House of Representatives

New International Tax Arrangements Bill 2003

Explanatory Memorandum

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

Chapter 1 - Foreign investment funds

Outline of chapter

1.1 Schedule 1 to this bill includes three amendments to the FIF rules in Part XI of the ITAA 1936. The amendments remove complying superannuation entities (and other eligible entities) from the FIF rules, increase the balanced portfolio exemption threshold from 5% to 10% and remove 'management of funds' from the FIF 'blacklist' of non-eligible business activities.

Context of amendments

1.2 The FIF rules attribute income to Australian residents from their offshore portfolio investments and investments that fall outside the CFC rules. The offshore investments targeted by the FIF rules are those that earn passive income (such as dividends and interest) which is not distributed and may be subject to zero or low tax rates in the offshore jurisdiction. There is a tax benefit from investing in such entities from deferring the derivation of income and converting income into capital gains. The FIF rules seek to remove these benefits.

1.3 The measures in this bill are designed to better target the FIF rules and reduce compliance costs associated with these rules. This will improve the competitiveness of the Australian managed funds and superannuation industries.

Summary of new law

1.4 The amendments remove complying superannuation entities, virtual PST assets and segregated exempt assets of life insurance companies from the FIF rules, increase the balanced portfolio exemption threshold from 5% to 10% and remove 'management of funds' from the FIF 'blacklist' of non-eligible business activities. These amendments are consistent with recommendations made by the Board of Taxation.

Comparison of key features of new law and current law
New law Current law
Complying superannuation entities, virtual PST assets and segregated exempt assets of life insurance companies will be exempt from the FIF rules. Fixed trusts where all the beneficiaries are complying superannuation entities (including some non-complying superannuation entities), virtual PST assets and segregated exempt assets of life insurance companies will be exempt from the FIF rules. Complying superannuation entities, virtual PST assets and segregated exempt assets of life insurance companies are potentially subject to the FIF rules.
The 'balanced portfolio exemption' threshold will be increased so that the exemption applies where not more than 10% of the value of the taxpayer's interests in FIFs are held in non-exempt FIFs. A 'balanced portfolio exemption' exists for interests in non-exempt FIFs the value of which is not more than 5% of the value of all the taxpayer's interests in FIFs.
'Management of funds' will no longer be included in the 'blacklist' of non-eligible business activities in the FIF rules. 'Management of funds' is included in the 'blacklist' of non-eligible business activities in the FIF rules.

Detailed explanation of new law

Exemption from the FIF rules for complying superannuation entities, certain assets of life insurance companies and certain fixed trusts

1.5 The tax benefits of investing in FIFs (i.e. deferring the derivation of income and converting income into capital gains) are greatest for taxpayers that have high marginal tax rates and can access the 50% CGT discount. The tax benefits of investing in FIFs are much lower for complying superannuation entities that are generally taxed at a flat rate of 15% and can only access a one-third discount on eligible capital gains.

1.6 Currently, complying superannuation entities are potentially subject to the FIF rules in Part XI of the ITAA 1936. Part XI will be amended to exempt complying superannuation entities from the FIF rules. Complying superannuation entities include complying superannuation funds, complying ADFs and PSTs. These entities take their meaning from the Superannuation Industry (Supervision) Act 1993. [Schedule 1, item 2, section 470; item 8, paragraph 519A(b) and subsection 519B(2)]

1.7 Where a complying superannuation entity becomes non-complying, the FIF exemption will not be available to the entity in relation to each year the entity is non-complying. Whether a superannuation entity is non-complying is determined in accordance with the Superannuation Industry (Supervision) Act 1993.

1.8 Part XI will be also be amended to exempt the 'virtual PST assets' and the 'segregated exempt assets' of life insurance companies from the FIF rules. Broadly, virtual PST assets are assets that support the complying superannuation business of life insurance companies. Income derived on virtual PST assets is concessionally taxed. Segregated exempt assets are assets that support the immediate annuity and current pension business of life insurance companies. Income derived on those assets is not taxed. [Schedule 1, item 5, section 470; item 7, section 470; item 7, section 470; item 8, paragraph 519A(a) and subsection 519B(1)]

Fixed trust

1.9 Fixed trusts where all beneficiaries are complying superannuation entities, virtual PSTs or segregated exempt assets of life insurance companies will also be exempted from the FIF rules. [Schedule 1, item 4, section 470; item 8, paragraph 519A(b) and subsection 519B(3)]

1.10 The purpose of this exemption is to ensure that where complying superannuation entities pool their investments through a fixed trust, the investments will not be subject to the FIF rules.

1.11 To qualify for the exemption all members of the trust must be complying superannuation entities (or certain assets of life insurance companies). Membership of the trust is tested at the end of each year. There is a limited concession that allows the FIF exemption to continue to apply where a complying superannuation entity becomes non-complying (explained below). [Schedule 1, item 4, section 470; item 8, paragraph 519B(3)(a)]

What if a member of a trust becomes non-complying?

1.12 Where a complying superannuation entity becomes non-complying, the FIF exemption may continue to be available to the trust provided:

·
the non-complying superannuation entity was a complying superannuation entity when it became a beneficiary of the trust; and
·
the entitlements of all non-complying superannuation entities are not more than 5% of the market value of the trust.

