House of Representatives

Taxation Laws Amendment Bill (No. 2) 1996

Explanatory Memorandum

(Circulated by the authority of the Treasurer,the Hon Peter Costello, MP)

Chapter 1 - Offshore banking units

Overview

1.1 The amendments in Part 1 of Schedule 1 of the Bill will amend the Income Tax Assessment Act 1936 (the Act) to:

·
extend the scope of the offshore banking unit (OBU) concessional tax regime;
·
exempt, from interest withholding tax, gold fees paid by OBUs as part of gold borrowings; and
·
make a minor technical correction.

Summary of the amendments

Purpose of the amendments

1.2 The proposed amendments will:

·
permit OBUs undertaking funds management on behalf of offshore persons to more fully diversify their global portfolios by allowing investments in Australian assets, subject to a 10 per cent limit (by value) on the Australian asset component of each investment portfolio. However, the income earned from managing the Australian component of the portfolio will not be eligible for the concessional tax rate;
·
provide an exemption from interest withholding tax for gold fees paid by OBUs as part of gold borrowings;
·
provide greater flexibility in the dealings between companies within a group by allowing borrowing and lending in Australian currency between related OBUs; and
·
make it clear that where an OBU is entitled to claim a foreign tax credit because of the operation of a double tax treaty an income tax deduction is not also available for the foreign tax paid.

Date of effect

1.3 The proposed amendments will apply from the commencement of an OBU's 1996-97 year of income. The interest withholding tax measure will apply to interest paid by an OBU during the 1996-97 and subsequent years of income.

Background to the legislation

What is an OBU?

1.4 The term offshore banking broadly refers to the intermediation by institutions operating in Australia of financial transactions between non-resident borrowers and non-resident lenders. It also includes the provision of financial services to non-residents in respect of transactions or business occurring outside Australia.

1.5 Declaration as an OBU is confined to certain financial entities being authorised banks subject to the Banking Act 1959 , wholly owned subsidiaries of banks which are already registered as OBUs and State banks and other financial institutions that the Treasurer is satisfied are appropriately authorised to carry on business as dealers in foreign exchange.

1.6 Income derived by an OBU from 'OB activities' is effectively taxed at a concessional rate of 10 per cent. The meaning of an 'OB activity' is set out in sections 121D, 121E and 121EA of the Act. The proposed amendments impact on two of these activities. These are 'borrowing or lending activity' as defined in subsection 121D(2) and 'investment activity' as defined in subsection 121D(6).

Investments in Australian assets

1.7 Under the current concessional tax regime for OBUs an 'investment activity' is the making or making and managing of investments (as a broker, an agent or a trustee) for non-residents, other than non-residents operating at or through a permanent establishment (for example, a branch) in Australia, if the investments are shares in non-resident companies, units in non-resident unit trusts, land and buildings outside Australia or other foreign assets. Investments cannot be made in Australian dollars. The fee income derived from making, or making and managing the investments is concessionally taxed.

1.8 Under current rules, OBUs that hold any component of Australian assets in their funds management portfolios do not qualify for the concessional tax rate for those activities. To allow OBUs to more fully diversify their global portfolios the Government has decided to allow OBUs undertaking funds management to invest in Australian assets on behalf of offshore persons (for example, non-residents), subject to a 10 per cent limit (by value) on the Australian asset component of each investment portfolio. However, the income earned from making and managing the Australian asset component of the portfolio will not be eligible for the concessional tax rate.

1.9 A new subsection 121D(6A) will allow OBUs, subject to the 10 per cent limit, to invest in shares in Australian companies, units in Australian unit trusts, land and buildings located in Australia or other Australian assets on behalf of offshore persons.

Removing the permanent establishment restriction

1.10 In undertaking the OB activity the other party to the transaction must be an 'offshore person'. The term 'offshore person' is defined in section 121E and in very broad terms means a non-resident, an offshore branch of a resident or another OBU.

1.11 As the law now stands, an OBU can only obtain concessional tax treatment on its fee income if it manages the funds of an offshore person who is a non-resident and that person does not have a 'permanent establishment' in Australia. 'Permanent establishment' is a technical term which basically means that a person has an economic connection with a country such as carrying on business in that country. A branch is a common example of a permanent establishment. Because managing an investment portfolio containing some Australian assets could be construed as having an economic connection with Australia, the current restriction imposed by paragraph 121E(a), that offshore persons are not permitted to have a permanent establishment, will be removed.

