April 5, 2012
Aussie and Yankee Recent Developments
This Report provides a brief update on tax developments in Australia and President Obama’s recent proposals for business tax reform.
I was fortunate to spend a week in Australia in mid-February, teaching at the University of Melbourne and soaking up some sunshine. Despite the unusually mild weather in Southwestern Ontario, it’s not the same as mid-20s to low 30s – shirtsleeves and shorts and alfresco dining.
While I was Down Under, I collected some new Aussie words to add to the examples I gave last year (Report 010). There is an underlying theme to these words but I assure you that they were selected randomly from the newspaper (The Australian) and television. You can no doubt get the gist of terms such as “tosser” and “wanker” without the need for any further explanation. Others, however, are a bit more opaque, or at least they were to me. One news item referred to a 911 call where the rescue team could not locate the victim and reported back to their base that they thought the call was a “furphy,” (sometimes spelled “furfie”) which means a false or unreliable rumour (also a synonym for BS). Another item discussing a recent business scandal referred to “financial rorts”; a rort is a fiddle, cheating, or defrauding of the system.
Finally, there was a report about the Australian Rules Football Association – Australian rules “footy” is a strange, very rough game that, as far as I am aware, is played only in Australia – organizing a campaign against violence against women. The reporter’s point was that, although the campaign was clearly a good thing, the title for it, “Taking the Tackle,” was silly. He wrote, “[t]he world’s greatest nong called the campaign ‘Taking the Tackle.’” A “nong,” as you might expect, is someone who is not very bright, an idiot; along the same lines, a “dag” is a nerd.
While I was in Australia, the leadership struggle between the current Prime Minister, Julia Gillard, and the former Prime Minister, Kevin Rudd, was in full swing. In Australia, a sitting PM can be replaced by a simple majority vote of the caucus without any party leadership convention. Last year Gillard replaced Rudd in this way and then narrowly won a national election, although she relies on the support of a third party (the Green Party) to govern. Rudd was ousted because his caucus members didn’t think they could win the election with him as leader. One of his major problems was a flip-flop on the imposition of a new carbon tax. Gillard took over and has committed to the carbon tax, which becomes effective on July 1 of this year, with the initial price set at $23 per ton. The tax is very controversial. There is strong opposition from business and the opposition parties, who repeatedly point out that Canada and the United States have rejected such a tax and that Australia should not go it alone with respect to an issue that requires a coordinated multinational response.
Gillard has stumbled on several other issues and her caucus became restless, with Rudd undoubtedly stirring the pot. Of course, cabinet solidarity precluded Rudd from openly campaigning for his old job, but this did not stop other members of the caucus from doing so. The situation came to a head in late February and Rudd issued a formal challenge. He was trounced in the secret ballot, with just over two-thirds of the caucus members voting for Gillard. Rudd was then forced to resign from Cabinet.
On the tax front, readers might be interested in a couple of recent tax developments in Australia. First, in October 2011 the government announced its intention to fund the establishment of a new Tax Studies Institute. The Institute will be independent of government and linked to universities. The government has committed to providing $1 million annually for 3 years as seed money for the Institute; consultations with the public are currently underway to determine the appropriate structure and permanent funding. These consultations are being conducted by the Board of Taxation (see www.taxboard.gov.au). As you might imagine, Australian tax academics are busily putting together their proposals.
In principle, a similar tax research institute would be a good thing for Canada. I have bemoaned the dearth of tax policy work in Canada for many years. The only place where tax policy is studied on an ongoing basis is in the Department of Finance; however, Finance’s tax policy work is saturated with politics, hardly independent, and non-transparent. We need independent tax policy work on an ongoing, systematic basis to generate ideas that the government can use and to allow Finance’s tax proposals to be evaluated effectively. Despite the clear need for independent tax policy research, I think it is very unlikely that the government would be willing to fund it or even give it moral support. If the need is going to be met, it will be because an organization with credibility and resources, such as the Canadian Tax Foundation, takes up the task.
The second Australian development of note is the announcement on March 1, 2012 of the government’s intention to amend Part IVA, the Australian general anti-avoidance rule. Since the government’s victory in the Hart case in 2004, taxpayers have been successful in several cases by arguing that they did not get a tax benefit because, in the absence of the scheme (the equivalent of our avoidance transaction), they would not have entered into transactions that resulted in any more tax than the tax that resulted from the transactions actually carried out.
The Australian GAAR applies if the taxpayer carries out a scheme for the sole or dominant purpose of getting a tax benefit. In several of the recent cases the counterfactual aspect of the definition of tax benefit has been crucial. This counterfactual aspect arises from the fact that, theoretically at least, the amount of the tax benefit must be determined by reference to a hypothetical, perhaps normative, transaction that the taxpayer would have carried out in the absence of the tax benefit. Speculating on what a taxpayer would have done, could have done, or should have done – and whether those alternative courses of action were reasonable – is a mug’s game. Fortunately, our courts have not fallen for this type of fanciful argument concerning the existence of a tax benefit.
The government intends to consult extensively on the necessary amendments. Regrettably, it is difficult to imagine our Department of Finance consulting in a comparable situation.
