House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Deputy Prime Minister and Treasurer, the Hon Wayne Swan MP)

Chapter 1

Investment manager regime - conduit income of 2010-11 and later income years

Outline of chapter

1.1 Schedule 1 to this Bill inserts new Subdivision 842-I into the Income Tax Assessment Act 1997 (ITAA 97). The Subdivision prescribes the treatment of returns, gains, losses and deductions on certain investments of widely held foreign funds. The amendments will apply where the returns or gains would otherwise be assessable income of the fund only because they are attributable to a permanent establishment in Australia which arises solely from the use of an Australian based agent, manager or service provider. Where the Subdivision applies, the relevant returns or gains will be treated as non-assessable non-exempt (NANE) income or will be disregarded and the deductions, losses, capital gains and capital losses will be disregarded.

1.2 The Subdivision together with new Subdivision 840-I of the Income Tax ( Transitional Provisions ) Act 1997 (see Chapter 2) will form the first two elements of an investment manager regime (IMR).

1.3 As the amendments made to the ITAA 1997 and explained in this Chapter relate to foreign income derived indirectly by a foreign resident via an Australian permanent establishment, these amendments are often referred to as the 'conduit income measures' or 'Element 2' of the IMR.

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

Context of amendments

1.5 Following the Board of Taxation's 2003 International Taxation report, 'conduit foreign income rules' (Division 802-A) were introduced into the income tax law. Under these rules, certain foreign income of a company paid directly, or through one or more other Australian entities, to foreign owners do not attract any additional Australian tax. The rules were designed to provide foreign investors who structure their foreign investments through Australian companies with a more neutral Australian tax outcome on foreign investments when compared to foreign investors who hold their foreign investments directly.

1.6 While the conduit foreign income rules provided relief from additional Australian taxation on conduit income received through an Australian company, the treatment of conduit income received through a managed fund remained uncertain.

1.7 The uncertain treatment of the conduit income of foreign funds was identified in Australia's Future Tax System Review ('the Henry Review') which recommended that the 'taxation arrangements applying to Australian managed funds and related services should be improved to provide greater certainty that conduit income will not be subject to Australian tax' (Recommendation 35).

1.8 Also the Australian Financial Centre Forum (the Forum) - established by the Government in September 2008, as part of its commitment to position Australia as a leading financial services centre - made a number of recommendations in relation to the taxation of foreign funds in Australia, including recommending the implementation of an IMR.

1.9 The Government responded to the Forum's report on 11 May 2010 and announced in-principle support for the introduction of an IMR.

1.10 The Government announced on 19 January 2011 changes to the tax law to ensure that relevant investment income of a foreign fund that is taken to have a permanent establishment in Australia solely because of its use of an Australian adviser, would be exempt from income tax. This announcement addressed the uncertain tax treatment of conduit income of managed funds as recommended by the Henry review.

1.11 Schedule 1 to this Bill introduces amendments to the tax law to give effect to the announcement made in January 2011 - the 'conduit income' measure. Schedule 2 to this Bill gives effect to the December 2010 announcement - the 'FIN 48' measure. Details of this measure are in Chapter 2. Summary of new law

1.12 The amendments introduced by Schedule 1 to the Bill prescribe the tax treatment of income of widely held foreign funds, and are designed to ensure that the complex tax issues that previously arose do not discourage foreign funds from engaging the services of an Australian intermediary. The amendments ensure that foreign funds that use Australian intermediaries are not subject to Australian tax on certain income that, in the absence of an Australian intermediary, would otherwise be foreign source income. This tax treatment will extend to foreign resident beneficiaries or foreign resident partners of foreign funds that receive or are attributed amounts through one or more interposed trusts or partnerships. Australian resident investors will not obtain any concession from this measure and the tax treatment of any income received from a fund by an Australian resident will remain unchanged.

1.13 Where the conditions of the amendments are met, certain types of investment income and gains will be excluded from Australian tax. In addition, losses or outgoings in respect of certain investments will be disregarded.

1.14 These amendments will apply to the 2010-11 and later income years. Comparison of key features of new law and current law

Detailed explanation of new law

Objects of Subdivision 842-I of ITAA 1997

1.15 The objects of the Subdivision are to:

•

ensure that certain income of widely held foreign funds which are not owned by a small group of investors, are not subject to Australian tax solely because the fund engages the services of an Australian based agent, manager or service provider to exercise a general authority to negotiate and conclude contracts on its behalf; and

•

ensure that Australian resident taxpayers continue to pay tax on their world-wide income.

