Bills Digest No. 80  1999-2000 New Business Tax System (Integrity and Other Measures) Bill 1999


Numerical Index | Alphabetical Index

WARNING:
This Digest was prepared for debate. It reflects the legislation as introduced and does not canvass subsequent amendments. This Digest does not have any official legal status. Other sources should be consulted to determine the subsequent official status of the Bill.

CONTENTS

Passage History
Purpose
Background
Main Provisions
Endnotes
Contact Officer and Copyright Details

Passage History

New Business Tax System (Integrity and Other Measures) Bill 1999

Date Introduced: 21 October 1999

House: House of Representatives

Portfolio: Treasury

Commencement: Royal Assent. However, for the application dates of the various measures discussed in this Digest, refer to the Main Provisions section.

Purpose

To:

  • amend the capital gains tax regime:
  • to remove the indexation of the cost base for such gains
  • reduce the amount of capital gain to be included in income for individuals, complying superannuation entities and trusts, and
  • introduce more favourable rules for the realisation of capital gains from small business assets
  • introduce various anti-avoidance measures to both improve the integrity of the taxation system and prevent abuse pending the proposed enactment of fundamental changes to the system of business taxation.

Background

As the Bill has no central theme the Background to the various measures will be discussed below. Proposed changes to the system of capital gains tax, company taxation and its impact on individuals and other entities has been referred to the Senate Standing Committee on Finance and Public Administration, which is due to report on 26 November 1999. Also refer to the forthcoming Library publication Proposed Reforms of Business Taxation, A Critical Assessment of Some Budgetary and Sectoral Impacts by members of the Economics, Commerce and Industrial Relations Group of the Information and Research Service.

Main Provisions

Capital Gains Tax (CGT)

Where a capital item is disposed of (to be more correct a CGT event occurs), the asset was acquired on or after 20 September 1985 and is not exempt, CGT may apply. Assets are acquired for their cost base and where this amount is less than the value for which the asset was disposed of, CGT is payable on the difference. Where an asset is held for longer than 12 months the cost base is indexed for movements in the CPI (this amount is known as the indexed cost base), so that only real gains are subject to CGT.

Gains may be subject to the averaging rules, under which 20% of the gain is included in income to determine the marginal rate applicable to the taxpayer and the amount of tax payable on this amount is multiplied by 5 to calculate the total CGT payable. Averaging can result in less tax being payable where, with the inclusion of 20% of the gain the taxpayer is still below the threshold for the highest marginal rate (ie. 48.5% including the Medicare levy).

Capital losses are calculated in a similar manner and can only be offset against capital gains and not other sources of income.

CGT raised $3.7 billion in 1997-98, compared with $2.3 billion in the previous year.(1)

The terms of reference for the Review of Business Taxation (Ralph Review) in relation to business investment and CGT included to examine:

  • In relation to business investments, the extent of reform in the areas of physical assets, financial assets/liabilities and intangibles and the potential use of accounting principles, taking into account the following considerations-
  • The need to encourage business development with an internationally competitive tax treatment of business investments
  • The potential benefits of bringing tax value and commercial value closer together, and
  • The goal of moving towards a 30% company tax rate
  • In relation to capital gains tax (CGT), the scope for:
  • Capping the rate of tax applying to capital gains for individuals at 30 per cent, and
  • Extending the CGT rollover provisions to scrip-for-script transactions.

The Review was asked to achieve, in addition to revenue neutrality for the entire package, revenue neutrality in respect of changes to CGT.(2)

Prior to the delivery of the Ralph Report to the government on 30 July 1999, members of the government, and in particular the Prime Minister, emphasised the need for CGT reform to make Australia more attractive for foreign investment. Referring to Australia's nominally higher rate of CGT and its affect on Australia's ability to attract capital from the US the Prime Minister was reported as saying:

There is little doubt in my mind that our present capital gains tax does act as a disincentive in a number of areas and if we are serious about the exercise on which we are all collectively embarked .... then some fundamental changes will need to be made in that area.(3)

Ralph Report

The Report's recommendations on CGT were designed to:

  • Enliven and invigorate the Australian equity markets
  • Stimulate greater participation by individuals, and
  • Achieve a better allocation of the nation's capital resources.(4)

To achieve these ends the Ralph Report recommended:(5)

  • For assets disposed of after 30 September 1999 by an individual, the person have the option of including half the nominal gain on the asset (ie the gain without indexation) where the asset has been held for 12 months or more; or all of the gain calculated by deducting from the value of the disposal the indexed cost base as at 30 September 1999.
  • For complying superannuation funds disposing of an asset after 30 September 1999, they be able to include either 2/3 of the nominal realised capital gain or the full gain based on the disposal value less the indexed cost base as at 30 September 1999.
  • That capital losses be offset against either the realised nominal gain or, if the indexation method is used, against the gain calculated after the indexation amount is deducted. After these steps, any discount (eg the 50% reduction in gains to be included by individuals) is to be applied. It was recommended that the taxpayer have the choice of which gains the losses be offset against (giving an incentive to use losses first against gains calculated using the indexation method as it is frozen at 30 September 1999).
  • Special rules that would result in similar treatment would apply to trusts pending the introduction of entity taxation from 1 July 2000.

