House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon John Dawkins, M.P.)

Chapter 5 Taxation of Excessive Components

Summary of proposed amendments

Purpose of amendment: Amendment of the Income Tax Rates Act 1986 (the Rates Act) and the Income Tax Assessment Act 1936 (the Act) to ensure the excessive component of an eligible termination payment is taxed at the top marginal rate of tax (currently 47%) plus Medicare levy.

Date of effect: The 1994-95 year of income and subsequent years.

Background to the legislation

What is an excessive component?

There is a limit (the reasonable benefit limit) on the amount of an eligible termination payment (ETP) which receives concessional tax treatment. Amounts in excess of that limit form the excessive component (EC) of the ETP.

What is the current and proposed tax treatment of the excessive component?

Under the current law, the EC is included in assessable income by subsection 27B(3) of the Act. In this way it is taxed at the taxpayer's marginal rates of tax under the Rates Act.

From 1 July 1994, the EC is to be taxed at the top marginal rate of tax (currently 47%) plus Medicare levy. However, it is to continue to be included in the recipient's assessable income so that allowable losses and deductions incurred by the taxpayer during the year, or carried forward from prior years, may reduce the taxable amount of the EC. No tax will be payable on the EC if the taxpayer's losses and deductions exceed the EC and other assessable income for the year.

How is the proposed tax treatment of the excessive component to be implemented?

The tax rates on taxable income of individuals are contained in the schedules to the Rates Act. Some of these schedules need to be amended to apply the appropriate rate of tax to the EC and other parts of taxable income. The other parts of taxable income may include a special income component, which is currently defined in subsection 3(1) of the Rates Act as net capital gains, abnormal income or the sum of both. The special income component of taxable income is subject to concessional tax treatment known as notional averaging.

Notional income

Schedule 9 of the Rates Act applies special rates of tax to taxable income which includes notional income under section 59AB or section 86 of the Act.

Section 59AB applies where there is a cessation of a business because of the loss or disposal of its assets as a result of which the taxpayer's assessable income includes a balancing charge. Section 86 applies where a taxpayer receives a premium for a lease of not less than 25 months duration. Notional income is worked out on the basis of taxable income.

If taxable income includes an EC, it may be necessary in some cases to recalculate notional income by using ordinary taxable income as the basis for calculation rather than the whole of taxable income. This is explained below.

Explanation of proposed amendments

Identification of the excessive component in taxable income

To ensure the correct amount of tax is levied on the EC, two parts of taxable income are to be identified for the purposes of the Rates Act: ordinary taxable income and the EC part of taxable income. These terms are to be defined in subsection 3(1) of the Rates Act.

Ordinary taxable income is taxable income less the EC part of taxable income. The EC part of taxable income is generally the amount of EC included in the taxpayer's assessable income under subsection 27B(3) of the Act. However, in some cases taxable income will be less than or equal to the amount of the EC included in assessable income. This will happen when the taxpayer has tax deductions or carry forward losses equal to or exceeding non-EC assessable income (if any). In such cases the taxable income will comprise an EC part only and no ordinary taxable income. [Subclause 36(b) - new definition in subsection 3(1) of the Rates Act]

It is also necessary to identify the respective amounts of special income component and EC in taxable income where the sum of those components is more than taxable income (i.e. where the taxpayer has excess deductions, namely allowable deductions greater than his or her assessable income from sources other than the EC or special income component).

In such cases, any excess deductions are to reduce the special income component before reducing the EC. Therefore the definition of special income component in subsection 3(1) is to be amended so that, if taxable income includes an EC, the special income component is:

•

the amount of special income component as currently defined in subsection 3(1) reduced by the amount (if any) by which the sum of the special income component (as currently defined) and the EC exceeds taxable income.

[Subclause 36(a) - amended definition of special income component in subsection 3(1) of the Rates Act]

If the result of the above calculation is zero or less than zero, there will be no special income component included in taxable income and the whole of the taxable income will be taxed as an EC.

