Explanatory Memorandum
CHAPTER 1 - Foreign income
Overview
1.1 This chapter describes the amendments to the foreign income provisions made by Part 1 of Schedule 1 of the Bill. There are four proposed amendments. These will:
- •
- provide that, for the purposes of the controlled foreign company (CFC) measures, the cost base of assets owned by a company that becomes a CFC after 30 June 1990 is their market value at the time the company became a CFC (section 1);
- •
- ensure that tax arising under the CFC measures is not avoided by liquidating the CFC (section 2);
- •
- clarify that a taxpayer is not entitled to a credit for foreign tax where the tax is refunded to the taxpayer or to any other person. A credit will also not be available where any other benefit is provided as a result of the payment of foreign tax (section 3);
- •
- clarify that the Commissioner of Taxation may make adjustments, reflecting arm's length values, to amounts used in determining whether a CFC has passed the active income test (section 4).
A glossary of some terms used in the foreign income provisions is at the end of this chapter.
Section 1 - CGT cost base uplift
Summary of the amendments
1.2 The amendments will provide that, for the purposes of the CFC measures, the cost base of assets owned by a company that becomes a CFC after 30 June 1990 is their market value at the time the company became a CFC. [Division 1]
1.3 The amendments are to apply for asset disposals after 30 June 1995. [Item 12]
Background to the legislation
1.4 Broadly, the Australian controllers of a CFC may be assessed on a capital gain derived by the CFC on the disposal of a tainted asset (normally financial instruments, e.g., loans, shares etc.). The amount of the capital gain is determined using a modified form of the capital gains tax provisions [Subdivision 7C of Part X].
1.5 One of the modifications made to the capital gains tax provisions is that a CFC is deemed to have acquired its pre 30 June 1990 assets for their market value at that date [section 412]. This treatment ensures that Australian controllers are not assessed on capital gains derived by a CFC to the extent those gains accrued prior to the commencement of the CFC measures.
1.6 The modification also has the affect that the Australian controllers of a CFC may be assessed on a capital gain referable to the period after 30 June 1990 and before the company became a CFC. It has been suggested that this treatment is unfair because the amount paid for shares in a company will reflect the underlying value of the company's assets.
1.7 It was submitted that only capital gains and losses which accrue after a company becomes a CFC should give rise to attributable income. Capital gains which accrue after a foreign company becomes a CFC only come within the Australian tax base because the foreign company has become controlled by Australian residents. It can be distinguished from the case of the disposal of a taxable Australian asset by a foreign company or the disposal of an asset by an Australian company because those assets remain within the Australian tax base irrespective of who controls the company.
1.8 The proposed amendments will remove the taxation of gains on non-taxable Australian assets that accrue prior to a company becoming a CFC thus facilitating corporate restructures. Compliance costs would also be reduced by removing the need to make asset valuations for a time prior to a company becoming a CFC.
Explanation of the amendments
1.9 The proposed amendments will provide that the attributable income of a CFC will only include a capital gain or loss on the disposal of an asset which accrues from the later of:
- •
- the time the asset was acquired or deemed to be acquired; and
- •
- the first day at the end of which the company became a CFC.
1.10 This result will primarily be achieved by substituting section 406 with a new section. [Item 5; new section 406]
1.11 Existing section 406 defines the term '30 June 1990 non-taxable Australian asset' which is used in the modifications that apply when calculating the attributable income of a CFC. The term is also used in other provisions dealing with the taxation of resident trust estates that become controlled foreign trusts and modifications to the capital gains tax provisions for asset disposals by former CFCs that become residents of Australia. Broadly, the effect of the term is that only capital gains and losses which accrue after 30 June 1990 on the disposal by a CFC or former CFC of non-taxable Australian assets will be subject to Australian tax.
1.12 New subsection 406 will ensure that capital gains and losses arising on the disposal of non-taxable Australian assets will only be subject to Australian tax to the extent they accrue after the later of 30 June 1990 and the time a company becomes a CFC. This will be achieved by substituting the term '30 June 1990 non-taxable Australian asset' with "commencing day non-taxable Australian asset". A CFC's 'commencing day' will be 30 June 1990 if the company was a CFC at that time. The commencing day will otherwise be the first day at the end of which a company became a CFC.
