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An Analysis of a Cash Flow Tax for Small Business  - WP 02/27

3  A CFT for small businesses

This section outlines how a CFT could apply to small businesses. It is based on a CFT developed by Treasury in 1997.

3.1  The basic rules

The proposed regime can be characterized as a “modified R-base” regime – for most taxpayers and most transactions, real transactions in goods and services are taxed on a cash-flow basis, while financing flows are tax-exempt. Table 5 sets out the basic rules for how businesses are taxed on various cash flows.

Table 5– Rules for taxing cash receipts and outgoings
Type of flow Rule
All cash outgoings Deductible immediately, if there is a connection between the outgoing and the derivation of taxable income
All cash receipts Taxable, unless they are derived in respect of a financial arrangement
All distributions of dividends, interest, principal and subscribed capital by a business Tax-free in the hands of recipients
Distinction in respect of expenditure or revenue connected with assets subject to cash flow treatment None
Losses that cannot be utilized Carried forward and uplifted by a risk-free rate of interest (a government bond rate).

3.1.1  Treatment of financing flows at the business level

The CFT designed by the Treasury 1997 proposed taxing value-added at source by providing that for almost all businesses, cash flows in respect of real assets will determine net taxable cash flow, financing flows will be ignored in calculating taxable income (non-deductible, non-assessable) but firms will be required to pay additional tax in respect of distributions other than from past contributions of capital, the risk-free rate of return on contributed capital, or income on which tax has previously been paid. This mechanism by which this is achieved relies on tracking qualifying capital and distributions through the operation of a “qualifying distributions account”.

The “qualifying distributions account” (QDA) was a mechanism designed to preserve the simplicity of an R-base CFT, while protecting the tax base. In the absence of the QDA there would be considerable pressure on the real asset/financial asset boundary – taxpayers would, for example, face strong incentives to characterise expenditures as real flows (perhaps as the cost of goods sold) and inflows as financial flows (perhaps as interest on trade finance extended to purchasers of the firm’s goods). Table 6 contains the rules for taxing financial flows.

Table 6– Rules for taxing financial flows
Type of flow Rule
Amounts lent to (subscribed in) a business Expenditure on debt and equity instruments issued by a business is not deductible since returns to such assets are tax-exempt. 
Tax treatment of borrowed money Principal on amounts borrowed by any business is non-taxable.  Repayments of principal and interest are non-deductible.
  Where money is borrowed for non-business purposes, the lender will have dealt with the loan on a cash flow basis, effectively exempting from tax the risk-free rate of return in the lender’s hands. 

3.2  Simplification potential of a CFT

A CFT offers two simplification potentials. First are those inherent in the tax, which are that many of the measurement and all of the timing issues of an income tax would disappear. For example, firms would not need to depreciate property over its life, since they receive an immediate deduction on acquisition. Likewise, on disposal, there are no issues of depreciation claw-back or a revenue/capital boundary: all proceeds are assessable. Importantly, a CFT is easy to understand and could, therefore, lead to a significant increase in the confidence that the owners of firms have in their understanding of how their tax liabilities have been generated.

The second set of advantages relate to how a CFT would be administered. The tax base of an “R Base” CFT is the same as the base for GST, less wages. This means that the GST and PAYE systems contain most, if not all the information needed to calculate a firm’s CFT liability.

For a firm trading exclusively in New Zealand, their CFT liability would be:

Liability = (8 x GST returned to IRD) – Gross wages paid[17]

All of the information contained in this formula is returned to IRD for other purposes, meaning that CFT liability calculations would involve zero additional compliance costs. A firm exporting goods or services would need to add in cash flows from exports that are zero-rated for GST purposes. This is because of CFT operates on an “origin basis” – firms receive a deduction for the cost of imported inputs and are assessed on the gains from exports, while GST operates on a “destination basis” – imports are taxed and exports are zero-rated.

Notes

  • [17]The figure 8 appears in the formula because the current rate of GST is 12.5%.
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