House of Representatives

Tax Laws Amendment (2004 Measures No. 2) Bill 2004

Explanatory Memorandum

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

Chapter 10 - Simplified imputation system - franked distributions received through certain partnerships and trusts

Outline of chapter

10.1 Schedule 10 to this bill amends Division 207 of the Income Tax Assessment Act 1997 (ITAA 1997), as part of the implementation of the simplified imputation system (SIS), which deals with the tax effect of receiving a franked distribution. The amendments will include adjustment rules to provide the calculation to adjust an entity's assessable income where a franked distribution flows indirectly to the entity through a trust or partnership and the entity has no entitlement to a tax offset.

10.2 The amendments will also:

·
rectify two technical defects that have been identified in Division 207;
·
make consequential amendments to other parts of Division 207 and other parts of the SIS;
·
update Division 207 so that it takes into account legislation that has been enacted since Division 207 came into operation; and
·
improve the readability of the provisions.

10.3 The anti-avoidance provisions in Division 7AA of Part IIIAA of the Income Tax Assessment Act 1936 (ITAA 1936), which are to be included in Division 207, will now be included in a later bill. These provisions apply to exempt institutions that are entitled to a refund of franking credits under the refundable tax offset rules in Division 67 of the ITAA 1997.

10.4 The trans-Tasman imputation measures in Division 220 of Part 3-6 of the ITAA 1997 that deal with the effects of receiving a supplementary dividend will also be amended to implement a minor policy change and ensure consistency with Division 207.

Context of amendments

10.5 The implementation of the SIS arose out of a recommendation of the Review of Business Taxation. In Treasurer's Press Release No. 58 of 21 September 1999 the Government announced its proposal to implement the SIS which aims to reduce compliance costs incurred by business by providing simpler processes and increased flexibility. Minister for Revenue and Assistant Treasurer's Press Release No. C57/02 of 14 May 2002 announced that the SIS would commence on 1 July 2002.

10.6 Division 207 of Part 3-6 of the ITAA 1997 is part of the core SIS rules introduced in the New Business Tax System (Imputation) Act 2002.

10.7 Although the changes to Division 207 generally apply from 1 July 2002, taxpayers will not be adversely affected. These changes clarify the operation of Division 207 but they do not change the way the law is currently applied.

Summary of new law

Franked distributions received through certain partnerships and trusts

10.8 Taxation Laws Amendment Act (No. 4) 2003, which received Royal Assent on 30 June 2003, introduced the new concept of non-assessable non-exempt income. It is necessary that the rules in Division 207 that deal with franked distributions made indirectly through trusts or partnerships properly deal with this class of income as well as exempt income. This is because a franked distribution may be exempt or non-assessable non-exempt income in the hands of a recipient entity.

10.9 In addition, it is necessary to amend the concept of:

·
a trustee's or beneficiary's share of the net income of a trust that is attributable to a franked distribution; and
·
a partner's individual interest in the partnership's net income (or partnership loss) that is attributable to a franked distribution.

This concept, which is present in the current and former imputation provisions, is used in determining an entity's share of a franking credit where the distribution has flowed indirectly to the entity through a partnership or trust or through a chain of trusts and partnerships. The application of the concept needs to be clarified to ensure that partners, trustees and beneficiaries can benefit from franked distributions in cases where the deductions of the partnership or trustee exceed the franked distribution.

Adjustment where no tax offset is allowed

10.10 Subdivisions 207-D, 207-E and 207-F of Part 3-6 of the ITAA 1997 contain rules to provide for an adjustment to an entity's assessable income where the entity receives a franked distribution indirectly through a partnership or the trustee of a trust but the entity is not entitled to a tax offset. The adjustment is required to prevent the entity's share of a franking credit being inappropriately included in its assessable income.

10.11 These rules apply in the following cases:

·
the recipient of a franked distribution is a non-resident;
·
the franked distribution is not taxed in the hands of the recipient (i.e. the income is exempt income or non-assessable non-exempt income in the hands of the recipient); or
·
the imputation system has been manipulated, so that no imputation benefits arise or the imputation benefits are denied.

10.12 These Subdivisions currently provide that an adjustment is to be made but do not specify how the adjustment is to be calculated. It was initially intended that these rules, which are to have the same operation as the former imputation rules in Part IIIAA of the ITAA 1936, be included in a later bill in new Subdivision 207-J. However, they will now be incorporated in the existing Subdivisions in Division 207.

Trans-Tasman imputation measures

10.13 The trans-Tasman imputation measures in Division 220 of Part 3-6 of the ITAA 1997 provide for an adjustment to the assessable income of an Australian shareholder in receipt of a franked distribution from a New Zealand (NZ) company where that company has paid a supplementary dividend in relation to the distribution. These rules could not be completed until the adjustment rules in Division 207 were completed.