It is also notable how quickly the government has acted to stop the unfavourable judicial decisions, indicating that it was not prepared to wait to see how the cases might have been decided on appeal.
Recent US Developments
Speaking of the world’s greatest nong, Rick Santorum certainly impressed by calling President Obama a “snob” for encouraging American kids to pursue post-secondary education. Our politicians say some pretty dumb things, but I can’t imagine one of the party leaders or a candidate for the party leadership saying something that inane.
But I digress. The recent US development I want to discuss is President Obama’s Framework for Business Tax Reform, a joint report of the White House and the Treasury, which was issued at the end of February, 2012. The brief Report makes the case for business tax reform and sets out the broad outline of the reform initiative, which consists of the following 5 elements:
1) Broaden the tax base and lower the statutory corporate tax rate
This proposed reform was the basic theme of the US 1986 tax reform exercise. Since then, however, the US system has become riddled with tax expenditures, loopholes, and tax planning opportunities. The US statutory corporate tax rate, at 39.2 percent, is the highest in the G-8; the effective rate on different industries varies widely, from 14 percent on utilities to 31 percent on construction and wholesale and retail trading. In addition, the current system causes serious distortions in investment decisions – the type of industry and assets acquired, the legal form of business, and the financing of the investment and its location.
The Report proposes to eliminate many tax expenditures and loopholes (including taxing carried interests as ordinary income rather than at the 15 percent capital gains rate, eliminating accelerated depreciation, reducing the corporate interest deduction to reduce the bias for debt financing, ensuring that large corporate and non-corporate entities are treated similarly, and reducing the gap between book and tax income). These are ambitious reforms and the details are lacking. For example, it is unclear how the interest deduction will be limited, but at least it has been placed on the tax reform agenda.
2) Lower the effective corporate tax rate on manufacturing
To encourage the manufacturing sector, the current production-activities deduction will be enhanced, with the result of reducing the effective rate on manufacturing profits to 25 percent (and even lower for advanced manufacturing, although the Report does not indicate which activities will qualify as advanced manufacturing). The R&D tax credit would be increased to 17 percent and made permanent, and, as in every other developed country, the tax incentives for renewable clean energy would be enhanced.
3) Tighten up the international tax system
The Report rejects the option of moving to an exemption system for foreign business income. To stop US multinationals from shifting operations and income abroad, the Report proposes a minimum tax on the earnings of foreign subsidiaries with a credit for any foreign tax paid on such earnings. In addition, the costs of moving operations abroad would no longer be deductible, but a new 20 percent credit would be introduced for the expenses of moving operations to the United States. More striking are proposals to impose current US tax on the excess profits from intangibles shifted to low-tax countries and to defer the deduction of interest allocated to shares of foreign corporations until the income is repatriated to the United States, usually in the form of dividends.
I don’t like the minimum tax idea. It reflects an inability to decide whether to allow full deferral for the business income of foreign subsidiaries of US corporations or to allow the complete elimination of deferral. The rules will undoubtedly be complex and lead to increased tax planning. The new provisions on moving expenses seem punitive and unlikely to have a significant impact since they are one-time costs. It will be interesting to see if they apply equally to foreign corporations that move their operations to or from the United States.
The proposal to defer the deduction of interest expenses on debt used to fund offshore operations is theoretically sound but very controversial. US multinationals will argue strongly that such a measure will adversely affect their international competitiveness. This issue has been debated in Canada for years but nothing has been done. (The enactment of section 18.2, followed by its repeal before becoming, effective counts for nothing.) The US situation is a little different because the United States does not have an exemption system for dividends from foreign corporations. As a result, the deduction of the interest expense should not be denied, but just deferred until dividends are received.
Thus, in the United States the issue is one of the timing of the deduction rather than the deductibility of expenses incurred to earn exempt income, as is the case in Canada with respect to dividends out of exempt surplus. The US situation is also different because the United States already has in place rules to allocate interest expense to foreign-source income for purposes of the indirect foreign tax credit. It has always seemed strange to me that the United States would adopt such complex interest allocation rules, but only for the limited purpose of the limitation on the foreign tax credit, and not to limit the deductibility of interest expense directly.
4) Tax simplification and reduction for small business
The Report proposes to allow small businesses to write off up to $1 million of capital costs immediately and to use the cash method of accounting if their gross revenue does not exceed $10 million annually. Other relief measures would include an increase in the immediate deduction for $10,000 of start-up costs and enhanced relief for the cost of health insurance for small businesses with up to 50 workers.
5) Revenue neutrality
The Report promises that the proposed business tax reforms will be revenue neutral in order not to increase the deficit.
The President’s international tax proposals are at the other end of the spectrum from the House Ways and Means Committee reforms proposed in October 2011. Those proposals involved moving to an exemption system for dividends from controlled foreign corporations (CFCs) and foreign branches and for capital gains on shares of CFCs if at least 70 percent of their assets are active business assets. Given the US congressional system of government, it seems unlikely that the President’s reform proposals will be enacted as is. It is even difficult to imagine a workable compromise. Nevertheless, it is still useful for the President to set out the broad outline of his vision for tax reform. The Department of Finance should do the same for Canada.