Throughout the 1980s and early 1990s, the Australian Tax Research Foundation and Monash University generated a myriad of serious tax research papers that unfortunately have had negligible impact on our current tax arrangements. It may already be too late or too difficult to change the major weakness in our system, the continually increasing reliance on personal income tax collections to raise the bulk of our revenue.
International comparisons clearly highlight the major challenges for changing our tax mix to raise revenue from other sources, particularly our inability to levy designated social security taxes on employers and the costs of the imputation credit system of company tax. To add to these constraints, the automatic CPI indexation of age and disability pension payments and unfunded superannuation pensions reduces the benefits of increasing GST tax collections via rate increases and expansion of the tax base.
Currently, the government is focussing on increasing CGT and tax on trust income but with the open-ended subsidy to superannuation assets continuing, the potential boost to revenue is not significant. As mentioned previously, my biggest concern is that budgetary pressures will force a future government to follow the rest of the world and revert to the classical company tax system by abolishing the franking credit system.
Doing this would further increase the CGT and personal income tax advantages of investing in superannuation, trusts, or personal name structures merely for taxation advantages. Companies of course are subject to CGT at the company tax rate with no allowance for inflation and despite recent criticisms of the new CGT arrangements for individuals they are not as harsh as the current rules applying to companies.
Abolishing the franking credit system would have two immediate benefits. The first is the immediate cancellation of the billions of dollars of unused franking credits brought forward from earlier tax years at no cost to revenue. The legislation grants companies the ability to choose how and when to distribute franking credits to shareholders. Companies can choose only to distribute fully franked dividends or include unfranked components reducing the percentage of dividends attracting franking credits.
As Professor Richard Vann and I highlighted in 1986 (An Examination of the Imputation Credit System in the Context of the Erosion of the Company Tax Base) this allows companies to reduce tax on shareholders by not distributing lightly taxed components of profits (e.g. tax concession income). Companies (especially private ones) are also free to vary the distribution of dividends according to the current tax positions of their shareholders, maximising distributions to shareholders in low-income years.
The second benefit is of course the added tax collected on dividends paid to shareholders. Even if the government reduces the company tax rate, say to 20%, to dampen criticism of the change the net overall effect on total collections would be large especially in the short term before investors adjust to the changed tax incentives. By far the biggest revenue boost would come from charities, pension and superannuation funds ceasing to receive 30% and 15% franking credit refunds.
Abolishing the imputation system negates the advantages currently available to non-resident taxpayers engaging in tax arbitrage deals with residents to gain access to franking credits. Since day one the legislation has helped arbitrage transactions that allow non-resident taxpayers (not eligible for franking credits) to transfer their franking credits to resident taxpayers and thereby share in the benefits available.
Our 1986 Australian Tax Forum paper outlined several legislative and administrative issues essential to protecting the integrity of the system. Successive governments have ignored these issues and instead have allowed unlimited scope for share lending in the system. To be eligible for the franking credits, resident taxpayers must have owned the shares for a minimum of 45 days.
This rule does not guarantee that they are in fact the beneficial owner of the shares. Unbelievably, even when resident and non-resident owners enter into contracts to borrow (lend) shares under a contract, the government does not treat the transaction as a sale even though a title transfer is involved. The widespread use of nominee companies provides a cloak of anonymity as to who the parties to the transaction are and who the beneficial owner really is.
To revert briefly to the CGT tax legislation on residents. An example of just what is possible under current legislation highlights the massive scope for behind-the-scenes arbitrage. I bought 10000 CBA shares in the original float at $5.40 a share. Today they are selling at around $165 each and with pressures on the property market consider the price will fall by say 20% in the short term. Selling on market would realise a gain of around $160 a share with an attached CGT liability of (50% of top rate) $37 per share.
This is more than the share price is likely to fall. So, what can I do? Thanks to derivatives markets and the lack of share lending restrictions, there are several options including buy a put option (could lose if price does not fall but cost would be tax deductible), sell a call option (could lose if price rises and forced to buy back option to retain shares) or enter a share lending agreement including with a related party. The share lending agreement (reliable counterparty) protects against losing the shares and gives a percentage of profits from the transactions.
Just why the legislation even allows the possibility of such share lending transactions defies rational explanation as does the lack of attention to evasion in the legislation. Consider our list in the 1986 article:
The best approach is legislative and administrative rules which clearly define such issues as:
-the beneficial owner of shares which are the subject of option or margin lending agreements;
-the attitude towards granting imputation credits on franked dividends paid on shares subject to an option when the party with the right to buy the share is not eligible for imputation credits: and
-whether the cloak of anonymity should be available to tax-exempt organisations, including through nominee companies when the legislation offers tax advantages.
With the use of nominee companies so widespread today, the scope for questionable avoidance and evasion transactions are unlimited. Allowing superannuation and pension funds taxed concessionally to engage in derivatives and share lending transactions with non-resident taxpayers opens the system for abuse.
Even a basic rule change to treat all share loan transactions as a disposable for capital gains tax and the 45-day rule purposes would be a major step forward and provide a major revenue boost. Reducing the scope for resident taxpayer access to franking credits attached to dividends beneficially owned by non-residents is a prerequisite for the long run survival of the imputation system.
The overriding goal should be as originally said to ensure that the benefits of franking credits are available only to resident taxpayers on company shares owned beneficially. A later Chapter will explore further options to reduce the revenue cost of franking credit refunds including introducing an airlines frequent flyer points use them or lose them approach (such as a five or ten year limit).