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How does TVM work? TVMs basic principles are expressed in a simpler and more rational method for calculating taxable income. Net incomeplusAdjustments.

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Presentation on theme: "How does TVM work? TVMs basic principles are expressed in a simpler and more rational method for calculating taxable income. Net incomeplusAdjustments."— Presentation transcript:

1 How does TVM work? TVMs basic principles are expressed in a simpler and more rational method for calculating taxable income. Net incomeplusAdjustments Special adjustments based on Government policy (eg R&D, capital gains discount, use of past losses etc) The overall change in the tax value of all assets and liabilities (including cash) TAX VALUE METHOD (TVM) - Policy Intent This document has been prepared by the TVM Legislation Group and ATO TVM project team reflecting development of TVM to October 2001. It has not been endorsed by the Government, Board of Taxation, Treasury or ATO. POLICY DRIVERSPOLICY INTENT We aim for a taxation system that: The scope of TVM is reform of the law supporting the calculation of taxable income. Income tax makes up the greatest component of the federal revenue base. But this significant part of the tax system is governed by a notoriously complex, lengthy and unstructured body of law – an historical accumulation of unassociated regimes and rules, backed by an ever increasing bulk of case law. TVM intends to define income in a manner structurally consistent with both economic and accounting approaches to income measurement. With this structure in place TVM should provide a robust and comprehensive structure for the income tax law that : While the proposed reform is significant and extensive, it is also largely subterranean – that is, it should not change tax outcomes (and therefore behaviour) for most taxpayers. Indeed, the basic parameters for the reform include: Why are we doing this? Current law - complex and unstructured The existing body of law is based on a variety of principles that have evolved over many years. Some principles still operate but are unnecessary, while others interact poorly. This causes problems in the legislation. Features of the existing law include: many different ways of doing things inadequate default treatment asymmetric treatment of income and expenses large volume of legislation These features create complexity, inequity and a lack of integrity in the law. This in turn adds to confusion and undue compliance costs for the community. TVM provides an opportunity to reform these features of the law. Under a TVM framework it would be possible to create law that is more simple, transparent and certain. Australia must have a taxation system which equips it for the coming decades, not for those that have passed. If we do not achieve this, Australians will not enjoy the standard of living that this nation has the potential to deliver. John Ralph, A Tax System Redesigned (July 1999) contributes to Australias economic growth promotes equity between taxpayers is more simple and certain. can handle the extent and complexity of the income tax base can operate into the future without need for continual amendments and corrections is capable of future modification still within the structure on which the law overall is based. TVM should not alter the nature of the income tax base TVM should be revenue neutral overall What is TVM about? Four basic principles underpin TVM: Rethinking (but not changing) the income tax base. Aligning with economic and accounting approaches. Applying tax values to classes of assets and liabilities. Distilling the methods already present (but obscured) in current law. from to covering the income tax base with many legislative regimes and rules that sometimes overlap and conflict covering the whole income tax base with a standardised legislative framework DRAFT FOR DISCUSSION 12 October 2001

2 2. Outcomes sought under TVM TAX VALUE METHOD (TVM) Overview of objectives This document has been prepared by the TVM Legislation Group and ATO TVM project team reflecting development of TVM to October 2001. It has not been endorsed by the Government, Board of Taxation, Treasury or ATO. 1. Problems with the current law 3. Revenue outcomes There are many problems in the current law, some of which are illustrated in this diagram. The nature of these problems is expanded upon in the attached document Why are we doing this?. TVM is about repairing the foundations of the income tax system (see the attached document What is TVM about?). These outcomes are sought (further details are in the attached document Why are we doing this?): These outcomes seek to provide improved equity, robustness, simplicity, transparency, certainty and durability. The attached document How does TVM work? outlines how the legislative mechanics of TVM would operate. A standardised concept of income that reflects the post-Review of Business Taxation (RBT) income tax base. Standardised core rules to support that concept (e.g. uniform cost rule). Shorter, clearer, more