Explanatory MemorandumCirculated By the Authority of the Treasurer, the Hon Wayne Swan MP
Chapter 2 - Regulation impact statement
2.1 This regulation impact statement relates to the Board of Taxation's (the Board) recommendations following its review of the foreign source income anti-tax-deferral (attribution) regimes.
2.2 The attribution rules provide integrity to Australia's residence based taxation system whereby Australian residents, in general, are taxable on their worldwide income.
2.3 Australia's attribution rules apply to ensure Australian residents cannot avoid or defer Australian tax by accumulating income offshore in a foreign entity. The attribution rules achieve this by taxing Australian residents on a current basis on their share of certain income accumulated in a foreign entity in which they hold an interest.
2.4 The current attribution rules - the controlled foreign company (CFC), foreign investment fund (FIF), transferor trust and deemed present entitlement regimes - were introduced in the early 1990s. Each regime applies to different kinds of interests and entities. In summary:
- The CFC regime applies to Australian residents with a controlling interest in a foreign company.
- The FIF regime applies to Australian residents with interests in foreign trusts or non-controlling interests in foreign companies and also applies to Australian residents with interests in foreign life assurance policies.
- The transferor trust regime applies where an Australian resident has made a transfer of property or services to a foreign trust for no, or insufficient, consideration.
- The deemed present entitlement regime applies to an Australian resident with an interest, including a future or contingent interest, in a foreign trust.
2.5 In general terms, the attribution rules target that income classified as being passive income. Passive income is generally considered to be highly mobile income, for example, interest, dividends, and royalties. The rules also currently target certain income from related-party transactions.
2.6 Australia's attribution rules were introduced progressively during the early 1990s, but are based on United States' rules developed in the 1960s. Since the attribution rules were introduced, globalisation has significantly affected the business environment faced by Australian businesses and seen them increasingly competing in the world economy. The changing business environment has led to the current rules being outdated, potentially impacting on offshore investment decisions that are not motivated by tax deferral reasons.
2.7 The Board in its discussion paper identified a number of problems with the existing attribution rules. These problems were classified under the following broad headings:
- coordination and distortionary problems - primarily as a result of multiple regimes applying concurrently, together with inconsistent rules applying to equivalent entity types;
- targeting problems - poorly targeted provisions, both in terms of distinguishing between passive and active income and identifying income that carries the greatest deferral risk;
- compliance cost problems - compliance costs that are disproportionate to the integrity risk; and
- complexity problems - the regimes are exceedingly complex.
2.8 In terms of complexity the rules were drafted at a time when a prescriptive black-letter law approach to the general design of the tax laws applied. As a result, they occupy around 400 pages of legislation and nearly 1,000 subsections (or approximately 25 per cent of the Income Tax Assessment Act 1936). The Board concluded that the volume of law needed and the accompanying level of complexity is disproportionate to the common policy outcome the regimes all set out to achieve - to identify and attribute to resident taxpayers their share of passive income derived by foreign entities in which they hold an interest.
2.9 The complexity of the attribution regimes, as well as the lack of high level and more immediately accessible exemptions, has resulted in high compliance costs for many Australian residents with foreign investments even where they ultimately have little or no attributable income to report.
2.10 These costs can also potentially impact on the competitiveness of Australians doing business offshore. For example, Australian-owned companies with offshore marketing hubs may be subject to tax on a current basis on their share of income accumulated in these hubs (attribution taxation) whereas their foreign-owned competitors may not be subject to similar attribution taxation in their home jurisdiction.
2.11 A further example is in the managed funds sector. To avoid the compliance costs associated with the FIF rules, fund managers often sell FIF interests immediately before the end of the year and reacquire them in the next moment in the following income year. Although this has the effect of bringing forward the taxing point on what would have otherwise been an unrealised gain, the savings in compliance costs are of such a magnitude that managed funds seldom refrain from this sell and buy-back practice.
2.12 In light of the problems and issues outlined above, the former government announced on 10 October 2006, a review of the attribution rules.
2.13 The terms of reference for the review were:
- to identify ways to reduce the complexity and compliance costs associated with the current foreign source income anti-tax-deferral regimes, including whether the regimes can be collapsed into a single regime; and
- to examine whether the anti-tax-deferral regimes strike an appropriate balance between effectively countering deferral and unnecessarily inhibiting Australians from competing in the global economy.
2.14 The review was conducted by the Board. The Board is an independent, non-statutory body established to advise government on various aspects of the Australian taxation system.
