People undertake investments directly or indirectly via companies or trusts in a wide variety of areas like the financial markets (from bank deposits to currency futures), commercial property, rental property, manufacturing, forestry, horticultural activities (like vineyards, olives and fruit), mining and petroleum projects, infrastructure projects and so on. How the income from associated assets (and liabilities, like debt funding) is taxed—that is, the shape of ‘business income taxation’—can have a big impact on the investment decisions themselves and, consequently, on the community’s overall welfare.

The imposition of tax on the income of investments to raise funds for government expenditures can effect people’s decisions in a variety of ways. It can, for example, affect the decision whether to spend money on consumption now or save it for future consumption and be taxed on the interest earned on the savings. It can also affect the decision whether to spend more time enjoying leisure time rather than working and paying tax on the wages earned.

Despite these distortions imposed by income taxation, it is theoretically possible to tax income from people’s investments in a way that leaves people taking pretty much the same sort of investment decisions after tax as before. The conceptual basis of achieving this is, in fact, simply to take a proportion each year from (apply a rate of tax to) what everyone knows comprises the annual income of each investment: annual net receipts (gross receipts from the investment less its recurrent costs) and annual change in value of the investment’s assets and liabilities. The shareholder, for example, who avidly checks share price daily knows that her annual income comprises not only dividend payments but also the change in value of her shares over the year. The rental property investor is not investing just for the annual net rental receipts but also for the hoped-for increase in value of the property. Investment decisions by each investor should not be greatly affected if this annual income—both positive (profits) and negative (losses)—across all investments were reduced by the marginal tax rate faced by that investor.

This theoretical—yet commercially sensible—way of taxing income from investments that has ‘neutral’ effect on investment decisions provides a framework for the design of business income taxation that has the potential to produce broad economic benefits. Those broad economic benefits do not include increasing ‘jobs’, a common catchcry accompanying proposed changes to business income tax arrangements. Aggregate employment levels and unemployment rates are determined mainly by the shape of labour market regulation, the nature of welfare systems and, particularly with an eye to cyclical unemployment, monetary and fiscal policies. The potential benefits of genuine tax reform that pushes towards neutral taxation of investment income are more about better blending the labour force with other productive resources like land and capital to increase living standards and consumption per head through increases in productivity.

Contrary to popular belief, a ‘free lunch’ is on offer. Increased welfare can result from the same resources of a country when those resources are better utilised through the removal of income tax treatment of investments that distorts investment decisions.

‘Tax reform’ means different things to different people. Some view it in terms of reduced tax rates. Others see it as changes to the law that reduce the scope for tax avoidance and evasion. Yet others see it as any change to the law that, superficially at least, provides perceived benefits to them relative to others. To government, any change in tax law under its watch is reform.

Genuine reform of the way the income from investments is taxed, however, is focussed on achieving the free lunch on offer: pushing towards a tax treatment that means government revenue is raised without impacting significantly on investment decision- making. Synonymous with such tax treatment is an investor mindset which has investors focussed on solid commercial profit, not distracted by the search for ways to structure their investment arrangements to avoid tax.

The free lunch comes from taxing the ‘income’ from investments measured in a common sense way that matches commercial reality. In contrast to the search for the ideal toothbrush, there is a known ‘pure’ taxation design to strive for—a design centred on including in the income tax base changing annual values of investment assets and liabilities.

In practice, the over-arching principle of taxable income including annual change in value of assets and liabilities cannot just be applied to people’s direct investments in local activities. The principle must be extended to accommodate the fact that people invest indirectly through local entities like companies or trusts—as well invest in foreign activities, again directly or indirectly.

An income tax framework with neutral impact on investment decisions must therefore encompass:

• Specification of the tax base—what is to be included in taxpayers’ assessable income, what deductions are to be allowed and how are losses to be handled?

• Design of ‘entity’ taxation—when people invest indirectly through entities how are they to be assessed for income tax purposes on the income of their entities (including when their entities distribute funds to them and when the entities are liquidated) and when they sell their interests in the entities?

• International dimension—when people invest either directly or indirectly in other countries how are the foreign taxes imposed on their investments’ earnings to be treated at home?

