Senate

Taxation Laws Amendment Bill (No. 4) 1997

Explanatory Memorandum

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

Chapter 1 - Thin capitalisation

Overview

1.1 Schedule 1 of the Bill will amend the thin capitalisation rules contained in Division 16F of Part III of the Income Tax Assessment Act 1936 (the Act) to:

·
reduce the allowable foreign debt to foreign equity gearing ratio for taxpayers who are not financial institutions from 3:1 to 2:1;
·
broaden the definition of 'foreign debt' in relation to companies who are not financial institutions to generally treat certain guaranteed debt from unrelated overseas lenders as foreign debt for thin capitalisation purposes;
·
amend the definition of 'foreign equity' for partnerships and fixed trusts;
·
limit asset revaluations for partnerships and trusts to market value changes;
·
deny discretionary trusts a gearing ratio to the extent their foreign equity cannot be effectively measured because of the existence of the trustee's discretion;
·
amend the definition of 'foreign investor' so that foreign partners, beneficiaries and trustees of Australian partnerships and trusts will be subject to the thin capitalisation debt to equity ratio requirement; and
·
repeal the specific anti-avoidance provisions dealing with back to back avoidance arrangements and instead apply the general avoidance provisions to counter such arrangements.

Summary of the amendments

Purpose of the amendments

1.2 The purpose of the amendments is to improve the effectiveness of the thin capitalisation rules. The proposed reduction in the foreign debt to foreign equity ratio from 3:1 to 2:1 will require foreign investors to structure their investments in Australian enterprises on a more commercial basis.

1.3 The definition of foreign debt in relation to companies is being expanded to include borrowings from an overseas lender either guaranteed by a foreign controller or subject to a security provided by a foreign controller. This amendment is designed to complement the proposal to decrease the foreign debt to foreign equity ratio so that foreign controllers will be required to provide adequate equity capital to Australian companies. This amendment will not apply to financial institutions.

1.4 In the absence of such a measure, a foreign controller of an Australian company could avoid the impact of the thin capitalisation rules by allocating debt rather than equity capital to the company from arm's length overseas lenders, with a guarantee or security provided by the foreign controller. In this situation, the Australian enterprise would be able to use the foreign controller's (or their non-resident associates') equity overseas to obtain a loan from an arm's length lender. This measure will not apply if the Commissioner can be satisfied that the Australian company could have borrowed the amount of the loan from a prudent arm's length lender without having the foreign controller's (or their non-resident associates') guarantee or security provided to the lender.

1.5 The amendments will deny a foreign controlled discretionary trust a deduction for interest paid to foreign controllers of the trust because the foreign equity of a discretionary trust cannot be measured in a meaningful way.

1.6 The definition of foreign equity for fixed trusts will be amended so that it is calculated on the basis of the foreign controllers' fixed interests in the capital or income of the trust. For partnerships, the definition of foreign equity will be based on partners' fixed interests in the capital or income of the partnership.

1.7 The specific provisions dealing with back to back avoidance arrangements will be repealed as the general anti-avoidance provisions of the income tax law are considered to more effectively counter such schemes. Back to back arrangements are used to give a transaction between related parties the appearance of being a transaction between arm's length parties by interposing an unrelated person between the related parties.

1.8 The asset revaluation rules in relation to partnerships and trusts will be brought into line with the current rules for companies. This will ensure that partnerships and trusts can only revalue assets up to their arm's length value. In addition, the asset revaluations will only be taken into account in determining a partnership or trust's foreign equity in the income year following the year in which the assets were revalued.

1.9 Foreign partners, beneficiaries and trustees of Australian partnerships and trusts will be subject to the thin capitalisation debt to equity ratio requirement, as well as the underlying Australian partnership or trust. This will still provide foreign partners, beneficiaries and trustees of Australian partnerships and trusts with some scope for borrowing from related-parties to invest in the partnership or trust.

Date of effect

1.10 The measures will apply from the 1997-98 income year. Transitional arrangements are provided for taxpayers with substituted accounting periods.

Background to the legislation

What is thin capitalisation?

1.11 Thin capitalisation is used to describe the situation where the ratio of non-arm's length debt to equity funding of an entity is considered to be excessive. Thin capitalisation of investments in Australia is influenced by the preferential taxation treatment provided to debt funding relative to equity funding. In the case of debt funding of a foreign controlled Australian company, interest paid by the company is deductible against its income and the interest income paid to its foreign investor is normally only subject to interest withholding tax at the rate of 10 per cent. In the case of equity funding, dividends paid to the foreign shareholders are generally paid from profits that are subject to the 36 per cent company rate of tax and under the imputation system are not subject to dividend withholding tax. This difference between the treatment of debt funding and equity funding creates the incentive for foreign controllers to maximise the debt funding and minimise the equity funding of their investments in Australian enterprises.

