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 2 - Foreign branch income, non-portfolio dividends and listed countries

Outline of chapter

2.1 Schedule 2 to this bill contains changes to:

the exemptions for non-portfolio dividends and foreign branch profits for Australian companies;
what is attributable income under the controlled foreign companies rules;
the underlying foreign tax credit provisions for Australian companies; and
the definition of 'listed country'.

2.2 Unless otherwise stated, all legislative references are to the Income Tax Assessment Act 1936 (ITAA 1936).

Context of amendments

2.3 The decision to expand the current exemptions for foreign non-portfolio dividends and foreign branch profits received by Australian companies is part of the Government's response to the Board of Taxation's report to the Treasurer on international taxation. This decision was announced in Treasurer's Press Release No. 32 of 13 May 2003. The amendments enable Australian companies and their controlled foreign companies to obtain more attractive rates of return from their operations in foreign markets, improving their ability to attract capital. This gives them greater flexibility in the allocation of capital in conducting their business operations.

2.4 The changes to the current exemptions remove an impediment to the distribution of foreign profits to Australia. This removes a deterrent to Australian companies expanding their active business offshore. Any passive or highly mobile income shifted to those offshore investments will continue to be taxed in Australia under controlled foreign company rules. Moreover, imputation credits are only available where company tax is paid in Australia. Any company choosing to relocate Australian operations offshore to take advantage of the expanded exemption for foreign dividends would forgo the benefit of being able to frank distributions of the profits from its business. Consequently, it is not expected that these changes will lead to a displacement of those Australian operations merely for tax purposes.

2.5 The expansion of the foreign non-portfolio dividend and foreign branch profits exemptions simplifies the foreign source income rules. As well as making the law easier to understand, this enables the cost of compliance for Australian companies which operate through foreign branches or foreign companies to be reduced.

2.6 This measure along with that in Schedule 1 to this bill also forms part of a systematic solution to the treatment of conduit income for Australian companies that have foreign shareholders. The exemption for foreign non-portfolio dividends and foreign branch income, where those amounts accrue to foreign shareholders, is a necessary step for Australia to become an attractive base for holding companies. Further measures to enhance the attractiveness of Australia as the base for conduit operations as well as providing significant opportunities to establish operations in Australia, will be implemented in later bills.

Summary of new law

2.7 Foreign non-portfolio dividends received by Australian companies are no longer included in assessable income. Similar amounts received by a controlled foreign company will no longer be attributed to an Australian entity.

2.8 The foreign branch profits exemption is expanded to cover branch profits derived in all foreign countries. This will allow all foreign branch income, with the possible exception of passive income, derived by Australian companies to be exempt from Australian tax. A similar outcome is achieved for the foreign branch operations of controlled foreign companies.

2.9 The current provision that provides foreign tax credits for underlying foreign company tax is repealed along with certain other specific foreign tax credit provisions for attributed foreign income. These provisions have been repealed because as a general rule the foreign income for which the foreign tax credits would have been provided will no longer be included in assessable income.

2.10 The provisions that currently attribute income and gains when a controlled foreign company changes residence from an unlisted country to a listed country or to Australia have been modified. This ensures non-tainted income and gains on non-tainted assets are no longer attributed when a change of residence occurs. This includes unrealised gains on non-tainted assets when a controlled foreign company changes residence to a listed country.

2.11 The categorisation of foreign countries has been greatly simplified. Limited-exemption listed countries become unlisted countries (together with those already classified as unlisted countries) and countries currently classified as broad-exemption listed countries are referred to as listed countries.

2.12 The expansion of the foreign non-portfolio dividend exemption limits the need to attribute deemed dividends. The specific provisions which deal with attribution of deemed dividends where they are paid directly or indirectly between controlled foreign companies are repealed and instead any Australian taxation depends on other, more general Australian tax rules (e.g. the general controlled foreign company attribution rules).

Comparison of key features of new law and current law

New law Current law
All foreign non-portfolio dividends paid to Australian companies are not assessable income. A foreign non-portfolio dividend paid to a resident company out of comparably taxed profits is not assessable income.
Non-portfolio dividends paid to a controlled foreign company are no longer attributed to Australian shareholders. Some non-portfolio dividends paid to a controlled foreign company may be attributed to an Australian shareholder.
Active foreign branch income derived by a resident company in any foreign country will be non-assessable income. Only tainted income will ever be assessable and that will depend on the branch failing an active income test in all cases. Foreign branch profits derived by a resident company from a comparably taxing country are generally exempt from Australian tax. There is no active income test for branches in broad-exemption listed countries and no income earned in branches in unlisted countries is exempt.
There will be no foreign tax credit for underlying tax paid on profits from which dividends are paid. Foreign tax credits are available for foreign underlying company tax deemed to be paid by a resident company that receives an assessable foreign dividend from a related foreign company.
Section 458 is repealed. Section 458 directly includes in the assessable income of an attributable taxpayer a non-portfolio dividend paid from a controlled foreign company in an unlisted country to another controlled foreign company in a listed country which doesn't tax the dividend. It also applies to certain other dividends.
Section 459 is repealed but in some cases the deemed dividend may be counted as part of the attributable income of a controlled foreign company. Section 459 directly attributes deemed dividends paid directly or indirectly between some controlled foreign companies to their Australian shareholders.
An attributable taxpayer's assessable income will include only:

unrealised gains accumulated on tainted assets; and
adjusted tainted income other than non-portfolio dividends,

where a controlled foreign company changes residence from an unlisted to a listed country.

An attributable taxpayer's assessable income includes:

unrealised gains accumulated on all assets; and
all distributable profits,

where a controlled foreign company changes residence from an unlisted to a listed country.

Countries are either listed or unlisted. The unlisted category includes countries previously classed as limited-exemption listed countries. The listed class consists of those previously called broad-exemption listed countries. The previous limited-exemption listed country list is used for one provision only. The controlled foreign companies rules, dividend rules and branch profits rules apply differently depending on the country concerned. Countries are classified as either broad-exemption listed countries, limited-exemption listed countries or unlisted countries.