To offset the revenue loss the Report recommended:

  • Averaging be abolished from the time of the announcement of the measures (the Report found that averaging contributed little to the aims outlined above while reducing revenue substantially. It was also found that averaging can result in considerable inequity).(6)
  • Indexation of the cost base be frozen as at 30 September 1999 (fewer reasons were found for the removal of indexation, the major ground for its removal, besides the need for offsetting revenue, was that foreign investors perceive Australia to have a higher rate of CGT on nominal gains based on the published maximum rate rather than the rate as calculated only on the real gain. The Report states:

Such misconceptions are not easily corrected and a change in the form of concession to something more akin to the types of concession available abroad would, in the Review's judgement, be more effective in attracting investors to Australian assets.(7)

In relation to small business (ie. businesses with assets valued at $5 million or less), the Report noted the CGT concessions available for goodwill, where 50% of the gain is not subject to tax, and where businesses are disposed of and rolledover into another eligible business or used for retirement. The Report recommended that the 50% goodwill concession be made more generally available and apply as a general 50% reduction on the CGT payable on active assets. For small businesses operated as sole traders or partnerships, the reduction would apply after the CGT concessions described above for individuals were applied. The current concessions in respect of sales where the proceeds are rolledover or used for retirement would be deducted from this amount. In effect, small businesses would pay a maximum CGT of 25% of any gain.(8)

The Report also contained measures affecting CGT that are not included in this Bill. These include proposed CGT relief for script for script takeovers and the removal of CGT for non-resident exempt pension funds. These measurers do not have a retrospective commencement date and will commence on the passage of the relevant legislation.(9)

Government Response

The government's response to the Ralph Report was announced by the Treasurer on 21 September 1999 and accepted, in relation to CGT, the recommendations outlined above, with the reduction in the rate of CGT applying from 1 October 1999 and the indexed cost base being frozen as at 30 September 1999.

In addition, it was announced that the current retirement relief available on the disposal of a small business would be expanded. Currently, individuals who are small business operators through sole trading, partnership, private company or most trusts (various conditions apply depending on the operating vehicle used for the business), may be eligible to have up to $500 000 exempted from CGT. To be exempt the amount must relate to an asset that passes the active asset test and the amount exempted from CGT will be treated as an eligible termination payment (ETP) for purposes of the superannuation reasonable benefits limit. (The treatment of ETPs for calculating a person's RBL can be complex but taxpayers generally receive concessional treatment compared with other amounts.) To be eligible for the exemption where the taxpayer is under 55 years, an amount equal to that to be treated as an ETP, and so exempt from CGT, must be rolledover immediately in accordance with the tax laws relating to the general treatment of ETPs (basically the amount must be rolledover to a complying superannuation fund, approved deposit fund or a retirement savings account).

Under the 21 September 1999 announcement, assets held for 15 years or longer would be exempt from CGT where:

  • the taxpayer disposes of the asset for retirement and has reached 55 years or is incapacitated
  • the asset is an active asset at the time of disposal
  • the asset has been an active asset for at least half of the previous 15 years
  • the asset has been held continuously for 15 years or more, and
  • if the asset has been subject to rollover, other than due to compulsory acquisition, being lost or destroyed or due to a marriage breakdown, the period of ownership will recommence.

The announcement also states that 'The exemption will not affect a taxpayer's superannuation reasonable benefits limit.', although whether this is to be treated as an ETP or exempt is not made clear.

This measure will commence from 20 September 2000.(10)

Revenue

The estimates of the revenue effect contained in the Ralph Report for the above measures are:

 

2000-1

$m

2001-2

$m

2002-3

$m

2003-4

$m

2004-5

$m

Individuals

Static Cost*

-330

-300

-290

-310

-300

Revenue from extra realisations

540

530

500

480

400

Superannuation funds

Static Cost**

-140

-100

-110

-100

-100

Revenue from extra realisations

70

50

40

40

30

Other entities

Freezing indexation

10

40

50

60

70

Cost of converting income to capital

-20

-50

-100

-150

-180

Total

130

170

90

30

-70

*Freezing of indexation, abolition of averaging and 50% exclusion

**Freezing of indexation and 1/3 exclusion

Source: Ralph Report, p. 732.

The above figures are based on a number of estimates, the most controversial of which relates to the estimate of additional revenue from extra realisations. Research suggests that if the rate of CGT is reduced this will encourage people to realise gains that would not have been realised and that increases in the overall level of gain realisation due to the lower impact of the tax on the person realising the gain will result in additional revenue. While such a response has general agreement, argument arises as to the extent of this effect and how much additional revenue it will contribute to offset the lower rate of tax. As can be seen from the above Table, the revenue from extra realisations is crucial to whether the proposed changes are relatively revenue neutral.

