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II. Unacceptable Alternatives to the Present System

16.21. It is thus clear that the existing system is in need of reform. Four alternative schemes, all of which have been seriously proposed in various contexts and all involving the outright abolition of one or other of the two taxes now imposed on income arising in companies, have been examined by the Committee. None of them can however be recommended.

Tax the Allocation of Profits

16.22. One system—perhaps the theoretical ideal—would require the company to allocate its annual profits to shareholders in accordance with their interests in those profits, and require shareholders to include the allocations in their incomes. There would be a like allocation of losses.

16.23. ‘Double taxation’ would be avoided, there being no separate company liability for tax. Equity would be served. The tax system would be neutral in all those respects referred to in paragraph 16.20 in which neutrality is at present lacking. In theory, liquidity problems for shareholders could be overcome by the company making cash distributions sufficient to cover personal tax at the maximum marginal rate on the allocation.

16.24. There is scope for such a system where corporate structures are simple enough for the interests of individuals in the company profits to be readily identified. In effect the company is taxed as a partnership. (Proposals enabling shareholders to elect to be taxed as a partnership when defined conditions are met are made later in this chapter.) But an arrangement of this kind could never be universally applied. Even when all shareholders in a company are individuals, it may be impossible to determine a correct allocation because different classes of shareholders may have differential rights to profits and those rights are not definitively expressed. The task of allocation will be that much greater when allocation must be made through a series of company shareholders. There may be additional practical problems.

16.25. There is a method of allocation available under the existing law involving bonus issues of shares from revenue profits. This method can, however, have only limited operation and could not be the general method of allocation. It involves a change in the company's capital structure by converting reserves into share capital. And it is hard to see how the method could be used when allocations have to be made through a number of companies.

16.26. The taxation of non-resident shareholders under this system would probably raise insuperable difficulties. The present system of taxing dividends received by non-residents involves a withholding tax which, with the underlying company tax, imposes what is thought to be an adequate flat rate of tax. The amount of withholding tax which can be imposed is limited to 15 per cent by a number of international agreements to which Australia is a party. Presumably those agreements would be construed so as to allow withholding tax on allocations; however, non-residents would not be taxed sufficiently unless the permitted amount of withholding tax were multiplied several times over. Double taxation agreements can be renegotiated, but a change of the kind envisaged might not easily be secured.

Tax Actual Distributions and Accruals in Value of Shares

16.27. Another system would tax shareholders only, on actual distributions and increases in share values, those increases reflecting, among other things, the profits

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not distributed. If decreases have occurred in the value of shares, these would need to be taken into account in determining the amount subject to tax. The system would reach undistributed profits only in so far as such profits are reflected in the value of shares. At the same time, it would reach other gains by the company, realised and unrealised, reflected in the value of its shares as well as increases in value due to changes in interest rates and other market factors.

16.28. The system would have many of the advantages of the allocation arrangement. But it is not feasible to tax capital gains from all varieties of assets on an accruals basis; hence this scheme would involve non-neutrality between shares and other assets. Also, while it might be practicable and was once proposed for Canada to tax capital gains on listed shares in this manner, the problems of an annual valuation of all shares would be intolerable. Finally, the implications for taxing non-residents would be akin to those of the allocation system.

Require Distribution of all Profits and Tax These Distributions

16.29. The method of requiring distributions would be the imposition of an undistributed profits tax not intended to raise revenue but to penalise a failure to distribute. Equity would be achieved. Neutrality would be restored in all respects except between retention and distribution of profits. This want of neutrality could be mitigated if the system allowed a bonus issue of shares to count as a cash distribution. The difficulties involved in regard to such bonus issues are adverted to in paragraph 16.25. A scheme of this kind, including the mitigation, was proposed in the economists’ study referred to in paragraph 1.5.

16.30. This system would have implications for the taxation of non-residents akin to those of the two systems just dismissed.

Tax the Company and Exempt Dividends from Personal Income Tax

16.31. Taxing the company while exempting dividends from personal income tax is clearly unacceptable on equity grounds. If the company was not to be used as a tax shelter by high-income shareholders, the rate of company tax would have to be the maximum marginal rate of personal tax, in which case it would be absurdly high for the lower-income shareholder. Unless the present maximum marginal rate is substantially reduced, the rate of tax would be out of line with rates of company tax abroad. Foreign portfolio investors would be deterred from making investments in Australian companies and direct investors would seek by various devices or excess reliance on loan capital to ensure that a controlled Australian company had little or no profits.