Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Chapter 3 - Tainted services income
3.1 Schedule 3 to this bill amends sections 448 and 450 of the Income Tax Assessment Act 1936 (ITAA 1936) to reduce the scope of tainted services income. Tainted services income will, in general, no longer include income from services provided by a company to a non-resident associate, or the overseas permanent establishment of an Australian resident. The amendments will improve the international competitiveness of Australian companies.
3.2 Unless otherwise stated, all legislative references are to the ITAA 1936.
3.3 The amendments are part of the Government's response to the Board of Taxation's report to the Treasurer on international taxation. Reducing the scope of tainted services income will improve the competitiveness of Australian companies with offshore operations, and reduce their compliance costs.
3.4 The controlled foreign companies rules include in the taxable income of an Australian taxpayer, the taxpayer's share of the specified income (known as attributable income) of a non-resident company in which they have a controlling interest. The income targeted for attribution is income that can readily be shifted offshore by taxpayers to non-resident companies that they own or control, to take advantage of any lower tax rates offshore. An equivalent approach is applied to the offshore permanent establishments (branches) of Australian companies.
3.5 One category of attributable income is called tainted services income. Tainted services income is, in general, income from services provided by a company to an Australian resident or to an associate of the company (including non-resident associates). It also includes income from services provided to a non-resident in connection with a business carried on by the non-resident through a permanent establishment in Australia.
3.6 Australian company groups with offshore operations often have a dedicated company provide particular services (e.g. computing services) to other group companies. Australian companies using such service centres are subject to the controlled foreign companies rules. Income earned by the service centres is currently tainted services income, with attendant tax and compliance costs. This, and the application of the rules in other cases involving offshore associates, puts Australian companies at a disadvantage against competitors not subject to equivalent rules.
3.7 This bill amends tainted services income to exclude income from services provided to non-resident associates, or the overseas permanent establishments of Australian residents. The changes will allow Australian companies to compete better internationally, with negligible risk to the tax base. They also provide a generally more neutral treatment between services provided to group companies by offshore service centres (currently attributable) as against the internal generation of those same services within each offshore group company (currently not attributable).
3.8 Services provided to Australian customers (Australian residents, other than in respect of their overseas permanent establishments, and non-residents' permanent establishments in Australia) will remain part of tainted services income. The amendments include a provision designed to prevent the amendments being misused to allow services to be provided to Australian customers in a way that falls outside of tainted services income.
3.9 The amendments in this Schedule generally reduce the scope of tainted services income. In general, tainted services income will now only include income from providing services to an Australian resident (other than in respect of an overseas permanent establishment), or to a non-resident in respect of a permanent establishment in Australia. Income from services provided indirectly to Australian residents, or the Australian permanent establishment of a non-resident, will be included in tainted services income, subject to certain requirements.
3.10 The amendments will apply to statutory accounting periods of companies beginning on or after 1 July 2004.
|New law||Current law|
|Tainted services income includes, in general, income from the provision of services by a company to:
|Tainted services income includes, in general, income from the provision of services by a company to:
|The same-country exemption is no longer required, as income from services provided to non-resident associates will, in general, no longer be included in tainted services income.||An exemption (the 'same-country exemption') applies to income from services provided to an associate that is a controlled foreign company and resident of the same (overseas) country as the service provider, subject to certain conditions.|
|Tainted services income also includes relevant income (including premium income) from providing services indirectly, subject to certain requirements.||No equivalent general provision exists in the current law.
Premium income from the indirect provision of reinsurance is included in tainted services income.
3.11 The new law generally reduces the scope of tainted services income. It does not otherwise alter the existing use of the tainted services income concept, which is:
- the tainted services income of a company that is a controlled foreign company may be attributed to Australian taxpayers with an attributable interest in that controlled foreign company (Part X); and
- the tainted services income of an overseas permanent establishment of an Australian resident company may be included in the assessable income of the company (section 23AH).
3.12 Currently, tainted services income includes income from providing services to an associate or to a 'Part X Australian resident' (referred to herein as a 'resident') (paragraph 448(1)(a)). Tainted services income also includes income (other than premium income) from providing services to an entity that is not a Part X Australian resident (a 'non-resident') in connection with a business carried on at a permanent establishment of the entity in Australia (paragraph 448(1)(b)).
