Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Chapter 5 - Regulation impact statement
5.1 The measures in this bill are part of the Governments broad ranging reforms which will give Australia a New Business Tax System. The reforms are based on the recommendations of the Review of Business Taxation, instituted by the Government to consider reform of Australias business tax system.
5.2 The Government instituted the Review of Business Taxation to consult on its plan to comprehensively reform the business income tax system, as outlined in ANTS. The Review of Business Taxations recommendations were designed to achieve a simpler, stable and durable business tax system.
5.3 The New Business Tax System is designed to provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings, as well as providing a sustainable revenue base so the Government can continue to deliver services to the community.
5.4 The New Business Tax System also seeks to provide a basis for more robust investment decisions. This is achieved by:
- using consistent and clearly articulated principles;
- improving simplicity and transparency;
- reducing the cost of compliance through principled tax laws that are easier to understand and comply with; and
- providing fairer and more equitable outcomes.
5.5 This bill is part of the legislative program implementing the New Business Tax System. Other bills have been introduced and passed already and are summarised in Table 5.1.
|New Business Tax System (Integrity and Other Measures) Act 1999||Received Royal Assent on 10 December 1999.|
|New Business Tax System (Capital Allowances) Act 1999||Received Royal Assent on 10 December 1999.|
|New Business Tax System (Income Tax Rates) Act (No. 1) 1999||Received Royal Assent on 10 December 1999.|
|New Business Tax System (Former Subsidiary Tax Imposition) Act 1999||Received Royal Assent on 10 December 1999.|
|New Business Tax System (Capital Gains Tax) Act 1999||Received Royal Assent on 10 December 1999.|
|New Business Tax System (Income Tax Rates) Act (No. 2) 1999||Received Royal Assent on 10 December 1999.|
|New Business Tax System (Venture Capital Deficit Tax) Bill 1999||Received Royal Assent on 22 June 2000.|
|New Business Tax System (Miscellaneous) Bill 1999||Received Royal Assent on 30 June 2000.|
|New Business Tax System (Miscellaneous) Bill (No. 2) 2000||Received Royal Assent on 30 June 2000.|
|New Business Tax System (Integrity Measures) Bill 2000||Received Royal Assent on 30 June 2000.|
|New Business Tax System (Alienation of Personal Services Income) Bill 2000||Received Royal Assent on 30 June 2000.|
|New Business Tax System (Alienated Personal Services Income) Tax Imposition Bill (No. 1) 2000||Received Royal Assent on 30 June 2000.|
|New Business Tax System (Alienated Personal Services Income) Tax Imposition Bill (No. 2) 2000||Received Royal Assent on 30 June 2000.|
|New Business Tax System (Simplified Tax System) Bill 2000||Introduced into the Parliament on 7 December 2000.|
|New Business Tax System (Capital Allowances) Bill 2001||Introduced into the Parliament on 24 May 2001.|
|New Business Tax System (Capital Allowances - Transitional and Consequential) Bill 2001||Introduced into the Parliament on 24 May 2001.|
5.6 The New Business Tax System will contribute to the fairness and equity of the tax system. It will also enhance Australias competitiveness through lower company and capital gains tax rates, and reduced compliance costs.
5.7 More particularly, the debt/equity rules contained in this bill provide a new approach for determining whether a financing arrangement is debt or equity for certain tax purposes. This new approach seeks to minimise uncertainty and provide a more coherent, substance-based test which is less reliant on the legal form of a particular arrangement than is the case under the current law. The debt/equity rules also enable the removal of a number of rules under the current law.
5.8 By paying greater regard to the economic substance of a transaction than the current legal form-based approach, the new approach prevents arrangements that mischaracterise an in-substance equity interest as debt. This type of mischaracterisation could allow inappropriate tax deductions for the issuer through deductible equity (i.e. in-substance equity providing returns which are tax deductible as if they were interest payments rather than frankable in the same way as dividends), and an undermining of the imputation system by allowing returns that are equivalent in economic substance to have different imputation tax consequences. Allowing returns which are equivalent in economic substance to have different imputation tax consequences could facilitate the streaming of franking credits.
5.9 Another objective of paying greater regard to the economic substance of a transaction is to prevent the use of the legal form of arrangements to mischaracterise a debt interest as an equity interest, resulting in the inappropriate franking of debt-like returns, or companies circumventing the proposed new thin capitalisation measures.
5.10 The majority of the measures in this bill arise directly from recommendations of the Review of Business Taxation. Those recommendations were the subject of extensive consultation. The implementation options for these measures can be found in Chapter 7 of A Platform for Consultation (pages 200-202) and recommendations 12.10 and 12.11 of A Tax System Redesigned (pages 442-448).
