The Senate

Income Tax and Social Services Contribution Assessment Bill (No. 3) 1964

Income Tax and Social Services Contribution Assessment Act (No. 3) 1964

the Minister's Second Reading Speech

This Bill proposes a number of important amendments to the Income Tax and Social Services Contribution Assessment Act. For the most part the measures proposed are in consequence of the Government's consideration of those sections of the report of the Ligertwood Committee on Taxation that deal with tax avoidance. The Bill embraces measures affecting the income tax treatment of companies, lease arrangements, trusts and partnerships, superannuation funds and alienations of income.

The measures proposed by the Bill will not affect the great majority of taxpayers. They are chiefly directed at closing loopholes in the law that are being sectionally exploited at present, and which may be expected to be more widely exploited if no remedial action is taken.

As I have already said most of the proposals arise out of the Government's consideration of the report of the Ligertwood Committee. For one reason or another, as I will explain as I go along it has been found either necessary or desirable to adopt modified versions of some of the Committee's recommendations and, indeed, in certain instances, to depart from them wholly or substantially. I need hardly say that a great deal of ingenuity is exercised in these matters of tax avoidance by some taxpayers and their advisers. New kinds of arrangements have become evident since the Committee finished its deliberations and the Committee did not, of course, have an opportunity to have a look at these.

With those few preliminary remarks I shall now turn to the measures contained in the Bill that affect the taxation of companies.

The existing income tax law contains a definition of a private company. The broad purpose of this is to distinguish for income tax purposes between companies that are controlled by a small number of individuals and companies in which the general public is substantially interested. A private company is taxd on its taxable income at a lower rate than applies to a public company, but it may be subject to an additional tax of 10/- in the Pd if it does not distribute a sufficient proportion of its taxable income to shareholders. In determining whether a private company has made a sufficient distribution of its taxable income, allowance is made for the primary tax payable by the company and a specified scale of profit retention.

The Ligertwood Committee noted that the present definition of a private company does not fulfil its function satisfactorily. The Committee pointed out that companies find it comparatively easy for income tax avoidance purposes to switch at will from private to public status, or vice versa. The switch from public to private status is made to receive the benefit of the lower rate of primary tax on taxable income, and the more common switch from private to public status to avoid tax on undistributed profits.

The Ligertwood Committee recommended a new approach to the matter. It suggested that a public company should be defined and that companies not falling within the definition should, with certain exceptions, be regarded as private companies for income tax purposes. The Committee proposed as a primary requirement for public status that the ordinary shares of the company be on the official list of a stock exchange.

The main features of the Committee's recommendations are being implemented by this Bill. In broad terms it is proposed by the Bill that a company will be a public company for income tax purposes if the ordinary shares issued by the company are, at the end of the relevant year of income, on the official list of a stock exchange and, if at no time during the year, 20 or fewer persons owned three-fourths of the paid-up ordinary capital, or controlled three-fourths of the voting power, or were entitled to three-fourths of distributions made by the company.

I may note that the Ligertwood Committee proposed that the test relating to capital, voting power and distributions should be based on the proportion of two-thirds. The Government sees no reason to depart from the less severe proportion of three-fourths that has proved satisfactory in the existing law.

Provision is being made by the Bill to ensure the continued public company status of certain types of companies and organisations that are at present public companies for income tax purposes. For example, clubs and non-profit companies will continue to be treated as public companies. So will subsidiaries of public companies. There are also provisions in the Bill that will authorise the Commissioner of Taxation to classify a company as a public company where this would be appropriate, even though the company fails to meet all of the prescribed tests.

The Ligertwood Committee also considered the question of avoidance of tax by the use of interlocked private companies. It noted that these arrangements frustrate the plan of the tax on undistributed profits of private companies by the circulation of dividends amongst a group of such companies. It observed that these arrangements depend for their effectiveness on the dividends being 100 per cent rebatable in the hands of the company receiving them and recommended that the rebate on dividends received by any company from a private company should be reduced by 15 per cent.

The Government has carefully considered the Committeese recommendation and sees no reason why the present situation should be disturbed in relation to dividends received by a public company from a private company. As to dividends received by one private company from another the Government has found the matter a very difficult one indeed. There is, on the one hand, a need for comprehensive legislation on the lines proposed by the Committee, yet on the other hand, there are cases where no reduction of the rebate would be warranted. The Government has concluded that the Committee's proposal would, in practice, prove unduly harsh in some cases and in others would not provide an effective discouragement to tax avoidance arrangements. In the face of this situation the Government has decided that in relation to dividends received by one private company from another the best course would be to reduce the rebate by 50 per cent but to authorise the Commissioner of Taxation to allow a full rebate where circumstances justify it. Provisions contained in the Bill are designed to do this.