3.13 Premium income in respect of providing insurance is treated separately from other services income (paragraphs 448(1)(c) to (e)). Certain income and gains of a company that is an Australian financial institution subsidiary are also included in tainted services income (subsections 450(6) to (8)).
3.14 The amendments have the effect of generally removing from the scope of tainted services income, the income a company derives from providing services to non-resident associates. [Schedule 3, item 1, paragraph 448(1)(a)]
3.15 The removal of services provided to non-resident associates is applied consistently to the treatment of insurance premium income and relevant Australian financial institution subsidiary income. [Schedule 3, item 2, paragraph 448(1)(c); item 3, subparagraph 448(1)(d)(i); item 4, paragraphs 448(1)(e) and (f); item 7, subparagraph 450(6)(c)(i); item 8, subparagraph 450(7)(d)(i); item 9, subparagraph 450(8)(b)(i)]
3.16 The existing same-country exemption (subsection 448(6A)) is repealed as removing services provided to non-resident associates makes it redundant. (Under the existing exemption, income from services provided by a controlled foreign company to another controlled foreign company that is an associate and resident in the same overseas country is not included in tainted services income, subject to certain conditions.) [Schedule 3, item 6]
3.17 The amendments provide for a more consistent treatment of income from services provided by a company to an entity in connection with a business carried on by that entity at a permanent establishment in Australia or in another country.
3.18 The current law includes in tainted services income, income (other than premium income) from services provided to a non-resident entity in connection with a business carried on by the entity at a permanent establishment in Australia. That is, the Australian permanent establishment of a non-resident is treated like a resident. The amendments extend this approach to premium income from providing reinsurance. [Schedule 3, item 4, paragraph 448(1)(f)]
3.19 The above approach is not formally extended to income from providing life and general insurance. In the life insurance case, a reference to a permanent establishment is unnecessary as it would have no practical application. In relation to general insurance, premium income from insuring property situated in Australia or events that can only happen in Australia is currently included in tainted services income. In effect, this current treatment already captures most general insurance that would be provided to the Australian permanent establishment of a non-resident.
3.20 The amendments also introduce an equivalent treatment for services provided to the overseas permanent establishments of residents compared with services provided to non-residents. That is, in general, income from such services will not be included in tainted services income. This achieves a symmetrical treatment between Australian permanent establishments (treated like residents) and overseas permanent establishments (treated like non-residents). [Schedule 3, item 1, subparagraph 448(1)(a)(ii); item 3, subparagraph 448(1)(d)(i); item 4, subparagraph 448(1)(e)(ii); item 7, subparagraph 450(6)(c)(i); item 8, subparagraph 450(7)(d)(i); item 9, subparagraph 450(8)(b)(i)]
3.21 Income from services provided by a company to a resident (other than in respect of an overseas permanent establishment) or the Australian permanent establishment of a non-resident, is to remain tainted services income. To prevent these amendments being used to avoid that result, income from such services provided, in effect, indirectly by a company will also be tainted services income in certain circumstances. [Schedule 3, item 4, paragraph 448(1)(g); item 5, subsection 448(1A)]
3.22 The indirect service rule is intended to prevent a non-resident entity or entities being interposed between a company providing services and its customers in Australia (see Diagram 3.1). The interposed entity or entities may be pre-existing or newly created, and include an overseas permanent establishment of an Australian resident. Without this rule, the company actually generating the services would not have tainted services income, as it provides the services to a non-resident or overseas permanent establishment of an Australian resident. The interposed entity itself could have tainted services income in respect of the services it contracts to provide to Australian customers. However, as it would be allowed a deduction for the services it purchased, it would have little net income to be taxed.
3.23 An indirect services rule was previously unnecessary as the income from a company providing services to a non-resident associate or overseas permanent establishment of an Australian resident (the interposed entity) was tainted services income. The indirect services rule achieves the same outcome, subject to certain requirements being met. The rule does not limit the generality of other provisions in sections 448 and 450 that include amounts in tainted services income. More specifically, tainted services income may be derived by a company, even though it has arranged for the services to be provided by another entity (e.g. by using a subcontractor or agent to carry out the work). The general anti-avoidance rule in Part IVA would also continue to apply, in particular to cases involving non-associate interposed entities.
