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Everybody’s talking and no-one says a word: contemporary tax reform in Australia and small business

Mark Morris La Trobe Business School Professor of Practice
By Mark Morris

One of the more enduring and pithy songs that the late John Lennon composed during his years outside the public eye was the witty and jaunty ‘Nobody told me (there’d be days like these)’ which lyrically kicks off with the ironic observation that ‘Everybody’s talking and no-one says a word’.

I am sure John would be plunged into despair that I invoke this lyric when discussing contemporary tax reform in Australia but it does resonate with me somewhat given the Turnbull Government appears to have retreated from major systemic tax reform whilst the Opposition is largely focusing on tinkering with reform to superannuation concessions, negative gearing and interest deductions claimed by multinationals.

However, neither party appears to be currently proposing any new substantial measures to simplify the Australian income tax regime for small business or to provide that sector with any meaningful incentives during a period of real economic malaise.

Accordingly, whilst the Government often refers to small business as being the engine room of the economy, and the Opposition proudly boasts on its website that it stands up for the middle class, neither party has currently proposed any fresh tax initiatives that either cut red tape or improve cash flow for small businesses.

In my view there are at least 4 tax policy ideas that could help revitalize the small business sector which should be considered in either the framing of the 2016 –17 Federal Budget or developing the small business taxation framework for the next elected government.

Whilst such reform proposals may not offer the systemic tax reform Australia desperately requires, they would nonetheless reduce the burgeoning compliance burden imposed on small business without triggering a major blow out to our seemingly entrenched Federal Budget Deficit.

These 4 initiatives can be summarized as follows:

1. Increase eligibility to be a small business entity

Under the existing tax law a small business entity is subject to a raft of concessions where that entity carries on a business and its ‘aggregated turnover’ is less than $2 million. Such concessions include, amongst others, accelerated tax depreciation relief and a lower company tax rate of 28.5% if the company is a small business entity.

As the $2 million threshold was effectively put in place from the 2007 tax year there is a strong case to argue that the threshold should be increased to at least $3 million to both reflect inflation over the intervening 9 years and to bring more entities within the small business entity framework.

The former Treasurer Mr. Hockey flagged that this was the next logical step when presenting to the Australian Chamber of Commerce and Industry’s Business Leader’s Summit on 17 August 2015 but noted that such an initiative was subject to Budgetary constraints. Following the appearance of the Cabinet Secretary Mr. Sinodinos on the ABC’s Insider’s program on 20 March 2016 it appears that the Government is also currently considering the merits of some type of company tax relief.

To the extent such an initiative is a cost to the Budget it could be funded by additional revenue raised by tightening superannuation tax breaks for high income earners as it is more imperative to grow the small business sector now rather than retain superannuation concessions for the wealth.

Such measures could include superannuation contributions being taxed as income in the hands of individuals at their marginal rates albeit subject to a 15% refundable tax offset rather than be taxed at a flat 15% rate.

Deloitte recently championed a variant of this proposal in its publication “Shedding light on the debate – Myth busting tax reform” which it suggested would generate a reform dividend of around $6 billion in the 2016-17 year.

Accordingly, if this change was made some corporate tax relief for small to medium sized companies appears achievable.

2. Redesign Division 7A

As any tax adviser servicing the SME market will tell you the most problematic and invidious set of provisions impacting small and medium-sized taxpayers are the provisions set out in ‘Division 7A’.

Essentially, Division 7A was introduced to automatically treat any payment, loan or debt forgiveness by a private company to a shareholder or an associate of a shareholder as an unfranked deemed dividend paid out of the company’s profits (assuming no stipulated exemptions were available).

Unfortunately these provisions have become inordinately complex over time following various tranches of technical amendments which have also brought trust distributions within the scope of these provisions.

The biggest problem area is the application of Division 7A where loans have been made by a private company to a shareholder or associate.

For example, the most common breach of Division 7A is where a private company makes a loan to an associated trust purely for business purposes but the loan to the trust is treated as an unfranked deemed dividend because it is either not in writing or the interest rate charged is below the annual benchmark interest rate. Prima facie this means that the amount of the loan may be regarded as a deemed dividend even though the borrower did not obtain any private benefit from the company which was the original underlying intention of Division 7A.

The Board of Taxation issued a comprehensive report to the Federal Government in November 2014 setting out how the Division 7A loan rules could be simplified, including proposing new criteria that would allow greater flexibility in terms of loan arrangements whilst providing sufficient rigour to crack down on disguised distributions of profits to shareholders and associates.

It also proposed that loans owed to private companies by associated trusts in the form of unpaid trust distributions could be taken outside the scope of Division 7A which would relieve such trusts from having to raid their working capital or sell assets to fund the payment of such distributions. The Board even set out measures to fund the impact of such a change as trusts electing this option would forego their entitlements to reduce any capital gain on the disposal of future assets (other than goodwill) under the 50% CGT Discount.

