FIXING THE DEFECTIVE JIGSAW.

• Date: 01 August 2021
• Author: Cooper, Graeme S.

CONTENTS I Introduction II Design A Taxing Depreciating Assets B Taxing Revenue Assets III Execution A The TOFA Regime B The Consolidation Regime IV The 'So What?' Question I INTRODUCTION

I wish to start this article with two aphorisms. The first is often ascribed to Mark Twain: 'The weather ... is a matter about which a great deal is said and very little done'. (1) The second is usually attributed to the less well-known American satirist and curmudgeon HL Mencken: 'there is always a well-known solution to every human problem--neat, plausible, and wrong'. (2) Taken together, they capture nicely the argument of this paper: faced with perennial complaints about the complexity of Australia's tax system, our policymakers prevaricated; but when they decided to act, they pursued approaches they believed to be clear and simple; they turned out to be wrong.

So, this article is about reform of tax laws, but not tax reform writ large. I say that because the term 'tax reform' is employed in public debates as if it were a single idea with an agreed meaning, but as the late Justice Hill reminded us, 'tax reform being subjective can have no fixed meaning'. (3) Ideas routinely floated under the label 'tax reform' are driven by different visions of the evil to be remedied: our taxes interfere too much in economic decisions (the work-leisure choice, the save-spend choice, and the invest here-invest there decision); our tax system discourages foreign investors; we must address bracket creep; the tax burden is regressive; our tax system is gender-biased; and so on. Different evils imply different (and often contradictory) actions: expand the goods and services tax ('GST'); decrease the corporate tax rate; impose a wealth tax or a digital services tax; repeal stamp duty; flatten the personal income tax rate scale; tax female wages at rates lower than male wages; and so on.

These visions of tax reform raise principally economic questions, but my focus is on the part of the tax system that lawyers created, and which they alone can fix: the design and execution of our tax laws. By 'design' I mean the architecture of the tax law--the assembly of the different components of a statute into a whole. (4) By 'execution' I mean the odd drafting styles that have been used by succeeding generations of drafters since 1995. (5) I will use the income tax for my examples, although the same story could be told about other Commonwealth taxes.

I choose this topic because I want to revisit topics that have occupied me for almost 25 years. I have written elsewhere, on many occasions and at tedious length, about the problems of Australia's tax legislation and I am going to revisit that work in this article. (6) Let me apologise to those who have heard this argument before and to those who don't need convincing, but I don't think one can say too often or too loudly just how poorly we are served by our legislation. Australia's income tax assessment Acts must be among the worst statutes one could ever encounter. (7) The tax legislation of any country is invariably complex and difficult--tax statutes everywhere are unique beasts--but our legislation excels in needless obscurity and difficulty.

I should say something about the title of this article. In 1986, Professor Ross Parsons delivered a famous lecture in which he likened the income tax to a supernova, (8) but I prefer a different metaphor: the income tax is more like a jigsaw puzzle, and a defective jigsaw at that--important pieces are missing, there are many duplicates, and the image we are to replicate has been deliberately blurred. My point is that, even if our legislators were minded to adopt a modern reform plan--say, a wealth tax or a destination-based, cash-flow corporate tax--that reform would likely be beset by exactly the same problems evident in the income tax. The legislation would be oddly written, and over time any coherence to the original design would be lost.

In my experience, while these problems of structure and execution are not unknown in other statutes, they are very pronounced in tax laws. The decisions about design and drafting are not accidents or mistakes--they are deliberate policy choices. And they are not viewed as unfortunate or unavoidable or misguided --they are seen as virtues. So, any change to address the problems I see would require abandoning current fashions and convictions. That might not be wishful thinking--there is evidence that some in government have now recognised the preoccupation of the last 25 years with a language experiment was misguided:

While useful in addressing a particular aspect of complexity, the overall value of simplifying the drafting of legislation without any change in underlying outcomes is questionable. Simplifying language can only do so much if the underlying policy remains highly complex. In many cases, it will simply make the complexity of the policy more apparent and, in practice, only benefits the very small section of society using the tax legislation itself or related guidance material. (9) While this epiphany--that focusing on different drafting styles is not especially productive--is welcome, the drafters of the 'Re:think: Tax Discussion Paper' have the diagnosis only half right. (10) They are right to doubt the value of the drafting experiments, but attributing the problems of our tax legislation to this new culprit--complex policy prescriptions--is misguided. None of the examples below involves complicated policies: they are instances of simple policies, badly delivered.

