Senate

Taxation Laws Amendment Bill (No. 2) 1994

Explanatory Memorandum

(Circulated by the authority of the Treasurer the Hon Ralph Willis, M.P.)

Chapter 14 - Foreign investments funds and foreign life insurance policies.

Introduction

14.1 The foreign investment fund (FIF) measures came into effect on 1 January 1993. The measures provide for the taxation, on an accruals basis, of investments held by Australian residents in non-controlled foreign companies, interests held by Australian beneficiaries in non-controlled foreign trusts, and investments in foreign life policies (FLPs) by Australian policy holders. Also, as part of those measures, new rules governing the taxation of Australian beneficiaries of foreign trust estates were introduced with effect from the 1992-93 income year.

14.2 The FIF measures aim to remove the tax advantage of deferring Australian tax by accumulating income in offshore companies and trusts that are not controlled by Australian residents. They complement the controlled foreign company (CFC) and transferor trust measures which have been in operation since the 1990-91 income year.

14.3 Amendments to the law are required to give effect to certain changes to the FIF measures which were announced by the Treasurer on 22 December 1993.

14.4 The proposed amendments will:

·
allow a holding company exemption from the FIF measures for certain indirect investments in company FIFs which carry on general insurance, life insurance, real property or multi-industry activities; and
·
exclude construction activities from the non-exempt list thereby making them eligible activities for the purposes of the active business exemption.

Each of these amendments is explained in its own section of this Chapter, following a short overview of the FIF measures.

Overview of the FIF measures

14.5 The FIF measures apply to Australian resident taxpayers who, at the end of an income year, have an interest in a foreign company or trust. The measures also apply to taxpayers who hold a FLP at any time during a year of income.

14.6 Broadly, the FIF measures operate to approximate a resident taxpayer's share of the undistributed profits of a FIF (called FIF income) and to assess the taxpayer on those profits. This treatment is designed to remove the deferral of Australian tax on the profits of a FIF which may otherwise arise where those profits are accumulated offshore rather than remitted to Australian investors.

14.7 The FIF measures provide a number of exemptions from FIF taxation. These exemptions are designed to exclude from the FIF measures interests in FIFs which are not the target of the measures. Where an exemption does not apply, the amount of FIF income to be included in a taxpayer's assessable income is determined using one of the following three taxing methods:

(a)
the market value method;
(b)
the deemed rate of return method; or
(c)
the calculation method.

In the case of FLPs, the amount of FIF income will be determined under the cash surrender value method or the deemed rate of return method.

14.8 Under these methods of taxation, a taxpayer's interest in a FIF is measured in relation to notional accounting periods of a FIF commencing on 1 January 1993 and for subsequent periods. The notional accounting period of a FIF is generally the same as a taxpayer's year of income. However, a taxpayer may elect to use the period for which the annual accounts of the FIF are made.

14.9 The assessable income arising under the FIF measures is included in the taxpayer's assessable income for the income year in which the notional accounting period of the FIF ends.

HOLDING COMPANY EXEMPTIONS

Summary of proposed amendments

Purpose of amendment

14.10 The amendments will allow a holding company exemption from the FIF measures for certain indirect investments in companies which carry on life insurance, general insurance, real property or multi-industry activities [Clause 72].

Date of Effect

14.11 The amendments will apply from the commencement of the FIF measures, 1 January 1993 [Subclause 2(4)].

Background to the legislation

14.12 There are currently exemptions from the FIF measures which may apply to an Australian taxpayer's interest in a company FIF where the FIF itself carries on life insurance, general insurance, real property or a combination of several specified activities. [Sections 506, 509, 511 and 523 respectively]

14.13 However, these exemptions do not apply to an interest held by an Australian taxpayer in a holding company FIF whose wholly owned subsidiaries are principally engaged in these activities. In contrast, there is a holding company exemption with regard to the exemption for company FIFs whose wholly owned subsidiaries are principally engaged in carrying on banking business. [Section 504]

Explanation of proposed amendments

14.14 It is proposed that the law be amended to provide an exemption from the FIF measures for a holding company FIF whose wholly owned subsidiaries are principally engaged in life insurance, general insurance, real property or several specified activities. These exemptions are modelled on the existing holding company exemption for banking [Clause 72].