Regrettably the recommendations of this review were to be subsumed into the Federal Government’s White Paper on Tax Reform which has now been consigned to history even though Division 7A reform is still chronically required.

Implementing the Board’s measured recommendations would materially assist both business and their tax advisors in complying with the tax laws and markedly improve productivity.

3. Simplify the small business CGT concessions

If you ask anyone who advises on the small business CGT concessions they will invariably tell you that accessing them can often be like winning a lottery for taxpayers who can successfully navigate the myriad of different rules that must be met in in order to extinguish or reduce a capital gain on the sale of their business.
The most contentious aspect of the small business CGT concessions is the $6 million maximum net asset value test. Indeed, virtually all of the major cases litigated over the past year concern compliance with this test which is poorly understood by taxpayers and is highly subjective in nature. This test must be met if the entity cannot otherwise meet the $2 million aggregated turnover test.

Essentially, the $6 million asset test involves determining the market value of all CGT assets held by the taxpayer and any related connected entities and/or affiliates reduced by any related liabilities.

Compliance with the test is quite counterintuitive as you have to include CGT assets which are outside the scope of the CGT rules such as pre-CGT acquired assets, depreciating assets and trading stock.

But the worst problem with the test is determining the market value of CGT assets just before their sale as there are often disputes between the ATO and taxpayers regarding the valuation of assets at that time.

We have even had cases where the sale consideration on a sale of shares between arm’s length parties was held to not be the shares’ market value as that valuation but had to be discounted to reflect the fact that the shareholder selling the shares did not control the company. Try translating that uncertainty to a small business taxpayer, let alone apply it.

As an alternative the subjective $6 million net assets test could be dumped and replaced by a higher aggregated turnover test which is calculated according to objective and transparent criteria. For example, the law could be amended so that an entity could obtain full access to the concessions if its aggregated turnover was less than $3 million but only 50% of the concessions if its aggregated turnover was more than $3 million but less than $4 million.

Sure some asset rich income poor entities would lose out but this tapered test could be readily interpreted by taxpayers and lead to much less uncertainty and disputation.

4. Streamlining the taxation of trusts

As someone who was heavily involved in the review of the taxation of trusts for many years I now recognize that any reform of this area is strewn with challenges, and that the best option is in fact to try and make the existing system work better and remove a range of anomalies.

To give an example of a bugbear, trustees still need to make a resolution before year end as to which beneficiaries will receive a share of the trust’s distributable income (which will in turn determine the beneficiaries’ share of taxable income). Accordingly, trustees need to able to divvy out trust distributions on some basis even though the trust’s accounts are not finalized let alone their tax returns. This is an unsatisfactory state of affairs and still leads to a great deal of confusion in the marketplace as well as being an unduly hectic addition to year end. This could be alleviated if the Government legislated that such a resolution could be completed within 2 months of year end as was former long standing administrative practice.

Different rules also apply to fixed trusts (e.g. unit trusts) and non-fixed trusts (e.g. family discretionary trusts) throughout the tax laws but there is no common definition as to what those terms mean for the purposes of various provisions littered throughout the legislation.

For instance, there are different rules regarding the recoupment of trust losses for fixed and non-fixed trusts as non-fixed trusts are subject to much more stringent rules.

However, the ATO has opined in a Decision Impact Statement on Colonial First State Investments Ltd v Commissioner of Taxation [2011] FCA 16 that there are very few trusts that are fixed trusts under the trust loss rules, and that they will be treated as non-fixed trusts in the absence of the Commissioner exercising a discretion to the contrary. In other words the demarcation between the legislative rules has now become blurred and you have to rely on the Commissioner to exercise a discretion to apply the more lenient trust loss rules applicable to fixed trusts.

Not surprisingly a leading mid-market practitioner recently likened his situation to being dumped in a quagmire as you often don’t know how to advise your client as to what they should do.

Finally, there is a lack of consistency between unit trusts and companies when it comes to being able to carry forward and utilize tax losses. Both entities are essentially subject to a continuity of majority ownership test. However, where that test is breached a company can rely on the same business test whereas a unit trust has no fallback equivalent test so that the tax losses are effectively lost when there is a change in majority beneficial ownership of a trust like a unit trust. There does not seem to be any sensible rationale for this distinction going forward especially given the prevalence of unit trusts trading as businesses.

Once again reform of this area has fallen off the radar now that the White Paper on tax reform has been dumped.

Nonetheless the plethora of unresolved issues concerning the taxation of trusts still need to be addressed and rectified.

Given the need to urgently simplify our tax system for small business it is disappointing that there is so much chatter about leadership, tax reform and a more agile economy without any real substantive tax policies for SMEs being advanced or sensibly debated.

As the late Mr. Lennon presciently observed everybody’s talking but no one is saying a word about the real issue.

The reality is that the current Government is correct in noting that Australia does not need any more tax reviews. There are plenty of good ideas out there already. What few leaders want to talk about is the cost of implementing much needed reform which will invariably result in losers as well as winners.

