Overview
4.1
Investors consider a range of factors when making investment decisions, including any tax concessions associated with various types of investments. Differences in the tax treatment of Australian and offshore investors may also impact on investment decision making.
4.2
This chapter contrasts the tax treatment of corporate bonds with other forms of debt financing to understand whether current taxation arrangements are hindering the development of the corporate bond market in Australia. In particular, consideration is given to the impact of tax on both issuers and investors to determine whether there are any impediments in the tax system that unduly restricts the uptake of corporate bonds, and the nascent retail corporate bonds market in particular.
4.3
Australia has a large pool of domestic savings through its superannuation industry. This chapter outlines the barriers and opportunities regarding investment by superannuation institutions and retirees in retail corporate bonds, and considers ways Australian businesses could benefit from a larger pool of domestic savings through its superannuation industry.
Tax treatment of investments
4.4
The Inspector-General of Taxation and Taxation Ombudsman (IGTO) and Gilbert + Tobin saw tax considerations as having only a limited or marginal impact on investors’ decisions. The IGTO, Ms Karen Payne, advised that tax settings were not ‘the answer’ to creating a stronger retail corporate bond market. Ms Payne further stated that corporates make decisions regarding equity or bonds based on more than just tax settings:
… corporates use non-tax reasons to determine how much of a debt stack they want and how much equity they need. So, again, it's not being driven by tax, but, if you were just looking at it through a pure tax lens, then the corporate would say: “It's more tax efficient to take a debt position and get an interest deduction than it is to take equity.” But it could be that equity is a more expensive form of capital raising than debt, so there's a trade-off.
4.5
Gilbert + Tobin told the Committee that it believes that different taxation methods were unlikely to have a significant impact on the corporate bond market’s ‘size and shape’ and that ‘the tax treatment of corporate bonds generally does not differ from that of other debt.’ It thought that ‘there is not a tax-related preference for other forms of debt over corporate bonds,’ and cautioned that:
… in considering a more neutral taxation of returns from debt and equity, care must be taken to have regard to the overall impact on the Australian tax revenue of such a proposal including the policy underpinning the different treatment of debt and equity returns.
4.6
Gilbert + Tobin referred to the 2014 Financial System Inquiry, which found
‘a bias for individuals and institutional investors (including superannuation funds) created by the dividend imputation system as potentially contributing to the lack of a deep domestic corporate bond market in Australia.’
4.7
The National Australia Bank Ltd (NAB) stated that ‘there seem to be limited barriers in the current system driven by tax,’ yet suggested that:
Through the use of potential tax incentives, the government could encourage further investment in fixed income as an asset class. This could also potentially support key government policy initiatives such as infrastructure investment through incentivising private sector funds to more heavily participate in debt directed toward government policy initiatives.
4.8
In contrast, several submitters saw the differential tax treatment as an impediment to growing a vibrant corporate bond market in Australia. Dr Shumi Akhtar outlined that the differential tax treatment of debt and equity investments may deter investment in corporate bonds:
An … important deterrent for Australian investors (on the supply side) investing in Australian corporate debt instruments is because of the differing tax treatment between equity and debt investments. Under Australia’s imputation tax system, an Australian investor earning $100 from an equity investment will enjoy a far more beneficial tax treatment as opposed to a debt investor of the same amount.
4.9
Senator Gerard Rennick also highlighted that Australia was ‘one of the few countries in the world to allow the offset of franking credits on dividend income,’ which has led many investors to ‘purchase equity in Australian companies rather than lend to Australian companies.’
4.10
Dr Rand Low (Dr Low) similarly stated that there was a ‘tax bias towards equities and real estate,’ and explained that:
The key issue here is that when you look at equities you have franking credits. If you look at real estate, you have negative gearing. You have nothing for corporate bonds. So what we suggest is that you allow corporate bond investors to have franking credits, but these are only accessible by self-managed super funds or Australian investors only.
4.11
The IGTO highlighted a Deloitte Access Economics (DAE) report, which outlined the tax benefits associated with some forms of investments:
Corporate bonds do not receive the tax benefits that some other investments receive, such as dividend imputation for shares or the possibility of negative gearing for investment properties. Indeed, some 14 per cent of private investors without corporate bond holdings cited this lack of tax effectiveness as a barrier to investment.