Detailed explanation of new law

Franked distributions received through certain partnerships and trusts

10.14 Subdivision 207-B is repealed and replaced with provisions that rectify a technical defect in the definition of the term 'flow indirectly'. In addition, the concept of 'an entity's share of a franked distribution' will replace the existing concept of a share (or interest) in the net income of a trustee of a trust or a partnership (or partnership loss) that is attributable to a franked distribution.

When does a franked distribution flow indirectly to an entity?

10.15 The definition of 'flow indirectly' in section 207-35 will be replaced so that a franked distribution can flow indirectly to an entity where the distribution, or part of the distribution, is exempt income or non-assessable non-exempt income in the hands of the recipient. Under the new definition, a franked distribution will be taken to flow indirectly to a partner in a partnership or to a beneficiary or the trustee of a trust if:

·
the distribution is made to a partnership or trustee of a trust or flows indirectly to the partnership or to the trustee or beneficiary of the trust as a partner or beneficiary [Schedule 10, item 7, paragraphs 207-50(2)(a), (3)(a) and (4)(a)] ; and
·
one of the following is satisfied:

·
the partner has an individual interest in the partnership's net income or is allowed a deduction for a partnership loss under subsections 92(1) and (2) of the ITAA 1936 [Schedule 10, item 7, paragraph 207-50(2)(b)] ; or
·
the beneficiary has a share of the trust's net income under paragraph 97(1)(a) of the ITAA 1936 or an individual interest in the trust's net income under paragraph 98A(1)(a) or (b) or 100(1)(a) or (b) of the ITAA 1936 [Schedule 10, item 7, paragraph 207-50(3)(b)] ; or
·
the trustee is liable to be assessed on a share of the trust's net income in respect of a beneficiary under section 98 of the ITAA 1936 or assessed on all or part of the trust's net income for that year under section 99 or 99A of the ITAA 1936 [Schedule 10, item 7, paragraph 207-50(4)(b)] ; and

·
the entity's share of the franked distribution as calculated in new section 207-55 is a positive amount. That is, the entity must have an entitlement to part or all of the franked distribution [Schedule 10, item 7, paragraphs 207-50(2)(c), (3)(c) and (4)(c)].

10.16 The rule operates so that a franked distribution can flow indirectly where the distribution is exempt or non-assessable non-exempt income in the hands of a recipient. For example, the rule applies where the ultimate recipient is a non-resident and, because of section 128D of the ITAA 1936, the distribution is non-assessable non-exempt income in the hands of the non-resident entity. Section 207-50 also clarifies that a franked distribution can flow indirectly where there is a partnership loss, or deductions of the trustee of a trust or partnership exceed the amount of the franked distribution.

Example 10.1 A franked distribution of $70 with $30 franking credits attached is made to a partnership which has two equal partners, an individual and the trustee of a trust that has one beneficiary. The partnership has losses from another business activity of $200 and therefore has an overall loss of $100. A loss of $50 is distributed to the individual partner and to the trustee.The trust has other income of $100 and therefore has net income to distribute to the beneficiary. Both the individual partner and the trustee are entitled to a franking credit of $15. The franked distribution flows indirectly to the ultimate recipients (i.e. the individual and beneficiary of the trust) as the franked distribution was taken into account in determining the partnership loss.

When does a franked distribution flow indirectly through an entity?

10.17 For the purposes of working out an entity's share of the franked distribution, it is also necessary to describe where a franked distribution flows indirectly through an entity. This occurs where there is an entity (intermediary entity) and the franked distribution flows through that entity to another entity (the focal entity) [Schedule 10, item 7, subsection 207-50(5)]. These terms are used in the table in subsection 207-55(1) to determine an entity's share of the franked distribution where it flows indirectly.

What is an entity's share of the franked distribution?

10.18 Under the existing imputation rules in Subdivision 207-B, the concept of an entity's share or interest in the net income of the trustee of a trust or partnership (or in the case of a partnership, an interest in the partnership loss) that is attributable to a franked distribution is used to determine an entity's share of a franking credit in relation to the distribution. This concept also existed in the former imputation rules. However, the application of the concept is uncertain where the deductions of a partnership or trustee of a trust exceed the amount of the franked distribution. It is intended that partners, trustees or beneficiaries benefit from the franking credit in these circumstances even though there is no actual receipt of the franked distribution.

10.19 This defect is overcome by introducing the concept of an entity's share of a franked distribution in new section 207-55. The share is taken to be a notional share because an entity may not actually receive its share of the franked distribution (i.e. the concept is defined so that it is undiminished by deductions of the partnership or trustee of a trust through which a franked distribution flows) [Schedule 10, item 7, subsections 207-55(1) and (2)]. That is, even though the entity does not receive an amount of the franked distribution because deductions exceed the amount of the franked distribution, the franking benefits may still flow through to the partner or beneficiary.

