House of Representatives

New International Tax Arrangements (Participation Exemption and Other Measures) Bill 2004

Explanatory Memorandum

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

Chapter 1 - Capital gains tax concession: active foreign companies

Outline of chapter

1.1 Schedule 1 to this bill inserts Subdivision 768-G into the Income Tax Assessment Act 1997 (ITAA 1997). The Subdivision will operate to reduce a capital gain or capital loss an Australian company or controlled foreign company makes from specified capital gains tax (CGT) events happening on or after 1 April 2004 to certain interests in a foreign company.

1.2 This chapter explains the measure and outlines how a company determines the extent to which it may reduce its capital gain or capital loss.

Context of amendments

1.3 This measure will provide Australian companies (and controlled foreign companies) with greater flexibility in corporate restructuring decisions where other avenues of CGT relief are not available.

1.4 The current application of Australia's income tax law to disposals of interests in a foreign company is relevant at two levels. First, Australian companies are generally subject to tax on any capital gains made on the disposal of interests in a foreign company. Second, any capital gains made by a controlled foreign company on the disposal of interests in a foreign company may be attributed back to the Australian shareholder under Part X of the Income Tax Assessment Act 1936 (ITAA 1936) as assessable income.

1.5 This measure will allow Australian multinational companies and their controlled foreign companies to compete more effectively in capital markets. Together with the changes discussed in Chapter 2, it may facilitate Australian multinational companies to repatriate the profits of the foreign active businesses to Australia without incurring Australian tax. That will more easily enable them to employ that capital and structure (or in fact restructure) their business in the most efficient manner possible.

1.6 This measure implements the Government's decision on Recommendation 3.10(2) of the Board of Taxation's report to the Treasurer on international taxation. The decision was announced in Treasurer's Press Release No. 32 of 13 May 2003. A secondary aim of the measure is to ensure that similar Australian tax consequences arise from the disposal of non-portfolio interests in a foreign company with an underlying active business as would occur from the sale of the underlying active foreign business assets of that company.

1.7 Australian companies are currently subject to tax on capital gains arising from the disposal of shares in foreign companies. This includes disposals of shares in foreign companies with underlying active businesses. Conversely, where the underlying active business assets of the foreign company are sold, any gain arising on that sale may escape attribution under the accruals regimes and be repatriated to Australia free from Australian tax if it is distributed through a non-portfolio dividend.

Summary of new law

1.8 The measure will reduce the capital gain or capital loss a company makes from several specified CGT events happening to shares (other than eligible finance shares or widely distributed finance shares) in a foreign company to the extent that the foreign company has an underlying active business. This measure will also apply to reduce attributable income arising from the same CGT events happening to shares owned by a controlled foreign company in a foreign company.

1.9 The CGT events to which these amendments apply are CGT events A1, B1, C2, E1, E2, G3, J1, K4, K6, K10 and K11.

1.10 In order to be eligible for this measure, the following conditions must be satisfied:

the company held a direct voting percentage in the foreign company of at least 10%; and
the requisite interest was held by the company for a continuous period of at least 12 months in the two years before the CGT event.

1.11 The extent to which the foreign company carries on an active business is determined by calculating an active foreign business asset percentage for the company. Broadly, the active foreign business asset percentage is the value of active foreign business assets held by the foreign company as a percentage of the value of all the assets of the foreign company. Certain assets are specifically excluded from this calculation.

1.12 A taxpayer may choose to apply either the market value method or the book value method to value the assets of the foreign company for the purposes of calculating its active foreign business asset percentage.

1.13 Where the taxpayer is unable to, or chooses not to, apply either the market value or book value method to calculate the active foreign business asset percentage of a foreign company, the taxpayer will be required to apply a default rule. Under the default rule, the result is that all of a loss is disregarded where a capital loss has arisen on the happening of the CGT event, or none of a gain is disregarded where a capital gain has arisen.

1.14 With the focus of the measure on the valuation of assets of the foreign company, special rules apply to shares a foreign company has in another foreign company. Although characterised as an active asset, the value of these shares that is used in the calculation of the value of the active foreign business assets is based on the subsidiary's active foreign business asset percentage. An active foreign business asset percentage may only be determined for a subsidiary where the company that disposes of the foreign company, has a direct and indirect voting percentage in the subsidiary company of at least 10%. Further, the foreign company must have a direct voting percentage of at least 10% in the subsidiary company. In other cases, the value of shares in other foreign companies (or in Australian companies) to be included as an active asset in the calculation of the active foreign business asset percentage will be zero.

1.15 In certain circumstances, provided the foreign subsidiary company or companies are 100% owned by the foreign company, the calculation of the active foreign business asset percentage may be undertaken on a consolidated basis.

1.16 Special rules apply to the calculation of the active foreign business asset percentage in relation to Australian financial institution subsidiaries and foreign life insurance and foreign general insurance companies. Certain financial instruments used by Australian financial institution subsidiaries in carrying on a business, where their sole or principal business is financial intermediary business, will be included within the definition of active foreign business asset. Concessionary treatment will also be provided to foreign life insurance and foreign general insurance companies to take into account the special regulatory and solvency requirements in each of those industries.

1.17 The measure will apply to specified CGT events happening on or after 1 April 2004.

Comparison of key features of new law and current law

New law Current law
A capital gain or capital loss a company makes on specified CGT events happening to shares in a foreign company will be reduced to the extent of the foreign company's active foreign business asset percentage. The whole of the capital gain or capital loss an Australian company makes on CGT events happening to shares in a foreign company is subject to the CGT provisions (without any equivalent reduction).
A capital gain or capital loss a controlled foreign company makes on specified CGT events happening to shares in a foreign company will be reduced to the extent of the foreign company's active foreign business asset percentage. This, in turn, alters the amount of attributable income of the controlled foreign company. A capital gain or capital loss a controlled foreign company makes on CGT events happening to shares in a foreign company is included in attributable income of the controlled foreign company where:

if the controlled foreign company is resident in a broad-exemption listed country and does not pass the active income test - the amount is adjusted tainted income that is eligible designated concession income in relation to any broad-exemption listed country;
if the controlled foreign company is resident in a non-broad-exemption listed country and does not pass the active income test - the amount is adjusted tainted income.

The measure applies to CGT events A1, B1, C2, E1, E2, G3, J1, K4, K6, K10 and K11. No equivalent.
Either the market value or book value method may be used in calculating the active foreign business asset percentage of the foreign company. No equivalent.
In certain circumstances, a foreign company's shares in a subsidiary foreign company may be characterised as an active asset to the extent of the subsidiary company's active foreign business asset percentage. No equivalent.
In certain circumstances, consolidated accounts can be used in the calculation of the active foreign business asset percentage. No equivalent.

Detailed explanation of new law

What does this measure do?

1.18 This measure applies to reduce any capital gain or capital loss that arises from certain CGT events happening to certain shares in a foreign company by the active foreign business asset percentage of that foreign company [Schedule 1, item 3, subsection 768-505(2)]. Paragraphs 1.21 to 1.22 discuss shares to which this measure applies. Paragraphs 1.23 to 1.36 discuss the CGT events to which this measure applies. Paragraphs 1.51 to 1.59 discuss the concept of the active foreign business asset percentage.

Who will the measure apply to?

1.19 This measure applies where either an Australian company or a controlled foreign company owns shares in a foreign company. In the case of an Australian company, the rules apply to reduce the capital gain or capital loss arising under Part 3-1 of the ITAA 1997 from certain CGT events that happen to shares in the foreign company (see paragraphs 1.23 to 1.36 for a discussion on the relevant CGT events).

1.20 In the case of a controlled foreign company, the rules will apply in the calculation of the controlled foreign company's attributable income under Part X of the ITAA 1936. In Part X a controlled foreign company is assumed to be an Australian resident for the purposes of calculating its attributable income. This includes applying Part 3-1 dealing with capital gains and losses (as modified by Subdivision C of Division 7 of Part X of the ITAA 1936) and new Subdivision 768-G of the ITAA 1997. Apart from this calculation of attributable income, the measure is not relevant where a foreign company owns shares in another foreign company. For example, it has no effect on the active income test nor on the definition of passive income under Part X.

What shares will be covered by the measure?

1.21 A share (other than an eligible finance share or a widely distributed finance share) in a company that is a foreign resident will be eligible for this measure [Schedule 1, item 3, paragraph 768-505(1)(b)]. Eligible finance shares and widely distributed finance shares are defined in Part X of the ITAA 1936.

1.22 The purpose of excluding such shares from the application of this measure is that the shares are, in substance, the equivalent of a debt rather than an equity investment.

Which CGT events are relevant?

1.23 This measure will only apply for CGT events A1, B1, C2, E1, E2, G3, J1, K4, K6, K10 and K11. [Schedule 1, item 3, paragraph 768-505(1)(c)]

1.24 The measure has been restricted to these CGT events in line with the policy of providing a concession where there has been a disposal or sale of shares in the foreign company and to minimise existing impediments to the ability of corporate groups to restructure their business.

1.25 The remaining CGT events in Division 104 have not been included for the purposes of this measure because:

they do not happen to shares and are therefore irrelevant; or
they have the primary purpose of maintaining integrity of the CGT provisions, and it would therefore be inappropriate to apply the measure to any capital gain or capital loss arising from those CGT events.

Disposal of a CGT asset

1.26 It is envisaged that CGT event A1 will be the most common CGT event giving rise to the application of this measure as it relates to the disposal of a CGT asset.

Other CGT events

1.27 CGT events other than CGT event A1 have been included in the measure because they are so closely related to an actual disposal under CGT event A1 and inequitable outcomes would result if they were not included.

CGT event B1

1.28 CGT event B1 effectively brings forward the time that a capital gain or capital loss arises under an agreement to pass use and enjoyment of a CGT asset from the time when the actual disposal takes place to the time when the use and enjoyment of the asset is transferred. Without the agreement, CGT event A1 would normally apply. Although it is envisaged that there would be very few, if any, situations in which CGT event B1 would apply to shares in a foreign company, the event has been included because it closely relates to the passing of title in the asset.

CGT event C2

1.29 CGT event C2 happens if the taxpayer's ownership of an intangible CGT asset ends because it is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered, forfeited or expired. The reasons for including this event for the purposes of this measure are two-fold:

this event may happen because a genuine transaction takes place in relation to the shares in the foreign company whereby the shareholding company no longer holds any ownership interests in the foreign company (e.g. redemption of shares in a company); and
if not included, this event could be used by a company to avoid application of this measure where it has made a capital loss from losing its ownership in the shares of the foreign company.

CGT events E1 and E2

1.30 CGT events E1 and E2 have specifically been included on the basis that they could allow a taxpayer to effectively sell the share in the foreign company without causing CGT event A1 to happen. For example, a company could either create a trust over the share or could transfer the share to an existing trust. In both cases, the company would no longer have beneficial ownership of the share. Although the company may retain legal ownership of the share, the beneficial owner of the share would now be the beneficiary of the trust.

CGT event G3

1.31 CGT event G3, which only gives rise to a capital loss, happens when a liquidator declares in writing that there is no likelihood that the shareholders in the company will receive any further distribution in the course of winding up the company. This event has been included to prevent a taxpayer from avoiding application of this measure where they have made a capital loss on their shares in the foreign company under CGT event G3, rather than under CGT event C2 (when the foreign company is eventually wound up).

