The time is right for complete redesign of the thousands of pages of Australian law in two income tax acts (1936 and 1997) for the taxation of income from investments. That is the law dealing with income from investments like those in manufacturing activities, mining, geared rental properties, infrastructure, fruit orchards, annuities, indexed bonds, and so on. The investments could be local or international and could be made directly or indirectly via entities like companies and trusts.

There has been continual grafting of amendments onto pre-existing archaic and deficient income tax law which has no over-arching guiding principles and is well out of kilter with commercial reality and commercial profit determination, particularly in relation to changing values of investment assets and liabilities. The overall result is a complex, lengthy and opaque patchwork of law without a clear framework to aid legal interpretation. References have been made by the legal fraternity to entering a parallel universe when opening up statutes dealing with business income taxation. It is time to consider removing that parallel universe.

Specifically in relation to taxation of entity income, confusion has recently been reported over the distinction between components of income or profit versus returns of capital in company distributions. A number of issues have also arisen over interpretation of the tax treatment of trust income. The Australian Treasury is reportedly considering a re-write of trust law in light of recommendations of the 2010 Henry Tax Review. A re-writing of entity taxation as a whole, including the international dimension, is a more appealing proposition.

Taxing Investment Income: without affecting worldwide investment decisions provides a simple and practical, yet principle-based, template for redesign of the law to tax investment income. Underpinning this template is a simple, common sense framework for income tax arrangements that have minimal impact on investment decisions. The design template deals with the three key facets of taxation of investment income: the tax base, taxation of entities and the international dimension.

Tax base (or taxable income). The over-arching concept here is that decisions by each investor should not be greatly affected if a proportional slice were taken off the annual income of all the investor’s possible investments – achieved by positive income (profits) being taxed at the investor’s tax rate and losses being deducted from the investor’s other income (and, ideally, losses attracting direct payments when other income is not available).

But the crucial question is: how is ‘income’ to be measured? Well, 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. Thus, commercial income from investment assets comprises annual net receipts plus annual change in value of the assets, whether or not the assets are sold in that year. For practical purposes, however, the template in Taxing Investment Income sees ‘change in value’ replaced by ‘change in tax value’ specified by government, where tax value is a generic term replacing current terms like depreciated value and cost base.

This is essentially the somewhat controversial ‘tax value method’ recommended by the 1999 Ralph Review of Business Taxation and subsequently canvassed at length in public consultations but, in the event, not pursued. Its lack of acceptance in part may have been the misconceived view that this design would necessarily bring with it significant change to the tax treatment of particular transactions. In fact, the design itself imposes no change to current tax treatment. It does offer, however, a solid legal foundation providing clarity, as well as consistent and simple over-arching design. It may also impose pressure for clear explanations of why changing tax value design employed for each group of assets and liabilities differs from the framework principle of change in actual value.

Taxation of entities. The over-arching principle here is for annual investment income of entities like companies and trusts to be included in the personal income tax assessments of shareholders and trust beneficiaries in the year the income arises. With taxable income measured the same for all taxpayers, the same tax is paid regardless of whether investments are undertaken by a sole trader, by a company or by a trust. For practical purposes, the template in Taxing Investment Income has taxable income, rather than full commercial income, of entities integrated with annual personal tax assessments of entity investors.

Australia’s full imputation system of company tax sees distributed local income taxed at each shareholder’s tax rate but the income could have arisen many years prior to distribution. At the time Australia’s full imputation system was introduced, integrating annual company income with shareholder assessments was canvassed as a future possibility should associated practical difficulties be ironed out. The experience in Australia of systems dealing with both full imputation and taxation of fixed trusts in the context of capital gains taxation plus restricting the integration to taxable income makes this design now possible – and not only for companies but for fixed and discretionary trusts as well.

Integrating taxable income requires no tax to be paid at the entity level, just as annual distributions of taxable income from fixed or discretionary trusts are currently taxed only in the hands of trust unit-holders or beneficiaries. Taxable income of entities would, however, be included in entity investors’ tax assessments regardless of the amount of income actually distributed. Entity investors being taxed on their entities’ taxable income even when the income was retained would not pose practical issues for closely held entities and the vast majority of widely held entities regularly pay annual distributions. Where an entity distributes taxable income each year, tax treatment would match Australia’s current fixed or discretionary trust treatment. Consistency of entity income taxation would not be achieved via full imputation arrangements (as recommended unsuccessfully by the Ralph review) but essentially in line with current trust treatment.

A full imputation system imposing tax at the entity level could be retained within the design to integrate taxable income. Domestic personal tax rates of domestic entity investors would still apply to their share of their entities' annual taxable income but the setting of the entity tax rate would likely focus on: arguments for a low company tax rate to attract mobile international capital funds; how much tax to impose on foreigners investing in, or through, domestic entities; tax integrity benefits sought; and minimising a temporary cash flow impact from entity tax withheld on say low income holders of units in cash management trusts (though administrative mechanisms to provide early refunds would be possible).

International dimension. The over-arching principle here is to flow foreign tax credits through to local entity investors and provide refunds for any excess foreign tax over local tax on the foreign income. That is required to ensure that no tax bias is imposed between investing locally and internationally. Full imputation mechanisms included in the design of integrating taxable income would enable this requirement to be met simply by adding foreign taxes to entity imputation accounts. Recognising the obvious tax revenue issue here, the template in Taxing Investment Income incorporates simple and flexible adjustment mechanisms, applied consistently to companies and trusts, to address concerns over local tax collections.

The design template for the income tax base and for entities’ taxation not only provides the solution to the legal parallel universe but also automatically accommodates any moves over time to line up tax values of assets and liabilities with their actual values in the commercial world – moves which themselves offer an associated ‘free lunch’ of productivity improvement.

Taxing Investment Income: without affecting worldwide investment decisions by Wayne Mayo, Kyscope Publishing, Canberra, 2011.

Wayne Mayo has authored a number of journal articles on business income taxation. He has had many years of hands-on policy experience dealing with business income tax issues while in the Australian Treasury, including during periods of tax reform in the 1980s (managing the Business Tax Policy Branch) and 1990s (coordinating policy development prior to, and during, the Ralph Business Tax Review).