Thin capitalisation rules

1.12 The thin capitalisation rules of the income tax law, contained in Division 16F of Part III of the Income Tax Assessment Act 1936, place a limit, by means of specified non-arm's length debt to equity funding ratios, on the amount of interest expense payable on related party debt that can be deducted for Australian tax purposes. The ratio assists in ensuring that an appropriate amount of profit is derived in Australia, and in protecting Australia's revenue base.

1.13 Under the current thin capitalisation rules the ratio of related party foreign debt to foreign equity cannot exceed 6:1 for financial institutions and 3:1 for other taxpayers. The ratio of 6:1 is allowed for investments in banks and non-bank financial institutions in recognition of their special funding needs. If a taxpayer exceeds the gearing ratio, deductions for interest paid on the related party debt are disallowed to the extent of the excess. The thin capitalisation rules apply to resident companies, trusts and partnerships. The rules also apply to foreign investors, which are defined as non-residents who derive Australian source assessable income other than in the capacity of a partner in a partnership or a trustee or beneficiary of a trust.

What is a foreign equity product?

1.14 The term 'foreign equity product' is defined in section 159GZA. It is a multiple of an Australian enterprise's foreign equity. In the case of financial institutions, the multiple is 6 and in all other cases it is 3. The foreign equity product is a term used in Subdivision C of the thin capitalisation rules, to determine the maximum foreign debt interest that an Australian enterprise may claim as a tax deduction. If an Australian enterprise exceeds its foreign equity product the enterprise's deduction for foreign debt interest will be disallowed to the extent that the foreign equity product has been exceeded.

What is interest withholding tax?

1.15 Division 11A of Part III of the Act imposes interest withholding tax (IWT) on interest paid to a person outside Australia by a resident of Australia. It also applies to interest paid to a person outside Australia by a non-resident, to the extent that the interest relates to a business carried on by the non-resident in Australia. IWT is a flat and final tax of 10 per cent imposed on interest paid to overseas lenders. The obligation for the collection of IWT is placed on the Australian entity paying interest overseas.

Explanation of the amendments

The new foreign debt to foreign equity gearing ratio of 2:1 for taxpayers who are non-financial institutions

1.16 The thin capitalisation foreign debt to foreign equity ratio for Australian enterprises who are not financial institutions (defined in section 159GZA of the Act) will be decreased from 3:1 to 2:1 [item 1; amendment to section 159GZA 'definition of foreign equity product']. A consequential amendment has been made in relation to the adjustment of the 'foreign equity product' in certain cases involving financial institutions (section 159GZM). This will ensure that the changed gearing ratio will be applied to cases where the equity of a foreign controller is ultimately invested in a financial institution as distinct from other investments. [Item 13]

Guarantees or securities provided by a foreign controller or a non-resident associate of a foreign controller

1.17 In relation to a resident company, overseas borrowings that are either guaranteed by a foreign controller or subject to a security provided by a foreign controller will generally be treated as foreign debt for thin capitalisation purposes. In addition, overseas borrowings by a resident company that are guaranteed by a non-resident associate of a foreign controller or subject to a security provided by a non-resident associate of a foreign controller will generally be treated as foreign debt [item 3; new subsection 159GZF(1A)]. New subsection 159GZF(1A) will not apply to financial institutions [paragraph 159GZF(1A)(a)] .

1.18 The elements of new subsection 159GZF(1A) are:

·
an Australian resident company owes an amount of money [new paragraph 159GZF(1A)(a)] ;
·
interest is either payable or may become payable, in respect of the borrowing, to an unrelated non-resident lender [new paragraph 159GZF(1A)(b)] . Note that if an amount is owing by a resident company to a foreign controller or their non-resident associates, the amount will be foreign debt under subsection 159GZF(1);
·
the interest is, or will be, an allowable deduction for the Australian company [new paragraph159GZF(1A)(c)] ;
·
the interest is not assessable income in Australia in the hands of the person providing the borrowing [new paragraph 159GZF(1A)(d)] . Thus if the person who provides the borrowing includes the interest income in its assessable income in Australia, the borrowing will not be treated as foreign debt. If a borrowing is provided by a company resident in Australia and it includes the interest in its Australian assessable income, the borrowing will not be treated as foreign debt. Similarly if the borrowing is provided by a non-resident company operating in Australia through a permanent establishment and the interest in respect of the borrowing is included in the permanent establishment's Australian assessable income, the borrowing will not be treated as foreign debt; and
·
the company has obtained from its foreign controllers or their non-resident associates a guarantee in respect of the borrowing or the borrowing is subject to a security provided by such persons [new paragraph 159GZF(1A)(e)] .

