House of Representatives

Tax Laws Amendment (2007 Measures No. 4) Bill 2007

Taxation (Trustee Beneficiary Non-disclosure Tax) Bill (No. 1) 2007

Taxation (Trustee Beneficiary Non-disclosure Tax) Act (No. 1) 2007

Taxation (Trustee Beneficiary Non-disclosure Tax) Bill (No. 2) 2007

Taxation (Trustee Beneficiary Non-disclosure Tax) Act (No. 2) 2007

Explanatory Memorandum

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

Chapter 1 - New foreign income tax offset rules

Outline of chapter

1.1 Schedule 1 to this Bill inserts Division 770 into the Income Tax Assessment Act 1997 (ITAA 1997).

1.2 This Schedule:

·
outlines the operation of the new foreign tax offset provisions, which allow taxpayers to claim relief - in the form of a tax offset - for foreign income tax paid on an amount included in their assessable income;
·
repeals Divisions 18, 18A and 19 and sections 79D, 79DA, 424 and 430 of the Income Tax Assessment Act 1936 (ITAA 1936); and
·
repeals and amends various other provisions in the ITAA 1936 and the ITAA 1997.

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

Context of amendments

1.4 The decision to remove the quarantining of foreign losses and foreign tax credits emanates from the Board of Taxation's report to the Government on international taxation ( International Taxation , 28 February 2003). The Government conducted a Review of International Taxation Arrangements to address the issues identified by the Board of Taxation. After consultation with the business community, it was acknowledged that the quarantining of foreign losses and foreign tax credits could no longer be justified.

1.5 The foreign tax credit and foreign loss quarantining rules formed part of the tax reforms introduced in 1986 and were justified on the basis of protecting Australia's tax base. As foreign source income became generally assessable, the foreign tax credit system provided relief from double tax. In particular, a credit was allowed for foreign income tax paid on an amount of foreign income included in assessable income. This credit was capped at the lesser of the Australian tax that would be payable on the foreign income or the actual foreign tax paid. Relief in excess of the foreign tax credit cap is not double tax relief and in such a situation, Australian revenue would effectively be subsidising the tax base of (generally high taxing) foreign countries.

1.6 The original justification to quarantine foreign tax credits was to protect the integrity of the foreign tax credit cap. In the event that a taxpayer had paid foreign tax over and above the Australian tax liability, excess credits were generated and could not be utilised. Without quarantining, it would be possible to move mobile income to a low-foreign-tax jurisdiction to soak up any excess foreign tax generated on the high-foreign-taxed (generally active) foreign income. This would be inconsistent with the intent of the foreign tax credit system, which was to provide relief to the extent that Australian residents would otherwise be subject to double, and excessive, taxation.

1.7 It was also felt necessary to implement rules quarantining foreign losses from domestic income, otherwise the foreign loss could be used to decrease Australian tax payable on Australian source income. The quarantining of foreign losses from domestic assessable income was further justified on the basis of a tax asymmetry that existed at the time. The asymmetry allowed taxpayers - mining companies in particular - to circumvent their Australian tax liability. A foreign branch would be established to conduct operations in a foreign jurisdiction. Due to the exploratory nature of mining companies, foreign losses would be generated in the start-up years and would be deducted from domestic income. When profitable, the taxpayer would incorporate the branch into a foreign company, allowing the profits to accumulate offshore, avoiding Australian tax. The foreign loss quarantining rules guarded against the exploitation of this tax asymmetry.

1.8 Different classes of foreign losses ensured that mobile income could not be moved offshore to utilise active foreign losses. Similarly, such classes for foreign tax credit purposes prevented taxpayers moving mobile income offshore to soak up losses generated from foreign (generally active) operations.

1.9 A number of circumstances were recognised as supporting the removal of the foreign loss and foreign tax credit quarantining rules. Recent changes to expand the active income exemption for foreign branches owned by resident companies had the effect of removing almost all active foreign income from Australia's tax base. With active income exempt, the propensity to generate active losses (as well as foreign tax credits on active income) diminishes. The expansion of the non-portfolio dividend exemption in 2004, together with the introduction of the capital gains exemption for disposals of non-portfolio interests in foreign active-business companies, resulted in the reduction of some creditable foreign taxes. Further, modifications made to Australia's thin capitalisation laws in 2001 were responsible for carving out debt deductions from foreign income deductions (allowing them to be applied against domestic assessable income) thereby reducing the potential for foreign losses to be generated.

1.10 The shift in Australia, since 1986, towards a participation exemption system removes the tax asymmetries that once prompted the need for the quarantining of foreign losses and foreign tax credits. The risks to Australia's tax base have diminished, reducing the need to have complex rules that quarantine foreign losses from Australian assessable income and divide foreign tax credits into different classes of assessable foreign income.

1.11 The decision to abolish foreign loss and foreign tax credit quarantining, announced by the Treasurer in Press Release No. 044 of 10 May 2005, prompted a review of the remaining complexity in the foreign tax credit rules. Consistent with Government practice to reduce complexity and the cost of complying with the tax law, the legislation is being rewritten as part of the ITAA 1997.

1.12 The new foreign tax offset rules will provide greater certainty to taxpayers and will reduce compliance and administration costs through:

·
the abolition of foreign loss and foreign tax credit quarantining;
·
the inclusion of a $1,000 de minimis cap; and
·
the removal of attributed tax accounts.

1.13 The changes will assist small and medium enterprises looking to expand offshore, by removing the need to implement systems to perform the tracking and collection of different classes of income, deductions and taxes when they try to penetrate a foreign market. The new rules will improve the relative attractiveness of Australia as a destination for international capital. The regional headquarters of a foreign group will no longer need to establish and maintain costly systems to comply with the redundant quarantining rules.

1.14 The changes in this Schedule also enhance the competitiveness and reduce the compliance costs of Australian based managed funds. The removal of quarantining will assist Australians in using Australian managed funds to diversify their investments overseas. It will also improve the competitiveness of Australian managed funds in attracting the management of funds from other countries.

1.15 The rewrite of the foreign tax credit rules also facilitated a review of the way correlative relief was provided for economic double taxation arising from a transfer pricing adjustment made by another country. In particular, the Government has taken the opportunity to align Australia's correlative relief practice more closely to that of the Organisation for Economic Co-operation and Development (OECD). This change will reduce the administrative costs confronting the Australian Taxation Office (ATO) and will advantage taxpayers, alleviating double taxation directly by adjusting taxable income.

1.16 Finally, with the removal of credits for underlying foreign taxes, an option has been introduced, as part of this Schedule, for certain taxpayers operating within the foreign investment fund rules to calculate attributable income using the controlled foreign company rules. This will give those taxpayers access to branch-equivalent calculations, the active income test and certain exemptions and modifications that apply within those rules.

1.17 Related to this option, a further change will effectively extend the current treatment of a foreign company, as an Australian financial institution subsidiary, to subsidiaries of Australian financial institutions that choose to calculate foreign investment fund income using the controlled foreign company rules. This will further encourage the expansion of the Australian banking industry into emerging offshore markets and ensure that certain income of the foreign financial intermediary business is treated as active, thereby reducing the extent of attribution under the current rules.

Summary of new law

1.18 Taxpayers will be entitled to a non-refundable tax offset for foreign income tax paid on an amount included in assessable income (a 'double-taxed amount'). This offset effectively reduces the potential Australian tax that would be payable on double-taxed amounts. The potential Australian tax will be reduced by the amount of the foreign income tax already paid on those double-taxed amounts or reduced to zero where the foreign income tax paid exceeds the potential Australian tax payable.

1.19 Entitlement to a tax offset will arise for taxpayers in the year an amount on which foreign income tax has been paid is included in their assessable income. It is not necessary for the taxpayer to pay the foreign income tax in the same income year that the amount is included in assessable income. To ensure the usual amendment periods do not restrict a taxpayer's right to claim double tax relief, the taxpayer will have four years from the time foreign income tax is paid in which to claim an offset.

1.20 In ascertaining the amount of foreign tax offset, taxpayers will no longer be required to quarantine assessable foreign income amounts into four separate classes. Rather, a taxpayer can combine all assessable foreign income amounts when working out a tax offset entitlement, allowing the taxpayer a greater averaging capacity than under the old foreign tax credit rules. This greater averaging capacity will minimise the amount of foreign income tax that goes unrelieved. Consequently, the mechanism allowing the carry-forward of excess foreign income tax will be removed.

1.21 Economic double taxation arising as a result of a transfer pricing adjustment by another country will no longer be remedied with a foreign tax credit. Australia will adopt OECD practice and allow the Commissioner of Taxation (Commissioner) to adjust the taxpayer's taxable income (or tax loss) in the event of a transfer pricing adjustment in the other country, so as to relieve potential double taxation.

1.22 Double tax relief, in the form of a foreign tax offset, will continue to be available for taxpayers using the foreign investment fund calculation method to ascertain their attributable income where the attributable taxpayer holds a direct interest in the foreign investment fund (the first-tier foreign investment fund company or trust).

1.23 A foreign tax credit will no longer be available for foreign tax paid by a second-tier foreign investment fund company or trust. This change is in line with the broad objective of these new rules to provide an offset only for foreign income taxes paid on the distribution of profits of the foreign company or trust (usually a withholding tax), which comprise amounts included in a taxpayer's assessable income. The removal of this credit for second-tier foreign investment funds using the calculation method will effectively leave the Australian taxpayer with a deduction for the foreign taxes paid.

1.24 To mitigate the impact of this change, a further option is included within the foreign investment fund rules. In calculating the income attributed to a taxpayer from a foreign investment fund that is a company, certain taxpayers will have an opportunity to use the controlled foreign company rules to calculate attributable income.

1.25 Taxpayers with previously attributed income will no longer be entitled to claim relief for the underlying foreign taxes paid on the distribution. They will, however, be able to offset, without limitation, the final withholding tax on the distribution (ie, the direct foreign income tax on the distribution).

1.26 Excess foreign income deductions - foreign losses - will no longer be quarantined from domestic assessable income (or from assessable foreign income of a different class). Resident taxpayers will no longer be required to make an election to offset domestic losses against assessable foreign income. Therefore, in utilising deductions, no distinction is made in respect of the source of the assessable income, whether foreign or domestic. A taxpayer combines both foreign and domestic deductions. Where the combined deductions exceed assessable income, the excess is a tax loss and applied against assessable income of a future income year.

1.27 Taxpayers that earn attributed income through controlled foreign companies will no longer quarantine revenue losses into separate classes. However, controlled foreign company losses will continue to be quarantined in the entity that incurred them.

1.28 These amendments will apply from income years, statutory accounting periods and notional accounting periods starting on or after the 1 July following Royal Assent. A taxpayer's excess foreign tax credits from earlier years or prior-year overall foreign losses that exist at commencement will be treated in accordance with the transitional rules. In particular, a taxpayer will amalgamate and convert existing excess foreign tax credits from the four classes of assessable foreign income into pre-commencement excess foreign income tax. Utilisation of pre-commencement excess foreign income tax will then be subject to the limits calculated under the new foreign tax offset rules.

1.29 Generally, overall foreign losses for a particular earlier income year will be grouped together and converted to a tax loss. Utilisation of the converted tax loss will be restricted for the first four years after commencement. Subsequent to the transitional period, any remaining tax loss will be subject to the ordinary loss utilisation rules.

Comparison of key features of new law and current law

New law Current law
Both Australian and foreign resident taxpayers are entitled to claim a tax offset for an amount included in the taxpayer's assessable income on which they have paid foreign income tax (a 'foreign tax offset').

An exception applies for certain residence-based foreign income taxes of foreign residents.

A foreign tax credit is available if the assessable income of a resident taxpayer includes foreign income in respect of which the taxpayer has paid foreign income tax.

Foreign tax credit entitlement arises for foreign residents only in respect of certain foreign film income.

Foreign tax offsets are determined on a whole-of-income basis and not on a class of income basis. The entitlement to a foreign tax credit and the amount of the credit is determined separately for four classes of foreign income.

The classes of foreign income are:

·
passive income;
·
offshore banking income;
·
an amount included in assessable income under section 307-50; and
·
other income.

A tax offset is only available for foreign income tax paid on an amount included in assessable income. A foreign tax credit is only available for foreign tax paid on assessable foreign income.
Foreign income tax is a tax imposed by a law, other than an Australian law, on income profits or gains.

The taxpayer must have paid the foreign income tax before an offset is available. An offset will not be available for credit absorption taxes or unitary taxes.

The taxpayer is deemed, in some circumstances, to have paid the foreign income tax when in fact it has been paid by someone else - for example, a spouse, trustee, partnership or foreign company - or if the foreign income tax has been withheld from the income at its source.

Foreign tax is a tax imposed by a law of a foreign country on income, profits or gains (excluding credit absorption taxes and unitary taxes).

The taxpayer must have paid and have been personally liable for the foreign tax before credit entitlement accrues.

The taxpayer is deemed, in some circumstances, to have paid and have been personally liable for the foreign tax when in fact it has been paid by someone else - for example, a spouse, trustee, partnership or foreign company - or if the foreign tax has been withheld from the income at its source.

Foreign income tax paid on assessable offshore banking income is reduced by the offshore banking eligible fraction (one-third) before being eligible for relief. No equivalent.
No equivalent. Foreign tax paid on an amount assessed under section 305-70 is reduced by the fraction that the assessable amount bears to the gross payment.
No equivalent. Foreign tax paid is reduced proportionately where the taxpayer could have elected (under the laws of the foreign country) to have the tax liability determined on an assessment basis.
The amount of the tax offset equals the sum of each amount of eligible foreign income tax paid, subject to a limit (or 'cap').

The foreign tax offset cap is based on the amount of Australian tax payable on the double-taxed amounts and other assessable income amounts that do not have an Australian source.

The amount of foreign tax credit is equal to the lesser of the foreign tax paid (reduced by any relief granted by the foreign jurisdiction) and the Australian tax payable in respect of the foreign income, profit or gain (the 'foreign tax credit cap').

Australian tax payable is calculated by applying the average rate of Australian tax of the taxpayer to the adjusted net foreign income of the taxpayer and deducting from this, the sum of any rebates that relate exclusively to the foreign income.

The taxpayer does not need to calculate the foreign tax offset cap if they elect to use the $1,000 de minimis cap. In this case, they cannot claim more than $1,000 of foreign income tax. No equivalent.
A tax offset is available for the foreign income tax paid on amounts not assessable under section 23AI or 23AK of the ITAA 1936 - that is, the distribution is made out of previously attributed income. The offset is limited to the foreign income tax paid on the distribution (normally the final foreign income tax levied ). The foreign tax paid at the attribution stage will not reduce the amount of the offset. A credit is available for the foreign income tax paid on amounts not assessable under section 23AI or 23AK of the ITAA 1936. The credit is the foreign income tax paid on the distribution (normally the direct foreign income tax ) as well as any underlying foreign income tax deemed paid with a reduction for the foreign tax paid at the attribution stage.
A tax offset is allowed for foreign income tax, Australian income tax and Australian withholding taxes paid by a foreign company where an amount is attributed under the controlled foreign company provisions in Part X of the ITAA 1936 or the foreign investment fund provisions in Part XI of the ITAA 1936 (under the calculation method).

If the attributable taxpayer is an Australian company it must have an attribution percentage of 10 per cent or more in the foreign company.

A credit is allowed for foreign and Australian taxes paid by a foreign company where an amount is attributed under the controlled foreign company provisions in Part X or the foreign investment fund provisions in Part XI of the ITAA 1936 (under the calculation method).

If the attributable taxpayer is an Australian company, it must be related to the foreign company.

Taxpayers using the foreign investment fund calculation method to determine attributable income are only entitled to a tax offset for the foreign income tax, Australian income tax and Australian withholding tax paid by the foreign company or trust in which the taxpayer holds a direct interest (the first level foreign investment fund company or trust). Taxpayers using the foreign investment fund calculation method to determine attributable income are entitled to a credit for foreign and Australian taxes paid by the first level foreign investment fund company or trust. A credit is also available for foreign and Australian taxes paid by a foreign company or trust in which that first level fund holds a direct interest (the second level foreign investment fund).
Certain taxpayers using the foreign investment fund calculation method to determine income to be attributed from a foreign company will have a further choice (within that method) to calculate that income using the controlled foreign company rules.

These taxpayers will then have access to full branch-equivalent calculations, the active income test and exemption. The income will still be attributed under Part XI of the ITAA 1936, thereby maintaining access to the tax offset for income attributed under Part XI of the ITAA 1936.

No equivalent.
There is no carry-forward of excess foreign income tax for use in a later year. An exception applies to excess foreign tax pertaining to the five years prior to commencement of the new rules. Where foreign tax is in excess of the foreign tax credit cap for each class of assessable foreign income, that excess may be carried forward for five years. The excess foreign tax can only be used where the foreign tax credit cap in a later year (for the same class of assessable foreign income) is greater than the foreign tax paid on that class of income.
A foreign tax offset forms part of an assessment and the taxpayer has four years from the time foreign income tax is paid (or, if subsequently adjusted, from that time) to amend an assessment. A foreign tax credit does not form part of an assessment. A taxpayer or the Commissioner may amend a foreign tax credit determination within four years from the original date of the determination, unless the amendment is to correct an error in calculation or a mistake in fact.
Foreign losses are no longer quarantined from domestic income or from other foreign losses of a different class. A taxpayer is no longer required to elect to apply domestic losses against foreign income. There is no distinction between a foreign loss and a domestic loss for the purpose of calculating taxable income.

A transitional rule applies in relation to existing foreign losses.

Foreign losses are quarantined from domestic income and the amount of the loss is determined separately for four classes of assessable foreign income.

The classes of income for foreign loss purposes are:

·
interest income;
·
modified passive income;
·
offshore banking income; and
·
all other assessable foreign income.

Domestic losses can only be applied against foreign income at the taxpayer's election.

Controlled foreign company losses continue to be quarantined in the entity that incurred them but are no longer quarantined on a class of income basis. Controlled foreign company losses are quarantined in the same classes as for Australian resident taxpayers.

Controlled foreign company losses are also quarantined in the entity that incurred them.

The Commissioner has the discretion to adjust the taxable income or tax loss of a resident taxpayer to remove the incidence of double taxation as a result of a transfer pricing adjustment by another country. A Division 19 (Part III of the ITAA 1936) foreign tax credit is available to a resident taxpayer for foreign tax paid by an associated foreign entity as a result of a transfer pricing adjustment by another country.

Detailed explanation of new law

Tax offset for foreign income tax paid on amounts included in assessable income - foreign tax offset

What is a foreign tax offset?

1.30 Pursuant to Australia's tax laws, resident taxpayers may be assessed on both their foreign and domestic sourced income. To prevent the double taxation of worldwide income that has been taxed in another country, resident taxpayers will be entitled to a non-refundable tax offset for foreign income tax paid on an amount included in their assessable income (a 'double-taxed amount') [Schedule 1, item 1, subsections 770-5(1) and (2)] . This tax offset will extend to foreign residents where certain requirements are satisfied.

1.31 The tax offset has the effect of reducing the Australian tax that would otherwise be payable on the double-taxed amount. The tax offset is limited to the lesser of foreign income tax paid or the foreign tax offset cap (the 'cap') [Schedule 1, item 1, sections 770-70 and 770-75] . In the event that the total foreign income tax paid exceeds the cap, no offset or deduction is allowed for the extra foreign income tax.

1.32 The cap is based on the Australian tax that would be payable on the double-taxed amounts and other assessable amounts that do not have an Australian source. (It is no longer a requirement to establish that a double-taxed amount has a foreign source.) The taxpayer may refrain from calculating the cap and instead choose to use the $1,000 de minimis cap. This de minimis cap is discussed further in paragraphs 1.127 and 1.128.

1.33 A taxpayer can only claim an offset for the income year in which the double-taxed amount is included in assessable income. It is possible that the taxpayer pays the foreign income tax in a different income year and so, to this end, the usual amendment periods do not apply. Rather, a taxpayer will have four years from the time they pay foreign income tax to claim a tax offset. Amendment period rules are discussed further in paragraphs 1.154 to 1.159.

1.34 Entitlement to an offset will only arise for foreign income taxes that are, in essence, imposed on a basis substantially equivalent to income tax imposed under Australian law, that is, generally a tax on income, profits or gains.

1.35 There are some circumstances where a taxpayer has not paid the foreign income tax. Entitlement will arise in these cases where another entity (including an individual) has paid the foreign income tax on behalf of the taxpayer.

1.36 The rules allowing company attributable taxpayers relief for income attributed under the controlled foreign company rules and foreign investment fund rules are tightened marginally. In particular, the attributable taxpayer will need, at a minimum, a 10 per cent attribution percentage in the foreign company before it is eligible for relief.

1.37 Further, the rules prescribing double tax relief for taxpayers that use the foreign investment fund calculation method to determine attributable income will be simplified. Attributable taxpayers will only be entitled to relief for foreign income taxes paid in respect of an interest in a first-tier foreign investment fund.

1.38 Entitlement to double tax relief will be simplified for distributions of income that has already been attributed to, and included in, the assessable income of a resident taxpayer ('previously attributed income'). Only the (final) foreign income tax imposed on these distributions will give rise to offset entitlement (namely, the direct tax on the distribution). The underlying foreign tax paid by the foreign company, or any interposed entity, is no longer eligible for a tax offset.

Who is entitled to a foreign tax offset?

General entitlement

1.39 A foreign tax offset is available to a taxpayer for foreign income tax paid on an amount that is all or part of an amount included in assessable income. There is no intention to stipulate whether the taxpayer is required to be a resident for entitlement purposes nor that the assessable amount has a foreign source. However, as the tax offset relates to foreign income tax paid in relation to assessable income, it will normally be the case (although not expressly specified in the law) that the taxpayer claiming the tax offset is a resident taxpayer [Schedule 1, item 1, subsection 770-10(1)] . Further, only the taxpayer that is assessed on the amount is entitled to the offset, even if in some cases, the foreign income tax has been paid by another entity.

1.40 Entitlement to the tax offset will only arise when, and to the extent that, the foreign income tax has been paid on an amount included in assessable income [Schedule 1, item 1, subsection 770-10(1)] . Foreign income tax paid on non-assessable non-exempt amounts (except for section 23AI and 23AK amounts) is disregarded. Only where the taxpayer has paid foreign income tax on an amount included in assessable income will double taxation, and consequently relief from double taxation, arise. If only part of an amount on which an amount of foreign income tax has been paid is included in assessable income (eg, foreign income tax paid on the foreign branch income of an Australian company), only the same fraction of the foreign income tax counts towards the tax offset [Schedule 1, item 1, note 2 in subsection 770-10(1)] .

1.41 A tax offset will only be available for the income year in which the double-taxed amount is included in the taxpayer's assessable income [Schedule 1, item 1, subsection 770-10(1)] . This will be the case regardless of when the foreign income tax is actually paid. That is, there is no requirement that the taxpayer paid the foreign income tax in the same income year in which the double-taxed amount is included in their assessable income. Consequently, if the taxpayer does not pay foreign income tax until a later year, on an amount included in their assessable income or if the foreign income tax paid is subsequently altered, they may need to lodge an amended assessment [Schedule 1, item 1, subsection 770-10(1)] . Rules pertaining to amendment periods are discussed in paragraphs 1.154 to 1.159.

Example 1.1 A resident taxpayer holds an annuity as 'qualifying security' (as defined in Division 16E of Part III of the ITAA 1936) for income years 1 July 2009 through 30 June 2015. The taxpayer pays foreign income tax on the annuity income in the income year ending 30 June 2015.The taxpayer will include in their assessable income (for income years 1 July 2009 through to 30 June 2015) those annuity amounts. Only when the taxpayer pays the foreign income tax will they be eligible for a tax offset. The tax offset will arise in each of the income years that an annuity amount was included in assessable income after foreign income tax is paid in respect of that amount.The taxpayer is required to apportion the paid foreign income tax among the income years that led to the annuity amount being included in the taxpayer's assessable income. As a result, the taxpayer will be required to lodge amended assessments for the earlier income years.

