Senate

Revised Explanatory Memorandum

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

Chapter 3 - Foreign tax credits

Outline of chapter

3.1 This chapter explains the rules that provide for the transfer of excess foreign tax credits from an entity that becomes a subsidiary member of a consolidated group to the head company of the group to enable the head company to use those excess credits. An entity that leaves the group will not have access to any excess foreign tax credits, including those it may have brought into the group at an earlier time.

3.2 This chapter also explains the rules that ensure a head company will be taken to have paid and been personally liable for the foreign tax paid by a subsidiary member of the group where the foreign income on which the foreign tax was paid is included in the head company's assessable income. The amendments explained in this chapter are contained in Schedules 6, 9 and 10 to this bill.

3.3 All references to sections and divisions are references to sections and Divisions of the ITAA 1936 unless otherwise stated.

Context of reform

3.4 Under the current law, Australian resident taxpayers can claim credits against the Australian tax payable for foreign taxes paid on foreign income included in their assessable income. Where a taxpayer is a company in a wholly-owned group the excess foreign tax credits of that company can be transferred to another company with insufficient foreign tax credits, provided both companies are members of the same group for the whole of the income year in which the credits are transferred.

3.5 The new consolidation regime will ensure the current foreign tax credit provisions operate appropriately for the head company of a consolidated group and that the consolidated group is not subject to international double taxation.

Summary of new law

3.6 Only the head company of a consolidated group will include foreign income in its assessable income under consolidation. Therefore, only the head company will need to use foreign tax credits to reduce its Australian tax liabilities.

3.7 Subsidiary members will transfer their excess credits to the head company when they become members of the group to enable the head company to use the excess credits. Special rules will ensure the head company can only use those excess credits at the end of the income year after the year the entity joined the group unless the transitional rule applies.

3.8 During the period that an entity is a member of the consolidated group, where it pays foreign tax on foreign income, the head company will be assessed on the foreign income and will be taken to have paid and been personally liable for the foreign tax paid by the subsidiary member.

3.9 When an entity leaves a consolidated group it will not take with it any excess foreign tax credits and it will only include foreign income in its assessable income for the period it is not a member of any consolidated group.

Detailed explanation of new law

3.10 In order to prevent international double taxation, the foreign tax credit provisions (Divisions 18, 18A and 18B of Part III) provide for the calculation of credits for foreign tax that can be used to reduce the Australian tax liability on foreign income included in the assessable income of an Australian taxpayer. To ensure the policy behind these provisions is maintained under the consolidation regime, additional rules have been inserted to:

•

ensure Divisions 18, 18A and 18B continue to operate for the head company of a consolidated group; and

•

allow the excess foreign tax credits (calculated under Division 18) of entities that become subsidiary members to be used by the head company.

3.11 Section 160AFE is amended to prevent members of wholly-owned groups from transferring excess foreign tax credits. The new section 160AFE will apply according to special rules explained in paragraphs 3.49 to 3.55.

Application of foreign tax credit provisions

3.12 The head company will be assessed on the foreign income derived by the consolidated group under the single entity principle (section 701-1 of the Consolidation Bill introduced on 16 May 2002). The head company will be deemed to have paid and been personally liable for the foreign tax paid by a subsidiary member on foreign income that is included in the head company's assessable income. [Schedule 6, item 2, section 717-10]

3.13 Section 717-10 of this bill ensures the head company will be held to have paid and been personally liable for the foreign tax paid by subsidiary members on foreign income that is included in the head company's assessable income. All the conditions contained in section 160AF will have been satisfied. Therefore the ordinary operation of section 160AF will allow a credit to the head company for the foreign tax that was paid.

3.14 The operation of section 717-10 will also ensure the head company of a consolidated group will be able to claim credits for foreign tax in respect of certain overseas film income under Division 18A and certain shipping income under Division 18B that is included in its assessable income.

