Senate

Taxation Laws Amendment Bill (No. 2) 1999

Explanatory Memorandum

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

Chapter 1 - Australia as a regional financial centre

Overview

1.1 The amendments contained in Schedule 1 to the Bill will amend the Income Tax Assessment Act 1936 (ITAA 1936) to implement a package of measures announced by the Prime Minister on 8 December 1997 as part of the Investing for Growth Statement (the Statement). The amendments also take account of the Treasurers Press Release No. 80 of 13 August 1998. The package is designed to, among other things, further enhance Australia's credentials as a world financial centre. In particular, measures included in the Australia-A Regional Financial Centre component of the Statement are aimed at making Australia a more attractive regional financial centre by building on Australia's existing advantages to ensure its participation in the increasing global trade in financial services.

1.2 Part 1 of Schedule 1 contains amendments that will:

Section 128F interest withholding tax exemption
widen the interest withholding tax (IWT) exemption provided under section 128F of the ITAA 1936 by removing, for eligible debentures issued by companies, the present requirements that they be issued outside Australia and that the interest be paid outside Australia;
allow issues of debentures or interests in debentures to Australian residents and still attract the IWT exemption under section 128F;
ensure that issues of bearer debentures made under section 128F to residents operating a business offshore would be within the scope of section 126;
extend the definition of company for the purposes of section 128F, to include a company acting in the capacity of a resident trustee, provided the trust is not a charitable trust and the beneficiaries of the trust are companies (as long as they are not trustee companies) for the purposes of section 128F;

Offshore Banking Units
extend the range of entities eligible to register as Offshore Banking Units (OBUs);
provide a tax exemption for income and capital gains of overseas charitable institutions managed by OBUs;
extend the range of eligible OBU activities to include:

-
custodial services;
-
trading in Australian dollars where the other party to the transaction is an offshore person;
-
trading in gold bullion with offshore persons in any currency;
-
trading in gold bullion with any person other than in Australian dollars;
-
trading in base metals and palladium bullion with offshore persons in any currency;
-
other trading activities (apart from currency trading) in Australian dollars with offshore persons;
-
eligible contract activities in Australian dollars with offshore persons; and
-
hedging in Australian dollars with related offshore persons;

remove the current anti-avoidance measure in section 128GB which prevents Australia being used as a conduit to channel loans to other countries;
reduce the capital gains tax liability where non-residents dispose of interests in OBU offshore investment trusts;
provide a foreign tax credit for foreign tax paid by an Australian resident OBU regardless of whether a Double Tax Agreement (DTA) applies;
remove the requirement that OBUs maintain separate nostro and vostro accounts; and
reduce the rate of OBU withholding penalty tax for breaches of the IWT concession from 300 per cent to 75 per cent.

Thin Capitalisation
relax the effect of the thin capitalisation loan back provisions so that an Australian subsidiary of a foreign bank may raise section 128F IWT exempt funds and on-lend those funds to a related Australian branch without affecting the subsidiaries thin capitalisation position.

1.3 Part 2 of Schedule 1 contains amendments that will:

Foreign Investment Funds
provide an exemption from the foreign investment fund (FIF) measures for interests in certain FIFs taxed on a worldwide basis in the United States (US);
provide a limited exemption for interests in certain FIFs taxed as conduit entities in the US; and
make these exemptions available when determining FIF income under the calculation method.

1.4 Consequential amendments will also be made to ensure:

the general trust provisions do not claw back the benefits of providing the exemption; and
the trustee of a trust FIF that qualifies for the exemption is taxed on the Australian source income of the trust under the general trust provisions.

1.5 Part 3 of Schedule 1 contains amendments that will:

Controlled Foreign Companies
provide an exemption from the controlled foreign company (CFC) measures for interests in US real estate investment trusts that derive income or hold assets principally in the US.

1.6 Regulation Impact Statements for the changes are provided at the end of the explanation for each Part.

Summary of the amendments

Purpose of the amendments

1.7 The purpose of these amendments is to further support the development of the funds management and corporate debt markets and to promote a more effective and competitive offshore banking regime. The measures will accommodate the integration of Australian financial markets into global markets.

1.8 The amendment to the thin capitalisation provisions will make it easier for a foreign bank branch operating in Australia to access loan funds that are exempt from IWT under section 128F. The amendment is required as a result of the interaction between Australia's thin capitalisation regime and IWT regime.

Date of effect

1.9 The legislation was first introduced into Parliament on 2July1998 as Schedule 3 to the Taxation Laws Amendment Bill (No.5) 1998 and lapsed when Parliament was prorogued for the election. The Statement announced that the measures were to apply from the date of introduction of the amending legislation. It is proposed that the legislation continue to apply from 2July1998 to ensure taxpayers are not disadvantaged by the delay in implementation.

Section 128F, Offshore Banking Units and Thin Capitalisation

1.10 Generally, the measures will apply from 2 July 1998.

Foreign Investment Funds

1.11 The exemption from the FIF measures will have effect for notional accounting periods of FIFs ending on or after 2 July 1998. The amendments to the calculation method and the consequential amendments to the general trust provisions will apply in relation to assessments for income years ending on or after 2 July 1998.