CGT event J1

1.32 CGT event J1 happens where a company that holds a CGT asset that was the subject of a roll-over under Subdivision 126-B ceases to be a member of a wholly-owned group.

1.33 CGT event J1 is specifically included in this measure to ensure that the part of the capital gain or loss that may arise on the application of CGT event J1 to a share in a foreign company receives the same treatment as any capital gain or loss that could otherwise arise on the actual disposal of the share in a foreign company.

CGT event K4

1.34 CGT event K4 happens where a CGT asset that is already owned by the taxpayer starts being held as trading stock and the taxpayer elects to have the asset treated as having been sold for its market value. Although this event does not happen in response to a change in the ownership of the asset, it has been included in the measure because it represents a change in the nature of the holding of the asset by the taxpayer and involves a deemed sale of the asset as a CGT asset.

CGT event K6

1.35 Inclusion of CGT event K6 means that any capital gain or capital loss arising on the sale by an Australian company or controlled foreign company of a pre-CGT share in a foreign company will be subject to this measure where that foreign company holds predominantly post-CGT assets. If this CGT event were not included, an Australian company or controlled foreign company would not be eligible for a reduction in their capital gain or loss from the disposal of their interest in a foreign company, even if they satisfied all the other conditions prescribed by this measure. That would clearly be inequitable and opposed to the policy intent of this measure.

CGT events K10 and K11

1.36 CGT events K10 and K11, which relate to foreign exchange gains and losses respectively, have been included as they are incidental to other CGT events that are relevant for the purposes of these measures, such as CGT event A1.

How long is the Australian company or controlled foreign company required to hold the interest?

1.37 Application of this measure is limited to any capital gain or capital loss arising from CGT events happening to a share in a foreign company where the shareholding company held a direct voting percentage of at least 10% in the foreign company for a continuous 12-month period in the two years before the CGT event. [Schedule 1, item 3, paragraph 768-505(1)(a)]

1.38 The requirements in relation to a minimum time and minimum shareholding are included to ensure that the availability of concessions under this measure is limited to structural holdings, that is, those shareholdings that may be considered to be part of the business structure of the shareholder company rather than a mere temporary investment. The intention of this measure is to allow companies to restructure their foreign structural shareholdings without being overburdened by Australian tax considerations.

Direct voting percentage

1.39 The concept of direct voting percentage has been used to ensure that it relates to a voting interest that an entity owns directly in another company. In other words, if there is a trust or a partnership interposed between the shareholding entity and the other company, then the first-mentioned company will be taken to not hold a direct voting percentage in the other company.

1.40 The direct voting percentage that an entity has in a foreign company is equal to the voting interest it holds in that foreign company (within the meaning of section 160AFB of the ITAA 1936) as a percentage of the voting power of that company (within the meaning of that section). [Schedule 1, item 3, subsection 768-550(1)]

1.41 However, the application of section 160AFB is modified for the purposes of this measure to ensure that if a partnership or trust is interposed between the shareholding entity and the company in which the shares are held the direct voting percentage in the company will be zero. [Schedule 1, item 3, paragraph 768-550(1)(b) and subsection 768-550(2)]

1.42 This modification for the purposes of the definition of 'direct voting percentage' is consistent with the application of the non-portfolio dividend exemption in section 23AJ of the ITAA 1936, which is only available in respect of non-portfolio dividends that have been paid to an Australian resident company by a foreign resident company.

Example 1.1 On 1 July 2003 an Australian resident company, Abbey Co, purchased the following shares in foreign-resident company Matt Co:

50% of the total number of shares in Matt Co carrying only rights to dividends; and
5% of the shares in Matt Co that carry the right to exercise voting power in that company.

On 1 July 2004, Abbey Co disposed of its entire shareholding (i.e. the shares carrying only rights to dividends, and the shares carrying voting rights). Any capital gain or capital loss made by Abbey Co in relation to any of the shares will not be reduced under this measure. This is because Abbey Co did not hold a direct voting percentage of 10% or more at any stage.If, on the other hand, Abbey Co had initially purchased 10% (rather than 5%) of the shares in Matt Co that carry the right to exercise the voting power in that company, the measure would apply to reduce any capital gain or capital loss made on the disposal of both the shares carrying voting rights and the shares carrying only rights to dividends (provided those shares are not eligible finance shares or widely distributed finance shares).

Minimum continuous shareholding period

1.43 In order to be eligible for the reduction under this measure, an Australian company is required to have a direct voting percentage in a foreign company for a continuous period of at least 12 months in the two years immediately before the CGT event. [Schedule 1, item 3, paragraph 768-505(1)(a)]

1.44 This requirement has been included as an integrity measure that is designed to prevent Australian companies or controlled foreign companies from accessing the reduction in capital gains where they have not recently held the requisite interest in the foreign company for at least a 12-month continuous period. Further, as mentioned in paragraph 1.38, this measure is designed to only apply in relation to shares that are part of the shareholder company's structural business rather than a mere temporary investment of the shareholder company.

1.45 It also allows for companies to sell down their shareholding in stages, provided this is carried out within 12 months of ceasing to hold the requisite voting percentage. This is discussed in further detail in paragraphs 1.47 to 1.49.

1.46 Adoption of the timing requirements is consistent with similar regimes in other jurisdictions.

Staggered sell-down

1.47 This measure may also apply where an Australian company or controlled foreign company holds less than a 10% direct voting percentage in the foreign company at the time of the CGT event. This will be the case where the Australian company or controlled foreign company held at least a 10% direct voting percentage for a continuous 12-month period in the two years prior to the relevant CGT event. In other words, the reduction in the capital gain or capital loss provided under this measure may continue to be available for up to 12 months after the Australian company or controlled foreign company has ceased to hold a direct voting percentage of at least 10% in the foreign company that it held for at least 12 months. [Schedule 1, item 3, paragraph 768-505(1)(a)]

1.48 The purpose of this rule is to allow companies to retain eligibility for the concession under this measure where they sell their shares in foreign companies in instalments.

Example 1.2 An Australian-resident company, Ken Co, purchased 20% of the shares in a foreign-resident company, Cath Co, on 1 July 2002. The shares carried the right to exercise 20% of the voting power in Cath Co. On 1 July 2004, Ken Co disposed of 11% of the shares in Cath Co, therefore retaining 9% of the shares in Cath Co. Ken Co subsequently disposed of 4% of the shares on 31 December 2004 and its remaining 5% shareholding in Cath Co on 1 July 2005.The transactions may be illustrated on a timeline as follows:

Based on the above, Ken Co would be eligible to the reduction under this measure for any relevant CGT events happening to its interest in Cath Co from 1 July 2003, that is, at a time when Ken Co had held a direct voting percentage of 10% or more in Cath Co for a continuous period of at least 12 months. Ken Co would then continue to be eligible for the reduction for any relevant CGT events happening until 30 June 2005, despite the fact that Ken Co had a direct voting percentage of less than 10% in Cath Co from 1 July 2004.On this basis, the disposals that would qualify for a reduction are:

the disposal of 11% on 1 July 2004; and
the disposal of 4% on 31 December 2004.

The disposal of 5% of the shares in Cath Co on 1 July 2005 would not qualify for the reduction as Ken Co did not hold a direct voting percentage of at least 10% in Cath Co for a continuous period of 12 months in the two years prior to the disposal.

1.49 It is possible that this measure will also apply where a company disposes of shares in the foreign company, where those particular shares have been held by the company for less than 12 months. This situation may occur where the shareholding company sold a direct voting percentage in the foreign company of at least 10% after holding it for a continuous period of at least 12 months. If the shareholding company then reacquired some shares in that foreign company, then it may be eligible to access the reduction provided under this measure if the shares were sold within 12 months of the first disposal.

Example 1.3 An Australian-resident company, Invest Co, acquired shares in a foreign-resident company, Target Co, on 1 January 2005, giving Invest Co a direct voting percentage of 40% in Target Co. On 1 January 2006, Invest Co disposed of the entire interest in Target Co so that, at that date, it no longer held any shares in Target Co. On 1 July 2006, Invest Co acquired 5% of the shares in Target Co, which it subsequently disposed of on 31 December 2006.The transactions are illustrated in the following timeline.

Based on the above, Invest Co will be eligible for the reduction for the disposal of the shares in Target Co on both 1 January 2006 and on 31 December 2006, despite the fact that Invest Co did not own any shares in Target Co between 2 January 2006 and 31 June 2006. This is due to the fact that Invest Co satisfies both the minimum shareholding requirements and the timing requirements in relation to its shareholding in Target Co from 1 January 2005 to 31 December 2006.

How is the capital gain or capital loss reduced?

1.50 Any capital gain or capital loss that arises from certain CGT events happening to shares in a foreign company is reduced under this measure by the active foreign business asset percentage of that foreign company at the time of the CGT event. [Schedule 1, item 3, subsection 768-505(2)]

What is the active foreign business asset percentage of a foreign company?

1.51 The concept of active foreign business asset percentage has been developed to determine the extent to which the foreign company carries on an active business.

1.52 An assessment of the nature of the assets held by a foreign company is considered to be the most practical representation of the extent to which that company is carrying on an active business. An underlying assumption of this measure is therefore that the assets characterised as active for the purpose of calculating the active foreign business asset percentage are used by the company in carrying on an active business.

1.53 Broadly, the active foreign business asset percentage of a foreign company is the value of active foreign business assets owned by the company as a percentage of the value of total assets owned by the company. [Schedule 1, item 3, subsections 768-520(1) and 768-525(1)]

1.54 One of two methods, market value or book value, may be chosen to value these assets. Paragraphs 1.60 to 1.98 discuss these methods in detail.

1.55 It is important to note that there are modified rules for the application of the active foreign business asset percentage for both foreign life insurance companies and foreign general insurance companies and foreign wholly-owned groups [Schedule 1, item 3, sections 768-530 and 768-535]. More detailed discussion on these modifications is provided in paragraphs 1.178 to 1.213 and 1.214 to 1.223.

1.56 The result of the active foreign business asset percentage calculation is rounded to the nearest whole percentage point. Where the result of the calculation is 90% or more, then the active foreign business asset percentage is taken to be 100%. If the result is less than 10%, the active foreign business asset percentage is taken to be zero. In all other cases, the result of the calculation is equal to the active foreign business asset percentage. [Schedule 1, item 3, step 5 in the method statement in subsection 768-520(1); step 5 in the method statement in subsection 768-525(1)]

1.57 Where the active foreign business asset percentage is less than 10%, all capital gains arising from certain CGT events happening to an eligible interest in a foreign company will be taxable. Similarly, all capital losses that arise from those CGT events happening to an eligible interest in a foreign company will be available to be deducted from any other capital gains or carried forward to be used against future capital gains. The main reason for the threshold at the lower end is that the situation where the overwhelming majority of the company's assets are not active is taken to be reflective of the fact that the business being carried on by the company is itself not of a sufficiently active nature to warrant application of this measure.

1.58 Conversely, where the active foreign business asset percentage is 90% or more, capital gains arising from certain CGT events happening to an eligible interest in a foreign company will be reduced to zero, and therefore exempted from tax. Likewise, all capital losses arising from those CGT events will be disregarded. They will therefore not be available to deduct against any capital gains arising during the income year nor will they be available to be carried forward to be deducted against future capital gains.