3.15 Under the new provisions there is no requirement that companies that effectively transfer foreign tax credits must be members of a wholly-owned group for the whole of an income year. The head company is entitled to a credit for any foreign tax paid in relation to the foreign income included in its assessable income, even if the entity that paid the foreign tax is not a member of the group at the end of the head company's income year. This enables the head company to claim the credit without having to determine whether the subsidiary member that paid the foreign tax remains in the group at the end of the income year.

3.16 The head company is also entitled to a credit for any foreign tax that was paid in relation to the foreign income included in its assessable income where an entity that left the group paid the foreign tax in relation to the foreign income after it left the group. However, the head company would be required to keep sufficient records to show how much foreign tax was paid on the foreign income included in the head company's assessable income.

3.17 Similarly, where an entity includes foreign income in its assessable income for a period before it becomes a subsidiary member of a consolidated group but where it pays foreign tax on that foreign income after it joins the group, the entity and not the head company will be entitled to the credit in relation to the foreign tax.

Example 3.1

Assume:

•

A Co, B Co, C Co and D Co formed a consolidated group on 1 July 2002. A Co is the head company with an income year from 1 July to 30 June;

•

in the current year of income year which is the 2004-2005 income year:

-

A Co received passive foreign income of $1,000 and pays foreign tax of $100;

-

B Co and C Co also receive passive foreign income of $600 and $300 respectively. B Co pays $90 foreign tax and C Co doesn't pay any foreign tax; and

-

D Co leaves the consolidated group on 31 March 2005 but receives foreign, other income of $500 before it leaves. D Co pays $200 foreign tax in relation to the foreign income of $500 on 14 April 2005; and

•

the group receives no other income and the group does not have excess foreign tax credits for earlier years.

Under the consolidation single entity rule, A Co will include all the foreign income it actually received as well as the foreign income from B Co, C Co and D Co in its assessable income ($2,400).

Section 717-10 will deem A Co to have paid and been personally liable for the foreign tax paid by B Co and D Co ($290). The total foreign tax paid by A Co is $390.

Under the ordinary operation of section 160AF, A Co will be entitled to a credit of $190 for foreign tax in relation to the passive income. The Australian tax payable on the passive foreign income is $570. A Co will also be entitled to a credit for foreign tax in relation to other income of $150 (some of the foreign tax paid by D Co) as A Co has the necessary records to show that the $200 foreign tax relates only to the $500 of foreign income included in its assessable income. A Co can carry-forward the other $50 of foreign tax to offset against Australian tax payable on future foreign income of that class.

No transfers to an entity leaving a group

3.18 Where a subsidiary member leaves a consolidated group, excess foreign tax credits from earlier years that have not been used by the head company during the leaving entity's membership of the group will not be available to the leaving entity. This is in accordance with the general treatment of a consolidated group. That is, where a subsidiary member of the group derives foreign income and pays foreign tax in respect of that income, the head company will be considered to have the foreign income and to have made the payment of tax.

New section 160AFE

3.19 The current section 160AFE provides the rules for carry-forward and transfer of excess credits for particular classes of foreign income. This section is repealed from 1 July 2003 except in special circumstances that are discussed in paragraphs 3.48 to 3.55. Section 160AFE has been repealed to prevent groups that do not form a consolidated group from transferring excess credits between credit and income companies within the group. However, a new section 160AFE will operate from 1 July 2003 that ensures excess foreign tax credits can continue to be carried forward for 5 years for all taxpayers.

3.20 Where an amount of foreign tax paid on foreign income included in assessable income of a taxpayer is less than the amount of Australian tax payable in respect of that foreign income (i.e. there is a shortfall), the taxpayer may increase the foreign tax amount under section 160AFE [Schedule 10, item 1, subsection 160AFE(1)]. Section 160AFE provides the rules to determine whether a taxpayer can access excess foreign tax credits from earlier years when they have a foreign tax shortfall for a particular class of foreign income in the current year. The excess foreign tax credits must relate to that same class of foreign income for which there is a foreign tax shortfall [Schedule 10, item 1, subsection 160AFE(5)] .

