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Catherines Chat

Wholistic Financial Solutions provides a lot of essential information and updates regarding the property investment industry. Check this page for the updates.

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Monday, September 05, 2011
Regards
Catherine Smith
Wholistic Financial Solutions
B.a.Comm, M.Tax, N.T.A.A, Dip(FP),Dip (MB), Dip (RE) J.P.
Accredited Property Investment Advisor (PIAA)
Recognized Taxation Specialist.
Registered Tax Agent and Public Practicing Accountant
Accredited Mortgage Consultant
Certified Master Results Coach & Performance Consultant
E catherine@wfscanberra.com.au
Ph: 6162 4546 Fax: 6162 4547
Mob: 0402 089 220

Buying Property in Trusts

Monday, August 29, 2011
I have heard that structuring your assets into a trust will provide protection in the case that a future relationship doesn't work out. Should I set up a business and put assets in that business name? Thanks Tony
April 19, 2011 6:44 PM
Catherine Smith said...
There are many pros and cons and you are best having an appointment for an issue like this. A legal advisor can explain trusts but they will not be able to help much with tax planning issues. We establish trusts regularly for clients. Once established and structured correctly for tax purposes then your solicitor can arrange the property transfers. In order to maximise tax efficiency we need to consider; 1) Which properties to transfer 2) How to structure the finance for maximum tax efficiency 3) Which trust to use, Unit, Discretionary or Hybrid 4) The negative gearing issues as the loss can get locked in the trust if not correctly structured 5) Who is the applicant for the finance – the Trust or yourself and this depends on type of trust and the negative gearing issues 6) Other issues are also Capital Gain Tax on the transfer and on later sales 7) The CGT effect on your Principal Place of Residence (PPOR) 8) And if that’s not enough, there are also Land Tax issues and these vary from state to state In others words, you need an appointment to work through it all.

Tax & Property - any questions ask here.

Wednesday, August 24, 2011
Tax & Property - any questions ask here.

Tax, Property, Superannuation, just Money issues - ask me here.

Wednesday, August 24, 2011
Tax, Property, Superannuation, just Money issues - ask me here?  That's right.  Free advice.  No catch.  It's a win / win - you get free advice - I get traffic to my website.  I have had over 20 years (and no longer counting) in the taxation, superannuation, property, business and finance areas.  Need help - just ask...

Protecting Assets through Trusts

Tuesday, April 19, 2011
I was recently asked by a client whether he should protect his assets using a trust.  My answer was as follows.

There are many pros and cons and you are best having an appointment for an issue like this. A legal advisor can explain trusts but they will not be able to help much with tax planning issues. We establish trusts regularly for clients. Once established and structured correctly for tax purposes then your solicitor can arrange the property transfers.

In order to maximise tax efficiency we need to consider;
1) Which properties to transfer
2) How to structure the finance for maximum tax efficiency
3) Which trust to use, Unit, Discretionary or Hybrid
4) The negative gearing issues as the loss can get locked in the trust if not correctly structured
5) Who is the applicant for the finance – the Trust or yourself and this depends on type of trust and the negative gearing issues
6) Other issues are also Capital Gain Tax on the transfer and on later sales
7) The CGT effect on your Principal Place of Residence (PPOR)
8) And if that’s not enough, there are also Land Tax issues and these vary from state to state

In others words, you need an appointment to work through it all.

Are Legal Fees tax deductible?

Tuesday, April 19, 2011
An interesting question and relevant to me personally at this point in time.  As usual the answer to the question varies depending on the facts.  Tax is like that - always grey areas.  Which is why it pays to have a good advisor, a really good advisor, and even better if you have one who knows how the ATO works due to experience working for such.  Anyway, back to the question.  It depends on what the case is about.  If the case is about defending an issue which is to do with your business or income, it can be deemed to be on 'revenue' account and tax deductible.  However, if the case is about non income related issues such as a claim for personal harassment or defamation or personal damages due to a firm's harassment then the fees will be on 'capital' account and not tax deductible.  Good news however, is that if on 'capital' account - the huge winnings for damages will be also on capital account and not taxable.

Why does the ATO pick on Soft Targets

Monday, March 07, 2011

SOFT TARGETS


Some commentators argue that the tax administration should focus on ‘taxes and taxpayers they can catch’.   Such a comment reflects a common belief that the Australian Taxation Office (ATO) could raise sufficient taxes by focusing on enforcing taxes that are easy to collect and/or focussing on taxpayers that are easy to monitor, also known as ‘easy pickings’ or ‘soft targets’. Interestingly, the ATO has also been accused of having a ‘revenue bias’ in it’s decisions and activities and failing to attack the more challenging issues.1 This accusation insinuates that the ATO focuses too many resources on the ‘easy’ areas in an attempt to maximize revenue whilst reducing administration costs. Some examples of ‘soft targets’ are:
·         Tax on dividend and interest income as these are electronically monitored, and
·         PAYE tax as this is deducted by the employer from all salary and wages paid. 

Some examples of the more challenging issues that face the ATO are:
·         The Cash Economy, and
·         Electronic Commerce. 

The above comment suggests that the ATO would be able to raise adequate revenue by focusing it’s resources on the easy areas and ignoring the more challenging issues.  This paper will discuss whether such an approach has efficacy.


Introduction:

“The essential criteria for assessing a tax system are equity, efficiency and simplicity.  An equitable tax system is critical, not only to the attainment of economic and social objectives, but also to the maintenance of basic respect for the tax system from which a high degree of voluntary compliance derives.” 2

According to it’s latest plan3 the purpose of the Australian Taxation Office (ATO) is: “To collect the revenue, properly payable, so as to fund services and support for the people of Australia”.  The ATO plan also states that it’s challenge is to have community support in all it does. 
____________________________________________________________
1.                   Carmody M. “The State of Play Five Years On”.  Address to Taxation Institute of Australia.  (Victorian Division.)  3 February 1998. 
2.                   Aust, Reform in the Australian Tax System. (Draft White Paper.) (Canberra. AGPS, 1985)
3.                   Australian Taxation Office 1995-1998 Plan.


As the Australian Taxation System is a system of Self Assessment, voluntary compliance is essential.  As outlined above, voluntary compliance relies on a basic respect for the tax system.  To maintain a basic respect for the tax system the ATO needs to achieve it’s purpose of collecting the revenue ‘properly payable’.  This paper will outline why the Australian Tax System would fail if the ATO focussed it’s resources on ‘soft targets’.  Whilst perhaps being an efficient and simple approach, it would not be equitable as it would not collect the revenue properly payable, and would result in a loss of respect for the tax system and an overall decrease in voluntary compliance.

It has been found that there are two main ways of increasing compliance, namely by improving taxpayer attitudes towards taxation or by increasing a tax authority’s ability to deter evasion.4 These two methods will now be elaborated upon.


Taxpayer Attitudes Towards Taxation:

Whilst the study of tax evasion/compliance is a relatively new area and the conclusions are varied, a common theme is the importance of feelings of equity and norm commitment.5

Findings indicate:
·         That many taxpayers think that compliance by others is lower than their own compliance.  This could indicate resentment of others not paying their fair share and also a willingness to engage in non-compliance if the opportunity presented itself. 6 
·         That the more evaders a taxpayer knows or is aware of, the poorer his compliance is likely to be. 7
·         Citizens no longer sense an expectation that they should fully and fairly comply with the system, but instead believe that the normal expectancy is a modicum of evasion.  Also referred to as the ‘bystander effect’, taxpayers may think that their evasion is only a minute amount of the revenue lost and would not make much of a difference. 8

__________________________________________________________________
4                     See Generally, Boyd CW, ‘The Enforcement of Tax Compliance: Some Theoretical Issues’,  (1986) 34.  Canadian Tax Journal. 588-599 at 590.
5                     See Generally, Wentworth DK & Rickel AU, ‘Determinants of Tax Evasion and Compliance’, (1985) 3 Behavioral Sciences and the Law.  455-466 at 463.
6                     See Generally, I Wallschutzky.  ‘Possible causes of Tax Avoidance and Tax Evasion’.  Unpublished PhD Thesis, University of Bath 1983.
7                     See Generally , Casanegra de Jantscher M, “Types of Tax Non-Compliance”.  (paper presented at the XVI General Assembly of the Inter-american Centre of Tax Administrators, Asuncion, Paraguay, 1982.)
8                     Above, note 5.


·         Taxpayers can reduce their guilt feelings accompanying deviant behavior by employing justifications such as ‘everyone does it’.  This is referred to as the ‘neutralization theory’.9 
·         Even if the direct revenue losses are small, a general awareness that many persons don’t comply may have a demoralizing effect on other taxpayers and prompt some of them to evade their liabilities. 10

Whilst focussing on ‘soft targets’ may be simple and efficient for the ATO in the short term, the long term effects could be disastrous.  “This behavior would condone a lot of tax evasion and would generate tax revenue in a way that would be far from optimal.  It would also conflict with other objectives of taxation such as neutrality and equity”. 11  The long term effect would be a serious deterioration in taxpayer’s attitude towards the payment of tax.  Taxpayers who are in the ‘soft target’ category would lose respect for the tax system, become resentful about others not paying their fair share and attempt to find ways to avoid or evade their taxes. 

This attitude is already evident in the Australian Community.  According to Tax Commissioner, Michael Carmody  “The general sentiment …is that salary and wage earners see themselves as the target, that they are bearing the weight of the tax system, while those in the cash economy and others with ‘smart advisors’ are getting out of paying their fair share”. 12

Some examples of ‘soft target’ taxpayers finding ways to avoid or evade their taxes are; negatively geared investments, hobby farms, tax driven investment schemes (e.g. Emu’s), interposing an entity such as a Family Company or Trust, or avoiding the PAYE scheme by converting to a Contractor.  Another common rebellion tactic is to take advantage of the cash economy by offering cash payments in return for a cheaper price.
____________________________________________________________
9.                   See Generally, Henderson, WT Jr, ‘Criminal Liability under the Internal Revenue Code: A Proposal to make the Voluntary Compliance System a Little less Voluntary’. (1992) 140. University of Pennslyvania Law Review.  1429-1461
10.                Above, note 7.
11.                Tanzi V & Shome P,  “A Primer on Tax Evasion”,   Bulletin for International Fiscal Documentation, IBFD, vol 48, no6/7 1994. 328-336
12.              Media Release 97/19  ‘Tax Office Responds to Task Force Report on Cash Economy’.



The effects of previously compliant taxpayers converting to avoiders/evaders can have disastrous long term consequences due to the ‘catastrophe effect’ and the ‘inertia theory’.  The catastrophe theory suggests that an initial decrease in the audit rate can result in a catastrophic increase in evasion.  The initial increase in evasion decreases the effectiveness/output of future audits, thereby further increasing evasion, whether further decreases the effectiveness/output of future audits, etc.13 The inertia theory asserts that after an individual routinely engages in a given practice, he has little incentive to change.  This applies to both compliant and non-compliant behavior.  The danger for the ATO is that if it does not maintain public confidence previous compliant taxpayers may convert to non-compliers and then their behavior may be very hard to change. 14

Whilst in the process of writing this paper the author was exposed to two classic examples of the ATO’s focus on ‘soft targets’ having a negative effect on taxpayer attitudes and increasing evasion.  In one example the taxpayer had been a subject of the ATO Project on Life Insurance Agents.  He received a letter advising him that information suggested that he had been in receipt of interest free loans that should have been subject to Fringe Benefits Tax.  He was requested to voluntarily admit to the misdemeanor, calculate his own liability and pay the amount.  In return he would be granted reduced penalties.  He was threatened that failure to comply would result in a full audit and maximum penalties.  He did as requested and voluntarily paid $7,500.00.  However, five of his associates ignored the letter and never heard from the ATO again.   Needless to say he is quite bitter and is unwilling to voluntarily comply in future.

In the second example, a relative who is an elderly pensioner has been subject to a Dividend and Interest check three times in three years. One error was as a result of an ATO mismatch.  The remaining two errors involved genuine mistakes resulting in less than $500.00 tax.  On the other hand, three other relatives are tradesmen practicing in the cash economy.  Despite considerable non-compliance, they have never been contacted by the ATO.  Needless to say, they are also increasing their non-compliance due to lack of ATO action and the pensioner is getting back at the ATO by paying cash at every opportunity.
____________________________________________________________
13.                Boyd CW, ‘The Enforcement of Tax Compliance: Some Theoretical Issues’, (1986) 34. Canadian Tax Journal.  588-599 at 590.
14.                Jenkins GP & Forlemu E, ‘Enhancing Voluntary Compliance by Reducing Compliance Costs: A Taxpayer Service Approach’, (unpublished) International Tax Program, Harvard University, 1993. 1-31.


As explained above focussing on ‘soft targets’ is not a viable long term option.  To maintain public confidence and respect for the tax system, the ATO has to be seen to be focussing on some of the more challenging issues.   A strong enforcement program, by deterring evasion, ensures that the tax burden is spread more equally and reassures honest taxpayers that their honesty is not misplaced. 15

Deterring Evasion:

It has been found that an individual’s decision to pay or evade tax “depends upon his attitude toward risk taking, his perception of the morality of the tax, and his perception of the probability of detection”. 16  Jenkins & Forlemu suggest that taxpayers will continuously attempt to evade taxes whenever the benefits from tax evasion outweigh the risk of detection and punishment.17  Studies have also shown that compliance varies directly with changes in the audit rate. 18

The above findings indicate that a taxpayer’s perception of the audit rate directly influences his ‘voluntary compliance’.  Many taxpayers’ view evasion as a ‘game’ in which the less likely they are to get caught the more they are willing to evade. 19  If taxpayer’s feel that the ATO is focussing on ‘soft targets’ only they are more likely to attempt to evade their taxes through some of the methods the ATO finds more challenging. To combat this the ATO needs to ensure that they are seen to be targeting the more challenging issues.  Some of the significant issues challenging the ATO are Electronic Commerce and the Cash Economy. These issues will now be discussed. 

Electronic Commerce:

According to the ATO’s Discussion Report on Tax and the Internet20 a high level of non-detection of tax evasion through the Internet could lead to tax evasion in a highly competitive global business environment.  Businesses may be forced to adopt non-compliant facilities to compete with other businesses, thus exacerbating non-compliance.   The migration of businesses to the Internet may then be increased due to tax avoidance and evasion opportunities it presents. It is important that there is broad neutrality between the treatment of businesses engaged in traditional physical commerce and those engaged in electronic commerce. 
____________________________________________________________
15.                Melia RM, “Is the Pen Mightier than the Audit?”.  (1987) 34. Tax Notes 1309.
16.                Above, note 13
17.                Above, note 14
18.                Alm J, Jackson BR & McKee M, ‘Estimating the Determinants of Taxpayer Compliance with Experimental Data’, (1992) 45. National Tax Journal.107-114.
19.                Above, note 11.
20.                ATO’s Discussion Report on Tax and the Internet  (ATO Electronic Commerce Project Team).   August 1997.  AGPS


According to Tax Commissioner, Michael Carmody in his speech ‘A Driving Force in Electronic Commerce’21 not addressing the electronic commerce issue could leave Australia without a taxation base that supports the Australian community.  The ATO recognizes this risk and must act now.

Cash Economy:

According to Tax Commissioner, Michael Carmody  “The cash economy represents a major cost to the Australian community in lost revenue and an unfair shouldering of the tax burden”.22

According to background research23 into the cash economy there is still no reliable estimate of the size of the cash economy. However, there is sufficient anecdotal evidence to suggest that it has a major impact on community perceptions of the fairness of the tax system and imposes significant costs to the Australian community in terms of:
·         Unfair price competition on honest business;
·         Welfare fraud;
·         Avoidance of superannuation, workers compensation and child support obligations; and
·         Lost tax revenue that is used to fund community services and government programs.

Further, the cash economy generates increased welfare costs as it impacts on means tested social benefits. 24

The ATO has recognized that of greater concern is the growing perception that tax evasion is an escalating problem which, if not addressed, may impact on the level of voluntary compliance with the taxation laws and in turn, government’s ability to fund their programs.  In particular, the ATO recognizes that tax evaders are seen to have a competitive advantage over businesses that do the right thing.  The message from the small business community is that the ATO needs to do its part in ensuring there is a level playing field. 25 

21.                Carmody M, ‘A Driving Force in Electronic Commerce’.  Tradegate ECA Business Forum.  16 September 1997.
22                 Above, note 12.
23                 Improving Tax Compliance in the Cash Economy.  Background Research.  http://atoassist/general/business/cashecon/compliance/htm
24                 Above, note 12
25                 Improving Tax Compliance in the Cash Economy.  Cash Economy Task Force Report.  12 May 1997.  Pg 12.




According to Tax Commissioner, Michael Carmody, 26 what makes the cash economy such a difficult issue to tackle is that the community has a split personality on the issue.  On one hand they realize they are victims of the cash economy and think that everyone should pay their fair share of tax.  On the other hand, the community willingly participates in it by accepting a lower ‘cash price’ for a product or service.  According to Curt Rendell, Chairman of the Institute of Chartered Accountants Small Business Committee, “While many PAYE taxpayers think they are getting a bargain for their house-painting or plumbing, they will end up paying more anyway, as the ATO tries to raise more revenue to make up for the tax lost in hidden cash transactions”. 27

Perhaps, these ‘soft target’ taxpayer’s are rebelling against the fact that they shoulder the majority of the burden of the tax system by making these cash payments.  The sentiment could be ‘Well, if you can’t beat em, join em and at least get some benefit from the wide cash economy’.

Conclusion:

The comment that the ATO should concentrate on taxes and taxpayers they can catch does not have efficacy in the long term. Such a focus, whilst being simple and efficient in the short term, is inequitable and would have disastrous consequences on long term revenue collections.  As explained above, revenue collections can be increased through improving taxpayer’s attitudes and deterring evasion.  The suggested approach would therefore not increase revenue collections as it would have negative effects on taxpayer attitudes therefore increasing evasion.  Instead the ATO needs to at least appear to be attempting to combat tax evasion in challenging areas such as the Cash Economy and Electronic Commerce.  As explained by Melia, RM, compliance requires good tax administration.  “Citizens must be confident that the tax laws are firmly and fairly enforced, that everyone is paying his or her fair share and that delinquents and evaders will be caught and punished”. 28


26.                Above, note 12.
27.                Ibid.
28.                Above, note 15.

Family Trusts and Taxation

Monday, March 07, 2011

Introduction


It has been stated that the Tax Commissioner and the treasurer would have ordinary Australians believe that those who operate their businesses and family affairs through trusts are nothing more than blatant tax cheats[i].   Further, the treasurer has made it quite clear that a review of trusts is necessary “to ensure that the taxation of trusts…do not permit tax avoidance or undue tax minimisation”.  The concern has arisen, apparently due to, information gathered by the Australian Taxation Office’s (ATO) High Wealth Individuals Tax Force[ii].

In order to combat the hypothesised abuse by High Wealth Individuals and other perceived inequities the Government has introduced, or is planning to introduce, complex, convoluted and draconian legislation to limit or eliminate the tax advantages of Trusts.

The RBT discussion paper ‘A Strong Foundation’ was released in November 1998.  It states that its objective is to agree on a system that enhances economic growth and is equitable and efficient[iii].The report identifies a key problem area of the current system as the ‘different taxation of different business entities’[iv].  It highlights the fact that, in many instances, the treatment of income depends on the nature of the entity.  The Report claims that the above anomaly is inequitable and distorts investment decisions[v]

Given the above, it is understandable that the RBT sought to review the taxation of trusts v companies.   However, it is questionable as to whether the current suggestion to tax trusts as companies overcomes the anomalies.  In fact, in many ways it exacerbates the problem as it proposes to extend the current inequitable taxation of companies to trusts[vi].  The Governments New Tax System as outlined in its paper “Tax Reform – not a new tax a new tax system’[vii]attempts to justify its decision on the basis that companies and trusts, unlike individuals and partnerships, have the benefit of limited liability and thus should be taxed accordingly, ie; by being penalised.  As succinctly, put by Ms Carey, Taxation Institute of Australia’s Tax Technical Director “instead of looking at ensuring the system is fair for everyone, it will make the system equally unfair for everyone”[viii]

However, this paper will not focus on the political correctness of the above Government decisions as these have been discussed in detail elsewhere[ix] and it is doubtful as to whether any further discussions or submissions to Government will influence their decision.  Instead, this paper will focus on the potential ramifications of the recent changes if they are not amended and the proposed changes if they are implemented in their current form.



Traditional use of family trusts


What is a trust?


According to Meagher RP, et al,[x] the trust was not in its origin and perhaps never has been primarily a device of commerce.  It was from early times and has continued to be an instrument of family settlement.

A trust can be described as ‘the whole relationship which arises between the parties in respect of the property the subject of the trust, and to regard the obligation of the trustee to the beneficiary and the interest of the beneficiary in the property as results flowing from the existence of that relationship’[xi].

Trusts can be generally divided into various categories.  Firstly whether they are express, implied or constructive.   ‘Express trusts may be created by any language which shows a sufficiently clear intention to create them’[xii].   Implied and constructive trusts, on the other hand, arise by operation of law and will not be discussed further.  

Express trusts may be created either by will (testamentary trust) or by declaration (inter vivos trust) and can be further divided into the following categories;
a)      public or private,
b)      simple or active,
c)      fixed or discretionary[xiii].

The traditional family trust is a express, private, active, discretionary trust either testamentary or inter vivos.  The most common examples of such trusts are;
¨      those used to run the family business,
¨      those used as an investment vehicle,
¨      child maintenance trusts,
¨       and testamentary trusts.

