Photo by Tarryn Myburgh on Unsplash

One question that has cut across recent Australian tax policy debates in relation to taxing corporations and private trusts, but has not been made explicit, is – when is it appropriate to apply entity taxation under domestic income tax systems? The answer to this also answers the corollary – in what circumstances should we apply flow-through tax designs?

The range of features that comprise each method of taxation (entity taxation and flow-through taxation) are set out in previous work (see here and here).

My recent article critically analysed the range of reasons that have historically been used to justify applying entity taxation to corporations. That article argued that those reasons ‘do not form one coherent narrative and are better seen as an unconnected set of justifications made retrospectively.’

If history does not provide an answer, the next question is – what criterion should we use?

I argue that we need one with a strong normative basis. For alternative vehicles, such as the private trust in Australia or the limited liability company (LLC) in the United States, a further design question is – to what extent should one method of taxation control the design?

The modern five ideas

Over the past century, countries have used five ideas.

Those ideas are that entity taxation should be applied when the vehicle:

  • takes corporate form;
  • provides owners with limited liability;
  • carries on active business or has predominantly active income;
  • is public, or
  • is economically separate from the owners.

The first idea is intuitive to many people, but it runs into problems when the range of vehicles expands to include ones with hybrid characteristics. The US has experience with these problems and has tried solutions, neither of which are ideal from a tax policy perspective. And while providing limited liability can affect the allocation of risk in relation to a vehicle’s activities, the literature is not clear about why this should be used as the criterion for determining the method of taxation, and there is no clear correlation between those who suffer unfunded damages and those who benefit from corporate tax revenue.

Therefore, this post focuses on the last three ideas as these are the most valuable.

Idea three – entity taxation should be applied when a vehicle carries on active business

The US has a long history of using the third idea to determine which method of taxation applies. For example, from 1935 onwards, carrying on active business caused a trust to be recharacterised as a company for federal income tax purposes. The primary rationale was to protect the corporate tax base from erosion.

In contrast, although Australian literature often presents the normative value of this idea as being self-evident, the nature of a vehicle’s activities and characterising the income that flows from those activities as active or passive has historically had less of a role in shaping the method of taxation in Australia. It only became important in 1985 when Australia introduced a rule to reclassify public trusts that carried on active business as corporations with the same rationale as the US. Australia has then used the active/passive distinction selectively since and not always with the same rationale. As an example, the rules for managed investment trusts (MITs) were bolted onto this distinction but that regime was designed to enhance Australia’s prospects as a financial services hub in the Asia-Pacific region.

There are several persuasive reasons for not using this idea:

  • Active business, passive activities and their extensions in relation to income are not terms of art and their meanings are malleable. This is problematic because the definitions could be impacted by lobbying and structuring, and this indicates that the distinction is not sufficiently robust.
  • There is likely to be elasticity around the composition of a vehicle’s activities and business.
  • Using this idea could lead to unintended consequences, for example, encouraging mergers and acquisitions to meet the particular threshold, and it could also cause switching problems at the boundary.
  • It could create a disincentive for vehicles to carry on active business and that would be counterproductive for economic growth.

Idea four – entity taxation should be applied when a vehicle is public

The American Law Institute’s Reporters’ Study on Private Business Enterprises (1999) favoured the fourth idea (apply entity taxation when the vehicle is public). It is easy to see the appeal. If public takes its usual meaning, namely as an entity whose ownership interests are on the official list of a stock exchange, then the task of identifying public vehicles is easy, both for the taxpayer and the revenue authority. This is advantageous because it provides certainty. Certainty is important when it comes to fundamental questions, such as which method of taxation will apply, as owners and investors want clarity for a range of reasons, including to gauge the return on investment. The other advantage of using the public/private distinction is that it is generally a point around which the other four ideas listed above coalesce, but it is an easier test to apply. A further advantage is that the choice to be public will generally be an inelastic feature of a vehicle. This is highly beneficial as it means that the tax system will not introduce distortions.

The public/private distinction has long history in US public finance literature and, in that context, it was connected with an administrability argument. Most notably, Richard Goode argued in 1946 that flow-through taxation was only manageable for corporations with a limited number of individual shareholders and one class of stock. Goode argued that applying flow-through taxation beyond this was unwieldy. That made sense given the manual nature of record-keeping then, but technological advances over the past 76 years make this argument more difficult.

Although the ALI Reporters’ Study on Private Business Enterprises advocated for the fourth idea, I argue that this is largely a choice of convenience, and that we should be testing for what is important in substance, not just what is most convenient.

Idea five – entity taxation should be applied when a vehicle is economically separate from its owners

As stated above, the fifth idea is what matters for imposing entity tax, and it is in substance what each of the historic justifications, discussed above, were searching for.

Literature on the Corporation and Corporate Law has advocated that the controlled/uncontrolled distinction is a key basis for indicating economic separation between corporations and shareholders. However, to date, countries have not applied it in determining which method of taxation to apply and I argue that we should start using it for this purpose.

The fifth idea is valuable because anecdotally there will generally be little to no elasticity around whether a vehicle is controlled/uncontrolled. As discussed above, this is important because it is best for the criterion to be as non-distortionary as possible. Anecdotally, it is also unlikely to be a feature that is desirable for taxpayers to manipulate.


This post summarises an article – Alex C Evans, ‘Parameters for Applying the Two Methods of Taxation: The Modern Five Ideas’ (2021) 36 Australian Tax Forum 403

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