I may add that the aim of these particular proposals is to ensure, within a reasonable time, either a tax payment by individual shareholders on dividends or a payment of additional tax on undistributed profits by the company.

There is one further matter concerning companies to which I should briefly refer. Honourable Senators will be aware that, paradoxical though it may seem, many unsuccessful companies have of recent years found that their accumulated losses constitute, in effect, a saleable asset. This arises from the fact that a loss incurred by a taxpayer in one year may be carried forward as a deduction against income of the taxpayer of the succeeding year. The maximum period of the carry-forward is seven years.

A profitable public company that is able to divert income to another public company with accumulated losses can escape taxation on the income until the losses have been absorbed, even though there has been no connection at all between its business and the business in which the loss company incurred the losses, and even though the proprietorship of the loss company has completely changed. Hence the traffic in shares of companies that have tax deductible losses available, but no prospects of income from which to deduct the losses.

For quite some time now the income tax law has contained provisions intended to deny a deduction for a loss incurred in an earlier year by a private company if, broadly speaking, more than 75% of the shares in the company had changed hands since the loss was incurred.

The Ligertwood Committee examined these provisions and found that they were ineffective in most cases and had inappropriate effects in some others. The Committee recommended their repeal but it also referred to the possibility of strengthening them and applying them to public companies as well as private companies. The Government has decided to adopt the alternative approach referred to by the Committee. Action is unnecessary in relation to sole traders or partnerships as they, at present, have no opportunity to realise on accumulated losses.

Putting the matter in a general way, it is proposed by the Bill that, in future, losses of a previous year will not be allowed as a deduction against the income of a year of incoet of a public company or a private company, unless there exists during both years a beneficial ownership by the same shareholders of shares in the company that carry at least 40% of the voting and dividend rights and 40% of entitlements to distributions of capital if the company were to reduce its capital or be wound up.

The Ligertwood Committee also considered the income tax treatment of lease transactions. It drew attention to the great complexity of the present law and instanced tax avoidance practices being extensively adopted to take advantage of weaknesses in the law.

Under the existing provisions a capital premium paid for a lease is taxed in the hands of the recipient when he receives it, and allowed as deductions to the payer in instalments spread over the term of the lease. The situation is, however, different as regards leasehold improvements made by a lessee. If the improvements not subject to tenant rights are made under a covenant with the lessor or with his written consent, deductions are allowed to the lessee for the full cost on the same basis as for a premium. The lessor, on the other hand, is taxed on only a proportion of the estimated value of the improvements as at the end of the lease.

Improvements that are not made under a covenant or with a written consent are treated in a different way again. Initially, the lessee is entitled to no deductions for their cost but, by relatively simple arrangements involving either a surrender or an assignment of a lease to an associated person, the whole of the expenditure becomes deductible. No part of the value of improvements made in these circumstances is taxable to the lessor.

The examples I have quoted show basic inconsistencies in the present complex provisions. These are accentuated when the lessor is a Government instrumentality or some other body that is exempt from income tax. In these cases income tax is not payable by the lessor and there is never any amount taxed to balance the tax value of the deductions available to the lessee.

The Ligertwood Committee recommended action designed to remedy some, but not all, of the existing inconsistencies and anomalies. Legislation to implement these recommendations would need to be highly complex and, in the Government's view, would lead to greater practical difficulties for both taxpayers and the Commissioner than the already considerable difficulties being experienced at present. Moreover, such legislation would not provide solutions for all of the problems.

The Government proposes by the Bill that the present lease provisions will have no application in respect of lease transactions entered into after the date on which the Treasurer announced these measures, that is, 22nd October 1964. However, the general effect of the present law in relation to lease transactions entered into before that date will not be disturbed. Where an entitlement to a deduction now exists in consequence of a transaction made before 23rd October, 1964, it will not be lost by reason of the proposed amendments.

Before leaving the subject of leases I should mention provisions which it is proposed should apply to a premium paid for a lease of property that is not used for producing assessable income, for example, a premium paid in lieu of, or in addition to, rent for a lease of a private house or flat. At present such a premium is assessable income of the recipient but the payer does not, of course, receive a deduction for it.

