House of Representatives

Taxation Laws Amendment Bill (No. 2) 1992

Taxation Laws Amendment Act (No. 2) 1992

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon John Dawkins, M.P.)

Chapter 5 Taxation of Foreign Source Income - Amendments

Clauses: 6,19,20,21,54,55,56,57

Overview

Amends several provisions relating to the taxation of foreign source income.

Taxation of Foreign Source Income - Amendments

Introduction

This Bill proposes several amendments to the provisions relating to the taxation of foreign source income. They are to:

·
correct anomalies in the calculation of a resident company's share of the net income of a partnership or trust where that net income includes foreign branch income.
·
exclude from tainted sales income of a controlled foreign company (CFC) proceeds from the sales of goods purchased from or sold to related parties by the CFC where the goods sold were manufactured, produced or substantially altered by the directors or employees of the CFC, and removes the requirement that the CFC substantially enhance the market value of the goods sold by it before the proceeds of those sales may be excluded from tainted sales income.
·
ensure that an election made by a CFC for capital gains tax roll-over relief for an asset disposal is binding when calculating the amount of a capital gain arising on a subsequent disposal of that asset.
·
provide wider capital gains tax roll-over relief for an asset disposal when determining whether a CFC passes the active income test.
·
eliminate unintended double taxation on a taxpayer in respect of certain types of dividends derived by a CFC.
·
reduce the income of a controlled foreign company that is attributed to resident taxpayers by dividends paid by the company to another company on certain transitional finance shares.
·
correct an inappropriate exemption provided to a life assurance company in relation to life assurance policies issued to non-residents who are not associates of the company.

They relate mainly to the provisions of the Act that deal with the accruals tax system introduced with general effect from the 1990-91 income year.

A detailed explanation of each of the amendments together with an overview of the Taxation of Foreign Source Income is contained in the Appendix to this Chapter.

Appendix to Taxation of Foreign Source Income

Taxation of Foreign Source Income : Overview of the Existing Law

Brief outline of the basic concepts in the taxation of Foreign Source Income.

The accruals tax system - controlled foreign companies

If Australian residents have specified interests in a non-resident company, then the accruals tax system may include certain income and gains derived by that company in the residents' assessable income. A non-resident company that is subject to these measures is called a controlled foreign company (CFC).

Attributable income

The income and gains of a CFC that may be included in the assessable income of resident taxpayers is called attributable income. That income is calculated, subject to some modifications, as if the CFC were a resident of Australia.

The active income test

The CFC's income will generally not be included in the assessable income of resident taxpayers if the CFC is predominantly engaged in active business operations. An active income test determines whether a CFC is to be treated as predominantly engaged in active business operations.

A CFC fails that test if, in broad terms, 5 per cent or more of the gross turnover of the CFC consists of tainted income. Tainted income includes passive income and income from certain related party transactions.

Listed and unlisted country CFCs

A listed country is a country that is treated as having a tax system that is generally comparable to Australia's. A list of these countries is contained in the Income Tax Regulations. An unlisted country is a country that is not listed in the Regulations.

Attributable income of a listed country CFC

The attributable income of a CFC that is a resident of a listed country will include :

·
certain tainted income that is taxed at concessional rates in the listed country. This type of income, called designated concession income, will be included in attributable income only if the CFC fails the active income test. A list of the income that is treated as taxed at concessional rates is contained in the Income Tax Regulations;
·
income from an unlisted country that is not taxed in the listed country; and
·
certain low taxed income that is derived, or treated as derived, from trusts.

Attributable income of an unlisted country CFC

5.1. The attributable income of a CFC that is a resident of an unlisted country includes :

·
certain tainted income, if the CFC fails the active income test; and
·
certain income that is derived, or treated as derived, from trusts.

Dividends paid by a CFC

The accruals tax measures will also include in the assessable income of a resident taxpayer amounts of dividends paid by an unlisted country CFC to a:

·
listed country CFC; or
·
controlled foreign trust (CFT).

The amount that is included in the assessable income of a resident taxpayer is the proportion that relates to the taxpayer's interest in the CFC or CFT that receives the dividend.

Definitions of Key Terms in the Taxation of Foreign Source Income

Certain terms that are used in this chapter are explained below.

'An associate'

In broad terms, an associate is any related party.

'An associate with an Australian connection'

This terms refers to an associate who is either:

·
a Part X Australian resident; or
·
or a non-resident who carries on business in Australia through a permanent establishment.

'CGT roll-over provisions'

In broad terms, this expression is defined to mean the roll-over relief measures contained in the capital gains provisions of the Act.

'Controlled foreign company' (CFC)

A controlled foreign company is, in broad terms, a non-resident company in which resident individuals, partnerships, companies or trusts hold specified interests. The meaning of the term controlled foreign company is set out in section 340 of the Act.

'Controlled foreign trust'

A controlled foreign trust is a non-resident trust in which resident individuals, partnerships, companies or trusts hold specified interests. The term includes a non-resident trust to which a resident person has transferred property or services in certain circumstances. The meaning of the term controlled foreign trust is set out in section 342 of the Act.

'Designated concession income'

This expression is discussed above under the heading 'Attributable income of a listed country CFC'.

'Eligible designated concession income'

Broadly, this expression is defined to mean income or profits which are designated concession income in relation to a particular listed country which are not subject to tax in another listed country.

'Non-portfolio dividends'

'Non-portfolio dividends' are dividends paid to a company with at least a 10% voting interest in the company paying the dividend.

'Part X Australian resident'

A Part X Australian resident is a resident of Australia other than one who is treated solely as a resident of a treaty partner country under a double taxation agreement between Australia and that country.

'Passive income'

In broad terms, passive income includes items of income such as:

·
interest;
·
annuities;
·
royalties;
·
receipts from the assignment of intellectual property; and
·
capital gains on the disposal of certain assets.

The term passive income is defined in section 446 of the Act.

'Statutory accounting period'

A statutory accounting period of a CFC is a period of 12 months, ending on 30 June unless the CFC has elected a 12 month period ending on another day (section 319).

'Tainted income'

Tainted income of a CFC is, broadly, income that is prone to tax minimisation. It includes passive income and income from related party transactions.

'Tainted sales income'

In broad terms, tainted sales income of a CFC is its income from transactions (concerning the sales of goods) with associates who also have an Australian connection. It forms part of the tainted income of a CFC which is used in the formulae applying the active income test to the CFC. The term tainted sales income is defined in section 447 of the Act.