1.13 The amendments will apply to asset disposals after 30 June 1995 [item 12] . Capital gains and losses arising on asset disposals prior to 1 July 1995 are unaffected. Accordingly, a loss referable to the period prior to a company becoming a CFC will normally continue to be available where the loss is realised prior to 1 July 1995.
1.14 An exception to this rule is where a company becomes a CFC after 30 June 1995. Where a company becomes a CFC after 30 June 1995, asset disposals made prior to the company becoming a CFC will not be taken into account when calculating attributable income. This ensures that a capital loss is not available where it is incurred prior to a company becoming a CFC and is justified on the basis that a capital gain would not have been attributable if it was derived prior to the company becoming a CFC. [Item 6; new section 408A]
1.15 The new terminology requires changes to other provisions. The terms '30 June 1990 non-taxable Australian asset' and '30 June 1990' are to be replaced where appropriate by 'commencing day non-taxable Australian asset' and 'commencing day' respectively [items 7, 8, 9, 10 & 11] . In addition, definitions of the new terms are to replace definitions of the former terms [items 1, 2, 3 & 4] .
1.16 The following examples illustrate how the new rules will apply.
1.17 A company which became a CFC on 1 August 1995 disposes of an asset on 1 October 1995. The asset was acquired on 1 May 1992.
1.18 Consequences - under the existing rules the capital gain or loss would be calculated on the change in value of the asset from 1 May 1992 to 1 October 1995. Following the amendments the asset will be deemed to have been acquired for market value on 1 August 1995 (i.e. when the company became a CFC). The capital gain or loss will therefore be calculated on the change in value of the asset from 1 August 1995 to 1 October 1995.
1.19 A company which became a CFC on 1 March 1993 disposes of an asset on 1 October 1995. The asset was acquired on 1 May 1992.
1.20 Consequences - under the existing rules the capital gain or loss would be calculated on the change in value of the asset from 1 May 1992 to 1 October 1995. Following the amendments the asset will be deemed to have been acquired for market value on 1 March 1993 (i.e. when the company became a CFC.) The capital gain or loss will therefore be calculated on the change in value of the asset from 1 March 1993 to 1 October 1995.
Section 2 - Dissolution of CFCs
Summary of the amendments
1.21 The amendments will ensure that an attributable taxpayer in relation to a CFC is attributed income under the CFC measures where the CFC is liquidated and ceases to exist before the end of the CFC's statutory accounting period. [Division 2]
1.22 The amendments are to apply to a company (being a CFC) that ceases to exist on or after the date of introduction of the Bill where the winding up or process that results in the company ceasing to exist begins on or after the date of introduction of the Bill. Typically, a company will commence winding-up when a court orders or members of the company pass a resolution to that effect. [Item 16]
Background to the legislation
1.23 The intention of the CFC measures is to tax certain foreign source income derived by CFCs on an accruals basis in the hands of attributable taxpayers. The income that is attributed under the CFC measures is not comparably taxed and is passive income or income derived from related party transactions.
1.24 Attribution of income under the CFC measures occurs at the end of a CFC's statutory accounting period which is a twelve month period running from 1 July to 30 June (subsection 319(1)) or another twelve month period that aligns with the CFC's usual accounting period (subsection 319(2)).
1.25 When a CFC enters into liquidation and ceases to exist before the end of its usual statutory accounting period no attribution of income occurs for the period of less than twelve months that commences from the end of its previous statutory accounting period to the time the company ceases to exist. Thus, the intent of the CFC measures may be defeated by a company liquidating and no longer existing at the end of its statutory accounting period.
Explanation of the amendments
1.26 A shortened statutory accounting period for a company that ceases to exist before the end of its usual statutory accounting period (as determined under the current section 319) is provided by the inclusion of a new subsection 319(6). Where a company is a CFC at the beginning of what would be its statutory accounting period under section 319 (ignoring subsection 319(6)) (paragraph 319(6)(a)) and the company ceases to exist before the end of its statutory accounting period then paragraph 319(6)(b) prescribes that the end of the statutory accounting period will be immediately before the company ceases to exist. [Item 13; new subsection 319(6)]
1.27 In most cases, a company will cease to exist when it is finally dissolved or de-registered under the company law applicable in its country of residence.
1.28 The provision of a shortened statutory accounting period for cases where a CFC ceases to exist under new subsection 319(6) necessitates amendment of section 371 and section 375 - provisions dealing with attribution credits and attributed tax account credits respectively.