1.19 The elements in new subsection 159GZF(1A) are the same as those in existing subsection 159GZF(1) with the exception that:

·
the amount owing is raised from someone that is not a foreign controller or non-resident associate of a foreign controller; and
·
the amount owing is either guaranteed by its foreign controllers or non-resident associates or is subject to a security provided by its foreign controllers or their non-resident associates.

1.20 However, if a resident company can establish to the satisfaction of the Commissioner that an amount owing to a non-resident lender could have been borrowed, whether or not on the same terms and conditions, without a guarantee or security from a foreign controller or non-resident associate of a foreign controller, the amount will not be treated as foreign debt [new subsection 159GZF(1B)] . This provision provides an exemption if the Australian resident company can establish that, in effect, the guarantee or security did not increase the amount the taxpayer could have borrowed. In other words the company's net equity was sufficient for it to obtain the same amount from a prudent lender without such a guarantee or security. In determining the borrowing capacity of a foreign controlled company, amounts owing to foreign controllers and their non-resident associates should be treated in the same manner as any other loans of the company. Related party loans should not be treated as quasi-equity.

1.21 In order to be able to obtain the benefit of new subsection 159GZF(1B) an Australian company must be able to establish for each income year that the guarantee or security provided by foreign controllers or their non-resident associates did not affect the amount of finance that the lender was willing to provide. The exemption in new subsection 159GZF(1B) is targeted at loans where a foreign controller has provided a guarantee or security in order to decrease the borrower's cost of borrowing. If this is the only effect of the guarantee or security, then the loan will not be treated as foreign debt.

1.22 For example, if an Australian company obtained a guarantee from its foreign controller for a loan of $100 million provided by an unrelated overseas bank, the loan will prima facie be foreign debt under new subsection159GZF(1A). If, however, the Australian company has net equity of $500million, and the company is able to establish that the guarantee did not affect its borrowing capacity, it will be able to satisfy the Commissioner that the loan is eligible for exemption under subsection159GZF(1B). Such a company would be clearly able to establish that a prudent lender would have provided it with a $100 million loan without the guarantee. In this situation the guarantee may have been provided to improve the company's credit rating in order to decrease its cost of borrowing.

Foreign equity for partnerships

1.23 The foreign equity of a partnership will be determined by calculating the fixed interests of foreign controllers and their non-resident associates in the net income (or loss) and capital of the partnership [item 8; new subsection 159GZG(3)] . This is achieved through a formula in new subsection 159GZG(3) that adds the fixed interests of foreign controllers and their non-resident associates in the net income (or loss) and capital of a partnership. Under the formula the maximum total interests in a partnership may be up to 200 per cent because the fixed interests of the foreign controllers and their non-resident associates in the net income or loss of the partnership may be different to their fixed interests in the assets of the partnership. Accordingly, under the formula the maximum total interests of foreign controllers is halved.

1.24 Under the formula in new subsection 159GZG(3) a partnership must determine its total partnership equity. This amount is then multiplied by the fraction determined under the formula. The term in the formula dealing with partnership capital is:

A/(A+B)

This fraction determines the proportion of the capital of a partnership which is attributable to foreign controllers or their non-resident associates. This is done on the basis of determining the partners' equity to which foreign controllers or their non-resident associates are entitled. The partners' equity must be based on the fixed interests of the partners in the assets of the partnership as reduced by amounts owed to the partnership by foreign controllers or their non-resident associates, other than amounts owed in respect of short-term trade credit. The numerator is therefore the sum of the foreign controllers' and their non-resident associates' net equity in the partnership. The denominator is the sum of the numerator and the net equity of partners who are not foreign controllers or their non-resident associates. If the foreign controllers and their non-resident associates are entitled to the entire net equity in the partnership the fraction will be 1/1. If the foreign controllers are entitled to half of the net equity of a partnership the fraction will be 1/2.

1.25 The term in the formula dealing with partnership income is:

C/(C+D)

This fraction determines the proportion of net partnership income (or loss) which is attributable to interests held by foreign controllers or their non-resident associates in the income (or loss). This is done by determining the amount of net partnership income derived by foreign controllers and their non-resident associates as a result of their fixed interests in the income of the partnership. This amount is the numerator. The denominator is the sum of the numerator and the partnership income derived by persons other than foreign controllers or their non-resident associates in respect of fixed interests in the income of the partnership. If the foreign controllers and their non-resident associates are entitled to the entire net income of a partnership, the fraction will be 1/1. If the foreign controllers are entitled to half of the net income of a partnership the fraction will be 1/2.

Example

Assume a partnership has four partners and that two partners who are non-residents of Australia are foreign controllers of the partnership. Assume that the other two partners are residents of Australia and that each partner has a 25 per cent fixed interest in the capital and net income or loss of the partnership. Assume that the net income of the partnership is $40,000 and the net equity of the partnership is $200,000.

