Based on recent polling and the impending Federal election, there is a high probability that the tax measures in the Government’s Federal Budget due to be handed down on 2 April 2019 will be “zombie” measures in the sense that whatever measures the Government announces are at risk of not being enacted as a consequence of a change in government.
Against this backdrop, the Australian Labor Party (Labor) is continuing to promote and explain its own tax policies in demonstrating its readiness for government. The theme running through Labor’s policies is the targeting of concessional tax treatment of income and gains other than salaries and wages. In explaining its tax policies, Labor is generally referring to these concessions as “loopholes”, “subsidies” and “concessions”. These are emotive words aimed at the popular vote, but are these measures targeted at the right places? We summarise Labor’s key income tax policies below.
The centrepiece of Labor’s tax policies is aimed at improving housing affordability, an issue that voters all around the country are capable of connecting with, especially those in the major cities, and comprises changes to negative gearing and the capital gains tax (CGT) discount.
Negative gearing refers to the practice of an investor making an investment that loses money in the short term (for example where interest expenses on a rental property exceed rental income), in the expectation of making gains in the future (e.g. on disposal of the property). The net investment loss is applied as a deduction against the investor’s salary and wage income, which can result in a refund of the investor’s PAYG withholding.
Labor’s policy in respect of negative gearing is as follows:
- Negative gearing will be limited to new housing from a yet to be determined date after the election.
- Losses from new investments in shares and existing properties will not be able to be applied against salary and wage income, but will be able to be applied as deductions against investment income and carried forward to offset any gain on the ultimate disposal of the investment.
Although framed in the context of residential property investment, Labor’s negative gearing policy extends beyond residential property investment and will also apply to other investments such as shares. Although not as common as borrowing to acquire real estate (presumably due to the higher risk and cost of margin lending), borrowing money to invest in shares with the purpose of deriving franked dividends and capital gains on disposal can be a tax effective strategy taking into account the deduction for the interest expense, the receipt of the franking credit and the potential availability of the CGT discount. Labor’s negative gearing measure (combined with the measure regarding franking credit refunds discussed below) may further limit the practice of margin lending.
Investors in residential property invest for the purpose of deriving rental income and making gains on disposal of the property. Individuals, trusts and complying superannuation entities that hold such investments for more than 12 months on capital account are entitled to discount the gains they make (by 50% in the case of individuals and trusts, and 33⅓% in the case of complying superannuation entities). Labor views this discount as an unaffordable tax subsidy and as such, proposes to halve the CGT discount for all assets purchased after a yet to be determined date, reducing the CGT discount from 50% to 25% in the case of individuals and trusts.
The changes will not affect investments made by superannuation funds and the CGT discount will not change for small business assets. Again, the measure is framed in the context of residential housing, but it appears Labor’s intent is for the measure to apply to investments in all types of assets.
The date from which the above two measures are proposed to apply is yet to be determined, but Labor has made it clear it intends existing investments to be grandfathered.
There is a fear that Labor’s proposed changes are unnecessary given the recent cooling of major capital city residential markets, and some commentators are warning that Labor’s negative gearing changes will put further downward pressure on home prices to the extent that price falls could be harmful to the economy.
Another commonly expressed fear is that Labor will expand its policies beyond residential premises. As we have noted, Labor expressly states its intentions in this regard. However, it is worth noting that there is a lack of commentary about Labor’s proposal to ensure the deductions that would be limited by the negative gearing change remain available to be used against current and future gains from investment assets (investment losses matched against investment income).
The imputation system was introduced in 1987 to ensure that company profits were only taxed once, as opposed to being taxed multiple times as those profits were distributed “upstream” to shareholders. In 2000, the system was changed to provide a refund of excess franking credits where a taxpayer’s tax liability was less than the franking credits available to the taxpayer.
Given the refund of excess franking credits, investing in companies that pay franked dividends is a popular investment strategy for almost all Australians, but particularly for superannuation funds (whether self-managed or not) and individuals with an effective tax rate of less than 30%. The reason for this popularity is that superannuation funds are generally taxed at 15%, meaning that any franking credits received by the fund that are in excess of the fund’s tax liability can potentially be refunded to the fund.