Exemption of Foreign Branch Profits of Australian Companies

Summary of the proposed amendments

The proposed amendments will provide that a resident company's share of the net income of a partnership or trust is to be calculated on the basis that the foreign branch profits of the partnership or trust, which would have been exempt from tax under section 23AH if those profits had been derived directly by the company, are exempt income of the partnership or trust.

Background to the legislation

The profits derived by an Australian company from a business carried on through a branch in a listed country (i.e., a comparably taxing country) are exempt from Australian tax to the extent that those profits:

·
have been subject to tax in a listed country; and
·
are not eligible designated concession income (section 23AH).

This exemption also extends to a resident company's share of the net income of a partnership or trust to the extent that it is comprised of foreign branch profits including where that income has passed through a number of interposed partnerships or trusts.

Presently, in calculating its net income, an interposed partnership or trust has to include foreign branch profits in its assessable income and can claim expenses incurred in deriving those profits. This is so even though a resident company partner or beneficiary, as the actual taxpayer, can exclude so much of its share of the partnership's or trust's net income which relates to those foreign branch profits. This treatment results in certain anomalies which may operate to the detriment of either the revenue or the taxpayer.

The revenue may be disadvantaged in instances where a partnership or trust has incurred an overall loss in respect of its listed country foreign branch. This is because, in calculating its net income, the partnership or trust can deduct an income loss from its other foreign income of the same class or a capital loss from a capital gain. That is, the partnership or trust is able to claim a deduction against its other foreign profits for losses incurred in deriving listed country branch profits even if it has a resident company as a partner or beneficiary. The reduction of the net income of the partnership or trust has the effect that the assessable portion of the company partner's or beneficiary's share of that income is also reduced.

A taxpayer may be disadvantaged in instances where a partnership or trust has derived listed country branch profits. This is because, in calculating its net income, the partnership or trust must deduct from those profits any losses incurred in relation to its other foreign income of the same class or, in the case of a capital gain, capital losses. Hence, the partnership or trust is forced to offset its losses against profits which would have been exempt it they were received by a resident company partner or beneficiary. Consequently, the partnership or trust cannot carry forward those losses to be offset against income derived in future years.

The same issues arise in relation to the manner in which foreign branch capital losses incurred by a trust are treated. It is intended that a company beneficiary should not obtain the benefit of a capital loss incurred by a trust where, had a capital profit been made instead, no Australian tax would have been payable by the company on the profit. However, a trust is presently able to deduct that loss from other capital profits derived by the trust.

Explanation of the proposed amendments

The amendment will apply where a resident company is a partner of a partnership or the beneficiary of a trust that derives comparably taxed listed country branch income. The amendment will also apply where a series of partnerships or trusts are interposed between the resident company and the partnership or trust that derives the comparably taxed listed country branch income (paragraphs 23AH(3)(a) and (b)).

The Bill makes two basic assumptions to identify the cases to which the amendments apply (paragraph 23AH(3)(c)). These are that:

·
comparably taxed listed country branch profits were the only income of the trust or partnership which derived those profits and that the profits are not exempt from tax; and
·
there are no allowable deductions from that income.

If, in these circumstances, an amount of the net income of the partnership or trust would be included in a resident company's assessable income, the amendment will treat the comparably taxed listed country branch income as exempt income of the partnership or trust (paragraphs 23AH(3)(c) and (d)). Because the income is exempt, the partnership or trust cannot claim a deduction for expenses incurred in deriving that income or carry forward a loss in that regard (paragraphs 23AH(3)(d) and (e)). This treatment of the income of the partnership or trust will be solely for the purpose of determining the share of the net income of a resident company that is a partner or beneficiary of that partnership or trust.

The amendment will apply where an amount of the partnership or trust income would, on the basis of the assumptions stated above, be included in the assessable income of a resident company partner or beneficiary under certain specified provisions of the tax law. These are:

(i)
subsection 92(1) - this subsection sets out the amounts to be included in the assessable income of a partner of a partnership;
(ii)
section 97 - this section sets out the amounts to included in the assessable income of a beneficiary of a trust who is not under a legal disability;
(iii)
section 98A - this section prescribes the amounts to be included in the assessable income of a non-resident beneficiary of a trust. (This section may be relevant in instances where an Australian resident company changes residence); and
(iv)
section 100 - this section sets out the amounts to be included in the assessable income of a beneficiary of a trust who is under a legal disability or is considered to have a vested and indefeasible interest in any income of a trust estate but is not presently entitled to that income.

Example A partnership has derived comparably taxed income of $15,000 from a branch in a listed country. It has deductions amounting to $30,000 in respect of that income. The partnership has also derived $5,000 income (of the same class of foreign income) through a branch in an unlisted country. A resident company is a partner of that partnership.In determining the resident company's share of the net income of the partnership, the assessable income of the partnership would not include the $15,000 branch income and no deduction would be available for the $30,000 expenses relating to that income. That is, in determining the company partner's share of the net income of the partnership, that net income would be $5,000 (the income from the PE in the unlisted country).Provisions corresponding to those relating to the taxation treatment of comparably taxed listed country branch profits will also be inserted to deal with a capital gain made or a capital loss incurred by a listed country branch of a trust of which a resident company is a beneficiary (subsections 23AH(9) and (9A)). These provisions also extend to cases where a series of partnerships or trusts are interposed between the trust that derives the capital gain or incurs the capital loss and the resident company concerned.The amendment will also ensure that a company beneficiary does not obtain the benefit of a capital loss incurred by a trust where, had a capital profit been made instead, no Australian tax would have been payable. It will also extend this treatment to instances where trusts or partnerships are interposed between the beneficiary and the relevant trust (subsection 23AH(9A)).

Commencement date

These amendments will apply from the 1992-93 year of income.

Clauses involved in the proposed amendments

Clause 6 will replace former subsections 23AH(3), 23AH(9) and 23AH(9A) with corresponding provisions that will ensure that a resident company's share of the net income of a partnership or trust is to be calculated on the basis that the foreign branch profits of the partnership or trust, which would have been exempt from tax under section 23AH if those profits had been derived directly by the company, are exempt income of the partnership or trust.

Subclause 65(3) provides that the amendments will apply from the 1992-93 year of income.

