Beating the Bush Blues
Tax and Industrial Relations
Why should tax be of interest to the H.R. Nicholls Society? Simple! Income tax collection processes and industrial relations powers have been intimately connected for a long time. The core issue is, and has been, the legislative power of the Tax Commissioner to collect income tax at source. This core item usually becomes lost, however, in the debate over the related issues of income-splitting and tax deductions.
My claim is that in the total social dynamic, the income tax collection system has been more important to industrial relations coverage than has the mafioso-like behavior of the unions. This dynamic is about to change.
Let me explain.
The capacity of the industrial relations system to rule over people's working lives is limited to where people are working in a common-law, master-and-servant employment relationship. That is, where one person, the employer, has the legal right to control the other person, the employee. People working outside the master--servant relationship are not ordinarily subject to the powers of industrial relations authorities.
In the tax area, the way in which the Australian Tax Commissioner has been able to collect income tax at source has been dependent on common-law employment determinations.
This common dependence of income tax collection systems and industrial relations powers on determinations of master-and-servant employment has, over time, caused tax-collecting authorities to become engaged in an alliance with industrial relations regulators. These two authorities, with outwardly different agendas, have found themselves in the same colluding bed.
This outcome has corrupted the integrity of the tax collection system.
The labour movement has understood this dynamic and has fought long and hard to prevent effective income-tax collection reform. In so doing they have been a significant contributor to the creation of alleged tax-loss schemes against which they so piously complain. Their duplicity has been cunningly masked by outpourings of moral indignation directed at contractors.
The current reform of the tax collection system has as one of its objectives the breaking of the nexus between common-law employment and income tax collection. The potential outcomes are liberty for the Tax Commissioner from common-law employment problems and greater freedom for people to choose the nature of the common-law status they wish to have when working.
The question to be answered is whether this intention---the breaking of the nexus---is fully reflected in both the tax legislation and the administrative processes and operational behavior of the Tax Commissioner.
Before examining that question, however, it is worth considering the historical development of income tax collection.
Milton Friedman, with some regret, describes his work as one of the architects of the income tax system in the USA. He says that US Federal income tax was meant as a temporary measure to overcome the problem of funding the Second World War. US Treasury concern in the 1940s was that massive debt funding of the First World War, was a major contributor to the Great Depression. Friedman bemoans the fact that temporary measures become permanent and grow when government has its hands in the public's purse. Australia has followed a similar course.
In the 1920s, '30s and '40s, the legal master-and-servant employment model was perhaps at its dominant height as the method for organizing business in capitalist societies. It was understandable that, in designing an income tax system, tax legislation should tie the power of tax officials to collect income tax at source to common-law employment. Common-law-employment dependent tax powers, at the time, would have caught the near total of the working population. This was the legislative model used in North America and Australia.
Around the late 1970s significant change in legal work-engagement methods began to emerge and have since accelerated. People are deserting the master-and-servant, wage-slave model for reasons unrelated to tax. But a consequence of this has been a shortening of tax officials' legislative reach.
The scale of the social movement away from wage slavery has only recently been authoritatively identified. In the first survey on this issue undertaken by the Australian Bureau of Statistics (released in February 2000), as of August 1998:
- 59 per cent of the workforce identified themselves as working in a full-time employment relationship.
- 20 per cent of the workforce identified themselves as being self-employed.
By contrast, surveys by the South Australian Institute of Labour in 1989 put the self-employed figure at somewhere around 3 per cent.
My suspicion is that this trend away from employment began earlier, and has been steeper in its growth, in the USA than it has in Australia.
These trends have alarmed tax authorities in USA, Canada and Australia. Many tax commentators and designers have not understood or accepted the social movement but have instead interpreted it as a massive and sinister tax-avoidance scam.
The Australian Tax Commissioner's approach to this loss of authority has been a combination of accommodation and aggression. The domestic building industry has been at the pointy end of the interface with the Commissioner. The spread of independent contracting is, however, huge. It now dominates the information technology and film industries and is penetrating traditional areas of manufacturing, finance, education and even the public service.
