House of Representatives

Explanatory Memorandum

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

Chapter 5 Changes to the rules for taxing branches of Australian companies

Overview

5.1 The amendments will modify the exemption under section23AH for amounts derived by an Australian company through a branch (ie, a permanent establishment) to allow the exemption to apply to amounts derived through a branch in a limited-exemption listed country. The following modifications will be made to the exemption for these branches:

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the exemption will generally not be available for branch income that is adjusted tainted income;

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the passive income of a branch conducting life assurance activities will not be reduced under subsection446(2);

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a branch and its Australian head office are to be treated as separate legal entities for the purpose of determining whether the branch has derived tainted sales income;

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branches of Australian financial institutions (AFIs) will be provided with an exemption for banking income broadly consistent with the exclusion from accruals taxation available under the CFC measures for AFI subsidiaries; and

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an active income test concession will be provided to allow branches to derive up to 5% of gross turnover as tainted income and still obtain full exemption under section 23AH for income amounts.

5.2 It is important to note that the treatment of branches in broad-exemption listed countries and in unlisted countries will not change. A summary of the changes to the treatment of branches is at Appendix F.

Modification to the approach for determining the exempt income of a branch in a limited-exemption listed country

Summary of the amendments

Purpose of the amendments

5.3 The amendments will exclude adjusted tainted income derived through a branch in a limited-exemption listed country from exemption under section23AH unless the branch passes an active income test.

Date of effect

5.4 The changes will apply to amounts derived by a branch on or after 1July 1997 (ie, from the commencement of the two list approach). [Subitems 120(1), (2), (3) & (4)]

Background to the legislation

5.5 An exemption under section 23AH is available for foreign income derived by an Australian company from a business conducted through a branch in a listed country providing the income is not eligible designated concession income (EDCI) and has been subject to tax in a listed country (subsection 23AH(1)). Broadly, EDCI is narrowly defined tainted income that has been concessionally taxed in a 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 (subsection 23AH(6)). In theory, the exemption under section23AH achieves the same result as the FTCS but relieves Australian companies from the compliance burden associated with claiming a foreign tax credit.

5.6 The exemption under section23AH requires modification if it is to apply for branches in limited-exemption listed countries because the concept of EDCI will not be applicable for amounts derived in those countries. The exclusion for amounts of EDCI is to be replaced with an exclusion for amounts of adjusted tainted income (ie, passive income, tainted sales income and tainted services income). Other foreign income derived in carrying on a business through a branch in a limited-exemption listed country will be exempt if subject to tax in a listed country. Gains on the disposal of land, buildings or depreciable property by a branch in a limited-exemption listed country that do not give rise to adjusted tainted income will generally continue to be exempt under subsection 23AH(6).

Explanation of the amendments

5.7 New paragraph 23AH(1)(ca) will have the effect that the exemption under section23AH will not be available for amounts of adjusted tainted income derived through a branch in a limited-exemption listed country unless the branch satisfies an active income test. [Item 1] The adjusted tainted income of a branch is to be determined in accordance with new subsection23AH(10A).

5.8 New subsection 23AH(10A) provides that the adjusted tainted income of a branch is to be determined in the same way as the adjusted tainted income of a CFC. The rules for determining adjusted tainted income are provided in section386 of the CFC measures. The only amounts that will be taken into account are those derived through the branch (new paragraph 23AH(10A)(a)). A taxpayer will also be treated as having a statutory accounting period the same as the taxpayer's year of income (new paragraph 23AH(10A)(b)). The term "statutory accounting period" is used throughout the CFC measures to refer to the period for which the attributable income of a CFC is being calculated. [Item 4]

5.9 Other modifications made by new subsection 23AH(10A) for the purposes of determining the adjusted tainted income of a branch and the rules for determining whether a branch passes the active income test are discussed later in this Chapter.