Controlled Foreign Companies

1.12 The proposed CFC amendments will apply for statutory accounting periods of CFCs ending on or after 2 July 1998.

Part 1- Withholding tax, Offshore Banking Units and Thin Capitalisation

Overview of Part 1 of the Chapter

1.13 Part 1 of Schedule 1 to the Bill will amend the ITAA 1936 to implement the section 128F, OBU and thin capitalisation measures. These measures are contained in Part 1 of Chapter 1 as follows:

Section 1 - section 128F;
Section 2 - OBUs; and
Section 3 - thin capitalisation.

1.14 An explanation of the dates of application is contained in Section4 and a regulation impact statement for the changes is provided in Section 5 .

Section 1 Section 128F interest withholding tax exemption

Background to the legislation

What is interest withholding tax (IWT)?

1.15 The taxation of Australian sourced interest paid or credited to non-residents, and residents operating through an offshore permanent establishment, (eg a branch) is subject to the provisions contained in Division 11A of the ITAA 1936. These provisions provide, in conjunction with the relevant Rates Act, that the recipient of Australian sourced interest is subject to withholding tax on the gross amount paid or credited. A rate of 10 per cent of the gross amount of the interest is imposed. The obligation for the collection of withholding tax is placed on the person making the payment.

What is the section 128F interest withholding tax exemption?

1.16 Under the current concession, the interest payable on debentures issued offshore is exempt from IWT provided certain conditions are met. Section 128F provides an exemption where a resident company issues debentures outside Australia; the interest payable by the resident company in connection with the debentures is paid outside Australia; the resident company issued the debenture outside Australia for the purpose of raising finance outside Australia; and the issue meets the requirements of the public offer test.

The definition of company in section 128F

1.17 Section 128F currently permits Australian resident companies to issue debentures which are eligible for the exemption. In addition, certain public bodies are treated as Australian resident companies for the purposes of section 128F, which enables them to qualify for the exemption in respect of their debentures issued overseas.

1.18 However, the term, company , is not defined for the purposes of the section 128F exemption and the question has arisen whether the term includes a company acting in the capacity of a trustee.

1.19 The proposed amendments will clarify the definition of company for the purposes of section 128F. The meaning will be extended to include a company acting in the capacity of a resident trustee for an Australian trust provided the trust is not a charitable trust and the beneficiaries of the trust are Australian companies, which are not trustee companies, for the purposes of section 128F.

The public offer test

1.20 There are a number of tests listed under subsections 128F(3) and 128F(4) which are collectively referred to as the public offer test. Companies are required, at the time of issuing debentures, to satisfy at least one of these tests in order to qualify for the section 128F exemption. The purpose of these tests is to ensure that lenders on overseas capital markets are aware that an Australian company is offering debentures for issue.

Loss of eligibility for the exemption

1.21 Currently an issue of debentures will fail the public offer test with a consequential loss of eligibility for the exemption, if at the time of issue, the issuing company is aware that the debentures will be acquired by a resident or an associate of the company.

1.22 The exemption will also be lost where the company issuing the debentures had reasonable grounds to suspect that the debentures would be acquired by a resident or an associate if the company. For example, if the Australian company issuing debentures was aware that a resident of Australia was proposing to acquire the debentures through an interposed overseas entity, the public offer test will not be satisfied for those debentures.

1.23 In order to further integrate the domestic and offshore corporate debt markets, the Government has decided to permit Australian residents, either within Australia or offshore, to acquire debentures or interests in debentures without affecting the eligibility of the issue as a whole for the section 128F IWT exemption.

What is a debenture?

1.24 The term debenture , in relation to a company is defined in section 6 of the ITAA 1936 as including stock, bonds, notes and any other securities of the company, whether constituting a charge on the assets of the company or not. This definition would include promissory notes or bills of exchange.

1.25 Broadly speaking, there are two classes of debentures, bearer and non-bearer. A bearer debenture is a debenture where the interest is payable to the person in possession of the security and details of the holder are not recorded. A non-bearer debenture or registered debenture is a debenture where the ownership of the security is recorded by or on behalf of the issuing company.

Tax treatment of debenture related interest paid to a resident

1.26 Generally, Australian residents who are paid interest in respect of debentures are subject to tax on the interest by assessment. Residents, other than residents who carry on business at or through a permanent establishment in another country, are not subject to interest withholding tax. Therefore, the section 128F exemption has no application for a resident in Australia and under the current law, if a company is aware that the debenture may be acquired by a resident the issue of debentures loses its eligibility for the exemption.

1.27 The proposed amendment will benefit residents who carry on business at or through a permanent establishment in another country as they will be able to acquire debentures which are eligible for the section 128F exemption. They will, however, continue to be liable for tax by assessment on interest.