[ Schedule 1, item 1, subsection 842-205(1 )]

1.16 These objectives are achieved by:

•

disregarding, or treating as NANE, certain income;

•

disregarding certain deductions and losses (including capital losses);

•

disregarding certain capital gains;

•

requiring a fund to pass a widely held test; and

•

excluding funds that are controlled by a small number of investors from being eligible for the exemption.

[ Schedule 1, item 1, subsection 842-205(2 )]

IMR foreign fund

1.17 The Subdivision applies to disregard certain amounts of an 'IMR foreign fund' that is a corporate tax entity, a trust or a partnership.

1.18 An entity will be an IMR foreign fund if it:

•

is not a resident of Australia at any time during the income year [ Schedule 1, item 1, subparagraph 842-230(a )( i )];

•

is not a resident trust estate under section 95(2) of the Income Tax Assessment Act 1936 (ITAA 1936) at any time during the income year [ Schedule 1, item 1, subparagraph 842-230(a )( ii )];

•

does not carry on a trading business in Australia, as set out in section 102M of the ITAA 1936 at any time during the income year [ Schedule 1, item 1, paragraph 842-230(b )];

•

is widely held at all times during the income year [ Schedule 1, item 1, subparagraph 842-230(c )( i )]; and

•

does not breach the 'concentration test' at any time during the income year [ Schedule 1, item 1, subparagraph 842-230(c )( ii )].

[ Schedule 1, item 1, section 842-230, and item 7, subsection 995-1(1 )]

Residency

1.19 In order for a fund to be an IMR foreign fund it must not be an Australian resident at any time during the income year. The relevant residency test will depend on the legal structure of the fund. Whatever residency test would ordinarily apply to the fund (for Australian taxation purposes) will apply in determining its residency status for the purposes of these amendments. For many funds the relevant test will be that in section 6 of the ITAA 1936.

1.20 In other cases specific provisions apply. For example if the fund is a corporate limited partnership (which is taxed like a company) section 94T of the ITAA 1936 will be applicable.

Trading business

1.21 The fund must not be carrying on a business in Australia other than an eligible investment business as set out in section 102M of the ITAA 1936. This means the fund can only carry on 'eligible investment business'. Eligible investment business is widely defined and includes:

•

investing in land for the purpose of deriving rent;

•

investing or trading in:

-

secured or unsecured loans;

-

bonds, debentures, stock or other securities;

-

shares in a company;

-

units in a unit trust;

-

futures contracts;

-

forward contracts;

-

currency swap contracts;

-

forward exchange rate contracts;

-

forward interest rate contracts;

-

life assurance policies; and

-

a right or option in respect of such a loan, security, share, unit, contract or policy.

[ Schedule 1, item 1, paragraph 842-230(b )]

1.22 'Eligible investment business' specifically excludes a number of arrangements identified in section 102MA of the ITAA 1936 such as:

•

arrangements that give a right to control the use of, or licence to use:

-

real property

-

goods or a personal chattel; or

-

intellectual property.

1.23 Although a foreign fund can qualify as an IMR foreign fund if is carrying on eligible investment business, the income from such business will not automatically qualify as IMR income or an IMR capital gain. That is, the IMR foreign fund must apply additional tests to determine what income will be excluded from taxable income (see paragraph 1.34 to 1.57). Broadly speaking, income which does not satisfy these tests will not be 'non-IMR' income and may be taxable in Australia depending on the circumstances. Further, the derivation of 'non-IMR' income does not of itself disqualify a fund from being considered an IMR foreign fund.

Widely held

1.24 In order for an entity to be an IMR foreign fund the entity must be widely held [ Schedule 1, item 1, subparagraph 842-230(c )( i ) and section 842-240 ]. Broadly, a fund will be considered to be widely held if its shares or units are listed on an approved stock exchange, it has a minimum number of members or a sufficient proportion of its membership interests are held, directly or indirectly, by specified types of entities.