1.59 The purpose of including a threshold at the upper end of the active foreign business asset percentage calculation is recognition that a company that is predominantly active may own some non-active assets that are incidental to the operation of the overall business. Further, the presence of the upper end threshold provides symmetry with the threshold at the lower end of the active foreign business asset percentage calculation.

Example 1.4

On 1 July 2004, Chrissy's Clothing Co, an Australian-resident company, disposed of the whole of its interest (a 100% direct voting percentage) in Nick's Pants Co, a foreign-resident company, that it originally acquired on 1 July 2001.Chrissy's Clothing Co determined that the average value of Nick's Pants Co's active foreign business assets as a percentage of Nick's Pants Co's total assets at the time of the disposal was 91%. Therefore, Nick's Pants Co's active foreign business asset percentage at that time is equal to 100%. Any capital gain made or capital loss realised by Chrissy's Clothing Co on disposal of its interest in Nick's Pants Co will therefore be reduced by 100% to zero.

How are assets to be valued for the purposes of calculating the active foreign business asset percentage of a foreign company?

1.60 A choice in valuation methodologies is provided for identifying the values of total assets and active assets for the purposes of calculating the active foreign business asset percentage of a foreign company. [Schedule 1, item 3, subsection 768-510(1)]

1.61 The choice may be made between:

market valuation [Schedule 1, item 3, subsection 768-515(1)] ;
book valuation [Schedule 1, item 3, subsection 768-515(2)] ; or
no valuations - apply default active foreign business asset percentage [Schedule 1, item 3, subsection 768-510(4)].

1.62 A formal choice is required to adopt market or book valuation. Certain criteria must be met before either method may be applied. [Schedule 1, item 3, sections 768-510 and 768-515]

1.63 The default active foreign business asset percentage, or third choice, is made by:

not making the formal choice to apply book or market valuations; or
formally choosing book or market valuation but not satisfying the particular criteria for using the chosen method.

1.64 Choice has been provided to ensure that all eligible taxpayers will have access to the reduction in capital gains and losses provided by this measure, regardless of their level of access to information, availability of financial accounts or their ability or willingness to incur the compliance costs associated with the different methods of valuation.

Who may choose the valuation method to be applied?

1.65 The choice to adopt the market value or book value method for calculating the active foreign business asset percentage of a foreign company is to be made by the holding company, that is, the company that holds the interest in the foreign company to which the relevant CGT events happen [Schedule 1, item 3, section 768-515]. Where the holding company is an Australian company, then the choice will be made by that company. However, where the holding company is a controlled foreign company, then pursuant to section 390 of the ITAA 1936, the choice will be made by the eligible taxpayer in relation to that eligible controlled foreign company.

1.66 There is no separate notification requirement that the taxpayer needs to make in relation to its choice regarding the asset valuation method used to calculate the active foreign business asset percentage. Rather, the way the taxpayer prepares its income tax return for the year of income in which the relevant CGT event happens is sufficient evidence of the choice. [Schedule 1, item 3, subsection 768-515(3)]

What are the criteria for applying market value methodology?

1.67 The taxpayer may adopt the market value method for calculating the active foreign business asset percentage for a foreign company if certain conditions are satisfied [Schedule 1, item 3, subsection 768-510(2)]. First, the taxpayer must choose to adopt the market value method [Schedule 1, item 3, paragraph 768-510(2)(a)]. Second, at the time of the CGT event there must be:

sufficient evidence of the total market value of all the assets included in the total assets of the foreign company; and
sufficient evidence of the total market value of all the active foreign business assets included in the total assets of the foreign company.

[Schedule 1, item 3, paragraph 768-510(2)(b)]

1.68 Regardless of the manner in which the market value of the total assets is ascertained and the methodology employed, it is necessary for there to be sufficient evidence kept of the methodology, the information used and the resulting valuations. The methodology itself must also be considered objectively to provide sufficient evidence of the market value of the assets.

1.69 The values of the assets used for the purposes of calculating the active foreign business asset percentage are to represent the current market values at the time the relevant CGT event happens to the holding company's shares in the foreign company. [Schedule 1, item 3, subsection 768-520(1)]

Sufficient evidence of the market value of all assets included in the total assets of the foreign company

1.70 It may not be necessary to value each asset included in the total assets of the foreign company to work out the market value of all assets included in total assets of the foreign company as required under step 1 in the method statement in subsection 768-520(1).

1.71 Rather, it is envisaged that the market value of the total assets as a whole may be ascertained by reference to the sale price of the shares disposed of. In the simple case where 100% of a company with $100 of liabilities is disposed of (in an arm's-length sale on the open market), the market value of the company will be the disposal price. The market value of the total assets of the foreign company will then be the disposal price (market value of the company) plus $100 (liabilities) less the market value of any assets of the company not included in the definition of total assets.

1.72 Consequently, the following steps may generally be used to ascertain the market value for the total assets of a foreign company:

Step 1 - Market value of the company plus
Step 2 - Market value of the liabilities less
Step 3 - Market value of assets in the company not included in total assets.

1.73 Factors that will affect the calculation of the market value of the company by reference to the disposal price for the shares include:

disposal of the shares at a discount or premium;
non-arm's-length disposal; and
disposal of a specific class of shares where the company has different classes of shares.

1.74 Whilst it is not necessary to ascertain the market value of all assets by reference to the sum of the market value for each asset included in the total assets, it is still permissible to calculate the market value of total assets this way.

Sufficient evidence of the market value of all assets included in the active foreign business assets of the foreign company

1.75 As for total assets it is not always necessary to calculate the market value of all assets included in the active foreign business assets of a foreign company as the sum of the market values of each individual active foreign business asset. [Schedule 1, item 3, subsection 768-520(1)]

1.76 Rather, it is envisaged that in the majority of cases it will be simpler to ascertain the market value of assets included in total assets that are not active foreign business assets (non-active assets). The market value of the active foreign business assets of the company may then be calculated as follows.

Step 1 - Market value of total assets [Schedule 1, item 3, step 1 in the method statement in subsection 768-520(1)] less
Step 2 - Market value of non-active assets.

Sufficient evidence of the market valuation of certain assets

1.77 There may be certain circumstances where the value of an asset as recorded in certain financial accounts of the foreign company may be sufficient evidence of market value.

Example 1.5 An Australian company, Hannah Pty Limited (Hannah Australia), holds shares in a foreign company Hannah New Zealand Pty Limited (Hannah NZ).A building was purchased by Hannah NZ on 1 July 2003 for $1 million. The transaction had conveyancing costs of $10,000 and other associated costs of $30,000. Therefore, the cost of the building was equal to $1,040,000.The amount of $1,040,000 is recorded in the books of Hannah NZ on the basis that the conveyancing and other associated costs are incidental costs directly attributable to the acquisition of the building. If Hannah Australia's interest in the foreign company is sold on 1 July 2005, the historical cost figure in the accounts for the building is not acceptable for the purposes of the market value method given that it is historical cost and does not take into account any change in value of the building over the time it was held.

Example 1.6 Following from the facts in Example 1.5, assume that the building increased in value by 15% each year in line with commercial property growth in that area. The value of the building at 1 July 2005 would therefore be:

$1,040,000 + (15% * $1 million) + [15% * ($1 million + 15% * $1 million)]
= $1,040,000 + $150,000 + $172,500
= $1,362,500

This would be represented as the current book value (fair value) of the asset for that year at the time the accounts were prepared.Given that the value appearing in the books would closely resemble the current value of the building, it would be an acceptable value to use under the market value method.

Example 1.7 Evie Australia Pty Limited (Evie Australia) is a holding company. It holds 100% of the shares in Owens New Zealand Pty Limited (Owens NZ). Owens NZ has only issued one class of shares. Owens NZ manufactures sun tanning equipment. Evie Australia sells 40% of its interest in Owens NZ to a third party at the arm's length market price of $200 million.The market value of the assets of Owens NZ could be derived from the sale price obtained upon disposal of the shares in the foreign company plus the market value of the liabilities of the company. This method alleviates the need to separately value all assets of a company.Thus, if in the circumstances of this example:

40% of the interests in the company are worth $200 million, then the market value of all interests in the company would be $500 million ($200 million divided by 40%);
the market value of liabilities is assumed to be $300 million;
the market value of 'passive' assets is $100 million; and
all of the assets of Owens NZ are assets included in the total assets under section 768-545,

then the calculation under steps 1 to 4 of subsection 768-520(1) would be:

(($500 million + $300 million) - $100 million) / $800 million = 700 / 800 = 88%

Accordingly, a capital gain or loss on the disposal of the interest in Owens NZ by Evie Australia would be reduced by 88%. The remainder would be left within the CGT rules.If the 40% interest in Evie NZ had a cost base of $100 million, there would be a gain of $100m ($200 million minus $100 million). This means that $88 million of the gain would be exempt and the remaining $12 million would be included in the calculation of Evie Australia's taxable income.

Example 1.8 Use the facts in Example 1.7 but assume that Evie Australia disposed of some of its interest in Owens NZ so that it now owns 40% of the shares. SMG Pty Ltd (a related Australian entity), which owns 16% of the shareholding in Owens NZ, approaches Evie Australia to sell its interest in Owens NZ. Evie Australia agrees to acquire this interest from SMG Pty Ltd for $100 million. Assume that this is a non-arm's-length price.If the $100 million consideration were accepted to be representative of the value of a 16% interest in Owens NZ, the value of all interests in Owens NZ would amount to $625 million ($100 million divided by 16%). The market value of the total assets in Owens NZ (the foreign company) under the market value methodology would be the sale price of the shares owned by SMG Pty Ltd in Owens NZ (grossed-up) plus the market value of the liabilities of Owens NZ. If it is assumed that the market value of the disposal of the shares is $625 million, this would result in a market value of the total assets of $625 million plus $300 million (liabilities of Owens NZ) which is equal to $925 million.However, as the acquisition price is not an arm's-length amount, it cannot be accepted as indicative of the market value of the company.Given that this amount does not represent the market value of the total assets, a market valuation of assets would need to be undertaken; assuming the same result as in Example 1.7.Thus, a gain or loss would be reduced by 88%. If the cost base of the shares owned by SMG Pty Ltd in Owens NZ is $50 million then the capital gain is $50 million ($100 million minus $50 million). The amount of capital gain is reduced to $6 million. The remaining $44 million would not be included in the calculation of SMG Pty Ltd's taxable income.

1.78 Note that it is necessary to separately identify the value ascribed to share assets for the purposes of identifying the value attributed to the shareholding under subsection 768-520(2). The actual market value of the shares would be replaced, in determining the market value of the active assets, by the amount determined under subsection 768-520(2). [Schedule 1, item 3, subsection 768-520(2)]

What are the criteria for applying the book value method?

1.79 The taxpayer may adopt the book value method for calculating the active foreign business asset percentage for a foreign company if certain conditions are satisfied [Schedule 1, item 3, subsection 768-510(3)]. First, the taxpayer must choose to adopt the book value method [Schedule 1, item 3, paragraph 768-510(3)(a)]. Second, the taxpayer must have access to recognised company accounts of the foreign company for the relevant periods [Schedule 1, item 3, paragraphs 768-510(3)(b) and (c)].