concise and intuitively accurate income tax law (making it easier to learn and use). Fewer disputes between taxpayers and the revenue authorities. Income and expenditure treatments more closely reflect economic outcomes. All income and expenditure gets a standard (default) treatment closer to the intended tax base. Improved implementation of future policy changes. Greater assurance of accurate policy implementation (departures from stated policy will be easier to identify). A better platform for developing tax products (e.g. tax returns and related instructions). TVM should not change the nature of the existing income tax base and should produce overall revenue neutrality. This does not mean the same result for every taxpayer in every case. Changes to particular tax outcomes may occur: Significant changes will be identified and costed. because of the standardisation inherent in TVM; or because TVM is a platform for policy changes (e.g. tax relief for black holes, improved treatment of rights and financial arrangements). 1915 - 2001 There has been significant change in the income tax base over this period. However, there has never been any strategic direction behind the change. Tax outcomes different from economic outcomes Complex and unstructured body of law No policy platform for legislative development Frequent technical corrections and growing anti-avoidance provisions Disjunctive operation (poor connections between rules) Arbitrage opportunities between different taxpayers and different tax treatments Overlaps and gaps (e.g. black holes) Error prone legislative process & implementation Law is harder to learn and apply Tax outcomes that do not match intent Many different ways of doing things Large volume of legislation Inadequate default treatment Timing anomalies Asymmetric treatment of income and expenses Recognises non-existent gains and losses DRAFT FOR DISCUSSION 12 October 2001

3 1. ITS ABOUT THE FOUNDATIONS... TAX VALUE METHOD (TVM) What is TVM about? Many applications of the 3-step diagnostic which underlies TVMs net income calculation already exist in the current law, even though the diagnostic is normally obscured by the use of different tests, labels or language. Some examples... This document has been prepared by the TVM Legislation Group and ATO TVM project team reflecting development of TVM to October 2001. It has not been endorsed by the Government, Board of Taxation, Treasury or ATO. This 3-step diagnostic can be seen as a theme of the existing law (i.e. part of the road base). However, that theme is obscured by the way the structure of the existing law has developed and in the language used to express the law. TVM lays a new foundation by distilling the theme into a set of universally applied principles. T H E T V M M E C H A N I S M 2. THE TVM MECHANISM IS A THEME IN THE EXISTING LAW T H E C R U X O F T H E P R O B L E M A N D T H E S O L U T I O N Do you have the liability? Normally, you only have a liability if it is a present legally recognised obligation that you owe Is there a liability? A liability is an obligation to provide future economic benefits The TVM mechanism uses a 3-step diagnostic to work out net income Step 1 - existence Step 2 - recognition Step 3 - tax value Is there an asset? An asset is a source of future economic benefits These definitions draw on the accounting meanings Do you hold the asset? Normally, you only hold an asset if it is property or a right that you own.. What is the assets tax value? Most assets have a tax value of cost (i.e. unrealised gains not taxed). What is the liabilitys tax value? Most liabilities have a tax value equal to the amount received to assume the liability. Ordinary income Income taxed when derived Asset: Right to be paid Hold: Is it your right? Tax value: Amount you have a right to receive Profit taxed when revenue asset realised Asset: The revenue asset Hold: Do you own it? Tax value: Amount subtracted from proceeds to calculate profit General deductionsTrading stock Expenditure deducted when incurred Liability: Obligation to pay Have: Have you incurred the expenditure? Tax value: Amount you are obliged to pay Annual difference in stock values taxed or deducted Asset: The trading stock Hold: Do you have the stock on hand? Tax value: Choice of cost, market value or replacement cost Capital allowances Depreciation deducted, profit on disposal taxed Asset: The depreciating asset Hold: Do you hold it? Tax value: Adjustable value Capital gains tax Gain on disposal taxed, loss reduces other gains Asset: The CGT asset Hold: Applicable CGT event Tax value: Cost base or reduced cost base Prepayments deductible in year services received Asset: The right to future services Hold: Did you pay for the right? Tax value: Expenditure written down as time expires Area of current law What that area of current law does How that area identifies an asset or liability How that area recognises the asset or liability The value given to the asset or liability for tax purposes TVM would change the law by extracting the TVM mechanism, which is part of the foundations to the current