2.15 In September 2008 the Board handed to Government its report which contained recommendations to address the terms of reference.
2.16 The Government announced in the 2009-10 Budget its response to recommendations from the Board following its review of the attribution rules (see the Assistant Treasurer's Press Release No. 049 of 12 May 2009).
2.17 In summary, the Government agreed that:
- the CFC provisions be retained as the primary set of rules designed to counter tax deferral arrangements:
- the CFC provisions be modernised by updating the definitions of what constitutes active and passive income together with the removal of the base company income rules;
- the existing exemptions within the CFC rules be retained, including the listed country and Australian financial institution subsidiary exemptions, and an additional exemption introduced for complying superannuation entities;
- a choice of attribution methods apply (the branch-equivalent calculation, market value, and deemed rate of return methods) where taxpayers are required to include attributable income in their assessable income; and
- the CFC provisions are rewritten in the Income Tax Assessment Act 1997 (ITAA 1997);
- the FIF provisions be repealed and replaced with a specific anti-roll-up fund measure targeting accumulation funds that reinvest interest-like returns;
- in the absence of FIF rules, closely held fixed trusts are brought into the rewritten CFC rules;
- the deemed present entitlement rules are repealed; and
- the transferor trust rules are retained with amendments to enhance their effectiveness and improve their integrity.
2.18 The Government decided not to proceed with the Board's recommendation of a listed public company exemption.
2.19 The Assistant Treasurer's Press Release No. 117 of 18 December 2009 announced the release for public consultation exposure draft legislation to repeal the FIF and deemed present entitlement rules. Legislation to give effect to the remaining reforms to modernise the CFC and transferor trust rules is being developed separately.
Assessment of impacts
Impact group identification
2.20 The most recent data from the Australian Taxation Office (ATO) indicates that the number of taxpayers currently subject to the attribution regimes are:
- for the 2006-07 year - 2,000 individuals declared that they received FIF income, 600 declared they were in receipt of CFC income and 50 included transferor trust income; and
- for the 2005-06 year - 3,000 businesses, superannuation funds and other entities declared they were in receipt of CFC and/or FIF income.
2.21 The above numbers do not take account of managed funds and their investors that effectively operate outside of the attribution rules because of 'bed and breakfast' transactions undertaken by fund managers (referred to in paragraph 2.11).
2.22 Implementation of the Government's announcement will impact on all of these taxpayers and their advisors. The benefits and costs of the announced reforms are explained in more detail below.
Analysis of costs/benefits
Taxpayers with non-controlling interests in foreign entities
2.23 Implementation of these reforms will have the biggest impact on those resident taxpayers with non-controlling interests in foreign investments. These taxpayers, unless they hold an interest in a roll-up fund, will benefit from significant compliance cost savings as they will no longer be subject to the requirements of the attribution rules.
2.24 Similarly, managed funds and superannuation funds would also have significant compliance cost savings. The repeal of the FIF regime would mean these entities would no longer be required to either maintain separate attribution accounts for each resident investor or undertake 'bed and breakfast' transactions (referred to in paragraph 2.11) in order to meet the requirements of the balanced portfolio exemption.
Taxpayers with controlling interests in foreign entities
2.25 Taxpayers with controlling interests in foreign entities should also benefit from a reduction in their compliance costs. The majority of these taxpayers are currently subject to the requirements of the existing CFC regime.
2.26 For these taxpayers compliance cost reductions will occur as a result of the introduction of improved exemptions.
2.27 Other changes that modernise the active/passive income divide to better recognise the changing global business environment that has evolved since the attribution rules were first developed, will also improve the competitiveness and productivity of Australian businesses with offshore operations.
2.28 Overall, the ATO's compliance cost assessment is that the proposed changes will have an on-going compliance cost savings for taxpayers of between $40 million to $80 million per year. (Transitional costs associated with implementation are estimated to cost between $40 million to $80 million.)
2.29 However, according to the ATO, the estimates of potential compliance cost impacts are conservative and do not represent the total compliance cost impact. For instance, no estimates are provided on the impact on professional fees that a taxpayer might be required to pay. This is due to the limitations of the data available and the more complex interaction of variables that influence the use of professional services and the setting of those fees.
2.30 Nor does the estimate of potential compliance cost impacts include savings for individual investors in managed funds who might have incurred costs associated with undertaking 'bed and breakfast' arrangements. Impacts on these individual investors are an indirect saving that the ATO's quantifications do not include.
