Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon. P.J. Keating, M.P.)
The main features of the Bill are as follows.
This Bill will replace, with effect from the commencement of the 1987-88 year of income, the various unilateral double taxation relief arrangements of the income tax law with a world-wide general foreign tax credit system.
Under this system, the foreign source income derived by Australian resident individuals (apart from certain salary and wages - see below) and by Australian resident companies will be subjected to Australian income tax. Credit, up to the amount of the Australian income tax referable to the relevant foreign income, will be allowed against the Australian tax payable for analogous foreign tax that is paid by the Australian resident on the foreign income.
To that end, the Bill will make two major changes to the present income tax law. First, it will repeal paragraph 23(q) of the Income Tax Assessment Act 1936 (the "Assessment Act") which now generally provides that, with certain exceptions (notably dividends and income other than salary and wages from Papua New Guinea), the foreign source income of Australian residents is exempt from Australian income tax if it is not exempt from income tax in the foreign country.
Notwithstanding the repeal of paragraph 23(q), salary or wages earned overseas that is subject to tax in the country of source will continue to be fully exempt from Australian income tax, but only where derived by the Australian taxpayer in performing the relevant duties overseas for a continuous period of at least 12 months. A proportionate exemption will apply where the period of service is from 3 to 12 months. The existing provisions for exempting from Australian tax the remuneration of Australian residents working overseas on approved projects will be retained.
However, the exempted foreign earnings of employees (including earnings by consultants on approved projects) will be taken into account in calculating the appropriate rate of Australian tax on other income, so that exemption of the foreign earnings will not also reduce the tax payable on the other income.
Foreign earnings that are not exempt from tax in the above cases will be subject to the general foreign tax credit system.
The other major change to be made to the present law by the Bill is the withdrawal, in relation to dividends received by an Australian resident company from an overseas company, of the rebate provided by section 46 of the Assessment Act. That rebate effectively operates to exempt from Australian tax all dividends received by an Australian resident company. Under the general foreign tax credit system, foreign dividends will be subject to tax in Australia, with credit being allowed for foreign tax paid on those dividends including, in the case of subsidiary companies, tax paid on the profits out of which the dividends are paid.
Particular features of the foreign tax credit system are described below.
The foreign taxes for which credit is to be allowed include those imposed by central, State and local governments provided such taxes are equivalent in nature to Australia's income tax. On this basis, credit will not be allowed for foreign unitary taxes or other taxes of that kind.
Certain foreign-source interest income will be quarantined, with separate foreign tax credit limits.
Interest derived from normal business activities (including banking) conducted in a foreign country will be excluded from quarantining. Interest derived from a foreign subsidiary will also be excluded, provided the subsidiary has not received interest, other than from its normal business activities, which amounts to more than 10 per cent of its profits.
To ensure that these quarantining measures have their intended operation, dividends received from foreign subsidiaries will be subject to tracing rules to overcome arrangements whereby interest is derived by a subsidiary instead of the Australian parent company, and is then effectively recharacterised as dividends remitted to Australia.
Subject to the credit for foreign tax being limited to the amount of Australian tax payable on the relevant foreign income, an Australian resident company which receives dividends from a foreign company will be allowed credit for both foreign withholding taxes on dividends received and, where the recipient Australian company and the foreign company are related, for the "underlying" foreign company taxes on that portion of the profits from which the dividends are paid.
An Australian company will be taken to be related to any number of linked foreign companies, (that is, there will be no limit on the number of tiers of subsidiaries for which credit for underlying tax will be allowed) provided -
- each company in the chain has at least a 10 per cent controlling interest in the company in the tier below; and . the Australian parent has an aggregate (direct or indirect) controlling interest of at least 5 per cent in each foreign company that is a member of the chain.
In many cases, the amount of foreign source income to be subject to Australian tax will be simply the gross amount of that income - this is generally the case under present law where dividends are received from overseas by a resident individual. Where the amount of foreign income actually received has been reduced by the payment of foreign tax on the relevant income, e.g., a withholding tax imposed on a dividend, the net amount received will be "grossed-up" by the amount of that tax.
In the case of foreign branches or other foreign business or commercial activities (such as the receipt of rents or royalties) of Australian resident taxpayers, the foreign source income to be subject to tax in Australia will be determined in accordance with Australian income tax law.
As noted earlier, an Australian resident company which receives dividends from an overseas subsidiary will be entitled to a credit for "underlying" foreign company taxes on that portion of the profits of the subsidiary from which the dividends is paid. For this purpose it is necessary to determine the amount of profits that are derived by the foreign subsidiary and available for distribution. At base, the profits of a foreign subsidiary as disclosed in its accounts will be used for this purpose. However, those figures will be subject to examination and adjustment as necessary to ensure that, having regard to the requirements of any law of the foreign country concerned relating to the maintenance of statutory reserves, and other relevant matters, those amounts reflect the profits derived and properly available for distribution.