Anti-avoidance measure

1.28 Under the current law, where interest is paid in respect of a bearer debenture to a person resident in Australia or to a non-resident carrying on business in Australia, section 126 provides that the issuing company will be subjected to tax if it fails to advise the Australian Taxation Office of the name and address of the holder of bearer debentures. The Income Tax (Bearer Debentures) Act 1971 imposes tax on the company at 47 per cent, the top marginal rate of tax for individuals.

1.29 However, if the interest is exempt from withholding tax because of sections 128F and 128GB (which refers to offshore banking units) then section 126 does not apply.

1.30 A consequential amendment to section 126 will broaden the scope of this anti-avoidance measure to include interest paid, in respect of a bearer debenture issued under section 128F, to residents who carry on business at or through a permanent establishment in another country.

Operation of the proposed measures

1.31 In order to encourage the development of the domestic corporate debt market the Government has decided to widen the IWT exemption in respect of debentures issued by companies. It will remove the requirements that these debentures be issued outside Australia for the purpose of raising finance outside Australia and that interest payable must be paid outside Australia.

1.32 The wider exemption will not be available to Commonwealth Government securities or securities issued by State or Territory central borrowing authorities (sovereign issues). However, the existing section 128F exemption applying to offshore issues of debentures will continue to be available to these entities.

1.33 Companies will still need to meet the public offer test in respect of all issues.

1.34 Companies will be permitted to issue debentures in Australia and offshore to residents and non-residents without affecting the overall withholding tax exemption. However, whilst interest payments paid offshore will qualify for the IWT exemption, residents acquiring debentures will be subject to tax on the interest by assessment.

1.35 There will be no restriction placed on where the interest is paid.

1.36 The proposed amendments will permit debentures to be issued simultaneously in Australia and overseas, to residents and non-residents.

1.37 For the purposes of section 128F, the meaning of company will be extended to include a company acting in the capacity of a resident trustee, provided the trust is not a charitable trust and the beneficiaries of the trust are companies, but not trustee companies, for the purposes of section 128F

1.38 Financial institutions involved in securitisation transactions will, therefore, be able to more easily access the section 128F interest withholding tax exemption. This is expected to increase competitive pressures in lending for home buyers and consumers by allowing lenders to access the cheapest funds free of withholding tax.

1.39 Section 126 will now impose a penalty rate of tax of 47% on the issuer of a bearer debenture if the issuer has failed to disclose the names and addresses of the debenture holders to the Australian Taxation Office where the interest is paid or credited to:

a resident located in Australia;
a resident carrying on a business in a country outside Australia at or through a permanent establishment; or
a non-resident carrying on business in Australia at or through a permanent establishment.

Explanation of the amendments

1.40 The proposed amendments to section 128F will remove the requirements that debentures be issued outside Australia and that interest payable must be paid outside Australia. An overview of how section 128F will operate after the amendments is provided at the end of this section in flow chart form.

1.41 The repeal of paragraphs 128F(1)(c) and 128F(1)(d) will allow companies to issue debentures either in Australia or offshore and will no longer restrict where interest payments may be made. [Item27] However, the wider exemption will not apply to sovereign issues.

The public offer test

1.42 Companies will still need to satisfy at least one of the public offer tests in respect of these issues. The existing requirement in paragraph 128F(3)(c) (the third public offer test) that the debentures be accepted for listing by an overseas stock exchange is amended by item 28 . This will remove the current restriction requiring the debentures to be listed on a stock exchange outside Australia and allow debentures to be listed on a stock exchange in Australia.

Acquisition by residents

1.43 An issue of debentures will not fail the public offer test where a resident acquires debentures either within Australia or offshore. This is achieved by the amendment proposed by item 29.

Acquisition by associates

1.44 The existing restriction prohibiting the issue of debentures to associates of the company will continue to apply under subsection 128F(5). The issue will fail the public offer test, with consequential loss of eligibility for the exemption, if the company was aware at the time of issue, that the debentures would be acquired by the issuing companies associate. [Item29]

1.45 Existing subsection 128F(6) will continue to deny the exemption if the issuing company was aware or should have been aware that the interest in respect of the debentures was paid to an associate of the company.

Central borrowing authorities

1.46 New subsection 128F(5A) will make it clear that the exemption will not be available to issues of debentures in Australia by:

Australian public bodies as defined in existing subsection 128F(7); or
State or Territory central borrowing authorities.

1.47 A central borrowing authority is defined in new subsection 128F(5A) as a body established for the purpose of raising finance for a State or Territory. New subsection 128F(5A) provides examples of central borrowing authorities. [Item 29]

Non-resident subsidiaries of Australian resident companies

1.48 Subsection 128F(8) allows certain fully owned non-resident subsidiaries of Australian resident companies to raise finance for their parents in a country listed in the Income Tax Regulations whilst retaining the exemption. The proposed legislation amends subsection 128F(8) to remove the requirement that interest must be paid outside Australia. [Items 30 and 31]

Interest paid by companies on bearer debentures

1.49 An amendment to paragraph 126(1)(c) will be made by item 23 to include holdings of bearer debentures by residents with a permanent establishment (eg, a branch) offshore.