1.42 In general, the new law maintains the current treatment with respect to net capital gains. Only foreign income tax paid on the whole or part of a capital gain (or capital gains) that is (are) included in the taxpayer's net capital gain in accordance with section 102-5 will be eligible for a tax offset [Schedule 1, item 1, subsection 770-10(1)] . Namely, where the taxpayer has paid foreign income tax on the whole or part of a capital gain that is included in their net capital gain, the requirement that the foreign income tax be paid in respect of an amount that is all or part of an amount included in assessable income will be satisfied.

1.43 If the taxpayer has a net capital loss for the year, the taxpayer will not be able to offset any of the foreign income tax paid on any particular capital gain because there is no net capital gain included in assessable income. That is, the taxpayer is not subject to double taxation on its capital gain. [Schedule 1, item 1, subsection 770-10(1)]

Example 1.2 A resident taxpayer makes a gain of $10,000 on the sale of a foreign asset which is subject to tax in a foreign country at a rate of 20 per cent.The taxpayer also realises a capital loss of $10,000 in respect of the disposal of an Australian asset.As there is no net capital gain included in the taxpayer's assessable income, the taxpayer is not eligible for a tax offset in respect of the foreign income tax paid on the sale of the foreign asset.

1.44 A foreign taxed gain that is treated as a capital loss in Australia (due to differences in the calculation of gains and losses), will not be regarded as a double-taxed amount nor will the foreign income tax be eligible for a tax offset. This is because the capital loss is not included in the taxpayer's assessable income, consequently, there is no double taxation of the loss and entitlement to a tax offset does not arise. [Schedule 1, item 1, subsection 770-10(1)]

1.45 Under the current law (subsection 102-5(1)), a taxpayer can choose the order in which capital gains are reduced by any capital losses. A taxpayer can continue to apply any capital loss or prior-year net capital loss firstly against those capital gains on which no foreign tax is paid and to which no Australian discount applies. The taxpayer may then apply the excess (if any) against those capital gains that attract an Australian discount and finally against those gains that have been subject to foreign tax. Ordering the application of capital losses in this way will yield the greatest foreign tax offset benefit for the taxpayer.

Example 1.3 The taxpayer realises the following capital gains and losses during the income year:

Foreign country D assessment
Purchase price of foreign asset D     $70,000
Proceeds from sale of foreign asset D     $200,000
Net foreign gain on sale of foreign asset D     $130,000
Foreign tax payable (30%)     $39,000
Foreign country B (nil assessment )
Purchase price of foreign asset B     $50,000
Proceeds from sale of foreign asset B     $65,000
Gain on sale of foreign asset B     $15,000
Foreign country B does not impose tax on capital gains made on the disposals of assets
Foreign country L
Purchase price of foreign asset L     $90,000
Proceeds from sale of foreign asset L     $50,000
Loss on sale of foreign asset L     ($40,000)
Australia
Cost base of asset A     $90,000
Capital proceeds from sale price of asset A     $150,000
Gain on sale of asset A     $60,000
Reduced cost base of asset H     $65,000
Capital proceeds of asset H     $25,000
Loss on sale of asset H     ($40,000)
Australian assessment
Income Domestic Foreign Total
Machinery sales - revenue $60,000   $60,000
Net capital gain *   $125,000 $125,000
Gross assessable income     $185,000
Less      
Allowable deductions from sales revenue (under Australian law)     $20,000
Taxable income     $165,000
Australian tax (30%) $49,500
Less
Foreign tax offset entitlement **     $37,500
Net Australian tax payable     $12,000
* The net capital gain is calculated as follows (assuming gains and losses on foreign assets are the same under Australian tax law as under the foreign laws):** For the calculation of the foreign tax offset cap see Example 1.20.
Capital gain on sale of foreign asset D   $130,000
Plus
Capital gain on sale of foreign asset B $15,000  
Capital gain on sale of Australian asset A $60,000  
Capital loss on sale of foreign asset L ($40,000)  
Capital loss on sale of Australian asset H ($40,000) ($5,000)
Net capital gain   $125,000
The taxpayer calculates net capital gain to ensure maximum allowable foreign tax offset.

·
First, the taxpayer adds the domestic capital loss and the foreign capital loss together.
·
Second, the taxpayer deducts this from the sum of the domestic capital gain and the foreign capital gain on which no foreign tax has been paid.
·
Finally, since this yields a capital loss, the taxpayer deducts this amount from the foreign capital gain in respect of which foreign tax has been paid.

Australian residents - foreign income tax paid on non-assessable non-exempt income

1.46 The current foreign tax credit system provides taxpayers with a credit for certain foreign income taxes paid on distributions made out of previously attributed income that are treated as non-assessable non-exempt income under either section 23AI or 23AK of the ITAA 1936. The current mechanism that provides relief for foreign income taxes paid on this previously attributed income is voluminous, highly complex and disproportionate to its degree of utilisation and compliance. Currently, to claim a credit for foreign income tax paid on previously attributed income, taxpayers are required to maintain attributed tax accounts. These accounts effectively trace the foreign tax paid on the attributed amounts and on the distribution as it makes its way to the taxpayer through a chain of offshore entities. These attributed tax accounts give rise to significant complexity and compliance costs for relatively small benefit in return.

1.47 For these reasons, entitlement to relief for foreign income taxes paid on previously attributed income has been substantially rewritten and simplified. In particular, taxpayers will no longer need to maintain complex and costly attributed tax accounts. [Schedule 1, items 77, 79 to 81, 89, 91 to 93, 123 to 126, 164 to 175, section 317, paragraphs 401(1)(d) and 461(1)(f) of the ITAA 1936, section 717-200, paragraph 717-205(c), section 717-235, paragraph 717-240(c)]

1.48 A resident taxpayer that receives non-assessable non-exempt income under either section 23AI or 23AK of the ITAA 1936 will be entitled to a non-refundable tax offset for the foreign income tax paid on the distribution. [Schedule 1, item 1, subsection 770-10(2)]

1.49 The foreign income tax in respect of these amounts refers only to the final or direct foreign income tax paid, and this will usually be a withholding tax. [Schedule 1, item 1, note 2 in subsection 770-10(2)]

1.50 The requirement that the foreign income tax be paid by the taxpayer , will be satisfied by the general rules prescribing when a taxpayer is regarded as having paid an amount of foreign income tax. [Schedule 1, item 1, section 770-130]

1.51 If the taxpayer otherwise qualifies for a foreign tax offset, then the amount of the tax offset will be increased by the foreign income tax paid in respect of the non-assessable non-exempt income. [Schedule 1, item 1, subsection 770-10(2)]

1.52 Entitlement to this tax offset is effectively limited to Australian residents since only Australian residents can receive a distribution out of previously attributed income that is non-assessable non-exempt income under either section 23AI or 23AK of the ITAA 1936.

Example 1.4 Aust Co. is an attributable taxpayer in relation to For Co. which is a controlled foreign company in an unlisted country. Aust Co. has an attribution account surplus in relation to For Co. of $1 million, having previously been subject to tax on attribution under section 456 of the ITAA 1936. For Co. subsequently declares and pays a dividend of $1 million to Aust Co. upon which withholding tax of $100,000 is imposed. As this amount does not exceed the attribution account surplus of Aust Co. in relation to For Co., it is treated as non-assessable non-exempt income of Aust Co. pursuant to section 23AI of the ITAA 1936. Aust Co. is also entitled to a foreign tax offset for the $100,000 foreign income tax as it is paid in respect of the dividend of $1 million.

Exception for certain foreign residents

1.53 Currently, only foreign residents that pay foreign tax on certain foreign film income which is assessed in Australia qualify for a foreign tax credit (under current Division 18A, Part III of the ITAA 1936). These amendments ensure that foreign residents will be entitled to an offset for some foreign income taxes paid that relate to their assessable income. [Schedule 1, item 1, subsection 770-10(1)]

1.54 The purpose for extending entitlement to foreign residents more generally is two-fold. First, the tax treaty concluded with the United Kingdom of Great Britain and Northern Ireland (UK) includes rules on non-discrimination. This may require Australia to provide double tax relief to (an Australian permanent establishment of) a UK resident where third-country income is derived (and taxed in that country) in connection with the carrying on of a business at or through an Australian permanent establishment. In this situation, Australia, as the country in which the permanent establishment is situated, could be obliged to provide relief for the third-country tax paid on the basis that an Australian resident entity deriving the same third-country income would be entitled to double tax relief.

1.55 Although the UK treaty is currently the only tax treaty that contains rules on non-discrimination (Finland and Norway have similar rules but are not yet in force), it is Australian tax treaty practice that rules on non-discrimination be agreed to in future Australian tax treaties.

1.56 Secondly, a broader approach to the inclusion of foreign residents in the new foreign tax offset rules can be rationalised on the grounds that Australia has some responsibility to grant double tax relief when choosing to assess foreign residents on their foreign source income. This may be the case in some situations with film income (see section 26AG of the ITAA 1936).

1.57 As an integrity measure, a foreign resident will not be able to claim a tax offset for foreign income tax it pays as a resident of a foreign country for the purpose of the foreign country's tax law (namely, residence-based taxation). One object of this provision is to avoid giving an offset for foreign income tax paid as a resident of another country on Australian source income. [Schedule 1, item 1, paragraph 770-10(3)(a)]

1.58 A foreign resident will, however, be entitled to a tax offset for foreign income tax it pays to its country of residence where it is paid on the basis of source. That is, where the foreign country levies tax on the income on a source basis (eg, a withholding tax paid to a permanent establishment in Australia), the foreign resident will be entitled to a tax offset where the taxpayer is also assessed on that income in Australia. [Schedule 1, item 1, paragraph 770-10(3)(b)]

1.59 This qualification to the foreign resident entitlement is also needed to continue the full operation of double tax relief found in current Division 18A, Part III of the ITAA 1936 for film income. However, a systemic approach ensures that any foreign resident in receipt of income that has been subject to tax in its country of residence, or in a third country, on a source basis will have access to double tax relief where Australia also assesses the income [Schedule 1, item 1, subsection 770-10(3)] . As a result of this systematic approach, this Schedule repeals sections 121EI and 160ZZY of the ITAA 1936 [Schedule 1, items 59 and 67] . A taxpayer that currently qualifies for a deduction for foreign tax under these provisions will now be entitled to an offset.

1.60 As well as applying to foreign residents, this restriction also applies to Australian residents who are also residents of one or more other countries and also pay foreign income tax because of that foreign residency.

1.61 This situation, of Australia assessing foreign residents on their foreign source income, will be rare (particularly in light of Australia's tax treaty obligations). It arises in respect of film income purely for integrity reasons. In particular, it relates to certain film tax concessions that accrue to Australian resident taxpayers who then depart Australia. The film income that relates to the earlier film tax concessions provided to the former Australian resident is generally assessed in Australia.

Example 1.5 Film Co. is a company resident in the foreign country A receiving income from the use of a film copyright. Film Co. was previously an Australian resident whose capital expenditure on the film qualified for deduction under a film concession (in particular, a section 124ZAFA (of the ITAA 1936) film concession).Film Co. exhibits the film in foreign country B and under Australian law, foreign country A is regarded as the country of source. Foreign country B does not impose tax on the income from the exhibition of the film. Foreign country A does however impose tax on Film Co. for the exhibition of the film.Film Co. is assessed on the income in Australia by virtue of section 26AG of the ITAA 1936. Film Co. is entitled to a tax offset in this situation because the foreign income tax paid is source-based taxation of a foreign resident.

Exception for previously complying funds and previously foreign funds

1.62 As with the existing law, the new law imposes a limit on the amount of foreign tax offset that is allowed for foreign income taxes paid by a:

·
trustee of a pooled superannuation trust; or
·
superannuation provider in relation to a superannuation fund or approved deposit fund,

to the extent the fund changes from a complying superannuation fund to a non-complying superannuation fund or from a non-resident superannuation fund to a resident superannuation fund. [Schedule 1, item 1, paragraph 770-10(4)(a)]

1.63 Where a superannuation fund changes from a complying fund to a non-complying fund or from a non-resident fund to a resident fund, the assessable income of the fund for that year includes the market value of the fund's assets (reduced for undeducted contributions made by fund members) at the start of the income year.

1.64 Where a non-complying fund or a resident fund includes an amount in assessable income under section 295-320 and the provider paid foreign income tax in respect of that amount (before the start of the income year), the fund is not entitled to a tax offset for the foreign income tax paid by the provider. [Schedule 1, item 1, subsection 770-10(4)]

1.65 Foreign income tax paid by the provider does not give rise to tax offset entitlement because the amount assessed under section 295-320 reflects the value of the fund's assets at the start of the income year and implicitly recognises a notional deduction for the foreign income tax paid before the start of the income year. To allow a tax offset for the foreign income tax paid by the provider in these circumstances would amount to a duplication of double tax relief.

Exception for credit absorption tax and unitary tax

1.66 Consistent with the current rules for foreign tax credits, an offset will be denied for unitary or credit absorption taxes. However, in the new law this is achieved by an explicit rule rather than by excluding those taxes from the definition of 'foreign income tax'. [Schedule 1, item 1, subsections 770-10(5) and 770-15(2) and (3)]

1.67 The definitions of 'unitary tax' and 'credit absorption tax' have the same effect as in current subsection 6AB(6) of the ITAA 1936. The slight change in wording is needed to incorporate the ITAA 1936 definition of 'law' which covers a law imposed by any part or place within a country.

Attributable taxpayers - controlled foreign company rules

1.68 In general, a foreign tax offset will continue to be available for company attributable taxpayers that are assessed under the controlled foreign company rules. In particular, where an amount is included in such an attributable taxpayer's assessable income under section 456 or 457 of the ITAA 1936, and the controlled foreign company paid foreign income tax, or Australian tax (income tax or withholding tax) in respect of that amount, the attributable taxpayer may be entitled to a tax offset [Schedule 1, item 1, subsection 770-135(1), subparagraphs 770-135(2)(a)(i) and (ii) and paragraphs 770-135(3)(a) and (b)] . Taxes taken to be paid by the controlled foreign company under subsection 393(4) will also continue to qualify for offset entitlement [Schedule 1, item 1, subsection 770-135(4)] . Paragraphs 1.113 to 1.115 discuss further the rules for what, and the extent to which, taxes paid by a controlled foreign company are treated as having been paid by an attributable taxpayer.

1.69 Section 770-135 replaces, but is not identical to, current sections 160AFCA and 160AFCB of the ITAA 1936 (which this Schedule is repealing). [Schedule 1, item 64]

1.70 Pursuant to this new provision, entitlement to a foreign tax offset will only arise where the attributable taxpayer's attribution percentage (direct and/or indirect) in relation to the controlled foreign company is 10 per cent or more (the association condition) [Schedule 1, item 1, subsection 770-135(5)] . The time at which this attribution percentage is tested will differ depending on whether the attributable taxpayer is attributed under section 456 or 457 of the ITAA 1936. For income attributed under section 456, the company will need to satisfy the attribution percentage requirement at the end of the controlled foreign company's statutory accounting period [Schedule 1, item 1, paragraph 770-135(5)(a)] . For income attributed under section 457, the requirement will need to be satisfied at the residence change time [Schedule 1, item 1, paragraph 770-135(5)(b)] .

1.71 This new method for determining how the attributable taxpayer is related to the controlled foreign company is a change from how the current rules operate. The current rules have a related foreign company requirement. It is intended that this change will simplify the rules granting a tax offset in this circumstance, as well as reduce the cost to taxpayers of having to comply with the current requirements.

1.72 The new attribution percentage requirement of 10 per cent will be a slight tightening for those attributable taxpayers that have less than a 10 per cent attribution percentage in the foreign company. These taxpayers are attributed income under section 456 or 457 of the ITAA 1936 because they are Australian controllers of a foreign company which is taken to be a controlled foreign company within the meaning of paragraph 340(c) of the ITAA 1936. The two other control tests for controlled foreign companies result in an amount being included in the attributable taxpayer's assessable income (under sections 456 and 457) only in circumstances where the taxpayer has an attribution percentage of at least 10 per cent. Therefore, the new attribution percentage will not affect attributable taxpayers in these two cases as they already satisfy the 10 per cent requirement.

1.73 It is expected that this change - to a straight 10 per cent attribution percentage - will have minimal (if any) effect, since it is rare for an attributable taxpayer to be attributed under Part X of the ITAA 1936 where the attribution percentage is less than 10 per cent. Further, this new requirement will more closely align the tax laws to the changes contained in the New International Tax Arrangements (Participation Exemption and Other Measures) Act 2004 , which rationalised the section 23AJ (of the ITAA 1936) non-portfolio dividend exemption.

Attributable taxpayers - foreign investment fund rules

1.74 The current foreign tax credit system provides attributable taxpayers with a credit for foreign income tax, or Australian tax (income tax or withholding tax) paid on income attributed under the foreign investment fund calculation method. The mechanism that provides relief for the foreign tax paid on this type of attributable income is voluminous, highly complex and disproportionate to its degree of utilisation and compliance.

1.75 For these reasons, double tax relief for foreign income taxes paid on income attributed under the foreign investment fund calculation method will be substantially simplified.

1.76 In line with current foreign tax credit rules, a foreign tax offset will only be available for taxpayers that are attributed with income under section 529 of the foreign investment fund rules where the calculation method is used to determine their attributable income.

1.77 However, the foreign tax offset in these cases is limited to situations where:

·
the foreign company or foreign trust has paid the tax [Schedule 1, item 1, paragraph 770-135(3)(c)] ;
·
the association condition is met (in the case of a foreign company only) [Schedule 1, item 1, paragraph 770-135(5)(c)] ; and
·
the calculation method is used [Schedule 1, item 1, subsection 770-135(6)] .

1.78 The first condition is the same as the existing requirement in the case of a first-tier foreign investment fund and the final condition is consistent with the current law. The new tax offset is limited to foreign income tax, or Australian tax (income tax or withholding tax) paid by first-tier foreign investment funds only. This can be contrasted to the current rules which also allow for a credit in the case of certain taxes paid by second-tier foreign investment funds, where the attributable income of the first-tier fund includes income from the second-tier fund.

1.79 A tax offset is no longer allowed in respect of second-tier foreign investment funds. The attributable taxpayer will instead receive a deduction for any foreign or Australian tax paid by the second-tier foreign company or trust. This change will reduce compliance costs for taxpayers and administration costs for the ATO, together with simplifying the tax law. The new rules are also consistent with the general move to deny a tax offset for foreign income tax paid by an entity in which the taxpayer holds an indirect interest where income is not received or attributed directly.

1.80 Like the case of attributable taxpayers in relation to controlled foreign companies, the second condition for foreign investment fund companies (the association condition) requires an attribution percentage (within the meaning of section 581 of the ITAA 1936) of 10 per cent or more. The definition of 'attribution percentage' has been amended such that it is now defined in relation to a controlled foreign company or a controlled foreign trust as well as a foreign investment fund that is a company [Schedule 1, item 188, the definition of 'attribution percentage' in subsection 995-1(1)] . This attribution percentage is tested at the end of the notional accounting period [Schedule 1, item 1, paragraph 770-135(5)(c)] .

1.81 Where the foreign investment fund is a trust, there is no attribution percentage requirement. These attributable taxpayers will continue to be entitled to relief (in the form of a tax offset) in respect of foreign income tax, or Australian tax (income tax or withholding tax) paid by the first-tier foreign trust proportionate to their interest in the trust. [Schedule 1, item 1, paragraph 770-135(7)(c)]

1.82 Paragraphs 1.116 to 1.118 discuss further the rules for what taxes paid by a foreign investment fund are treated as having been paid by an attributable taxpayer.

What foreign taxes are eligible for a tax offset?

1.83 A tax offset will be available for those foreign income taxes that are substantially equivalent to Australian income tax. That is, the foreign income tax must be levied on the taxpayer's income, profits or gains of an income or capital nature, or be similar to Australian withholding tax that is imposed in place of a tax on the net amount of income. [Schedule 1, item 1, subparagraphs 770-15(1)(b)(i) and (ii)]

1.84 Inheritance taxes, annual wealth taxes or net worth taxes are not taxes on income, profits or gains and therefore will not be eligible for a tax offset. Further, foreign tax based on receipts, turnover or production, are not considered foreign income tax.

1.85 Foreign taxes specified within any of Australia's tax treaties, for which Australia is obliged to provide relief, will be considered to be foreign income taxes for the purpose of allowing a tax offset [Schedule 1, item 1, subparagraph 770-15(1)(b)(iii)] . For example, the Philippines tax treaty has rules pertaining to tax sparing. These tax sparing amounts will be treated as a foreign income tax under the International Tax Agreements Act 1953 .

1.86 Consistent with the current rules for foreign tax credits, an offset will be denied for unitary or credit absorption taxes (see the discussion in paragraphs 1.66 and 1.67).

1.87 In order to give rise to entitlement, the foreign income tax must be imposed by a law other than an Australian law [Schedule 1, item 1, paragraph 770-15(1)(a)] . It must be a law validly made by or under an authority recognisable by the Commonwealth of Australia. The foreign income tax can be imposed under a law of a national or supra-national government, a state or province, or at the local or municipal level of government.

1.88 The new definition of 'foreign income tax' no longer requires the tax to be imposed by a foreign country. The removal of this criterion broadens the scope of entitlement to cater for foreign income taxes imposed by supra-national confederations such as the European Union.

1.89 A resident taxpayer assessed on income received from a European Union institution will be eligible for a tax offset to the extent foreign income tax has been paid. Specifically, where a taxpayer has paid foreign income tax to the European Union on income included in their Australian assessable income, they will be entitled to a tax offset. These taxpayers are not currently entitled to relief because the requirement that the foreign tax be imposed by a foreign country is not satisfied (current paragraph 6AB(2)(a) of the ITAA 1936).

Example 1.6 Trixie is a retired employee of the European Central Bank who now resides in Australia. Trixie receives a pension from the European Central Bank and pays foreign income tax to the European Union on that pension. As a resident of Australia, Trixie also pays Australian tax on her pension.Trixie will be entitled to a tax offset against the Australian tax payable on her pension for the foreign income tax she has paid to the European Union.

Requirement to reduce foreign income tax paid on assessable offshore banking income

1.90 Foreign income tax paid on assessable offshore banking income of an offshore banking unit will be adjusted by the (offshore banking) eligible fraction.

1.91 Entitlement to an offset for foreign income tax paid on assessable offshore banking income will therefore only arise for a fraction (currently one-third) of the amount of foreign income tax paid. This is consistent with the treatment afforded to assessable offshore banking income as well as the allowable offshore banking deductions. [Schedule 1, item 1, subsection 770-10(1) and items 55 to 61, paragraph 121B(3)(d), subsection 121EG(3A) and paragraph 121EH(e), subsection 121EJ(1) of the ITAA 1936]

1.92 The reduction of foreign income tax recognises that two-thirds of foreign income tax paid in respect of offshore banking income relates to offshore banking income that is non-assessable non-exempt income. Double tax does not arise to the extent that the foreign income tax paid relates to non-assessable non-exempt income.

1.93 Although this treatment is not currently applied to foreign tax paid on assessable offshore banking income, the consequences are less prevalent. This is because the foreign tax currently paid on assessable offshore income is quarantined from that paid on all other assessable foreign income. Moreover, an offshore banking unit would seldom have an opportunity to utilise the additional foreign income tax. With the removal of foreign tax credit quarantining, the offshore banking unit could use this additional foreign tax to shelter other types of low-taxed foreign source income, which is not the desired outcome.