4.12
Notwithstanding, the IGTO also highlighted that the DAE report noted that this meant there were less political risks associated with corporate bond investments, as they were less likely to be impacted by future government changes to tax policy.
4.13
FIIG Securities Limited (FIIG Securities) told the Committee that Australian retail corporate bond investors felt they were ‘unfairly penalised’ and argued that there ‘should be a level playing field’ across asset classes and that their tax treatment should be equitable. They described the absence of benefits for fixed securities compared to other types of investments:
Current structural characteristics of the Australian taxation system such as the dividend imputation system (shares) and negative gearing (property) do not have an analogous concessional treatment when it comes to corporate bond or fixed income investment.
4.14
FIIG Securities was of the view that the Australian Government and the Treasury should ‘provide greater incentive for corporate bond and other fixed income investment in Australia’ and that ‘there is a fundamental need for structural changes in the Australian taxation system’. They advised:
The current imbalance in the tax treatment of the various asset classes has served to dramatically and dangerously distort asset allocation practises in Australia such that they are extremely different to other Organisation for Economic Co-operation and Development countries and materially divergent from what is considered to be well documented best practises… Australian companies looking to raise debt capital have little to no opportunity to do so outside of the traditional credit providers, whose appetite for risk may not be consistent, available or suitable. It means that the borrower and investor are forced to take greater risk.
4.15
FIIG Securities further outlined, however, the political realities of achieving this goal:
In an ideal scenario, the Australian Taxation System should simply promote each of the asset classes in a simple and equitable manner … to remove any distortion which has longer term structural and cultural detrimental effects. … An obvious solution to remedy this imbalance in relation to equities was comprehensively rejected by the Australian voters at the last election and political appetite to address negative gearing in the property sector is also understandably closed-mouthed.
4.16
In light of these considerations, FIIG Securities also recommended that a level playing field could be achieved through the implementation of providing ‘tax exemptions on bonds in a self-managed superannuation portfolio up to an allocation of 40 per cent of the portfolio.’
4.17
The Australian Financial Markets Association (AFMA) suggested considering ‘the extent to which tax asymmetries have stymied the development of the corporate bond market in Australia’ and considered that a holistic review of the tax treatment of savings vehicles:
AFMA’s position is that the different tax treatment of corporate bonds, particularly for investors, and the extent to which this treatment has hindered the growth of the Australian corporate bond market, should be considered as part of a more holistic review of the tax treatment of savings vehicles, and potentially the tax system more broadly.
4.18
AFMA further suggested that there was a need ‘to acknowledge that there is a bias towards the concessional treatment for equities vis-à-vis debt and to consider some sort of consistent discount across savings vehicle classes.’
4.19
King & Wood Mallesons (KWM) suggested introducing a new tax concession for Australian bondholders to encourage domestic investment and address the ‘structural imbalance’ in the tax treatment of investment vehicles. KWM advised that:
The Australian tax system provides significant incentives for investment in equities, and for investment in bonds by foreign residents. The dividend imputation system provides Australian residents with a credit for the tax paid by the company referable to the dividend amount, and in some cases this can result in a refund. There is no equivalent concession for interest derived by an Australian resident on a bond. In isolation, this incentivises investment by Australian residents into Australian equities as opposed to Australian bonds… Foreign residents receive a dividend withholding tax exemption on fully franked dividends and are exempt from interest withholding tax on debentures that have been publicly offered under section 128F of the Income Tax Assessment Act 1936 (Cth).
Domestic and international tax arrangements
4.20
Data from The Treasury shows that the issuance of corporate bonds in Australia is much lower than in the United States of America (US),
New Zealand and Europe, which are all described as having ‘thriving retail corporate bond markets.’
4.21
FIIG Securities commented on international capital markets in the US and Europe, which they said ‘have a fundamentally different approach to asset allocation which is mature and fostered by sophisticated taxation systems which don’t seek to favour or prioritise one particular asset class over the other.
4.22
Dr Akhtar commented on Australia’s corporate debt activity compared to its closest debt market competitors and stated:
Australia falls severely short in its corporate bond issuance on offer relative to Singapore (which had three times more corporate bond issuances than Australia) and Hong Kong (double the number of corporate bond issuances compared to Australia).