Definition of company

1.50 Without affecting its meaning elsewhere in this Act, the extended meaning of the term company for the purposes of section 128F will be inserted in subsection 128F(9). (Item32)

Overview of Section 128F - Flow Chart 1

Overview of Section 128F - Flow Chart 2

Section 2 Offshore Banking Units

Background to the legislation

The offshore banking unit regime

1.51 The term offshore banking broadly refers to the intermediation by institutions operating in Australia in 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.

1.52 Under the present law, 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, State banks and other financial institutions that the Treasurer is satisfied are appropriately authorised to carry on business as dealers in foreign exchange: subsection 128AE(2).

1.53 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 ITAA 1936. For ease of explanation this document refers to OBU activities rather than OB activities.

Operation of the proposed measures

1.54 The proposed amendments extend both the range of eligible entities and eligible activities. The measures will increase the attractiveness of the OBU regime by reducing the compliance burden and widening the concessions available.

Entities eligible to apply for OBU status

1.55 As mentioned above, declaration as an OBU is currently confined to the financial entities listed in subsection 128AE(2). In order to facilitate greater non-bank competition for offshore business, the Government has decided to extend OBU status to:

funds managers incorporated under the Corporations Law which are:

-
money market corporations subject to the Financial Corporations Act 1974 or fully owned subsidiaries of these corporations;
-
holders of securities dealers licences under the Corporations Law;
-
holders of investment advisers licences under the Corporations Law;

life insurance companies registered under the Life Insurance Act 1995 ; and
other companies, including providers of custodial services, determined by the Treasurer to be OBUs.

Income tax exemption for offshore charities managed by an OBU

Charitable institutions

1.56 Currently, non-resident charitable institutions whose investments are managed by an OBU receive the same tax treatment as other offshore investors. Namely, income and capital gains derived from the offshore assets are exempt. However, income or capital gains derived from Australian assets are not exempt from income tax and are subject to Part IIIA of the ITAA 1936.

1.57 To encourage funds management by OBUs as well as investment in Australia by offshore charities, the Government has decided to exempt all income and gains of overseas charitable institutions where:

the investments which give rise to the income or gains are managed by an OBU; and
the charitable institution is exempt from tax in its home jurisdiction.

1.58 For the purposes of the measure overseas charitable institutions will be defined as those which would be exempt under item 1.1 of section50-5 of the Income Tax Assessment Act 1997 if they:

had a physical presence in Australia and incurred their expenditure and pursued their objectives principally in Australia; and
are exempt from income tax in the country in which they are resident.

1.59 The proposal is similar to the existing portfolio investment activity described in subsection 121D(6A) of the ITAA 1936. This activity allows OBUs to manage portfolio investments on behalf of non-residents subject to a 10 per cent limit on Australian assets. However, under the proposed activity there will be no limitation on the proportion of Australian assets which may be held.

The OBUs fee income

1.60 Consistent with the portfolio investment activity under subsection 121D(6A), OBUs will only be eligible for the 10 per cent concessional tax rate on the component of the management fee which relates to the foreign assets. The component relating to the Australian assets will be taxed at the full company rate.

Extension of eligible OBU activities

Custodial services

1.61 The Government has decided to extend the range of OBU activities to allow OBUs to provide custodial services to non-residents.

What are custodial services?

1.62 Custodial service providers (custodians) offer a broad range of services directed at investment related activities. In contrast to fund managers, custodians perform these functions at the direction of their clients. Some common entities providing custodial services as part of their broader activities are global banking groups, funds management groups and insurance companies.

1.63 Custodial services include the following:

safe-keeping of assets (the physical security and storage of assets);
settlement of transactions (the finalisation of financial matters to the point of settlement);
foreign exchange dealings;
collection of income (the collection and distribution of interest and dividend income);
corporate actions (the notification of and follow-up regarding upcoming corporate events in which clients have an interest);
securities management;
reporting and advisory services; and
tax reclamation (obtaining tax refunds where appropriate).

Implementation of the measure

1.64 Currently OBUs undertaking portfolio investment activities described in subsection 121D(6A) are allowed to make and manage investments on behalf of non-residents. Under this activity OBUs are permitted to invest in Australian assets subject to a 10 per cent limit (by value) on the Australian asset component of each investment portfolio.

1.65 As custodians provide similar services to those provided by fund managers, the new custodial services activity will be included within the existing portfolio investment activity. The amendments will allow OBUs to undertake custodial services at the direction of non-residents.

The OBUs fee income

1.66 Consistent with the portfolio investment activity under subsection 121D(6A), OBUs will only be eligible for the 10 per cent concessional tax rate on the component of the management fee which relates to the offshore assets. The component relating to the Australian assets will be taxed at the full company rate.

Currency trading

1.67 Under the current concessional tax regime OBUs are allowed to trade on their own behalf in spot or forward foreign currency, or options or rights in respect of foreign currency, with any person, but not where the trade involves Australian currency on either side of the transaction: paragraph 121D(4)(e).

