Appendix 2: Tax summary

The Inquiry has identified a number of taxes that distort the allocation of funding and risk in the economy. The Inquiry also identified other tax issues that may adversely affect outcomes in the financial system. Unless they are already under active Government consideration, the tax issues listed below should be considered as part of the Tax White Paper process.

Differentiated tax treatment of savings

The tax system treats returns from some forms of saving more favourably than others. For example, interest income from bank deposits and fixed-income securities are taxed relatively heavily. This distorts the asset composition of household balance sheets and the broader flow of funds in the economy.

To the extent that tax distortions direct savings to less productive investment opportunities, a more neutral tax treatment would likely increase productivity.

The relatively unfavourable tax treatment of deposits and fixed-income securities makes them less attractive as forms of saving and increases the cost of this type of funding.

Negative gearing and capital gains tax

Capital gains tax concessions for assets held longer than a year provide incentives to invest in assets for which anticipated capital gains are a larger component of returns. Reducing these concessions would lead to a more efficient allocation of funding in the economy.

For leveraged investments, the asymmetric tax treatment of borrowing costs incurred in purchasing assets (and other expenses) and capital gains, can result in a tax subsidy by raising the after-tax return above the pre-tax return. Investors can deduct expenses against total income at the individual's full marginal tax rate. However, for assets held longer than a year, nominal capital gains, when realised, are effectively taxed at half the marginal rate. All else being equal, the increase in the after-tax return is larger for individuals on higher marginal tax rates.

The tax treatment of investor housing, in particular, tends to encourage leveraged and speculative investment. Since the Wallis Inquiry, higher housing debt has been accompanied by lenders having a greater exposure to mortgages. Housing is a potential source of systemic risk for the financial system and the economy.

Dividend imputation

The case for retaining dividend imputation is less clear than in the past. To the extent that dividend imputation distorts the allocation of funding, a lower company tax rate would likely reduce such distortions.

By removing the double taxation of corporate earnings, the introduction of dividend imputation (in 1987) reduced the cost of equity and the bias towards debt funding. This contributed to the general decline in leverage among non-financial corporates.

However, the benefits of dividend imputation, particularly in lowering the cost of capital, may have declined as Australia's economy has become more open and connected to global capital markets. If global capital markets set the (risk-adjusted) cost of funding, then dividend imputation acts as a subsidy to domestic equity holders. That would create a bias for domestic investors, including superannuation funds, to invest in domestic equities. Imputation provides little benefit to non-residents that invest in Australian corporates.

For investors (including superannuation funds) subject to low tax rates, the value of imputation credits received may exceed tax payable. Unused credits are fully refundable to these investors, with negative consequences for Government revenue.

Mutuals cannot distribute franking credits, unlike institutions with more traditional company structures. This may adversely affect mutuals' cost of capital, with implications for competition in banking.

Interest withholding tax (IWT)

For non-residents, repatriated income from Australian investments is, in some cases, subject to withholding tax. The unequal tax treatment of repatriated income may affect the funding decisions of Australian entities and place Australia at a competitive disadvantage internationally.

Lower, more uniform withholding tax rates would unwind these distortions; however, since withholding taxes help protect the integrity of the tax system, reforms should consider the potential implications for tax avoidance.

Withholding tax varies depending on a range of factors, including the type of funding, the country of the non-resident and the relationship between the non-resident and the domestic recipient of the funding.

Withholding taxes generally increase the required rate of return for foreign investors, which reduces the relative attractiveness of Australia as an investment destination. Where foreign investors can pass on the cost to domestic recipients of funds, this raises the cost of capital in Australia.

For financial institutions, different funding mechanisms are subject to different rates of IWT. Reducing IWT (for the relevant funding mechanisms) would reduce funding distortions, provide a more diversified funding base and, more broadly, reduce impediments to cross-border capital flows.

For foreign bank branches in Australia, interest paid on funds borrowed from the offshore parent is deductable, limited to the London Interbank Offered Rate (LIBOR) cap. This can prevent the branch from claiming the full interest cost of borrowing.

Australia's IWT regime also applies to derivative transactions. Under G20 commitments, certain standardised over-the-counter derivatives need to be collateralised and cleared through a regulated central counterparty (CCP). In Australia, outbound interest payments on collateralised positions may be subject to IWT (flows from Australian participants to offshore CCPs, or flows from Australian CCPs to offshore participants). This may increase costs for Australian participants and adversely affect liquidity in Australian derivatives markets.