Changes to the Income Tax Collection System
Let us clearly understand the problem from the tax system and tax officials' perspective. Tax officials are charged with fulfilling a legislative instruction to collect tax. From an administrative angle, the most effective tax systems are ones in which voluntary compliance is maximized and in which tax is collected at source. Tax auditing and compliance activity is expensive, not cost-effective and something tax designers seek to minimize.
In Australia, the PAYE arrangements have evolved as the primary 'at source' collection system and it is around them that the ATO's administration systems are constructed. But PAYE legislation only gives the Commissioner power to collect an individual's income tax at source if the individual is in a common-law, master-and-servant employment relationship. The key provision is Section 211C of the Income Tax Assessment Act 1936, which requires 'employers' to deduct instalments of tax from payments of salary or wages to 'employees'.
In an effort to overcome independent contractor leakage from PAYE, the Australian Tax Commissioner has argued that the legislative powers under section 221A(1) of the Act being 'wholly or principally for labour...', extended the Commissioner's powers to contractors.
In various attempts to prove the point, the Commissioner has, in the past, aggressively sought to enforce this extended view of his powers. The Courts, however, have not agreed with the Commissioner. On ten separate occasions during the late 1980s and 1990s, the High Court rejected the Commissioner's view that PAYE legislative powers extended beyond common-law employees.
Another approach was to attempt to change the income tax legislation to bring independent contractors into PAYE. The last time this was attempted was under Federal Treasurer Willis in 1994. The problem was that the labour movement, ever mindful of their dependence on tax legislation for their own powers, saw the legislative change as an opportunity to destroy independent contracting. The Willis amendments, known as Taxation Law Amendment Bill No 5, were dropped when a change of government occurred.
In effect, the Willis amendments sought to deny independent contractors the right to exist as such by legislatively declaring contractors to be common-law employees. The approach had strong parallels to the 1999 Queensland IR Act (Section 275) and its legislative attempt to turn free, independent contractors into wage-slave employees.
Had the Willis tax amendments succeeded, they would have put the Tax Commissioner on a collision course with a broad social movement toward freedom, equity and justice. Bad for tax collection and bad for society!
The Tax Commissioner's other approach was to create an administrative at source tax collection system for contractors called PPS. When developed, the PPS system was limited to the building and related industries. PPS has always been seen by the Commissioner as administratively messy and at best providing a temporary plug to an expanding hole.
We come, then, to the state of the dilemma as it has stood through most of the 1990s:
- PAYE has been declining as the dominant revenue base.
- As independent contracting has grown, there has been pressure to extend PPS beyond the building industry.
- The Tax Commissioner has developed tests to limit people entering the PPS system and prevent PAYE disintegration. In effect, the tests became quasi-common-law rulings, a task for which the Commissioner has no legitimate expertise or authority.
- Because the quasi-common-law tax tests largely sought proof of contractor status on the basis of the existence of company structures, the impetus for structuring has been enormous.
- In the Commissioner's view, structuring has enabled individuals to split income and claim deductions so as to avoid tax.
- Lurking in the background has been the labour movement, in its many chameleon disguises, consistently seeking to use the Commissioner's dilemma for their own purposes, namely, to make life difficult for PPS payers and to force people into PAYE wage-slavery employment.
In short, the linking of the Tax Commissioner's 'at source' income-tax collection powers to common-law, master-and-servant employment relationships has been a negative in times of vast social change:
- It has corrupted the tax collection system, making it an instrument of the industrial relations system.
- It has limited the right of people to free themselves from the inequality and injustice of the master-and-servant employment relationship.
With at least one in five of the Australian workforce not working in a traditional employment relationship and with the trend growing rapidly, the tax collection system has been forced to modernise.
The tax collection system has been in urgent need of updating to accommodate a changed and changing society. The Tax Commissioner should not be forced to be an arbitrator or commentator on the relationships people choose to have when they work.