5.10 The amendments to subsections 23AH(6) and (7) will allow the exemption under section 23AH to apply to gains or profits of a capital nature from the disposal of land, buildings or depreciable property by a branch in a limited-exemption listed country providing the gains or profits are subject to tax in a listed country. The exemption will not be available, however, for gains or profits of a capital nature that give rise to adjusted tainted income (new paragraphs 23AH(6)(f) and 23AH(7)(f)). [Items2 & 3]

Modification of passive income for branches of life assurance companies in limited-exemption listed countries

Summary of the amendments

Purpose of the amendments

5.11 The amendments will modify the definition of passive income to ensure that subsection446(2) does not reduce the passive income of a branch conducting life assurance activities in a limited-exemption listed country.

Date of effect

5.12 The changes will apply to amounts derived by a branch on or after 1July 1997 (ie, from the commencement of the two list approach). [Subitems 120(1), (2), (3) & (4)]

Background to the legislation

5.13 A modification is required to the rules in the CFC measures for determining passive income (ie, a component of adjusted tainted income) if those rules are to be applied to a foreign branch of a life assurance company. Subsection 446(2) provides an exclusion from passive income for life assurance activities conducted by a CFC using funds obtained from unrelated foreign policy holders. This exclusion should not apply in determining the passive income of a branch because a similar exclusion currently exists for life assurance activities conducted through a foreign branch (section 112C). To allow a reduction of passive income under subsection446(2) and also an exclusion under section 112C would result in an inappropriate duplication of a tax concession.

Explanation of the amendments

5.14 New paragraph 23AH(10A)(c) ensures that the passive income of a branch in a limited-exemption listed country is not reduced under subsection 446(2). [Item 4]

Branches in limited-exemption listed countries to be treated as separate legal entities for the purpose of determining tainted sales income

Summary of the amendments

Purpose of the amendments

5.15 The amendments will provide that a foreign branch in a limited-exemption listed country and its Australian head office are to be treated as separate legal entities for the purpose of determining whether the branch has derived tainted sales income. Amounts of tainted sales income derived by these branches will not qualify for exemption under section23AH unless the branch satisfies an active income test.

Date of effect

5.16 The changes will apply to amounts derived by a branch on or after 1July 1997 (ie, from the commencement of the two list approach). [Subitems 120(1), (2), (3) & (4)]

Background to the legislation

5.17 Tainted sales income (section 447) normally arises from the sale of goods by a CFC where the goods are sold to or acquired from an associate who is a resident of Australia (or a branch of an associate in Australia) and the goods were not substantially altered by the CFC. The following example shows how the sale of goods by an Australian company through a foreign subsidiary can give rise to tainted sales income.

Example

A company resident in Australia (Ausco) manufactures goods in Australia for $10 and sells the goods to a subsidiary resident in the Republic of Korea (Koreaco) for $10. The goods are not substantially altered by Koreaco. Koreaco sells the goods to overseas third parties for $100.

In this case Koreaco would be treated as deriving tainted sales income of $100 because the goods were sold to Koreaco ("the company") by Ausco (another "entity") that is both an associate of Koreaco and a Part X Australian resident (paragraph 447(1)(a)).

5.18 Consistent with the treatment of goods sold through CFCs, tainted sales income is to arise for goods sold through a branch in a limited-exemption listed country if the branch does not substantially alter the goods. The rules for determining the tainted sales income of a CFC are not, however, entirely suitable for the purposes of determining the tainted sales income of a foreign branch. One difficulty is that a foreign branch and its Australian head office are the same legal entity and therefore there can be no sale of goods from the Australian head office to the branch. The requirement in section447 that the goods must have been purchased from an associate in Australia will thus not be satisfied. This difficulty is illustrated by the following example.

Example

A company resident in Australia (Ausco) manufactures goods in Australia for $10. Ausco sells the goods through its branch in the Republic of Korea to overseas third parties for $100. The Korean branch does not substantially alter the goods.

The $100 sales income would not be treated as tainted under the current rules in section447 because the requirement that the goods are sold to "the company" by another "entity" is not satisfied (paragraph 447(1)(a)). The transfer of goods from Ausco's head office in Australia to its Korean branch is not a sale of goods because it is a transfer within a company and not between companies. The sales income of $100 would therefore not be included in adjusted tainted income and could qualify for exemption under section 23AH even if the branch does not satisfy the active income test (discussed later in this Chapter).