Example 1.7 Big Bank Ltd is an Australian resident bank that is declared an offshore banking unit. Big Bank Ltd derives offshore banking income as follows:

Source Income (A$) Expenses (A$) Foreign tax paid (A$)
Borrowing and lending activity - commission 15,000 900 1,500
Borrowing and lending activity - interest 20,000 600 3,000
Advisory activity 50,000 6,000 16,500
Total assessable offshore banking income 85,000 7,500 21,000
Australian assessment
Assessable offshore banking income (85,000 x 10/30) 28,333
Allowable offshore banking deductions (7,500 x 10/30) 2,500
Taxable income 25,833
Australian tax (25,833 x 0.30) 7,750
Less
Offset entitlement* (21,000 x 10/30) 7,000
Net Australian tax payable 750
* The offset entitlement is equal to the lesser of foreign income tax paid and Australian tax payable. The amount of foreign income tax paid in respect of the assessable portion of offshore banking income is the amount of foreign income tax paid multiplied by the eligible fraction:

$21,000 * 10/30 = $7,000

This is less than the Australian tax payable of $7,750. Big Bank is therefore entitled to an offset equal to the amount of foreign income tax paid in respect of the assessable component of offshore banking income.

Requirement to gross-up assessable income amount

1.94 The requirement to gross-up a double-taxed amount by the foreign income tax paid in respect of that amount is fundamental to any foreign tax offset system. The amount of income that is subject to tax in a taxpayer's country of residence is the gross amount of the income, before any payment of foreign income tax.

1.95 There will be some circumstances in which a taxpayer will not have to do anything to achieve that outcome, namely, where foreign income tax is paid on a net assessment basis. In this situation, the taxpayer determines the double-taxed amount before the payment of foreign income tax and it is this amount that is included in assessable income. There is no requirement to expressly gross-up the double-taxed amount in these cases because foreign income tax has not been deducted from the amount included in assessable income. However, where the foreign income tax is withheld from the amount paid or credited to the taxpayer, that tax amount must be added to the net amount received by the taxpayer before including it in assessable income.

1.96 Where a taxpayer has paid foreign income tax (or is treated as having paid foreign income tax) on an amount included in their assessable income, pursuant to general tax law principles, the amount included in the taxpayer's assessable income is the amount before the payment of that foreign income tax. That is, the amount is grossed-up, by the amount of foreign income tax paid, before being included in assessable income. Therefore, notwithstanding that current section 6AC of the ITAA 1936 is being repealed, there is no change in the policy intent [Schedule 1, item 26] . General tax law principles dictate that in this situation the amount included in assessable income is the grossed-up amount (eg, subsections 6-5(2) and (4)). It would make little sense to allow both a deduction and a credit for the amount of foreign income tax by taxing only the net amount of income and then allowing an offset for the foreign income tax.

1.97 The attributable income of a controlled foreign company and foreign investment fund is calculated net of any foreign income tax paid, and it is this net amount that is included in the attributable taxpayer's assessable income. Thus, the attributable taxpayer is effectively entitled to a deduction for foreign taxes (and Australian taxes) paid on an amount included in the controlled foreign company's or foreign investment fund's notional assessable income. It is only where the attributable taxpayer is eligible for a foreign tax offset that there is a requirement to gross-up the attributable income amount. The amount will be grossed-up by the amount of foreign income tax, income tax or withholding tax they are deemed to have paid. [Schedule 1, item 1, subsection 770-135(8)]

Example 1.8 A resident taxpayer invests directly in a foreign company. The foreign company pays a dividend of $100 and deducts $15 withholding tax, thereby making a net distribution of $85 to the resident taxpayer.The taxpayer will gross-up the net distribution for foreign tax paid under common law concepts. The amount included in the taxpayer's assessable income is therefore $100. The taxpayer may then be entitled to claim a tax offset for the $15 withholding tax.The amount of the tax offset will be determined in accordance with the foreign tax offset limit rules.

When will foreign income tax be treated as paid by the taxpayer?

1.98 Consistent with the current rules (in subsection 6AB(3) of the ITAA 1936), a taxpayer will be treated as having paid foreign income tax on an amount included in their assessable income where the foreign income tax has effectively been paid by someone else on their behalf under an arrangement with the taxpayer or under the law relating to the foreign income tax [Schedule 1, item 1, subsections 770-130(1) and (2)] . The current requirement that the taxpayer be personally liable for the foreign tax has been removed to simplify the law. The requirement that the taxpayer 'paid' the foreign income tax (on an amount included in assessable income) effectively achieves the same outcome. Accordingly, where one taxpayer has paid foreign income tax on behalf of another taxpayer, relief from double tax will continue to be denied for the first taxpayer because the foreign income tax paid by them is not in respect of an amount included in their assessable income. Rather, the taxpayer that includes the double-taxed amount in assessable income may be entitled to relief.

1.99 The intention of the foreign income tax paid deeming provisions, is to ensure that the right taxpayer obtains the foreign tax offset. For example, where an entity (including an individual) has paid foreign income tax in a representative capacity for a taxpayer, but the taxpayer has actually borne the economic burden of the foreign income tax, it is the taxpayer who will be taken to have paid the foreign income tax and be entitled to the tax offset.

1.100 The foreign income tax must be paid by another entity under an arrangement with the taxpayer or under a law relating to the foreign income tax [Schedule 1, item 1, subsection 770-130(2)] . It is intended that foreign income taxes paid by the taxpayer will include those taxes paid indirectly by the taxpayer or paid by someone else and covers foreign income tax that has been paid by:

·
deduction or withholding;
·
a trust in which the taxpayer is a beneficiary;
·
a partnership in which the taxpayer is a partner; or
·
the taxpayer's spouse.

1.101 The foreign income tax paid in these circumstances must have some material connection with the amount included in the taxpayer's assessable income (or with an amount that is non-assessable, non-exempt income under section 23AI or 23AK of the ITAA 1936). This nexus or link between the foreign income tax paid and the income included in the taxpayer's ordinary income or statutory income arises from the phrase '...in respect of a taxed amount...'. [Schedule 1, item 1, subsections 770-130(1) and (2)]

Example 1.9 A resident individual, Barry, invests directly in a foreign company (For Co.). For Co. pays a dividend of $100 and deducts $15 withholding tax, making the net distribution $85.Barry will include $100 in assessable income and will also be entitled to claim a tax offset for the $15 withholding tax deducted by For Co. as Barry is deemed to have paid the withholding tax.Barry will determine the amount of the tax offset in accordance with the foreign tax offset limit rules.

1.102 The link between foreign income tax paid by someone else and the income included in the taxpayer's ordinary income or statutory income will also be met in cases where foreign entities elect for flow-through treatment of taxation. For instance, an Australian resident taxpayer who is a member of a US limited liability company that has elected to be treated as a partnership in the US will be entitled to a tax offset for foreign income tax imposed by the US on distributions from the limited liability company.

1.103 Even where the Australian resident has not elected for the US limited liability company to be a foreign hybrid, the Australian resident will be entitled to a tax offset for the US withholding tax imposed on the distribution of the profits of the limited liability company. The tax offset will be in respect of the gross amount (pre-US tax) paid to the Australian resident. This is irrespective of the fact that the amount is regarded as a 'dividend' under Australian tax law and a 'distribution of partnership profits' under US law.

Example 1.10 Aust Super Fund is a trustee of a complying superannuation entity and an Australian resident taxpayer that holds a 2 per cent interest in a US limited partnership (a foreign investment fund interest).The US limited partnership elects for flow-through treatment to apply to it under the laws of the US. That is, it is not taxed on its profits but rather tax is borne by the partners on their share of the partnership distribution.The taxpayer's share of partnership profits for the year of income is $1 million which is US-sourced income (the tax treaty Australia has with the US determines this).Tax of $350,000 is withheld by the US limited partnership (in compliance with US tax law) in respect of the distribution it makes to the taxpayer. (The tax has been properly imposed in accordance with the US Convention.)The taxpayer does not make an election under subsection 485AA(1) of the ITAA 1936 to treat the US limited partnership as a foreign hybrid limited partnership. Accordingly, the US limited partnership is taxed under Australian tax law as a company in accordance with Division 5A of Part III of the ITAA 1936.Although the absence of an election pursuant to section 485AA means that the interest held by the taxpayer in the US limited partnership is still a foreign investment fund interest, the taxpayer (being a trustee of a complying superannuation entity) is exempt from foreign investment fund taxation by virtue of Division 11A of Part XI of the ITAA 1936.The amount (the distribution of partnership profits characterised as a dividend) of $1 million is included in Aust Super Fund's assessable income (and the distribution of partnership profits is characterised as a dividend). Aust Super Fund, although not having paid the US tax of $350,000 personally (since the US limited partnership has been taxed on the distribution on a withholding basis), will be treated as having paid the foreign income tax in respect of the amount included in its assessable income and so will be entitled to a tax offset.The amount of the tax offset will be subject to the tax offset limiting rules.

1.104 The link between foreign income tax paid by someone else and the income included in the taxpayer's ordinary income or statutory income is not however, boundless. A taxpayer receiving dividends from a foreign company will not satisfy the nexus in respect of foreign company tax paid on the profits from which the dividend was distributed.

1.105 A taxpayer in receipt of a foreign pension from a foreign superannuation fund will also not satisfy the nexus in respect of any foreign income tax paid by the foreign superannuation fund on its income.

1.106 Although the foreign income tax in these two scenarios reduces the amount of income that a taxpayer receives, the foreign company and the superannuation fund are not regarded as flow-through entities under Australian law. Rather, they are liable to tax in their own right and that foreign income tax is commonly referred to as underlying tax. This is distinguishable from the situation in which a partnership or trust pays foreign income tax on partnership or trust income that is taxed in the hands of the resident taxpayer under Australian tax law on a flow-through basis, thus reducing the amount distributed or credited to the taxpayer. In these cases, while the partnership or trust pays the foreign income tax, it is the resident partner or beneficiary that bears the economic burden (under Australian law) of that foreign income tax.

1.107 The phrase '...in respect of an amount (a taxed amount ) that is all or part of an amount included in your ordinary income or statutory income...' is also intended to allow an apportionment or slicing of foreign income tax for conduit or flow-through entities such as trusts and partnerships. This apportionment is intended to guard against more than one taxpayer claiming a tax offset for the same amount of foreign income tax. [Schedule 1, item 1, subsections 770-130(1) and (2)]

Example 1.11 A partnership (that comprises two Australian partners with equal shares) earns $1,000 of partnership net income and pays $100 of foreign income tax on that income.The two partners include $500 each in their assessable income. They will both be entitled to a tax offset to the extent that foreign income tax is paid in respect of the amount included in their assessable income. Each partner is deemed to have paid some of the foreign income tax.As the $100 of foreign income tax cannot be paid in respect of both taxpayers' assessable income, the foreign income tax paid is apportioned according to each partner's share of partnership net income that is included in their assessable income. Therefore, both partners can each claim an offset for $50 of foreign income tax, because this is the proportionate amount of foreign income tax paid in respect of the amount included in their assessable income (ie, (500/1,000) x $100).

When foreign income tax is treated as paid by the taxpayer - beneficiaries of trust estates

1.108 Subsection 770-130(3) replaces current subsection 6AB(4) of the ITAA 1936. Subsection 770-130(3) continues to ensure the flow-through of tax offset entitlement where a beneficiary receives a trust distribution that includes income received by the trust on which foreign income tax has already been paid - that is, the trust itself has not paid the foreign income tax [Schedule 1, item 1, paragraph 770-130(3)(b)] . This is distinct from the deeming provision discussed in paragraph 1.100. In that case, the foreign income tax is paid by the trust [Schedule 1, item 1, subsection 770-130(2)] .

1.109 When applied in conjunction with section 6B of the ITAA 1936, it also guarantees that the character and source of income flows through a trust (or multiple trusts or a combination of trusts and partnerships) to a beneficiary. The language of section 6B '...attributable to...' in addition to '...derived from a particular source...', ensures that the character of the distribution as well as the source of the income remains unchanged. [Schedule 1, item 1, paragraph 770-130(3)(a)]

1.110 Two common scenarios in which subsection 770-130(3) may be used to deem a beneficiary to have paid foreign income tax are:

·
where the trust receives income on which foreign income tax is paid by deduction; and
·
where the trust is a beneficiary in another trust and the other trust paid the foreign income tax.

Example 1.12 Holly is the sole beneficiary of foreign trust B. Holly is presently entitled to all the income of foreign trust B. Foreign trust B owns shares in a foreign company, For Co. D.For Co. D pays a dividend to foreign trust B and the dividend is subject to foreign withholding tax. Foreign trust B distributes the income to Holly and the distribution is subject to further foreign withholding tax. Since Holly has not paid the foreign income tax on the distribution from For Co. D to foreign trust B; and since foreign trust B has not paid the foreign income tax, Holly will rely on subsection 770-130(3) to treat the foreign income tax paid by For Co. D to be foreign income tax that she paid. Further, Holly will rely on subsection 770-130(2) to treat the foreign income tax paid by foreign trust B as tax she paid.

Example 1.12 - where the trust receives income on which foreign income tax is paid by deduction

1.111 The foreign income tax paid is intended to flow through to the taxpayer in the scenario contained in Example 1.12. Ultimately, the double-taxed amount is the beneficiary's ordinary income or statutory income and consequently, the beneficiary should be entitled to claim an offset for the foreign income tax paid by someone else. It is irrelevant whether there are one or more tiers of trusts or partnerships interposed.

Example 1.13 Consider the following investment structure:

Example 1.13 - where the trust is a beneficiary in another trust and the other trust paid the foreign income tax

A resident individual invests directly in Managed Fund A. Managed Fund A in turn invests in Managed Fund B, which has a direct interest in a US company.The US company pays a dividend of $100 and deducts $15 withholding tax, making the net distribution $85. The amount distributed to the individual is ultimately attributable to the dividend paid by the US company. The individual will include $100 in assessable income and will be entitled to claim a tax offset for the $15 withholding tax.The taxpayer will determine the amount of the tax offset in accordance with the foreign tax offset limit rules.

Example 1.14 Assume the same investment structure as outlined in Example 1.13.The US company pays a dividend of $100 and deducts $15 withholding tax, making the net distribution $85. Managed Fund B has $30 of deductible expenses and consequently distributes $55 to Managed Fund A. The amount distributed to the individual is ultimately attributable to the dividend paid by the US company. The individual will receive the $55 from Managed Fund A and will be deemed to have paid the withholding tax and will be deemed to have paid the withholding tax and so will include $70 in its assessable income. The individual will be entitled to claim a tax offset for the $15 withholding tax.The taxpayer will determine the amount of the tax offset in accordance with the foreign tax offset limit rules.

Example 1.15 Assume the same investment structure as outlined in Example 1.13.The US company pays a dividend of $100 and deducts $15 withholding tax, making the net distribution $85. Managed Fund B has $110 of deductible expenses, resulting in a net loss of $10, and consequently does not make any distribution for the income year.Because the individual does not receive the dividend, entitlement to a tax offset does not arise (ie, the taxpayer is not subject to any double taxation). The foreign income tax (deemed) paid by Managed Fund B is not carried forward for use in a later year.

1.112 The amount of foreign income tax that the taxpayer may claim as an offset is the amount by which the income they included in assessable income has been reduced because of the foreign income tax. [Schedule 1, item 1, paragraph 770-130(3)(c)]

Foreign income tax treated as paid by the taxpayer - controlled foreign companies

1.113 Current subparagraphs 6AB(2)(b)(i), (ii) and (v) of the ITAA 1936 have been rewritten but continue to ensure that certain attributable taxpayers are treated as having paid foreign income tax on amounts attributed under section 456, 457 or 529 of the ITAA 1936. [Schedule 1, item 1, section 770-135]

1.114 For amounts attributed to an Australian company under section 456, the amount of foreign income tax taken to be paid by the company is the sum of foreign income tax, Australian income tax and Australian withholding taxes paid by the controlled foreign company multiplied by the company's interest in the controlled foreign company [Schedule 1, item 1, paragraphs 770-135(3)(a) and (7)(a) and subsection 770-135(4)] . This is intended to represent the portion of income tax borne by the foreign company that is relevant to the taxpayer.

1.115 For amounts attributable under section 457, the amount of foreign income tax is taken to be the sum of the amounts of the foreign income tax, and Australian tax (income tax and withholding tax) paid by the controlled foreign company to the extent they are attributable to the amount included in the attributable taxpayer's assessable income. [Schedule 1, item 1, paragraphs 770-135(3)(b) and (7)(b) and subsection 770-135(4)]

Example 1.16 Aust Co. is a resident company which owns 70 per cent of the paid-up share capital of For Co., a controlled foreign company resident in an unlisted country. Therefore, Aust Co. has a 70 per cent direct attribution interest in For Co. and an attribution percentage of 70 per cent in relation to For Co.During the statutory accounting period ending 31 March 2009, For Co. derives income of $100,000 comprised of capital gains (on the disposal of tainted assets) and royalty income. This means that For Co. fails the active income test and all of its income is included in its notional assessable income (sections 384 and 432 of the ITAA 1936).For Co. pays tax on its income in the unlisted country at the rate of 20 per cent. The tax of $20,000 is a notional allowable deduction of the controlled foreign company under section 393 of the ITAA 1936, resulting in attributable income of $80,000 for For Co. Aust Co. includes in its assessable income (under section 456 of the ITAA 1936) the attributable income of For Co. multiplied by the attribution percentage (ie, 70% x $80,000 or $56,000). Aust Co. is also deemed to have paid foreign income tax of $14,000 (70% of $20,000). Aust Co. must gross-up its assessable income by $14,000, but can claim a tax offset for the same amount, subject to the tax offset limit rules.

Foreign income tax treated as paid by the taxpayer - foreign investment funds

1.116 Where an attributable taxpayer includes an amount in their assessable income under section 529 of the ITAA 1936 and meets the conditions set out in subsection 770-135(1), the amount of foreign income tax the attributable taxpayer is taken to have paid is worked out under paragraph 770-135(7)(c) [Schedule 1, item 1, subsection 770-135(1), subparagraph 770-135(2)(a)(iii) and paragraph 770-135(2)(b)] . The amount of foreign income tax the attributable taxpayer is taken to have paid is the sum of all the tax amounts paid by the foreign investment fund for the notional accounting period multiplied by the attributable taxpayer's percentage share of the total calculated profit of the foreign investment fund [Schedule 1, item 1, paragraph 770-135(7)(c)] .

1.117 The tax amounts include amounts of foreign income tax, and Australian tax (income tax and withholding tax) paid by the foreign investment fund in respect of an amount included in its notional assessable income [Schedule 1, item 1, paragraph 770-135(3)(c)] . The attributable taxpayer's percentage share of the total calculated profit of the fund is the taxpayer's own share of the calculated profit divided by the fund's total calculated profit for the notional accounting period [Schedule 1, item 1, paragraph 770-135(7)(c)] .

1.118 Where the foreign investment fund is a trust, the amount of foreign income tax is the amount of foreign income tax, or Australian tax (income tax or withholding tax) paid by the trust, commensurate with the attributable taxpayer's interest in the trust. [Schedule 1, item 1, paragraphs 770-135(2)(b) and (7)(c)]

Example 1.17 Aust Co. owns 30 per cent of the paid-up capital in For Co., a foreign investment fund. Aust Co. works out its foreign investment fund income under section 529 of the ITAA 1936 by using the calculation method. For Co.'s calculated profit under the calculation method is $1 million after a notional deduction of $300,000 is allowed for foreign income tax paid. Aust Co.'s share of the calculated profit of For Co. is 30% x $1 million or $300,000, based on its shareholding in For Co.As Aust Co.'s share of the calculated profits of For Co. is 30 per cent, it is deemed to have paid 30 per cent of the foreign income tax paid by For Co. which is calculated as 30% x $300,000 or $90,000 and the amount included in assessable income is $390,000.Accordingly, Aust Co. can claim a tax offset for that amount, subject to the tax offset limit rules.

When foreign income tax is not treated as paid by the taxpayer

1.119 A taxpayer is not entitled to a tax offset for paid foreign income tax if the tax is refunded to the taxpayer or to any other entity [Schedule 1, item 1, paragraph 770-140(a)] . Further, entitlement to an offset will not arise if the taxpayer (or any other entity) receives any other benefit as a direct result of the payment of foreign income tax [Schedule 1, item 1, paragraph 770-140(b)] .

1.120 The current subsection 6AB(5A) of the ITAA 1936 was introduced to target arrangements entered into that allowed a taxpayer to generate false foreign tax credits. The new law continues to deny an offset in these circumstances, but is not limited to the generation of a false tax offset.

1.121 Section 770-140 is intended to uphold the integrity of the core principle underpinning the foreign tax offset rules. That is, a taxpayer is only entitled to an offset for foreign income tax paid on an amount included in their assessable income. To the extent that a taxpayer receives a refund of foreign income tax, or a taxpayer is the recipient of a benefit resulting in the removal (or reduction) of double taxation, the obligation (on Australia) to provide double tax relief diminishes.

1.122 It is not a requirement that the refund of foreign income tax or the benefit calculated by reference to the foreign income tax be provided to the taxpayer that actually paid the foreign income tax. A tax offset will also be denied if the refund or benefit is provided to an entity other than the taxpayer that paid the foreign income tax. [Schedule 1, item 1, section 770-140]

1.123 Consistent with the current rules, an offset will not be denied where the only benefit is a reduction in the tax liability of the taxpayer or another entity. This is to ensure that entitlement is still available where a foreign country provides an imputation credit, a rebate of tax or similar type of concession. The offset will however be denied if the concession results in a refund to the taxpayer (or other entity). [Schedule 1, item 1, paragraph 770-140(b)]

1.124 An offset will be denied to the taxpayer if they, or any other entity, receive a benefit because of the payment of foreign income tax and the benefit is calculated by reference to the amount of foreign income tax paid. It is not a requirement that the benefit results in the generation of a false tax offset. A benefit may arise from the exploitation of arbitrage opportunities resulting from mismatches in debt and equity classifications and the different status granted to foreign hybrid entities. For example, where an enhanced yield is obtained by a taxpayer entering into a structured finance arrangement.

Example 1.18 Austco (an Australian resident company) derives certain income in a foreign country. Under the rules of that country, advance corporation tax is levied on the basis of a particular formula. For the income year, Austco pays advance tax of $50,000 and treats the amount as foreign income tax for the purposes of Division 770.Austco later finds out that it is entitled to a special concession under the rules of the foreign country which has the effect of fully refunding the tax of $50,000 that was previously paid. Since Austco has received a refund in respect of the advance tax of $50,000, Austco is taken to not have paid the foreign income tax on that income.

How is the foreign tax offset limited or capped?

1.125 The starting point for a taxpayer in determining the amount of tax offset entitlement is to ascertain the total foreign income tax paid on amounts included in their assessable income. [Schedule 1, item 1, section 770-70]

1.126 It will then be necessary to ensure that the amount of the tax offset only relieves double taxation. The foreign tax offset is not intended to relieve all foreign taxation by subsidising the tax base of a foreign jurisdiction. The tax offset is therefore limited to the potential amount of Australian tax on the double-taxed amount (this translates to the foreign tax offset cap) [Schedule 1, item 1, subsection 770-75(1)] . There is one exception to the calculation of this cap and it is the $1,000 de minimis cap [Schedule 1, item 1, paragraph 770-75(2)(a)] . This $1,000 cap threshold is an alternative to the calculated cap and promotes simplicity and reduced compliance costs.

What is the $1,000 de minimis cap?

1.127 If the total foreign income tax paid is less than or equal to $1,000 (the $1,000 de minimis cap), the taxpayer is not required to calculate the foreign tax offset cap [Schedule 1, item 1, paragraph 770-75(2)(a) and note 1 in subsection 770-75(2)] . Provided the requirements in section 770-10 are satisfied, the taxpayer's tax offset will equate to the total foreign income tax paid on the double-taxed amounts included in assessable income [Schedule 1, item 1, section 770-70] .