Example 10.2 A franked distribution of $70 with $30 franking credits attached is made to the trustee of a trust. The deductions incurred in deriving the distribution amount to $110. The trustee derives other assessable income of $100 so the net income of the trust is $90. The trustee has two equal beneficiaries to which the $90 is distributed.The franked distribution is taken into account in determining the net income of the trustee and, as such, each beneficiary's share of the franked distribution is $15 (this is despite neither beneficiary receiving an amount of the franked distribution because the deductions of the trustee exceed the amount of the franked distribution).Under new section 207-45, both beneficiaries are entitled to a tax offset of $15.

10.20 An entity's share of a franked distribution is determined under the table in new subsection 207-55(3). This calculation is used to determine the entity's share of the franking credit on a franked distribution where the distribution flows indirectly. A focal entity's share of a franked distribution is calculated by referring to the share of the intermediary entity's share of the franked distribution to which the intermediary entity is entitled. Column 2 in the table provides the intermediary entity's share and column 3 in the table provides the focal entity's share. The table operates so that an entity's share of a franked distribution can be calculated where the distribution flows indirectly:

·
to a partner in a partnership or to a beneficiary or the trustee of a trust; or
·
through a chain of trusts or combination of trusts and partnerships.

An entity's share of a franked distribution is its share of a franked distribution as the focal entity. [Schedule 10, item 7, subsection 207-55(3)]

Example 10.3 A franked distribution of $70 with $30 franking credits attached is made to a partnership. The partnership has two equal partners, an individual and a trustee with two equal beneficiaries.When determining the share of a franked distribution to which the beneficiaries of the trust are entitled, apply item 4 in the table in subsection 207-55(2). In determining the trustee's share of the franked distribution as the intermediary entity, apply column 2 in item 4 in the table which refers back to item 1 as the trustee is a partner in a partnership. As the trustee is entitled to a 50% share of the partnership's net income its share of the franked distribution (as the focal entity) is $35.To work out the beneficiaries' share of the franked distribution apply column 3 in item 4. As each beneficiary's share of the franked distribution is 50% of the trust's net income, each beneficiary's share of the franked distribution is $17.50. To work out each of the beneficiary's share of the franking credit apply the formula in section 207-57.

10.21 In the case of a trust, the table operates so that if deductions exceed assessable income (i.e. there is a loss) there can be no amount which flows indirectly through it to another entity. [Schedule 10, item 7, column 2 in item 3 in the table in subsection 207-55(3)]

What is an entity's share of the franking credit?

10.22 New section 207-57 operates to determine the amount of an entity's share of the franking credit on a franked distribution. The following formula operates to allocate the franking credit:

Amount of the franking credit on the franked distribution * (Entity's share of the franked distribution / Amount of the franked distribution)

[Schedule 10, item 7, section 207-57]

Example 10.4 Continuing Example 10.3, the trustee's share of the franking credit on the franked distribution is equal to $15 ($30 * ($35 / $70)) where $30 is the amount of the franking credit on the franked distribution, $70 is the amout of the franked distribution and $35 is the trustee's share of the franked distribution. Each beneficiary's share of the franking credit on the franked distribution is equal to $7.50 ($30 * ($17.50 / $70)) where $15 is the amount of the franking credit on the franked distribution, $70 is the amount of the franked distribution and $17.50 is each beneficiary's share of the franked distribution.

Other amendments to Subdivision 207-B

10.23 Sections 207-40, 207-45 and 207-50 are repealed and replaced with sections 207-35 and 207-45. Subsection 207-35(1), which replaces section 207-40, grosses-up the partnership's or trustee's assessable income by the amount of the franking credits attached to a franked distribution made to the partnership or trustee. The grossing-up rules do not apply in relation to a corporate tax entity that is a partnership or trustee or a complying superannuation entity that is a trustee. Also, a technical defect relating to a distribution flowing indirectly to a partner of a partnership or to a beneficiary or trustee of a trust in former paragraphs 207-40(1)(b) and 207-40(2)(b) is removed.

10.24 Subsection 207-35(3), which replaces section 207-45, identifies the amount of the franking credit included in an entity's (i.e. a partner or a beneficiary or the trustee of a trust) assessable income when a franked distribution flows indirectly to it through a partnership or trust using the concepts introduced in new Subdivision 207-B. This subsection ensures that the amount included in the entity's assessable income that is attributable to the franking credit on a franked distribution is always proportionate to the partner's or beneficiary's share of the franked distribution. [Schedule 10, item 7, subsection 207-35(3)]

10.25 A beneficiary's share of the net income of a trust, for example, would generally include an amount attributable to the franking credit on a franked distribution received by the trustee, which would be included in the beneficiary's assessable income under section 97, 98A or 100 of the ITAA 1936. The amount included in the beneficiary's assessable income that is attributable to the franking credit on the franked distribution received by the trust should be, and would often be, proportionate to the beneficiary's share of the cash amount of the franked distribution.

10.26 It is possible, however, that the amount attributable to the franking credit is not proportionate. For example, a discrepancy between the beneficiary's share of the distribution and the amount of the franking credit included in the beneficiary's assessable income may occur where the beneficiaries of a trust do not all have an interest in the dividend income of the trust. A share of the franking credit on a franked distribution would generally be included in the share of the net income of the trust of all the beneficiaries, including those beneficiaries who do not have an interest in the dividend.