Recognised company accounts

1.80 The average value of total assets of the foreign company and the average value of active foreign business assets of the foreign company are calculated by using the asset values disclosed in the two most recently available recognised company accounts that represent periods ending at least six months but no more than 18 months apart. [Schedule 1, item 3, subsections 768-525(2) and (3)]

1.81 Recognised company accounts of a foreign company are accounts that are prepared in accordance with:

the accounting standards prepared by the responsible body in Canada, France, Germany, Japan, New Zealand, United Kingdom (UK) or United States of America (USA), or the international accounting standards; or
commercially accepted accounting principles that give a true and fair view of the financial position of the foreign company.

[Schedule 1, item 17, definition of 'recognised company accounts' in subsection 995-1(1)]

1.82 It is intended that accounts that have been prepared in accordance with the accounting standards of Canada, France, Germany, Japan, New Zealand, UK or USA, or the international accounting standards, would be used in preference to accounts prepared in accordance with commercially accepted accounting principles.

1.83 The second element of recognised company accounts is based on paragraph 432(1)(c) of the ITAA 1936. It is anticipated that, under this option, the foreign company's accounts would be prepared in accordance with the accounting standards that are generally in use in the country in which the foreign company is resident or in which the foreign company carries on its principal business activities. Accepted accounting principles would usually mean the accounting standards developed and enforced by the relevant accounting authority in relation to each country. The ability of a foreign company to choose between different sets of commercially accepted accounting principles is restrained by the requirement that accounts must give a true and fair view of the financial position of the company. [Schedule 1, item 17, definition of 'recognised company accounts' in subsection 995-1(1)]

1.84 It is intended that the most recent recognised company accounts would include completion accounts, that is, those accounts that have been prepared solely for the purpose of the disposal of shares in the foreign company.

Average value of assets

1.85 In working out the active foreign business asset percentage of a foreign company in accordance with the book value method it is necessary to calculate the average values of total assets and active foreign business assets. [Schedule 1, item 3, subsection 768-525(1)]

1.86 Recognised company accounts are prepared on a particular day in relation to the position of the company on a particular day which may or may not correlate with the time of the CGT event to which the measure applies. In short, the recognised company accounts may not represent the position of the foreign company at the time of the CGT event but rather the position of the company at an earlier point in time.

1.87 Rather than use the values in a single set of recognised company accounts (possibly) prepared for a different time to the time of the CGT event, average values using two sets of company accounts are required. The use of two sets of accounts in relation to the two prescribed periods for which accounts were prepared will provide a more balanced view of the overall position of the company. Consequently, the use of average values will produce an active foreign business asset percentage that is more reflective of the active nature of the company throughout the relevant period.

1.88 Further, this approach minimises the potential for manipulation of the active foreign business asset percentage by acquiring active assets for the purposes of a single reporting period. The requirement for average values is also consistent with the integrity rule requiring that the holding company own the eligible interest in the foreign company to which the relevant CGT event happens for a period of at least 12 months prior to the CGT event.

1.89 The relevant periods for which recognised company accounts are required are:

the most recent period that ends no more than 12 months before the time that the relevant CGT event happens and for which the foreign company has recognised company accounts; and
the most recent period that ends between six months and 18 months before the end of the period mentioned above and for which the foreign company has recognised company accounts.

[Schedule 1, item 3, subsections 768-525(2) and (3)]

1.90 If there are multiple periods for which the foreign company has recognised company accounts it will be the consecutive accounts that are closest to the time immediately prior to the CGT event that end no less than six months and no more than 18 months apart that are required to be used.

1.91 Where the foreign company does not have recognised company accounts for one of the required periods, then the taxpayer will not be able to apply the book value method in relation to that foreign company [Schedule 1, item 3, paragraphs 768-510(3)(b) and (c)]. The taxpayer will be required to choose either the market value method or have the default method apply in relation to calculating the active foreign business asset percentage for that foreign company.

1.92 However, if the foreign company did not exist before the start of the period ending no more than 12 months prior to the CGT event and it does not have more than one set of recognised company accounts, then the values of the assets for the earlier period are taken to be zero [Schedule 1, item 3, subsection 768-525(6)]. In other words, where the foreign company has not been in existence long enough to have more than one set of recognised company accounts, then the taxpayer will still be able to apply the book value method in calculating its active foreign business asset percentage.

1.93 The taxpayer will not be able to adopt the book value method where the foreign company has recognised company accounts for the relevant periods but the taxpayer cannot get access to them. This may be the case where the foreign company being disposed of (FC1) has recently purchased shares in a subsidiary foreign company (FC2) in which it has a direct voting percentage of at least 10%. Although FC1 may have some difficulty in getting access to recognised company accounts of FC2 for periods prior to its acquisition, inability to acquire the accounts will mean that the book value method cannot be adopted in relation to FC2 (but it still may be able to be used for FC1).

Example 1.9 An Australian company, Alex Co, disposes of 100% of the shares in a foreign company, Lou Co, on 10 July 2006. Lou Co prepares completion accounts in anticipation of the sale for the period ending on the date of the disposal. The completion accounts are for the period 1 July 2006 to 10 July 2006. Lou Co is a quarterly reporting company in its local jurisdiction (the United Kingdom) and has accounts prepared in accordance with the accounting standards of the United Kingdom for each quarter aligning with a 1 July accounting period.Consequently there are recognised company accounts available for the following periods:

1 July 2006 to 10 July 2006;
1 April 2006 to 30 June 2006;
1 January 2006 to 31 March 2006;
1 October 2005 to 31 December 2005;
1 July 2005 to 30 September 2005;
1 April 2005 to 30 June 2005, and so on.

The relevant accounts to be used by Alex Co in calculating the active foreign business asset percentage are the accounts for the periods 1 July 2006 to 10 July 2006 and 1 October 2005 to 31 December 2005. The first set of accounts ends on the day of the CGT event and the second set of accounts ends (31 December 2005) more than six months before the end of the first period (10 July 2006).

1.94 The value of an asset of a foreign company at the end of a period is taken for the purposes of the book value method to be the value of the asset as shown in the recognised company accounts of the foreign company for that period [Schedule 1, item 3, paragraph 768-525(5)(a)]. If the value of the asset is not disclosed in the recognised company accounts for that period, then the value of the asset is taken to be zero for the purposes of the book value method [Schedule 1, item 3, paragraph 768-525(5)(b)]. Therefore, assets of the company not recorded in the accounts, such as internally generated goodwill, will be ascribed a zero value.

1.95 The value of an asset will not be zero if its value is not individually recorded in the recognised company accounts but is reflected in the value ascribed to a class of assets. In that case the asset has a value in the accounts.

1.96 Where all assets in a class are included in total assets or active foreign business assets there is no need to individually identify the value for each particular asset. If, however, not all assets included in the class of assets are included in the particular calculation, that is total assets or active foreign business assets, then it will be necessary to deconstruct the accounts to identify the values of the relevant assets that are reflected in that class of assets.

1.97 For example, in working out the sum of values of every asset included in the total assets under step 1 or 2 in the method statement in subsection 768-525(2), it is not necessary to separately identify the value of each asset provided all the assets included in the value of a class of assets are included in total assets. If, however, derivative assets are included in a class of assets along with other assets, the value ascribed to the derivatives in the accounts must be identified and excluded [Schedule 1, item 3, paragraph 768-545(1)(c)]. The same applies for working out the sum of values for every active foreign business asset in accordance with steps 1 and 2 in the method statement in subsection 768-525(3).

1.98 Note that it is necessary to separately identify the value ascribed to share assets for the purposes of identifying the value attributed to the shareholding under subsection 768-525(4). [Schedule 1, item 3, subsection 768-525(4)]

When does the default method apply?

1.99 Where the taxpayer is either not able to apply either the market value or the book value method, or does not make a choice in relation to either the market value or book value method, it will be required to adopt the default method. [Schedule 1, item 3, subsection 768-510(4)]

1.100 The default method prescribes the value of the active foreign business asset percentage. The value of the active foreign business asset percentage under the default method will vary depending on whether it is to be applied to a capital gain or capital loss. In the case of a gain, the active foreign business asset percentage will be 0% and the amount of the gain will be fully taxable. In the case of a loss, it will be 100% and the full amount of the capital loss will be disregarded.

1.101 It is intended that the default method will apply in the cases where, for example:

taxpayers cannot get access to the appropriate financial information in relation to a foreign company to use either the market value or book value method; or
the taxpayer does not make a choice to use either the book or market value method and is unwilling to incur compliance costs in relation to a foreign company (e.g. where the capital gain or loss that arises from the relevant CGT event happening is small).

1.102 The default rule has been included as an incentive for taxpayers to take all reasonable steps to use either the market value method or the book value method. In particular, the default rule is an integrity measure that aims to prevent a company that has made a capital loss under this measure from gaining a benefit just because it has chosen not to calculate the active foreign business asset percentage.

1.103 It is envisaged that this rule will have two separate applications. The first is the calculation of the active foreign business asset percentage for the foreign company being disposed of. The second application is calculation of the active foreign business asset percentage for subsidiary companies of the foreign company being disposed of. The application of this measure to subsidiary companies of the foreign disposal company is discussed in further detail in paragraphs 1.144 to 1.155.

What are active foreign business assets?

1.104 The definition of active foreign business asset is broadly based on existing definitions in the income tax law of 'tainted asset' in section 317 of the ITAA 1936 and 'active asset' in section 152-40 of the ITAA 1997. It is intended that the proportion of assets owned by the foreign company that satisfy the definition of active foreign business asset provides a reasonable reflection of the extent to which the company is carrying on an active business.

1.105 There are several conditions that must be satisfied in order for an asset to be classified as an active foreign business asset. First, the asset must be an asset included in the total assets of the company, as defined in section 768-545 [Schedule 1, item 3, paragraph 768-540(1)(a)]. This condition has been included to prevent distortions in the active foreign business asset percentage that may occur where assets that are included in the numerator of the calculation are not included in the denominator of that calculation, or vice versa.

1.106 Secondly, the asset must be one of the three kinds of assets. The first kind of asset is an asset that is used, or held ready for use, by the company in the course of carrying on a business [Schedule 1, item 3, subparagraph 768-540(1)(b)(i)]. The purpose of this restriction is to ensure that only business assets have the opportunity to be classified as an active foreign business asset under this measure.

1.107 The second kind of asset is goodwill. Goodwill has been specifically listed as an active foreign business asset on the basis that there may be some doubt as to whether goodwill can be used by a company in the course of carrying on a business [Schedule 1, item 3, subparagraph 768-540(1)(b)(ii)]. For example, in subsection 152-40(1), assets that may be used, or held ready for use, in the course of carrying on a business are distinguished from intangible assets, such as goodwill, that are inherently connected with a business that is carried on. Further, goodwill has been specifically included to avoid the necessity of having to apportion goodwill between active and other assets.

Shares in a company

1.108 The third alternative is a share in a company. Although shares are not normally considered to have an active character, they have been included within the definition of active foreign business assets for the purposes of this measure in order to facilitate the testing of subsidiary foreign companies for the presence of an active business [Schedule 1, item 3, subparagraph 768-540(1)(b)(iii)]. If shares were not treated as active for the purposes of this measure, then the active foreign business asset percentage of subsidiary foreign companies could not contribute to the active foreign business asset percentage of their foreign parent company [Schedule 1, item 3, subsections 768-520(2) and 768-525(4)]. The treatment of shares for the purposes of calculating the active foreign business asset percentage is discussed in more detail in paragraphs 1.143 to 1.160.