1.25 An entity - a foreign fund - will be considered widely held for the purposes of this measure if:

•

the fund's units or shares are listed on an approved stock exchange;

•

all of the funds membership interests are held, directly or indirectly, by an entity whose units or shares are listed on an approved stock exchange;

-

an approved stock exchange is a stock exchange that is listed in Schedule 5 of the Income Tax Assessment Regulations 1997 .

•

the fund has at least 25 members;

•

all of the fund's membership interests are held by an entities that has at least 25 members;

-

member of an entity is defined in section 960-130. Broadly, a member of:

:

a company, is a shareholder of the company;

:

a trust, is a beneficiary of the trust, unit holder or object of the trust. For the purposes of the widely held test an object of a trust is ignored;

:

a partnership, is partner in the partnership; or

:

a corporate unit trust or a public trading trust, is a unit holder in the trust.

•

25 per cent or more of the 'total participation interest' (as defined in section 960-180, includes direct and indirect participations interests in the fund) is held by;

-

life insurance companies that are not Australian residents;

-

foreign superannuation funds with at least 50 members; or

-

funds established by exempt foreign government agencies for the principal purposes of funding pensions of foreign citizens or contributors; or

•

it is held by a type of entity specified in the regulations.

[ Schedule 1, item 1, section 842-240 ]

Concentration test

1.26 In addition to satisfying the widely held test (see paragraph 1.25) an entity must not breach the concentration test at any time during the income year. This condition ensures that an entity which is widely held is not controlled by a small group of investors.

1.27 A foreign fund will breach the concentration test if 10 or fewer entities have a total participation interest in the fund of 50 per cent or more. [ Schedule 1, item 1, subsection 842-240(4 )]

1.28 Entities that satisfy the concentration test and foreign widely held entities that satisfy subsection 842-240(3) are not counted when applying the concentration test.

1.29 This recognises that these entities participation interests represent diversified investors rather than the interests of a concentrated group of investors. Consequently, if a foreign widely held entity held 100 per cent of the a foreign fund, that fund would not breach the concentration test as 10 or fewer entities (that are counted) do not have a 50 per cent or greater participation interest in the foreign fund.

Participation interest

1.30 In applying the widely held test it is necessary to identify the total participation interest of each member of a foreign fund. Total participation interest is defined in section 960-180 and includes both direct and indirect participation interests. Broadly, a direct participation interest in another entity is the proportion of ownership or control that one entity has directly in the other entity. An indirect participation interest in another entity is, broadly, the proportion of ownership or control an entity has in another entity through one or more interposed entities.

Wind-down phases

1.31 An entity which is winding down prior to ceasing to exist may not be able to satisfy the requirements of the widely held test or the concentration test solely or largely because of the process of winding down. To ensure that an entity does not fail either of these tests in the year it ceases to exist, the entity will be taken to have satisfied the requirement in subsection 842-230(c) - that is, the entity will be taken to be widely held and not to have breached the concentration test - if it was an IMR fund in the previous year. [ Schedule 1, item 1, section 842-235 ]

1.32 This will ensure that where an entity, which was previously an IMR foreign fund, ceases to exist during an income year the treatment of IMR income, IMR deductions, IMR capital gain and IMR capital losses available under the Subdivision will not be denied simply because of the process of winding down of the entity's activities prior to ceasing to exist.

IMR amounts

1.33 Amounts which are to be disregarded in determining an IMR foreign fund's taxable income, net income, partnership loss or net capital loss include:

•

returns and gains from certain financial arrangements (which in the case of corporate tax entity are treated as NANE income);

•

deductions relating to that income;

•

capital gains and capital losses arising from certain financial instruments; and

•

deductions relating to capital gains which are disregarded.

IMR Income

1.34 For an amount to be treated as IMR income, the amount:

•

must be attributable to a return or gain from a financial arrangement covered by section 842-245; and

•

would otherwise be assessable income only because the income is attributable to a permanent establishment which exists because of the engagement of an Australian resident agent, who habitually exercises a general authority to negotiate and conclude contracts on its behalf.

