Chapter 1: The review process



Building a foundation for business tax reform

The Business Tax Working Group (Working Group) was established following the Tax Forum in October 2011 to consider what kind of business tax system will best support Australia's future growth prospects. This report on the treatment of tax losses should be seen as the first instalment in a two-part exercise that aims to provide a foundation for business tax reform that will help Australian businesses continue to grow and change in response to the challenges and opportunities presented by the volatility of the global economy and the fast-growing economies of Asia.

Our terms of reference require the Working Group to focus on how best to relieve the tax burden on new investment in the short term through changes to the treatment of tax losses.¹ Later in the year we will consider whether a further corporate tax rate cut or a move towards a business expenditure tax system, including an allowance for corporate equity, would best support new business investment in the longer term.

The Working Group notes that the timeframe for completing this report was not sufficient to fully explore the net-benefit of potential losses reforms and offsetting savings. In the time provided however, reform options have been identified that are likely to remove impediments in the tax system to business investment and innovation and increase the ability of businesses to respond to changes in economic conditions. Where possible, the Working Group has outlined possible design features that could increase the effectiveness or affordability of its recommendations.

Now more than ever, businesses are under pressure to adapt and change their business models to overcome challenges and make the most of opportunities arising from changes in the Australian and the global economy. This will involve businesses exploring new strategies or diversifying into different markets. This type of activity necessarily involves new investment, for example in machinery, equipment and training of new and existing staff. Such activities will involve expenditure that is not immediately recouped and require businesses to take risks.

The business tax system currently imposes higher effective rates of tax on investments that have some risk of failure. This penalty against risk taking can influence the kinds of investments undertaken and how much investment occurs. Alleviating the tax burden on new investment through reforms to the tax treatment of losses will improve both the quality and quantity of new investment. Policies that remove impediments in the tax system to business investment and innovation will enhance productivity growth in all sectors of the economy, particularly those under pressure to change.

Many losses occur only as a consequence of the arbitrary annual tax accounting period being less than the life of most investments. Investments in machinery, R&D, intangible capital and so forth which record a net taxable income over the project life can show a recorded loss in a particular year (or years) because of lags of more than a year before the investment generates revenues, temporary losses because of a cyclical downturn or natural disaster, or because of close-down costs exceeding revenue. The absence of full refundability means these investments face higher effective tax rates than the statutory tax rate. The key reform option explored in this report is a form of loss carry back. The Working Group has also identified some areas for further work, particularly to ensure that loss integrity rules are appropriate and adapted to the modern commercial environment. Additional reforms to the treatment of losses would have required more substantial savings to be found. Consultations revealed that the support of some stakeholders for changes to the treatment of tax losses is contingent on such changes not compromising the opportunity for more fundamental reforms of the business tax system.

Loss refundability would achieve economic neutrality but is not practical

Immediate loss refundability (that is, refunding a loss at the taxpayer's marginal tax rate) would decrease the bias against risk taking in the economy and improve cash flows for companies in a tax loss position. However, immediate refundability would also have a significant impact on government revenues including by providing an incentive for taxpayers to illegitimately create losses. Additionally, the Working Group is mindful that other jurisdictions do not provide immediate refundability of losses.

As we stated in our interim report, the Working Group does not consider immediate refundability to be a viable reform option for the tax treatment of losses in the foreseeable future. Instead, the Working Group has used immediate refundability as a benchmark for economic neutrality against which to assess alternative reform options.

Chapter 2 summarises why access to tax losses is important and Chapters 3 and 4 discuss ways of getting closer to the benchmark through loss carry back and loss carry forward.

The Working Group has focussed on corporate tax rules

For this report, the Working Group focussed on companies, as this tends to be the organisational form preferred by businesses undertaking risky investment, particularly those drawing on external capital. Businesses operating through a company structure typically face more constraints on their ability to realise the value of their tax losses than businesses operating through alternative structures (other than for trusts). For these reasons, the Working Group considered it was appropriate to focus its attention and its final recommendations on companies and entities that are taxed like companies.

However, the Working Group is mindful that businesses operate through a range of alternative legal structures, sometimes in combination with a corporate vehicle. Where possible, the Working Group has identified the benefits and risks of extending the reform to such entities. The Government may revisit these issues at a later date. For example, if loss carry back is successfully implemented for companies, the Government could further consider extending it to unincorporated businesses.

The Working Group was also encouraged by stakeholders to consider possible reforms to the trust loss r
ules. However, the complexity of those rules is such that it would not have been possible for the Working Group to give them adequate consideration in the time available. The Government is aware of the need to update and rewrite the trust loss rules.² On that basis, the Government could consider referring such a review to a separate process (such as Treasury's current review of trust rules).

