VI. Proposal to Allow an Election to be Taxed as a Partnership

16.79. An alternative to the present system—the allocation by the company of all its profits to its shareholders, the allocation reflecting their interests in those profits, and the taxing of those profits to the shareholders—was dismissed in paragraph 16.24, principally because of the impracticability of applying it to all companies.

16.80. The Committee does, however, consider it appropriate that the law, whether or not an imputation system is adopted, should specify the conditions of a corporate regime within which an arrangement of this kind is practicable, and should allow the shareholders of a company meeting those conditions to elect to be taxed on allocations in the manner in which partners are taxed.

16.81. The United States has had a system of election for a number of years and is currently considering its reform. A similar system was proposed for Canada, both by the Carter Commission in 1966 and in the subsequent government White Paper of 1969. The proposal has not been implemented, possibly because a similar result to a system allowing an election is achieved in Canada by the provisions described later in paragraph 16.97. Those provisions ensure that smaller companies are taxed in a way which involves payment ultimately of no more tax than would have been paid had the business been carried on in partnership form, and may involve a deferral of tax in the meanwhile. In the United Kingdom the Report of the Committee of Inquiry on Small Firms (Bolton Committee, 1971) recommended that close companies—the equivalent of Australian private companies—should be allowed to elect to be taxed as partnerships. The fact that this recommendation has not been acted on may be because the United Kingdom has now adopted provisions, described in paragraph 16.98, allowing a lower rate of tax on smaller companies.

16.82. As explained in paragraphs 16.100–16.101, the Committee does not favour provisions along Canadian or United Kingdom lines. Its proposal to allow an election to be taxed in the manner of a partnership has therefore a more important function in its overall recommendations for the taxing of company profits.

16.83. It is not proposed to spell out in detail the system Australia might adopt. There are, however, certain issues of principle bearing on the scope of the system to which reference should be made. Some indication will be given, in a general description of a proposed system, of the inevitable complexities involved.

Eligibility to Elect

16.84. A number of issues relating to eligibility to elect call for examination. These concern the possibility of confining the election to companies whose profits are below a specified limit and whose income is not investment income; the possibility of confining the election to companies whose income is derived from Australian sources; the restrictions that should be imposed in terms of numbers of shareholders, the kinds of shareholders, and the capital structure of the company.

16.85. Amount and nature of company profits. In the United States the election is available whatever the amount of company profits, and in this respect there is no

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attempt to confine the election to smaller companies. In Canada the Carter Commission would have confined the election to companies with incomes below $200,000. In the Committee's view the election to be taxed in the manner of a partnership is not primarily directed to assisting small companies, but is a means of ensuring that company profits are taxed fairly. It follows that there should be no restriction on the election by reference to the amount of company profits.

16.86. The United States law denies the election to a company deriving 20 per cent or more of its income from investments, though it has been proposed that this restriction be eliminated. The Committee does not think it appropriate to impose such a restriction. The availability of the election to an investment company is consistent with the treatment proposed in paragraphs 16.116–16.117 of investment income of companies that have not elected.

16.87. The United States does not allow an election when more than 80 per cent of a company's income is derived from foreign sources. The only reason for such a restriction would seem to be the administrative complications involved in allowing tax credits to shareholders; but in the Committee's view these are not sufficient to justify discriminating between companies with domestic-source and companies with foreign-source income.

16.88. Number and nature of shareholders. The compliance and administrative costs of an election system will be minimised if the election is confined to companies with small numbers of shareholders all of whom are individuals and beneficially entitled. In the United States the number of shareholders may not exceed ten, though it has been proposed that this be raised to fifteen to allow greater flexibility, making it possible, for example, to issue shares to key employees. The Committee favours the maximum number of shareholders being set at ten, at least until the administrative problems involved in an election system have been carefully assessed.

16.89. All shareholders should be individuals who are beneficially entitled. An exception might be made of the administrator of a deceased estate; but the system could not be conveniently applied where a shareholder is another company. All shareholders and the company itself should be resident in Australia.

16.90. Capital structure of the company. If the allocation of profits to shareholders is to be made as easy as possible, all shares in the company should carry the same rights to income and capital. In the United States all shares must be of the same class, though consideration is currently being given to allowing also a class of shareholders without voting rights who have rights to fixed annual distributions and to a fixed amount upon redemption. The Committee would take the view that, at the outset at least, only one class of shares should be allowed.

Manner and Timing of Election and Manner of Termination of Election

16.91. The working out of detailed provisions as to the manner and timing of an election and the manner of termination of an election will be assisted by drawing on United States experience. If, as suggested in paragraph 16.93, both profits and losses are allocated to shareholders by reference to their daily holdings of shares throughout the year, it will be necessary to set the time for making an election early in the year of income and to deem a shareholder who signs an election to have been a shareholder from the beginning of the year. A person who acquires shares thereafter should be deemed to have consented to the election unless he gives the Commissioner notice of revocation. Subject to this, the unanimous consent of all shareholders should be

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required. All shareholders who have consented would need to join in any revocation. A new shareholder who has not consented might, however, bring about a revocation by giving notice to the Commissioner.

16.92. Unanimity of consent, in the view of the Committee, is necessary to prevent prejudice to a minority shareholder who might otherwise be forced to accept liability to tax on profits he has no immediate prospect of receiving.

Consequences of Election and of Termination of Election

16.93. When an election applies, the taxable income or allowable loss of the company should be allocated to shareholders in accordance with their daily holdings of shares during the year of income. This will accord with the law as proposed in the United States where, for the present, allocation on daily holdings applies only to losses. Allocations of taxable income to shareholders will bear the same character as the income had in the hands of the company. There will need to be rules by which income of any class, for example dividends carrying an imputation credit, are treated as being spread over the allocations. Capital gains and losses will be allocated.

16.94. Special rules will be necessary to deal with pre-election accumulated income or pre-election losses of the company.

16.95. Allocations taxed to a shareholder will increase the cost of his shares for purposes of tax on any gain made on realisation of the shares. An actual distribution to a shareholder from allocated profits will not be taxed to the shareholder but will reduce the cost of his shares.

16.96. The revocation of an election in any year should be treated as relating to the whole of that year. To minimise scope for tax planning that might be practised by moving into and out of the election system, and to minimise administrative complications, the right to make a fresh election after a revocation should be restricted. In the United States a fresh election may not be made until five years after the revocation, except with the leave of the Revenue.