Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Chapter 2 - Overview of the foreign source income regime
2.1 The regime for taxing foreign source income comprises:
- the controlled foreign company (CFC) measures (Part X);
- the foreign investment fund (FIF) measures (Part XI);
- the transferor trust measures (Division 6AAA of Part III);
- other measures in Division 6 of Part III relating to the taxation of interests in non-resident trusts; and
- the foreign tax credit system or "FTCS" (Division 18 of Part III and related provisions).
2.2 The proposed changes impact primarily on the CFC measures and to a lesser extent on the transferor trust measures and the foreign tax credit system. Minor changes are to be made to the FIF measures.
2.3 The objective of the CFC measures is to tax Australian shareholders on their pro rata share of a CFC's tainted income (ie, passive, tainted sales and tainted services income) as it is earned unless the income is comparably taxed offshore or the CFC satisfies an active income test. Broadly, tainted income arises from investments and arrangements that are likely to be significantly influenced by taxation considerations. Examples of tainted income include interest, royalties, dividends and amounts arising from certain related party transactions.
2.4 The CFC measures focus on tainted income because it is the most mobile form of income and is thus readily diverted for tax planning purposes to avoid or defer Australian tax. Transactions involving tainted income are also most easily used to divert income properly sourced in Australia to foreign entities through transfer pricing practices or by giving income an artificial foreign source. The taxation of tainted income as it is earned ensures that investments offshore that produce tainted income are not favoured over similar investments in Australia for purely taxation reasons.
2.5 Active income (ie, income other than tainted income) is generally exempt from accruals taxation under the CFC measures to allow Australian businesses to compete effectively in low tax countries. This exemption is not considered a serious risk to the revenue or the Australian economy because the location of investments that produce active income tend to be primarily influenced by considerations other than tax. It is therefore less likely that these investments will be undertaken offshore for taxation reasons. An exemption is also provided for tainted income where a CFC satisfies an active income test (section 433) in recognition that a CFC may derive small amounts of tainted income that are incidental to an active business.
2.6 A list of countries (Appendix C) is currently used to reduce compliance and administrative costs of the CFC measures. The costs are reduced by providing an exemption for most types of income that have been taxed in a listed country. The exemption is provided on the basis that only limited tax deferral opportunities are available in listed countries and concessions which offer deferral opportunities can be identified and designated in the Income Tax Regulations.
2.7 Under the CFC measures, Australian taxpayers are liable to pay tax, on a current year basis, on income or gains earned by foreign companies in which they have a controlling interest, notwithstanding that the income or gains have not yet been derived by the taxpayers. The Australian controllers of a CFC are called "attributable taxpayers".
2.8 An attributable taxpayer is required to include in assessable income its share of the attributable income of the CFC (section 456). Subject to some modifications, the attributable income of a CFC is calculated using the same tax rules that apply to Australian resident companies. The amount of a CFC's attributable income depends on whether the CFC is resident in a "listed" or "unlisted" country and on whether the CFC's activities are such that it may take advantage of the exemption for active income.
2.9 Generally, all income of a tainted nature derived by a CFC resident in an unlisted country is attributable if the CFC fails the active income test. In contrast, the attributable income of a listed country CFC normally includes only concessionally taxed amounts of narrowly defined tainted income (ie, eligible designated concession income or "EDCI") which is also tainted under the broader definition of tainted income in the CFC measures (ie, "adjusted tainted income"). The rules for determining whether an amount is EDCI are provided in section 317 of the Principal Act and Part 8A of the Income Tax Regulations.
2.10 Appendix A provides a diagrammatic summary of the current CFC measures.
2.11 The transferor trust measures attribute the income of a non-resident trust to an Australian resident who has, directly or indirectly, transferred value to the trust. Broadly, this treatment will apply if the trust is treated as a resident of an unlisted (ie, low tax) country, or has derived EDCI from a listed country, and the transfer was made:
- in the case of a discretionary trust, at any time; or
- in the case of a non-discretionary trust, after 12 April 1989.
2.12 The FIF measures apply to Australian resident taxpayers who have an interest in a foreign company or trust at the end of a year of income that is not subject to the CFC or transferor trust measures. The measures also apply to taxpayers who hold a foreign life policy at any time during a year of income.
2.13 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 directed at preventing the deferral of Australian tax where profits are accumulated offshore in a FIF rather than remitted to Australian investors.
2.14 Exemptions from the FIF measures are provided for a wide range of investments in active businesses where the risk of tax deferral is not likely to be significant. Exemptions are also available to exclude interests in FIFs that are not the target of the measures (eg, a small investor exemption is provided for individuals who hold investments in FIFs and FLPs not exceeding $50,000 in value).
2.15 Foreign source income derived by an Australian resident is generally subject to Australian income tax (eg, subsection 25(1)) and a credit for foreign tax paid on the income is allowed against the Australian tax payable under the FTCS. The credit cannot exceed the amount of Australian tax that would otherwise be payable on the foreign income.
2.16 A resident taxpayer can claim a credit for foreign dividend withholding tax paid on an assessable dividend from a foreign company. In addition, a resident company that receives a dividend from a "related" foreign company is allowed a credit for foreign tax paid by the foreign company on profits out of which the dividend was paid (ie, "underlying tax").
2.17 A foreign company is related to an Australian company if the Australian company has a direct voting interest of at least 10% of the voting power of the foreign company. This relationship can extend through any number of tiers of foreign companies.
2.18 An exemption under section 23AJ applies to non-portfolio dividends paid to Australian resident companies from comparably taxed profits. A dividend is a non-portfolio dividend if it is paid to a company that holds at least 10% of the voting power in the company paying the dividend. Broadly, a non-portfolio dividend derived by a resident company will be exempt under section 23AJ if the dividend was:
- paid by a listed country company out of profits which have not been previously attributed to the taxpayer (section 23AI applies to exempt dividends paid from previously attributed profits); or
- paid by an unlisted country company out of profits that have been fully taxed in Australia or in a listed country.
2.19 An exemption is provided for dividends paid from profits taxed in listed countries because the potential Australian tax liability on the dividends would be largely offset by a credit for foreign tax. In theory, the exemption under section 23AJ achieves the same result as the FTCS but relieves Australian companies from the compliance burden associated with claiming a credit for foreign tax.
2.20 Section 23AH provides a similar exemption for amounts derived by an Australian company through a branch in a listed country. The exemption is available for foreign income derived by an Australian company from a business conducted through a branch in a listed country where the income is not EDCI and is subject to tax in the listed country. The exemption can also apply to a capital gain on the disposal of land, a building or depreciable property used by the branch in the conduct of its business.