Tainted Sales Income

Summary of the proposed amendments

The amendment will exclude from tainted sales income of a CFC amounts received from the sales of goods purchased by the CFC from related parties, or sold by the CFC to related parties only where the goods sold were manufactured, produced or substantially altered by the directors or employees of the CFC.

The amendment will also have the effect that, for amounts received from the sale of goods to be excluded from tainted sales income, it will no longer be necessary that the activities of the CFC should substantially enhance the market value of the goods.

Background to the legislation

The current legislation

In broad terms, tainted sales income of a CFC is its income from transactions with related parties who also have an Australian connection. It includes:

·
proceeds of sales made by the CFC where the CFC purchased goods from related parties and sold those goods without having made any substantial alterations to the goods; and
·
proceeds of sales made by the CFC to related parties.

In either case, the related party must be:

·
an associate who is a resident; or
·
a non-resident associate who carries on business through a permanent establishment (PE) in Australia. [Subsection 447(1)].

Tainted sales income could arise only where the CFC has purchased:

·
the goods sold; or
·
material that was incorporated in the goods sold. [Subsection 447(1)]

The concept of tainted sales income has an important place in the foreign source income measures. Tainted sales income forms part of the tainted income of a CFC which is used in the formulae applying the active income test to the CFC. A CFC that fails the active income test will have its tainted income attributed to resident shareholders who hold interests in the CFC.

Tainted sales income does not include proceeds of sales made by the CFC where it substantially altered the goods that were sold with the result that the market value of those goods were substantially enhanced (exclusion). This exclusion was provided to taxpayers to facilitate the competitiveness of Australian controlled businesses operating in foreign jurisdictions.

Agency and subcontracting arrangements

It has been argued that, under the current legislation a CFC could subcontract its business activities, or conduct them through agents, and claim the benefit of the exclusion where the CFC was not engaged through its directors or employees in carrying on an active trade or business operation in the foreign country.

Value added change to goods

The current law requires that to qualify for the exclusion, the goods produced by the genuine business activities of the CFC undergo a value added change through the substantial enhancement of the market value of the goods . This restriction makes the availability of the exclusion dependent on market forces that are beyond the control of the taxpayer.

Explanation of the proposed amendments

The proposed amendments will provide that the benefit of the exclusion from tainted sales income will be available only where a CFC's active conduct of a trade or a business is carried out substantially by its directors and employees.

Tainted sales income will include the proceeds from the sale of goods where:

·
the goods were sold by the CFC to an associate with an Australian connection; or
·
the goods were purchased by the CFC from an associate with an Australian connection; or
·
a component from which the goods were made by the CFC, was purchased by the CFC from an associate with an Australian connection.

The income from these sales may be excluded from tainted sales income only by a specific exclusion provided in the legislation. [Proposed subsections 447(4), (4A) and (4B)] .

Before the exclusion from tainted sales is available to a CFC, the CFC must fulfil two requirements. The CFC must:

·
alter the goods substantially or, manufacture or produce a new article with a different identity from the goods it purchased (first tier of tests) ; and
·
perform a substantial part of these activities through its directors and employees (second and third tier of tests) .

First tier of the tests for exclusion from tainted sales income

The first tier of the tests is intended to ensure that only genuine business activities occurring through the active conduct of a trade or business by the CFC in the foreign country will obtain the benefit of the exclusion. The first tier of the tests examine whether a genuine business activity has been conducted through either substantial alteration, manufacture or production of goods by the CFC.

Where a new and commercially distinct article has not been brought into existence by the genuine business activities of the CFC, the goods must be substantially altered if they are to obtain the benefit of the exclusion. The words 'substantial' and 'substantially' take their meaning from their context. In every instance in section 447, the use of either of those words means 'large or weighty' or 'considerable, solid or big' ( Palser v Grinling [1948] AC 291 at page 317).

The words 'substantial' and 'substantially' import a notion of relativity. Before a conclusion whether the activities carried out by the CFC's directors and employees should be regarded as substantial, they need to be compared in relation to all of the activities required to bring about the altered state or new identity of the goods.

The test to determine whether or not an article is manufactured was adopted by the High Court per Dixon J. in FC of T v Jack Zinader Pty Ltd (1949) 78 CLR 336 at page 343 and was formulated by Darling J. in McNicol v Pinch (1906) 2 KB 352 at page 352 where his Lordship said:

The essence of making or manufacturing is that what is made shall be a different thing from that out of which it is made.

This test was applied in FC of T v Jax Tyres Pty Limited 85 ATC 4001.

Manufacture brings into existence a commercially distinct article with a new identity. A manufacturing process changes the identity of the goods eg cocoa made into chocolate bars brings into existence goods with a new and different identity.

Manufacture or production does not include packaging or labelling of purchased goods. Repair and maintenance will also not constitute manufacture or production.

A van that has gone through a conversion to a mobile campervan still retains the identity of a van but has new attributes. It is only where the new attributes are of such a degree ie large, weighty, considerable, solid or big that the exclusion from tainted sales income of 'substantial alteration' would be available.

Diagram of First Tier of Test

Diagram of First Tier of Test

Second tier of the tests

The second tier of the tests allows a CFC to subcontract or carry out through agents a part of its activities provided the directors or employees conduct a substantial part of its operations relating to the goods . For example, a small part of a manufacturing process may be subcontracted.

The second tier recognises commercial reality that some active businesses find it convenient to subcontract small segments of their genuine business activities that go to manufacturing, producing or substantially altering goods. The activities that the CFC conducts must in comparison be large, weighty, considerable, solid or big, in respect to the overall activities required to bring the new goods into existence or to substantially alter the purchased goods.

Third tier of the production test

The 'substantial production' exclusion from tainted sales income is the only test that has a third tier proposed subsection 447(4B). This tier operates where goods have been produced by the CFC and then used by the CFC in the manufacture of an article with a new identity. The third tier requires that the CFC carry out through its directors and employees:

·
a substantial part of the production; and
·
a substantial part of the manufacture of the item produced by the CFC.

Removal of value added change to goods

The amendments will remove the requirement that the activities of the CFC should substantially increase the market value of the goods. This amendment will focus the first tier of the tests on the physical change of the goods ultimately sold by the CFC. [Proposed subsection 447(4C)]

Commencement date

Proposed paragraphs 447(1)(c) and (d) and proposed subsections 447(4), (4A), (4B), (4C) and (6) will apply to a CFC with effect from the statutory accounting period of that CFC commencing after [introduction date]

Clauses involved in the proposed amendments

Clause 63: amends section 447 of the Act by omitting subsection 447(4) and inserting proposed paragraphs 447(1)(c) and (d), and proposed subsections 447(4), (4A), (4B),(4C) and (6).