3.21 A taxpayer has excess foreign tax credits from an earlier year if the amount of foreign tax paid on foreign income of a particular class that is included in assessable income in that year exceeds the Australian tax payable on that foreign income. The excess foreign tax credit amount is the difference between the foreign tax paid and the Australian tax payable. [Schedule 10, item 1, subsection 160AFE(4)]

3.22 A taxpayer can only use excess foreign tax credits up to the amount of the foreign tax shortfall in the current year for the particular class of foreign income. The excess foreign tax credits from the previous 5 years ending before the current year in which the shortfall occurred may be used. However, the excess foreign tax credits that occurred in the earliest years of the 5 year period and that relate to the particular class of foreign income must be used first (i.e. on a first-in, first-out basis). [Schedule 10, item 1, subsection 160AFE(3)]

Use of excess foreign tax credits by a head company

3.23 Where a head company of a consolidated group has a foreign tax shortfall for a particular class of foreign income in an income year, the head company can use excess foreign tax credits from earlier years of subsidiary members of the group [Schedule 6, item 2, section 717-15] ,as well as its own excess foreign tax credits. Any excess foreign tax credits used must relate to the particular class of foreign income.

3.24 A head company can only use excess foreign tax credits from earlier years of a subsidiary member if the current year of income is not the year in which the entity became a subsidiary member (i.e. it is not the joining year of the subsidiary member). Rules for joining years are discussed in paragraphs 3.28 to 3.40. The excess foreign tax credits of a subsidiary member are calculated under the rules contained in the new section 160AFE and become transfer credits for the head company in the income year after the joining year. [Schedule 6, item 2, subsection 717-15(2)]

3.25 Section 717-15 of this bill operates to transfer excess foreign tax credits of subsidiary members to the head company whether or not the head company ever has a foreign tax shortfall. Section 717-15 also ensures that subsidiary members no longer have their excess foreign tax credits from earlier years should they leave the consolidated group [Schedule 6, item 2, paragraph 717-15(2)(b)] . A subsidiary member will also not be able to access its own excess foreign tax credits from earlier years where it leaves the consolidated group in the year it joined the group. This is discussed in detail in paragraphs 3.32 to 3.35.

3.26 The transfer credits of earlier years from all the subsidiary members will be pooled with the head company's own excess foreign tax credits from earlier years [Schedule 6, item 2, paragraph 717-15(2)(c)] . The transfer credits will increase the amount of the excess foreign tax credits for a particular earlier year and will be subject to the same 5 year restriction as contained in the rules in section 160AFE. The pooled excess foreign tax credits will also only be available to reduce a foreign tax shortfall for a particular class of foreign income [Schedule 6, item 2, subsection 717-15(4)] .

Example 3.2

Assume:

•

A Co, B Co, C Co and D Co formed a consolidated group on 1 July 2002. A Co is the head company with an income year from 1 July to 30 June;

•

E Co joined the consolidated group on 1 April 2005;

•

C Co left the consolidated group on 31 December 2004;

•

in the current year of income year which is the 2004-2005 income year:

-

A Co receives passive foreign income of $1,000 and pays foreign tax of $150. A Co has excess foreign tax credits in relation to passive income for 2003 and 2004 of $20 and $25 respectively;

-

B Co also receives passive foreign income of $600 and pays $90 foreign tax. B Co has excess foreign tax credits for the 2001 and 2002 income years of $50 and $15 respectively, for that class of income;

-

before C Co left the group it received passive foreign income of $400 but didn't pay any foreign tax;

-

D Co received foreign, other income of $500 on which it pays $200 foreign tax. D Co has an excess foreign tax credit for this class of income for the 2002 income year of $30; and

-

from 1 April 2005 to 30 June 2005 E Co receives $200 of passive foreign income on which it pays $20 foreign tax and $300 of foreign, other income on which it pays $24 foreign tax. E Co has an excess foreign tax credit for the 2004 income year in relation to passive income of $10; and

•

the group derives no other income.