CGT asset that has the necessary connection with Australia

1.109 An asset that is a CGT asset that has the necessary connection with Australia is specifically excluded from the definition of active foreign business asset [Schedule 1, item 3, paragraph 768-540(1)(c)]. The definition of 'necessary connection with Australia' provided in section 136-25 of the ITAA 1997 has been modified for the purposes of this measure to include a share or an interest in an Australian resident public company and a unit in an Australian resident unit trust, no matter what the size of the beneficial ownership in the share, interest or unit. This modification has been made to ensure that interests of less than 10% in Australian resident public companies and Australian resident unit trusts are not treated as active assets.

1.110 The purpose of this exclusion is to ensure that similar Australian tax consequences arise from the disposal of a non-portfolio interest in a foreign company, as from the disposal of the underlying active foreign business assets of that foreign company. Without this exclusion, opportunities may arise for an Australian resident company to effectively dispose of 'Australian assets' free from Australian tax where the company disposes of a foreign 'active' subsidiary company through which it holds those Australian assets. The measure was never intended to provide this benefit.

1.111 Similarly, in the case of a controlled foreign company holding CGT assets that have the necessary connection with Australia, the controlled foreign company would be subject to CGT on any capital gain from the disposal of those assets. It would be inconsistent with current Australian tax treatment to allow the shareholders in the controlled foreign company to dispose of their shares free from Australian tax where the gain is, in effect, attributable to the unrealised gain on assets that have a necessary connection with Australia.

Excluded assets

1.112 Certain assets have been specifically excluded from the definition of active foreign business asset for the purposes of this measure [Schedule 1, item 3, paragraph 768-540(1)(d) and subsection 768-540(2)]. These specific exclusions have been broadly based on existing provisions in the income tax law that deal with the distinction between active and not active assets or income. In particular, consideration was given to the definition of 'tainted asset' in section 317 of the ITAA 1936 and the definition of 'active asset' in section 152-40 of the ITAA 1997.

Financial instruments

1.113 The purpose of this exclusion is to characterise those assets that are financial instruments, other than shares or trade debts, as not active [Schedule 1, item 3, paragraph 768-540(2)(a)]. This treatment is generally consistent with both the definition of 'tainted assets' in section 317 of the ITAA 1936 and the definition of 'active assets' in section 152-40 of the ITAA 1997.

1.114 On the basis that the term 'financial instrument' is not specifically defined for Australian income tax purposes, it is intended that this term take on its ordinary accounting meaning. It is envisaged that assets that will come within this exclusion include, but are not limited to loans (including deposits with a bank or financial institution), debenture stock, bonds, debentures, certificates of entitlement, bills of exchange, promissory notes or other securities. Although this includes loans and other financial transactions with related companies, the special rule in relation to wholly-owned groups may apply to these types of transactions. The rules relating to wholly-owned groups are discussed in paragraphs 1.214 to 1.223.

1.115 An exception to the exclusion of financial instruments from active assets is made for trade debts [Schedule 1, item 3, paragraph 768-540(2)(a)]. To the extent that receivables are trade debts, they have been considered to constitute active assets within the meaning of section 152-40 if they are used solely in carrying on a business. It is intended that 'trade debt' takes on its ordinary meaning.

1.116 Derivatives are not covered by this exclusion because they are specifically excluded from assets included in total assets [Schedule 1, item 3, paragraph 768-545(1)(c)]. Derivatives therefore do not satisfy the first condition to be classified as an active foreign business asset [Schedule 1, item 3, paragraph 768-540(1)(a)]. The exclusion of derivatives from the calculation of the active foreign business asset percentage is discussed in paragraphs 1.138 to 1.142.

1.117 Special treatment is provided to Australian financial institution subsidiaries in relation to the characterisation of financial instruments for the purposes of calculating their active foreign business asset percentage [Schedule 1, item 3, paragraph 768-540(3)(a)]. The treatment of Australian financial institution subsidiaries for the purposes of this measure is discussed in more detail in paragraphs 1.161 to 1.177.

Example 1.10 James Co, a foreign-resident company, manufactures tents which it sells domestically and on the export market. As James Co is exposed to exchange rate volatility from fixed price export contracts it enters into derivative arrangements to hedge against foreign exchange movements. Spare cash is accumulated during the year which is invested in bank term deposits or bills of exchange rather than kept in a transaction bank account. Credit is extended to domestic retailers for a period of 120 days, which is the normal period in which stock is sold.The derivatives are not active assets as they are excluded from total assets. Investments in bills of exchange or term deposits are used to derive interest income in the course of carrying on the business, so are not active assets. The trade debt is a business facilitation mechanism excluded from the definition of a financial instrument, so therefore is an active asset.

Certain types of shares

1.118 The second exclusion from the definition of active foreign business asset relates to shares that are eligible finance shares or widely distributed finance shares [Schedule 1, item 3, paragraph 768-540(2)(b)]. Both 'eligible finance share' and 'widely distributed finance share' are defined in Part X of the ITAA 1936. The reason that these types of shares have been excluded from the definition of active foreign business asset is that they are, in substance, the equivalent of a debt rather than an equity investment. Further, it is intended that this measure provide consistent tax treatment to that provided by the non-portfolio dividend exemption in section 23AJ of the ITAA 1936. This means that it would not be appropriate to 'look-through' these shares to test the nature of the underlying business of the foreign company in which the shares are held as any dividends paid by the foreign company out of profits from the disposal of that business would be subject to Australian tax in full.

Interests in a trust or partnership

1.119 Both an interest in a trust and an interest in a partnership are specifically excluded from the definition of active foreign business asset. [Schedule 1, item 3, paragraph 768-540(2)(c)]

1.120 Characterisation of interests in partnerships and trusts as not active means that these entities will not be looked through for the purpose of calculating the active foreign business asset percentage of a foreign company. Consequently, where the foreign company being disposed of holds an interest in a subsidiary company through a partnership or a trust, the active assets of that subsidiary company will not contribute to the active foreign business asset percentage of the foreign company. Therefore, any interest that the foreign company holds in that subsidiary company through the partnership or trust will effectively be treated as not active as the interest held by the company in the partnership or trust is a non-active asset.

Example 1.11

On 1 July 2004, Aus Co disposed of its entire interest in For Co. In calculating the active foreign business asset percentage for For Co, the whole value of For Co's interest in Partnership will be treated as not active. This means that the assets of any underlying subsidiaries, such as For Sub, will not be taken into account in calculating For Co's active foreign business asset percentage, regardless of the level of the indirect interest that For Co has in For Sub.

1.121 Application of the active foreign business asset percentage of tiers of companies is discussed in greater detail in paragraphs 1.143 to 1.160.

Life insurance policies

1.122 Life insurance policies are the fourth specific exclusion from the definition of active foreign business asset [Schedule 1, item 3, paragraph 768-540(2)(d)]. The exclusion of life insurance policies is recognition of the fact that they are generally considered to be comprised mainly of an investment component, and may therefore be characterised as being like a financial instrument. Rather than attempting to split these assets into active and non-active components, in the interests of simplicity they are to be treated entirely as non-active. This may be contrasted with general insurance policies which tend to have no investment component.

1.123 Note that special treatment is provided to life insurance and general insurance companies in relation to the calculation of the active foreign business asset percentage [Schedule 1, item 3, section 768-530]. The application of this measure to life insurance and general insurance companies is discussed in detail in paragraphs 1.178 to 1.213.

Rights or options to certain assets

1.124 Rights or options to acquire a financial instrument, an interest in a company, trust or partnership, or a life insurance policy are also excluded from the definition of 'active foreign business assets'. [Schedule 1, item 3, paragraph 768-540(2)(e)]

1.125 These types of assets are considered to have a nature that is not active on the basis that the 'underlying' assets are also not active. Further, this exclusion applies to a right or option to acquire an interest in a company, despite the fact that interests in companies receive active treatment under this measure. The main reason is that an interest in a company effectively will not be treated as an active foreign business asset under this measure where there is another person in a position to affect the rights of the interest holder, for example, where the other person has a right to acquire interests in the company.

1.126 In other words, the value of an interest in a company will only be included in the value of active foreign business assets where the foreign company has a direct voting percentage of 10% or more in the subsidiary company. A company has a direct voting percentage in another company if it has a voting interest in the other company within the meaning of section 160AFB of the ITAA 1936 [Schedule 1, item 3, subsection 768-550(1)]. Section 160AFB of the ITAA 1936 provides that a company does not have a voting interest in another company if a person is in a position, or may become in a position, to affect that right, for example, if that person has a right, power or option to acquire that right.

Cash or cash equivalent

1.127 To the extent that cash and cash equivalents do not come within the ordinary meaning of 'financial instruments', they will also be excluded from the definition of active foreign business assets [Schedule 1, item 3, paragraph 768-540(2)(f)]. Cash and cash equivalents are not defined in the ITAA 1936 or ITAA 1997. It is intended that they will adopt their ordinary accounting meanings for the purposes of this measure.

1.128 Special treatment is provided to Australian financial institution subsidiaries in relation to cash or cash equivalents for the purpose of calculating their active foreign business asset percentage [Schedule 1, item 3, paragraph 768-540(3)(a)]. The treatment of Australian financial institution subsidiaries for the purposes of this measure is discussed in more detail in paragraphs 1.161 to 1.177.

Assets deriving passive income

1.129 Assets whose main use in the course of carrying on business is the derivation of passive investment income (namely interest, an annuity, rent, royalties or foreign exchange gains) are specifically excluded from the definition of active assets except where:

the asset is an intangible asset and its market value has been substantially enhanced through development, alteration or improvement to the asset; or
the main use for deriving rent was only temporary.

[Schedule 1, item 3, paragraph 768-540(2)(g)]

1.130 This treatment is consistent with the definition of 'active asset' in section 152-40 of the ITAA 1997.

1.131 The concept of 'main use' in relation to the derivation of passive investment income will take into account various factors in relation to the asset such as:

comparative time of use of the asset for various purposes;
comparative level of income derived from different uses of the asset;
comparative physical use of the asset (e.g. floor space in a building); and
any change in use of the asset over the period the active foreign business asset percentage is being calculated.

No single factor will necessarily be determinative.

1.132 Special treatment is provided to Australian financial institution subsidiaries in relation to assets that derive interest, annuities or foreign exchange gains for the purpose of calculating their active foreign business asset percentage [Schedule 1, item 3, paragraph 768-540(3)(b)]. The treatment of Australian financial institution subsidiaries for the purposes of this measure is discussed in more detail in paragraphs 1.161 to 1.177.

Example 1.12 The active foreign business asset percentage is required to be calculated for Buffalo Co, which owns a five story office building. Buffalo Co uses two floors of the building for carrying on a car valuation business and rents out the remaining three floors to an unrelated company. The rental income from the building represents about 20% of the total income derived by the company.In this case a substantial, although not a majority, of the floor space of the building is used for the carrying on of a business. However, the income derived from the conduct of the business is 80% of total income (business plus rentals). Having regard to these factors, the main use of the building is not deriving rent income, so therefore the building is not excluded from being an active asset.

1.133 A further example of an asset not being excluded from being an active assets is where an intangible asset has been substantially developed, altered or improved so that its market value has been enhanced.