The historical advantages and disadvantages of such family trusts will now be discussed in general before moving onto recent and proposed changes that could fundamentally affect the decision to use such family trusts.  In conclusion, it will be decided whether each type of family trust is viable in the uncertain and continually changing future.

Tax Advantages of Family Trusts.


¨      A person can divert income (other than personal exertion income as to which see later) away from themselves into the trust structure.
¨      The trustee can distribute income and capital in varying amounts between beneficiaries each year, and can even distribute different types on income to different beneficiaries (subject to the dividend imputation anti-avoidance rules). 
¨      The trustee can determine the distributions in a way that minimises tax.
¨      The trust is seen as a conduit as income that passes through it to the beneficiaries retains its character.  This is important as tax preferences such as the indexation factor of a capital gain, are able to be passed onto beneficiaries.
¨      A substantial advantage of a testamentary trust and some Child maintenance trusts is that children under the age of eighteen can receive distributions which are taxed at normal rates instead a the penalty children’s rates under Div 6AA ITAA.
¨      Distributions to disabled minors are taxed at the much lower adult rates.


‘Non-tax’ Advantages of Family Trusts:


As can be seen the traditional tax advantages of trusts are substantial.  However, there are also significant ‘non-tax’ or commercial advantages to the trust structure.  These include:
¨      Asset Protection from potential creditors and in the event of marital breakup[xiv].
¨      Benefits and income can be passed onto beneficiaries without ownership of the assets.
¨      Limited liability is available if the trustee is a company.
¨      Continuity  - a trust has a semi-permanent existence.
¨      Social security assets tests do not usually include trust assets.
¨      Flexibility in structure.
¨      Privacy as details are not accessible by the public.
¨      Estate planning – passing assets/businesses onto future generations.
¨      Legal formalities of winding up trusts are generally simpler than those for companies.

Disadvantages of Family Trusts:


As with everything in life, where ever there are advantages there is almost always disadvantages.  These include:
¨      The disadvantageous effect of distributions to minors from inter vivos trusts.
¨      Losses can only be offset against income of the trust and cannot be distributed to beneficiaries.
¨      Where grossed up dividends are less than losses from other sources, not only are franking credits lost, but the carried forward losses are reduced by the amount of the franking credit.
¨      The cost of creating and administering a trust is significant.
¨      Trust law is complex.
¨      Government intervention and changing tax laws are always a possibility.
¨      Loss of ownership where assets are given to the trust.

In addition to the above disadvantages, there are also potential problems with many of the above listed advantages, due to the application of the anti-avoidance provisions of the current tax regime and other recently introduced legislative chnages.  These will now be discussed.


Potential Existing Problem with trust structure:


Alienation of income:


As mentioned above, one of the fundamental tax advantages of trusts is their ability to divert income away from a particular taxpayer and then split the income between other taxpayers.  However, caution must be exercised when attempting to divert and split income from ‘personal services’. 

Income from personal services is income which is earned by an individual taxpayer, predominantly as a direct reward for personal effort, the exercise of personal skill or the application of labour[xv].  Personal Services income is distinguished from income derived from property or assets[xvi].  Income from property and assets is capable of being assigned or diverted by transferring the property or assets to another person or entity, ie; a family trust.  However, it is the ATO’s view, as expressed in numerous rulings[xvii], that income from personal services cannot be ‘alienated’. 

Alienation of personal services income occurs where income is diverted from the taxpayer whose services generated the income, so that it is legally derived by an interposed entity, usually a family company or trust.  Of particular concern to the ATO is where that income is then split between the taxpayer and their family members or retained in the interposed entity.

The ATO has recently commenced an extensive audit project on alienation of income through interposed entities.  The ATO has used various mechanisms to assess the personal service income to the taxpayer.  These include, determining the whole arrangement to be a sham, using Section 17, 19 and 25(1), or as a last resort Part IVA[xviii].  The ATO is firm on its stance that where alienation is effected for the sole or dominant purpose of avoiding tax, the general anti-avoidance provisions of Part IVA of the Act will apply[xix].  The ATO achieves this by determining that the ‘scheme’ is the diversion of personal service income to the interposed entity.  Part IVA generally allows the Commissioner to cancel the tax benefit under the scheme.  The courts and tribunals have confirmed the view that alienation of personal services income, predominantly for the purpose of reducing income tax, is ineffective for tax purposes[xx].  It can be concluded from the case law that the personal services income will, in cases involving tax avoidance, be assessable to the person who performed the services.

Basically, the avoidance of the application of these provisions is fairly simple – don’t contravene them.  Either resist the temptation to divert personal service income through the trust or if circumstances exist so as to make this commercially attractive, ensure that all of the personal service income, less related allowable deductions, is distributed wholly to the personal service provider.




Potential problems caused by recent changes:


The tax advantages of Trusts have been subject to continual legislative attempts to reduce or eliminate certain advantages.  The most recent changes include the potential application of CGT Event No 4, the application of Div 7A to beneficiaries who are corporate shareholders, the disclosure of ultimate beneficiary rules, the dividend streaming rules, the decision to extend the FBT rules to beneficiaries and, of course, the trust loss measures.  Each of these and their effect on family trusts will now be discussed.


CGT Event E4


CGT Event E4 happens where:
            “(a) a trustee of a trust makes a payment to you in respect of a unit or an interest in a trust…and
            (B) some or all part of the payment …is not included in your assessable income”[xxi]

There has been some contention that this provision may apply to the distribution of tax preferred income and result in either a capital gains tax liability or a reduction in the beneficiaries cost base of their units or interests.  However, the Commissioner has determined that the predecessor to CGT Event E4 has no application to discretionary trusts[xxii] and any attempt to alter this opinion  would probably not be upheld by an appellate court[xxiii].  It is therefore presumed that these provisions will not apply to family trusts.


Div7A application to corporate shareholder/beneficiaries


S109UB of Div 7A deems a loan to a shareholder of a private company by the trustee of a trust estate to be a loan by the private company if the company is presently entitled to the income and that income has not been paid to the company.  The loan will be bought within the scope of Div 7A and may be deemed to be an unfranked dividend.  This provision is fairly narrow in its scope but should be kept in mind.

Disclosure of ultimate beneficiary:


From August 1998, a withholding tax will be applied to all closely-held trusts where no ultimate beneficiary is disclosed.  The purpose of this rule is to ensure that tax is collected and income is not disguised through ‘chains’ or multiple trust structures[xxiv].  It is envisaged that, in the absence of contrived and convoluted  tax planning, these changes would not affect the average family trust structure.



Dividend Streaming Rules


S177EA(5)???


On 31 December 1997 the Government released amending legislation to prevent trading in franking credits.  It applies to shares purchased after 31/12/97 and applies to all trusts other than family trusts as defined in the trust loss provisions[xxv].

The legislation denies franking credits to a beneficiary of a trust if the beneficiary is exposed to less tan 30% of the risks and opportunities of the shares held.  Perhaps unintendedly, the provisions operate in such a manner so as to deny all beneficiaries of discretionary trusts their entitlement to franking credits.  The only way to avoid this draconian and unfair provision is to make a family trust election[xxvi], the pros and cons of which will be discussed later. 

The dividend streaming rules also apply to testamentary trusts once the estate is fully administered[xxvii].   This results in a significant disadvantage to testamentary trusts that hold shares.

Proposed FBT changes from 1/4/00:


It is proposed from April 2000, to extend FBT to non-employee relationships including beneficiaries of trusts.  Interest free loans and the provision of assets such as the family farm house, holiday house, boat, etc, to beneficiaries will be taxed at the highest marginal rates.  This change has the potential to adversely affect existing trusts who hold family assets as trust property and provide these for the benefit of the beneficiaries.  The classic example is the holding of the family farmhouse within the family trust.         

(transitional provisions???)

The Trust Loss measures:


The trust loss measures are primarily contained in Taxation Laws Amendment (Trust Loss and other Deductions) Bill 1997. They operate to deny or limit deductions for prior year losses and debt deductions unless certain tests are passed.  Generally, these rules apply when a change in ownership or control occurs or where there is abnormal trading of units. These Bills received Royal Assent in 1998 and apply from 9 May 1995 for losses and 20 August 1996 for debt deductions.

The trust loss measures divide trusts into three broad categories being; fixed trusts, non-fixed trusts and excepted trusts.  The family trust will usually fall under the category of a non-fixed trust or a excepted trust, the later if it has elected to be a family trust (as to which see later).  Deceased estates and testamentary trusts (for the first five years after date of death) are also considered to be excepted trusts.  Excepted trusts (other than family trusts) are not subject to the new provisions.

 

Family trust elections:


In order to qualify as a family trust the trustee must make an election in the trust’s income tax return.  The election must specify an individual as the individual whose family group is to be taken into account.  In order to make this election the trust must also satisfy the control test at the end of the year of income in which the election is made.

The trust may also make an irrevocable interposed entity election to include any company, partnership or trust in it’s family group.

Consequences of election:


The effect of such an election is that the trust will not need to satisfy the continuity of ownership test or the pattern of distribution test.  The trust will still have to satisfy a  income injection test but only where benefits flow to members outside the family group.

The consequence of the election is that a new tax called the Family Trust Distribution Tax (FTDT) is imposed at 48.5% of any distribution by family trust to persons or entities outside the family group.  Ironically, the FTDT will apply to all distributions to outsider and not just the component attributable to the loss.

Some of the difficulties posed by the provisions include[xxviii]:

i)                    The lack of ability to later alter or revoke the Family Trust election.  A change in family circumstances, such as divorce or death, (two potentially common occurrences) could necessitate the termination of the existing trust and settling a new trust.  This could be a very costly exercise in terms of accounting and legal fees, capital gains tax and stamp duty.

ii)                  The difficulty of disposing of an interposed entity without attracting the FTDT.

iii)                The inflexibility with regard to inter-generational transfers of assets as the great grand-children are not included in the definition of a family.

Consequences of non-election:


If a family trust does not elect to be a family trust then it will usually be classified as a non-fixed trust and only be able to deduct the above deductions if it passes; the income injection test, the pattern of distributions test, the 50% stake test, and the control test.  The technicalities of each of these will not be discussed in detail,  however it would be reasonable to assume that:

¨      The income injection test is only of relevance if it is expected that an ‘outsider’[xxix] may inject income.  This may be very likely given the narrow definition of ‘outsider’ for trusts other than family trusts.

¨      The 50% stake test would not be relevant to most standard discretionary trusts as the beneficiaries for not hold fixed entitlements.

¨       The control test should be satisfied by most family trusts[xxx]

¨      The pattern of distributions test is likely to be the most difficult test to pass and the trustee will need to carefully consider the test when determining distributions.


To elect or not to elect:


As can be seen above there are disadvantages of making a family trust election. Thus, the election should not be made without thorough examination of the possible consequences.  The trustee or tax planner should consider[xxxi]:
¨      The type of loss incurred.
¨      The likelihood of passing the relevant tests.
¨      The prospect of future distribution to members outside the family group.
¨      The prospect of the need for income injection by outsiders.
¨      Possibility of later revocation of the election.

Obviously, no such examination is necessary until such time as the trust has losses or debt deductions that may be subject to the provisions.  The provisions are principally designed as an anti-avoidance measure to eliminate trafficking in trust losses.  It has also been stated that it is not an abuse of the tax system if a family wishes to share wealth and losses and that the measures are not designed to affect small business[xxxii].  It is therefore submitted that the provisions should not effect most family trusts that are set up to run a profitable family business, child maintenance trusts and testamentary trusts after the five year exclusion period.

But beware Dividend Streaming Rules:


Having just concluded that the trust loss measures should not affect most family trusts, one still has to consider the above mentioned Dividend Streaming Rules which deny franking credits to discretionary trusts that don’t make a family trust election.  The denial of franking credits is a significant disadvantage and would, in most circumstances, necessitate that a family trust that holds shares should make the election.  They would therefore be subject to all of the above outlined disadvantages of making the election.

Potential problems caused by proposed recent changes:

 

In addition to all the past and current changes to trusts the Government has decided to overhaul the entire taxation of trusts through the ‘New Tax System’ and the Ralph review.



The final Ralph report was released on September 22 1999, but unfortunately the future of trusts is still uncertain.  The Government has decided to defer the introduction of the entity regime until 1 July 2001.  It is clear that the Government intends to tax trusts as companies regardless of any submissions evidencing the adverse consequences of such.  However, it is unknown as to whether the Government will consider carve outs for family trusts and what transitional measures will be introduced for existing trusts.  The following discussion will therefore only outline some of the possible ramifications of the proposal to tax trusts as companies.

Entity taxation - Taxing trusts as Companies


Under entity taxation, trusts are to be taxed comparably with companies.  All distributed profits, including tax preferred profits, will be taxed at the entity level and the tax will be imputed to the shareholder/beneficiaries. Excess imputation credits will be refundable to the shareholder/beneficiaries.

            Affect on flow through of tax-preferred income:


Some authors believe that the new tax system’s proposal to tax trusts as companies makes no difference to their tax effectiveness because beneficiaries would receive full tax credits for tax paid by the trust and low income earners can obtain a tax refund of these tax credits[xxxiii].However, it is believed that such authors have overlooked the effect of the loss of flow through effect for tax preferences. 

Tax preferences effectively lost through the new regime include, but are not limited to:
¨      The previous 50% exemption for CGT of Goodwill of a business (now replaced by the 50% exemption for active assets).
¨      Distributions of exempted gain on pre-CGT property.
¨      The inflationary component of any CGT (for pre-Ralph assets).
¨      The new 50% exemption from CGT for assets sold post-ralph.
¨      Deferral of tax liability through averaging, excelerated depreciation, etc.

It appears that some of the above items may be subject to transitional provisions[xxxiv] if the gain is ‘realised’ prior to the introduction of the new regime.  However it is unknown as to what the definition of realised will be.  Will all trusts be required to sell their assets or will a re-valuation suffice?

In conclusion, under the proposed new system, trusts may no longer be the most effective structure to hold capital appreciating assets.  This will seriously affect the benefit of using trusts as investment vehicles and to run the family business. 

            Affect of reduced Company tax rate:


Other authors[xxxv] have heralded the fact that the Trust tax rate will drop to match the company tax rate thus making the retaining of income in trusts more advantageous than as is at present.  This sentiment seems to ignore the fact that most family trusts have corporate beneficiaries which effectively already enables trusts to take advantage of the company tax rate.  

Div 7A implications


The above discussed, fairly narrow application, of Div 7A to trusts may be considerably expanded under the new regime, in that, all loans to beneficiaries may be subject to Div7A.  It is unknown at this stage the exact application of this rule to trusts under the new regime.

Affect on existing Dividend Streaming  Rules:


It would appear that dividend streaming practices will be rendered unnecessary by the new regime as all distributions will be franked and excess credits refundable to the beneficiary/shareholder.  Therefore, the above mentioned provisions will probably be repealed although this has not yet been announced.

Affect on Trust Loss Provisions:


It has been stated that the tax reform document indicates the worst of both worlds in relation to losses in that, the new trust losses will continue to apply under the new regime[xxxvi].  This seems unbelievable but remains questionable until the exact details of the new measures are released. 

Will family trusts still be allowed to rest is peace under the new regime?

(or should they be buried once and for all?)

As stated by Richard Friend, of Arther Andersons, ‘trusts are still a “valuable tool” for individuals who do not wish to risk holding assets in their own name.  They still remain the most flexible vehicle you can have[xxxvii].  Wilst this may be the case, I seriously doubt their effectiveness for tax purposes and will now consider each individual type of family trusts and its viability into the future.

 

As an Investment Vehicle:


One would have to weigh up commercial advantages outlined above and the tax advantage gained through income splitting and income diversion against the tax dis-advantage of the loss of tax preferences.  The decision to continue to use a trust structure for the purchase of capital appreciating assets would depend upon the investment portfolio, ie; whether it is geared towards fully franked dividends or capital growth, and the expected inflation rate over the life of the asset.

In general, it is suggested that if the new tax system proposal are passed as presented it would not be a good idea to establish a trust as an investment vehicle due to the inability to flow through tax preferred income, in particular, the tax free component of any capital gain. 



To run the family business:


As above with investment trust, one would need to weigh the commercial and tax advantages of income splitting against the adverse consequences of the proposals.  In summary;
¨      the Trust Loss provisions should not affect profitable businesses, but do beware; that making interposed entity election may affect subsequent sale of business,
¨      avoid holding capital appreciating assets such as shares and property,
¨      will lose benefit of 50% goodwill exemption (or the new 50% active asset exemption) on sale of business when distributed to beneficiaries.

In general, it is suggested that it if the new tax system proposals are passed as presented it would be borderline as whether or not to establish a trust for the family business.  If it is anticipated that the business or it’s assets will not be sold, or sold for minimal gain, the trust structure may still be viable.  In addition, if protection of assets was a important consideration (due to the nature of the business) then the taxpayer may be willing to sacrifice the loss of tax preferences in return for limited liability.

Child Maintenance Trusts:


Child Maintenance Trusts, if correctly formulated[xxxviii], currently result in considerable tax benefits as distributions to minor beneficiaries are excepted income under Division 6AA.  This means that they are not subject to the usual penalty rates that apply to minors.

The Review of Business Taxation – Platform for Consultation Discussion Paper 2[xxxix] states that Child Maintenance trusts may be excluded from the new provisions as a trust to which beneficiaries are absolutely entitled.  The paper further states that ‘with the availability of refunds for excess imputation credits and the maintenance of the current criteria for excluding these trusts from Div 6AAA, the tax outcome would be little changed’[xl]. Thus it would appear that the tax effectiveness of child maintenance trusts may be maintained under the proposed new tax system in that exemption from the penalty rates on distributions to minors is to be maintained.  Of course, the effect of the loss of flow through of tax preferences would have to be considered, it is suggested that the above tax advantage would usually outweigh this disadvantage and child maintenance trust will continue to be viable wealth creation vehicles.

Testamentary Trusts:


According to The Review of Business Taxation – Platform for Consultation Discussion Paper 2[xli].  Deceased estates are excluded from the new provision for the first two years from the date of death.  However, testamentary trusts are not excluded.  The paper makes no mention of whether the current advantageous tax consequences of distributions to minors from testamentary trusts will be maintained.  Presuming that it will be, the same conclusion as to child maintenance trusts applies, ie; they will continue to be tax effective.

The only caution would be to carefully watch the effect of the dividend streaming rules (if they are not repealed) if the testamentary trust holds shares on behalf of the beneficiary.

What about existing trusts? – should they be laid to rest?


In addition to considering the effectiveness of establishing family trusts in the future, tax planners should also be considering what to do with existing trusts.  The following is a brief summary of some of the things to consider[xlii].
¨      It may be appropriate to realise gains on capital appreciating assets and transfer these to other business vehicles such as partnerships or individuals.
¨      Watch the transitional arrangements carefully to ensure full advantage is taken
¨      Review beneficiary loan accounts


CONCLUSION:


Given all of the above changes is it questionable as to whether it is still appropriate to use trusts as vehicles for investments and family businesses.  The ASCPA, the National Farmers Federation and others[xliii] are currently lobbying the Government to reconsider some of the above changes and proposals.  In particular, the ASCPA states that ‘nearly 260,000 small businesses will be affected by the proposed changes’.  The ASCPA calls for an exclusion from the new provisions for trusts that make a family trust election, including testamentary trusts and child maintenance trusts, because these trusts are already subject to a number of restrictions[xliv]

The ASCPA recommendations are a common sense solution to the Government’s concerns that Trusts are being used for tax avoidance.  Given that the Prime Minister has stated that the new measures are “a way to eliminate the unfair advantages to some issues of trusts, while at the same time respecting the role of trusts as well-used vehicles for asset protection and holdings by both farmers and small business”[xlv] one would hope that the ASCPA recommendations are accepted.

However, until the uncertainty is clarified tax advisers, financial planners and taxpayers should take all of the above comments into consideration when deciding whether to use a trust structure for family circumstances.


