Report - Provisions of the taxation laws amendment Bill (No. 2) 1997

Report - Provisions of the taxation laws amendment Bill (No. 2) 1997

Membership of the Committee

Senate Economics Legislation Committee

Core Members

Senator Alan Ferguson (Chairman) (Liberal Party - SA)
Senator the Hon. Nick Sherry (Deputy) (Australian Labor Party - TAS)
Senator Grant Chapman (Liberal Party -SA)
Senator the Hon. Peter Cook (Australian Labor Party - WA)
Senator Andrew Murray (Australian Democrats - WA)
Senator John Watson (Liberal Party - TAS)

Senator Crane substitutes for Senator Watson on matters covered by the Industrial Relations portfolio.

Participating Members

Senator E. Abetz (Liberal Party - TAS)
Senator M. Bishop (Australian Labor Party - WA)
Senator R. Boswell (National Party of Australia - QLD)
Senator B. Brown (Australian Greens - TAS)
Senator B. Childs (Australian Labor Party - NSW)
Senator B. Collins (Australian Labor Party - NT)
Senator J. Collins (Australian Labor Party - VIC)
Senator M. Colston (Independent - QLD)
Senator S. Conroy (Australian Labor Party - VIC)
Senator B. Cooney (Australian Labor Party - VIC)
Senator J. Faulkner (Australian Labor Party - NSW)
Senator B. Harradine (Independent - TAS)
Senator K. Lundy (Australian Labor Party - ACT)
Senator S. Mackay (Australian Labor Party - TAS)
Senator D. Margetts (WA Greens - WA)
Senator B.J. Neal (Australian Labor Party - NSW)
Senator K. O'Brien (Australian Labor Party - TAS)
Senator C. Schacht (Australian Labor Party - SA)

Secretary

Mr Robert Diamond
SG.64, Parliament House
Canberra ACT 2600
Tel: (06) 277 3540
Fax: (06) 277 5719

Research Officer: Merrilyn Pyle

 

Background to the inquiry

The Taxation Laws Amendment Bill (No.2) 1997 was introduced in the House of Representatives on 13 February 1997 with the second reading adjourned on the same day.  On 6 March 1997 the Senate Selection of Bills Committee Report No. 4 of 1997 referred provisions of the Bill to the Economics Legislation Committee for examination and report by 30 May 1997.

As reasons for referral of the Bill, the Selection of Bills Committee Report stated the Committee should:

"Inquire into schedule 2 of the Bill as to whether it goes far enough in ensuring that fair tax is being paid in relation to non-resident, dividend and royalty withholding tax, (and) whether schedule 5 opens possible new areas of tax avoidance in this regard."[1]

As listed in appendix 1 to this report, the Committee received six submissions in respect of the Taxation Laws Amendment Bill (No.2) 1997.  The Committee regrets the submissions arrived too late in the inquiry process for a public hearing to be conducted.

 

Effect of the Bill [2]

The Taxation Laws Amendment Bill (No.2) 1997 amends taxation legislation to give effect to a number of 1996-97 Budget measures designed to prevent tax avoidance and address abuse of certain tax provisions and anomalies in the tax law.

The Bill also amends the interest withholding tax provisions as announced by the Treasurer in June 1996 in an effort to inject further competition into the Australian financial market and, in particular, the home lending market and update the provisions to reflect current overseas financial arrangements. Accordingly, the Bill proposes amendments in the following areas:

Amendments related to net capital losses

Amends Part IIIA of the Income Tax Assessment Act 1936 to ensure that:

  • net capital losses will attach to the year of income in which they are incurred and are recouped or transferred within a company group in the order in which they are incurred; and
  • where a net capital loss is transferred within a company group, the transferee company is required to satisfy the same recoupment tests (for example, the continuity of ownership test or the same business test) that apply to the transferor company.

Withholding tax avoidance

Amends the withholding tax provisions and Part IVA of the income tax law to:

  • extend the general anti-avoidance provisions of the Act - Part IVA - so that they apply to non-resident interest, dividend and royalty withholding tax;
  • address arrangements which attempt to convert an interest income stream into another income form which it is argued is not 'interest' or 'in the nature of interest';
  • impose withholding tax where royalties are derived by a resident in similar circumstances to those by which interest is subjected to withholding tax under subsection 128B(2A) of the Act;
  • ensure that withholding tax is payable where tax exempt bodies are interposed between an Australian resident payer and a non-resident recipient; and
  • remove any doubt that the withholding tax provisions apply to dividends paid out of capital reserves.