Allowing OBUs to undertake investments activities with residents and non-residents

1.12 Under the current law, when making an investment on behalf of an offshore person the other party to the transaction must be a non-resident who does not have a permanent establishment in Australia: subsection 121D(6) and paragraph 121E(a). This restriction will be removed in relation to Australian assets in order to allow OBUs to purchase Australian assets from or make loans to both residents and non-residents (whether or not they have a permanent establishment in Australia). In relation to non-Australian assets the current permanent establishment restriction will also be removed and OBUs will be able to invest with non-residents (whether or not they have a permanent establishment in Australia). However, purchases of non-Australian assets from residents will not be permitted.

Income tax and capital gains derived through investment trusts

1.13 Section 121EL currently exempts income and capital gains derived by OBU offshore investment trusts in the course of investment activities. Section 121EL, in effect, exempts offshore persons investing through OBUs from Australian tax. In its current form section 121EL would, once the above amendments to section 121D are made, have the effect of exempting the OBU investment trust and, therefore, the offshore persons from Australian tax even on the Australian component of the investment. Therefore, section 121EL needs to be amended to make it clear that the income derived from the Australian asset component will not be exempt from income tax and that capital gains will accrue under Part IIIA.

Borrowing or lending in Australian dollars between related OBUs

1.14 Income derived from borrowing or lending money or gold to an offshore person is also concessionally taxed under the OBU regime. In order to protect the Australian domestic money market, however, the law provides that if the offshore person is a related person (as defined in section 121C and which includes another OBU) the money cannot be in Australian dollars.

1.15 The Government has decided to remove the current restriction on the borrowing or lending in Australian dollars between related OBUs in order to allow greater flexibility in dealings between companies within a group given the fact that the money must originally have been borrowed offshore. Subsection 121D(2) is to be amended to allow borrowing and lending between related OBUs in any currency.

Interest withholding tax exemption for gold fees

1.16 As noted above, income derived from borrowing or lending money or gold to an offshore person is concessionally taxed under the OBU regime. In addition, an exemption from interest withholding tax (IWT) is available for interest paid by OBUs to non-residents where the money borrowed is part of a borrowing activity and the money is used to fund other OB activities: section 128GB.

1.17 As part of a gold loan contract, the borrower is required to pay an additional amount of gold known as a 'gold fee'. In taxation ruling TR92/5 the Australian Taxation Office has ruled that gold fees are payments in the nature of interest and if a gold fee is paid to a non-resident an IWT liability will arise.

1.18 Gold fees paid by OBUs to non-residents where the gold borrowed is part of a borrowing activity and the gold is used to fund other OB activities are not currently exempt from IWT. The Government has decided to amend the IWT provisions to exempt these payments. The measure will provide consistency in the treatment of interest paid by OBUs whether it is paid in the form of moneyor gold.

Treatment of foreign tax

1.19 Under the foreign tax credit system, a foreign tax credit is available only to residents for foreign tax paid on foreign income. As a foreign tax credit is not available for offset against Australian tax payable on 'OB income' (income derived from OB activities) because the income is deemed to have an Australian source, the OBU regime allows a tax deduction (section 121EI).

1.20 Under the terms of a number of Australia's double tax agreements, however, the source article provides that where foreign tax (for example interest withholding tax) is paid on income the source of the income is deemed to be in the foreign country. It is possible, therefore, that an OBU may attempt to claim both a credit and a deduction in respect of the same amount of tax.

1.21 Section 121EI is to be amended to make it clear that where a taxpayer is entitled to claim a foreign tax credit, an income tax deduction is not allowable.

Explanation of the amendments

Investments in Australian assets

1.22 The amendments will introduce a distinction between merely making an investment on behalf of an offshore person and both making and managing of such an investment given that the purpose of the proposed measure is to extend the scope of funds management activities. Accordingly, the measures will only extend the scope of the OBU regime in situations where the investments are both made and managed by the OBU. The existing rules will apply where the OBU merely makes an investment on behalf of an offshore person. [Items 6, 8, 9 and 10 - new subsection 121D(6A)]

1.23 The meaning of the term 'investment activity' will be extended to include the managing of (as a broker, an agent or a trustee) a portfolio investment during an investment management period for non-residents, where:

·
if the investments are shares in non-resident companies, units in non-resident unit trusts, land and buildings outside Australia or other foreign assets the investment is made with a non-resident;
·
if the investments are Australian things the investment is made with either a non-resident or resident;
·
the currency in which investments are made is not in Australian dollars;
·
the investment portfolio comprises more than one Australian thing; and
·
the average Australian asset percentage of the portfolio investment is 10 per cent or less. [New subsection 121D(6A)]

Portfolio investment

1.24 The proposed amendments will introduce the concept of a 'portfolio investment'. This term is defined in new subsection 121DA(1) [items 5 and 11] as one or more investments managed by an OBU (as a broker, an agent or a trustee) under a contract or trust instrument for the benefit of a non-resident.

