Henry Report

Whatever pleasure or reward you might derive from the activity yourself, there is always the risk that the elephant might roll over and squash you in the middle of the night.

Even if you managed to pleasure the elephant for a while as well.

When a government goes to bed with an Adviser, the government derives some credibility from the perceived taste of its choice of bedfellow. Hence, some fleeting pleasure.

However, it's very easy for the bedfellow to be emasculated by the endeavour.

The Adviser's role is to suggest and propose and, perhaps, to seduce.

However, the government, faced with a never-ending choice of Advisers and suitors, has the enviable prerogative to either recline or decline.

High Level Review

The Henry Report was intended to be, and did end up being, a high level review of the tax system.

However, when you ascend to this height, you inevitably confront the ideological foundations of the tax system.

Thus, the driving force of the Henry recommendations is issues like fairness and efficiency.

Fairness

The fairness issue ends up being a grab bag of issues founded on the principle that you are being treated more favourably than me.

Thus, the issue risks getting tied up in the politics of envy.

Efficiency

The efficiency issue uses the language of business, but ultimately it is driven by a bureaucratic desire to extract as much tax as possible with as little effort as possible.

The efficiency issue, therefore, is likely to have little appeal to individual taxpayers (except to the extent that it results in someone else paying more tax, but not me).

Implications for Business Succession Planning

The following comments focus on the implications of the Henry Report (and the Government's responses) for Business Succession Planning.

Increase in Employer Superannuation Contributions

It is proposed that employer contributions increase from 9% to 12% over time.

Government Response

The government has decided to implement this proposal.

Implications

This proposal was designed to result in greater funds in the superannuation environment.

When combined with a lower rate of tax payable by the Super Fund, it will increase the amount of superannuation available to fund retirement benefits in the long-term.

However, it will increase the wages cost and therefore the capital value of business.

The proposal will be introduced progressively at 0.5% per annum.

Businesses should be able to take this additional remuneration into account when determining the amount of cost of living increases to wages and salaries.

Reduction in Corporate Tax Rate

It is proposed that the corporate tax rate reduce from 30% to 28%.

Government Response

The government has decided to implement this proposal in two steps.

Implications

Theoretically, this means that the net value of companies will increase over time, because of their ability to retain higher levels of earnings.

However, the increase in retained earnings must be offset by the additional cost of staff as a result of the increase in Employer Superannuation Contributions.

To the extent that the marginal tax rates of shareholders remain the same, the reduction of the corporate tax rate will have little impact on the total amount of tax paid collectively by the company and its shareholders.

If the corporate rate is reduced, the franking credit will be reduced.

Therefore, to the extent that after-tax profits are distributed as dividends, the shareholders simply end up paying a higher level of tax after allowance for the franking credit.

In a sense, this initiative really only alters the timing of payment of the tax, not the collective amount of tax.

Subject to these comments, the initiative could encourage people to embrace a corporate structure for their business, rather than use a Sole Trader, Partnership or Trust structure.

However, the perceived savings could be illusory, unless the business is dependent on retained earnings for working capital.

In the case of a Company, the retained earnings will only attract the corporate tax rate, until they are eventually distributed to the Shareholders as dividends.

Hwever, in the case of the other business structures, the total profits must be distributed out (at which point they are taxed at marginal rates) and then borrowed back in by way of Loan Accounts.

Capital Gains Tax

It is proposed that the 50% CGT concession be removed.

Government Response

In the interests of business and community certainty, the Government has advised that it will not implement the proposal to reduce the CGT discount at any stage.

However, the detailed wording of this advice refers to Recommendations 14 and 17(c), which are about different issues.

Thus, it is not yet 100% certain that this proposal has been ruled out.

Implications

This proposal will result in higher CGT liabilities where there are no other applicable exemptions.

The rationale of the proposal partly depends on the following initiative with respect to a Savings Income Discount, so it is likely that the two proposals would be considered as a package.

40% Savings Income Discount

It is proposed that income from capital that has already beeen taxed as income receive a concessional treatment when it is re-invested in some form.

Thus, it is proposed that there be a 40% reduction in the tax applicable to income derived from re-invested capital.

Government Response

The government has not decided to implement this proposal yet.

However, equally, it has not ruled it out.

Implications

The proposal will apply to capital gains derived from the reinvestment of the capital.

Thus, it would partly counteract the removal of the 50% CGT concession.

Income from Own Business

It appears that the proposal is not intended to apply to investment in the taxpayer's own business.

Thus, reinvestment in your own business would receive a less favourable tax treatment than investment in a public company or someone else's business.

The rationale is the desire to treat personal services income the same across different taxpayers.

If the owner of the business receives a dividend or distribution, then the proposal seems to be that it should be treated the same as a wage or salary paid to the individual taxpayer.

However, the proposal ignores the fact that some of the dividend or profit payable by the business might be attributable to sources other than the taxpayer's own labour (e.g., the profit generated by staff, intellectual property or the sale of goods).

If the individual taxpayer is already being paid a market salary for their services, then presumably all of the dividend or distribution is attributable to business profit.

Personal Services Income from Own Business

It is proposed that income effectively derived by a business from the labour of its owner/managers be treated as personal income of the owner/managers.

This would remove the ability to pay tax at the corporate rate and retain the profits in the company (pending subsequent distribution of a dividend to the shareholders).

Again, this initiative really only alters the timing of payment of the tax, not the collective amount of tax.

Government Response

The government has not decided to implement this proposal yet.

However, equally, it has not ruled it out.

Implications

The proposal is consistent with the ATO's long-term desire to tax personal services income in the hands of the individual who performs the service.

This is a highly contentious issue.

It could be minimised if the company and individual tax rates were much closer (e.g., if the top marginal tax rate was much closer to the company tax rate).

