New The unconvincing case for 25% - Microsoft · 2018. 4. 26. · 5 This was enacted by the Tax Laws Amendment (Small Business Measures No. 1) Act 2015 (Cth). 6 The 27.5% rate was

51

The unconvincing case for 25%

Graeme Cooper*

Abstract

This article examines several elements of the case currently being advanced for reducing Australia’s corporate tax rate to 25%. In essence, the proposal is for an immediate, certain and widely dispersed revenue loss wagered in the hope of triggering a contingent and deferred response from a narrow target. The article revisits the history of this proposal and the development of the argument in the last two decades. It then queries some impressions embedded in the current debate — that the proposal is for a tax cut, that a 30% rate on commercial profit is actually paid (or meant to be paid) by most companies, that the imputation system will negate much of the cost of the lost revenue and that most foreign investors will benefit from a reduced corporate rate. The article concludes that, while the proposal may be sensible for other reasons, the case currently being made is unconvincing.

Keywords: corporate rate; corporate tax; imputation; tax cuts.

* Sydney University Law School. This article is a portion of a larger project on capital income taxation being undertaken with Patricia Apps, Ray Rees and Richard Vann.

This article was accepted for publication on 3 November 2017.

03_ATF-33_1_Cooper_Print.indd 51 3/23/2018 4:37:50 PM

52 (2018) 33 AUSTRALIAN TAX FORUM

1. The 25% proposal

The proposal announced by the Treasurer in the May 2016 Budget — the Ten Year Enterprise Tax Plan1 — for a gradual reduction of Australia’s corporate tax rate became one of the major points of difference between Australia’s major political parties in the July 2016 election and has remained an obvious point of difference since then. This was not the first time that the corporate tax rate had featured in Australian political debate but it was a key distinction between the parties, with both the ALP and Greens promising that, if elected, they would not proceed with the proposed gradual reduction of the rate to 25% by 2026 for all companies.

This article is about the cogency of the arguments which underpinned the Budget proposal and the government’s election policy. To be clear, the article is not directly addressing the difficult normative question, should Australia’s corporate tax rate be reduced to 25%, and the consequential issues — by what date, at what speed, for which companies, and so on.

As will be seen, the case for reducing the corporate rate, both in the past and in the current debate, is very largely based on the effects that a reduction would have on levels of foreign direct investment in Australia.2 But the focus of this article is on the question, how compelling are the arguments that lie behind that recommendation? The case being made is that an immediate, certain and widely dispersed revenue loss3 should be wagered in the hope of triggering a contingent and deferred response from a narrow target audience.4 Do the reasons advanced so far suggest that is a good bet?

1 Australia, Budget 2016-17: Budget paper no. 2 (2016) 40-41. Available at http://budget.gov .au/2016-17/content/bp2/download/BP2_consolidated.pdf.

2 The Budget papers declare “a more competitive company tax rate will encourage investment, raise productivity, increase GDP and over time raise real wages and living standards”. Australia, above n 1, 40.

3 Just how large the revenue loss might be, and who would benefit from it, has been the subject of heated exchanges in political circles. At the time of the 2016 Budget (Tuesday 3 May 2016), the Treasury estimate was $2.7b over the four-year forward estimates period. Australia, above n 1, 41. By Friday of Budget week (Friday 6 May 2016), this figure had been elaborated to $48b over 10 years by Treasury Secretary John Fraser during evidence given in Senate Economics committee hearings. Senate Economics Legislation Committee, Official Committee Hansard, 6 May 2016, 11 (“the cost of these measures to 20-26-27 is $48.2bn in cash terms”). By 11 May 2017, the Treasurer had amended this figure to $65b over 10 years, the figure which is now used in the public debate as the likely cost of the measure. House of Representatives, Hansard, 11 May 2017, 4392.

4 There does not appear to have been any similar challenge to the size of the gain estimated to arise — an increase to GDP of 1% by 2026. Senate Economics Legislation Committee, Official Committee Hansard, 6 May 2016, 11, evidence of John Fraser (“Treasury has estimated that the government’s tax package [will] increase the level of GDP by a little over 1 per cent in the long term”).


53THE UNCONVINCING CASE FOR 25%

It is, of course, quite conceivable that the corporate rate should be reduced to 25%, but for reasons quite different to those advanced so far — that there are beneficial, but entirely domestic, consequences that would follow or that we are somehow being unfashionable in not following current international trends. In short, the 25% rate might be good policy or bad; the argument of this article is that the case presented so far is less than compelling.

Part of the problem for those who wish to see a rate cut lies in the breadth of the terrain that the corporate tax covers: the one policy instrument applies largely indiscriminately to small companies and large companies, to privately held and widely held companies, to those undertaking active business operations and those holding mostly passive investments, to those needing to go to capital markets for further funding and those that are stable or even in decline, those that raise their capital locally and those that rely significantly on foreign markets, and to those principally with local shareholders as well as those with a large proportion of foreign shareholders. Unless some nuances are introduced to the base or the rate or both, it is a very blunt instrument.

There is no doubt that Australia’s corporate tax system might be adjusted to incorporate more nuance and differentiation, but the debate about the rate has not attempted much differentiation: the case seems to be based on a “one-size-fits-all” view of the corporate tax rate — arguments are presented because they are seen as persuasive for one sector, even though they will have impacts on all other sectors and are not especially cogent in those arenas. In fact, that is the lesson of the recent past: the case for a rate reduction is advanced using arguments relevant for large, publicly owned, foreign-funded companies that need further capital; the benefit of the recent rate cuts have been delivered to small, privately owned, locally funded, possibly stagnant companies. The incongruity between policy proposal and practical outworking is striking.

And finally, it is perhaps worth pausing to say the main focus is on the merits of the debate as it is presented in tax policy circles. The article will occasionally allude to the political debate and the popular media, but criticising politicians or the media for being less than accurate is hardly worth the effort.

2. Some (recent) tax history

The May 2016 Budget was not the first time that the idea of a reduction to the corporate tax rate was raised in Australian tax policy circles. Indeed, it is an outcome that is probably now accepted as inevitable by many in the community: it might not happen today; it may not happen tomorrow; but it will happen one day.

The momentum of Australian tax history would tend to support that view. The 30 years since 1986 have seen Australia’s corporate tax rate decline (almost) steadily



from 49%. The 49% rate declined to 39% (1988), and then to 33% (1993), followed by an aberrant and temporary increase to 36% (1995), and then the decline resumed, to 34% (2000) and on to the current 30% (2001).

Alongside this steady decline, a new trend emerged directed just to the small business sector: in the May 2014 Budget, the government announced that a separate 28.5% rate would be applied from 2015 to small companies (with turnover under $2m per annum),5 and in the May 2016 Budget, the government announced that this rate would decline further to 27.5% from 2016 and be extended to more small companies (with turnover under $10m per annum).6

As originally enacted, the 27.5% corporate rate applied to “the taxable income of a company [that] is ... a small business entity for a year of income”, meaning that a company would enjoy the lower rate in full or not at all.7 The definition of a “small business entity” requires that the company “carry on a business in the current year”.8 This suggests that a company which carries on passive investment activities can enjoy the 27.5% rate if it carries on any business activity. The threshold for what amounts to carrying on a business is notoriously modest.9 Indeed, it was possibly even the case that the 27.5% corporate tax rate would extend to all companies below the threshold, even those which derive only investment income. The possibility that companies “carry on business” almost by definition is not a new idea, but it was most recently put into the public domain by the ATO in TR 2017/D2, a ruling directed to determining the residence of companies which, as an aside, took the position that:10

“… generally, where a company is established or maintained to make profit or gain for its shareholders it is likely to carry on business... This is so even if the company only holds passive investments, and its activities consist of receiving rents or returns on its investments and distributing them to shareholders.”

This draft ruling prompted a press release from the Minister for Revenue that “the policy decision made by the Government to cut the tax rate for small companies was not meant to apply to passive investment companies”,11 and in September 2017, an exposure draft of an amending Bill was released proposing a further demarcation:

5 This was enacted by the Tax Laws Amendment (Small Business Measures No. 1) Act 2015 (Cth). 6 The 27.5% rate was legislated in the Treasury Laws Amendment (Enterprise Tax Plan) Act 2017

(Cth). A separate tax concession was also proposed at the same time for unincorporated small businesses.