Labor proposes to make franking credits no longer refundable for individuals and superannuation funds (for the avoidance of doubt, the offset against tax otherwise payable will be retained). Endorsed income tax exempt charities and not-for-profit institutions with deductible gift recipient status are proposed to be excluded from this measure. Pensioners and allowance recipients are also proposed to be excluded from this measure.
Based on our observations on media reports, this is unsurprisingly a particularly controversial measure amongst self-funded retirees and some high profile fund managers.
The measure is proposed to apply from 1 July 2019.
Discretionary trust “loopholes”
In July 2017, Labor announced its policy of introducing a minimum 30% tax rate for discretionary trust distributions to people over the age of 18. This policy is proposed to apply from 1 July 2019 and is aimed at the perceived mischief of “income splitting” through the use of discretionary trusts. The 30% rate has been chosen to align with the corporate tax rate of 30% that applies to companies (other than companies that are base rate entities which are currently taxed at 27.5%) on the principle that those able to split their income through a family trust are typically carrying on some form of business and that business could be equally carried on by a corporate.
It is common for family owned businesses to be run through discretionary trust structures, as well as for a family’s investments to be held in discretionary trusts with income and returns being distributed to beneficiaries that are family members, or a corporate beneficiary owned by those family members. Income of the trust can be distributed in a manner which can result in less tax being paid if all of the income was derived by a single individual. For example, under existing law, distributions made under discretionary trusts might lead to a beneficiary receiving trust distributions that are taxed at a low rate or not at all (for example, if a beneficiary receives less than $18,200 from the trust and no further income in a tax year, the beneficiary may not be liable to pay tax that year).
This measure of imposing a minimum 30% tax rate is proposed to only apply to discretionary trusts, meaning that non-discretionary trusts such as special disability trusts, deceased estates and fixed trusts should not be impacted. Farm trusts and charitable trusts are also proposed to be excluded. At this time, we presume that “farm trusts” refers to trusts through which farming businesses are operated, noting that it is not a defined term. It seems the policy behind this farm trust exclusion recognises that income from farming is unpredictable so farm trusts should continue to be able to distribute income to beneficiaries taxed in accordance with marginal rates. Presumably many other small business that operate through discretionary trusts will feel that their income is equally unpredictable.
Limit on deductibility of managing tax affairs
Labor proposes to impose a $3,000 limit on the amount that individuals can deduct from their assessable income in relation to the management of their tax affairs. The limit appears to have originated in Bill Shorten’s 2017 budget reply speech where he stated that in 2014-15, 48 Australians earned more than $1 million and paid no tax, and one of the biggest tax deductions those taxpayers claimed was expenditure incurred in managing their tax affairs, averaging over $1 million. In underlining the purpose of the limit, Bill Shorten proclaimed that “loopholes for millionaires means middle Australia pays more tax”.
Recognising our own self-interest in relation to this proposed change, we consider this limit to be ill-conceived for various reasons, including:
- A limit may discourage taxpayers from seeking out professional advice, which may in turn lead to greater non-compliance.
- The $3,000 amount does not appear to be tied to a particular reference point. In our experience, a $3,000 fee for the preparation of a tax return by a tax agent (let alone obtaining tax advice on unusual events such as a transaction during the course of a year) does not go a long way.
- It fails to recognise that individuals can carry on business; thus, the tax law would be distortive of behaviour by pushing individuals to form entities to carry on business.
Lifting the top marginal tax rate for individuals
The top marginal tax rate for individuals is currently 47% (inclusive of the Medicare levy), noting that the temporary 2% Budget Repair Levy ceased to apply from 1 July 2017. Labor proposes to lift the top marginal tax rate to 49%, which is effectively re-introducing the Budget Repair Levy but on a permanent basis. The rationale for this policy is that the budget is not yet adequately repaired. It will be interesting to see what comes of the 2019/2020 budget as there appears to be some windfall gains available, which may result in this proposal being removed. Whether it is removed or not, one would hope for a lifting of the income tax brackets significantly to address bracket creep and the brain drain that Australia suffers.