[i]               Intax, April 1998, pg 20
[ii]               see generally, “Trust Structures:  Witch-hunt of the wealthy”, The Tax Specialist, Vol 1, No 1, pgs 14-20_
[iii]              Review of Business Taxation (RBT) discussion paper ‘A Strong Foundation’.  Commonwealth of Australia 1998. AGPS. Pg v
[iv]              ibid @ xi
[v]               See generally, Review of Business Taxation (RBT) discussion paper ‘A Strong Foundation’.  Commonwealth of Australia 1998. AGPS
[vi]              See generally, TIA Submission.  The trust loss amendments.  Vol 1. No 3.  The Tax Specialist. February 1998, pg 163.  Trust Losses: Unfairness of the Draconian measures. The Tax Specialist.  Vol 1. No 2.  Oct 1997, pg 74.  Tax Reform:  Prospects for Change.  The Tax Specialist.  Vol 1.  No 5.  June 1998, pg234. Les Szekely.  Are Trusts Dead?  Intax.  Nov 1997, pg 16.   Paul Drum.  Trusts: Changing the Rules.  Australian CPA, November 1998.  The Tax Specialist.  Glower J.  Vol 2, No 4, April 1999, pg 194
[vii]             Commonwealth of Australia 1998. AGPS. Pg 109
[viii]             Simon Gaylard.  Double Vision.  Taxation in Australia.  Vol 32, No 10, May 1998, pg 512.
[ix]              As above @ vi
[x]               Meagher RP, & Gummow WMC,   Jacobs’ Law of Trusts in Australia (Sydney: Butterworths, 5th ed, 1986.pg3
[xi]              Meagher RP & Gummow WMC,   Jacobs’ Law of Trusts in Australia (Sydney: Butterworths, 5th ed, 1986. Para 104
[xii]             ibid @ 201
[xiii]             ibid @ 306
[xiv]             However, the Family Court does have wide powers in relation to trust property in the event of a marital breakup.  Such powers include the ability to remove the trustee and appoint the divorced spouse as trustee or to set aside the transfer of property to the trust.  (CCH.  Tax Planning: Trusts.  903-110
[xv]             see IT2639, para 3
[xvi]             ibid, para 8
[xvii]            (IT 2121, 2330, 2503, 2639, TD 95/34 & 94/71
[xviii]           see generally, SBI Curriculum.  Training Module – Alienation of Personal Services Income through Interposed Entities.  March 1997.  ATO.
[xix]         ** Part IVA applies when:
¨       There is a scheme as defined in section 177A;
¨       A tax benefit as defined in section 177C(1) is obtained by a taxpayer in connection with the scheme;
¨       The scheme is one to which Part IVA applies having regard to the matters set out in section 177D; and
The Commissioner is entitled, under section 177F to determine that ‘personal services’ income be included in the assessable income of the service provider.
[xx]             (Tupicoff v FcofT 84 ATC 4367. FcofT v Gulland Watson & Pincus. 85, ATC, 4765.   Bunting v FcofT. 89, ATC, 5245.   Daniels v FcofT. 89, ATC, 4830.  Case W58, 87, atc, 524.  Case X90, 90, ATC, 648. Case Y13, 91, ATC, 4990.   Case Y28, 91, ATC, 296. Case Y29, 91,ATC, 301.   Liedig v FcofT, 94, ATC, 4269.  Osborne V FcofT, 95, ATC, 4323
[xxi]             ITAA97 sec. 104-70(1)
[xxii]            (see Tax Determination 97/15)
[xxiii]           The Tax Specialist.  John Glover. Volume 2, No 4, April 1999, pg 194)
[xxiv]           Paul Drum.  Trusts: Changing the Rules.  Australian CPA, November 1998
[xxv]            The Tax Specialist.  Trusts Reform: Credit where its due.  Vol 1, No 3, Feb 98, pg 122-124
[xxvi]           ibid
[xxvii]           (The Tax Specialist.  Robert Glover…)
[xxviii]          see generally Taxation in Australia.  Family trusts and trust losses.  Volume 32, No 5, Nov 97, pg 237

[xxix]           However note that the definition of an outsider differs for trusts other than family trusts.  For trusts other than family trusts, an outsider is any person other than the trustee of the trust or a person with a fixed entitlement to the income or capital of the trust (s270-25(2)).  Therefore, a purely discretionary beneficially is an outsider for trusts other than family trusts.  This may be reason in itself for the trust to elect to be a family trust.
[xxx]        Taxation of Trusts – Study Guide.  Walpole, M, et al.  UNSW. 1999.

[xxxi]           Ibid @ 3.38
[xxxii]           Intax.  April 1998, pg20
[xxxiii]          Michael Laurence.  Business Review weekly.  August 24, 1998, pg 25.  The family trust is dead…long live the family trust.  Lawrence Myers.  Weekly Tax Bulletin.  No 46, ATP, 98.  Personal trust havens disappear.  Tim Boreham.  Australian. 22/9/99.
[xxxiv]          Taxation in Australia.  The Common Entity System.  Assessing the regime proposed for companies and trusts.  Vol 33, No 3, Sep 98, 137.
[xxxv]           Above iiixxx.
[xxxvi]          The Common Entity System.  Taxation in Australia.  Vol 33, No 3, September 1998, pg 137.
[xxxvii]         Personal trust havens disappear.  Tim Boreham.  Australian. 22/9/99.
[xxxviii]         Ie; in accordance ith TR 98/4
[xxxix]          Commonwealth of Australia.  AGPS. 1999, pg 487
[xl]              ibid @ 482
[xli]             ibid @ 504

[xlii]         see generally, Les Szekely.  Intax. Nov 1997, pg 15


[xliii]            (Simon Gaylard.  Double Vision.  Taxation in Australia, Vol 32, No 10, May 1998.  Trusts Review:  Tax reforms are unwarranted.  The Tax Specialist. Vol 1. No 2, Oct 1997, pg 82. Financial Review.  Farmers to fight move on Family Trusts. Brendan Pearson. 23/9/99).  Trust tax ‘traps investor’. Kirsten Lawson.  Canberra Times. 22/9/99.
[xliv]        (Media Release.  CPA.  Ralph changes to Trusts a blow for small business.  20 July 1999) 

[xlv]             (Robert Skeffington and Robert Gottliebsen.  Business Review Weekly.  August 24, 1998, pg 23)

Income Splitting & Taxation

Monday, March 07, 2011
Income Splitting: An underlying philosophy of the Australian Taxation System?



Catherine Smith
B.a.Comm(A cc) C.P.A.


Masters of Taxation Program


ATAX
University of New South Wales


Tax Policy Unit

0401

October 2000





Abstract............................................................................................................................... 3
The Problem Outlined:............................................................................................ 4
Introduction:................................................................................................................... 4
What is the problem?.................................................................................................... 5
Why has it grown?.......................................................................................................... 6
What is the problem with the growth in ‘independent contractors’.... 7
What has the Government done to address the problem?....... 9
Pre ’96 election proposals:........................................................................................ 9
Post election Project:................................................................................................ 10
Reason why not addressed earlier????............................................................. 11
The Government has finally taken action......................................... 13
(or has it?)......................................................................................................................... 13
RBT Proposals:.............................................................................................................. 13
Industry reactions:....................................................................................................... 13
The Measures introduced:.......................................................................................... 15
Effectiveness of the new measures:........................................................................... 15
Where to from now?.................................................................................................... 18
Family Taxation:......................................................................................................... 18
Compulsory or Elective?......................................................................................... 19
Elective ‘Joint Filing’:............................................................................................... 21
Appropriate Rate:........................................................................................................ 21
An Aggregate Model:.................................................................................................. 22
An Average Income Model:........................................................................................ 22
Alternative Rate:.......................................................................................................... 22
Inequitable, Inefficient and Complex:.............................................................. 23
Unfair to two income families:.................................................................................. 23
Unfair to Individuals:................................................................................................. 26
Cost Prohibitive:.......................................................................................................... 26
Alternatives to family taxation:....................................................................... 27
Conclusion:..................................................................................................................... 27
Align or reduce the Top Marginal Rates?............................................ 28
Conclusion:...................................................................................................................... 29
Appendix One:.................................................................................................................. 30
Bibliography.................................................................................................................. 31






Abstract


Traditional canons of a taxation system are equity, efficiency and simplicity.[1]  One presumes the Government continually strives to balance these factors when determining strategic directions for the taxation system. This however, does not appear to be the case in the area of ‘income splitting’.

One must question why it has taken the Government so long to act on this issue?  To give tacit approval to income splitting?  So as not to interfere with industries that have been established on the basis of income splitting?  To encourage business and jobs in certain industries? Or as an indirect alternative to family taxation? 

This paper will outline what ‘income splitting’ is, why it has been growing so rapidly, why it is a problem, what the Government has done (or not done) to resolve the problem and finally, what should be done to resolve the problem.

The Problem Outlined:


Introduction:


The Government has been aware of the inequity, inefficiency and complexity caused by ‘income splitting’ since at least 1975.[2]  Income splitting creates inequity as it enables people in similar situations to be taxed quite differently.  It creates inefficiency as it generates extensive work for the Australian Taxation Office (ATO) and the Judiciary in attempting to address the problem.  It creates complexity by encouraging taxpayer’s to establish complicated entities or contracts.  Such complexity is also evidenced by the numerous sections in the Income Tax Assessment Act (ITAA) specifically designed to deal with income splitting[3]. It has become obvious to all that the existing system is not working.

Income splitting has been tacitly accepted by Government for decades.  The tax laws have indirectly and directly allowed income to be split through various mechanisms.  This has been achieved by the extensive use of companies, trusts, assignments, partnerships and leases between husband and wife (to name a few). While the concept of income splitting is readily applicable to all forms of income (eg; business income, investment, capital gains and personal services income), I have restricted my analysis in this paper to the topical issue of splitting ‘personal services income’, particularly through the use of ‘independent contractors’ and ‘personal service entities’.  As explained by Jeff Reilly, et al, “by the 1970’s personal service entities were in such widespread use that many tax practitioners would have described their use as an ordinary commercial or family dealing”[4]

Recently the Government has been concerned by the rapid growth of ‘independent contractors’[5] and personal service entities.  Previously the problem was prevalent only in certain key industries, predominantly, Building & Construction.  Recent research however, revealed a whole new range of workers hired under contractual arrangements.  These workers included industries such as shipbuilding, mining, computing, sales and even public service[6] and airline workers[7].

The previous Labor Government proposed a partial solution to the problem (as to which see later), but upon change of government the proposal was ‘thrown out’.  The ATO was instructed to continue to apply the existing, as explained above, deficient law.  It was only after an extensive Review of Business Taxation, (RBT)[8], that the Government accepted recommendations to partially[9] address the problem.  However, the final legislation differs markedly from the RBT recommendations and has been described as ‘a complete pushover of a piece of legislation’.[10]

What is the problem?


Briefly, the problem is that many ‘employers’ or ‘service requirers’ are increasingly choosing to hire their ‘employees’, ‘workers’ or ‘service providers’ under contract as opposed to traditional ‘employer/employee’ relationships.

The final Vabu[11]decision was a landmark loss for the ATO.  Vabu was the culmination of many years of court decisions consistently against the ATO’s assertion that workers engaged as contractors were in essence ‘employees’.  Vabu clearly indicates the Court’s recognition of modern day contractor relationships.[12]  This decision (and all those preceding) has made it very difficult for the ATO to enforce its withholding tax provisions where traditional employment relationships have been recharacterised.  The provisions are avoided by ensuring that the contract is for a ‘result’ not for ‘labour’ and includes a clause that allows the contractor to delegate the work to others.[13]

Why has it grown?


The use of the ‘independent contractor’ has grown due to many
perceived advantages. 

From the point of view of the employer these include:[14]
  • Avoidance of on-costs such as payroll tax, worker’s compensation, fringe benefits tax and superannuation guarantee.
  • Avoidance of the compliance costs of the above.
  • Avoidance of industrial problems such as; awards, leave entitlements, unions, unfair dismissals, etc.
  • Increased flexibility of labour, ie; able to hire and fire.
  • Avoidance of vicarious liability that attaches to employees.

From the point of view of the employee these include:[15]
  • Tax advantages.
  • More flexibility in terms of when, where and how they work.
  • Escaping the burden of PAYE taxes.

Not all of the above perceptions are valid.  The employer still faces the risk that the ‘contractor’ will be found by the courts to be an employee.  As expressed by Gray J in discussing the characterisation of the employee /contractor distinction:

“the parties cannot create something which has every feature of a rooster, but call it a duck and insist that every-body else recognise it as a duck…”.[16]

Despite this risk, it is most often the case that the suggestion to become a ‘contractor’ comes from the employer[17] as, if properly structured, such an arrangement can significantly reduce their on-costs.  To properly structure the arrangement, most employers insist that the individual form an ‘interposed entity’ such as a partnership, company, or trust.[18]  This does offer the employer some protection from the above problems as the legislative requirements for most of the above impositions require that the contract be with an individual and not an entity.[19]

The perceived tax benefits to the employee are much more dubious.  As will be discussed later, it is the ATO’s publicly stated opinion in numerous tax rulings[20] and countless media releases[21] that the perceived tax advantages are just that – ‘perceptions’.   As succinctly explained by Mike Bannon[22] “this daydream is often put to rest by the stark reality of our tax laws”.  To continue the analogy – the daydream of taxpayers has become the nightmare of the ATO in attempting to deal with the ever-increasing number of taxpayers avoiding income tax through income splitting arrangements.       

What is the problem with the growth in ‘independent contractors’


From the ATO’s perspective, the problem with the increase in ‘independent contractors’ is the ‘perceived’ tax advantages that include:[23]
  • Not being caught by the PAYE net.  This  increases the Commissioner’s costs of collection.[24]
  • Deferral of Tax Collected and potential for non-lodgment.[25]
  • Reduced superannuation guarantee contributions.
  • Ability to have ‘personal exertion income’ taxed at the Company rate.
  • Ability to ‘split income’ with family members, thereby reducing overall tax burden.
  • Ability to claim many more deductions, such as; cost of travelling from home to work, increased “aged based” superannuation benefits, car & superannuation for family members, home office expenses, etc.
  • Reduction in High Income Earner Superannuation Surcharge and Medicare Surcharge.
  • Manipulation of FBT on car benefits provided to associates

The ATO’s primary concern and focus has been on the ‘alienation of personal services income’ through the use of interposed entities.  Alienation of personal services income occurs where income is diverted from the taxpayer whose services generated the income, so that it is legally derived by an interposed entity, usually a family company or trust.  Of particular concern to the ATO is where that income is then split between the taxpayer and their family members or retained in the interposed entity.

Income from personal services is income that is earned by an individual taxpayer, predominantly as a direct reward for personal effort, the exercise of personal skill or the application of labour.[26]  It is the ATO’s view, as expressed in numerous rulings[27], that income from personal services cannot be ‘alienated’. 

The utilisation of this form of income splitting has been estimated by varying sources to cause tax revenue leakage of between $100 million to $8 billion per annum.[28]  In addition, it is presumed  there would be correlating leakages in terms of employer superannuation contributions, super surcharges, Medicare levies and surcharges, child support payments and increased social security benefits.  

The following diagram can visually demonstrate the increasing incidence of owner managers of incorporated enterprises.[29]

So if the revenue leakages are of the magnitude outlined above, one would presume that the Government has done all it can to address the problem?

What has the Government done to address the problem


Pre ’96 election proposals:


The May 1995 Federal Budget stated that certain labour market practices could, if no action was taken by the Government, have significant consequences for income tax and, in particular, PAYE revenue collection arrangements.  The Budget indicated that the law would be amended to ensure the PAYE provisions covered payments for the labour of an individual.  Further, it stated that the Government would be releasing a discussion paper that would set out the broad design features of new measures to counter alienation of personal services income.   It also quantified that, if no action were taken, the impact on the income base could be in the order of several hundred million dollars per annum.

Consequently, in late 1995, Income Tax Amendment Bill (No 5) 1995 was introduced into Federal Parliament to put into effect the proposed PAYE changes.  The discussion paper was also prepared. 

However, subsequent to the Labour Party’s defeat, the new Treasurer, Peter Costello, announced[30] that the Liberal government had decided not to proceed with the amendments or the release of the discussion paper.  Further the Government “asked the Commissioner of Taxation to ensure he continues to apply the existing provisions of the tax law, including the general anti-avoidance provisions”.

Post election Project:


In light of the above announcement, the ATO announced a National Project in December 1996.  The Project, a “Joint WHT/SBI Compliance Research and Improvement Project” focused on PAYE Erosion (due to the increased use of Independent Contractors) and Alienation of Personal Services Income.[31]

Briefly, the Project Aims were to articulate the ATO view, undertake a compliance program to safeguard the operation of the law, enforce the law, and highlight any legislative deficiencies.[32]

During the project the ATO made it clear that various mechanisms were to be used to assess the personal service income to the taxpayer (ref media articles).  These include, determining the whole arrangement to be a sham, using Sections 17, 19 and 25(1), or as a last resort Part IVA of the ITAA.[33]  The ATO remained firm on its stance that where alienation is effected for the sole or dominant purpose of avoiding tax, the general anti-avoidance provisions of Part IVA of the ITAA will apply.[34]    The courts and tribunals have confirmed the view that alienation of personal service income, predominantly for the purpose of reducing income tax, is ineffective for tax purposes.[35] 

However, there are intrinsic problems with the necessity for the ATO to rely on Part IVA to strike down such arrangements.  Firstly, the lack of specific rules creates a compliance problem due to the uncertainty of the law.  Many taxpayers and their advisers manage to make a reasonable argument that their situation is outside the scope of the provisions.  Secondly, the nature of Part IVA requires that the ATO engage considerable resources in detecting those taxpayers that still believe they are outside the scope.  Thirdly, as mentioned above, given that Part IVA determinations require case by case decisions, further expenditure on resources becomes necessary.  And fourthly, these determinations are open to challenge in the courts, thus further occupying the judicial system.

Overall, the ATO has achieved some of the Project’s aims, most particularly in highlighting the need for legislative change.  However, the Project has not yet been completed and it’s recommendations are not yet  finalised or published.  It may well be reasonable to suggest that such recommendations  will now been made redundant through the announcements of the RBT.

Reason why not addressed earlier????


The Government has been accused of ‘scandalous dereliction of duty that has cost the revenue several hundred million dollars a year”[36]. It could be hypothesised that this inaction by the Federal Government has been to implicitly allow income splitting to continue.  The underlying reasons for this could be;
¨       so as not to interfere with certain industries established on the basis of long held income splitting practices,
¨       as an incentive to small business (particularly in certain industries), to compensate them for risk,
¨       as a method of encouraging investment and jobs,
¨       or perhaps even as an indirect alternative to family taxation by allowing families in certain industries to split income. 

 
It is not then surprising to see the intervention of industry bodies such as the HIA and MBA in a parsimonious attempt to maintain the status of many of their members.  It was acknowledged by the present Government that the reason they did not proceed with the previous Government’s proposals to address this issue (see above) was due to representations by certain industries.[37] 

It can be presumed then that a “no change” policy was an indirect mechanism to allow tax “incentives” in certain industries to continue.  As correctly put by Warren, N.A. “clamping down on incorporation is anti-small business and this poses a major dilemma for a Government intent on encouraging the small business sector”.[38]

However, such a “no change” policy would not be openly admitted to by Government as this would not be acceptable tax policy (particularly to salary and wages employees). Economists would also argue that the risk of investing in any industry should be adequately compensated by the returns from profit.  Competitive economic theory dictates that the higher the undiversifiable financial risk the higher the economic return.  Accordingly, financial risk should not be underwritten by Government tax policy, unless done so overtly, by providing specific tax concessions or grants. 

A true cynic might also suggest that many politicians (on all sides), the judiciary and the wealthy have (their snouts in the trough) considerable vested interests in allowing the current regime to continue. 

The possibility that the inaction is an indirect alternative to family taxation can be evidenced by the building and construction industry where it is well known that almost all married contractors form husband and wife partnerships and split their incomes.  Whilst aware of this scenario, the Federal Government and the ATO have virtually turned a blind eye to such arrangements.[39]  Attempts to address income splitting within the building industry have been labelled as “harassing battlers trying to earn an honest living”.[40]

The Government can no longer afford to continue to ignore the issue.  The comprehensive Review of Business Taxation (RBT) that has been undertaken and the ensuing Report[41] has made it clear that the inequity of income splitting of personal services income cannot be allowed to continue.  The Federal Treasurer announced in his press release[42] that the Federal Government would adopt new measures to contribute to the fairness and equity of the tax system. Again a cynic might suggest that this was a forced outcome, as “to not do so would have left the business tax package more than $2 billion short of revenue neutrality”.[43]  It is also worth noting that it has been insinuated that the only reason the Federal Government instructed the Ralph Committee to review this issue was due to increasing pressure from the Australian Democrats in the tenuous GST negotiations at that time.[44]

The Government has finally taken action

(or has it?).


RBT Proposals:


The Ralph proposals were essentially designed to address alienation of income through interposed entities where the individual (service provider) is basically akin to an employee.  The Ralph committee recognised that “it is clearly inequitable to allow these practices to continue”.[45]

The Ralph committee stated that if this particular area were not addressed, the level of avoidance would grow to $3 billion per year.[46]

The Review recommended that the criteria to determine if one is an employee should be a comprehensive test based on the Victorian payroll tax system.  The review described this as the most ‘robust’ model.[47]

Industry reactions:

           
The Australian Society of Certified Practicing Accountants (ASCPA) publicly stated its disappointed with the proposals and stated that the “proposed approach could treat individuals in similar situations very differently”.[48]  The Institute of Chartered Accountants has similar concerns about the broadness of the measures.[49]  Ray Regan, of the National Tax and Accountants Association (NTAA) stated that the measures would result in contractors paying an extra 52% in tax and hiring organizations paying an extra 25% in on-costs.[50]  It is interesting that these bodies are concerned with ‘obvious inequities’ of the proposals yet did not seem concerned with the inequities of the previous law.  

The Master Builders Association (MBA) raised the most objections stating that “the decision will have industrial ramifications and would undermine the efficiency of the housing sector, which has been underpinned by the contract system”.  Further that the proposals are “inappropriate and will create inefficiencies in the housing sector”.[51]  The HIA, the other major player in the debate,  stated the proposals would hurt ordinary homebuyers by pushing prices up. “Every brick laid will roughly double in cost” and “many contractors will be sold down the river”.[52]  Further that they would have “major ramifications for the economy”.[53]  The Information Technology industry is also concerned that the “change threatens the dynamism of the IT industry”.[54]

However, none of the representations spell out how these inefficiencies might arise. It is difficult to accept these objections as the Ralph Review makes it clear that there is no attempt to affect the relationship between service providers and business and it does not seek to make them common-law employees.  What the RBT recommendations do is try to make some people meet their full and proper tax obligations.[55]

If it is the case that housing prices will rise because taxpayer’s are being forced to pay the correct amount of tax then this is entirely appropriate.  Tax avoidance of this type should not be used as a mechanism for reducing costs and keeping marginal businesses afloat.  The fact that tax avoidance is used by industry bodies to justify their positions and attempt to bargain an outcome to maintain this position borders on contemptible.   Even more reprehensible is the fact that such bargaining has persuaded the Government.