Amendment of Schedule 7

Schedule 7 provides the general rates of tax for individual taxpayers. Part I covers residents and Part II, non-residents. Each part contains three clauses:

•

clause 1 taxes income at the marginal rates specified in the relevant table;

•

clause 2 provides an averaging formula for taxing income containing a special income component; and

•

clause 3 provides an averaging formula for taxing income of primary producers containing a special income component.

Marginal tax rates under Schedule 7

Clause 1 of both Part I and Part II is to be amended so that:

•

the rate of tax on the EC part of taxable income is 47%; and

•

the rates of tax on ordinary taxable income are the marginal rates specified in the table in the clauses.

[Subclauses 37(a), (b), (e) and (f) - amended clause 1 of Parts I and II of Schedule 7 of the Rates Act]

Each part of taxable income will be identified and taxed separately. Therefore, in determining the tax on ordinary taxable income, the EC part is ignored.

Notional averaging under Schedule 7

Under clause 2 (for taxpayers other than primary producers) and clause 3 (for primary producers) of Parts I and II of Schedule 7, the tax payable on every dollar of taxable income containing a special income component is the sum of:

•

Component A , i.e. the amount of tax payable under clause 1 on taxable income reduced by the special income component (the reduced taxable income); and

•

Component B , i.e. five times the difference between:

-

the tax payable under clause 1 on the reduced taxable income (or average income for primary producers) plus one fifth of the special income component, and

-

the tax payable under clause 1 on reduced taxable income (or, for primary producers, average income);

divided by Component C (taxable income).

Essentially, the averaging provisions described above apply the average of the marginal rates of tax that would be payable on one fifth of the special income component to the whole of that component. To effect that, one fifth of the special income component is included in the 'top slice' of taxable income (i.e. the part of taxable income which attracts the highest marginal rate(s) of tax).

The averaging provisions would not, however, operate in the same way if the taxable income included an EC and was taxed according to the proposed amendments to clause 1. This is because, by separating the EC from ordinary taxable income and taxing it separately, the top slice of income occupied by the special income component would be lowered by the amount of the EC (i.e. it would usually be subject to lower rates of marginal tax).

The taxation of a special income component should not depend on whether taxable income includes an EC. Therefore clauses 2 and 3 of Parts I and II are to be amended so that the tax rate applicable to the special income component included in taxable income which also includes an EC is:

•

the rate (or the average of the rates if there is more than one) that would apply to one fifth of the component if it was included in the top slice of taxable income (including the EC) and taxed at the rates which apply to ordinary taxable income as specified in the table in clause 1.

The remaining part of the taxable income (i.e the reduced taxable income) is to be taxed according to clause 1 (as amended).

In clause 3 of both parts to Schedule 7, Component B is determined by calculating the tax on 'a taxable income equal to' the amounts specified in paragraphs (c) and (d) of the clause. Therefore, to implement the method described above for taxing the special income component, the clause is to be amended by inserting the proviso that Component B is calculated as if the taxable income referred to is ordinary taxable income (i.e. as if the whole of the taxable income was subject to the rates specified in the table in clause 1). [Subclauses 37(d) and (h) - amended clause 3 of Parts I and II of Schedule 7 of the Rates Act]

The same proviso is also to be inserted in clause 2 of both parts. However, for the proviso to operate effectively, paragraph (d) of clause 2 needs to be amended to replace the reference to Component A with a reference to tax payable on a taxable income equal to the reduced taxable income. That amendment is necessary because Component A is taxed at the rates specified in clause 1, including the 47% rate on the EC part of taxable income. In Component B, the whole of the reduced taxable income is to be taxed at the marginal rates which apply to ordinary taxable income as specified in the table in clause 1. [Subclauses 37(c) and (g) - amended paragraph 2(d) of Parts I and II of Schedule 7 of the Rates Act]

Examples

The following examples illustrate the application of Schedule 7 to taxable income containing an EC. They are based on 1991-92 rates of tax and, except where indicated, do not take into account rebates, credits or the Medicare levy.