Taxation for resident and non-resident lenders
4.23
The IGTO advised that ‘although investors preference are likely to be determined by a range of non-tax related factors’ it is worth considering:
Whether the Australian tax settings and foreign capital requirements can contribute to circumstances which favour capital bond raisings in foreign markets. That is, because the after-tax return received by resident versus non-resident investors for an Australian issue or foreign issue or corporate bonds can differ.
4.24
The IGTO added that:
Non-residents are generally subject to a final ten per cent interest withholding tax subject to the terms of any relevant double tax agreement and any specific exemptions provided under domestic laws.
4.25
Senator Gerard Rennick explained to the Committee that offshore lenders have a distinct tax advantage over Australian lenders in relation to corporate bonds:
Australian lenders are subject to the full corporate tax rates on their interest margin. On other hand, offshore lenders who issue a corporate bond, subject to certain conditions are not subject to any withholding tax in Australia because they can receive an exemption under s128F of the Income Tax Assessment Act … If the foreign lender has structured a special purpose funding vehicle in a nil or low taxing jurisdiction, they will pay a much lower tax rate on their interest margin than an Australian lender.
4.26
Senator Rennick added that the result of these arrangements is that ‘the cost of foreign debt will be lower than domestic debt,’ and that ‘as a result onshore entities will use foreign debt to fund their operations,’ which may lead to a ‘greater reliance on foreign debt’ in Australia, adding that:
Australia needs to attract or welcome foreign capital given our small population size. Whilst all investment is welcome, our country does not need to give special treatment to foreigners to attract investment and capital.
4.27
Mr Julian Cheng from Gilbert + Tobin further outlined this issue:
… [there is a] distinction between foreign residents and Australian residents investing in debt, including corporate bonds, and the differential rates of tax there, where an investor from offshore would typically be taxed the withholding tax of 10 percent on the returns and on corporate bonds as compared to an Australian resident investor, who could be taxed up to 45 per cent depending on whether they're an individual or a super fund, which might have access to a lower rate of tax.
4.28
Dr Shumi Akhtar similarly stated:
…Australian resident lenders are disadvantaged relative to non-resident investors due to the seemingly different tax treatment. A more favourable tax treatment of debt income would go a long way towards encouraging local investors and lenders to dive into debt market investments. This is especially critical for our senior investors and retirees.
4.29
Gilbert + Tobin considered that neutralising the apparent presence for foreign investors to be an ‘overly simplistic analysis’ and that ‘while there are differences between the tax treatment of Australian resident and foreign resident investors who invest in Australian corporate bonds or debt, there is broadly no difference between the taxation of corporate bonds as compared with other forms of debt financing. For example:
…increasing our withholding tax rate on interest (when combined with the tax ultimately borne in foreign jurisdictions) may reduce the pool of investors available to invest in debt. Some foreign investors may be subject to a higher rate of tax on the interest in their home jurisdictions and may be entitled to a foreign tax credit for withholding tax deducted in Australia.
Supporting domestic investment
4.30
Mr Philip Harvey from KWM advised that reasons corporates may look overseas for funding include a diversity of investor markets and that some markets (such as the US) offer greater certainty and the option of longer duration bonds.
4.31
AFMA also highlighted that offshore markets provide greater certainty for investors:
… one of the drivers for issuers to issue in offshore markets as opposed to in Australia is that there is greater certainty on price and volume with respect to issuing in the offshore market. That is, the depth and liquidity that exists in offshore markets provides stiff competition to issuance in the Australian market.
4.32
FIIG Securities considered that:
Australian Borrowers and Corporates (including Corporate Treasurers) should have confidence in accessing capital in their own domestic market without having to consider offshore alternatives or at least in conjunction with.
4.33
To encourage domestic investment in bonds, FIIG Securities suggested that ‘a tax on issuers who source debt capital from offshore (which would act as an impediment) would assist with progress in the development of the domestic debt capital market.’
4.34
Senator Rennick recommended that to ‘create or at least give fair opportunity to a domestic retail corporate bond market,’ a solution is to:
… raise withholding tax rates so they are commensurate with or even above the tax rates incurred by lenders in Australia. To ensure no double taxation, the foreign lender should be entitled to a tax offset on the tax payable in its resident country. If the foreign lender is worse off, this can be resolved by setting up a permanent establishment in Australia which will ensure that double taxation doesn’t apply by applying transfer pricing rules. Taxing should focus on cumulative rate of tax paid between two countries rather than double taxation.