Dividends received from a foreign subsidiary and in respect of which credit for underlying company tax is allowable will be treated as being paid out of a pool of the distributing subsidiary's accumulated profits, and so subject to the average rate of foreign tax imposed on those profits over the period of accumulation. This pooling approach, which is of an anti-avoidance nature, will apply on a prospective basis, i.e. to profits accumulated by the foreign subsidiary from the first accounting period beginning after the introduction of the Australian foreign tax credit system with effect from the commencement of the 1987-88 income year.
Dividends will be treated as paid first out of the pool of all accumulated profits derived by the subsidiary. Dividends in excess of the pool of accumulated profits will be treated as paid out of profits of earlier accounting periods (i.e., profits derived by the subsidiary in periods preceding the commencement of the Australian foreign tax credit system) and then on a last-in-first-out basis.
Where the amount of foreign tax paid on foreign-source income exceeds the Australian tax payable on that income, the excess foreign tax will not be carried forward or carried back. However, excess foreign tax credits arising in a year of income will be transferable within wholly-owned company groups for set off against Australian tax payable on other non-interest foreign income derived by other companies in the group in the same income year.
Any accumulated foreign losses incurred by an Australian resident taxpayer in the period of 7 years preceding commencement of the foreign tax credit system in Australia, and any future losses incurred by such taxpayers (i.e., by foreign branches and in relation to other business and commercial activities conducted overseas), will be available to be carried forward for a maximum period of 7 years and set off against later income from the same branch or activity in the same country. Only the resulting net amount of that later income will be taken into account as assessable income for Australian income tax purposes in the subsequent year.
Losses incurred in relation to interest income will be quarantined and only allowed to be set off against future interest income from the same source.
Domestic losses will be available for carry forward to offset later domestic profits as at present, or, at the taxpayer's option, will be allowed to be offset against foreign profits in the year in which the loss is incurred.
Income from foreign branches will be required to be expressed in Australian income tax returns in Australian currency at the average exchange rate for the year of income, or the part of that year, in which the income was derived. Any foreign tax paid in respect of that income will be converted at the exchange rate prevailing at the time when the tax was actually paid or withheld.
A taxpayer deriving salary and wage income that is not to be exempt from Australian tax and is therefore subject to the foreign tax credit system (see earlier notes) will be required to include that income in his or her income tax return in Australian currency at a rate equal to the average exchange rate over the period of the year during which the taxpayer earned that income. In these cases also, the amount of foreign tax paid on the salary and wage income concerned will be translated to Australian currency at the rate prevailing when the tax was paid.
Other amounts of foreign income derived by Australian resident individuals and companies, and the amount of foreign tax paid on that income (including, in the case of dividends, where credit is allowable for underlying foreign company tax), will be converted into Australian currency at the exchange rate prevailing when the income is remitted to Australia. If some of the income is not remitted in the year of income, it will be deemed to have been remitted to Australia on the last day of the year of income.
The foreign tax credit system will operate to subject to Australian tax, and to allow credit for foreign tax paid in respect of, income derived by overseas branches of Australian life insurance companies to the extent only that such income is remitted to Australia.
Many developing countries offer incentives in the form of tax holidays or tax reductions to encourage foreign investment to assist in the development of those countries. In the absence of special provisions to recognise such incentives, they would be nullified by a foreign tax credit system, i.e., the country of residence of the investor would effectively collect any tax that is forgone by a developing country. Traditionally, provisions - called "tax sparing" provisions - to avoid this result are included in a comprehensive taxation agreement between the two countries concerned. Australia has followed this approach, but the Bill will also enable tax sparing to be granted on a country by country basis by regulations made for that purpose. Where tax sparing is granted either by way of regulation or under the terms of a comprehensive taxation agreement, the tax forgone by the foreign country under the relevant tax incentive measures will be deemed to have been paid by the Australian taxpayer. This will carry entitlement to a credit for the amount of foreign tax forgone (in addition to any foreign tax still paid) on the foreign income concerned.
As with other foreign income that will be subject to the foreign tax credit system, the relevant income of the Australian taxpayer will be grossed-up for assessment purposes by the foreign tax for which credit is to be allowed against the Australian tax payable on that income, i.e. the relevant income will be grossed-up by both the amount of any foreign tax paid, and the amount of tax forgone, on that income.
The Bill will also make several consequential amendments to other provisions of the income tax law as a result of the introduction of the general foreign tax credit system. A major category is the amendments to be made to the Income Tax (International Agreements) Act 1953 to repeal various provisions of that Act. The provisions concerned are those which allow credit for foreign tax on dividends, interest and royalties subject to limited rates of foreign tax in accordance with provisions of the various agreements for the avoidance of double taxation which Australia has concluded with other countries. As the new general foreign tax credit system will apply to such income, these provisions are no longer necessary and are to be repealed.
The foreign tax credit system will apply from the commencement of the 1987-88 income year, i.e., the year of income commencing on 1 July 1987. In the case of taxpayers with substituted accounting periods, the system will first apply to the accounting period that substitutes for that year of income.
A more detailed explanation of the provisions of the Bill is contained in the following notes.