Henry Tax Review

The Federal Government released the long awaited Henry Review which has the overall objective to strengthen growth to maximise Australia’s wealth creation potential. The review was charged with completing a “root and branch” approach whilst providing a “blue print” for the Australian tax system to respond to the current deficiencies, take into consideration our ageing population, environmental pressures and address our lack of national savings over the next 10 to 15 years.

Even though Australia survived the Global Financial Crisis without descending into a recession we are faced with the challenges of:
-          shifting world economic activity;
-          a changing labour market;
-          the rise of Asia; and
-          ever increasing standard of living expectations.

Consequently the Henry Tax Review contained 138 comprehensive recommendations covering personal income tax, superannuation, family assistance payments, small business and retirement incomes. For a copy of the full report please click here.

Even though the report contained a large number of recommendations, the government has:
-          responded by making initial changes to the tax system (as outlined below);
-          released a report outlining the reasons for the current announcements stemming from the report (for a copy of the full report please click here); and
-          announced a list of recommendation made by the review that it will not adopt or proceed with in future (as outlined below).

The government’s response: Initial changes to the tax system

§         A reduction in company tax from 30 to 28 per cent by 2015.
§         Small business to benefit from company tax cut to 28 per cent from 2012 and other write-off concessions for small business. This includes an increase to $5000 of the immediate write-off threshold (up from $1000). 
§         Introduction of a 40 per cent Resources Super Profits Tax from July 2012 including a refundable credit to resource entities from state royalties.
§         An infrastructure fund to be paid to the states each year to start at $700 million in 2012.

Superannuation changes:

-          A 12 per cent Superannuation Guarantee (SG) – commencing with a 0.25 per cent increase in 2013-14 and 2014-15, followed by 0.5 per cent increments until the SG reaches 12 per cent by 2019-20. The three year lead time recognises that employers and employees need to factor this into future wage negotiations. Note:  The SG rate increase is a government initiative and not a recommendation of the review.

-          A low income earners government contribution – from 1 July 2012. The government will provide a contribution of up to $500 annually into the superannuation account of workers on adjusted taxable incomes of up to $37,000. This will provide a reward for savings for low income earners by ensuring no tax is paid on SG contributions. The government will also retain the co-contribution scheme.
-          Concessional superannuation contribution caps for those nearing retirement – from 1 July 2012. Workers aged 50 and over with superannuation balances below $500,000 will be able to make up to $50,000 in annual, concessional superannuation contributions. This measure is expected to benefit 275,000 people.

-          Raising the SG age limit from 70 to 75 – from 1 July 2013. The SG age limit will be raised to 75, which for the first time means workers aged 70 to 74 will be eligible to have SG contributions made on their behalf. Around 33,000 employees are expected to benefit from this measure.

These announcements should provide confidence and a boost to income in retirement for many Australians. The introduction of the “catch up concessional contribution cap” for clients over age 50 with superannuation balances under $500,000 provides certainty after 1 July 2012, whilst the increase in the superannuation guarantee contribution rate to 12 per cent will make a significant impact to retirement savings especially for younger workers. For older workers seeking to maximise the contributions, they will need to reduce the level of salary sacrifice to accommodate for the continued rise in the SG contribution rate – albeit a reduction in the tax effectiveness of a salary sacrifice strategy.

These announcements are subject to industry consultation before the draft legislation will be available for review. At this stage, superannuation splitting between couples (including same sex and opposite sex couples) will prove effective. This may present a long term opportunity for a client to split with a spouse in order to keep their account balance under $500,000 and to retain access to the catch up concessional contribution cap whilst over age 50.

Other strategies may become relevant such as smoothing of investment returns within Self Managed Superannuation Fund or transition to retirement in order to actively manage a client’s account balance to remain within the $500,000 limit. Clients should consider superannuation splitting at a younger age over a longer period of time.

Even though the government will increase the age for receiving SG contribution support from age 70 to 75, it is unlikely this will have a significant impact due to this age bracket working reduced hours (ie part-time) and transitioning into retirement.