[Schedule 1, item 8, paragraphs 519B(4)(a) and (c)]

1.13 In relation to the first dot point, it does not matter if a complying superannuation entity is later notified that it was non-complying for the year in which it became a beneficiary of the trust. [Schedule 1, item 8, subsection 519B(5)]

1.14 Allowing the FIF exemption to continue to apply to the trust where the interests of non-complying superannuation entities in the trust are relatively small, will ensure that the majority of members who are complying superannuation entities are not penalised.

1.15 However, should the interests of beneficiaries that are non-complying superannuation entities exceed the 5% threshold, the exemption will not apply to the trust in each year that the threshold is exceeded. In these circumstances, all beneficiaries (including complying and non-complying superannuation entities) will effectively become liable to tax on any FIF income of the trust.

Example 1.1 A fixed trust with 100 units is established on 1 January 2010. In 2010 holders of all units in the trust are complying superannuation entities. The trust's income year is the calendar year. Consequently, the trust is exempt from the FIF rules in 2010.In 2011, there was a single non-complying superannuation entity that held four units (4%). The trust will be exempt from the FIF rules in 2011.In 2012, there were two non-complying super entities: one that held four units (4%) and one that held two units (2%). The fixed trust is not entitled to the FIF exemption for 2012 as the entitlements of non-complying superannuation funds exceed the 5% threshold (4% + 2% = 6%).In 2013, all unit holders are complying superannuation entities. The fixed trust is exempt from the FIF rules for 2013.

Will the FIF exemption apply to a chain of trusts?

1.16 The FIF exemption can apply to a chain of fixed trusts. A fixed trust whose only beneficiary is a fixed trust that qualifies for the FIF exemption will also qualify for the FIF exemption. [Schedule 1, item 8, subsections 519B(3) and (4)]

1.17 A fixed trust whose beneficiaries comprise fixed trusts that qualify for the FIF exemption, complying superannuation entities (and potentially non-complying superannuation entities entitled to not more than 5% of the assets of the fixed trust) virtual PST assets and segregated exempt assets will also qualify for the exemption. [Schedule 1, item 8, subsections 519B(3) and (4)]

Example 1.2 In the following example each of Trusts A, B and C are fixed trusts. Each beneficiary of Trust C is a complying superannuation fund (CSF). Trust B has only two beneficiaries: Trust C and a CSF. Trust B is the only beneficiary of Trust A. Trusts A, B and C qualify for the FIF exemption.

Diagram of example

If, for some reason Trust C did not qualify for the FIF exemption, neither Trust B nor Trust A would qualify for the exemption. If, for some reason Trust B did not qualify for the exemption, neither would Trust A.

Increase the balanced portfolio exemption threshold from 5% to 10%

1.18 The balanced portfolio exemption in Division 14 of Part XI provides an exemption from the FIF rules where the value of the FIF interests that otherwise would not be exempt is no more than 5% of all the taxpayer's interests in FIFs (other than interests that are exempted because of Division 2 or 11). This exemption is known as the 'balanced portfolio exemption' because it recognises that taxpayers with a balanced portfolio may hold some non-exempt FIF interests. Such taxpayers are not subject to the FIF rules.

1.19 The amendment in this bill will allow taxpayers to qualify for the exemption where the value of the non-exempt FIF interests represents no more than 10% of all the FIF interests. This increase in the threshold recognises that changing investment trends may mean that a 5% threshold is no longer sufficient to allow Australian investors to achieve appropriate offshore portfolio diversification. [Schedule 1, item 9, Division 14 of Part XI (appropriate heading); item 10, section 524; item 11, paragraph 525(1)(c)]

Removal of 'management of funds' from Schedule 4 to the ITAA 1936

1.20 Division 3 of Part XI provides an exemption from the FIF rules for interests in foreign companies that carry on an 'active' business. Broadly, a FIF interest in a foreign company will qualify for this exemption if the company is taken to be principally engaged in any activities other than the non-eligible business activities that are listed in Schedule 4 to the ITAA 1936. Currently, Schedule 4 lists seven non-eligible activities, including the activity of 'management of funds'. Schedule 4 will be amended to remove management of funds from the list. [Schedule 1, item 12, paragraph (f) of Schedule 4]

1.21 The list in Schedule 4 is known as a 'blacklist' because it seeks to identify those foreign companies that derive predominantly passive income (or hold passive assets) and therefore are companies that the FIF rules generally seek to target. Management of funds will be removed from the 'blacklist' because the activity of managing funds for others is not of itself an activity that involves deriving passive income or holding passive assets (other than on behalf of investors in the funds). Fund managers derive fees for services such as holding and managing assets for others. This should be considered an 'active', rather than 'passive' income-earning activity.

1.22 In the event that fund managers do hold passive investments (other than on behalf of investors in the funds), these holdings are likely to constitute the activity of 'investment in tainted assets, or tainted commodity investments, within the meaning of section 317'. This is a non-eligible business activity under item (c) of Schedule 4.

Application and transitional provisions

1.23 The exemption from the FIF rules for complying superannuation entities (and certain assets of life insurance companies) and the increase in the balanced portfolio exemption will apply to income years beginning on or after 1 July 2003. [Schedule 1, item 13]

1.24 The removal of 'management of funds' from Schedule 4 to the ITAA 1936 will apply in relation to notional accounting periods of FIFs beginning on or after 1 July 2003. [Schedule 1, item 13]

Consequential amendments

1.25 A consequential amendment is required to ensure that the deemed present entitlement rules do not apply where a complying superannuation entity (or certain assets of life insurance companies) qualifies for the exemption from the FIF rules. [Schedule 1, item 1, paragraph 96A(1)(c)]


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