balance the public sector input. 3-22 The Board must be strong and independent. It must not be subservient to public service control or direction. They must not be rendered impotent by constrictions on their scope, their funding or their information or reporting lines. Appendix D to the Discussion Paper shows how "consultative arrangements" have proliferated. The effectiveness of these committees and other bodies varies, but some, at least, provide no more than a token nod in the direction of consultation without any expectation by those who have put them in place that events will be seriously challenged by their existence. This must be avoided at all costs. 3.3.2 Taxation Administration Review Board The Taxation Administration Review Board would oversee the proper administration of the Australian Taxation Office, and recommend improvements where necessary. We recommend that a proposal recently adopted in the United States be used as the basis for as Australian board of this nature, with appropriate changes to reflect our different Constitution. In the US, the National Commission on Restructuring the Internal Revenue Service 24 has recently recommended the establishment by Congress of an independent Board of Directors to oversee the IRS. Board members would be appointed by the President, confirmed by the Senate and would be removable at will by the President. The role of this Board is to be responsible for the overall administration of the IRS. It will have no involvement in specific matters in the areas of interpretation or enforcement of the tax laws. The role of the US Board will be to guide the direction of long term strategy at the IRS, appoint and remove senior leadership and hold IRS management accountable. It will give a long term perspective to tax administration rather than short term priorities and emergencies. The US Board will not be involved in taxation policy. Its powers are to be: Review and approve the Commissioner's recommendations regarding IRS strategic and business plans, and IRS goals and measures relative to those plans. Review and approve the Commissioner's recommendations regarding major operational and organisational plans. Appoint and compensate the Commissioner and review and approve the Commissioner's recommendations regarding the appointment, evaluation and compensation of IRS executives. Review and approve the Commissioner's recommendations regarding the IRS budget with particular emphasis on ensuring that the budget supports the IRS strategic and business plans. Review the IRS annual financial audits. Provide annual stewardship reports to the President, the Congress and the American public regarding the matters under its jurisdiction. It is clear that, on this basis, members of the Australian Taxation Administrative Review Board would not need detailed knowledge of tax legislation: administration experience is the more essential skill-set for membership of this Board. We also recommend that such a Board be answerable to the Parliament, and that it be 24 The US Federal equivalent of our Australian Taxation Office. 3-23 constituted as an Advisory Board. It follows that the Chairman of this Board should be an independent, non-executive member - that is, the Commissioner of Taxation should not be Chairman, though he should be a member of the Board. 3.3.3 General matters The public interest should be protected by ensuring that both Boards could give advice directly to the Treasurer (or even the Prime Minister) where considered necessary, and, that where advice either to the Commissioner or Ministers was not acted upon, that would be required to be reported to Parliament in the Annual Report of the Australian Taxation Office. The mechanism should ensure that, whilst the bureaucrats are unambiguously responsible for the tax system, they are effectively obliged to consider the advice of the Boards very carefully, and to only override that advice in extraordinary circumstances when absolutely convinced of the correctness of contrary views. Board members should be subject to existing Commonwealth public service laws relating to disclosure and conflict of interest. In addition, each Board should develop its own corporate governance processes, in line with best practice. Of particular importance will be the formalising of processes involving declaration of conflicts of interests, which are clearly of extreme importance in this context. Board members could be dismissed by the responsible Minister, subject to the normal appeal procedures. 3.4 Legislative Design Principles It is appropriate at this point to revert to the statements of the legislative design principles suggested in paragraph 6.86 and following of the Discussion Paper. The statement that the Legislative Design Principles25 should focus mainly on the user end of the system, so as to produce a tax system that works better for taxpayers and administrators as well as achieving the desired objectives, is a general statement which can readily meet overall acceptance from a wide variety of interest groups. There can be no doubt that much can be done to improve tax legislation. The principles laid out here are a good standard by which these efforts may be judged. But at the end of the day the first focus of concern remains determination of appropriate policies through consistent application of principle to known objectives. In particular, formulation of the Legislative Design Principles cannot be undertaken in isolation from the underlying taxation policy. When one looks at the individual Legislative Design Principles, while at a cursory glance they appear unobjectionable, when one ascertains how they are to be applied in practice, the process appears far more problematic. Many of these legislative design principles cannot be dealt with in isolation. In particular, many of them pertain more to policy issues which, when resolved, will only then be able to be implemented in satisfactory legislation. If the underlying policies are unclear, uncertain and inconsistent, it must follow that the legislation will also have these defects. In many cases, it would appear that the existing business taxation system is a reflection of deliberate government policies whose underlying merit needs to be addressed before it will be possible to prepare legislation giving effect to the Legislative Design Principles stated in the 25 A Strong Foundation para 58, paras 6.86 et seq. 3-24 Discussion Paper. Moreover, to give effect to those Legislative Design Principles, it will be important that the business interests affected by any policy initiative are given the opportunity to provide adequate input into its formulation before such legislation is introduced into parliament. 3.5 Matters flowing out of the objective determination of taxation policy and the proper legislative response to that policy If it is possible for Australia to attain a mechanism whereby legislation can be drafted for introduction into Parliament that is clear and adequately addresses the policy requirements without unintended consequences or the imposition of countervailing cost burdens on the taxpayer community, then a number of other issues which are a problem under the existing system resolve themselves. These include: Legislation by Press Release. Legislative Gap Filling by Public Rulings. The Pressure for Private Rulings to attain certainty. Extinction of Practices by the Australian Taxation Office to mollify administratively harsh effects of the Legislation. Each of these existing concerns will now be considered under separate headings. 