10.27 In this case, the assessable income of the beneficiaries will be adjusted. The assessable income of the beneficiaries with an interest in the dividend income will include an amount equal to their proportionate share of the franking credit based on their interest in the dividend. The assessable income of the other beneficiaries will not include any amount attributable to the franking credit on the distribution.

10.28 An entity that is the ultimate recipient of a franked distribution to whom a distribution flows indirectly is entitled to a tax offset for that income year equal to its share of franking credit attached to the distribution. The ultimate recipients of a franked distribution are the recipients that can use the tax offset and include individuals, corporate tax entities, trustees that are liable to be assessed under section 98, 99 or 99A of the ITAA 1936 or trustees of eligible entities within the meaning of Part IX of the ITAA 1936 (e.g. certain superannuation funds, approved deposit funds and pooled superannuation trust). [Schedule 10, item 7, section 207-45]

Adjustment where franked distribution is not taxed

10.29 Existing Subdivision 207-D (which deals with franked distributions flowing indirectly to non-residents) and existing sections 207-110 and 207-115 of Subdivision 207-E (which deal with franked distributions that are exempt or non-assessable non-exempt income) will be amended. These rules are replaced with general rules to be contained in a new Subdivision 207-D which deal with franked distributions that are exempt or non-assessable non-exempt income in the hands of the recipient entity.

Adjustment where a distribution is made to an entity

10.30 If a franked distribution is made to an entity and the distribution is exempt income or non-assessable non-exempt income in the hands of that entity, then the franking credit on the distribution is not included in the entity's assessable income and there is no entitlement to a tax offset. [Schedule 10, item 8, subsection 207-90(1)]

10.31 If a franked distribution is made to an entity, and part of that distribution is exempt income or non-assessable non-exempt income in the hands of the entity, then the franked distribution is taken to be reduced by that part and the amount of additional income included in the entity's assessable income and the tax offset to which the entity is entitled are reduced proportionately [Schedule 10, item 8, subsection 207-90(2)]. For example, where a franked distribution of $70 with $30 franking credits is made to an entity and $35 of the distribution is non-assessable non-exempt income in the hands of the entity, then the entity only includes an additional amount of $15 in its assessable income (i.e. gross-up is reduced to $15) and its tax offset is reduced to $15.

Adjustment where distribution flows indirectly to an entity

10.32 If a franked distribution that flows indirectly to an entity is exempt income or non-assessable non-exempt income in the hands of the entity, an adjustment is made to the entity's assessable income to remove the entity's share of the franking credit, there is no entitlement to a tax offset and the distribution does not flow indirectly through it to another entity. [Schedule 10, item 8, subsection 207-95(1)]

10.33 The effect of a distribution not flowing indirectly to another entity is that the lower tier entity will not have any amount of the franking credit included in its assessable income and will not be entitled to a tax offset. It should be noted that for other purposes of the income tax law the distribution flows through to a lower tier entity as exempt or non-assessable non-exempt income (i.e. the concept of 'flow indirectly' is only relevant for imputation purposes).

10.34 The adjustment to the entity's assessable income is set out in Table 10.1. The adjustment is a deduction where the distribution flows indirectly to a partnership or beneficiary and a reduction when it flows indirectly to a trustee. Where a franked distribution flows indirectly to the trustee of a trust, reduction rules apply (as opposed to deduction rules) because the deductions of the trust have already been taken into account in determining the trust's net income.

Table 10.1
Provision Circumstance Deduction allowed
Item 8, subsection 207-95(2) Franked distribution flows indirectly to a partner. The entity is allowed a deduction for that income year equal to the entity's share of the franking credit on the distribution.
Item 8, Subsection 207-95(3) Franked distribution flows indirectly to a beneficiary of a trust. The beneficiary can deduct the lesser of:

·
its share of the net income of the trust (the share amount mentioned in subsection 207-50(3); and
·
the amount of its share of the franking credit on the distribution.

Item 8, Subsection 207-95(4) Distribution flows to trustee of a trust. The trustee can reduce the net income of the trust by the lesser of:

·
the entity's share of the amount of the net income of the trust mentioned in subsection 207-90(4); and
·
the amount of the entity's share of the franking credit on the distribution.

10.35 The 'lesser of' rule that applies in the case of trusts ensures that a beneficiary or trustee is unable to create a loss as a result of the adjustment to remove the effect of a franking credit from an entity's assessable income.

Example 10.5 A franked distribution of $70 with $30 franking credits attached is made to a trust with two equal beneficiaries, an individual and a company. The distribution is non-assessable non-exempt income in the hands of the company. Under subsections 207-95(1) and (3), the company is allowed a deduction equal to its share of the franking credit. The distribution (i.e. $15) and the company has no entitlement to a tax offset.