Foreign equity =$200,00 * (1/2)*((100,00/200,000)+(20,000/40,000))
Foreign equity = $100,000

In this example half of the equity of the partnership will be attributable to foreign controllers. The foreign equity product of this partnership will be $200,000 ($100,00*2). The foreign controllers and their non-resident associates will be entitled to lend up to $200,000 under the new thin capitalisation provisions.

Foreign equity for trusts

Calculation of foreign equity if a trust derives net income

1.26 The foreign equity of a trust will be determined by calculating the fixed interests of foreign controllers and their non-resident associates in either the net income for a year of income or capital of the trust [item 8; new subsection 159GZG(4)] . This is achieved through a formula in new subsection 159GZG(4) that aggregates the fixed interests of foreign controllers and their non-resident associates in the net income and capital of a trust. Under the formula the maximum total interests in a trust may be up to 200 per cent because one group of foreign controllers may have a fixed interest in all the trust net income and another group of foreign controllers may have a fixed interest in all the capital of the trust. Accordingly, under the formula the maximum total interests of foreign controllers is halved.

1.27 Under the formula in new subsection 159GZG(4) a trust must determine its total trust equity. This amount is then multiplied by the fraction determined under the formula. The term in the formula dealing with trust capital is:

A/(A+B)

This fraction determines the proportion of the capital of a trust which is attributable to foreign controllers or their non-resident associates. This is done on the basis of determining the beneficiaries' equity to which foreign controllers or their non-resident associates are entitled. The beneficiaries' equity must be based on the fixed interests of beneficiaries in the assets of the trust. The numerator is the sum of the foreign controllers' and their non-resident associates' net equity in the trust. The denominator is the sum of the numerator and the net equity of beneficiaries who are not foreign controllers or their non-resident associates. If the foreign controllers and their non-resident associates are entitled to the entire net equity in the trust the fraction will be 1/1. If the foreign controllers are entitled to half of the net equity of a trust the fraction will be 1/2.

1.28 The term in the formula dealing with trust income is:

C/(C+D)

This fraction determines the proportion of net trust income for a year of income which is attributable to foreign controllers or their non-resident associates. This is done by determining the amount of net trust income derived by foreign controllers and their non-resident associates as a result of their fixed interests in the income of the trust. This amount is the numerator. The denominator is the sum of the numerator and the trust income derived by beneficiaries other than foreign controllers or their non-resident associates in respect of fixed interests in the income of the trust. If the foreign controllers and their non-resident associates are entitled to the entire net income of a trust, the fraction will be 1/1. If the foreign controllers are entitled to half of the net income of a trust the fraction will be 1/2.

Example

Assume there are two foreign controllers of a trust and one foreign controller is entitled to the entire net income for a year of income from the trust which is $10,000. Assume that the other foreign controller has a fixed interest in the entire capital of the trust which is $100,000.

Foreign equity = $100,000 * (1/2) * ((100,000/100,000) + (10,000/10,000))
Foreign equity = $100,000

In this example the entire net equity of the trust will be attributable to foreign controllers. The foreign equity product of this trust will be $200,000 ($100,000*2). The foreign controllers and their non-resident associates will be entitled to lend up to $200,000 under the new thin capitalisation provisions.

Example

Assume there are two foreign controllers in relation to a trust. One foreign controller has a fixed interest in half of the net income for a year of income of the trust and a resident beneficiary has a fixed interest in the other half of the net income of a trust. One foreign controller has a fixed interest in half of the capital of the trust with a resident beneficiary having a fixed interest in the other half of the trust capital. Assume that the trust has income of $10,000 and net assets of $100,000. The foreign equity calculation will be:

Foreign equity = $100,000 * (1/2) * ((50,000/100,000) + (5,000/10,000))
Foreign equity = $50,000

In this example, the foreign controllers are entitled to half of the net equity of trust and therefore the trust will have foreign equity of $50,000. The foreign equity product of this trust will be $100,000 ($50,000*2). The foreign controllers and their non-resident associates will be entitled to lend up to $100,000 under the new thin capitalisation provisions.