3.6 Limiting Legislation By Press Release The Taxation Institute strongly supports the proposal of the Review of Business Taxation to limit the practice of legislating by press release. It is our submission that the resort to "legislation" by press release should be exceptional rather than routine, (even when made in the context of the budget), and should be accompanied by a statement explaining the reasons for its adoption. Legislation by press release is undesirable for the following reasons Except in the case of the simplest of amendments it is impossible to foreshadow in a press release the detailed provisions of an Act of Parliament. Consequently, until a bill introducing the amendments is introduced into Parliament, the tax rules affected by the announcement are uncertain. A corollary of the foregoing is that when the proposed law emerges in the form of a bill or draft legislation, the amendments may be wider than announced or may include provisions not clearly foreshadowed in the original announcement. Taxpayers who relied on the announcement in the interim may find that their reasonable assumptions about the content of the amendments were incorrect. When this occurs the amending legislation is in fact retrospective in effect. A particularly pernicious outcome may occur where the government is unable to guarantee passage of legislation implementing an announcement. For example, if, as has happened, the Senate rejects the amending legislation announced in a media release, taxpayers who have acted in reliance on the announcement will only discover after the government abandons the amendments that they remain subject to the original legislation despite the media release. It involves an usurpation of Parliament's legislative power by the Executive. It places Parliament in the invidious position of either agreeing to 3-25 the legislation without significant amendment or bearing the odium of overturning arrangements which many people may have made in reliance on the ministerial statement.26 It is inconsistent with the principle of self assessment. Self assessment requires taxpayers to determine their own tax liabilities based on the tax laws applicable at the relevant time. In some cases, the delay between a media release announcing a change to the law and the introduction of the amending legislation has been so lengthy that the legislation implementing the announcement has not appeared in the time for lodgment of the affected taxpayers' income tax returns. As a result of the above "legislating" by press release undermines confidence in and respect for the rule of law and the tax system. In order to illustrate the concerns we have expressed about the practice of legislating by press release we have included a particular example that illustrates those concerns in an Appendix A to this submission. It is submitted that with better policy development following consultation and with better drafting, it should be possible to address tax changes in a single prospective bill. Where the Government decides to legislate by press release it should explain at the time of the media release why it has chosen to use this technique. The need to provide an explanation would impose a useful discipline, which should help ensure that the technique is only adopted when the need is genuine. The explanation should also help taxpayers to understand the reasons behind setting the date of effect at the date of the announcement. The Taxation Institute acknowledges that legislating by press release may be justified where the change is a simple one (as, for example, in the case of a change of tax rates), where the revenue consequences are dramatic or where a tax avoidance scheme which is viable under existing law has to be struck down immediately. However, occasions for legislating by press release should be rare. It is an admission of defeat for the system. Routine tax legislation affecting business should only come into effect after affected taxpayers have had sufficient time to study the legislation and to understand its impact. Preferably, this should be no earlier than the date of royal assent. The taxation Institute supports the adoption of the criteria listed in paragraph 7.23 of "A Strong Foundation" for determining whether the commencement date of legislation should precede the date of Royal Assent. 3.7 Legislative Gap Filling by Public Rulings The Taxation Institute believes that an efficient ruling system is now vital to the administration of the business tax system. This arises because of the complexity of the law and the certainty that should be gained from knowing the Australian Taxation Office"s position. There are however practical deficiencies inherent in the structure of the present ruling system. 26 Senate Standing Committee for the Scrutiny of Bills, Annual Report 1986-87, Parliamentary Paper No. 443 of 1987 at p 12. 3-26 The Taxation Institute has seen an comprehensive Discussion Paper prepared by Professor Graeme S Cooper of the Faculty of Law, the University of Melbourne Improving the Operation of the Income Tax Ruling System dated December 1998. This paper under the auspices of the Australian Society of CPAs is a most useful contribution in addressing the deficiencies of both public and private rulings in Australia. The Taxation Institute generally endorses Professor Cooper"s findings. There are however some points to which we would like to add emphasis. 3.7.1 A Lack of Certainty The binding ruling system was introduced to promote certainty for taxpayers. However, as the Bellinz case27 has revealed, not all rulings fulfil this objective The first problem with the binding public ruling system is that the rulings are only binding on the Commissioner where the arrangement in question is precisely similar to that ruled. In the opinion of the Taxation Institute rulings are required to have broader scope to deliver the practicality the system requires. This problem is exacerbated by qualifying terms in rulings It appears that a binding ruling qualified in some way gives the Commissioner sufficient latitude to discriminate against arrangements that are in substance the same but not "precisely similar" to those ruled on. Mr Justice Merkel made the following observation: "By making a ruling that states that it is binding "to the extent it is capable of being a public ruling", or that a particular arrangement is "likely to be regarded as a hire purchase arrangement", or the tax treatment of a particular arrangement is to be "generally" as outlined the Commissioner is not providing the certainty that binding rulings are intended to provide. Further, rulings in such terms obviously have a tendency to mislead, which is antithetical to the system of certainty and fairness provided to taxpayers by the public ruling system." (Emphasis added). [98 ATC 4399, at 4417] Perhaps it can be said that most public rulings of the past do no more than indicate what the Commissioner is likely to do. Correction of this uncertainty in current and future rulings does not cue the past. In recent cases, namely Crommelin, Mercantile Mutual Insurance and Steele, the Commissioner advanced arguments in court that contradicted the philosophy enunciated in certain public but non-binding rulings. What these cases reveal is that the Commissioner does not necessarily follow the "black letter" of his own non-binding rulings. More importantly it seems that there is nothing in the law to prevent the Commissioner departing from his rulings in this manner. The Taxpayer"s Charter, which states that the Australian Taxation Office can be expected to "give you advice and information that you can rely on" must now seem as being heavily qualified. It is submitted that underlying rulings there is generally a philosophy either to permit or proscribe, as the case might be, specified tax outcomes. To the extent that rulings enunciate such a philosophy the Commissioner should be bound to adhere thereto during a ruling"s currency in respect of arrangements that are substantially the same as those the subject of the ruling. 