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T V M – t he arguments for and against

T V M – t he arguments for and against. Geoff Lehmann 24 July, 2001. PwC. T he arguments for.

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T V M – t he arguments for and against

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  1. TVM – the arguments for and against Geoff Lehmann 24 July, 2001 PwC

  2. The arguments for In 1995 Professor Richard Vann wrote: “Australia’s tax laws are a stupefying mess, as anyone who has tried to read or teach them immediately knows. I have been involved with the tax laws of some 50 countries in various ways; in terms of drafting (and at the very detailed policy level), Australia’s qualifies as the worst tax law or, at best, one of the very few worst.”* *“Improving Tax Law Improvement: An International Perspective” a paper for the Australian Tax Research Foundation,13 September 1995 PricewaterhouseCoopers

  3. The arguments for – the faults of the existing system • Duplication of rules – ordinary income, statutory income and capital gains, slightly different rules, overlap, inconsistency, ad hoc additions • Income/capital distinction inherited from the 18th century, just as “salary and wages” was based on employer/employee relationship and vicarious liability – concepts imported from other areas of law, not custom designed for income tax • These concepts broke down under a determined attack from the Barwick High Court – specific anti-avoidance rules such as current year loss rules were the response– that is when the “mess” began – mid 1970s PricewaterhouseCoopers

  4. The arguments for – the faults of the existing system • Income/capital distinction based on case law – perhaps 50,000 pages of decisions which are indeterminate • Lord Greene: “There have been many cases that fall on the borderline. Indeed in many cases, it is almost true to say that the spin of a coin would decide the matter almost as satisfactorily as an attempt to find reasons.” (IRC V British Salmson Aero Engines Ltd [1938] 2KB 482) • Cooling’s case to Montgomery’s case – it took about a decade to resolve if lease incentives were assessable – “let’s leave it to the courts” – not a good way of resolving tax policy PricewaterhouseCoopers

  5. The arguments for – the faults of the existing system • Conceptual rigidity – capital/income distinction is a holistic concept – in theory – so that it is difficult to legislate that some things will be capital that are on revenue account or vice versa without undermining the rather dubious integrity of the system • Unresolved issues in the existing system – eg whom do you tax when there is a difference between taxable and trust income? • Complexity of the existing detailed rules – eg Australia’s hundreds of pages of CFC rules, when France, a much larger exporter of capital, has CFC legislation that occupies less than a page PricewaterhouseCoopers

  6. The arguments for – alternatives to the existing system • Tax Law Improvement Project was an attempt to rewrite the existing rules in plainer language and more orderly format – an overall failure with some modest successes, for example CGT rules in 1936 Act occupy 300 pages, in 1997 Act we have 38 CGT events and about 500 pages of CGT rules • Accounting rules – even more indeterminate than legal concepts based on case law – “true and fair”, lack of “materiality”, may result in alternative numbers being equally correct – but tax has to be a specific amount PricewaterhouseCoopers

  7. The arguments for – alternatives to the existing system • Taxable income based on accounting standards practicable only for listed entities – temptation for unlisted, privately owned entities to under-report – not acceptable to retain existing system for unlisted entities and allow listed entities to report on the basis of accounting results • Import income tax law from another country – UK, US, New Zealand, Singapore – the problem is inherited expectations – starting with a blank page and preserving existing entitlements while utilising new concepts is the only alternative to continuing with a re-jigged TLIP that includes big P policy changes PricewaterhouseCoopers

  8. Tax value method ITAA 1997 core rules ))) ((( ))) Details What does TVM do? PricewaterhouseCoopers

  9. What does TVM do? • Rules to work out income tax liability • Rules to work out taxable income • Rules to work out net income • Rules to work out taxable income adjustment • Core concepts to support calculation of net income PricewaterhouseCoopers

  10. Policy superiority of TVM to existing rules • Note there are rules to work out net income and rules to work out taxable income adjustment • Adjustments – ie departures from policy purity are self-evident and do not taint the core concepts – this acts as a brake on bad policy, tax expenditures etc • Sounder base for further reform – TVM should extend into detailed rules – reconsider need for detailed CFC rules in view of fact we have a full imputation which creates an incentive to earn taxable income in Australia PricewaterhouseCoopers

  11. Practical superiority of TVM to existing rules • Deal with an issue once, eg one set of rules to cover depreciating assets and liabilities • Eliminate much existing complication, eg debt forgiveness, most of CGT PricewaterhouseCoopers

  12. Arthur Murray – TVM resolves uncertainty • Under current law – it’s not clear whether refundability is required for Arthur Murray to apply • TVM says no requirement for refundability – implicit in example 1.3 of EM PricewaterhouseCoopers

  13. Arthur Murray – year when services provided, income recognised Closing tax value of assets - Opening tax value of assets - Closing tax value of liabilities - Opening tax value of liabilities [Receipts – payments] + [ 0 – 0 ] + [ 0 – 0 ] – [ 0 – 500 ] = 500 PricewaterhouseCoopers

  14. Arguments against TVM • Why does no other country have TVM? Answer: no other country has developed an income tax system as bad as Australia’s – an unstable operating system that is liable to “crash” – need to rebuild from the bottom up. TVM is already implicit in parts of our system and other countries’ rules, eg trading stock. No other country has had to consider rebuilding from the bottom up. • TVM will replace indeterminacy of capital/revenue distinction with new uncertainties and we’ll lose the benefit of existing case law. Answer: Criticism accepted – however all legislation applies indeterminately to facts – the existing law has one big uncertainty – what is on revenue/capital account? Hopefully TVM will replace this with smaller uncertainties.