Government quick to rule out some recommendations

The government has been quick to announce a list of recommendations made by the Henry Tax Review that it will not adopt or proceed with in future.  The list includes the following:

-          Include the family home in means tests (see Recommendation 88c).
-          Introduce land tax on the family home – this is a state tax and thus an issue for the states (see Recommendations 52 & 53).
-          Require parents to work when their youngest child turns four (see Recommendation 85).
-          Hit single income families (see Recommendations 92 & 93).
-          Restrict eligibility to rent assistance for families (see Recommendation 103).
-          Do any changes to the tax system that harm the not-for-profit sector, including removing the benefit of tax concessions, raising the gift deductibility threshold or changing income tax arrangements for clubs (see Recommendations 9e, 13, 41, 43 & 44).
-          Reduce overall remuneration to the members of our defence forces (see Recommendations 6d, 8c & 9e).
-          Reduce the CGT discount; apply a discount to negative gearing deductions, or change grandfathering arrangements for CGT (see Recommendations 14 & 17c).
-          Remove the Medicare levy (see part of Recommendation 5).
-          Reduce indexation of the age pension (see Recommendation 84).
-          Remove the benefits of dividend imputation (see Recommendation 37).
-          Think of hitting pensioner and low income concessions for utilities, transport and other essential services (see Recommendation 107).
-          Introduce a bequests tax (see Recommendation 25).
-          Align preservation age with pension age (see Recommendation in AFTS Retirement income strategic issues paper).
-          Offer a government annuity product (see Recommendation 22).
-          Ask the States to charge market rents to public housing recipients (see Recommendation 106).
-          Abolish the luxury car tax (see Recommendation 80).
-          Index fuel tax to CPI (see Recommendation 65).
-          Change alcohol tax in the middle of a wine glut and where there is an industry  restructure underway (see Recommendation 71).
  
Further detailed analysis of the Henry Tax Review

The following information includes a detailed analysis of five main areas of the Henry Tax Review.

1. Personal income tax

Some of the highlights within the personal income tax section of the report are outlined as follows:

• Progressivity in the tax and transfer system should be delivered through the personal income tax rates scale and transfer payments. A high tax-free threshold with a constant marginal rate for most people should be introduced to provide greater transparency and simplicity. 
• The primary unit in the personal tax system should continue to be the individual, and subsidies for dependants through the tax system should be restricted. Optional couple assessment for people of late retirement age (i.e. income is assessed jointly for taxation purposes).  
• Income support and supplementary payments should be tax-exempt (e.g. family assistance payments and payments that are similar in nature to income support such as scholarships). 
• The Medicare levy and structural tax offsets — the low income, senior Australians, pensioner and beneficiary tax offsets — should be removed as separate components of the system and incorporated into the personal income tax rates scales. If a health levy is to be retained, it could be applied as a proportion of the net tax payable by an individual. 
• To remove complexity and ensure government assistance is properly targeted, concessional offsets should be removed (e.g. mature age worker, employment termination payments), rationalised (e.g. existing dependency offsets should be replaced with a single dependant tax offset), or replaced by other payments. 
• Consistent with recommendations by the National Health and Hospitals Reform Commission which means the medical expenses tax offset should be removed whilst the Medicare levy surcharge and assistance for private health insurance should be reviewed as part of the package of tax and non-tax policies relating to private health insurance. 
• All forms of wages and salary for Australian resident taxpayers should be taxable on an equivalent basis and without exemptions (eg exemptions for foreign employment income should be removed and such income should be taxed at marginal tax rates). 
• Consideration should be given to a revised regime to prevent the negative consequences of alienation of personal services income that would extend to all entities earning a significant proportion of their business income from the personal services of their owner-managers, whether in employee-like or non-employee-like cases.  
• A standard deduction should be introduced to cover work-related expenses and the cost of managing tax affairs to simplify personal tax for most taxpayers. Taxpayers should be able to choose either to take a standard deduction or to claim actual expenses where they are above the claims threshold, with full substantiation. 
• There should be a tighter nexus between the deductibility of the expense and its role in producing income. 
• Gift deductibility should be retained, with the deductibility threshold raised from $2 to $25. 
• Provide a 40 per cent savings income discount to individuals for non-business related:
       (a)     net interest income;
       (b)     net residential rental income
             (including related interest 
             expenses);
       (c)     capital gains (and losses); and
       (d)     interest expenses related to listed
             shares held by individuals as non-
             business investments. 
• All forms of wages and salary for Australian resident taxpayers should be taxable on an equivalent basis and without exemptions. For example, private education payments provided in respect of employment or as an incentive to undertake employment and employment-related payments should be assessed as income and taxed at marginal tax rates. 
• Consideration of alternative company tax income arrangements and dividend imputation consideration should be given to extending the discount to other savings income such as:
• Rationalising and streamlining the current small business capital gains tax concessions (eg removing the active asset 50 per cent reduction and 15-year exemption concessions).
• Removing current grandfathering provisions relating to assets acquired before the commencement of capital gains tax.
• Rewriting the capital gains tax legislation using a principles-based approach that better integrates it with the rest of the income tax system.

