Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Chapter 2 - Finance shares
2.1 The proposed amendments in Schedule 2 of the Bill will amend the Income Tax Amendment Act 1936 (the Act) to:
- address tax avoidance arrangements involving Eligible Finance Shares (EFS) and Widely Distributed Finance Shares (WDFS);
- ensure that EFS dividends and WDFS dividends do not qualify as non-portfolio dividends; and
- deny an underlying foreign tax credit for dividends paid on EFS and WDFS.
2.2 The amendments will exclude dividends paid on EFS and WDFS from qualifying as non-portfolio dividends and from being eligible for an underlying foreign tax credit.
2.3 The changes will apply to dividends paid on EFS or WDFS on or after 3 February 1997 which is the date the measures were announced. [Item 6]
2.4 The Controlled Foreign Company (CFC) provisions contained in Part X of the Act provide special treatment for EFS and WDFS in recognition that these shares are in effect the equivalent of a debt rather than an equity investment.
2.5 Where shares qualify as EFS under section 327 they are eligible for special treatment under sections 350, 356 and 394. EFS held by Australian Financial Institutions (AFIs) are excluded from both the calculation of the direct control interest (subsection 350(5)) and the direct attribution interest (subsection 356(4)) in the company in which the AFI holds the EFS. This has the general effect that an AFI will not be subject to attribution on the CFC's income solely because it has financed the foreign entity by taking up an issue of EFS.
2.6 Further section 394 ensures that the attributable income of other shareholders (eg ordinary shareholders) does not include any amount that relates to the AFI's EFS dividend. This is achieved by allowing a CFC to claim a deduction when it pays a dividend on an EFS. The profits remaining, for attribution purposes, then equate to the profits available to the ordinary shareholders.
2.7 Where shares qualify as WDFS under section 327A they are also eligible for special treatment but only under sections 356 and 394. Subsection 356(4) provides for their exclusion from the calculation of the direct attribution interest in the company in which the WDFS are held and that company (if a CFC) is able to claim a section 394 deduction on any WDFS dividend it pays.
2.8 The Act affords certain tax treatments to shares that qualify as non-portfolio dividend shares in recognition of the fact that the investment represents a direct and active participation in the business of the foreign company (ie., in recognition that it is an equity investment). A non-portfolio dividend is defined as the dividend paid on a share which entitles the holder to control 10% or more of the voting interest in the offshore company (sections 160AFB and 317). Taxpayers who hold shares with the requisite voting interest can in certain circumstances derive dividend income in an exempt form or where the dividend income is assessable be entitled to an underlying foreign tax credit.
2.9 In contrast portfolio dividends are generally assessable in the recipient's hand and a credit is allowed for withholding tax (ie., no credit is given for the foreign underlying tax).
2.10 Tax avoidance schemes have been detected whereby AFIs exploited the tax treatment afforded to non-portfolio share dividends described in paragraph 2.8. It was never intended that this tax treatment would extend to dividends paid on EFS and WDFS which are afforded special tax treatment equating them to debt instruments.
2.11 To ensure that EFS and WDFS are treated in an equivalent manner to a debt instrument, dividends from these classes of shares will be treated as portfolio dividends by denying them non-portfolio dividend status.
2.12 Further the proposed amendments will deny holders of EFS or WDFS access to the underlying foreign tax credit, such credits not being available to portfolio share holdings.
2.13 The Bill amends paragraph 160AFB(4)(a) by inserting the words 'other than EFS and WDFS within the meaning of Part X' after 'beneficial owner of shares'. This ensures that EFS and WDFS dividends will not be able to access non-portfolio dividend status. Dividends from these classes of shares will no longer qualify as non-portfolio dividends, wherever the term appears in the Act. This will ensure, amongst other things, that they do not qualify as an exempting receipt for the purposes of section 23AJ and in certain circumstances will not qualify as notional exempt income under sections 402 and 403. Further this amendment will prevent an underlying foreign tax credit being claimed in respect of dividends paid on these classes of shares. Such treatment was intended for ordinary shareholders who beneficially own shares in an entity with a voting interest of 10% or greater. [Item 1]
2.14 The section 317 definition of non-portfolio dividend is also amended to exclude EFS and WDFS dividends. This is to ensure the dividends paid on these categories of shares do not qualify as non-portfolio dividends through the holding of other classes of shares. [Item3]
2.15 The Bill will also amend section 160AO to ensure the maximum foreign tax credit allowable for dividends paid on EFS and WDFS is limited to the foreign tax paid on the dividend, generally referred to as withholding tax. This will ensure that dividends paid on EFS and WDFS do not qualify for an underlying foreign tax credit through the holding of other classes of shares for any purposes of the Act. New subsection 160AO(4) makes it clear that in determining the tax paid on the dividend amounts of foreign underlying tax that are deemed to have been paid are ignored. [Item 2 - new subsections 160AO(3) and (4)]
2.16 The reference to 'Widely Distributed Finance Share Dividends' in paragraphs 402(2)(c) and (d) is superfluous with the amendment to section 317 and will be removed. [Items 4 and 5]