House of Representatives

Tax Laws Amendment (Loss Recoupment Rules and Other Measures) Bill 2005

Explanatory Memorandum

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

Chapter 5 - Conduit foreign income

Outline of chapter

5.1 Schedule 2 to this Bill inserts Division 802 into the Income Tax Assessment Act 1997 (ITAA 1997). This Schedule also makes changes to various provisions in the Income Tax Assessment Act 1936 (ITAA 1936). The changes provide tax relief for conduit foreign income, which generally is foreign income received by a foreign resident through an Australian corporate tax entity. Generally, the measure only applies to foreign income that is ordinarily sheltered from Australian tax when it is received by the Australian corporate tax entity.

5.2 This chapter:

·
explains the conduit foreign income measure which will provide tax relief for conduit foreign income;
·
describes how a corporate tax entity will calculate an amount of conduit foreign income; and
·
explains how conduit foreign income can pass through a series of Australian corporate tax entities to ultimate foreign owners free of Australian tax.

5.3 All legislative references are to the ITAA 1997 unless otherwise stated.

Context of amendments

5.4 This measure implements the Government's decision to establish foreign income account rules. This decision was in response to Recommendation 3.11(1) of the Board of Taxation's report to the Treasurer on international taxation. The decision was announced in the Treasurer's Press Release No. 32 of 13 May 2003.

5.5 Foreign residents who structure their foreign investments through Australian entities will often be subject to Australian tax on the income from those investments either when the income is derived or when it is distributed to the foreign residents. However, if the foreign residents derived that income directly, or through an interposed foreign entity, the income would not be subject to Australian tax because foreign residents are taxed only on their Australian source income. Similar differences may arise in connection with offshore banking activities in Australia and operations conducted in the Joint Petroleum Development Area under the treaty with East Timor. By reducing those tax differences, the measure will improve Australia as an investment choice for foreign investors.

5.6 However, this measure does not, nor is it intended to, remove any Australian tax paid by the interposed Australian entity on the income from the foreign investments. Nor does it refund any of that entity-level tax when the income is distributed to foreign investors. To do either of these things would mean giving foreign-owned Australian companies an unfair competitive advantage over Australian-owned companies when it comes to investing offshore (and could involve quite complex law). Nevertheless, it is important to note that there is no Australian entity-level tax on the profits from carrying on or disposing of offshore active businesses. Notwithstanding these limitations, what is done by these amendments will improve the attractiveness of Australia as a location for regional holding companies and particular businesses of foreign groups. The measure will also enhance the ability of Australian entities with foreign investments to compete for foreign capital and therefore encourage them to remain Australian residents if their foreign shareholding becomes significant.

5.7 The conduit foreign income measure replaces the foreign dividend account provisions contained in Division 11A of Part III of the ITAA 1936. Those provisions provide rules for foreign non-portfolio dividends to flow through an Australian company to foreign shareholders free from dividend withholding tax. The conduit foreign income measure provides relief from Australian tax on distributions to foreign shareholders of a broader range of foreign income and gains than the foreign dividend account rules.

5.8 This measure also ensures conduit foreign income can flow through more than one Australian corporate tax entity by removing Australian company tax on this income when it is distributed. This removes a limitation in the foreign dividend account rules. That limitation meant that foreign residents did not get tax relief for conduit foreign income where they invested indirectly, through Australian entities, in other Australian entities that earned foreign income. Removal of that limitation should provide greater flexibility in structuring holding company arrangements in Australia, including via joint ventures between Australian and foreign investors.

Summary of new law

5.9 The conduit foreign income measure makes two significant changes to the income tax law. First, it broadens the categories of foreign income earned by an Australian corporate tax entity which can be distributed to foreign owners free of Australian tax. Secondly, the measure provides a mechanism to ensure that Australian tax is not payable where conduit foreign income is distributed through one or more further Australian corporate tax entities.

5.10 A dividend withholding tax exemption will be provided for conduit foreign income that is paid to foreign residents. Where the conduit foreign income is distributed to the foreign shareholder via an Australian permanent establishment the income will not be assessable. Australian corporate tax entities that receive an unfranked distribution declared to be conduit foreign income will not pay Australian tax on that income if the conduit foreign income is on-paid to shareholders. The Australian corporate tax entity must pay an equivalent amount of conduit foreign income (net of related expenses) within a certain time period. Where these conditions are met, the Australian corporate tax entity will treat the amount of the conduit foreign income in the unfranked distribution it received as non-assessable non-exempt income.

5.11 Broadly, amounts considered to be conduit foreign income are amounts of foreign income and gains that are earned by or through an Australian corporate tax entity and not taxed in Australia at the entity level. Some examples of conduit foreign income are:

·
foreign non-portfolio dividends received by an Australian company;
·
foreign income and certain capital gains derived directly or indirectly by an Australian company from carrying on business in a foreign country through a permanent establishment;
·
capital gains on the disposal of shares in a foreign company with an underlying active business; and
·
foreign income (eg, royalties) and net capital gains included in the assessable income of a corporate tax entity where the Australian tax liability on that income is reduced by foreign tax credits.

5.12 An Australian corporate tax entity can only declare an amount of an unfranked distribution to be conduit foreign income if it has records that demonstrate that it has at least that much conduit foreign income to distribute.

5.13 Conduit foreign income can be calculated from the start of an income year starting on or after 1 July 2005. However, a distribution can only be declared to be conduit foreign income on or after Royal Assent. Entities with income years starting before 1 July 2006 but after Royal Assent will only be able to make such declarations from the start of that year.

5.14 Transitional rules ensure that the existing foreign dividend account provisions generally operate until the time an entity can make a distribution that is declared to be conduit foreign income.

Comparison of key features of new law and current law
New law Current law
Conduit foreign income received by or from an Australian corporate tax entity will be able to be distributed to foreign shareholders without incurring dividend withholding tax. Foreign non-portfolio dividends received by an Australian company can be distributed to foreign shareholders without incurring dividend withholding tax.
Subject to specified time limits, an Australian corporate tax entity will not pay Australian tax on an unfranked distribution it receives that is declared to be conduit foreign income, to the extent that it on-pays the distribution to its shareholders. No equivalent.
Conduit foreign income will be reduced by most expenses that reasonably relate to that income. The foreign dividend account is debited by the amount of expenses that relate to the dividend and that would have been deductible if the section 23AJ dividends were treated as assessable income.
A capital gain that is reduced because of the operation of section 768-505 or disregarded because of the operation of section 23AH of the ITAA 1936 will increase the amount of conduit foreign income. A capital loss that is reduced or disregarded under those provisions will decrease conduit foreign income. No equivalent.
Foreign tax credits are grossed up and included in conduit foreign income. The amount reflects an amount of assessable foreign income that cannot be distributed as a fully franked distribution. No equivalent.
Distributions that are non-assessable non-exempt income under section 23AI or section 23AK of the ITAA 1936 or amounts not assessed because of paragraph 99B(2)(e) of the ITAA 1936, will not be included in conduit foreign income. Section 23AI or section 23AK of the ITAA 1936 amounts, or amounts not assessed because of paragraph 99B(2)(e) of the ITAA 1936, do not give rise to a foreign dividend account credit which means those amounts cannot be distributed free of withholding tax under the foreign dividend account rules.
Conduit foreign income is adjusted if an Australian corporate tax entity streams a frankable distribution with an amount declared to be conduit foreign income to some shareholders and not others or different amounts of conduit foreign income are declared for different shareholders. Similar anti-streaming rules are currently contained in the foreign dividend account provisions and in the imputation rules.
Penalties will apply where an Australian corporate tax entity declares an amount to be conduit foreign income where that amount is greater than the amount of conduit foreign income the entity has available to distribute. A penalty applies where the foreign dividend account percentage resulted in an amount of a foreign dividend account declaration exceeding the foreign dividend account surplus.

Detailed explanation of new law

Broad outline

5.15 As a result of these amendments, an Australian corporate tax entity is able to make an unfranked distribution to its foreign owners free of dividend withholding tax to the extent that the distribution is declared to be conduit foreign income [Schedule 2, item 1, paragraph 802-15(1)(b)] . This declaration must be made on or before the day on which the distribution is made [Schedule 2, item 1, subsection 802-15(2)] . Similarly, where the distribution is attributable to an Australian permanent establishment of the foreign shareholder, it will not be assessable income of the foreign shareholder to the extent it is declared to be conduit foreign income [Schedule 2, item 1, paragraph 802-15(1)(a)] . That amount will be non-assessable non-exempt income of a foreign resident recipient. This means that the amount of conduit foreign income will not reduce any Australian tax loss of the foreign resident, particularly where the distribution is received through a permanent establishment in Australia. Where the distribution is made to a partnership with foreign partners or a trust with foreign beneficiaries, the conduit foreign income amount will be exempt from withholding tax, or will be non-assessable non-exempt income, to the extent that tax would otherwise have been payable. In certain circumstances an unfranked distribution declared to be conduit foreign income that is paid to an Australian corporate tax entity will not be included in the entity's assessable income [Schedule 2, item 1, section 802-20] .