Tax practitioners and other intermediaries
2.31 Tax practitioners representing entities in either the Large or Small Medium Enterprise markets will be the most directly affected by the proposed changes. It is entities operating in these markets that tend to conduct offshore business, with larger businesses tending to have the greatest exposure.
2.32 It is estimated that 400 registered tax agents service these markets. These tax agents may initially incur additional costs when familiarising themselves with the new rules. However, this is not expected to be significant given that the new rules are based on the retention of the existing CFC rules and the repeal of the FIF rules.
2.33 The impact on the tax agents representing the remaining markets sectors would depend on their clients' exposure to the new rules, but this is not expected to be significant.
2.34 As a result of implementing these changes the ATO may incur initial costs associated with system and tax form changes and the need to provide additional advice to taxpayers and tax practitioners, including by way of tax rulings. Costs may also be incurred in retraining staff. This is not expected to be significant as the CFC rules are being retained and the FIF rules are being repealed. The ATO has indicated that these costs would be $3.1 million for the 2010-11 income year.
2.35 Although it was anticipated that the new regime would result in ongoing administration costs savings, the ATO has estimated that the ongoing administrative cost would be in the order of $1.3 million per year.
2.36 The Board's recommendations will provide a number of economic benefits across a number of fronts:
- For Australian managed funds, the abolition of the FIF rules will significantly reduce their compliance costs which in turn will enhance their global competitiveness and attractiveness to foreign investors.
- For Australian corporates:
- modernising and better targeting the rules by abolishing the FIF and base company income rules, together with updating the definitions of what constitutes active and passive income, will improve their competitiveness and productivity; and
- improved exemptions, including a more effective exemption for complying superannuation funds, will significantly reduce compliance costs for eligible taxpayers.
- For taxpayers generally, and administrators:
- abolition of the FIF and deemed present entitlement rules, in conjunction with rewriting the CFC rules into the ITAA 1997 will simplify and scale back the volume of law, as well as bringing the prospect of consolidating the two income tax Acts a significant step closer.
2.37 The Board conducted extensive consultation with stakeholders throughout the review process.
2.38 Initially, targeted consultation sessions were held with selected representatives from industry and the professional tax bodies, as well as the Treasury and the ATO, to help develop the Board's discussion paper. Public consultation meetings were then held in both Melbourne and Sydney following the release of that paper and, again, following the release of the Board's position and issues papers. The public consultations forums were advertised in the press as well as on the Board's website.
2.39 Consultation was conducted early in the review so that interested parties could comment on policy and design issues underlying the foreign source income attribution rules.
2.40 Further, targeted consultations were also held with particular taxpayers throughout the review period.
2.41 Written submissions were also sought by the Board in response to their discussion paper and, again, in response to their position and issues papers.
2.42 Appendices A and B of the Board's Report contains the list of organisations or individuals who either made submissions to the Board or attended consultations meetings.
2.43 Stakeholders were unanimous in seeking changes to the existing rules. Changes were sought on the basis that the rules were outdated, complex, compliance intensive, and distortionary.
2.44 Stakeholders were also in agreement in seeking more modern, high level exemptions; and a range of exemption options.
2.45 Public consultation meetings were also held in Sydney and Melbourne following the release of the Treasury discussion paper in June 2009. Written submissions were also sought from interested parties in response to the Treasury's discussion paper.
2.46 An exposure draft of the legislation giving effect to the Government's decision to repeal the FIF and the deemed present entitlement rules was released for public consultation on 18 December 2009 and interested parties provided comments on the exposure draft Bill.
2.47 A consultation paper on the reform of the CFC rules was released in January 2010, with submissions due by 1 March 2010.
Conclusion and recommended option
2.48 The Government announced reforms to the attribution rules as part of the 2009-10 Budget. The Government agreed to implement all of the Board's recommendations other than the listed public company exemption (recommendation 2).
2.49 The above analysis shows that this approach would result in significant compliance cost savings for affected taxpayers when compared to the existing regimes.
2.50 The approach also aligns the rules to changes in the business environment that have occurred as a result of globalisation. The Government's approach provides flexibility when compared to the current regimes, recognising that many offshore investment decisions are not motivated by tax deferral reasons.
Implementation and review
2.51 Consistent with the Government's commitment for consultation with stakeholders in accordance with the Tax Design Review Panel's report Better Tax Design and Implementation, draft legislation to implement these reforms will involve consultation with affected stakeholders. The repeal of the FIF and deemed present entitlement rules has already been the subject of such consultation.
2.52 The Board in delivering its report to Government, noted that the Treasury, when developing any legislation, should involve both the Board and the other stakeholders who participated in the review's consultation process. The repeal of the FIF and deemed present entitlement rules has been conducted in accordance with this advice.