1.128 Further, where the taxpayer has also paid foreign income tax in respect of an amount that is non-assessable non-exempt income under either section 23AI or 23AK of the ITAA 1936, the offset (either capped at $1,000 or less, depending on the amount of foreign income tax paid), will be increased by the amount of foreign income tax paid in respect of those amounts. [Schedule 1, item 1, section 770-80]

Requirement to calculate the foreign tax offset cap

1.129 If the total foreign income tax paid is greater than $1,000, the taxpayer has two options. First, the taxpayer may elect to offset only $1,000 of foreign income tax paid [Schedule 1, item 1, subsection 770-75(2)] . In this case, the taxpayer is not required to calculate the foreign tax offset cap. However, any foreign income tax paid in excess of the $1,000 cap will be wasted. It cannot be used in any future income year or by any other taxpayer.

1.130 Alternatively, if the taxpayer wishes to offset more than $1,000 of foreign income tax paid, they will be required to calculate the foreign tax offset cap [Schedule 1, item 1, paragraph 770-75(2)(b)] . The taxpayer will then be entitled to offset foreign income tax paid up to the amount of the cap. If the calculation yields a result less than $1,000 the taxpayer may disregard the calculated foreign tax offset cap and instead offset foreign income tax paid up to the $1,000 de minimus cap.

1.131 In the event that the tax offset limit (whether worked out as $1,000 or the calculated cap) is greater than the total foreign income tax paid on double-taxed amounts included in assessable income, the taxpayer can increase the offset, up to the amount of the tax offset limit, by any pre-commencement excess foreign tax they may have [Schedule 1, item 5, subsection 770-230(2) of the Income Tax (Transitional Provisions) Act 1997] . For an explanation of the utilisation of this pre-commencement foreign income tax, see paragraphs 1.299 to 1.326.

How to calculate the foreign tax offset cap

1.132 The foreign tax offset cap is the Australian tax payable on a taxpayer's double-taxed amounts and other assessable amounts that do not have an Australian source.

1.133 The Australian tax payable is the extra amount of Australian income tax that the taxpayer would have to pay because of the double-taxed amounts (and other assessable amounts that do not have an Australian source). The Australian tax payable is therefore the difference between income tax including the double-taxed amounts and other assessable amounts that do not have an Australian source, and income tax excluding those amounts. [Schedule 1, item 1, paragraph 770-75(2)(b)]

1.134 The taxpayer is therefore required to calculate two different amounts in order to determine the limit on the amount of tax offset entitlement. The first amount is the income tax payable by the taxpayer for the income year before any tax offsets or penalties are applied. The second amount is the income tax payable by the taxpayer for the income year before any tax offsets or penalties are applied and assuming certain other amounts are disregarded. The taxpayer subtracts the second amount from the first amount to determine the cap and consequently, the maximum amount of tax offset allowable. [Schedule 1, item 1, paragraph 770-75(2)(b) and subsection 770-75(3)]

1.135 This approach ensures that the taxpayer is using their highest marginal rate of tax, effectively resulting in a top-slice of income approach in ascertaining the Australian tax payable on the double-taxed amounts (and other assessable amounts that do not have an Australian source). This is a change from the current approach of calculating the cap based on an average tax rate.

1.136 Tax offsets are disregarded in the calculation of income tax payable for simplicity as well as clarity [Schedule 1, item 1, subsection 770-75(3)] . Where a taxpayer has paid foreign income tax and is entitled to a tax offset, the determination of the cap would become circular if the calculations took account of tax offsets available to a taxpayer. In particular, the taxpayer would need to know the amount of the foreign tax offset in order to calculate the cap, however, in many cases the cap will determine the amount of foreign tax offset.

1.137 In calculating the second amount of income tax payable, the taxpayer is required to disregard certain amounts of assessable income and certain deductions. [Schedule 1, item 1, subparagraph 770-75(2)(b)(ii) and subsection 770-75(4)]

1.138 The amounts taken out of the taxpayer's assessable income are:

·
so much of any amount in respect of which the taxpayer paid foreign income tax [Schedule 1, item 1, subparagraph 770-75(4)(a)(i)] ; and
·
ordinary income or statutory income that is not from an Australian source and in respect of which no foreign income tax has been paid [Schedule 1, item 1, subparagraph 770-75(4)(a)(ii)] .

1.139 The first of the income-disregarding rules captures the double-taxed amounts, that are the assessable income upon which foreign income tax has been paid or deemed to have been paid. The words 'so much of any amount' ensure that only the relevant part of the assessable income upon which foreign income tax has been paid is disregarded for the purposes of the cap calculation.

1.140 In the event that a taxpayer has paid foreign income tax on a capital gain that comprises part of their net capital gain, only that capital gain on which foreign income tax has been paid will be disregarded [Schedule 1, item 1, subparagraph 770-75(4)(a)(i)] . That is, the taxpayer in this situation does not disregard the entire net capital gain. This is consistent with the current treatment afforded to foreign tax paid on capital gains which form all or part of a taxpayer's net capital gain. If the disregarded amount in this example was the entire net capital gain, the proxy for the Australian tax payable would be inaccurate and in particular, the result would give rise to an increased cap. It follows that only those deductions that reasonably relate to the disregarded capital gain will be disregarded [Schedule 1, item 1, subparagraph 770-75(4)(b)(ii)] . That is, the taxpayer does not disregard all deductions that reasonably relate to the entire net capital gain.

Example 1.19 Aust Co. derives a capital gain of $2 million (on which foreign income tax is paid) and a gain in respect of the disposal of an Australian asset of $1 million (on which no foreign income tax is paid). Aust Co. therefore includes $3 million in its assessable income as a net capital gain. For the purposes of the first income-disregarding rule, only the capital gain of $2 million is disregarded, since this represents the part of the assessable income of Aust Co. upon which foreign income tax has been paid.

1.141 The inclusion of foreign source income that has not been subject to foreign income tax as the second of the income-disregarding rules is consistent with the current approach of including within the cap, for a particular class of assessable foreign income, all assessable foreign income of that class, irrespective of whether foreign tax has been paid in respect of that income. This has the effect of increasing the amount of the foreign tax offset cap [Schedule 1, item 1, subparagraph 770-75(4)(a)(ii)] . The inclusion of all foreign source income, although inconsistent with a pure double-tax-relief approach, allows the taxpayer a greater averaging capacity, in that all high foreign taxed amounts are amalgamated with low foreign taxed amounts. Note that assessable offshore banking income upon which no foreign income tax has been paid is deemed to have an Australian source pursuant to section 121EJ of the ITAA 1936. Accordingly, it is not included in the second income-disregarding rule.

1.142 Specific mention is no longer made for section 305-70 amounts; or ITAA 1936, section 102AAZD, 456, 457, 459A or 529 amounts that are included in the taxpayer's assessable income because they will fall within the first two income amount categories. In particular, if a taxpayer has not paid foreign income tax on an amount included in their assessable income under these sections the amount would be expected to be classified as not having an Australian source under judicial rules of source.

1.143 The income-disregarding rules are designed to apply cumulatively. That is, income that is disregarded under subparagraph 770-75(4)(a)(i) cannot be disregarded a second time where it also falls within the scope of subparagraph 770-75(4)(a)(ii).

1.144 The second element in the cap calculation requires the taxpayer to assume that they are not entitled to certain deductions. The expenses that are 'disregarded' are:

·
debt deductions, to the extent they are attributable to the taxpayer's overseas permanent establishments [Schedule 1, item 1, subparagraph 770-75(4)(b)(i)] ;
·
other deductions that reasonably relate to the disregarded income amounts for the income year [Schedule 1, item 1, subparagraph 770-75(4)(b)(ii)] ; and
·
during the transitional period, any convertible foreign loss deducted by the taxpayer in the income year [Schedule 1, item 5, section 770-35 of the Income Tax (Transitional Provisions) Act 1997] .

1.145 Whether a deduction reasonably relates to the disregarded income amounts will be a question of fact depending on the circumstances of the taxpayer. Expenses that relate exclusively to the disregarded income amounts will be ignored in calculating the second element of the cap calculation. Deductions that relate to both the disregarded income amounts and other assessable income will need to be apportioned on a reasonable basis between the different income amounts. [Schedule 1, item 1, subparagraph 770-75(4)(b)(ii)]

1.146 The nature and size of the taxpayer's business, the type of income concerned and the methods used by the taxpayer to account for foreign income and expenses may be relevant in determining how the taxpayer should apportion deductions. A common example of the type of deduction a taxpayer will need to apportion would be head office expenses incurred by a taxpayer who operates both in Australia and overseas and which are relevant to the operation of both activities.

1.147 Provided the approach adopted is objective and results in a reasonable apportionment of the deductions, it will (generally) be acceptable. To the extent such expenses are considered to reasonably relate to the disregarded income amounts, they will be ignored in calculating the second element of the cap calculation. [Schedule 1, item 1, subparagraph 770-75(4)(b)(ii)]

1.148 The exclusion of debt deductions that are attributable to the taxpayer's overseas permanent establishment is consistent with the thin capitalisation changes introduced in 2001 (the New Business Tax System (Thin Capitalisation) Act 2001 ) [Schedule 1, item 1, subparagraph 770-75(4)(b)(i)] . This does not include expenses (including financing costs) incurred by an Australian company in earning income that is non-assessable under section 23AH of the ITAA 1936. In contrast, other debt deductions are not disregarded for the purposes of the second element of the cap calculation. This preserves the existing treatment of debt deductions as falling outside the cap calculation, consistent with the thin capitalisation changes referred to above.

1.149 The exclusion of deducted convertible foreign losses when calculating the second income tax payable amount has the effect of reducing the foreign tax offset cap by the tax effect of the amount of utilised convertible foreign loss. Of course, the deducted foreign losses will also reduce the first tax payable figure. A convertible foreign loss is subject to special deductibility rules during the five-year transitional period. (See paragraphs 1.228 to 1.298, which deal with the transitional rules for converting a foreign loss of a particular class of assessable foreign income into a tax loss and the utilisation of such losses.) Consequently, utilised convertible foreign losses will only influence the calculation for this five-year period.

1.150 This is an integrity rule ensuring that the tax offset limit reflects the reduced amount of assessable income upon which foreign tax has been paid, after taking into account utilised convertible foreign losses in that year. This approach is similar to existing subsection 160AFD(4) of the ITAA 1936 which reduces the assessable foreign income of a particular class for the purposes of the cap rule to the extent that a loss of that particular class has been applied to reduce assessable foreign income of that class in the relevant income year.

Example 1.20 Assume the same facts from Example 1.3.The amount of net capital gain included in the taxpayer's assessable income relates solely to the foreign capital gain in respect of which foreign tax has been paid. Therefore, the whole amount of foreign income tax is counted for foreign tax offset purposes.The taxpayer is entitled to an offset for the lesser of the foreign tax paid ($39,000) and the Australian tax payable in respect of the foreign net capital gain that is included in assessable income (even though only part of the capital gain on foreign asset D is included in the taxpayer's net capital gain). The Australian tax payable is calculated as follows:

$125,000 * 0.30 = $37,500

Therefore, the taxpayer is entitled to an offset of $37,500.

Example 1.21 Austco is an Australian resident company that derives the following taxable income for the 2008-09 income year:

Portfolio dividend (from Foreign Country A)
(foreign income tax paid of $100,000)
$1,000,000
Interest income (from Foreign Country B)
(no foreign tax paid)
$1,000,000
Australian-sourced income $1,000,000
Total assessable income $3,000,000
Less :
Interest expense * $500,000  
Other expenses related to Australian-sourced income $500,000  
Total allowable deductions $1,000,000
Taxable income $2,000,000
Australian tax payable $600,000
* Debt deduction - not attributable to an overseas permanent establishment of Austco - incurred in relation to dividend income.Austco calculates its tax offset cap in the following way (assuming Austco does not choose the $1,000 cap): Step 1 - Work out the amount of tax payable by Austco $600,000 Step 2 - Work out the tax payable by Austco if the assumptions in subsection 770-75(4) were made Assume that Austco's assessable income did not include the following amounts:

·
Portfolio dividend - $1,000,000
This is an amount in respect of which foreign income tax was paid.
·
Interest income - $1,000,000
This is ordinary income from a source other than an Australian source.

Even though the debt deduction of $500,000 is incurred in relation to the dividend income from Foreign Country A, it is not disregarded for the purposes of the cap calculation since it is not attributable to an overseas permanent establishment of Austco.Therefore, the tax payable by Austco based on the assumptions in subsection 770-75(4) is nil (ie, taxable income of $2,000,000 less exclusion of interest and dividend amounts of $2,000,000). Step 3 - Work out the amount of tax payable at Step 1, less the tax payable at Step 2 $600,000 - $0This amount of $600,000 is the tax offset limit.As the foreign income tax paid of $100,000 is less than the tax offset limit of $600,000, Austco is entitled to a tax offset of $100,000.

1.151 In the event that the first calculation (before any tax offsets or penalties are applied) that a taxpayer calculates is nil (eg, the taxpayer is in a loss position), the taxpayer's tax offset limit will also be nil. In this case, the taxpayer will not be in a position to offset any of the foreign income tax paid on amounts included in assessable income. Further, because there is no carry-forward mechanism, this foreign income tax cannot be used to reduce Australian tax. It cannot be refunded nor transferred to another taxpayer.

1.152 The amount of the calculated cap will be increased to the extent the taxpayer has paid foreign income tax on amounts that are non-assessable non-exempt income under either section 23AI or 23AK of the ITAA 1936. The amount of the increase in the offset will be the amount of the foreign income tax paid in respect of the non-assessable non-exempt income [Schedule 1, item 1, section 770-80] . This foreign income tax will usually be the final (direct) withholding tax imposed by the foreign country from which the distribution is paid. That is, the taxpayer will no longer be entitled to claim an offset for the underlying foreign income taxes paid on such a distribution. However, there is effectively no cap on the foreign income tax paid in respect of these amounts, nor any effort made to relate them to the Australian tax paid on the relevant attributed income.

1.153 Following on from paragraph 1.151, if the taxpayer is in a loss position, resulting in a calculated cap of nil, and also has foreign income tax paid on an amount that is non-assessable non-exempt income under either section 23AI or 23AK of the ITAA 1936, entitlement to an offset will not arise even though the calculated cap is non-zero. Further, because there is no carry-forward mechanism, this foreign income tax cannot be used. It cannot be refunded or transferred to another taxpayer.

Amendment of assessments - contingent amendment period

1.154 Entitlement to a tax offset for foreign income tax paid on an amount included in assessable income arises when the foreign income tax has been paid in relation to the income year in which the double-taxed amount is included in the taxpayer's assessable income. However, it may be that the taxpayer paid the foreign income tax in a different income year to when the amount is included in assessable income due to differences between the tax systems of foreign countries and Australia. [Schedule 1, item 1, section 770-190]

1.155 To ensure the usual amendment periods do not restrain the taxpayer's ability to claim an offset for foreign income tax paid, section 770-190 will modify the usual amendment period. For foreign tax offset purposes, the taxpayer will have four years from the time they pay foreign income tax to lodge an amended assessment [Schedule 1, item 1, section 770-190] . That is, the amendment period does not depend upon when the double-taxed amount was included in assessable income.

1.156 If a taxpayer includes an amount in assessable income for an income year but paid foreign income tax in a subsequent year of income, they may need to lodge an amended assessment when the foreign income tax is paid. However, the amendment to allow the taxpayer to claim a foreign tax offset is in relation to the income year in which the amount was included in the taxpayer's assessable income and not the income year the foreign income tax was paid. Accordingly, the modified amendment rules permit the taxpayer to lodge an amendment for that earlier income year within a period of four years from the time of payment of the foreign income tax. In the absence of this modified amendment rule, the normal amendment rules contained in section 170 of the ITAA 1936 may prevent the taxpayer from claiming a foreign tax offset.

1.157 In the event that the taxpayer paid foreign income tax that is subsequently increased or reduced, then the four-year amendment period will commence from the latter point in time [Schedule 1, item 1, subsection 770-190(1) and paragraphs 770-190(2)(a) to (c)] . Foreign income tax may subsequently be reduced if the foreign jurisdiction allows the carry-back of losses. In this case, the loss that is carried-back will reduce the amount of tax levied on the taxpayer in the foreign jurisdiction, namely, the amount of foreign income tax paid for tax offset purposes is reduced. The four-year period commences when the taxpayer receives a foreign tax refund or is given a credit because the deduction for the loss is allowed.

1.158 Alternatively, a taxpayer that lodges an assessment with a foreign jurisdiction as well as Australia may acquire new information after lodgement. If the taxpayer was required to lodge an amended assessment in the foreign jurisdiction and was subject to additional foreign income tax, the amendment period will commence from the subsequent payment of foreign income tax. [Schedule 1, item 1, subsection 770-190(1) and paragraph 770-190(2)(b)]

1.159 The modified amendment rules do not apply if the foreign tax offset is amended because of changes to the calculation of the foreign tax offset limit (as distinct from an increase or decrease in the amount of foreign tax paid) [Schedule 1, item 1, subsection 770-190(2)] . A change to the calculation of the offset limit is not one of the specified amendment events. The Commissioner may conduct an audit of a taxpayer and determine that the taxpayer has inflated the tax offset limit, which in turn affects the amount of the foreign tax offset. In this situation, the usual amendment periods will apply.

Example 1.22 Aust Co. (an Australian resident company) holds a rental property in the US. Aust Co. sells the property and makes a gain in the 2009-10 income year. The gain is taxed in the US and Aust Co. pays the tax before lodging its return for 2009-10.Subsequently, the US tax is reduced because of the favourable outcome of a dispute over deductions and Aust Co. receives a refund in February 2012. Aust Co. has until 2016 to amend its tax for the 2009-10 income year. As a result, Aust Co. may be required to pay additional Australian tax.

Method of relieving double tax resulting from a transfer pricing adjustment

1.160 Australia is obliged, under most of its international agreements (including tax treaties), to provide relief (to a resident company) from economic double taxation that arises as a result of a transfer pricing adjustment by a tax treaty partner country. Relief from economic double taxation in these circumstances ('correlative relief') is usually provided in the rules on associated enterprises (generally Article 9 of Australia's tax treaties).

1.161 Economic double taxation will occur where two companies resident in different countries - that is, two separate legal entities - are effectively taxed on the same income, without either country providing relief for the tax imposed by the other (eg, a parent company resident in Italy and a subsidiary company resident in Australia). This is in contrast to juridical double taxation, which occurs where a company pays tax on the same income in two different countries without either country providing relief for the tax imposed by the other. For example, a single legal entity that has its head office in its country of residence and a permanent establishment located in another country.

1.162 Generally, the amount of correlative relief will be determined in accordance with the treaty and in particular by the rules governing the mutual agreement procedure. There are two stages to this process: the first stage involves the resident company presenting its case to the Australian competent authority who then considers whether the case is justified, and if so, whether it can reach a satisfactory solution. The second stage is where the Australian competent authority must endeavour to resolve the case by mutual agreement with the competent authority of the tax treaty partner country. Stage two will be relevant when the Australian competent authority is not able to arrive at a satisfactory solution itself.

1.163 At the conclusion of the mutual agreement procedure, the Australian competent authority advises the taxpayer of the result. In the event that the taxpayer is not satisfied with the outcome reached, they can usually activate their domestic appeal rights. In such cases, the agreement reached under the mutual agreement procedure will not be implemented.

1.164 Currently, in the majority of transfer pricing cases, correlative relief is granted by way of a credit pursuant to section 160AI of Division 19 of Part III of the ITAA 1936 (a 'Division 19 credit'). Where the resident company is in a loss position, entitlement to correlative relief does not arise at that time. Consequently, the Commissioner will only allow a Division 19 credit when the resident company returns to profit and otherwise has some Australian tax to pay.

1.165 To give effect to international obligations arising from Australia's international agreements, these amendments will allow the Commissioner to make an appropriate adjustment to taxable income, or a tax loss, to relieve the double taxation (or potential future double taxation if the taxpayer is in a loss position) arising from a transfer pricing adjustment [Schedule 1, items 128 and 211, item 6 in the table in subsection 4-15(2), subsection 24(3) of the International Tax Agreements Act 1953] . This aligns Australia's tax practice with that of the international community.

1.166 This principle will apply equally to all tax treaties irrespective of whether the treaty has a specific correlative relief provision provided in the rules on associated enterprises [Schedule 1, item 211, subsections 24(1) and (2) of the International Tax Agreements Act 1953] . This does not require the Commissioner to provide correlative relief to relieve economic double taxation in non-treaty cases.

1.167 The Commissioner will have recourse to section 24 of the International Tax Agreements Act 1953 to prevent economic double taxation arising from a transfer pricing adjustment for all treaty countries, notwithstanding that the Commissioner may not be under an obligation to do so in all cases [Schedule 1, item 211, subsection 24(2) of the International Tax Agreements Act 1953] . Currently, the German, Italian and Swiss tax treaties do not have correlative relief provisions. Consequently, where a transfer pricing adjustment in one of these three countries indirectly affects an Australian taxpayer, the Commissioner will be in a position to prevent economic double taxation and determine the amount of the taxpayer's taxable income or tax loss [Schedule 1, item 211, subsection 24(3) of the International Tax Agreements Act 1953] .

1.168 The Commissioner will determine the amount of the adjustment in the same way, irrespective of whether the treaty has a correlative relief provision provided in the rules on associated enterprises. [Schedule 1, item 211, subsections 24(2) and (3) of the International Tax Agreements Act 1953]

1.169 The taxpayer will lodge a mutual agreement procedure request and if the Australian competent authority agrees with the primary adjustment, the Commissioner will make a corresponding adjustment to reduce the taxpayer's taxable income (even to the extent of giving rise to a tax loss) or increase a tax loss. Where the Australian competent authority is not able to arrive at a solution itself, they will commence negotiations under the mutual agreement procedure with the competent authority of the treaty partner country responsible for the primary adjustment. The Commissioner will then reduce the taxpayer's taxable income, even to the extent of giving rise to a tax loss or increase the tax loss by the amount of the adjustment that has been agreed to by both competent authorities. In the event that the two competent authorities do not reach agreement, the taxpayer's taxable income (or tax loss) will be adjusted by what the Commissioner regards as appropriate given the circumstances of the case. [Schedule 1, item 211, subsections 24(2) and (3) of the International Tax Agreements Act 1953]

1.170 The taxpayer will always have an opportunity to initiate the mutual agreement procedure and it will always be open to the Australian competent authority to agree to the mutual agreement procedure - provided it is in accordance with the requirements of the rules on mutual agreement. That is, the absence of a provision for correlative relief does not preclude the operation of the mutual agreement procedure. Moreover, there is nothing in the domestic tax laws preventing the Commissioner from commencing the mutual agreement procedure. Because of this, the Commissioner will always proceed in the same way to determine the amount of the adjustment.

1.171 These amendments will also extend to those tax treaties that expressly specify that relief from the economic double taxation must be in the form of a credit (currently, the only tax treaty that includes a credit relief article is the Japanese tax treaty, Article 17(2)). The issue of treaty override does not arise in this situation because the treaty crediting provision has no application. Since there is no additional tax charged - the Commissioner having removed the incidence of double taxation by adjusting taxable income - there is no double taxation. Therefore, the need to comply with the tax treaty crediting provision dissipates and no issue of treaty override arises.

1.172 Currently, entitlement to correlative relief by way of a Division 19 credit is not subject to any time limits. The new mechanism for preventing double taxation will also not be subject to any domestic time limits. [Schedule 1, item 68, subsection 170(11) of the ITAA 1936]

Example 1.23

Before adjustment After adjustment
Indy Co. provides goods to Austral Co. for no consideration Country B determines the arm's length consideration for the goods to be $100,000 and increases the profit of Indy Co. by $100,000

($100,000 subject to economic double taxation)

Example 1.23 - method of relieving double tax

Indy Co. is a company resident in a tax-treaty partner country - Country B - and provides goods for no consideration to its wholly-owned subsidiary, Austral Co., a company resident in Australia.Country B conducts an audit of Indy Co. and increases the profits of Indy Co. by $100,000 on the basis that if Indy Co. and Austral Co. had been dealing on an arm's length basis, Austral Co. would have paid Indy Co. $100,000 for the goods.As a result of this primary transfer pricing adjustment effected by Country B, $100,000 of profits is subject to economic double taxation.Austral Co. lodges a mutual agreement procedure with the Australian competent authority, asserting that it has been taxed not in accordance with the provisions of the tax treaty between Australia and Country B.The Australian competent authority agrees that the $100,000 adjustment reflects an arm's length consideration. The Commissioner adjusts Austral Co.'s taxable income down by $100,000.