Bequest Tax

The Report raises the spectre of a bequest tax.

This is a euphemism for a Death Duty.

The Report does not go as far as recommending the new tax.

However, it wishes to promote further study and community discussion of the options.

Government Response

In the interests of business and community certainty, the Government has advised that it will not implement the proposal to introduce a bequests tax (Recommendation 25) at any stage.

Implications

The rationale for this proposal is that people who inherit wealth from their family should pay tax at the same rate as people who earn the same amount of income from their own labour.

This argument seems to be inconsistent with the rationale of the 40% Savings Income Discount proposal.

However, it also seems to ignore the difference between capital and income.

If my parents have accumulated capital, they will normally be expected to have paid the appropriate income and capital gains tax on the capital.

If they lived, any income from their capital would presumably be subject to the 40% Savings Income Discount.

However, if they died, it is proposed that their beneficiaries pay tax not just on the income from the capital, but on the capital itself.

Rather than treating income equally, this proposal treats the capital of taxpayers differently, according to whether they lived, or died and passed their wealth onto their beneficiaries.

Insurance Strategies

If any form of bequest tax is introduced, it will encourage the utilisation of insurance as a strategy to fund the anticipated tax liability without requiring any assets of the estate to be sold.

Cap on Annual Contributions

It is proposed that the cap on annual contributions be $25,000 (or $50,000 for people aged 50 or over).

It is proposed that the cap be indexed.

Government Response

The government has decided to implement this proposal.

After Tax Superannuation Contributions

It is proposed that superannuation contributions be made out of after-tax income.

Government Response

The government has not decided to implement this proposal yet.

However, equally, it has not ruled it out.

Implications

It is proposed that there be a flat-rate refundable tax offset, so that the majority of taxpayers do not pay more than 15% tax on their contributions.

Presumably, this means that contributions by taxpayers on the standard marginal tax rate of 35% would be taxed at no more than 15%.

Thus, the offset would presumably be set at a maximum of 20% (i.e., 35% less 20% = 15%).

However, because the discussion is framed in terms of the majority of taxpayers and the standard marginal tax rate of 35%, it is not clear whether the offset would be as great for taxpayers on marginal tax rates higher than 35%.

Thus, if the offset is set at 20%, then taxpayers on a marginal rate of 45% would end up paying 25% (i.e., 45% less 20% = 25%) on the income that they contribute.

This would mean that they are 10% worse off than they are under the current system (after taking into account the 15% tax on contributions payable by the fund).

The rationale of this initiative is to create equity between taxpayers in terms of how much tax benefit they obtain from their contributions.

Non-Concessional Contributions

If all contributions were to be after-tax, then it appears that the distinction between concessional and non-concessional contributions would no longer apply.

Thus, the proposed cap on annual contributions might effectively spell the end of the ability to make additional contributions beyond the cap that was previously applicable to concessional contributions.

This would seriously limit the ability to make substantial catch-up contributions, especially in the case of business owners.

Insurance Cover in Super

This tax treatment would have to be taken into account when considering the relative merits of holding insurance cover inside or outside superannuation.

Currently, to the extent that Insurance Premiums are deductible to the Fund, the contribution to the Fund out of which the Premium is paid is not subject to any tax in the hands of the Taxpayer or the Fund.

The deduction for the expenditure on the Premium is offset against the contribution, thus reducing the amount of the contribution that is subject to contributions tax.

Thus, a Taxpayer effectively obtains a deduction for the Premium.

However, if this proposal is implemented, the contribution will be subject to net tax of 25% in the hands of a Taxpayer on the highest marginal tax rate (or 15% on the standard rate of 35%).

See the comments below about Premiums funded out of the after-tax income of the Fund.

No Taxation of Contributions to Superannuation Funds

It is proposed that contributions not be taxed in the hands of the Superannuation Fund.

Government Response

The government has not decided to implement this proposal yet.

However, equally, it has not ruled it out.

Implications

This proposal means that the Fund would receive the whole of the contribution.

However, subject to the amount of the offset, the total level of contributions might be lower, depending on the cash flow implications of paying contributions out of after-tax income.

Taxation of Income of Superannuation Funds

It is proposed that all income and capital gains of super funds be taxed at 7.5%.

Government Response

The government has not decided to implement this proposal yet.

However, equally, it has not ruled it out.

Implications

This is a 50% reduction of the current income tax rate of 15%.

This will result in higher net funds in the superannuation environment.

Insurance Cover in Super

As mentioned above, if the Insurance Premiums are paid out of the Taxpayer's after-tax contribution to the Fund, then there could be an increased tax liability with respect to these arrangements.

However, if the Premiums are paid out of the after tax income of the Fund, then the effective tax rate could be 7.5%.

However, assuming that the Premium continues to be deductible to the Fund, the Premium would reduce the assessable income of the Fund.

Thus, in effect, Premiums paid out of the after-tax income of the Fund would not have been subject to any income tax liability.

This would preserve the current situation.

However, it would be necessary for the income of the Fund to be high enough to pay the Premium.

The proposed changes would therefore result in a different tax outcome, depending on whether the Premium was paid out of the contribution or the after-tax income of the Fund.

Conclusion

Dr. Henry has given it his best shot.

However, the government was in no mood for a steamy love affair, when the main focus of its attention is seducing a fickle electorate over the next six to nine months.

For the moment, at leats, the elephant has rolled over and declined.

Now Henry has to wait around, licking his wounds and wondering whether he will be vindicated.

Unfortunately, radical reform proposals take 25 years to be implemented.

25 years is a long time to wait for vindication.

Politics is not necessarily concerned with whether a proposal is right.

It usually wants something right now.

Dr. Henry might be Mr. Right.

However, he is not Mr. Right Now.

Adviser Tip

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