II DESIGN

My catalogue of structural flaws in the design of the income tax law has many entries: regime duplication and overlap (typically by legislative accretion); legislating inconsistent regimes; legislating regimes that are internally flawed; failure to remove legislative detritus; legislating by omission; legislative amnesia; and so on.

Another pervasive problem is the unending chase. The simplest way to demonstrate what I have in mind is with an example: one taxpayer borrows a machine from another to use in its business, and the borrower agrees to pay for the privilege. The borrower will want to know whether it can deduct the payment it is making to the lender, but in order to answer that question it now has to navigate a course through a plethora of regimes:

* Is the payment deductible or should it be absorbed as a cost or neither? That will require a journey through the Income Tax Assessment Act 1997 (Cth) s 8-1, divs 40, 240, 242, 250 ('ITAA 1997').

* That answer might then be affected by whether the arrangement amounts to a 'debt interest', (11) which will mean inquiring into ITAA 1997 div 974 or ss 25-85, 26-26.

* There is also a remote possibility that this might be a 'financial arrangement' which means looking at ITAA 1997 div 230 to be sure the conditions for the licensing exception are met. (12)

* The tax system also requires the borrower to think about compliance obligations such as no-ABN withholding in the Tax Administration Act 1953 (Cth) sch 1 div 12 ('Tax Administration Act'), and this brings into play ITAA 1997 s 26-105.

* The borrower will also have to examine how much debt it is currently carrying and consider whether the arrangement will be affected by the thin-capitalisation rules in ITAA 1997 div 820.

* If the owner happens to be a foreigner, a new complication arises: the borrower will need to establish whether the asset is connected to a permanent establishment of the lender here and to look at the Income Tax Assessment Act 1936 (Cth) s 128B ('ITAA 1936') to decide whether the lender is liable to interest-withholding tax or royalty-withholding tax, because if either is relevant, that will raise different compliance obligations for the borrower under the Tax Administration Act and bring into play ITAA 1997 s 26-25.

* If the owner is foreign there is the possibility that the transaction might be a hybrid financial arrangement, (13) or the lender might be a hybrid entity or there might be a hybrid arrangement or entity one or more stages removed from these parties, and that would trigger ITAA 1997 div 832.

After that exhausting chase, the answer to that borrower's question is: you may be able to deduct all of the payment, some of the payment, none of the payment, or something else entirely.

Too many matters in tax do not admit simple answers because of the way our legislation is constructed. In this article, I choose to dwell on regime duplication and overlap. Duplicating an existing tax regime with a newer version is habitual in Australia's tax laws--there is a clear preference for being deliberately overambitious: 'leave the existing tax claim in place, add another tax claim as well'. The difficulties of regime duplication can be seen in many places. It is perhaps the most annoying and unnecessary design defect and, once done, it is very hard to solve.

Take, for example, the taxation of financial arrangements regime ('TOFA'). (14) When it was enacted in 2009, (15) it was decided that TOFA would simply overlay all the existing law for taxpayers who were inside TOFA: the multitude of rules dealing with the assessability (or deductibility) of interest; the treatment of discounts or premiums on the issue of securities; profit (or losses) on the sale of debt securities; writing off bad debts; forgiveness of debts; the treatment of debt denominated in foreign currencies; and so on. All of those rules remained in place and applied, and TOFA applied as well. (16) The duplication was to be handled by an ordering rule and a numerical calculation: in most cases, the TOFA rules would be applied first and the income tax rules applied second. (17) Any amount taken into account in making the TOFA calculations would be excluded in making the income tax calculation. (18) That sounds simple but problems still arise. Take debt forgiveness. The statutory debt-forgiveness rules are applied before TOFA. (19) That creates a circularity...