27 Bellinz v F C of T 98 ATC 4399 3-27 Another problem with the public ruling system is the lack of a process for contesting public rulings directly. Taxpayers should be able directly to challenge public rulings. At present taxpayers can either seek a private ruling on the same arrangement as the public ruling or proceed with the transaction and challenge their tax assessment. In the view of the Taxation Institute, much of the uncertainty in the wording of public rulings and the capacity for the Commissioner to endorse or reject them accordingly would be resolved if the rulings were taken out of the purely administrative arena and made disallowable instruments of Parliament. The present system of tabling public rulings does not go far enough and Parliament should have the power to disallow public rulings where, for example, a ruling is at odds with the law. It is also submitted that non-binding public rulings issued before the binding public ruling system should afford taxpayers at least the same protection as binding public rulings. The formal introduction of a doctrine of reasonable expectations would address this. 3.8 The Desire for Private Rulings to Attain Certainty With respect to the specific proposals canvassed in the Discussion Paper the Taxation Institute is broadly in agreement with the proposals. Specifically the Taxation Institute supports the proposal to extend the binding rulings system to questions of fact, procedural or administrative matters. The suggestion that the Commissioner should be permitted to base a ruling on information obtained from sources other than the applicant seems acceptable, provided that information is made available to the applicant for comment before the ruling issues. It is equally acceptable for additional information to be presented before Courts or Tribunals in any review of a ruling. The case for charging for private rulings needs to be made out more fully. Most ruling applications involve considerable effort and often expense on the part of the applicant. Imposing additional expense may price rulings beyond the reach of some taxpayers. It seems difficult to accept the suggestion that frivolous ruling applications are being made and that charging might curtail such applications from being made. Importantly the Commissioner is not required to rule if the application is frivolous. As far as the public purse is concerned it should be understood that many taxpayers incur considerable expense in fulfilling their role as unpaid tax collectors of PAYE, PPS, Non-Resident and Resident Withholding Taxes to name a few. These burdens don't fall evenly on the taxpayer community. Similarly the system of private rulings should promote greater voluntary compliance with tax laws, thus reducing enforcement costs that might otherwise be incurred at a cost to the public purse. In the alternative if these charges were to be introduced, they should be applied in engaging external non-Australian Taxation Office advisers. Furthermore, as the taxpayer is bearing the cost, applicants should be allowed to jointly brief the adviser and receive a copy of the advice. It is difficult to comprehend why private rulings seem to take an inordinate amount of time to issue. It appears that the TAA is predicated on the assumption that ruling applications would generally be ruled on within 3 months, and in the 3-28 exceptional cases requiring the Commissioner to apprise the applicant of the reasons for the delay 28 . Often the commercial sensitivities are affected by the delays: in the Bellinz case the ruling was issued 9 months after the application was made. It is not the only example. The Australian Taxation Office backlog is large and growing. A review (perhaps by the proposed administrative board) should be undertaken of what is causing these delays. The suggestion to set a time limit after which in a negative ruling would be deemed to issue: this forces taxpayers into litigation far more frequently than is currently the case and at greater expense. On balance, the Taxation Institute does not support such a proposal but something must be done to end the unacceptable delays in this area. "Forum shopping" is perhaps the manifestation of the varying degrees of the Australian Taxation Office"s independence. That is to suggest that some Australian Taxation Office officers apply the law while others toe the "party-line". Such an inference could also be drawn from the Australian Taxation Office"s practice of "embargoed topics", areas of unsettled law in relation to which the Australian Taxation Office essentially refuses to rule. The practice of embargoed topics surely must be the antithesis of why a ruling system exists in the first place. The Taxation Institute submits that the law should be amended to require the Australian Taxation Office to publicly report on private ruling requests still outstanding after 6 months, including details of the area of law involved. The Taxation Institute supports the proposal to introduce a database of the technical content of private rulings. Further the Taxation Institute supports the proposal to permit a kind of "class order" private ruling, for instance to allow employers to obtain a ruling on how employees participating in an employee share plan are likely to be taxed. 3.9 Reasonable Expectation One of the impediments to certainty (and equity) in the Australian Taxation System at the present time is the continual need for the Australian Taxation Office to administer the law in ways that do not abide with the exacting requirements of the taxation legislation. Some alleviation of these concerns could be made if a notion of materiality was endorsed as a principle for attaining a more efficient taxation system. Outside of this, there is a need for the adoption of a doctrine of reasonable expectation. This doctrine would operate as a basis of estoppel against the Australian Taxation Office from departing from positions, which have induced reasonable expectation of concessional behaviour from the Australian Taxation Office. Most significantly, this would assist taxpayers by providing certainty when relying upon public rulings that are merely administratively binding. Bellinz serves as a timely reminder that placing reliance on the administrative practice of the Commissioner may leave one vulnerable to the discretionary withdrawal of that practice – see also David Jones Finance v FCT 91 ATC 4135. But there are other circumstances where the doctrine may be usefully applied, particularly where the Australian Taxation Office has adhered consistently to a course of conduct in assessing the taxpayer or taxpayers generally and has allowed a reasonable expectation to develop among taxpayers or their agents that the law will be applied in a particular way. These arrangements might be described as 28 Sec. 14ZAO TAA 3-29 "extra statutory concessions" and if, unlike the United Kingdom, the Australian Taxation Office is reluctant to admit the existence of these practices formally, the development of a doctrine of reasonable expectations will provide some degree of certainty for the taxpayer against the possibility of that taxpayer being singled out for distinctive treatment for reasons that are collateral to the matter under consideration. Whilst there is a clear role for administrative practice to address anomalies and the "grey areas" in the law, it should only ever be a stop gap measure until legislation can be framed. 