Detailed explanation of new law

Foreign non-portfolio dividends

2.13 Non-portfolio dividends paid from a company resident in a listed country are currently not included in the assessable income of resident company recipients. Some dividends paid by a company resident in an unlisted country may also not be included where the dividend is paid out of profits that were taxed in a listed country.

2.14 The previous policy was to exempt comparably taxed profits upon distribution to a resident company. Division 6 of Part X (about exempting receipts, profits and profits percentage) provided a mechanism for this, particularly for dividends paid by companies resident in unlisted countries. The Treasurer's announcement in Press Release No. 32 of 13 May 2003 meant that the comparable tax requirement was removed, allowing an exclusion from assessable income for all non-portfolio dividends.

2.15 Some of the profits of a foreign company might be taxed in Australia under Part X or Part XI but, apart from that, they are able to be repatriated to a resident company non-portfolio shareholder free of Australian company tax. This measure is principally aimed at removing the Australian company tax burden from active business income earned by a foreign subsidiary company resident in any foreign country. As a result of this policy change, section 23AJ now applies more simply to all non-portfolio dividends paid by foreign companies [Schedule 2, item 4, section 23AJ]. The policy change also means Division 6 is no longer required and is repealed [Schedule 2, item 57].

Foreign branch profits

2.16 Currently, resident companies do not include in assessable income certain foreign branch income and certain capital gains derived from a business carried on through a permanent establishment in a listed country. The amounts are not assessable and are not exempt income under section 23AH. A resident company may be a partner in a partnership or beneficiary of a trust that has a permanent establishment in a foreign country (there may also be several interposed partnerships and trusts between the resident company and the partnership or trust). In such circumstances, similar amounts of foreign branch income and capital gains, derived from a business carried on through the permanent establishment, are also exempt to the extent of the company's indirect interest in that income or those gains.

2.17 One of the main conditions for the current exemption is that the foreign income must be subject to tax in a listed country. Income taxed in a listed country generally means that the foreign income is considered to have been comparably taxed to income derived in Australia. Currently, listed countries are broad-exemption listed countries and limited-exemption listed countries. Broad-exemption listed countries are countries with very similar income tax systems to Australia while limited-exemption listed countries are countries with broadly comparable income tax systems to Australia. These definitions are to be repealed and the listed country definition will have a different meaning. These changes are discussed in more detail in paragraphs 2.99 to 2.104.

2.18 Currently, if the listed country is a broad-exemption listed country, the foreign income must not be eligible designated concession income in relation to any broad-exemption listed country for the exemption to apply. Eligible designated concession income is income that a particular country does not tax at all (such as dividends) or taxes at reduced rates to attract particular forms of business or financial activity. There is no active income test for a permanent establishment in a broad-exemption listed country by which all its income could be exempt.

2.19 If the listed country is a limited-exemption listed country, the foreign income must not be adjusted tainted income of the permanent establishment. Alternatively the permanent establishment must pass the active income test. Adjusted tainted income is broadly defined as passive income, tainted sales income and tainted services income. The foreign income must also have been subject to tax in a listed country for the exemption to apply.

2.20 Foreign branch capital gains and losses are disregarded where the gain or loss relates to a disposal of particular assets that are used wholly or principally to produce foreign income in carrying on a business in a listed country. The particular assets are land, buildings or depreciating assets, which are not Australian assets. Further, the gain must not be eligible designated concession income for a permanent establishment in a broad-exemption listed country or adjusted tainted income for a permanent establishment in a limited-exemption listed country.

2.21 The current section 23AH has been substituted with a new section 23AH. The new section provides an exemption to a resident company for most foreign income and gains (the exceptions are discussed below) derived through a foreign permanent establishment in either a listed or unlisted country. The exemption will also continue to be available to resident companies that are partners in a partnership or beneficiaries of a trust (or where there are several interposed partnerships and trusts). The exemption applies to the extent of the company's indirect interest in the amounts derived through the permanent establishment.

2.22 The amounts that continue to form part of assessable income of the resident company as a result of the new section 23AH more closely match the income that would be attributed under Part X from a controlled foreign company resident in the same foreign country as the permanent establishment.

No 'subject to tax' test

2.23 The 'subject to tax in a listed country' test in the current section 23AH has been omitted in the new section. There is no longer a concern with the level of foreign tax paid on either the profits from which a non-portfolio dividend is paid or the profits derived through a permanent establishment of a resident company. [Schedule 2, item 1, subsections 23AH(2) and (3)]

2.24 The removal of the subject to tax test is implicit in the existing decision for the non-portfolio dividend exemption in relation to the controlled foreign company case and was intended in the branch case. Retention of the requirement that the income be subject to tax in a listed country in the branch case would have been inconsistent with the stated policy of ensuring that active business income earned offshore would be free of Australian company tax.

Active income test

2.25 An active income test is currently provided for a company that has a permanent establishment in a limited-exemption listed country. However, an active income test is not available under the current rules for a permanent establishment in either a broad-exemption listed country or an unlisted country. To more closely mirror the controlled foreign company rules the new section 23AH provides an active income test for a permanent establishment in either a listed country (current broad-exemption listed countries) or an unlisted country (current limited-exemption listed countries and others). [Schedule 2, item 1, subsections 23AH(5) and (7)]

2.26 The active income test used in the new section 23AH is based on the active income test in section 432 of Part X. The section 432 active income test is used with some appropriate assumptions and certain modifications to make those provisions and other provisions that feed into that section work in a permanent establishment case. In particular, one assumption is to treat the permanent establishment as a separate entity from the company, trust or partnership entity to work out whether the entity has passed the active income test. [Schedule 2, item 1, subsection 23AH(12)]

2.27 Now that an active income test can be applied in relation to a permanent establishment in a listed or unlisted country, only where the permanent establishment fails the active income test would any foreign income be taxable in Australia to a resident company. That is, if the permanent establishment is predominantly deriving what is regarded as active income, all its income is exempt from Australian company tax.