[ Schedule 1, items 1 and 8, subsection 842-250(1 ) and 995-1(1 )]

1.35 IMR income of a foreign fund which is a corporate tax entity is treated as NANE income. [ Schedule 1, item 1, paragraph 842-210(3 )( a )]

1.36 The IMR income of an IMR foreign fund which is a flow through vehicle is taken into account in determining the fund's non-IMR net income, non-IMR partnership net income, and non-IMR partnership loss. In effect, the IMR income of a flow through vehicle IMR foreign fund is disregarded in calculating:

•

amounts which are included in the assessable income or deductions of a foreign resident beneficiary or foreign resident partner of the fund; or

•

amounts on which a trustee of a fund may be subject to tax.

Financial arrangement

1.37 For an amount to be treated as IMR income, the amount must be attributable to a return or gain from a financial arrangement. However, financial arrangements which give rise to a non-portfolio interest in another entity or control of another entity are excluded and consequently returns or gains from such arrangements are not treated as IMR income. Such financial arrangements are excluded to ensure that the only returns and gains from passive investments are treated as IMR income.

1.38 Financial arrangements which do not give rise to IMR income are:

•

debt interests, equity interests, and financing arrangements which are neither debt or equity, in an entity which the fund has a total participation interest of 10 per cent or more;

•

derivative financial arrangements that relate to:

-

a debt interest, equity interest, or a financing arrangement which is neither debt or equity, in an entity which the fund has a total participation interest of 10 per cent or more; or

-

a capital gains tax (CGT) asset that is taxable Australian real property or an indirect Australian real property interest; or

•

arrangements which allow the fund to:

-

vote at the board of directors;

-

participate in making financial, operating or policy decisions in respect of the operation of the issuer of the financial arrangement; or

-

deal with the assets of the issuer of the financial arrangement other than where the issuer breaches the terms of the financial arrangement.

[ Schedule 1, item 1, section 842-245 ]

1.39 Debt interest is defined in Division 974, and includes bonds, loans, promissory notes, and bills of exchange. Equity interest is defined in section 995-1 and includes equity interests under Subdivision 974C (equity interests in a company) and also an equity interest in a trust or partnership.

1.40 Derivate financial arrangement is defined in subsection 230-350(1). For the purposes of section 842-245, a derivative financial arrangement relates to another financial arrangement or to a CGT asset if the derivative financial arrangements, is or would be a hedging financial arrangement for the purposes of Division 230, or is a deliverable derivative and the fund will either acquire or cease to have the financial arrangement or CGT asset which is the subject of the derivative.

Permanent establishment

1.41 In addition to being attributable to financial arrangements covered by section 842-245 (see paragraphs 1.38 to 1.40), for an amount to be treated as IMR income, the amount must otherwise be assessable income only because the fund has a permanent establishment in Australia and that permanent establishment has arisen because the fund utilises the services of an Australian entity that habitually negotiates and concludes contracts on behalf of the fund. This means that, where the fund has a permanent establishment for other reasons (for example because it has a manufacturing plant in Australia), it will continue to be subject to the normal taxation rules that apply in respect of permanent establishments and the IMR exemption will not apply. These provisions are not intended to provide an exemption where the fund has a 'bricks and mortar' permanent establishment in Australia (that is, where the fund has a presence and is carrying on business in Australia and deriving Australian sourced income). [ Schedule 1, item 1, paragraph 842-250(1 )( b )]

1.42 The intention of the Subdivision is to ensure that a fund does not pay Australian tax on income where, but solely for the use of an Australian entity that exercises a general authority to negotiate and conclude contracts on behalf of a foreign fund creating an Australian permanent establishment, that income would be foreign source income. In other words, the exemption is designed to restore the fund's position as if it had made an investment directly (other than through a 'bricks and mortar' permanent establishment in Australia) and not had any Australian presence.

1.43 Here, the 'entity' includes (but is not limited to) such entities as agents (dependent and independent), brokers, managers, advisors, lawyers and accountants. The term should be read widely and is intended to cover any Australian resident entity that exercises a general authority to negotiate and conclude contracts on behalf of a foreign fund and therefore may result in that fund having a permanent establishment in Australia. [ Schedule 1, item 1, subsection 842-250(1 )]

IMR deduction

1.44 Expenses which relate to earning IMR income or an IMR capital gain are to be excluded from the calculation of an entity's taxable income, tax loss, net income or partnership loss.

1.45 As the IMR income of a IMR foreign fund that is a corporate tax entity is treated as NANE, expenses incurred in deriving that income are not deductible because of the operation of paragraph 8-1(2)(c) of the ITAA 1936.