Holding company exemption for life insurance business

14.15 New section 507A will be inserted into the Income Tax Assessment Act to provide for the holding company exemption for life insurance business [Clause 73].

14.16 To qualify for the holding company exemption for life insurance business:

(i)
the taxpayer's shares in the holding company are to be widely held and actively traded on an approved stock exchange [Paragraphs 507A(1)(a) and (2)(b)];
(ii)
the holding company must be classified on an approved stock exchange or an approved international sectoral classification system as being engaged in the carrying on of life insurance [Paragraph 507A(2)(a)];
(iii)
the holding company must have one or more wholly owned subsidiaries. That only subsidiary, or those subsidiaries considered together, must be principally engaged in the active carrying on of a life insurance business, and a subsidiary must also be authorised under the law of its place of residence to carry on life insurance business. [Subsection 507A(3)]

14.17 The principal activities of one or more subsidiaries are to be determined by calculating the sum of the gross value of the assets of each wholly owned subsidiary which are used in carrying on life insurance business and comparing that sum with the sum of the gross value of the assets of each wholly owned subsidiary. The comparison to be used is set out in the next paragraph.

14.18 The subsidiaries will be taken to be principally engaged in the carrying on a life insurance business if the total gross value of the assets of the subsidiaries which are used in carrying on life insurance business is at least half of the total gross value of assets of the subsidiaries.

14.19 The provisions are structured such that if there is only a single subsidiary, new subsection 507A(5) applies to determine if that subsidiary is principally engaged in the active carrying on of life insurance business. Where two or more subsidiaries are involved, new subsection 507A(6) contains the appropriate test. Both tests are carried out by applying sections 507(3) to (11), which apply the existing direct FIF exemption for life insurance business.

Holding company exemption for general insurance activities

14.20 New section 509A will be inserted into the Income Tax Assessment Act to provide for the holding company exemption for general insurance business [Clause 74].

14.21 To qualify for the holding company exemption for general insurance activities:

(i)
the taxpayer's shares in the holding company must be of a class of shares in that company that are widely held and actively traded on an approved stock exchange [Paragraphs 509A(1)(a) and 509A(2)(b)];
(ii)
the holding company must be classified on an approved stock exchange or an approved international sectoral classification system as being engaged in carrying on a business of general insurance [Paragraph 509A(2)(a)];
(iii)
the holding company must have one or more wholly owned subsidiaries. That only subsidiary, or those subsidiaries considered together, must be principally engaged in the active carrying on of a general insurance business and at least one subsidiary must also be authorised under the law of its place of residence to carry on general insurance business. [Subsection 509A(3)]

Holding company exemption for real property activities

14.22 New section 511A will be inserted into the Income Tax Assessment Act to provide for the holding company exemption for real property activities [Clause 75].

14.23 To qualify for the holding company exemption for real property activities:

(i)
the taxpayer's shares in the holding company must be of a class of shares in that company that are widely held and actively traded on an approved stock exchange [Paragraphs 511A(1)(a) and 511A(2)(b);]
(ii)
the holding company must be classified on an approved stock exchange or an approved international sectoral classification system as being engaged in activities of construction, capital improvement of real property, earning rent from letting commercial real property managed, maintained and serviced by the company or its subsidiaries, provision of management services for real property, agency on sales or purchase of commercial real property, or any combination of these [Paragraph 511A(2)(a)]
(iii)
the holding company must have one or more wholly owned subsidiaries. That only subsidiary, or those subsidiaries considered together, must be principally engaged in the active carrying on of any one or more of the activities listed in subparagraph 511(b)(ii) [Subsection 511A(3)].

Holding company exemption for multi-industry activities

14.24 New section 523A will be inserted into the Income Tax Assessment Act to provide for the holding company exemption for multi-industry activities [Clause 76].

14.25 To qualify for the holding company exemption for multi-industry activities:

(i)
the taxpayer's shares in the holding company must be of a class of shares in that company that are widely held and actively traded on an approved stock exchange [Paragraph 523A(1)(a) and subsection 523A(2)]
(ii)
the holding company must have one or more wholly owned subsidiaries. That only subsidiary, or those subsidiaries considered together, must be principally engaged in the active carrying on of any two or more of the activities listed in subparagraph 523(b)(ii). [Subsection 523A(3)]

14.26 Subparagraph 523(b)(ii) forms part of the test for the existing direct FIF exemption for multi-industry activities. The listed activities include life insurance, general insurance, the various real property activities relevant to section 511 and 511A, and eligible activities within the meaning of Division 3.