Clause 68 *: provides that the amendments will operate from the start of a CFC's statutory accounting period which commences after [date of introduction].

Active Income Test - CGT Roll-Over Relief

Summary of the proposed amendments

The proposed amendment relates to the foreign source income (FSI) measurers in Part X of the Income Tax Assessment Act 1936 (the "Act').

The amendment will:

·
extend the capital gains tax (CGT) roll-over relief which is available when determining whether a controlled foreign company (CFC) passes the active income test so that the relief available is analogous to that available for the purposes of calculating its attributable income; and
·
ensure that an election made for CGT roll-over relief in relation to the disposal of an asset when determining whether a CFC passes the active income test will be binding when calculating the capital gain on a subsequent disposal of that asset.

Background to the legislation

Section 438 of the Act modifies the calculation of gross turnover and passive income derived from the disposal of an asset where a CFC applies for CGT roll-over relief. The relevant roll-over provision is to apply to both the active income test and the calculation of attributable income of the CFC. The gain on the disposal of the asset is excluded from the gross turnover and passive income when applying the active income test. It is also excluded in calculating the attributable income of the CFC.

Subsection 438(2) sets out the modifications to be made where an application is made for CGT roll-over relief. Under the current law, an election for roll-over relief when calculating turnover for the active income test can be made only for disposals of an asset that involve two entities (paragraphs 438(2)(a) and (b)). Thus, roll-over is not available where the disposal of an asset does not involve two entities, e.g., where there is an involuntary disposal of an asset or an asset is lost, damaged or destroyed.

Explanation of the proposed amendments

The proposed amendments will modify two areas of Part X of the Act. The first area relates to section 438 which provides CGT roll-over relief for asset disposals by a CFC when determining whether it passes the active income test. The second relates to section 421 which currently provides for the making of an election by a CFC under the CGT roll-over provisions when calculating its attributable income.

Extension of roll-over relief

In broad terms, existing subsection 438(2) only provides CGT roll-over relief for disposals of an asset that involves two entities.

The amendment will extend that relief to cover asset disposals by a CFC that do not involve two entities (see proposed subsection 438(2A)* in Clause 62 ). If a CFC elects to apply the roll-over provisions to the disposal of a particular asset for the purposes of the active income test, then proposed section 438(2A) will:

·
determine the acquisition cost of any replacement asset (see paragraph 438(2A)(e)),
·
provide that the CFC has not derived any gain or loss in respect of the disposal of the asset (see paragraph 438(2A)(d)).

In situations where a doubt could arise whether an asset has been disposed of by another person, e.g., where there is a redemption or cancellation of shares or units in a unit trust, new subsection 438(2B) in Clause 62 will provide that such cancellations or redemptions do not constitute disposals to another person.

Elections

The CGT roll-over provisions, under which elections can be made, are relevant for the provisions relating to:

·
the active income test; and
·
the calculation of attributable income.

Section 421 outlines how elections are to be made under the CGT roll-over provisions which are relevant for attributable income calculations. These amendments will now provide an equivalent provision in section 438 relating to the making of elections that are relevant to the application of the CGT roll-over provisions for active income test purposes (see new subsection 438(3A) in Clause 62 ).

New subsection 438(3A) has been accorded priority over the existing election provisions contained in section 421. In other words, an election made for the purposes of subsection 438(3A) will also have effect for the purposes of section 421. Section 421 has been amended to provide for this outcome. [Clause 61]

Commencement date

The amendments relating to the extension of roll-over relief made by section 438(2A) will enable taxpayers to benefit from the amendment from the time the accruals tax measures took effect. The accruals tax measures commenced generally from the 1990-91 income year.

The amendments relating to elections made by subsections 438(3A) and subsections 421(2) and (3) take effect from the date of introduction of the Bill into Parliament.

Clauses involved in the proposed amendments

Clause 62: inserts new subsections 438(2A) and (2B) into Part X of the Act to extend the CGT roll-over relief provisions in the active income test to cater for disposals that do not involve two entities.

Clause 62: provides that the amendment made by Clause 61 * in relation to subsections 438(2A) and (2b) will operate from the time the accruals tax measures took effect. The accruals tax measures commenced generally from the 1990-91 income year. The amendment will operate to the taxpayer's advantage.

Clause 61 and 68: inserts new subsections 421(2) and (3), and subsection 438(3A) into Part X of the Act to ensure that a CGT roll-over election made by a CFC on the disposal of an asset, which is relevant for the active income test, will be binding when calculating the capital gain on a subsequent disposal of that asset.

Clause 68: provides that the amendments made by clauses 62 and 62 to subsections 421(2) and (3), and subsection 438(3A) operate from the date of introduction of the Bill into Parliament.

Dividends Paid by Controlled Foreign Companies - Elimination of Double Taxation

Summary of the proposed amendments

The proposed amendments relate to the foreign source income (FSI) measures in Part X of the Income Tax Assessment Act 1936 (the 'Act').

The main amendment will eliminate the double taxation that could arise in the case of the transfer of certain property or services, that are deemed to be dividends, between:

·
an unlisted country controlled foreign company (CFC); and
·
a related listed country CFC.

The double taxation could now arise as the deemed dividend could, in some circumstances, be included twice in the assessable income of resident taxpayers who hold interests in the CFC:

·
once as a dividend (section 459); and
·
again as the taxpayer's share of the income of the CFC that receives the dividend (subparagraph 385(2)(a)(ii)).

The other amendment will align the exclusion (see paragraph 402(2)(d)) from the income of a CFC for certain non-portfolio dividends with the provisions (viz, section 458) that include those dividends directly in the assessable income of resident taxpayers with interests in the CFC.

Background to the legislation

Section 47A of the Act operates to deem certain transfers of property or services made by an unlisted country CFC to a shareholder or an associate of a shareholder to be dividends.

Where the recipient of the deemed dividend is a listed country CFC, section 458 or 459, as the case may be, includes the dividend in a resident taxpayer's assessable income provided that the taxpayer holds interests in both CFCs.