law, and giving it a broader application as a standard mechanism for working out taxable income (i.e. the base of the road will become uniform material). Revenue / capital Ordinary income General deductions Nexus test Link between income and expenses Principles (Sub-grade) All gainsAll losses Entities liable to tax Tax levied annuallyHistoric cost basis Tax base (Earthworks) Law concepts & themes (Road base) Legislation (Tarmac) TLIP focussed on legislative expression only Gaps and overlaps are common Different concepts and themes make the road uneven The current tax law is founded on a variety of principles which have been introduced over the past 65 years. Some principles still operate but are unnecessary, while others interact poorly. This causes the problems in the legislation. No gaps or overlaps Consistent concepts and themes in the foundations make the road smoother Current systemTax Value Method Flow concept of income Gain concept of income TVM style mechanism Trading stock Capital allowances Principles (Sub-grade) All gainsAll losses Entities liable to tax Tax levied annuallyHistoric cost basis Tax base (Earthworks) Law concepts & themes (Road base) Legislation (Tarmac) Tax value mechanism Step 1 - existence of asset or liability Step 2 - recognition of asset or liability Step 3 - tax value of asset or liability Basic principles stay the same under TVM TVM will not change the fundamental parameters of the income tax base which, after the RBT recommendations on recognising expenditure, is virtually universal Consequential changes to legislative expression Other tests TVM will standardise concepts and themes at this layer, with some consequential changes to outcomes Compare the income tax system with a road. The driver travelling along the road suffers the effects of potholes, cracks and bumps in the road and believes there are problems with the tarmac. However, the problems are often caused by the road's poor foundations, not the weakness of its surface. In the same way, the user of the tax law sees problems with that law and thinks those problems come from the way the law is expressed (hence the Tax Law Improvement Project). However, like the road, the underlying problem is often not the law's expression, but its foundations. Rather than constantly repair the tarmac, a better plan is to fix that part of the roads structure that causes the problems. Better foundations to the road will improve the surface: it will crack less often, contain fewer bumps and require less repair. The user will have a better journey but will still only experience how the road is to travel upon, not what is under the surface. Many of the problems with the income tax law are due to the laws concepts and themes. This is the level that determines the way taxable income is expressed in law. The thesis is that the best plan is to fix the law by fixing this foundation. The analogy is that good road builders do not keep working on the surface. They look at the whole structure of the road and fix the part that causes the problem. The analogy may not prove anything about TVM, but it helps us understand the solution it proposes. DRAFT FOR DISCUSSION 12 October 2001

4 A. ONE WAY OF DOING THINGSB. APPROPRIATE DEFAULT TREATMENTD. REDUCED VOLUME OF LEGISLATIONC. SYMMETRICAL TREATMENT TAX VALUE METHOD (TVM) Why are we doing this? T H E P R O B L E M T H E T V M S O L U T I O N 1. Current law - complex and unstructured Changes in the tax base have been made by ad hoc additions to the law, leading to legislative volume and systemic complexity. The resulting complex interactions have led to uncertainty for taxpayers (business decisions harder to make) and make amending the law complex and difficult (leading to the need for more technical corrections with additional uncertainty for taxpayers). The deficient foundation and structure of the income tax law creates inequity and a lack of robustness. Taxpayers can have gains taxed and losses recognised at the wrong time. Other taxpayers can arbitrage the deficiencies to avoid or defer the taxation of gains or bring forward the recognition of losses. Symmetrical treatment of income and expenses... A key design principle of TVM is that the treatment of income should mirror the treatment of expenses. The only variation is where policy decisions require it. So, as a general proposition, if you pay money, you should get tax relief for it when you get the benefits of the expenditure. Symmetrically, if you receive money, you should be taxed on it when you give the benefits for which you received the money. Symmetry is achieved through mirroring treatment of assets and liabilities. Symmetry makes the law more equitable and robust… An example... $10,000 paid in Year 1 Obligation to provide services in Year 2 Taxed on $10,000 income in Year 2 when services provided Deduction of $10,000 in Year 2 when services received eliminates double counting without special rules recognition of liabilities in symmetry with assets resolves timing anomalies makes it harder to arbitrage timing differences between taxpayers Simpler analytical processes... The