  15. Arguments against TVM • Small business case, tax reform fatigue. Answer: if TVM causes substantial implementation problems and system changes for small businesses it should not proceed. However (hopefully) it should be possible for TVM to be implemented so that small businesses do not have to significantly change their systems for calculating taxable income if they choose not to. • If TVM does not change the amount of taxable income that is returned, is the cost of change worthwhile – is it “change for the sake of change”? Answer: TVM will not change the amount returned in 99.99% of cases, but where the existing law is unclear it may produce a different result. If TVM lasts for say 50 years, the cost is (hopefully)acceptable

  16. Arguments against TVM • Will TVM be compatible with our international treaties, will non-residents operating in Australia be able to get credits for Australian tax in their country of residence? Answer: European countries calculate taxable income differently from common law countries, but they still allow foreign tax credits. If Australia’s TVM legislation uses phrases such as “taxable income” it is unlikely that foreign countries will disallow credits for Australian tax • TVM computations would be more complex than under the existing system. Answer: this argument is valid if, say, individuals will be obliged to compare the opening and closing value of their liabilities etc. Hopefully this will not be necessary – some “short cuts” should be made available within TVM for small business and non-business taxpayers

  17. Arguments against TVM • TVM is a Trojan horse for a move towards taxing unrealised gains. Answer: unrealised gains could easily be taxed through some minor changes to the 1936/1997 Act. The only safe course of action is to abolish income tax altogether.

  18. Routine rights and liabilities - s6-45 – a problem area • Rights and liabilities under unperformed contract – you have provided and received no economic benefits under the contract at year end (except the mutual liabilities arising under the contract) • Rights and liabilities where benefits received match benefits provided - rights and liabilities will only be “routine” if there are no economic benefits provided or received of earlier or later years that relate to benefits received or provided in current year PricewaterhouseCoopers

  19. Example of routine rights and liabilities EM example 7.12 • Business premises lease entered into in year 1. It does not start until year 2. Rights and liabilities are “routine” • In year 2, tenant entered into possession. So long as rent is paid on time and reasonably relates to occupation period, the rights and liabilities are “routine” – i.e. their tax value is nil PricewaterhouseCoopers

  20. Routine rights and liabilities Section 6-45(3) • Economic benefits you provide during income year under contract (as proportion of total value of benefits you have provided, will provide under the contract) is reasonable having regard to the total value of: • Economic benefits you receive during income year under contract (as proportion of total benefits you have received, will receive undet the contract) PricewaterhouseCoopers

  21. Routine rights and liabilities What does section 6-45(3) mean? • Assuming taxpayer has 30 June year end, if annual insurance contract entered into on 10 July, it will be a routine right and liability as premium for 365 days is reasonably proportionate to benefit received in current year being 355 days insurance - element of prepayment proportionately small • Annual insurance contract entered into by same taxpayer on 1 January would not be a routine right as lack of proportionality between benefits provided and received for income year - recognise 6 months of insurance contract as asset at year end PricewaterhouseCoopers

  22. Section 7A-30 – Item 1 – exercise of option analysed – a problem area • If an option is exercised to acquire an asset, the intention is that the first element of the tax value of the asset is the tax value of the option • The second element (by implication) includes the exercise price

  23. Section 7A-30 – Item 1 – exercise of option analysed (continued) • What causes the tax value of the right to fail? If you no longer hold it – the right cannot have a tax value • If part of it ceases, see s7B-130(2)

  24. Section 7A-30 – Item 1 – exercise of option analysed (continued) • Exercise of option – section 7A-55 states proceeds of realising an asset are each amount you receive because you stop holding it • Section 8-28(1) (“non-cash benefits you give) will treat this as the market value of the option – possible tax liability if market value has increased • Alternatively does s7B-161 apply (substituting assets consisting only of rights for other such assets)? If so, tax value of option is received and is the cost of the new asset – no tax liability.