1.46 However, IMR income of IMR foreign funds that are trusts or partnerships and IMR capital gains of any IMR foreign fund are not NANE income. Rather they are simply disregarded.

1.47 Therefore, amounts incurred in earning IMR income or an IMR capital gain are not included in the taxable income of an IMR foreign fund, IMR deductions are specifically disregarded.

1.48 The IMR deduction for an income year is the total amount of deductions for that income year to the extent that those amounts are attributable to the gaining of the fund's IMR income, IMR capital gain, pre-2012 IMR income and pre-2012 IMR capital gain. [ Schedule 1, item 1, subsection 842-250(2 )]

1.49 The inclusion of amounts attributable to pre-2012 IMR income and pre-2012 capital gains in IMR deduction prevents amounts incurred after the 2010-11 income year that are attributable to income or a gain which was disregarded under Subdivision 842-I of the Income Tax ( Transitional Provisions ) Act 1997 - the FIN 48 measures - from being deductible.

1.50 IMR deductions include amounts deductible under the general deduction provision - section 8-1 - but also amounts which may otherwise be deductible under another provision of the income tax law, but which relate to IMR income.

IMR capital gain

1.51 The IMR capital gain of an IMR foreign fund is the sum of the capital gains in an income year referrable to a permanent establishment in Australia that arises solely as the result of the IMR foreign fund engaging an entity that is a resident of Australia to habitually exercise a general authority to negotiate and conclude contracts on its behalf and the capital gain is made in respect to a CGT asset which is:

•

used in the carrying on of a business through a permanent establishment in Australian other than an asset which is taxable Australia real property or an indirect interest in Australian real property; or

•

is an option or right to acquire to acquire such an asset.

[ Schedule 1, items 1 and 4, subsections 842-255(1 ) and 995-1(1 )]

IMR capital loss

1.52 An entity's IMR capital loss is the sum of the capital losses in an income year to the extent that the fund has a permanent establishment in Australia solely as the result of engaging an entity that is a resident of Australia to habitually exercise a general authority to negotiate and conclude contracts on its behalf and the capital gain is made in respect to a CGT asset which is:

•

used in the carrying on of a business through a permanent establishment in Australian other than an asset which is taxable Australian real property or an indirect interest in Australian real property; or

•

is an option or right to acquire such an asset.

[ Schedule 1, items 1 and 5, subsections 842-255(2 ) and 995-1(1 )]

Other IMR amounts

Non-IMR net income, non-IMR Division 6E net income non-IMR net capital gain of a trust

1.53 A trust's non-IMR net income is the amount of net income, disregarding IMR income (or an amount attributable to IMR income) and IMR deductions for the income year. [ Schedule 1, items 1 and 11, subsections 842-260(1 ) and 995-1(1 )]

1.54 A trust's non-IMR Division 6E net income is amount of net income calculated under Division 6E of the ITAA 1936, Division 6E net income, disregarding IMR income and IMR deductions and the things mentioned in subparagraphs 102UW(b)(i) to (iii) of the ITAA 1936 in relation to the income year. [ Schedule 1, items 1 and 9, subsections 842-260(2 ) and 995-1(1 )]

1.55 A trust's non-IMR net capital gain is the amount of net capital gain, disregarding any IMR capital gain (or an amount referable to an IMR capital gain) and IMR capital loss in relation to the income year. [ Schedule 1, items 1 and 10, subsections 842-260(3 ) and 995-1(1 )]

Non-IMR partnership net income and non-IMR partnership loss

1.56 Non-IMR partnership net income or non-IMR partnership loss is broadly the net income or partnership loss of the partnership, disregarding IMR income of the partnership (or an amount attributable to IMR income) and IMR deductions of the partnership for the income year. [ Schedule 1, items 1, 12 and 13, section 842-265 and subsection 995-1(1 )]

Application of the Subdivision to taxable entities and flow through entities

1.57 The Subdivision applies to foreign funds that are either 'taxable entities' (such as companies and corporate limited partnerships) and 'transparent' or 'flow-through entities' (such as partnerships and trusts). The structure of the foreign fund will dictate the level at which the measures apply to exclude IMR amounts. Where a fund is a taxable entity, the exclusion will occur at the fund level. Where a fund is a flow through entity, the exclusion will occur at the trustee level as well as the foreign resident beneficiary level or at the foreign resident partner level in the case of a partnership.