Example 1

Matthew (a resident taxpayer) has a taxable income of $50,000 made up of:

•

pension $22,000

•

salary and wages $10,000

•

allowable deductions $2,000

•

excessive component $20,000

Therefore the EC part of his taxable income is $20,000. Ordinary taxable income is $50,000 - $20,000, i.e. $30,000.

Calculation of the gross tax payable on Matthew's taxable income of $50,000:

Step 1: Calculate the tax on the EC part of taxable income:

$20,000 x 47% = $9,400


Step 2: Calculate the tax payable on the ordinary taxable income:

This is calculated according to the table in clause 1 of Schedule 7; the marginal rates of tax in column 2 of the table are applied to the ordinary taxable income of $30,000,

i.e. $6,594

Step 3: Add the answers to Steps 1 and 2 together, i.e. the sum of the tax on the EC part of taxable income and the tax on the ordinary taxable income, to find the gross tax payable on Matthew's taxable income:

$9,400 + $6,594 = $15, 994


Example 2

Jane (a resident taxpayer) has a taxable income of $85,000 made up of:

•

excessive component $50,000

•

post-June 1983 component of an ETP $40,000

•

allowable deductions $ 5,000

Therefore the EC part of her taxable income is $50,000. Ordinary taxable income is $85,000 - $50,000, i.e. $35,000.

Calculation of the gross tax payable on Jane's taxable income of $85,000:

Step 1: Calculate the tax on the EC part of taxable income:

$50,000 x 47% = $23,500


Step 2: Calculate the tax payable on the ordinary taxable income:

This is calculated according to the table in clause 1 of Schedule 7; the marginal rates of tax in column 2 of the table are applied to the ordinary taxable income of $35,000,

i.e. $8,494

Step 3: Add the answers to Steps 1 and 2 together, i.e. the sum of the tax on the EC part of taxable income and the tax on the ordinary taxable income, to find the gross tax payable on Jane's taxable income:

$23,500 + $8,494 = $31,994


Under section 159SA of the Act, Jane is entitled to an ETP rebate on the post-June 1983 component of her ETP. Jane's ETP is from a taxed superannuation fund. Although Jane is over 55 she does not have a low rate threshold because of ETPs she received in previous years. Therefore the maximum rate of tax on the whole of the post-June 1983 component contained in ordinary taxable income is 15%.

Therefore the maximum tax Jane will pay on the post-June 1983 component contained in ordinary taxable income is 15% x $35,000 = $5,250.

The difference between this and the tax payable on the component at ordinary rates (calculated above in Step 2) is $3,244. Therefore Jane is entitled to an ETP rebate of $3,244.

Example 3

John (a resident taxpayer) has a taxable income of $55,000 made up of:

•

pension $30,000

•

net capital gain $10,000

•

excessive component $15,000

Therefore the EC part of his taxable income is $15,000. Ordinary taxable income is $55,000 - $15,000, i.e. $40,000.

Calculation of the gross tax payable on John's taxable income of $55,000:

Step 1: Calculate the special income component:

Paragraph (a) of the definition applies so the component is the net capital gain of $10,000.

Step 2: Calculate the reduced taxable income, i.e. the taxable income less the special income component:

$55,000 - $10,000 = $45,000


(This comprises $15,000 EC and $30,000 ordinary taxable income)

Step 3: Calculate the tax payable on the reduced taxable income (under clause 1 of Schedule 7), i.e. the sum of:

•

$15,000 (EC part) x 47% = $7,050


•

$30,000 (ordinary taxable income) x rates set out in column 2 of the table = $6,594

= $13,644

This is Component A in clause 2 of Part 1 of Schedule 7.

