Part 2: Does the CFC satisfy the active income test?

Part 2 deals with the operation of the active income test but does not cover the operation of the special rules for banks, other financial institutions and insurance companies in Subdivision F of Division 8 of Part X of the ITAA 1936.

Section 1	Terms used in this part
Section 2	Conditions to be met to satisfy the active income test
Section 3	Is the tainted income ratio less than 5%?

Section 1: Terms used in this part

Meaning of passive income

Dividends

Passive income includes dividends (within the meaning of section 6) and:

• unit trust dividends received from a corporate unit trust or a public trading trust
• a distribution made by a liquidator which is deemed to be a dividend.

Interest income

Passive income includes tainted interest income, which is all interest income except for interest derived through an offshore banking unit. It also specifically includes:

• amounts in the nature of interest (for example, discounts)
• income earned from hire purchase and other property financing transactions
• accrued interest on discounted and other deferred interest securities issued after 16 December 1984
• interest deemed to be derived where a CFC assumes the rights of a lender through the purchase of securities through a secondary market
• factoring income.

Tainted rental income

There are three categories of tainted rental income:

• rent from associates
  • income from any leases between a CFC and an associate and any income that arises where rent is paid to the CFC by an associate
   
• lease of land
  • income from related party lease transactions
  • income from leases of land, including fixtures, in respect of land situated in a country other than the CFC’s country of residence
  • income from leases of land, including fixtures, in respect of land situated in the CFC’s country of residence, unless a substantial part of the income is attributable to the provision of labour-intensive ‘property management services’ by directors or employees of the CFC in connection with the land
   
• ships and aircraft
  • income from the lease of ships or aircraft, cargo containers for use on ships or aircraft or plant or equipment for use on board ships, unless the income relates to the provision of operating crew in relation to ships and aircraft or maintenance or management services by the CFC's directors or employees.
   

Special excluded rental income

An amount of rental income will not be treated as tainted if the following three requirements are satisfied:

• the amount is derived from an associated CFC resident in the same country
• the amount is taxed at the normal company rate of tax in that country, and
• the payment of the amount did not wholly or partly give rise to a notional allowable deduction for the associated CFC.

The second requirement is based on whether an amount has been taxed at the normal company rate of tax in a country. For an amount to be treated as taxed at a country's normal company rate, the amount must be taxed at the same rate applicable to the company's other non-dividend income or at a higher rate. In addition, there can be no entitlement to a credit, offset or tax concession in the taxation of the amount.

For the third requirement, it is assumed that the associated CFC failed the active income test. The requirement will not be satisfied if a payment would have resulted in a notional allowable deduction for an associated CFC if the CFC had been required to work out its attributable income.

Tainted royalty income

Tainted royalty income includes income derived from assigning any copyright, patent, trademark or other like property or right.

Specifically excluded from tainted royalty income are royalties received from unrelated persons in the course of carrying on a business where the CFC substantially develops or improves the property or right for which the royalty is paid. For example, if a CFC develops software and licenses it to an unrelated party, the royalty income is not tainted.

Net gains on the disposal of tainted assets

The net gain (that is, the sum of gains, less losses) from the disposal of tainted assets is included in passive income.

What is a tainted asset?

Tainted assets include:

• all shares, interests in trusts and interests in partnerships
• most financial instruments, such as loans, forward and futures contracts, swaps, other securities and life assurance policies
• rights or options over any of the above.

An asset will also be tainted if it is held by a CFC to derive tainted rental income. In order to determine whether an asset is used to produce tainted rental income, you must look at the use of the asset over the whole time of ownership. If the purpose changed during that period, the asset will be treated as being used to produce tainted rental income if this was the purpose for the majority of the period of ownership.

Also, an asset will be treated as a tainted asset if it is not trading stock or is not used solely in carrying on business.