Subparagraph 385(2)(a)(ii) specifies certain amounts that are to be taken into account in calculating the income of a listed country CFC that is to be included in the assessable income of residents who hold interests in that CFC. An amount is so included where that amount:

·
is not listed in the Income Tax Regulations as concessionally taxed income of a listed country; and
·
is not treated as having a source in the listed country; and
·
is not subject to tax in any listed country.

An amount that is deemed to be a dividend under section 47A and taxed to an Australian taxpayer under section 459 may, in certain circumstances, be included in the assessable income of that taxpayer under section 456 as the taxpayer's share of the attributable income of the listed country CFC that received the amount.

For example, where an unlisted country CFC provides an interest-free loan to a listed country CFC, section 47A operates to deem the loan to be a dividend. Where each of the two CFCs is a directly owned subsidiary of an Australian company, section 459 includes the deemed dividend in the assessable income of the Australian company. Subparagraph 385(2)(a)(ii) may also operate to include the amount of that deemed dividend in the attributable income of the listed country CFC. That attributable income would then be included, under section 456, in the assessable income of the resident company. Accordingly, the amount of the dividend would be included twice in the assessable income of the resident company - once under section 459 and again under section 456.

With regard to section 458, it includes in the assessable income of a resident taxpayer amounts of certain 'non-portfolio dividends' (as defined in section 317) paid by an unlisted country CFC to a listed country CFC. This inclusion occurs if the resident taxpayer holds certain interests in both CFCs when the dividend is paid.

Presently, under paragraph 402(2)(d), those non-portfolio dividends are excluded in calculating the attributable income of a CFC that receives the dividends, if a resident taxpayer holds certain interests in the CFC at the end of the accounting period of the CFC in which the dividends are received rather than at the time the dividends are paid.

Explanation of the proposed amendments

The elimination of double taxation will be achieved by providing that the income of a CFC that may be included in the assessable income of a resident under section 456 will not include an amount of a deemed dividend that would be included in the assessable income of that resident under section 459 (paragraph 402(2)(da) in subclause 60(2)).

Paragraph 402(2)(da), in effect, sets out the circumstances in which an amount of a dividend could be included in the assessable income of a resident taxpayer under section 459. It treats those dividends as exempt income of the CFC. Thus, it would not be subject to attribution to resident taxpayers under section 456.

The amendment will also align paragraph 402(2)(d) that excludes certain non-portfolio dividends from the attributable income of a listed country CFC with the provisions of section 458 that subject those dividends, in certain circumstances, to Australian tax. Paragraph 402(2)(d) is being amended to treat the non-portfolio dividends as exempt income of the CFC that received the dividend where the resident taxpayer holds interests in that CFC, as well as in the CFC that paid the dividends, at the time the dividend was paid.

Commencement date

The amendment relating to paragraph 402(2)(da) will enable attributable taxpayers to benefit from the exemption from the time the accruals tax measures took effect. The accruals tax measures commenced generally from the 1990-91 income year.

The amendment relating to paragraph 402(2)(d) operates from the date of introduction of the Bill into Parliament.

Clauses involved in the proposed amendments

Subclause 60(2): inserts new paragraph 402(2)(da) to exclude, from the income of a listed country CFC, certain dividends received by the CFC which have previously been directly attributed to a resident taxpayer under section 459. The subclause also makes a minor technical amendment to the existing provisions of paragraph 402(2)(d).

Subclause 68(6): provides that the provisions of new paragraph 402(2)(da) will apply from the commencement of the accruals tax measures which is generally the 1990-91 income year.

Subclause 68(5): provides that the amendment to paragraph 402(2)(d) will operate from the date of introduction of the Bill into Parliament.

Transitional Finance Shares

Summary of the proposed amendments

The proposed amendments relate to the foreign source income measures in Part X of the Income Tax Assessment Act 1936 (the 'Act').

The amendments will modify the attribution rules under which the attributable income of a controlled foreign company (CFC) is attributed to certain Australian "attributable taxpayers". This will have the effect that the attributable income will be calculated after deducting dividends paid by the company to a related company which holds certain finance shares.

Background to the legislation

The existing foreign source income measures require taxpayers to include in their assessable income a share of the attributable income of a CFC. The attributable income is, subject to some exceptions, calculated without regard to dividends that may be paid by the CFC. Two of the exceptions provided are for:

·
dividends paid on "eligible finance shares" issued to a subsidiary of an Australian Financial Intermediary, such as a bank; and
·
dividends on a public issue of "widely distributed finance shares".

The dividends paid on these shares are a substitute for interest on loans.

The proposed amendments will provide a similar exception where funds raised by a CFC under an issue of widely distributed finance shares are then provided to a related CFC through a share issue on similar terms. The shares issued are called "transitional finance shares".

The term "transitional finance shares" is used because the benefit of the proposed amendment is to be of limited duration. It will apply to certain finance arrangements that were entered into before the release of the Foreign Source Income Information Paper on 12 April 1989* . The benefits will apply to dividends paid before 1 July 1998 on the transitional finance shares** .

The respective operations of the widely distributed finance share and transitional finance share measures are illustrated in the following diagrams

DIAGRAM 1

Illustration of Widely Distributed Finance Shares amendment

Company B <-- funds may be lent Company A <-- funds raised by public issue of widely distributed finance shares Members of public

Effect of amendment is to allow a deduction from attributable income of shareholder of Company A for dividends paid on widely distributed finance shares. Company B is a CFC and would be allowed a deduction for interest paid to Company A on the loan from Company A.

DIAGRAM 2

Illustration of proposed Transitional Finance Shares amendment

Company B <-- funds provided through share issue Company A <--funds raised by public issue of widely distributed finance shares Members of public

Effect of proposed amendment would be to also allow a deduction from attributable income of shareholder of Company B for dividends paid on shares that are issued by Company B to Company A on substantially the same terms as widely distributed finance shares issued by Company A.

Why are the changes required?

Unless dividends paid by the CFC on these transitional finance shares are excluded in the calculation of its attributable income, the attributable taxpayers (usually ordinary shareholders who are Australian residents) would be attributed to much of the income of the CFC. Without the exclusion, the attributed income would include the income required to be paid out as dividends to a related CFC which, in turn, pays a like dividend to the shareholders of widely distributed finance shares.

These widely distributed finance share dividends and transitional finance share dividends are, in effect, a substitute for interest on loans.