Commentary: 

Change in personal income tax rates: The report provides an indicative personal income tax rates scale which is progressively delivered through a $25,000 tax-free threshold and a constant marginal tax rate of 35 per cent up to $180,000.

An increased tax-free threshold would increase the amount of tax-free income for low income earning Australians from $15,000 to $25,000 (based on the low income earner tax offset for the 2009/2010 financial year which applies to taxable income less than $30,000 and reduces up to $63,750).

For a high income earner earning $180,000 pa, this would provide a tax saving of $1,600 (ie $55,850 using 2009/2010 tax scales less $54,250 under the proposed new system whilst ignoring Medicare levy). Note: based on marginal tax rates for the 2010/2011 financial year, the benefit reduces to $300 for a client earning $180,000.

For an average income earner on $80,000 per annum, they will be worse off by $1,400 for the 2009/2010 financial year and $1,700 for the 2010/2011 financial year if implemented (ie tax on $80,000 based on current marginal tax rates will be $17,550 in comparison to $19,250 whilst ignoring Medicare levy).

Removal of tax offsets: Removing some of the tax offsets available to working Australians (eg mature age workers offset or medical expenses tax offset) will address the indirect nature of these offset whilst applying a higher tax-free threshold and adjustments to personal income tax rates.

Imputation credits: The review concludes that the dividend imputation credit system should be retained in the short to medium term, but consideration should be given to alternatives as part of a broader overhaul of the company tax system.

Changes to negative gearing: The report has recommended a savings income discount of 40 per cent be applied to net rental income from residential investment property or interest expenses related to listed shares held by clients. The review has not recommended the removal of negative gearing but it may diminish the value of tax benefit of the strategy.

The savings income discount will reduce the tax effectiveness of negative gearing for high income earners whilst having an impact on the various underlying asset class (eg impact the available supply of residential housing).

Changes to taxation on savings: If adopted, the 40 per cent savings income discount on interest income should alleviate the disincentives for clients to retain cash or fixed investments. It remains to be seen whether this change will alter savings patterns although it does not alleviate the impact of inflation and clients will still need to seek growth investments as part of their long term retirement planning strategy.

Insurance bonds and dividends are not included in the 40 per cent discount: The Review recommended that the 40 per cent discount on savings only applies to net interest income; net residential income (including related interest expenses); capital gains and interest expenses relating to listed shares. It was not to apply to dividends or to insurance bonds.  However, insurance bonds will still benefit from the reduction in the corporate tax rate.  
 Initial government response

The government has indicated the Medicare levy will not be removed whilst the savings income discount of 40 per cent will not apply to capital gains (which currently sits at 50 per cent) or to negative gearing. Other changes to the grandfathering arrangements for capital gains tax for assets purchased prior to the introduction of capital gains tax in 1985 (ie pre 1985 CGT assets) will not be adopted.