5.16 Under section 202-75 a corporate tax entity is required to provide a distribution statement to its owners when it makes a frankable distribution. The distribution statement must be in a form approved by the Commissioner of Taxation and include certain information. It is anticipated that the approved form of a distribution statement will require the portion of the distribution declared to be conduit foreign income to be shown. The entity receiving the distribution can rely on the amount of the conduit foreign income declared in the distribution statement. A resident shareholder that is not a corporate tax entity can ignore this information because amounts declared to be conduit foreign income do not change the resident's taxable income or tax payable. It is expected that partnerships or trustees in receipt of this information will deal with it in the same way in which they handle franking credits on distribution statements.

5.17 This measure revolves around amounts treated as conduit foreign income. Unlike the foreign dividend account provisions, the measure does not prescribe a detailed mechanism of credits and debits for an entity to use to determine the amount of its conduit foreign income. An entity is also not required to know the amount of its conduit foreign income at all times by keeping a rolling balance of its conduit foreign income. However, the law does say what is included in or excluded from conduit foreign income at a particular time by reference to transactions or events happening up to that time. [Schedule 2, item 1, section 802-25]

5.18 An entity that carries on business must keep records to record and explain all transactions that are relevant for income tax purposes under section 262A of the ITAA 1936. This means that an entity would need to keep records to explain the amount of conduit foreign income it has at the time it makes a distribution declared to be conduit foreign income. If an entity makes a declaration before making the distribution it would need to have a record to explain the amount of its conduit foreign income at the time of the declaration.

5.19 This measure will apply to Australian corporate tax entities. An entity that is an Australian resident company or corporate limited partnership at a particular time is an Australian corporate tax entity at that time. If the entity is a corporate unit trust or public trading trust, it is an Australian corporate tax entity if it is a resident unit trust for the income year in which the time occurs. [Schedule 2, item 17, subsection 995-1(1)]

5.20 The following paragraphs describe how the legislation operates for Australian companies. However, as the legislation generally applies to other types of corporate tax entities, the explanations also apply, with the appropriate modifications, to those other entities and to head companies of consolidated groups. The legislation does not apply in calculating the attributable income of controlled foreign companies as those entities cannot have conduit foreign income. Therefore, they would not be able to declare a distribution to be conduit foreign income and so cannot treat any dividend income they receive as non-assessable non-exempt income under the new legislation.

Calculation of conduit foreign income

5.21 This measure is designed to allow conduit foreign income to flow through Australian companies to foreign shareholders without being taxed further in Australia.

The basic conduit foreign income amount

5.22 Broadly, conduit foreign income is a foreign amount derived by an Australian company which the company has available to distribute as a profit to its shareholders. Much of that income or gain is exempt from Australian tax when derived by the company and so would be subject to withholding tax when distributed to the company's foreign owners. This is the income that these provisions are primarily targeting. Foreign amounts that are normally included in an Australian company's assessable income are excluded from conduit foreign income in the first instance because they generate franking credits that allow the net profit amount to be distributed to foreign shareholders free of further Australian tax [Schedule 2, item 1, subsection 802-30(2)] . If foreign tax credits reduce the Australian tax liability in relation to the assessable foreign income then an amount is included in conduit foreign income. This is explained in paragraphs 5.63 to 5.67.

5.23 Initially, an amount is included in conduit foreign income if it satisfies the following three conditions:

·
The amount must be ordinary or statutory income derived by the company.
·
The income would not be assessable income if the company were treated as a foreign resident.
·
The income is included in an income statement or similar statement.

[Schedule 2, item 1, subsection 802-30(1)]

5.24 In respect of the third condition above, it does not matter whether the amount has been included in an income statement before it is derived for tax purposes or will be included in one after derivation. However, conduit foreign income can still only include amounts derived in income years that start after 30 June 2005. This condition is based on accounting concepts and is used as a mechanism to restrict conduit foreign income to amounts of distributable profits. It is appropriate to use accounting concepts because these determine the actual amounts a company may distribute.

5.25 In order to give more certainty to which of these amounts is to be included in conduit foreign income, the basic tax concepts of ordinary and statutory income derived by the company are used. One intended effect of this is to exclude unrealised profits or gains and foreign exchange gains (except to the extent that the tax law explicitly deals with them). Using these tax concepts minimises compliance costs as an Australian company would be required to use this information to prepare its income tax returns. The meanings of ordinary and statutory income underpin Division 6.

5.26 The final requirement for determining conduit foreign income is to know whether the income amount is foreign. Instead of using the definition of 'foreign income' in section 6AB of the ITAA 1936 a more general approach has been adopted, again using Division 6. That Division does not deal explicitly with the foreign source income of an Australian resident, as residents are initially required to include income from all sources in assessable income. Foreign residents, on the other hand, only include in assessable income Australian source income or other specified amounts. The remainder of their income is effectively foreign source income.

5.27 Hence, the Australian company is treated as though it were a foreign company for the purpose of this initial determination, to capture all types of foreign income. The company is not treated as a resident of any particular foreign country which means that none of Australia's tax treaties impacts on the calculation, with the exception of the Taxation Code for the Timor Sea Treaty because it governs activity in the Joint Petroleum Development Area and it applies to persons regardless of their residence. Targeting the amounts derived by the company that would not be assessable under Division 6 if the company were a foreign resident more generally identifies the income that is considered to be foreign income of an Australian company. The effect of this approach is that generally no Australian source income is included in the calculation of conduit foreign income. However, some exceptions to that outcome are discussed in paragraphs 5.34 to 5.38.

5.28 Generally, the reference to an income statement will be to the income statement of the company which derived the amount but it may be recorded in another entity's income statement. A similar statement is any sort of financial statement that is prepared to determine the amount an Australian company can distribute to its members. Financial statements (as defined by the Australian Accounting Standards) are to be prepared by certain entities governed by the Corporations Act 2001 . The types of entities include public companies, registered schemes and large proprietary companies.

5.29 The reference to the income statement is to the income statements of the individual entities that form part of a consolidated or multiple entry consolidated (MEC) group. The reference is not only to the income statement of the head company. Groups that prepare consolidated accounts where individual members of the group do not prepare an income statement can rely on similar statements that may be prepared by those subsidiaries or on the consolidated income statement of the group.

5.30 Amounts that are applied for the benefit of a company are also considered to be derived by the company [Schedule 2, item 1, subsection 802-30(7)] . For example, withholding tax deducted by a foreign entity from a payment to the Australian company will be treated as an amount derived by the Australian company. Those amounts are likely to be included in an income statement because the gross amount of the distribution would contribute to profit and the foreign tax would be an expense.

5.31 Foreign income amounts that are assessable (eg, interest and royalties) can generally be distributed as a franked distribution to the extent Australian tax is paid on those amounts. Since no withholding tax is payable on those distributions, foreign income amounts that are included in the company's assessable income under existing provisions are excluded from conduit foreign income, to avoid a double benefit arising. The possibility that unfranked distributions which include conduit foreign income might be non-assessable non-exempt income is ignored at this stage of the calculation [Schedule 2, item 1, subsection 802-30(2)] . The assumption that the company is a foreign resident does not apply when determining those amounts. Foreign tax credits that reduce an Australian tax liability on the foreign income give rise to conduit foreign income in the next income year (see paragraphs 5.63 to 5.67 for more details).

5.32 The amount that is left is essentially the foreign income on which no Australian company tax is payable (eg, foreign branch income or non-portfolio dividends exempt under section 23AH or section 23AJ of the ITAA 1936, respectively). This amount may be called the basic conduit foreign income amount.

Example 5.1: Primary elements of basic conduit foreign income

Primary elements of basic conduit foreign income

Ausco is wholly-owned by Forco B and has a controlled foreign company, Forco A. It owns 60 per cent of Forco A. No income is attributed to Ausco in the 2005-06 or 2006-07 income years.On 2 January 2007 Forco A distributes a $600 dividend to Ausco from which 5 per cent withholding tax is deducted ($30). Interest expenses that relate to deriving the dividend income from Forco A amount to $50.Ausco received various amounts of assessable foreign income from small investments totalling $150 (on which $21 foreign tax is paid) during the income year ended 30 June 2007. Ausco incurred $50 of expenses that related to that foreign income.Ausco purchases all the shares in a foreign company HK Co on 1 June 2006 for $10,000. The foreign company assets are all active assets. Ausco sold HK Co for a capital gain of $500 on 15 June 2007.Ausco does not derive any other income in the year ended 30 June 2007.Ausco wants to declare and make an unfranked distribution to its parent company on 31 August 2007. How much of that distribution can it declare to be conduit foreign income?The $600 dividend from Forco A qualifies to be included in Ausco's basic conduit foreign income - it is ordinary income included in its income statement that would not be assessable income if Ausco were a foreign resident. Moreover, it remains included because it is not actually assessable income for Ausco. The $150 of assessable foreign income qualifies in the first instance but is then excluded because it is actually assessable income. None of the capital gain on the disposal of the shares in HK Co is included because it would not be statutory income for a foreign resident. (The calculation for determining the amount of capital gain (or loss) included in conduit foreign income is described in Example 5.3.)Under the general record keeping rules, Ausco would need to record all amounts (income, gains and expenses) relevant to the calculation of its conduit foreign income.

5.33 A public trading trust or a corporate unit trust may not have any amounts that form basic conduit foreign income (except where either is the head company of a consolidated group). The calculation of the net income of these trusts generally means that all their ordinary and statutory income will be assessable. These entities are not entitled to most foreign income exemptions that an Australian company is entitled to. But section 23AH of the ITAA 1936 does allow the exemption from tax for foreign branch profits of trusts to flow through to Australian company beneficiaries. Further, to the extent that those trusts may be entitled to foreign tax credits on foreign income or if they receive a dividend declared to be conduit foreign income those amounts may be conduit foreign income. This will enable these entities to pay unfranked distributions declared to be conduit foreign income.

