Tighter rules and higher thresholds key to tackling tax avoidance

Recent laws passed by the Federal Parliament provide a real example of the most effective way to tackle tax avoidance issues – tighten the rules around the issue of concern but introduce higher thresholds to exempt all taxpayers to whom the rules should not really apply.

The end result is a more rigorous system targeted that those taxpayers where the issue is most significant.

Tightening of the Thin Capitalisation Rules

The new laws relate to the thin capitalisation provisions.   The new legislation has cut the maximum level of debt a multinational can hold within its Australian operations.

Debt is one of the key tax planning areas for multi-nationals.  The tax cost of interest payments on debt is usually much lower than the tax imposed on corporate profits.  Therefore, by maximising debt for operations in “higher tax” countries (such as Australia), a multi-national can achieve a lower average tax rate across their business.

Under the existing thin capitalisation rules, a multinational could have a debt to equity ratio of

3:1 in Australia.   However, the Government considered that a 3:1 ratio was out of kilter with current commercial practice and open to abuse resulting in a lower tax revenue for Australia.

By lowering the debt to equity ratio to 1.5:1 the Government believes it will achieve a position more in keeping with current commercial practice and will dramatically reduce the opportunity for tax avoidance activity in this area.

As with any new or revised tax measure, there are going to be issues.  For example, this change allows businesses a very short timeframe within which to refinance existing debt arrangements.

Increasing the Threshold to exempt majority of SMEs

It is well recognised that the base erosion and profit shifting (BEPS) problem, it is predominantly an issue for larger businesses.  As such, measures to tackle this issue should not apply to the majority of small to mid-size businesses.

The Government has achieved this by excluding from the new thin capitalisation rules any taxpayer with less than $2 million in “debt deductions” – which is principally interest and associated financing costs.   The old threshold was $250,000 – an eight-fold increase.

The new threshold takes all but the most highly geared small to mid-size business out of the thin capitalisation rules and focuses the tighter laws on the larger businesses.

The approach taken by the Government is one that should be encouraged – tighten the rules but exempt all those taxpayers for whom the rules really should not apply.

A new approach to tax legislation?

The challenge for the Government is taking this principle and applying it more broadly.

In tackling the international profit shifting problem being faced by Australia and other countries, increased regulation and reporting are seen as core components of the solution.   This may be appropriate for large corporates, however, for small to mid-size business who don’t have the same financial resources at their disposal, increased reporting and tighter tax laws equates to greater compliance costs.

Increasing the cost of compliance could lead to less compliance.  Historically, the greater the relative cost and complexity in the tax system the lower the levels of compliance.

Australian small to mid-size business are highly compliant with tax laws when considered on an international basis.  Over 95% of Australian tax revenue is collected without the need for active compliance activity.  Italy, by way of contrast, collects only 75% in this way.

Increased compliance costs will also inevitably lead to a stifling of business innovation – small to mid-size business are typically the source of significant innovation.

Any Australian solution to the BEPS problem should focus specifically on those who are creating the issue, minimising the collateral damage to other taxpayers, in particular the small to mid-size business.

The challenge for the Government will be in maintaining the tighter rules/higher threshold approach with future changes as such an approachis something which unfortunately Australia has not historically been good at.