3.24 Application of the indirect services rule is conditional on meeting certain requirements. A number of these requirements are intended to prevent the indirect services rule applying in cases where the provision of services indirectly is inadvertent or unintended (when viewed objectively). The requirements, which are discussed in more detail below, are:
- services provided by the company to an associated entity are received by another entity (i.e. an Australian customer);
- the services are provided by the company under a scheme with the relevant purpose; and
- the income from the services would have been tainted services income if provided directly.
3.25 The indirect services rule looks at whether:
- the company provides services to an entity, where that entity is an associate of the company; and
- another entity receives those services. That is, they have been provided to that other entity by the company, through one or more interposed entities (the first of which is an associate); and
- that other entity was an Australian customer - either a resident, other than in respect of an overseas permanent establishment, or the Australian permanent establishment of a non-resident.
[Schedule 3, item 5, paragraphs 448(1A)(a) to (d)]
3.26 Importantly, the services originally provided by the company need to be the services received by the Australian customer, and not merely a service of the same kind. If the service received is a different service or a service so modified or transformed as to have lost its original character (in substance rather than form), then the rule does not apply. However, where particular services are simply bundled with other services or goods before final sale to an Australian customer, those particular services would still have been received by the customer.
Example 3.1 Archi Co and Plans Co are both members of the same corporate group, and controlled foreign companies. Archi Co provides architectural services (house designs) to Australian customers. Plans Co also develops building and house plans. Case A: Plans Co provides Archi Co (an entity that is an associate) with a suite of highly specified house designs. Archi Co markets these into the Australian market, assisting customers in choosing the most appropriate design, but otherwise making no changes. In this case, Plans Co has indirectly provided services to Australian customers, with the house designs received by those customers the same as those originally provided by Plans Co to Archi Co. Case B: Plans Co provides Archi Co with a suite of highly specified house designs. Archi Co uses these designs as a technical reference and source of ideas, but otherwise provides custom-designed house plans to Australian customers to suit their individual preferences. In this case, the services provided by Plans Co are not those received by Archi Co's Australian customers, even though services of the same kind were received.
Example 3.2 TelCo, a controlled foreign company, provides international telecommunication services using satellites. The marketing and sale of these services is undertaken exclusively through two associated non-resident group companies, TelPac and TelUSA.TelPac purchases telecommunications services from TelCo and retails and distributes them into the Asia-Pacific, including a significant proportion to Australia. Australia is a major focus of TelPac's marketing. TelUSA purchases similar telecommunications services from TelCo, but (consistently with the business plans of both TelCo and TelUSA) retails and distributes them exclusively into the United States.In retailing and distributing telecommunications services purchased from TelCo, TelPac adds billing, other customer-related administrative services, and incidental technical services to the telecommunications services it on-sells to its customers.The telecommunication services provided by TelCo to TelPac (an associated entity) are the services received by TelPac's Australian customers, notwithstanding the billing and other incidental services provided by TelPac. The telecommunications services sold by TelPac have not lost their original character from the telecommunications services purchased by TelPac from TelCo.
3.27 The services provided by the company need to be provided under a scheme. The scheme must have been entered into or carried out for a purpose, other than an incidental purpose, of providing those services to Australian customers. [Schedule 3, item 5, paragraphs 448(1A)(a) and (f)]
3.28 'Scheme' is defined in subsection 995-1(1) of the Income Tax Assessment Act 1997. It has a broad scope and means any arrangement, or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. It would encompass, for example, a common business structure in which a corporate group has a retail company interposed between the group company actually producing the service and the group's customers.
3.29 Whether a purpose of the scheme is to enable Australian customers to receive those services is to be objectively determined. That is done by considering whether a reasonable person, looking at the available information, would conclude that the scheme's purpose was to enable Australian customers to receive those services. It is unnecessary to show that an actual intention of the party or parties to the scheme was to provide those services to Australian customers. Subsection 448(1A) does not require that a purpose of the scheme was to obtain a tax benefit.
3.30 It is enough that a reasonable person would conclude that a purpose of the scheme was to enable those services to be received by Australian customers. That purpose does not have to be the sole or dominant purpose, but an incidental purpose is disregarded. A purpose will be incidental if it is a minor purpose. It may also be incidental if it occurs fortuitously or subordinate to another purpose of the scheme, or merely follows that other purpose as its natural incident.