Step 4: Calculate the tax on the special income component:

5 x the difference between (a) and (b):

(a)

tax payable on the reduced taxable income plus 20% of the special income component (assuming it is made up of ordinary taxable income):

i.e. tax on $45,000 + (20% x $10,000) at the rates set out in column 2 of the table

= $13,934

(b)

tax payable on the reduced taxable income (assuming it is made up of ordinary taxable income):

i.e. tax on $45,000 at the rates set out in column 2 of the table

= $13, 014

i.e. 5 x ($13, 934 - $13, 014)

= $4,600

This is Component B in clause 2 of Part I of Schedule 7

Step 5: Add the answers to Steps 3 and 4 together, i.e. the tax on the reduced taxable income and the tax on the special income component, to find the gross tax payable on John's taxable income:

$13,644 + $4,600 = $18,244


Example 4

Mary (a resident taxpayer) has a taxable income of $45,000 made up of:

•

salary and wages $10,000

•

net capital gain $25,000

•

excessive component $30,000

•

loss on rental property $20,000

Therefore the EC part of her taxable income is $30,000. Ordinary taxable income is $45,000 - $30,000, i.e. $15,000.

Calculation of the gross tax payable on Mary's taxable income of $45,000:

Step 1: Calculate the special income component:

The capital gain ($25,000) plus the EC part of taxable income ($30,000) exceeds the taxable income of $45,000 by $10,000, so paragraph (b) of the definition applies.

Therefore the special income component is:

$25,000 - $10,000 = $15,000


Step 2: Calculate the reduced taxable income, i.e. the taxable income less the special income component:

$45,000 - $15,000 = $30,000


(This comprises an EC part only)

Step 3: Calculate the tax payable on the reduced taxable income (under clause 1 of Schedule 7):

$30,000 (EC part) x 47% = $14,100


Step 4: Calculate the tax on the special income component:

5 x the difference between (a) and (b):


(a)

tax payable on the reduced taxable income plus 20% of the special income component (assuming it is made up of ordinary taxable income):

i.e. tax on $30,000 + (20% x $15,000) at the rates set out in column 2 of the table

= $7,734

(b)

the tax payable on the reduced taxable income (assuming it is made up of ordinary taxable income):

i.e. tax on $30,000 at the rates set out in column 2 of the table

= $6,594

i.e. 5 x ($7,734 - $6,594)

= $5,700

This is Component B in clause 2 of Part I of Schedule 7

Step 5: Add the answers to Steps 3 and 4 together, i.e. the tax on the reduced taxable income and the tax on the special income component, to find the gross tax payable on Mary's taxable income:

$14,100 + $5,700

= $19,800

Primary production income

Primary production rebates and complementary tax

A taxpayer to whom section 156 of the Act applies (referred to as a primary producer), or a trustee liable to be assessed on primary production income, is:

•

entitled to a rebate if the amount of tax payable on taxable income for the year exceeds the amount of tax that would have been payable on the taxable income at the prescribed notional rates; and

•

required to pay complementary tax if the amount of tax payable on taxable income for the year is less than the amount of tax that would have been payable on the taxable income at the prescribed notional rates.

The notional rate of tax applicable to section 156 is prescribed in Schedule 8 of the Rates Act.

A reference to taxable income in section 156 does not include any amount of the taxable income which is a net capital gain or abnormal income (paragraph 149A(1)(b)). Therefore the amount of the rebate or complementary tax is unaffected by the receipt of such income. A corresponding provision is required in relation to the EC part of taxable income to prevent a primary producer who receives an EC from having the tax payable on the EC partly off-set by a primary production rebate, or receiving a reduction in the complementary tax that would otherwise have been payable if the EC was not included in taxable income.

Therefore paragraph 149A(1)(b) is to be amended by excluding the EC part of taxable income from the definition of taxable income for primary production purposes. [Clause 28 - amended paragraph 149A(1)(b) of the Act]

Corresponding to the exclusion of the EC from taxable income, paragraph 149A(1)(a) is also to be amended to ensure that, as with net capital gains, assessable income for primary production purposes does not include the EC part of taxable income. [Clause 28 - amended paragraph 149A(1)(a) of the Act]

The amendments to subsection 149A(1) also exclude from taxable and assessable income death benefits assessable under proposed subsection 27B(1A). This exclusion is explained in Chapter 3.