The extent of additional revenue from the reduction in CGT rate will depend on the ratio of increase of activity to the fall in rate (the elasticity of the fall in rates). If this is -1 the revenue effect is neutral while a smaller figure would result in overall revenue loss and a larger figure in revenue gain. The estimates used in the Report approximate to elasticity of -1.7 in the first two years with a decline to a longer term ratio of -0.9. The basis for the figures was:

A study commissioned by the Australian Stock Exchange and provided to the Review concluded that translating the US literature into the Australian context would suggest a longer term elasticity of more than minus 0.9.

and

The Review believes that a strong response effect ought to be expected in both the short and long terms - especially in the short term. In the first two years of the measure the Review has estimated that, on average, there will be an increase of around 50 per cent on the normal rate of realisations of gains as asset holders who face a lower tax penalty(11) under the proposal realign their portfolios. The realisations profile adopted by the review corresponds in approximate terms to an elasticity of about minus 1.7 in the first and second years after implementation. The implicit elasticity in the longer term declines to around minus 0.9. (12)

Some commentators have suggested that the elasticity assumptions used in the Report are too high or risky. After noting US experience and alleging that the assumptions used by the Ralph Report are 40% higher than used in the US, a commentator notes that a member of the US Congressional Research Service found of the assumptions used in the US 'New evidence on the size of this realisation response suggests that the magnitude used in current revenue estimates may be too large for the intermediate and longer run'. The US assumptions were for a short term response of 1.2 and long term 0.7.(13) The article also quotes an economist at Access Economics as stating that the long term response is 'at the top end of the range' and that the short term figure indicates that 'Treasury's normal conservative approach to its estimates have not been followed'.(14) The strength of these assumptions underlining the revenue figures will continue to be one of the most debated points of the Report's views regarding CGT.

The propensity for people to rearrange their affairs so that returns can be taken as lower taxed capital gains rather than income also has the potential to increase the cost of the proposed changes to CGT rates. With the proposal to include only half the receipt from capital gains in income to be taxed at marginal rates, compared to full inclusion of income from other sources such as wages, salary, interest and dividends, there is a significant incentive, where possible, to take receipts as capital gains rather than income. Prior to the introduction of CGT, significant resources were devoted to the creation of schemes which disguised income as capital and differing treatment in the taxation of returns from capital and income can be expected to lead to a significant revival of such activity. While changes to the interpretation of taxation laws by the courts and tax legislation, and new anti-avoidance measures both contained in this Bill and announced by the Treasurer on 11 November 1999, will significantly reduce leakages from income compared to pre-CGT conditions, leakages can be expected and, as the above Table shows, the Ralph Report makes an allowance for such changes. The revenue loss, which shows a yearly increase, is estimated to grow from $20 million in 2000-01 to $180 million in 2004-5.

As with the additional revenue from extra realisations, the amount of potential lost revenue has been disputed. The Report gives little indication of the methodology behind the calculations for the revenue loss(15) and alternative effects have been suggested. It has been reported that, based on a change from income to capital gains of 2.5%, revenue loss would be $900 million in the first year and $4.5 billion over 5 years.(16) Estimates of potential revenue effects are necessarily dependant on a number of assumptions, such as the attitude of the ATO and courts towards schemes designed to convert income to capital gains and the willingness and ability of companies to convert dividends to capital gains, and the accuracy of the various estimates will only be seen over time if the measures are introduced as proposed.

Finally, the principal author of the Report, Mr Ralph, has expressed the view that the revenue estimates contained in the Report are conservative and that, if there is a period of high inflation, the rate of CGT may need to be adjusted downwards to prevent an unintended increase in revenue from CGT.(17)

General Reaction

Industry groups have generally commented favourably on the proposed changes to CGT, while other groups have raised concerns, principally regarding the distribution of potential gains to individuals from the measures. Many of the favourable industry comments were not directed specifically at the CGT changes, instead providing commentary on the effects of the Ralph Report and government response as a whole. Some of the CGT comments were:

Australian Chamber of Commerce and Industry: ACCI is of the view that the Report 'has the overwhelming support of the business community.' In relation to the CGT changes, their view is that:

The lowering of the Capital Gains Tax rate ,...[other proposed changes to CGT are referred to] are amongst the measures which will improve both the level of investment and the flexibility with which capital can be shifted into more productive forms.(18)

Australian Biotechnology Association:

The CGT reform will offer the necessary internationally competitive, tax-based incentives for accelerated investment in Australian innovation.(19)

National Farmers Federation:

On first reading, the removal of Capital Gains Tax on assets held for more than 15 years by individual retiring farmers is the highlight of the package.

We estimate that nearly 70 per cent of farmers have owned their farms for 15 years, and this single initiative will provoke sighs of relief from the majority of farming families across the country.

Particularly welcome changes include the exemption of 50 per cent of all gains from CGT, with a further exemption for active small business assets, and enhanced rollover relief into superannuation funds and acquisition of new business assets.

However, the removal of indexation of capital gains may still mean that some farmers could be disadvantaged under the changes, if their assets increase in value at a rate less than the inflation rate. Under the existing system, these farmers would pay no CGT.(20)

Most of the commentaries opposed to the proposed changes in CGT can be seen as falling into two categories: those opposed to the potential effect on investors and those who disagree on equity grounds. An example of the first category can be seen in the last paragraph of the NFF comments quoted above. This comment is based on the potential under the proposed system of CGT being payable when an investor has, in real terms, made a loss on their investment. With indexation CGT would not be payable unless there has been a real return on the investment. Other comments that fall within this category are principally concerned with the potential impact of the proposed changes in a high inflation environment. It should also be noted that many of the comments that criticise part of the announced package form part of an overall commentary that also supports many of the changes. Examples of these commentaries include:

Taxation Institute of Australia: The TIA generally supported the announced changes to CGT but saw some possible negative effects, stating:

The reduction in the effective CGT rate, although welcomed, could lead to persons favouring investments which have a capital yield over those which have an income yield.