5.11 The transitional rules to allow issuers of financial instruments to elect to have the current law apply to existing interests until 1 July 2004 provides an appropriate balance between, on the one hand, ensuring that the measures have consistent application to all issuers relatively quickly and, on the other hand, allowing for continuity in private sector decision-making and providing issuers sufficient time to redeem instruments in an orderly manner.
5.12 The potential compliance, administrative and economic impacts of the measures in this bill have been carefully considered, both by the Government, the Review of Business Taxation and the business sector. The Review of Business Taxation focused on the economy as a whole in assessing the impacts of its recommendations and concluded that there would be net gains to business, government and the community generally from business tax reform. Submissions received during consultation did not indicate significant concerns about compliance issues.
5.13 Financial institutions, as the predominant issuers of hybrid instruments, will need to familiarise themselves with the impact that debt/equity re-characterisation may have on their operations.
5.14 As issuers of hybrid instruments, life insurers and general insurers will be impacted although to a lesser degree than financial institutions. As investors, these companies are substantial users of these instruments.
5.15 Large/medium business, to the extent that they issue these instruments, will need to understand the re-characterisation issues.
5.16 Superannuation funds, large/medium business, small business, and individuals will be impacted to the extent that they invest in hybrids. The re-characterisation issues will have minimal impact on these entities.
5.17 Non-resident investors in debt/equity hybrid instruments will be impacted to the extent that the character of the returns on those instruments changes. The impact will be on the relevant withholding tax rate, which will be zero if the return is franked, and up to 30% if unfranked. The compliance impact for these investors is minimal.
5.18 Investors in hybrid instruments will also need to familiarise themselves with the new rules. However, issuers will generally advise investors of the tax treatment of the instruments and under the current law are required to notify recipients of the extent to which dividends are franked.
5.19 It is not possible to reliably estimate the number of instruments or issuers that will be affected by the changes. However, the number of issuers who issue complex debt/equity hybrid instruments is relatively small.
5.20 As is standard with new measures, entities affected by them will need to incur a small cost in either familiarising themselves with the new law or having advisers familiarise themselves with the new law. However, the new debt test, relying as it does on a single organising principle, is more coherent, comprehensive and certain than the current law and therefore a small reduction in compliance costs could be expected for issuers on an on-going basis. Most issuers of hybrids have a sophisticated understanding of the tax law and have ready access to high level tax advice so that they would quickly and easily understand the changes to the law.
5.21 The majority of debt/equity hybrid issuers are large companies, including financial institutions, life insurers and general insurers. The new rules will predominantly impact upon their operations to the extent instruments they have issued change character from debt to equity or equity to debt. However, the taxation treatment of most debt/equity hybrids will remain unchanged under the new rules, resulting in no compliance cost either to the issuer or investor.
5.22 In addition the new law will allow issuers of interests issued before release of the exposure draft bill to elect to have the current law apply to them until 1 July 2004. This will require issuers to examine their position and determine whether or not to make an election. In making an election the issuer is required to provide to the Commissioner in writing details of the interest that is on issue. The required information should be readily available to the issuer and will involve minimal compliance costs to collate and provide it to the Commissioner.
5.23 It is anticipated that most issuers will make this election, hence few instruments will change character on 1 July 2001. This transitional election facilitates continuity in private sector decision making and allows issuers sufficient time to redeem instruments in an orderly manner. Companies that elect to have this 3 year grandfathering arrangement apply will have no compliance issues associated with the new rules.
5.24 However, the tax treatment of some interests will change under the new law, either because they are currently not frankable and may be deductible under the current law but will become frankable and non-deductible under the new law, or because they are currently frankable under the current law but may become deductible and non-frankable. The compliance implications of this change in tax treatment depend on the tax profiles of the issuers and holders, and whether the arrangements remain in place under the new law. However, any change from current compliance costs is unlikely to be significant and is a consequence of the overall tax system which differentiates debt from equity.
5.25 A change in the tax treatment of a return may cause some affected companies to incur minor costs in notifying investors of the change in the treatment of the return. These costs may involve preparing the information (for example, in conjunction with normal provision of payment details) and providing it to investors by way of correspondence or newspaper advertisements.
5.26 A change in the tax treatment of a return on an interest from being frankable to being deductible is unlikely to have any material impact on compliance costs. This is because issuers would simply claim a deduction in relation to the return instead of providing a dividend statement to the recipient indicating the extent to which it is franked. The recipient would then just include the return as assessable income without having to consider any franking consequences.
5.27 In the reverse case where a return ceases to be deductible but becomes frankable under the new law there is expected to be a minimal impact on compliance costs. Both issuers and investors would need to address the franking consequences of the return. However, companies already have systems in place to deal with the franking of dividends and those systems could equally be applied to the franking of other distributions. Investors in receipt of franked returns would treat them in exactly the same way as franked dividends and would be unlikely to incur additional compliance costs in doing so.
