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

5  Particular issues for a CFT on small businesses[21]

This Section outlines two particular issues that need to be resolved if a CFT were introduced for small business, namely a definition of “small” and how to integrate a CFT with an income tax, which is especially relevant for the owners and financers of firms if those people have other income that is subject to income tax treatment.

5.1  Limiting CFT to small businesses

As this paper is concerned with the issue of taxing small businesses it is necessary to develop a definition of small business. Any set of rules should comply with a range of criteria. First they should objective: that is based on facts, not intentions or purpose. The rules should themselves be simple. All decisions should be based on existing or past events, not future events. Finally, where possible and desirable, any rules should be based on existing concepts in the tax system.

5.1.1  What is a business?

The first part of any definition is “business”. The distinction between “savings” and “being in business” is a fine one: both involve the idea of using capital for future gain. Intermediated savings might look considerably different from being in business, but in substance they are the same thing: a deposit in a bank becomes someone else’s (borrowed) capital.

Using existing concepts from the tax system, one possible distinction is that to qualify for cash flow treatment, a firm must be engaged in “taxable activities” within the meaning of the GST Act[22]. This closely accords with the everyday notion of being in business.

5.1.2  What is small?

A key difficulty in designing a definition of small business is not coming up with an adequate description; rather it is in designing a set of rules that cannot be manipulated by large businesses. That is, a set of rules that do not allow a large business to re-configure itself into a series of small businesses. This is only an issue if the intention is to limit a CFT to a sub-set of the economy.

Small can have a number of dimensions. It can relate to any one or more of the following criteria: the number of owners of a firm, the number of employees, turnover or profit.

A quintessential small business in New Zealand has the following features: one or two principals who both own the firm and work in it, less than five other employees and the principals mainly provide the financial capital themselves, with external capital provided by commercial loans mortgaged over the assets of both the business and the principals.

Turnover and profit are much more variable. Any financial threshold above which income tax treatment applies will be arbitrary. A key issue is that the threshold should be determined before a tax year starts, since to do otherwise would give rise to the possibility of firms unexpectedly going over the boundary and thus having to be subject to income tax when their expectation was CFT. This might not be a great issue if the transition from CFT to income tax is relatively smooth, but this is unlikely to be the case.

Table 7 sets out one possible set of rules for deciding what is a small business.

Table 7 – Rules for being a small business
Criteria Rule
Type of business Must be incorporated
Number of shareholders Five or fewer, all of whom are natural persons and none of whom is acting in their capacity as a trustee
GST status Must be registered for GST purposes
Activity Must undertake a “taxable activity” for the purposes of the GST Act.

5.2  Integration with the rest of the tax system

Treasury’s previous work on a CFT has examined the application of a CFT to the whole economy. The proposition here is to limit a CFT to small businesses. This raises particular issues in relation to the integration of the tax treatment of firms taxed under a CFT with their owners and creditors.

Under the New Zealand imputation system, the tax treatment of companies and the individuals who own them are integrated. That is, the policy is that New Zealanders should be taxed on the income they earn through a company once, as close in time as possible to when it is earned, at the marginal rate of the taxpayer. In practice, taxing the company on its income and taxing dividends paid to shareholders achieve this, with imputation credits meaning that tax at the company level can offset tax at the personal level. If the company’s tax rate and the marginal tax rate of the shareholder are the same, then no additional tax is payable by the shareholder. Likewise, returns to debt are only taxed once under the New Zealand system, but a different mechanism is used. Interest payments are deductible to the company (subject to a business test), with interest income being assessable to the creditor. This means, in effect, that the return on capital financed by debt is taxed at the marginal tax rate of the creditor.

Under an “R base” CFT, financial transactions between a firm and its financers are excluded by tax: payments of dividends and interest (and principal) are neither deductible nor assessable, either within the firm or to investors. Under a “R + F”, financing is taken into account. Borrowers include loan principal (but not equity raised) in taxable cash income and deduct payments of interest and principal. Lenders deduct principal when they make a loan and include loan repayments – principal and interest – in taxable income. Provided the tax base of a firm is comprehensive, then an R and R + F base both provide the same economic result.

If a CFT were limited to small businesses and their owners, with income tax treatment applying to the rest of the tax system, there would need to be special rules for taxing dividends received from CFT businesses. Consider the example of a CFT firm in the early years of its life. If the firm has made large capital purchases, it is likely to have tax losses, but would still have positive cash flow that it wants to distribute to its owners. Under CFT rules, there would be no tax implications for the firm: the distribution is exempt. However, under the normal imputation rules, such dividends would be non-imputed, and therefore taxable in the hands of the shareholder. However, applying income tax treatment to dividends coming from a CFT company would simply be a clawing-back of CFT treatment. It would be necessary, therefore, to have a special rule to exempt all dividends received from CFT companies.

However, such an exemption might itself create further problems. If all dividends flowing from a company subject to a CFT were exempt, then there would be an incentive to interpose a CFT company between a taxpayer and other companies subject to income tax as a way of reducing income tax liabilities.

Consider a company subject to income tax treatment that has earned untaxed income (for example, capital gains). Under existing income tax rules, it would pay unimputed dividends to its shareholders, who would then have a tax liability. If an R Base CFT were introduced, then payment of such dividends to a company taxed under a CFT would not give rise to any tax liability at the CFT company level. Under the rule just discussed for taxing dividends paid by CFT companies, the payment of a dividend by the CFT company out of unimputed dividends received by the CFT company would also be tax free in the hands of shareholders. An R + F Base CFT would not seem to solve this problem, since the receipt and payment of a dividend would wash-out, leaving the company with no CFT liability.

The twin challenges of integrating a CFT on part of the economy with an income tax on the remainder are to preserve CFT treatment on payments made to owners and financiers of firms subject to that tax, while at the same time ensuring that a CFT is not used to avoid income tax treatment applying elsewhere. The principal difficulty seems to be that from an income tax perspective, companies taxed under a CFT look very much like onshore tax havens.

It would be possible to devise a set of tax rules that would successfully integrate a CFT and an income tax. Doing so in a way that does not eliminate the simplification advantages of a CFT might, however, prove impossible.

Notes

  • [21]An issue not discussed in this paper is the international dimension of a CFT: how to tax New Zealand firms on the income they earn offshore and how to tax non-residents owners of New Zealand small businesses. This reasons for this omission are two-fold: small businesses tend not to engage in much cross-border trade or have cross-border owners, thus rendering much of the possible discussion irrelevant. Secondly, while the international dimension adds further economic and revenue arguments against a CFT, it does not add any additional reasons for having one. Treasury (1997) contains a detailed discussion of the international aspects of a CFT. See also p 173 ff. of Shome and Schutte (1995).
  • [22]Section 6(1) of the Goods and Services Act defines, “taxable activity” to mean: “Any activity which is carried on continuously or regularly by any person, whether or not for a pecuniary profit, and involves or is intended to involve, in whole or in part, the supply of goods and services to any other person for a consideration; and includes any such activity carried on in the form of a business, trade, manufacture, profession, vocation, association, or club”.
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