The Measures introduced:


The Ralph proposals (or some permutation thereof) received royal assent on 30 June 2000 and apply from 1 July 2000.[56]  They are known as Divisions 84 – 87, Part 2-42, and ITAA 1997.

The measures attempt to restrict the ability of individuals to reduce tax by diverting income from personal services to another entity.  The measures also attempt to limit work-related deductions to those that would have been available had the service provider been employed by the service requirer. 

To be considered a ‘personal services business’ a business must pass one of four tests:
  • The ‘unrelated clients test’,
  • The ‘employment test’,
  • The ‘business premises test’, or
  • The contract is ‘for a result’, and requires the individual to provide ‘plant/equipment or tools of trade’ and the individual is ‘liable for rectifying defects’.

Contractors will be able to self assess against the first three tests where less than 80 per cent of their personal services income is earned from one source.  Where 80 per cent is more of their personal services income is obtained from one source, the contractor will need to apply for a determination form the Commissioner.

Further the government has given the ATO the flexibility to have regard to ‘customs and practice’ in an industry.[57]
           
There will be no withholding requirement on the part of the service requirer.

Effectiveness of the new measures:


The measures aim to create equity, efficiency and simplicity by attempting to:
¨       Tax taxpayers in similar situations in a similar way.
¨       Clarify the uncertainties in the current law, thus reducing compliance costs for the ATO, the Judiciary and taxpayers.
¨       Remove the current incentives to form interposed entities solely for the purpose of income splitting.

However, the legislation introduced into law falls significantly short of its original goals.  In fact, the legislation introduced hardly reconciles with the initial Ralph proposals. 

The measures do not address the failings of the existing law and in fact, legislate the current inequity by effectively ‘allowing anyone with a smart accountant to avoid the provisions’.[58]  

As quite correctly described by Senator Campbell:

“In this country tax bills are usually about closing the tax net, tightening tax loopholes and making people pay their fair share.  This bill is almost unique in the sense that the government has almost fallen over itself to allow people to exempt themselves from the provisions”.[59]

The provisions have been further described as “a $440 million dollar rollback of the Governments stated intentions”, “a clear example of the governments weakness” and “yet another broken promise”.[60] 

Even more to the point is the claim that this is “The government, faced with competing interests of, firstly reducing tax avoidance and, secondly, furthering the proliferation of employment contractors, have adopted a spineless approach.  They have chosen to outlaw tax avoidance but create a series of criteria under which business can opt out”.[61]

Some of the problems inherent in the measures include:

  • As the measures embody the doctrine of self-assessment, many taxpayers may still consider themselves outside the scope with little or no regard to the facts viewed in an objective manner.  This will likely lead to little reduction in the propensity of a taxpayer to represent their own position as being “reasonably arguable”.  The ATO will still have to expend considerable resources identifying such taxpayer’s, arguing cases, and eventually testing the new, yet no more clearly defined, boundaries in court. 
  • The unrelated client’s test is a ‘fait accompli’ for those that earn less than 80% of their income from one source.  Obviously they are receiving income from two or more sources.  This makes the remaining tests irrelevant for these taxpayers.
  • Even for those who earn more than 80% of their income from one source, the ‘unrelated clients test’ is wide enough to drive a truck through.  All one need to do is advertise their services and do an odd job on the weekend (even if only for family or friends).  As described by Senator Campbell ‘anyone who cannot pass this test is not trying….I never saw anything less likely to stop anyone evading tax in my life’.[62] 
  • The ‘results’ test introduced at a late stage due to industry pressure (no difficulty in guessing which industry) basically introduces all of the common law problems with the existing law into legislation.  As has been found with the current law[63], it is possible to structure almost every contract to ensure it emphasises ‘producing a result’.  The bricklayer contracts (not for labour) but to build a wall.  The Computer Consultant contracts (not for labour) but to produce or test a program.  Even the humble Public Servant can contract (not for labour) but to produce a report.  Not to mention couriers.
  • The ‘results’ test also introduces a very subjective test, how many tools? How much liability? It will cost taxpayers very little to simply include clauses in their contracts and buy a few tools and some insurance.  In fact, most of them already do this to get around the existing common law provisions.
  • There is no further detail on the ‘customs and practice’ discretion provided to the ATO.  However, as this is being claimed as a major victory by the Building industry[64] one can presume it will be applied as a ‘no change’ policy for this industry.
  • Even for those who admit to being captured by the provisions, there is no withholding requirement on the service provider.  This may result in failure to lodge returns and an increased burden on ATO debt recovery facilities.

It would appear that the government has gone two steps forward and three steps backward on this issue.  Far from simplifying and clarifying the law as it currently stands, the proposed measures have the potential effect of ensuring existing practices are legitimised.  Surely this must be contrary to the Federal Governments intentions?  Perhaps not.

It would appear that once again the Federal Government has succumbed to industry pressure and media hype.  The industry and media accusations outlined above may have affected the Federal Government’s chance of winning the next election if the public accepted the, unproven contentions, of the media hype that upward pressure will be applied to housing prices due to the proposals. 

This legislation is a classic example of political propaganda at its worst.  The Government has not only appeased pressure groups by ensuring the current inequities are allowed to continue, but has legislated these inequities into law.  Further, and worse still, it portrays to the mugs that know no better, that it has taken action to reduce such inequity.

Where to from now?


As it is unlikely that the Federal Government will ever address the problem directly, it is necessary to examine other alternatives.  Such alternatives include:
  • Changing the unit of taxation from the individual to the family.
  • Aligning the top marginal rates.

Each of these alternatives will now be examined briefly before concluding with the recommended way forward for the Australian Taxation System.

Family Taxation:


It is unquestionably inequitable that a taxpayer earning business income and splitting it several ways will pay less tax than another taxpayer earning the same income.  This was recognised as far back as 1974 by the Whitlam Government.[65]  According to recent research, contractors in the building industry on average paid $6217 less in tax than their PAYE counterparts per annum.[66]  This is manifestly unfair.  As the Federal Government seems unable (or unwilling) to prevent ‘income splitting’ for those that are able to, an equitable way forward often proposed is to allow all taxpayer’s to income split by treating the family as the taxing unit or ‘joint filing’.

The idea of treating the family as the taxing unit has been muted since 1975 when the Asprey Committee considered joint returns.  It stated that “…in practice married couples largely share or pool their expenditure.  Much is jointly consumed…it is their ability to pay rather than the way the total is formally divided between them”.[67]

Family taxation or some form of joint filing applies in many countries including; Belgium, France, Germany, Greece, Ireland and the United States.  Australia could examine the practice of these countries in order to determine best practice.  The Taxation Institute of Australia (TIA) recommends the adoption of the German model where basically the couples combined income is halved, the tax on that is calculated and then doubled.[68]  Interestingly, this would provide the same tax payable as for those who ‘income split’ under the current system.  However, it would make it more equitable as it would apply to all families rather than only those who have the opportunity to do so.

As explained by the TIA such a proposal would create an environment where setting up complicated minimisation strategies would not be attractive to most families.[69]

Whilst the above solution may appear, at first glance, to be an equitable and viable alternative, it has its own inherent problems and raises many equity, efficiency, simplicity and policy concerns.  These will now be elaborated on.

Compulsory or Elective?


Firstly, it has to be decided whether to make the system compulsory or elective.

The right to be taxed as an individual has always been a principle of taxation in Australia.[70]  To withdraw this right for women, by requiring her to file jointly with her husband, has been described as to lump her with “infants, idiots and insane persons in the category of an incapacitated person”.[71]  As concluded by Asprey, K.W. the taxation system should pay full regard to and treat all women, whether married or single, as completely free and individual persons.[72]   Such a step backward from the current system would be seen as retrograde to women in particular and would not be accepted by the majority of the electorate.  It is also true that many men would not want their finances compulsorily intermingled with their wives.

Secondly, the assumption made above that in practice married couples largely share or pool their expenditure has been widely contested.  Studies have demonstrated a marked complexity of financial arrangements, from complete sharing and integration to extreme inequality of access to resources.[73]  To assess tax payable by one spouse by reference to the income of the other is grossly unfair if that spouse does not have access to the income of the other.

Thirdly, compulsory joint filing can result in either a ‘marriage penalty’ or ‘marriage advantage’ by changing the tax payable on the basis of marital status.[74]  Tax policy should remain ‘marriage neutral’ as the marriage decision is essentially a private choice.[75]

Fourthly, it can be quite difficult to define the ‘marriage unit’.  Regard must be given to the ever-increasing complexity of ‘social arrangements’.  In contemporary society, de-facto couples have a right to be accepted as ‘married’ and have been on many instances recognised by the courts as such.  However, it is administratively difficult (if not impossible) to correctly determine  de-facto status.  This is further complicated by the increasing phenomenon of ‘same-sex’ couples.  A marriage biased tax system could result in taxpayer’s (of all walks and kinds)  structuring their affairs so as to be considered de-facto or not.  Further still, are the complications of extended family units such as certain nationalities where it is commonplace for parents, children, in-laws and grandparents to all reside under one roof.  Finally, there are the complications caused by family companies and trusts, ie; whether the income of these should also be included in the family’s income.

For all of the above reasons, it is concluded that compulsory ‘joint filing’ is not feasible in an Australian context.  Indeed, the Asprey Committee in 1975, recommended that families be provided with the option of taxation on a family unit basis.  This overcomes social policy concerns that the individual has a right to be taxed and some of the problems with the definition of a family.

Elective ‘Joint Filing’:


The notion of elective ‘joint filing’ raises many questions and problems that will now be discussed.

Appropriate Rate:


Firstly, is the difficulty in determining an appropriate ‘married unit’ tax model.  Looking to international comparisons for assistance there seems to be basically three prominent options;
  • an aggregate model,
  • an average model,
  •  or a model somewhere in between.

An Aggregate Model:


An aggregate model is basically calculated by adding together the couples’ income and applying the applicable tax rate schedule (which would have to be determined after extensive revenue analysis).

The problem with an aggregate model is that it results in a higher tax payable for the married unit, known as the ‘marriage penalty’ or the ‘marriage disadvantage’[76](see Appendix one for calculations).  If such a system were optional no couples would elect to be taxed under the regime.  The implementation of such a scheme would therefore seem improbable.

An Average Income Model:


An average income model, as recommended by the TIA (above), effectively allows all electing couples to ‘income split’.  It is achieved by adding together the couples income, dividing it in two, applying the appropriate marginal rate and then multiplying the tax payable by two.  Whilst on the surface this system appears equitable, a deeper analysis of such a regime raises more equity concerns than it resolves.

Alternative Rate:


The remaining choice of a rate somewhere between the aggregate and the average model has, by its very nature, all of the problems associated with both rates, albeit to a lesser degree.   Lambert and Beer have examined various models including complete income splitting, dependent children only income splitting, and income splitting up to certain thresholds and conclude that under all options there are more taxpayers worse off than taxpayers better off.[77] 

The particular equity, efficiency and simplicity problems associated with family taxation will now be explored in detail.



Inequitable, Inefficient and Complex:

 

Unfair to two income families:


Firstly, the only beneficiaries of such a regime would be ‘one income’ couples, where the working partner (usually the husband) is earning income that is currently unable to be split (generally salary and wages), and the spouse has chosen not to work.  Lambert and Beer have economically demonstrated this.[78]  This regime disadvantages and is discriminatory against ‘two income’ couples, sole parents and single individuals (elaborated upon later).  As succinctly put by Edwards, M “The old tax canon that a married man should pay less tax than an unmarried man on the same income is becoming indefensible from both an equity and an efficiency perspective”.[79]

In relation to ‘two income’ couples, should Couple C (a ‘two-income couple) pay the same tax as a Couple B (a ‘one-income’ couple) on the same overall income (see Appendix 1 for calculations)?  The ‘two-income’ couple may include legitimate ‘income-splitting’ couples where both partners equally contribute to an income earning venture or where both partners earn salary and wages.  The ‘one income’ couple have made a lifestyle choice that one spouse is not going to work.  In my opinion, and the opinion of others[80], this choice results in many lifestyle advantages over the ‘two income’ couple. 
Firstly there is considerable, although hard to measure, value in the unpaid ‘household work’ performed by the non-working spouse. This ‘household work’ includes management tasks such as ‘strategic decision making, negotiation, initiation, policy, budgeting, time management, priority setting, etc,’.[81]  The household in effect can be viewed as a little ‘factory’, a multi-person unit producing meals, health, skills, children, education, etc.[82] This ‘household work’ also has to be performed by the ‘two-income’ couple but sometimes at the expense of their income (if they pay for it to be done, eg: a housekeeper and convenience food) or at the expense of their leisure time.  Expenses incurred for a private purpose are not deductible (even if they are earned to assist you to return to work) and leisure time is not taxed.[83]  And as so rightly explained by Scott Burns, “Time, not money, is the fulcrum and measure of our experience”.[84]  The ‘one income’ couple have significantly more ‘time’ than the ‘two income’ couple.  A subsidy to leisure time provides no benefit to society[85] and is inequitable as this subsidy is at the expense of other taxpayers who do not indulge in such luxury[86].  Taking this one step further, it has even been suggested that because of the above, both a utilitarianism and an ability to pay approach indicate that a’ two income family should pay less tax than a one income family’.[87]

Secondly, the ‘household work’ performed by the non-working spouse enhances the earning capacity of the working spouse by increasing their available time to undertake more work or acquire further skills.

Thirdly, the non-deductible nature of childcare expenses (an issue in itself) severely disadvantages the ‘two-income’ family. Should a ‘two-income’ couple who earn the same as a ‘one-income’ couple pay the same tax when the ‘two-income’ couple may pay up to $300.00, or more, per week in childcare, to enable them to earn the second income?  This is demonstrated by the U.S. approach whereby couples are jointly taxed, but childcare is deductible.[88]

Fourthly, the ‘two-income’ couple may also incur significant non-deductible expenses in earning their income such as travel to and from work and work clothing.


Fifthly, married couple taxation would generally mean lower marginal tax rates for the primary earner and higher rates for the secondary earner (relative to individual unit taxation).[89]  This would be a powerful incentive, combined with the interaction of the withdrawal of social welfare payments[90], to deter the non-working spouse from entering into the paid workforce.[91]  In fact, it has been estimated that such a regime would result in a fall of about 9% in the labour supply of working married women.[92]

Finally, it has been postulated that two income couples already bear more tax than any other types of families.[93]  Any further increase in this tax burden (relative to one income couples) would further exacerbate this inequity.

Some additional administrative problems that arise are in relation to privacy.  What if the couple don’t want each other to know their income details and who gets the refund or bill?  In addition, the PAYE TID system would become very difficult to administer.[94]

Further, the above mentioned problems in relation to the definition of ‘marriage’ would still arise.


Unfair to Individuals:


In relation to individuals, marital income averaging is particularly harsh on single taxpayers.[95]  Why should Master A pay significantly more tax than Mr B purely because he is not married (see Appendix 1 for calculations).  All of the above examples in relation to a ‘two-income’ couple also apply to an individual.  This was the main criticism of the US system that resulted in the introduction of a new rate schedule to ensure that a single person’s tax would not exceed that of a married couple on the same income by more than 20%.[96]

One could also be very provocative and raise the controversial fact that each individual has the choice as to whether to marry or not and whether to have a child, or children, or not.  Leaving social welfare arguments aside, should one taxpayer be financially forced to subsidise the personal choice of another taxpayer?

The above mentioned harshness to individuals is further exacerbated in the situation of single parents.  The single parent is unable to utilise the benefits of income splitting but they will face the higher tax rates/GST rates required to fund such a proposal (see below)

Cost Prohibitive:


Finally, the annual cost to the revenue of adopting such a system has been estimated to be some 3.9 billion.[97]   To maintain revenue neutrality, the rate scale would have to be lifted by 2.21% across the board[98] or the additional revenue raised through other taxes, such as a higher GST rate.  This would be to the detriment of all taxpayers and very harsh on low-income taxpayers, single parents, and low ‘two income’ couples who would not gain substantially from the proposed regime.



Alternatives to family taxation:


As concluded by Lambert & Beer income splitting does not differentiate between families with or without dependents, nor by the number of dependents.[99]  In contrast, family payment systems can be designed so as to directly benefit couples based on the number of children.  Lambert and Beer modelled the affect of spending the cost of introducing income splitting (3.9 billion as outlined above) directly on families with dependent children and concluded that such a proposal is more effective in assisting families.[100]  

Conclusion:


It is for all of the above reasons that most OECD countries have moved away from joint taxation.[101]   In relation to Australia, in line with the conclusion of the 1975 Draft White Paper the Government should maintain the individual as the unit of taxation for reasons of:

·         Equity to individuals and ‘two-income’ couples.[102]
·         Efficiency to minimise the distortion of choice between paid employment v ‘household work’.[103]
·         Simplicity as the individual system is administratively simpler.
·         Policy to promote equal employment opportunity, independence of women[104] and neutrality of marriage choice.[105]

As can be seen allowing all families to ‘income split’ only advantages one sector of the community and disadvantages the rest.  Such a system would only be reasonable tax policy if it were the Government’s intention to encourage women to stay at home with their children.  In my opinion, and the opinion of others[106], the Government does not intend and has no place to make such policy.

Although it may be arguable that ‘family taxation’ may overcome the problem of ‘income splitting’, this would only be a viable solution if it was justifiable on other grounds.  “Two inequities do not make an equity”.[107] 

Align or reduce the Top Marginal Rates?


In its recent discussion paper[108] the Government acknowledges that the level of income tax is too high[AGL1].  The proportion of taxpayers now falling into the top tax bracket is 20%, compared with only 1% in 1970. 

The government agrees in its above mentioned discussion paper that high marginal rates result in individuals entering into tax minimisation arrangements.  The most common being the diversion of their income to an ‘interposed entity’, usually a Company, to have their income taxed at the Company rate currently at 36%.

As noted by the TIA not all taxpayers have the capacity to enter into such arrangements and nor should such be seen as necessary.[109]

Aligning the top marginal rate to be equivalent with the Company rate removes some of the incentives to incorporate.  “This should be a precise alignment to send a strong and unambiguous signal that there is no tax arbitrage that can be extracted from incorporating”.[110]

As Australia’s company tax rate is already in the upper half of the global rate tables, it would not be economically feasible to increase the Company tax rate.[111]  It would be more feasible to reduce the top marginal rate (and FBT rate) down to equate with the Company rate.  Such a move could be made economically feasible, as part of an overall reform package, by introducing a broad based consumption tax at an adequate rate to compensate for the loss of revenue.

Interestingly, it appears that the Government has no intention of adopting the above alternative.  In contrast, they are proposing to reduce the Company rate down to 30% and have left the top marginal rate unchanged (although increased the income at which this rate cuts in marginally).

Even if such a proposal were adopted it would not remove the incentive to ‘income split’ with family members to take advantage of the progressive nature of the tax rates.  It would however ameliorate the incentive to some extent by making it less profitable.[112]

Conclusion:


It is unlikely that there will be any chance of further reforms in this area in the near future.  The Federal Government was hesitant to examine the issues initially and, and explained above, only referred them to the RBT committee under duress.  The RBT have concluded their review and the Federal Government has managed to water down the proposals enough to ensure status quo is not disturbed.  As explained above family taxation is not a viable option and reducing marginal rates is not on the horizon.

It would therefore seem that the only solution is to allocate the ATO enough resources to effectively enforce the new legislation, albeit that it is clearly deficient.  A saving grace is that legislation provides, that where the service provider receives more than 80% of their income from one source, they are required to apply to the Commissioner for a ‘personal services business’ determination.  In other words it is the Commissioner who will determine whether the above outlined deficient ‘unrelated clients test’ and ‘for a result test’ apply to these contractors.  If the Commissioner is given adequate resources to thoroughly investigate thousands of applications then there is some hope that the more blatant cases will be halted.

Such thorough investigation will require considerable resources to sort the facts from the truth, test the borderline cases in court, and conduct audit programs to verify that those that have ‘self-assessed’ have done so correctly.    A further saving grace is that where these audits reveal blatant structuring to avoid these provisions Part IVA will still operate.  So, as put by the ASCPA, ‘it is not quite open slather on income splitting’.[113]

In fact the Democrats suggest that such audit program should encompass a random sample of 2500 audits.[114]  This all seems remarkably similar to the existing, resource intensive, alienation of income project that the ATO has been conducting for over 3 years.

In the words of the famous childrens' nursery rhyme, “and the wheels of the bus go round and round………”.



Appendix One:


Taxpayer
Income
Tax
Individual
Sys
Tax
Aggregate
Sys
Tax
Average
Sys
Master A
$50,000
$14,102
$14,102
$14,102





Mr B
$50,000
$14,102


Mrs B
$0
$0


Total
$50,000
$14,102
$14,102
$9,044





Mr C
$25,000
$4,522


Mrs C
$25,000
$4,522


Total
$50,000
$9,044
$14,102
$9,044



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Apps P, ‘Effects of a tax mix change’ in Taxation towards 2000.  J.G. Head & R. Krever(eds) . (Australian Tax Research Foundation.  Monash University. 1997.Conference Series No: 19, Pg 117).


Asprey K W, Aggregation of incomes of Husband and Wife in Family Unit Taxation. Taxation Review Committee.  Commissioned Studies.  (Canberra: AGPS,1975, pg.6).




Aust, Reform of the Australian Taxation System, (Draft White Paper) (Canberra: AGPS, 1975, pg 60). 










Aust, Review of Business Taxation.  A Tax System Redesigned.  (RBT Report) (Canberra: AGPS, July 1999).