Average income

The proposed amendments to subsection 149A(1) will also have the effect of removing the EC from the calculation of average income (which is based on taxable income of the current year and prior years). This is appropriate because, if the rebate or complementary tax is not able to off-set tax on the EC, it would be inappropriate to include the EC in calculating average income (since it would increase that income and reduce the rebate or increase the complementary tax otherwise payable).

Schedule 8

In Schedule 8 of the Rates Act, Division 1 of Parts I and II, and clause 2(a) of Division 2 of Part I, provide for the determination of notional rates of tax based on the tax payable on average income. Since average income will not contain an EC, no amendment is required to the determination of notional rates.

Clause 2(b) of Division 2 of Part I, and Division 2 of Part II, provide for the determination of a notional tax rate on the basis of certain primary production trust income. The proposed amendments to subsection 149A(1) explained above (in conjunction with subsection 149A(2), which extends the operation of subsection 149A(1) to trust income) will ensure the primary production trust income does not include an EC. Therefore no amendment is required to the determination of notional rates in relation to trust income either.

However, subparagraph (2)(b)(ii) of Division 2 of Part I does need to be amended because it refers to taxable income in the table in clause 1 of Schedule 7. As explained above, 'taxable income' in the table is to be replaced by 'ordinary taxable income'. Therefore a corresponding amendment is required to Schedule 8. [Clause 38 - amended subparagraph (2)(b)(ii) of Division 2 of Part I of Schedule 8 of the Rates Act]

Schedule 9 (notional income)

Notional income

Schedule 9 of the Rates Act provides for the rate of tax on the taxable income of a taxpayer deriving notional income under section 59AB or section 86 of the Act. The rate applicable to the whole of the taxable income is the average rate (calculated under Schedule 7) that would apply to a taxable income equal to the notional income.

Both subsection 59AB(4) and subsection 86(1) provide that the notional income calculated under those provisions is determined for the purpose of any Act whereby a rate of tax upon the taxable income of a taxpayer is fixed by reference to a notional income. Currently, Schedule 9 of the Rates Act applies a single rate of tax, fixed by reference to notional income, to taxable income. However, the amendments to Schedule 9 described below apply more than one rate to taxable income containing notional income and an EC. Therefore subsection 59AB(4) and subsection 86(1) are to be amended so they apply to determine a notional income for the purpose of any Act that fixes a rate or rates of income tax by reference to a notional income. [Clauses 26 and 27 - amended subsections 59AB(4) and 86(1) of the Act]

Rates of tax prescribed by Schedule 9

If taxable income includes an EC, it is not appropriate for the average rate of tax determined under Schedule 9 to apply to the whole of the taxable income. Therefore the EC is isolated and taxed at 47%. [Subclauses 39(a) and (c) - new paragraph 1(a) of Parts I and II of Schedule 9 of the Rates Act]

The rate of tax applicable to the ordinary taxable income is to be based on the notional income. However, since the EC is treated separately, the notional income should not include an amount attributable to the EC. Therefore the rate of tax applicable to ordinary taxable income is to be the amount of tax payable (under Schedule 7) on a taxable income equal to the non-EC notional income, divided by the number of whole dollars in the non-EC. [Subclauses 39(a) and (c) - new paragraph 1(b) of Parts I and II of Schedule 9 of the Rates Act]

Non-EC notional income is the notional income calculated in accordance with section 59AB or section 86 as if ordinary taxable income rather than taxable income was used as the basis for the calculation. If ordinary taxable income is zero, there is no notional income. [Subclauses 39(a) and (c) - new paragraph 1(b) of Parts I and II of Schedule 9 of the Rates Act]

Notional averaging under Schedule 9

The formulae provided in clause 2 of Parts I and II of Schedule 9 for notional averaging of a special income component are essentially the same as those provided for notional averaging in Schedule 7, except that, in Component B, "reduced notional income" (i.e. notional income reduced by the special income component) is used instead of "reduced taxable income".