Dual resident companies

Amends the provisions of the Income Tax Assessment Act 1936 in respect to certain dual resident companies (and non-individual entities that are treated as companies) to deny specified benefits that are available in respect to resident companies and ensure the application of specified anti-avoidance measures that are targeted at non-resident companies.

Removal of standard superannuation contribution limit

This measure removes the right of employers to elect to use a standard contribution limit to calculate the upper limit of deductions allowable in relation to superannuation contributions they make for the benefit of their employees.  To calculate the upper limit all employers will be required to use their employees' age based limits.

Interest withholding tax and related provisions

Amends the interest withholding tax provisions of the Income Tax Assessment Act 1936 (the Act) to:

  • extend the section 128F exemption to wholesale borrowings by Australian companies by replacing the existing wide distribution test with a public offer test;
  • repeal the use of funds in an Australian business requirement in the existing section 128F;
  • restrict the section 128F non-resident borrowing subsidiary exemption to subsidiaries resident in countries listed in the Income Tax Regulations;
  • provide that the section 128F exemption will not be available if the company pays interest to an associate where the company issuing the debentures is aware or should have been aware that the interest was paid to an associate; and
  • introduce self assessment procedures for claiming the section 128F exemption.

Amends the income tax provisions of the Act to prevent an income tax deduction being claimed in respect of interest which is subject to interest withholding tax where the tax has not been deducted from the interest payment.

Amends the bearer debenture tax provisions of the Act to:

  • provide an exemption for bearer debentures issued by an Offshore Banking Unit; and
  • subject interest in relation to bearer debentures which are issued overseas by an Australian company and where interest is paid overseas, to taxation under the interest withholding tax provisions.

Amends the foreign bank branch provisions (Part 111B) of the Act to define the term 'interest' as having the same meaning as in the interest withholding tax provisions.

Amends the Income Tax (Bearer Debentures) Act 1971 to restrict the rate of tax to the top marginal rate.

Amends the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 to ensure that it will deal with the transitional period in relation to the section 128F interest withholding tax exemption.

Leases of luxury cars

Inserts a new Schedule into the income tax law that provides a legislative framework for the taxation treatment of leases of luxury cars. The lessor is treated as having loaned the lessee the money to acquire the car.  The lessor is taxed on the finance charge component of the lease payments, but not the lease payments themselves.  The lessee is able to deduct the finance charge component of the lease payments, but not the lease payments.  The lessee is also treated as the owner of the car entitled to relevant depreciation deductions.

 

Issues Raised in Evidence

Schedule 2 - Amendment of the Income Tax Assessment Act 1936:

                     Withholding tax avoidance

General concerns

In considering proposed changes to withholding tax arrangements the Australian Owned Companies Association submit that the underlying philosophy for a withholding taxation system should embody the tenets:

  • That there is fairness and that those who get a benefit or incur costs should be required to contribute at a reasonable rate in return for the benefit received or for the costs incurred.
  • That Australian citizens, investors and shareholders should not be at a disadvantage in comparison to foreign investors and shareholders. What is contributed to the ATO should be at the same maximum rate for both Australian and foreigner.
  • That Australia has an urgent need for more overseas investment earnings as dividends, and incentives should be given to encourage this.[3]

In the context of these principles the Australian Owned Companies Association advocates an increase in the rate of withholding tax so that foreign investors contribute at the same rate as Australian investors.  The Association bases its recommendation on the fact that "..by having nil or low levels of withholding tax the Australian Government is subsidising the Treasuries of major investing countries such as Japan, USA, UK and Germany."[4]

In contrast to the position of the Australian Owned Companies Association, Coopers and Lybrand submits that the withholding tax liability effectively is borne by the Australian individual or business making the payment.  In support of this view, Coopers and Lybrand refer to "gross up" clauses whereby the payer is required to pay the non-resident party an amount which, after deducting any Australian withholding tax, gives the non-resident party its required return.  Coopers and Lybrand believes that "Australian businesses would not be able to attract foreign investment or other funds without the presence of such gross up clauses.[5]