4-30 4 4.1 OTHER ADMINISTRATIVE ISSUES Taxation dispute resolution The Taxation Institute welcomes a review of the methods of dispute resolution addressed in the Discussion Paper.29 The willingness of the Australian Taxation Office to subject disputes to mediation is long over due. Mediation in taxation disputes could have wide application. Furthermore, resort to arbitration (as distinct from the existing formal review and appeal processes) may well be efficient in cases where the taxation outcomes turn on such matters as apportionment of cash receipts or payments over particular heads or in the case of valuations. In the context of the appeal processes, there is a significant deficiency in the existing arrangement in that a question of fact determined by the Administrative Appeals Tribunal cannot be reviewed upon appeal to the Federal Court. This, as is noted in para 8.20, has lead to considerable inefficiencies and is believed that justice would be better served (or at least made more efficient) if the restrictions on the jurisdiction of the Federal Court were lifted. 4.2 Interaction of Income tax with other taxes FBT is a prime example of the difficulties that result from an abandonment of principle. It taxes the employer on the income in kind of the employee. The capacity to attribute fringe benefits to employees on group certificates now exists and the opportunity now arises to abolish this tax. FBT is without doubt the most unpopular tax introduced in the last 20 years. Some reasons for this are: The lucky recipient of the benefits is not taxed on any non-cash benefits they receive as a result of their employment; the employer not only has the expense of giving those benefits 30 to the employee: he must also pay the tax; but not all employers pay the tax so giving rise to tax arbitrage opportunities and market distortions; the legislation is very complex; many things not normally considered to be benefits are legally taxable; and the employer is totally exposed, in terms of penalties, for FBT record-keeping errors and fraud perpetrated by the employee. 4.2.1 Abolition of Fringe Benefits Tax This behaviour is exacerbated where the employer enjoys preferred FBT status, as is the case with health care and charitable organisations. 29 30 A Strong Foundation paras 8.9 and 8.18 to 8.24 Anyone can become a provide of fringe benefits, although most usually the provider is also the employer. However, it is the employer who is always responsible for paying the FBT, even where that employer has no direct knowledge of the arrangements. See the very wide definitions of "arrangement" and "fringe benefit" in section 136(1) of the FBTAA. 4-31 The Taxation Institute calls on the Review to give business a break: recommend the repeal of FBT. There is no other single measure (including the introduction of a GST) which would restore small business confidence as much as the repeal of this hated tax. We advocate the introduction of new income tax law which taxes employees on benefits received from employment, based on amounts shown on the group certificate and having the following features: simple, readable law which is not overly prescriptive; taxes specific benefits only - those which might loosely be termed "salary packaging": cars, generally using a formula method similar to the FBT "statutory method"; non-remote housing - based on actual cost; goods and services provided to employees at below the employer's cost, where the total provided was above a certain monetary threshold. (This would cover the cheap airline tickets given to airline employees, and low-interest loans. Employees could claim deductions for work-related expenses - such as depreciation on free laptops, a portion of holidays with a small work element, etc); forgiveness of debts greater than a certain monetary amount; and any personal expenses paid by the employer on behalf of the employee. Examples include telephone bills, school fees, overseas holidays, home loan interest etc. The employee could then claim any work-related deductions against that amount in his own tax return - for example, for work-related telephone calls; all the above specifically-taxed items would appear on the employee's PAYE group certificate, and be taxed to the employee on his tax return. This approach is already being considered to prevent erosion of the Superannuation Surcharge. The income could be subject to the pay as you go system, and the appropriate tax would be paid quarterly by the employee; reasonable (defined using a standard monetary amount for various localities) living-away-from-home allowances paid in cash would be exempt from income tax; all other benefits from the employer would be tax-free.31 The sorts of benefits which would no longer require record-keeping, by any party, would include: all remote housing and allied benefits housing while living-away-from-home all expenses related to relocation for work purposes occasional use of employer-owned equipment and consumables 31 benefits received from third parties - such as holidays provided to motor vehicle dealer salesmen by the motor vehicle manufacturer - would be subject to tax under existing section 21A of ITAA 1936. Indeed, aspects of this law could serve as a model for the proposed new law for employees 4-32 and indeed all the numerous exemptions which are currently spelt out in great detail but which could now be ignored completely by everybody including the legislators; employees take responsibility for their own income (both cash and non-cash) and have a full understanding of how they are taxed. The resources released to the Australian Taxation Office by the abandonment of FBT could be deployed in a more thorough audit of employees" returns where claims for work related expenses are already of concern. The relationship between FBT and income tax for expatriates (both Australians going overseas and foreigners coming to Australia) has always been one of the shadowy areas of the law 32 . This topic will require careful thinking in the development of any new law, as expatriates (of both types) are often influential people and the personal image they carry of Australian tax laws has wide implications for our international trade. But the distortion and potential for double taxation arising under FBT should be ended. The Taxation Institute believes the above model is an equitable basis upon which to rebuild the taxation of employee benefits. We strongly recommend that the Review seriously considers this proposal, even though is differs very markedly from the current model. Only bold action will restore principle and common sense to this important area of the law. 4.3 Integration of Taxpayer Compliance with other taxes, including GST The proposed goods and services tax is, strictly speaking, outside the scope of the reviews or reviews enquires and