The tainted assets referred to in the preceding paragraphs, such as shares, will be tainted assets whether or not they are trading stock or are used in carrying on business. Exclusion of commodity investments

Commodity investments are not tainted assets; they are treated separately when working out net tainted commodity gains.

Proceeds from trading in tainted assets

Income derived in carrying on a business of trading in tainted assets is included in passive income.

Net tainted commodity gains and losses

The net gain on the disposal of tainted commodity investments is included in passive income.

What is a tainted commodity gain or loss?

A tainted commodity gain or loss arises from the disposal of a tainted commodity investment.

What is a tainted commodity investment?

Commodity investments that are tainted include futures or forward contracts for a commodity (or a right or option on such a contract) unless the contract relates to carrying on a business of:

• producing or processing the commodity, or
• using the commodity as a raw material in a production process.

Where these conditions are not met, the investment can be excluded from being a tainted commodity investment if the contract, right or option relates to a transaction where the resultant physical sale of the commodity will not be tainted sales income. The contract must also have been entered into for the sole purpose of eliminating or reducing adverse financial consequences from fluctuations in the price of the commodity.

Net tainted currency exchange gains and losses

A net tainted currency gain is the total of the tainted currency exchange gains less the total of the tainted currency exchange losses. If this is a positive figure, there is a net gain; if not, the amount is ignored.

What is a tainted currency exchange gain or loss?

A gain or loss from a currency exchange fluctuation will be tainted unless it falls within one of the following categories:

• the underlying transaction was for the purchase of goods from an unassociated person
• the underlying transaction was for the purchase or sale of depreciable plant or equipment that was used mainly to produce income that is not passive, tainted sales or tainted services
• the underlying transaction was a hedge for one of the preceding transactions
• the CFC was carrying on business as a currency trader and no other party to the transaction was an associate or an Australian resident.

Meaning of tainted sales income

The tainted sales income of a CFC includes that part of gross turnover that represents sales income where the goods sold were purchased from or sold to:

• an associate who is a Part X Australian resident, or
• an associate who is not a Part X Australian resident but carried on business in Australia through a permanent establishment.

Sales which result in tainted sales income

Purchased from	Tainted sales?
Associated Australian	Yes
Associated non-resident (via Australian branch)	Yes
Unassociated Australian	No
Associated non-resident (not via Australian branch)	No
Unassociated non-resident	No

Purchases which result in tainted sales income on sale

Sold to	Tainted sales?
Associated Australian	Yes
Associated non-resident (via Australian branch)	Yes
Unassociated Australian	No
Associated non-resident (not via Australian branch)	No
Unassociated non-resident	No

Exclusions from tainted sales income

Manufacturing exclusion

The main exclusion from tainted sales income is sales where the CFC manufactures, extracts, produces or substantially alters the goods sold: for example, this would include sales from mining and quarrying operations.

This exclusion will apply only where the goods sold were manufactured, produced or substantially altered by the directors or employees of the CFC. The packaging and labelling of goods is not considered to be a substantial alteration of those goods.

The exclusion will not be available where the CFC subcontracts the manufacture, production or substantial alteration to agents or subcontractors. However, the fact that a CFC subcontracts some operations will not disqualify it from the manufacturing exclusion if directors or employees of the CFC carry out a substantial part of the manufacture, production or substantial alteration.

Hospitality exclusion

Also excluded from tainted sales income are sales that, broadly, arise from the tourism and hospitality industry. These are sales provided in connection with a hotel, motel, guesthouse, restaurant, bar or other place of entertainment or recreation.

Passive income exclusion

Amounts of passive income are excluded from tainted sales income. This prevents double counting.

Meaning of tainted services income

Tainted services income, in broad terms, means income derived from the provision of services by a company to:

• a resident (except in connection with a foreign permanent establishment of the Australian resident), or
• a non-resident in connection with the non-resident’s Australian permanent establishment.

Tainted services income also includes income derived from services provided indirectly to Australian residents, subject to certain requirements.