net income calculation allows the income tax effects of every transaction to be analysed and explained using a common conceptual framework. Example: you pay legal fees relating to an asset Transaction Change in assets? Do you hold it? What is its tax value? Change in liabilities? Do you have it? What is its tax value? Currently, all these questions arise: is the payment incurred in producing income? is the payment revenue or capital? is the payment private or domestic? is the asset covered by one or more statutory income regimes? is the payment part of the cost of the asset? do one or more statutory deduction rules apply? does a rule preventing overlaps apply? is the asset held? is the payment part of the tax value of the asset? is the payment private or domestic (individuals)? does an adjustment apply? Under TVM, these questions arise: Foundation of TVM is a closer reflection of the intended tax base... So, for example, tax relief is given for all business expenditure unless there is a special rule to prevent it. The timing of the relief is set by the tax value of the asset or liability concerned and its rate of decline or increase. A default treatment that is a closer reflection of the intended tax base simplifies the law and improves equity and durability... less law needed intended treatment given more often (because it deals better with future developments) less need to amend law to meet future developments Tax relief for expenditure under TVM... Scope required for relief of all business expenditure Statutory exceptions (e.g. entertainment expenses) Actual relief given 1936 Much of this volume is in rules for calculating taxable income, especially filling in holes in the revenue and capital concepts. These rules have been relentlessly amended in response to commercial and policy changes, tax minimisation and inequities. The law has grown from around 1,400 pages in 1985 to around 4,300 pages today. The longer the law, the harder and more costly it is to learn and to find the applicable rules. A rough measure of the problem... an unstructured accretion of legislative changes over decades pages ITAA 2001 The legislation can depart from the intended tax base because future developments are not foreseen or because complex interactions are not understood. Gaps appear in what is intended to be covered. The foundation based on the outmoded revenue/capital concept means that income and expenses not falling within (inadequately) specified extensions get a default treatment inconsistent with the intended scope of the post-RBT income tax base. C O N C E P T S Ordinary Income Statutory Income Many proceeds rules Many liability concepts General deductions Specific deductions Many cost rules Many non-cash transaction rules...lack of consistent principles... The current law uses many different sets of rules to describe the tax base: How these systems and concepts apply under the current regime is a function of historical development rather than consistently applied underlying principles. The lack of consistent principles leads to: complex analytical processes to determine the income tax consequences of a transaction timing anomalies (inconsistencies or inadequacies in when gains and losses are recognised) (e.g. Myer Emporium case) double counting (e.g. Country Magazines case) and black holes no cohesively defined platform for future developments an error prone legislative development process An illustration... CGT Traditional Securities Capital Allowances Special Receipts Certain Recoupments DIV 16E Trading Stock Ordinary Income and General Deductions Legislation CORE CONCEPTS Investment assets Depreciation Trading Stock Zero tax values Financial Standardised core concepts to support calculation of net income: asset and liability definitions holding rules for assets & liabilities tax value rules cost and proceeds rules non-cash transaction rules rules for splitting and merging of assets & liabilities Standardising core concepts simplifies the law and makes it more equitable and robust... simplifies analytical processes reduces volume of law helps eliminate double counting eliminates black holes An example: tax relief for expenditure... Scope required for relief of all business expenditure Scope of relief under general deduction rule (s.8-1) Statutory extensions (e.g. capital allowance rules) Statutory exceptions (e.g. entertainment expenses) Actual relief given Expenditure blackholes Different legislative provisions bring income and expenditure to account at different times. It is common for income to be taxed to the recipient before the payer can claim a deduction, and vice versa. For instance, the treatment of liabilities often doesnt mirror that of the corresponding rights (e.g. some lump sums paid for granting rights are taxed on receipt but tax relief is only given to the payer through a capital loss when the right terminates). These inadequacies distort the choice of business arrangement, so that tax issues interfere with allocation of investment funds. This leads to inequity and a lack of robustness in the law. A. MANY DIFFERENT WAYS OF DOING