The Working Group has focussed on revenue losses

The reforms considered in this report have potential application to both revenue losses and capital losses. However, the Working Group considers that the case for reforming the treatment of capital losses is a less compelling priority for the Government and has, with one important exception, confined its recommendations to revenue losses. The exception is the discussion of loss integrity rules in Chapter 4 which has application to both revenue and capital losses.

As noted in the Working Group's interim report, capital losses are 'quarantined' meaning that they can be offset against capital gains in working out a net assessable capital gain but cannot be deducted from revenue gains. Some stakeholders questioned whether the quarantining of capital losses continues to be appropriate for companies. They pointed out that companies no longer enjoy the benefit of calculating capital gains using a cost base that is indexed for inflation and are denied the capital gains tax (CGT) discount available to other entities. However, it should also be noted that capital gains are taxed on a realisation basis, potentially giving taxpayers the ability to defer the tax liability indefinitely. This advantage may be seen as justifying a relatively more restrictive approach to the treatment of capital losses than revenue losses.

Although properly reflecting the realisation basis of the capital gains tax regime is an important consideration, the Working Group's decision to focus on revenue losses is based more on practical business considerations. In particular, revenue receipts tend to be regular and are relied on by businesses to meet their day to day cash flow needs. By contrast, capital receipts and capital expenditures tend to be irregular and infrequent. The Working Group considers that targeting the treatment of revenue losses will have the most impact in terms of removing the bias against risk-taking and providing business with increased cash flow when it is most needed.

The Government may wish to revisit the treatment of capital losses at a later stage.

The international dimension of tax reform is important

There is scope for global corporations to shift profits and costs between different jurisdictions in pursuit of a tax outcome, even with restrictions on transfer pricing and thin capitalisation. Unilateral changes to our tax loss rules that are out of step with the rest of the world may create arbitrage opportunities for companies to locate their tax losses in Australia. This would come at a cost to revenue without any associated gain to the economy as a whole.

This context has influenced the Working Group's consideration in respect of the possible implementation of a loss carry back reform option and approaches to company loss integrity rules.

The treatment of 'black hole' expenditure should be reviewed

In its interim report, the Working Group noted that targeted reforms to the 'black hole' provision in section 40-880 of the ITAA 1997 might complement reforms to the treatment of losses. In particular, it raised the possibility of allowing black hole expenditure to be written off over a shorter period than the current 5 years.

The 'black hole' provision in section 40-880 is a 'provision of last resort' that allows businesses a deduction over five years for capital expenditure that would not otherwise be recognised for tax purposes. Broadly, business expenditure qualifies for the five year write-off where it is not otherwise deductible (either immediately or over time under a capital allowance provision) and is not included in the cost base of a CGT asset. In practice, section 40-880 tends to apply to expenditure relating to the commencement of a business, expenditure to bring about a structural change to an existing business and expenditure that relates to the cessation of a business. These types of expenditure tend to be associated with activities undertaken in periods in which companies incur tax losses, suggesting that improvements to the black hole provisions would complement loss reform.

A number of stakeholders submitted to the Working Group that the black hole provision applies to expenditure that confers no enduring benefit on the taxpayer or that has no obvious connection with any ongoing asset it owns. This means that the choice of the deduction rate is largely arbitrary. While not endorsing the view that black hole expenditure should be immediately deductible, the Working Group believes there may be scope to shorten the deduction period that applies to certain expenditures without offending the policy of section 40-880.

A shorter write-off period for certain black hole expenditures may provide much needed cash flow to a business during its start-up phase, or may assist in funding restructuring. Different considerations arise for businesses being wound up. As noted in the interim report, the effect of an extended write-off period for shut-down expenses is that deductions are often wasted because of a lack of future income for the deductions to offset. A shorter write-off period, especially if combined with a loss carry back as discussed in Chapter 3, would reduce this wastage.

The Working Group does not propose to recommend reforms to section 40-880 as part of this report. However, the Working Group confirms that it agrees with stakeholders that the treatment of black hole expenditure warrants further attention.

The Working Group will give further consideration to the treatment of black hole expenditure, along with the broader issue of capital allowances generally, as part of its consideration of longer term reforms to the tax system.

The Working Group was asked to identify offsetting savings

The terms of reference require the Working Group to identify offsetting savings to fund any recommended reforms to the treatment of tax losses and for recommendations to adopt a particular long-term direction for the business tax system.

The Working Group's consideration of options to reform the treatment of losses and offsetting savings has been based on estimates of their potential revenue impact prepared by Treasury consistent with normal costing guidelines.³ Treasury has costed the introduction of loss carry back along the lines discussed in this report (see Chapter 3) at $450 million over the forward estimates period. For illustrative purposes, the cost over the forward estimates period of $450 million would be broadly equivalent to savings over the forward estimates from a 0.125 percentage point increase in the company tax rate from 1 July 2013. The cost of any reforms to the same business test (as discussed in Chapter 4) will depend on the model ultimately adopted.