recommendations. However it must be recognised that if compliance costs are to be restrained, it is essential for common rules to be evolved with respect to both systems. This applies at many levels but a simple example will suffice to illustrate the need to avoid duplication of effort or the negation of initiatives for limiting compliance in one tax through the more strict demands of another: Suppose a taxpayer engaged in business operates a motor vehicle. For the purposes of the income tax law he is presented with a range of options to modify the strictness of his obligations in demonstrating that the motor vehicle costs he claims as an allowable deduction are costs attributable to the business use of the vehicle (and not private use). But this taxpayer will also be seeking to claim credits for his input taxes under the GST on expenses attributable to the motor vehicle (such as repairs like fuel and the like). The modifications to the record keeping requirements in the substantiation rules would be negated if, for GST purposes, the taxpayer was obliged to track his expenditures to the last cent when claiming credits for input taxes. 4.4 Preservation of Taxpayer Rights The Review should note the attack being mounted on legal provisional privilege by the Commissioner in recent times. It is recognised that the Commissioner has difficulties with the self assessment system but the remedy is not an attack on the 32 Due to the lack of law. Expatriate taxation is a particularly specialised area, and many of the problems encountered are not covered, or are handled inadequately, by the present legislation. 4-33 rights of citizens in seeking legal advice which have demonstrated, over the centuries, that they bring benefits in the justice system that out weigh a short term inconveniences to bureaucrats. Conversely, the Charter of Taxpayers Rights remains as a wish list without any sanctions being imposed on the Commissioner for breaches by the Australian Taxation Office, whereas the taxpayers obligations under that charter are reinforced by penalty resumes within the taxation legislation, and under the administrative control of the Commissioner. Even handedness demands that the Australian Taxation Office be subject to culpable sanctions for failing to comply with the taxpayers charter. One such sanction might be exposure to civil liability for negligence in circumstances where the Commissioner has failed to give a ruling or has mislead a taxpayer as to his position in a ruling leading that taxpayer to loss or damage. 5-34 5 CONCLUSION The Taxation Institute thanks Review the opportunity of responding to A Strong Foundation. We trust the forgoing has addressed areas of concern and that the recommendations of the Institute will be given their due weight. If there are any issues on which further amplification is required, please contact: Mr Geoff Petersson Taxation Institute of Australia 7th Floor 64 Castlereagh Street SYDNEY NSW 2000 Tel: (02) 9232 3422 Fax: (02) 9221 6953 Email: firstname.lastname@example.com Appendix A 6 6.1 DISADVANTAGES OF RETROSPECTIVE LEGISLATION IN THE CONTEXT OF TAXATION LAWS AMENDMENT (TRUST LOSS) BILL 1997 Introduction Legislation by Press Release and retrospective legislation has become a fact of life in the area of taxation law. In the last decade, tax legislation commencing on the date of Royal Assent is the exception rather than the rule. More often than not, taxation legislation will apply retrospectively from the date it has been announced. Trust losses is no exception. The measures to combat "trafficking in trust losses" were announced by the former Treasurer, Ralph Willis, in the 9 May 1995 Budget. When the first draft of the proposed trust loss measures were initially introduced into Parliament on 28 September 1995 as part of Taxation Laws Amendment Bill (No 4) 1995, it was clear that the draft legislation not only attacked "trafficking in trust losses", but constituted an attack against the use of trusts in general when no trading in losses was involved. Although the provisions are conveniently referred to as the "Trust Loss" provisions, they not only affect carried forward losses but bad debts and all other current year allowable deductions to the trust. In CC (New South Wales) Pty. Limited (In Liquidation) -v- FC of T 97 ATC 4123 the Federal Court considered the operation of Part IVA in the context of a scheme aimed at utilising trust losses. Mr Justice Sackville after making a comprehensive review of the operation of Part IVA, by way of obiter indicated that Part IVA would have applied to the arrangement in that case. The decision indicates that Part IVA would defeat blatant artificial contrived arrangements seeking to take an unintended advantage of trust losses and, therefore, brings into question the need for the complex trust loss provisions of the kind that have now been introduced. The general criticism made of retrospective legislation and "legislation by Press Release" and their application to the Trust Loss provisions are broadly summarised as follows: It involves a usurpation of Parliament"s legislative power by the Executive. "It placed Parliament in the invidious position of either agreeing to the legislation without significant amendment or bearing the odium of overturning arrangements which many people may have made in reliance on the ministerial statement." (Senate Standing Committee for the Scrutiny of Bills, Annual Report 1986-87, Parliamentary Paper No 443 of 1987, at page 12) The position described by the Standing Committee for the Scrutiny of Bills was very relevant to the passage of the Trust Loss measures. It took three years of review before a final form of legislation was formalised. Constantly, 2 throughout that process, Parliament, and in particular the Senate, had to consider the advantages and disadvantages of departing with the Government of the day"s Press Releases. The Press Release, does not generally conform to the draft legislation when introduced before Parliament. Another aspect of this criticism is that the press release is usually vague and unclear as to how the law will apply. Taxpayers and tax practitioners alike could be forgiven for thinking that the proposed amendments announced in the 9 May 1995 Budget were to attack trafficking in trust losses. However, as stated above, when the legislation was introduced before Parliament, it involved an attack on every deduction and every loss claimed by a trust. The announcement in the 9 May 1995 Budget was not clear as to how the proposed measures to attack "trafficking in trust losses" were to apply in general. There is an excessive delay between the time of the announcement and the introduction of the draft legislation. The measures were announced on 9 May 1995 but were not passed by both Houses of Parliament until April 1997. The fate of taxpayers and tax advisors alike in coming to terms with amendments regarding trust losses begins with the analysis of the history of events leading up to passing of Taxation Laws Amendment (Trust Losses) Bill 1997:6.2 History of the Trust Loss Measures Budget 1995 -9 May 1995 The Labor Government announce that measures will be introduced to stop trafficking in trust losses. 28 September 1995 Taxation Laws Amendment Bill (No. 4) introduced which contains the first trust loss provisions in Bill form. These measures do not become law. Budget 1996 - 20 August 1996 The Coalition Government announce that the trust loss provisions are to be re-drafted and amended. Some of the proposed measures widen the scope of the former Government"s proposals. 