What will the changes do?

Exclusion of dividends paid on transitional finance shares will ensure that the attributable taxpayers are not attributed income they will never receive.

Transitional finance shares are to be excluded in calculating the proportion of the income of the CFC that is attributed to resident taxpayers. This will be done by excluding those shares from the calculation of a direct attribution interest in a CFC or a controlled foreign trust (CFT) (section 356 of the Act).

Likewise, the shares will be excluded for the purpose of calculating a taxpayer's direct attribution account interest in a company (section 366 of the Act). The purpose of attribution accounts is to ensure that distributions out of previously attributed income are not taxed again on distribution.

In addition, in calculating the attributable income of a company, under sections 384 or 385 of the Act, a deduction is to be allowed under section 394 for dividends paid out on transitional finance shares.

Why are the changes only transitional?

Because of the complexity of this kind of finance arrangement (where funds are channelled through related companies) a permanent change in the law would present unacceptable compliance and administrative problems. A short term amendment to accommodate finance arrangements that are of limited duration and to which taxpayers were already committed is justified on equity grounds. For this reason, the change in the law will be transitional only.

Explanation of the proposed amendments

What are transitional finance shares ?

The conditions required for a share to qualify as a transitional finance share are set out in new section 327B at Clause 56 . They include requirements about:

·
the widely distributed finance shares issued to fund the purchase of the shares being tested;
·
the shares being tested;
·
the timing of dividends paid;
·
the relationship between the company that issues the shares and the company that takes up the shares; and
·
the common ownership of the company that issues the transitional finance shares and the company that takes up the issue by an ultimate parent company.

A sunset clause ensures that the benefits of the amendment cannot be extended beyond 30 June 1998. Only the dividends paid by that date will qualify for the benefits provided by these amendments.

The transitional finance share provision is structured so that shares can be tested as transitional finance shares at any time prior to 1 July 1998. The shares will be tested, for example, at the time section 356 is applied to calculate the attributable taxpayer's direct attribution interest in a CFC. Where all of the tests in section 327B are met the shares will be transitional finance shares at that particular time.

The tests in section 327B are based on continuing compliance so that shares will only qualify as transitional finance shares if:

·
they have not previously failed the tests; and
·
they also pass the tests on their current application.

The shares being tested -

Widely distributed finance shares issued to fund the shares being tested

Transitional finance shares are finance shares issued by a CFC and taken up by another CFC which has itself issued widely distributed finance shares (see diagram 2 above). The conditions for widely distributed finance shares are generally contained in section 327A.

In the transitional finance share measures there are additional conditions about widely distributed finance shares that are issued to raise funds for the acquisition of the transitional finance shares. They are:

·
the widely distributed finance shares must have been issued before the release of the Government's Information Paper on the taxation of Foreign Source Income on 12 April 1989 (IP time);
·
the sole purpose of the issue of widely distributed finance shares must have been to fund the acquisition of the finance shares; and
·
the issue of widely distributed finance shares must also comprise the whole of a common issue of shares by the first company. That is, if there is a split issue of widely distributed finance shares all of the shares covered by each part of the issue must be used to fund the subsequent acquisition of finance shares.

The finance shares must have been issued within a reasonable time after the issue of the widely distributed finance shares by the first company.

The issue of finance shares must also comprise the whole of a common issue of shares by the second company. That is, if there is a split issue of finance shares all of the shares covered by the sub-issue must be funded from the prior issue of widely distributed finance shares.

The rights and obligations of the parties to the two share issues must be substantially similar. In effect, this means that the finance shares will substantially mirror the widely distributed finance shares. Critical factors are the amount and timing of capital subscribed under the share issues and the provisions for redemption of the shares.

In determining whether these are substantially similar, the reasonable costs of the first issue and the time when funds from one of the issues, are available for payment through to the other issue will be taken into account. The timing of dividends paid to shareholders of the first company must also substantially reflect the timing of dividends on the finance share issue.

Finance shares

Before shares are accepted as transitional finance shares they must first fit within the broader categorisation of finance shares. In general, if the dividends paid on shares are substituted for interest on a loan then the shares will be regarded as finance shares. Relevant considerations include:

·
how the amount of dividends on the shares are calculated (eg, as a percentage of the share capital raised under the finance arrangement); and
·
the conditions on the regularity and manner of payment of those dividends.

The timing of dividends paid

There are four conditions about the timing of the accrual and payment of dividends on the finance shares and widely distributed finance shares which ensure that the dividends are paid regularly and in time at all levels. These conditions are applied to dividends that accrued and were paid during the 24 month period prior to the time when the finance shares are tested to see if they qualify as transitional finance shares. The time when the finance shares are tested is called "the test time".

To apply these conditions the dividends (which are a substitute for interest on a loan) are assumed to be interest. In the notes that follow, a reference to interest accruing during a particular period on the transitional finance shares is a reference to the dividends that accumulated during that period on those shares.

The first condition is that the interest accrued at intervals of not more than 12 months.

Example 1

Example 1 Timeline

In this example, A to B is the 24 month period prior to the test time. C and D are interest accrual dates which fall between A and B and are not more than 12 months apart.The second condition is that interest accruing for the 12 month period between 12 and 24 months before the test time was paid not later than 12 months after it accrued.

Example 2

Example 2 Timeline

In this example, A to B is the 24 month period prior to the test time. C is the interest accrual date and D is the interest payment date. These dates fall between A and B and are not more than 12 months apart.The third condition provides a link between the dividends on the widely distributed finance shares and the accrued interest on the transitional finance shares referred to above. Dividends paid on the widely distributed finance shares during the 12 months ending at the test time must be wholly attributable to interest that accrued during the 12 months immediately preceding the time of the dividend payment.

Example 3

Example 3 Timeline

In this example, A to B is the 24 month period prior to the test time. C is the interest accrual date and D is the payment date for the widely distributed finance share dividends. These dates fall between A and B and are not more than 12 months apart.The fourth condition is that the amount of dividends paid on the widely distributed finance shares in the 12 months prior to the test time is approximately equal to the total amount of interest to which the dividends relate.

Common ownership

The company which issues the widely distributed finance shares (the first company) and the company which issues the finance shares (the second company) must be under common ownership. This means that 90% or more of the paid-up capital (excluding the finance share capital) must be beneficially owned, directly or indirectly, by the same ultimate parent company. A tracing mechanism is provided for measuring interests held through one or more intermediate companies.