1.29 To prevent double taxation an attribution account is maintained by a taxpayer with an attributable interest in a CFC. In the case of income attributed under section 456 the attribution credit arises at the end of the statutory accounting period of the CFC. However, with the inclusion of a shortened statutory accounting period (new subsection 319(6)) it is not appropriate for the credit to arise immediately before the company ceases to exist as this could lead to double taxation when income of the CFC which is subject to attribution at the end of the statutory accounting period is distributed before the company ceases to exist.
1.30 When a CFC has a shortened statutory accounting period because the company ceases to exist (new subsection 319(6)) the attribution credit under paragraph 371(1)(a) will arise at the beginning of the statutory accounting period. [Item 14; new paragraph 371(5)(aaa)]
1.31 In cases where new subsection 319(6) does not apply the attribution credit under paragraph 371(1)(a) will arise at the end of the statutory accounting period. [Item 14; new paragraph 371(5)(a)]
Attributed tax account credits
1.32 The purpose of attributed tax accounts is to account for foreign tax that has been paid on income attributed to a taxpayer under the CFC measures. An attributed tax account credit arises at the end of the CFC's statutory accounting period when income is attributed to a taxpayer under 456. For the reasons outlined above in relation to the timing of attribution credits, it is not appropriate for the attributed tax account credit to arise immediately before a CFC ceases to exist.
1.33 When a CFC has a shortened statutory accounting period because the company ceases to exist (new subsection 319(6)) the attributed tax account credit under paragraphs 375(1)(a) and 375(1)(da) will arise at the beginning of the statutory accounting period. [Item 15; new paragraph 375(3)(aa)]
1.34 In cases where new subsection 319(6) does not apply the attributed tax account credit under paragraphs 375(1)(a) and 375(1)(da) will arise at the end of the statutory accounting period. [Item 15; new paragraph 375(3)(a)]
1.35 The following example illustrates the operation of the amendments.
1.36 A CFC elects a statutory accounting period that aligns with its usual accounting period of 1 January to 31 December. The company members pass a resolution to wind-up the company on 1 August 1995 and it is finally de-registered in accordance with the corporation law where it is resident on 2 November 1995. As the company has ceased to exist during what was its statutory accounting period, new subsection 319(6) creates a new statutory accounting period - 1 January 1995 to 2 November 1995.
1.37 As the CFC's statutory accounting period ended on 2 November 1995, any attributable amounts from the period 1 January to 2 November 1995 will be included in an attributable taxpayer's year of income ending on 30 June 1996. For the purpose of keeping attribution accounts and attributed tax accounts, amounts included under section 456 and the claimable foreign tax paid on that section 456 amount will be credited in the taxpayer's respective accounts in relation to the CFC on 1 January 1995.
Section 3 - Refunds of foreign tax
Summary of the amendments
1.38 The amendments will clarify that a taxpayer is not entitled to a credit for foreign tax where the tax is refunded to the taxpayer or to any other person. A credit will also not be available where any other benefit is provided as a direct result of the payment of foreign tax. [Item 17 of Division 3]
1.39 The amendments are to apply to refunds of tax made after the date of introduction of the Bill. [Item 18]
Background to the legislation
1.40 Cases have been encountered where some foreign governments have proposed arrangements to collect tax from a taxpayer and subsequently refund that tax or provide some form of benefit to the taxpayer or to another person. These arrangements can be used to generate a false foreign tax credit on profits channelled through or derived in those countries.
1.41 The generation of a false foreign tax credit could be a problem because the credit may be used to reduce Australian tax payable on foreign source income. This would be an abuse of provisions intended to provide relief from double taxation.
Explanation of the amendments
1.42 The proposed amendments will make it clear that arrangements to generate false foreign tax credits will not be tolerated. If an amount of foreign tax paid does not truly represent the genuine amount payable, a foreign tax credit will not be allowed for any amount subsequently refunded or otherwise made available to the taxpayer or any other person. [New subsection 6AB(5A)]
1.43 The amendment primarily deals with the refund or provision of a benefit via another person to the payer of foreign tax. The existing law clearly has the effect of reducing a foreign tax credit for a refund of tax to the payer.