1.58 This approach is designed to ensure that an Australia member in a foreign fund which is a flow through entity, does not access the exclusion which may be available to foreign resident members of the fund.

IMR foreign funds that are taxable entities

1.59 Where the IMR foreign fund is a corporate tax entity under section 960-115, the IMR income of the fund is treated as NANE and any IMR deduction, IMR capital gain and IMR capital loss are disregarded in calculating the fund's taxable income, tax loss or net capital loss. [ Schedule 1, item 1, subsection 842-210(3 )]

1.60 Where in an income year, IMR deductions exceed IMR income or IMR capital losses exceed IMR capital gains, a loss cannot be carried forward to future income years and net capital losses are not available to the extent that the loss is attributed to IMR amounts. [ Schedule 1, item 1, subsection 842-210(4 )]

1.61 As the Subdivision does not apply to any distributions (including capital distributions) received from a company or a corporate limited partnership, the tax treatment of such distributions remains unchanged by the amendments.

Example 1.1

FMF1, a foreign resident company, is an IMR foreign fund for the purposes of Subdivision 842-I. FMF1 engages an Australian manager to manage a portfolio of Japanese bonds on its behalf giving rise to a permanent establishment in Australia. FMF1 also conducts non-intermediated trades, that is, it purchases and sells financial assets directly in Australia. For the 2012-13 income year, FMF1 has the following income and expenses:

Income	$	$
Interest income from bonds issued by a Japanese company	200,000
Gains on the sale of bonds issued by the Japanese company	150,000
Unfranked dividends paid by a company listed on ASX	30,000
Rental income from Australian commercial property	55,000
Gain on sale of Australian shares (not land rich)	32,000
Total Income		467,000
Expenses
Rental property expenses	12,000
Management and advisory fees (paid to Australian advisers and managers in relation to Japanese bonds)	38,000
Loss on sale of Australian commercial property	25,000
Total expenses		75,000
Net Profit		392,000

The gain on the sale of the Japanese bonds is considered to be on revenue account while the gain on the sale of the Australian shares and the loss on the Australian commercial property are considered to be on capital account.

The taxable income or tax loss and the net capital loss of FMF1 will be calculated under the existing provisions of the income tax law but taking account of the modifications introduced by new Subdivision 842-I. Broadly, this means that income, deductions, and capital gains and capital losses that relate to certain financial arrangements are not included in the calculation of the funds taxable income or tax loss and net capital loss. More specifically, as FMF1 is a corporate tax entity it means that it will:

•

treat IMR income as NANE; and

•

disregard IMR deductions, IMR capital gains; and IMR capital losses.

Income tax treatment of FMF1's income and expenses $ 200,000 interest income and $ 150,000 gain from the sale of the Japanese bonds

As both the interest, and the gain on sale:

•

relate to financial arrangements which are subject to Subdivision 842-I; and

•

would have otherwise been (that is without Subdivision 842-I) assessable income, but only because of the engagement of the Australian manager which has given rise to a permanent establishment in Australia;

both amounts are IMR income and are treated as NANE income. If the IMR fund was a trust, the amounts would be disregarded.

$ 32,000 gain on sale of Australian shares

The $32,000 gain on the Australian shares is disregarded under Division 855, therefore Subdivision 842-I has no application.

Unfranked dividends of $ 30,000 and rental income of $ 55,000

The rental income is Australian source income and would be assessable income irrespective of whether FMF1 had a permanent establishment. Therefore the amount does not constitute IMR income and is unaffected by Subdivision 842-I.

The unfranked dividends are subject to withholding tax and are not assessable income. Therefore the amount does not constitute IMR income and is unaffected by Subdivision 842-I.

Management and advisory fees of $ 38,000

The management and advisory fees relate to the Japanese bonds, the income from which is IMR income and is NANE under Subdivision 842-I. As a result of subsection 8-1(2), the $38,000 is not deductible as it is incurred in deriving NANE income.

If the IMR fund was not a corporate tax entity, the income from the Japanese bonds would be disregarded rather than be NANE income. Therefore the management fees of $38,000 would not be denied under subsection 8-1(2) and would be considered an IMR deduction and therefore disregarded.