The treatment of some particular amounts

5.34 At first, an unfranked distribution from an Australian company would be included in the conduit foreign income of the Australian company that received the distribution. This amount is ordinary income that would be included in an income statement and is not assessable income if the recipient Australian company is treated as a foreign resident. Section 128D of the ITAA 1936 specifically excludes amounts from assessable income where those amounts are subject to withholding tax. A distribution paid to a foreign shareholder is subject to withholding tax. Similarly, if a distribution includes an amount of conduit foreign income, that amount is excluded from assessable income [Schedule 2, item 1, subsection 802-15(1)] . This means that some Australian source income is included in conduit foreign income in the first instance. However, as the distribution is in fact included in the company's assessable income, the amount is appropriately excluded from conduit foreign income by the second step. The same process rightly excludes interest or royalty income paid by an Australian resident to the company.

5.35 Net capital gains in relation to assets with the necessary connection with Australia are included in assessable income of a foreign resident and therefore are statutory income. However, the search here is for amounts that are not included in assessable income. No capital gains will meet the conditions of being statutory income and not being included in assessable income of a foreign resident. Further, disregarded capital gains or losses are not ordinary or statutory income and so are not included in basic conduit foreign income. This means no capital gain amounts will be included in basic conduit foreign income. However, some capital gains (and losses) are specifically included in conduit foreign income under other provisions (see paragraphs 5.54 to 5.62).

5.36 Capital gains and losses on CGT assets acquired before 20 September 1985 are usually disregarded which means they are not included in calculating net capital gains. Because a disregarded gain or net gain is not statutory or ordinary income, those amounts will not be included in basic conduit foreign income. Nor will a disregarded loss or net loss reduce basic conduit foreign income. These amounts are not included under the specific provisions dealing with capital gains and losses even where they relate to foreign assets because the proposed measure is primarily about future investments. It is not the intention of the new measure to impact on past investment decisions and it would add considerable complexity to identify which pre-CGT gains and losses should be given conduit foreign income treatment. On the other hand, gains or losses on assets acquired on or after 20 September 1985 but before this Bill receives Royal Assent are dealt with because it was relatively easier to decide which of them is foreign.

5.37 The amount of income from offshore banking activities of an offshore banking unit in Australia that is not included in assessable income because of section 121EG of the ITAA 1936 will normally be included through the above steps in the company's basic conduit foreign income. While this income may not always be foreign income, even leaving aside section 121EJ of the ITAA 1936, it is intended that it be conduit foreign income. In this way, the income will receive the same tax treatment in Australia as if it had been derived directly by a foreign resident operating as an offshore banking unit in Australia.

5.38 Similarly, some of the business profits derived by an Australian company from activities conducted in the Joint Petroleum Development Area that are governed by the Timor Sea Treaty and the associated Taxation Code will be conduit foreign income. The relevant portion is the 90 per cent of business profits that are not taxed in Australia (but are taxed in East Timor). The reason for this is similar to that for the untaxed portion of offshore banking income. That portion of business profits still has to satisfy the other requirements for conduit foreign income. That is, it must consist of ordinary or statutory income that is included in an income statement.

Adjustments to the basic conduit foreign income amount

Unfranked distributions of conduit foreign income

5.39 The basic conduit foreign income amount is increased by the amount of an unfranked distribution paid to the company that is declared to be conduit foreign income [Schedule 2, item 1, paragraph 802-30(3)(a)] . The amount of conduit foreign income is shown on a distribution statement. An Australian company will receive a distribution statement that shows the amount that the company can include in its conduit foreign income. This simple mechanism allows for the transfer of an amount of conduit foreign income from one Australian company to another. The impact on the paying company's conduit foreign income is discussed in paragraphs 5.68 to 5.70. The amount that is included in the recipient company's conduit foreign income may be reduced when some of the unfranked distribution remains assessable (see paragraphs 5.71 to 5.75).

5.40 A company that receives a trust or partnership distribution that includes a share of a frankable distribution that was declared to include conduit foreign income includes that share of the declared conduit foreign income amount in its own conduit foreign income. The company would include its share of the declared conduit foreign income amount where it is presently entitled to the income of the trust. [Schedule 2, item 1, paragraph 802-30(3)(b)]

Foreign non-portfolio dividends

5.41 Section 23AJ of the ITAA 1936 treats foreign non-portfolio dividends as being non-assessable non-exempt income. The section only applies to Australian companies and not to other types of corporate tax entities. The amount of those dividends is included in basic conduit foreign income to the extent that the amount is included in an income statement. Non-portfolio dividends considered to be a return of capital under accounting principles are not included in an income statement or in basic conduit foreign income. An adjustment is required to increase the basic conduit foreign income amount by the amount of a non-portfolio dividend that is not already included in that amount, to preserve the current treatment of non-portfolio dividends. [Schedule 2, item 1, paragraph 802-30(3)(c)]

5.42 Foreign portfolio dividends are included in assessable income which means they will not be included in basic conduit foreign income [Schedule 2, item 1, subsection 802-30(2)] . An adjustment is not required to include any of those amounts in conduit foreign income in the same way as for non-portfolio dividends because they are not given conduit treatment under existing law. However, to the extent that a foreign tax credit is allowed for these dividends, the conduit foreign income amount will be increased (see paragraphs 5.63 to 5.67).

Income representing amounts previously taxed under the accruals tax regimes

5.43 The basic conduit foreign income amount is reduced by any amount:

·
that is excluded from the company's assessable income under section 23AI or 23AK both of which are in the ITAA 1936 [Schedule 2, item 1, paragraph 802-30(4)(a)] ; or
·
that is not included in assessable income because of paragraph 99B(2)(e) of the ITAA 1936 [Schedule 2, item 1, paragraph 802-30(4)(b)] .

5.44 Amounts are excluded from assessable income by sections 23AI and 23AK and paragraph 99B(2)(e) because those amounts represent amounts that were previously taxed in Australia through the accruals tax rules. The provisions prevent amounts being taxed twice in Australia: once under the accruals rules and again when amounts are paid to Australian recipients.

5.45 A franking credit arises for a company where Australian tax is paid on amounts included in assessable income under the accruals rules. An amount that is excluded from assessable income under section 23AI, 23AK or paragraph 99B(2)(e) can still be distributed by an Australian company as a franked distribution. The franking credits that could be used relate to the Australian tax that would have been paid under the accruals tax rules. Fully franked distributions generally do not incur any further Australian tax in the hands of foreign or company recipients. This means there is no need to treat this income as conduit foreign income because it will pass through Australia without further taxation. Where a foreign tax credit arises in respect of section 23AI or 23AK amounts, an amount would be added to conduit foreign income in the following year (see paragraphs 5.63 to 5.67).

Non-assessable foreign income with franking credits attached

5.46 Foreign dividend income does not usually have franking credits attached to that income. However, where a foreign company can choose to apply the Australian imputation system the foreign company keeps a franking account and is able to pay frankable distributions to its shareholders. The frankable distributions may have franking credits attached to them. Only Australian shareholders of the foreign company benefit from receiving the attached franking credits. An Australian company that receives those dividends can credit its own franking account with those credits if the dividends are assessable. The Australian company is then able to use those franking credits to frank its own distributions.

5.47 If an Australian company received foreign income with franking credits attached, it could distribute that income as a fully franked distribution to the extent of the franking credits it received. Conduit foreign income is already reduced by assessable foreign income which would give rise to franking credits which means it is only franking credits for non-assessable foreign income which must be considered.

5.48 As discussed previously, distributions that are fully franked can pass through Australia without further taxation. This means the income should not be treated as conduit foreign income to the extent it can be distributed fully franked. The basic conduit foreign income amount is reduced by an amount using the following formula:

available franking credit x [(1 - general company tax rate) / general company tax rate]

The available franking credit is the amount credited to the Australian company's franking account at the time the company received the dividend. The available franking credit is restricted to the amount that relates to the amount of the foreign dividend that still remains in the basic conduit foreign income amount. [Schedule 2, item 1, paragraph 802-30(4)(c)]

Expenses related to amounts included in conduit foreign income

5.49 Expenses that relate to the total amount included in conduit foreign income, as discussed so far, reduce conduit foreign income. There does not have to be actual matching of the individual expenses to individual amounts of the conduit foreign income. These would normally be expected to be expenses taken into account in preparing the company's income statement and would not necessarily be limited to expenses incurred solely in earning the conduit foreign income. Expenses should reduce the amount of conduit foreign income because the profit available for distribution that is sourced from foreign income is reduced. Correctly reducing the amount of conduit foreign income prevents other types of income being distributed as an unfranked distribution declared to be conduit foreign income. [Schedule 2, item 1, subsection 802-30(5)]

5.50 The expenses that are reasonably related to the conduit foreign income are those expenses that would ordinarily be considered to relate to deriving the income. The term 'expense' has its ordinary meaning in the context of the application of the provisions. That is, as these provisions would generally apply to a company that carries on business, the term 'expense' would take its meaning from the application of that term to companies carrying on business. An example of such an expense would be any foreign tax paid on the foreign income. How related an expense is to the conduit foreign income is a question of fact based on the test of what a reasonable person would say.