Example 1.24 Same facts as Example 1.23, however, the Australian competent authority does not agree with the primary adjustment. The Australian competent authority will engage the competent authority of Country B pursuant to the mutual agreement procedure.Both competent authorities reach an agreement on what adjustment is justified both in principle and in amount. It is agreed that the arm's length price is $60,000.The Commissioner informs Austral Co. and reduces Austral Co.'s taxable income by $60,000.

Example 1.25 Same facts as Example 1.23, however, the Australian competent authority does not agree with the primary transfer pricing adjustment. The Australian competent authority will engage the competent authority of Country B pursuant to the mutual agreement procedure.Both competent authorities fail to reach an agreement as to what adjustment is justified both in principle and in amount. The competent authority of Country B believes the adjustment should be $100,000 and the Australian competent authority has reason to believe the adjustment should be $60,000.The Australian competent authority informs Austral Co. of the result and the Commissioner proposes to reduce Austral Co.'s taxable income by $60,000, leaving $40,000 subject to economic double taxation.If Austral Co. disagrees with the outcome then Austral Co. may commence domestic appeal rights (where available).

Excess foreign income deductions (foreign losses)

1.173 A longstanding feature of Australia's taxation law requires resident taxpayers to offset assessable income with allowable deductions. Where the allowable deductions exceed assessable income, the excess is a tax loss that can be used to offset assessable income in a future income year (subject to the usual loss recoupment rules).

1.174 Currently, deductions incurred in deriving foreign income must be applied against assessable foreign income of the same class (of which there are four). Where the deductions exceed the assessable foreign income of the same class, current section 79D of the ITAA 1936 prevents the excess from being a deduction. These rules effectively quarantine excess foreign income deductions from domestic income and were implemented primarily to prevent taxpayers from taking advantage of taxation asymmetries. However, recent international tax changes have largely removed these taxation asymmetries, consequently removing the original justification for the foreign loss quarantining rules.

1.175 The new rules will no longer quarantine foreign losses into four separate classes, nor will they quarantine foreign losses from domestic assessable income (also eliminating the election for a taxpayer to apply domestic losses against assessable foreign income) [Schedule 1, items 36, 37 and 64] . The changes will remove the distinction between what is foreign and what is domestic for the purposes of applying deductions and prior-year losses. That is, deductions and prior-year losses that are applied by a taxpayer to reduce their assessable income may include both a foreign and domestic component.

Example 1.26 Owen, an Australian resident taxpayer, is an economist employed by a government department and has employment income of $100,000 for the year ended 30 June 2020. Owen also has a loss of $20,000 from a failed foreign business venture, incurred in the year ended 30 June 2019 as well as a prior-year unrecouped loss of $5,000 incurred in the year ended 30 June 2018.During the year, Owen incurred tax return expenses of $100 and paid $900 for subscriptions to economic periodicals.Owen would calculate his taxable income for the 2019-20 tax year as follows:

Salary 100,000
Assessable income 100,000
Less :
Subscriptions 900  
Tax return expenses 100  
Loss on foreign business venture 20,000  
2017-18 prior year tax loss 5,000  
Total allowable deductions (26,000)
Taxable income for 2019-20 74,000

Losses incurred by a controlled foreign company

1.176 The treatment of foreign losses will be extended to losses incurred by a controlled foreign company. However, losses will continue to be quarantined in the controlled foreign company that incurred them. The four revenue classes of losses will be removed, in effect creating one revenue class for the purposes of applying deductions and prior-year losses. [Schedule 1, items 94 to 122, subsections 425(1) to (4), paragraph 426(a), subparagraphs 426(a)(i) and 426(a)(ii), section 426, paragraphs 427(b) and 427(ba), section 429, subsection 431(1), paragraphs 431(2)(a) and (b), subsections 431(4), (4A), (4B), (4D) and (5) of the ITAA 1936]

1.177 Further, a controlled foreign company will be able to offset a revenue loss against a net capital gain because of the repeal of subsection 424(2) of the ITAA 1936. [Schedule 1, item 94]

1.178 The controlled foreign company, in determining notional assessable income, assumes Australian residency (paragraph 383(a) of the ITAA 1936). Notional assessable income is therefore determined in accordance with Australian tax law. Since capital losses are quarantined from all other assessable income under Australian tax law (subsection 102-10(2)), a controlled foreign company will be required to quarantine capital losses from all other notional assessable income.

Foreign investment fund calculation method - option for notional calculation using the controlled foreign company rules

1.179 Currently, a taxpayer with an interest in a foreign investment fund (a foreign company or foreign trust) can use one of three calculation methods within Division 18 of Part XI of the ITAA 1936 to determine if any income accrued from that fund to the taxpayer.

1.180 One of those methods is the calculation method. This method can be applied to determine if any foreign investment fund income accrued to the taxpayer from a particular foreign investment fund (a foreign company or a foreign trust). In calculating this income the calculation method can also be used for any interest that this company or trust has in another foreign company or trust (a second-tier foreign investment fund). The calculation method is not available for any entities below this second-tier foreign investment fund.

1.181 To mitigate the impact of removing credits for foreign taxes paid by a second-tier foreign investment fund, a further option is available to a taxpayer that uses the calculation method to determine foreign investment fund income. Certain taxpayers will have an opportunity to base this calculation on the controlled foreign company rules in Part X of the ITAA 1936. [Schedule 1, item 3, section 559A of the ITAA 1936]

1.182 This will provide these taxpayers access to branch-equivalent calculations, the active income test and exemptions that relate to the calculation of the notional assessable income and notional allowable deductions of a foreign company that is a controlled foreign company.

When can a choice be made to make notional controlled foreign company calculations under the foreign investment fund calculation method?

1.183 A choice to work out notional income and notional deductions under Part X of the ITAA 1936 can only be made once the taxpayer has first elected to apply the calculation method in respect of the interest in the foreign investment fund. The calculation method is in Subdivision D of Division 18 of Part XI of the ITAA 1936, and may be used to determine whether any foreign investment fund income accrued from a particular foreign investment fund to a taxpayer. [Schedule 1, item 3, section 559A of the ITAA 1936]

1.184 This Schedule also inserts subsection 535(4A) in the ITAA 1936. The existing restriction on the use of the calculation method for taxpayers who have previously elected to use the calculation method in respect of a foreign investment fund, but have not continued to use that method in subsequent years, is relaxed. [Schedule 1, item 2, subsection 535(4A) of the ITAA 1936]

1.185 A taxpayer to which this rule would apply, can again choose to apply the calculation method in relation to that interest in the foreign investment fund, but only where the taxpayer is also making an election for notional controlled foreign company calculation treatment under section 559A of the ITAA 1936. This is to ensure that a taxpayer who now wishes to make the choice under section 559A is not precluded from doing so purely because that taxpayer has previously elected into, and then out, of the calculation method in relation to a particular foreign investment fund. [Schedule 1, item 2, subsection 535(4A) of the ITAA 1936]

1.186 The main points to note about the ability to make the choice (within the calculation method of the foreign investment fund rules) to work out notional assessable income and notional allowable deductions of a foreign investment fund under Part X of the ITAA 1936 are as follows:

·
it is only available to a taxpayer with an interest in a foreign company;
·
it is only available where the taxpayer has an attribution percentage (as defined in Part X of the ITAA 1936) of 10 per cent or more in the foreign company; and
·
once the choice is made in relation to a certain year, it can only be made for a subsequent year if it has been made for each intervening year.

[Schedule 1, item 3, subsection 559A(1) of the ITAA 1936]

The requirement for a 10 per cent attribution percentage in the foreign company

1.187 The first condition for the choice to be made in relation to a foreign investment fund under section 559A of the ITAA 1936 is that the fund must be a foreign company [Schedule 1, item 3, paragraph 559A(1)(a) of the ITAA 1936] . The choice cannot be made in relation to a foreign investment fund that is a foreign trust because the controlled foreign company rules only deal with the calculation of notional assessable income and notional allowable deductions in relation to a foreign company.

1.188 The second condition is that the taxpayer must have an attribution percentage of 10 per cent or more in relation to the company at the end of the company's notional accounting period [Schedule 1, item 3, paragraph 559A(1)(b) of the ITAA 1936] . The test is applied at the end of the notional accounting period, consistent with the determination of the calculated profit or calculated loss of the foreign company in respect of a notional accounting period under section 580 of the ITAA 1936.

1.189 The attribution percentage takes its meaning from Part X of the ITAA 1936 [Schedule 1, item 3, subsection 559A(9) of the ITAA 1936] . The Part X definition has been adopted (as opposed to the 'attribution percentage' definition in Part XI) in order to adequately deal with the second-tier foreign company case. The 10 per cent test applies in respect of the indirect interest held by the actual (attributable) taxpayer in the second-tier foreign investment fund. The 10 per cent test does not apply separately for the direct interest held by the actual taxpayer and the first-tier foreign investment fund and again for the direct interest held by the first-tier foreign investment fund in the second-tier foreign investment fund. [Schedule 1, item 3, paragraph 559A(8)(a) of the ITAA 1936]

1.190 The 10 per cent requirement is set as an indirect interest to ensure the election is only available in respect of those foreign companies for which the actual taxpayer is likely to have access to the financial information of the subsidiary company to be able to sufficiently calculate the foreign investment fund income using the rules in Part X of the ITAA 1936. Further, the indirect 10 per cent requirement is consistent with other measures that require an analysis of the financial information of a subsidiary company. For example, the total voting percentage requirement under the participation exemption rules in Subdivision 768-G is specified in a similar way.

1.191 The Part X definition of 'attribution percentage' achieves this result as it combines the direct attribution interest in the company and the aggregate of the indirect attribution interests in the company. The 'attribution percentage' definition in Part XI of the ITAA 1936 would not achieve this result in the second-tier foreign investment fund case because it only applies in respect of a direct interest held in a foreign investment fund.

1.192 The consequential amendment to this Schedule to change the definition of attribution percentage in subsection 995-1(1) will not impact on these changes. Those changes are discussed in paragraph 1.80. [Schedule 1, item 3, subsection 559A(9) of the ITAA 1936]

1.193 The actual attribution of the foreign investment fund income (calculated under Part XI of the ITAA 1936 using the choice provided within the calculation method under section 559A of that Act) to the taxpayer, still occurs under Part XI itself (through the operation of section 580 of the ITAA 1936). The controlled foreign company rules are only used to work out the notional income and notional deductions of the foreign investment fund.

1.194 As the taxpayer is required to determine the direct attribution interest in qualifying to make the choice in relation to the foreign company, it is not expected that the taxpayer will be subject to any additional compliance costs as a result of using the Part X attribution percentage in paragraph 559A(1)(b) of the ITAA 1936. This is because the attribution percentage under section 581 of the ITAA 1936 (which is broadly similar to the direct attribution interest for Part X purposes) is used to determine the taxpayer's share of the calculated profit of a company.

Does a taxpayer's choice in a prior year impact on whether a choice can be made in the current year?

1.195 The final condition to be met for the choice to be made in relation to a foreign company is that the choice must be made in relation to each notional accounting period subsequent to the first notional accounting period for which the choice is made [Schedule 1, item 3, paragraph 559A(1)(c) of the ITAA 1936] . This rule applies even if the taxpayer is unable to make the choice (if, for example, the taxpayer's attribution percentage in relation to the company falls below 10 per cent). This rule is consistent with the general rule that applies in relation to elections to use the calculation method under section 535 of the ITAA 1936.

1.196 In the case of applying the foreign investment fund calculation method to a second-tier foreign investment fund (a discussion of which appears in paragraphs 1.221 to 1.227), it is the Australian (attributable) taxpayer that actually makes the election under:

·
subsection 390(1) of the ITAA 1936 if the taxpayer made a choice for notional controlled foreign company calculation in relation to the first-tier foreign investment fund; or
·
paragraph 577(1)(a) of the ITAA 1936 if the taxpayer did not make that choice in relation to the first-tier foreign investment fund.

What is the effect of making a choice?

1.197 Once a taxpayer makes a choice in relation to a foreign investment fund under section 559A of the ITAA 1936, certain assumptions are made to ensure Part X of the ITAA 1936 can be applied effectively, namely:

·
the foreign investment fund is treated as a foreign investment fund that is a controlled foreign company;
·
the taxpayer is treated as an attributable taxpayer under Part X of the ITAA 1936;
·
the notional accounting period is treated as a statutory accounting period;
·
the notional income of the foreign company is treated as notional assessable income under Part X of the ITAA 1936;
·
the notional deductions of the foreign company are treated as notional allowable deductions worked out under Part X of the ITAA 1936; and
·
if the taxpayer is an Australian financial institution at a particular time in the year, the foreign company in relation to whom the choice is made is treated as an Australian financial institution subsidiary at that time.

Why are the assumptions relating to the foreign company, the taxpayer and the notional accounting period made?

1.198 Division 7 of Part X of the ITAA 1936 deals with the calculation of attributable income of a controlled foreign company for its statutory accounting period. Attributable income is calculated separately for each attributable taxpayer with requirements that a company is a controlled foreign company and there are one or more attributable taxpayers in relation to the company.

1.199 The terms controlled foreign company (eligible controlled foreign company), statutory accounting period (the eligible period) and attributable taxpayer (the eligible taxpayer) all feed into the provisions dealing with notional assessable income and notional allowable deductions for the eligible controlled foreign company.

1.200 To ensure the relevant provisions in Part X of the ITAA 1936 dealing with the notional assessable income and notional allowable deductions can be applied, the foreign investment fund is treated as a foreign investment fund that is a controlled foreign company. The taxpayer, choosing to apply section 559A of the ITAA 1936, is treated as an attributable taxpayer in relation to the foreign investment fund. In the case of a first-tier foreign investment fund choosing to apply section 559A in relation to a second-tier foreign investment fund, it is the first-tier foreign investment fund that is treated as an attributable taxpayer and the second-tier foreign investment fund is treated as a foreign investment fund that is a controlled foreign company. [Schedule 1, item 3, paragraphs 559A(2)(a) and (b) of the ITAA 1936]

1.201 Further, the calculation of attributable income under the controlled foreign company rules relies on the statutory accounting period of the controlled foreign company. This is generally each 12-month period finishing at the end of 30 June, but with an option to use some other 12-month period (section 319 of the ITAA 1936). Under the foreign investment fund rules, foreign investment fund income accrues to the taxpayer in respect of a notional accounting period of the foreign investment fund. The notional accounting period of the foreign investment fund is generally a period that is a year of income of the attributable taxpayer, with the choice of an election for a 12-month period based on the period for which the foreign investment fund's accounts are made out. Therefore, the notional accounting period may differ from the statutory accounting period.

1.202 The new rules treat the notional accounting period of the foreign investment fund as the statutory accounting period. This allows the foreign investment fund in relation to which a choice is made under section 559A of the ITAA 1936 to continue using the actual notional accounting period of the foreign investment fund to determine the notional assessable income and notional allowable deductions under Part X of the ITAA 1936. [Schedule 1, item 3, paragraph 559A(2)(c) of the ITAA 1936]

1.203 A flow-on effect of this approach is that when the income is actually attributed under Part XI of the ITAA 1936, the number of days in the notional accounting period throughout which the taxpayer had the interest can continue to be applied. Further, if in a later year the taxpayer does not choose to apply section 559A of the ITAA 1936 in relation to a foreign investment fund, the foreign investment fund will continue to use the same notional accounting period it used when applying section 559A of the ITAA 1936 for the earlier period.

Replacement of notional income with notional assessable income, and notional deductions with notional allowable deductions under Part X of the ITAA 1936

1.204 Once the taxpayer has elected to use the calculation method in relation to a foreign investment fund and has made a choice under section 559A of the ITAA 1936, the taxpayer will determine the notional assessable income under Part X of that Act. This is instead of using the provisions in Part XI of that Act. [Schedule 1, item 3, paragraph 559A(3)(a) of the ITAA 1936]

1.205 Therefore, the notional income rules in Part XI of the ITAA 1936 are effectively 'turned off' and the notional assessable income rules in Part X of the ITAA 1936 apply. As with notional income, similar rules apply in respect of notional deductions. The notional deduction rules in Part XI are effectively 'turned off' and the notional allowable deduction rules in Part X apply. [Schedule 1, item 3, paragraphs 559A(3)(a) and (b) of the ITAA 1936]

1.206 However, there are five specific rules that alter the treatment of notional income and notional deductions. Three of these specific rules reapply certain provisions in Part XI of the ITAA 1936 to effectively deal with an interest a foreign investment fund may have in a second-tier foreign investment fund which, in turn, may have an interest in a third-tier foreign investment fund. These three rules are discussed in paragraphs 1.221 to 1.223.

1.207 The remaining two general rules relate to the calculation of capital gains of the foreign investment fund, and the utilisation of losses of the foreign investment fund from a prior year.

Special rules for profits or gains of a capital nature

1.208 Instead of applying the special rules in Subdivision C of Division 7 of Part X of the ITAA 1936 (dealing with certain modifications around the commencing day and commencing day asset) in the calculation of any capital gains that would be included in notional assessable income under Part X of the ITAA 1936, any profits or gains of a capital nature are instead determined on the basis of the period that would have been used under Part XI of that Act. [Schedule 1, item 3, subsection 559A(5) of the ITAA 1936]

1.209 This rule ensures that any choice in relation to a foreign investment fund under section 559A of the ITAA 1936 will not:

·
refresh the cost base of assets that are held by the foreign investment fund;
·
change the time of acquisition of an asset held by a foreign investment fund; or
·
impact on the events that result in a capital gain being ignored.

A special rule for the utilisation of prior-period losses of the foreign investment fund

1.210 In working out the notional deductions of the foreign investment fund under paragraph 559A(3)(b), sections 431 and 429 of Part X of the ITAA 1936 will be ignored [Schedule 1, item 3, paragraph 559A(4)(a) of the ITAA 1936] . These sections provide a notional allowable deduction for:

·
a loss of the controlled foreign company in respect of an earlier period; and
·
certain losses that arise in respect of certain exempt income (a concept known as sometimes-exempt income loss which is specific to the modified loss rules in Subdivision D of Division 7 of Part X of the ITAA 1936).

1.211 The effect of disregarding these sections is that the main operative provisions in Subdivision D of Division 7 of Part X of the ITAA 1936 (the Subdivision being modified by this Schedule to the Bill) will not apply in relation to the foreign investment fund. There will be no need to calculate the sometimes-exempt-income gain or loss under section 425 of the ITAA 1936, because the provisions where those calculations apply (sections 429 and 431 of the ITAA 1936) are disregarded in working out the notional allowable deductions of the foreign investment fund.

1.212 Instead, section 572 of Part XI of the ITAA 1936 will apply to include any notional deduction for any calculated loss of an earlier period (where it has not previously been applied) in working out the foreign investment fund's notional allowable deductions. Conceptually, a loss of an eligible controlled foreign company will not actually arise under section 426 of the ITAA 1936. This is because the notional calculations of notional assessable income and notional allowable deductions merely feed into the calculated loss calculation in Part XI of that Act. In any case, any 'loss' of a foreign investment fund that is treated as a controlled foreign company because of an election under section 559A of the ITAA 1936 will not be able to be taken into account under Part X of that Act if, in a later period, the foreign company in which the taxpayer has an interest becomes a controlled foreign company. This is because of the operation of subsection 431(3) of the ITAA 1936 (despite the application of section 428 of the ITAA 1936).

1.213 Where a taxpayer makes a choice to apply section 559A of the ITAA 1936 in relation to a foreign investment fund, a calculated loss may arise in respect of that foreign investment fund. Section 430 of the ITAA 1936 is being repealed (as a consequential amendment to the repeal of section 79D of the ITAA 1936) [Schedule 1, item 116] . Therefore, all notional allowable deductions will be able to be included in notional deductions under subsection 559(2) of the ITAA 1936. This then feeds into the calculated loss under subsection 559(4) of the ITAA 1936 which, in respect of future periods, impacts on the stock of prior-period calculated losses under section 572 of that Act.

Why are certain foreign companies treated as an Australian financial institution subsidiary?

1.214 As a consequence of the new choice within the calculation method, the rules for what foreign companies are treated as a subsidiary of an Australian financial institution entity have been expanded. Where a taxpayer that makes an election for this new calculation method treatment in relation to a foreign company is an Australian financial institution, the foreign company will be treated as an Australian financial institution subsidiary under Part X of the ITAA 1936. [Schedule 1, item 3, paragraph 559A(3)(c) of the ITAA 1936]

1.215 The modifications in Subdivision F of Division 8 of Part X of the ITAA 1936 for Australian financial institution subsidiaries may then apply in determining attributable income of the company if the foreign company is carrying on a banking business or a business whose income is principally derived from the lending of money.

1.216 This will ensure that Australian financial institutions that are making non-controlling investments into foreign markets (including emerging markets) may no longer be subject to attribution on certain business income that would otherwise be treated as passive income (such as interest income). This will particularly benefit those Australian financial institutions whose investments currently do not qualify for exemption under the foreign investment fund rules.

1.217 The rule to treat the foreign investment fund as an Australian financial institution subsidiary applies to both the first-tier foreign investment fund and the second-tier foreign investment fund. [Schedule 1, item 2, paragraphs 559A(3)(c) and (8)(a) of the ITAA 1936]

1.218 Consistent with the current foreign investment fund calculation method rules in Division 18 of Part XI of the ITAA 1936, it is not possible for a third-tier foreign investment fund to be treated as an Australian financial institution subsidiary. This is because the choice for notional controlled foreign company calculation treatment relies on the ability to use the calculation method to determine the foreign investment fund income that accrues to a taxpayer. The calculation method can only ever be applied in relation to a first-tier and a second-tier foreign investment fund (subject to certain qualifying rules). It can never be applied in relation to a third-tier foreign investment fund.

1.219 As a consequence of these foreign companies being afforded treatment as an Australian financial institution subsidiary, an amendment is made to the participation exemption rules in Subdivision 768-G. This amendment provides for similar 'active' treatment in relation to the assets of the foreign company. These amendments are further discussed in paragraph 1.345.

1.220 The approach of 'superimposing' the controlled foreign company calculation of attributable income on the foreign investment fund calculation method ensures that the foreign company is not actually a controlled foreign company as defined in Part X of the ITAA 1936. Therefore, if a taxpayer chooses the notional controlled foreign company calculation within the foreign investment fund calculation method the equity interest in the foreign investment fund will not be 'controlled foreign entity equity' for thin capitalisation purposes under Division 820.

Example 1.27 Oz Bank holds a 20 per cent foreign investment fund interest in Sing Co. which in turns holds a 50 per cent interest in Malay HoldCo. Malay HoldCo in turn holds a 100 per cent interest in Malay Co.Oz Bank makes a choice under section 559A of the ITAA 1936 in relation to its interest in Sing Co. As Oz Bank is an Australian financial institution, Sing Co. is treated as an Australian financial institution subsidiary for the purposes of working out its notional income and notional deductions under Part X of the ITAA 1936.Oz Bank's attribution percentage in relation to Malay HoldCo is 10 per cent, therefore the choice under section 559A can be made by Sing Co. in relation to Malay HoldCo.Malay HoldCo itself is treated as an Australian financial institution subsidiary for the purposes of working out its notional income and notional deductions under Part X of the ITAA 1936.Although the attribution percentage (as defined in Part X of the ITAA 1936) of Oz Bank in Malay Co. is 10 per cent, a choice for the calculation method cannot be made by Malay Hold Co because of the operation of subparagraph 579(b)(ii) in relation to a third-tier foreign investment fund.