Rental property expenses of $ 12,000

The rental property expenses relate to the rental property income of $55,000 which is unaffected by the provisions of Subdivision 842-I and is neither IMR income nor IMR capital gain. Therefore the expenses are also unaffected by the Subdivision and will be deductible under section 8-1.

Loss on the sale of Australian commercial property of $ 25,000

As the loss arises from the disposal of taxable Australian property, it is not affected by Subdivision 842-I.

Table 1.2 FMF1's taxable income and net capital loss are:

Assessable Income	$
Rental income from Australian commercial property	55,000
Deductions
Rental property expenses	12,000
Taxable income	43,000
Net capital loss (to be carried forward)	25,000

IMR foreign funds that are flow though entities

1.62 Where the IMR foreign fund is not a taxable entity but a 'flow through' entity, in particular a partnership or a trust, the IMR income and any IMR deduction, IMR capital gain and IMR capital loss are disregarded in calculating:

•

a foreign resident beneficiary's or foreign resident partner's taxable income, tax loss or net capital loss [ Schedule 1, item 1, sections 842-215 and 842-220 ]; or

•

the amount on which a trustee may be assessable [ Schedule 1, item 1, section 842-225 ].

Foreign resident beneficiary that is not a trust or partnership

1.63 Section 842-215 sets out rules for calculating taxable income of an entity that is the foreign resident beneficiary of an IMR fund, where the fund is a trust and the foreign resident beneficiary is a taxable entity. The purpose of the section is to ensure the alignment of the IMR with rules pertaining to the calculation of amounts for trusts.

1.64 Where a foreign resident beneficiary of an IMR foreign fund is a taxable entity, for the purposes of calculating its taxable income or tax loss any income attributable to an IMR amount is to be disregarded and no Australian tax consequences in respect of these amounts. [ Schedule 1, item 1, section 842-215 ]

1.65 A foreign resident beneficiary of an IMR foreign fund that is a taxable entity will still be liable to pay tax its non-IMR related income and capital gains, in line with the ordinary tax treatment of those amounts. [ Schedule 1, item 1, subsections 842-215(3 ) and ( 4 )]

1.66 This measure is also intended to apply when there are interposed flow through entities, including both partnerships and trusts, between the IMR foreign fund and a beneficiary that is not a flow through entity - which would normally be a natural person or a corporate tax entity.

Example 1.2

Using the scenario in Example 1.1 assume FMF1 is a foreign resident trust, that is an IMR foreign fund for the purposes of Subdivision 842-I. Foreign beneficiary 1 (FB1) is a taxable entity and has a 5 per cent interest in FMF1.

Diagram 1.1

Section 842-215 applies to FB1 as it is a foreign resident and a beneficiary of a trust (FMF1) as stipulated in subsection 842-215(2). To calculate FB1's Australian tax liability, subsections 842-215(3) and (4) must be applied.

First, FB1 needs to calculate FMF1's non-IMR net income, non-IMR Division 6E net income and non-IMR net capital loss. As reflected in Example 1.1, FMF1 has a non-IMR net income of $43,000 and a non-IMR net capital loss of $25,000.

As FB1 is a foreign resident, the trustee of FMF1 will be liable to be assessed under section 98 of the ITAA 1936. Section 842-225 will make the trustee liable to pay tax only in relation to FB1's share of the non-IMR net income of the trust. As FB1 has a 5 per cent interest in FMF1, the trustee will be liable to pay tax on an amount of $2,150.

FB1 will also include in its assessable income under subsection 98A(1) of the ITAA 1936 its share of FMF1's non-IMR related activities. FB1's assessable income will therefore include $2,150 being its individual interest in the non-IMR net income of the trust. To prevent double tax, FB1 may deduct under subsection 98A(2) of the ITAA 1936 the tax paid by the trustee on the share of the non-IMR net income from the tax assessed against itself.

Foreign resident partner that is not a trust or partnership

1.67 Section 842-220 sets out rules for calculating taxable income of an entity that is the foreign resident partner of an IMR fund, where the foreign resident partner is a taxable entity. The purpose of the section is to ensure the alignment of the IMR with rules pertaining to the calculation of amounts for partnerships.