7 S 23 of the Income Tax Rates Act 1986 (Cth).8 S 328-110(1) of the Income Tax Assessment Act 1997 (Cth) (ITAA97). 9 TR 1997/11 and TR 2017/D2.10 Ibid. 11 Minister for Revenue, “ATO tax ruling”, media release, 4 July 2017. Available at http://kmo

.ministers.treasury.gov.au/media-release/056-2017/.



small companies would not enjoy the 27.5% rate if 80% or more of their income consisted of various kinds of passive income, a position that would continue until 2023.12

So while (some) small companies now enjoy a 27.5% corporate rate, the promise of a 25% rate for all companies remains elusive. In the recent past, the idea that Australia’s corporate tax rate was too high has featured in at least four tax reform projects promoted by the government of the day, as well as in Treasury’s own published papers. This brief excursion into the history starts from 1998.

2.1 Review of Business Taxation (1998)

The 1998 statement, A new tax system, by the Howard Government was dedicated mostly to the introduction of the GST and consequent reductions to personal income taxes, but it did foreshadow “the prospect … of moving towards a company tax rate of 30 per cent”13 from the then current 36% rate, something which occurred in 2001. Most of the serious analysis of corporate tax and the business tax base was deferred and consigned to the Review of Business Taxation (the Ralph review) set up after the government was returned to power. While that review focused mainly on design issues in the business tax base and the models for taxing business intermediaries,14 a key recommendation (recommendation 11.9) involved reducing the depreciation rates (advancing the time at which capital-intensive industries would bear tax) and using the proceeds from that measure to fund the reduction in the corporate tax rate to 34% and then 30%.15

The principal justifications advanced at that time focused on the impact of a lower rate on foreign investors: that the measure would “move Australia more into line with our competitors for international capital flows and will thus have a positive effect on the level of investment, economic growth and jobs”,16 sending “a strong signal to the

12 Treasury Laws Amendment (Enterprise Tax Plan Base Rate Entities) Bill 2017 (Cth), released for comment on 18 September 2017. Available at https://static.treasury.gov.au/uploads/sites/1/2017/09/c2017-t220217-Exposure-Draft.pdf. See also Minister for Revenue, “Excluding passive investment companies from the small business tax rate”, media release, 18 September 2017. Available at http://kmo.ministers.treasury.gov.au/media-release/094-2017/.

13 Treasurer, Tax reform: not a new tax; a new tax system (1998) 18.14 A separate report published during the review compared aspects of Australia’s corporate tax

regime with the treatment in 27 countries, either from the region or other developed countries. It noted, “the Australian rate of 36 per cent is lower than that in a number of the major OECD countries such as France, Germany and Japan but is on the high side compared with most other countries, including some smaller OECD countries”. Review of Business Taxation, An international perspective (1999), para 3.7.

15 Review of Business Taxation, A tax system redesigned (1999) ch 11.16 Ibid 425.



foreign investor, especially if accompanied by a clear and user friendly tax system”.17 It would “make the headline rate of corporate tax internationally competitive, both in terms of the Asia Pacific region and compared with the corporate tax rate operating in capital exporting countries”18 and a lower rate would reduce the possibility that foreign investors would not be able to claim full credit for the Australian tax imposed.19 But the measure was also supported for its impact on domestic matters: it would eliminate a structural dissonance by “[aligning] the company tax rate with the 30 per cent marginal tax rate applicable to most individual taxpayers”,20 and it would allow “Australian companies to maintain dividend flows to shareholders while increasing the levels of retained income and investment”.21

But the report was remarkably candid about its lack of confidence that these benefits — the growth dividend and extra revenue — would follow:22

“The estimated revenue impacts of virtually all the measures considered by the Review are subject to a significant degree of uncertainty. In many cases the available data have been inadequate to provide soundly based estimates and assumptions, some highly judgmental, had to be made in order to calculate the likely impact of a measure. In other cases measures are expected to result in significant behavioural responses and there is no objective basis on which to estimate the likely size of such responses.”

And it conceded that the trade-off — accelerated depreciation or a lower company tax rate — did not have an obvious answer. In effect, the report was recommending increasing the tax on the mining industry (“accelerated depreciation does provide considerable benefits to capital intensive industries”23) to pay for a tax cut that would benefit the entire corporate sector:24

“… there was a substantial majority of submissions favouring a reduction in the tax rate over continuation of accelerated depreciation. The decision as to which measure will deliver the strongest economic growth and vitality is crucial and will have a significant influence on the future shape of the Australian economy. It is essentially a judgment call. If the Government believes that reducing the company tax rate will deliver the best outcome, the elimination of accelerated

17 Ibid.18 Ibid 424.19 Ibid 425.20 Ibid.21 Ibid.22 Review of Business Taxation, above n 15, 23.23 Ibid 25.24 Ibid 24-25.



depreciation will be necessary to achieve this… [But] the revenue neutrality constraint required that a judgment be made between these two options.”

Ultimately, the capital intensive industries were unable to persuade the government against this policy, the government took that gamble and the corporate tax rate was reduced from 36% to 34% and then 30%.

2.2 Australia’s future tax system (Henry review, 2007–09)

A decade later, the Henry review25 continued this refrain arguing for a further reduction to the corporate rate from 30% to 25%:26

“Reducing taxes on investment would increase Australia’s attractiveness as a place to invest, particularly for foreign direct investment. Reducing taxes on investment, particularly company income tax, would also encourage innovation and entrepreneurial activity. Such reforms would boost national income by building a larger and more productive capital stock and by generating technology and knowledge spillovers that would improve the productivity of Australian businesses and employees.”

While generally supporting the merits of the rate cut, the report did note two caveats: a higher corporate rate reduced the opportunity for residents to defer tax on their personal income by shifting it into a company; and there was little reason to reduce the corporate rate on investments that are immobile.27 Ultimately, the review recommended “the company income tax rate should be reduced to 25 per cent over the short to medium term”28 but even the main authors were sceptical about just how compelling the case was.29

Most of the discussion in the review was devoted to making the case for the 25% rate; little attention was given to just how to fund it, although there are some hints. At one point, the review cites research which claims to demonstrate that “a shift away from company income tax towards greater reliance on taxing other less mobile factors of production, or on consumption, has the greatest potential to increase GDP and growth”.30 At another point, the review noted, “arrangements for charging for the use of non-renewable resources should be introduced at the same time [as a cut

25 Treasury, Australia’s future tax system, report to the Treasurer (2009). 26 Ibid 149.27 Ibid 156.28 Ibid 167.29 G Smith, “The Henry review and taxing business income and rents” (2010) 43 Australian

Economic Review 442, 424 (“… in this author’s judgment, available economic models provide at best only a broad indication of the possible economy-wide impacts of such a reform”).

30 Treasury, above n 25, at 151.



to the corporate rate]”.31 While the issue is not explored in any depth, if pushed for a response, it seems plausible to speculate the review would have replied that the corporate rate cut should be funded by higher taxes on wages, a rent tax on natural resources and an increase to the GST.

2.3 Business Tax Working Group (2011–12)

The decision by the Treasurer in October 2011 to convene the Business Tax Working Group was an interesting exercise in the process of tax policy development. The Treasurer announced the creation of “a working group that will look at how our tax system can best help businesses respond to the pressures of a changing economy” with particular emphasis on the tax treatment of business losses and “options like reducing the corporate tax rate further or alternatives such as allowances for corporate equity”. The working group consisted of tax practitioners, unionists, industry representatives, and academics. Only one Treasury official was involved, although Treasury provided the Secretariat. The working group was asked both to come up with the proposals and then “to identify options to fund any proposals from within the business tax system”.32 So, the trade-off which the working group was required to manage was to fund a reduction to the corporate tax rate from expansion to the tax base.