To achieve consistency with the treatment of goods sold by an Australian parent to its foreign subsidiary, the income derived by the Korean branch should be treated as tainted sales income.

Explanation of the amendments

5.19 New paragraph 23AH(10A)(d) provides that a branch in a limited-exemption listed country will be taken to have purchased goods from its Australian head office for the purposes of determining tainted sales income if the goods would have been purchased by the branch from the head office assuming:

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the branch were a distinct and separate company (called the PE company) from the head office (called the HQ company);

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the PE company and the HQ company were engaged in the same or similar activities under the same or similar conditions as the branch and the head office respectively; and

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the PE company were dealing wholly independently with the HQ company.

5.20 The HQ company is also be treated as an associate of the PE company. [Item4]

5.21 The following example shows the effect of the modifications for determining the tainted sales income of a branch.

Example

A company resident in Australia (Ausco) manufactures goods in Australia for $10. Ausco (Aust) sells the goods through its branch in the Republic of Korea to overseas third parties for $100. The Korean branch does not substantially alter the goods.

New paragraph 23AH(10A)(d) will treat Ausco (Aust) and the Korean branch as separate companies for the purposes of determining the tainted sales income of the branch. Ausco (Aust) will also be treated as an associate of the Korean branch. The Korean branch would therefore be treated as having derived tainted sales income of $100 because the goods were sold to "the company" (the Korean branch) by another "entity" (Ausco (Aust)) that is both an associate of the branch and a Part X Australian resident (paragraph 447(1)(a)).

5.22 The modifications made by the amendments are to apply only where goods are acquired by a branch from its head office and not where the head office acquires goods from the branch (new paragraph 23AH(10A)(e)). In the latter case, the sale of goods by the head office is taxable in Australia under the general provisions of the Principal Act and the head office is allowed a deduction for the cost of goods purchased by the branch. No amount is derived by the branch because generally arrangements within the same legal entity do not give rise to income or outgoings for taxation purposes. The exemption under section 23AH is thus not applicable to the sale of goods by the head office.

5.23 The modifications to tainted sales income for branches will therefore apply for the purposes of paragraphs447(1)(a), 447(1)(c) and 447(1)(e) and not for the purposes of paragraphs 447(1)(b), 447(1)(d) and 447(1)(f). The modifications will also apply in determining tainted services income arising from the disposal of assets acquired by a branch of an AFI from its Australian head office (ie, for the purposes of paragraphs 450(6)(c), (7)(d) and (8)(b)). [Item 4]

5.24 Modifications are not required to the rules for determining the tainted services income of a branch because tainted services income can arise from arrangements involving only two parties. In contrast, a minimum of three parties is required before an arrangement can give rise to tainted sales income (ie, a provider of goods, a distributor of the goods and an ultimate purchaser of the goods).

Exemption for branches of AFIs in limited-exemption listed countries

Summary of the amendments

Purpose of the amendments

5.25 The amendments will provide branches of Australian financial institutions (AFIs) in limited-exemption listed countries with an exemption for banking income broadly consistent with the exclusion from accruals taxation available under the CFC measures for AFI subsidiaries.

Date of effect

5.26 The changes will apply to amounts derived by a branch on or after 1July 1997 (ie, from the commencement of the two list approach). [Subitems 120(1), (2), (3) & (4)]

Background to the legislation

5.27 Interest and certain other amounts of otherwise tainted income derived by an AFI subsidiary are generally excluded from tainted income if earned in carrying on a financial intermediary business (sections 449 and 450). A "financial intermediary business" is a banking business or a business whose income is principally derived from the lending of money (section317). This exclusion will also be available in determining adjusted tainted income for branches of AFIs conducting financial intermediary business in limited-exemption listed countries.

5.28 The terms "AFI" and "AFI subsidiary" are defined in sections 317 and 326 respectively. An AFI can be a bank, a State bank, a registered financial corporation or a life assurance company. It can also be a combination of more than one of these entities. An AFI subsidiary is a company controlled by five or fewer AFI entities or in which an AFI entity has a 40% control interest. An "AFI entity" is a company that is an AFI or a wholly owned subsidiary of an AFI.