How does the choice rule apply to second and third-tier foreign investment funds?

1.221 Three special rules are included to ensure that the choice for notional controlled foreign company calculation within the calculation method applies to second-tier foreign investment funds as it applies to a direct interest in a foreign company (first-tier foreign investment funds).

1.222 The first special rule is relevant for the purposes of working out the notional income of the foreign investment fund under Part XI of the ITAA 1936. It applies where a foreign investment fund has an interest in a second-tier foreign investment fund. It also applies where a second-tier foreign investment fund has an interest in a third-tier foreign investment fund. In those cases the existing rules in sections 575 to 579 of the ITAA 1936 apply in relation to the actual (attributable) taxpayer. This is despite the assumptions under subsection 559A(3) of the ITAA 1936. [Schedule 1, item 3, subsection 559A(6), paragraph 559A(7)(b) and subparagraph 559A(8)(b)(ii) of the ITAA 1936]

1.223 The second and third special rules apply to 'turn off' the rules in Part X of the ITAA 1936 that also calculate any foreign investment fund income accruing under Part XI of that Act. As sections 576 and 579 of the ITAA 1936 apply in relation to a second-tier and third-tier foreign investment fund, paragraphs 384(2)(ca) and 385(2)(ca) (which deal with notional assessable income of a controlled foreign company from an interest in a foreign investment fund under Part XI of the ITAA 1936) are disregarded. This ensures there is no double counting of income accruing from any second-tier and third-tier foreign investment fund. [Schedule 1, item 3, paragraph 559A(7)(a) and subparagraph 559A(8)(b)(i) of the ITAA 1936]

1.224 This approach of maintaining the operation of sections 575 to 579 is consistent with maintaining the operation of the rules in Part XI of the ITAA 1936 more generally and simply 'superimposing' the notional assessable income and notional allowable deduction calculations from Part X of the ITAA 1936.

1.225 The two general exceptions to the broad rules of working out the notional income and notional deductions of a foreign investment fund in subsection 559A(3) also apply to a second-tier foreign investment fund. These rules are discussed in paragraphs 1.208 to 1.213.

Example 1.28 At the end of year 1, an Australian taxpayer, South Co holds a 10 per cent direct shareholding in foreign company West Co and a 5 per cent direct interest in foreign company North Co. West Co has a 50 per cent interest in North Co as indicated in the following diagram.

Example 1.28 - Second and third-tier foreign investment funds

Assume the direct shareholding percentages equate to direct attribution interest percentages under Part X of the ITAA 1936.Under the foreign investment fund calculation method, South Co elects, under section 559A of the ITAA 1936 to use the notional controlled foreign company calculation to work out the notional income and notional deductions of West Co. In the process of determining the notional income of West Co, the notional income of North Co must be determined. This is determined by applying section 576 and not paragraph 384(2)(ca) or 385(2)(ca) of the ITAA 1936.In determining the notional income of North Co in respect of West Co's 50 per cent interest, section 575 of the ITAA 1936 applies and West Co can make the choice under section 559A to use the notional controlled foreign company calculation to work out the notional income and notional deductions of North Co, as South Co's attribution percentage in North Co is 10 per cent (5 per cent direct and 5 per cent indirect attribution interest).Assuming South Co makes the election in relation to its indirect interest in West Co (because of the operation of subsections 390(1) and 559A(1) of the ITAA 1936), West Co's notional assessable income includes the 50 per cent share of the calculated profit of North Co.South Co must make a separate election for its direct 5 per cent interest in North Co. This is a separate process to the election that it makes in relation to West Co's interest in North Co. However, the indirect attribution interest in North Co held through West Co ensures the 10 per cent attribution percentage in paragraph 559A(1)(b) of the ITAA 1936 is met.If, at the end of year 2, South Co's interest in West Co dropped to 5 per cent it would not be able to make a choice under section 559A of the ITAA 1936 in relation to either West Co or North Co in relation to year 2 (because the 10 per cent attribution percentage in paragraph 559A(1)(b) is not met). In subsequent years, South Co is not able to make a choice under section 559A in relation to its interest in West Co or North Co.

1.226 Note that the choice under section 559A of the ITAA 1936 cannot be made in relation to a third-tier foreign investment fund. This is consistent with the operation of section 579 of that Act and the fact that the calculation method can only ever be used in relation to a first-tier and second-tier foreign investment fund of a taxpayer. [Schedule 1, item 3, subparagraph 559A(8)(b)(ii) of the ITAA 1936]

1.227 The modifications to the notional deduction rules in relation to the utilisation of a calculated loss of a prior period of a foreign investment fund equally apply in the case of a second-tier foreign investment fund. Section 578 of the ITAA 1936 ensures that any calculated loss of a second-tier foreign investment fund as determined by section 572 will be taken into account in determining the notional deductions of the second-tier foreign investment fund. These modifications are discussed in paragraphs 1.210 to 1.213. [Schedule 1, item 3, subsection 559A(6) and paragraph 559A(4)(b) of the ITAA 1936]

Transitional provisions

Treatment of pre-commencement foreign losses

1.228 A taxpayer will be entitled to deduct existing overall foreign losses from any assessable income subject to certain restrictions. It is the intention of these restrictions to continue prevailing taxpayer behaviour and limit the impact on the Australian revenue base.

1.229 The transitional rules therefore require the taxpayer to extinguish particular overall foreign losses. The losses that the taxpayer must extinguish are those that are effectively trapped currently and cannot be utilised and those with a low or nil utilisation rate. The transitional rules also impose an annual limit on utilisation for the losses that remain for the first four years after commencement. A taxpayer may disregard the deduction limit in each of the first four years after commencement if they have a small amount of foreign losses. The purpose of this deduction limit is to closely mimic the rate of loss utilisation that would occur under the current rules.

What is a convertible foreign loss?

1.230 When the amendments commence at the start of a taxpayer's commencement year (see paragraph 1.330), taxpayers will be required to convert any overall foreign loss of a particular class (excluding capital losses) that have not yet been utilised (under current section 160AFD of the ITAA 1936) to a tax loss. When an overall foreign loss of a particular class is converted, the income year in which it was made will remain the same - it will not be refreshed.

1.231 A taxpayer is not required to satisfy the general loss recoupment tests when converting an overall foreign loss of a particular class to a tax loss. Rather, a taxpayer will need to satisfy these tests when they go to deduct the loss from assessable income in the commencement year or a subsequent year of income.

1.232 A taxpayer will have a convertible foreign loss, for an earlier income year, if:

·
they have an unrecouped overall foreign loss of a particular class of assessable income (within the meaning of current section 160AFD of the ITAA 1936) [Schedule 1, item 5, paragraph 770-5(1)(a) of the Income Tax (Transitional Provisions) Act 1997] ;
·
the overall foreign loss was made in any of the most recent 10 income years ending before the start of the commencement year [Schedule 1, item 5, subsection 770-5(2) of the Income Tax (Transitional Provisions) Act 1997] ; and
·
an overall foreign loss remains after disregarding certain amounts [Schedule 1, item 5, paragraph 770-5(1)(b) of the Income Tax (Transitional Provisions) Act 1997] .

1.233 The amount of the convertible foreign loss for each earlier year is the sum (across the income classes) of each overall foreign loss for the earlier year after disregarding certain amounts [Schedule 1, item 5, subsection 770-5(3) of the Income Tax (Transitional Provisions) Act 1997] . That is, for each of the most recent 10 income years ending before the commencement year:

·
the taxpayer reduces each overall foreign loss in respect of a particular class of assessable foreign income consistent with section 770-10 of the Income Tax (Transitional Provisions) Act 1997 ; and
·
for each earlier income year, the taxpayer sums the amount of each overall foreign loss that remains after applying section 770-10 of the Income Tax (Transitional Provisions) Act 1997 .

1.234 The result is the amount of the convertible foreign loss for the earlier income year. In effect, this removes the classes of assessable foreign income, leaving the taxpayer with a single convertible foreign loss (of no particular class). A taxpayer could potentially have 10 convertible foreign losses, one for each of the most recent 10 income years ending before the commencement year. [Schedule 1, item 5, subsection 770-5(3) of the Income Tax (Transitional Provisions) Act 1997]

How does a taxpayer reduce an overall foreign loss of a particular class of assessable foreign income?

1.235 Before summing together each overall foreign loss of a particular class of assessable foreign income for an earlier income year, the taxpayer is required to reduce each overall foreign loss for certain events [Schedule 1, item 5, section 770-10 of the Income Tax (Transitional Provisions) Act 1997] . These events are set out in a method statement.

1.236 Step 1 in the method statement requires company taxpayers that have existing overall foreign losses in the 'all other assessable income' class to reduce the loss (worked out under paragraph 770-5(1)(a) of the Income Tax (Transitional Provisions) Act 1997 ) to the extent it is a loss or outgoing incurred in gaining or producing income that would be the company's non-assessable non-exempt income if it were gained or produced in the commencement year [Schedule 1, item 5, step 1 in the method statement in section 770-10 of the Income Tax (Transitional Provisions) Act 1997] . This will mainly affect companies that incurred losses prior to 2004 through branches in what were then unlisted countries. For example, a company taxpayer that has an existing overall foreign loss in the 'all other assessable income' class that was incurred in earning what is now exempt foreign branch income (under section 23AH of the ITAA 1936) will be required to disregard that loss.

1.237 The intent of this restriction is to uphold the integrity of the changes introduced as part of the New International Tax Arrangements (Participation and Other Measures) Act 2004 . This Act had the effect of exempting foreign income of companies comprising non-portfolio dividends, active capital gains and active branch income, (such income became non-assessable non-exempt income) by broadening the exemptions to all countries and not just previously listed countries.

1.238 An overall foreign loss made in producing such income (usually quarantined in the 'all other assessable income' class) is effectively trapped since there is no (or little) assessable foreign income (of that class) against which it can be deducted. To allow taxpayers the ability to deduct an overall foreign loss that they cannot currently deduct would be to provide them with a windfall gain (and the Australian revenue base with a windfall loss). Therefore, an overall foreign loss made in producing what is now non-assessable non-exempt income will be extinguished. [Schedule 1, item 5, step 1 in the method statement in section 770-10 of the Income Tax (Transitional Provisions) Act 1997]

1.239 This treatment does not extend to deductions that are allowed for expenses incurred in earning non-assessable non-exempt income under section 23AI or 23AK of the ITAA 1936. This is because those deductions should have been allocated to the 'modified passive income' class and because they were incurred in producing what may still be attributable income.

1.240 For all other taxpayers, there is no reduction under step 1 and the result of step 1 will simply be the amount worked out under paragraph 770-5(1)(a) of the Income Tax (Transitional Provisions) Act 1997 . [Schedule 1, item 5, step 1 in the method statement in section 770-10 of the Income Tax (Transitional Provisions) Act 1997]

1.241 Step 2 in the method statement requires a taxpayer with an overall foreign loss older than seven years, but not more than 10 years (when measured from the first income year starting on or after the 1 July after commencement), to halve the loss (that remains after step 1) [Schedule 1, item 5, step 2 in the method statement in section 770-10 of the Income Tax (Transitional Provisions) Act 1997] . The new regime will provide for an increased rate of utilisation due to the removal of all quarantining. Therefore, consistent with the intention of maintaining current taxpayer utilisation rates, it is necessary to halve existing overall foreign losses that are between eight and 10 years in age.

1.242 Although not expressly mentioned in the method statement, there is no change from the current law in respect of the commercial debt forgiveness rules. This is because the commercial debt forgiveness rules have already been applied in determining the 'recouped' portion of the overall foreign loss in respect of a particular class of assessable foreign income. The unrecouped portion of the overall foreign loss, to the extent that it is convertible, will then be subject to the commercial debt forgiveness rules upon utilisation.

1.243 There is also no change in the treatment of capital losses.

What happens to a taxpayer's convertible foreign loss?

1.244 The purpose of section 770-1 of the Income Tax (Transitional Provisions) Act 1997 is to permit a taxpayer to convert, to a tax loss, convertible foreign losses for the purpose of determining taxable income for income years starting on or after the commencement year. Subdivision 36-A sets out the general rules governing the deductibility of prior-year tax losses. The taxpayer must demonstrate the existence of a tax loss before the Subdivision has any application. Since a convertible foreign loss will not satisfy the definition of a 'tax loss' in section 36-10, section 770-1 of the Income Tax (Transitional Provisions) Act 1997 deems the convertible foreign loss to be a tax loss. [Schedule 1, item 5, subsection 770-1(1) of the Income Tax (Transitional Provisions) Act 1997]

1.245 By deeming the convertible foreign loss to be a tax loss for the earlier income year, the convertible foreign loss effectively forms part of a taxpayer's tax loss (if any) [Schedule 1, item 5, subsection 770-1(1) of the Income Tax (Transitional Provisions) Act 1997] . Therefore, the taxpayer's tax loss for the earlier year is the sum of:

·
any tax loss for that year arising under section 36-10, 165-70, 175-35 or 701-30 [Schedule 1, item 5, paragraph 770-1(1)(a) of the Income Tax (Transitional Provisions) Act 1997] ; and
·
the amount of convertible foreign loss for that earlier year [Schedule 1, item 5, paragraph 770-1(1)(b) of the Income Tax (Transitional Provisions) Act 1997] .

1.246 The amount of the taxpayer's tax loss will be this amount rather than the amount worked out in section 36-10, 165-70, 175-35 or 701-30 [Schedule 1, item 5, subsection 770-1(1) of the Income Tax (Transitional Provisions) Act 1997] . However, to the extent that a taxpayer has already deducted a tax loss it cannot be deducted again (see subsection 36-15(6) for non-corporate tax entities and subsection 36-17(8) for corporate tax entities).

1.247 Where the taxpayer had an amount of taxable income for an earlier year and an overall foreign loss in that year, and the overall foreign loss is converted to a tax loss under these rules, it will not reduce the amount of that taxable income. [Schedule 1, item 5, subsections 770-1(1) and (3) of the Income Tax (Transitional Provisions) Act 1997]

1.248 In this scenario, the taxpayer will have an amount of taxable income as well as a (converted) tax loss. These transitional rules do not allow a taxpayer to deduct an overall foreign loss, made in an income year prior to the commencement of these rules, in any income year prior to the commencement year [Schedule 1, item 5, subsection 770-1(3) of the Income Tax (Transitional Provisions) Act 1997] . An overall foreign loss cannot currently be utilised in this way, because of section 79D of the ITAA 1936, and there is no intention to alter this treatment for income years beginning prior to the commencement year.

1.249 A convertible foreign loss for an earlier year will therefore be deductible as a tax loss (deemed to be incurred in the same earlier year) only in respect of the commencement year and later income years [Schedule 1, item 5, subsection 770-1(3) of the Income Tax (Transitional Provisions) Act 1997] . (An exception to this rule for consolidated groups is discussed in paragraphs 1.270 to 1.274) This guarantees that a taxpayer does not deduct the convertible foreign loss from domestic assessable income in any income year prior to the commencement year.

1.250 Notwithstanding a convertible foreign loss is treated as a tax loss that may be deducted in income years beginning on or after commencement, each overall foreign loss that comprises the convertible foreign loss will retain its ownership history. By treating an earlier income year as a loss year, each overall foreign loss of a particular class of assessable foreign income that comprises the convertible foreign loss is treated as being made in that earlier income year for the purposes of applying Subdivision 36-A. [Schedule 1, item 5, subsection 770-1(2) of the Income Tax (Transitional Provisions) Act 1997]

1.251 Once a convertible foreign loss is deemed to be a tax loss, the usual deductibility rules apply (see Subdivision 36-A). In particular, section 36-25 directs the taxpayer to the relevant loss recoupment provisions. A taxpayer will only need to satisfy these provisions when deducting the (converted) tax loss from assessable income. Once the recoupment tests are satisfied, the taxpayer can immediately deduct (subject to sufficient income) the total of the convertible foreign losses up to a $10,000 limit or the amount stipulated by the deduction limit. These deductibility rules are discussed in paragraphs 1.254 to 1.260.

What is the starting total for a loss parcel?

1.252 Once a taxpayer has reduced the relevant overall foreign losses and the amount is summed together for each eligible earlier income year, they are required to aggregate the additional tax losses resulting from convertible foreign losses to arrive at a starting total for all those losses taken together (namely, the loss parcel ) [Schedule 1, item 5, section 770-20 of the Income Tax (Transitional Provisions) Act 1997] . That is, the loss parcel calculation does not take into account other tax losses that the entity may have under the existing law. It is simply the aggregate of all the overall foreign losses for the preceding 10 income years (reduced according to the method statement).

1.253 The starting total cannot be affected by subsequent events, other than an amendment of an earlier year overall foreign loss figure.

Example 1.29 At the end of the commencement year Loss Co. determines that it has incurred the following tax losses:

·
year ended 30 June 2004: $50,000 (with no amount of convertible foreign loss);
·
year ended 30 June 2005: $60,000 (with an amount of $20,000 being the convertible foreign loss); and
·
year ended 30 June 2006: $70,000 (with the entire amount being a convertible foreign loss).

Loss Co.'s loss parcel consists of the tax losses incurred in the year ended 30 June 2005 and the year ended 30 June 2006 (the tax loss incurred in the year ended 30 June 2004 is not affected by the operation of section 770-1 of the Income Tax (Transitional Provisions) Act 1997 and is therefore not included in the loss parcel).The starting total for the loss parcel is $90,000 (being the sum of the convertible foreign loss amounts of the relevant tax losses).

How to deduct a converted foreign loss

1.254 Where a taxpayer's starting total for their loss parcel is $10,000 or less, no special deductibility rules are applicable. Further, where a taxpayer has a starting total for their loss parcel of more than $10,000, they may choose to reduce one or more of their convertible foreign losses such that their starting total equals $10,000. In that case too, no special deductibility rules would apply, but the excess of the starting total over $10,000 would never be deductible. This election must be made in the commencement year. [Schedule 1, item 5, section 770-15 of the Income Tax (Transitional Provisions) Act 1997]

1.255 The effect of this threshold is to avoid the special rules on deductibility. In effect, the taxpayer can deduct the entire (converted) tax loss at the end of the first income year beginning on or after commencement (provided there is sufficient taxable income and the general loss recoupment tests are satisfied).

1.256 A taxpayer that does not apply the $10,000 limit will be subject to special rules on utilisation, which intend to closely mimic current taxpayer utilisation rates for these losses. The special rules only apply to a component of the tax loss. This component, the foreign loss component , is the amount of the tax loss that comprises the convertible foreign loss. [Schedule 1, item 5, section 770-25 of the Income Tax (Transitional Provisions) Act 1997]

1.257 The taxpayer divides the starting total of the loss parcel into five equal portions [Schedule 1, item 5, section 770-30 of the Income Tax (Transitional Provisions) Act 1997] . The calculation of each portion is not contingent on how many losses fail the general loss recoupment tests or how many losses are reduced under the commercial debt forgiveness rules for forgiveness years commencing with or following the commencement year.

1.258 For example, if a taxpayer has a foreign loss component that does not satisfy the loss recoupment tests, or if a taxpayer's foreign loss component is reduced because of the commercial debt forgiveness rules, they will not be required to recalculate the starting total of the loss parcel. At the end of the commencement year, the taxpayer can use a maximum of one portion of the starting total (subject to the usual tax loss deductibility rules). [Schedule 1, item 5, item 1 in the table in subsection 770-30(1) of the Income Tax (Transitional Provisions) Act 1997]

Example 1.30 Heidi (an Australian resident taxpayer) has a starting total for her loss parcel of $12,000 and does not elect to reduce the quantum of any of the losses to bring the starting total to within the $10,000 threshold. The loss parcel contains four overall foreign losses, each worth $3,000.The maximum amount of the foreign loss component that Heidi can deduct in the commencement year is $2,400 (one-fifth of $12,000).One of the overall foreign loss components converted to a tax loss permanently fails the loss recoupment test so it can no longer be deducted. However, this does not reduce the starting total below the $10,000 limit. The maximum amount of the foreign loss component Heidi can deduct as a tax loss is still calculated by reference to the sum of the tax losses in the loss parcel. The maximum amount that Heidi can deduct in the commencement year remains $2,400, even though she will only ever be able to deduct $9,000 of the foreign losses.

Example 1.31 Lauren (an Australian resident taxpayer) has a starting total for her loss parcel of $100,000. At the end of her commencement year, Lauren deducts $20,000 ($100,000 x 1/5). She must have sufficient assessable income to deduct the $20,000.In the first income year after commencement, Lauren has a debt that is forgiven under the commercial debt forgiveness rules. The net forgiven amount is $40,000 which reduces the foreign losses she has to $40,000. However, the starting total of the loss parcel remains unchanged at $100,000.At the end of the first income year after commencement, Lauren deducts $20,000 (($100,000 x 2/5) - $20,000).At the end of the second income year after commencement, Lauren deducts another $20,000 (($100,000 x 3/5) - ($20,000 + $20,000)). After which, Lauren has no further convertible foreign loss to deduct and the transitional rules in Division 770 of the Income Tax (Transitional Provisions) Act 1997 no longer have application to Lauren.

1.259 The taxpayer can use another portion in each of the three income years ending after the commencement year [Schedule 1, item 5, items 2 to 4 in the table in subsection 770-30(1) of the Income Tax (Transitional Provisions) Act 1997] . Further, the taxpayer is able to deduct the remaining amount of a portion that it was unable to use in a prior income year, if for example it had insufficient assessable income [Schedule 1, item 5, items 2 to 4 in the table in subsection 770-30(1) of the Income Tax (Transitional Provisions) Act 1997] . In the fourth income year ending after the commencement year (and subsequent income years), the taxpayer can deduct any remaining foreign loss component without restriction (subject to those restrictions that apply generally to the deductibility of tax losses) [Schedule 1, item 5, subsection 770-30(2) of the Income Tax (Transitional Provisions) Act 1997] .

Example 1.32 Jess Co. (an Australian company) has a tax loss with a foreign loss component of $50,000 (and does not elect to apply the limit). The maximum amount of tax loss that Jess Co. can deduct in the commencement year is $10,000 (1/5 x $50,000). Assume for the purposes of this example that Jess Co. has no other undeducted pre-commencement tax losses.Jess Co. has assessable income less deductions (other than prior-year losses) of $8,000 in the commencement year. Jess Co. satisfies the general loss recoupment tests and can therefore deduct up to $8,000 of its foreign loss component.Jess Co. makes a tax loss of $2,000 in the first income year after the commencement year and cannot deduct any of its converted foreign losses.Jess Co. has assessable income less deductions (other than prior-year losses) of $20,000, in the second income year ending after the commencement year. The maximum amount of the foreign loss component that Jess Co. can deduct is three-fifths of the starting total, less the amount of losses deducted in years 1 and 2. That is, the maximum foreign loss component Jess Co. can deduct in the income year is capped at $30,000 - $8,000 = $22,000. Jess Co. satisfies the general loss recoupment tests and deducts $20,000 of the foreign loss component.Jess Co. has assessable income less deductions (other than prior-year losses) of $10,000, in the third income year after the commencement year. The maximum amount of tax loss Jess Co. can deduct is four-fifths of the starting total, less the amount of losses utilised in the previous three income years. That is, the maximum foreign loss component Jess Co. can deduct in the income year is capped at $40,000 - ($8,000 + $20,000) = $12,000. Jess Co. satisfies the general loss recoupment tests and can therefore deduct $10,000 of the foreign loss component.Jess Co. makes a loss of $5,000 in the fourth income year after the commencement year and cannot deduct any of its tax loss.In the fifth year after commencement, Jess Co. has assessable income less deductions (other than prior-year losses) of $30,000. Because the deduction limit no longer applies to Jess Co., the remaining foreign loss component can be deducted without restriction. Jess Co. satisfies the general loss recoupment tests and can therefore deduct the remaining $12,000 of the foreign loss component.(Provided Jess Co. satisfied the general loss recoupment tests, the tax losses made in the first and fourth year after the commencement year could also be deducted. This is consistent with the first-in first-out basis of application.)