Example 1.13 A foreign company, For Co, owns the trade name 'Clifthanger', valued at a market value of US$100 million in its balance sheet, which it licences out to derive royalty income. Clifthanger is an adventure sports training system. The trade name was created and developed by the company over a period of time as part of its adventure sports business, increasing its value from US$50 million two years ago. While the intangible asset derives royalty income, it is an active asset because it has been substantially developed and improved by the company so that its market value has been substantially enhanced.

What assets are included in the total assets?

1.134 An asset is included in the total assets of a foreign company if at the time of calculating the active foreign business asset percentage the following conditions are satisfied:

the asset is a CGT asset;
the foreign company owns the asset; and
if the foreign company is not an Australian financial institution subsidiary whose sole or principal business is financial intermediary business, the asset is not a derivative asset.

[Schedule 1, item 3, subsection 768-545(1)]

1.135 An asset that does not satisfy all of the above conditions for inclusion as part of total assets of the foreign company will be excluded from the active foreign business asset calculation. [Schedule 1, item 3, paragraph 768-540(1)(a)]

CGT asset

1.136 A CGT asset is defined in section 108-5 of the ITAA 1997. It is specified as being any kind of property or a legal or equitable right that is not property.

Ownership of assets

1.137 A foreign company is considered to own the CGT asset where it is both the legal and beneficial owner of that asset at that time.

Derivative assets

1.138 Derivative assets are specifically excluded from the definition of 'assets included in the total assets' [Schedule 1, item 3, paragraph 768-545(1)(c)]. This exclusion effectively treats derivative assets as active to the same extent as all remaining assets of the foreign company that are included in total assets.

1.139 Derivatives are excluded from total assets in recognition of their potential use in the active business activities of the company. Derivatives may be assets or liabilities. However, if the derivative is a liability, it falls outside the scope of this measure. The character of a derivative as an asset or liability will vary depending on the market. If the derivative is 'in the money' it is an asset. Otherwise it will be a liability. This position may change daily for some instruments. The approach adopted in this rule prevents the need to make this classification.

1.140 The definition of derivative has essentially been adopted from subsection 761D(1) of the Corporations Act 2001. The main changes from that definition of derivative are that foreign exchange contracts are not excluded and the exclusions under subsection 761D(3) of the Corporations Act 2001 have been added back for the purposes of this measure. This means that arrangements such as the following will be included in the definition of derivative:

deliverable forward contracts;
contracts for the future provision of services;
arrangements covering financial products outlined in subsection 764A(1) of the Corporations Act 2001; and
financial instruments excluded by regulation.

1.141 A single future time period, being one business day, will also be used for all derivatives. Presently the Corporations Act 2001 provides foreign exchange contracts with a different time period to that of all other derivatives. [Schedule 1, item 3, paragraph 768-545(3)(b)]

1.142 Due to the complex and fluid nature of financial arrangements, and derivatives in particular, provision for regulations to outline specific inclusions and exclusions has been provided for, if required in the future. [Schedule 1, item 3, subsections 768-545(2) to (4)]

How are share assets to be valued in the case of a tier of companies?

1.143 The extent to which a foreign company is carrying on an active business, and therefore, the extent to which the relevant capital gain or capital loss in relation to that foreign company is reduced under this measure, is based on the active foreign business asset percentage of the foreign company. Paragraphs 1.51 to 1.59 discuss the concept of the active foreign business asset percentage.

1.144 In calculating the active foreign business asset percentage, the value of all active foreign business assets must be determined [Schedule 1, item 3, subsections 768-520(1) and 768-525(3)]. Within this calculation is a requirement that the value of any shares (that are active foreign business assets) in a subsidiary company is modified by the active foreign business asset percentage of that subsidiary company (if certain requirements are met) or is zero (if the requirements are not met). These sufficient interest requirements are discussed in paragraphs 1.149 to 1.155.

1.145 If the subsidiary company itself owns a share (which is an active foreign business asset) in another subsidiary company (the lower tier company), the same rule applies. An interest that the foreign company has in a subsidiary company, and other lower tier companies, may be characterised as an active asset only to the extent of the subsidiary company's active foreign business asset percentage. [Schedule 1, item 3, subsections 768-520(2) and 768-525(4)]

1.146 This rule has the effect that the active foreign business asset percentage of lower tier companies in which the holding company has a sufficient interest may contribute to the active foreign business asset percentage of the foreign company being disposed of by the Australian company or controlled foreign company.

1.147 The purpose of allowing the active foreign business asset percentages of lower tier companies to contribute to the foreign company's active foreign business asset percentage is to determine whether the foreign company has an underlying active business. In other words, where the foreign company has a sufficient interest in a lower tier company, it is arguable that the nature of the business of the lower tier company contributes to the nature of the business carried on by the foreign company. This will be particularly relevant, but not restricted to, foreign holding companies.

1.148 Special rules can apply to companies that are part of a foreign wholly-owned group [Schedule 1, item 3, section 768-535]. Where these rules apply a share owned by one of the companies in the wholly-owned group in another of those companies in the wholly-owned group is effectively ignored [Schedule 1, item 3, subsection 768-535(4)]. The effect of this is that the active foreign business asset percentage of the foreign wholly-owned group is calculated on a group basis, rather than on application at each level in the chain of companies. These grouping rules are discussed in detail in paragraphs 1.214 to 1.223.

What are the sufficient interest requirements?

1.149 The sufficient interest requirements that must be met for the application of the valuation rules for shares held by a foreign company in a foreign subsidiary company are:

the foreign company has a direct voting percentage of 10% or more in the foreign subsidiary company; and
the company disposing of the share (the holding company) has a total voting percentage of 10% or more in the foreign subsidiary company.

[Schedule 1, item 3, subsections 768-520(2) and 768-525(4)]

1.150 If one or both of these requirements is not met, it will not be necessary to calculate the active foreign business asset percentage for the foreign subsidiary company. The value of the share in that company will be zero when calculating the active foreign business assets of the foreign company. [Schedule 1, item 3, item 2 in the table in subsection 768-520(2) and item 2 in the table in subsection 768-525(4)]

Direct voting percentage

1.151 Each foreign company is required to have at least a 10% direct voting percentage in the immediate foreign subsidiary company in order to limit this measure to companies that have the opportunity to participate to some extent in the business of the subsidiary company. Further, an interest holding of 10% is consistent with the level of interest required for the non-portfolio dividend exemption under section 23AJ of the ITAA 1936. It is also consistent with the level of interest required for the application of the measure to the CGT event in relation to a share in a foreign company, but, unlike that provision, does not require the interest to be held for any particular time.

Total voting percentage in subsidiary company

1.152 In addition, the holding company is required to have a total voting percentage (i.e. direct and indirect voting percentage) of at least 10% in the foreign subsidiary company. The main purpose of this requirement is to ensure that the taxpayer has adequate access to the financial information of the subsidiary company to be able to sufficiently comply with the requirements under this measure. This requirement becomes more important as the active foreign business asset percentage is calculated for subsidiary companies further down the chain, where it may be quite difficult to get access to sufficient information to be able to perform the calculation.

1.153 The reason that interests are traced by reference to the holding company (i.e. the Australian company or controlled foreign company that disposes of a foreign company) rather than by reference to the foreign company being disposed of is to ensure that the taxpayer has sufficient access to information.

1.154 A company has a total voting percentage in a foreign subsidiary company equal to the sum of the company's direct voting percentage and the company's indirect voting percentage in that subsidiary company [Schedule 1, item 3, section 768-560]. A company's indirect voting percentage in a subsidiary company is calculated by multiplying the following:

the company's direct voting percentage in an interposed company (the intermediate company); and
the sum of:

-
the intermediate company's direct voting percentage in the subsidiary company; and
-
the intermediate company's indirect voting percentage in the subsidiary company.

[Schedule 1, item 3, subsection 768-555(1)]

1.155 If the company's indirect voting percentage in the lowest tier subsidiary company may be traced through more than one chain of subsidiaries, then the result of the calculation above for each separate chain is added together to determine the company's indirect voting percentage [Schedule 1, item 3, subsection 768-555(2)]. In other words, where the entity has a direct voting percentage in more than one subsidiary company, each of which may have a direct or indirect voting percentage in the lowest tier subsidiary company, then the company's indirect voting percentage is to be worked out by tracing through each subsidiary company.

Example 1.14

The total voting percentage that Co A has in Co E is the sum of Co A's direct and indirect voting percentages in Co E. As Co A does not have any direct voting percentage (DVP) in Co E, only its indirect voting percentage (IVP) in Co E is relevant.The indirect voting percentage that Co A has in Co E is the sum of the indirect voting percentage through Co B and the indirect voting percentage through Co C. The formula would appear as follows:

Where:

DVPAB is the direct voting percentage of Co A in Co B;
DVPBE is the direct voting percentage of Co B in Co E;
IVPBE is the indirect voting percentage of Co B in Co E;
DVPAC is the direct voting percentage of Co A in Co C;
DVPCE is the direct voting percentage of Co C in Co E;
IVPCE is the indirect voting percentage of Co C in Co E.

[Schedule 1, item 3, section 768-550] In order to work out the indirect voting percentage that Co A has in Co E, it is necessary to first calculate the indirect voting percentage that Co B and Co C each has in Co E. The indirect voting percentage that Co B has in Co E is calculated as follows:

The indirect voting percentage that Co C has in Co E is:

The indirect voting percentage that Co A has in Co E is therefore:

If Co A were to dispose of its shares in Co B, Co E could be tested (i.e. the active foreign business asset percentage calculation can be made for Co E). This is because Co A holds 31% total voting interest in Co E, and Co D (and Co B) has a direct voting percentage in Co E of 10%. Therefore, Co E's active foreign business asset percentage will be relevant for the valuation of both Co D and Co B's shares in Co E. [Schedule 1, item 3, item 1 in the table in subsections 768-520(2) and 768-525(4)] If in the example above Co A had no shareholding in Co C, the total voting percentage that Co A would have in Co E would instead be 6%. As this is less than 10%, Co E could not be tested, even though both Co B and Co D have a 10% direct voting percentage in Co E. [Schedule 1, item 3, item 2 in the table in subsections 768-520(2) and 768-525(4)]

What is the 'bottom-up' approach in calculating the active foreign business asset percentage?

1.156 Generally, the active foreign business asset percentage is to be calculated for the foreign company and each subsidiary company individually, as though each subsidiary company was the foreign company being disposed of. However, the special rules that can apply to companies that are part of a foreign wholly-owned group (see paragraphs 1.214 to 1.223) may partially (or entirely) eliminate this mechanical approach of going through each subsidiary company individually.

1.157 When calculating the active business percentage for numerous subsidiary companies, it will be necessary to first calculate the percentage for the lowest subsidiary company in which the foreign company and the holding company have a sufficient interest. The active foreign business asset percentage will then be calculated for the preceding subsidiary company, with its interest in the lowest subsidiary company being active to the extent of the active foreign business asset percentage of the lowest subsidiary company. [Schedule 1, item 3, note to subsections 768-520(2) and 768-525(4)]

Example 1.15 Aus Co holds a direct voting percentage in For Co 1 of 50%, For Co 1 holds a direct voting percentage in For Co 2 of 30% and For Co 2 holds a direct voting percentage in For Co 3 of 100%. Aus Co's indirect voting percentage in both For Co 2 and For Co 3 is therefore 15%. The group structure is illustrated in the diagram below.