1.68 Where a foreign resident partner of an IMR foreign fund is a taxable entity, for the purposes of calculating its taxable income, net loss or net capital loss, any income attributable to an IMR amount is to be disregarded and no Australian tax consequences in respect of these amounts. [ Schedule 1, item 1, section 842-220 ]

1.69 A foreign resident partner of an IMR foreign fund that is a partnership, will still be liable to pay tax on its non-IMR related income and capital gains, in line with the ordinary tax treatment of those amounts.

1.70 This provision is also intended to apply when there are interposed entities, between the IMR foreign fund and the partner.

Example 1.3

Using the scenario in Example 1.1 assume FMF1 is a foreign partnership that is an IMR foreign fund for the purposes of Subdivision 842-I. Foreign Partner 1 (FP1) has a 5 per cent interest in FMF1.

Section 842-220 applies to FP1 as it is a foreign resident and a partner of an IMR fund (FMF1) as stipulated subsection 842-220(2). To calculate FP1's Australian tax liability, the adjustments in subsection 842-220(3) must be applied.

In working out FP1's tax liability, FP1 needs to calculate FMF1's non-IMR partnership net income or non-IMR partnership loss. As reflected in Example 1.1, FMF1 has a non-IMR partnership net income of $43,000.

In applying paragraph 842-220(3), the $32,000 gain on sale of Australian shares will be disregarded in calculating FP1's capital gain or loss as it is an amount referable to an IMR capital gain.

As FP1 is liable for tax under Division 5 of Part III of the ITAA 1936, subsection 842-220(3) will make FB1 liable for tax on its share of FMF1's non-IMR related activities. As FP1 has a 5 per cent interest in FMF1, FP1's assessable income will include $2,150 for the income year, and FB1 will have a capital loss $1,250 which it can use against capital gains or carry forward (which is 5 per cent of the loss on the sale of Australian commercial property of $25,000 - as the loss arises from the disposal of taxable Australian property, it is not affected by Subdivision 824-I).

Treatment of trustee of an IMR foreign fund

1.71 Section 842-225 sets out rules for calculating the taxable income of the trustee of an IMR fund. The purpose of the section is to ensure the alignment of the IMR with rules pertaining to the calculation of amounts for trustees.

1.72 For the purposes of calculating the taxable income of a trustee of an IMR foreign fund, any tax loss or net capital loss, any income attributable to an IMR amount is to be disregarded and no Australian tax payable. [ Schedule 1, item 1, section 842-225 ]

1.73 A trustee of an IMR foreign fund will still be liable to pay tax on non-IMR related income and capital gains, in line with the ordinary tax treatment of those amounts.

Application and transitional provisions

1.74 The main provisions of Subdivision 842-I will apply to assessments for the 2010-11 income year and later income years.

1.75 Some of the provisions contained in this Subdivision will have effect where a business profits article contained Australia's agreements (within the meaning of the International Tax Agreements Act 1953 ) apply. Such agreements and the business profits articles themselves are defined in Subdivision 815-A, which was introduced into the Parliament under the Tax Law Amendment (Cross-Border Transfer Pricing) Bill (No. 1) 2012. Given that that Bill has not yet received Royal Assent, this Subdivision includes stand-alone provisions which provide a definition for business profits article that may be used in the event that Subdivision 842-I is enacted before Subdivision 815-A.

1.76 In the event that Subdivision 815-A and Subdivision 842-I are both enacted, additional provisions are included in this Bill which will repeal the business profits article definition contained in this Subdivision, and will instead implement those contained in Subdivision 815-A. In addition, because Subdivision 815-A also includes a definition for 'international tax agreement', this Subdivision will also utilise that definition once it is enacted. The provisions giving effect to these specific amendments will only apply in the event that both this Bill and the Tax Law Amendment (Cross-Border Transfer Pricing) Bill (No. 1) 2012 are enacted, with the later of the day of Royal Assent for each Bill being the relevant day from which they will apply. [ Schedule 1, items 2 and 17 ]

Consequential amendments

1.77 The definition of 'business profits article' is repealed from item 9 of Schedule 1 of the Tax Laws Amendment ( Cross Border Transfer Pricing ) Act ( No. 1 ) 2012 subsections 995-1(1) and replaced with a new definition. [ Schedule 1, items 3 and 16 ]