Certainly, individuals generally will be looking to turn income into capital. It was to combat such arrangements that CGT was initially introduced.

The indexation trade-off for a lower CGT rate may seem attractive for individuals in times of low inflation, but it will lose its lustre if the Australian economy experiences again high rates of inflation.(21)

The last point was dealt with in greater depth by the Real Estate Institute of Australia (REIA). REIA has been reported as saying that under the proposed rules investors would need capital growth at twice the rate if inflation to be better off under the changes and that they would advantage short term investment over long term, lower yield investments. The President of REIA is reported as stating:

Most Australians will pay more capital gains tax and the Government's own revenue projections prove that, with CGT revenue actually increasing in the out years.

The bulk of the proposed CGT reforms will benefit speculators, tax avoiders and big business, at the expense of the average mum and dad investor.(22)

This view was reinforced by the chief executive of REIA, who is reported as saying:

Every commentator in Australia said "boy isn't this great", but I think they've missed the point - that it's not great unless you get high capital growth, and the average investor gets moderate capital growth, and if you get moderate capital growth, you're worse off.(23)

Equity arguments concentrate on the different proposed treatment of returns from capital gains and those from other sources, such as labour, interest and dividends, and the perception that capital gains mostly accrue to higher income individuals. Dealing with the later point first, it must be noted that debate in this area is constrained by the lack of recent statistics on the breakdown of CGT as paid by income group, as the latest available statistics are for the 1996-97 financial year. Using these figures, the following comments can be made on the distribution of taxable capital gains for individuals in 1996-97:

  • in relation to the amount of capital gains made, 39.8% were made by individuals with taxable income of less than $50 000 and 60.2% with taxable income above this amount
  • for CGT paid, 25.9% was paid by individuals with taxable income below $50 000, and 74.1% with taxable incomes above this amount, and
  • there is a concentration of gains made and CGT paid in the $50 000 to $99 999 taxable income range. As a percentage of capital gains made and CGT paid, this group accounted for 25.4% and 26.5% respectively.(24)

In relation to equity the following comments have been made:

ACOSS:

Our analysis using official Taxation Statistics shows that a typical investor on $100 000 a year will receive a Capital Gains Tax (CGT) savings of $7 554 a year - seven times more than a typical investor on $30 000 a year who will only get a $1 109 saving.

The gap between the rich and the poor will widen considerably unless the Government reviews or the Senate rejects the proposal to halve the rate of capital gains tax.(25)

Anglicare Australia:

The proposed cuts to capital gains tax are neither logical nor fair. Income from capital gains should not be taxed at a lower rate than business income from other sources. This can only open up tax avoidance opportunities which will primarily benefit higher income earners and erode our income tax base.

Brotherhood of St Lawrence:

High income Australians of good will should consider whether they have already received enough benefits from tax reform, given they'll be paying $62 a week less in income tax. Middle income Australians who have an interest in shares or property investments should consider whether the capital gains tax cuts are worth the price they will probably have to pay - reductions in health, education, aged and child care services on which they rely.(26)

Measures contained in the Bill

Changes to CGT are contained in Schedules 8 and 9 of the Bill.

Indexation for the cost base will not apply to assets acquired after 11.45 am on 21 September 1999 and for assets acquired before that date indexation will cease on 30 September 1999. In the calculation of indexation for assets acquired before that time, the value of the indexation will be calculated using the figure applicable to the quarter ending 30 September 1999 (Schedule 8).

Schedule 9 of the Bill deals with the reduced rate of CGT. Proposed section 102-3 of the Income Tax Assessment Act 1997 (ITAA97) provides that the concession rules will apply only to assets held by individuals, superannuation entities and trusts that have been held for at least 12 months and do not include indexation in the calculation of their cost base.

For indexation to be included in the calculation of the cost base of an asset, the individual or relevant trustee must elect that this method is to be used in relation to the asset (proposed subsection 114-5(2)).

A capital gain will be a discount capital gain if:

  • the event triggering realisation of the gain occurred after 11.45 am on 21 September 1999
  • the gain accrued to an individual, a complying superannuation entity or a trust
  • there is no indexed cost base for the asset, and
  • the asset has been held for at least 12 months (proposed sections 115-5 to 115-25).

There are some special rules that apply where assets are acquired through certain rollovers or due to the death of the previous owner. The rules deem an earlier acquisition time that that which actually occurred (proposed section 115-30).

Even if these requirements are satisfied, gains from the following events cannot be a discounted capital gain:

  • a lessor receiving payment for changing a lease
  • a receipt for an event relating to a asset, or
  • partial realisation of an intellectual property right (proposed subsection 115-25(3)).