10 February 1997 The Treasurer releases Exposure Draft legislation titled "Proposed Measures Dealing with Trust Losses" Budget 1997 - 13 May 1997 3 Further changes are announced restricting the measures as they impact on family groups. 1 October 1997 Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997 (150 pages) introduced together with three other Bills, Family Trust Distribution Tax Primary Liability Bill 1997 Family Trust Distribution Tax (Secondary Liability) Bill 1997 Medicare Levy Consequential amendment (Trust Loss) Bill 1997 23 October 1997 Bills passed by the House of Representatives without amendment. 6.3 Latest Changes Several fundamental changes were made by the Senate concerning the application of the provisions for family trusts. The Bill received Royal Assent on 16 April 1998. 6.4 Lodging Tax Returns In Light Of The Above History The indicative cost of legislation by Press Release in the case of the Taxation Laws Amendment (Trust Losses) Bill 1997 can be seen in an examination of beneficiaries and trustees obligations to lodge income tax returns and what beneficiaries and trustees have to contend with in complying with their tax return lodgement obligations. The returns of beneficiaries and trustees for the years between the announcement of the trust loss measures from May 1995 to April 1998 together with the likely due dates for lodgement of those returns is described in the following table: Tax Return for year ended 30 June 1995 1996 1997 Return lodged by Tax Agent 31 March 1996 31 March 1997 31 March 1998 Non Tax Agent lodged Return 31 October 1995 31 October 1996 31 October 1997 We also note, that most trustees must resolve by 30 June of each year how the net income of the trust is to be dealt with. Preparing and Lodging 1995 Income Tax Returns The 1995 Budget was handed down on 9 May 1995, approximately one and a half months before year end. The Press Release stated that the proposed measures were 4 only to attack "trafficking in trust losses". As such the typical beneficiary and trustee of a small trust and their advisors did not generally consider that the announcement affected them. Ordinary transactions and income distributions concerning trusts were not considered to be trafficking in a trust loss. Most tax advisors viewed the announcement as an attack on selling loss trusts and various other schemes and variations of that theme involving a transfer of the benefit of a trust loss to an arm"s length third party. There was no mention in the press release that dealings within family groups would be affected. In fact the family trust election appeared to confirm this view. Hence, in reliance of the Treasurer"s announcement, the trustees of these small trusts would have resolved to distribute income in a particular way oblivious of any affect it may have on their deductions and carried forward losses. By the time the legislation was initially introduced on 28 September 1995 it was clear that the measures were a direct attack on the deductions and losses within all trust whether there was a tax avoidance motive or not. This left beneficiaries and trustees who did not have a tax agent less than one month to attempt to understand the Trust Loss Bill and how it impacted on them. Notwithstanding, as most of the tests that had to be satisfied in the Trust Loss provisions revolved around who received a trust distribution, it was already too late to do anything about the measures. The resolution to distribute income had already happened at 30 June 1995. Even so, when the draft legislation was introduced the concession concerning family trusts was practically irrelevant. Under the original draft legislation, the family trust concession only applied where all of the beneficiaries of the trust were within the same family group. Nearly every discretionary trust and many fixed trusts had charities and companies which beneficiaries had a share or interest in as potential beneficiaries of those trusts. Consequently, nearly every non fixed trust (discretionary trust) could not be a family trust. Taxpayers relying on the draft legislation and Press Release would have to amend their trust deeds to remove the offending beneficiaries to come within the family trust election as it stood then. Some new trusts set up after the introduction of the first draft confined the beneficiaries to the family group. Amendment of existing trust deeds to be within the family trust concession could have resulted in severe capital gains tax liabilities because any amendment to a trust deed could potentially be considered to be a resettlement of the trust. On resettlement of a trust, one view is that the trust disposes all of its assets for capital gains tax purposes and re-acquires them. Under the capital gains tax provisions, the disposal and re-acquisition occurs at market value. If that occurred, all the unrealised gains on those assets would become subject to capital gains tax. Those that did amend their trust deeds in reliance of the initial draft still face that risk of a re-settlement of the trust. The most difficult test in the draft provisions to overcome in the original draft Bill and presently in the final form of the legislation is the "income injection test". As announced in the Treasurer"s Press Release on Budget night, it was stated that a 5 trust will fail the income injection test if it is clear that "trust losses are trafficked under an arrangement". The elements of the test were set out as follows: "(a) consideration has been, or will be, given under an arrangement to the trust or to a person connected with the trust; the consideration is different from that which would have been given at arm"s length under the arrangement if there were no trust losses; the trust derives assessable income that is sheltered by the losses; and a person not connected with the trust, or who became connected with the trust under the arrangement, derives a benefit under the arrangement." (b) (c) (d) The test as originally drafted deviated from the Press Release as only paragraphs (c) and (d) needed to be satisfied (refer sub-section 270-10(2)). What this meant was that taxpayers relying on the 9 May 1995 Press Release could have at 30 June 1995 made a distribution which ultimately offended the "income injection test" as it subsequently appeared in the draft legislation. We point out that the draft legislation was released on 28 September 1995, some few months after 30 June1995 but, made retrospective to 9 May 1995. Again, those taxpayers that had tax agents were in no better a position because nearly every trust deed required that the trustee resolve to distribute the income on or before 30 June that year. Consequently, beneficiaries and trustees preparing their 1995 returns had to contend with the inconsistencies between the Press Release and the draft legislation, in addition to coming to terms with such a complex piece of legislation in a short period of time. The majority of these taxpayers had to consult their advisors and spend significant amounts of money for tax advice just to lodge their 1995 return and review their affairs for future years. The transitional provisions did not assist in any significant way and did not deal with any inconsistency between the Press Release and the original draft legislation. To add insult to injury, beneficiaries and trustees who lodged their returns