The task of identifying the costs of particular reforms and the savings available from business taxation or spending options has been challenging. Business tax expenditures are not as extensive since the removal of accelerated depreciation for most industries that followed the Review of Business Taxation.⁴ The most recent Tax Expenditures Statement (TES)⁵ reveals that there are significant tax expenditures in relation to the research and development (R&am
p;D) tax offsets, the concessionary treatment for certain expenditure related to exploration and prospecting and the concessionary treatment of certain depreciating assets used in certain industries. In addition to large tax expenditures, Treasury also raised changes to Australia's thin capitalisation rules as a potential savings option. Potential offsetting savings are set out in Appendix B.

Some targeted, confidential consultation on potential savings options in these areas was undertaken with a group of stakeholders as part of a round of confidential consultation conducted in March 2012 (as discussed below). While useful in helping the Working Group to continue progressing its thinking, it did not constitute widespread and transparent public consultation on specific savings options that would have been required for the Working Group to make clear recommendations in this report.

In the time available, the Working Group has not been able to thoroughly assess the potential adverse impacts on taxpayers from removing existing business tax concessions. Accordingly, we have been unable to form a view on what the net-benefit of such options might be if they were pursued in combination with particular business tax reforms. The Working Group considers that further analysis and consultation is required before it can reach any particular conclusions.

The Working Group has undertaken consultation

The Working Group has engaged with stakeholders in two ways: first by inviting written submissions in response to its interim report and second by following up with a round of more limited targeted, confidential consultation meetings.

The interim report was released on 11 December 2011, with interested members of the public given eight weeks to make written submissions. The interim report was necessarily a high-level document outlining the current tax treatment of losses, highlighting the potential impacts of the current tax treatment of losses on decision making and cash-flow and providing information on possible reforms.

In response to the interim report, the Working Group received 24 submissions.⁶ The Working Group would like to thank all of those organisations and individuals who made submissions. Some expressed disappointment that the Working Group's interim report did not contain an indication of likely costs and possible savings options. The Working Group preferred to first gain an understanding of business views about possible reforms before developing specific savings proposals to offset the costs of those reforms. It was also not possible, at the time, to include any discussion about the potential offsetting savings in the interim report. Only in light of this information was the Working Group able to focus on the potential savings task and to undertake some further targeted, confidential consultation. Accordingly, there has not been widespread and transparent public consultation about any potential offsetting measures.

After considering written submissions, the Working Group undertook a round of confidential consultation meetings with stakeholders in Melbourne, Sydney, Brisbane and Perth. The confidentiality of these discussions permitted Working Group members to be more open in testing the trade-offs involved in alternative packages of reforms and potential sources of offsetting savings than would otherwise have been the case. The Working Group thanks those organisations and individuals that made themselves available for this process.

Conclusion

The Working Group's interim report on the tax treatment of losses canvassed a range of possible reform options. Based on the response to that interim report and further analysis, the Working Group has come to some more considered views about what reforms to the tax treatment of losses would be worthwhile pursuing.

The same level of analysis and consultation has not been possible in relation to potential offsetting savings options in the time available. The Working Group considers that further analysis and consultation is required before any conclusions can be drawn.

Recommendation

Recommendation 1:

The Working Group recommends that:

• the Government note the savings options identified in this report; and
• further analysis and consultation be undertaken before taking a decision to implement them.

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¹ Refer to Appendix A for the Business Tax Working Group's terms of reference

² The Treasury, Modernising the taxation of trust income — options for reform: Consultation Paper, November 2011, pp 3.

³ Treasury has assessed the revenue impacts of reform options and potential offsetting savings identified by the Working Group over the forward estimates period in accordance with its approach to the costing of budget proposals and election commitments (see the election commitment costing guidelines). The Working Group understands that these costing estimates are generally based on micro-simulation modelling using Australian Taxation Office company tax return data spanning 2003-04 to 2009-10. More recent significant changes in actual business investment, profits and loss utilisation that depart from what was seen in the data time period may result in significant changes in the impacts of these proposals. While the Treasury has not provided costings beyond the 2012-13 Budget forward estimates period, it has provided an indication of the cost or savings at 'maturity', being when the financial impact is no longer affected by transitional factors.

⁴ Review of Business Taxation, A Tax System Redesigned: More certain, equitable and durable, Report, July 1999, pages 305-327.

⁵ The Treasury, 2012, Tax Expenditures Statement 2011, Canberra. It should be noted that although the TES was used as a way of identifying potential savings, the costs in the TES do not represent the actual savings to the budget from their removal. The TES estimates compare the current concessional treatment to a mature alternative (that is, non-concessional TES benchmark) and do not reflect behavioural responses. On the other hand, budget estimates consider the timing of how the new system would be implemented and sometimes include behavioural responses.

⁶ A list of public submissions can be found at Appendix C.