The government has not ruled out further changes and consultation within the area of company taxation (including the dividend imputation credit system). The imputation credit system will remain and this has been confirmed by the Treasurer Wayne Swan who would not remove it at any stage.

Even though one of the key recommendations is to simplify the income tax system with a standard deduction for the majority of taxpayers, this will be considered within the next term after the election which is expected later this year. At this stage, any future changes to the personal income tax rates will be shelved by the Treasurer for at least four years.

The Treasurer has been clear the recommended changes to the tax system that harm the not-for-profit sector (including removing the benefit of tax concessions) or raising the gift deductibility threshold will also not be adopted.
  
2. Retirement incomes/superannuation

Some of the highlights within the retirement incomes section of the report are outlined as follows:

• The tax on superannuation contributions in the fund should be abolished. Employer superannuation contributions should be treated as income in the hands of the individual, taxed at marginal personal income tax rates and to receive a flat-rate refundable tax offset.
• An offset should be provided for all superannuation contributions up to an annual cap of $25,000 (indexed). The offset should be set so the majority of taxpayers do not pay more than 15 per cent tax on their contributions. The cap should be doubled for people aged 50 or older.
• An annual cap on total contributions should continue to apply.
• The offset should replace the superannuation co-contribution and superannuation spouse contribution tax offset.
• Compulsory superannuation contributions made by employers should not reduce eligibility for income support or family assistance payments. They should also not form part of the calculation for child support.
• The rate of tax on superannuation fund earnings should be halved to 7.5 per cent. Superannuation funds should retain their access to imputation credits. The 7.5 per cent tax should also apply to capital gains (without a discount) and the earnings from assets supporting superannuation income streams. 
• The restriction on people aged 75 and over from making contributions should be removed. However, a work test should still apply for people aged 65 and over. There should be no restrictions on people wanting to purchase longevity insurance products from a prudentially regulated entity.
• The government should support the development of a longevity insurance market within the private sector. 
• The government should consider offering an immediate annuity and deferred annuity product that would allow a person to purchase a lifetime income. This should be subject to a business case that ensures the accurate pricing of the risks being taken on by the government. To limit the government’s exposure to longevity risk, it should consider placing limits on how much income a person can purchase from the government.
• The government should help make people more aware of the retirement income system, and therefore better able to manage their superannuation, by increasing the regularity of SG contributions, making it easier for people to manage their superannuation and providing people with a single point of contact for government agencies. 
• While no recommendation is made on the possible introduction of a tax on bequests, the government should promote further study and community discussion of the options.

Commentary: 

The recommendations contained within the report are not as extensive as the government’s superannuation announcements.

The government has not adopted a change in the collection of tax on superannuation contributions via a taxpayer’s personal income tax return. The review includes an analysis on the progressive taxation of superannuation contributions and in particular this new method will allow the government to reduce the tax concessions available to high income earners above $180,000 by reducing the offset available to 20 per cent.

At this stage, the government has not announced that it will reduce the tax effectiveness of superannuation contributions for high income earners by imposing a 25 per cent contributions tax rate (ie marginal tax rate of 45 per cent less 20 per cent offset). The government has instead focused on increasing the SG rate, but introducing a 25 per cent contributions tax rate may be addressed within their next term in government.

As part of these announcements, the government has failed to extend the contribution age to over 75 but it has stopped short of removing the co-contribution scheme as included within the report.

The government has chosen not to comment on the introduction of the flat 7.5 per cent tax on earnings (including capital gains) on both superannuation and pension accounts. This reduction would increase the tax effectiveness of concessional contributions (i.e. salary sacrifice) for high income earners. On the other hand, the government had excluded the tax-free super for over 60 from the tax review. Therefore, current retirees could experience a de-facto tax limited to the pension earnings if introduced.

Initial government response

The government has indicated that it will not offer a government annuity product which would have a direct impact on the private sector offering annuities. A preference exists to support the industry to remove the barriers to offer this product by issuing long term securities or help annuity providers manage risk in order to address the concerns regarding longevity risk. 