2.53 Once introduced, the Treasury and the ATO will monitor this taxation measure on an ongoing basis.
Schedule 1: Repeal of the FIF and deemed present entitlement rules
|Bill reference||Paragraph number|
|Items 1 and 2, 6, 8, 10, 12 and 13, 17 to 19, 35, 38, 48, 50 and 51, 63, 66 to 68, 74, 81 and 82 and 87, subsection 6(1) (definition of 'approved stock exchange'), subsection 6(1)(paragraph (l) (definition of 'passive income'), subsection 6AB(1), subsection 82 KZL(1) (definition of 'approved stock exchange'), paragraphs 102AAU(1)(b), subparagraphs 102AAU(1)(c)(ix), subsections 102AAU(7) to (9), subsection 317(1)(definition of 'grossed-up amount'), subparagraphs 356(4B)(b)(ii) and 356(4C)(b)(ii), subsection 402(4), subsection 272-140(1) in Schedule 2F (definition of 'approved stock exchange'), subsections 116-10(7) (note 1) of the ITAA 1997, subsections 703-75(4) (note) and 715-660(1) ( items 1 and 2 in the table) of the ITAA 1997, sections 768-900, 770-135 (heading), subsections 770-135(1), (2) and (6) to (8), subsection 995-1(1) (definition of 'approved stock exchange'), subsection 995-1(1) (definition of 'attribution percentage') of the ITAA 1997 and subsection 66(5) (paragraph (b) of the definition of 'listed security') of the Superannuation Industry (Supervision) Act 1993||1.48|
|Items 3 to 5, subsection 6(1)||1.51|
|Item 7, section 23AK||1.25|
|Item 7, section 23B||1.27|
|Item 9 and subitem 93(1), section 96A||1.23|
|Item 9, section 96A||1.22|
|Items 9 and 37, Part XI and sections 96B and 96C||1.14|
|Items 11, 21, 25, 27, 29 and 30, 32 and 33, 69 to 71 and 79, sub-subparagraphs 102AAU(1)(c)(viii)(B), subsection 371(2), subparagraph 384(2)(d)(iii), paragraphs 385(2)(a), (b) and (d), sub-subparagraph 385(2)(d)(iv)(B), subsection 385(4), paragraph 389(a), paragraphs 770-135(3)(b) and (c), 770-135(5)(b) and 960-50(10)(c) of the ITAA 1997||1.53|
|Items 14 to 16 and 83 to 86, definition of 'FIF attribution account entity', 'FIF attribution account payment', 'FIF attribution debit' in subsection 317(1) of the ITAA 1936, definition of 'FIF', 'foreign life assurance policy', 'foreign investment fund' and 'notional accounting period' in subsection 995-1(1)||1.49|
|Items 20, 22 to 24, 26, 28, 31, 34, 36, 39, 47, 64 and 65, 70, 72 and 73 and 80, paragraphs 371(1)(aa) and 371(1)(ab), subsections 371(2A) to (2D), paragraphs 371(5)(aa), 371(5)(ab) and 384(2)(ca), subparagraph 384(2)(d)(iv), paragraph 385(2)(ca), subparagraph 385(2)(d)(v), subsections 402(2A) to (2C), Subdivision E of Division 7 of Part X, Schedules 3 to 5 to the ITAA 1936, sections 70-70, 768-965 and 768-975 of the ITAA 1997, paragraphs 770-135(3)(c), 770-135(5)(c), 770-135(5) (note) and 960-50(10)(d) of the ITAA 1997||1.50|
|Items 40 to 46, sections 10-5, 11-55 and 12-5 of the ITAA 1997||1.54|
|Item 49, subsection 230-460(12)||1.31|
|Items 52 to 61, Subdivision 717-D of Part 3-90 (heading), section 717-200, paragraph 717-205(c), sections 717-220 and 717-230, Subdivision 717-E of Part 3-90 (heading), section 717-235, paragraph 717-240(c), sections 717-255 and 717-265 of the ITAA 1997||1.52|
|Item 62, subsection 768-533(1)||1.33|
|Items 75 to 78, subsections 830-10(1) and (2), and subsections 830-15(1) and (5)||1.41|
|Items 76, 78 and 96, subsections 830-10(2) and 830-15(5)||1.36, 1.47|
|Items 88 to 91, subsections 401(1) and (3), subsections 461(1) and (3)||1.29|
|Items 92 and 94, section 613||1.28|