Definition of "interest" for withholding tax purposes

Item 1 of Schedule 2 to the Bill proposes amendments to the definition of "interest" in section 128A of the Income Tax Assessment Act 1936. The proposed changes will substantially broaden the category of payments which will be subject to interest withholding tax, and were widely criticised in evidence to the Committee. A number of groups including the Taxation Institute of Australia, Arthur Andersen and Coopers and Lybrand warn that there is significant risk that the amendments could apply to a wide range of genuine financial market transactions, for example, interest rate swap agreements (including cross currency swap agreements), forward exchange rate agreements, caps, collars, floors and options which are widely recognised as not being subject to withholding tax.

The Taxation Institute of Australia specifically noted the areas of repurchase agreements and factoring arrangements as likely to be inappropriately subject to the proposed new definition of interest. The Institute condemned this probable outcome, submitting that neither repurchase agreements nor factoring arrangements are entered into for the purposes of avoiding withholding tax. Factoring arrangements, for example, are entered into for financial advantages (ie including lower financing costs and cash flow advantages).[6]

In summary, the Taxation Institute of Australia submitted that the intention of the proposed changes is to prevent arrangements which have the effect of avoiding interest withholding tax by converting interest into some other form of payment which would not attract interest withholding tax. However, in the Institute's view, the proposed changes in the Bill do not reflect such an intention and if enacted are likely to create substantial uncertainty in the financial and derivatives markets.  In support of this view, Coopers and Lybrand suggests the Committee rejects proposed section 128(1AB) and propose an alternative amendment to ensure that genuine financial market transactions entered into in the normal course of a financial institution's business are not adversely affected.[7]

Following representations made to the government, the Committee notes that the government may proceed with some technical amendments concerning the definition of interest in respect of withholding tax.

Retrospectivity of proposed Schedule 2 amendments

Item 19 of Schedule 2 to the Bill provides that the proposed amendments concerning withholding tax avoidance would apply from the Budget night on which they were announced, namely 7:30pm, 20 August 1996. The proposed retrospectivity was widely condemned in evidence to the Committee, given its disregard for when a transaction may have been negotiated and thus likelihood of imposing withholding tax where there was no expectation a liability would arise. 

The Taxation Institute of Australia comments the retrospectivity "...is particularly harsh and unreasonable because the proposed amendments to Part IVA (of the Income Tax Assessment Act 1936) are intended to expand the scope of Part IVA and not to merely remove any doubt or uncertainty about the application of the existing provisions of Part IVA."[8]  The Corporate Tax Association adds that the transactions likely to be affected "..typically involve the offshore financing of major capital assets (eg ships, aircraft, major plant items) by Australian companies striving to be internationally competitive.  Withholding tax on such international funding arrangements is never borne by overseas lenders and invariably results in an additional tax burden on Australian borrowers."[9]

In further opposition to the retrospectivity of proposed amendments Coopers and Lybrand submit that given Part IVA is a purpose based, anti-avoidance provision it is inappropriate for the amendments to apply retrospectively. In accordance with this, the Committee was encouraged to recommend that the application date for the proposed amendments to Part IVA be amended to apply to schemes (ie defined in section 177A to include agreements, arrangements etc.) entered into after 20 August 1996 (the date of the announcement) or 13 February 1997, being the date on which the Bill was introduced in Federal Parliament.[10] Alternatively, the Corporate Tax Association suggested that a "grandfathering" period of possibly three years following Royal Assent be granted, during which affected taxpayers could re-structure their existing arrangements in accordance with the proposed new laws.

Part IVA: Reasons for no grandfathering

The Committee has received submissions in relation to grandfathering of the proposed measures dealing with withholding tax avoidance (including in relation to new subsection 128B(2C)) and the extension of Part IVA of the Income Tax Assessment Act 1936.  These submissions point out that the measures will apply to payments made after the 1996-97 Budget even where the payments are made in relation to contracts entered into before that date.

The Government considers that where it believed tax avoidance practices are being addressed, grandfathering of the anti-avoidance provisions may provide an indication to taxpayers that new avoidance arrangements can be entered into without the risk of being caught by any legislative response.