The working group presented its “case for a cut in the company tax rate” and repeated the common themes: that “a lower company tax rate [is] central to Australia’s international competitiveness through its attractiveness as an investment destination” and would “encourage capital flows … considered crucial for Australia’s long-term investment prospects, economic growth and employment”.33 “A company tax rate reduction could assist businesses to more easily fund investment opportunities through capital markets by lowering the pre-tax required rate of return for investors”34 and would also address the potential deleterious effect for investors from countries which operate a foreign tax credit system of the reductions occurring to corporate rates in their home countries.35 And it would “make Australia less susceptible to profit shifting by multinationals”.36

31 Ibid 167.32 Treasurer, “Business Tax Working Group – membership and terms of reference”, press release,

123/2011, 12 October 2011. Available at http://ministers.treasury.gov.au/DisplayDocs.aspx? doc=pressreleases/2011/123.htm&pageID=003&min=wms&Year=2011&DocType=0.

33 Business Tax Working Group, Final report (2012) 1-2. Available at www.treasury.gov.au/~ /media/Treasury/Publications%20and%20Media/Publications/2012/BTWG_Draft_Final/Downloads/PDF/BTWG-Draft-final-report.ashx.

34 Ibid 2.35 Ibid 3.36 Ibid 4.



The working group assessed the benefits of a cut to the corporate tax rate separately for three groups. First, the short-term benefits of the reduced corporate rate would flow predominantly to “capital owners in the form of enhanced levels of profitability [which] may be reinvested within the business or distributed to shareholders”.37 Second, increased investment in the corporate sector “could increase the marginal product of labour, resulting not only in higher economic growth but also higher wages in the long term”.38 Third, for non-resident investors, the working group proposed that “investment induced by the lower company tax will in the long run drive down the pre-tax return so that these investors end up with about the same after-tax return”.39

Ultimately, the project failed to deliver the hoped-for political compromise. The options proposed in the August 2012 consultation paper — imposing tighter limits on the amount of interest deductible by companies, slowing the rate of recovery under depreciation regimes or curtailing the research and development (R&D) incentive — all proved unacceptable to significant constituencies. The working group concluded there was “a lack of agreement in the business community to trade-off the base broadening options … for a cut in the company tax rate”.40

But in addition to the lack of consensus about who should pay, there was apparently also some doubt about the substantive merits of the cut. The working group also noted concerns about the potential revenue loss — corporate tax revenue would be foregone without question, but the potential revenue from the base-broadening measures was uncertain:41

“In coming to the view that a cut in the company tax rate funded from within the business tax system should not be pursued at this time … the Working Group and stakeholders … identified risks associated with pursuing proposals to offset the costs of a company tax rate cut when the potential revenue saving from those proposals are uncertain.”

2.4 Re:think (2015)

The discussion paper released by Treasury in 2015 as part of the ill-fated tax white paper process continued the same theme and expanded on some of the earlier messages: compared to other countries, Australia relies heavily on the corporate tax, our headline rate is high by international standards, a large percentage of the corporate tax is collected from a few large companies, and this makes our system

37 Ibid 6.38 Ibid 6-7.39 Ibid 7.40 Ibid 13.41 Ibid 13.



precarious and vulnerable.42 More importantly, a high corporate tax rate can stifle economic growth:43

“Reducing Australia’s corporate tax rate would increase Australia’s appeal as a place to do business. It would encourage higher levels of investment in Australia and lead to capital deepening, which promotes growth in productivity, innovation, employment and wages. In the near term, lower taxes would provide an increased incentive for non-residents to invest in Australia. In the long run, increased investment would benefit all Australians.”

And a lower corporate tax rate would reduce the incentive for tax planning and profit shifting.44

Unlike the Henry review, Re:think did not explicitly recommend a reduction to the corporate rate. Rather, having laid out the problems said to follow from the corporate tax and a high rate, being a discussion paper, the document then left readers to make submissions in response to two questions: How important is Australia’s corporate tax rate in attracting foreign investment? How should Australia respond to the global trend of reduced corporate tax rates?45

Given that there was no explicit recommendation, it is not surprising that there was no explicit discussion about how a cut to the corporate rate might be funded but the discussion paper had an extended passage on the imputation system and its problems.46 Indeed, this section is one of the most fully developed critiques in the paper. The authors claim at various places that imputation delivers a windfall return to resident investors, and consequently Australian residents have an incentive to invest more of their savings in Australian shares rather than other investment classes, especially foreign equities; it reduces the attractiveness, and thus effectiveness, of corporate tax concessions; it has increased the complexity of the tax system; it discourages Australian-owned companies from expanding offshore; similar tax outcomes can be achieved (and are achieved offshore) by less complex mechanisms; and it provides little benefit for non-resident shareholders in Australian companies.

The implication of the text is clear — there will be clear benefits from replacing imputation with some other mechanism that more cheaply and easily mitigates the harmful effects of a pure classical system. The juxtaposition of these two topics — the problems of a high corporate rate and the difficulties of imputation — was consistent

42 Treasury, Re:think – tax discussion paper (2015) 74-77.43 Ibid 78.44 Ibid 80, 82.45 Ibid 81.46 Ibid 82-85.



with the rumours circulating at the time that there was an appetite within Treasury to reduce the corporate tax rate and replace the lost revenue by eliminating shareholder franking credits.47

2.5 Treasury papers (2015, 2016)

Until the Henry review, much of the argument for reducing the corporate tax rate is based on theory and intuition: it is assumed that Australia needs to import large quantities of foreign capital; it is assumed that foreign financiers or investors are highly sensitive to Australian corporate tax rates; it is assumed that higher levels of capital will be productively invested; and so on. Henry and Re:think referred favourably to foreign empirical and theoretical literature on the possible growth dividend from cuts to the corporate tax but, on the whole, little attention was paid to empirical or econometric work which might validate (or negate) the results which theory and intuition suggested would occur for the simple reason that no empirical work existed (at least in the public domain) that related to the Australian economy. That changed during 2015 when Treasury released a working paper modelling the effects of a cut to the corporate rate48 and then again in the febrile atmosphere of the impending 2016 election campaign when the government decided, under pressure from the ALP, to release the Treasury and private sector modelling on which it relied to justify its election policy.49

The intuition behind this work was the same as the message that had appeared in the earlier reports: the means of buttressing the case was new, but not the case itself. So for example, the 2016 paper argued that “any improvement in Australia’s living standards must be driven by a higher level of labour productivity [which in the past has] largely been driven by capital deepening [from] increased foreign investment [which will be induced by a] company income tax cut ... even after allowing for increases in other taxes or cutting government spending to recover lost revenue”.50

47 G Hutchens, “Economists float better ways to sort out debt”, Sydney Morning Herald, 1 May 2014, 6 (quoting sources arguing, “there is a very strong case against dividend imputation”); N Khadem, “Push is on to tackle the big tax taboos”, Sydney Morning Herald, 7 February 2015, 5 (referring to “repeated calls over the years to abolish the system, which costs about $20 billion a year in federal revenue”).

48 L Cao et al, Understanding the economy-wide efficiency and incidence-effects of major Australian taxes. Available at www.treasury.gov.au/PublicationsAndMedia/Publications/2015/working -paper-2015-01.

49 M Kouparitsas, D Prihardini and A Beames, Analysis of the long term effects of a company tax cut. Available at www.treasury.gov.au/PublicationsAndMedia/Publications/2016/working -paper-2016-02. Private sector modelling undertaken by KPMG and Independent Economics was also released at the instigation of the Treasurer during the election campaign in May 2016.

50 Ibid 1.



The modelling was subject to immediate criticism by some organisations51 and commentators,52 as well as some academics.53 The limitations of the modelling are discussed in detail in the paper by Rees and Vann in this volume and will not be examined here.54

But it is relevant to this article to dwell on just what was being examined in each of these papers. The 2015 paper estimated and ranked the marginal excess burden of a number of tax instruments — stamp duty and company tax were said to have high marginal excess burdens. The implication of the paper was that these taxes should be cut and the lost revenue replaced by taxes which were said to have lower marginal excess burdens: the 2016 paper discussed an increase to land tax, a higher tax on wages and an increase to the GST, and suggested all would be preferable.