Australian Investment Guarantee (AIG)
With the purpose of stimulating business investment, Labor proposes to introduce an AIG, which will allow all businesses to immediately deduct 20% of the value of eligible depreciable assets in the year in which a depreciable asset is acquired. Unlike relatively recent “investment allowance” tax incentives that applied for temporary periods only, the AIG is intended to be permanent.
The key design features of the AIG are:
- Eligible assets will include tangible assets (such as plant and equipment) and intangible assets (such as patents and copyrights).
- Assets that are eligible for the research and development concession will not be eligible.
- Structures, buildings and passenger vehicles will also not be eligible.
- It will only apply to investments valued at over $20,000 to make it targeted at productivity enhancing investments.
The AIG is proposed to apply from 1 July 2021.
Changes to the thin capitalisation rules
The Australian law presently denies debt deductions that foreign controlled or outward investing Australian taxpayers may claim where their debt levels exceed certain prescribed limits. These thin capitalisation rules are designed to prevent multinational entities from shifting profits out of Australia by funding their Australian operations with high levels of debt (as opposed to equity) which reduces the entity’s taxable income.
There are currently three tests used to determine the abovementioned prescribed limit:
- The safe harbour debt amount – broadly limits the amount of debt used by an Australian taxpayer to finance its Australian operations to 60% of the difference between the value of its assets and non-debt liabilities.
- The arm’s length debt amount – broadly limits the amount of debt used by an Australian taxpayer to finance its Australian operations to the amount the taxpayer could reasonably expect to borrow on an arm’s length basis from a third party.
- The worldwide gearing debt amount – broadly limits the amount of debt used by an Australian taxpayer to taxpayer to finance its Australian operations at a gearing level consistent with the Australian taxpayer’s worldwide group.
Labor proposes to amend the thin capitalisation rules such that taxpayers can only use the worldwide gearing debt amount. This means that if an Australian taxpayer has an average 30% gearing ratio across its global group, it will only be able to deduct interest expenses on debt up to a 30% gearing level. This measure is aimed squarely at the heart of multinationals. When one considers the multinational anti-avoidance law, diverted profits tax, filing of general purpose financial reports with the Australian Taxation Office, a 100 fold increase in penalties and country-by-country (CbyC) reporting, large multinationals (particularly inbound investors) may start to wonder if Australia is a place they want to do business. We have previously observed that Australia needs to be mindful that it is a net importer of capital and hence must remain competitive in attracting that capital.
It is uncertain when this measure is proposed to apply from.
Tax transparency measures
There has been a significant increase in the level of tax transparency and availability of tax information in recent years. The ATO started publishing certain information (accounting income, taxable income and tax payable) in respect of the 2013-14 year, we now have a voluntary tax transparency code and some companies are preparing “taxes paid” reports. Although tax transparency measures can be a powerful tool in promoting compliant behaviour, non-tax people can be misled by the information.
Labor intends to build on existing tax transparency measures by introducing a suite of tax transparency measures to target tax evasion and minimisation across borders. The key proposals are:
- The public disclosure of CbyC reports lodged by multinational companies with global turnover of over $1 billion. This information is currently shared amongst revenue authorities but the public availability of this information may be viewed as commercially sensitive by some taxpayers.
- Changes to the Corporations Act requiring companies to disclose to shareholders any dealings in tax havens. Presumably this measure relies on shareholders holding management accountable where tax havens are being used, but would it be more effective if companies had to publicly disclose any dealings in tax havens? Shareholders are interested in economic returns, whereas the public will be more interested in making companies earn their social licence.
- Reducing the threshold for the application of the tax transparency measures (under which accounting income, taxable income and tax payable are published) to private companies to $100 million (from $200 million).
- Recording the beneficial ownership of Australian listed companies on a publicly accessible register. The purpose of this measure is to allow people to understand who owns Australian companies such that shareholders cannot use “complex structures and sham ownership” to avoid complying with transparency rules.
As we head to a Federal election in May 2019, these proposals will be aired and challenged. It will be interesting to see what happens in the lead up to and following the election. Look out for our Budget newsletter which, this year, will include the opposition’s response.
Please contact one of our tax experts if you would like to discuss how these measures may impact you.