Minimum Distribution Requirements

16.102. Reference has already been made to the distinction drawn in the Act between public and private companies and to the undistributed profits tax intended to compel minimum distributions by private companies.

16.103. At the inception of Commonwealth income taxation in 1915, it was provided that if a company did not make a reasonable distribution a deemed distribution could be made and the distribution assessed as income in the hands of the shareholders; however, the concept of ‘reasonable distribution’ was left undefined. The amending Act of 1922 fixed two-thirds of the taxable income as a reasonable distribution and provided that tax on deemed distributions would be imposed on the company, the tax so imposed being the tax that would have been paid by the shareholders on the amount unreasonably retained had it been distributed to them. The practice of the Commissioner at this time was to limit the application of the provisions to closely controlled companies, i.e. companies controlled by a few individuals.

16.104. The Ferguson Commission recommended in its first report, in 1932, that the deemed distribution provisions be limited in a way that would give legislative approval to the Commissioner's practice. It was said that:

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‘The dividend policy of a public company in which the public are substantially interested, and whose shares are dealt in on the Stock Exchange, is not likely to be affected by consideration of the amount of tax which will be paid by individual shareholders. The influence of shareholders will be exerted to induce the directors to distribute as much and not as little as possible, and its published accounts will show what profit has been earned, and how it has been appropriated.’

The 1934 Amending Bill gave effect to the recommendation. The amended law defined a private company and confined the deemed distribution provisions to such companies.

16.105. The definition of a private company was complex; but it did not cover all closely-controlled companies, and company structures were adopted to escape the definition. In the early 1950s the Spooner Committee recommended a new definition of a private company, intended to prevent such escape; and it also recommended that in place of the tax calculated by reference to deemed distributions, there should be a tax on company profits designed to force distributions. The tax proposed was to be a penalty levy applicable to so much of the profits of the company after payment of company tax and after deduction of a retention allowance as had not been distributed within a defined period. The recommendation of the Committee was adopted by amendment to the Act in 1952.

16.106. The new definition did not succeed in preventing the practice of employing company structures that fell outside the definition though in fact the companies were closely-controlled. Moreover, companies coming within the definition were able formally to satisfy the requirement to make a sufficient distribution by distributing to a series of related companies (known as chains) or around circles of related companies (known as snakes). The profits thus remained in a pipeline of companies forever moving between companies but never being taxed to individual shareholders.

16.107. In 1964, following recommendations of the Ligertwood Committee in 1961, yet another attempt was made to define a private company, this time by defining a public company and providing that all other companies would be private. The provisions allowing a tax rebate on dividends passing between companies were amended at the same time. The practice of storing profits in a pipeline of companies is now prevented by a partial denial of the rebate when dividends are received by a private company from another private company. However, the Commissioner is given a discretion to allow a full rebate. That discretion will ordinarily be exercised if the Commissioner is satisfied that the dividends will reach the hands of persons, who are not private companies, within 22 months of the end of the year of income in which the dividends were received by the company claiming the full rebate.

16.108. But the new definition of private company, like its predecessors, failed to embrace all closely-controlled companies. Again company structures were adopted by which closely-controlled companies escaped the definition, this time exploiting the provisions making a subsidiary of a public company a public company. Amendments to the definition were made in 1973 with the object of preventing this avenue of escape.

16.109 The history surveyed in the previous paragraphs reflects two assumptions. The first, recognised by the Ferguson Commission, is that because of pressure exerted by their shareholders listed companies in which the public are substantially interested may be expected to distribute sufficient profits, ultimately to individuals, to prevent

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the company affording a tax shelter. The second is that it is possible to draw a distinction between such companies and others that need to be put under a legal discipline to make adequate distributions.

16.110 Experience over the years tends to belie the latter assumption. But whether or not an effective distinction can be drawn, the question remains whether the first assumption—that listed companies in which the public are substantially interested do not afford tax shelters—is correct.

16.111. Empirical evidence casts some doubt on the correctness of the assumption. Distribution policies of listed companies in which the public are substantially interested may reflect a variety of purposes that management is seeking to further. But if in fact the distribution policy of a company involves substantial retention of profits, it will give tax advantages to high-income shareholders whether or not management has this in mind, though it is true that the retained profits in terms of their value to the shareholders in the market place may be less than the amount retained.

16.112 The Committee has given some consideration to the technical aspects of an extension of minimum distribution requirements to all companies. Apart from the aspect about to be mentioned, the general structure of the present undistributed profits tax presents no problems. In this it contrasts with the earliest provisions requiring minimum distribution: those provisions, though formally applicable to all companies, could only be effectively administered in relation to closely-controlled companies. However, as a measure to prevent the storing of profits in a pipeline of companies, the present undistributed profits tax could not be applied to all companies, since a company whose shares are widely held cannot know the ultimate destination of distributions it makes to other companies. An alternative to undistributed profits tax would have to be considered.

16.113 Two methods of ensuring that no tax advantage attends the holding of profits in a pipeline of companies deserve some consideration. The first is the method used in the United States and involves denying exemption to a fraction of a dividend received by a company from another company at each point of movement of profits in the pipeline. This method was in fact proposed by the Ligertwood Committee which suggested that the fraction of a dividend denied exemption should be set at 15 per cent—the fraction actually employed in the United States. However, unless dividends moving within a group of companies are accorded special treatment, as in fact they are in the United States, the method involves an arbitrary and wide-ranging cascade tax on company profits. Even if such special treatment is given, there remains an element of cascade taxation where dividends move through companies that are not members of a group.

16.114 The second method involves an adaptation of a Canadian scheme which at present applies in that country only to dividend income received by closely-controlled investment companies. A company receiving a dividend would hold that dividend in a separate account. The dividend would be subject, in the hands of the company, to a refundable tax at a rate reflecting the tax that an individual shareholder on the maximum marginal rate would pay, after making allowance for any tax credit available to him under the prevailing imputation system. When a dividend is paid by the company from the amount in this account, the tax would be refunded to the company. If such distributions are made in a year of income so as to absorb all dividends received by the company in that year of income, there will of course be no net refundable tax payable. The method involves some complications where the company receiving the dividend has suffered a loss in an earlier year or in the year of income; the company might

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not, in these circumstances, have any immediate prospect of paying a dividend which would generate the refund of tax. In such circumstances the company might be allowed to apply the loss against the dividend received and so avoid payment of the refundable tax; in the result, however, it will have applied the loss to relieve tax at the refundable tax rate, which will be less than the company tax rate.

16.115 These observations suggest that it might be technically feasible to extend minimum distribution requirements to all companies. The possible gain in equity must, however, be weighed against the costs involved. These costs include not only those of administration and compliance but also the loss of neutrality between retention and distribution of profits. In the Committee's view, the costs are likely to outweigh the gain in equity, and therefore the extension of minimum distribution requirements to all companies is not recommended.