Investment management period

1.25 The investment management period means either the whole or a part of a year of income. [New subsection 121D(6A)]

Australian things

1.26 The term 'Australian things' is defined in new subsection 121DA(5) [items 2 and 11] as shares in resident companies, units in resident unit trusts (as defined in section 102Q), land or buildings in Australia, loans made to Australian residents or other assets in Australia.

1.27 The inclusion of loans made to residents within the definition of Australian things will allow for situations where, for example, money is deposited with a bank on a short term basis prior to using the funds to invest in other assets.

Calculating the average Australian asset percentage

1.28 In order for the OBU to obtain the concessional rate of tax on the fee income derived from the non-Australian asset component of the investment portfolio the 'average Australian asset percentage' of the portfolio investment must not exceed 10 per cent.

Monthly Australian percentage

1.29 The 'monthly Australian asset percentage' is, in broad terms, the percentage of Australian assets, calculated by reference to the value of the assets, in the investment portfolio for a particular month or part of a month. [Items 4 and 11 - new subsection 121DA(3)]

1.30 The calculation of the monthly Australian asset percentage for part of a month will be necessary where, for example, the OBU commences or ceases to manage an investment portfolio part way through the month.

1.31 A further requirement is that the monthly Australian asset percentage be calculated according to reasonable accounting practice and on the same basis for all months of a year of income. This will require the valuing of the assets to be undertaken in accordance with reasonable accounting practice and will allow OBUs to use their existing records to calculate the monthly Australian asset percentage. It also provides flexibility in that it does not impose any stringent timing requirements as to when the calculations must be done, as long as, it is consistent during the year of income. [New subsection 121DA(4)]

Average Australian asset percentage

1.32 The 'average Australian asset percentage' is the average, over the year of income, of the monthly Australian asset percentages. [Items 3 and 11 - new subsection 121DA(2)]

1.33 Where the average Australian asset percentage in respect of the portfolio investment exceeds 10 per cent, the activity will no longer fall within the definition of 'investment activity' in new subsection 121D(6A) and the whole of the fee income will be subject to the general company rate of tax.

Assessable OB income

1.34 In broad terms, the income from OB activities of an OBU is taxed at a rate of 10 per cent. Rather than providing a special rate of tax for this purpose, the assessable income and allowable deductions are adjusted downwards to achieve the same result. Each amount of income and each amount of allowable deductions is reduced by a fraction referred to as the 'eligible fraction'. The eligible fraction is 10 divided by the general company tax rate applicable to the year of income. As the rate of company tax is currently 36 per cent the fraction is:

10/36

1.35 The OBU's assessable OB income will be reduced by the average Australian asset percentage in respect of the portfolio investment concerned. This will have the effect of taxing the fee income derived from the non-Australian asset component of the investment portfolio at the concessional rate of 10 per cent. The fee income derived from managing the Australian asset component of the portfolio will not be eligible for the concessional tax rate and will be subject to the general company tax rate. [Items 1, 12 and 13 - new subsection 121EE(3A)]

Allowable deductions

1.36 The reduction in the OBU's assessable OB income (as explained in the previous paragraph) will mean that expenses incurred in managing an investment portfolio which qualifies for the concessional rate of tax will not fall within the definition of 'exclusive OB deduction' in subsection 121EF(3). The expense will, therefore, relate to both OB and non-OB activities and will need to be apportioned as a general OB deduction: subsection 121EF(4).