2.28 If the permanent establishment fails the active income test, the only amounts of foreign income that may be included in the resident company's assessable income are amounts that are adjusted tainted income. The 'adjusted tainted income' definition is based on the same definition in Part X with appropriate assumptions and certain modifications to make those provisions and other provisions that feed into that section work in a permanent establishment case. [Schedule 2, item 1, subsection 23AH(13)]

2.29 A number of assumptions and modifications are the same for both the 'active income test' and the adjusted tainted income definition. The common assumptions are contained in subsection 23AH(14). [Schedule 2, item 1, subsection 23AH(14)]

2.30 The active income test and the adjusted tainted income definition in the new section 23AH are very similar to the active income test and the adjusted tainted income definition in the old provision. The main differences are as a result of the changes to the definition of tainted services income and the impact that those changes have on services provided to offshore entities. Generally, any income from the provision of services to non-residents or to the foreign permanent establishments of Australian residents will not be tainted services income. The active income test and adjusted tainted income definition in the old section 23AH would have been equally impacted by the tainted services income changes. Those changes are discussed in Chapter 3.

Foreign income

Permanent establishment in a listed country

2.31 Where a permanent establishment in a listed country fails the active income test, the foreign income that continues to be taxable is only foreign income that is adjusted tainted income and which is also eligible designated concession income. This concept is slightly narrower than that used in the old provision but more closely matches the income that would be attributed under Part X from a controlled foreign company resident in a listed country. [Schedule 2, item 1, subsection 23AH(5)]

Permanent establishment in an unlisted country

2.32 Where a permanent establishment in an unlisted country fails the active income test, the foreign income that continues to be taxable is only foreign income that is adjusted tainted income. This closely matches the income that would be attributed under Part X from a controlled foreign company resident in an unlisted country. [Schedule 2, item 1, subsection 23AH(7)]

Capital gains and capital losses

2.33 The active income test in subsection 23AH(12) does not include net capital gains in the calculation. Also, there is no exclusion for capital gains where a permanent establishment passes the active income test. This intentionally mirrors the policy in the old provisions that treated capital gains and capital losses separately without taking into account whether or not the permanent establishment passed the active income test.

2.34 Any gains or losses from capital gains tax (CGT) events that occur in relation to Australian assets (i.e. assets that have the necessary connection with Australia under section 136-25 of the Income Tax Assessment Act 1997 (ITAA 1997)) of a permanent establishment continue to be included in the resident company's net capital gains. The new section 23AH is not intended to provide any exemption for capital gains made in relation to the disposal of Australian assets by a resident company.

2.35 A capital loss that results from a CGT event happening to a tainted asset used in carrying on business through a permanent establishment may be included in the calculation of the resident company's net capital gains. A capital loss is included only where, if there had been a gain in relation to the CGT event, the gain would have been included in the calculation of the resident company's net capital gains. [Schedule 2, item 1, subsection 23AH(4)]

Permanent establishment in a listed country

2.36 A resident company includes in the calculation of its net capital gains any capital gain or capital loss as a result of a CGT event happening in relation to a tainted asset that is used in carrying on a business through a permanent establishment in a listed country where:

the gain is also eligible designated concession income; or
there is a loss but if there had been a gain, the gain would have been eligible designated concession income.

[Schedule 2, item 1, subsection 23AH(6)]

Permanent establishment in an unlisted country

2.37 A resident company includes in the calculation of its net capital gains any capital gain or capital loss arising as a result of a CGT event happening in relation to a tainted asset that is used in carrying on a business through a permanent establishment in an unlisted country. [Schedule 2, item 1, subsection 23AH(8)]

Interposed partnerships and trusts

2.38 The new section 23AH also provides an exemption to a resident company that is a beneficiary of a trust or a partner in a partnership (or where there are several interposed partnerships or trusts). The trust or partnership derives income through carrying on business through a permanent establishment in a listed or unlisted country. The amount that is not assessable and not exempt income under section 23AH depends on the resident company's indirect interest in the trust or partnership income.

2.39 The general principle is that the amounts that are included in assessable income of a resident company are the amounts that would have been included had the business of the permanent establishment been carried on directly by the resident company taking into account the company's actual portion of the income. Further, the net income of a trust or partnership in relation to a resident company will not include the permanent establishment income that would not have been assessable nor exempt income if the company had derived that permanent establishment income directly.

Foreign income

2.40 Firstly, in considering the permanent establishment as though it were a separate entity, determine whether it passes the active income test. If it does, then the resident company's share of the net income of a trust operating through the permanent establishment does not include any foreign income derived through the permanent establishment. Similarly, the resident company would not include in assessable income its interest in the partnership's net income to the extent any amount relates to the foreign income derived through the permanent establishment of the partnership. [Schedule 2, item 1, subsection 23AH(10)]

2.41 A resident company's interest in a partnership loss is calculated without taking into account foreign branch income that would have been non-assessable non-exempt income had the permanent establishment income been derived directly through the company's permanent establishment, where the permanent establishment passes the active income test. That is, if the foreign permanent establishment derived income that would not be assessable if a resident company's permanent establishment had derived the income, and in ignoring that foreign income the partnership had a partnership loss, then the resident company is entitled to its share of the partnership loss. [Schedule 2, item 1, subsection 23AH(10)]

2.42 Where the permanent establishment fails the active income test and it is in a listed country, the resident company's share of the net income of the partnership or trust, or its share of a partnership loss, includes a portion of the foreign branch income that is adjusted tainted income and eligible designated concession income. Similarly, where the permanent establishment is in an unlisted country, the resident company's share of the net income of the partnership or trust (or of a partnership loss) includes a portion of the foreign branch income that is adjusted tainted income. The amount included in the resident company's assessable income arising out of the permanent establishment operations would be the amount that the company would have derived if it had carried on business through the permanent establishment directly, to the extent of its actual interest. [Schedule 2, item 1, subsection 23AH(10)]

Capital gains and capital losses

2.43 Where a CGT event occurs in relation to a tainted asset used in carrying on a business through a permanent establishment of a trust in an unlisted country resulting in a capital gain, then so much of the resident company's share of the gain will be included in its share of the net income of the trust. Similarly, where the permanent establishment is in a listed country, then so much of the resident company's share of the gain that is eligible designated concession income will be included in its share of the net income of the trust. However, nothing is included in the net income of the trust for a gain on an asset that is not a tainted asset, as far as the resident company beneficiary is concerned. [Schedule 2, item 1, subsection 23AH(11)]