5.51 There are some expenses that relate to foreign income that will not reduce the amount of conduit foreign income. These are expenses that are deductible from a company's assessable income whether or not the foreign income they relate to is included in assessable income. An example of an expense that is deductible even though the foreign income is not assessable is an interest expense that is an allowable deduction under section 25-90. Expenses that are deductible do not reduce conduit foreign income because they reduce the amount of franking credits that would be available to pay fully franked distributions. If the conduit foreign income was also reduced there would be foreign income that could not be distributed free of withholding tax. This would effectively mean double counting the expenses.

5.52 Frankable distributions declared to be conduit foreign income may be included in assessable income or may be non-assessable non-exempt income (see explanation in paragraphs 5.76 to 5.86). When calculating expenses that might otherwise be deductible for the purpose of reducing the conduit foreign income amount, the whole amount of such dividends is treated as non-assessable non-exempt income. [Schedule 2, item 1, subsection 802-30(5)] . An adjustment is made at a later time when it is known to what extent such dividends remain assessable (see paragraphs 5.72 to 5.75).

Example 5.2: Subtracting related expenses Assume the same facts as in Example 5.1. How much of the Ausco's expenses are subtracted from the $600 of basic conduit foreign income?First, the $50 of interest expenses are not subtracted because they are deductible under section 25-90. The withholding tax of $30 taken from the dividend paid by Forco A is subtracted as it is a non-deductible expense. Neither the $21 foreign tax expense nor the $50 of other expenses incurred in earning the assessable foreign income is deducted because that income is not included in basic conduit foreign income. Therefore, the basic conduit foreign income amount is reduced by $30.

Other things that affect conduit foreign income

5.53 The basic conduit foreign income amount adjusted by any amounts described in paragraphs 5.39 to 5.52 results in an amount to be included in the company's conduit foreign income [Schedule 2, item 1, subsection 802-30(6)] . Other events may also affect the amount of conduit foreign income an Australian company has available to distribute. Those effects and their timing are described in paragraphs 5.54 to 5.75.

How do capital gains affect conduit foreign income?

5.54 Conduit foreign income may be increased by certain capital gains of an Australian company that are not included in the calculation of its net capital gain. An Australian company only includes its net capital gains in statutory income. Individual capital gains and losses that make up the net amount are neither statutory nor ordinary income. This means that the individual capital gains (and the capital losses discussed in paragraphs 5.59 to 5.61) must be explicitly included in (or excluded from) conduit foreign income.

5.55 A capital gain (or part of it) may be excluded from the calculation of a net capital gain by section 768-505. This section operates when certain CGT events happen in relation to non-portfolio interests in foreign companies. The non-portfolio interest must be shares and the company must hold at least a 10 per cent voting interest in the foreign company. The capital gains would generally relate to amounts received as a result of the sale of shares in foreign companies with an underlying active business.

5.56 Where a capital gain for an Australian company is reduced under section 768-505 the amount of the reduction is added to conduit foreign income [Schedule 2, item 1, paragraph 802-35(1)(a)] . Those amounts are included in conduit foreign income because they are gains that would not be taxable in Australia if the shares in the foreign company had been held directly by a non-resident. Distributions of those amounts would be unfranked as no Australian tax is payable which means there are no franking credits available. To ensure Australian tax is not paid on those amounts when distributed to foreign residents those distributions can be declared to be conduit foreign income.

5.57 Certain capital gains are ignored in the calculation of a net capital gain because of the operation of section 23AH of the ITAA 1936. Broadly, section 23AH applies to capital gains made directly or indirectly by an Australian company in disposing of non-tainted assets used in deriving foreign branch income. The amount of the capital gain disregarded under section 23AH is included in conduit foreign income. [Schedule 2, item 1, paragraph 802-35(1)(b)]

5.58 The amount of any capital gain that is not taxable in Australia under the Alienation of Property Article of the Taxation Code for the Timor Sea Treaty is also included in conduit foreign income. That article primarily covers gains and losses of a capital nature from the alienation of property situated in the Joint Petroleum Development Area. Ninety per cent of any such gain is not taxable in Australia (but may be taxable in East Timor) and that amount is included in conduit foreign income. [Schedule 2, item 1, paragraph 802-35(1)(c)]

How do capital losses affect conduit foreign income?

5.59 Conduit foreign income is reduced by certain capital losses of an Australian company that are not included in the calculation of a net capital gain. A capital loss (or part of it) may be ignored in the calculation of net capital gains by section 768-505. Where a capital loss for an Australian company is reduced by the operation of section 768-505 the amount of the reduction reduces conduit foreign income. [Schedule 2, item 1, paragraph 802-35(2)(a)]

5.60 Capital losses made directly or indirectly by an Australian company may be ignored because of the operation of section 23AH of the ITAA 1936. The amount of the capital loss disregarded under section 23AH reduces conduit foreign income. [Schedule 2, item 1, paragraph 802-35(2)(b)]

5.61 The amount of any capital loss that is disregarded in Australia under the Alienation of Property Article of the Taxation Code for the Timor Sea Treaty reduces an entity's conduit foreign income. Ninety per cent of any loss covered by the Article is disregarded for Australian tax purposes and that amount is subtracted from conduit foreign income. [Schedule 2, item 1, paragraph 802-35(2)(c)]

When do capital gains and losses affect conduit foreign income?

5.62 Capital gains and losses that result from a CGT event in an income year and which are relevant to the calculation of conduit foreign income are likely to be calculated at the end of that income year. To avoid errors that might arise from a requirement for an immediate adjustment of conduit foreign income because of these events, some delay in making the adjustments is prescribed in the legislation. The amount of a capital gain or loss not included in the calculation of a net capital gain under section 768-505 changes conduit foreign income at the end of the income year in which the relevant CGT event occurred. Similarly, capital gains and losses disregarded under section 23AH of the ITAA 1936 and the Alienation of Property Article of the Taxation Code for the Timor Sea Treaty affect the amount of conduit foreign income at the end of the income year in which the relevant CGT event occurred. The net disregarded gain or loss will be taken into account at the end of the income year. [Schedule 2, item 1, subsection 802-35(3)]

Example 5.3: Capital gains Again assume the same facts as in Example 5.1. How much, if any, of the capital gain from the sale of the shares in HK Co would be included in Ausco's conduit foreign income at the end of the income year?Since all the assets of HK Co are assumed to be active assets, all of the capital gain from the disposal of Ausco's interest in it would be disregarded. Therefore all the gain would be included in Ausco's conduit foreign income.

Is assessable foreign income included in conduit foreign income?

5.63 The calculation of conduit foreign income, to this point, has captured foreign income and gains that are not included in assessable income. Allowing a credit for foreign tax paid on foreign income and gains included in assessable income (eg, rents and royalties) effectively means that no Australian tax is payable on some of that foreign income/gain. This means there are less franking credits available to enable the distribution of the foreign income or gain to be franked.

5.64 To address this deficiency, an amount is added to conduit foreign income where an Australian company has claimed foreign tax credits. This enables it to distribute all its assessable foreign income (net of expenses) without further Australian tax to its foreign shareholders. The amount is based on the amount of foreign tax credit calculated under section 160AF of the ITAA 1936 for the income year immediately before the one in which the adjustment to the conduit foreign income is made. The amount added to the conduit foreign income is calculated using the following formula:

foreign tax credits x [(1 - general company tax rate) / general company tax rate]

[Schedule 2, item 1, section 802-40]

5.65 The credit is grossed up to determine the amount of net foreign income that, as a result of the foreign tax paid, is effectively free of any further Australian tax and therefore qualifies as conduit foreign income.

5.66 This amount is included in a company's conduit foreign income in the income year immediately following the one for which the credit arose. This is because the foreign tax credits available under section 160AF generally cannot be properly ascertained until after the end of the relevant income year. The amount is included in conduit foreign income in the next year at an appropriate time. [Schedule 2, item 1, section 802-40]

5.67 Because this inclusion is based on the amount of foreign tax credit allowed for a year, if there is excess foreign tax for a particular class of foreign income in a year, that additional foreign tax would lead to an increase in conduit foreign income only when it was used in a later year to shelter further foreign income from Australian tax. If there is an overall loss for a class of foreign income, no foreign tax credit is allowed for that income and no adjustment is made to conduit foreign income. Effectively an adjustment will be made in a later year when some or all of the loss is recouped and the foreign tax credit that is then allowed is reduced. Therefore, no specific adjustment needs to be made to the amount of foreign tax credit when calculating conduit foreign income because excess foreign tax or a foreign loss is carried forward.

Example 5.4: The inclusion of assessable foreign income Assume the same facts as in Example 5.1. How much of the net assessable foreign income from minor investments would be included in Ausco's conduit foreign income?Ausco would be allowed a foreign tax credit for the $21 of foreign tax in its assessment for the 2007 income year and would have to pay $9 of Australian tax on this assessable foreign income. Applying the above formula, Ausco's conduit foreign income would be increased by $49 (=$21 x 7/3) in the 2008 year when that credit had been calculated. (Together with the ability to pay a franked dividend of $21 out of the franking credit of $9 arising from the payment of Australian tax on this income, Ausco would be able to distribute all the net amount of that income ($70) to its parent company free of withholding tax.)

How do previous declarations affect conduit foreign income?