through a tax agent were required to lodge their return by 31 March 1996. Although they had more time to come to terms with the draft legislation, Parliament had been dissolved prior to 31 March 1996 and the Bill containing the trust loss measures had lapsed. This left taxpayers in the onerous situation of either preparing their returns and planning their affairs having regard to draft legislation which may or may not have been adopted by a subsequent government or continuing to prepare the returns and plan their affairs as if the legislation did not exist. There was also no statement as to the likely penalties if taxpayers had underpaid their tax for the 1995 year as a result of the enactment of the original draft of the Trust Loss Bill. Preparing and Lodging 1996 Income Tax Returns By March 1996 there was a change in government. The new Coalition government announced that they were reviewing the position in relation to the Trust Loss Bill. On 20 August 1996 in the 1996 Budget, the Treasurer, Mr Costello, 6 announced that the Coalition were to re-draft the trust loss provisions. Some of the proposed measures widened the scope of the former government"s proposals such as the extension to the trust loss provisions to cover bad debts claimed by a trust. Nevertheless, the Coalition government announced changes to the family trust election concession to give it broader application together with some token relief for trusts which are jointly owned by arm"s length parties. Again, trustees had to resolve by 30 June 1996 where the net income of the trust was to be distributed. These distributions had to be made in absence of the Coalition government"s announcement. A second draft of the provisions was not released until 10 February 1997. Non tax agent lodged trust returns and returns of beneficiaries had to be lodged a few months after the Coalition government"s Budget announcement but long before any draft legislation was released. Tax agent lodged returns had approximately a month and a half to come to terms with the new legislation. Notwithstanding, at the time of the 1996 Budget and the release of the draft legislation, it was all too late. Trustees had to make their resolutions prior to 30 June. At 30 June 1996, the trustees were faced with the prospect of the legislation being reintroduced in its original form or taking a risk that the new government would amend it in a manner that would assist them. Trustees also had to spend significant amounts of money on legal and or tax advice in order to deal with the intolerable situation of not having any firm idea as to the final form of the trust loss measures. At about this time, it became apparent that entrepreneurs seeking to start up new businesses could not be advised to put those businesses in a trust if those businesses were going to make losses in the earlier years. No tax advisor could give any opinion as to whether the losses incurred in the earlier years were to be deductible in later years. Taxpayer arranging their affairs in accordance with the initial draft of the trust loss measures could conceivably pay more tax than those who waited to see the Coalition"s draft. Nevertheless, the income injection test still stifled distributions of income within family groups. The only "outsider to the trust" was the trustee. Consequently, even though the situation was fairer in 1996, it did not assist many taxpayers. Preparing and Lodging 1997 Income Tax Returns By 30 June 1997, trustees and beneficiaries alike had a better idea as to the final form of the Trust Loss Bills. It was also not until October 1997 that any statement was made as to what taxpayers should do if they have lodged their returns in a manner inconsistent with the proposed trust loss measures. In the Explanatory Memorandum to the October 1997 Bill at paragraph 2.13: "Taxpayers may have quite properly lodged returns for the 1994-1995, 1995-1996 and 1996-1997 without regard to the proposed trust loss measures. 7 However, taxpayers may be obliged to amend their returns for these income years if the commencement date of the trust loss measures affects the validity of the deductions claimed in those years. The Commissioner will not seek to apply penalties and interest against any underpayments of tax provided returns are amended within a reasonable time after the measures became law. If amendments are not made promptly, the normal penalty interest provisions apply." However, no provision in the Bill nor any statement by the Commissioner of Taxation either affirms or denies the statement made in the Explanatory Memorandum. There was no guidance as to what a reasonable period of time is and no statement as to which penalty and interest provisions will apply if taxpayers have lodged outside a reasonable period of time. In an environment of self assessment, this uncertainty is intolerable. Further, the introduction of these measures have placed costs on taxpayers to positively take action to amend their income tax returns for the 1995, 1996 and 1997 years of income. Trusts that are jointly held by unrelated arm's length parties A common structure prior to the introduction of the trust loss measures was a unit trust which was equally held by two unrelated arm"s length parties. The holding of the units in the unit trust are often held by those parties" family discretionary trusts. The original Press Release in the 1995 Budget did not allude to the fact that fixed trusts which are held by discretionary trusts would be treated in exactly the same manner as a discretionary trust. Notwithstanding, this structure was common in the case of property holdings. A rental property or investment property would be held in the unit trust which was jointly owned by the family discretionary trusts of two unrelated parties. These property holding unit trusts would often make losses. Income being the rental would be insufficient to fund the cost of borrowings to acquire the property. Consequently, to ensure that the unit trusts had sufficient funds to meet the interest commitments, the discretionary trusts would distribute income to the unit trust. There would typically be a time lag between the distribution and the payment of the distribution. The introduction of the trust loss measures placed these sort of arrangements under peril. The discretionary trusts could no longer distribute income to support the unit trust because the unit trust would more than likely fail the income injection test once it received the distribution. Further, for arrangements that existed prior to 1995, the discretionary trusts could also fail the "pattern of distributions test" once the distributions to the unit trust ceased. Hence, losses in both a discretionary trust and unit trust could be denied. The family trust election was also of no benefit because no family group had control of the unit trust. Consequently, no interposed entity election could be made by the unit trust. The transitional measures to remove this difficulty provided little comfort because it only applied to the 50% Stake Test. There was no attempt to alleviate the problem as far as the income injection test was concerned. 