Comparatively few premiums are paid in these circumstances but, following the introduction of the measures I have already described, there would, in the absence of some safeguard, be a tendency for lessors of private houses, and other properties not used by the occupier to produce assessable income, to look for the payment of a premium instead of rent. A provision to prevent loss of revenue in these circumstances is proposed by the Bill.

The next matter covered by the Bill to which I would refer relates to the taxation of certain income of trust estates.

The existing law has for many years provided a special basis of assessment for trusts set up by a taxpayer for his unmarried children under the age of 21 years. Under these provisions the tax payable on the income of such a trust is the amount that would have been payable by the taxpayer if he had not set up the trust. These provisions were examined by the Ligertwood Committee which found them to be unsatisfactory in practice. The Committee proposed that the scope of the provisions should be made wider. It also proposed that a tax of 10/- in the Pd should be charged on income of a trust if the deed of trust permits the settlor to vary its terms in favour of a minor unmarried relative.

In the circumstances now prevailing, it is unlikely that the Committee's proposal would prove reasonably effective. Nowadays it is found that large numbers of trusts are being set up in such a way that the special basis of assessment is circumvented. These devices are attractive because, if enough trusts are set up, very substantial amounts of income can be accumulated either completely free of tax or at a negligible tax cost. The devices rely a lot for their effectiveness on the fact that a taxable income of a trust estate of Pd208 or less is free of tax.

The Government proposes special measures to counter these devices. It is, at the same time, very much aware that not all trusts in which income is accumulated are set up with the purposes of avoiding tax that would otherwise be payable. With this in mind it is proposed by the Bill that the Commissioner of Taxation will be obliged to consider all the relevant facts of each particular case. The Commissioner will be authorised not to apply the new provisions where it would be unreasonable for them, as measures directed to preventing tax avoidance, to apply. Specific matters that the Commissioner must consider for this purpose are stated in the legislation.

The basic proposal regarding trusts is that a special rate of tax shall apply to trust income to which no person is presently entitled, that is to say, to income which is being accumulated in the trust. The special rate will not, in any circumstances, apply to the trust estates of deceased persons. The rate proposed, and to be formally declared at an appropriate time, is 10/- in each Pd of income.

The Bill also proposes measures arising out of recommendations of the Ligertwood Committee concerning the taxation of a share of partnership income which a partner does not effectively control.

The broad concept of the Ligertwood Committee's proposals in this connection is that such income should be taxed as though each of the other partners had received a share of it proportionate to his agreed share in partnership profits. Te Government has concluded that this basis would, in some cases, be unfair to other members of the partnership and, accordingly, does not propose to adopt it. The Government considers a better approach is to make the partner lacking control of the income liable for the tax and, where appropriate, apply a special rate of tax. The Bill adopts this approach to the problem. Separate legislation declaring the rate of tax payable on uncontrolled partnership income will be introduced at an appropriate time. I say now, however, that it is proposed that the income shall be taxed at the relevant partner's personal rate of tax or 10/- in the Pd whichever is the higher.

The Ligertwood Committee formed the view that certain partners under the age of 21 years ought to be deemed to lack control of their shares of partnership income. While recognising the basic merit of the Committee's view the Government considers the age qualification of 21 years unduly high. In reaching this conclusion, the Government has paid particular regard to family farm partnerships. What the Government proposes is that partners under the age of 16 years shall be deemed to lack control. Allowance will, however, be made for the value of any services rendered by such a partner in producing the assessable income of the partnership.

I pause here to refer again to a matter I have already touched on. The general measures proposed by the Bill are to counter tax avoidance. To be effective they have to be comprehensive, but it is also important that they should not affect arrangements which do not have the purpose of tax avoidance. To ensure this, it has been necessary to authorise the Commissioner not to apply particular provisions when the relevant facts do not warrant their application. The Commissioner will have this power in relation to the provisions relating to partnerships.

I shall pass on now to the matter of alienation of income not accompanied by a transfer of the assets producing the income. As Honorable Senators will know, most people cannot effectively transfer income to others so as to avoid or reduce the tax payable on it. Wage earners cannot so transfer their wages. Professional men cannot transfer their professional fees, and so on. The position then is that these devices can be used only by a relatively small section of the taxpaying community and thus confer a sectional advantage.

The Ligertwood Committee recommended that income alienated in the way I have mentioned should bear the tax it would have borne if the alienation had not been made, but only where the alienation is in favour of a minor unmarried relative of the taxpayer. If implemented, the Committee's proposal would have a very limited effect. The Government has given much careful thought to this matter and proposes by this Bill that a person who makes an assignment of income to another person, but retains the assets that produce the income, shall be taxed as though the assignment had not been made. This position will, however, apply only in relation to assignments made after 22nd October, 1964 and which will, or may, apply to income derived over a period of less than seven years.