Services includes any benefit, right or privilege provided under an arrangement for the performance of work or the provision of facilities: for example, performance of technical, managerial or transport work.

Tainted services income

Provided to	Tainted services?
Associated Australian	Yes
Associated non-resident (via Australian branch)	Yes
Unassociated Australian	Yes
Associated non-resident (not via Australian branch)	No, subject to indirect services rule
Unassociated non-resident (via Australian branch)	Yes
Unassociated non-resident (not via Australian branch)	No

Exclusions from tainted services income

General exclusions

Tainted services income does not include:

• royalties
• any income in respect of a lease of land
• any income from trading in assets, or
• gains from currency exchange rate fluctuations, commodity investments and assets.

Manufacturing exclusion

There is an exclusion from tainted services income where the service relates to goods manufactured by a CFC – for example, payments for after-sales service or income derived under a service contract for equipment manufactured by a CFC.

Hospitality exclusion

Also not included in tainted services income are services that, broadly, arise from the tourism and hospitality industry: these amounts are services provided in connection with a hotel, motel, guesthouse, restaurant, bar or other place of entertainment or recreation.

Passive and tainted services income exclusion

Tainted services income does not include passive income or tainted sales income; this prevents double counting.

Indirect services rule

Income from services provided to an Australian resident or Australian permanent establishment of a non-resident is tainted services income. Income from services provided indirectly to certain Australian residents or Australian permanent establishments will also be tainted services income where the following conditions are met:

• services provided by the company to an associated entity are received by another entity that is an Australian resident
• the services are provided under a scheme (as defined in section 995-1 of the ITAA 1997), and
• the income from the services would have been tainted income if they had been provided directly by the company to the ultimate recipient.

The services originally provided by the company have to be the same services that are provided to the ultimate recipient.

Section 2: Conditions to be met to satisfy the active income test

A CFC has to satisfy the following five conditions to pass the active income test:

• It is a resident of a foreign country.
• It carries on business at or through a permanent establishment in its country of residence.
• It keeps proper records.
• It can substantiate that it has met the active income test.
• Its tainted income ratio is less than 5%.

Condition 1 – the CFC is a resident of a foreign country

The CFC must be a resident of a particular country throughout the statutory accounting period. A change of residence of the CFC does not mean that the CFC will fail the active income test. However, it must have been a resident of a particular country both before and after the change, and must have been in existence at the end of the statutory accounting period.

New companies

If a CFC was in existence for only part of a statutory accounting period, it must be a resident of a particular country throughout the period in which it existed – that is, in the period from incorporation to the end of the statutory accounting period.

Treatment of dormant companies

The term ‘in existence’ does not include a company that is dormant within the meaning of former Part VI of the Companies Act 1981. A CFC that is dormant for the whole of the statutory accounting period will fail the active income test. However, because the CFC is dormant, it will have no income or gains and will have no attributable income.

Is the CFC resident in a particular country?

Yes	Read on.
No	The CFC has failed the active income test. Go straight to part 3.

Condition 2 – the CFC carries on business at or through a permanent establishment in its country of residence

The CFC must carry on business at or through a permanent establishment in its country of residence for the whole of a statutory accounting period in which it is in existence.

What is a permanent establishment?

The definition of permanent establishment is contained in section 6 of the Act. The term includes a fixed place of business through which the CFC carries on business operations. However, it specifically excludes a place where a person:

• is engaged in business dealings through a commission agent or broker who is acting in the ordinary course of business and receiving customary rates of remuneration
• is carrying on business through an agent who does not have, or does not usually exercise, a general authority to negotiate and conclude contracts or to fill orders from stock situated in the country
• maintains the place solely for the purpose of purchasing goods or merchandise.

Did the CFC carry on business through a permanent establishment in its country of residence?

Yes	Read on.
No	The CFC has failed the active income test. Go straight to part 3.

Condition 3 – the CFC kept proper records

The figures used in the active income test are mainly drawn from accounting records and, in general, are not adjusted to comply with tax law concepts; as a result, the accounts of the company must be properly prepared.