Removing the permanent establishment restriction

1.37 New subsection 121D(6A) reflects the change in policy by allowing OBUs to invest on behalf of a non-resident whether or not the non-resident has a permanent establishment in Australia. [New paragraph 121D(6A)(a)]

Allowing OBUs to undertake investments activities with residents and non-residents

1.38 Similarly, the restriction that when making an investment on behalf of an offshore person the other party to the transaction must be a non-resident who does not have a permanent establishment in Australia is removed in new subsection 121D(6A) . OBUs will be able to purchase Australian assets from or make loans to both residents and non-residents (whether or not they have a permanent establishment in Australia). [New paragraph 121D(6A)(c)]

1.39 in relation to non-Australian assets OBUs will be able to invest with non-residents (whether or not they have a permanent establishment in Australia). However, purchases of non-Australian assets from residents will not be permitted. [New paragraph 121D(6A)(c)]

Income tax and capital gains derived through investment trusts

1.40 The amendments made to section 121EL make it clear that the income, profits or capital gains of the trust estate that are derived from the Australian asset component will not be exempt from Australian income tax and that capital gains will accrue under Part IIIA. [Items 15, 16 and 17 - new paragraphs 121EL (f) and (g)]

Example

1.41 AusOBU managed an investment portfolio for three and a half months during a year of income. The portfolio comprises of shares in both resident and non-resident companies. AusOBU produces reports on the portfolio it manages from its records on a monthly basis. It uses this information to calculate the average Australian asset percentage.

1.42 AusOBU derives a fee of AUD57,500 for managing the portfolio.

Total Value of the Investment Portfolio
Month AUD
1 5,000,000
2 5,500,000
3 6,000,000
4 5,750,000
Value of the Australian Assets
Month AUD
1 200,000
2 275,000
3 240,000
4 201,250
Monthly Australian Asset Percentage
Month   %
1 200,000 4
---------
5,000,000
2 275,000 5
---------
5,500,000
3 240,000 4
---------
6,000,000
4 201,250 3.5
---------
5,750,000

Average Australian Asset Percentage

4 + 5 + 4 + 3.5 = 16.5 = 4.125% --------------- ---- 4 4

1.43 As the average Australian asset percentage does not exceed the 10 per cent limit, AusOBU is eligible for the concessional rate of tax on the fee income derived from the non-Australian asset component of the investment portfolio.

Assessable OB income

1.44 $57,500 - ($57,500 x 4.125%) = $55,128

Borrowing or lending in Australian dollars between related OBUs

1.45 Item 7 amends paragraphs 121D(2)(a) and (b) to remove the current restriction on the borrowing or lending in Australian dollars between related OBUs.

Interest withholding tax exemption for gold fees

1.46 Item 18 amends subsection 128AE(1) to insert a definition of 'offshore gold borrowing'. This term is defined to mean borrowing gold from an offshore person.

1.47 Items 24 and 26 amend subsections 128GB(1) and 128GB(4) to provide the exemption from interest withholding tax for gold fees paid by OBUs in respect of an offshore gold borrowing.

1.48 Subsection 128GB(3) is amended by item 25 to exclude offshore gold borrowings from section 128GB when the borrowings are used as part of the arrangement described in subsection 128GB(3).

Other consequential issues relating to the interest withholding tax exemption

1.49 Item 19 also amends subsection 128AE(1) to insert a definition of 'tax exempt gold'. This term is used, broadly, to describe that part of an offshore gold borrowing in respect of which an interest withholding tax exemption will be treated as having been available. The definition has application in determining whether dealings in those borrowings are liable to attract a special penalty tax under section 128NB.

1.50 Subsections 128AE(5), (7), (8), (9) and (11) will be amended to deem gold to retain or lose its status as tax exempt gold in certain situations. [Item 21]

1.51 Subsection 128AE(4) is to be amended to provide for offshore gold borrowing to be treated as tax exempt gold for the purposes of the withholding tax provisions. [Items 20 and 21]

1.52 Subsections 128AE(9) and 128AE(11) will also be amended by Item 23 to bring offshore gold borrowings within those provisions.

1.53 Subsection 128AE(8) will also be amended by item 22 to clarify that an amount transferred can be either money or gold.

1.54 Items 27 and 28 amend section 128NB in order to bring offshore gold borrowings within the special penalty tax imposed by the section.

Treatment of foreign tax

1.55 Item 14 inserts new subsection 121EI(2) to make it clear that where a taxpayer is entitled to claim a foreign tax credit an income tax deduction is not allowable.

Application

1.56 The amendments to the OBU provisions apply to assessments of income for 1996-97 and subsequent years of income. The interest withholding tax amendments apply to interest paid by an OBU during the 1996-97 and subsequent years of income. [Item 29]


View full documentView full documentBack to top