The 2016 paper was much more explicit, addressing a company tax rate cut more directly. It modelled cutting the corporate tax rate and replacing the lost revenue from three possible sources: “an increase in lump-sum taxes; an increase in the average personal income tax rate; and a cut in real government spending on goods and

51 J Daley and B Coates, “The full story on company tax cuts and your hip pocket”, The Conversation, 18 May 2016. Available at https://grattan.edu.au/news/the-full-story-on-company-tax-cuts -and-your-hip-pocket/; D Richardson, “Cutting the company tax rate – why would you?”, discussion paper, Australia Institute (2015). Available at http://taxwatch.org.au/wp-content/uploads/2015/12/Cutting-the-Company-Tax-Rate-Why-Would-You.pdf; D Richardson, “Company tax cuts: what the evidence shows”, discussion paper, Australia Institute (2016). Available at www.tai.org.au/sites/defualt/files/P245%20Company%20tax%20-%20what%20the%20evidence%20shows.pdf.

52 See, for example, J Mather, “Benefits of company tax cut would flow to foreigners, then workers”, Australian Financial Review, 21 Mar 2016. Available at www.afr.com/news/policy/tax/benefits-of-company-tax-cut-would-flow-to-foreigners-then-workers-20160321-gnn0jn; P Martin and M Kenny, “Federal election 2016: company tax cut claims built on uncertain foundations, modeller says”, Sydney Morning Herald, 30 June 2016. Available at www.smh.com.au/federal-politics/federal-election-2016/federal-election-2016-company-tax-cut-claims-built -on-uncertain-foundations-modeller-says-20160630-gpvh62.html; R Gittins, “Mathematical modelling merely a machination”, Sydney Morning Herald, 27 February 2016, 6; R Gittins, “Hard -working Aussies help pay for company tax cut”, Sydney Morning Herald, 16 May 2016. Available at www.smh.com.au/business/the-economy/hardworking-aussies-help-pay-for-company-tax -cut-20160514-gov8gg.html; S Long, “The strange modelling used to sell company tax cuts”, ABC, 3 Jun 2016. Available at www.abc.net.au/news/2016-06-03/long-the-strange-modelling -used-to-sell-company-tax-cuts/7473480.

53 J Dixon and J Nassios, Modelling the impacts of a cut to company tax in Australia, Centre of Policy Studies, Victoria University, 2016. Available at www.copsmodels.com/ftp/workpapr/g-260.pdf (“... a cut to the company tax rate would attract more foreign investment to Australia, [but] there is a lag between new investment activity and capital growth, and a large share of future company profits will accrue to foreign investors [and] increased wages will reduce returns to domestically owned capital”); J Dixon, “Election 2016 debate: does the company tax cut pass the cost-benefit test?”, Australian Financial Review, 23 June 2016. Available at www.afr.com/opinion/election -2016-debate-does-the-company-tax-cut-pass-the-costbenefit-test-20160621-gporqw.

54 R Rees and R Vann, “International tax post-BEPS: is the corporate tax really all that bad?” 2017.



services”.55 It is notable that two options which were appealing in 2015 — increasing land tax and increasing the GST — were not examined in 2016. It is just as curious that the mythical “lump sum tax” was examined instead. The 2016 paper concluded that any of these three proposals would improve welfare, with the result in each case driven by the same phenomenon:56

“… a company income tax cut ... even after allowing for increases in other taxes or cutting government spending to recover lost revenue [will lower] the before tax cost of capital [which] encourages investment, which in turn increases the capital stock and labour productivity.”

3. Some observations of the case

The previous section has demonstrated two consistent and repeated propositions: that a reduced corporate tax rate is now the orthodox starting position in any debate about the future of the corporate tax in Australia, and that this proposal is advanced because of a view that reducing the rate will increase levels of foreign direct investment into Australia and induce consequential growth in the Australian economy. This section of the article offers a rather different assessment of that orthodoxy.

3.1 The real proposal is a tax switch, not a “cut”

While the current debate has been framed in the media and by our politicians as a debate about a tax “cut”, a more accurate way of describing the debate is to regard it as a discussion about a tax mix switch — decreasing the tax on corporate profits and increasing the tax on some other revenue source.

Australia’s tax policymakers appreciate, though it is rarely emphasised, that any sizeable reduction to the corporate tax rate will not be self-funding, not even in the long term. While there may well be a “growth dividend”, it seems no-one expects the increase in economic activity will be so large that the tax on that extra activity will replace the lost corporate tax. As was noted above, the Review of Business Taxation was remarkably candid about its lack of confidence that a sufficient growth dividend and extra revenue would follow from a cut to the corporate rate.57 The Business Tax Working Group was also unsure about the ability to replace corporate tax lost from a tax rate cut.

So the language of “cut” obscures the real impact of the proposal and the real questions: who should pay more tax so that the corporate rate can be reduced; who will benefit from cuts and who will suffer from increases? Just what other revenue

55 Kouparitsas, Prihardini and Beames, above n 49, 2. 56 Ibid 27.57 See above n 22.



source should be expanded to recover the lost tax is rarely mentioned in public discourse (the discussion above may have given the misleading impression that this topic is front-and-centre in the policy literature) but, while it has featured in some policy documents, the discussion is often muted and brief.

Unlike the chorus of approval for reducing the corporate rate to 25%, there is most definitely no consensus on what taxes should be increased to fund this; options seem to cover the spectrum of possibilities.

One suggestion is to reverse the impact of the reduced rate by expanding the corporate tax base. As was noted above, the Review of Business Taxation proposed recovering the abandoned corporate tax by expanding the base of the corporate tax and while this was successfully accomplished in the late 1990s, a subsequent attempt to employ the same strategy overseen by the Business Tax Working Group failed. The working group proposed funding the reduced corporate tax rate by broadening the corporate tax base through tightening interest deductions, slowing depreciation rates or tightening the R&D concession. None of these options proved palatable to the relevant constituency — capital-intensive industries in particular mounted a successful campaign against the tax increase. The base broadening/rate reduction strategy which had succeeded in the 1980s and 1990s failed in 2012 possibly because the debate now is decidedly not a breakeven proposition for the targeted sectors.

In the mid-1980s, the calculus seemed to be that a lower rate applied to a broader base left most taxpayers in roughly the same position as they were in the high rate-narrow base world — in other words, they were indifferent to between the base/rate combinations. This is definitely not the case in the current environment. The opportunities for base broadening are few and very specific; the losers know exactly who they are and they know that they are funding the tax cut for everyone else.

But even if it were possible, one must wonder whether suggesting a rate/base trade-off makes much logical sense in advancing the 25% rate. The idea of funding a reduction to the headline rate by broadening the base was palatable because it achieves no net increase or decrease for taxpayers, but if the total tax collected remains unaffected, this means the deleterious effects of a corporate tax must also remain. Tax-induced incentives to invest in one kind of activity rather than another might be reduced by base-broadening, but the inefficiencies caused by collecting revenue from the corporate tax rather than some other revenue source are not affected at all. But so far as non-resident investors are concerned, while they might be clear beneficiaries of such a policy, this strategy carries with it the odd implication that businesses care more about the headline rate than the bottom line: foreigners who were unwilling to invest in Australia when the tax system displayed a high rate/narrow base suddenly become enthusiastic when the system shifts to low rate/broad base.

A variant on this argument is to fund the reduction to the corporate tax by repealing the imputation system. As noted above, this idea has had some academic



support,58 is hinted at by the juxtaposition of topics in Re:think and re-surfaces in the media every few years, prompted by some business groups.59 The consequence of such a move would ultimately depend on the design of the system that was put in place as the substitute for imputation; the idea of returning to a pure classical system is implausible. Nevertheless, whatever shape the replacement would take, the implication of a reform along the lines indicated would have to involve an increase to the tax borne by resident shareholders such as institutional investors, superannuation funds and some individuals.

