House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 9 - Technical changes in relation to foreign tax credit provisions

Outline of chapter

9.1 This chapter explains the phasing out of the existing grouping rules for foreign tax credits and other rules concerned with the use of foreign tax credits.

Context of reform

9.2 The rules for terminating the current section 160AFE of the ITAA 1936 and applying the new section 160AFE were introduced in the June Consolidation Bill. However, these rules were not fully developed and did not apply appropriately in some cases to a head company of a consolidated group with a SAP. The rules also did not apply appropriately to a head company where the consolidation day was not the first day of an income year and was before 1 July 2003.

9.3 The rule introduced in Schedule 9 of the June Consolidation Bill, allowing for accelerated use of a joining entitys excess foreign tax credits from earlier years, did not deal adequately with cases involving SAPs.

9.4 It is arguable that the exit history rule may provide a means for an entity that left a consolidated group to claim excess foreign tax credits that the head company would also have claimed. The rule explained in this chapter has been introduced to ensure there is no double counting of excess foreign tax credits.

Summary of new law

9.5 The rules contained in this bill ensure that:

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the current section 160AFE operates until the time a consolidated group is formed or until 1 July 2003, whichever is the earlier. The only exception (which is contained in item 3 of the June Consolidation Bill) is where a head company with a SAP forms a consolidated group from the beginning of the first income year starting after 30 June 2003 but before 1 July 2004. In that situation the current section 160AFE will operate until the end of the income year before the consolidation day;

•

the new section 160AFE will apply from the beginning of the day after the day the current section 160AFE ceases to apply and for all subsequent income years that end after that day;

•

a head company gains accelerated use of a joining entitys excess foreign tax credits from earlier years where the head company has a SAP and the companies were members of a wholly-owned group prior to consolidation. This rule applies where the consolidated group is formed in the transitional period (1 July 2002 to 30 June 2004); and

•

there is no double counting of excess foreign tax credits and that once excess foreign tax credits of subsidiary members have become those of the head company they do not leave the consolidated group.

Detailed explanation of new law

Applying the new section 160AFE to a company with a SAP

9.6 The current section 160AFE of the ITAA 1936 deals with the transfer of foreign tax credits between wholly-owned group members and the carry forward of excess foreign tax credits. The new section 160AFE (in Schedule 10 to the June Consolidation Bill) only provides for the carry forward of excess foreign tax credits.

9.7 Both the current and new section 160AFE generally operate on an income year basis and apply to entities with ordinary income years and to those with SAPs. The current section 160AFE is effective at the end of an income year. However, a consolidated group may form on a day that is partway through an income year. Items 5 to 9 of Schedule 15 to this bill, as described in paragraphs 9.9 to 9.23, enable the current section 160AFE to apply to a period that is less than an income year as though the period were an income year.

9.8 Item 2 in Schedule 10 to the June Consolidation Bill provides that the repeal and replacement of section 160AFE will apply to income years and non-membership periods commencing after 30 June 2003. However, item 2 will not apply if the taxpayer has a SAP, instead item 5 or 7 of Schedule 15 to this bill applies depending on whether or not a consolidated or MEC group has formed [Schedule 15, item 2] . Item 2 would also not apply where a taxpayer that has a SAP forms a consolidated or MEC group from the first day of the income year starting after 1 July 2003 and before 1 July 2004. In this case item 3 of Schedule 10 of the June Consolidation Bill or item 6 of Schedule 15 to this bill would apply. As item 2 of Schedule 10 could not have applied then neither could item 5 or 7 of Schedule 15 to this bill.

Taxpayers with SAPs that dont form a consolidated or MEC group

9.9 Item 5 applies to a taxpayer with a SAP, provided item 3 of the June Consolidation Bill does not apply, where the taxpayer has not become a member of a consolidated or MEC group at 1 July 2003. The current section 160AFE applies until and including 30 June 2003 and not at any later date. The new section 160AFE applies to the taxpayer from 1 July 2003. [Schedule 15, subitem 5(2)]

9.10 The period from the beginning of the SAP income year until 30 June 2003 is treated as though it were an income year (the short period income year) to allow the current section 160AFE to operate [Schedule 15, subitem 5(3)] . In particular, the current section 160AFE allows a credit company to transfer excess credits to an income company if both companies are group companies. This means that group companies may (if they meet the condition contained in item 8) transfer excess credits (as determined under the current section 160AFE) for the period ending 30 June 2003. The excess credits that are transferred have to be used for the income year in which that short period income year occurs. That is, the transferred credits cant be carried forward for 5 years. The condition in item 8 is explained in paragraphs 9.14 to 9.16.