4.35
Senator Rennick further recommended that the government ‘seek to ensure that 50 per cent of the profits sent offshore from payments such as interest, royalties are declared as assessable income in Australia and taxed at the same rate as income earned in Australia.
4.36
Senator Rennick also pointed to Ireland as an example, where the corporate tax rate is 10 cents with a withholding tax of 15 per cent on some items, which the Senator said is to ‘encourage capital into Ireland but punish that [which] is sent from Ireland.’
4.37
Gilbert + Tobin similarly stated that there were differences between the tax treatment of Australian residents and foreign resident investors, but that detailed government modelling would be required before any reforms (such as an increase in the interest withholding tax rate) were considered.
4.38
Mr Cheng from Gilbert + Tobin also added that there were international factors at play:
… Australia's entered into treaties with a lot of other countries. So even increasing the withholding tax rate under our domestic legislation, if most of this is coming in from treaty jurisdictions, Australia's treaties generally provide for a 10 per cent cap in any event. So you're really only going to be getting an uplift in terms of the revenues from foreign residents investing in corporate debt if their countries are not treaty jurisdictions.
4.39
Dr Low and Dr Terry Marsh stressed the ‘importance of parity in tax treatment and regulations’ and made several tax adjustment recommendations:
Harmonising Australian corporate bonds and competing securities; and across both domestic and international investors… Providing tax rebates on the bond coupons of companies from specific industries … in which the Australian government is encouraging growth and investment… Allowing capital loss from bond default to be deducted from other income.
4.40
The IGTO pointed to the ‘need for the ATO to provide greater tax certainty in the form of public and private rulings’ and related concerns from practitioners about the decrease of binding advice provided by the ATO. For example, the IGTO explained that:
Depending on the nature of the bond, it can be classified as either a debt or equity interest for Australian taxation purposes. However, the relevant classification for tax purposes can be difficult to make in some circumstances and need not align with accounting or market classifications. That is, the debt versus equity divide is not strictly a bright line test for all purposes.
Superannuation investment
4.41
The IGTO pointed to DAE research that highlighted a low level of superannuation investment in bonds:
The DAE Report observes that, in 2016, bonds comprised less than 10 per cent of Australian superannuation fund investment portfolios - less than the Organisation for Economic Cooperation and Development average of 40 per cent … The DAE Report noted that low levels of bond holdings are particularly evident in Self-managed Superannuation Funds which had one per cent of assets held in debt securities in 2017.
4.42
The Association of Superannuation Funds of Australia Ltd (ASFA) added, however, that superannuation funds ‘make investments in accordance with the best interests of their members, and that is to optimise risk adjusted returns over the long term.’
4.43
Some submitters highlighted to the Committee the potential for Australia’s superannuation industry to be a larger source of domestic capital.
Senator Rennick stated that Australia’s $3 trillion superannuation industry ‘could and should be used to fund Australian industry,’ and that it also ‘disproves the myth that Australia has a shortage of capital.’
4.44
The ASFA saw Australian Prudential Regulation Authority (APRA) superannuation funds as a ‘key investor segment for Australian corporate bonds’, indicating that ‘ASFA estimates that APRA-funds hold around
$60 billion in Australian corporate bonds, which comprises around
10 per cent of the market.
4.45
ASFA outlined the use of corporate bonds by its members:
APRA-regulated superannuation funds invest in Australian corporate bonds as part of a diversified portfolio of investments. As at the end of June 2020, superannuation funds had direct holdings of Australian corporate bonds totalling $34 billion, as well as indirect holdings. Overall, ASFA estimates that holdings of Australian corporate bonds by superannuation funds total around $60 billion.
4.46
ASFA stated that ‘superannuation funds stand ready to mobilise the savings of Australian workers to help fund new investments by Australian corporates.’ There were a number of barriers, however, to superannuation funds increasing their investment in corporate bonds. Structural impediments outlined by ASFA included:
‘there is only a small number of new bond issues each year (around 30 per year) in the Australian market’, and ‘issuance tends to be concentrated in a few industries (particularly banking and resources),’ which ‘limits funds’ capacity to diversify credit risk in their portfolios;’ and
‘investment in a particular corporation’s bonds may add to concentration risk in a fund’s broader portfolio,’ if the fund has a ‘correlated exposure to that corporation through holdings of the corporation’s listed equities.’