As well, a gain cannot be a discount capital gain if:

  • the CGT event arose under an agreement made within 12 months of acquiring the asset (proposed section 115-40)
  • the asset was a share in a company with less than 300 members, or interest in a trust with less than 300 beneficiaries, and the relevant company or trust acquired more than half of the cost base of its assets within 12 months of the CGT event (proposed section 115-45)
  • where the company/trust in which the share is held has at least 300 members/beneficiaries, up to 20 individuals have fixed entitlements to at least 75% of the income or capital of the company/trust or 75% of the voting rights in the company or, if the trust has voting rights in respect of the activities of the trust, 75% of those voting rights, or
  • it can be reasonably concluded that, having regard to the matters listed, the rights attached to the share or interest in the trust can be varied so that any of the above would apply (proposed section 115-50).

The discount percentage is dealt with in proposed subdivision 115-B. For an individual or trust it will be 50% and for a complying superannuation entity 33.3%.

Proposed subdivision 115-C contains special rules for trusts and will apply where the trust has distributed amounts attributable to a capital gain. In such a case, an amount equal to the person's entitlement will be attributed to the person and if the capital gain has been discounted by the trust, twice this amount will be attributed to the taxpayer. The taxpayer will then be able to apply any capital losses they may have to this capital gain and apply the discount rate, where relevant to the remaining amount. To prevent double taxation, a deduction will be allowed for the amount attributed to the taxpayer under these provisions as section 102-5 will already include such an amount in the calculation of tax payable. (This is a mechanism to allow recipients of such gains to offset any capital losses they have.)

Application: Amendments relating to the indexation of the cost base will apply from 11.45am on 21 September 1999 and those relating to the inclusion of amounts in assessable income (ie the discount of gains) will apply to the year of income including 21 September 1999 and later income years (item 14 of Schedule 9).

Integrity

The main considerations of the Ralph Review in regard to the integrity of the business tax system were to examine ways to prevent long term revenue leakage and also to identify and recommend strategies regarding possible short term measures to address both transitional measures that may arise due to implementation of the recommendations of the report and measures necessary to combat current methods of avoidance.

The distinction must be made between tax evasion, which involves activities that are contrary to taxation laws, rulings and determinations, and avoidance, which can be classified as activities that fall within the letter of the law but which are undertaken and structured not for commercial purposes but for the reduction of tax. The Ralph Report states:

Tax avoidance could be characterised as a misuse of the law rather than a disregard for it. It involves the exploitation of structural loopholes in the law to achieve tax outcomes that were not intended by the drafters of the legislation or by the Parliament.(27)

By definition, evasion usually involves offences against the ITAA36, ITAA97 or the Crimes (Taxation Offences) Act 1980, while evasion and avoidance are countered by either the general anti-avoidance power contained in Part IVA of the ITAA36 or specific anti-avoidance provisions. Extensive law has arisen on the interpretation of Part IVA and the precise application of the measures is beyond the scope of this Digest. However, in simple terms Part IVA has three main components:

  • is there a scheme
  • was a tax benefit obtained, and
  • was the scheme entered into or carried out with the sole or dominant purpose of obtaining a tax benefit?

The sole or dominant purpose test is also contained in the anti-avoidance provisions of the GST but in that area is also extended to include a second element, ie. is it reasonable to conclude that

the principal effect of the scheme, or part of the scheme, is that the avoider gets the GST benefit from the scheme directly or indirectly (see section 165-5 of A New Tax System (Goods and Services Tax) Act 1999).

The principal effect test adds further grounds for the challenge of avoidance but was rejected by the Ralph Report, although few substantial reasons were given for the rejection. The Report states:

The Review considered arguments for and against including 'the principal effect' test in the GAAR [general anti-avoidance rule - ie Part IVA]. None of the submissions to the Review that addressed the issue supported the principal effect test because of its potential wide scope to disturb business practices that have a genuine commercial purpose. On balance, the Review concluded there did not appear to be a strong need for the principal effect test, albeit that the test is included in the GST law.(28)

The Report recommended a number of steps to address avoidance, with emphasis being placed on the need to address structural flaws in the tax system, the need to take action within a relatively short time after a practice is discovered and, as a final measure, the use of specific anti-avoidance measures. The Report also envisaged the need to take action to address specific areas likely to arise due to the implementation of its recommendations.

The Report rejected the concept of requiring companies to pay a minimum rate of company tax. Such a scheme would require a company to pay the greater of the amount of tax using the normal tax calculations and a minimum amount based on a percentage of its profits, or the profits adjusted to take account of specific deductions. A minimum tax rate was seen as having a number of problems, including denying companies full access to incentives designed to encourage specific activities, such as the 125% deduction for research and development; difficulties with accounting standards that currently would not allow standardisation across all sectors; and that equity could be better addressed by having regard to the final destination of the profits earned by companies. Finally, the Report recommended that many of the avoidance problems associated with companies could be better addressed by implementing structural reform of the company tax system recommended in the Report.(29)

In relation to maintaining and improving the integrity of the company tax system the Report recommended a three tiered approach, with first preference for structural reform, followed by use of the general anti-avoidance rule (GAAR) and finally specific anti-avoidance measures. The recommendations were:

  • That where specific tax avoidance is being driven by structural flaws:
  • Structural reform of the tax system be adopted as the primary mechanism for responding to such tax avoidance
  • The government of the day undertake appropriate structural reform
    • As soon as practicable, and
    • In any event, within 12 months of the identification of the structural flaw; and

  • The GAAR be used to maintain the tax system integrity pending implementation of appropriate structural reform.
  • That where a non-structural response to tax avoidance is required:
  • The GAAR be used as the preferred response to that tax avoidance, and
  • Specific anti-avoidance rules be formulated only if they offer a more structured, targeted and cost-effective response than the GAAR, with such rules to be :
    • Subject to thorough appraisal in terms of identified criteria, and
    • Recommended to government, and implemented, within 12 months of identification of that tax avoidance.(30)

The decision to implement a significant majority of the recommendations of the Ralph Report can be seen as an endorsement of the desire to address perceived structural flaws in the system. This approach was further endorsed when more wide ranging ant-avoidance rules were announced in the Stage 2 response to the Report, released by the Treasurer on 11 November 1999. In addition to anti-avoidance rules, it was also announced that entity taxation would commence from 1 July 2001

As noted above, the Report also made a number of specific recommendations to address current flaws and transitional matters while the major structural reforms are introduced. A number of these measures are dealt with in this Bill. The amendments are often of a technical nature and will generally only be briefly described.

Disposal of Leases and Leased Plant

As part of the consultation process prior to the release of the Report, a Discussion Paper titled A Platform for Consultation was released which contained a number of policy options. This paper was released on 22 February 1999. Difficulties with the use of assignment of leases to minimise tax were outlined in the Paper and also in a Press Release from the Treasurer dated 22 February 1999. The Press Release stated, in part, that concern had been raised that deficiencies identified in the Discussion Paper may be subject to greater abuse and that:

The Government gives notice that it proposes to take such action as is necessary with effect from 22 February. The precise action taken will be announced having regard to the Review's final recommendations.

The principal method of tax avoidance identified was the attachment of a debt or other liability to a lease and the subsequent sale of the lease or a wholly-owned subsidiary which held the lease. The Report identified three main methods of this process:

  • the use of high depreciation values and minimal lease payments in the first periods of the leases life to ensure high deductions, so reducing tax liability, and the subsequent disposal of the lease once the deductions were no longer available and before high lease payments were due
  • the value of debts disposed of not being taken into account in determining the consideration paid for the lease, and
  • the use of rollover provisions to ensure that balancing charges, such as the recoupment of high early depreciation deductions, are not paid.(31)

The Report recommended that, from 22 February 1999, the full consideration received, including the value of the disposal of any debt, be included in the income of the disposer, and that where a subsidiary is used, so that the subsidiary rather than the asset is disposed of, the full market value of the asset be included in the value of the subsidiary and that if the subsidiary has not paid any relevant tax within 6 months (eg from clawed back depreciation), be paid by the former owners of the subsidiary.(32) These recommendations were endorsed in Attachment R to the Treasure's Press Release of 21 September 1999.

Changes to the treatment of the disposal of leases and leased plant are contained in Schedule 1 of the Bill.

Where an interest in a lease is disposed of, all or part of the lease period occurs on or after 22 February 1999 and the total of:

  • the money received for the plant
  • the value of any reduction in liability due to the disposal, and
  • the market value of any other benefit received.

is more than the written-down value of the plant, or if no balancing amount is included in income, the excess or amount is included in assessable income unless it is included under another provision or is subject to specific rollover relief (proposed section 45-5).

Similar rules apply for the disposal of an interest in a partnership that has disposed of leased plant (proposed section 45-10).

Proposed section 45-15 deals with the situation where a company has a 100% owned subsidiary which leases equipment to another party and 50% or more of that subsidiary is disposed of and the written down value of the plant is less than its market value. In such cases, the market value of the plant is taken into account in determining any tax liability of the subsidiary.

Similar rules will apply where the subsidiary leases plant in partnership and the partnership is disposed of (proposed section 45-20).

In the above two cases, if an amount is included in the subsidiaries tax liability and has not been paid within 6 months, each company that was a beneficial owner of the subsidiary, and in the same group of companies, will become liable for the unpaid tax (proposed section 45-25).

Reductions in the amount included in assessable income will be allowed where the asset was held prior to 21 September 1999 and the amount taken to have been received for the plant under the previous proposed provisions exceeds the cost of the plant. The amount to be included will be reduced by the lesser of the amount that the cost exceeds the cost base and the difference between the proceeds as calculated under the previous sections and the plant's cost. The reduction will not apply to pre-CGT assets or for the assets listed in proposed section 45-30 (eg cars, personal use assets and plant used to produce exempt income).

Application: Assessments including 22 February 1999 and for later years (item 18 of Schedule 1).

Value Shifting Through Debt Forgiveness

Value shifting occurs when the value of one asset is reduced and transferred to another to enable the asset holder to secure a tax advantage. An example, now illegal, was the process of asset stripping of 100% owned companies leaving them with tax obligations and no means of meeting them. Many other methods exist for legal value shifting, including methods such as increasing the value of assets not subject to CGT by reducing the value of an asset subject to CGT. Examples of asset shifting methods are given in the Report.