2.44 Where a capital loss results but an amount would have been included in the calculation of the resident company's share of the net income of the trust if there had been a gain in relation to the CGT event then the loss can also be included in the calculation. [Schedule 2, item 1, subsection 23AH(11)]

2.45 Partners in a partnership hold a proportionate share in the assets of a partnership. Where a CGT event occurs in relation to a tainted asset of the partnership that is used in carrying on business through a permanent establishment in an unlisted country, then a resident company partner includes in its calculation of net capital gains the amount of the capital gain or capital loss in relation to the tainted asset. [Schedule 2, item 1, subsection 23AH(11)]

2.46 If the tainted asset of the partnership is used in carrying on business through a permanent establishment in a listed country then the capital gain must also be eligible designated concession income. A capital loss can be used in calculating net capital gains of a partner if instead of a loss there was a gain that would also be eligible designated concession income. [Schedule 2, item 1, subsection 23AH(11)]

2.47 The provisions also operate through several interposed partnerships or trusts and relate only to the resident company's share of the foreign income, capital gains or capital losses.

Example 2.1 Aust Co is a 50% partner in a partnership, For Co is the other partner. The partnership carries on a mining business through a permanent establishment in an unlisted country. The partnership's income year starts on 1 July as does Aust Co's income year.In the 2006-2007 income year, the income from the mining business is $100, another $150 is net tainted rental income from leasing some equipment to another entity. This is the only income of the partnership. The equipment that was leased is sold in December 2006. The total capital gain is $20. Each partner's share of the gain is $10.The amount that Aust Co includes in its assessable income is 50% of the $150 of tainted income and $10 of the capital gain from the disposal of the tainted asset.

Certain dividends and foreign branch profits not included in attributable income

2.48 The controlled foreign companies rules in Part X generally provide for income to be attributed to Australian resident taxpayers where they have a controlling interest in a foreign company. Section 389 specifically excludes the operation of sections 23AH and 23AJ for the purposes of calculating the amount to be attributed (the controlled foreign company's attributable income). However, similar provisions essentially replicate those sections within the controlled foreign companies rules. The current provisions dealing with non-portfolio dividends and foreign branch profits in a similar way are paragraphs 402(2)(c) and (d), section 403 and to some extent section 404.

Non-portfolio dividends received by a controlled foreign company

2.49 The expanded section 23AJ makes all non-portfolio dividends non-assessable non-exempt income. The controlled foreign companies rules will be aligned more directly with this approach. This alignment will be achieved by removing from section 389 the reference to section 23AJ [Schedule 2, item 5, paragraph 389(a)]. This will allow the section 23AJ expanded exemption to apply to the calculation of attributable income and removes the need for paragraphs 402(2)(c), (d) and 403(b). Section 404 is discussed further in paragraph 2.104 [Schedule 2, item 6; item 7, section 403].

2.50 Since all non-portfolio dividends received by a controlled foreign company will no longer be included in its attributable income, they are also excluded from the active income test. This is to prevent their inclusion in the test from leading to the attribution of other tainted income. [Schedule 2, item 70, paragraph 436(1)(e)]

Removing section 458

2.51 Section 458 also deals with non-portfolio dividends and directly includes in the assessable income of a resident attributable taxpayer a non-portfolio dividend paid from one controlled foreign company to another controlled foreign company or to a controlled foreign trust or an interposed partnership or trust. This section is no longer appropriate for dividends paid by one controlled foreign company to another because all non-portfolio dividends received directly or indirectly by a controlled foreign company are to be exempt from attribution.

2.52 The current operation of section 458 is generally restricted to cases where non-portfolio dividends are paid by a controlled foreign company in an unlisted country to one in a listed country that does not subject the dividend to normal taxation. This was partly because of the previous policy of restricting the exemption for non-portfolio dividends paid to resident companies to dividends paid out of comparably taxed profits. Since this is no longer the policy, another rationale for the current provision is removed. Therefore section 458 is repealed. [Schedule 2, item 8]

2.53 Although the section is repealed, those non-portfolio dividends would be included in the net income of a trust or partnership where they are paid to a controlled foreign trust, an Australian trust or a partnership. This could lead to an amount being included in the attributable income of a controlled foreign company that is a beneficiary of the trust or a partnership. The same outcome would also occur where a non-portfolio dividend is deemed to be paid as a result of section 47A.

2.54 As well as reducing the payment of Australian tax and so removing a possible barrier to the more efficient use of capital, the removal of section 458 will also considerably reduce compliance costs and complexity.

Foreign branch profits of a controlled foreign company

2.55 A similar provision in Part X, paragraph 403(a), replicates the purpose of section 23AH in relation to a controlled foreign company resident in an unlisted country that carries on business through a permanent establishment in a broad-exemption listed country. This notional exemption is more generous than the current exemption in section 23AH as paragraph 384(2)(a) starts with an amount that is adjusted tainted income. The notional exemption in paragraph 403(a) ensures the amount is also eligible designated concession income. The section 23AH exemption only excludes income that is not eligible designated concession income whether or not the income was adjusted tainted income.

2.56 The provision in section 23AH that exempts certain foreign income derived through a permanent establishment in a limited-exemption listed country is not mirrored in Part X for a controlled foreign company resident in an unlisted country. However, the normal operation of paragraph 384(2)(a) ensures that amounts derived by that controlled foreign company from a permanent establishment in a limited-exemption listed country that would be attributed to a resident entity are similar to the amounts that would be assessed to a resident company.

2.57 Where a controlled foreign company is resident in a limited-exemption listed country, paragraph 384(2)(aa) provides a similar result to section 23AH in relation to a controlled foreign company that carries on business through a permanent establishment. Paragraph 384(2)(aa) includes certain amounts in attributable income that are not adjusted tainted income, where those amounts have not been subject to tax in a listed country. Where a controlled foreign company is resident in a broad-exemption listed country and carries on business through a permanent establishment in any foreign country, the normal operation of paragraph 385(2)(a) achieves the desired result.