Calculation of foreign equity if a trust incurs a loss or has no net income

1.29 If a trust does not derive net income or incurs a loss for an income year, the foreign equity of the trust will be determined on the basis of the foreign controllers' fixed interest in the assets of the trust [item 8, new subsection 159GZG(4A)] . This is achieved through a formula in new subsection 159GZG(4A) that determines the fixed interests of foreign controllers in the capital of a trust. As a beneficiary cannot have a fixed interest in a trust loss, the formula in new subsection 159GZG(4A) does not apply to trust income. 1.30 Under the formula in new subsection 159GZG(4A) a trust must determine its total trust equity. This amount is then multiplied by the fraction determined under the formula. The formula is:

A/(A+B)

This fraction determines the proportion of the capital of a trust which is attributable to foreign controllers and their non-resident associates. This is done on the basis of determining the beneficiaries' equity to which foreign controllers and their non-resident associates are entitled. The beneficiaries' equity must be based on the fixed interests of beneficiaries in the assets of the trust. The numerator is the foreign controllers' net equity in the trust. The denominator is the sum of numerator and the net equity of beneficiaries who are not foreign controllers or their non-resident associates. If the foreign controllers and their non-resident associates are entitled to all the net equity in a trust the fraction will be 1/1. If the foreign controllers and their non-resident associates are entitled to half of the net equity of a trust the fraction will be 1/2.

Example

Assume there are two foreign controllers of a trust and one foreign controller is entitled to the entire net income of the trust. Assume that the other foreign controller has a fixed interest in half of the capital of the trust and a resident beneficiary has a fixed interest in the other half of the capital of the trust. Assume further that the equity of the trust is $100,000 and the trust incurs a loss for the income year.

Foreign equity = $100,000 * (50,000/100,000)
Foreign equity = $50,000

In this example, half of the net equity of the trust will be attributable to foreign controllers. The foreign equity product of this trust will be ($50,000*2) $100,000. The foreign controllers and their non-resident associates will be entitled to lend up to $100,000 under the new thin capitalisation provisions.

Determination of a trust's balance sheet 1.31 In order to determine the foreign equity of a trust, a notional balance sheet for the trust must be prepared at the end of the income year. The foreign equity of a trust is the fixed interests of the foreign controllers in the equity of the trust at that time, having regard only to the use of trust property in producing assessable income of the foreign controllers or their non-resident associates. The foreign equity determined through the preparation of the notional balance sheet must then be reduced by any amounts owing to the trustee of the trust by foreign controllers or their non-resident associates other than amounts owing in respect of short-term trade credit.

Asset revaluation reserves for partnerships and trusts

1.32 In preparing a notional balance sheet for the purpose of the foreign equity calculations, a partnership or trust is allowed to revalue assets of the partnership or trust. A partnership or trust may only revalue assets up to their arm's length values [item 8; new subsection 159GZG(4B)] . For this provision to apply the partnership or trust must provide for asset revaluation reserves in it accounting records [new paragraph 159GZG(4B)(a)] . If the arm's length value of the assets of a partnership or trust are less than the amount shown in the balance sheet as representing the asset revaluation reserve, the asset revaluation reserve will be adjusted in accordance with the arm's length value changes for the purposes of determining the foreign equity of the partnership or trust [new paragraph 159GZG(4B)(b)] . For example, if a trust's asset revaluation reserve is $10,000 at the end of a year of income and the value of the assets has declined since the previous income year by $5,000, the trust's asset revaluation reserves are to be reduced to $5,000.

1.33 Credits to an asset revaluation reserve may only be included at the beginning of an income year, based on revaluations undertaken in the previous income year [new paragraph 159GZG(4B)(c)] . For example, if a trust has its income year ending on 30 June, the arm's length value of its assets has increased by $10,000 and the revaluation is included in its accounting records for that year, the increase will only be taken into account in the calculation of the trust's foreign equity for the following income year.

Foreign equity: Discretionary trusts

1.34 The foreign equity of a trust will be based on the fixed and indefeasible interests of foreign controllers and their non-resident associates in either the net income or capital of the trust. If a trust is treated as a discretionary trust under the definition in new subsection 159GZG(13), the trust's foreign equity will be reduced by the trust's maximum discretionary percentage. [Item 12; new subsections 159GZG(12) and (13)]

1.35 If the entire income or capital of a trust is subject to a discretionary power, the trust will be treated as having foreign equity of nil. If a trust is treated as having foreign equity of nil, its foreign equity product will be nil and it will be unable to obtain a deduction for interest on loans from foreign controllers or non-resident associates of the trust. Such discretionary trusts will only be able to obtain a deduction for interest on borrowings from arm's length parties or resident associates.

1.36 New subsection 159GZG(12) provides for apportionment of the foreign equity of discretionary trusts. This apportionment will apply to trusts in which some beneficiaries hold fixed interests in either the income or capital of the trust.

1.37 The foreign equity of a discretionary trust is determined by a three step process. Firstly the 'current equity amount' of a trust must be determined. This is the foreign equity of the trust determined under new subsection 159GZG(4). The second step is to determine if at any time during a year of income a trust was a discretionary trust [new paragraph 159GZG(12)(b)] . The third step is to determine the foreign equity of the trust using the formula in new subsection 159GZG(12). The formula, based on the definition of discretionary trust in new subsection 159GZG(13), determines the maximum proportion of a trust's income or assets that is subject to a discretion in respect of either the income or capital of the trust. This proportion is expressed as a percentage, called a 'maximum discretionary percentage'. A trust's current equity amount is then reduced by the maximum discretionary percentage.