1.44 It is necessary for the new provision to apply to refunds and benefits provided to any other person due to the vast array of arrangements that can be used to receive an indirect benefit from the payment of foreign tax. In practice the person receiving the benefit will normally be closely associated with the payer. However, arrangements may involve persons whose only connection with the payer is a commercial relationship or an association with a person who is a party to a commercial relationship.
1.45 A credit will normally be denied where a benefit is provided to any person that is calculated with regard to foreign tax paid by the person seeking to claim the credit (new paragraph 6AB(5A)(b)). There are two types of benefits which will not result in the denial of a tax credit.
1.46 First, a foreign tax credit will not be denied where a general benefit arises for the payer or to another person as a result of the payment of foreign tax. A general benefit is a benefit other than a benefit that arises as a direct result of tax paid by the payer (new subparagraph 6AB(5)(b)(i)).
1.47 Secondly, a credit will not be denied where the only benefit is a reduction in a tax liability of the payer or another person (subparagraph 6AB(5A)(b)(ii)). This exclusion is intended to ensure that a credit is not denied where a country provides an imputation credit, a rebate of tax, a foreign tax credit or a similar type of concession. A credit will be denied if a concession results in more than a reduction of a tax liability, e.g. an amount becomes payable to the taxpayer or to another person.
1.48 Whilst the existing law can be used to deny false foreign tax credits, the amendment will ensure that the law is capable of dealing with emerging opportunities to generate false credits.
Section 4 - Tainted income
Summary of the amendments
1.54 The amendments will clarify that the Commissioner of Taxation may make adjustments, reflecting arm's length values, to amounts used in determining whether a CFC has passed the active income test. [Item 19 of Division 4]
1.55 The amendments will apply for statutory accounting periods of CFCs ending after 30 June 1995. [Item 20]
Background to the legislation
1.56 The Australian controllers of a CFC are generally not taxed on the CFC's tainted income where it passes the active income test (paragraph 384(2)(a), subparagraph 385(2)(a)(i) and Division 8 of Part X). This treatment ensures that small amounts of tainted income derived by a CFC are exempt from taxation on a current basis where the CFC primarily carries on a genuine business activity.
1.57 The active income test relies on amounts shown in the recognised accounts of a CFC (section 434) and is only available where those accounts have been prepared in accordance with commercially accepted accounting principles and the accounts provide a true and fair view of the financial position of the CFC (paragraph 432(1)(c)).
1.58 Problems have been encountered in applying the active income test where a CFC has entered into non arm's length transactions with a related party. The Commissioner may make adjustments reflecting arm's length values when determining a CFC's attributable income (section 400 & Division 13 of Part III). It is not clear, however, whether the adjustments affect the active income test because the amounts used for the purposes of the test are those recorded in the recognised accounts of a CFC and not necessarily amounts which have been adjusted for income tax purposes.
1.59 An inability to make adjustments to amounts used in determining the active income test may result in a CFC satisfying the test in circumstances where it should have failed. The Australian controllers of the CFC may thereby escape accruals taxation on tainted income which should be caught by the CFC measures.
Explanation of the amendments
1.60 The Commissioner will be able to make adjustments for the purposes of the active income test where, in calculating the attributable income of the CFC, the Commissioner would make a transfer pricing adjustment in relation to the acquisition or supply of property by the CFC. [New subsection 434(3)]
1.61 New subsection 434(3) would in practice apply only to transactions not covered by section 440. Section 440 provides that arm's length values are to be used in applying the active income test to the calculation of gains and losses on the disposal of assets other than trading stock.
1.62 It is not accepted that adjustments cannot be made under the existing law to amounts used in determining whether a CFC has passed the active income test. The amendment will clarify that adjustments can be made.
Glossary
1.63 A person who has, in general, a 10 per cent or greater interest in a Controlled Foreign Company or in a non-resident trust for the purposes of Part X of the Principal Act.
1.64 An attribution account establishes a link between:
- •
- income that has been attributed to the taxpayer from an entity; and
- •
- income actually distributed to that taxpayer by the entity.
1.65 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 on an accruals basis.
Controlled foreign company or CFC
1.66 A company that is not a resident of Australia and is controlled by five or fewer residents - see Part X of the Principal Act.
1.67 The statutory accounting period is used as the measurement period of the CFC measures. It is a period of 12 months, ending on 30 June, unless the foreign company has elected for a 12 month period ending on another day (section 319).