Specific anti-avoidance measures in relation to offshore permanent establishments

In relation to the specific amendments in new subsection 128B(2C) of the Bill, the ATO advises that the implementation provisions in the bill are consistent with previous withholding tax amendments. When the interest withholding tax provisions were strengthened in 1973 to cover interest payments made through offshore permanent establishments of Australian residents, the amendments announced by the then Treasurer applied to interest payments made after the date of the announcement (2 July 1973).  The absence of any grandfathering of pre-existing contracts can be explained in terms of the general policy behind the introduction of the interest withholding tax regime - that interest payments by residents to non-residents should be subject to withholding tax unless specific exemptions applied - its introduction being sufficient notice of the legislative intent.

The emergence of a practice of making royalty payments through permanent establishments created a need for a similar legislative amendment, on similar terms to the interest withholding tax provision, to ensure that such royalty payments are brought within the general policy of the royalty withholding tax regime that was introduced in 1992.  The ATO also advises that following the introduction of the Royalty Withholding Tax regime in 1992 it has seen the emergence of this technique to seek to avoid withholding tax on royalty payments. Some companies have done this in the face of clear evidence that these were viewed as minimisation techniques by the ATO and, as is evident in at least one copy of advice obtained by the ATO, that they could expect the ATO to act on obtaining evidence of it occurrence.

While views may differ as to what constitutes retrospectivity, the proposed amendments will not allow for clawback of interest or royalty withholding tax in respect of past payments and, in that sense, the measures are prospective.

Schedule 5 - Interest withholding tax and related provisions

Interest withholding tax exemption under section 128F

The Interest Withholding Tax exemption amendments of the Bill were strongly supported in evidence to the Committee on the grounds that they would remove a restriction which has prevented low cost overseas funds being lent to Australian homebuyers and consumers. PUMA Management Limited submitted that providing lenders with access to the cheapest overseas funds free of withholding tax is an important measure in maintaining competitive pressure to the benefit of Australia's homebuyers.[11]

 

Senate Scrutiny of Bills Committee's Consideration of the Bill

The Senate Scrutiny of Bills Committee considered the Taxation Laws Amendment Bill (No.2) 1997 in its second report of 1997. The Scrutiny of Bills Committee noted that item 19 of Schedule 2 to the Bill provides that the Schedule's proposed amendments would have effect from Budget night 1996, and therefore prior to Royal Assent. However, the Committee further noted that given the amendments concern a budget measure, they may be treated as "..something of a special case."[12] In support of its position, the Scrutiny of Bills Committee refers to a paper titled The Operation of the Senate Standing Committee for the Scrutiny of Bills, 1981-85, in which the then Chairman of the Committee, Senator Tate, stated:

It is customary...for budgetary measures to be made retrospective to the date of their announcement on Budget night and for changes to taxes, levies, fees to be given effect from the date of their introduction into Parliament.[13]

The Scrutiny of Bills Committee also acknowledged the retrospectivity provisions contained in Schedule 5 of the Bill.  Item 15 of Schedule 5 provides that the amendments proposed by Part 2 of the Schedule would apply in respect of a debenture issued on or after 1 January 1996 and therefore prior to Royal Assent.  However, given a transitional provision (item 16) quarantines interest paid on such debentures before the commencement of Part 2, the Scrutiny of Bills Committee accepts this retrospectivity.

Item 18 in Part 3 of Schedule 5 proposes that the Schedule 5 amendments apply to interest paid on or after 1 January 1996.  The effect of the amendments is to deny Australian residents an income tax deduction in respect of a payment of interest overseas if those persons have neither deducted nor remitted interest withholding tax to the Australian Taxation Office.  In respect of this proposed retrospectivity the Scrutiny of Bills Committee observes "..that the date of the 1 January 1996 is the same as the date from which the amendments in Part 2 commence. The relevant interest in Part 2, however, is quarantined until the commencement of these provisions. Neither the explanatory memorandum nor the second reading speech give any reason for requiring the relevant interest in Part 3 to be affected retrospectively from 1 January 1996.

