Australia: A lower company tax rate. At what cost?

The 2010 Henry Review into Australia's future tax system recommended the introduction of a resource rent tax be coupled with a 5% reduction in the corporate tax rate from 30% to 25%, being the average for small to medium size OECD economies.

In response to the Henry Review, the Government initially opted for a 28% target which was revised to 29% and then abandoned in the May 2012 Federal Budget. Admittedly, the Henry Review recommended a 40% resource rent tax on all non-renewable resources and it ended up being a 22.5% tax on coal and iron ore only. But a deteriorating economic and fiscal outlook is no doubt also to blame.

The Government however remains committed to cutting the corporate tax rate. But the commitment comes with the catch that it must be funded by equivalent savings found elsewhere in the business tax system. Some may say this does not amount to a tax cut at all but of course the various rules apply in different ways to companies in different situations. So the outcome for a particular company may be a tax cut, a tax increase or it may be tax neutral.

The Treasurer charged the Business Tax Working Group with finding the savings necessary to fund a tax cut. The Group released a Discussion Paper on 13 August 2012 which estimates the cost of a 5% rate cut at $26 billion over the forward estimates. The Discussion Paper then outlines potential savings that add up to around $10 billion. So a 5% cut is really out of the question. The Australian Financial Review described such a cut as "dead on arrival" of the Discussion Paper. A 1% or 2% cut looks to be more achievable.

The Government wants the cut funded from the business tax system in order to preserve a budget surplus. The other side of the argument is that a lower rate should boost productivity leading to higher tax collections (that is, more income taxed at a lower rate may equal more tax). Both sides of the argument have merit.

One difficulty is that Australia is looking to achieve a lower rate by eliminating concessions so we can compete with economies that have a lower rate and still have concessions. Put another way, Australia could end up with a lower rate and still not get a competitive advantage.

Another difficulty is that many of the potential savings would hit the energy and resources sector. Such potential savings relate to:

• the deductibility of interest on debt finance;
• the depreciation of plant and equipment, especially in the oil and gas sector; and
• the treatment of expenditure on exploration.

The Discussion Paper provides a number of alternatives for each area of potential savings. In the case of debt finance, the alternatives include reducing the safe harbour debt to equity ratio from 3:1 to 1.5:1 (that is, a halving of the permitted level of debt) or capping interest deductions at a percentage of EBITDA.

In the area of depreciation, the alternatives include reducing the rates of depreciation under the "diminishing value" method and removing statutory caps on the effective life of certain assets. Both would impact the ability to depreciate assets on an accelerated basis.

In relation to exploration expenditure, the alternatives involve a shift from an immediate deduction to a deduction over 5 years or the effective life of the project. Another alternative is to exclude feasibility studies from exploration expenditure.

The energy and resources sector has been propping up the economy. The Discussion Paper notes the level of capital expenditure in the sector has gone through the roof over the last 10 years while capital expenditure in the manufacturing and other sectors has declined.

A willingness to take risks with the energy and resources sector assumes that Australia's resources will be exploited because they are immovable. That may be true over the long term. But in the short to medium term multinational resources companies have to make investment decisions about projects in different parts of the world. Even local resources companies are increasingly looking at projects in Africa. Australia could miss out in the process if it is not careful.

Cutting the company tax rate involves making tough decisions. There will be winners and losers.

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