The Ralph Report suggests a two stage approach to combating asset shifting, first through the introduction of general rules to address the current flaws in the system and secondly to immediately introduce a more limited approach to counter practices already identified to the Treasurer. The general rules are recommended to have effect from 1 July 2000 and the specific rules are recommended to cease to have effect from that date.(33)

The Discussion Paper A Platform for Consultation identified debt forgiveness as an area of concern and the Report recommends that specific action be taken to address the problem. Debt forgiveness operates without the transfer of an asset and so is exempt from current rules but allows value to be transferred from one company in a group to another so that a realisable loss arises in one company while the gain for the other is not realised or is subject to more favourable tax treatment. The Report recommended that any CGT advantage created by value shifting be negated by adjustments to the relevant cost bases and that such a measure have effect from 22 February 1999 and cease on 1 July 2000, at which time it is envisaged that the general recommendations will have come into force.(34)

Value shifting through debt forgiveness is dealt with in Schedule 2 of the Bill. Proposed section 139-10 provides that an adjustment may have to be made (see below) where a number of conditions are satisfied, including:

  • there is a trigger event that will result in a shift in value from a creditor company to a debtor company
  • there is a substantial reduction in the value of the debt because the trigger event is done by the creditor company on or after 22 February 1999
  • the creditor and debtor companies are commonly owned, and
  • there is a shift in value from the creditor company to the debtor company because the amount received for the debt is less than value of the debt.

Proposed section 139-25 provides for an adjustment through the reduction in the cost base and reduced cost base of shares in the creditor company to reflect the increased gain through the debt forgiveness. The reduction in the cost base is based on their market value immediately before and after the reduction in the value of the debt, so that reductions in debt value will have less effect in a falling market. There may be different reductions for different classes of shares (proposed section 139-30).

Where the activity involves the reduction in the value of a loan, and the share value of the creditor company has been reduced to nil or there are no shares in the company, the debtor company must reduce its cost base to reflect the gain through the loan reduction (proposed section 139-35). In certain circumstances, such as where there is more than one loan or cross share holding, different reduction amounts may apply (proposed section 139-40).

Proposed section 139-45 provides for a reduction in the cost base where the gain through debt forgiveness or loan reduction is received through indirect ownership (ie in situations where the benefit flows through interposed entities).

Where the cost base is reduced through the action of any of the above provisions, the cost base for the holder of the increased value asset will be increased by a corresponding amount (proposed section 139-50).

Application: For trigger events that occur on or after 22 February 1999 (item 5 of Schedule 2).

Transfer of Assets Within Company Groups

This method is used within company groups to produce losses in an appropriate, for tax minimisation, member of a group as a loss is transferred through members of the group, a process known as loss cascading. Under the Ralph Report, this area was proposed to be addressed through the introduction of entity taxation as under that system changes in intra-group interests would not be recognised. With the deferral of the introduction of entity taxation until 1 July 2001 the Treasurer announced that an anti-avoidance measure would be brought forward to prevent the exploitation of the opportunity delay in its introduction would allow. (35)

Proposed subdivision 170-D, which will be inserted into ITAA97 by Schedule 4, will apply where a number of conditions are satisfied, including:

  • a deferred event would have resulted in a company making a capital loss which results in a deduction being able to be claimed, and
  • whether there is a sufficient link between the companies based on residency and how the companies are linked, which will depend on the amount of control that one of the companies may exercise over the other.

Provision is also made in proposed section 170-265 to trace the connections between various entities through interposed entities.

If the proposed subdivision applies, and the company which originally held the capital loss would have been entitled to claim that loss, that loss is to be disregarded (ie so it cannot, for tax purposes, be transferred) (proposed section 170-270).

If, subsequently, the company receiving the loss ceases to be sufficiently connected to the original company or the asset ceases to exist, the entitlement to the loss will return to the originating company (proposed section 170-275). However, proposed subsection 170-280 provides for a reversal of the ability to claim for the loss if a sufficient reattachment occurs within 4 years.

Application: Generally, from 21 October 1999 (the date of introduction of the legislation) (item 19 of Schedule 4).

Transfer of Losses Within Wholly-owned Company Groups

This measure is designed to address a similar situation to that described above but differs in that the loss, rather than the entity incurring the loss, is transferred.

The process is also known as loss cascading but in this instance uses the ability of group companies to transfer losses and their associated deductions and rebates to secure the most advantageous tax position for the group of companies as a whole. However, in the case of loss transfers the Report recommended that action be taken prior to the introduction of the entity taxation regime and that changes to CGT cost bases be used as an interim measure from 22 February 1999 to nullify potential gains. It was also recommended that the measures cease to have effect from the introduction of the entity taxation regime.(36) This was endorsed by the Treasurer's announcement of 21 September 1999.

Proposed subdivision 170-C will apply where the company transferring and receiving a loss that results a capital gain loss to the company to which it is transferred are members of the same group, and will also apply where the group companies hold a sufficient interest in another entity (ie where indirect interests can be used to achieve similar results as described above). Proposed section 170-210 will apply to transfers of losses and will reduce the cost base for any group company that has an interest in the company to which the loss is transferred. The amount of the reduction will reflect the tax advantage otherwise gained by the first, group company. Proposed section 170-220 will apply similar rules where the amount being transferred is an actual capital loss (as distinct from a loss that may give rise to a capital loss).