The following example shows how the tracing mechanism is used to measure common ownership.

Example 4

Example 4 - How the tracing mechanism is used to measure common ownership

In this example the first and second offshore companies have 90% common ownership.There are a number of conditions in the widely distributed finance share provisions of section 327A which require the company that issues the widely distributed finance shares to be a publicly listed company or a subsidiary of a publicly listed company.There is also a requirement for wide ownership of the shares in the publicly listed company. These are similar to the tests in section 103A of the Act which are used for determining whether a company is treated for taxation purposes as a public company, or as a subsidiary of a public company but do not contain the discretionary powers provided to the Commissioner under that section.The effect of these conditions, combined with the common ownership requirement for transitional finance shares, is that the company that issues the transitional finance shares will be a public company or a company that is a subsidiary of a public company.

Modification of widely distributed finance shares

It is proposed to modify the widely distributed finance share provisions for the purpose of the transitional finance share measures. The object of the modification is to allow tracing through bare trust arrangements for the purpose of applying the public company test in subsection 327A(2).

The public company test in subsection 327A requires 75 percent or more of the voting, dividend and capital rights for the ordinary shares in a company to be held by not less than 21 entities. Where shares are held on trust by a nominee or other bare trust arrangement the modification will ignore the trustee or nominee and allow the beneficial owner of the voting shares etc. to be counted as one of the entities for the purpose of the test.

This will have two results:

·
The first is that, in the transitional finance share measures, references to "widely distributed finance shares" are to be read as the widely distributed finance share measures in their modified form discussed above.
·
The second result arises where finance shares qualify as transitional finance shares. In that case, the modified tests are applied to determine whether the shares issued by the first company to fund the acquisition of transitional finance shares from the second company are widely distributed finance shares.

Extended meaning of "widely distributed finance shares" - funding of transitional finance shares

Section 327A of the Principal Act, as amended by Taxation Laws Amendment Bill (No.4) 1991, contains the tests for widely distributed finance shares. This section is to be amended to extend the meaning of "widely distributed finance shares" to allow for the modification discussed above where widely distributed finance shares are issued to fund an acquisition of transitional finance shares. New subsection 327A(1A) provides for the modification.

Direct attribution interest in a CFC or CFT

Section 356 of the Act contains the rules for determining an entity's direct attribution interest in a CFC or a CFT.

Transitional finance shares are to be ignored when calculating a direct attribution interest [Clause 57].

Direct attribution account interest in a company

Section 366 of the Act defines a direct attribution account interest in a company. This is relevant for determining attribution debits and credits to eliminate double taxation when a company pays a dividend out of previously attributed income.

Transitional finance shares are not to be included in calculating a direct attribution account interest. [Clause 58]

Notional allowable deduction for eligible finance share dividends, widely distributed finance share dividends and transitional finance share dividends

Section 394 of the Act allows a deduction in calculating the attributable income of a CFC for eligible finance share dividends and widely distributed finance share dividends paid by a CFC during a specified time. This deduction ensures that the attributable taxpayers in relation to the CFC are not subject to attribution on income that they do not receive because it is paid out by the CFC as a dividend on the eligible finance shares or widely distributed finance shares.

The amendments will allow a similar deduction for dividends paid on transitional finance shares [Clause 59] .

Definitions of "transitional finance share" and "transitional finance share dividend" are to be inserted in existing section 317 by [Clause 54] .

Additional notional exempt income - unlisted or listed country CFC

Section 402 of the Principal Act treats certain amounts, in calculating the attributable income of a CFC, as exempt income, including specified non-portfolio dividends. A transitional finance share dividend will be excluded from the classes of non-portfolio dividends referred to in section 402. [Clause 60]

Commencement date

The amendments in relation to transitional finance shares and widely distributed finance shares will take effect from the date on which the foreign source income measures took effect, generally the 1990/91 income year.

With one exception, the foreign source income measures in Part X of the Act will, therefore, always be read in their amended form. However, those amendments are to be disregarded in determining whether a person has committed an offence against the record keeping requirements in Division 11 of Part X before the date of Royal Assent in relation to the amendments made by Clauses 55, 57, 58, 59 and 60. This will avoid any possibility of a retrospective offence. [Clause 74] These amendments will, in general, be of benefit to taxpayers.

Clauses involved in the proposed amendments

Clause 54 : amends section 317 of the Principal Act - the general definition section of Part X - to insert new definitions of 'transitional finance share' and 'transitional finance share dividend'.

Clause 55: will amend section 327A of the Principal Act, as amended by Taxation Laws Amendment Bill (No.4) 1991, to insert new subsection (1A). It modifies the operation of the widely distributed finance share measures where shares are issued to finance an acquisition of transitional finance shares.

Clause 56 : inserts new section 327B after section 327A of the Act. It sets out the requirements for a share to qualify as a transitional finance share.

Clause 57 : includes reference to transitional finance shares in section 356 of the Act - direct attribution interest in a CFC or CFT.

Clause 58 : includes reference to transitional finance shares in section 366 of the Act - direct attribution account interest in a company.

Clause 59 : includes reference to transitional finance shares in section 394 of the Act - notional allowable deduction for eligible finance share dividends, widely distributed finance share dividends and transitional finance share dividends.

Clause 60 : will amend section 402 of the Act so that a transitional finance share dividend will not be treated as notional exempt income.

Clause 68: commencement date.

Clause 74: transitional - Part X record keeping offences.

Taxation of the Income of Life Assurance Companies

Summary of the proposed amendments

The proposed amendments will provide that:

(a)
no part of a life assurance company's income (including foreign income derived other than through a permanent establishment (PE) in another country) arising from its Australian operations is to be exempt from tax on the basis that it relates to policies held by non-residents;
(b)
a life assurance company is liable to tax on that part of its income from a PE in a listed country (i.e., a comparably taxing country) that is not exempt from tax under section 23AH and which does not relate to unrelated non-resident life policy holders; and
(c)
a life assurance company is liable to tax on that part of its income from an unlisted country PE that does not relate to life policies issued to unrelated non-resident life policy holders.

These amendments will have effect from the 1991-92 year of income.

Background to the legislation

Exemption of Foreign Branch Profits of Australian Companies (Section 23AH)

The profits derived by an Australian company from a business carried on through a branch in a listed country are exempt from Australian tax to the extent that those profits have been subject to tax in a listed country and are not eligible designated concession income (section 23AH). This exemption is available to the branch profits of an Australian resident life assurance company.