2.58 The policy behind the introduction of the new sections 23AH and 23AJ is mirrored in the Part X provisions by repealing paragraph 384(2)(aa) and amending section 403. This ensures there is no longer a 'subject to tax' test for income derived by a controlled foreign company where that income is not adjusted tainted income. [Schedule 2, item 58; item 7, section 403]

2.59 The new section 403 provides for an additional notional exempt income amount where a controlled foreign company resident in an unlisted country carries on business through a permanent establishment in a listed country. The range of situations to which this will apply has been changed because of the changed meaning of listed and unlisted countries as discussed in paragraphs 2.99 to 2.104.

Section 47A and section 459 changes

Section 47A

2.60 The current section 47A deems certain distributions from controlled foreign companies in unlisted countries to be dividends. If a resident entity treats the amount as a dividend then the amount is treated as a dividend for all purposes of the ITAA 1936 and the ITAA 1997. If the amount is not treated as a dividend but should have been, the deemed dividend is included in assessable income. No foreign tax credits are allowed and the dividend is not treated as non-assessable non-exempt income under section 23AI or section 23AJ.

2.61 Section 47A will still operate to deem amounts to be dividends and, in some cases, that amount will be included in assessable income of a resident under section 44. With the change to section 23AJ, all non-portfolio dividends will be exempt, including deemed dividends under section 47A paid from a controlled foreign company resident in an unlisted country to a shareholder with a non-portfolio interest. This change means the penalty provision in section 47A that causes concern to resident companies will not be applied to prevent the application of section 23AJ. To the extent a deemed dividend is paid to a resident company and it meets the definition of a non-portfolio dividend the resident company will exclude it from the calculation of assessable income in the preparation of its income tax return. [Schedule 2, item 17, subsection 47A(2)]

2.62 The repeal of section 458 and Division 6 of Part X also impact on the application of section 47A which has been amended to take account of those changes. [Schedule 2, items 16 to 19, subsections 47A(2), (7) and (16)]

Section 459

2.63 Section 459 interacts with section 47A to ensure profits transferred from a controlled foreign company in an unlisted country to another controlled foreign company (or to a controlled foreign trust or an interposed partnership or trust) are included in a resident attributable taxpayer's assessable income. Both controlled foreign companies have to have a common attributable taxpayer. Section 458 may also have operated in this situation but section 459 only operated where section 458 did not apply (i.e. where the deemed dividend would not be a non-portfolio dividend).

2.64 Similar arguments discussed in paragraphs 2.51 to 2.54 for the repeal of section 458 apply equally to section 459 which is also repealed [Schedule 2, item 8]. This is intended only to remove the special direct attribution of the dividend amounts to the attributable taxpayer.

2.65 Amounts that are deemed to be dividends by section 47A may be included in attributable income of a controlled foreign company with the repeal of paragraph 402(2)(da) [Schedule 2, item 6]. An amount that is a deemed dividend and is a portfolio dividend may be included in an attributable taxpayer's assessable income under section 456. In a similar way to where section 458 could have applied to a deemed dividend, an amount could also be included in the attributable income of a controlled foreign company via the net income of an interposed partnership or trust. Whether the deemed dividend paid to a resident or non-resident associate of the controlled foreign company is taxable will depend on the general assessment or Part X provisions.

Section 423

2.66 Section 423 has been amended to reflect the fact that a deemed dividend may now be included in attributable income which will be assessable to a resident taxpayer under section 456 rather than via section 458 or section 459 [Schedule 2, item 69, paragraph 423(2)(d)]. A deemed dividend may be taxed to a resident attributable taxpayer where an asset has been transferred by their controlled foreign company for less than market value to another of their controlled foreign companies. A capital gain may arise where the asset is later disposed of by the second controlled foreign company. Section 423 prevents double taxation where any amount of the capital gain relates to the previously taxed deemed dividend. The capital gain amount is reduced by the amount on which the attributable taxpayer has paid tax.

2.67 Section 116-85 of the ITAA 1997 is a provision that essentially achieves the same purpose as section 423 for a resident entity disposing of an asset. Item 3 in the table in subsection 116-85(1) has been rewritten and the whole of subsection 116-85(3) has been repealed. Subsection 116-85(3) was repealed because it was no longer needed to explain how a capital gain was calculated for a resident company which is automatically calculated under Parts 3-1 and 3-3 of the ITAA 1997 anyway. Item 3 in the table in subsection 116-85(1) was rewritten because part of it is no longer required. [Schedule 2, item 81, item 3 in the table in subsection 116-85(1) of the ITAA 1997; item 82]

Section 457 changes

2.68 Section 457 currently attributes an amount directly to an attributable taxpayer in a controlled foreign company that changes residence from an unlisted country to a listed country or to Australia. This was to ensure that amounts that had not been attributed from the unlisted country controlled foreign company could not be repatriated to Australia free of the tax that would normally be paid on a non-portfolio dividend from that controlled foreign company. The amount that was attributable was the taxpayer's share of the distributable profits of the controlled foreign company at the time it changed residence plus net unrealised gains on the controlled foreign company's assets. The amount could be reduced to the extent that those profits could have been distributed free of tax under section 23AI because of earlier attribution of income from the controlled foreign company.

2.69 With the extension of the exemption for non-portfolio dividends to all countries, this provision is not required to the same extent. In particular, there is no need to tax the distributable profits of past statutory accounting periods. The removal of the attribution of these amounts at the time of the residence change reflects the policy that Australian tax should only be paid, if at all, when these profits are distributed to resident shareholders or under the general controlled foreign companies rules. Along with that change, there is also no need to avoid possible double taxation by deducting the taxpayer's attribution surplus in the controlled foreign company. All the references to attribution surplus have been removed. [Schedule 2, items 71 and 73]

2.70 The amount to be attributed under section 457 is principally the amount that would be attributed for the period since the end of the preceding statutory accounting period of the controlled foreign company if it had remained a resident of the unlisted country. Non-portfolio dividends received by the controlled foreign company in that period will not be included in the calculation under section 457 because they will no longer be included in attributable income. [Schedule 2, item 72, subsection 457(2), definition of 'adjusted distributable profits']