  25. Exercise of option analysed - conclusion • At this stage TVM does not seem to adequately handle exercise of option – what is an ‘asset consist[ing] only of …. rights”? • Potential “taxing point” on exercise – differs from current CGT rules – section 134-1(4) “A capital gain or loss the grantee makes from exercising the option is disregarded” • At present TVM rules are confusing – however 1997 CGT rules are not much better regarding options – section 160zz(7) became ss104-40(5), 116-65, 134-1! PricewaterhouseCoopers

  26. Division 7BSplitting, Merging, Transforming and Substituting Assets or Liabilities – a problem area PwC

  27. Amounts you are taken to receive or pay – s7-127 • An amount you are taken to receive or pay because of Div 7B • Is taken into account in addition to • Any amount you actually receive or pay and any amount you are taken to receive by a provision other than Div 7B

  28. Legislative example of s7B-127 • Asset split into several assets, that involves you getting a non-cash benefit • “You may be taken to receive or pay an amount because of Division 8” (non-cash transactions) • What does this example mean? Does s7B-127 do anything?

  29. Division 8Notional Receipts and Credits under credit and other non-cash transactions – a problem area PwC

  30. Division 8 – guide – s8-1 • 2-sided non-cash transaction (eg sale of goods on credit) • 1-sided non-cash transaction (an arrangement with a non-cash benefit on 1 side and nothing on the other) • Does not apply to transactions where a non-cash benefit is exchanged for money eg land is sold for cash (s8-5) PricewaterhouseCoopers

  31. Division 8 – guide – (continued) Where 2-sided or 1-sided non-cash transaction Div 8 allows you to work out: • The cost of an asset you get under the arrangement • The proceeds of realising an asset under the arrangement • The proceeds of assuming or increasing a liability under the arrangement • The costs of extinguishing a liability PricewaterhouseCoopers

  32. “Cash-like” benefits – s8-28(1)(2) • “For each cash-like benefit that you give … you are taken to receive an amount equal to the market value of the benefit” • A “cash-like benefit” is a non-cash benefit an entity gives by starting to have, or increasing a “financial liability” PricewaterhouseCoopers

  33. “Other non-cash benefits” – s8-28(3) • If you give a non-cash benefit under an arrangement that is not a cash-like benefit • You are taken to receive for the non-cash benefit an amount equal to the total market value of the 1 or more non-cash benefits you get PricewaterhouseCoopers

  34. Section 8-28 – Formula in EM at 11.57 Deemed receipt for the non-cash benefit given Market value of non-cash benefit given Total market value of all non-cash benefits entity gets = X Amounts actually paid Total market value of all non-cash benefits given +

  35. Non-cash benefits you get – s8-29 • If you get only one non-cash benefit you are taken to pay for it an amount equal to the total of all amounts you are taken to receive because of s8-28 • If you get 2 or more non-cash benefits you are taken to pay amounts whose total equal the total of all amounts you are taken to receive because of s8-28 • The amount you are taken to pay for each non-cash benefit is the same proportion of that total as the market value of that non-cash benefit is of the total market value of the 2 or more non-cash benefits

  36. Disregarded non-cash benefits – s8-31A(1) • If you get a non-cash benefit pursuant to a right that you have and as a result all or part of that right ends • The ending is a non-cash benefit that you give • DISREGARD both non-cash benefits (arising under s8-27(3)) when applying Division 8

  37. Section 8-31A(1) – Example 11.3 from EM • W pays O $1 million for plane to be supplied in 12 months • W has an asset consisting of the aeroplane • When W gets the aeroplane his right ends • DISREGARD the non-cash benefit W gives when his right to receive the aeroplace ends and the non-cash benefit O gets when the right to receive the aeroplane ends PricewaterhouseCoopers

  38. Disregarded non-cash benefits – s8-31A(2) • If you give a non-cash benefit pursuant to a liability you have and as a result that liability decreases or ends • The ending is a non-cash benefit you get • DISREGARD both non-cash benefits (arising under s8-27(3)) when applying Division 8 PricewaterhouseCoopers

  39. Policy reason for disregarding certain non-cash benefits under s8-31A • EM at 11.74: s8-31A required so that a gain or loss on a right or liability (due to a change in market value) is “rolled-over” into non-cash benefit acquired • Example 11.4: A pays B $100,000 for land to be conveyed 6 months later. When land is conveyed to A, it is now worth $150,000. Section 8-31A allows gain to be rolled-over PricewaterhouseCoopers

  40. Why cash-like benefits (and cash) treated differently from other non-cash benefits? EM Example 11.5 • A promises to pay $100 in the future (or pays $100 cash now) for an asset with an MV of $150 • Division 8 treats A’s promise to pay $100 as a cost of $100 rather than treat A as having made a gain of $50 on the transaction – gain not recognised PricewaterhouseCoopers

  41. Non-cash benefit given for non-cash benefit of greater market value – Example 11.6 • A changes truck (which has a written down and market value of $100,000) for a bulldozer (which has a market value of $120,000) • A will be treated as receiving $120,000 for the truck and his tax value for the bulldozer will be $120,000 – gain is recognised • Under current law bulldozer is treated as purchased for $100,000 and truck as sold for $120,000 – double tax PricewaterhouseCoopers

  42. Diagram 11.5 – Reconstruction of 2-sided non-cash transaction with cash on both sides PricewaterhouseCoopers

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