THINGSB. INADEQUATE DEFAULT TREATMENTD. LARGE VOLUME OF LEGISLATIONC. ASYMMETRIC TREATMENT Company ACompany B TVM will reduce the volume of the income tax law by distilling the 3-step asset/liability diagnostic that is a theme of the current law and elevating it to the higher level core rules (see the column A and the document The essential thesis). In similar fashion, the volume of law would be reduced by the use of common core rules across all the asset and liability classes (see column A). For example, the re-drafting of the capital gains tax rules under TVM has shown a reduction of about 70% in the areas re-drafted. The robustness inherent in TVM (see columns B and C) should reduce the volume of law by eliminating the need for some special rules, including some anti- avoidance rules. Shorter legislation makes the law easier to learn and use. 2. TVM - law with a clear foundation Simpler law adds to certainty and makes amending the law less difficult and more transparent (the true effect of amendments is easier to identify) These problems are reflected in products (e.g. rulings and other publications) used to support compliance with the law This document has been prepared by the TVM Legislation Group and ATO TVM project team reflecting development of TVM to October 2001. It has not been endorsed by the Government, Board of Taxation, Treasury or ATO. Taxpayer A assessed in earlier income year Taxpayer B gets loss in later income year +$ 0 -$ time Because there are many sets of rules in place, there are inevitably many overlaps and gaps. Special rules try to eliminate the overlaps and further special rules are added every year to try to cover the gaps. This means the law is not durable. A rough projection of the outcome?... pages 1936 ITAA 2001 DRAFT FOR DISCUSSION 12 October 2001

5 EXAMPLES of the LEGISLATIVE MECHANISM AT WORK TAX VALUE METHOD (TVM) How does TVM work? T H E M E C H A N I S M A T W O R K K E Y M E C H A N I C S DRAFT FOR DISCUSSION 12 October 2001 This document has been prepared by the TVM Legislation Group and ATO TVM project team reflecting development of TVM to October 2001. It has not been endorsed by the Government, Board of Taxation, Treasury or ATO. THE KEY MECHANICS These examples compare the current treatment of some transactions with their treatment under TVM as a means of illustrating TVMs legislative mechanics. They all use the TVM net income formula, which is: The TVM mechanism uses a 3-step diagnostic to work out net income Do you have the liability? Normally, you only have a liability if it is a present legally recognised obligation that you owe Is there a liability? A liability is an obligation to provide future economic benefits Step 1 - existence Step 2 - recognition Step 3 - tax value Is there an asset? An asset is a source of future economic benefits These definitions draw on the accounting meanings Do you hold the asset? Normally, you only hold an asset if it is property or a right that you own. What is the assets tax value? Most assets have a tax value of cost (i.e. unrealised gains not taxed). What is the liabilitys tax value? Most liabilities have a tax value equal to the amount received to assume the liability. Individuals will ignore most private or domestic items (e.g. receiving birthday presents, buying dinner). Taxpayers who are not individuals will not have any private or domestic items and, so, will be able to work out their cashflow (receipts minus payments) as the difference between their opening and closing cash. Sometimes, there will be adjustments to net income to convert it to taxable income. Adjustments will usually be made for policy reasons (e.g. to apply the CGT discount). $20,000 Continuing the example, suppose that 75% of the services were provided over the course of the year of payment with the other 25% provided over the course of the following year. Current law: Under the prepayment rules, Cogal gets a deduction in the first year for half its payment ($10,000). The other $10,000 is claimed in the second year. The deduction under the prepayment rules is worked out on the basis of time rather than actual consumption of benefits. TVM: Net income for the first year would look like this: [0 – 20,000] + [5,000 – 0] – [0 – 0] = –15,000 The asset at the end of the year is the right to the remaining consulting services, whose tax value reflects that 75% of the services have been received in that year. It partly matches the $20,000 payment. In the second year, net income looks like this: [0 – 0] + [0 – 5,000] – [0 – 0] = –5,000 Cogals assets have declined by $5,000 because its right to the rest of the consulting services was satisfied. The difference in outcome reflects the appropriate economic allocation as recommended by the RBT. Cogal Ltd pays Intones Consulting, a management consulting firm, $20,000 cash to advise on a restructuring of its divisions. The advice is given in the same income year as the payment. Current law: Cogal gets an immediate deduction for the $20,000 (assuming it is a revenue expense). TVM: Net income would look like this: [0 – 20,000] + [0 – 0] – [0 – 0] = –20,000 The