How does the deduction of a foreign loss component affect the foreign tax offset cap?

1.260 By allowing a deduction for some or all of the starting foreign loss component, some assessable income is being sheltered from Australian tax. Consistent with the current regime, that assessable income is assumed to be an amount that has borne foreign income tax. In relieving double taxation of such amounts it is appropriate that the foreign tax offset cap amount be reduced by the Australian tax payable on the amount of the foreign loss deduction. [Schedule 1, item 5, section 770-35 of the Income Tax (Transitional Provisions) Act 1997]

Example 1.33 Marshall Co. is an Australian resident company and in the commencement year has a starting total for its loss parcel of $30,000. Marshall Co. does not choose to reduce its convertible foreign losses to $10,000 in order to disregard the deduction limit.Marshall Co. claims a deduction for $6,000 ($30,000 x 1/5) of the foreign loss component in the commencement year.Marshall Co. has also paid $30,000 of foreign income tax on an amount ($150,000) included in its assessable income and has other deductions relating to the double-taxed amounts of $24,000.The change in taxable income, for the purposes of working out the foreign tax offset cap is therefore $120,000 ($150,000 - ($24,000 + $6,000)) and not $126,000 ($150,000 - $24,000).

Application of transitional foreign loss rules to consolidated groups

1.261 To ensure the transitional foreign loss rules can apply to consolidated groups in the same way as they apply to all other taxpayers, additional provisions are required.

When were transferred overall foreign losses made?

1.262 The loss year in which a head company is taken to have made an overall foreign loss, by virtue of subsection 707-140(1), is not relevant when applying the reduction provisions in sections 770-5 and 770-10 of the Income Tax (Transitional Provisions) Act 1997 . [Schedule 1, item 5, subsection 770-80(1) of the Income Tax (Transitional Provisions) Act 1997]

1.263 A head company must only have regard to a transferred overall foreign loss, where that loss was incurred by the transferring entity in any of the most recent 10 income years ending before the commencement year (see paragraph 1.330). [Schedule 1, item 5, subsection 770-80(2) of the Income Tax (Transitional Provisions) Act 1997]

1.264 A head company must reduce a transferred overall foreign loss by half, where that loss was incurred in an income year other than the most recent seven income years ending before the commencement year. [Schedule 1, item 5, subsection 770-80(3) of the Income Tax (Transitional Provisions) Act 1997]

Example 1.34 Join Co. became a subsidiary member of the Head Co.'s consolidated group on 1 July 2003 (the joining time). At the joining time, an overall foreign loss (which had been incurred by Join Co. in the income year ended 30 June 1995) was transferred, under Subdivision 707-A, to Head Co. from Join Co.Head Co. will not have regard to the overall foreign loss transferred from Join Co. as it was made (disregarding the operation of section 707-140) in an income year ending more than 10 years before the commencement year.That is, even though Head Co. is taken (under subsection 707-15(1)) to have made the loss in the year ended 30 June 2004 (the year in which the loss was transferred to Head Co.), it is the income year in which Join Co. actually incurred the loss (the year ended 30 June 1995) that is relevant in determining whether the loss was made in the most recent 10 income years ending before the commencement year.

How much of a converted foreign loss may be transferred?

1.265 The purpose of section 770-85 of the Income Tax (Transitional Provisions) Act 1997 is to ensure a joining entity is able to transfer a tax loss that has a foreign loss component to the head company of a consolidated group.

1.266 The deduction limit imposed on the foreign loss component of a tax loss will not prevent the whole of the tax loss (or the undeducted amount) from being transferred from a joining entity to a head company (or from the head company to a new head company in a subsequent transfer). [Schedule 1, item 5, section 770-85 of the Income Tax (Transitional Provisions) Act 1997]

1.267 The amount of a tax loss that can be transferred from a joining entity to a head company is prescribed by paragraph 707-5(1)(b) as the amount of the loss that could be utilised in the trial year, disregarding the joining entity's income or gains. In the case of a tax loss that has a foreign loss component, the amount of the foreign loss component that could be utilised is the amount calculated under section 770-30 of the Income Tax (Transitional Provisions) Act 1997 . This would have the effect of limiting the amount of the transferred tax loss.

1.268 The intention of section 770-85 of the Income Tax (Transitional Provisions) Act 1997 is therefore to ensure the joining entity can transfer the entire foreign loss component to the head company. This treatment will also extend to subsequent transfers when the head company of a consolidated group joins another consolidated group.

1.269 Section 770-85 of the Income Tax (Transitional Provisions) Act 1997 does not disrupt the application of the general loss recoupment tests, which are required as part of paragraph 707-5(1)(b). The loss recoupment tests will apply when a joining entity transfers a tax loss that has a foreign loss component to a head company, in the same way they apply when a joining entity transfers all other tax losses to a head company.

What happens to convertible foreign losses if an entity joins a consolidated group during the commencement year?

1.270 The purpose of section 770-90 of the Income Tax (Transitional Provisions) Act 1997 is to ensure a joining entity is able to transfer a tax loss, that has a foreign loss component, to the head company of a consolidated group where part of the trial year occurs before commencement, that is, where the joining time is in the commencement year.

1.271 Subdivision 707-A sets out the rules governing the transfer of previously unutilised tax losses from a joining entity to a head company. The Subdivision only has application in respect of a 'sort of loss' (see paragraph 707-115(1)(a)). Since a convertible foreign loss is treated as a tax loss, this requirement will be satisfied.

1.272 In addition, the 'sort of loss' must be made by the joining entity in an income year ending before the joining time - the trial year (see paragraph 707-115(1)(b)). Since section 770-1 of the Income Tax (Transitional Provisions) Act 1997 only treats the convertible foreign loss of an earlier income year as a tax loss for the purposes of the commencement year and later income years, the joining entity will not be in a position to satisfy the requirement where the joining time is in the commencement year. [Schedule 1, item 5, section 770-1 of the Income Tax (Transitional Provisions) Act 1997]

1.273 Therefore, where an entity that has a tax loss with a foreign loss component joins a consolidated group during the commencement year of the head company, such that part of the trial year occurs before the start of the commencement year, section 770-90 of the Income Tax (Transitional Provisions) Act 1997 ensures that section 770-1 of that Act operates in relation to the trial year. [Schedule 1, item 5, section 770-90 of the Income Tax (Transitional Provisions) Act 1997]

1.274 The convertible foreign loss is therefore treated as a tax loss for an income year beginning prior to the commencement year. This is the only exception to section 770-1 of the Income Tax (Transitional Provisions) Act 1997 .

What happens to the starting total and foreign loss component when an entity joins a consolidated group?

1.275 A head company inherits the starting total and foreign loss component of a joining entity when that joining entity transfers a tax loss (that has a foreign loss component). This ensures that the head company does not recalculate or refresh the starting total of a transferred loss parcel at the joining time. Even where one of the losses making up the loss parcel cannot be transferred to a head company because of the application of the loss recoupment tests, the starting total will not be affected. Therefore, a transferred tax loss will retain:

·
its foreign loss component;
·
the starting total for the loss parcel to which the tax loss belongs; and
·
the deduction history.

[Schedule 1, item 5, section 770-95 of the Income Tax (Transitional Provisions) Act 1997]

1.276 The transferred losses from a joining entity remain in a separate bundle and the head company will have a separate bundle for each joining entity that joins the consolidated group. The starting totals for all bundles the head company may have (in addition to the starting total for the group) are not aggregated. Subdivision 707-C of Part 3-90 (in conjunction with these new rules), then prescribe how the head company can utilise the transferred losses.

What happens to the deduction limit where an entity joins a consolidated group part-way through the head company's income year and the joining entity has utilised part of its foreign loss component in its non-membership period?

1.277 Special rules apply where an entity (that has a tax loss with a foreign loss component) has a non-membership period before it joins a consolidated group [Schedule 1, item 5, section 770-100 of the Income Tax (Transitional Provisions) Act 1997] . In that case, it will deduct its converted foreign loss up to the deduction limit (subject to the usual loss recoupment tests) in that non-membership period. This is because a non-membership period is treated as an income year under subsection 701-30(3).

1.278 The table in subsection 770-30(1) of the Income Tax (Transitional Provisions) Act 1997 only operates to identify deductions allowed to the entity that incurred the loss. In a consolidation context, a special rule is required to ensure deductions claimed by joining entities in respect of the loss are taken into account in determining the deduction limit for the head company.

1.279 Consequently, if a non-membership period ends before the end of the head company's income year mentioned in an item in the table in subsection 770-30(1) of the Income Tax (Transitional Provisions) Act 1997 , the head company must reduce its deduction limit by the amount utilised by the joining entity in that non-membership period [Schedule 1, item 5, subsections 770-100(2) and (3) of the Income Tax (Transitional Provisions) Act 1997] . This is an integrity measure to ensure there is no potential for double deductions in the same income year. In particular, because the joining entity has already exhausted the portion (or part thereof) for the non-membership period, which ends within the head company's income year, it cannot be deducted again.

1.280 The head company, in this situation, will only be able to deduct the remaining portion (if any) at the end of its income year, pursuant to section 770-30 of the Income Tax (Transitional Provisions) Act 1997 .

Example 1.35

Example 1.35 - integrity measure

Sub Co., on 1 July 2008 (the start of its commencement year) calculates it has a tax loss in respect of the 2007 income year with a foreign loss component of $100 million. This foreign loss component constitutes the starting total in respect of Sub Co.'s loss parcel.Sub Co. is able to deduct 1/5 of the starting total - $20 million - in the commencement year.Sub Co. joins the Head Co. consolidated group on 1 February 2010. As a result, Sub Co. has a non-membership period from 1 July 2009 to 31 January 2010. Sub Co. is able to deduct 2/5 of the starting total less the amount deducted in the commencement year($40m - $20m = $20m). Due to insufficient income, Sub Co. can only deduct $10 million.The remaining 2007 tax loss of $70 million transfers to Head Co. on 1 February 2010. When Head Co. seeks to utilise the tax loss in its 2010 income year (which ends on 30 September 2010) it must take into account the amounts utilised by Sub Co. in respect of income years or non-membership periods ending before 30 September 2010.Head Co.'s deduction limits in respect of the transferred 2007 tax loss are calculated as follows:

·
2010 income year (Head Co.'s first income year ending after the commencement year): $40m - ($20m + $10m) = $10m. In this case, the reduction is achieved entirely under section 770-100.
·
2011 income year (Head Co.'s second income year ending after the commencement year): $60m - ($20m + $10m + $10m) = $20m. In this case, the first two reductions are achieved under section 770-100 and the third reduction is achieved under section 770-30 (ie, the portion deducted by Head Co. in its preceding income year).

How does the available fraction method apply to the transferred foreign loss component?

1.281 A foreign loss component is not subject to the available fraction method of utilisation whilst it is also subject to the deduction limit in section 770-30 of the Income Tax (Transitional Provisions) Act 1997 [Schedule 1, item 5, subsection 770-105(2) of the Income Tax (Transitional Provisions) Act 1997] . Also, the head company applies the available fraction for each bundle to income or gains that have been reduced by deductions for all foreign loss components (both group and transferred) [Schedule 1, item 5, subsection 770-105(3) of the Income Tax (Transitional Provisions) Act 1997] .

1.282 This section applies to a bundle of losses irrespective of whether the transfer took place before or after the start of the commencement year for the joining entity. It is irrelevant whether, at the time of transfer, the bundle included a tax loss that had a foreign loss component or an overall foreign loss in respect of a particular class of assessable foreign income. As long as a head company has a transferred tax loss that has a foreign loss component, which is subject to the deduction limit in section 770-30 of the Income Tax (Transitional Provisions) Act 1997 , Subdivision 707-C will have modified application. [Schedule 1, item 5, paragraph 770-105(1)(b) of the Income Tax (Transitional Provisions) Act 1997]

1.283 Since the utilisation of a foreign loss component is restricted by the deduction limit, any further restriction on the utilisation by the available fraction would be unnecessary (given the goal of the deduction limit is to maintain current taxpayer utilisation rates). Subdivision 707-C will therefore be disregarded in the first four income years after commencement when determining the amount of foreign loss component that may be utilised. [Schedule 1, item 5, subsection 770-105(2) of the Income Tax (Transitional Provisions) Act 1997]

Example 1.36 The Consolidated Group is working out the group's taxable income for the 2008-09 income year.The group's assessable income in the other category is $120,000. Its deductions relating to that income are $70,000.The group has a carried-forward tax loss incurred in the 2006-07 income year with a foreign loss component of $96,000. The starting total for the loss parcel containing the tax loss is $120,000.The group's remaining transferred losses as at the start of the 2008-09 income year are set out in the table. Assume that the loss recoupment tests are passed in respect of all the losses sought to be deducted.

Loss bundle Available fraction Unused transferred losses Year originally incurred
Bundle 1 0.2 $50,000 tax loss (100% foreign loss component)

$20,000 tax loss

2004

2007

The transferred tax loss with the foreign loss component is in a loss parcel with a starting total of $60,000 (ie, $10,000 of the foreign loss component was deducted in an income year or non-membership period ending before the end of the Consolidated Group's 2008-09 income year).The available fraction method determines the amount of losses that can be used from bundle 1. Step 1: Work out the categories of group income or gains Category: other assessable incomeReduce other assessable income by current year deductions and deductions for the foreign loss component of group and transferred tax losses:

$120,000 - ($70,000 + $24,000 + $14,000) = $12,000

Where the deductions for the foreign loss component are worked out as follows:
Tax loss Starting total Multiplied by 2/5 Less amounts previously deducted equals allowable deduction
$96,000 group tax loss $120,000 $48,000 $24,000 $24,000
$50,000 transferred tax loss $60,000 $24,000 $10,000 $14,000
Step 2: Apply bundle 1's available fraction to each category Category: other assessable income

0.2 * $12,000 = $2,400

Step 3: Work out a (notional) taxable income for bundle 1
Assessable income ($) Deductions ($)
Other assessable income 2,400 Tax losses (bundle 1) 2,400
Total 2,400 Total 2,400
Therefore, Consolidated Group is able to use $2,400 of the $20,000 tax loss in bundle 1. Work out Consolidated Group's actual taxable income
Assessable income ($) Deductions ($)
Other assessable income 120,000 Deductions 70,000
  Group loss (foreign loss component) 24,000
  Transferred tax loss (foreign loss component) 14,000
  Transferred tax loss 2,400
Total 120,000 Total 110,400
Consolidated Group's taxable income is $9,600.

Application of the transitional foreign loss rules to multiple entry consolidated groups

1.284 Section 770-110 of the Income Tax (Transitional Provisions) Act 1997 provides that Subdivision 770-B of that Act has effect in relation to a multiple entry consolidated group in the same way it has effect in relation to a consolidated group. [Schedule 1, item 5, section 770-110 of the Income Tax (Transitional Provisions) Act 1997]

Application of transitional foreign loss rules to controlled foreign companies

1.285 To ensure the transitional foreign loss rules can apply to controlled foreign companies in the same way as they apply to all other taxpayers, special provisions are required.

1.286 A controlled foreign company will no longer be required to quarantine losses into classes of notional assessable income. Rather, the four classes of notional assessable income will be collapsed into one class. The new rules will continue to quarantine controlled foreign company losses in the entity that incurred the loss.

What is a convertible controlled foreign company loss?

1.287 When the amendments apply, a controlled foreign company will be required to convert to a (classless) loss, any loss in relation to notional assessable income of a particular class that has not yet been taken into account (under current section 431 of the ITAA 1936).

1.288 A controlled foreign company will have a loss, for an earlier statutory accounting period, if:

·
they have an undeducted loss in relation to notional assessable income of a particular class (under current section 426 of the ITAA 1936);
·
the loss was made in any of the most recent 10 statutory accounting periods ending before the commencement period (see paragraph 1.330); and
·
a loss remains after disregarding certain amounts.

[Schedule 1, item 5, section 770-165 of the Income Tax (Transitional Provisions) Act 1997]

1.289 The amount of the loss is the sum of each loss in relation to notional assessable income of a particular class for the earlier period after disregarding certain amounts [Schedule 1, item 5, subsection 770-165(3) of the Income Tax (Transitional Provisions) Act 1997] . That is, for each of the most recent 10 statutory accounting periods ending before the commencement period for the controlled foreign company:

·
the controlled foreign company reduces each loss in relation to notional assessable income of a particular class consistent with section 770-170 of the Income Tax (Transitional Provisions) Act 1997 ; and
·
for each earlier statutory accounting period, the controlled foreign company sums the amount of each loss that remains after applying section 770-170 of the Income Tax (Transitional Provisions) Act 1997 .

1.290 The result is the amount of the convertible controlled foreign company loss for the earlier statutory accounting period. In effect, this removes the classes of notional assessable income, leaving the controlled foreign company with a single convertible controlled foreign company loss for some or all of the most recent 10 statutory accounting periods ending before the commencement period. [Schedule 1, item 5, section 770-165 of the Income Tax (Transitional Provisions) Act 1997]

1.291 This process is essentially the same as for a resident taxpayer applying Subdivision 770-A of the Income Tax (Transitional Provisions) Act 1997 .

How does a controlled foreign company reduce a loss of a particular class of notional assessable income?

1.292 Before summing together each loss of a particular class of notional assessable income, the controlled foreign company is required to reduce each loss subject to the conversion rules set out in a method statement in section 770-170 of the Income Tax (Transitional Provisions) Act 1997 . [Schedule 1, item 5, section 770-170 of the Income Tax (Transitional Provisions) Act 1997]

1.293 Step 1 of the method statement applies only to a controlled foreign company that has an existing loss in respect of the 'all other amounts' class of notional assessable income. The controlled foreign company must reduce the loss (worked out under paragraph 770-165(1)(a) of the Income Tax (Transitional Provisions) Act 1997 ), except to the extent it is attributable to income that would be the company's notional assessable income or sometimes-exempt income. [Schedule 1, item 5, step 1 in the method statement in section 770-170 of the Income Tax (Transitional Provisions) Act 1997]

1.294 Step 2 of the method statement requires a controlled foreign company with a loss older than seven years, but not more than 10 years (when measured from the first statutory accounting period starting on or after the 1 July following commencement), to halve the loss (that remains after step 1). [Schedule 1, item 5, step 2 in the method statement in section 770-170 of the Income Tax (Transitional Provisions) Act 1997]

What happens to a convertible controlled foreign company loss?

1.295 A controlled foreign company has a loss for an earlier statutory accounting period equal to its convertible controlled foreign company loss for that period when determining its attributable income for the commencement period and later statutory accounting periods. [Schedule 1, item 5, subsection 770-160(1) of the Income Tax (Transitional Provisions) Act 1997]

1.296 Subdivision D of Division 7 of Part X of the ITAA 1936 sets out the general rules governing the deductibility of a controlled foreign company loss. The controlled foreign company must have a loss under section 426 of that Act before the Subdivision has any application.

1.297 The amount of the controlled foreign company's loss for an earlier period (being a period before the commencement year) will be the amount worked out under Subdivision 770-C of the Income Tax (Transitional Provisions) Act 1997 . The controlled foreign company then deducts the loss in accordance with the rules prescribed in section 431 of the ITAA 1936.

1.298 A convertible controlled foreign company loss will be treated as a loss only for the purpose of applying Part X of the ITAA 1936 to statutory accounting periods beginning on or after the commencement period [Schedule 1, item 5, subsection 770-160(2) of the Income Tax (Transitional Provisions) Act 1997] . This guarantees that the controlled foreign company does not deduct the convertible controlled foreign company loss from notional assessable income in any statutory accounting period prior to the commencement period.

Treatment of pre-commencement excess foreign tax

1.299 Currently, a taxpayer has the ability to utilise excess foreign tax in an income year so long as it is in accordance with section 160AFE of the ITAA 1936. The amendments in this Schedule will continue to provide taxpayers with this facility only in respect of excess foreign tax - pre-commencement excess foreign income tax - that exists at the time these foreign tax offset rules commence (see paragraph 1.330).

1.300 The carry-forward facility found in current section 160AFE will be removed from the tax law for all other purposes [Schedule 1, item 64] . The reason for this is two-fold. Currently, in order to use excess foreign tax, a taxpayer is required to maintain detailed records, outlining the class of assessable foreign income to which it belongs, the year in which it arose and the amount that remains (if part of the excess has already been applied). The removal of the carry-forward facility will relieve taxpayers of this burden, resulting in a compliance cost saving.

1.301 Further, due to the removal of foreign tax credit quarantining, taxpayers will have greater income averaging capabilities. That is, only one foreign tax offset limit is calculated, compared to the four currently required. With this increased foreign tax offset limit, taxpayers will rarely generate excess foreign tax, thus removing the need for a carry-forward facility.

1.302 These amendments provide for the possibility of an increase in the taxpayer's foreign tax offset amount when the taxpayer has pre-commencement excess foreign income tax. As discussed (see paragraphs 1.125 to 1.153), entitlement to a tax offset will be limited to the lesser of the foreign income tax paid or the foreign tax offset cap (or, where the taxpayer does not calculate the cap, the $1,000 de minimis cap). To the extent that the foreign income tax paid by the taxpayer is less than $1,000 or the calculated cap, a foreign tax shortfall will exist. A taxpayer can reduce this shortfall (and top up the foreign income tax paid) by utilising eligible pre-commencement excess foreign income tax.

What pre-commencement excess foreign income tax can be utilised if there is a foreign tax shortfall?

1.303 When the new foreign tax offset rules commence all taxpayers must convert existing excess foreign tax credits from the previous five income years to a classless bundle of pre-commencement excess foreign income tax - to the extent they have not already been applied [Schedule 1, item 5, subsection 770-220(1) of the Income Tax (Transitional Provisions) Act 1997] . The conversion of excess foreign tax from the five income years preceding commencement is a continuation of the current five year restriction found in paragraph 160AFE(3)(a) of the ITAA 1936.

1.304 The amount of pre-commencement excess foreign income tax will be the sum of all eligible excess foreign tax credits. [Schedule 1, item 5, subsection 770-220(2) of the Income Tax (Transitional Provisions) Act 1997]

Company taxpayers

1.305 Company taxpayers that have existing excess foreign tax credits in the 'other income' class can only convert a portion of them to the bundle of pre-commencement excess foreign income tax. To the extent that the excess has arisen in earning what is now non-assessable non-exempt income, it cannot be converted [Schedule 1, item 5, item 4 in the table in subsection 770-220(3) and section 770-225 of the Income Tax (Transitional Provisions) Act 1997] . The intent of this restriction is to uphold the integrity of the changes introduced as part of the New International Tax Arrangements (Participation and Other Measures) Act 2004 . This Act had the effect of making additional active branch income non-assessable non-exempt income. Because this income is not assessable in Australia, double taxation does not arise. Therefore, excess foreign tax on (what is now) non-assessable non-exempt income will not contribute to the foreign tax offset.

Offshore banking units

1.306 Taxpayers that have existing excess foreign tax credits in the 'offshore banking income' class are also restricted in the amount that they can convert to the bundle of pre-commencement excess foreign income tax. The amount converted will be the amount of excess foreign tax credits (in the offshore banking income basket) multiplied by the offshore banking eligible fraction [Schedule 1, item 5, item 2 in the table in subsection 770-220(3) of the Income Tax (Transitional Provisions) Act 1997] . The eligible fraction is currently one-third (see subsection 121EG(4) of the ITAA 1936).