Under the consolidation single entity rule A Co will include all the foreign income it actually derived as well as the foreign income from B Co, C Co, D Co and E Co in its assessable income ($3,000).

Section 717-10 will deem A Co to have paid and been personally liable for the foreign tax paid by B Co, D Co and E Co ($334). The total foreign tax A Co has paid is $484.

Under the ordinary operation of section 160AF, A Co will be entitled to a credit for foreign tax in relation to the passive income of $260. The Australian tax payable on the passive foreign income is $660. A Co will also be entitled to a credit for foreign tax in relation to other income of $224. The Australian tax payable on the foreign other income is $240.

A Co has a foreign tax shortfall in relation to passive income of $400 and $16 in relation to other income. Under the combined operation of section 160AFE and section 717-15, A Co can access the excess foreign tax credits of B Co and D Co but not the excess foreign tax credits of E Co.

A Co uses all of B Co's earlier year excess foreign tax credits to reduce the Australian tax payable starting with the credits that relate to the 2001 income year. A Co then uses its own excess foreign tax credits that relate to the 2003 and 2004 income year. A Co must still pay Australian tax of $290 on the passive income. A Co will use $16 of D Co's excess foreign tax credits that relate to the 2002 income year to reduce the Australian tax payable to nil on the other income. The remaining excess foreign tax credits will become A Co's excess foreign tax credits in relation to the 2002 income year.

At the end of the 2005-2006 income year, A Co will be able to access the excess foreign tax credits that E Co brought into the group if A Co has a foreign tax shortfall in relation to passive income.

3.27 Unlike the credits for foreign tax arising under Division 18, any credits for foreign tax held by an entity under Division 18A or Division 18B (before it becomes a subsidiary member of a consolidated group) will not be utilised by the head company. The new provisions preserve the policy that these credits cannot be transferred within a group. Further, Division 18A and Division 18B credits cannot be carried forward to a future year. Therefore, rules that have been developed for Division 18 to allow for the transfer of any excess credits held by a subsidiary member to a head company are not required for Divisions 18A and 18B.

Where an entity joins a consolidated group during an income year

Rules for the joining entity

3.28 Special rules are required where an entity (a joining entity) joins a consolidated group during the income year to ensure sections 160AF and 160AFE apply appropriately to the joining entity.

3.29 Section 717-20 operates where an entity joins a consolidated group in an income year and there is a period in that year in which the entity is not a member of any consolidated group. [Schedule 6, item 2, subsection 717-20(1)]

3.30 Where an entity joins a consolidated group for the first time and the time it joins is not at the beginning of an income year, the period from the beginning of the income year until the time it joins a group is a non-membership period. The start and end of a non-membership period are treated as though they were the start and end of an income year. [Schedule 1, item 2, subsection 701-30(3) of the Consolidation Bill introduced on 16 May 2002]

3.31 The joining entity will calculate its assessable income at the joining time as though it was the end of an income year. If foreign income is included in the assessable income for the non-membership period and foreign tax was paid on that income, section 160AF applies to determine the amount of any credit for the foreign tax for that period.

3.32 Where the joining entity has a foreign tax shortfall for the non-membership period that starts at the beginning of the income year, the joining entity can use excess foreign tax credits from earlier years as calculated under the new section 160AFE [Schedule 6, item 2, subparagraph 717-20(3)(a)(i)] . The entity will not be able to use those excess foreign tax credits for earlier years if it has another, later non-membership period in the joining year [Schedule 6, item 2, subparagraph 717-20(3)(a)(ii)]. The head company of the consolidated group which it joined and left will be treated as having the excess foreign tax credits for earlier years [Schedule 6, item 2, paragraph 717-15(2)(a)] .

