Senate

Taxation Laws Amendment Bill (No. 4) 1995

Income Tax (Franking Deficit) Amendment Bill 1995

Income Tax (Deficit Deferral) Amendment Bill 1995

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Ralph Willis, MP)
This Memorandum Takes Account of Amendments Made by the House of Representatives to the Bill as Introduced

Chapter 4 - Franking credits - international profit misallocation

Overview

4.1 Schedule 2 of the Bill will amend Part IIIAA of the Income Tax Assessment Act 1936 (the Act) to provide that no franking credits arise under the imputation system for tax paid by companies where a payment of tax is made in relation to profits which have been misallocated offshore through transfer pricing or non-arm's length dealings.

Summary of the amendments

Purpose of the amendments

4.2 The amendments of the income tax law will ensure that franking credits, in certain circumstances, cannot be used to largely negate the additional company tax payable as a result of an adjustment to reflect arm's length dealings where profits have been misallocated offshore. In certain circumstances, franking credits could, instead of relieving the second tier of tax on company profits, be used to frank profit distributions that would not otherwise be franked dividends. This could occur where the 'profits' which have been taxed under the transfer pricing or non-arm's length dealing adjustment provisions of Division 13 of the Act or a double taxation agreement have been misallocated to an offshore affiliate. Where 'profits' have been shifted or misallocated offshore, unlike other additional tax situations, they are not available for distribution by an Australian resident company.

Date of effect

4.3 The amendment will apply to original and amended assessments which issue after the 1995-96 Budget announcement on 9 May 1995, irrespective of the income year to which the misallocation of profit adjustment relates.

Background to the legislation

4.4 Both Division 13 and the double tax agreements entered into by Australia with other countries contain provisions aimed at ensuring that the Australian revenue is not disadvantaged by transfer pricing practices and non-arm's length dealings which shift or misallocate profits offshore. For taxation purposes, these provisions provide for profits to be notionally increased in accordance with arm's length principles ie. a misallocation of profit adjustment.

4.5 Under the current imputation system for tax paid by companies, a misallocation of profit adjustment resulting in additional tax payable by an Australian resident company will give rise to a franking credit. In certain circumstances, this franking credit may be used to largely negate the additional tax payable by the resident company.

4.6 This occurs, for example, where an Australian resident company misallocates profits to a foreign affiliate and is subsequently subject to a transfer pricing adjustment which notionally increases the profits of the Australian resident company for taxation purposes. The notionally increased 'profits', however, are not actual profits of the Australian resident company and are not available to that company for distribution by way of a dividend. Any franking credit arising as a result of the transfer pricing adjustment could therefore, under the present system, be used to frank distributions of profits which would otherwise be unfranked. In other words, the franking credit could be used to reduce the amount of profits it could otherwise distribute only as unfranked dividends.

4.7 On the other hand, an Australian resident company, which has complied with the arm's length principles embodied in the income tax law, would have actual profits available for distribution. It could not use franking credits arising from payment of tax on its actual profits to reduce the amount of profits which it could otherwise distribute only as unfranked dividends. Generally, unfranked dividends are subject to withholding tax if paid to a non-resident shareholder and are fully taxable if paid to a resident shareholder. Franked dividends are exempt from withholding tax if paid to a non-resident shareholder and resident shareholders obtain the benefit of the franking rebate from the dividend.

4.8 To remedy this anomaly, the proposed amendment will provide that no franking credits arise where a payment of tax is made in relation to a misallocation of profit adjustment. Similarly, where a misallocation of profit adjustment is subsequently reduced (eg. upon objection, review or appeal), a franking debit will not arise upon the issue of an amended assessment where the payment of tax for the original misallocation of profit adjustment did not give rise to a franking credit.

Explanation of the amendments

4.9 Under the provisions of Part IIIAA of the Act, the amount of franking credits or debits arising from the payment or refund of tax is equal to the 'adjusted amount' of the tax paid or refunded. (In this chapter, references to a refund of tax includes reductions of tax and crediting or applying tax refunds against other liabilities.)

4.10 Under section 160APA of the Act the 'adjusted amount' is determined by the formula:

Basic amount*(1-applicable general company tax rate/applicable general company tax rate)

In relation to franking credits and debits arising from the payment and refund of tax, the 'basic amount' is the amount of tax paid or refunded.

4.11 To exclude franking credits or debits arising from the payment or refund of tax where those amounts are attributable to a misallocation of profit adjustment, the basic amount will be reduced by the 'reduction amount'. [Item 15; new subsections 160APAAA(1) and (3)]

4.12 The 'reduction amount' will be defined to mean the payment of tax (either wholly or partly) that arises as a result of the application or operation of:

subsection 136AD(1), (2) or (3) or 136AE(1), (2) or (3). These provisions apply where, in relation to an international agreement, a taxpayer has supplied property for less than an arm's length consideration or no consideration or has acquired property for more than an arm's length consideration; or
paragraph 1 or 2 of Article 9 of the Vietnamese agreement or a provision of any other double taxation agreement that corresponds to either of those paragraphs. These provisions apply to international non-arm's length dealings between associated enterprises resident in tax treaty partner countries.

[Item 15; new subsection 160APAAA(2)]

4.13 A 'double taxation agreement' will be defined to mean an agreement within the meaning of the International Tax Agreements Act 1953. [Item 15; new subsection 160APAAA(4)]

4.14 The operation of the amendments is demonstrated in the following examples.

Example #1 - Ordinary company (tax paid) Following an amended assessment, for its 1993-94 income year, a company pays additional tax of $30,000, three quarters of which (i.e. $22,500) is attributable to a misallocation of profit adjustment.The franking credit resulting from the payment of additional tax would be calculated as follows:

section 160APMD (payment of tax after the final instalment)

class B franking credit = adjusted amount of the tax paid
= (basic amount less reduction amount) * 67/33 (section 160APA)
= ($30,000 - $22,500#) * 67/33
= $15,227

Example #2 - Ordinary company (tax refund) A company receives a tax refund of $10,000 in relation to its 1992-93 income year, one quarter of which (ie. $2,500) is attributable to a reduction of a previous misallocation of profit adjustment for which a franking credit was previously denied.The franking debit resulting from the refund would be calculated as follows:

section 160APYBA (refunds of company tax)

class A franking debit = adjusted amount of the tax refund
= (basic amount less reduction amount) * 61/39 (section 160APA)
= ($10,000 - $2,5000##) * 61/39
= $11,731

# This is the amount of tax paid that is attributable to the misallocation of profit adjustment
## The is the amount of tax refund attributable to the misallocation of profit adjustment


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