Further measures in the Bill arise out of the Ligertwood Committee's recommendations concerning superannuation funds for employees. Measures relating to deductions for contributions to these funds follow the broad plan outlined by the Committee, and I do not propose to elaborate further on these at this stage.

The Ligertwood Committee also made recommendatiosm concerning the exemption from tax of superannuation funds. For the purposes of its proposals the Government has, in effect, divided these funds into three broad classes. The first class is one with which Honorable Senators will be quite familiar, that is, the traditional type of fund to which employers contribute for the benefit of their employees. The second class of fund accepts contributions from the general public and is not necessarily restricted to providing benefits for employees. These funds do, however, serve a useful purpose in providing retirement benefits for some employees who are not catered for by the traditional type of fund. They are, nevertheless, used also by contributors to some extent to accumulate income free of tax. In addition to the two broad types of funds I have mentioned there are also some funds which are in the form of superannuation funds but which are really only a means of accumulating capital and at the same time gaining freedom from tax on the income derived through the fund.

The Ligertwood Committee's broad proposals concerning the exemption of income of the traditional type of fund are being implemented by the Bill. Income of these funds will, generally speaking, continue to be exempt from tax if the existing rules regarding investment in public securities are adhered to.

The Committee proposed that a fund that does not comply with the tests it specified should be taxed on the excess of its current income over its income for the year ended 30th June, 1961. Largely for the reason that this basis would operate over-severely in relation to funds established since 1961 the Government does not propose to adopt this recommendation. The Government proposes an alternative basis which is, broadly stated, that a fund that does not meet the tests for full exemption will, in effect, be exempt from tax on its income up to an amount equal to 5 per cent of the net cost of its assets. To receive this exemption, these funds will be required to meet somewhat different tests from those that have to be met by fully exempt funds. As the level of exemption is to be limited to 5 per cent of cost of assets the Government does not propose to apply the "30/20" investment rule to these funds.

A further proposal of the Ligertwood Committee was that no superannuation fund should be exempt from tax on dividends from private companies and, in certain circumstances, other income derived from a private company. The Government considers, however, that a full and unconditional withdrawal of the exemption on private company dividends would not be warranted in all cases. Accordingly, it proposes that the Commissioner of Taxation will examine each case on its individual merits to determine whether such dividends should be taxed in full, without regard to any exemption otherwise available to a fund. To be treated in a corresponding way is income from a transaction by a superannuation fund with a person not dealing with the fund at arm's length. This income is to be taxed in full if it exceeds the amount that might have been expected to be received by the fund from the same transaction with a person dealing with the fund at arm's length, for example, a person completely independent of, and unassociated with, the fund.

As to rates of tax on the income of superannuation funds, no variation is proposed in relation to traditional type funds that may be subject to tax only if there is a failure on the part of the trustee to observe the "30/20" investment rule. Partially exempt funds and non-exempt funds are to pay 10-a in the Pd on income that is subject to tax. It is proposed that this rate shall also apply to income of any fund for employees that is to be taxed in the special circumstances I have already described. The rate of tax is being formally declared by another Bill on which I propose to speak shortly.

I come now to the final matter dealt with by this Bill. This is the matter of payments by a taxpayer to his relatives. Expressed broadly, the existing law has for many years provided that those amounts may be allowed as deductions only to the extent that the Commissioner of Taxation considers them to be reasonable in amount for their purpose. This Bill proposes to amend the law so that this principle is, in specific terms, applicable in relation also to payments by a partnership to a relative of a partner. It is also proposed by the Bill that any amount of such a payment that is not allowed as a deduction will in general not be treated as income of the recipient.

There remains for me to mention the commencing dates of the proposed measures. In general, the new law will be applicable for the first time in assessments on income of the coming income year- 1965-66. The amendments concerning leases are one exception. These will apply as from the day after the Treasurer announced the proposals, that is, from 23rd October, 1964. The measures applying to income of superannuation funds derived from certain private company dividends or transactions not at arm's length are the only other exception. These measures will also be effective as from 23rd October, 1964. Alienations of income made on or after 23rd October, 1964, will be subject to the proposed new basis of assessment in the income year 1965-66.

A memorandum giving detailed explanations of the measures contained in the Bill has been made available to Honorable Senators and I do not propose to say any more about the various provisions at this stage.

I commend the Bill to the Senate.