The active foreign business asset percentage is first calculated For Co 3. If the active foreign business asset percentage of For Co 3 is 70%, then shares in For Co 3 held by For Co 2 will be taken to be 70% active. Only 70% of their value (market or book, as chosen) will be counted as an active asset. [Schedule 1, item 3, item 1 in the table in subsections 768-520(2) and 768-525(4)] The active foreign business asset percentage is then calculated for For Co 2. Assume the active foreign business asset percentage of For Co 2 is 90% (taking into account that only 70% of the value of the shares in For Co 3 is active). On the basis that the threshold for the active foreign business asset percentage is 90%, shares in For Co 2 held by For Co 1 will be taken to be 100% active. That is, 100% of the value of those shares will be counted as an active asset.The active foreign business asset percentage is then calculated for For Co 1. Assume that the active foreign business asset percentage of For Co 1 is 80% (taking into account that 100% of its shares in For Co 2 are active).Therefore, Aus Co's capital gain or capital loss on the disposal of all, or any, of its interest in For Co 1 will be reduced by 80%. [Schedule 1, item 3, subsection 768-505(2)]

What is the effect of not having access to valuation information?

1.158 Where the taxpayer cannot access the appropriate information to be able to adopt either the market value or book value method in relation to a subsidiary company, the active foreign business asset percentage of the subsidiary company will be either 100%, if a capital loss arose to the holding company from the shares in the foreign company, or zero, if a capital gain arose. [Schedule 1, item 3, subsection 768-510(4)]

What is the treatment of interposed partnerships and trusts?

1.159 The calculation of the indirect voting percentage allows tracing through interposed companies to determine the percentage interest that the top entity holds in the lowest tier company. However, calculation of the indirect voting percentage does not allow tracing through partnerships or trusts because of the restriction in the definition of 'direct voting percentage'. [Schedule 1, item 3, subsection 768-550(2)]

1.160 The restriction in relation to tracing through partnerships or trusts for the purpose of determining the indirect voting percentage is consistent with the treatment of interests in partnerships and trusts held by the foreign company as non-active for the purpose of calculating the foreign company's active foreign business asset percentage. [Schedule 1, item 3, paragraph 768-540(2)(c)]

How does the measure apply to financial institutions?

1.161 Certain financial institutions calculate their active foreign business assets using modified definitions of total assets and active foreign business assets.

1.162 The modifications provide for derivative assets to be included in the total assets and certain financial instruments to be included in active foreign business assets.

1.163 The modifications are provided in recognition of the fact that financial institutions hold, trade in and dispose of certain financial instruments as part of their active rather than mere passive investment activities.

1.164 One of the aims of these modifications is to ensure that gains from the disposal of Australian financial institution subsidiaries that hold certain financial instruments are treated commensurately under this measure with the treatment under the controlled foreign companies regime of income and gains from trading in certain financial instruments held by Australian financial institution subsidiaries. Where the trading income or gain is treated as passive income or tainted services income, the asset is not an active asset.

To which financial institutions do the modified definitions of total assets and active foreign business assets apply?

1.165 The financial institutions to which the modified definitions of total assets and active foreign business assets apply are Australian financial institution subsidiaries whose sole or principal business is financial intermediary business. [Schedule 1, item 3, paragraphs 768-540(1)(e) and 768-545(1)(c) and subsection 768-540(3)]

1.166 The meaning of both Australian financial institution subsidiary and financial intermediary business for this measure is the same as the meaning in Part X of the ITAA 1936. The use of these terms to identify the financial institutions to which the special treatment of various financial instruments relates facilitates the symmetrical treatment of both the entities and financial instruments.

What are the modifications to the active foreign business assets of Australian financial institution subsidiaries?

What assets are included in the active foreign business assets of Australian financial institution subsidiaries?

1.167 The active foreign business assets of an Australian financial institution subsidiary include:

financial instruments;
cash or cash equivalents; and
assets whose main use in the course of carrying on the business of the company is to derive interest, annuities or foreign exchange gains.

[Schedule 1, item 3, subsection 768-540(3)]

What assets are excluded from the active foreign business assets of Australian financial institution subsidiaries?

1.168 Although Australian financial institution subsidiaries receive special treatment in relation to financial instruments under this measure, some financial instruments that are owned by Australian financial institution subsidiaries continue to be excluded from the definition of active foreign business asset if certain conditions are satisfied. [Schedule 1, item 3, paragraph 768-540(1)(e)]

1.169 There are two categories of assets that continue to be treated as not active under this measure. The first must satisfy the following conditions:

the asset is an asset mentioned in subparagraph 450(4)(b)(i) or (ii) of the ITAA 1936;
the asset was acquired from another entity; and
either of the conditions mentioned in subparagraphs 450(6)(c)(i) and (ii) was satisfied in relation to the other entity at the time of the acquisition.

[Schedule 1, item 3, paragraph 768-540(4)(a)]

1.170 The assets mentioned in subparagraphs 450(4)(b)(i) and (ii) are as follows:

loans (including deposits with a bank or other financial institution); and
debenture stock, bonds, debentures, certificates of entitlement, bills of exchange, promissory notes or other securities.

1.171 The conditions in subparagraphs 450(6)(c)(i) and (ii), as changed by the measure discussed in Chapter 3, are that the entity was either:

a Part X Australian resident and the acquisition was not in connection with a business carried on by the entity at or through a permanent establishment of the entity in a foreign country; or
not a Part X Australian resident, but the acquisition of the asset from that entity was in connection with a business carried on by the entity at or through a permanent establishment of the entity in Australia.

1.172 In other words, where the specified financial asset was acquired from an Australian resident in Australia or from a permanent establishment of a foreign resident in Australia, then it will continue to be excluded from the definition of active foreign business asset.

1.173 The second category of assets that are excluded from the definition of active foreign business asset must satisfy the following conditions:

the asset relates to a debt to which factoring income (within the meaning of Part X of the ITAA 1936) of the foreign company relates; and
the condition in paragraph 450(8)(b) of the ITAA 1936 is satisfied in relation to the debt.

[Schedule 1, item 3, paragraph 768-540(4)(b)]

1.174 Factoring income is defined in section 317 of the ITAA 1936 to mean income derived from carrying on a business of factoring.

1.175 The condition in paragraph 450(8)(b) of the ITAA 1936, as amended by the measure discussed in Chapter 3, is that the debt to which the factoring income relates was acquired from, or disposed of to, another entity where either of the following conditions is satisfied at the time of the acquisition or disposal:

the entity was a Part X Australian resident and the acquisition was not in connection with a business carried on by the entity at or through a permanent establishment of the entity in a foreign country; or
the entity was not a Part X Australian resident, but the acquisition or disposal was in connection with a business carried on by the entity at or through a permanent establishment of the entity in Australia.

1.176 Consequently, an asset relating to a debt to which factoring income relates will be treated as not active under this measure where the debt was acquired from, or disposed of to, an Australian resident in Australia or from a permanent establishment of a foreign resident in Australia.

What are the modifications to the total assets of Australian financial institution subsidiaries?

1.177 Total assets of companies that are not Australian financial institution subsidiaries exclude derivatives. For the purposes of calculating the active foreign business asset percentage of an Australian financial institution subsidiary whose sole or principal business is financial intermediary business, derivative assets are included in total assets. Inclusion of derivatives in total assets at this level then provides for them to be treated as active where appropriate under the application of the definition of active foreign business assets. [Schedule 1, item 3, paragraph 768-545(1)(c)]

How does the measure apply to insurance companies?

1.178 The calculation of the active foreign business asset percentage for foreign life and foreign general insurance companies is modified in order to take into account the special regulatory and solvency requirements placed on insurance companies. The modifications are based on the treatment of life insurance and general insurance companies in Part X of the ITAA 1936 in relation to the calculation of the passive income of a controlled foreign company. It is intended that the modifications under this measure mirror the treatment under Part X.

1.179 Although the modifications differ for foreign life and foreign general insurance companies, the result for both is that the active foreign business asset percentage of the foreign life or foreign general insurance company is increased by increasing the amount of active foreign business assets.

What is a foreign life insurance company?

1.180 A foreign life insurance company is a company that is a foreign resident whose sole or principal business is life insurance [Schedule 1, item 15, definition of 'foreign life insurance company' in subsection 995-1(1)]. Life insurance in this definition is to take on its ordinary meaning.

1.181 The definition of foreign life insurance company does not adopt the ITAA 1997 definitions of life insurance company or life insurance business. Life insurance companies, under the ITAA 1997, must be registered under the Life Insurance Act 1995.

1.182 Foreign companies are not eligible to be registered to carry on a life insurance business in Australia. Rather, a foreign life insurance company must incorporate an Australian subsidiary that must then be registered to carry on business of life insurance in Australia. On this basis foreign life insurance companies will never be registered under the Life Insurance Act 1995.

What is a foreign general insurance company?

1.183 A foreign general insurance company is a company that is a foreign resident whose sole or principal business is insurance business [Schedule 1, item 14, definition of 'foreign general insurance company' in subsection 995-1(1)]. Insurance business is defined as for the Insurance Act 1973, that is, the business of undertaking liability, by way of insurance (including reinsurance), in respect of any loss or damage, including liability to pay damages or compensation, contingent upon the happening of a specified event, and includes any business incidental to insurance business as so defined, but does not include certain businesses such as life insurance business.

1.184 In application, the definition of foreign general insurance company reflects the definition of general insurance company in Part X of the ITAA 1936.

What modifications are required in the calculation of the active foreign business asset percentage for insurance companies?

1.185 The calculation of the active foreign business asset percentage for both life insurance and general insurance companies is modified in section 768-530 [Schedule 1, item 3, section 768-530]. The modifications have been made to acknowledge the requirements on insurance companies to hold a certain level of 'non-active foreign business assets' for both regulatory purposes and as part of prudent business activities.

1.186 For life insurance companies, the value of active foreign business assets is modified to include the value of non-active assets held to meet untainted insurance policy liabilities [Schedule 1, item 3, subsections 768-530(3) and (4)]. Untainted insurance policies are insurance policies that do not give rise to tainted services income. The insurance policies that do give rise to tainted services income are those where the owner of the policy is an Australian resident.

1.187 For general insurance companies, the value of active foreign business assets is modified to include the value of non-active assets that relate to untainted outstanding claims of the company [Schedule 1, item 3, subsections 768-530(3) and (4)]. Untainted outstanding claims are so much of the outstanding claims of the company at the end of the statutory accounting period that are referable to general insurance policies that do not give rise to tainted services income of the company of any statutory accounting period.

Choice of market value or book value methods

1.188 In calculating the modified active foreign business asset percentage, insurance companies may still choose to apply the book value or market value method. [Schedule 1, item 3, section 768-515]

Market value method

1.189 If an insurance company chooses to calculate its active foreign business asset percentage using the market value method it will, in practice, use a mixture of market values and book values to calculate the value of its active foreign business assets.

1.190 Market values will be used to calculate the value of assets included in the total assets and active foreign business assets of the foreign company for the purposes of steps 1 and 2 in the method statement in subsection 768-520(1).

1.191 However, the book values recorded in the recognised company accounts for the most recent statutory accounting period ending at or before the CGT event will be used to calculate the amount by which the value of active foreign business assets is to be increased (the amount applicable under subsection 768-530(4)). [Schedule 1, item 3, subsection 768-530(3)]

Book value method

1.192 In applying the book value methodology the insurance company may only use recognised company accounts for its statutory accounting periods [Schedule 1, item 3, subsection 768-530(2)]. The same accounts must be used to calculate the initial value of active foreign business assets and total assets and the amount by which the active foreign business assets will be increased (the amount applicable under subsection 768-530(4)) [Schedule 1, item 3, subsections 768-525(2) and (3) and subsection 768-530(3)].