The accounts must be prepared in accordance with commercially accepted accounting principles. Where there are commercially accepted accounting principles in the country of residence of the CFC, it is acceptable if the accounts of the CFC comply with those principles. In other cases, it is acceptable if the accounts of the CFC comply with Australian commercially accepted accounting principles.

The documents you must take into consideration are:

• the profit and loss statement and financial statements
• any ledgers or journals
• any notes, statements or reports that are attached to, or meant to be read with, these accounts.

The accounts of a CFC for a statutory accounting period must give a true and fair view of the financial position of the CFC. If the accounts are prepared in accordance with commercially accepted accounting principles, but do not give a true and fair view, the CFC will fail the active income test.

Treatment of partnerships

Where a CFC is a partner in a partnership, the CFC's share of the partnership income must be taken into account. This means that the partnership must also keep proper accounts. If the partnership does not keep proper accounts, the CFC will fail the active income test.

Has the CFC and every partnership in which it was a partner kept proper accounts that give a true and fair view?

Yes	Read on.
No	The CFC has failed the active income test. Go straight to part 3.

Condition 4 – the CFC can substantiate a claim that it has met the active income test?

A CFC must have, and be able to produce, accounts to substantiate your claim that the CFC has passed the active income test. If the CFC is a partner in a partnership, that partnership must also keep accounts to substantiate amounts derived by the partnership. If the CFC or partnership does not have the accounts, or does not produce them, the CFC is taken to have failed the active income test. See chapter 5 for details of the substantiation requirements and the procedures.

Is the CFC and any partnership in which it is a partner able to substantiate your claim?

Yes	Read on.
No	The CFC has failed the active income test. Go straight to part 3.

Condition 5 – the CFC’s tainted income ratio is less than 5%

To pass the active income test, the tainted income ratio of a CFC for a statutory accounting period must be less than 0.05: that is, less than 5%. If both the bottom line and the top line of the relevant formula are nil, the CFC is taken to have passed the active income test.

Section 3: Is the tainted income ratio less than 5%?

The tainted income ratio for a CFC is worked out as follows:

Gross tainted turnover ÷ gross turnover

Gross turnover

Broadly, the gross turnover of a CFC is the sum of the company’s net gains and gross revenue. Work out the gross turnover using the following five steps:

1. identify the total gross revenue derived by the CFC
2. exclude certain comparably taxed amounts
3. exclude the proceeds of certain asset disposals
4. add back net gains arising from certain asset disposals
5. add the CFC's share of the gross turnover of each partnership in which it was a partner.

The figures used are mainly drawn from the accounts of the CFC. If the accounts are prepared in a foreign currency, there is no need to convert the amounts to Australian dollars.

Step 1 – Identify total gross revenue

The total gross revenue is the sum of amounts shown in the accounts of a CFC as gross revenue: that is, deductions are not taken into account.

Do not include amounts that have not been brought to account in the period; for example, an amount may not be recognised in the accounts because its receipt is extremely doubtful. This amount would not be included in gross revenue. However, the exclusion of the amount must be in accordance with commercially accepted accounting principles and give a true and fair view of the CFC's financial position.

Step 2 – Exclude comparably taxed amounts

Certain comparably taxed amounts are excluded from the active income test. They are:

• a franked dividend
• an amount included in the CFC’s assessable income in any year of income, unless the amount is only subject to dividend or interest withholding tax or is not fully taxed; for example, certain shipping or insurance premiums
• an amount arising from the disposal of an asset that is taxable Australian property
• an amount that is an attribution account payment to the extent that the profits from which the payment was made have been previously attributed to you
• an amount derived through a branch in a listed country if the amount is taxed in that country
• a non-portfolio dividend from a foreign company.

Because trust amounts arising to a CFC are attributed regardless of whether the CFC passes the active income test, they are also excluded from the tainted income ratio calculation.