5.28 In the case of both possibilities, issuers of interests that change character as a result of the reforms have the option of refinancing so that they remain on their preferred side of the debt/equity borderline. That is, while the new measures do not require refinancing, some issuers may make a commercial decision to refinance to obtain a desired tax result. There will be a cost (which is difficult to estimate) to issuers associated with this refinancing; the cost will depend on a number of factors including the size, complexity, extent of underwriting and currency of the issue.
5.29 It is also very difficult to estimate the extent to which refinancing will occur as a result of the new measures. First, in the transitional period up to 1 July 2004 some affected issuers that elect to have the current law apply, may refinance or otherwise terminate their hybrids for reasons unrelated to the tax changes. Second, the measures facilitate a change of debt/equity treatment by a change to the terms of an interest so that it falls on the preferred side of the debt/equity borderline; this would obviate the need for a refinancing.
5.30 In addition, the systemic changes to the debt/equity borderline will result in less reliance on specific anti-avoidance rules, with consequent compliance and administrative savings for both taxpayers and the ATO. In general, for issuers of straightforward debt and equity instruments, the compliance impacts of the new measures will be relatively minor.
5.31 The administrative impact on the ATO will be minimised as it is anticipated that most issuers of hybrid instruments will elect to maintain their current taxation treatment. The education needs of companies will be low, as most of these taxpayers are large sophisticated companies with ready access to taxation advice.
5.32 Issuers will, from a commercial standpoint, be required to tell their holders of changes to the character of returns. With regard to instruments that are equity instruments for tax law purposes the issuer will be required to notify the holder of any franking implications. However, the ATO will also have a responsibility to ensure that taxpayers are informed of changes affecting them. This could potentially impact across all business lines. However, the ATO response could be limited to checking that issuers are informing their holders. Since most companies will elect to have their current taxation treatment maintained, the administrative cost to the ATO of checking on the few issuers that are impacted by the new rules will be minimised.
5.33 The revenue impact of this measure is unquantifiable, although it will protect the revenue base from erosion from deductible returns on certain future financial instruments that are equity in economic substance but debt in legal form. To the extent that the revenue base is not protected, there could be a potential significant loss to annual revenue. The measures improve the integrity of the tax system and help to provide a sustainable revenue base by reducing the opportunity for tax arbitrage by taxing interests by reference to their economic substance rather than their legal form.
5.34 The taxation treatment of most current debt/equity hybrids will remain unchanged. However, the tax treatment of some interests will change, either because they are currently not frankable and may be deductible under the current law but will become frankable and non-deductible under the new law, or because they are currently frankable under the current law but may become deductible instead under the new law. The revenue implications of this change in tax treatment depend on the tax profiles of the issuers and holders, whether the issuers elect to apply the transitional arrangements provided by the measure, and whether the arrangements remain in place under the new law.
5.35 The New Business Tax System will provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings. The economic benefits of these measures are explained in more detail in the publications of the Review of Business Taxation, particularly A Platform for Consultation and A Tax System Redesigned.
5.36 The measures in this bill will contribute to these broader economic goals by reducing uncertainty, improving the integrity of the tax system and helping to provide a sustainable revenue base. The debt/equity rules facilitate the effective pricing of financial arrangements through more coherent taxation laws improving the operation of the capital markets.
5.37 The consultation process began with the release of ANTS in August 1998. The Government established the Review of Business Taxation in that month. Since then, the Review of Business Taxation has published 4 documents about business tax reform: in particular A Platform for Consultation and A Tax System Redesigned in which it canvassed options, discussed issues and sought public input.
5.38 Throughout that period, the Review of Business Taxation held numerous public seminars and focus group meetings with key stakeholders in the tax system. It received and analysed 376 submissions from the public about reform options. Further details are contained in paragraphs 11 to 16 of the Overview of A Tax System Redesigned .
5.39 In analysing options, the published documents frequently referred to, and were guided by, views expressed during the consultation process.
5.40 The measures in this bill have also been subject to extensive consultation since the Review of Business Taxation reported to Government. For example, the measures have been the subject of ongoing discussions with focus groups comprising representatives of large corporations in the main, including the banking industry and their advisers, and representatives of professional taxation bodies. In addition the measures were included with the proposed thin capitalisation rules in an exposure draft bill, on which there has been extensive consultation following submissions made by interested parties.
5.41 The measures contained in this bill are expected to provide a net benefit to society as the economic benefits of certainty, integrity and sustainable revenue will exceed the costs. The measures should be adopted to support a more structurally sound business tax system as it applies to issuers of financial instruments. They are an integral part of the New Business Tax System.