The use of reduced notional income instead of reduced taxable income is not relevant for present purposes. Therefore the definition of Component B is to be amended in the same way as clause 3 in Schedule 7 (explained above). The amendment will ensure that in Component B the EC part of reduced notional income is taxed at ordinary marginal rates. [Subclauses 39(b) and (d) - amended clause 2 of Parts I and II of Schedule 9 of the Rates Act]

Example

The following example illustrates the application of Schedule 9 to taxable income containing an EC. It is based on 1991-92 rates of tax and does not take into account rebates, credits or the Medicare levy.

Samantha is a resident taxpayer. The assets of Samantha's business were destroyed in a fire and the business ceased as a result. Because of insurance proceeds she received on the depreciated assets, her assessable income included a balancing charge under section 59AB of the Act.

Her taxable income for the year is $26,000, made up of:

•

excessive component $20,000

•

Balancing charge $10,000

•

allowable deductions $ 4,000

Therefore the EC part of her taxable income is $20,000. Ordinary taxable income is $26,000 - $20,000, i.e. $6,000.

Calculation of the gross tax payable on Samantha's taxable income of $26,000:

Step 1: Calculate the tax on the EC part of taxable income:

$20,000 x 47% = $9,400


Step 2: Calculate non-EC notional income:

Notional income calculated under section 59AB of the Act using ordinary taxable income instead of taxable income, i.e. one third of $6,000 (subsection 59AB(6))

= $2,000.

Step 3: Calculate tax payable on ordinary taxable income, i.e. tax payable on notional income at the rates contained in the table in clause 1 of Schedule 7:

Tax on $2,000 = 0

Therefore tax payable on ordinary taxable income is zero.

Step 4: Add the answers to Steps 1 and 3 together, i.e. the sum of the tax on the EC part of taxable income and the tax on the ordinary taxable income, to find the gross tax payable on Samantha's taxable income:

$9,400 + zero = $9,400


Rates of tax on other types of income

Trust income

Schedule 10 of the Rates Act provides for the rates of tax payable by a trustee under section 98 or 99 of the Act. The rates provided are determined by reference to the rates in Schedules 7 and 9, which are to be amended as explained below.

As with Schedule 8, an amendment is required to paragraph 2(b) of Part I of Schedule 10 to replace 'taxable income' with 'ordinary taxable income'. [Clause 40 - amended paragraph 2(b) of Part I of Schedule 10 of the Rates Act]

General income of minors

The taxation of income of minors is addressed in Schedules 11 and 12 of the Rates Act. Schedule 12 applies where a trustee is liable to be assessed under section 98 of the Act. Both Schedules are divided into Part I (residents) and Part II (non-residents).

Clause 2 of both parts in both schedules provides for the tax rate on eligible taxable income of minors (or, in Schedule 12, the trust beneficiary's share of that income). Broadly speaking, eligible taxable income is unearned income of minors. However, it does not include amounts received after the death of a person from a superannuation fund, approved deposit fund or employer (i.e. it does not include an ETP). Therefore clause 2 will not apply to an EC received by a minor and it does not need to be amended.

As with Schedule 10, the tax rates on other income of a minor are generally determined by reference to Schedules 7 and 9 (clause 1 of Parts I and II of Schedules 11 and 12). Therefore no amendment is required to clause 1 either.

Notional averaging under Schedules 11 and 12

Clause 3 of both parts of Schedules 11 and 12 provides for a rate of tax payable on the whole of a minor's taxable income which includes a special income component (Schedule 11) or a capital gains component (Schedule 12). Therefore the clause needs to be amended so that, where a minor's taxable income also includes an EC, the appropriate tax rate can be applied to the EC.

The formulae provided in clause 3 are slightly different from the formulae provided in Schedules 7 and 9. However the differences are not material and clause 3 is to be amended in the same way as clause 3 of Schedule 7 (explained above). The amendment will ensure the EC in reduced taxable income (or, in Schedule 12, the reduced share) is taxed at 47% in Component A, but will be taxed at ordinary marginal rates in Component B. [Clauses 41 and 42 - amended clause 3 of Parts I and II of Schedules 11 and 12 of the Rates Act]