10.36 A rule similar to subsection 207-90(2) is included in relation to a franked distribution that flows indirectly to an entity where part of the share of the franked distribution is exempt or non-assessable non-exempt income in the hands of the entity. For the purpose of applying the deduction rules in subsections 207-95(2) and (3) and the reduction rule in subsection 207-95(4), the rule applies to reduce the amount of the franking credit referred to in those subsections in the same proportion that the share of the franked distribution is exempt or non-assessable non-exempt income. [Schedule 10, item 8, subsection 207-95(5)]

10.37 In addition, the franked distribution that flows through to an entity is reduced by the part of the distribution that is exempt or non-assessable non-exempt income. This ensures that the tax offset to which the entity is entitled is appropriately reduced. [Schedule 10, item 8, subsection 207-95(6)]

Example 10.6 A franked distribution of $70 with $15 franking credits attached is made to a partnership (i.e. a distribution that is not fully franked). The partnership includes an additional amount of $15 in its assessable income under section 207-35 because of the distribution.The partnership has two equal partners, X and Y. X is a non-resident. X receives a distribution of $42.50 which includes a franked part of $17.50, an unfranked part of $17.50 and an additional amount of $7.50 due to the grossing-up of the partnership's assessable income by the amount of the franking credit. Under section 128D of the ITAA 1936, the franked and unfranked parts are non-assessable non-exempt income in the hands of the non-resident. Therefore, the non-resident has assessable income of $7.50.As such, subsection 207-95(1) applies to the non-resident and a deduction of $7.50 is allowed to remove the share of the franking credit from the non-resident's assessable income.

Exceptions to the rule in Subdivision 207-D

10.38 As part of the restructure of Division 207, Subdivision 207-E now only deals with exceptions to the adjustment rules in Subdivision 207-D. These exceptions are the same as in existing section 207-120. This Subdivision entitles certain entities to a tax offset even though the franked distribution (or the share of the franked distribution) is exempt income or non-assessable non-exempt income in the hands of the recipient entity. Where the franked distribution is made to an entity, the tax offset is equal to franking credit attached to a distribution. Where the franked distribution flows indirectly to an entity, the tax offset is equal to the entity's share of the franking credit.

10.39 The two exceptions to the rules in Subdivision 207-D are franked distributions made or flowing indirectly to:

·
exempt institutions that are eligible for a refund where the distribution does not flow indirectly to the entity as a partner in a partnership; and
·
eligible superannuation entities (i.e. complying superannuation funds, approved deposit funds and pooled superannuation trusts) and life insurance companies where;

·
the exemption under sections 282B, 283 and 297B of the ITAA 1936 and paragraph 320-35(1)(b) for income relating to current pensions applies; and
·
the income is non-assessable non-exempt income under paragraph 320-37(1)(a) or (d)) for income of a life insurance company that is a friendly society relating to income bonds, funeral policies and scholarship plans.

[Schedule 10, item 11, subsection 207-110(1)]

10.40 The effect of these rules is that the distribution does not flow indirectly through the entity to another entity and:

·
where the distribution is made to an entity, the entity is entitled to a tax offset equal to the franking credit on the distribution under section 207-20; or
·
where the distribution flows indirectly to an entity under subsections 207-50(2) to (4), the entity is entitled to a tax offset equal to its share of the franking credit under section 207-45.

[Schedule 10, item 11, subsection 207-110(2)]

10.41 The consequence that the distribution does not flow indirectly to another entity ensures that multiple tax offsets cannot be claimed from a single franked distribution. For example, this could occur where a charitable trust that is an exempt institution is a beneficiary of another exempt institution.

Manipulation of the imputation system

10.42 The consequences for an entity receiving a franked distribution where the imputation system has been manipulated are currently set out in Subdivision 207-F of the ITAA 1997. Section 207-145 deals with distributions made to an entity and section 207-150 deals with franked distributions that flow indirectly to an entity. It should be noted that under the definition of 'flow indirectly' in section 207-50 a franked distribution flows indirectly to a trustee liable to be assessed under section 98, 99 and 99A of the ITAA 1936.

Adjustment where distribution is made to an entity

10.43 Section 207-145 is repealed and replaced with rules with the following changes:

·
the references to a receiving entity are removed;
·
paragraph 207-145(1)(g) is inserted to ensure that if a distribution flows indirectly through a lower tier entity, franking benefits will not be available to the lower tier entity;
·
the reference to paragraph 204-30(3)(b) in paragraph 207-145(1)(b) is changed to paragraph 204-30(3)(c);
·
a reference to franking credit benefit is changed to imputation benefit, consistent with the terminology used in the SIS; and
·
an amendment to the rule in subsection 207-145(2), which apportions a franking credit in circumstances where the Commissioner of Taxation (Commissioner) makes a determination under paragraph 177EA(5)(b) of the ITAA 1936 that no imputation benefit is to arise in respect of a specified part of a franked distribution for an entity. The amendment ensures that the rule operates as intended. A rule is also included which reduces the franking credit on the distribution.