5.68 A company's conduit foreign income will be reduced where it makes an unfranked distribution that includes an amount declared to be conduit foreign income. The amount of the reduction is equal to the amount of the distribution that the company has declared to be conduit foreign income. [Schedule 2, item 1, section 802-45]

5.69 The amount of the reduction also includes amounts that are taken to have been declared to be conduit foreign income under the anti-streaming rule (see paragraphs 5.89 to 5.94). These are amounts that should have been declared to be conduit foreign income to ensure all membership interests received the same amount of conduit foreign income.

5.70 After the company has declared an amount to be conduit foreign income, the remaining balance can be included as part of any later declarations that the company may make. [Schedule 2, item 1, note to section 802-45]

How do distributions received from other Australian corporate tax entities affect conduit foreign income?

5.71 If a company receives an unfranked distribution from another Australian company it is able to include those amounts declared to be conduit foreign income in its own conduit foreign income [Schedule 2, item 1, paragraph 802-30(3)(a)] . The receiving company treats the distribution received in one of two ways for the purposes of determining its own taxable income. Either:

·
the distribution (or part of it) is non-assessable non-exempt income if an amount of conduit foreign income is on-distributed (see paragraphs 5.76 to 5.86); or
·
the distribution continues to be included in the assessable income of the company.

5.72 The conduit foreign income of a company is reduced where an amount of conduit foreign income it receives from another Australian company remains assessable income. This is done because including some or all of the distributed conduit foreign income in assessable income means that subsequent distributions paid out of that amount can be franked. [Schedule 2, item 1, subsection 802-50(1)]

5.73 The amount of the reduction is the amount of the distribution that has been included in assessable income less any expenses that reasonably relate to that amount [Schedule 2, item 1, subsection 802-50(2)] . This may include some expenses that are not deductible for income tax purposes. All relevant expenses are subtracted from the assessable amount of the distribution because they previously reduced the conduit foreign income amount (see paragraphs 5.49 to 5.52).

5.74 The due date for lodgement of the company's tax return would be an appropriate time at which to reduce the company's conduit foreign income. If a company is granted an extension of time to lodge its tax return the new due date becomes the appropriate time for reducing the conduit foreign income.

5.75 By the time the company lodges its tax return for an income year, there should be no amount left in its conduit foreign income that relates to a distribution of conduit foreign income the company received in that income year. The distribution declared to be conduit foreign income that a company receives will have either been distributed as conduit foreign income or included in assessable income.

Example 5.5: Impact of a received CFI amount on a company's conduit foreign income Aust Co 2 received from Aust Co 1 a $100 distribution. All of the distribution was declared to be conduit foreign income. Aust Co 2 had $20 of expenses that relate to the distribution.Assume that Aust Co 2 distributed an unfranked distribution, $60 of which is declared to be conduit foreign income. This means that $75 of the $100 was treated as non-assessable non-exempt income (see Example 5.6). The balance of $25 remains part of Aust Co 2's assessable income for that income year.Aust Co 2's conduit foreign income would be reduced by $20($25 - $5) because Aust Co 2 had expenses of $5 ( ¼ of $20) in relation to the assessable amount of $25.In summary, the transactions affect Aust Co 2's conduit foreign income in the following way if Aust Co 2 were to keep a rolling balance:

·
the $100 distribution is included in its conduit foreign income when Aust Co 2 receives the distribution;
·
the $20 of expenses that relate to the distribution reduces the amount of conduit foreign income when those expenses are incurred;
·
the $60 Aust Co 2 paid out as conduit foreign income reduces the conduit foreign income at the time of the declaration (or the making of the distribution); and
·
the $20 that is the net amount of the dividend included in assessable income reduces the amount of conduit foreign income when Aust Co 2 lodges its tax return.

Distributions between Australian corporate tax entities

5.76 Generally, an Australian company would include the amount of an unfranked distribution in its assessable income and would pay Australian tax on that amount. However, under this measure an unfranked distribution declared to be conduit foreign income may end up being non-assessable non-exempt income. The reason for treating an unfranked distribution in this way is to allow conduit foreign income to flow through additional Australian companies to foreign shareholders without incurring any Australian tax. A distribution is treated as not assessable and not exempt where three conditions are met.

5.77 The first condition is that an Australian company receives from another Australian company an unfranked distribution which has an amount declared to be conduit foreign income. The distribution statement will show the amount of the unfranked distribution that is conduit foreign income. The conduit foreign income amount shown on the distribution statement is called ' a received CFI amount '. [Schedule 2, item 1, paragraphs 802-20(1)(a) and (b)]

5.78 The second condition is that the company that receives the distribution must make an unfranked distribution it declares wholly, or in part, to be conduit foreign income. This is to ensure that the conduit foreign income is passed on to shareholders and not accumulated in interposed Australian companies. The amount the company declares to be conduit foreign income is called ' a declared CFI amount '. [Schedule 2, item 1, paragraph 802-20(1)(c)]

5.79 The third condition is that the unfranked distribution that the recipient company has declared to be conduit foreign income must be distributed within the required time. The time is before the due date for lodgement of the income tax return of the recipient company for the income year in which the distribution was received [Schedule 2, item 1, paragraph 802-20(1)(c)] . The due date for lodgement includes any extension obtained by the company from the Australian Taxation Office (ATO).

5.80 The third condition ensures that Australian tax relief is given to an Australian company only where it distributes conduit foreign income in a timely manner. Without this time restriction compliance and administration costs in keeping track of conduit foreign income over long periods of time would increase. In addition, there could be undue deferral of Australian tax on unfranked foreign income accruing to the benefit of Australian shareholders.

How is the amount of non-assessable non-exempt income calculated?

5.81 The company calculates the amount of unfranked dividends that will not be assessable and will not be exempt by using the formula set out in paragraph 5.84 [Schedule 2, item 1, subsection 802-20(2)] . First, the company adds all the received CFI amounts (amounts of unfranked distributions that are declared to be conduit foreign income) that it received in the income year for which the calculation is being made. The company then adds all the declared CFI amounts (amounts of unfranked distributions that it declared to be conduit foreign income) it has declared for the period from the beginning of the income year until the time it lodges its tax return for that income year.

5.82 The company cannot count a declared CFI amount more than once [Schedule 2, item 1, subsection 802-20(4)] . This means that where an amount is declared to be conduit foreign income before the lodgement of the tax return for the previous year but after the beginning of the current year the amount can only be used once in the calculation of the total declared CFI amount . The amount can either be used in calculating the amount of non-assessable non-exempt income for the preceding year or in the calculation for the current year if there had been no received CFI amount in the preceding income year.

5.83 A distribution that is non-assessable non-exempt income will not reduce the loss of an Australian company. The loss company must meet all the conditions that allow an unfranked distribution that it receives and has been declared to be conduit foreign income to be non-assessable non-exempt income. This includes the condition that the company that received the distribution must also make an unfranked distribution of conduit foreign income before lodging its tax return. If the company is unable to make a distribution because of insufficient profits the unfranked distribution it received will remain assessable income and will reduce its tax loss.

5.84 The amount of a received unfranked distribution that is non-assessable non-exempt income cannot exceed the amount of the distribution that was declared to be conduit foreign income. The amount that is non-assessable non-exempt income is the lesser of the total received CFI amounts or the amount calculated using the following formula:

total received CFI amounts x [total declared CFI amounts / (total received CFI amounts - related expenses)]

The idea of the denominator in this formula is to determine how much of the total received CFI amount remains as profit available for distribution. [Schedule 2, item 1, subsection 802-20(2)]

5.85 Where there is nothing left of the total received CFI amount because of expenses that relate to that amount (as distinct from using that amount for other purposes), then the whole of the received CFI amount will be non-assessable non-exempt income. This will ensure that that conduit foreign income is not taxed in Australia. Where the received CFI amount is wholly non-assessable non-exempt income all expenses that relate to that amount will not be deductible. [Schedule 2, item 1, subsection 802-20(3)]

5.86 Where an amount of conduit foreign income is distributed through one or more partnerships or trusts to another Australian company, the outcome in terms of how much if any of that amount is not assessable income of the company should be the same as if the amount had been distributed directly to the company. This is achieved by applying the rules in Subdivision 207-B to frankable distributions as they apply to franked distributions and to conduit foreign income amounts as they apply to franking credits. Where there is a chain of trusts and/or partnerships the rules are applied iteratively to each partnership or trust. In the case of a distribution of conduit foreign income received by a trust, this rule will apply when the company is presently entitled to a share of the income of the trust. If the trustee is taxable on some or all of the distribution under section 99 or section 99A of the ITAA 1936, none of that amount will be non-assessable. In that case, the trustee will be treated like an individual and not like a company for the purposes of this provision. [Schedule 2, item 1, subsection 802-20(5)]

Example 5.6: Calculating non-assessable non-exempt income Aust Co 1 and Aust Co 2 are both Australian resident companies.Aust Co 1 pays an unfranked distribution of $100 to Aust Co 2. All of the $100 received by Aust Co 2 is declared to be conduit foreign income (the total received CFI amounts is $100).Aust Co 2 has $20 of deductible expenses relating to the $100 dividend.Aust Co 2 makes an unfranked distribution of $90. Aust Co 2 declares $60 of the $90 to be conduit foreign income (the total declared CFI amounts is $60).The amount that is not assessable income and is not exempt income for Aust Co 2 is:

$100 x ($60 / $80) = $75

Note 1: The remaining $25 is included in Aust Co 2's assessable income and it can deduct $5 of the expenses (the part that is related to the $25).Note 2: If Aust Co 2 had instead made a distribution that declared $80 to be conduit foreign income the whole of the $100 distribution it received would be non-assessable non-exempt income.