Capital gains tax
4.47
The IGTO commented on the taxation of the disposal of corporate bonds and emphasised that:
Tax implications and consequences from proceeds (gains or losses) made from the disposal of corporate bonds may vary depending on individual circumstances and the type of investor… The profit from the redemption of corporate bonds is generally treated as ‘other income’ and not treated as concessionally taxed capital gains. Conversely, where there [is] a loss made on redemption, a ‘revenue’ deduction can be claimed and no capital loss recognised.
4.48
Gilbert + Tobin commented on the differential tax treatment of capital gains for the redemption of bonds, stating:
In relation to capital gains on the disposal of equities, Australian resident investors (excluding companies) may also be entitled to a 50 per cent capital gains tax (CGT) discount such that they are only subject to Australian tax on 50 per cent of any capital gains. Complying superannuation funds may be entitled to a lesser CGT discount of 33.3 per cent. The position is different for debt in that no CGT discount is available for gains [that] may arise on the disposal or redemption of bonds.
4.49
Dr Low noted that the majority of superannuation savings was invested in equities. To encourage investment in bonds, he put forward a proposal involving capital gains tax concessions:
… we need to encourage people to rebalance their portfolios from equities onto bonds. For the issuers, why they may be reluctant to do this, it's because of capital gains tax. So we suggest that we provide some sort of capital gains tax concession that allows superannuation funds or self-managed superannuation funds to swap up to 40 per cent of their total holdings towards corporate bonds. This would engender or encourage the take-up of corporate bonds as well.
4.50
Dr Low further suggested an alternative could be to use a ‘glide path’ for tax concessions to encourage individuals to increase their investment in corporate bonds as they get closer to retirement:
Basically, individuals who are, let's say, 20 to 30 years should have a lower allocation of corporate bonds, and if they grow older they should increase their allocation of bonds and follow a glide path, where basically the capital gains tax concessions follows that glide path. So that should nudge asset allocation towards high-grade corporate bonds in retirement funds and also try to level the playing field between equities and real estate and corporate bonds.
Committee comment
4.51
Investors in Australia and internationally will consider the tax treatment of any type of investment as part of their decision making. This may include decisions as to whether to invest in debt or equity; or whether to invest domestically or offshore.
4.52
Evidence provided to the Committee highlights that corporate bonds do not attract the same level of tax concessions as other investment options, such as shares or real estate. In addition, the Committee heard that Australian investors may be disadvantaged in comparison to offshore investors, due to differential tax treatment.
4.53
The Committee is of the view that further consideration of these issues by the Australian Government should be part of a holistic review of the tax treatment of savings vehicles or the tax system more broadly, to ensure that any changes in one area do not have any unintended consequences or flow-on effects.
4.54
The Committee was interested in the comparison of tax arrangements for debt financing in Australia with other economies to identify avenues to better support domestic investment and recovery efforts. This is especially in light of the recent crises which have deeply impacted Australia’s economy and jobs, including the 2019-2020 bushfires and the COVID-19 pandemic.
4.55
The Committee found that Australia has a large pool of domestic savings through its superannuation system, and that there is an opportunity to increase the investment of superannuation in corporate bonds. Corporate bonds offer an opportunity for superannuation funds and self-funded retirees to increase diversity in their portfolios, while providing more stable returns and lower risk than other types of investment.
4.56
The Committee recommends that the Australian Government investigates the impact of increasing tax incentives to support the development of the corporate bond market to create alternative sources of funding and increase opportunities for investors to diversify their investment portfolios.
4.57
The Committee recommends that the Australian Government further engages with mature and sophisticated international capital markets to determine how Australia could adjust its taxation system to further enhance domestic and international investment through the growth of the corporate bond market.
4.58
The Committee recommends that the Australian Government investigate options to remove barriers inhibiting the investment of superannuation in the Australian corporate bond market.
Mr Jason Falinski MP
Chair
6 October 2021