Income of Private Investment Companies
16.116 The present undistributed profits tax applied to private companies in effect imposes a penalty on the company if it does not distribute what remains of profits after company tax and after a retention allowance. Originally the retention allowance was seen as enabling the company to hold back funds for the maintenance and expansion of its business operations. Even when the retention allowance had ceased to depend on any exercise of discretion by the Commissioner as to the amount of a reasonable retention, this purpose of the allowance continued to be reflected in the diminishing fractions applied to successive slices of profits in computing the amount of the allowance. The present law applies one fraction—50 per cent—to all after-tax profits whatever their amount. There is in the result very little suggestion of the original purpose: the present retention allowance is basically no more than a method of fixing how much of the company's profits should be taxed at shareholders’ individual rates. In one respect, however, the original purpose does find a continuing expression. The retention allowance on income from property—income not accompanied by the same degree of commitment to hold back funds for the continuance of business operations—is fixed at the much lower figure of 10 per cent, or, in the case of private company dividends, at zero.
16.117 As long as the separate system of company taxation remains, and even under a limited imputation system, there is a general bias against the use of the corporate form. The result of the less generous retention allowance on income from property is that such bias is correspondingly greater where the corporate form is used as a vehicle of investment in property other than shares. In the Committee's view this additional bias is unjustified, and it therefore recommends that the retention allowance in respect of income from property other than shares be brought into line with that applying to other income.
16.118 In contrast with the special bias against the use of the corporate form as a vehicle for deriving income from
other kinds of property, the present law gives rise to a significant incentive to use the corporate form as a vehicle
for deriving income from shares. An individual with a portfolio of share investments can secure significant tax saving
by vesting the portfolio in a private investment company which will derive the dividends on those shares. Because of
the tax rebate on dividends allowed to a company, the dividends will not be taxed in the hands of the investment
company. The effect of the retention allowance of 10 per cent of the amount of the dividends (available unless the
dividends are from private companies) is that tax on this fraction of the dividends can be indefinitely deferred. The
prospect of undistributed profits tax
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will force a distribution of the remainder; but tax on the
individual who vests his portfolio in a company can be delayed for at least one year, and as long as three years,
after the derivation of the dividends by the company. (The longer delay is achieved by the interposition of other
private companies between the individual and the company holding the portfolio of shares.)
16.119 Where a business is carried on through a private company, a deferral of tax on dividends paid by the company can be obtained by vesting the shares in that company in an interposed private holding company. There will be no retention allowance in this case, but again tax can be deferred for at least a year, and longer if further companies are interposed.
16.120 The Committee recommends that measures be introduced to prevent this deferral of tax. The measures should be applied to a private investment company as defined for this purpose: the definition would be based on income from property being the predominant element in the company's income. The measure would employ the technique of a refundable tax to which reference was made in paragraph 16.114. The company holding the portfolio of shares would be subject to tax at a rate equivalent to the tax an individual on the maximum marginal rate would pay, after making allowance for any tax credit available to him under the prevailing imputation system. There would be corresponding refunds on distribution. The same regime would apply to any interposed company.
16.121. If the Committee's recommendation is adopted, there will need to be either a phasing-in period or adequate notice of its introduction, in order to accommodate liquidity problems that will inevitably arise in some instances.