1.68 The proposed legislation extends this activity in order to allow transactions in Australian currency where the other party to the transaction is an offshore person. The term offshore person is defined in section 121E and in broad terms means non-residents (excluding Australian branches of non-residents), foreign branches of Australian residents and OBUs. The measures, however, continue to prohibit Australian dollar trading with Australian residents not operating through foreign branches.

Gold trading

1.69 The range of eligible OBU activities also permits OBUs to trade in gold bullion with offshore persons where any money payable or receivable is not Australian currency: paragraph 121D(4)(f).

1.70 The proposed legislation will extend this activity by broadening the parties with which an OBU may trade and removing, in the case of offshore persons, the currency restriction. The proposal is as follows:

offshore persons - the existing currency restriction will be removed and OBUs will be permitted to trade in gold bullion with offshore persons where any money payable or receivable under the trade is in Australian currency; and
residents and non-residents operating through a permanent establishment in Australia - OBUs will be permitted to trade in gold bullion with residents and Australian branches of non-residents but the existing currency restriction will apply. That is, no Australian dollar transactions will be permitted.

Metals trading

1.71 Trading with an offshore person in silver and platinum bullion, or rights in respect of such bullion, is permitted under the OBU regime, as long as any money payable or receivable is not Australian currency. The measures will remove the currency restriction.

1.72 Currently physical trading in the base metals (aluminium, aluminium alloy, zinc, tin, lead, nickel and copper) is not a trading activity under subsection 121D(4) and, therefore, is not an eligible OBU activity.

1.73 At present, physical trading in palladium bullion is also not an eligible OBU activity. Palladium is a rare element of the platinum group and is traded in the precious metals market.

1.74 Derivative transactions in base metals and palladium bullion, however, are currently eligible contract activities under subsection 121D(5). In order to allow all transactions in an OBUs global commodities book to be eligible OBU activities, the Government has decided to extend trading activities to include physical trading in base metals and trading in palladium bullion with offshore persons in any currency. These measures have been provided as a result of industry representations. They were not included in the Statement.

Other trading activities

1.75 Currently OBUs are permitted to undertake a number of distinct trading activities (apart from currency trading) with offshore persons where any money payable or receivable is not in Australian currency or where the shares, eligible contracts, securities or units traded are not denominated in Australian currency: subsection 121D(4). It is proposed to extend this activity to allow transactions in Australian currency with offshore persons.

Eligible contract activities

1.76 Under the existing concessions OBUs are allowed to enter into a futures contract, a forward contract, an options contract, a swap contract, a cap, collar, floor or similar contract with offshore persons where any money payable or receivable is not in Australian currency: subsection 121D(5). This activity will be extended to allow transactions in Australian currency with offshore persons.

Hedging

1.77 Hedging of interest rates and currency is used to manage exposure to risk from borrowing and lending activities. Hedging is currently permitted with an offshore person in Australian currency as long as the counter-party is not a related person: subsection 121D(8).

1.78 In broad terms, a related person is an associate of the OBU or any permanent establishment of the OBU through which activities other than OBU activities are carried on. The terms related person and associate are defined in section 121C.

1.79 The Government has decided to extend this activity by removing the related person restriction. This will allow OBUs to trade in Australian currency with their associates and offshore permanent establishments (eg. a branch).

Interest paid on offshore borrowings under conduit arrangements

1.80 Section 128GB provides an exemption from IWT on interest or gold fees paid by OBUs to non-residents where the money or gold borrowed is part of a borrowing activity and the money or gold is used to fund other OBU activities. Subsection 128GB(3) is a measure designed to protect another countries tax base by preventing an OBU situated in Australia being used as a conduit to channel the loan. It does this by denying the IWT exemption where an OBU is used as a mere conduit for a loan transaction.

1.81 In order to increase the attractiveness of the concessional tax regime by allowing back-to-back offshore loans through an OBU, the Government has decided to remove this anti-avoidance measure.

Capital gains tax exemption for disposals of interests in OBU offshore investment trusts

1.82 The Government has decided to reduce the capital gains tax (CTG) liability of non-residents disposing of their units in OBU offshore investment trusts. The purpose of the measure is to remove the CTG liability on gains relating to the underlying foreign assets held by these trusts.

What is an OBU offshore investment trust?

1.83 Under subsections 121D(6) and 121D(6A) an OBU may undertake investment activities on behalf of non-residents as trustee or central manager and controller of a trust. The trust is broadly referred to as an OBU offshore investment trust.

The Australian asset percentage

1.84 The portfolio investment activity described by subsection 121D(6A) allows OBUs to invest in Australian assets on behalf of non-residents subject to a 10 per cent limit on the Australian asset component of each investment portfolio. In broad terms, the Australian asset percentage of an investment portfolio is the percentage of Australian assets held in the portfolio.

1.85 In the case of an investment activity under subsection 121D(6), OBUs are not permitted to invest in Australian assets. Therefore, in these cases the Australian asset percentage will be zero.

Capital gains tax implications

1.86 If a non-resident beneficiary of an OBU offshore investment trust disposes of an interest (unit) in the trust a CTG liability may arise. However, this will only be the case where the unit is a CTG asset having the necessary connection with Australia.