The Tax Commissioner's powers are silent on, and irrelevant to, the cohabitation preferences of people. Whether people are married, defacto, transient, heterosexual, gay, bi, swinging, open, religious, irreligious, eco-pure, eco-ravaging or any other form of lifestyle is not of legislative concern to the Tax Commissioner when it comes to the power to collect income tax. Equally, the Tax Commissioner should not have to be dependent on common-law status at work.
So we come to 1 July 2000 and the first true redesign of the tax collection system undertaken since income tax was introduced. The design has as one of its primary objectives the untying of the Tax Commissioner's collection powers from common-law dependency.
The objective of neutralizing common-law employment dependency is central to the new PAYG system, an objective generally not recognized and one that has become confused in the debate over income-splitting.
The Government's intentions are made clear in two key documents:
1. Tax Reform not a new tax a new tax system (ANTS)
The 'ANTS' document, as it is known in Treasury, is the principal document produced by the Federal Government that establishes the principles and structures of the proposed reformed tax system and upon which the Government went to the 1998 election. The PAYG components established in ANTS are substantially intact in the 2000 legislative form. ANTS states that
... Australia's core withholding system---the Pay As You Earn (PAYE) system---relies heavily on outmoded ideas of master and servant to define obligations. It simply has not kept pace with labour market trends and is falling further behind. Australia needs a modern, comprehensive withholding system for payments to workers.
2. Treasury Fact Sheet No 703
Fact sheet 703 is the primary fact sheet explaining what the intent of the Ralph Review was on income-splitting. In all the processes proposed, Treasury states that
'It (the measures) will have no effect on the legal relationship between the entity and the person paying for the services'.
If this intention is put into practice effectively, the government will have achieved important reform with wide-reaching implications:
- The Tax Commissioner will have a clear legislative brief to collect income tax, at source, without having to depend on lifestyle and managerial choices made by people.
- The tax system will have the corrupting linkages to the industrial relations system removed, thereby enabling debate and choices on our working lives to be conducted specifically on the working life issues.
The big question is---are the intentions reflected in practice?: Legislation and ATO operational practice
1. Does the new legislation remove the tie to common-law employment?
In assessing the implementation of the government's intentions, examination of the legislation is the most important factor. If there is anything in the tax legislation that could be considered by a court to declare the existence of common-law employment, the reforms will have failed. (No doubt, labour lawyers will be combing through the legislation searching for such a linkage!)
I am not a solicitor, so I cannot provide an authoritative assessment. But I have read the legislation with an eye to finding fault and feel confident about the following comments.
The key pieces of legislation to understand are the GST, ABN and PAYG legislation. These first appeared in early 1999. The early versions are pretty impressive at neutralizing the common-law employment issue. This has been done largely through introducing new terminology that has specific administrative tax meaning only. The terminology includes 'withholding', 'instalment income', 'instalment group', 'entity', 'activity statement' and 'notional tax'.
The consolidated legislation has only been printed and available in the last few weeks. On my reading, save for some reservations on the ABN registration criteria, the legislation seems to be successful at removing the Commissioner's dependence on common-law employment..
As for the proposed legislation resulting from the Ralph Review, it is important to remember that the debate over income alienation was not directed at the Tax Commissioner's powers to collect income tax. The Ralph proposals cover how personal income tax rates are applied after tax has been collected.
2. Is the new tax collection administrative system neutral on common-law employment?
Legislation is one issue, but if the administrative systems of the ATO are biased against contractors, peace between the ATO and contractors will not have been achieved.
The indicators at this stage are mixed---there are some grounds for optimism but unanswered questions leave cause for concern.
We know the following:
- The battle between PPS and PAYE will no longer exist as both are consumed in the new catch-all system, PAYG.
- Common-law employees are clearly caught within PAYG.
- Contractors who work through labour hire are caught within PAYG.
- Individual contractors who work direct and have an ABN can choose to be caught within PAYG by signing a 'voluntary agreement'.
- Contractors who do not wish to enter PAYG can remit their own income tax, at source, but will require an ABN if they don't want their client/s to withhold 48.5 per cent of invoices.
This multi-pronged process is designed to maximize pressure on all income earners to be within the PAYG system. It successfully and broadly captures income earners no matter what their common-law work status.