[Schedule 10, item 14, subsections 207-145(1) and (2)]

10.44 It is possible that the apportionment rule in subsection 207-145(2) (which reduces the entity's gross-up and tax offset where there has been manipulation of the imputation system) and subsection 207-90(2) (which reduces the entity's gross-up and tax offset where part of the franked distribution is exempt income or non-assessable non-exempt income in the hands of an entity) may both apply in relation to the same distribution. In this case, the rule in subsection 207-145(2) will apply after the appropriate reduction has been made under paragraph 207-90(2)(c). [Schedule 10, item 14, subsection 207-145(3)]

Adjustment where distribution flows indirectly to an entity

10.45 Section 207-150 currently deals with the consequences of receiving a franked distribution where the imputation system has been manipulated and the franked distribution flows indirectly to the recipient. Section 207-150 is repealed and replaced to include rules to adjust an entity's assessable income where there has been manipulation of the imputation system and the entity's entitlement to a tax offset is denied.

10.46 The deduction where a franked distribution flows indirectly to a partner or beneficiary of a trust, or reduction in the grossing-up of assessable income where the distribution flows indirectly to the trustee of a trust, is set out under subsections 207-150(2) to (4). These are the same amounts as set out in Table 10.1. [Schedule 10, item 14, subsections 207-150(2) to (4)]

10.47 If the deduction or reduction rules above apply to an entity, the entity is denied a tax offset and the franked distribution does not flow indirectly through the entity to other entities (i.e. no franking credit or tax offset will be available to lower tier entities). [Schedule 10, item 14, subsection 207-150(1)]

10.48 If the Commissioner makes a determination under paragraph 177EA(5)(b) of the ITAA 1936 that an imputation benefit is not to arise in respect of a part of a franked distribution, then the relevant entity's share of the franking credit, as referred to in the adjustment rules in subsections 207-150(2) to (4), is proportionately reduced [Schedule 10, item 14, subsection 207-150(5)]. An additional rule is included which provides that the entity's entitlement to a tax offset in relation to the reduced franked distribution that is not affected by the Commissioner's determination, is also proportionately reduced so that it equals the remaining amount of the franking credit [Schedule 10, item 14, subsection 207-150(6)].

Example 10.7 A franked distribution of $70 with $30 franking credit attached is made to a partnership with two equal beneficiaries one of which is X, an individual. The Commissioner makes a determination under paragraph 177EA(5)(b) in relation to 50% of X's share of the franked distribution (i.e. $17.50 of the distribution).X is entitled to a deduction under subsection 207-150(2) worked out under subsection 207-110(6) equal to, $7.50 (($35 - $17.50) / 35) * $15.X is entitled to a reduced tax offset in relation to that part of the franked distribution that has not been subject to the determination. The reduced tax offset that is calculated under subsection 207-110(7) is $7.50 ($15 - $7.50). This equals the reduced amount of franking credit included in X's assessable income.

10.49 It is possible that an adjustment to an entity's assessable income to remove its share of a franking credit could be allowed under subsection 207-150(1) (which applies where there has been manipulation of the imputation system) and subsection 207-95(1) (which applies when the whole of the distribution is exempt income or non-assessable non-exempt income in the hands of the entity). To avoid a double deduction, a deduction is only allowed under subsection 207-150(1). [Schedule 10, item 14, subsection 207-150(7)]

10.50 Subsection 207-150(5) (which applies where the Commissioner makes a determination under paragraph 177EA(5)(b) of the ITAA 1936 that an imputation benefit is not to arise in respect of a part of a franked distribution) and subsection 207-95(5) (which applies where part of the franked distribution is exempt income or non-assessable non-exempt income in the hands of the entity) could also both apply in relation to a franked distribution made to an entity. In this case the rule in subsection 207-150(5) is applied after the rules in section 207-95. [Schedule 10, item 14, subsection 207-150(8)]

10.51 Amendments are also made so that new section 207-150 incorporates the new concepts and terminology used in Subdivision 207-B. The reference in paragraph 207-150(1)(b) to 204-30(3)(b) is changed to paragraph 204-30(3)(c).

10.52 Sections 207-160, 207-165 and 207-170 describe when a franked distribution that flows indirectly through a partnership or trust is to be treated as equivalent to an interest payment. These rules which separately deal with distributions made to a partner in a partnership or a beneficiary or the trustee of a trust are merged into one rule that describes when a franked distribution is treated as an interest payment in these circumstances. The section is updated to be consistent with new concepts in Subdivision 207-B. [Schedule 10, item 15, section 207-160]

Amendment to trans-Tasman imputation rules

10.53 Division 220 of Part 3-6 of the ITAA 1997 contains rules which allow NZ companies to maintain an Australian franking account and attach Australian franking credits to dividends.

10.54 Sections 220-400 and 220-405 provide rules to deal with the effect of a NZ company paying a supplementary dividend in relation to a franked dividend to an Australian shareholder. A supplementary dividend is a payment paid by a NZ company to a non-resident shareholder as part of NZ's foreign investor tax credit regime. In effect, it represents a refund of the NZ company tax paid in respect of the underlying income to ensure that the effective tax rate for a non-resident investor does not exceed the NZ company tax rate.