The government has ruled out introducing a tax on bequests even though there will be a significant intergenerational wealth transfers over the coming twenty to thirty years.

3. Means testing – age pension

The report included various recommendations regarding Government Welfare Payments (eg age pension). However, the most important focus of the report is on the current income and asset tests for income support payments which should be replaced with a comprehensive means test based on a combined measure of employment income, business income and deemed income on assets.

The comprehensive means test would:
(a)     extend deemed income on assets in addition to financial assets, including superannuation income streams, rental housing and other asset classes (whether income-producing or not). Superannuation income streams where deeming income would be difficult to apply would be tested on gross income but with an actuarially fair deduction for capital;
(b)     have low and high deeming rates based on the returns expected from a portfolio of assets held by a prudent investor. These rates should be set by reference to an appropriate benchmark;
(c)     continue the means test exemption for owner-occupied housing up to a high indexed threshold;
(d)     set a high capped exemption for personal-use assets;
(e)     retain the current concessional treatment of employment income for certain allowances and pensions;
(f)       have different income free areas for pensions and allowances; and
(g)     remove the liquid assets waiting period and the sudden-death cut-out that applies to people on certain payments.

Commentary: 

It was expected the report would contain recommendations to transition to a single income test assessment for age pension as mentioned within the Retirement Income Strategic Issues Paper (released on 12 May 2009). This will simplify the means testing for age pension entitlement. However, coupling the extension of deeming to superannuation income streams, rental housing and other asset classes (eg land), this will have significant impact on clients’ age pension entitlements.

Clients who have sought to obtain investment returns above the standard deeming rates have been rewarded in the past. However, with the introduction of expected portfolio returns set in reference to appropriate benchmarks will warrant a rethink of the strategy into the future.

Advisers should be aware of these potential changes and whether or not a client over age 60 should commence a superannuation income stream to secure the favourable income test treatment (ie gross income less Centrelink Deductible Amount) will be worth considering.

Initial government response

The government has stated that it will not include the family home in means tests which will bring a sigh of relief to many Australians that may be asset rich but income poor during retirement due to the size of the family home.
  
4. Business (including small businesses)

Some of the highlights within the business section of the report are outlined as follows:

• The company income tax rate should be reduced to 25 per cent over the short to medium term with the timing subject to economic and fiscal circumstances.
• The current small business capital gains tax concessions should be rationalised and streamlined by removing the active asset 50 per cent reduction, the 15-year exemption concession and increasing the lifetime limit of the retirement exemption by permanently aligning it with the capital gains tax cap for contributions to a superannuation fund.
• The small business entity turnover threshold should be increased from $2 million to $5 million, and adjustments to the $6 million net asset value test should be considered.
• State payroll taxes should eventually be replaced with revenue from more efficient broad-based taxes that capture the value-add of labour.
• The luxury car tax should be abolished.
• Companies should be allowed to carry back a revenue loss to offset it against the prior year’s taxable income, with the amount of any refund limited to a company’s franking account balance.
• The capital allowance arrangements for small business should be streamlined and simplified, by:
• allowing depreciating assets costing less than $10,000 to be immediately written-off, and
• allowing all depreciating assets (except buildings) to be pooled together, with the value of the pool depreciated at a single declining balance rate.
• Fringe benefits that are readily valued and attributable to individual employees should be taxed in the hands of employees through the PAYG system. The scope of fringe benefits that are subject to tax should be simplified along with the following changes: 
• Market value should generally be used to value fringe benefits.
• The current formula for valuing car fringe benefits should be replaced with a single statutory rate of 20 per cent, regardless of the kilometres travelled.
• All fringe benefit tax (FBT) exemptions should be reviewed to determine their continuing appropriateness.
• Not-for-profit entities’ FBT concessions should be reconfigured.

Commentary: 

The recommendation to reduce the corporate tax rate to 25 per cent is a much needed boost to Australian small businesses.