1.38 The maximum discretionary percentage is defined in new subsection 159GZG(12) as meaning the amount determined using a table in that subsection. The table is divided into four categories, called cases. Each case is based on the three paragraphs of the definition of discretionary trust in new subsection 159GZG(13).

1.39 A discretionary trust is defined in new subsection 159GZG(13) as essentially a trust in respect of which any proportion of the interests of beneficiaries are not fixed. A trust will be treated as a discretionary trust if any one of the tests in new paragraphs 159GZG(13)(a), (b) or (c) are satisfied.

1.40 A trust will be a discretionary trust if a person, including a trustee, is empowered by whatever means to exercise a power of appointment or other discretion [new paragraph 159GZG(13)(a)(i)] . Also, if the power or discretion either in its use, or failure to use, results in determining the beneficiaries who may benefit under a trust, and the trust makes distributions to those beneficiaries, the trust will be held to be a discretionary trust [new paragraph 159GZG(13)(a)(ii)] .

1.41 The second test relates to a beneficiary's right to income or capital of a trust [new paragraph 159GZG(13)(b)] . A trust will be treated as a discretionary trust where one or more of its beneficiaries have a contingent or defeasible interest in some or all of the trust's income or capital.

1.42 The third test applies where the trustee of another trust, in respect of which both the conditions in new paragraph 159GZG(13)(a) are satisfied, benefits or is capable of benefiting from the first trust whether by the exercise of a power of appointment or otherwise. [New paragraph 159GZG(13)(c)]

Case 1: Discretionary power in relation to either trust income or capital

1.43 Under Case 1, if paragraph (a) of the new definition of discretionary trust in new subsection 159GZG(13) only applies in relation to a trust, the maximum discretionary percentage is the greatest percentage of the trust's income or capital that is subject at any time during the relevant income year ('the current year of income') to a trustee's discretion. If both the income and capital are subject to a discretion, the greater percentage is the maximum discretionary percentage. If either all the income, or capital, of a discretionary trust is subject to a discretionary power, the maximum discretionary percentage will be 100 per cent. Such a trust will have foreign equity of nil. If a trust's greatest percentage is less than 100 per cent, the foreign equity of the trust will be apportioned under the formula in new subsection 159GZG(12).

Example 1

Assume that a trust has a capital beneficiary with a fixed interest in the assets of the trust and another beneficiary with a fixed interest in half of the trust's income. The trustee has a discretion on how the other half of the net income of the trust will be distributed. Assume further that the foreign equity of the trust, called current equity amount, is $100,000. The maximum discretionary percentage will be 50 per cent because under Case 1 half of the net income of the trust is subject to a discretion. Applying the formula in new subsection 159GZG(12) the foreign equity of the trust will be:

Foreign equity = $100,000 - ($100,000 * 50 per cent)
Foreign equity = $50,000

Example 2

Assume the same facts as in Example 1, except that the trustee has the power to allocate up to three quarters of the trust's assets to certain beneficiaries. The maximum discretionary percentage will be 75 per cent as the trustee's discretion in relation to capital applies to a greater proportion of the trust's assets than the trustee's discretion in the relation to the income of the trust. Applying the formula in new subsection 159GZG(12) the foreign equity of the trust will be:

Foreign equity = $100,000 - ($100,000 * 75 per cent)
Foreign equity = $25,000

Case 2: Contingent or defeasible interests in trust income or capital

1.44 Under Case 2, if paragraph (b) of the definition of discretionary trust in new subsection 159GZG(13) only applies in relation to a trust, the maximum discretionary percentage is the percentage of the trust's income or capital to which the trust's beneficiaries have a contingent or defeasible interest. If both the income and capital are subject to a contingent or defeasible interest, the greater percentage is the maximum discretionary percentage. If the discretionary interest is 100 per cent the trust will be treated as having foreign equity of nil. If a trust's maximum discretionary percentage is less than 100 per cent, the foreign equity of the trust will be apportioned under the formula in new subsection 159GZG(12).

Example

Assume that a trust has two beneficiaries, one of which has a fixed interest in 50 per cent of the income and capital of a trust, and the other will be entitled to 50 per cent of the trust income and capital on reaching 21 years of age. Assume further, that the trust has current equity of $100,000. Prior to the contingent beneficiary reaching legal majority, the trustee may capitalise half of the income of the trust. The maximum discretionary percentage will be 50 per cent as one beneficiary has a contingent interest in 50 per cent of the net income and assets of the trust:

Foreign equity = $100,000 - ($100,000 * 50 per cent)
Foreign equity = $50,000

Case 3: Discretionary powers and concurrent contingent or defeasible interests

1.45 Under Case 3, if both paragraphs (a) and (b), but not paragraph (c) of the definition of discretionary trust in new subsection 159GZG(13), apply in relation to a trust, the maximum discretionary percentage is the greater of the percentage of the trust's income or capital that either is subject to the power or discretion mentioned in paragraph (a) or to which one or more of the trust's beneficiaries have a contingent or defeasible interest. Case 3 applies to provide that in this situation it is the greatest discretionary interest that is treated as the maximum discretionary interest of the trust.