Aust, Review of Business Taxation.  A Tax System Redesigned.  (RBT Report) (Canberra: AGPS, July 1999). 









Aust, Taxation Review Committee Full Report (Asprey Report) (Canberra: AGPS, 1975).











Aust, Taxation Review Committee Full Report (Asprey Report) (Canberra: AGPS, 1975).











Bannon M, ‘Mythical images emerge of life as a Contractor’.  Sunday Times.  April 12 1998. pg 10.










Boreham T, ‘Putting Contractors on PAYE’, Business Review Weekly, January 29,1993. pg 23.      










Case Report (1997) 74 IR 466.
















Cass B & Whiteford P, ‘Income support, the labour market and the household’.  Households Work. (University of Melbourne. 1989, pg 149).







Cass B & Whiteford P, ‘Income support, the labour market and the household’.  Households Work. (University of Melbourne. 1989, pg 149).    






Chochula P, Senior Tax Counsel, ‘Employees v Contractors’.  Continuing Professional Development Program.  Seminar Paper. (ATO: February 1998).






Draper M, ‘Women in the home’, Households Work. (University of Melbourne, 1989, pg 86).











Edwards, M, ‘The income unit in Australian tax and social security systems’ , (Institute of Family Studies, 1984).









Edwards, M, ‘The income unit in Australian tax and Social Security Systems’, (Institute of Family Studies, 1984).









Fenton Jones M, ‘Crunch Time for Contractors’.  The Australian Financial Review.  Friday, November 12, 1999. pg 56.








Financial Review, 11 August 2000. 















Galper H, ‘Tax Proposals of the U.S. Treasury Department’  Australian Tax Research Foundation , pg 23.










Head JG, ‘Changing the Tax Mix’.  Papers presented at a conference organised by the centre of policy studies - Monash University (Australian Tax Research Foundation). 




HIA Housing.  Australia, May 2000, pg 67.















http://www.cpaonline.com.au/html/aa/200006/pg-aa200006-tax.htm













Income Tax Rulings 2121, 2330, 2503, 2639, 2129, 2408, D9/97,













Ironmonger, D.  ‘Households and the household economy’. Households Work.  (University of Melbourne. 1989, pg 5).









J.G. Head, ‘Changing the Tax Mix’.  Papers presented at a conference organised by the centre of policy studies - Monash University.  J.G. Head.






Lambert S & Beer G, ‘Taxing the Individual or the Couple: A Distribution Analysis’.  NATSEM, University of Canberra. Discussion Paper No. 15, September 1998, pg 3.




Lampe A, ‘A strike on splitting’, The Sydney Morning Herald.  16 April 1997, pg 5. 











Lehmann G, ‘First, stem the exodus from PAYE’. The Australian.  Friday, September 26, 1997, pg 24










Mark Hanrahan, Tax Practice Briefing, A Tax Counsel and Practice Management Publication.  Number 14, August 1997.








McCoy T, ‘You might be good at computing but…’  The Canberra Times.  February 14,2000.










Media Release - NTAA. Ralph Review stage 2 attacks up to 800,000 contractors.  12 November 1999.










Mike Bannon,  ‘ATO gets tough with Companies’, Canberra Times, 27 March 1994.  











Mike Bannon, ‘Splitting your Income May Attract Penalty’, Canberra Times, 5 February 1995.











Mike Taylor, ‘Finance looks at contracting out’, Canberra Times, 9 September 1997. 











Millar B, ATO, ‘Contractors, Employees & PAYE’  A presentation to the Taxation Institute of Australia, (NSW, 1996).








Morgan DR, ‘An Agenda for Tax Reform’.Pg 12.  Apps P, ‘A Comparative Analysis of Income Tax and Transfer Options’. Australian Tax Reform. In Retrospect and Prospect.  JG Head(ed).  Papers presented at a conference organised by the Centre of Policy Studies, Monash University.  (Australian Tax Research Foundation.  Conference Series No: 8, 1989, pg 264.)
Pender H,  The Joy of Tax.  (Australian Tax . Discussion Paper no.. February Research Foundation.  1997. Research Study Number 26, pg 83).






Porter: re TWU (1989) 34 IR 179 at 184.















Press Release no.71, Treasury. 20 August 1996.














Press Release. No.074. The New Business Tax System: Stage 2 Response.












Rees P ‘Crackdown on ‘trust’ tax cheats’. The Sunday Telegraph, 24 August 1997, pg 45.











Reilly J & Szekely L, Contracting and Income Splitting. (Australia: CCH, 1988).












SBI Curriculum.  ‘Training Module – Alienation of Personal Services Income through Interposed Entities’.  (ATO: March 1997).








Senate Economics Legislation Committee. Parliament of Australia. June 2000, pg 10.











Senate Hansard: New Business Tax System (Alienation of Personal Services Income) Bill 2000.  21 June 2000, p14411.








Senate Hansard: New Business Tax System (Alienation of Personal Services Income) Bill 2000.  Senator Campbell.  21 June 2000, p14411. 







Skotnicki T,’Union revives ‘subbie’ tax battle’.  Business Review Weekly, June 18, 1999, pg 46.










Skotnicki T,’Union revives ‘subbie’ tax battle’.  Business Review Weekly, June 18, 1999, pg 46.










Smith C, ATO,  ‘A Joint WHT/SBI Compliance Research & Improvement Project”.  Industry Report.  Federal Government’. (ATO: June 1998). (unpublished)





Smith, C, ATO.   ‘A Joint WHT/SBI Compliance Research & Improvement Project’.  Industry Report.  Federal Government. (Canberra: June 1998). (unpublished)





Stiglitz, JE.  Economic of the Public Sector.  WW Norton & Company.  New York, pg 528.











Stotsky J, ‘The choice of Taxable Unit’. In Tax Policy Handbook.  Shome P.  (Fiscal Affairs Department  International Monetary Fund.  Washington, D.C. 1995, Pg 124).




Superannuation Guarantee (Admin)Act 1992 s12(3),  Income Tax Assessment Act (ITAA) 1936 s221(1), Fringe Benefits Tax Assessment Act (FBTAA)   s136(1).





Switzer P, ‘Tax Office to give micro operations splitting headache’.  













Tax Tips. Issue no:2, (ATO Canberra Branch, May 1995). 













Taxation Institute of Australia.  Moving Away from Employment Relationships. Part 1.   (Western Australian State Convention. May 1997), at 541.






Taxation Reforms: Problems and Aims, Treasury Taxation Paper No 1, (Canberra: AGPS, 1974, pp3-7). 










Taxation Rulings IT 2121, 2330, 2503, 2639, 2129, 2408, TD 95/34 & 94/71, D9/97











Thomson R: Deputy Chief Tax Counsel, ATO, ‘Alienation of Personal Services Income’. A paper presented to the Australian Society of CPA’s.  Tax Update: 27 February 1997. 




Treasurer’s Press Release No 71, 20 August 1996.














Tupicoff v F C of T (84) ATC 4367. F C of  T v Gulland Watson & Pincus. (85), ATC, 4765.   Bunting v F C of T. (89), ATC, 5245.   Daniels v F C of T. (89), ATC, 4830.  Case W58, (87), ATC, 524.  Case X90, (90), ATC, 648. Case Y13, (91), ATC, 4990.   Case Y28, (91), ATC, 296. Case Y29, (91),ATC, 301.   Liedig v F C of T, (94), ATC, 4269.  Osborne V F C of T, (95), ATC, 4323
Vabu Pty Ltd v F C of T (1996) 33 ATR 537; 96 ATC 4898 (Vabu)













Van Leeuwen H, ‘Employees pedaling away from PAYE’, The Australian Financial Review,  September 8, 1997, pg 7.









Warren N, Tax facts and tax reform.  Australian Tax Research Foundation.  Research Study No. 31, 1998, pg 84.









Warren NA & Harding A, ‘Who pays the Tax Burden in Australia’ Estimates for 1996-97. NATSEM, University of Canberra:  Discussion Paper no.39. February 1999.




Warren NA, ‘Australian Tax Reform process: Flawed from the Start’.  Paper presented at a Business Tax Forum: Strategies and Solutions organised by ATAX at the Sheraton n the Park, Sydney, 15 September 1998, pg 14.
Way N,  Contractors: The pinch of tax reform. Business Review Weekly, March 10, 2000.  











Willis R, ‘Ralph’s tax crackdown was Labor policy’. The Australian Financial Review.  November 11, 1999, pg 23.













[1] See generally; Aust, Taxation Review Committee Full Report (Asprey Report) (Canberra: AGPS, 1975).
[2] Ibid
[3] Such as Income Tax Assessment Act 1936 Part IVA and Div6.
[4] Reilly J & Szekely L, Contracting and Income Splitting. (Australia: CCH, 1988)pp??.
[5] Independent studies have found, in 1994, one in thirteen workers, was a self employed contractor.  Over 500,000 people, or 7.5% of the workforce was self-employed.  The corresponding figure five years earlier was only 3.3%. Taxation Institute of Australia.  Moving Away from Employment Relationships. Part 1.   (Western Australian State Convention. May 1997), at 541.
[6] See generally; Mike Taylor, ‘Finance looks at contracting out’, Canberra Times, 9 September 1997.  Mike Bannon,  ‘ATO gets tough with Companies’, Canberra Times, 27 March 1994.   Mike Bannon, ‘Splitting your Income May Attract Penalty’, Canberra Times, 5 February 1995.
[7] Financial Review, 11 August 2000.  Case Report (1997) 74 IR 466.
[8] Aust, Review of Business Taxation.  A Tax System Redesigned.  (RBT Report) (Canberra: AGPS, July 1999). 
[9] .  The proposed Alienation of Personal Services Income regime is only a partial measure in that it, in no way, redresses the situation of those with investments or non-Personal Services Income being able to split income with impunity.  Such is the case in regard to the Entity Taxation proposal.   The government clearly acknowledges that the new measures do not stop income splitting through family discretionary trusts. Aust, Review of Business Taxation.  A Tax System Redesigned.  (RBT Report) (Canberra: AGPS, July 1999).
[10] Senate Hansard: New Business Tax System (Alienation of Personal Services Income) Bill 2000.  Senator Campbell.  21 June 2000, p14411. 
[11] Vabu Pty Ltd v FcofT F C of T (1996) 33 ATR 537; 96 ATC 4898 (Vabu)
[12] See generally; Mark Hanrahan, Tax Practice Briefing, A Tax Counsel and Practice Management Publication.  Number 14, August 1997.
[13] See generally; Mark Hanrahan, Tax Practice Briefing,  A Tax Counsel and Practice Management Publication.  Number 14, August 1997.
[14] See generally; Taxation Institute of Australia.  Moving Away from Employment Relationships. Part 1.   (Western Australian State Convention. May 1997), at 540.   Millar B, ATO, ‘Contractors, Employees & PAYE’  A presentation to the Taxation Institute of Australia, (NSW, 1996).
[15] Ibid.
[16] Re Porter: re TWU (1989) 34 IR 179 at 184.
[17] Millar B, ATO, ‘Contractors, Employees & PAYE’  A presentation to the Taxation Institute of Australia, (NSW, 1996).
[18] See generally; Smith, C, ATO.   ‘A Joint WHT/SBI Compliance Research & Improvement Project’.  Industry Report.  Federal Government. (Canberra: June 1998). (unpublished)
[19] Superannuation Guarantee (Admin)Act 1992 s12(3),  Income Tax Assessment Act (ITAA) 1936 s221(1), Fringe Benefits Tax Assessment Act (FBTAA)   s136(1).
[20] Income Tax Rulings 2121, 2330, 2503, 2639, 2129, 2408, D9/97,
[21] Lampe A, ‘A strike on splitting’, The Sydney Morning Herald.  16 April 1997, pg 5.  Tax Tips. Issue no:2, (ATO Canberra Branch, May 1995).  Agent News, Issue No 35, (ATO Canberra Branch. August – September 1994).
[22] Bannon M, ‘Mythical images emerge of life as a Contractor’.  Sunday Times.  April 12 1998. pg 10.
[23] See generally, ‘Alienation of Personal Services Income Project.  A Joint WHT/SBI Compliance Research & Improvement Project’. Executive Summary & Recommendations.  (ATO, December 1998).
[24] See generally; Moving Away from Employment Relationships. Part 1.   (Western Australian State Convention. May 1997), at 541.
[25] See generally; Chochula P, Senior Tax Counsel, ‘Employees v Contractors’.  Continuing Professional Development Program.  Seminar Paper. (ATO: February 1998).
[26] See Taxation Ruling IT2639, at 3
[27] See generally, Taxation Rulings IT 2121, 2330, 2503, 2639, 2129, 2408, TD 95/34 & 94/71, D9/97
[28] Boreham T, ‘Putting Contractors on PAYE’, Business Review Weekly, January 29,1993. pg 23.  Van Leeuwen H, ‘Employees pedaling away from PAYE’, The Australian Financial Review,  September 8, 1997, pg 7.  ‘Income Splitting Blitz’  The Sunday Mail (SA) 12 October 1997.  Rees P ‘Crackdown on ‘trust’ tax cheats’. The Sunday Telegraph, 24 August 1997, pg 45.
[29] Aust, Review of Business Taxation.  A Tax System Redesigned.  (RBT Report) (Canberra: AGPS, July 1999).
[30] Press Release no.71, Treasury. 20 August 1996.
[31] Thomson R: Deputy Chief Tax Counsel, ATO, ‘Alienation of Personal Services Income’. A paper presented to the Australian Society of CPA’s.  Tax Update: 27 February 1997. 
[32] Ibid
[33] See generally, SBI Curriculum.  ‘Training Module – Alienation of Personal Services Income through Interposed Entities’.  (ATO: March 1997).
[34]             ** Part IVA applies when:
·         There is a scheme as defined in section 177A;
·         A tax benefit as defined in section 177C(1) is obtained by a taxpayer in connection with the scheme;
·         The scheme is one to which Part IVA applies having regard to the matters set out in section 177D;  
·         The Commissioner is entitled, under section 177F to determine that ‘personal services’ income be included in the assessable income of the service provider.
The ATO achieved this by determining that the ‘scheme’ is the diversion of personal service income to the interposed entity.  Part IVA generally allows the Commissioner to cancel the tax benefit under the scheme.
[34]             Tupicoff v FcofT F C of T (84) ATC 4367. FcofT F C of  T v Gulland Watson & Pincus. (85), ATC, 4765.   Bunting v FcofTF C of T. (89), ATC, 5245.   Daniels v FcofTF C of T. (89), ATC, 4830.  Case W58, (87), atcATC, 524.  Case X90, (90), ATC, 648. Case Y13, (91), ATC, 4990.   Case Y28, (91), ATC, 296. Case Y29, (91),ATC, 301.   Liedig v FcofTF C of T, (94), ATC, 4269.  Osborne V FcofTF C of T, (95), ATC, 4323
[35] Ibid.
[36] Willis R, ‘Ralph’s tax crackdown was Labor policy’. The Australian Financial Review.  November 11, 1999, pg 23.
[37] Treasurer’s Press Release No 71, 20 August 1996.
[38] Warren N, Tax facts and tax reform.  Australian Tax Research Foundation.  Research Study No. 31, 1998, pg 84.
[39] Switzer P, ‘Tax Office to give micro operations splitting headache’.  
[40] ‘Hands off battlers’.  Sunday Mail.  October 12, 1997.
[41] Aust, Review of Business Taxation.  A Tax System Redesigned.  (RBT Report) (Canberra: AGPS, July 1999).
[42] Press Release. No.074. The New Business Tax System: Stage 2 Response.
[43] Willis R, ‘Ralph’s tax crackdown was Labor policy’.  The Australian Financial Review,  November 11, 1999, pg 23.
[44] See generally; Skotnicki T,’Union revives ‘subbie’ tax battle’.  Business Review Weekly, June 18, 1999, pg 46.
[45] Above note 40.
[46] Senate Hansard: New Business Tax System (Alienation of Personal Services Income) Bill 2000.  21 June 2000, p14411.
[47] Senate Hansard: New Business Tax System (Alienation of Personal Services Income) Bill 2000.  21 June 2000, p14412.
[48] Fenton Jones M, ‘Crunch Time for Contractors’.  The Australian Financial Review.  Friday, November 12, 1999. pg 56.
[49] Ibid.
[50] See generally; Media Release - NTAA. Ralph Review stage 2 attacks up to 800,000 contractors.  12 November 1999.
[51]Fenton Jones M, ‘Crunch Time for Contractors’.  The Australian Financial Review.  Friday, November 12, 1999. pg 56.   Chandler M, ‘Subcontract business torpedoed’.  The Australian Financial Review. 16 February 2000, pg 30. 
[52] Media Release - NTAA. Ralph Review stage 2 attacks up to 800,000 contractors.  12 November 1999.
[53] Senate Economics Legislation Committee. Parliament of Australia. June 2000, pg 10.
[54] See generally, Way N,  Contractors: The pinch of tax reform. Business Review Weekly, March 10, 2000.  McCoy T, ‘You might be good at computing but…’  The Canberra Times.  February 14,2000. 
[55] Way N,  Contractors: The pinch of tax reform. Business Review Weekly, March 10, 2000. 
[56] Except for certain PPS payees who have been excluded from the provisions until 1 July 2002.
[57] HIA Housing.  Australia, May 2000, pg 67.
[58] Senate Hansard: New Business Tax System (Alienation of Personal Services Income) Bill 2000.  21 June 2000, p14411.
[59] Ibid @ p14412.
[60] Senate Hansard: New Business Tax System (Alienation of Personal Services Income) Bill 2000.  21 June 2000, p14411.
[61] Senate Hansard: New Business Tax System (Alienation of Personal Services Income) Bill 2000.  Senator Campbell.  21 June 2000, p14411.
[62] Senate Hansard: New Business Tax System (Alienation of Personal Services Income) Bill 2000.  Senator Campbell. 21 June 2000, p14413.
[63] Smith C, ATO,  ‘A Joint WHT/SBI Compliance Research & Improvement Project”.  Industry Report.  Federal Government’. (ATO: June 1998). (unpublished)
[64] HIA Housing.  Australia, May 2000, pg 67.
[65] See generally; Taxation Reforms: Problems and Aims, Treasury Taxation Paper No 1, (Canberra: AGPS, 1974, pp3-7).  Aust, Taxation Review Committee Full Report (Asprey Report) (Canberra: AGPS, 1975).
[66] See generally; Skotnicki T,’Union revives ‘subbie’ tax battle’.  Business Review Weekly, June 18, 1999, pg 46.
[67] Aust, Taxation Review Committee Full Report (Asprey Report) (Canberra: AGPS, 1975).
[68] See generally; ‘Tax reform. Let there be no half measures’.  Taxation in Australia. Volume No 1.  No:4.  April 1998, pg192.
[69] Ibid, at pg192.
[70] See generally; Aust, Taxation Review Committee Full Report (Asprey Report) (Canberra: AGPS, 1975).
[71] Asprey K W, Aggregation of incomes of Husband and Wife in Family Unit Taxation. Taxation Review Committee.  Commissioned Studies.  (Canberra: AGPS,1975, pg.6).
[72] Ibid.
[73] See generally; Cass B & Whiteford P, ‘Income support, the labour market and the household’.  Households Work. (University of Melbourne. 1989, pg 149).  J.G. Head, ‘Changing the Tax Mix’.  Papers presented at a conference organizedorganised by the centercentre of policy studies - Monash University.  J.G. Head.   Albon R, ‘Australian Tax Unit: An Evaluation’. Australian Tax Research Foundation, Pg 333.
[74] See generally; Stotsky J, ‘The choice of Taxable Unit’. In Tax Policy Handbook.  Shome P.  (Fiscal Affairs Department  International Monetary Fund.  Washington, D.C. 1995, Pg 124).
[75] Lambert S & Beer G, ‘Taxing the Individual or the Couple: A Distribution Analysis’.  NATSEM, University of Canberra. Discussion Paper No. 15, September 1998, pg 3.
[76] See generally; Asprey K W, Aggregation of incomes of Husband and Wife in Family Unit Taxation. Taxation Review Committee.  Commissioned Studies.  (Canberra: AGPS,1975, pg.6).  Head J G, ‘Changing the Tax Mix’.  Papers presented at a conference organizedorganised by the centercentre of policy studies - Monash University.   Galper H, ‘Tax Proposals of the U.S. Treasury Department’  Australian Tax Research Foundation , pg 23.
[77] See generally; Lambert S & Beer G, ‘Taxing the Individual or the Couple: A Distribution Analysis’.  NATSEM, University of Canberra. Discussion Paper No. 15, September 1998.
[78] See generally; Lambert S & Beer G, ‘Taxing the Individual or the Couple: A Distribution Analysis’.  NATSEM, University of Canberra. Discussion Paper No. 15, September 1998,.
[79] Edwards, M, ‘The income unit in Australian tax and Social Security Systems’, (Institute of Family Studies, 1984).
[80] See generally; Lambert S & Beer G, ‘Taxing the Individual or the Couple: A Distribution Analysis’.  NATSEM, University of Canberra. Discussion Paper No. 15, September 1998, pg 6.  & Apps, PF. ‘The tax unit: an Australian perspective’, in Head J, Taxation Issues of the 1980’s, (Australian Tax Research Foundation, Sydney. 1983).
[81] Draper M, ‘Women in the home’, Households Work. (University of Melbourne, 1989, pg 86).
[82]Cass B & Whiteford P, ‘Income support, the labour market and the household’.  Households Work. (University of Melbourne. 1989, pg 149).
[83] See generally; Apps P, ‘Effects of a tax mix change’. Head JG & Krever R,(eds) ‘Taxation towards 2000’.  (Australian Tax Research Foundation.  Monash University. 1997, Pg 109).
[84] Ironmonger, D.  ‘Households and the household economy’. Households Work.  (University of Melbourne. 1989, pg 5).
[85] This argument has been contended by others who suggest that a tax system that encourages women to enter the labour force may have adverse affects on the family structure and educational attainment of children.  (see Stiglitz, JE.  Economic of the Public Sector.  WW Norton & Company.  New York, pg 529.)  However, this opinion of this author remains that such a value judgement (ie; whether women should work or stay at home with the children) has no place in tax policy.
[86] See generally; Edwards, M, ‘The income unit in Australian tax and social security systems’ , (Institute of Family Studies, 1984).
[87] Stiglitz, JE.  Economic of the Public Sector.  WW Norton & Company.  New York, pg 528.
[88] Ibid.
[89] See generally; Aust, Reform of the Australian Taxation System, (Draft White Paper) (Canberra: AGPS, 1975, pg 60).  Pender H,  The Joy of Tax.  (Australian Tax . Discussion Paper no.. February Research Foundation.  1997. Research Study Number 26, pg 83).
[90] See generally; Warren NA, ‘Australian Tax Reform process: Flawed from the Start’.  Paper presented at a Business Tax Forum: Strategies and Solutions organised by ATAX at the Sheraton n the Park, Sydney, 15 September 1998, pg 14.
[91] See generally; Aust, Reform of the Australian Taxation System, (Draft White Paper) (Canberra: AGPS, 1975, pg 60).   Head JG, ‘Changing the Tax Mix’.  Papers presented at a conference organizedorganised by the centercentre of policy studies - Monash University (Australian Tax Research Foundation).  Morgan DR, ‘An Agenda for Tax Reform’.Pg 12.  Apps P, ‘A Comparative Analysis of Income Tax and Transfer Options’. Australian Tax Reform. In Retrospect and Prospect.  JG Head(ed).  Papers presented at a conference organizedorganised by the Centre of Policy Studies, Monash University.  (Australian Tax Research Foundation.  Conference Series No: 8, 1989, pg 264.)
[92] See generally; Lambert S & Beer G, ‘Taxing the Individual or the Couple: A Distribution Analysis’.  NATSEM, University of Canberra. Discussion Paper No. 15, September 1998, pg 10. 
[93] Warren NA & Harding A, ‘Who pays the Tax Burden in Australia’ Estimates for 1996-97. NATSEM, University of Canberra:  Discussion Paper no.39. February 1999.
[94] See generally; Lambert S & Beer G, ‘Taxing the Individual or the Couple: A Distribution Analysis’.  NATSEM, University of Canberra. Discussion Paper No. 15, September 1998, pg 9. 
[95]  See generally; Albon R, ‘Changing the Tax Mix’.  Papers presented at a conference organizedorganised by the centercentre of policy studies. Monash University.  J.G. Head(ed). (Australian Tax Research Foundation). “Australian Tax Unit: An Evaluation’. Pg 331.
[96] Aust, Taxation Review Committee Full Report (Asprey Report) (Canberra: AGPS, 1975, pg 133)
[97] See generally; Lambert S & Beer G, ‘Taxing the Individual or the Couple: A Distribution Analysis’.  NATSEM, University of Canberra. Discussion Paper No. 15, September 1998, pg 11.
[98] Ibid
[99] Ibid @ pg 30.
[100] Ibid, pg 35.
[101] See generally; Lambert S & Beer G, ‘Taxing the Individual or the Couple: A Distribution Analysis’.  NATSEM, University of Canberra. Discussion Paper No. 15, September 1998, pg 7. 
[102] See generally; Albon R ‘Changing the Tax Mix’.  Papers presented at a conference organizedorganised by the centercentre of policy studies.  Monash University.  J.G. Head(ed).  (Australian Tax Research Foundation. Australian Tax Unit: An Evaluation. Pg 331).
[103] Ibid.
[104] See generally; Aust, Reform of the Australian Taxation System, (Draft White Paper) (Canberra: AGPS, 1975, pg 62).
[105] See generally; Albon R ‘Changing the Tax Mix’.  Papers presented at a conference organizedorganised by the centercentre of policy studies.  Monash University.  J.G. Head(ed).  (Australian Tax Research Foundation. Australian Tax Unit: An Evaluation. Pg 330).
[106] See generally; Apps P, ‘Effects of a tax mix change’ in Taxation towards 2000.  J.G. Head & R. Krever(eds) . (Australian Tax Research Foundation.  Monash University. 1997.Conference Series No: 19, Pg 117).
[107] Ibid.
[108] ‘The Australian Taxation System in need of Reform’. Statement by The Honourable Peter Costello, MP.  (Canberra: AGPS,  1998, pg 3).
[109] See generally; ‘Tax reform.  Let there be no half measures’.  Taxation in Australia. Volume No 1.  No:4.  April 1998.
[110] Lehmann G, ‘First, stem the exodus from PAYE’. The Australian.  Friday, September 26, 1997, pg 24
[111] ‘See generally; Tax reform.  Let there be no half measures’.  Taxation in Australia. Volume No 1.  No:4.  April 1998.
[112] See generally; Aust, Reform of the Australian Taxation System, (Draft White Paper) (Canberra: AGPS, 1975, pg 60).  Edwards, M, The income unit in Australian tax and social security systems, (Institute of Family Studies, 1984).
[113] http://www.cpaonline.com.au/html/aa/200006/pg-aa200006-tax.htm
[114] Senate Economics  Legislation Committee.  Parliament of Australia.  Canberra, 2000, pg 25.