The report has also recommended a mix bag regarding CGT for small business owners selling. The increase to $5 million (from $2 million) for small business turnover will broaden access to the small business concessions but with the removal of the 50 per cent active asset reduction and the 15 year exemption may lessen tax planning opportunities. Many small business owners close to retirement plan to utilise the sale proceeds for their retirement funding but even if the retirement exemption is increased to the CGT exemption limit of $1,155,000 (2010/11 year), this will be limited to only the assessable capital gain and not the sale proceeds (like under the 15 year exemption). Small businesses should welcome the recommendations to depreciable small business assets and revenue losses.

The announced changes to FBT will diminish the benefit of salary packaging a vehicle under the statutory formula but there has been no mention of changing the operating cost method which can provide tax benefits for taxpayers utilising a vehicle predominantly for work proposes.     

Initial government response

The government’s recommendation to reduce the corporate tax rate from 30 per cent to 28 per cent is welcomed and should encourage long term economic growth. Eligible small businesses will be entitled to the rate drop two years prior (from the 2012/13) to other companies that will be implemented in the 2014/15 financial year.
  
The government has gone only half way on the changes to depreciation by allowing small businesses to write-off assets worth up to $5,000 (recommendation was $10,000).
  
5. Other interesting Henry recommendations

• Current family payments, including Family Tax Benefit Parts A and B, should be replaced by a single family payment. The new family payment should:
       (a) cover the direct costs of children in  a low-income family (that is, the costs associated

           with   food, clothing, housing, education expenses); and
     (b) assist parents nurturing young children to balance work and family
          responsibilities.

• The direct cost of children in the family assistance component should be a per child payment.
       (a) Rates of payment should increase with the age of the children to recognise the

          higher costs associated with older children. Three rates of payment should
          apply: for 0–11 year olds; 12–15 year olds and 16–18 year olds while
          in secondary school. These age bands would appropriately accommodate the
          increasing costs of children (this would require higher payments rates for 12, 16 and
          17 year olds). The Baby Bonus should be abolished and a small supplementary
          payment, reflecting the direct costs of a new-born baby, should be paid over the first
          three months.
     (b) A shared-care rate to recognise the higher costs of separated families should
          be considered, taking into account interactions with child support as well as other income
          support payments.
     (c) Additional payments for larger families, including the Large Family Supplement,
          the Multiple Birth Allowance for children over one year, and higher thresholds for
          larger families should be reconsidered as the case for these payments is not strong.

• Child Care Benefit and Child Care Rebate should be combined into a single payment to parents (or to child care centres) in respect of each child based on a percentage of child care costs. The payment should have the following features:
       (a) a high rate of subsidy for low-income families that covers most of the costs of child

          care (up to 90 per cent). This would involve a small co-payment for low-income
          families;
     (b) a base rate of assistance for all families that use child care to facilitate parental
          engagement in the workforce. The base rate of assistance should be set as a
          proportion of child care costs, with reference to the marginal tax rate faced by the
          majority of taxpayers. (Based on the indicative personal income tax rates scale in Part Two
          Section A1, this would indicate a rate of assistance of 35 per cent);
     (c) access to the base rate of assistance subject to a requirement that parents participate
          in   work, education or training. Where parents are not participating, the maximum rate
          of assistance should be available for a limited number of hours. The number of hours
          subsidised without a participation requirement should be the same as the number of
          hours of universal  access to pre-school (15 hours by
          2013); and
     (d) coverage of the full costs of child  care for at-risk children and children
          facing multiple disadvantages, without participation requirements
          on parents.

• The child care payment should be means tested down to the base rate of assistance based on family income and should have regard to the interaction with other means tested payments (income support and family payments) and marginal tax rates, to ensure that effective marginal rates of tax are not excessive.

Conclusion

The government’s response to the Henry Tax Review can be viewed as a key component of its upcoming election campaign later this year and it should feature heavily in next week’s budget.

Over the coming months, the government has stated it will continue to comment on a number of other areas considered within the review, especially making tax time simpler for everyday Australians, improving incentives to save, and improving the governance and transparency of the tax system. It is quite clear this could represent a full second term agenda (if re elected).

“Summary contributed by Futuro’s key partners”.