1.87 In this context, category number 6 of section 136-25 of the Income Tax Assessment Act 1997 provides that a unit in a unit trust has the necessary connection with Australia if:

the unit trust is a resident trust for CTG purposes for the income year in which the CTG event (the disposal of the unit by the beneficiary) happens; and
the beneficiary, and their associates, beneficially owned at least 10% of the issued units in the trust at any time during the 5 years preceding the CTG event (the disposal of the units by the beneficiary).

1.88 The proposed legislation reduces the CTG liability to make it proportional to the share of the gain which relates to any underlying Australian assets held by the OBU offshore investment trust under subsections 121D(6) and 121D(6A) where:

the OBU offshore investment trust is a unit trust; and
the Australian asset percentage is not more than 10 per cent.

OBU income and foreign tax credits

1.89 Under the foreign tax credit system, a foreign tax credit is available only to residents for foreign tax paid on foreign income. A foreign tax credit is not available for offset against Australian tax payable on OBU income because the income is deemed to have an Australian source: section 121EJ. Instead the OBU regime allows a tax deduction: section 121EI.

1.90 Under the terms of a number Dates, however, the source article provides that where foreign tax is paid on income, the source of the income is deemed to be in the foreign country. Where this arises the legislation makes it clear that OBUs cannot claim both a foreign tax credit and a deduction: subsection 121EI(2).

1.91 To provide for greater neutrality in the treatment of OBUs which are residents of Australia, the Government has decided to provide a foreign tax credit for foreign tax paid by these OBUs regardless of whether a DTA applies. As is currently the case, however, an OBU will not be permitted to claim both a foreign tax credit and a deduction.

1.92 OBUs which are non-residents will still be permitted to claim a deduction as they will not be entitled to a foreign tax credit.

Separate nostro and vostro account requirement

1.93 As the law now stands, OBUs are required to maintain a separate pool of funds and to keep separate identifiable records, including separate nostro accounts in respect of OBU activities. These records must be maintained as though the OBU were a bank conducting banking activities with another person: section 262A. Vostro accounts may also be maintained by financial institutions.

1.94 In the context of Australian OBUs, nostro (our) accounts are foreign currency denominated accounts maintained by Australian OBUs with foreign banks for the purpose of settling foreign currency transactions. Vostro (your) accounts are Australian dollar accounts maintained by foreign banks with Australian OBUs for the purpose of settling foreign currency transactions.

1.95 In order to reduce compliance costs, the proposed legislation will remove the requirement to operate separate nostro or vostro accounts. However, an OBU will still need to maintain sufficient records, in accordance with generally accepted accounting principles and section262A, to identify OBU transactions passing through the accounts.

Reduction of OBU withholding penalty tax

1.96 An OBU may be liable under section 128NB of the ITAA 1936 for a special penalty tax where funds, that are subject to the OBU interest withholding tax concession under section 128GB of the ITAA 1936, are dealt with by the OBU in a manner excluded by the legislation. For example, where the funds are lent directly or indirectly to an Australian resident, used for general banking activities or used for other purposes by the financial institution of which the OBU is a part.

1.97 The penalty tax is imposed by the Income Tax (Offshore Banking Units) (Withholding Tax Recoupment) Act 1988 at a rate of 300 per cent on the amount of withholding tax that would have been paid if the concession had not applied.

1.98 The Government has decided that the current level of penalty is excessive. The measure will amend the Income Tax (Offshore Banking Units) (Withholding Tax Recoupment) Act 1988 to reduce the penalty tax from 300 per cent to 75 per cent. The proposed new rate is more in line with penalties applying to breaches of the OBU income tax concessions, however, it will continue to provide a significant disincentive to use funds subject to the IWT concession for general banking activities.

Explanation of the amendments

Entities eligible to apply for OBU status

1.99 Item 24 amends subsection 128AE(2) to extend the range of entities which the Treasurer may declare as OBUs. These are:

life insurance companies registered under the Life Insurance Act 1995 ; [New paragraph 128AE(2)(d)]
a company incorporated under the Corporations Law that provides funds management on a commercial basis other than solely to related persons. The company may be either:

1.
registered and included in the category of money market corporations under the Financial Corporations Act 1974; or [New subparagraph 128AE(2)(e)(i)]
2.
a fully owned subsidiary of a corporation in 1 above; or [New subparagraph 128AE(2)(e)(ii)]
3.
a holder of a dealers licence or an investment advisers licence granted under Part 7.3 of the Corporations Law; and [New subparagraph 128AE(2)(e)(iii)]

other companies, including providers of custodial services, determined by the Treasurer to be OBUs. [New paragraph 128AE(2)(f) ]

1.100 For the purposes of new paragraph 128AE(2)(f), new subsection 128AE(2AA) will require the company to make a written application to the Treasurer. [Item 25] The Treasurers determination must specify the date when the company commences to be an OBU. [New subsection 128AE(2AB)]