There are some questions, however, for which answers remain unclear:
- What is the status of contractors who apply for, and are refused, an ABN?
- Does the ABN Registrar's discretionary power to award or remove an ABN become a quasi-common-law employment/contractor test?
- Could future governments, who take a hard line against contractors, direct the Registrar to refuse contractors an ABN?
The answers to these questions are not clear because a good deal seems to be left to the Registrar's discretionary interpretation over what constitutes a 'personal services business'. The debate over the Ralph recommendations demonstrates how critical these questions are.
If there is failure in the new system, it is an apparent failure within the legislation to give income earners 100 per cent clarity about what, for tax purposes, constitutes a 'personal services business'. Leaving the Registrar with discretionary powers opens the system to abuse and conflict and puts at risk maximum voluntary compliance. Admittedly, the problem that I see in the legislation is at the margins, but this does not alter the principle that legislators have a duty to deliver clarity on this matter.
But perhaps the answers are best considered from the perspective of the integrity of the tax collection system. If ABN registrations of individual contractors were rejected, the PAYG system would be compromised.
The Tax Commissioner has a vested interest in tracing each and every commercial transaction in the community and the ABN is the primary cross-reference tool that will facilitate computer-generated tracing. If an anti-contractor government changed the rules, or instructed the Registrar to use the interpretative powers to refuse ABN registrations, the government would be stripping important auditing powers from the Commissioner and creating tax avoidance.
The debate over income-splitting has generated great heat and accusations that the government has wanted to get rid of contractors. I will make two limited comments.
First, contrary to most accusations and on the best available evidence, large-scale income-splitting in the community is unproven. In the only authoritative and detailed investigation of income-splitting, the practice was shown to be minor.
During 1997 and 1998 the ATO conducted the 'Alienation of Personal Services Project'. An ATO status report of December 1998 showed the following:
- 65,000 taxpayers were profiled for investigation as likely income-splitters.
- 55,000 notices were sent to taxpayers initiating review of tax returns.
- 5,403 taxpayers were specifically targeted for tax review.
- 1,104 tax agents were visited in the taxpayers' review process.
- 714 taxpayers were issued adjustments notices.
- Percentage increases in tax paid varied from 1.9 per cent to 11.6 per cent per taxpayer.
Furthermore, it is understood that the additional tax raised was below that expected of any random audit of taxpayers' returns. It is known that the project was wound down because the additional revenue raised did not cover the cost of the audit. The conclusion of the audit was that the vast majority of people structure for legitimate business purposes and not for tax purposes.
I find it odd that the results of this, the only detailed, factual and reliable audit undertaken, received no official coverage during the recent debate on income-splitting.
My second comment is on the definition of income-splitting. Income-splitting has been one of those issues that everyone seems to think everyone understands but when it comes to precise definition, there is mute silence.
Those who continue to make accusations of income-splitting, and there are many, have a responsibility precisely to define the point in a transaction at which a payment to an individual from an entity ceases to be an expense in earning an income and becomes a tax dodge.
Take a typical example: If the spouse of a carpenter contractor is a partner in the contractor's business, at what point do payments to the spouse cease to be legitimate partnership payments and become income-splitting? Are partnerships to be disallowed? Are two-person companies to be abolished?
This simple question will, I suspect, not disappear and accusations that contractors are income-splitting will continue. However, I repeat that income-splitting issues do not relate to income tax collection but rather to the rate of tax to be imposed on an income earner. Further, the answer to this critical legal, social and economic question should not be left to the arbitrary and discretionary powers of tax bureaucrats. Rather, it should be clearly stated in legislation.
My discussion has focused on the at-source, income tax collection powers of the Tax Commissioner and the nexus between those powers, common-law employment and industrial relations.
When considering the new PAYG system from this perspective, the design is looking impressive. Although some reservations remain, we can be optimistic that collection of tax under PAYG will sever the relationship between the tax collection system and industrial relations regulation.
If my assessment is accurate, the days of the exploitation of the tax
collection system for the enforcement of industrial relations regulation
may be numbered.