The Committee further notes that the amendments give effect to an announcement by the Treasurer in June 1996. As the Bill has been introduced more than 6 months after the announcement and as the committee is unaware of any draft bill being published in the interim, the resolution of the Senate of 8 November 1988 may apply.  That resolution states that:

...where the Government has announced, by press release, its intention to introduce a Bill to amend taxation law, and that Bill has not been introduced into the parliament or made available by way of publication of a draft Bill within 6 calendar months after the date of that announcement, the Senate shall, subject to any further resolution, amend the Bill to provide that the commencement date of the Bill shall be a date that is no earlier than the date of introduction of the Bill into the Parliament or the date of publication of the draft Bill."[14]

The Scrutiny of Bills Committee has sought the Treasurer's advice as to why these interest payments have not been quarantined.  Pending a response from the Treasurer the Scrutiny of Bills Committee draws Senators' attention to the provision, as it may be considered to trespass unduly on personal rights and liberties, in breach of principle 1(a)(i) of the (Scrutiny of Bills) Committee's terms of reference.[15]

Recommendation

The Committee recommends that the bill be passed.

 

Senator Alan Ferguson
Chairman

 

Minority Report - Senator Andrew Murray

Taxation Laws Amendment Bill (No. 2) 1997

Senator Andrew Murray
Minority Report

The Australian Democrats dissent from the Committee's recommendation that the bill be passed in its present form, as we believe that the provisions in the bill fail to fully deal with leakage from the tax system through non-resident withholding tax arrangements.

The Democrats instigated this inquiry into the Taxation Laws Amendment Bill No 2 because of a concern that the Government's proposal to deal with withholding tax avoidance were inadequate to deal with the full scope of the problem. The evidence to the Committee, and research conducted by others, shows clearly that this is the case.

The extent of tax avoidance through withholding tax arrangements has long been a matter of contention. The House of Representatives Standing Committee on Finance and Public Administration reported on this matter in March 1991 in its report "Follow the Yellow Brick Road." The Committee, based on estimates by taxation academic Barbara Smith, suggested that tax avoidance on interest withholding tax by non-residents could have been as much as $943 million in 1988/9 alone[16], although the Taxation Office estimates the revenue loss was probably less than $380 million.[17] Since then, the Taxation Office has moved to close at least some of the withholding tax loopholes, with this Bill alone estimated to raise $100 million a year from 1997/8 on. In that respect, the bill is a welcome advance on current law.

Evidence presented to the Committee suggest that the loss to Australian revenue through perfectly legal withholding tax structuring is considerably higher than that. The Australian Owned Companies Association (AOCA) in its submission, pointed out that it is perfectly legal for a foreign investor to structure his/her arrangements to reduce their Australian tax rate to a maximum of 10 per cent, while an Australian investor will always end up paying at their maximum marginal rate, usually 48.7 per cent. [18]

Withholding tax on dividends paid to non-residents is particularly anomalous. The tax law in Australia set an ordinary withholding tax on dividends paid overseas of 30 per cent. However, taxation treaties with most nations have reduced this rate to 15 per cent. When dividend imputation was introduced by Treasurer Keating in July 1987, it was determined that fully franked dividends paid to non-resident shareholders would be made exempt from withholding tax. As AOCA pointed out in its submission, this has resulted in most dividends escaping out of Australia without any tax being paid by the shareholders. In 1995/6 dividends paid to foreign investors totalled $12.843 million, but withholding tax on dividends netted only $153 million, just 1.2 per cent of dividends.[19]

This treatment can be contrasted with resident shareholders. With such shareholders, franked dividends at the top marginal rate are taxed at an effective rate of 19.8 per cent after taking into account imputation credits. If dividends paid to foreign investors were taxed at the same effective rate, the Australian tax office would have been $2.39 billion better off last financial year. That is the cost to the Australian taxpayer of the current withholding tax arrangements on dividends. As many countries do not give their taxpayers a tax credit for company tax paid, but only for withholding tax paid, Australia is directly subsiding the treasuries of other countries. [20]

The withholding tax arrangements on interest create other difficulties.  Tax treaties typically reduce the tax paid to foreign investors on interest earned in Australia to just 10 per cent. AOCA points out that this very low rate allows foreign investors to avoid payment of company tax by arranging a loan through a third party from the foreign parent to the Australian subsidiary. The interest on this loan becomes a tax deduction, with only nominal interest withholding tax at a maximum rate of 10 per cent payable.[21] To combat this, the AOCA recommended that withholding tax payable on interest paid on foreign borrowings by companies from related companies, non-bank financial institutions or other unlicensed organisations should be at the rate of 48.7 per cent. [22]