Step 3 – Exclude proceeds from certain asset disposals

Amounts that arise from asset disposals are excluded from the gross revenue. However, this exclusion does not extend to disposals of trading stock. Amounts included in gross revenue from currency exchange rate fluctuations and commodity investments are also excluded.

Step 4 – Add back net gains

The amounts that were excluded under step 3 are brought back into gross turnover as net amounts. There are three separate net amounts:

• the net gain from the disposal of commodity investments
• the net gain from currency exchange rate fluctuations
• the net gain from the disposal of other assets that are not trading stock or commodity investments.

In each case, to determine the net gain, the sum of the individual gains is reduced by the sum of the losses. If there is a net loss, the amount is ignored and does not reduce the gross turnover. It is important to note that there is a separate calculation of net gain for each of the categories. Do not take comparably taxed amounts into account.

Consideration paid or received for asset disposals must be included at market value. Where an amount has been written down in the accounts, the write-down is to be ignored.

Step 5 – Include partnership turnover

A CFC's share of the gross turnover of a partnership must be added to the CFC's gross turnover. This is done for each partnership in which the CFC is a partner. This means that you must go through the same process (steps 1 to 4) for each partnership.

In working out the total, treat the partnership as if it were a CFC. The partnership is assumed to be a resident of the same country as the CFC.

Result of steps 1 to 5

Add the amounts at steps 2 and 3. Take this total away from the total revenue at step 1. The balance is the gross revenue after exclusions.

Add the totals of steps 4 and 5. This is the CFC's gross turnover.

Gross tainted turnover

Gross tainted turnover is the part of the gross turnover that is either passive income, tainted sales income or tainted services income.

Broadly, passive income includes:

• dividends
• tainted interest income
• annuity income
• tainted rental income
• tainted royalty income
• amounts derived as consideration for the assignment in whole or part of any copyright, patent, design, trademark or other like property or right
• net gains on the disposal of a tainted asset
• income derived in carrying on a business of trading in tainted assets
• net tainted commodity gains
• net tainted currency exchange gains.

Tainted sales income and tainted services income are, broadly, income from certain transactions with, or originating from, associates or Australian residents.

The gross tainted turnover is worked out using the following five steps:

Step 1

Identify the part of gross revenue that is passive income.

Step 2

Add the part of gross revenue that is tainted services income.

Step 3

Add the part of gross revenue that is tainted sales income.

Step 4

Add the part of the gross turnover that is net tainted gains.

Step 5

Add the CFC's share of the gross tainted turnover of each partnership in which it was a partner.

Identify the tainted part of gross revenue (steps 1, 2 and 3)

Identify which parts of the gross revenue are passive income, tainted sales income or tainted services income: that is, determine the tainted part of the result after step 3 of the calculation of gross turnover.

Identify tainted net gains (step 4)

Identify the parts of the net gains that are tainted; that is:

• the part of the net gain from the disposal of commodity investments that is tainted
• the part of the net gain from currency exchange rate fluctuations that is tainted, and
• the part of the net gain from the disposal of assets (other than trading stock or commodity investments) that is tainted.

Each of the net tainted gains is calculated separately and cannot exceed the amount of the net gain to which it relates. In each case, you will need to calculate the net gain and the net tainted gain. If the net tainted gain is greater than the net gain, use the net gain instead of the net tainted gain.

Identify the CFC's share of a partnership's gross tainted turnover (step 5)

Go through steps 1 to 4 for each partnership in which a CFC was a partner. The CFC's share of the gross tainted turnover of each partnership is then added to the CFC's tainted income that was derived directly.

Working out the tainted income ratio

The tainted income ratio is worked out by dividing the gross tainted turnover of a CFC by the gross turnover of the CFC.

The following is a simple example of how to work out the tainted income ratio:

Is the tainted income ratio less than 5%?

Yes	The CFC has passed the active income test. Go to part 3.
No	The CFC has failed the active income test. Go to part 3.