A further variation on this argument was recommended by the Henry review: to reduce the corporate rate to 25% but to impose at the same time an offsetting increase in a separate tax on economic rents. At that time, the obvious candidate was the mining industry which appeared to be earning supra-normal returns, but the experiment with a rent tax on profits from mining resources did not fare well. Today, the banking sector is the area which appears to be generating economic rents and the decision to impose the major bank levy in the May 2017 Budget was justified by the Treasurer, at least in part, on the basis that banks were making super profits.60 This tax may prove more robust than the mining tax as it does not attempt to calculate the rent earned by the bank; rather, it is calculated by reference to the bank’s liabilities. In other words, the industry is presumed to be making rents and is subjected to an extra tax on that basis, but the tax is not structured in a way that requires calculating the economic rent.

If we move on from funding the corporate tax cut from within the corporate tax, the next option is to increase the tax on consumption through an increase to the rate or base of the GST. This was the strategy hinted at in the 2015 Treasury working paper, but increases to the GST are perceived to be political death and so, not surprisingly, this option has never found favour with our politicians.61 A third option would be to

58 G Kingston, “Dividend imputation or low company tax?” (2015) JASSA: the journal of the Securities Institute of Australia 11 (“the headline rate could be cut to 20 per cent if abolishing dividend imputation were used to finance this [but] abolition of imputation should await a cut in our top marginal personal tax rate”).

59 See, for example, J Mather, “Dumping dividend imputation would allow 20% corporate tax rate”, Australian Financial Review, 9 June 2015. Available at www.afr.com/news/politics/national/dumping-imputation-would-allow-20pc-corporate-tax-rate-20150609-ghjwma; P Coorey, “Sacrifice dividend imputation for tax cuts: business”, Australian Financial Review, 9 February 2016. Available at www.afr.com/news/politics/sacrifice-dividend-imputation-for-tax-cuts -business-20160208-gmoz8b.

60 Treasurer, “Turnbull government delivers on major bank levy”, media release, 20 June 2017. Available at http://sjm.ministers.treasury.gov.au/media-release/055-2017/ (“both by domestic and international standards, the major banks are very profitable and the cost of the levy represents a small share … of profits”).

61 In February 2016, the Treasurer released Treasury modelling of a cut to personal income tax rates funded by increasing to the GST rate to 15%. The purpose of the Treasurer’s media release was to reassure voters that this option was not being seriously pursued. Treasurer, “Release



(consciously) increase the tax on labour income. A fourth option would be to increase the tax on real estate. A fifth option, cutting expenditure by an equivalent amount, was considered in the 2016 Treasury working paper, but has never been seriously pursued in the other more widely circulated tax policy documents, probably for the reason that it is not politically feasible to cut such large amounts from government spending.

If we examine what has actually occurred since 2014, there has been no conscious policy to execute the tax mix switch, just an unfunded cut to the rate for small businesses. In the absence of any new tax instrument, any expansion in the corporate tax base, a decline in the overall revenue collections or reduction in government spending, the small business rate is effectively being paid for by bracket creep. During 2015 and 2016, the government focused a lot of energy on explaining why personal marginal rates had to be reduced,62 but that imperative has been quietly forgotten. The corporate tax rate has been cut, and the impacts of wage inflation have contributed to meeting the cost.

3.2 Observations on the 30% rate

A second misapprehension in this debate is that the rate of tax borne by corporate profits is, and is meant to be, 30%. To be fair, this assertion comes mostly from politicians and the media who insist on speaking of companies as if they were distinct taxpayers, separate from their shareholders, employees or consumers of their products — it is implicit in the language of companies not paying their fair share of tax and giving a huge tax cut to Australia’s largest companies. Even in a classical system, treating a company as somehow bearing the corporate tax burden is misleading, but one would have hoped that commentators would understand the point in a country with an imputation system, as imputation is a mechanism that has the (perhaps unintended) virtue of demonstrating in its very essence that the burden of the corporate tax does not lie with the company.

The impression that 30% is meant to be paid by all companies is buttressed in the public mind by the current focus on corporate tax avoidance. The fact that companies do not pay the headline 30% tax rate on their commercial profits routinely features prominently in the current heated atmosphere — the taint connected in the public imagination to Apple, Amazon, Google, Starbucks, Microsoft, and so on. In December 2015, the ATO released the first tranche of data disseminated under public disclosure

of tax modelling”, media release, 12 February 2016. Available at http://sjm.ministers.treasury.gov.au/media-release/005-2016/ (“the scenario did not represent a preferred option by the government”).

62 Treasurer, “The economic case for personal tax cuts”, media release, 24 August 2015. Available at http://jbh.ministers.treasury.gov.au/speech/027-2015/. See also Treasurer, “Release of tax modelling”, above n 61 (“the modelling clearly shows the economic benefits that can flow as a result of Australians being unshackled from higher taxes resulting from bracket creep”).



laws which had been enacted in 2013 requiring the ATO to publish information about the tax affairs of large corporate taxpayers. That information related to 1,538 public and foreign-owned companies with turnover exceeding $100m and revealed that only 960 paid any company tax for the 2013-14 year. The average rate of that group was 26.1% of their taxable income. The average for all companies was 16%. A second data set for 321 private companies with a turnover exceeding $200m was released in March 2016 and it showed an average rate of 27% for the 223 companies which paid any corporate tax, and an average rate of 19% for the entire group.

Critics point to large discrepancies between commercial profit, the tax paid and the headline corporate rate and infer misfeasance from the fact that the company does not pay the nominal headline rate.63 It does not seem to be well understood that the amount of tax paid in any particular country expressed as a percentage of corporate profits will rarely be 30% for a variety of innocuous reasons. The first is corporate tax concessions, such as accelerated depreciation or R&D tax credits, significant amounts of foreign income and corporate losses. Indeed, a company which is resident in Australia but owned by foreigners and earning only foreign source income is meant to have no Australian tax liability at all, and its shareholders are meant to suffer no dividend withholding tax. There is, by design, no Australian tax payable by anyone in such a structure.64

Second, the significant differences between the notions of commercial profit and taxable income mean that the tax by a company will almost never be 30% of its commercial profit. This is the so-called “book-tax discrepancy” — financial accountants and tax authorities disagree significantly about how much profit a company has made.

Another part of the story is the different treatment of companies based on how their owners have chosen to capitalise them. For companies owned by foreigners, Australian law puts a de facto limit on how much the Australian company can borrow: for every $100 of assets located in Australia, the company can borrow up to $60; the other $40 will need to be funded by equity.65 The profit of an Australian company that has been leveraged by its offshore owners to the maximum amount allowed is effectively subject to a tax rate of 18% — the return on the 40% of its income funded by equity is taxed at 30%, while the return on the 60% funded by debt is taxed at 10%. If the accounts of the foreign parent consolidate the Australian subsidiary into the parent entity, the consolidated accounts will typically eliminate the intra-group interest payment and receipt meaning the consolidated accounts will show the group earning $100 of Australian source income but paying only $18 in Australian tax.

63 See, for example, K Walsh, “Starbucks avoids paying tax in Australia for 12 years”, Australian Financial Review (7 January 2013).

64 This happens as a deliberate consequence of the conduit foreign income rules; Div 802 ITAA97.65 Div 820 ITAA97.



But leaving aside tax avoidance, tax concessions, the conceptual differences between commercial profit and the tax base, and funding decisions, the Australian tax system will almost always ensure that the amount charged to the company, even when it starts at the nominal 30% rate, does not stay at 30%. The tax rate eventually paid on corporate taxable income might be anywhere from 0 to 47% or even higher. That happens because of the twin design features of the Australian corporate tax: (i) an imputation system for distributed profits; and (ii) the classical system for retained profits.

For distributed profits, the logic of the imputation system insists that one has to integrate the position of shareholders. Once that is done, it is more accurate to think and to speak of the tax rate on company profits as intentionally lying somewhere between 0 and 47% of taxable income. Just where can depend on many matters but some critical issues are: the identity of its shareholders (individuals, superannuation funds, charities and other companies enjoy differentiated benefits under the imputation system); whether they have a tax liability and its size; and their location (residents will typically derive a greater benefit from the imputation system than non-resident shareholders). This equivocation is driven by the imputation system and it is conscious.

