By now, you will have realised why I consider the introduction of the imputation credit system has vastly improved the Australian tax system by removing a major distortion of the way in which Australians own their investments. Sure, as implemented it still provides an incentive for higher marginal tax rate investors to keep a larger percentage of their profits in the company and defer paying further tax until a later date or profiting from lower taxed capital gains.
Nevertheless, taxing company profits twice, once in the hands of the company and then again taxing dividends at full marginal rates discriminated much more severely against company investors. Double taxation encouraged and rewarded strategies such as higher levels of gearing, using management and other fees to reduce company tax bills and reinvesting profits to increase the possibility of receiving more favourably taxed capital gains.
Why then you may well ask why does in a world context Australia stand virtually alone and remain after close to 40 years the only tax system not double taxing dividends paid to residents? My considered assessment is that as a large debtor country we need and will continue to need the maximum possible domestic investment of our capital. To put it plainly, if we no longer encourage Australians to invest in Australian businesses, the already large annual outflow of annual savings will grow and further slow the growth of our economy.
Our long-standing struggle to collect tax from the overseas technology and essential services giants involves dealing with the multiple and devious ways they have of avoiding our company tax by tax-effectively boosting their deductible expenses shipping earnings out of Australia at low withholding tax rates. My IMF experience with one of America’s top evasion and avoidance experts opened my eyes (even though in the 1970s) about the difficulties involved in taxing multinationals.
One example. Without spotters’ fees (ie sizeable percentage rewards for whistleblowers, disgruntled employees, former spouses etc) the US system would not be anywhere near as effective as it was then and still is raising m hundreds of billions annually. When we were helping Swaziland deal with Lonrho and other overseas investors, one fee paid that year in the US for the actual set of books in Switzerland exceeded $20 million.
If the ATO or government was able to force huge overseas participants in our economy to receive all income and pay all expenses out of a company, the ATO may have hope of making a fair assessment of their tax at the company tax rate. Instead, they must deal with royalties, licence fees, internal loans,, and the extensive use of transfer pricing to disguise profitability.
Enough about this perpetual headache for our tax administrators, the imputation credit system greatly reduces the need and incentive for Australian owned companies to reduce their annual tax liabilities especially when the 30% company tax rate is less than or equal to the marginal personal tax rate of most recipients. The huge exception is of course pension and superannuation funds subject to no or 15% income tax.
That is why leading Sydney Law School tax expert Professor Richard Vann and I were so astonished when on Treasury advice Paul Keating first introduced the imputation credit system in 1987 excluding non-taxable pension and superannuation funds from receiving franking credits on their investments. (SEE our detailed 1987 article on this topic). They balked at the huge cost of paying imputation credit refunds to this sizeable percentage of share investors.
You would have thought our now very highly paid and superannuated Treasury officials would have kept up with the times especially after Warren Buffets’ multiple warnings of the threats derivatives provide for our financial system. These days there are no problems of just like splitting the atom splitting the ownership of company shares into its two components, a share in the ownership of the business and the right to a stream of income.
Instead of owning shares pension and super funds could easily instead own options to buy the shares and company debt. In my post public service career started in 1986, 1987 was a boom year helping my broker mentor split the share atom for two listed companies targeting pension and super fund investors. The attractions were lower underwriting costs and less diminution of existing equity.
By separately offering free options to buy shares (usually at a 10% premium to the VWAP price) and subscribe for company debt (redeemable at any time to exercise the free options), the two companies we helped were able to raise capital more cheaply at lower cost because all the interest cost was tax deductible. And glory be the superannuation and pension fund investors were incredibly happy to hand over their cash flow and receive tax-free income.
It only took 12 months for the government to realise they had stuffed up. Their solution extending the access to franking credits to all domestic shareholders introduced another stuff-up, taxing super but not pension fund income at a 15% tax. This new tax obviously aimed to limit the extent of the cash refunds to these large investors.
Unfortunately for the integrity of the tax system, the new superannuation tax arrangements were never scrutinised for their long run sustainability especially after the 2007 changes which virtually removed any substantial tax on lump sum withdrawals from super funds. I will return to this issue in a later Chapter.