Application: Schedule 5 will commence on 22 February 1999 (subclause 2(2)).

Change in Ownership or Control

Schedule 6 of the Bill aims to address the situation where a company with unrealised tax losses comes under new ownership or control. The acquisition and use of such companies and their losses was part of many tax evasion/avoidance schemes in the early 1980's which were addressed at the time by requiring a continuity of ownership in the companies for the losses to be allowable deductions. The amendments contained in Schedule 6 will tighten the rules for continuity of ownership and will prevent losses being used if the new tests are not satisfied. The new tests require:

  • a continuity of ownership of the end owners of the company that acquired the loss so that there is greater tracing of the ultimate beneficiary of the realisation of the losses, and
  • continuity of ownership and control of the companies must continue from the time the loss is made until it is realised.

13 Month Rule

The '13 month rule' allows for the immediate deduction of expenditure related to services that will be finalised within 13 months of the expenditure being incurred. The rule was criticised in the Report for allowing the bringing forward of deductions to an earlier tax year and also as breaching the general accounting rules relating to expenditure and assets. It was also criticised on the ground that it would allow the deduction to be claimed in one year while the expenditure was accrued as income for the service provider in a later year as the service must have been provided before the amount is received as assessable income. The Report recommended that the '13 month rule' be abolished and that prepayments for 12 months or less be included in both expenditure and receipt at the time incurred. It was also recommended that transitional arrangements apply for a five year period so that a percentage of the prepayment that would otherwise be treated as an asset be phased in over that period. This approach was adopted in the Government's response to the Report.(37)

Schedule 7 will implement the changes discussed above. The current 13 month rule will be abolished and transitional arrangements substituted for work covering the 13 month period. The proposed rules require a percentage of the expenditure to be deducted in the year of expenditure, up to a year including 21 September 2002, with the remainder being deductible in the next year of income (the amounts range from 80% in the first year and 20% in the next year in a year of income including 21 September 1999 to 20% and 80% respectively for expenditure incurred in a year of income including 21 September 2002). The amendments will remove the ability to bring forward deductions as currently allowable under the 13 month rule and move the majority of the deduction to the next year (proposed section 82KZMB of ITAA36 deals with the transitional arrangements).

Application: The above amendments will apply to expenditure incurred after 11.45am on 21 September 1999 (item 12 of Schedule 7).

Endnotes

  1. Australian Financial Review, 27 October 1999.

  2. Report of the Review of Business Taxation, A Tax System Redesigned, July 1999 (Ralph Report), p. vi.

  3. Australian Financial Review, 16 July 1999, p. 4.

  4. Report of the Review of Business Taxation, A Tax System Redesigned, July 1999, p. 598.

  5. Ibid., pp. 595-7.

  6. Ibid., p. 599.

  7. ibid., p. 600.

  8. Ibid., pp.586-9

  9. The Treasurer, Press Release, 21 September 1999, Attachments G and H.

  10. The Treasurer, Press Release, 21 September 1999, Attachment F.

  11. The use of the word 'penalty' rather than a more neutral word, such as burden or cost, can be contrasted with recent statements by the Commissioner of Taxation relating to ethics and taxation emphasising the community value of taxation and the need to change much of the current culture towards the payment of tax (see Australian Tax Practice Daily News Service, 29 October 1999.

  12. Op cit, pp. 733 and 34.

  13. The article refers to elasticity figures as positive figures rather than the negative figures used in the Report. However, they are directly comparable and the plus or minus sign can be ignored in this instance.

  14. Australian Financial Review, 23 September 1999.

  15. Op cit, p. 731.

  16. Australian Financial Review, 4 November 1999.

  17. Outcomes of the Review of Business Taxation, Parliamentary Library Seminar, 19 October 1999.

  18. ACCI, Media Release, 18 October 1999.

  19. Australian Biotechnology Association, News Release, 29 September 1999.

  20. NFF, News Release, 21 September 1999.

  21. Taxation Institute of Australia, Media Release, 21 September 1999.

  22. The Age, 29 September 1999.

  23. The Canberra Times, 23 September 1999.

  24. From Australian Taxation Office, Taxation Statistics 1996-97, Detailed Tables.

  25. ACOSS, Media Release, 23 September 1999.

  26. Church Agencies and ACOSS Media Release, 12 October 1999.

  27. ibid., p. 46.

  28. ibid., p. 241.

  29. ibid., p. 284-6.

  30. ibid., p. 242.

  31. ibid., p. 402.

  32. ibid., p 400-1.

  33. ibid., Section 6.

  34. ibid., p 270-1.

  35. The Treasurer, Press Release, 21 September 1999, Attachment Q.

  36. ibid., p. 268.

  37. ibid., Attachment J.

Contact Officer and Copyright Details

Chris Field
16 November 1999
Bills Digest Service
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ISSN 1328-8091
© Commonwealth of Australia 1999

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Published by the Department of the Parliamentary Library, 1999.

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