Example 3.3 Further to Example 3.2, the course of conduct between TelCo and TelPac constitutes a scheme. A reasonable person would, given the facts, conclude that the scheme was entered into or carried out for a purpose of providing services to Australian customers. The purpose is not merely an incidental purpose.However, a reasonable person would conclude - looking at the arrangement between TelCo and TelUSA, their business plans and the actual sales pattern of TelUSA - that TelCo did not have the required purpose under a scheme involving TelUSA. This would still be true if TelUSA did in fact occasionally provide a few services to Australian customers and this pattern did not change significantly over time.
Example 3.4 Design Co is a controlled foreign company that designs machines for making precision tools. Under an agreement, an associated non-resident group company, Sales Co advertises and sells Design Co's services to the Australian market exclusively.Under that agreement, when Sales Co contracts with an Australian customer to provide a particular machine design, it then contracts with Design Co to produce the actual design which Sales Co forwards on.Income from the machine design services provided by Design Co to Sales Co, is income from services provided to an entity that is an associate (Sales Co), and that are received by other entities that are Australian customers.The use by Design Co of Sales Co to market its machine design services and act as the legal interface with customers is a scheme. Given that Design Co uses Sales Co, a related group company, to market its services exclusively to Australian customers, a reasonable person would conclude that the scheme was entered into or carried out for the requisite purpose.
3.31 There is a further requirement for the indirect services rule to apply. It must be the case that if the relevant service had been (directly) provided by the company to an Australian customer, then the income from doing so would have constituted tainted services income to the company under another part of section 448 or section 450 (and taking into account the exceptions in subsections 448(2) to (6)). Without this additional requirement, in certain cases income from services provided indirectly (e.g. general insurance) could constitute tainted services income, whereas, if the same services were provided directly, the income from providing the services would not be tainted. [Schedule 3, item 5, paragraph 448(1A)(e)]
Example 3.5 Insure Co, a non-resident company, provides general insurance to Australian based customers. All of Insure Co's insurance policies are reinsured by Reinsure Co, a controlled foreign company and non-resident member of the same corporate group.Insure Co provides general insurance to the Australian permanent establishment of Foreign Co, an unrelated party. One general insurance policy is for a property of the permanent establishment situated in Australia, and another policy is for an event that could happen outside of Australia.Assuming that the other requirements of the indirect services rule are met, would the services Reinsure Co provides indirectly to Foreign Co be tainted services income if provided directly?Reinsure Co directly providing insurance to Foreign Co in respect of the Australian situated property of Foreign Co's permanent establishment would be tainted services income under subparagraph 448(1)(d)(ii). Indirectly providing such insurance (i.e. by reinsuring the policies) would therefore also be tainted services income.Reinsure Co directly providing insurance to Foreign Co's permanent establishment in Australia in respect of an event that could happen outside of Australia would not be tainted services income under subparagraph 448(1)(d)(iii). Hence, even if all other requirements are met, income relating to this reinsurance is not tainted services income.
3.32 Current provisions relating to income from providing reinsurance indirectly in certain cases are repealed. The indirect services rule will now cover these cases. [Schedule 3, item 4]
3.33 The amendments apply to statutory accounting periods of companies beginning on or after 1 July 2004. To avoid doubt, it is expressly stated that these statutory accounting periods include years of income that are assumed to be statutory accounting periods for the purposes of section 23AH. [Schedule 3, item 10]
3.34 The statutory accounting period of a controlled foreign company is, in general, each 12-month period ending 30 June. However, a controlled foreign company can elect for its statutory accounting period to end on a different date. The attributable income of a controlled foreign company, in respect of a particular statutory accounting period, is included in the assessable income of relevant taxpayers in the year of income in which the statutory accounting period ends.
3.35 Tainted services income is also relevant to section 23AH, which operates with respect to the year of income of a taxpayer. Section 23AH (both as it currently is, and as replaced by Schedule 2 to this bill) provides that, in determining adjusted tainted income (which includes tainted services income) and applying the active income test for the purposes of section 23AH, the taxpayer's statutory accounting periods are the same as its years of income.