2.71 As is currently the case, there is an adjustment to that basic amount for unrealised gains on its assets in the case where the controlled foreign company becomes a resident of a listed country. However, now those unrealised gains are limited to those on the tainted assets of the controlled foreign company because Australian tax is not to be imposed on gains on the disposal of its 'active' assets, even on distribution to a non-portfolio shareholder. The reference to adjusted tainted income in this case picks up the modifications to the cost bases of what are called 'commencing day assets' in Subdivision C of Division 7 of Part X. Where some of those tainted assets are shares in other foreign companies, the measure discussed in Chapter 1 may be applicable to reduce the notional gain or loss arising from the assumed disposal of those shares. [Schedule 2, item 72, subsection 457(2), definition of 'adjusted distributable profits']

Foreign tax credits

2.72 Foreign tax credit provisions were introduced in Division 18 of Part III to prevent international double taxation. A foreign tax credit is generally provided where a resident entity includes foreign income in its assessable income and foreign tax was paid on the foreign income (section 160AF). Where a resident company receives a foreign dividend from a foreign related company, foreign tax credits are also available for the foreign tax paid on the profits from which the dividend was paid (section 160AFC). For this to occur, the dividend must be included in assessable income (section 160AF).

2.73 With the introduction of the new measures, all non-portfolio dividends will be excluded from assessable income. This means that foreign tax credits would not be required to prevent double taxation in relation to non-portfolio dividends. In particular, foreign tax credits for underlying foreign company tax will not be required, which allows section 160AFC to be repealed. [Schedule 2, item 37]

2.74 The repeal of section 160AFC impacts on several other provisions but generally the foreign tax credit facilitated by section 160AFC was only available if a resident company received a non-portfolio dividend. The impact on other provisions is discussed below.

2.75 Section 160AFC was the mechanism for calculating the foreign tax credit to be allowed for underlying company tax when a company received an assessable foreign dividend from a related company. The conditions for a dividend paid from a related company (as defined in section 160AFB) are similar to the conditions for a non-portfolio dividend.

2.76 Dividends paid by a related foreign company to a resident company may not always be non-portfolio dividends and thus are included in the assessable income of the company receiving them. With the repeal of section 160AFC, foreign tax credits for underlying foreign company tax will no longer be available for those related company dividends that are included in assessable income of a resident company. However, the resident company will still be entitled to foreign tax credits for foreign tax paid on the dividends.

2.77 If certain finance share dividends (which cannot be non-portfolio dividends) were paid to a resident company, section 160AO specifically restricted the amount of the foreign tax credit that may otherwise arise. The underlying company tax amounts were excluded from the meaning of foreign tax paid by the company by subsection 160AO(4). Repealing section 160AFC ensures underlying foreign tax credits are no longer available for finance share dividends and means that section 160AO can be simplified (as well as not having to consider or remember its application). [Schedule 2, item 44]

Foreign tax credits in relation to attributable income

2.78 Section 160AFCA ensures a foreign tax credit can arise for a resident company where foreign tax is paid on an amount that is included in assessable income under section 456. It no longer provides underlying foreign tax credits.

2.79 Section 160AFCA relies in part on a notional deduction being available under section 393. Under section 393 foreign or Australian taxes paid by a controlled foreign company in relation to amounts included in notional assessable income are notional allowable deductions. This provision also includes in the amount of foreign tax, the amount calculated under section 160AFC in relation to non-portfolio dividends paid to controlled foreign companies that are included in notional assessable income (subsection 393(2)). There is no further requirement for this notional deduction as a controlled foreign company will no longer include a non-portfolio dividend in notional assessable income.

2.80 Subsections 393(2) and 393(3) are repealed with the extension of the exemption for all non-portfolio dividends. [Schedule 2, item 67]

2.81 Section 160AFCB ensures a foreign tax credit can arise where foreign tax is paid on an amount that is included in assessable income under section 457 because of a change of residence of a controlled foreign company. It also provides a foreign tax credit for underlying foreign company tax amounts if a non-portfolio dividend is included in the amount attributed under section 457 to a resident company.

2.82 Amounts may continue to be attributed under section 457 but this provision has been modified to ensure non-portfolio dividends are not attributed. (The modifications to section 457 are discussed in paragraphs 2.69 to 2.71.) Section 160AFCB has been rewritten to remove the references to non-portfolio dividends and section 160AFC. [Schedule 2, item 38, section 160AFCB]

2.83 Section 160AFCC ensures a foreign tax credit can arise where foreign tax is paid on an amount that is included in assessable income under section 458. In the future no amounts are included in assessable income under section 458 as the provision is repealed. (The repeal of section 458 is discussed in more detail in paragraphs 2.51 to 2.54.) This means that section 160AFCC can also be repealed. [Schedule 2, item 39]

Foreign tax credits for previously attributed income

2.84 Double Australian taxation could arise when previously attributed foreign income is repatriated. However, this is avoided by providing an exemption under section 23AI for dividends paid from a controlled foreign company out of previously attributed income. A similar exclusion is provided for dividends paid from a foreign investment fund under section 23AK. Nevertheless, an entity may have paid foreign tax on the distributed income after attribution as well as Australian tax when the income was attributed. This means, to some extent, there could continue to be double taxation on the distributed amounts. However, sections 160AFCD and 160AFCJ ensure an entity is entitled to foreign tax credits for foreign tax paid on amounts that are not included in assessable income because of sections 23AI and 23AK, respectively.

2.85 The foreign tax credits available under sections 160AFCD and 160AFCJ relate to the direct withholding tax paid on the dividend. A further credit to a resident company may also be available under these sections for underlying foreign tax that was paid in relation to the foreign income from which the non-portfolio dividend was paid to the resident company. The current meaning of underlying tax in those provisions includes an amount of foreign tax calculated under section 160AFC to pick up this latter credit.

2.86 The repeal of section 160AFC means that the definition of 'underlying tax' contained in sections 160AFCD and 160AFCJ cannot be applied. However, to ensure underlying foreign tax credits will continue to be available, a new definition of underlying tax has been inserted into those provisions. [Schedule 2, item 41, subsection 160AFCD(2); item 43, subsection 160AFCJ(4)]

Non-portfolio dividends and underlying tax credits - section 160AFCD

2.87 A number of conditions in the new definition of underlying tax are similar to the old requirements. The new definition of underlying tax in section 160AFCD applies where:

an attribution account payment which is a non-portfolio dividend is paid to a resident company;
that attribution account payment includes an amount that is not assessable because of section 23AI; and
foreign tax has been paid in relation to the attribution account payment. The foreign tax can include foreign tax paid on the profits from which the non-portfolio dividend was paid.