3.33 An entity will also not be able to use excess credits from a non-membership period that occurs at an earlier time than the current non-membership period by applying the new section 160AFE [Schedule 6, item 2, subparagraph 717-20(3)(a)(ii)]. The head company of the consolidated group that it joined and left will be treated as having the excess credits for the earlier non-membership period under section 717-15 [Schedule 6, item 2, paragraph 717-15(2)(a)] . For the head company these credits for a non-membership period will be treated as excess foreign tax credits for earlier years.

3.34 A joining entity will have an excess foreign tax credit for a non-membership period according to the new subsection 160AFE(4). That will be the case where the joining entity has paid foreign tax on foreign income in a non-membership period that exceeds the Australian tax payable in respect of the foreign income. The excess foreign tax credit amount will be the difference between the foreign tax paid and the Australian tax payable.

3.35 Where an entity is a subsidiary member of a consolidated group at the start of an income year and then leaves the group before the end of the income year, the entity will not have access to any excess foreign tax credits from earlier years, that it may have had before joining the consolidated group. [Schedule 6, item 2, subparagraph 717-20(3)(b)]

Rules for the head company

3.36 Generally, the head company of a consolidated group will not be able to use excess credits for a non-membership period of a joining entity at the end of the head company's income year in which the non-membership period occurs [Schedule 6, item 2, section 717-15] . However, in the year after a joining year the head company can use the excess credits for the non-membership period that accrued to the entity that joined the group the previous year [Schedule 6, item 2, section 717-15] .

3.37 Transfer credits under section 717-20 will include the joining entity's excess foreign tax credits for a non-membership period that occurs in the joining year provided the non-membership period did not end at the end of the income year that was the year the entity joined the group [Schedule 6, item 2, subsection 717-20(5)]. For the purpose of section 717-15, credits for a non-membership period in the joining year will be transfer credits for the head company in the following year of income [Schedule 6, item 2, subsection 717-20(4)] .

3.38 If an entity has been a subsidiary member of 2 or more consolidated groups in an income year, the head company of the first consolidated group will access all the excess foreign tax credits for earlier years and any credits for non-membership periods before the entity joined the first group.

3.39 The head companies of subsequently joined groups will only have access to excess credits for a non-membership period that occurs immediately before the entity joined the relevant consolidated group. The subsequent head companies will not have access to any excess foreign tax credits for earlier years in relation to the joining entity. [Schedule 6, item 2, paragraph 717-15(2)(b)]

3.40 If a non-membership period for a joining entity ended at the end of an income year that was a joining year for the entity, the head company of the last consolidated group the entity left will not be able to access excess credits for that non-membership period. [Schedule 6, item 2, subsection 717-20(5)]

Where a wholly-owned group consolidates in the transitional period

3.41 Generally, the head company of a consolidated group cannot access the excess foreign tax credits of subsidiary members until the income year after the year in which the subsidiary member joined the group. This would mean that wholly-owned groups that formed a consolidated group before the end of the transitional period (i.e. before 1 July 2004) would be denied use of the excess foreign tax credits of the subsidiary members for more than 12 months.

3.42 Under the current rules in section 160AFE for transferring excess foreign tax credits, group members have to be part of a wholly-owned group for the whole of an income year. However, special rules have been developed for the transitional period to ensure that wholly-owned groups can continue to use excess foreign tax credits of group members at the end of the income year in which the consolidated group is formed. These rules will be contained in the IT(TP) Act 1997.

3.43 Where a wholly-owned group forms a consolidated group in the transitional period, for example, between 1 July 2003 and 30 June 2004, the head company will be able to use excess foreign tax credits of subsidiary members at the end of the 2004 income year. [Schedule 9, item 2, section 717-15]

3.44 The subsidiary members and the head company of the consolidated group must be part of the same wholly-owned group from the start of the head company's income year until the time the consolidated group is formed . Where a subsidiary member comes into existence after the start of the income year, the entity must be a member of the wholly-owned group for the whole period from the time it comes into existence until the time the consolidated group is formed. [Schedule 9, item 2, subsection 717-15(2)]