1.101 The determination under new subsection 128AE(2AA) must be made in accordance with written guidelines made by the Treasurer under new subsection128AE(2AD) . These guidelines are disallowable instruments for the purposes of section 46A of the Acts Interpretation Act 1901 . Broadly speaking, this means that the disallowable instruments must be laid before both Houses of Parliament and that either House may pass a resolution disallowing any of the instruments. [New subsection 128AE(2AE)]

Income tax exemption for offshore charities

Eligible overseas charitable institutions

1.102 Item 4 will insert a new definition into section 121C in order to define institutions which will be eligible for the exemption. Broadly, the term overseas charitable institution is defined to mean an institution whose income:

would be exempt from tax under item 1.1 of section 50-5 of the Income Tax Assessment Act 1997 if the charitable institution had a physical presence in Australia and incurred its expenditure and pursued its objectives principally in Australia ; and
is exempt from income tax in the country in which it is resident.

Investment activity Portfolio investment for charitable institutions

1.103 The proposed amendments will insert a new activity which is described in the legislation as investment activity portfolio investment for charitable institutions . For ease of explanation the new activity will be referred to in this document as the charitable investment activity . [Items 5 and 15, new subsection 121D(6B)] The charitable investment activity is similar in concept to the existing portfolio investment activity under subsection 121D(6A).

1.104 The meaning of the term investment activity will be extended to include the managing as a broker, an agent, a custodian or a trustee of a portfolio investment during an investment management period for the benefit of overseas charitable institutions where the portfolio investment was made by the OBU or the overseas charitable institution. [Item 15, new subsection 121D(6B)]

1.105 The new activity will link into the existing definition of portfolio investment in subsection 121DA(1). This definition is to be amended by item 17 to include the management by an OBU as custodian, under a contract or trust instrument, of investments for the benefit of an overseas charitable institution.

Investment management period

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

The OBUs fee income

The Australian asset percentage

1.107 Unlike the existing portfolio investment activity under subsection 121D(6A), the charitable investment activity does not place a limit on the proportion of Australian assets which may be held in the investment portfolio. Therefore, the Australian average percentage will not be relevant when determining whether the activity constitutes a charitable investment activity.

1.108 However, from the perspective of the OBUs fee income, the average Australian asset percentage will be relevant when determining the proportion of this income which will be subject to the concessional rate of tax. This percentage is essentially the average, over a defined period, of the monthly Australian asset percentages of the investment portfolio. The calculation of this percentage is shown below.

Monthly Australian asset percentage

1.109 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: subsection 121DA(3). 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.

1.110 The monthly Australian asset percentage must be calculated according to reasonable accounting practice and on the same basis for all months of a year of income. This allows 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: subsection 121DA(4).

Average Australian asset percentage

1.111 The average Australian asset percentage is the average, over the year of income, of the monthly Australian asset percentages: subsection 121DA(2). Item 18 will amend subsection 121DA(2) which defines the term average Australian asset percentage so that a link is created with the new charitable investment activity under new subsection 121D(6B) .

Assessable OB income

1.112 In broad terms, the income from OBU activities 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 deduction 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

1.113 Item 19 will amend subsection 121EE(3A) in order to reduce the OBUs assessable OBU income (that is, income from eligible OBU activities) 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.

Allowable deductions

1.114 The reduction in the OBUs assessable OBU income (as explained in the previous paragraph) will mean that expenses incurred in managing a charitable investment portfolio will not fall within the definition of exclusive OBU deduction in subsection 121EF(3). The expense will, therefore, relate to both OBU and non-OBU activities and will need to be apportioned as a general OBU deduction: subsection 121EF(4).

Example

1.115 AusOBU managed a charitable investment portfolio for three and a half months during a year of income. The portfolio comprised shares in both resident and non-resident companies. AusOBU produced reports on the portfolio it managed from its records on a monthly basis. It used this information to calculate the average Australian asset percentage.

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

A B C D F
Month Total Value of the Investment Portfolio AUDm Australian Asset Value AUDm Monthly Australian Asset Percentage (C/B) Average Australian Asset Percentage
1 5.0 4.5 4.5/5.0 = 90%
2 5.5 5.0 5.0/5.5 = 91%
3 6.0 6.0 6.0/6.0 = 100%
4 5.75 5.5 5.5/5.75 = 95%
94%

Assessable OBU income

$57,500 x 94% = $54,050

Therefore, AusOBU would be concessionally taxed on AUD3,450.

The exemptions from income tax and withholding tax

1.116 The income and gains derived by the overseas charitable institution from the assets managed by an OBU under the new charitable investment activity will be exempt from income tax. The form of the exemption will depend on whether the OBU is acting in the capacity of trustee of an OBU offshore investment trust or as custodian, broker or agent of the overseas charitable institution. Additionally, the type of income will also determine the form of the exemption.

1.117 The proposed legislation amends section 121EL to exempt income and gains of the OBU offshore investment trust derived in the course of, or in connection with, an investment activity covered by new subsection 121D(6B) . [Item 21] New paragraph 121ELA(1)(b) will exempt distributions of income from the OBU offshore investment trust to the overseas charitable institution.