Example

Assume that a trust has two beneficiaries. One beneficiary has a fixed interest in half of the net trust income and the trustee has a discretion as to the distribution of the other half of the net trust income. The other beneficiary has a fixed interest in 25 per cent of the trust's capital and has a defeasible interest in 75 per cent of the trust's capital. In this situation both paragraphs 159GZG(13)(a) and (b) apply concurrently to the trust. The maximum discretionary percentage will be 75 per cent because the capital beneficiary has a defeasible interest in three quarters of the trust's assets.

Case 4: Maximum discretionary percentage of 100 per cent

1.46 Under Case 4, if paragraph (c) of the definition of discretionary trust in new subsection 159GZG(13) applies in relation to a trust, the maximum discretionary percentage is 100 per cent. This will be the result whether or not either of the paragraphs (a) or (b) of the definition apply. New paragraph 159GZG(13)(c) applies if a beneficiary of a trust is a beneficiary in the capacity of a trustee of another trust in which the two conditions in new paragraph 159GZG(13)(a) are satisfied. A trust will be treated as a discretionary trust if the trustee of the other trust is capable of benefiting from the first trust whether by the exercise of a power of appointment or otherwise.

Consequential amendment

1.47 Section 159GZG(9), which involves a measure of the foreign equity of a partnership, trust or foreign investor, will be amended to take into account new subsection 159GZG(12). [Item 11]

Foreign partners, beneficiaries and trustees of partnerships and trusts

1.48 Foreign partners, beneficiaries and trustees of Australian partnerships and trusts will be subject to the thin capitalisation debt to equity ratio requirement, as well as the underlying Australian partnership or trust. This will be achieved by amending the definition of 'foreign investor' so that it no longer excludes partners in partnerships, beneficiaries of trusts and trustees of trusts. [Item 2; amendment to section 159GZA 'definition of foreign investor']

1.49 The foreign equity of a 'foreign investor' will include the investor's fixed interest in either the net income or capital of the underlying partnership or trust. Where the foreign investor is a beneficiary of a discretionary trust, the foreign equity will be based on the fixed and indefeasible interests of the foreign investor in either the net income or capital of the trust. [Item 10; new subsections 159GZG(5A) and (5B)]

1.50 To the extent that the income or capital of the trust is subject to a discretionary power, as described in new paragraph 159GZG(13)(a), it will be disregarded in calculating the foreign investor's equity [new paragraph 159GZG(5A)(a)] . To the extent that a beneficiary's interest is a contingent or defeasible interest, as described in new paragraph 159GZG(13)(b), it will also be disregarded in the calculation of foreign equity [new paragraph 159GZG(5A)(b)] . These amendments are a consequence of foreign equity not being capable of being effectively measured in those circumstances and complement the measures contained in Schedule 1 for determining the foreign equity of a discretionary trust.

1.51 When calculating a foreign investor's equity, any interest in a discretionary trust, where the trustee of another discretionary trust benefits, or is capable of benefiting under the first mentioned trust, is also to be disregarded [new subsection 159GZG(5B)] . The amendments will ensure that the foreign equity that a beneficiary has in an Australian trust is limited to fixed interests in the trust.

1.52 Paragraph 159GZG(5)(a), which defines the 'foreign equity' of a 'foreign investor', has been amended to reflect the revised definition of a 'foreign investor'. [Item 9]

Repeal of sections 159GZO and 159GZP

1.53 Sections 159GZO and 159GZP deal with back to back arrangements using intermediaries to give related party transactions the appearance of being transactions between arm's length parties in order to avoid the application of the thin capitalisation rules. Section 159GZO applies to loans from a foreign controller to its Australian enterprise provided through unrelated intermediaries and it re-characterises such loans as foreign debt. Section 159GZP applies to an Australian enterprise providing funds to its foreign controller through unrelated intermediaries and re-characterises such loans as equity loan-backs, which are reductions in the foreign equity of the enterprise. These provisions are being repealed because the general anti-avoidance provisions of Part IVA of the Act are considered to more effectively deal with such arrangements. [Items 14 and15]

1.54 As a result of the proposed repeal of section 159GZO the references to section 159GZO in paragraphs 159GZF(1)(c), 159GZF(2)(c), 159GZF(3)(c) and 159GZF(4)(c) will be deleted. [Items 4, 5, 6 and 7]