8 As a result of the introduction of trust loss measures, the parties concerned had at least three choices: wind up the arrangement by selling the property and distributing whatever gain was made on the sale of that property to the relevant parties and paying any capital gains tax; continue with the arrangement and lose the interest and other deductions in relation to the rental property; One of the unrelated parties would take control of the unit trust and make the appropriate family trust and interposed entity elections. The party not covered by the family trust and interposed entity elections would have to be compensated for the fact that it could not distribute income to the unit trust. 6.5 General Comments and Conclusions We point out that taxpayers must lodge their returns in an environment of the self assessment system. Ideally, under the self assessment system, taxpayers should be in a position to self assess their tax liabilities with a significant degree of certainty. Introducing legislation which impacts on deductions and losses incurred by trusts which is unclear, confusing and difficult to understand even as far as a tax advisor is concerned, is inconsistent with the idea of self assessment. The timing of the introduction of the amendments did not assist either taxpayers in complying with the tax law. Further the raising of revenue was delayed. As the original draft legislation was both difficult to understand and widespread in its effect, it generated an outcry from the profession and taxpayers alike. The discussion which was generated between government, the profession and taxpayers ultimately contributed in the delay to the passage of the legislation and the collection of any revenue. Presently, there is much debate over the form of the tax system as far as trusts are concerned. A result of the reform of the taxation system concerning trusts could result in further changes to the trust loss measures. Although, we appreciate the government"s intention to stamp out tax avoidance as quickly and efficiently as possible, we do not consider that the decision to issue a Press Release took into account the fact that the ultimate form of the legislation was attacking a broad spectrum of commercial transactions. We do not consider that the Government balanced the aim of stamping out tax avoidance against the uncertainty caused to legitimate commercial transactions involving trusts in general. We point out that those trafficking in loss trusts were the minority group of taxpayers affected by the draft legislation. The anti avoidance measures announced often impinged on legitimate commercial transactions which involved trusts. As highlighted above, the Trust Loss measures added a further level of complexity to the consideration of the taxation issues affecting most transactions involving trusts. Tax 9 Advisers had to consider the effect of the provisions in every transaction involving a trust without any certainty of the final form of the Trust Loss Bill. In addition, those taxpayers with access to sophisticated tax advice, are more capable of arranging their affairs so as to maximise the effect of any concessions to minimise the effect of the anti avoidance provisions. 10 Appendix B 7 Carry back of company losses The Asprey Report 33 in 1975 recommended that the carry back of losses be permitted. At present, under Australia's tax laws, losses may be off-set against income/gains earned in the current year of income, with any unutilised losses being carried forward into subsequent income years to be off-set against later income/gains. This approach recognises that in the early years of a business, losses may occur which may be used to off-set against later profits. However, it fails to recognise that losses occurring during an economic downturn following a profitable period of economic activity distort the appropriate level of taxation that a taxpayer should be subjected to over the medium to longer term. This distortion of the appropriate level of taxation is already recognised in the averaging of income provisions available to artists, composers, inventors, performers, production associates, sportspersons and writers under current tax laws. In exactly the same way, a system of carry back of losses recognises that it is not always appropriate to levy tax for one year of income without regard to previous years. In 1975, the Asprey Committee acknowledged this problem by making a recommendation that the law be amended to allow a carry back of losses for a period of two years. In addition, the carry back of losses has been permitted in a number of other countries for some years. Both the US and UK have well established regimes for loss carry back. In both the UK and the US, losses are permitted to be carried back for up to 3 years. At the present time, other countries with loss carry back provisions include France, Germany, Hungary, Ireland, The Netherlands and Norway. In view of this precedent, it is proposed that both income and capital losses should be allowed to be carried back. A possible model might be one where the period of carry back would initially be for 1 year, with an extensions to 2 and 3 years introduced progressively over a 4 year period. This would mean that after 2 years the carry back period would be extended to 2 years, and after 4 years" operation, the carry back period would be extended to 3 years. The approach would limit any impact on the Revenue. The cost to Revenue is one that arises from timing issues, rather than a permanent loss to Revenue. Appropriate safeguards should be introduced to prevent the utilisation of losses by unrelated entities, and in circumstances where there has been a prior change in ownership. In addition, under the current system of imputation, a corporate taxpayer would be required to make appropriate adjustments to the company's franking account to reflect the adjustment in assessable income for the relevant income year of the entity. It is proposed that a company would only be able to take advantage of carry 33 Chapter 8 11 back of loss provisions if that company has an excess of franking credits in its franking account at the relevant time. The loss carryback measures should also extend to capital losses incurred by business taxpayers. Appendix C Generic Tax Policy Process STRATEGIC PHASES 1-3 Output from phases 1-2 widely publicised by Government -–possibly through Budget documentation 1. Economic Strategy* Reconciliation with other Government Objectives 2. Fiscal Strategy* TACTICAL PHASES 4-5 Phases 3-5 are linked with the Budget process and have a high degree of simultaneity 3. Three Year Tax Review Strategy* 4. Rolling Three Year Work Program* EXTERNAL INPUT External input, as appropriate, through Green Paper (ideas) stage and/or through White paper (detail) stage by either: 1. Secondment of personnel from private sector; 2. A permanent advisory panel; 3. Issues based Consultative Committees; 4. Submissions on Consultative Document. 5. Annual Work and Resource Plan* OPERATIONAL PHAES 6-8 6. Detailed Policy Design* 7. Formal Detailed Consultation & Communication 8. Ministerial and Cabinet Sign-off of Detailed Policy* 9. Legislative Drafting (phases 6-12) LEGISLATIVE PHASES 9-13 10. Ministerial and Cabinet Sign-off of Legislation* Issues encountered at later stages of the process, and decisions taken to change policy, may lead to reconsideration of earlier phases 11. Introduction of Bill Consultative committee may be required to explain the intent of their recommendations to Select Committee 12. Select Committee Phase 13. Passage of Legislation IMPLEMENT AND REVIEW PHASES 14-16 14. Implementation of Legislation 15. Post Implementation Review 16. Identification of Remedial Issues * Cabinet Decision
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