For companies which do not distribute all of their after-tax profits, the imputation system is not enlivened (at least for the current shareholders). Instead, a classical system still operates, with a second unrelieved layer of tax imposed on the shareholders (triggered at the time of sale of the shares, rather than at the time of distribution). But it is still not very meaningful to emphasise the headline corporate rate of 30% for these companies. The shareholders of these companies will suffer the burden of the 30% tax collected from the company and a second layer of tax (usually) levied at CGT rates on the profit made from selling shares in a company with retained profits. The CGT rate will vary depending on a variety of factors, such as: where the shareholder is resident (non-resident sellers will typically not face a CGT liability unless they hold at least 10% of the company and the company is land-rich); whether the selling shareholder is an individual, superannuation fund or company (each of these classes of taxpayer faces differing marginal rates on capital gains); in the case of individuals and superannuation funds, the length of time during which the shares were held (individuals and superannuation funds can enjoy a CGT discount but only if the shares were held for one year), and whether the shares are in a company which is a small business entity (selling shareholders can enjoy even lower CGT rates on the sale of shares in companies which are themselves small business entities).

In short, Australian tax might reach almost 63% (tax on $100 at 30% collected from the company and tax at 47% on the remaining $70 collected from the shareholder). And where the current shareholder is having the shares redeemed by the issuing company, either in an off market share buyback or in the process of liquidating the



company, a combination of both the imputation system and CGT system is probably in play.66

These examples demonstrate how the tax burden on corporate profits rarely starts at 30% and almost never ends there, and that outcome happens without artifice or manipulation. In short, there are some circumstances where corporate profits could possibly be subject to tax at 30%, but that would require many circumstances to coalesce; it may happen, but it is probably not very common. So, to speak of cutting “the 30% corporate tax rate” is not an even moderately nuanced way of thinking about the corporate tax rate.

3.3 The impact of imputation

Australia’s imputation system features prominently in the debate about reducing the corporate rate.

An important part of the case for reducing the headline rate is the proposition that, because of “dividend imputation, company income tax effectively acts as a withholding tax on company profits that represent a return to either the savings of Australian investors or the labour of owner-operators of businesses that operate through companies”.67 This idea was implicit in the prior discussion about how the tax rate on distributed corporate profits could be anywhere between 0 and 47%. If the corporate tax is merely a withholding mechanism against the tax owed by resident shareholders, and there is perfect crediting or refunding of amounts withheld, logic suggests the corporate rate can be increased or decreased at will without doing permanent damage to the tax base — any tax not collected from the company because of the rate reduction will be recovered through higher collections at the shareholder level. (Similarly, any excess tax collected from the company might simply be refunded to shareholders in a system with refundable credits. The refund of excess imputation credits to some classes of shareholders introduced in 2000 gave further support for this argument that the imputation system meant corporate tax was merely a prepayment of the shareholder’s tax.68) Re:think took the position that, “for resident shareholders, corporate income tax is a withholding tax, or a pre-payment of individuals’ income tax”.69 The authors continued, “Australian investors would still pay tax at their marginal tax rate on company dividends through the imputation system and so would not benefit from a company tax cut to the same extent”.70

66 Ss 159GZZZQ and 47 of the Income Tax Assessment Act 1936 (Cth) (ITAA36).67 Treasury, above n 25, 150.68 The measure was enacted by the New Business Tax System (Miscellaneous) Act (No. 1) 2000 (Cth).69 Re:think, above n42, 77.70 Ibid 80.



This “wash-out” argument is a reassurance that imputation will reverse the impact of a corporate rate cut and is an important part of the story that the corporate rate can be cut to 25% without doing serious damage to the country’s revenue: the apparent cost of lost corporate tax revenue is matched by an offsetting reduction in available imputation credits, and correspondingly higher shareholder tax.

But the policy papers acknowledge that there is a limit to this argument: the corporate tax cannot be cut too far, for other reasons. The Henry review added the important caveat that the corporate tax was needed to prevent the indefinite retention of corporate profits — retained corporate profits should suffer tax, so reducing the corporate rate to 0, for example was not appropriate:71

“Australian residents who are shareholders in or owner-operators of companies could significantly reduce the personal income tax they pay by retaining income in companies. Company income tax therefore operates as an integrity (or backstop) measure for the personal income tax system to limit the deferral or avoidance of income tax.”

This is the “floor” aspect of the argument. The underlying observation here is that a shareholder level tax cannot be collected from shareholders in the absence of a distribution by the company and the distribution policy is essentially at the discretion of the major shareholders. But, so the argument goes, at least the corporate rate will serve as a floor.

But both parts of this story — the wash-out aspect and the floor claim — are misleading, whether we are examining the private company sector or listed companies. There are two different reasons to doubt this reassuring story.

First, with regard to the wash-out element, there is at least anecdotal evidence suggesting that private companies do not pay substantial amounts of dividends, and certainly do not pay dividends of sufficient size or to classes of entities where additional tax would be triggered in the shareholder’s hands. Because the distribution policy of private companies is typically controlled by an individual or family group, it is entirely plausible to suspect that the controllers (and certainly the professional advisers to the controllers) will arrange the affairs of the company so that the corporate tax (or, tax at the corporate rate) is the only tax that will be paid. If that is true, any reduction to the corporate rate is a permanent loss of tax revenue that will not be reversed by the imputation system.

To understand how this comes about, it is important to realise that the small-to-medium size enterprise (SME) segment of the economy typically does not operate through companies; companies will be players in the small business but the commercial activity is most likely to be undertaken by a constellation of companies and trusts.

71 Treasury, above n 25, 150.



First, the commercial activity will be undertaken by the trustee of a discretionary trust which will own all of the business assets, raise the necessary finance, conduct the business operations and allocate (though not necessarily distribute) profits to objects of the trust. The trustee of the operating trust will most likely be a company rather than an individual. The constellation of entities involved in the small business will probably also include a second company as an object of the discretionary trust — the so-called “bucket company”. Its function is to receive trust income that might otherwise be allocated to beneficiaries with a marginal tax rate exceeding 30%.72

In this simple model, the trustee company will not pay corporate tax since it does not earn the income of the business for itself — any change to the corporate rate is simply irrelevant to it. The company which is one of the objects of the discretionary trust is affected by a change to the corporate tax rate in two ways: it will pay the corporate tax rate on the share of the trust’s taxable income allocated to it, so that if the rate declines, its tax own liability declines as well. But the issue that is relevant for this article is, what happens to the company’s profits after it has paid the corporate tax rate? The answer to that question is not self-evident but there are a number of possibilities: the income may well simply be accumulated and reinvested in passive investments; the after-tax profits may be lent back to the trustee company which undertakes the business if the profits are needed to fund business expansion; or the after-tax profits might be retained and invested in income-earning assets. In any of these cases, no top-up tax will be triggered; the income remains taxed at the corporate rate only.

In so far as the shareholders need cash (ie their needs have not been met already by salaries paid to them by the trustee for their work in the business or by distributions to them as beneficiaries of the trust), a dividend may be paid to them, but probably only to the extent of the available franking credits and only where the impact of the dividend would not take them into the 32.5% tax bracket. It is unlikely that an unfranked dividend would be paid to them and it is also unlikely that a dividend would be paid if the effect would be to trigger top-up tax in the hands of the shareholders.

In short, the over-arching goal will be to ensure that none of a business’ profits are ever taxed at a rate that exceeds the corporate rate. If that is the controllers’ (or advisers’) prime directive, and it is possible to execute that strategy while satisfying the cash needs of all participants, a reduction to the corporate rate has a real and lasting effect for resident shareholders, just as it does for non-resident shareholders.

Unfortunately, ATO data about the distribution practices of private companies is not presented in a way that allows for this intuition to be substantiated, but anecdotal evidence — which is to say, gossip, rumour, innuendo and a few Google searches — suggest that this is a common tax planning structure.

72 Under current rates, the 32.5% tax rate for resident individuals applies to taxable income between $37,001 and $87,000; s 12, Sch 7 of the Income Tax Rates Act 1986 (Cth).