Exemption of Income Attributable to Certain Policies (Section 112A)

Under the present law, the assessable income of a life assurance company does not include a portion of the income of an "Australian statutory fund" or other fund that is maintained by the company to meet its obligations under policies issued by the fund (section 112A). This provision has the effect that income attributable to investments that cover, amongst other things, life policies issued to unrelated non-resident policy holders by offshore PEs of the life assurance company is not taxed in Australia.

The proportion of the income of a statutory fund which is to be excluded from the assessable income of a life assurance company for a particular income year is to be determined by applying the following formula to the income from that fund's assets:

(calculated liabilities estimated to arise under, amongst other things, eligible non-resident policies in that fund) / (calculated liabilities estimated to arise under all life policies)

Basically, the calculated liabilities estimated to arise under eligible non-resident policies in a statutory fund is the valuation of the amount which that statutory fund will be liable for in respect of those policies. The value of those liabilities will be reduced where the rate of compound interest used by the life assurance company when calculating that liability is less than a rate of 4% (section 114). Similarly, the calculated liabilities estimated to arise under all life policies is the valuation of the amount that the statutory fund will be liable for in respect of all its life policies as adjusted where the rate of compound interest used to calculate that liability is less than a rate of 4%.

An "eligible non-resident policy" is a life assurance policy that is issued by a life assurance company in the course of a business carried on by the company at or through a PE of the company in a foreign country. The policy must also be vested in an entity that is not an associate of the company or an Australian resident who is not treated for the purposes of a double tax agreement between Australia and another country as a resident solely of that other country (subsection 110(1)).

The combined effect of sections 23AH and 112A

A life assurance company which has issued policies to non-residents through a PE in a listed country may be exempt from tax in relation to a larger amount of its income than is appropriate. This is because:

(a)
its comparably taxed profits referable to a PE in a listed country are exempt from tax (section 23AH); and
(b)
the policies issued by that PE to non-residents form part of the denominator and the numerator of the formula used to determine the proportion of the profits of the company (including profits from Australian sources) that are to be exempt from tax.

Example An Australian statutory fund has calculated liabilities of $50,000 referable to Australian policies and $20,000 referable to life policies issued to unrelated non-residents through a PE in a listed country. The income derived from the assets of the fund during the year of income was $80,000. $50,000 of this income relates to Australian sources and $30,000 was derived through a PE in a listed country and was comparably taxed by that country.Under section 112A -

·
the assessable income of the life assurance company referable to the income of the fund which was derived through the PE in a listed country would be reduced by:

$30,000 x ($20,000 / ($20,000 + $50,000)) = $8,571.43

The balance, i.e, $21,428.57, will be exempt from tax under section 23AH. That is, the whole of the $30,000 income derived through the PE is exempt. In any event, the whole of the income amount of $30,000 would be exempt from tax under section 23AH.
·
the assessable income of the life insurance company referable to Australian sources would be reduced by:

$50,000 x ($20,000 / ($20,000 + $50,000)) = $14,285.71

Hence, the life insurance company is assessable on only $35,714.29 (i.e., $80,000 - $30,000 - $14,285.71).

Explanation of the proposed amendments

The formula in section 112A for determining the proportion of the income of a statutory fund which is to be excluded from the assessable income of a life assurance company for a particular income year will no longer include a component relating to "eligible non-resident policies". A separate formula is to be inserted in new section 112C for the purposes of determining the proportion of the income of a statutory fund derived from policies issued to eligible non-residents in carrying on a business in a foreign country at or through a PE. This proportion of the income is to be excluded from the assessable income of a life assurance company because it relates to "eligible non-resident policies".

The new formula will apply to each amount of income derived by a life assurance company where that amount was derived (subsection 112C(1)):

(a)
by carrying on a business through a PE of the company in a foreign country;
(b)
from the assets in a fund maintained by the company for the purposes of its life assurance business;
(c)
from assets described in the accounts of the PE business as assets of the PE business; and
(d)
from sources in a foreign country or foreign countries.

In addition, the amount of income which satisfies the above tests is to be reduced to the extent that the assets from which it was derived were not held to cover liabilities referable to policies issued in the course of carrying on the PE business.

A statement from a professionally qualified actuary setting out the calculated liabilities in relation to the life policies issued by the PE, and certifying that the assets shown in the financial statements of the PE are not excessive in relation to those liabilities, would generally be accepted in this regard.

The proportion of each amount which will be exempt from tax is to be determined by applying the following formula (subsection 112C(2)):

Calculated liabilities for eligible non-resident policies / Total calculated liabilities

The calculated liabilities for eligible non-resident policies is the valuation of the amount that the company will be liable for in respect of eligible non-resident policies that were issued in the course of its business carried on through the PE. As at present, the value of those liabilities will be reduced where the rate of compound interest used by the life assurance company when calculating that liability is less than a rate of 4%.

The total calculated liabilities is the valuation of the amount that the company will be liable for in respect of all policies issued in the course of its business carried on through the PE. Similarly, the value of those liabilities will be reduced where the rate of compound interest used by the life assurance company when calculating that liability is less than a rate of 4%.

The above formula will also apply to reduce a 'modified 160Z gain amount' or an 'ordinary 160Z gain amount' (as defined in section 110) if, had the relevant gain been income, section 112C would have applied to that income.

Commencement date

These amendments will apply from the 1991-92 year of income. The decision to apply the amendments with effect from the 1991-92 income year has been taken having regard to the fact that:

·
the relief that would otherwise be provided would be inappropriate; and
·
there is adequate time for making returns of income and payment of taxes for that year.

Clauses involved in the proposed amendments

Clause 21 inserts new section 112C which will exempt a portion of certain amounts of income derived by a life assurance company which is referable to life insurance policies issued in the course of the company's PE business.

Clause 20 ensures that section 112A will no longer apply in relation to eligible non-resident policies by omitting references in that section to those types of policies.

Clause 19 modifies the manner in which the "modified 160Z gain amount" and "ordinary 160Z gain amount" as defined in subsection 110(1) are to be determined. The modification is required to accommodate situations where both section 112C and section 112A are to apply to a gain.

Subclause 65(8) provides that these amendments will apply from the 1991-92 income year.


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