The key takeaway point of this Chapter is that the imputation credit system reduces the complexity of taxing business operations owned and undertaken by resident taxpayers. The only substantial advantage available to high marginal rate taxpayers is the ability to defer payment of the added tax above the corporate tax rate built into the higher marginal tax rates.
Even then, there are ways of limiting the benefits of carrying forward unused franking credits for use in future tax years. For example, my private company has a couple of millions of dollars of franking credits carried forward from as long ago as1987 available for my or my heirs use later. They exist because I do not need more income and paying out the dividends would result in a modest added tax burden.
One simple change would be to introduce an airline frequent flyer scheme plan rule of use it within say 10 years or lose it. This would reduce the benefits of tax deferral. Of greater importance to the integrity and retention of the imputation system is strengthening the defence against the current widespread abuse of the scheme by non-resident investors with large holdings of Australian shares.
Being street smart, let me tell you about a tale from the period of double taxation, where the only taxpayers not taxed on their company dividends was other companies. By what were known as Section 46 rebates, one company could pay free of tax a dividend to another company with no further tax levied on the recipient company.
To fund my Christmas presents in 1986, I self-published a quite successful book “25 Tax and Investment Strategies” which included Chapter 13 “Never Pay Tax on a Dividend “explaining how individuals could gain the benefit of Sec 46. Of course, that possibility only lasted less than 6 months after the ATO paid $10 to buy a copy of the Book. Such are the problems created by the greater scrutiny of personal income taxpayers than of companies especially at that time.
I would love to be proved wrong by factual evidence that the ATO was aware of the strategies used by the banks and other financiers to maximize their access to Sec 46 rebates and now imputation credits available to non-resident shareholders, With the introduction of franking credits, the problem of using the Sec 46 credits of residents has disappeared, but the tax advantage of gaining access of the franking credits of non-residents remains.
Let me make clear under the legislation non-residents were and are not eligible for the benefit of either the Sec 46 rebate or franking credits. So, I am talking about the stark difference between the listed and beneficial owner of a share. With most internationally owned shares in street name Nominee Companies, our open-ended share lending rules create multiple opportunities to hide the beneficial (ultimate) owner of the shares.
Of especial concern is the legislation that does not trigger capital gains tax liability on the lender of a share sold or short sold by the borrower. There is a minimum 45 day holding period for eligibility for franking credits and if residents hold shares lent by a non-resident for at least 45 days, how can the ATO check that the resident owning those lent shares is eligible for franking credits on their dividends.
This is all extremely complicated stuff, but you can understand how difficult administering a system involving huge nominee companies, profit maximizing financial institutions using complex transactions and derivatives to disguise beneficial ownership is. Way back in the mid-1970s when Professor Swan and I were ensconced in the Tax Office it was clear that even the top ATO administrators were not on top of transfer pricing issues let alone complex beneficial ownership issues.
One prime example was the Reserve Bank Rule limiting my ability to borrow for investments from the banks. That forced me to seek funds from other lenders. One instance convinced me that the lender was keen to get access to the Sec 46 rebates (not available to me) on my dividends offering a significantly lower interest rate on loans to buy dividend paying shares than for (better collateral) property investments. By registering the shares offered as collateral into their nominee company name, they must have been able to access my Sec 46 rebates.
Everything could be under control but having the brief experience of dealing with the Lonrho’s of this world guided by a seasoned expert I wonder. Why do not we build in simple safeguards to reduce pressure on the ATO and sure up the integrity of the tax system.
Here is my list.
Treat any loan of a share by any shareholder as a CGT event and the end of the holding period for imputation credit eligibility.
Possibly extend the minimum 45 day holding period to say 90 days to increase the effectiveness of the above change.
Prohibit superannuation and pension funds from lending or borrowing shares or lending money to non-residents secured by Australian shares eligible for imputation credits.
Require all claimants of imputation credits to verify they are the beneficial owners of the shares and eligible for the franking credits.