CONSTRUCTION ACTIVITIES

Summary of proposed amendments

Purpose of amendment

14.27 The amendments will exclude activities in connection with construction from the general non-exempt list of activities for the purposes of the FIF measures thereby making them eligible activities for the purposes of the active business exemption [Clause 77].

Date of effect

14.28 The amendments will apply from the commencement of the FIF measures, 1 January 1993 [Subclause2(4)].

Background to the legislation

14.29 The active business exemption from the FIF measures applies to interests in company FIFs principally engaged in certain active business, known as eligible activities. [Section 497]

14.30 These eligible activities include all activities other than those non-exempt listed activities described in Schedule 4 of the Act. [Subsection 496(1)]

14.31 Accordingly, the reference to "activities in connection with real property" in paragraph (g) of Schedule 4 means that construction activities will not normally be eligible activities for the purposes of the active business exemption. ( Note, however, there is currently a specific exemption from the FIF measures for interests in certain company FIFs which are principally engaged in the active carrying on of construction. [Section 511])

Explanation of proposed amendments

14.32 It is proposed to amend the law to exclude construction activities from the general non-exempt list of activities for the purposes of the FIF measures thereby making them eligible activities for the purposes of the active business exemption. In other words, in addition to the specific exemption contained in section 511 of the Act, a general exemption will now apply under the active business exemption to interests in companies principally engaged in the carrying on of construction activities.

14.33 This amendment will be achieved by amending paragraph (g) of Schedule 4 of the Act to exclude activities in connection with construction [Clause 79 - amendment to Schedule 4]. A consequential change to section 496 is also required [Clause 78 - amendment to subsection 496(2)].

GLOSSARY

Calculation method

An alternative method, available at the taxpayer's election, to determine the amount to be included in a taxpayer's assessable income under the FIF measures. The amount is calculated by determining a taxpayer's share of a FIF's profits. A FIF's profits are calculated using rules similar (but simpler than) those that apply for a resident taxpayer.

Cash surrender value method

Method of taxation applying to taxpayers who have an interest in a FLP. In general, the amount included in assessable income is calculated by measuring the increase, if any, in the cash surrender value of an interest in a FLP between the last day of the previous notional accounting period and the last day of the current notional accounting period, with an adjustment for acquisitions, disposals and distributions.

Deemed rate of return method

The backup method to determine the amount to be included in the taxpayer's assessable income under the FIF measures which is used where it is not possible to use the market value method and a taxpayer does not choose (elect) to use the calculation method. The amount is calculated by applying a deemed rate of return to the value of the FIF or FLP interest.

FIF

A foreign investment fund.

FIF attribution account

An attribution account establishes a link between:

·
income that has been attributed under the FIF measures to the taxpayer from an entity; and
·
income actually distributed to that taxpayer by that entity.

This makes it possible to identify when, and to what extent, it is necessary to provide relief from double taxation on the distribution of profits which have been taxed under the FIF measures.

FLP (Foreign Life Policy)

A FLP is a life assurance policy (as defined in subsection 482(2)) issued by a non-resident.

Interest in a FIF

The total of all instruments in a company held by the taxpayer (such as a share, option, convertible note etc.) or in a trust (such as a unit, option to acquire a unit, a note convertible into a unit).

Market value method

The primary method to determine the amount to be included in the taxpayer's assessable income under the FIF measures. In general, the amount is calculated by measuring the increase, if any, in the market value of a FIF interest between the last day of the previous notional accounting period and the last day of the current notional accounting period with adjustment for acquisitions, disposals and distributions.

Notional accounting period

The period by reference to which the FIF measures will apply. In general, this will be the same as the taxpayer's year of income. The taxpayer may elect that the notional accounting period coincide with the accounting period that the FIF uses for reporting to shareholders or beneficiaries. In relation to FLPs, the taxpayer may elect that the notional accounting period of the FLP coincide with the period for which cash surrender values are available.


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