And if the focus shifts from the SME sector to the listed sector, there are reasons to be sceptical about the wash-out story here as well. Australia operates an imputation system for distributed profits, but it also operates a classical system for retained profits. The retention of profits in listed companies is an important part of the story which is often overlooked in the rush to emphasise imputation. Most of Australia’s most prominent companies do not pay out all of their profits as distributions and many pay no distributions at all.73 For example, Origin Energy has not paid a dividend since March 2016. In February 2016, BHP-Billiton abandoned its announced policy of progressively increasing its dividend payouts. The retention of profits is commonplace, not an aberration:74

“Dividends are also usually concentrated among the largest companies, and this is borne out in the Australian data. The increase in dividend distributions over the past decade has been entirely driven by the ASX 200 companies, and particularly by the largest dividend payers … the majority of listed companies outside of the ASX 200 do not pay dividends.”

Ultimately this story, both in the SME sector and in the listed sector, means that the benefits of a reduction to the corporate tax rate will be permanent and will flow to high income resident individuals because there will be limited opportunity for imputation to recover the lost tax, due to modest distributions to shareholders by listed entities outside the ASX 200, and in the SME context, no distributions at all to shareholders facing a marginal rate higher than the corporate rate. Consequently, it is likely to be a common situation that top-up tax is not triggered at the shareholder level, and without that tax the “corporate tax is simply withholding” argument fails.75

Second, there is reason to doubt the second element of the reassuring story: that a reduction to the corporate tax rate will be not especially critical because the corporate rate will always serve as a floor to the amount of tax paid. The challenge to this argument stems from the basic design of the imputation regime.

Australia’s imputation system was never constructed on a “use-it-or-lose-it” basis — that is, unused imputation credits at the end of a year live indefinitely in the company’s accounts and can be enjoyed by shareholders in subsequent years. For the

73 M Bergmann, “The rise in dividend payments”, (2016) Reserve Bank Bulletin 47, noting the ratio of dividend payments to operating cash flows is currently over 50%.

74 Ibid 52.75 It is worth noting that the authors of Re:think did allude to this differentiation noting arguments

against reducing the corporate tax rate for small privately owned companies. See Re:think, above n 42, 80 (“a reduction in the corporate tax rate … would exacerbate the existing disparity between the corporate rate and the highest marginal tax rate in the individuals income tax system [which] would increase incentives to engage in tax planning”).



most part, franking credits even survive a change to the ownership of the company.76 And the decision in 2000 to make surplus imputation credits refundable in cash to various classes of shareholders (individuals, superannuation funds and certain classes of charities) means that the company tax payments made while the company is operating are more akin to bank deposits than a permanent impost. It is a simple strategy to retain taxed profits while the company is operating and to withdraw the profits as dividends once the owners are ready to retire, at a time when they face a tax rate that is lower than the corporate rate. Re:think acknowledged that, “for individual resident shareholders, the effectiveness of company tax as a withholding tax is reduced if dividend distributions are delayed until a period where the shareholders are subject to a relatively low marginal tax rate in the individuals income tax system (for example, in retirement)”.77

If the shareholders can afford to stagger the distributions appropriately, the entire amount collected from the company while it was operating can be returned to the shareholders, albeit without interest and in deflated dollars. But the idea that the “company income tax … operates as an integrity (or backstop) measure [which limits] the deferral or avoidance of income tax” paints far too rosy a picture.

3.4 Reducing the corporate rate is crucial for foreigners

As was noted above, the case for reducing the corporate tax rate rests almost entirely on its impact on foreign investors: it is assumed that Australia needs to import large amounts of foreign capital, and that foreign investors are highly sensitive to the headline corporate tax rate. Most often the case is put in terms of Australia needing to be competitive with other destination countries (that Australia’s headline rate is viewed as too high and unattractive compared to the headline rates of countries in our region which might be competing for inbound investment), though one should not discount the argument that Australia needs to be attractive compared to domestic investment (Australia’s headline rate needs to be lower than the rates in capital exporting countries if we are to entice investors to invest anywhere offshore rather than simply leave their capital in the country of origin).

76 The two major exceptions arise from the exempting account rules (which are triggered when companies are sold by non-resident shareholders or tax exempt entities to residents) and the consolidation regime (the franking account of a corporate group remains with the head entity when a subsidiary company is sold to another owner). Div 208 (exempting company rules) ITAA97. So far as consolidation is concerned, s 709-60(2)(a) ITAA97 transfers a joining company’s franking account to the head entity and s 709-70 ITAA97 ensures that the subsidiary’s account remains dormant while it is a member of the group. Consequently, when it leaves the group, it will have no franking credits to take with it from the periods before and while it was a member of the group. And some franking consequences are ascribed to the head entity (and not the leaving company) even for some events occurring after the company left the group under ss 709-95 and 709-100 ITAA97.

77 Re:think, above n 42, 78.



Understandably, this argument about how to increase levels of foreign investment is framed in terms of tax design; it does not take into account the government’s non-tax options for attracting foreign investment. The analysis is about the ability of the government to use the corporate tax rate as a lever; whether tax is the best lever or not, is not part of the debate. Similarly, market conditions and environmental circumstances outside the scope of government control are also ignored. And the possibility that rates of return in Australia might be higher than for other countries in the region or in capital exporting countries — that is, that economic rents might be earned in some markets because of monopoly conditions operating in the Australian economy — does not have much traction in a tax policy debate. Nor does the debate emphasise any other features of the tax system, such as tax policy instability, extreme legislative complexity or unpredictable administration. It is not a compelling criticism of a tax debate to say that it dwells too much on tax, or even that it dwells too much just on one aspect of the tax system, but the absence of any parallel discussion of other drivers or impediments to foreign investment is noticeable.

The argument typically continues that the headline rate matters for non-residents in a way that does not apply to resident investors because residents have the full benefit of imputation credits, while the imputation system is of little relevance to foreign investors:78

“For foreign equity investors in Australia, company income tax generally acts as a final tax, supplemented by dividend withholding tax on distributions paid to non-residents. In limited circumstances tax is also paid on capital gains, in the case of non-portfolio holdings in a ‘land rich’ company or on Australian sourced ‘ordinary income’. Company level taxes are therefore the primary means of taxing foreign equity investments.”

Hence, reducing the headline rate of the corporate tax is presented as the principal tax instrument available to governments if it wants to use the tax system as the means to encourage greater levels of foreign investment into Australia. But just what kind of local firms and types of foreign investors are we talking about?

Obviously, we are talking about local companies that are sufficiently sophisticated to be able to access foreign markets for capital. This is not the SME sector, and yet they will be one of the free riders carried along by any reduction to the corporate rate.

And we are only talking about companies that are seeking to expand. Again, this is not all Australian businesses. Not every business is continually in the market seeking new capital, and yet established and stable companies will also be free riders carried along by any reduction to the corporate rate.

78 Treasury, above n 25, 150.



And we are talking about companies that cannot find sufficient capital in Australia. Again, this is not all Australian companies. The imputation system creates a well understood bias for residents to invest in Australia rather than offshore, and to invest in equities rather than debt, so there are already mechanisms in the system which mitigate to an extent the need for Australian companies to have recourse to foreign capital markets. As one commentator noted, “there is no evidence that Australia has difficulty attracting foreign capital — indeed, on occasions it is arguable that we get too much”.79 In 2016, the Treasurer said the world is awash with capital looking for places to be invested — citing Japan and Germany where investors are willing to accept negative returns on their savings — a message that undercuts to some extent this argument that Australia has to change its tax policy to lure foreign capital away from other opportunities.80 (One would think any positive return after-tax should be sufficient when a negative return is seen as the best alternative on offer!)

Probably neither position is entirely true: perhaps Australian companies do not find it especially easy to attract foreign capital, and it may be that foreign investors do need some further impetus best done in the form of a tax saving to abandon the world of negative returns. But given the home country bias and the substantial pool of superannuation savings looking for a local home, there must be some doubt about just how pressing is the problem of Australian companies unable to find sufficient capital from Australian markets.