Example 5.7: Calculating non-assessable non-exempt income when the recipient has other conduit foreign income The same facts as in Example 5.6 apply in relation to the amount of conduit foreign income Aust Co 2 receives from Aust Co 1.However, as a result of other foreign amounts it has received Aust Co 2 makes an unfranked distribution of $200. It can declare the entire amount to be conduit foreign income.In this case, the amount that is not assessable income and is not exempt income for Aust Co 2 is $100.This is the lesser of:

the total received CFI amounts being $100; and
the amount calculated using the formula

$100 x [$200 / ($100 - $20)] = $250

Example 5.8: Calculating non-assessable non-exempt income when the recipient has non-deductible expenses The same facts as in Example 5.6 apply in relation to the amount of conduit foreign income Aust Co 2 receives from Aust Co 1. However, as well as the deductible expenses Aust Co 2 has non-deductible expenses of $5 that relate to the dividend it received.Aust Co 2 makes an unfranked distribution of $90. Aust Co 2 declares $60 of the $90 to be conduit foreign income (the total declared CFI amounts is $60).The amount that is not assessable income and is not exempt income for Aust Co 2 is:

$100 x ($60 / $75) = $80

Note: The remaining $20 is included in Aust Co 2's assessable income and it can deduct $4 (the part of the $20 deductible expenses that is related to the assessable $20 amount).

What is the interaction between a deduction under section 46FA of the ITAA 1936 and an amount that is conduit foreign income?

5.87 An Australian company wholly-owned by a foreign company may get a deduction under section 46FA of the ITAA 1936. A deduction is allowed for unfranked non-portfolio dividends received by an Australian company that are on-paid to the foreign parent. The deduction is available in the income year in which the flow-on dividend is paid. However, by these amendments, an unfranked non-portfolio dividend received by a resident company declared to be conduit foreign income may be treated as being non-assessable non-exempt income if the requisite amount of conduit foreign income is paid to the foreign parent within the prescribed time (see paragraphs 5.76 to 5.86).

5.88 Without an explicit rule a company would receive a double tax benefit from the same non-portfolio dividend it receives once it on-distributed it to the foreign parent company. The amount would be a deduction for the company under section 46FA and would be excluded from assessable income if the distribution is treated as non-assessable non-exempt income. The company may choose whether to treat the dividend as non-assessable non-exempt income or claim a deduction when on-distributed. However, the company will be prevented from choosing both options where the dividend has been on-distributed to the foreign parent company. [Schedule 2, item 1, section 802-55]

What happens if a company streams distributions declared to be conduit foreign income to particular shareholders?

5.89 The policy behind this measure is that all members of a company receive conduit foreign income in proportion to their interest in the company. That is, unfranked distributions declared to be conduit foreign income are not to be streamed to foreign shareholders in preference to resident shareholders. In this way conduit foreign income amounts distributed to resident individuals are intentionally wasted. This is little different to the wastage that occurs where foreign shareholders receive franked distributions where resident shareholders would otherwise have a greater use for the attached imputation credits.

5.90 Given the policy not to stream income to particular shareholders that would most benefit from the receipt of that income, a company should distribute its conduit foreign income to all its shareholders in the same proportion as their membership interests. Membership interests that do not include a right to receive distributions are ignored for this purpose [Schedule 2, item 1, subsection 802-60(3)] . All distributions made during a franking period (generally, a period of 6 months in the case of public companies and an income year in the case of private companies) must have the same proportion declared to be conduit foreign income for all shareholders [Schedule 2, item 1, subsection 802-60(2)] . At least one of the distributions must include some conduit foreign income for this rule to apply. [Schedule 2, item 1, subsection 802-60(1)]

5.91 An adjustment will be made to the company's conduit foreign income where a company does not declare an equal proportion of conduit foreign income on the distributions it makes during a franking period. Even if there is a breach of the franking benchmark rule and a fully franked dividend is paid in a period when an unfranked distribution which includes conduit foreign income is paid, an adjustment will be required. The amount of the adjustment is the amount required to reduce the conduit foreign income to the amount it would have been if the same proportion of conduit foreign income had been declared equally on all the distributions made during the period. The adjustment is based on the distribution with the greatest proportion of declared conduit foreign income. The adjustment is in addition to the amount initially declared by the company to be conduit foreign income. [Schedule 2, item 1, subsections 802-60(1) and (2)]

5.92 An administrative penalty is imposed on the company only if an adjustment to its conduit foreign income results in a negative amount of conduit foreign income at the relevant time. The relevant time is the time when a dividend is declared, or where there is no declaration when a distribution is made. See paragraphs 5.95 to 5.100 for a discussion of the new penalty arrangements.

5.93 There is no immediate penalty if the adjustment to the company's conduit foreign income results in the conduit foreign income remaining positive. Instead the reduction to conduit foreign income will affect the amount that the company can distribute as conduit foreign income in the future. [Schedule 2, item 1, note to subsection 802-60(2)]

Example 5.9: Streaming of conduit foreign income The membership interests in an Australian company are split equally between Australian shareholders and foreign shareholders. Assume the company has $100 of conduit foreign income. It has $200 available for distribution.The company makes a declaration to distribute unfranked dividends totalling $160 to all its shareholders ($80 to the resident shareholders and $80 to the foreign shareholders). It declares that the $80 to its foreign shareholders is conduit foreign income. It does not make the same declaration to its resident shareholders.In this instance, the company would be deemed to have declared the $80 unfranked dividend paid to the residents to be conduit foreign income. The company's conduit foreign income is reduced by a further $80 at the time the dividend declaration is made.The additional $80 adjustment will mean that the amount of the company's conduit foreign income is minus $60. The company is therefore liable to a penalty on the $60 (see Example 5.10). This is the amount of conduit foreign income taken to have been declared in excess of the amount available.

5.94 The consequences that result from streaming distributions only affect the company making the distributions. This means shareholders can continue to rely on the amount that was declared to be conduit foreign income in the statements they receive. [Schedule 2, item 1, subsection 802-60(4)]

What happens if a company over declares an amount of conduit foreign income?

5.95 A company will be liable to a penalty if it declares a distribution to include more conduit foreign income than it has available. At a particular time, a company overstates its conduit foreign income if it declares or makes a frankable distribution and the amount of the unfranked part declared to be conduit foreign income exceeds the amount of the company's conduit foreign income. It should be remembered that the penalty imposed for over declaring conduit foreign income is a penalty on the company making the distribution and not on the shareholders. It is not intended that the amount distributed to shareholders nor the declared conduit foreign income amount would be changed. [Schedule 2, item 25, subsection 288-80(1) of the Taxation Administration Act 1953 ]

5.96 The relevant time for a company to determine the amount of conduit foreign income it is able to distribute will depend on whether it declares a dividend or simply makes a distribution without a prior declaration. If a company makes a dividend declaration, the relevant time will be at the time of the declaration. Where no declaration is made, the relevant time will be the time the company actually makes the distribution. [Schedule 2, item 25, paragraph 288-80(1)(c) of the Taxation Administration Act 1953 ]

5.97 The penalty is a composite amount that depends on the extent to which the distribution was paid to resident or foreign shareholders or a mixture of both. The over declared amount is apportioned between foreign and Australian membership interests and each allocation is then multiplied by an appropriate penalty rate. [Schedule 2, item 25, subsection 288-80(2) of the Taxation Administration Act 1953 ]

5.98 How much is paid to foreign or resident shareholders is determined by whether amounts are required to be withheld from the distribution under section 12-210 of the Taxation Administration Act 1953 . Membership interests in respect of which withholding is required, or would be required if section 12-300 of the same Act were disregarded, are counted as foreign membership interests [Schedule 2, item 25, definition of 'foreign membership interests' in subsection 288-80(4) of the Taxation Administration Act 1953 ] . The remaining membership interests are called Australian membership interests [Schedule 2, item 25, definition of 'Australian membership interests' in subsection 288-80(3) of the Taxation Administration Act 1953 ] .

5.99 Where distributions on Australian membership interests are over declared to be conduit foreign income, the penalty rate is the company tax rate. This is called the general company tax rate. The resident shareholders that would benefit the most from an over declaration of conduit foreign income would be Australian companies. The penalty rate equates to the level of company income tax that may not be paid by those companies because of the over declaration. The over declaration means there is an opportunity for too much of the distribution to be treated as non-assessable non-exempt income. [Schedule 2, item 25, subsection 288-80(3) of the Taxation Administration Act 1953 ]

5.100 Where distributions on foreign membership interests are over declared to be conduit foreign income, the penalty rate is 50 per cent of the tax rate specified in subparagraph 7(a)(ii) of the Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974 . The current rate in that subparagraph is 30 per cent which means the penalty rate will be 15 per cent. The 15 per cent penalty is comparable to the withholding tax rate in many tax treaties. However, in recently negotiated tax treaties, this rate has been reduced to zero, 5 or 10 per cent for non-portfolio distributions. The 15 per cent rate represents a balanced outcome between those rates and the 30 per cent rate applicable to distributions to residents of non-tax-treaty countries. This rate is called the applicable withholding tax rate. [Schedule 2, item 25, subsection 288-80(4) of the Taxation Administration Act 1953 ]

Example 5.10: Over-declaration penalty Using the same assumptions as in Example 5.9 and assuming that total membership interests number 200, the total amount of the penalty is $13.50:

30% x $60 x [100 (Australian membership interests) / 200 (total membership interests)] = $9
15% x $60 x [100 (foreign membership interests) / 200 (total membership interests)] = $4.50

Consolidated and MEC groups

5.101 Consolidated and MEC groups are particular groups of entities for income tax purposes. A consolidated group is made up of a head company (an Australian resident) and subsidiary members (all Australian residents). A MEC group has a provisional head company during an income year and subsidiary members, similarly restricted to Australian residents. A MEC group has a head company only at the end of an income year. The rules for consolidated and MEC groups are contained in Part 3-90. Generally, rules that relate to consolidated groups apply equally to MEC groups.