1.307 This restriction is intended to uphold the integrity of the new foreign tax offset rules and promote consistency within the offshore banking regime. To encourage offshore banking through Australia, the income from the offshore banking activities of an offshore banking unit carried on in Australia is taxed at a concessional rate and the allowable deductions are reduced proportionately. There is currently no provision that reduces the foreign income tax paid on assessable offshore banking income commensurate to the reduction in assessable offshore banking income and allowable offshore banking deductions. However, any excess foreign tax in this class is currently quarantined from income in other classes thereby preventing that foreign tax from being used to shelter other income, which is subject to low foreign tax, from Australian tax.

1.308 To ensure that any excess foreign tax in respect of assessable offshore banking income cannot be used to shelter other low foreign taxed income earned by the offshore banking unit, the foreign income tax paid on assessable offshore banking income will be reduced in accordance with the eligible fraction [Schedule 1, item 5, item 2 in the table in subsection 770-220(3) of the Income Tax (Transitional Provisions) Act 1997] . This reduction will apply for both excess foreign tax credits in this class carried forward under the current regime and for future foreign income tax paid on assessable offshore banking income under the new regime [Schedule 1, item 5, item 2 in the table in subsection 770-220(3) of the Income Tax (Transitional Provisions) Act 1997 and item 57, subsection 121EG(3A) of the ITAA 1936] .

How can a taxpayer utilise pre-commencement excess foreign income tax?

1.309 A taxpayer can utilise pre-commencement excess foreign income tax in any one of the five income years subsequent to commencement, provided foreign income tax paid by the taxpayer is less than the $1,000 de minimus cap or the calculated cap - namely, to the extent there is a foreign tax shortfall [Schedule 1, item 5, subsection 770-230(2) of the Income Tax (Transitional Provisions) Act 1997] . The amount utilised cannot exceed the extent of the shortfall [Schedule 1, item 5, subsection 770-230(4) of the Income Tax (Transitional Provisions) Act 1997] . In effect, the taxpayer is topping up the amount of foreign income tax paid to the maximum allowed, whether it is the $1,000 de minimis cap or the calculated tax offset cap [Schedule 1, item 5, subsection 770-230(3) of the Income Tax (Transitional Provisions) Act 1997] .

1.310 To the extent a taxpayer utilises pre-commencement excess foreign income tax (or has utilised carried-forward excess foreign tax credits under the current section 160AFE of the ITAA 1936), it cannot be utilised again at any time in the future. [Schedule 1, item 5, subsection 770-230(5) of the Income Tax (Transitional Provisions) Act 1997]

1.311 It is expected that the taxpayer would utilise pre-commencement excess foreign income tax on a first-in first-out basis. This basis of utilisation will be the most advantageous for the taxpayer given the five year life span of the excess foreign tax. For example, if a taxpayer has pre-commencement excess foreign income tax that relates to the 2003-04 income year as well as pre-commencement excess foreign income tax that relates to the 2005-06 income year, the taxpayer will utilise those that relate to the 2003-04 income year first because they will expire after the 2008-09 income year.

1.312 For the first five years of the new regime, a taxpayer who has a foreign tax shortfall will be able to utilise pre-commencement excess foreign income tax that has not already been utilised (and provided it has not already expired) [Schedule 1, item 5, subsection 770-230(5) of the Income Tax (Transitional Provisions) Act 1997] . Consistent with the current rules, pre-commencement excess foreign income tax (for an earlier income year) has a five year life span and if it is not used within the five years, it can never be used by the taxpayer. Thereafter, a taxpayer who has a foreign tax shortfall will not be entitled to utilise pre-commencement excess foreign income tax. Due to the five year life span, no excess foreign tax will exist beyond that time [Schedule 1, item 5, paragraph 770-230(2)(b) of the Income Tax (Transitional Provisions) Act 1997] .

Example 1.37 Austco is an Australian resident company that converts excess foreign tax credits of $5,000 relating to the 2005-06 income year, into pre-commencement excess foreign income tax of $5,000 for that income year.For the 2009-10 income year, Austco pays foreign income tax of $7,000 in respect of an amount included in its assessable income and calculates its foreign tax offset limit as $10,000. As the tax offset of $7,000 (before the application of the pre-commencement excess foreign income tax) is less than the tax offset limit of $10,000, Austco can add pre-commencement excess foreign tax of $3,000 to the tax offset for the year of income.This leaves $2,000 of unused pre-commencement excess foreign tax.For the 2010-11 income year, Austco pays foreign income tax of $4,000 in respect of an amount included in its assessable income and calculates its foreign tax offset limit as $5,000. As the tax offset of $4,000 (before the application of any pre-commencement excess foreign income tax) is less than the tax offset limit of $5,000, Austco can add pre-commencement excess foreign income tax of $1,000 to the tax offset for the year of income.This leaves $1,000 of unused pre-commencement excess foreign income tax.For the 2011-12 income year, Austco pays foreign income tax of $8,000 in respect of an amount included in its assessable income and calculates its foreign tax offset limit as $10,000. Although the tax offset of $8,000 (before the application of any pre-commencement excess foreign income tax) is less than the tax offset limit by $2,000, the remaining amount of $1,000 pre-commencement excess foreign income tax cannot be used to increase the tax offset for the income year since it relates to the 2005-06 income year which is not one of the five most recent years before the current year.

Application of transitional foreign tax offset rules to consolidated groups

1.313 The purpose of these amendments is to ensure the current consolidation rules pertaining to the transfer of excess foreign tax credits are broadly continued in the transitional rules for the transfer of pre-commencement excess foreign income tax. The relevant sections within Division 717 are thus replicated (with some minor modifications to reflect the change in terminology) into the Income Tax (Transitional Provisions) Act 1997 .

1.314 As described in section 770-285 of the Income Tax (Transitional Provisions) Act 1997 , the main object of Subdivision 770-E of that Act is to allow the head company of a consolidated group to apply pre-commencement excess foreign income tax of any joining entity that becomes a subsidiary member of the group at an appropriate time [Schedule 1, item 5, paragraph 770-285(a) of the Income Tax (Transitional Provisions) Act 1997] . The second object is to prevent any entity other than the head company from using pre-commencement excess foreign income tax that has been transferred to the head company of a consolidated group by an entity that becomes a subsidiary member of the group [Schedule 1, item 5, paragraph 770-285(b) of the Income Tax (Transitional Provisions) Act 1997] .

Transferring pre-commencement excess foreign income tax from a subsidiary member to a head company

1.315 Where an entity becomes a subsidiary member of a consolidated group, the single entity principle dictates the transfer of all income, deductions and offsets from the joining entity to the head company. These transitional rules operate to ensure consistent treatment for pre-commencement excess foreign income tax. Where an entity joins a consolidated group any pre-commencement excess foreign income tax a joining entity may have will be transferred to the head company of a consolidated group at the joining time. It is a condition that the joining entity join the consolidated group before or at the start of the head company's income year in which it wishes to use the transferred excess foreign income tax. [Schedule 1, item 5, subsections 770-290(1) and (2) of the Income Tax (Transitional Provisions) Act 1997]

1.316 The transferred pre-commencement excess foreign income tax will be pooled with the head company's own pre-commencement excess foreign income tax and any other transferred pre-commencement excess foreign income tax from other subsidiary members [Schedule 1, item 5, paragraph 770-290(2)(b) of the Income Tax (Transitional Provisions) Act 1997] . Because of the five year life span for pre-commencement excess foreign income tax, the years in which any pre-commencement excess foreign income tax of the head company, and any transferred to it by joining entities, must be separately identified. These amendments deem the foreign income tax to be paid by the head company in order to satisfy the basic requirement in Division 770 of the Income Tax (Transitional Provisions) Act 1997 that the foreign income tax be paid by the taxpayer claiming the offset [Schedule 1, item 5, subsection 770-290(2) of the Income Tax (Transitional Provisions) Act 1997] . If, subsequently, the head company becomes the joining entity of another consolidated group, any remaining pre-commencement excess foreign income tax from a previous year will be transferred to the new head company, and the new head company is deemed to have paid that tax in that earlier year [Schedule 1, item 5, subsection 770-290(3) of the Income Tax (Transitional Provisions) Act 1997] .

1.317 The head company cannot use the transferred pre-commencement excess foreign income tax of a subsidiary member until the end of the head company's income year following the year in which the entity joined the group. This will be the case whether or not the entity is still a member of the group at the time. Utilisation will then be subject to the same conditions described in paragraphs 1.303 to 1.312. That is, a head company will only use pre-commencement excess foreign income tax (from any five of the preceding income years) to the extent there is a foreign tax shortfall.

What happens if a subsidiary member of a consolidated group is not a member of a consolidated group for part of an income year?

Rules for the joining entity

1.318 Consistent with the current rules in Subdivision 717-A, special rules are required where an entity (a joining entity) joins a consolidated group during the entity's income year, to ensure the joining entity can use some of its pre-commencement excess foreign tax and transfer the rest to the head company of the consolidated group.

1.319 Section 770-295 of the Income Tax (Transitional Provisions) Act 1997 operates where an entity joins a consolidated group in an income year and there is a period in that year in which the entity is not a member of any consolidated group. [Schedule 1, item 5, subsection 770-295(1) of the Income Tax (Transitional Provisions) Act 1997]

1.320 Where the joining entity has a foreign tax shortfall for the non-membership period that starts at the beginning of its income year, the joining entity can use pre-commencement excess foreign income tax from earlier years as calculated under the new section 770-220 of the Income Tax (Transitional Provisions) Act 1997 [Schedule 1, item 5, subsection 770-295(3) of the Income Tax (Transitional Provisions) Act 1997] . The joining entity will not be able to use that pre-commencement excess foreign income tax for earlier years if it has another, later non-membership period in the joining year [Schedule 1, item 5, subsection 770-295(3) of the Income Tax (Transitional Provisions) Act 1997] . This is because the head company of the consolidated group which it joined and left will be treated as having the pre-commencement excess foreign tax for earlier years not used by the joining entity [Schedule 1, item 5, subsection 770-290(2) of the Income Tax (Transitional Provisions) Act 1997] .

1.321 Where an entity is a subsidiary member of a consolidated group at the start of an income year and then leaves the group before the end of the income year, the entity will not have access to any pre-commencement excess foreign income tax from earlier years that it may have had before joining the consolidated group. This will have become pre-commencement excess foreign income tax of the head company when the entity joined the group. [Schedule 1, item 5, subsection 770-295(3) of the Income Tax (Transitional Provisions) Act 1997]

Rules for the head company

1.322 Generally, the head company of a consolidated group will not be able to use pre-commencement excess foreign income tax for a non-membership period of a joining entity at the end of the head company's income year in which the non-membership period ends. However, in the year after a joining year the head company can use the pre-commencement excess foreign income tax for the non-membership period that accrued to the entity that joined the group the previous year. Of course, the joining entity can only have pre-commencement excess foreign income tax for a non-membership period if that period commenced before the beginning of the commencement income year for the joining entity. [Schedule 1, item 5, section 770-290 of the Income Tax (Transitional Provisions) Act 1997]

What happens if a subsidiary member leaves the consolidated group?

1.323 Where an entity joins a consolidated group, only the head company of the consolidated group can use the pre-commencement excess foreign income tax of the joining entity. [Schedule 1, item 5, section 770-300 of the Income Tax (Transitional Provisions) Act 1997]

1.324 Where an entity subsequently leaves the consolidated group, it will not be able to use the pre-commencement excess foreign income tax it had prior to joining the group or any that the head company otherwise had. This is because a leaving entity cannot take any pre-commencement excess foreign income tax with it when it leaves the consolidated group. [Schedule 1, item 5, section 770-305 of the Income Tax (Transitional Provisions) Act 1997]

1.325 These rules apply regardless of whether the leaving entity joins another consolidated group or remains a separate entity.

Application of the transitional foreign income tax offset rules to multiple entry consolidated groups

1.326 The transitional foreign income tax offset rules have effect in relation to a multiple entry consolidated group in the same way they have effect in relation to a consolidated group. [Schedule 1, item 5, section 770-310 of the Income Tax (Transitional Provisions) Act 1997]

Repeal of transitional provisions

1.327 Division 770 of the Income Tax (Transitional Provisions) Act 1997 will be repealed from 30 June 2014. The transitional provisions pertaining to overall foreign losses will not have any operation after this time. The deduction limit on utilising convertible foreign losses applies for the first four income years ending after the commencement year. Further, the transitional provisions pertaining to pre-commencement excess foreign income tax will not have any effect after this point in time. This is due to the fact pre-commencement excess foreign income tax only has a life span of five years. [Schedule 1, item 227]

1.328 The repeal of these transitional rules will not impact on how a taxpayer's tax loss or a loss of a controlled foreign company are utilised. As mentioned above, the utilisation of these losses is governed by Division 36 and Subdivision D of Division 7 of Part X of the ITAA 1936, respectively.

Savings and application provisions

1.329 The amendments contained within this Schedule apply in relation to income years, statutory accounting periods and notional accounting periods starting on or after the 1 July following the day on which this Bill receives Royal Assent. [Schedule 1, item 222]

1.330 The first period of application is called the commencement year or the commencement period in the transitional provisions.

1.331 The amendments pertaining to the relief of double tax resulting from a transfer pricing adjustment (section 24 of the International Tax Agreements Act 1953 ) apply in relation to income years ending before and after Royal Assent. However, the operation of the existing credit relief mechanism in Division 19 of Part III of the ITAA 1936 is partially preserved in relation to income years ending before Royal Assent. [Schedule 1, item 224]

1.332 The amendments to the Fringe Benefits Tax Assessment Act 1986 , which remove references to foreign income deductions, apply from when that term ceases to have meaning for the relevant employee. That time will be the start of the commencement year for that employee, which will usually be 1 July following Royal Assent. [Schedule 1, item 222]

Special application provision for section 802-40

1.333 The amendments contained within this Schedule have a delayed application in respect of section 802-40. This is to ensure that section continues to operate as intended with a one-year lag from when a foreign tax credit is obtained. [Schedule 1, item 223]

General savings provision

1.334 The general savings provision prevents an assessment being affected by any provision that is repealed or amended by this Bill, if the assessment relates to a period or event before the repeal or amendment. [Schedule 1, items 225 and 226]

1.335 The general savings provision also preserves powers, duties, rights and obligations in relation to the time before the repeal or amendment. If a right or obligation already existed before the repeal or amendment, section 8 of the Acts Interpretation Act 1901 would probably already preserve it. However, the savings provision goes further.

1.336 This savings provision extends to powers and duties as well as to rights and obligations. That is intended to make sure that the whole of a repealed provision's previous operation can be preserved where necessary.

1.337 It also ensures that powers, duties, rights and obligations can still come into existence after the repeal or amendment if they relate to an earlier period or event. This means, for example, that a taxpayer can object to an assessment that is made after the provision which empowered the assessment, and the provision which empowered the objection, has been repealed. [Schedule 1, items 225 and 226]

Specific savings provisions

Correlative relief

1.338 Division 19 of Part III of the ITAA 1936 provides a general power to the Commissioner to make or amend a credit determination. This Schedule preserves this power in relation to income years when Division 19 was operative, where such a determination is made before Royal Assent. The power is retained to this extent whether it relates to a determination initiated by the Commissioner or a self-determination of a credit entitlement by the taxpayer. [Schedule 1, subitems 224(1) and (2)]

Consequential amendments

1.339 Provisions of the ITAA 1936 and the ITAA 1997 are amended by this Schedule to accommodate the new foreign tax offset system and the removal of the current foreign tax credit system. Amendments remove references to provisions that no longer apply, for example, attributed tax accounts, and apply prospectively from the date this Bill commences.

1.340 The new foreign tax offset continues to be non-refundable and non-transferable. In addition it can no longer be carried forward. In respect of tax offset rankings therefore, the foreign tax offset comes before the child care tax offset (item 25 in the table in subsection 63-10(1)) but after the tax offsets covered by item 20 in that subsection. [Schedule 1, items 143 to 145, item 22 in the table in subsection 63-10(1)]

1.341 The definition of 'passive income' (in current Division 18, Part III of the ITAA 1936), which includes 'interest income' and 'passive commodity gains' has been amended and moved to section 6 of the ITAA 1936. This definition is currently relevant for the calculation of the mature age worker tax offset in Subdivision 61-K. The modifications made to the definition therefore take into account that the mature age worker tax offset applies only to individual taxpayers and not corporate tax entities [Schedule 1, items 18 to 20, subsection 6(1) of the ITAA 1936] . As with other definitions in subsection 6(1) of the ITAA 1936, these definitions apply as long as a contrary intention (eg, an alternative definition) is not indicated in other provisions. Therefore, they do not replace the definitions of 'passive income' in Part X of the ITAA 1936 or of 'interest' in Division 11A of Part III of the ITAA 1936.

1.342 The definition of 'voting interest' in current section 160AFB of the ITAA 1936 will be moved to Part X of the ITAA 1936. This definition continues to be relevant for the definition of a 'non-portfolio dividend'. [Schedule 1, items 82, 83, 88, 176 to 178, sections 317 and 334A of the ITAA 1936 and paragraph 768-550(1)(a), subsection 768-550(2)]

1.343 Section 6D is inserted into the ITAA 1936 which provides that some offsets in the ITAA 1997 are treated as credits under the ITAA 1936. This provision is currently in section 160AHA of the ITAA 1936 (which this Bill is repealing) and continues to be relevant for other credit provisions in the ITAA 1936. [Schedule 1, items 28 and 66, section 6D of the ITAA 1936]

1.344 Section 431 of the ITAA 1936 allows the past losses of a controlled foreign company to be deducted against notional assessable income of the controlled foreign company under certain conditions. As well as removing all references to the quarantining classes, the section has been amended to remove the references to statutory accounting periods starting before 1 July 1997 because losses of those periods will no longer be deductible. Subsection 431(4) of that Act has also been rewritten in a more positive manner and subsections (4A) and (4C), which both deal with changes to the list of countries, have been combined. In applying these provisions, whether the controlled foreign company was a resident of a listed country or of an unlisted country at the end of an earlier statutory accounting period is to be determined on the basis of the current list of listed countries and not on the basis of what were listed countries at that earlier time. The set of listed countries was substantially reduced (to seven countries) in 2004. [Schedule 1, items 117 to 122, subsection 431(1), paragraphs 431(2)(a) and (b), subsections 431(4), (4A), (4B), (4D) and (5) of the ITAA 1936]

1.345 As a result of a taxpayer making a choice under subsection 559A(1) of the ITAA 1936, in relation to a foreign company, and that company being afforded treatment as an Australian financial institution subsidiary (discussed in paragraphs 1.214 to 1.219), the rules in Subdivision 768-G are amended by this Schedule. If the foreign company's sole or principal business is a financial intermediary business, the special rules in relation to the treatment of assets under Part X of the ITAA 1936 also apply for the purpose of Subdivision 768-G. This will impact on the way the assets are treated for the purpose of determining the active foreign business asset percentage of a foreign company (and other related rules). [Schedule 1, item 4, section 768-533]

1.346 Some provisions of the Taxation (Interest on Overpayments and Early Payments) Act 1983 are repealed as a result of the new foreign tax offset forming part of a taxpayer's assessment. There will, however, continue to be a limit on payment of interest where the Commissioner provides correlative relief in respect of foreign income tax (see Part III of that Act). [Schedule 1, items 213 to 221, subsections 3A(1), 3A(1A) and 3A(2), paragraphs 3A(2)(c) and 9(1A)(b) and 11(b) of the Taxation (Interest on Overpayments and Early Payments) Act 1983]

1.347 Changes to the foreign hybrid rules in Division 830 do not affect the operation of those rules. The changes simply reflect the new definition of 'foreign income tax' inserted into the ITAA 1997. The foreign hybrid rules will continue to operate in respect of the same types of foreign taxes as before these amendments were introduced. [Schedule 1, items 182 to 187, paragraphs 830-1(a), 830-10(1)(b), 830-10(1)(c), 830-15(1)(b), 830-15(2)(b) and 830-15(3)(b)]

General

1.348 Many consequential amendments result from the renaming of 'foreign tax credit' to 'foreign tax offset'. [Schedule 1, items 8, 25, 38 to 51, 69 to 75, 78, 133, 139, 146, 148 to 152, 179 to 181, paragraph 22(4)(c) of the Bank Integration Act 1991, subsection 6AB(6), section 102AAB, subsections 102AAM(2) to (4) and 102AAM(4A), section 102AAZC, subsection 177A(1), paragraphs 177(1)(bb), 177(1)(f), 177C(2)(d), 177C(3)(ca), 177C(3)(g), 177F(1)(d) and 177F(3)(d), section 317 of the ITAA 1936, subsections 205-20(4) and 205-70(2), paragraphs 220-400(1)(c) and 220-405(1)(d), section 802-40]

1.349 Other consequential amendments have resulted from repealing Divisions 18, 18A and 19 of Part III of the ITAA 1936 and moving the provisions governing entitlement to a tax offset for foreign income tax paid on an amount included in assessable income to Division 770. [Schedule 1, items 6, 7, 9 to 17, 21 to 37, 52 to 54, 62 to 67, 76, 84 to 87, 90, 109, 127, 129 to 132, 134 to 138, 140 to 142, 144, 145, 147, 153 to 163, 195 to 210 and 212, section 195-1 of the A New Tax System (Goods and Services Tax) Act 1999, paragraph 19(1)(b), subparagraph 19(1)(ba)(ii), paragraph 24(1)(b), subparagraph 24(1)(ba)(ii), paragraph 44(1)(b), subparagraph 44(1)(ba)(ii), paragraph 52(1)(b), subparagraph 52(1)(ba)(ii) of the Fringe Benefits Tax Assessment Act 1986, subsections 6AB(1), (2) and (6), section 6D, subsections 23AI(2), 23AK(2), 46FA(11), 46FB(6), 47A(2), 102L(6) and 102T(7), sections 121K, 160ADA and 317, subsection 324(1), paragraphs 389(a) and 427(b) of the ITAA 1936, sections 10-5, 12-5, 13-1, 36-10 and 36-25, paragraph 61-570(2)(c), subsection 205-70(2), paragraphs 305-75(2)(b), 305-75(3)(b), 305-75(5)(a), 701-1(4)(c) to (g), 707-110(2)(b) and 707-110(2)(c), subsections 707-130(1), 707-310(3) and 713-225(6A), Subdivision 717-A, subsection 701D-1(1), paragraphs 701D-10(3)(a) and (b) and 707-325(1)(d), subsection 707-325(9), paragraph 707-326(1)(b), subsections 707-328A(6) and 830-20(3), paragraph 830-20(4)(c), subsections 830-20(4) and 830-20(5) of the Income Tax (Transitional Provisions) Act 1997, subsections 4(2), 11FA(3) and 11FB(3) of the International Tax Agreements Act 1953, paragraph 14ZW(1)(aaa) of the Taxation Administration Act 1953]

1.350 Further consequential amendments have resulted from removing the classes of notional assessable income from the controlled foreign company rules in Part X of the ITAA 1936. [Schedule 1, items 94 to 108, 110 to 122, subsections 425(1) to (4), paragraph 426(a), subparagraphs 426(a)(i) and (ii), section 426, paragraphs 427(b) and 427(ba), section 429, subsection 431(1), paragraphs 431(2)(a) and (b), subsections 431(4), (4A), (4B), (4D) and (5)]

1.351 Definitions have also been inserted into the Dictionary for 'credit absorption tax', 'foreign income tax' and 'unitary tax' and a modification has been made to 'tax loss' [Schedule 1, items 189, 191, 193 and 194, subsection 995-1(1)] . The definitions of 'foreign tax' and 'excess foreign tax credits' (in the Dictionary) have consequently been repealed [Schedule 1, items 190 and 192] . However, 'foreign tax' continues to be defined in the ITAA 1936 because of the residual need for that definition in other areas of the ITAA 1936. Some parts of section 6AB of the ITAA 1936 have been repealed. Those provisions were necessary for foreign tax credit purposes and in general have been rewritten into Division 770 [Schedule 1, items 22 and 24, subsections 6AB(1), 6AB(1A), 6AB(1B), 6AB(2) and 6AB(6)] .


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