Explanation of the amendments

5.29 New paragraph 23AH(10A)(f) provides that the exemption for branches of AFIs is to be determined in the same way as the exemption for AFI subsidiaries under the CFC measures. It is assumed for this purpose that an AFI entity is an AFI subsidiary. New paragraph 23AH(10A)(d) will also provide that a branch in a limited-exemption listed country and its Australian head office are to be treated as separate legal entities for the purpose of determining whether the branch has derived tainted services income under subsections 450(6), (7) or (8). A similar assumption is made for the purposes of determining the tainted sales income of a branch which is discussed above in the previous section. [Item 4]

Active income test for branches in limited-exemption listed countries

Summary of the amendments

Purpose of the amendments

5.30 The amendments will provide an active income test concession to allow branches in limited-exemption listed countries to derive up to 5% of gross turnover as tainted income and still obtain full exemption under section23AH for income amounts.

Date of effect

5.31 The changes will apply to amounts derived by a branch on or after 1July 1997 (ie, from the commencement of the two list approach). [Subitems 120(1), (2), (3) & (4)]

Background to the legislation

5.32 An active income test similar to that which applies for CFCs is also to apply for branches in limited-exemption listed countries. The active income test (section 432) provides an exemption from accruals taxation for small amounts of tainted income that are considered incidental to the conduct of an active business.

Explanation of the amendments

5.33 Normally amounts of adjusted tainted income derived through a branch in a limited exemption listed country will not be exempt under section 23AH (new subparagraph 23AH(1)(ca)(i)). New subparagraph 23AH(ca)(ii) provides, however, that the adjusted tainted income of a branch in a limited-exemption listed country can qualify for exemption under section 23AH if the branch passes an active income test. [Item 1] In this regard it should be noted that the active income test will only apply to income amounts. The treatment of gains arising on the disposal of assets by a branch is determined under subsection 23AH(6) and (7) and will not be affected by new subparagraph 23AH(1)(ca)(i).

5.34 The rules for determining the active income test are provided in new subsection23AH(10B). [Item 4] Broadly the active income test that currently applies for unlisted country CFCs is to be used for branches. As discussed in Chapter 4, this active income test will also apply to all CFCs.

5.35 A number of modifications are required to adapt the active income test for branches. First, the only amounts that will be taken into account are those derived through the branch (new paragraph 23AH(10B)(a)). Secondly, the year of income of a taxpayer will be used as the statutory accounting period of the taxpayer's branch for the purposes of applying the test (new paragraph 23AH(10B)(b)). Thirdly, the provisions of the active income test outlined in the following table will not apply to branches because they are only relevant to companies.

5.36 Fourthly, the modifications to adjusted tainted income discussed previously in this Chapter are to apply in determining the gross tainted turnover of the branch (new paragraphs 23AH(10B)(d), (e), (f) and (g)). [Item 4]

5.37 In cases where a taxpayer has a year of income commencing on a day other than 1 July, the changes to the treatment of branches will apply part way through a year of income. In these cases, the active income test is to be determined having regard only to amounts derived after 1 July 1997 (new paragraph 23AH(10B)(h)).

Example

A taxpayer with a year of income from 1April to 31March has a branch in a limited-exemption listed country that derived tainted income of $10,000 from 1 April 1997 to 30 June 1997 and $50,000 from 1 July 1997 to 31 March 1998. The branch derived $100,000 in total during the period 1 April 1997 to 30 June 1997 and $900,000 during the period 1 July 1997 to 31 March 1998.

In this case, the active income test would be determined with regard only to amounts derived during the period from 1July 1997 to 31 March 1998. The branch's gross tainted turnover would therefore be $50,000 and its gross turnover would be $900,000. The branch would thus fail the active income test because the ratio of tainted income to total income exceeds 0.05. The $50,000 tainted income derived after 30 June 1997 would therefore not be exempt under section 23AH. The $10,000 tainted income derived prior to 1 July 1997 may be exempt under section 23AH providing the income is not EDCI.