10.55 Section 220-400 reduces both the gross-up and the entitlement to a tax offset by the amount of the supplementary dividend where a distribution is made to an entity. Section 220-405 reduces both the additional amount included in a taxpayer's assessable income because of a franking credit and the entitlement to a tax offset by the amount of a supplementary dividend where a distribution flows indirectly to a partner in a partnership or to a beneficiary or the trustee of a trust. These rules could not be finalised before the completion of Division 207.

10.56 Subsections 220-405(2) to (8) are repealed and replaced with provisions that provide for the necessary adjustments where a supplementary dividend flows indirectly to a partner or a beneficiary or the trustee of a trust.

10.57 In the case of a partner or beneficiary:

·
the partner or beneficiary is allowed a deduction that is equal to so much of its share of the supplementary dividend as does not exceed its individual interest or share amount referred to in subsections 207-50(2) and (3) for the income year; and
·
the tax offset to which the partner or beneficiary is entitled is reduced by the amount of the deduction but not by an amount that exceeds its share of the franking credit on the franked distribution.

[Schedule 10, item 40, subsection 220-405(2)]

10.58 In the case of a trustee:

·
the share amount as referred to in subsection 207-50(4) in relation to the franked dividend is reduced by the recipient's share of the supplementary dividend but not by an amount greater than that share amount; and
·
the recipient's tax offset entitlement is reduced by the amount of the reduction but not by an amount that exceeds its share of the franking credit on the franked distribution.

[Schedule 10, item 40, subsection 220-405(3)]

10.59 However, if the franked distribution was:

·
exempt or non-assessable non-exempt income in the hands of the recipient entity; or
·
there had been manipulation of the imputation system so that no imputation benefits arise or the imputation benefits are denied,

then this section does not apply. [Schedule 10, item 40, subsection 220-405(4)]

10.60 If the franked distribution is partly exempt or non-assessable non-exempt income in the hands of the recipient, or the Commissioner has made a determination under paragraph 177EA(5)(b) in relation to a specified part of a distribution, then the franking credit is reduced by the supplementary dividend before the amount is further reduced under subsection 207-95(5) or 207-150(6). [Schedule 10, item 40, subsection 220-405(5)]

10.61 A supplementary dividend flows indirectly to an entity in the same way a franked distribution flows through to an entity as if a reference to a share of a franked distribution were a reference to a share of the supplementary dividend. [Schedule 10, item 40, subsection 220-405(6)]

10.62 An entity's share of a supplementary dividend is proportionate to its share of the franked distribution. [Schedule 10, item 40, subsection 220-405(7)]

10.63 To remove doubt, section 220-405 will not have the effect of including the entity's share of the supplementary dividend in its assessable income for an income year. [Schedule 10, item 40, subsection 220-405(8)]

10.64 Subdivisions 207-B (which deals with the effect of receiving a franked distribution through a partnership or trust), 207-D (which deals with the case where there is no gross-up and tax offset where the distribution is non-assessable income) 207-E (which deals with the exceptions to the rules in Subdivision 207-D) and 207-F (which deals with the consequences where the imputation system has been manipulated) operate subject to this section. [Schedule 10, item 40, subsection 220-405(9)]

Other amendments to Division 220

10.65 Items 33 and 34 make amendments to section 220-400 to insert references to section 207-20. [Schedule 10, items 33 and 34]

10.66 Items 32 and 39, which repeal paragraphs 220-400(1)(d) and 220-405(1)(e), make a minor policy change to remove a technical defect in these subsections [Schedule 10, items 32 and 39, paragraphs 220-400(1)(d) and 220-405(1)(e)]. These paragraphs require that that the taxpayer reduce both its gross-up (or assessable income where the franked distribution flows indirectly) and tax offset by the amount of the supplementary dividend if the taxpayer's income tax is reduced to some extent by a foreign tax credit. The difficulty with the existing provisions is that whether the taxpayer uses any of its foreign tax credit during the income year depends on whether the taxpayer's assessable income is reduced below the tax-free threshold as a result of the supplementary dividend, thus creating a circularity problem. In addition, these amendments will remove the potential for certain taxpayers to obtain the double benefit of being able to utilise foreign tax credits (which can be carried forward) in later income years and the full amount of the tax offset (i.e. unreduced by the amount of the supplementary dividend).