The head company of a consolidated or MEC group with a SAP

9.11 Item 7 applies to a taxpayer with a SAP that becomes the head company of a consolidated group on the day the group comes into existence and that consolidation day is on or after 1 July 2003. However, the consolidation day is not the beginning of the first income year starting after 1 July 2003 (those cases are dealt with by item 3 of the June Consolidation Bill). The taxpayer can choose to apply the current section 160AFE for the period ending 30 June 2003, but not any later, to determine whether it has excess foreign tax credits to transfer to other group members. The new section 160AFE applies to the taxpayer from 1 July 2003 whether it chooses to do this or not. [Schedule 15, item 7]

9.12 If the taxpayer chooses to apply the current section 160AFE, the period from the beginning of the SAP income year until 30 June 2003 is treated as though the period were an income year [Schedule 15, subitem 7(3)] . Applying the current section 160AFE allows a credit company to transfer excess credits to an income company if both companies are group companies. This means that group companies may (if they meet the condition contained in item 8) transfer excess credits at the end of 30 June 2003 to reduce the Australian tax liability of other members of the group. The excess credits that are transferred (and we are not talking about a consolidated group) have to be used for the income year in which that short period income year occurs. That is they cant carry them forward for five years.

9.13 If the head company chooses to apply the current section 160AFE it will mean the head company will have to make a notional calculation of its Australian income tax liability at 30 June 2003 to determine whether it has excess foreign tax credits at that time. The head company is not required to actually end an income year and pay any income tax liability for itself for the period treated like an income year. It is considered unlikely that a head company would choose to treat a period like an income year unless it wanted to transfer excess credits to other members of the wholly-owned group because it will receive any excess credits from other group members upon formation of the consolidated group.

The 12 month rule

9.14 To maintain the integrity of the current section 160AFE that only allows transfers between group companies that have been group companies for the whole of the income year (which is usually 12 months) a 12 month rule applies.

9.15 Where a period is treated as though it were an income year, the requirement in paragraph 160AFE(1D)(b) is changed from an income year test to a 12 month test. A credit company can transfer excess credits to an income company only if they are group companies continuously for 12 months. For the purposes of items 5 and 7 the continuous 12 month period will be the 12 months ending at 30 June 2003. For item 6 cases the continuous 12 month period will be the 12 months ending on the day before the consolidation day. [Schedule 15, items 8 and 9]

9.16 The 12 month rule may be reduced where either the credit company or income company are not in existence for the whole period. In this situation the credit company and income company must be group companies for a continuous period from the time they are both in existence until 30 June 2003 for items 5 and 7 cases. For item 6 cases it will be the continuous period from the time they are both in existence until the consolidation day. [Schedule 15, subitem 8(2), paragraph(b) and subitem 9(2), paragraph (b)]

Applying the new section 160AFE to a head company that consolidates partway through an income year

9.17 Item 3 of the June Consolidation Bill is an exception to the application of the new section 160AFE provided for in item 2 of that bill. Item 3 of that bill ensures that the new section 160AFE applies to a consolidated group or MEC group that came into existence prior to 1 July 2003. Item 6 of Schedule 15 to this bill applies instead of item 3 where consolidation occurs before 1 July 2003 and partway through an income year. [Schedule 15, item 3]

9.18 Item 6 applies to a taxpayer that becomes the head company of a consolidated or MEC group that came into existence on a day that is not the beginning of an income year. The day the group came into existence must be on or after 1 July 2002 and before 1 July 2003. This provision applies to taxpayers that have a normal income year and to those that have a SAP. [Schedule 15, item 6]

9.19 If the taxpayer does not have a SAP the taxpayer can choose that the period from 1 July 2002 until the consolidation day is treated as though the period were an income year for the purpose of applying the current section 160AFE [Schedule 15, subitem 6(3)] . Similarly, if the taxpayer has a SAP the taxpayer can choose to treat the period from the beginning of the income year in which the consolidation day occurs until just before the consolidation day as though the period were an income year [Schedule 15, subitem 6(4)] .

9.20 If the taxpayer makes the choice to treat the particular period as though it were an income year, the current section 160AFE will apply for that period. This will allow the prospective head company to transfer excess credits to an income company if both companies are group companies and the condition in item 8 is met (see paragraphs 9.14 to 9.16). As there would be compliance costs involved for a head company making a choice to treat a period like an income year it is expected that the head company would only make a choice if it had excess credits to transfer to other group companies.

9.21 The rule in item 6 is not necessary for entities that become subsidiary members of a consolidated group as section 701-30 of the May Consolidation Act treats a non-membership period as though it were an income year. This would mean the current section 160AFE would apply to non-membership periods that occur before a consolidation day that is before 1 July 2003 to allow subsidiary members to transfer excess credits to other group members. Of course, entities that become subsidiary members of a consolidated group no longer need to apply either the old or new section 160AFE unless they once again are not members of any consolidated group. In that case, items 2 and 3 of the June Consolidation Bill have the result that the new section 160AFE applies.

9.22 Entities that become subsidiary members of a consolidated group can transfer excess credits to the head company under section 717-15 or 717-20 of Schedule 6 to the June Consolidation Bill. If entities become subsidiary members of a consolidated group in the transitional period, the time of use of the transferred excess credits by the head company would be governed by section 717-15 or 717-20 of Schedule 9 to the June Consolidation Bill.