result is the same as the current law. Cogals $20,000 cash payment simply reduces its net income. Continuing the example, look at the consulting firms position in the prepayment case. Current law: Intones Consulting has received $20,000 but only 75% has been earned, so only $15,000 is assessable income in the first year. The other $5,000 will be assessable income, under ordinary income principles, when the remaining advice is given in the second year. Note the lack of symmetry with the deduction available to Cogal. TVM: Net income for the first year would look like this: [20,000 – 0] +[0 – 0] – [5,000 – 0] = 15,000 The result is the same as the current law. The firms $20,000 cash receipt is partly matched by a $5,000 increase in its liabilities (obligation to provide future advice). The second year would look like this: [0 – 0] + [0 – 0] – [0 – 5,000] = 5,000 The decline in the firms liabilities increases its taxable income. Note that the treatment is in symmetry with the treatment of Cogals prepayment. PAYMENT FOR SERVICESPREPAYMENT FOR SERVICES RECEIVING THE PREPAYMENT Jacks Bookshop $10,000 Current law: Jack would deduct the $10,000 it spent and return the $8,000 from sales as assessable income. It would also account for any difference between its opening and closing stock. Choosing cost as its method of valuing the books, its $5,000 increase in stock (half of the $10,000) would be assessable income. These transactions increase Jacks taxable income by $3,000. TVM: Net income would look like this: [8,000 – 10,000] + [5,000 – 0] – [0 – 0] = 3,000 The result is the same as the current law. Jacks closing stock on hand (tax value $5,000) and cash received from sales ($8,000) is reduced by the $10,000 cash it paid, leaving $3,000 to be taxed. Amanda buys Cranmere, a rural property, for $1m in year 1. In year 2 its market value increases to $1.5m. She enters into negotiations to sell it and does sell it in year 3. Current law: Amanda would have made a capital gain of $0.5m in year 3. She would be taxed on $0.25m because the gain would be reduced by $0.25m for the 50% capital gains tax discount. TVM: Net income for year 1 would look like this: [0 – 1m] + [1m – 0] – [0 – 0] = 0 There is no taxable income because Amandas $1m payment is matched by the tax value of the land. In year 2, her net income is: [0 – 0] + [1m – 1m] – [0 – 0] = 0 There is no change, even though the propertys market value has gone up, because the tax value of investment assets like this equals their cost. In year 3, net income is: [1.5m – 0] + [0 – 1m] – [0 – 0] = 0.5m Amandas receipt of $1.5m is offset by the decline of $1m for the land, realising the $0.5m gain. She would then have an adjustment of –$0.25m for the 50% investment asset discount (currently called the capital gains tax discount). Jack Pty Ltd buys some books for $10,000 towards the end of the year. By the end of the year, it has sold half of them for $8,000. Cogal buys new plant at the start of the year for $50,000. Current law: Cogal could deduct a portion of the $50,000 worked out to spread the deduction over the plants 20 year effective life. The amount deducted depends on which depreciation method Cogal chooses. Cogal chooses to use the straight line method. The deduction works out to $2,500 per year. TVM: Under TVM, Cogal would go through the same process but, instead of working out a deduction, it would be working out how much the plants tax value declines. In the first year net income would look like this: [0 – 50,000] + [47,500 – 0] – [0 – 0] = –2,500 Cogals $50,000 cash spent is partly matched by the tax value of the plant at year end ($47,500). The difference is a –$2,500 taxable income effect. In the second year, net income would look like this: [0 – 0] + [45,000 – 47,500] – [0 – 0] = –2,500 The –$2,500 effect is attributable to the decline in the tax value of the plant. The same result would apply for each of the remaining years in its effective life. TVM changes the legislative expression of how to work out taxable income and tax loss to... Net incomeAdjustments Cashflow plus Change in the tax value of assets you hold (excluding cash) less Change in the tax value of liabilities you have Capital gains discount R&D Gifts Unused tax losses Other adjustments... + DEPRECIATIONTRADING STOCK CAPITAL GAINS When is there income under TVM? There is income under TVM when there is an unmatched increase in cash or the tax value of assets, or an unmatched decrease in the tax value of liabilities. When is there a deduction under TVM? There is a deduction under TVM when there is an unmatched decrease in cash or the tax value of assets, or an unmatched increase in the tax value of liabilities. Individuals and STS taxpayers ignore some assets and liabilities for cash basis treatment Exclude appropriate private or domestic items for individuals Others can work out cashflow as the difference between opening and closing cash Closing tax value of assets Opening tax value of assets Closing tax value of liabilities Opening tax value of liabilities ReceiptsPayments 12 3 456


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