3.45 Section 717-20 also operates where the consolidated group comes into existence during an income year that is in the transitional period. The head company has access to excess credits for the non-membership period that occurs from the start of the income year until the time the consolidated group forms. The head company will be able to use those excess credits of subsidiary members at the end of the income year in which the group came into existence. [Schedule 9, item 2, section 717-20]

3.46 The head company of a consolidated group must use the excess credits that relate to that non-membership period prior to using the excess credits from earlier years. [Schedule 9, item 2, paragraph 717-20(3)(b)]

3.47 These transitional period rules will also apply appropriately to head companies with SAPs. However, the application of these rules to SAPs is still being developed.

Application and transitional provisions

3.48 The rules dealing with foreign tax credits for consolidated groups apply from 1 July 2002.

3.49 Item 2 in Schedule 10 provides that the repeal and replacement of section 160AFE by the Schedule will apply to income years commencing after 30 June 2003 and non-membership periods commencing after that date. References to non-membership periods is necessary because section 701-30 of the Consolidation Bill introduced on 16 May 2002 treats the beginning and end of such periods as the beginning and end of an income year but the periods are not actually an income year of the subsidiary member.

3.50 A new section 160AFE was required to remove the provisions relating to the transfer of excess credits between companies in a wholly-owned group. The new section 160AFE will maintain the policy of the current section 160AFE that allows taxpayers to carry forward excess credits for 5 years. [Schedule 10, item 1, section 160AFE of the ITAA 1936]

3.51 Item 3 is an exception to the application of section 160AFE provided for in item 2. It ensures that the redrafted section 160AFE applies to a consolidated group or MEC group that comes into existence prior to 1 July 2003 or on the first day of the head company's first income year that starts after 1 July 2003 (provided that day is before 1 July 2004). The new section 160AFE will apply for income years, or non-membership periods, starting on or after that first day of the consolidated or MEC group.

3.52 By exception, the new section 160AFE will apply for income years, or non-membership periods, starting after 30 June 2003 where the taxpayer does not become a member of a consolidated group or MEC group. It has the same application where a group with a head company that has a SAP does not consolidate from the first day of an income year which is after 1 July 2003 but before 1 July 2004.

3.53 Additionally, item 3 ensures that the current section 160AFE (which includes the grouping provisions) continues to apply prior to consolidation. This will mean that up until the time of consolidation, companies in a wholly-owned group (including the company that becomes the head company of the group) can transfer excess credits from one to another when determining their pre-consolidation tax liabilities. Any excess credits remaining on the consolidation day can be used by the head company in accordance with the rules set out in sections 717-15 and 717-20.

3.54 Special rules are being developed to deal with the situation where a consolidated group comes into existence during the 2002-2003 income year to ensure the application of the new section 160AFE will apply for the period from the date of consolidation until the end of the income year. These rules will also ensure that the current section 160AFE will operate until the date of consolidation (or 1 July 2003 if that is earlier for those with SAPs to allow excess foreign tax credits to be transferred between all members of a wholly-owned group in that period.

3.55 Additionally for SAPs, further measures will be added to terminate the operation of the existing section 160AFE and to apply the new section 160AFE from 1 July 2003 (or the consolidation day if that is earlier) where the:

•

head company with the SAP consolidates during the 2003-2004 income year (other than on the first day of its income year);

•

head company with the SAP consolidates after the 2003-2004 income year; or

•

group doesn't consolidate at all.

3.56 Item 4 ensures that where credits have been allowed in an earlier income year under section 160AFE prior to its amendment such use of the credits will satisfy the rule in the new paragraph 160AFE(3)(d).

Consequential amendments

3.57 Consequential amendments have been made to subsection 995-1(1) of the ITAA 1997 to include a new dictionary term, 'excess foreign tax credits'. [Schedule 12, item 1]

3.58 Other amendments consequential to the measures in this chapter will be included in subsequent legislation.