2.88 An attribution account payment which is a non-portfolio dividend may ultimately be paid to a resident company through a chain of interposed foreign companies. In such circumstances, foreign tax credits may be available for foreign underlying tax paid by the interposed foreign companies. However, the tax credits are limited to the foreign tax paid on the profits from which the non-portfolio dividend was paid to the resident company to the extent that it relates to the exempt section 23AI part.

2.89 If the conditions in paragraph 2.87 are satisfied, the amount of the underlying tax the resident company is entitled to claim as a foreign tax credit is:

the amount of foreign tax paid by the company making the attribution account payment (the non-portfolio dividend) on the profits from which the dividend was paid; and
where non-portfolio dividends are paid through a chain of interposed companies, the amount of foreign tax paid on the profits from which those dividends were paid and any withholding tax paid on them.

2.90 The amount of the credit is limited to that portion of the underlying tax that relates to the proportion of profits that were actually distributed and which can be traced to previously attributed income. It is the amounts by which the section 23AI part of the dividend would have been greater if there had been no foreign tax paid [Schedule 2, item 41, subsection 160AFCD(2), definition of 'underlying tax']. This is best illustrated by Example 2.2.

Example 2.2

Diagrammatic representation of Example 2.2

Aust Co is an attributable taxpayer in relation to all three companies, B Co, C Co and D Co, in this example. The statutory accounting periods and income years are 1 July to 30 June. Aust Co keeps attribution accounts in relation to B Co, C Co and D Co to enable it to claim a non-assessable non-exempt amount under section 23AI. Assumptions B Co earns income of $100 that is attributed to Aust Co on 30 June 2005. On 1 July 2006 B Co pays C Co a non-portfolio dividend of $100.The non-portfolio dividend is C Co's only income. C Co pays company tax of $2 on its income of $100. On 1 July 2007 C Co pays D Co a non-portfolio dividend of $98.Country C imposes a withholding tax of 5% ($4.90) on the dividend paid to D Co by C Co. The non-portfolio dividend is D Co's only income. D Co does not pay any further company tax on its income.On 1 August 2008 D Co pays Aust Co a non-portfolio dividend of $93.10. Country D imposes a withholding tax of 2% ($1.86) on the payment of that dividend. Calculation of the underlying tax The underlying tax component according to the definition of the underlying tax in section 160AFCD would consist of:

the tax paid by C Co - $2 of company tax; and
the tax paid by D Co - $4.90 of dividend withholding tax.

The underlying tax amount is $6.90. If this amount of foreign tax hadn't been paid, the section 23AI exempt part would have been that much greater. Calculation of underlying tax where only part of the attribution account surplus is paid If D Co had chosen to distribute only part of the profits that formed the attribution account surplus in D Co's attribution account then only part of the credit for underlying tax paid would be provided. For example, if D Co had paid Aust Co a $50 dividend on 1 August 2008 the amount of underlying tax credit would be:

50 / 93.1 * 6.90 = $3.71

Credit for direct taxes

The withholding tax of 2% imposed by country D on the payment of the non-portfolio dividend to Aust Co is taken into account as the direct tax component in the formula in paragraph 160AFCD(1)(b).

Non-portfolio dividends and underlying tax credits - section 160AFCJ

2.91 Section 160AFCJ also contains a definition of 'underlying tax' which operates in much the same way as the underlying tax definition explained in relation to section 160AFCD (see paragraphs 2.87 to 2.90).

2.92 A resident company is able to claim a foreign tax credit in relation to a foreign investment fund attribution account payment that is exempt under section 23AK. The amount of a credit for foreign underlying tax is calculated in relation to a foreign investment fund attribution account payment which is a non-portfolio dividend. As discussed in relation to section 160AFCD the amount of the credit is the amount by which the section 23AK part of the dividend would have been greater if there had been no foreign tax paid. [Schedule 2, item 43, subsection 160AFCJ(4), definition of 'underlying tax']

2.93 The amendments to the underlying tax definition in section 160AFCJ have not affected the meaning for underlying tax that currently relates to an entity that is deemed to have paid tax under subparagraph 6AB(3)(a)(ii).

Changes to attribution account credits and debits

2.94 Attribution accounts are the mechanism used by resident attributable taxpayers to keep track of attributed foreign income that has been included in their assessable income. The accounts also keep track of attribution account balances as they are moved via distributions of profits from the controlled foreign company, whose income was previously attributed, directly or indirectly to the attributable taxpayer.

2.95 A resident attributable taxpayer is able to claim an amount as exempt under section 23AI to the extent of the attribution account payment (usually a dividend) or the amount of the attribution surplus for the entity making the payment, whichever is the lesser amount. Separate attribution accounts are kept for each interposed company in the chain. The successive credits and debits to those attribution accounts enable the tracing of attribution account balances until the payment to the resident. As discussed above, foreign tax credits are available for amounts exempt under section 23AI. The attribution accounts are also used to trace amounts paid between interposed companies in working out the amount of underlying foreign tax that relates to an exempt section 23AI part of a non-portfolio dividend.

2.96 Section 371 defines circumstances that give rise to a credit to the attribution account (an attribution credit). In particular, an attribution credit arises where an amount is included in the assessable income of a taxpayer because of section 458. Amounts are no longer included in the assessable income of a taxpayer under section 458. This means an attribution credit is no longer required and paragraph 371(1)(c) and the related subsection 371(3) are repealed. [Schedule 2, items 51 and 52]

2.97 Section 372 defines circumstances that give rise to a debit to the attribution account (an attribution debit). Subsection 372(3) reduces an attribution debit where a company resident in an unlisted country pays a non-portfolio dividend to the attributable taxpayer or to an interposed company. The purpose of this provision is to maximise the amount of the dividend that would be exempt under the old section 23AJ (or the equivalent for an interposed controlled foreign company). The amount of the attribution debit was then determined by the balance of the attribution account and the remaining amount of the dividend.