Development of new financial markets that trade non–AUD denominated financial products (for example, RMB-denominated products) requires making markets across borders. Greater certainty regarding how withholding taxes are applied in these markets, and better alignment of the regime with regional trading partners, would aid market development.

The Research and Development (R&D) Tax Incentive

The R&D Tax Incentive provides businesses with annual tax offsets for eligible R&D costs.

Submissions broadly support the regime, although some argue that more frequent access to tax offsets would help alleviate firms' cash flow constraints, particularly for new ventures.

Tax treatment of Venture Capital Limited Partnerships (VCLPs)

Simplifying the tax rules for VCLPs and streamlining Government administration of the regime would reduce barriers to fundraising. A 2011 Board of Taxation review (Review of taxation arrangements under the Venture Capital Limited Partnership regime) made recommendations to simplify the regime. In 2013, Government provided in-principle support for the recommendations.

Tax treatment of funds management vehicles

In 2009, the Johnson Review (Australia as a financial centre: Building on our strengths) recommended changes to the tax treatment of funds management. Government has implemented some of the proposed changes but is still considering others, including expanding the range of collective investment vehicles (CIVs).

Typically, offshore investors require an investment vehicle that allows flow-through of any tax liabilities from the vehicle to the end investor. However, Australian tax law does not allow for the types of vehicles that both provide for flow-through and are familiar to offshore clients (particularly in Asia). A broader set of appropriate vehicles would better facilitate the management of foreign funds.

The Board of Taxation reviewed tax arrangements applying to CIVs in 2011. Government is yet to release the report.

Tax treatment of superannuation: Tax concessions

Tax concessions in the superannuation system are not well targeted to achieve provision of retirement incomes. This increases the cost of the superannuation system to taxpayers and increases inefficiencies arising from higher taxation elsewhere in the economy, and the distortions arising from the differences in the tax treatment of savings. It also contributes to the broader problem of policy instability, which imposes unnecessary costs on superannuation funds and their members and undermines long-term confidence in the system (see Chapter 2: Superannuation and retirement incomes).

Tax treatment of superannuation: Differentiated tax rates on earnings

Earnings are taxed at 15 per cent in the accumulation phase, but are untaxed in the retirement phase. This can act as a barrier to funds offering ‘whole-of-life' superannuation products and increases costs in the superannuation system.

Aligning the earnings tax rate between accumulation and retirement would reduce costs for funds, help to foster innovation in whole-of-life superannuation products, facilitate a seamless transition to retirement and reduce opportunities for tax arbitrage (see Chapter 2: Superannuation and retirement incomes).

Tax treatment of legacy products

Legacy products are financial products that are outdated and closed. These include some life insurance policies and interests in managed investment schemes.

Legacy products are a drag on the efficiency of product providers, which ultimately may lead to higher costs for consumers. In 2009, Government proposed a framework for rationalising legacy products; however, this has not yet led to an implemented solution. One significant issue is the tax treatment of underlying assets when legacy products are converted or consolidated into products with equivalent features or benefits (see Recommendation 43: Legacy products in Appendix 1: Significant matters).

Duties on insurance

Insurance taxes are levied by the states and territories. All states impose stamp duties on general insurance premiums, while some states impose additional levies—for example, fire service levies.

Insurance taxes mean that individuals and businesses must pay more to achieve the same risk reduction. Reducing duties on insurance would assist in dealing with underinsurance.

Tax treatment of non-operating holding companies (NOHCs)

With regard to corporate groups that include regulated entities, a group headed by a NOHC may give legal and operational separation to the group's regulated and non-regulated activities. In Australia, few financial groups are headed by NOHCs, and none of the four major banks operate under this structure.

A NOHC structure may provide financial institutions with greater flexibility in their activities. For regulators, a NOHC structure may facilitate supervision and resolution. However, restructuring carries significant costs for corporate groups, including tax implications.

Making a move to a NOHC structure tax neutral would reduce disincentives to adopt this corporate structure.

Goods and services tax (GST)

GST is not levied on most financial services. This may contribute to the financial system being larger than it otherwise would be.

Financial service providers that do not charge GST still must pay GST on inputs, but cannot claim input tax credits. Providers pass this cost on to consumers in the form of higher prices.

As a result, households could be over-consuming financial services compared to what they would consume if GST was applied to these services. Because the GST is embedded in prices charged to businesses, but not charged explicitly, businesses cannot claim input tax credits. This could result in businesses consuming fewer financial services than otherwise would be the case.