However, until we get that much needed leadership many of us frustrated with the current inertia on tax reform can justifiably mutter to ourselves ‘No-one told me there’d be days like these’.

The Reform We Have To Have: The Superannuation Challenge

Mark Morris La Trobe Business School Professor of Practice
By Mark Morris

Like many baby boomers I am reluctantly coming to terms with the need to bump up my superannuation contributions so that I can fund a reasonable lifestyle in retirement.

However, I find it hard to generate much enthusiasm for the prospect given the tantalising alternatives of an annual trip to London or an upgrade of the family car. Nonetheless the rationalist in me knows it is something I should do.

Accordingly, one of the very last things I want to grapple with when I struggle to make extra superannuation contributions is yet another barrage of tax changes to our superannuation laws.

However, I accept that tax changes to our superannuation regime are now inevitable as the costs of maintaining the existing superannuation rules are unsustainable and difficult to justify in the more straightened times we live in.

In part, this is because Treasury’s 2014 Tax Expenditures Statement vividly illustrates the burgeoning costs of maintaining our current superannuation regime most of which was set in place way back in May 2006 when the country was thriving under the mining boom. For example, Treasury estimated that the cost of maintaining the concessional tax treatment of employer sponsored contributions alone would be $18.1 billion for the 2016-17 year.

At the same time the Turnbull Government needs to urgently find sufficient revenue to finance the cuts in corporate and personal tax rates needed to lift national investment and productivity in a period of falling revenues.

In this context it looks increasingly unlikely that such cuts will be fully financed through an increase in the Goods and Services Tax rate and/or base, especially given the Opposition’s commitment to fight such reforms.

Accordingly, the Turnbull Government is slowly but surely building up its rhetoric on superannuation reform including its oft mentioned references to tax reform which is both fair and equitable.

In doing so it rarely refers to the fact that it is easier to sell superannuation reform where the impact of cost savings only hit home at some vague point in the future as opposed to GST reform where increased prices will immediately hit the hip pocket.

You really grasp such reforms are almost fated to occur when the Financial Services Council urge the Federal Government to cut back superannuation concessions for high income earners as they did on January 14. When a peak body representing superannuation and management funds calls for a revamp of superannuation concessions for the wealthy you know that a major overhaul to the superannuation regime is almost certainly on the agenda.

Hence, as there is growing consensus that there needs to be some form of superannuation reform, what policy options are available to effect those changes? Especially if the Federal government wants to generate sufficient revenue to help finance more broad-based tax reform?

In my view the Federal government should consider four major policy changes.

First and foremost there is real merit in revisiting Recommendation 18 of the Henry Tax Review which proposed that the tax on superannuation contributions be abolished, and that superannuation contributions should be taxed as income in the hands of individuals at their marginal rates, albeit subject to a 15% refundable tax offset.

In these circumstances a high income earner subject to the current highest marginal rate of tax of 49% would obtain a 15% tax offset in respect of any employer superannuation contributions made whilst a low income earner on the 19% tax rate would similarly receive a 15% tax offset thereby leading to a more equitable tax treatment of superannuation contributions.

We would therefore avoid the current scenario where a multi-millionaire’s superannuation fund effectively pays 15% tax on contributions received being the same 15% tax rate that would apply to a fund receiving employer contributions made on behalf of a sales assistant deriving an annual taxable income of $40,000.

Deloitte recently championed a variant of this proposal in its publication “Shedding light on the debate – Myth busting tax reform” which it suggested would generate a reform dividend of around $6 billion in the 2016-17 year. Not surprisingly similar changes are also the centrepiece of the recent modelling undertaken by the Financial Services Council in tandem with PWC on possible superannuation reforms.

Second, the Turnbull Government should consider the former Government’s proposal that income derived by a fund in pension mode should only be tax-free up to $100,000 a year with any excess subject to tax at a rate of 15%. Whilst this change was only expected to generate around $350 million back in April 2013 the revenue take from such a proposal could be further increased if transitional relief under that measure was ditched and a more punitive rate than 15% applied to funds generating $300,000 or more taxable income per year.

Third, we should revisit the notion that funds are entitled to a refund for excess imputation credits. It is wholly appropriate that funds should be able to extinguish their 15% tax liability during the contributions phase but another thing altogether to allow them to also get a refund of the 15% surplus franking credits on dividends franked at 30% in the dollar.

Finally, it makes little sense that funds in the contribution phase should only pay an effective tax rate of 10% on any capital gains made, being a one third discount on the 15% tax rate that applies to such funds. In a sense this is a doubling up of concessions as the fund is already subject to a low rate of tax being 15% and does not require an additional CGT concession to encourage investment.

Of course we should all recognise that implementing the above changes will invariably mean that some people are worse off being predominantly high income earners.

As is the case with any tax reform some will lose and will have to wear some grief.

However, such changes are absolutely crucial if we are to sustain a superannuation regime which is both robust and fair, and which will provide the additional revenue needed to finance much needed tax reform.

Put simply, superannuation tax reform is a change we have to have if the country is to prosper.

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