Application

1.55 The amendments made by Schedule 1 apply in relation to the 1997-98 income year and all later income years. [Item 16]

Transitional provisions - taxpayers with substituted accounting periods

1.56 The transitional provisions propose modifications to the application of the thin capitalisation measures for those Australian taxpayers who have a substituted accounting period [item 17] . Taxpayers with substituted accounting periods will be either early balancing taxpayers or late balancing taxpayers. Such taxpayers will have their income year divided into two notional income years ending on 30 June 1997 and commencing 1 July 1997 respectively. The existing thin capitalisation rules will continue to apply to the notional income year ending on 30 June 1997. The amendments contained in this Schedule will apply to the second notional year commencing on 1 July 1997.

1.57 A taxpayer with a substituted accounting period will calculate its foreign equity as usual, at the end of its income year, and this amount will be treated as the foreign equity for both notional income years. As usual, the taxpayer may increase its foreign equity before the end of its income year to ensure it does not exceed its foreign equity product. A taxpayer with a substituted accounting period will not have to calculate its foreign equity at 30 June 1997.

Late balancing taxpayers

1.58 An Australian taxpayer with a substituted accounting period for the 1996-97 income year that ends after 30 June 1997 will divide the 1996-97 income year into two notional income years. The first notional year will cover the period from the commencement of the taxpayer's income year until 30 June 1997. The second notional year will cover the remainder of the taxpayer's 1996-97 income year.

1.59 For example, for a taxpayer with its 1996-97 income year ending 31August 1997, the first notional income year will be from 1 September 1996 to 30 June 1997 and the second notional year will be from 1 July 1997 to 31 August 1997.

1.60 For the purposes of calculating the amount of foreign debt interest that is not allowable as a deduction, the term "days in year of income" in subsections 159GZS(3), 159GZT(4), 159GZU(3), 159GZV(3) and 159GZW(3) is defined as 365 for both the first and second notional years. The taxpayer's foreign equity for the 1996-97 income year will be used in both notional income years without any adjustment [paragraph (b) of subitem17(1)] . A taxpayer's foreign equity is calculated under section 159GZG.

Early balancing taxpayers

1.61 An Australian taxpayer with a substituted accounting period for the 1997-98 income year that ends before 30 June 1998, will divide the 1997-98 income year into two notional years. The first notional income year will cover the period from the commencement of the taxpayer's 1997-98 income year until 30 June 1997. The second notional income year will cover the remainder of the taxpayer's income year.

1.62 For example, for a taxpayer with its 1997-98 income year ending on 31 December 1997, the first notional income year will be from 1January 1997 to 30 June 1997, and the second notional year will be from 1July 1997 to 31 December 1997.

1.63 For the purposes of calculating the amount of foreign debt interest that is not allowable as a deduction, the term "days in year of income" in subsections 159GZS(3), 159GZT(4), 159GZU(3), 159GZV(3) and 159GZW(3) is defined as 365 for both the first and second notional income years. The taxpayer's foreign equity for the 1997-98 income year will be used in both notional income years without any adjustment [paragraph (b) of subitem 17(2)] . A taxpayer's foreign equity is calculated under section 159GZG.

Example

A foreign controller company has a wholly owned Australian subsidiary (Ausco) which it has funded with $1 million of equity and a $3 million loan with interest payable at 5% per annum ($150,000 per annum).

Ausco has a substituted accounting period ending 31 December 1997 for its 1997-98 income year and is therefore an early balancing taxpayer. Ausco's first notional income year will be from 1 January 1997 to 30 June 1997 whilst Ausco's second notional income year will be from 1 July 1997 to 31 December 1997. The existing thin capitalisation provisions of Division 16F will apply unchanged to the first notional year whilst the new measures will apply to the second notional income year. The taxpayer's foreign equity product for the first notional income year will be $3 million which is equal to its maximum foreign equity product of $3 million (based on a foreign debt to foreign equity gearing ratio of 3:1). As the taxpayer has not exceeded the set thin capitalisation threshold, the interest in respect of the first notional income year will not be disallowed.

In relation to the second notional income year, the taxpayer's foreign equity product is $3 million, which breaches the new prescribed foreign equity product of $2 million (based on a foreign debt to foreign equity gearing ratio of 2:1). Consequently interest in respect of the excess foreign debt will be disallowed. The amount of the taxpayer's foreign debt interest to be disallowed is calculated under subsection 159GZS(3) as follows:

= $150,000 * (($3,000,000 - ($1,000,000 * 2))/3,000,000) * (184/365)
= $25,205

In this example the taxpayer will be allowed a deduction of $124,795 for the 1997-98 income year in respect of foreign debt interest.


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