1.193 In applying the book value methodology it is necessary to calculate the average active foreign business assets and average total assets of the insurance company using recognised company accounts for two statutory accounting periods. The value of the active foreign business assets and the additional amount is calculated under each set of accounts and then averaged.

Calculation of the active foreign business asset percentage

1.194 In practice, an insurance company must first value all total assets and active foreign business assets using the chosen valuation methodology [Schedule 1, item 3, sections 768-520 and 768-525]. This first valuation does not include the modification to the value of active foreign business assets.

1.195 The difference between the two values, total assets and unmodified active foreign business assets is the value of non-active foreign business assets.

1.196 The proportion of active insurance amount to total insurance assets must then be calculated. [Schedule 1, item 3, subsection 768-530(4)]

1.197 The proportion of active insurance amount to total insurance assets is then applied to the value of the non-active foreign business assets. The result of the calculation is the amount by which the active foreign business assets of the insurance company is increased. [Schedule 1, item 3, subsections 768-530(3) and (4)]

1.198 The active insurance amount and total insurance assets will differ for life insurance companies and general insurance companies.

Life insurance companies

1.199 The active insurance amount of a life insurance company is the amount of the company's untainted policy liabilities as defined in subsection 446(2) of the ITAA 1936 [Schedule 1, item 3, subsection 768-530(4)]. Broadly speaking, this definition identifies the amount of the company's policy liabilities as is referable to life assurance policies that do not give rise to tainted services income of the company of any statutory accounting period. That is, the amount of the total policy liabilities of the company that relate to life insurance policies owned by foreign residents.

1.200 The total insurance assets of a life insurance company are the total assets as defined in subsection 446(2) of the ITAA 1936 [Schedule 1, item 3, subsection 768-530(4)]. That is, the average of the total assets of the company for the statutory accounting period. Note that this does not mirror the assets included in the total assets of the life insurance company used in calculating the active foreign business asset percentage.

1.201 In identifying the ratio of untainted policies to total insurance assets, the sum of all assets of the company is required. This would normally be determined by including all the assets disclosed on the company's balance sheet for the statutory accounting period.

1.202 The value ascribed to total insurance assets may be a different amount to the value of assets included in total assets under section 768-545 as certain assets, including derivatives, are excluded from the definition of assets included in the total assets for life insurance companies. [Schedule 1, item 3, paragraph 768-545(1)(c)]

General insurance companies

1.203 The active insurance amount of a general insurance company is calculated using the following formula:

total general insurance assets - net assets - tainted outstanding claims + solvency amount

[Schedule 1, item 3, subsection 768-530(5)]

1.204 Broadly speaking, this formula identifies the foreign business assets that actually relate to untainted outstanding claims of the company.

1.205 Total general insurance assets are the total assets of the company at the end of the statutory accounting period as defined in subsection 446(4) of the ITAA 1936.

1.206 Net assets means the excess at the end of the statutory accounting period of the total assets of the company over the total liabilities as defined in subsection 446(4).

1.207 Solvency amount has the same meaning as that in subsection 446(4). The solvency amount is added to the calculation in recognition of the fact that the amount of net assets related to policies giving rise to tainted services income is greater than the amount of assets held to support the outstanding claims on those policies.

1.208 Tainted outstanding claims of the general insurance company are so much of the outstanding claims of the company at the end of the statutory accounting period as are referable to general insurance policies that give rise to tainted services income of the company of any statutory accounting period (as defined in subsection 446(4)).

1.209 General insurance policies that give rise to tainted services income are defined in paragraphs 448(1)(d) to (f), as amended, as policies where:

the insured person is an associate of the company or an Australian resident;
the insured property, at the time of making the contract, was situated in Australia;
the insured event is one that can only happen in Australia;
the risks of an Australian resident insurer from its Australian business are being reinsured by the company; or
the risks of a foreign insurer from its Australian business are being reinsured by the company.

1.210 An outstanding claim is an amount that the company would, at the end of the statutory accounting period, based on proper and reasonable estimates, need to set aside and invest in order to meet liabilities of the company that have arisen or will arise:

under general insurance policies (including reinsurance policies, but not including life assurance policies); and
in respect of events that occurred during or before the period.

1.211 The total general insurance assets of the general insurance company are also defined in subsection 446(4). They are the total assets of the company at the end of the statutory accounting period. Again, note that this does not mirror the assets included in the total assets of the general insurance company used in calculating the active foreign business asset percentage.

How do the grouping provisions apply to life insurance companies and general insurance companies?

1.212 Life and general insurance companies may be members of a wholly-owned group formed in accordance with section 768-535 under a top foreign company (see paragraphs 1.214 to 1.223). If the holding company chooses to form a wholly-owned group that contains an insurance company, the nature of the insurance company, and modifications for calculating the active foreign business asset percentage, are ignored. The active foreign business asset percentage, including its modifications, is only calculated in relation to the top company of the group. The top company will never be a life or general insurance company. [Schedule 1, item 3, subsection 768-530(1) and subparagraphs 768-535(1)(b)(ii) and (iii)]

1.213 The active foreign business asset percentage is only calculated in relation to the top company of the group. Therefore to allow a life or general insurance company to be the top company would apply the modified calculation of the active foreign business asset percentage in relation to the assets of any non-insurance entities included in the group. Consequently, neither life nor general insurance companies can be the top company of a wholly-owned group.

What modifications are made for foreign wholly-owned groups?

1.214 In certain circumstances where the determination of the active foreign business asset percentage involves a tier of foreign companies the calculation may be done on a consolidated basis for wholly-owned companies comprising or within that tier of companies. This removes the need to determine the active foreign business asset percentage for each individual company in the tier where those companies are considered part of the wholly-owned group. Rather, one calculation is performed for the top foreign company in the wholly-owned group that also covers all its 100% owned foreign subsidiary companies.

1.215 The use of consolidated amounts reflects the principle that within a wholly-owned group, internal transactions, and particularly internal debt and equity funding, should not affect the extent to which the foreign company being disposed of is considered to have an underlying active business.

1.216 It is the holding company that makes the choice to calculate the active foreign business asset percentage of the top foreign company on a consolidated basis as part of determining the foreign company's active foreign business asset percentage [Schedule 1, item 3, subsection 768-535(2)]. This choice will be reflected by the way the taxpayer prepares its income tax return [Schedule 1, item 3, subsection 768-535(3)]. There is no requirement that the Commissioner of Taxation be advised of this choice.

1.217 At the time of the CGT event a consolidated approach may be used to calculate the active foreign business asset percentage provided that:

the top foreign company of the wholly-owned group is not:

-
an Australian financial institution subsidiary (within the meaning of Part X of the ITAA 1936);
-
a foreign life company; or
-
a foreign general insurance company;

the top foreign company and one or more of the other foreign companies are part of the same wholly-owned group; and
each of the subsidiary foreign companies is a 100% subsidiary of the top foreign company.

[Schedule 1, item 3, subsection 768-535(1)]

1.218 Although the top foreign company cannot be a foreign life company or a foreign general insurance company these entities are still able to be part of a wholly-owned group. Foreign life companies or foreign general insurance companies that are included as part of the wholly-owned group are, however, unable to use the modifications set out in section 768-530 as the foreign company referred to in that section is the top foreign company.

1.219 Though not compulsory, if the choice is made to consolidate, all companies:

for which the active foreign business asset percentage is otherwise required; and
which can form a wholly-owned group,

must be included in the group that is dealt with as a single entity.

1.220 In this way, the group is comprised of a single top foreign company and the other companies are the subsidiary foreign companies. Therefore, the top foreign company will be the only company in that group that is not a 100% subsidiary of another company in the group. [Schedule 1, item 3, paragraph 768-535(1)(c)]

1.221 Where a choice has been made to use a consolidated approach, each 100% owned subsidiary company of the top foreign company is treated as if it were a part of the top foreign company, rather than being a separate entity [Schedule 1, item 3, subsection 768-535(4)]. That is, both the active foreign business assets and the total assets of the top foreign company are calculated on a consolidated basis [Schedule 1, item 3, subsection 768-535(5)]. All intra-group assets and liabilities are effectively ignored, including shares held by one company in another group company or debt owed by one company to another group company.

1.222 Where a subsidiary foreign company is not 100%-owned, then a separate active foreign business asset percentage calculation is still required for that company in order to determine the active value of the shares that the wholly-owned group holds in that company. Similarly, if a company in the tier has less than a 100% interest in the wholly-owned group it must undertake a separate active foreign business asset percentage calculation once it has determined the value of its shares in the top foreign company of the wholly-owned group.

Example 1.16

In the above example, Aus Co is disposing of its interest in For Co 1. If Aus Co wishes to access the CGT concession it must determine the active foreign business asset percentage of For Co 1.For Co 2, For Co 3, For Co 4, For Co 5 and Aust Sub are members of a wholly-owned group. However, the only group that may be formed for the purposes of this measure must consist of all of the following companies: For Co 2, For Co 3, For Co 4 and For Co 5.Aust Sub is excluded from the group as it is not a company for which the active foreign business asset percentage must be calculated as the interest in that company is not an active asset in accordance with the exclusion in paragraph 768-540(1)(c).The top company in the group is For Co 2. A sub-group cannot be formed under For Co 3 as the top company then would itself be a foreign subsidiary company that is, itself, a 100% subsidiary of another member of the wholly-owned group. The group is comprised only of one unique top company and 100% subsidiaries of that top company.Separate calculations are required for For Co 6 and for For Co 1. For Co 3's 50% interest in For Co 6 is deemed to be held by For Co 2 as top company of the wholly-owned group.

1.223 Where the holding company has made the choice to consolidate several foreign companies, the recognised consolidated accounts of the top foreign company and its subsidiary are treated as being the recognised company accounts of the top company [Schedule 1, item 3, subsection 768-535(6)]. The market value method can also be applied on a consolidated basis by adopting the principle in subsection 768-535(4).

Application of measures to consolidated groups

1.224 The measures discussed above generally relate to a resident company, other than one that is a trustee of a trust. However, in some circumstances a company may be a trustee of a corporate unit trust or public trading trust that is a head company of a consolidated group under Subdivision 713-C of the ITAA 1997. The new measures apply to a company in the capacity of a trustee of a corporate unit trust or public trading trust that is the head company of a consolidated group.

Application and transitional provisions

1.225 This measure will apply to specified CGT events happening on or after 1 April 2004. [Schedule 1, item 1]

1.226 Commencement on this date ensures that taxpayer behaviour remains unaffected by the start date of this measure.

Consequential amendments

1.227 An item is included in the table in section 102-30 of the ITAA 1997 referring to special rules in Subdivision 768-G about capital gains and capital losses. [Schedule 1, item 2]

1.228 References to statutory accounting period in the ITAA 1997 have been amended in line with the addition of 'statutory accounting period' to the dictionary in Division 995 of the ITAA 1997. [Schedule 1, items 4 to 9]

1.229 Several other definitions of terms used in Subdivision 768-G are inserted into the dictionary in Division 995 of the ITAA 1997. [Schedule 1, items 10 to 20]


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