5.102 Head companies and provisional head companies are Australian corporate tax entities. Corporate tax entities calculate their conduit foreign income at a particular time [Schedule 2, item 1, section 802-25] . This means a head company is also able to calculate its conduit foreign income at a particular time. Subsidiary members are treated as part of the head company which means amounts of conduit foreign income they receive are treated as being received by the head company [Schedule 2, item 15, section 715-875] . Subsidiary members of a consolidated group do not calculate their own amounts of conduit foreign income.

5.103 Ordinary and statutory income of a subsidiary member is deemed to be derived by the head company [Schedule 2, item 15, section 715-875] . It is the head company that is treated as a foreign resident to work out if an amount is included in the first step when calculating its basic conduit foreign income amount. However, the condition that an amount is included in an income statement does not mean the amount must be included in an income statement of the head company. Instead, the amount may be included in the income statement of the subsidiary member that received the amount.

5.104 It should be noted that any new provision which deals with distributions between Australian corporate tax entities will have no application where distributions are made between members of the same consolidated or MEC group. Those distributions are ignored for taxation purposes under the consolidation rules.

5.105 Where a company joins a consolidated group, the extended application of the entry history rule will ensure amounts of conduit foreign income received by the company before it joins the group will be amounts the head company can treat as conduit foreign income [Schedule 2, item 15, subsection 715-875(1)] . Subsequent amounts that the company receives will become the amounts received by the head company as previously discussed. If the company later leaves the consolidated group it will be unable to take an amount of conduit foreign income with it [Schedule 2, item 15, section 715-880] . Amounts that were received by the company either before it joined the group or while it was a member of a consolidated group will remain with the head company of the group.

Application and transitional provisions

5.106 These amendments allow a company to calculate the amount of its conduit foreign income from the beginning of its first income year that starts on or after 1 July 2005. All relevant transactions that occur after that time should be taken into account whenever in the future a company wants to declare a dividend to include conduit foreign income. In accordance with the general rules for the keeping of records, the company must have appropriate records to substantiate its calculation of conduit foreign income at any such time in the future. The amendments repealing or amending existing provisions dealing with the foreign dividend account regime apply from the date of Royal Assent, subject to the transitional rule discussed in paragraph 5.114. So too does the new penalty provision but it can only be relevant from the time that a company can declare a dividend to comprise conduit foreign income which may be after that date. [Schedule 2, item 26]

5.107 Transitional rules affect the first year of this calculation for those companies with an income year that starts on or after 1 July 2005 and before 1 July 2006. The application of those rules will also depend on whether that income year starts before or after Royal Assent.

What modifications apply to companies with an income year that starts on or after 1 July 2005 but before Royal Assent?

5.108 There are four transitional rules that apply to a company whose income year starts on or after 1 July 2005 but before Royal Assent. [Schedule 2, subitem 27(1)]

5.109 The first rule ensures that a company can only declare an amount to be conduit foreign income where that declaration is made on or after the date of Royal Assent [Schedule 2, subitem 27(2)] . However, a company can continue to make declarations from a foreign dividend account until the time of Royal Assent. The current foreign dividend account rules will continue to operate until that time. This allows those amounts to be distributed free of any dividend withholding tax.

5.110 The second rule ensures a foreign dividend account surplus that exists at the end of the day before Royal Assent can be converted to conduit foreign income at that time. The amount included in a company's conduit foreign income will be equal to the amount of the surplus at that time [Schedule 2, subitem 27(3)] . This allows the company to declare distributions of those amounts to be conduit foreign income on or after Royal Assent, which in turn means those amounts can be distributed free of any dividend withholding tax. Expenses incurred by the company after Royal Assent that relate to dividends that gave rise to credits in the foreign dividend account do not reduce conduit foreign income. Conduit foreign income will not be reduced even though those expenses may have given rise to a debit under paragraph 128TB(1)(b) of the ITAA 1936.

5.111 The third rule ensures that non-portfolio dividends that are a credit to a foreign dividend account for the period up until Royal Assent cannot also be included in a company's conduit foreign income. [Schedule 2, subitem 27(4)]

5.112 The final rule prevents these companies from including in the calculation of conduit foreign income for the first year amounts that relate to foreign tax credits. This is because those amounts relate to credits received for foreign income derived in a period prior to the commencement of this measure. [Schedule 2, subitem 27(5)]

Example 5.11: The first year starts before Royal Assent Assume that Royal Assent for this Bill is 16 December 2005. Aust Co 1 has a 1 July to 30 June income year and maintains a foreign dividend account (FDA). It has an FDA surplus of $100 at 1 July 2005.Aust Co 1 receives the following amounts in the 2006 income year

·
section 23AJ exempt dividends from:

-
ForCo 1: $500 on 1 August 2005;
-
ForCo 2: $750 on 1 February 2006.

Withholding tax was/will be paid on the non-portfolio dividends as follows:

·
ForCo 1: $50 (10%)
·
ForCo 2: $75 (10%)

Aust Co 1 also derives $5,000 of active foreign branch income from the provision of services on 31 August 2005 and incurred expenses of $1,000 in earning that income. This income will be excluded from assessable income under section 23AH for the 2006 income year.Aust Co 1 declares an unfranked dividend of $500 on 15 September 2005. Aust Co 1 wants to declare another unfranked dividend of $3,000 on 15 March 2006.For the period up until the end of the day immediately before the date of Royal Assent, Aust Co 1 would continue to maintain its foreign dividend account. On 1 September 2005 Aust Co 1 has an FDA surplus of $550. The FDA has the following credits (there are no debits):
$100 - FDA surplus as at 1 July 2005;
$450 - net dividend received from ForCo 1 on 1 August 2005
Aust Co 1 can make a foreign dividend account declaration percentage of 100 per cent in relation to the unfranked dividend declared on 15 September 2005. The FDA surplus after the payment of the dividend is $50.On the day of Royal Assent, Aust Co 1's FDA surplus of $50 can be treated as being conduit foreign income. When Aust Co 1 declares its dividend on 15 March 2006, the amount of conduit foreign income that it has available to distribute would be $4,725 calculated as:
$50 - the FDA surplus transferred to conduit foreign income;
$5,000 - foreign branch income derived on 31 August 2005;
($1,000) - expenses incurred in earning foreign branch income;
$750 - dividend received 1 February 2006;
($75) - foreign tax expense payable on the $750 dividend.
Aust Co 1 will therefore be able to declare the entire $3,000 unfranked dividend to be conduit foreign income as the amount of its conduit foreign income at that time is greater than the unfranked dividend which it intends to declare. This would reduce the conduit foreign income amount to $1,725. This amount can then be used to declare future unfranked distributions as conduit foreign income.

What modifications apply to companies with an income year that starts on or after Royal Assent but before 1 July 2006?

5.113 There are three transitional rules that apply to a company whose income year starts on or after Royal Assent but before 1 July 2006. [Schedule 2, subitem 28(1)]

5.114 The first rule ensures the provisions relating to the repeal of the foreign dividend account rules will not take effect until the start of the first income year that commences on or after Royal Assent. This will allow those companies to make declarations from their foreign dividend account up until that time. Those dividends can then be distributed free of withholding tax because the repeal of the existing withholding tax exemption will also not apply until the start of that first income year. [Schedule 2, subitem 28(2)]

5.115 The second rule ensures the foreign dividend account surplus that exists at the start of the first income year after Royal Assent is converted to conduit foreign income at that time [Schedule 2, subitem 28(3)] . The amount included in a company's conduit foreign income will be equal to the amount of the surplus at that time. The conversion of the foreign dividend account surplus means that a company can continue to pay those unfranked dividends to foreign shareholders without incurring any dividend withholding tax.