10.67 Item 35 repeals subsections 220-400(4) and (5) and replaces them with provisions that ensure that where a franked distribution is made to an entity and part of the distribution is exempt income or non-assessable non-exempt income in the hands of the entity or the imputation system has been manipulated (i.e. section 207-90 or 207-145 apply) then those rules operate as if the adjustments made in relation to supplementary dividends had been made first. [Schedule 10, item 35, subsections 220-400(4) to (6)]

10.68 Item 36 replaces the heading to section 220-405 so that it more accurately reflects its purpose. [Schedule 10, item 36, section 207-405]

10.69 Item 37 amends paragraph 220-405(1)(c) to include correct references to sections which provide for a taxpayer's entitlement to a tax offset. [Schedule 10, item 37, paragraph 220-405(1)(d)]

Consequential amendments

Division 207

10.70 Item 23 repeals subsection 67-25(1B) of the ITAA 1997 and replaces it using the new terminology and concepts used in Division 207. [Schedule 10, item 23]

10.71 Items 3 and 4 make consequential changes to Part 3-6 of the ITAA 1997 by updating the legislative reference in paragraph 204-30(6)(b) and correcting the terminology in item 4 in the table in section 205-15. [Schedule 10, items 3 and 4]

10.72 Items 5 and 6 make changes to the Guide to Division 207 and Subdivision 207-A that are consequential to the changes made to Subdivisions 207-B, 207-D, 207-E and 207-F including changes to section numbers and terminology. [Schedule 10, items 5 and 6]

10.73 Items 9 and 10 change the heading and the Guide Material to Subdivision 207-E to reflect its new purpose. Item 12 inserts a heading before section 207-130. [Schedule 10, items 9, 10 and 12]

10.74 Item 13 changes the Guide Material to Subdivision 207-F to reflect its new purpose. [Schedule 10, item 13]

10.75 Items 18 and 19 make changes to Division 208 that deal with exempting entities and former exempting entities to update section references. [Schedule 10, items 18 and 19]

10.76 Item 41 updates a reference in item 6 in the table in subsection 219-15(2) to update terminology, (i.e. 'partnership or trust' to 'partnership or the trustee of a trust'). [Schedule 10, item 41]

10.77 Item 42 replaces subsection 220-410(2) to include appropriate references to provisions in Division 219 which deals with imputation for life companies. [Schedule 10, item 42]

Division 208

10.78 Division 208 of the ITAA 1997 contains rules designed to prevent franking credit trading for companies with controlling shareholders for whom franking credits have limited or no value. Generally, these rules treat franked distributions made by these companies (referred to as exempting entities) as being unfranked in the hands of the recipient shareholders.

10.79 Broadly, an exempting entity is a corporate tax entity where 95% of the accountable shares or interests in the entity are owned directly, or indirectly, by prescribed persons. Prescribed people are persons that have no, or limited use of franking credits. These include tax exempt entities and non-residents.

10.80 There is an unintended consequence with the interaction of Division 207, which allows certain tax exempt entities to claim a tax offset (i.e. an eligible institution), and Division 208. The consequence is that an eligible institution will be denied a tax offset (and therefore an entitlement to refundable imputation credits) if it holds 95% or more shares in a subsidiary (including where that percentage interest is held with other prescribed persons).

10.81 To rectify the technical defect, the definition of prescribed person and persons taken to be prescribed persons in Division 208 are amended so that a company or trustee that is eligible for a refund will not be a prescribed person. The amendment is also made for the purposes of the ITAA 1936. [Schedule 10, items 1, 2, 16, 17]

Amendments to definitions in subsection 995-1(1)

10.82 Consequential amendments are made to subsection 995-1(1) of the ITAA 1997 to make changes to the definition of 'flows indirectly', introduce the new definition of 'share of a franked distribution' and update a section reference in the definition of 'share of a franking credit'. [Schedule 10, items 20 to 22]

Application and transitional rules

10.83 The amendments to Division 207 generally are to apply to events that occur on or after 1 July 2002, the commencement of the SIS rules. Other amendments that take effect from that date are those contained in items 29 and 41.

[Schedule 10, subitem 43(2)]

10.84 Amendments at items 24 to 28, which introduce the new concept of non-assessable non-exempt income, are to apply to assessments for the 2003-2004 income year and later income years, consistent with the introduction of the non-assessable non-exempt concept in the income tax law. [Schedule 10, subitem 43(3)]

10.85 The amendments to the trans-Tasman imputation measures take effect from 1 April 2003, the commencement of those measures. [Schedule 10, subitem 43(4)]

10.86 The amendment to the definition of prescribed person in sections 160APHBF and 160APHBG in the ITAA 1936 is to apply from 1 July 2000 (the commencement date of the provisions allowing a refund of franking credits for certain charities and gift-deductible organisations). [Schedule 10, subitem 43(1)]

Transitional

10.87 A transitional rule is required for the purposes of sub-paragraph 207-110(1)(b)(ii) so that, for the period from 1 July 2002 until the start of the 2003-2004 income year, the references to an amount being 'non-assessable non-exempt income' are treated as references to the amount being neither assessable income nor exempt income. This rule is necessary because Division 207 of the ITAA 1997 applies from 1 July 2002 and the relevant amendments to those provisions apply from that date. However, the amendments refer to 'non-assessable non-exempt income', a concept that does not appear in the law until the 2003-2004 income year. [Schedule 10, item 44]


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