The House of Representatives Committee was also concerned that Australian residents might contrive arrangements using non-resident third parties to convert interest earned in Australia into interest paid overseas. It recommended that the Commissioner be given a discretion to impose the top marginal rate of tax on such arrangements[23] , and that interest streamed through a trust to non-treaty country beneficiaries should be subject to ordinary non-resident rates of tax rather than the withholding tax rate.[24]

Yet, while Schedule 2 of this bill closes the scope for some loopholes, instead of addressing the issues with the taxation of interest paid to non-residents in a  comprehensive way, the bill also adds to the opportunities for avoiding withholding tax. Schedule 5 of the bill  extends the exemption from interest withholding tax to a wider range of loans in Australia. The Australian Taxpayers' Association has questioned the fairness of this measure, with its National Director Peter McDonald  asking why should non-residents be exempt from tax on their Australian income:

"Australians have to pay up to 48.7 per cent on interest they earn on savings, plus provisional tax is payable at up to 51.6 per cent if a resident earns $1,000 or more on interest income. Under existing rules., there is a real disincentive to save which is caused by high marginal rate and provisional tax payable on savings. Consequently, Australia's savings rate has decreased and borrowing has increased. These new rules will only add further incentives to borrow and less incentive to save....We are most concerned about the inequity of the different tax treatment between residents and non-residents."[25]

AOCA expressed similar concerns about the extent to which foreign borrowing has been encouraged by the interest withholding tax system. The Association pointed out that interest and dividends paid overseas constituted 95 per cent of Australia's current account deficit, and have grown from $20 billion in 1992 to $27.8 billion in 1996.

The Australian Democrats recognise that much of the scope for tax minimisation in withholding tax arises not from Australian law, but from tax treaties. Indeed, it could be argued that the general framework of tax treaties with typically low 10-15 per cent withholding tax disadvantages capital-importing countries like Australia at the expense of capital exporting countries. It is no surprise then to find that general international tax arrangements were largely designed by capital exporting countries as part of the Bretton Words arrangements after World War II. Indeed, the growing difficulties with international tax arrangements has lead one of Australia's most prominent tax economists, Professor John Head of Monash University, to call for a "GATT on taxes" to ensure tax is properly paid and equitably shared.

The rising level of foreign debt and foreign investment in Australia has seen the disadvantage suffered by Australia as a result of withholding tax also rise. In the past fifteen years, Australia's net foreign liabilities (ie. net foreign debt and net foreign equity investments) has risen from about 20 per cent to a massive 58.5 per cent of GDP.[26] That means that a very large proportion of our economy, almost 40 per cent of GDP, is increasingly being taxed at the concessional withholding tax arrangements rather than at full resident rates. With a growing proportion of our national income flowing to non-residents, Australian authorities need to give urgent attention to any holes in our tax net, while also lobbying to minimise the extent of our internationally disadvantaged position.

While the five anti-avoidance measures announced in this bill, combined with the measures announced in the Budget on taxation of foreign sourced income and trading in franking credits, are welcome improvements, they fall well short of what is necessary to ensure that foreign investors pay their fair share on income earned in Australia. The contribution of undertaxation of income paid to non-residents to the Budget deficit and to the fall in national savings generally obviously needs urgent and detailed consideration.

Recommendations:

  1. While not opposed to the anti-avoidance provisions in the bill dealing with non-resident withholding taxes, the Committee believes that the provisions fall well short of guaranteeing that non-residents pay an appropriate amount of tax on income earned in Australia.
  2. The Committee recommends that the Government give consideration to amending the bill to remove the exemption for fully franked dividends from payment of withholding tax, and consideration to raising the level of withholding tax on dividends to 20 per cent.
  3. The Committee recommends that the Government give further consideration to amending the bill to tax interest on loans through a related company by a non-resident at the top marginal tax rate, and consideration to the use of discretionary trusts to minimise payment of withholding tax.

 

Senator Andrew Murray

 

Appendix 1 - List of Submissions

1

Australian Owned Companies Association Ltd

NSW

2

PUMA Management Limited

NSW

3

Taxation Institute of Australia

NSW

4

Coopers & Lybrand

NSW

5

Corporate Tax Association

VIC

6

Arthur Andersen

NSW

Navigation: Contents