Page: 23
 [AGL1]Surely this must be a MARGINAL rate in which case they are not paying 43% of EACH dollar, only those between 38,000 and 50,000.  To achieve an AVERAGE rate of 43%, the individual must be earning in excess of 1,000,000!!!

GST & The Cash Economy

Monday, March 07, 2011
GST & the Cash Economy –
An outline of the principles & principals of the Australian GST Law:
Will they Help or Hinder?

Catherine Smith
Ba.Comm(Acc). C.P.A.

Masters of Taxation Program

ATAX
University of New South Wales

Principles of GST Unit
0223

November 2000




index



 


Abstract


It has been postulated for several decades by political leaders from both major parties, that a fundamental ‘principle’ of the GST is that it provides a solution to tax evasion in the cash economy.  However, overseas experience indicates to the contrary.  This paper will examine what is meant by the term ‘cash economy’, why it exists and why the Australian Taxation Office (ATO) needs to address it.   This paper will then examine the fundamental ‘principals’ of the Australian GST law and their likely affect on the cash economy.  This paper will then suggest possible legislative solutions available to the Government.


Introduction


The Government has repeatedly stated that the New Tax System (ANTS) will improve compliance and impact on the cash economy.  The whole package has been stated to ‘enhance community confidence in the fairness of the system and specific measures will make greater in-roads into the cash economy’.[1] According to the ANTS proposals the new measures will net an excess of $3.5 billion in tax revenue over three years.[2]  This estimate is based on the assumption of 95% compliance with the GST by the Treasury’s estimated $18 billion dollar cash economy.[3]

As with all political issues the Opposition tells a much different story.  They cite a major International Monetary Fund (IMF) study of GST systems around the world which concluded:  ‘Like other taxes, VAT is evaded….increasing rates for VAT make the tax conspicuous and makes successful evasion all the more valuable to the trader and public alike.’[4]

So what is the likely Australian experience?

This paper will examine;
¨      The nature of the cash economy and taxpayer evasion in this area. 
¨      The experience of other countries.
¨      The basic ‘principals’ of the Australian GST system.
¨      Whether these ‘principals’ will deter the cash economy.
¨      Whether there are any legislative solutions available to the Government.

 


The Cash Economy:


What is the Cash Economy?


The cash economy can be defined as “market-based production of goods and services, whether legal or illegal that escapes detection in the official estimates of GDP (gross domestic product).”[5]  The focus of this paper will be on legal activities only as these are considered the largest part of the cash economy.[6]   

According to background research[7] into the cash economy there is still no reliable estimate of the size of the cash economy.  However it has been estimated to be anywhere between 3.5 and 13.4% of GDP, or in dollar terms between $3.9 billion and $15.1billion per annum.[8]  The risk of the cash economy to the administration of the GST has been identified by the ATO GST Compliance Management Team to be in the category of a ‘severe’ risk.[9] 


This paper will analyze the likely impact of GST on the cash economy in the Small and Medium Enterprise (‘S&ME’) businesses[10].  These businesses have more opportunity to deal in cash and it has been suggested that these businesses form the largest part of the cash economy[11].

Why is it important to address the Cash Economy?


Aside from the obvious revenue drain, it is important for the ATO to deal with, and be seen to be dealing with, the cash economy.  According to the Draft White Paper “The essential criteria for assessing a tax system are equity, efficiency and simplicity.  An equitable tax system is critical, not only to the attainment of economic and social objectives, but also to the maintenance of basic respect for the tax system from which a high degree of voluntary compliance derives”.[12]   As the Australian Taxation System is based on the principle of self-assessment, voluntary compliance is essential.  As outlined above, voluntary compliance relies on a basic respect for the tax system.  To maintain community confidence and thereby engender that basic respect for the tax system, the ATO needs to achieve its purpose of collecting the revenue ‘properly payable’.  To fail to address the cash economy would not be equitable as it would not collect the revenue properly payable, would result in a loss of respect for the tax system and an overall decrease in voluntary compliance. 

According to Tax Commissioner, Michael Carmody the cash economy represents a major cost to the Australian community in terms of:
  • Unfair price competition on honest business;
  • Increased welfare costs as it impacts on means tested social benefits.[13]
  • Avoidance of superannuation, workers compensation and child support obligations; and
  • Lost tax revenue that is used to fund community services and government programs.

The ATO has recognized that of greater concern is the growing perception that tax evasion is an escalating problem which, if not addressed, may impact on the level of confidence in the tax system.[14] 

Particularly, during the introduction of ANTS, and in particular the politically sensitive and emotive issue of the GST, community confidence and support is imperative.

Taxpayer Non-compliance – why is eluding the taxman so attractive?


US Audit evidence suggests ‘that only about one third of individual taxpayers set out to cheat in a significant way’ (emphasis added).[15]  Whilst this quote has been used by the ATO to support the fact that most taxpayers voluntarily comply, it depends on whether you look at the cup being half empty or half full.  One third of taxpayers cheating in a significant way appears quite high.  What about the ‘non-significant’ cheating, does this make up another one third?  But considering that the majority of taxpayers are salary and wage earners with little opportunity to cheat, the cheating statistics could be about 100% of those that can.

Whilst the study of tax evasion/compliance is a relatively new area and the conclusions are varied, a common theme is the importance of feelings of equity and norm commitment.[16]

Findings indicate:
·         Many taxpayers think compliance by others is lower than their own. [17]
·         The more evaders a taxpayer is aware of, the poorer his compliance is likely to be. [18]
·         Citizens no longer sense an expectation that they should comply with the system, but instead believe normal expectancy is a modicum of evasion.
·         Also referred to as the ‘bystander effect’, taxpayers may think their evasion is minute and would not make much difference. [19]
·         Taxpayers reduce their guilt feelings accompanying deviant behavior by employing the ‘neutralization theory’ that ‘everyone does it’.[20] 
  • Even if the direct revenue losses are small, a general awareness that many persons don’t comply has a demoralizing effect on taxpayers and may prompt them to evade their liabilities.[21]

Taxpayer Non-Compliance in the Cash economy:


Directly relevant to the cash economy is the finding that “the primary motivation for non-compliance is often to expand business through offering customers a product at a price that does not reflect the proper levels of taxation.  Non-compliance is the means of gaining a market edge”.[22] 

Further, if non-compliance does not attract effective responses, two consequences arise:
i)                    the business of the non-complier expands; and
ii)                  competitors of the non-complier adopt similar practices in order to maintain their business and reduce the non-complier’s market edge.[23]

Whilst overlooking the real importance and impact of the cash economy may be simple for the ATO in the short term, the long-term effects could be disastrous.  “This behavior would condone a lot of tax evasion and would generate tax revenue in a way that would be far from optimal.  It would also conflict with other objectives of taxation such as neutrality and equity”. [24] 

According to Tax Commissioner, Michael Carmody, [25] what makes the cash economy such a difficult issue to tackle is that the community has a split personality on the issue.  On one hand they realize they are victims of the cash economy and think that everyone should pay their fair share of tax.  On the other hand, the community willingly participates in it by accepting a lower ‘cash price’ for a product or service. 

Perhaps, compliant taxpayers are rebelling against the fact they shoulder the majority of the tax burden by making these cash payments.  The negative externality can be summarized as ‘Well, if you can’t beat em, join em and at least get some benefit from the cash economy’.

The effects of previously compliant taxpayers converting to avoiders/evaders can have disastrous long-term consequences due to the ‘catastrophe effect’ and the ‘inertia theory’.  The catastrophe theory suggests an initial decrease in the audit rate can result in a catastrophic increase in evasion.  The initial increase in evasion decreases the effectiveness/output of future audits, thereby further increasing evasion, which further decreases the effectiveness/output of future audits, etc.[26]

The inertia theory asserts that after an individual routinely engages in a given practice, he has little incentive to change.  This applies to both compliant and non-compliant behavior.  The danger for the ATO is that if it does not maintain public confidence previous compliant taxpayers may convert to non-compliers and then their behavior may be very hard to change. [27]

To maintain public confidence and respect for the tax system, the ATO has to be seen to be focusing on the cash economy. The general community must see that a deliberate practice of non-compliance does not create a significant and unfair commercial advantage but is met by an effective, forceful, timely and importantly a public, response from the ATO.[28]  A strong enforcement program, by deterring evasion, ensures that the tax burden is spread more equally and reassures honest taxpayers that their honesty is not misplaced. [29]

 

Will GST help or hinder the cash economy?


Overseas Experience:


Overseas experience clearly indicates that the introduction of a GST contributes to the growth of the cash economy.[30]  In fact, in Canada studies revealed “a substantial increase in the underground economy since the introduction of the GST.  The underreporting of income means not only GST revenue is lost, but also associated income tax”.[31]  It has even been suggested the Canadian cash economy has more than doubled since the introduction of the GST.[32] 

According to Ray Regan, the President of the National Taxation and Accountants Association (NTAA), reports have confirmed the growth of the cash economy upon introduction of the GST in England, Italy and Israel.[33]  Research in the United Kingdom also found that more than one in three British consumers regularly negotiate cash deals to avoid GST.  Further, 70% did not consider it ‘morally wrong’ to pay a trader in cash in order to avoid the GST.[34] 

European Commission Economists also report that the Black Economy is growing.[35]  Estimates of VAT evasion range from 2-4% in the UK to 40% in Italy.[36]

The ‘evidence overwhelmingly suggests that GST increases the degree of cheating’.[37]  Particularly, in the area of home repair and renovation, where the suppliers labour is a large proportion of the cost.  The existence of a GST gives the customers an additional incentive to pay cash and be a party to the tax evasion.[38]

It has been suggested that Australia’s experience should differ from other countries due to the unique principals of the Australian GST Law.[39]  The validity of this claim, and other claims as to the efficiency of GST[40], in combating evasion in the cash economy, will now be examined.

‘Principals’ and ‘Principles’ of Australian GST Law and their effect on the Cash Economy:


When considering whether the postulated unique principals of the Australian GST Law will deter the cash economy, it is necessary to first examine whether there are any unique principals that apply to the cash economy.  An examination of the principals of the Australian GST Law quickly reveals that there are no such unique principals that apply directly to the cash economy.  Businesses that operate within the cash economy are treated akin to all other businesses.  There are no specific provisions that deal with cash payments and it is not illegal to pay or accept cash for goods and services.   Thus it is necessary to examine the general principals of the GST Law and decide whether these principals will have an effect on the cash economy.

Unless  otherwise stated all legislative references hereafter are to A New Tax System (Goods & Services Tax) Act 1999 (‘GST Act’).


Registration Principals:


A taxpayer is required by Division 23-5 to register if they are;
 *carrying on an *enterprise with an *annual turnover that meets the *registration threshold (* terms are defined terms in the Act). 

An enterprise is defined by Section 9-20 to be an activity, or series of activities, done:
a)      in the form of a business; or
b)      in the form of an adventure or concern in the nature of trade; or
c)      …

The registration threshold is defined in Section 23-15 to be (except for non-profit bodies):
a)      $50,000; or
b)      such higher amount as the regulations specify.

Section 23-10 allows a taxpayer to register as long as they are carrying on an enterprise.

The effect of these provisions on all businesses, including those who deal in cash, is that businesses with a turnover (projected or actual) above $50,000 are required to register for GST.  Whereas businesses with a turnover (projected or actual) below $50,000 may choose to register for GST.   

According to section 7-1 GST is payable on *taxable supplies.   ‘Taxable supplies’ are defined by Section 9-5 to be if:
a)      you make the supply for *consideration; and
b)      the supply is made in the course or furtherance of an *enterprise that you *carry on; and
c)      the supply is connected with Australia; and
d)     you are *registered or *required to be registered.
However, the supply is not a *taxable supply to the extent that it is *GST-free or *input taxed.

Section 9-10 further defines ‘supply’ to be ‘any form of supply whatsoever’.

Section 9-15 defines consideration to include ‘ any payment, or any act or forbearance, in connection with a supply of anything;…


The effect of these provisions on all businesses, including those who deal in cash, are that Registered businesses are required to charge 10% (as per 9-70) GST on all supplies of goods and services, that are for consideration, in furtherance of their enterprise (as defined above) and connected with Australia).  It should be noted that a crucial principal of the Australian GST system is that under Section 9-70, the liability to pay the GST to the ATO rests on the supplier, not the customer.  This means, that if a supplier fails to add 10% GST to the value of the goods, he will still be liable for GST on 1/11th of the price.

The definition of consideration is very wide and includes the payment of cash.  As the definition of consideration includes ‘any act’ it is also wide enough to apply to Barter transactions, which are a common feature of the cash economy.

Businesses that do not Register (and are not required to be registered) will not have to charge GST on their goods and services.  It is worth noting that businesses that are not registered are therefore not required to charge GST are able to undercut their competitors by 10%.  Alternatively, they can match their competitors prices but pocket the extra 10%.  This ability is countered to some extent by the input tax credit mechanism.

Input Tax Credit Principals:


Another fundamental principle of the Australian GST Law is that it is designed so as to prevent cascading of tax.  This basically means that the tax is only collected on the final price of the goods or services.  However, tax is collected at each stage of the process and cascading is prevented through the ‘input tax credit’ mechanism.[41]

Under Section 7-5, the amounts of GST and amounts of *input tax credits are set off against each other to arrive at the *net amount. 

As per Section 7-1 (2) ‘entitlements to input tax credits arise on *creditable acquisitions and *creditable importations[42].          


Under Section 11-5, you make a creditable acquisition if:
¨      You acquire a thing for a *creditable purpose,
¨      The supply of the thing to you is a *taxable supply,
¨      You provide, or are liable to provide, *consideration for the supply, and
¨      You are *registered or *required to be registered.

Under Section 11-15 you acquire a thing for a creditable purpose to the extent that you acquire it in *carrying on your enterprise.  However, you do not acquire the thing for a creditable purpose to the extent that the acquisition relates to making of supplies that would be *input taxed or of a private or domestic nature.

Section 29-10(3) specifies that: If you do not hold a *tax invoice… a) the input tax credit …is not attributable to that tax period.

The affect of these provisions on all businesses, including those who operate in cash, are that a registered business can claim input tax credits, which offset its GST amounts, to the extent that it acquires things in the carrying on of its enterprise.  However, the acquisition has to be a taxable supply, that is; the vendor must be registered or required to be registered and must have charged GST on the sale.

A registered business cannot claim an ‘input tax credit’ where the item was purchased for input taxed[43] or private purposes. The words in Section 11-15 ‘to the extent that’, indicate that if a business buys an item partly for creditable and partly not for creditable purposes, it will need to apportion the ‘input tax credits’.  Unlike income tax deductions, ‘input tax credits’ can be claimed for capital purchases.

It goes without saying, that unregistered businesses cannot claim any input tax credits.


Affect of the Registration and Input tax credit principals on the Cash Economy:


The combined effect of the Registration requirements and the Input tax credit mechanism on the cash economy, according to Michael D’ascenzo (ATO) is that many of the businesses operating in the cash economy are below the $50,000 GST registration threshold and are thus not required to register.  However, he believes that there is some incentive for them to register to gain input tax credits.[44]  This was evidenced by the New Zealand experience[45] where 180,000 registrations were expected but 280,000 actually registered.[46] 

The ANTS proposals also state that those that don’t register will at least pay some tax due to the inability to claim their input credits.[47] 

However, the incentive to register, and the tax forgone, if a business does not register is not great where the major business input is labor or profit margins are high.  This has been verified by European and New Zealand experience where it has been found evasion is common in trades such as decorating, carpentry, plumbing and gardening, where taxable inputs are small and value added is high,[48] and where services are provided to householders.[49]  The reason for this is twofold. Firstly, the input tax forgone is only on a minor amount of tools and materials.  Secondly, as householders have no requirement for input tax credits the business is not often requested to provide a tax invoice (as to which, see later).  This as mentioned above, means that a business can undercut its registered competitors or raise its price 10% to match its competitors and pocket the extra.  Thus, any input tax forgone is often more than compensated for by the increased price charged.  It must also noted that many of their inputs may have fallen in price due to the removal of the sales tax previously imbedded in prices.