5.116 The final rule prevents these companies from including in the calculation of conduit foreign income for the first year, amounts that relate to foreign tax credits. That is, these entities are unable to include in their first income year's amount of conduit foreign income, amounts that relate to foreign tax credits. [Schedule 2, subitem 28(4)]

Consequential amendments

5.117 Several items repeal or amend provisions that relate to the foreign dividend account rules. These rules are repealed as a result of the introduction of the conduit foreign income measure. [Schedule 2, items 7, 8, 9, 16 and 19 to 24, paragraph 128B(3)(gaa), section 128D and Subdivision B of Division 11A of Part III of the ITAA 1936, Subdivisions 717-J and 717-X and subsection 995-1(1)]

5.118 There are also several consequential amendments resulting from making a distribution of conduit foreign income non-assessable non-exempt income of a foreign resident. [Schedule 2, items 4, 5, 10 and 14, subsections 102AAW(1) and 121G(12) and subparagraph 159GZZZQ(4)(b)(i) of the ITAA 1936 and subparagraph 118-12(2)(a)(vi)]

5.119 Other provisions have been replaced with provisions that reflect the change from the foreign dividend account rules to the new conduit foreign income measure. [Schedule 2, item 13, paragraphs 703-75(3)(c) and (d)]

5.120 Notes have been added to subsections 44(1) (concerning assessable dividends) and 128B(1) (concerning withholding tax on dividends paid to non-residents) of the ITAA 1936 to alert taxpayers to the fact that they do not apply to dividends that are declared to be conduit foreign income. [Schedule 2, items 2, 3 and 6, subsections 44(1) and 128B(1) of the ITAA 1936]

5.121 An item includes a reference to new provisions in the list of circumstances when a non-resident is taken to have quoted a tax file number. [Schedule 2, item 11, paragraph 202EE(1)(d) of the ITAA 1936]

5.122 An item updates the checklist in section 11-55 to include a reference to distributions of conduit foreign income. [Schedule 2, item 12, section 11-55]

5.123 A definition of 'conduit foreign income' has been inserted in the Dictionary. [Schedule 2, item 18, subsection 995-1(1)]

REGULATION IMPACT STATEMENT

Policy objective

5.124 The conduit foreign income measure is a further instalment of reforms following the Review of International Taxation Arrangements . The overall purpose of the reforms is to build on Australia's position as an attractive place for business and investment.

5.125 This measure is designed to provide tax relief for conduit foreign income, which generally is foreign income received by a foreign resident through an Australian co-rporate tax entity. Generally, this measure only applies to foreign income that is ordinarily sheltered from Australian tax when it is received by the Australian corporate tax entity.

The objectives of this measure

5.126 The conduit foreign income measure aims to reduce tax impediments for foreign investors who structure their foreign investments through Australian entities. This is intended to provide those investors with a more neutral Australian tax outcome on those investments when compared to the foreign investors who have direct holdings in their foreign investments.

5.127 Reducing tax barriers will enhance Australia as an investment choice for foreign investors. This will improve the attractiveness of Australia as a location for regional holding companies of foreign groups. This measure will also enhance the ability of Australian entities with foreign investments to compete for foreign capital and therefore encourage them to remain Australian residents if their foreign shareholding becomes significant.

Implementation options

5.128 The conduit foreign income measure (originally known as the foreign income account measure) arises from the recommendations made by the Board of Taxation as part of the Review of International Taxation Arrangements . The Board's recommendation was to proceed with the foreign income account rules as recommended by the report on the Review of Business Taxation: A Tax System Redesigned .

5.129 The basis for the implementation of this measure can be found in the Board of Taxation's report, International Taxation: A Report to the Treasurer (the Board's Report), the Treasury's consultation paper, Review of International Taxation Arrangements (Consultation Paper) and John Ralph's report, Review of Business Taxation: A Tax System Redesigned (the Ralph Report).

5.130 This measure, and principles underlying it, were discussed in the Board's Report in Recommendation 3.11(1), pages 104 to 106, the Consultation Paper under Option 3.11, pages 50 to 52 and the Ralph Report in Recommendations 21.1 to 21.5, pages 647 to 650.

5.131 This measure will ensure no withholding tax is imposed on an unfranked distribution paid to non-resident owners to the extent that the distributing entity declared the distribution to be conduit foreign income.

5.132 This measure will also allow conduit foreign income to flow through a chain of Australian entities to the ultimate non-resident owners without there being any Australian tax imposed. This allows foreign owners of Australian entities involved in Australian joint ventures to access the benefits of this measure. Addressing this issue was seen as removing a limitation that exists in the current foreign dividend account rules that are being replaced by this measure.

5.133 The Treasury and ATO will monitor this taxation measure, as part of the whole taxation system, on an ongoing basis.

Assessment of impacts

Impact group identification

5.134 The conduit foreign income measure in this Bill specifically impacts on Australian corporate tax entities making distributions to non-resident owners out of foreign profits. Corporate tax entities that distribute amounts declared to be conduit foreign income to other Australian entities are also affected.

5.135 In general, an Australian corporate tax entity is an entity that is an Australian resident company or corporate limited partnership. A corporate unit trust or public trading trust is also an Australian corporate tax entity if it is a resident unit trust for the relevant income year.

Analysis of costs / benefits

5.136 It has not been possible to provide a fully detailed analysis of the impacts on compliance costs because of the lack of available information on affected taxpayers. However, some general observations are outlined below.

Compliance costs

5.137 There may be increased compliance costs for taxpayers who want to take advantage of this measure. Corporate tax entities will have a minor increase in their compliance costs as a result of the need to change their distribution statements to include information that appropriately identifies the components of the distribution including amounts declared to be conduit foreign income.

5.138 Increased compliance costs may also arise for corporate tax entities in determining the amount of their conduit foreign income. However, this Bill seeks to minimise these costs by not prescribing detailed accounting requirements that have to be satisfied.

5.139 Unlike the foreign dividend account provisions, the measure does not prescribe a mechanism for entities to use to determine the amount of their conduit foreign income. An entity is not required to know the amount of its conduit foreign income at all times. However, it is required to keep sufficient records to explain the amount of conduit foreign income it has at the time it makes a distribution declared to be conduit foreign income. Where an entity makes a declaration before making the distribution it would need records to explain the amount of its conduit foreign income at the time of the declaration.

5.140 For corporate tax entities already in receipt of foreign income, the increased compliance costs should be minimal as they would generally have systems in place which identify this type of income. However, systems may need to be set up for those entities whose only conduit foreign income amounts are distributions declared, in whole or in part, to be conduit foreign income that are received from other Australian entities. These entities will need to identify that income so that it remains free of Australian tax if on-distributed within specified time constraints.

5.141 Taxpayers may also incur some additional compliance costs if they require advice from the ATO and tax professionals in respect of this measure.

Administration costs

5.142 As a result of this measure, the ATO may incur some initial costs in making changes to its material and educating its staff about the measure. It may also incur costs in providing advice to taxpayers, including by public and private rulings.

5.143 The ATO may also incur additional costs in its compliance activity to ensure that taxpayers are complying with the requirements of this measure.

Government revenue

5.144 The financial impact of the conduit foreign income measure is outlined in Table 5.1

Table 5.1: Financial impact of the conduit foreign income measure
  2005-06 2006-07 2007-08 2008-09
Introduce a conduit foreign income measure (as announced in November 1999) applying to all foreign income. -$5 million -$20 million -$20 million -$25 million

Economic benefits

5.145 This measure provides relief from Australian taxation for distributions made by Australian corporate tax entities to their foreign owners, to the extent that the distributions relate to amounts of conduit foreign income.

5.146 But for special rules, there is disparity in the Australian tax treatment of foreign residents deriving most sorts of foreign income through direct foreign investment and those foreign residents deriving the same foreign income through an Australian entity. This discourages foreign entities from using Australia for their regional holding companies. It could also mean that Australian entities are less likely to attract foreign capital if they want to expand offshore.

5.147 The conduit foreign income measure will provide a more comprehensive conduit treatment than the current foreign dividend account rules. The measure will apply to a wider range of foreign income ensuring such income can be distributed to foreign resident owners without incurring withholding tax. This measure will also extend the scope of conduit treatment for foreign income by allowing foreign income to effectively flow through a chain of Australian entities without any additional Australian tax being payable. This further enhances the benefits for foreign investors in Australian companies.

5.148 This measure will encourage the establishment in Australia of regional holding companies for foreign groups and will improve Australia's attractiveness as a continuing base for our multinational companies by improving their ability to compete for foreign capital.

Consultation

5.149 Business, legal and accounting representatives and the ATO have been consulted extensively and have actively assisted in developing this measure. This involved the establishment of an advisory group constituted by members of industry and professional peak bodies to help in the design of legislation. The more technical issues and the details of the measure were referred to a particular sub-group, known as the Conduit Working Group.

5.150 Groups consulted as part of the process outlined above include the:

·
Business Council of Australia.
·
Australian Bankers' Association.
·
Taxation Institute of Australia.
·
Corporate Tax Association.
·
Law Council of Australia.
·
Institute of Chartered Accountants in Australia.
·
Certified Practising Accountants Australia.

5.151 Suggestions on the legislative details of the measure made by working group members were adopted where they were consistent with the intended policy objectives and the integrity of the measure. Account was also taken of submissions received from interested parties as a result of the legislation having initially been released for comment as an exposure draft.

5.152 The consultative groups have been supportive of the consultation process and of the final form of the measure.

Conclusion

5.153 This measure is a further instalment of reforms to implement the Government's response to the Review of International Tax Arrangements . The measure is consistent with the Government's policy objectives of increasing the attractiveness of Australia as a location for business and investment.

5.154 The conduit foreign income measure encourages the establishment of regional holding companies for foreign groups and improves the ability of Australian companies to compete for foreign capital. This is achieved through the provision of additional taxation relief for conduit foreign income. While access to the benefits of this measure will necessarily involve some increase in compliance costs for taxpayers, these costs have been minimised to the greatest extent possible having regard to integrity concerns.

5.155 The Treasury and ATO will monitor this taxation measure, as part of the whole taxation system, on an ongoing basis.


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