Against these three dimensions of income tax design, some key features of a tax neutral framework, all of which involve practical implementation difficulties, are:

• incorporating in the income tax base annual accrued changes in value of all investment assets including property and company shares (required under the over-arching neutrality principle);

• providing ‘full loss offset’ via say government cash payment equal to a taxpayer’s annual loss times the tax rate when the taxpayer does not have sufficient positive taxable income from other investments against which to fully offset the loss (required to maintain balance across the full range of possible investment outcomes);

• integrating the annual income of entities directly into the personal income tax assessments of those investing via the entities (necessary for neutrality between direct and indirect investment); and

• allowing credit for foreign taxes on investments in other countries to flow back through local entities to individual local investors (aimed at ensuring that overall tax paid on offshore investments is driven by local, not foreign, income tax design).

In this framework, absent the international dimension, the rate of tax faced by an investor can be considered to be of secondary importance. It is the structure of the income tax law that is most crucial. A structure of income taxation with neutral impact on domestic investment decisions can accommodate any rate or rates of tax, set to raise government revenue required, without compromising tax neutrality.

Introducing the international scene, however, raises two key issues relevant to domestic tax rates and tax revenue. First, the design of foreign tax crediting arrangements is a crucial ingredient to the generalisation of the neutrality framework and one that inevitably involves a trade-off with domestic tax revenue collection. Secondly, if the annual income of domestic companies is integrated into the personal tax assessments of local shareholders, it might seem that a zero company tax rate could be seriously contemplated. However, with foreigners investing in, or through, home country companies, the level of the domestic company tax rate may hinge primarily on how much domestic tax is to be imposed on those foreign investors.

Given the significant practical implementation issues associated with the neutrality framework, this book would be of no practical use if it presented only theoretically pure design for the taxation of income from investments. Realistic design has to recognise these difficulties but also not be constrained by the legacy of past business income tax design built up over the years in an ad hoc manner without clear design principles. Thus, the book aims at presenting practical design that is based on the principles underpinning the neutrality framework and is also capable of accommodating future reforms that move income tax law towards the ‘pure’ neutrality framework.

Chapter 2 gives an overview of the tax design framework for neutral investment decision-making and its application to local direct investments, local indirect investments via entities (like companies and trusts) and investments made internationally via local entities. Three investors are involved: Jim, a local investor, and Francis and Raymond, two investors in other countries. The chapter sets the pure neutrality framework against common contemporary treatment and the practical design template to follow in later chapters of the book (Chapters 4, 5 and 6). Chapter 3 then steps back to explain concepts underpinning the neutrality framework, including its application in the presence of inflation and risk. The final three chapters deal with the three dimensions of income tax design in a way that caters for realistic income tax design based on the neutrality framework.

• The tax base. Chapter 4 replaces ‘change in value’ of investment assets and liabilities under the neutrality framework with ‘change in tax value’ so that government, as usual, specifies year-by-year values for tax purposes of particular assets and liabilities. As local investor Jim searches for tax-reducing opportunities across different types of assets, practical ways of determining annual tax values that approximate actual value are discussed for various assets and liabilities. The possibility of government-backed full loss offset is raised in the context of annual tax value matching actual value (most particularly, in relation to accrued capital gains).

• Entity taxation. Chapter 5 replaces integration of actual income under the neutrality framework with integration of taxable income, drawing on Australian experience with full imputation company tax arrangements and fixed trust arrangements in the context of CGT. As Jim analyses investment opportunities via companies and trusts, an inquiry in Jim’s country is searching for a principles-based tax regime to be applied consistently across all entities in that country. Analysis by the inquiry shows how integrating taxable income readily accommodates future moves towards integrating actual income.

• International dimension. Chapter 6 shows how mechanisms associated with ‘pure’ design for the flowing of foreign tax credits through companies to local shareholders can be adjusted without introducing complexity to accommodate concerns over local income tax collection. Jim, Francis and Raymond are all involved.

Tables on the last few pages of the book illustrate the ‘bliss point’ of taxation of investment income where the practical design template morphs into the pure neutrality framework applying everywhere and, as a consequence, investors worldwide are making investment decisions as if no income taxation applied to them at all.