It is also claimed that taxpayers have an incentive to return their sales in order to claim their input tax credits.[50]  This claim is patently incredulous.  It is equivalent to saying I’ll give you $100 if you give me $50 back.  In addition, most businesses are not so foolhardy as to try to evade all taxes.  Most will choose some fraction of the sales not to report and then claim all of the materials and input tax credits against the reported income.[51]  The Government has accepted that the introduction of the GST will not change this situation.[52]

ABN Principals:


The ABN provisions are not part of the GST Law but are contained in……..  Businesses are not required to obtain an ABN, however under Section…, payers are required to withhold tax at the highest marginal rate from all payments made to a recipient who does not supply an ABN.

Further Section 29-70 specifies that a *tax invoice for a taxable supply must contain an ABN of the entity that issues it.  

***(Validity of Abn requirements)

The effect of these provisions on all businesses, including those who operate in the cash economy, is that a business is only entitled to an input tax credit on acquisitions for which it holds a *tax invoice specifying an ABN.

Affect of the ABN Principals on the Cash Economy:


Michael D’Ascenzo (ATO) points out that GST registered businesses will prefer to deal with ABN registered businesses so they can obtain the tax invoices required to claim input tax credits and do not have to withhold tax from the payment.[53]  According to the Government “the strength of the ABN is that if you want to stay in the black economy you have to stay in it in its entirety”.[54]  However, other countries have found that the quantitative significance of this is not be large.[55]  Any aboveground enterprise would have already demanded invoices from it suppliers for the purpose of income tax substantiation.  Those suppliers determined to stay under-ground would have already devised methods of falsifying invoices.  The only additional requirement will be a false ABN.[56]

A business may simply quote a business name and ABN that it has obtained from the electronic register[57].  Alternatively, it may declare a false ABN and rely on the fact that most payers will not verify the ABN against the electronic register.

Many examples of fictitious invoices are found by ATO auditors.  Examples can range from:
  • the small operator who, when requested to provide an invoice, writes one in an invoice book obtained from the local supermarket, to
  • large scale fraud schemes, such as those recently found in Sydney by the NSW Building & Construction Audit Team (see appendix 1 for full discussion).  In these cases, the operator falsified his own invoices to justify large cash with- drawls that he was using to pay cash wages.

It is believed that the ABN requirements will not rectify the above examples. 

Crack down on Contractors:


It has also been claimed that the ABN laws will prevent people moving into the cash economy by opting out of employment relationships and avoiding withholding taxes.[58]  No further detail is given as to how this might work and it is doubtful that this claim is correct.  To opt out of withholding all a taxpayer need do is apply for an ABN and then quote this to the payer (or as mentioned above, quote a false ABN).  At least under the previous system payments in some high-risk industries[59] were still subject to withholding and/or reporting.   In fact, it has been recognized by the ATO that there will be increased incentive for individuals to become contractors (and obtain an ABN) as no form of withholding will apply.[60]  It is also recognized by the ATO that this can cause serious problems for revenue collections if taxpayers do not put aside money to meet their tax bills.

Self Policing ‘Principle’:


A much heralded ‘principle’ of the GST Law is that it is self-policing. Basically, one firm’s outputs are another firm’s inputs and therefore invoices can be crosschecked between firms.  As explained above, to claim an input tax credit a business must hold a tax invoice obtained from the vendor business.  Thus, a tax auditor can theoretically, cross check the purchase invoices from one firm against the sales invoices from another firm.  This was a common technique used by the recent ATO Audit Project on Sales Tax Computer Fraud.

However, as found in the UK and Asia, this does not work due to the resources required for such detailed checking.[61]  As succinctly put by Neil Brooks ‘most countries do not have the technical capacity of matching information returns collected for one tax base, let alone matching documents from two’.[62] In fact all commentators have one common conclusion – the theoretical self-checking mechanism does not work.[63]

Even where a taxing authority dedicates resources to such intensive cross-checking, such as in the above mentioned project, the mechanism breaks down when invoices are falsified (as discussed above).  Many times an auditor is unable to trace vendor firm, which has given false contact details on the invoice or may not even exist.

 

Tax periods and GST Return Principals:


Under Section 27-5 a taxpayer’s tax periods are each period of 3 months ending on 31 March, 30 June, 30 September or 31 December in any year, except to the extent that:
a)      an election is in force under section 27-10; or
b)      the Commissioner determines otherwise under this division. 

Under Section 27-10 a taxpayer can elect to have monthly tax periods.

Under Section 27-15 the Commissioner must determine the tax periods applicable to a taxpayer to be monthly if;
a)      he is satisfied that their annual turnover meets the tax period turnover threshold  (set by 27-15(3) to be $20 million); or
b)      he is satisfied that they will be carrying on an enterprise for less than three months; or
c)      he is satisfied that they have a history of failing to comply with the tax obligations….

Under Section-5 & 10, a taxpayer who is registered or required to be registered must give the Commissioner a GST return showing the net amount for each tax period on or before the 21st day of the month following the end of the tax period.

The effect of the provisions on all business is self explanatory.  The effect of these provisions on cash economy businesses is that, even if they are not registered, they are required to lodge GST returns as they are *required to register (see above explanation of this term).  Most cash economy businesses will be required to lodge quarterly, however, if the Commissioner is able to satisfy himself as to their delinquency, he may determine that they are required to lodge monthly.

It has been claimed that these provisions equate to an inherent principle of the GST Law - that it enables more accurate data matching.  The ATO claims that “the GST, the alignment of business payments, the establishment of the ABN and the new withholding arrangements will, together, result in more timely receipt of better information and a more comprehensive matching capability for the Tax Office to act upon.[64].


However, enhanced detection ability is unlikely for the following reasons:
  • If the taxpayer is only skimming a small percentage and doing so consistently (see Appendix one for fuller discussion). Comparative ratios across businesses are notoriously inaccurate and, to date, no tax assessment based on such has ever been successful.  They can be used as an indicator for case selection but the success of this will depend on ATO resources available for follow up (as to which, see later).
  • If the taxpayer is operating completely outside the system as there will not be any data to match.
  • Due to lack of ATO resources for such data matching (see Appendix one for fuller discussion).   

Multi-staged tax ‘principle’:


As outlined above, it is a principle of the Australian GST system that GST is not to be cascading.  However, tax is charged on each transaction and cascading is prevented through the input tax credit mechanism.  This is to be compared with the previous Sales Tax regime, where tax was only charged on the last leg of the transaction (usually when a good was sold from the manufacturer to the end user or retailer).

Further, it is claimed that the principle of replacing a tax primarily collected at the manufacturing level with one collected at all levels should decrease the evasion.  This is supposedly because even if one level evades at least some tax is collected at other levels.  However, to the contrary, it has been found that due to the multi-stage aspect of the tax ‘there are many more points in the economy at which scope for fraud exists’.  This is particularly so at the retail level.  Many buyers have no need for invoices so sales may go unrecorded.  If the retailer claims all of the GST paid as an input tax credit against other sales, then all the GST is refunded to the retailer and no GST is collected on the sale.[65]  In fact, if all levels of the chain are evading, the tax lost is simply compounded.


Tax on Cash Income when spent ‘principle’:


A final argument for the GST hindering the cash economy is the principle that those that benefit from the cash economy will now at least be taxed when they spend their cash.[66]  This argument appears reasonable on the surface. However, further analysis reveals its fundamental flaws.  Firstly, this has always been the case as the majority of goods have had hidden sales tax imposed.[67]  Secondly, this argument does not address the social inequity of Mr Salary&Wage Earner who also pays the same amount of tax on goods that he purchases with his after tax income. Thirdly, even if correct, the argument is said to be seriously exaggerated in its impact.[68]


Administrative Factors regarding Australia’s GST Law:


ATO Costs:


The ATO's costs of monitoring GST compliance are also compounded.  According to Patrick Gallagher, Deputy Director ATAX, University of New South Wales, under Sales Tax, 421 taxpayers pay 58% of the Sales Tax.[69]  In contrast it is estimated that over one million taxpayers will be involved in the GST system and most of these will be small businesses.[70]


What changes could the Government make to the GST LAW?


Industry reporting:


Common sense, and statistical studies confirm, that non-compliance is lowest where there is withholding and somewhat greater where there is information reporting.[71]  Further, IRS studies have found that when auditable records are produced (such as a tax invoice with an ABN) but no information is reported to the IRS, non-compliance remains substantial.[72] 

Therefore a possible compliance measure could be to introduce industry reporting.  The PAYG legislation provides for the application of reporting requirements in high-risk industries.  According to D’ascenzo “this will be especially relevant in industries where businesses have significant cash dealings”.[73]  If enabled, this could require payers to provide the ATO with the details of all payments, including the ABN of the supplier.  This would be similar to the previous requirements under the Prescribed Payments (PPS) and Reportable Payments (RPS) Systems. 

The Cash Economy Task Force support this recommendation but stress that it any proposals to extend withholding or reporting systems need to demonstrate that the burden imposed on third parties is justified in terms of the benefits of increased. [74]   It is suggested that the extension of the new PAYG system to industries previously covered by PPS and RPS would not impose considerable compliance costs on these industries.  These industries are accustomed to such reporting and recognize the need for such.  In fact, anecdotal evidence suggests that Industry Bodies, tax agents and taxpayer’s are all concerned about the ‘lack of withholding’ under the new arrangements as they realize that this may make it more difficult for some taxpayers to meet their tax liabilities.


Income Tax Return Recording & Reporting:


A proposal considered by the IRS was a ‘toll charge approach’.  The approach was to require taxpayers to divide their business expenses into cash & cheque payments and declare this information on their tax return.  Further, the taxpayer would also be required to fill in a schedule detailing all the names and addresses (and ABN’s) of those payees which had been paid cash.  If they fail to fill in these details they are not entitled to the tax deduction.[75]

This approach imposes no burden on taxpayers who do not pay cash and not an onerous burden on those that do.  Most importantly, it would have a substantial effect on payers and recipients of cash.  Finally, those that choose to forgo the deduction rather than report the information effectively pay tax for the recipient.[76]

A similar reporting requirement could also be introduced to require businesses to report non-ABN payments.  This information could be cross-checked against remittances to ensure payers are deducting and remitting.

Making payer liable where reasonable suspicion:


In Belgium, the client is made liable for the VAT if workers they employ are not registered.[77]  This is similar to the Australian requirement under Section  12-190 of the A New Tax System (Pay as You Go) Act 1999 that the payer is required to withhold where the payee does not quote an ABN.  The payer is liable to a penalty under section 16-25 equal to the amount they failed to withhold.

The government could take this one step further and enact similar provisions to those enacted to deal with Sales Tax Fraud in the delinquent Computer Industry.  Section 91X of the Sales Tax Assessment Act required a payer to withhold the sales tax component of the purchase price when they purchased Part 7A goods (basically computer goods) from an unaccredited person.  Further section 91X(3) required the payer to take reasonable steps to determine whether the person was accredited.  If a payer failed to take these reasonable steps then they could be made liable for the Sales Tax that should have been deducted.

Such reasonable steps could include verifying the veracity of the business ABN by checking the electronic register.[78]

It may be considered that such provisions would be too onerous for all taxpayers to comply with.  If so, the Government could consider enacting such provisions only in particularly delinquent industries.

Require Pre-printed & Numbered Invoices:


The Belgium government requires hotels, restaurants and cafes to use pre-numbered invoices.  This however may not stop the business failing to fill out an invoice, so in Italy, consumers at restaurants and hotels can be stopped by the police on leaving the premises and asked to show their receipt.  Even this is not foolproof as it has been found that some restauranteers employ “escorts” to accompany patrons to their car and then pocket the receipts.[79] 

It is unlikely that such heavy-handed techniques would be acceptable to the Australian community and as evidenced they are not foolproof anyway.

Provide Incentives for Customers to request receipts:

           
Some countries have considered running lotteries by using customer’s cash transaction receipts or allowing a tax rebate for home expenditure to encourage the obtaining and retaining of receipts.  The Cash Economy Task Force considered that these proposals are not warranted as the ATO does not have a cost-effective way of using such data in a way that would justify the cost to government of providing the incentives.[80]    

Provide Incentives for Customers to Report Information:


A proposal not considered by the Task Force was the offering of rewards to payers of cash who inform the ATO.  This could be a powerful deterrent to some forms of tax evasion.  As stated by Feffer, G “a moonlighting plumber or carpenter would think twice about discounting for cash if he believed the payer might obtain a reward for turning him in”.[81]  Such rewards would only be paid for accurate and verifiable information that warranted investigation.

The ATO already has designed and implemented the infrastructure and technology to handle such information.  It is submitted that the ATO should investigate the viability of this option further.

Householder Reporting


Further to providing incentives for householders to obtain receipts, the Government could take this one step further and make it a mandatory requirement.  Further, in delinquent industries the Government could consider requiring householders to report to the ATO.

As outlined above, the majority of the cash economy evasion occurs in the provision of services to householders.  This was countered to some extent by the previous PPS system that required householders and owner builders to report payments to the ATO.  A similar system could be implemented for the GST

Making Better use of Austrac information:


Currently cash transactions over $10,000 that involve financial institutions are required to be reported to the ATO.  Also, any suspicious transactions under this threshold are also reported. 

Consideration should be given to improving the Austrac facility by:
¨      Lowering the reporting threshold.
¨      Widening the definition of those required to report.[82]
¨      Cross-referencing data with ABN details.
In addition, the people required to report such transaction could be widened.[83]

The Cash Economy Task Force support these options but admit that its feasibility would have to be determined in conjunction with the availability of ATO resources to follow up such information (as to which see later).[84]

Conclusion


This paper has shown that the political fanfare about GST attacking the cash economy is just that – fanfare.  Overseas experience clearly indicates significant growth in their cash economy’s upon the introduction of a GST.  There is nothing unique about the Australian GST Law that is far superior to other countries in terms of its influence on the cash economy.  The ABN, whilst a minor deterrent, is easily falsified.  As explained, there are no particular GST laws that apply to the specifically to the cash economy.   

It has been explained that, despite politician promises to the contrary, the GST will probably increase the cash economy.  This has been reported widely in the Australian media[85].

As also explained in Appendix one, there are administrative measures that the ATO could implement to assist in addressing the cash economy.  These include; integrating business lines, ensuring they have educated and experienced staff and dedicating sufficient resources to the prevention of fraud.  However, as concluded by Appendix one, these measures are not sufficient to fully combat the cash economy.
and the community perceives that the ATO’s does not have the ability to address the problem.  

As community confidence is imperative to the Australian taxation self assessment system and the introduction of the New Tax System and the GST, it is recommended that the Government consider implementing legislative strategies to convince the Australian taxpaying community that they are taking the cash economy problem seriously.  Some viable strategies include legislative amendments to:
¨      Invoke industry reporting requirements,
¨      Introduce tax return reporting requirements,
¨      Provide cash incentives for dob-ins,
¨      Make better use of Austrac data.

It is submitted that until the Government is willing to show that it is taking the cash economy seriously by introducing specific legislation to address it, it will continue to flourish.  After all, in all honesty, who isn’t going to pay cash to secure a 10% better deal?





Appendix 1:

Major compliance risks for Australia:


The major risks for these ‘SME’ businesses have already been identified by the ATO.[86]  Some of these risks apply directly to the cash economy and others are factors that may encourage the business to go ‘underground’.  Some of these factors include:

  • Confusion about obligations.
  • Inadequate record keeping.
  • Poor cash flow planning resulting in inability to remit GST, PAYG(W) and pay PAYG (I). 
  • Non-lodgment of BAS (Business Activity Statement) may lead to escalating debt.
  • Tax Agents many not want to represent these businesses.

The above may result in the following risks for the ATO in relation to cash economy participants:

  • Non-registration for ABN and/or GST
  • Non-remittance of GST & PAYG(W).
  • Non-withholding where there is no ABN.
  • Obtaining an ABN to avoid withholding but not lodging BAS and paying PAYG & GST.
  • Non-disclosed sales/income.
  • Over-claimed expenses/input tax credits.

What does the ATO have planned  & is it enough?


Underlying Philosophies:


The ATO bases its compliance programs on two corporate philosophies being; the Taxpayer’s Charter and the ATO Compliance Model. 

Briefly, the Taxpayer’s Charter recognizes that the Australian Taxation System is based on taxpayers voluntarily complying with the law.  This requires the ATO to take responsibility to assist taxpayers understand their obligations and provide a high level of service. 


The Compliance Model has been designed to complement to Taxpayer’s Charter.  The model recognizes that taxpayer compliance is influenced by many motivating factors including Business, Industry, Sociological, Economic and Psychological (BISEP) factors.  The model proposes a hierarchical approach to compliance that involves:
  • Understanding taxpayer behavior
  • Building community partnerships
  • Increased flexibility in the ATO operations to encourage and support compliance
  • More and escalating regulatory options to enforce compliance.

The Compliance Model indicates that whilst the ATO has an obligation to understand taxpayer behavior, it also has an obligation to enforce compliance. 

GST Audit Work:


GST Audit work is planned to commence in April 2001 (unless fraud is indicated).[87]

It is planned that compliance work will encompass the following strategies:[88]
  • Automated Contact
  • Telephone Contact
  • Advisory Visits
  • Enterprise Registration Checks
  • Sensitive Issue Enquiry’s
  • GST Specific Check
  • GST Review
  • Comprehensive Audit
  • Fraud Investigation

The above tactics are a clear example of the Taxpayer’s Charter and the Compliance Model at work.  Initial contact will be ‘gentle’, i.e.; by letter or phone.  Some taxpayers may voluntarily comply after this initial contact.  For others, an Advisory Visit or Specific Check may have to be undertaken.  However, if these do not get the taxpayer back on track, contact is escalated to a Review, Audit or Investigation.

Will these Audit Strategies deter the Cash Economy?


It would be expected that those that are not complying due to lack of understanding, lack of bookwork ability, or perhaps a degree of ‘liaise fare’ would respond well to the initial contacts.  However, it must be recognized that there is a degree of deliberate evasion that these contacts will not address.  This can be broken up into two main elements:
i)                    The deliberate skimming of a small percentage of the top by otherwise compliant taxpayers, and
ii)                  Deliberate Evasion by non-compliant taxpayers.

The ATO’s Cash Economy Project, in particular the Building & Construction Project, has been focusing on these two areas for some time now with mixed success.

Skimming off the top:


The first issue has been addressed primarily through increased presence within the industry and increased coverage with ‘Real time reviews’.   This issue is particularly hard for the ATO to address.  Such cash transactions are rarely detected in the audit process and they are inherently difficult to quantify.[89]  Industry Ratios and Costs of Living can be analyzed to determine whether the taxpayer is returning adequate income.  But at the end of the day, if the taxpayer is only taking a small amount of the top and spending it on untraceable items, cash income is impossible to prove.  As an Auditor, I have been faced with the situation of a taxpayer saying “Yes, of course I take cash.  Everyone does.  I spend it on grog and food.  I have no idea how much, could be a couple of hundred to a couple of thousand.  I don’t keep a record of it”.  What could I do, but thank him for his honesty, tell him not to do it again and close the file.

Calculated across the economy, this ‘small’ evasion represents a huge loss to the revenue.[90]  However, the ATO needs to consider whether it is cost effective to commit the intensive resources required to address this type of evasion.  A similar situation exists in London where the authorities deliberately turn a blind eye to restaurateurs operating on a cash basis.[91]

However, as explained earlier, the ATO needs to maintain a presence and give the impression that it is still focusing on this area to deter this type of evasion from escalating.  However if the ATO and the Government, are serious about addressing this, they should consider introducing additional measures which will be discussed later.

Deliberate Evasion:


In relation to the cash economy, deliberate evasion can be evidenced in various ways, from the tradesman who remains completely out of the system, to structured and systematic fraud. 

In fact, it has been suggested that there are taxpayers with experience in VAT frauds who enter countries upon introduction of the GST with the sole intention of committing GST fraud.[92]  The first major GST frauds in New Zealand were detected within seven months of commencement and involved sums in excess of $4million.  These frauds are committed in a very similar way to the evasion found in the ‘Bodgie’ schemes in Australia recently. 

The ‘Bodgie’ schemes are predominantly being undertaken by Irishmen who enter the country with the sole intention of committing fraud.  These schemes have already netted the entrepreneurs with ‘tens of millions of dollars’[93].  The schemes involve pocketing the PAYE & PPS taxes that should otherwise be remitted to the ATO. 

Phoenix’s are a similar scheme which involve escalating the taxes due payable to the ATO and liquidating at the first sign of ATO suspicion.  The ATO recently detected phoenix companies defrauding the revenue by more than $100 million.[94]

Other schemes are even more blatant and simply involve paying workers and suppliers cash in hand and failing to deduct and or remit the taxes.  Schemes of this nature are reported to be evading taxes of up to $50 million in the NSW Construction Industry alone.[95]

All of these schemes may become even more prevalent under GST as the evasion simply becomes 10% more profitable.

What is the ATO doing to deter Deliberate Evasion?


The ATO has been undertaking substantial work in the area of ‘Serious Non Compliance Re-engineering’ and has reviewed overseas best practice as part of the LB&I ‘Optimizing the Basics’ Project.[96]  The Project is attempting to improve the ATO’s capacity to address serious evasion.  .[97]  It has been recognized that the ATO’s traditional response can be very time consuming, resource intensive and with no certainty of a successful outcome.  The ATO also only has very limited resources devoted to dealing with serious evasion.[98]  The Project recognizes that the most crucial factor in addressing such evasion is adequate resources. This will be elaborated on later.

What else could the ATO do?