2.98 The treatment for dividends from listed countries was different. The attribution debit was determined largely by the attribution account balance. Any remaining amount of the dividend would always be exempt under the old section 23AJ (or the equivalent provision for a controlled foreign company). Since non-portfolio dividends from all countries are to be exempt there is no longer a need to have this special ordering rule and therefore subsection 372(3) is repealed. [Schedule 2, item 55]

Changing the definitions of listed and unlisted country

2.99 A further consequence of the extended exemption for non-portfolio dividends is the modification of the listing of countries. There are currently two types of listed counties in Schedule 10 of the Income Tax Regulations 1936: broad-exemption listed countries in Part 1 and limited-exemption listed countries in Part 2.

2.100 The seven countries on the broad-exemption listed country list are considered to have income tax systems very similar to Australia's. More than 50 countries on the limited-exemption listed country list have income tax systems considered to be broadly comparable to Australia's, but not to the same extent as for broad-exemption listed countries. Most countries with which Australia has a double tax agreement are listed countries on either the broad-exemption listed country or the limited-exemption listed country list.

2.101 The purpose of this system is to provide more favourable tax treatment to listed countries that tax comparably to Australia than to unlisted countries which generally don't have a comparable tax system to Australia. The profits of companies resident in a broad-exemption listed country are treated most favourably. For example, a limited range of income is attributable under the controlled foreign companies rules. Currently, for companies resident in limited-exemption listed countries, the main aspect of the favourable tax treatment is an exemption for non-portfolio dividends.

2.102 This expansion of the non-portfolio dividend exemption to all countries largely removes the purpose of the limited-exemption listed country list and makes it unnecessary to have two separate types of listed countries. The current broad-exemption listed country and limited-exemption listed country definitions will be repealed as those terms will no longer be used. [Schedule 2, items 85 and 86]

2.103 More favourable tax treatment is still available to the seven broad-exemption listed countries. These countries will be reclassified as listed countries [Schedule 2, item 87, subsection 320(1)]. This change will result in all other countries, including the current limited-exemption listed countries, falling within the category of unlisted countries. All countries will have the same treatment for non-portfolio dividends, rather than the current case which only applies to broad-exemption listed countries and limited-exemption listed countries. This is the Government's announced intention.

2.104 The list of countries currently designated as limited-exemption listed countries will remain relevant for one purpose. Section 404 excludes from attributable income all dividends (including portfolio dividends) paid from a company resident in any listed country to a controlled foreign company that is also resident in a listed country. To allow this treatment to continue to apply, in particular for portfolio dividends, the current limited-exemption listed countries will be reclassified as section 404 countries [Schedule 2, item 89, subsection 320(1), definition of 'section 404 country'; item 90, section 404]. The necessary changes to the regulations to reflect these new names for the lists of countries will be made as soon as possible.

Application of measures to consolidated groups

2.105 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 provisions

2.106 The expanded exemption for non-portfolio dividends and related changes contained in Part 2 and 3 of Schedule 2 to this bill apply to dividends paid after 30 June 2004. It is irrelevant when the profits were earned to pay those dividends. It is also irrelevant in which income year or statutory accounting period the dividend is paid as long as it is after 30 June 2004.

2.107 The expanded exemption for foreign branch profits and the consequential change to the restriction for deductions for certain bad debts applies to income years starting on or after 1 July 2004.

2.108 The changes contained in Part 4 (about changes to the classification of countries and the definition of a listed country) and Part 5 of Schedule 2 to this bill (consequential changes in relation to the changes to the classification of countries) apply to income years of a resident entity starting on or after 1 July 2004. Where the changes in Parts 4 and 5 relate to calculating the attributable income of a controlled foreign company, the changes apply to statutory accounting periods starting on or after 1 July 2004.

Consequential amendments

2.109 Consequential amendments have been made to several provisions to remove references to provisions that have been repealed. For example, all references to sections within Division 6 of Part X, sections 160AFC, 458 and 459 have been removed from all provisions as those sections have been repealed.

2.110 The repeal of the definitions of broad-exemption listed country and limited-exemption listed country has resulted in consequential amendments to several provisions to remove references to those names. Generally, where the term 'broad-exemption listed country' is used the term 'listed country' has replaced that term.

2.111 Other consequential amendments of a more substantial nature are discussed below or have already been discussed.

Section 63D

2.112 The changes to section 23AH impact on section 63D which restricts the amount of a deduction for a bad debt incurred in a money lending business where the income would have been exempt under section 23AH. Section 63D has been modified to take account of the fact that this provision can now apply to branches in all foreign countries. [Schedule 2, item 2, subsection 63D(1); item 3, subsection 63D(2)]

Changes to the foreign dividend account provisions

2.113 The current foreign dividend account measure in Subdivision B of Division 11A of Part III was introduced to enable certain foreign source dividends paid to a resident company to be paid to non-resident shareholders free from dividend withholding tax to the extent that Australian company tax is not paid on the foreign dividends. The measure related to non-portfolio dividends either exempt under section 23AJ or which were included in assessable income but for which a foreign tax credit reduced the Australian tax payable.

2.114 The exemption from dividend withholding tax is provided where a resident company pays an unfranked dividend from the foreign dividend account. Broadly, the foreign dividend account is credited with foreign non-portfolio dividends and is debited with expenses, including Australian tax, that relate to those dividends. A debit also arises where a dividend is paid to foreign shareholders free of dividend withholding tax.

2.115 The change to expand the operation of section 23AJ impacts on the foreign dividend account rules which can now be simplified. Non-portfolio dividends will no longer be included in assessable income which means the foreign dividend account provisions dealing with assessable non-portfolio dividends can be repealed. The only credit to a foreign dividend account is where a resident company receives a non-portfolio dividend that is not assessable and not exempt income under section 23AJ [Schedule 2, item 25, subsections 128TA(1) and (2)]. There will no longer be a requirement for debits to the foreign dividend account that relate to Australian tax paid [Schedule 2, items 27 and 28].


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