We are also talking about Australian companies seeking equity investors: foreigners who would prefer to invest through debt instruments (for example, the fabled foreign pension funds and others seeking stable long-term income streams) are not seeking to take an equity stake in an Australian company, and consequently, are not affected by the corporate tax rate suffered by the company which has borrowed from them. The investors might be affected by interest withholding tax rates though typically unrelated lenders would not be subject to Australian interest withholding tax.81 So, for example, many of the very substantial fundraising activities undertaken by Australian banks in recent years are unaffected by the corporate rate because the banks are raising funds by issuing debt to investors.

79 M Keating, “Mid-year economic and fiscal outlook”, (21 December 2016). Available at https://johnmenadue.com/michael-keating-mid-year-economic-and-fiscal-outlook-2016/.

80 Treasurer, “Staying the course – strengthening our resilience in uncertain economic times” (Speech, 25 August 2016). Available at http://sjm.ministers.treasury.gov.au/speech/015-2016/.

81 S 128F ITAA36. In rare cases, unrelated lenders might unexpectedly be presented with a withholding tax liability, but they will typically be able to pass the cost of the tax back to the borrower by the terms of the borrowing contract. Related lenders are more often affected by Australia’s interest withholding tax. But they too will more likely be concerned by the interest withholding tax rate than the corporate rate, especially since withholding taxes are imposed on the gross interest outflow, rather than the foreigner’s net profit from the loan.



Nor is it clear that a reduction to the headline corporate tax rate would have a serious impact on foreign investors who seek to take a portfolio position in an Australian company. Foreign investors who would be interested in a portfolio interest in an Australian company would include foreign pension funds, sovereign wealth funds, investment fund managers, and so on. Non-residents hold a significant portion of the Australian equities market but there are reasons to doubt that the Australian corporate tax is an important criterion in deciding whether to invest in, say, the Australian market rather than, say, the Tokyo market. In so far as foreign portfolio investors are seeking a location for their funds, it is not clear that the corporate rate suffered by the entities in which they are investing would be s significant driver of their decision. Foreign portfolio investors are essentially seeking to achieve a hurdle rate of return based on the cost of the equities and the likely returns by way of dividends and gains, to be derived during the expected holding period (which might be anything from a few minutes to many years). It seems reasonable to suspect that the foreigner’s rate of return will be much more, and more directly, affected by issues such as the state of the markets in which the investee company is operating, the distribution policies of its management or the random movements of stock prices than the Australian corporate rate. And even if reducing the corporate rate would produce a noticeable change to the investor calculus, it is likely to be a one-time event, which would then be capitalised into the price of Australian stock.

Another reason to doubt the significance of the corporate rate for portfolio investors is the position of the company seeking to raise the funds. Even if foreign portfolio investors might be concerned by the corporate rate applied to the Australian entities in which they were interested in investing, Australian companies will typically not go to foreign portfolio investors when they are seeking to raise modest amounts of equity capital: securities laws in other countries will typically make the issue of securities by a foreign company to investors there a complex, costly and time-consuming process.82 Australian companies seeking portfolio equity will likely find it cheaper and more convenient to issue their securities on the Australian market, and foreigners who are minded to do so can then buy the securities on market.

The previous discussion is about the impact of the corporate rate on the entities into which foreign portfolio investors might be seeking to invest. There is another dimension to this question — would a reduction to the corporate tax rate affect the foreign investors directly, by reducing the Australian tax liability foreign investors would otherwise face? The answer is probably “no” as the investors are already largely

82 Evidence of this problem can be seen in the restriction usually expressed in a prospectus preventing non-resident shareholders from taking up shares when an Australian company is seeking to raise further equity. For example, in August 2017, when Yancoal Australia sought to raise $3.1b to fund its acquisition of Coal and Allied, the entitlement offer and any new shares could not be advertised or sold to US shareholders. The Entitlement offer booklet was prominently marked, “Not for distribution or release in the United States”, Yancoal Australia, Entitlement offer booklet, 1 August 2017. Available at www.asx.com.au/asxpdf/2017802/pdf/43135rzl4hhd4l.pdf.



immune from Australian tax: to the extent that the Australian entity pays a franked dividend, the foreign investor will suffer no withholding tax, and any gains made on the sale or redemption of the investment will be tax-free in the hands of the investor as gains and losses from portfolio investments do not suffer Australian tax capital gains tax.83

Finally, any policy about the underlying corporate tax rate will have no impact on foreign investors seeking to make a direct asset purchase (for example, buying a large parcel of industrial land, an oil field, an electricity generating plant or an office tower) or to take a stake in the large Australian businesses which trade in the form of trusts.84 It is a distinctive feature of the Australian commercial landscape that economic activity involving real estate and infrastructure is typically undertaken in the form of a trust. Being a trust, no entity level tax, akin to the corporate tax, is imposed under Australian law and so there is no entity level tax to be reduced. Instead, investors pay tax themselves on their share of the income earned through the trust structure. Foreign investors will typically face the imposition of managed investment trust withholding tax at the rate of 15% on distributions made to them.85

So, having discounted foreign investment into SMEs, stable companies not seeking further capital, foreign investors seeking to lend, foreign investors seeking a portfolio equity interest, foreigners who are buying assets or foreigners investing into a trust, we are left with the main focus of this policy: foreign investors who might be looking to take a non-portfolio equity position in an Australian company, either by establishing an Australian subsidiary or by buying an existing Australian company from its current shareholders.

It may be that foreign direct investment is sufficiently mobile that a reduction in the Australian corporate rate can be the needed inducement for foreigners to change the location of their operations, but placed against that possibility are the many and assured free riders on a lower rate: the high net wealth individuals who own substantial stakes in Australian companies, the SME sector where foreign investment is an irrelevant concept, existing companies where investment was undertaken based on the current rate and any rate reduction is simply a windfall, and stable companies not needing to

83 There is a possibility that, as a matter of Australian domestic law, the foreign portfolio investor might be liable to Australian income tax, but the absence of a permanent establishment in Australia should mean that the foreigner suffers no Australian tax in this situation as well. In addition, foreign investors who are fund managers are offered a further targeted exemption from Australian tax on their trading profits under the investment manager regime. Subdiv 842-I ITAA97.

84 So, for example, a glance at the top 20 entities listed on the Australian Stock Exchange measured by market capitalisation reveals three that are not (predominantly) companies: Transurban Group (which is a staple of shares and units), Scentre Group (another stapled security) and Westfield (also a stapled security). Significant economic activity in these groups is undertaken through the trust (rather than the corporate) side of the staple.

85 Income Tax (Managed Investment Trust Withholding Tax) Act 2008 (Cth).



go to any capital markets. And this, of course, is the underlying dilemma: any increase in economic activity is speculative, far in the distance and currently estimated to be a modest 1% after 10 years; the loss of corporate tax revenue is both immediate and more assured. In summary, there may well be a case for reducing the corporate tax, but so far this body of work does not present an especially compelling argument to sustain that conclusion.

One final comment concerns the relevance for Australia of the tax reform package enacted in the US in December 2017. The Treasurer has argued that the US decision to reduce its corporate tax rate to 21% makes the case for Australia to act even more compelling, but this enthusiasm should probably be tempered once two further elements are added to the picture.

First, the rate cut was accompanied by many significant base-broadening measures such as abolishing loss carry-backs, limiting loss carry forwards, restricting interest deductibility, imposing a one-time tax on earnings held in offshore subsidiaries, imposing immediate tax on foreign intangible income under a second CFC-style regime, enacting rules against hybrid instruments and entities, imposing taxes on residents paying deductible amounts to related non-residents, and so on. As was noted above, it is not obvious where any similar broadening to the Australian base might occur.

Secondly, while it is true the IMF revised upward its estimate of the rate of growth in the US economy in light of the US changes once legislated, in its view the increase in GDP is due more to the immediate expensing of spending on plant and equipment than to the impact of the rate reduction. The evidence of this is that the increase in GDP is short-lived and reverses once the immediate expensing regime expires in 2023. The lesson seems to be that expensing is powerful while rate cuts are not; but that effect is principally only to bring forward outlays that would have occurred anyway, just a bit later.


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New The unconvincing case for 25% - Microsoft · 2018. 4. 26. · 5 This was enacted by the Tax Laws Amendment (Small Business Measures No. 1) Act 2015 (Cth). 6 The 27.5% rate was