9.23 The rules for the transitional period for the phasing out of foreign tax credit grouping provisions are different to rules for phasing out the loss grouping provisions. The difference reflects the view that foreign tax is generally paid at specific points in time and is not necessarily evenly spread across a period.

Periods are not earlier income years

9.24 Item 10 ensures that the period that is treated like an income year in item 5, 6 or 7 is not treated as an earlier year of income when determining excess foreign tax credits under the new section 160AFE at the end of the real income year that includes that period.

9.25 Where a head company has chosen to treat a period like an income year and has applied the current section 160AFE to transfer excess credits to other group members, the head company cannot double count the foreign tax paid in that part-year period to determine its own foreign tax credits at the end of the income year in which the consolidation day occurred.

Example 9.1

Assume:

A wholly-owned group of A Co, B Co and C Co has been a group with the same members continuously from 1 January 1999. The three companies use a SAP from 1 January to 31 December.

The group becomes a consolidated group on 1 July 2003 and A Co is the head company.

All foreign income is of the same class.

All domestic income and income tax in relation to that income is ignored for this example.

A Co

For the income year 1 January 2003 to 31 December 2003 A Co pays foreign tax of $1,750 on foreign income that will be included in its assessable income for the year.

A Co determines that $1,000 of foreign tax relates to the period from 1 January 2003 until 30 June 2003 and that the remainder relates to the period 1 July 2003 to 31 December 2003.

The Australian tax payable on the same foreign income for the period 1 January 2003 to 30 December 2003 is $800. The Australian tax on the remainder of the foreign income for the period 1 July 2003 to 31 December 2003 is also $800.

As B Co and C Co are members of the consolidated group from 1 July 2003, A Co will be assessed on any foreign income derived by B Co and C Co from 1 July 2003.

B Co and C Co

B Co and C Co each have a non-membership period from 1 January 2003 to 30 June 2003. As they are members of a consolidated group at the end of their year of income they will only calculate their Australian tax liability for the non-membership period (i.e. from 1 January 2003 to 30 June 2003 (section 701-30 of the May Consolidation Act)).

C Co doesnt receive any foreign income. B Co receives foreign income that it includes in its assessable income for the non-membership period. B Co pays $150 foreign tax on the foreign income. The Australian tax payable on that foreign income is $300.

B Co derives further foreign income (and pays foreign tax of $50) after 30 June 2003 but A Co will be assessed on that foreign income and A Co will be deemed to have paid and been personally liable for the foreign tax (section 717-10 of the June Consolidation Bill).

Applying item 6

A Co chooses to treat the period from 1 January 2003 to 30 June 2003 like an income year and applies the current section 160AFE. A Co has excess credits it can transfer to B Co (as the condition in item 8 is satisfied) of $200. However, B Co can only use $150 so A Co and B Co enter into an agreement that A Co transfer $150 of its excess credits to B Co.

At 31 December 2003 A Co calculates its income tax liability. A Co includes in its assessable income the foreign income it has derived from 1 January 2003 to 31 December 2003 and foreign income B Co has derived from 1 July 2003 to 31 December 2003. The total foreign tax paid on that foreign income is $1,800 ($1,750 by A Co and $50 by B Co). The equivalent Australian tax payable on the foreign income is $1,750.

However, A Co cannot use all the $1,750 foreign tax it has paid as it has transferred $150 of the amount to B Co. A Co can only claim a foreign tax credit under section 160AF of the ITAA 1936 of $1,650 (i.e. $1,750 - $150 + $50). Therefore, A Co will be required to pay a further $100 ($1,750 - $1,650) Australian income tax.

Accelerated access to foreign tax credits in the transitional period

9.26 The rule contained in this bill ensures that sections 717-15 and 717-20 of the IT(TP) Act 1997contained in Schedule 9 to the June Consolidation Bill apply in the situation where the head company of a wholly-owned group consolidates before 1 July 2004 but has a SAP [Schedule 15, item 1, section 717-30 of the IT(TP) Act 1997] . The rule will substitute this condition for the condition in paragraph 717-15(1)(b) and paragraph 717-20(1)(b). The condition being replaced by the rule in this bill applies to the head company of a wholly-owned group that consolidates before 1 July 2004 where the head company has a year of income ending on 30 June.

9.27 Provided the other conditions in these sections are also satisfied, the head company of a consolidated group will be able to utilise excess foreign tax credits of an earlier year or non-membership period transferred to the head company in the income year in which the group is formed rather than have to wait until the next income year.

Excess foreign tax credits do not leave a group

9.28 An entity does not have excess foreign tax credits from earlier years that belong to a head company of a consolidated group when the entity ceases to be a subsidiary member of the group. The exit history rule contained in section 701-40 of the May Consolidation Act will not operate to allow excess foreign tax credits to leave a consolidated group. [Schedule 7, item 2, section 717-30]