Integrate business lines:


As outlined above, it is claimed that increased and more timely reporting of information to the ATO will enhance the ATO’s ability to match this data and detect and action anomalies.  As also pointed out above this depends on the ATO’s ability and resources.  It is submitted that the ATO should, as soon as practically possible, integrate the GST and the Small Business Lines.  Other countries have recognized the importance of linking the administration of VAT to other taxes.[99]  The importance of VAT enforcement having joint controls and audits with income tax was pointed out to the Government by the GST Senate Committee.[100]

Whilst, the business lines remain separate, it remains very hard to expect enforcement officers to understand, audit and cross match both GST and Income Tax.  It is further submitted, that it is not until enforcement officers fully understand both taxes, that they will be able to fully detect anomalies.

Educated & Experienced Staff:


Experience in overseas countries has shown that Fraud Investigation is a very important factor in creating a climate of self-compliance.[101]   

Many overseas countries (such as the European Union, Indonesia and Asia) realized that the lack of experienced officers was a significant problem in dealing with VAT fraud.  To combat this problem they felt it was essential to establish expertise in all areas of auditing, from accountants through to solicitors[102].  Each inspector is fully trained in accounting, taxation, criminal law and information gathering.[103]

Further, in China the inspectors are put through very rigid and thorough training programs involving examinations, prizes and awards for outstanding achievement.  Any inspectors failing the program were not allowed to enforce VAT.

Further, that it was most efficient to have all of these experienced officers stationed within special investigative units.[104]

This is obviously very difficult in the current economic climate due to the shortage of skilled accountants and bookkeepers.  The ATO is also severely hampered by the current industrial awards governing the public service.  In an ideal world, the ATO would be able to recruit qualified Accountants, Auditors and Solicitors and pay them a wage commensurate with their worth.  The ATO would then have some chance of detecting, auditing and proving very elaborate fraud schemes.

In the meantime however, the ATO needs to ensure that its Audit staff is fully trained in all aspects of Accounting, Auditing and Taxation (including both Income Taxation and GST as outlined above).  It is noted that to date the GST line have been intent on recruiting people with a high level of people and communication skills.  Whilst it is accepted that this is valid for the educative phase of the implementation, the ATO now needs to recruit experienced accountants and auditors.  This is not to say that Accountants and Auditors do not have people skills but that the ATO needs to recruit people with the appropriate balance of both aspects.  

Enough Resources Dedicated to Fraud Detection:


It has been found that an individual’s decision to pay or evade tax “depends upon his attitude toward risk taking, his perception of the morality of the tax, and his perception of the probability of detection”. [105]  Jenkins & Forlemu suggest that taxpayers will continuously attempt to evade taxes whenever the benefits from tax evasion outweigh the risk of detection and punishment.[106]  Studies have also shown that compliance varies directly with changes in the audit rate. [107]

The above findings indicate that a taxpayer’s perception of the audit rate directly influences his ‘voluntary compliance’.  Many taxpayers’ view evasion as a ‘game’ in which the less likely they are to get caught the more they are willing to evade.[108] 

It is accepted that, the majority of the ATO’s resources have been dedicated to implementation and education.[109]  However, as outlined by the New Zealand experience (see above) the ATO needs to recognize that GST Frauds will start from day one.  The ATO needs to consider allocating more resources to GST enforcement to, at least, give the impression of an audit presence.

Is it enough?


A common thread running through all of the above suggestions is that the effectiveness of these measures is determinant upon the ATO having adequate experienced, educated and competent staff to detect and action anomalies in a timely manner.  There currently exists a growing awareness of the ATO’s lack of ability in this regard.[110] 
This paper has therefore focused on other strategies that the Government could do to combat the cash economy.


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[1] Parliament of Australia: Senate Committee: GST Main Report. http://www.aph.gov.au/senate/committee/gst/main/chapt16a.htm
[2] ‘Tax reform: not a new tax, a new tax system.  Authorised by the Hon. Peter Costello, MP, Commonwealth Treasurer.  Fact Sheet No:140.  Canprint Communications.  Canberra.
[3] Parliament of Australia: Senate Committee: GST Main Report. http://www.aph.gov.au/senate/committee/gst/main/chaptr14.htm
[4] Parliament of Australia: Senate Committee: GST Main Report. http://www.aph.gov.au/senate/committee/gst/main/chapt16.htm
[5] Smith P, ‘Assessing the Size of the Underground Economy: The Statistics Canada Perspective’, Canadian Economic Observer, Statistics Canada Catalogue (May 1994), no. 11-010, 3.16-33, at 3.18.
[6] Spiro P, ‘Evidence of a Post-GST Increase in the Underground Economy’.  Canadian Tax Journal, (1993), Vol 41, No.2. 
[7] Improving Tax Compliance in the Cash Economy.  Background Research.  http://atoassist/general/business/cashecon/compliance/htm
[8] ‘Tax Reform: Let there be no half measures’.  Taxation Institute of Australia.  Volume No 1, No 4, April 1998, pg 192.  Blondell J, ‘Black Art’, Charter, April 1998, pg20.  Cole A. ‘Why GST is good news for the Cash Economy’.  BRW.  June 23, 2000, pg 71.
[9] GST Compliance Management.  ‘Compliance Compendium’, chapter 1, Part B: Risk Analysis.  http://atoconnect/gst/OrgStrat/Content/ComplianceCompendium/GSTComplyPartB.htm
[10] The S&ME sector is defined, for the purposes of this paper, as enterprises with a Total Business Income (TBI) between Nil and $10m
[11] Hill R & Kabir M, ‘Tax Rates, the Tax Mix, and the growth of the underground Economy in Canada: What can we infer?’  (1996), Canadian Tax Journal.  Canadian Tax Foundation. Vol 44, No 6.
[12] Aust, Reform in the Australian Tax System. (Draft White Paper.) (Canberra. AGPS, 1985)
[13] Media Release 97/19  ‘Tax Office Responds to Task Force Report on Cash Economy’.
[14] Improving Tax Compliance in the Cash Economy.  Cash Economy Task Force Report.  12 May 1997.  Pg 12.
[15] Andreoni, Erard and Feinstein, 1998:820 in D’ascenzo M, (ATO), ‘Y2K relationships – the ATO and you post 2000’.  Taxation in Australia.  Volume 34, No 8, February 2000.
[16] See Generally, Wentworth DK & Rickel AU, ‘Determinants of Tax Evasion and Compliance’, (1985) 3 Behavioral Sciences and the Law.  455-466 at 463.
[17] See Generally, I Wallschutzky.  ‘Possible causes of Tax Avoidance and Tax Evasion’.  Unpublished PhD Thesis, University of Bath 1983.
[18] See Generally , Casanegra de Jantscher M, “Types of Tax Non-Compliance”.  (paper presented at the XVI General Assembly of the Inter-american Centre of Tax Administrators, Asuncion, Paraguay, 1982.)
[19] See Generally, Wentworth DK & Rickel AU, ‘Determinants of Tax Evasion and Compliance’, (1985) 3 Behavioral Sciences and the Law.  455-466 at 463.
[20] See Generally, Henderson, WT Jr, ‘Criminal Liability under the Internal Revenue Code: A Proposal to make the Voluntary Compliance System a Little less Voluntary’. (1992) 140. University of Pennslyvania Law Review.  1429-1461
[21] See Generally , Casanegra de Jantscher M, “Types of Tax Non-Compliance”.  (paper presented at the XVI General Assembly of the Inter-american Centre of Tax Administrators, Asuncion, Paraguay, 1982.)
[22] Serious Non Compliance Re-engineering Report. (Draft) ATO. Version 11, Jan 2000, pg 8.
[23] Ibid.
[24] Tanzi V & Shome P,  “A Primer on Tax Evasion”,   Bulletin for International Fiscal Documentation, IBFD, vol 48, no6/7 1994. 328-336
[25] Blondell J, ‘Black Art’, Charter, April 1998, pg20.  Media Release 97/19  ‘Tax Office Responds to Task Force Report on Cash Economy’.
[26] Boyd CW, ‘The Enforcement of Tax Compliance: Some Theoretical Issues’, (1986) 34. Canadian Tax Journal.  588-599 at 590.
[27] Jenkins GP & Forlemu E, ‘Enhancing Voluntary Compliance by Reducing Compliance Costs: A Taxpayer Service Approach’, (unpublished) International Tax Program, Harvard University, 1993. 1-31.
[28] Serious Non Compliance Re-engineering Report. (Draft) ATO. Version 11, Jan 2000, pg 8.
[29] Melia RM, “Is the Pen Mightier than the Audit?”.  (1987) 34. Tax Notes 1309.
[30] Hill R & Kabir M, ‘Tax Rates, the Tax Mix, and the growth of the underground Economy in Canada: What can we infer?’  (1996), Canadian Tax Journal.  Canadian Tax Foundation. Vol 44, No 6.
[31] Spiro P, ‘Evidence of a Post-GST Increase in the Underground Economy’.  Canadian Tax Journal, (1993), Vol 41, No.2,
[32] Cole A. ‘Why GST is good news for the Cash Economy’.  BRW.  June 23, 2000, pg 71.
[33] Parliament of Australia: Senate Committee: GST Main Report. http://www.aph.gov.au/senate/committee/gst/main/chaptr14.htm pg3.
[34] Tait A, ‘Evasion, Enforcement and Penalties’.  Value Added Tax.  International Practice and Problems.  (IMF, Washington, 1988, pg 304).
[35] ‘A fairer tax system with no GST’.  Labors Approach to Tax reform.  Labor Government.  (Canberra: 1998, pg 57)
[36] Tait A, ‘Evasion, Enforcement and Penalties’.  Value Added Tax.  International Practice and Problems.  (IMF, Washington, 1988, pg 304).
[37] ‘GST Adding to the Underground Economy’, The Toronto Star, August 19, 1991.
[38] Spiro P, ‘Evidence of a Post-GST Increase in the Underground Economy’.  Canadian Tax Journal, (1993), Vol 41, No.2.
[39] Parliament of Australia: Senate Committee: GST Main Report. http://www.aph.gov.au/senate/committee/gst/main/chaptr14.htm pg3.
[40] D’ascenzo M, (ATO), ‘Y2K relationships – the ATO and you post 2000’.  Taxation in Australia.  Volume 34, No 8, February 2000.
[41] Except for input taxed supplies that are provided to a business that later charges GST.  Effectively, GST will be charged on GST in these cases.
[42] Due to tight customs regulations over imports, Creditable importations are not a common aspect of the cash economy and will not be discussed further.
[43] Supplies that are input taxed are defined in Section 9-39 as to be supplies that are input taxed under Division 40…These include; financial supplies (40-5), residential rent (40-35), sales of residential premises (40-65), supplies of residential premises by way of long term lease (40-70), precious metals (40-100) and school tuckshops and canteens (40-130).  These activities are not considered relevant to the cash economy and therefore *input taxed supplies will not be discussed any further.

[44] D’ascenzo M, (ATO), ‘Y2K relationships – the ATO and you post 2000’.  Taxation in Australia.  Volume 34, No 8, February 2000, pg 427.
[45] Ryan A, ‘Compliance Issues’. Business Essentials, ASCPA, Sep 1998.
[46] It has also been argued that this was due to charities and other small organization rather than black market businesses.  Stephens RJ, ‘New Zealand Tax Reform’, in Australian Tax Reform in Retrospect and Prospect.  Head, JG (ed)  Australian Tax Research Foundation.  Conference Series: No 8.  (Melbourne: 1989, pg 85).
[47] ‘Tax reform: not a new tax, a new tax system.  Authorised by the Hon. Peter Costello, MP, Commonwealth Treasurer.  Fact Sheet No:140.  Canprint Communications.  Canberra.
[48] Tait A, ‘Evasion, Enforcement and Penalties’.  Value Added Tax.  International Practice and Problems.  (IMF, Washington, 1988, pg 304).
[49] Chapman, R.  ‘GST: The New Zealand experience’.  Charter, April 1998, pg 28.
[50] Spiro P, ‘Evidence of a Post-GST Increase in the Underground Economy’.  Canadian Tax Journal, (1993), Vol 41, No.2
[51] Ibid.
[52] Parliament of Australia: Senate Committee: GST Main Report. http://www.aph.gov.au/senate/committee/gst/main/chapt14.htm pg 4.
[53] D’ascenzo M, (ATO), ‘Y2K relationships – the ATO and you post 2000’.  Taxation in Australia.  Volume 34, No 8, February 2000, pg 427.
[54] Parliament of Australia: Senate Committee: GST Main Report. http://www.aph.gov.au/senate/committee/gst/main/chapt14.htm
[55] Spiro P, ‘Evidence of a Post-GST Increase in the Underground Economy’.  Canadian Tax Journal, (1993), Vol 41, No.2.
[56] A supplier can fake an ABN by quoting another businesses’ ABN or simply pluck a number out of the air.  There is currently no requirement on the payer to determine the validity of the ABN.
[57] www.abr.business.gov.au or phoning 13 72 26
[58] Parliament of Australia: Senate Committee: GST Main Report. http://www.aph.gov.au/senate/committee/gst/main/chapt14.htm
[59] Those industries covered by Prescribed Payments System (PPS) & Reportable Payments System (RPS).
[60] SB Compliance Risk Analysis.  Building & Construction Industry.  Compliance Management Integration Forum.  Nov 99.
[61] Sanford C, ‘Value-Added Tax – United Kingdom Experience’.  In Changing the Tax Mix.  Head, JG (ed).  Australian Txa Research Foundation.  Conference Series No 6.  (Sydney: 1986, pg 250).  Yoingco A, et al, ‘The VAT experience in the Philippines’ Asian-Pacific Tax & Investment Research Centre.  (Manila: 1988, pg 78).
[62] Brooks N, ‘The Canadian Goods & Services Tax: History, Policy and Politics’.  Australian Tax Research Foundation, Research Study No: 16, Public sector Management Institute, 1998).
[63] Tait A, ‘Evasion, Enforcement and Penalties’.  Value Added Tax.  International Practice and Problems.  (IMF, Washington, 1988, pg 304).
& Sanford C, ‘Value-Added Tax – United Kingdom Experience’.  In Changing the Tax Mix.  Head, JG (ed).  Australian Txa Research Foundation.  Conference Series No 6.  (Sydney: 1986, pg 250).  Ridwan M, et al, ‘The VAT Experience in Indonesia’, in Yoingco A, et al, ‘The VAT experience in Asia’ Asian-Pacific Tax & Investment Research Centre.  (Manila: 1988, pg 78).
[64] ANTS, Chapter 4, pg 150.
[65] Brooks N, ‘The Canadian Goods and Services Tax:  History, Policy and Politics’.  Australian Tax research Foundation.  Research Study No.16.  (1992)
[66] GST: Myths, Lies and Tax Reform.  Institute of Chartered Accountants in Australia,  Pg3.
[67] With the obvious exemptions of staple food, basic clothing, etc.
[68] Bascand, G ‘Implications of Alternative Tax Bases’ in in Australian Tax Reform in Retrospect and Prospect.  Head, JG (ed)  Australian Tax Research Foundation.  Conference Series: No 8.  (Melbourne: 1989, pg 275).
[69] On 1996/97 figures. 
[70] Gallagher, P. ‘Not a new tax…compliance and costs and GST’.  http://www.ozemail.com.au/~bwrees/gst-rep1.htm
[71] Feffer G, et al, ‘Proposals to Deter and Detect the Underground Cash Economy.  Income Tax Compliance, pg 295.
[72] Ibid.
[73] D’ascenzo M, (ATO), ‘Y2K relationships – the ATO and you post 2000’.  Taxation in Australia.  Volume 34, No 8, February 2000, pg 427.
[74] Improving Tax Compliance in the Cash Economy.  Report, April 1998.  Cash Economy Task Force. (Canberra: 1998).
[75] Feffer G, et al, ‘Proposals to Deter and Detect the Underground Cash Economy.  Income Tax Compliance, pg 300.
[76] Ibid.
[77] Tait A, ‘Evasion, Enforcement and Penalties’.  Value Added Tax.  International Practice and Problems.  (IMF, Washington, 1988, pg 304).
[78] Above note 53.
[79] Tait A, ‘Evasion, Enforcement and Penalties’.  Value Added Tax.  International Practice and Problems.  (IMF, Washington, 1988, pg 304).
[80] Improving Tax Compliance in the Cash Economy.  Report, April 1998.  Cash Economy Task Force. Recommendation 4.10. (Canberra: 1998).
[81] Feffer G, et al, ‘Proposals to Deter and Detect the Underground Cash Economy.  Income Tax Compliance, pg 302.
[82] For example, include any merchant or person providing goods or services or perhaps high risk categories such as bookmakers and travel agents.
[83] Burgess, V. ‘Call to use ABN’s to Detect Crime’.  The Canberra Times.   September 2,2000.
[84] Improving Tax Compliance in the Cash Economy.  Report, April 1998.  Cash Economy Task Force. Recommendation 5.2.  (Canberra: 1998).
[85] Walsh, K. ‘Can GST kill the Cash Economy’.  The Sunday Telegraph.  June 4, 2000.  Crossley, P.  ‘Why GST is Good News for the Black Economy’.  Business Review weekly.  June 23, 2000, pg 68.
[86] See generally, SB Compliance Risk Analysis – Summary Report. Compliance Management Integration Forum, October 1999.
[87] D’ascenzo M, (ATO), ‘Y2K relationships – the ATO and you post 2000’.  Taxation in Australia.  Volume 34, No 8, February 2000.
[88] GST Compliance Management.  ‘Compliance Compendium’, chapter 1, Part D: Compliance Strategies.  http://atoconnect/gst/OrgStrat/Content/ComplianceCompendium/GSTComplyPartD.htm
[89] Feffer G, et al, ‘Proposals to Deter and Detect the Underground Cash Economy.  Income Tax Compliance, pg 293.
[90] Spiro P, ‘Evidence of a Post-GST Increase in the Underground Economy’.  Canadian Tax Journal, (1993), Vol 41, No.2.
[91] Cole A. ‘Why GST is good news for the Cash Economy’.  BRW.  June 23, 2000, pg 71.
[92] Latimer N, ‘GST Fraud: the New Zealand Experience’.  Inland Revenue.
[93] ‘The Bodgie – Five Irishmen face charges over bodgie scam’.  The Irish Echo, October 6, 1999.  Hepworth, A. ‘Crime Authorities crack down on budding bodgie’. Financial Review. 2 October 1999.  ‘Bodgie Bubble had to burst’.  The Irsih Echo. October 7, 1999.  Baird, J. ‘Five charged on building labour fraud’. Sydney Morning Herald. 1 Ovtober 1999.  ‘Irish face tax fraud charges’.  Sydney Telegraph. 1 October 1999. 
[94] Chandler, M. ‘ATO swoop on builders after missing $100m.  Financial Review, 25 November 1999. 
[95] Humphries, D. ‘Cash in hand tax blitz’.  The Sydney Morning Herald.  August 17, 1999.
[96] Serious Non Compliance Re-engineering Report. (Draft) ATO. Version 11, Jan 2000, pg 16.
[97] Serious Non Compliance Re-engineering Report. (Draft) ATO. Version 11, Jan 2000, pg 4.
[98] Ibid.
[99] Yoingco A, et al, ‘The VAT experience in Asia’ Asian-Pacific Tax & Investment Research Centre.  (Manila: 1988, pg 17).
[100] Parliament of Australia: Senat eCommittee: GST Main Report. http://www.aph.gov.au/senate/committee/gst/main/chapt16a.htm
[101] Yoingco A, et al, ‘The VAT experience in Asia’ Asian-Pacific Tax & Investment Research Centre.  (Manila: 1988, pg 35).
[102] Yen cc, et al, ‘The VAT Experience in the Republic of China (Taiwan)’ in Yoingco A, et al, ‘The VAT experience in Asia’ Asian-Pacific Tax & Investment Research Centre.  (Manila: 1988, pg 48).
[103] Yoingco A, et al, ‘The VAT experience in Asia’ Asian-Pacific Tax & Investment Research Centre.  (Manila: 1988, pg 36).  Ridwan M, et al, ‘The VAT Experience in Indonesia’, in Yoingco A, et al, ‘The VAT experience in Asia’ Asian-Pacific Tax & Investment Research Centre.  (Manila: 1988, pg 78).
[104] Aronowitz AA, et al, ‘Value-Added Tax Fraud in the European Union’.  (Kugler Publications. Amsterdam, 1996). 
[105] Boyd CW, ‘The Enforcement of Tax Compliance: Some Theoretical Issues’, (1986) 34. Canadian Tax Journal.  588-599 at 590
[106] Jenkins GP & Forlemu E, ‘Enhancing Voluntary Compliance by Reducing Compliance Costs: A Taxpayer Service Approach’, (unpublished) International Tax Program, Harvard University, 1993. 1-31.
[107] Alm J, Jackson BR & McKee M, ‘Estimating the Determinants of Taxpayer Compliance with Experimental Data’, (1992) 45. National Tax Journal.107-114.
[108] Tanzi V & Shome P,  “A Primer on Tax Evasion”,   Bulletin for International Fiscal Documentation, IBFD, vol 48, no6/7 1994. 328-336
[109] D’ascenzo M, (ATO), ‘Y2K relationships – the ATO and you post 2000’.  Taxation in Australia.  Volume 34, No 8, February 2000, pg 423.

[110] Grbich, Y. ‘After Bellinz and Ralph – A New Focus for Decision Making in the Australian Tax System’.  UNSW, Sep 2000.    Bannon, M. ‘Deluge of reform proves taxing for accountants and businesses’.  The Canberra Times.  May 20, 2000. 

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