Income tax and capital gains derived through OBUs acting as custodian, broker or agent

1.118 Where the investment is managed by the OBU as custodian, broker or agent, income from the charitable investment activity will be derived by the overseas charitable institution. New paragraph 121ELA(1)(a) will provide an exemption for income derived by an overseas charitable institution where:

the income is a payment or outgoing from an OBU; and
the payment or outgoing was made in relation to the OBUs eligible activities. [Item 22]

Withholding tax exemption

1.119 Item 26 will amend paragraph 128B(3)(a) to provide an exemption from interest, dividend and royalty withholding tax in relation to income derived by an overseas charitable institution where that income is exempt under new subsection 121ELA(1) . [Item 22]

Extension of eligible OBU activities

1.120 As the proposed amendments have extensively widened the range of eligible activities (as described below) that qualify for the concessional tax treatment a summary has been included in Table1 which appears at the end of this section.

Custodial Services

Extending the existing portfolio investment activity

1.121 The measures will extend the scope of the portfolio investment activity by allowing OBUs to make and manage investments as custodian on behalf of non-residents by amending subsection 121D(6A). [Item 13]

1.122 The term portfolio investment is defined in subsection 121DA(1) 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. Item 17 will amend the definition of portfolio investment in subsection 121DA(1) to include the management by an OBU as custodian, under a contract or trust instrument, of investments for the benefit of a non-resident.

1.123 After these amendments the portfolio investment activity described in subsection 121D(6A) will allow an OBU to manage (as broker, agent, custodian or 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.

1.124 Therefore, the expanded activity will allow OBUs, subject to a 10% per cent limit, to manage as custodian Australian investments (eg. shares in Australian companies, units in Australian unit trusts, land and buildings located in Australia) on behalf of non-residents.

1.125 Existing paragraph 121D(6A)(b) will also be amended to allow the non-resident investor as well as the OBU to make the investment which will be managed by the OBU. This will accommodate the situation arising under custodial services where the client makes the investment, for example purchasing an asset, and the custodian holds and deals with the investment at the direction of the client. [Item 14]

1.126 Consistent with the existing provisions, where the average Australian asset percentage in respect of the portfolio investment held under the custodial arrangement exceeds 10 per cent, the activity will not fall within the definition of a portfolio investment activity in subsection 121D(6A) and the whole of the fee income will be subject to the general company rate of tax.

The OBUs fee income

1.127 As is currently the case, the OBUs assessable OB income from providing the services to the non-resident will be reduced by the average Australian asset percentage in respect of the portfolio investment concerned. An explanation on how this percentage is calculated is shown at paragraphs 1.105 to 1.109. This has 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 making and 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: subsection 121EE(3A).

Currency trading

1.128 Item 10 inserts new paragraph 121D(4)(ea) which will allow OBUs to trade in any currency with an offshore person.

Gold trading

1.129 Item 11 repeals existing paragraph 121D(4)(f) and substitutes a provision which will apply solely to gold trading activities. New subparagraph 121D(4)(f)(i) will allow trading in gold bullion with an offshore person in any currency. New subparagraph 121D(4)(f)(ii) permits trading in gold bullion, or in options or rights in respect of such bullion, with a person other than an offshore person provided that any money payable or receivable is not in Australian currency.

Metals trading

1.130 New paragraph 121D(4)(g) will be inserted by item11 to allow trading in silver, platinum or palladium bullion or in options or rights in respect of such bullion with an offshore person. This amendments extends the existing concessional activities by allowing trading in silver, platinum and palladium bullion with an offshore person in Australian currency.

1.131 New paragraph 121D(4)(h) expands trading activities to allow base metals trading with an offshore person in Australian currency. [Item11]

Other trading activities

1.132 The proposed amendments to subsection 121D(4) made by items6, 7, 8 and 9 allow trading in securities issued by non-residents, eligible contracts (where amounts payable are payable by non-residents), shares in non-resident companies and units in non-resident trusts with an offshore person to be in any currency.

Eligible contract activities

1.133 Existing subsections 121D(5) is amended by item 12 to extend eligible OBU activities to include eligible contract activities with an offshore person in Australian currency.

Hedging

1.134 Amendments to subsection 121D(8) by item 16 remove the related person restriction.

Interest paid on offshore borrowings under conduit arrangements

1.135 Item 33 repeals subsections 128GB(3) and 128GB(4) to allow back-to-back offshore loans through an OBU.

Capital gains tax exemption for disposals of interests in OBU offshore investment trusts

1.136 The proposed amendments will insert new subsection 121ELA(2) and new section 121ELB to give effect to the Governments decision to reduce the capital gains tax liability of non-residents disposing of their units in OBU offshore investment trusts. [Item 22] The provision applying to the particular disposal will depend on whether the income , profits or gains of the trust came from an investment activity covered by existing subsection 121D(6) or 121D(6A) or new subsection 121D(6B) .

Investment activity under subsection 121D(6)

1.137 In the case of an investment activity under subsection 121D(6), OBUs are not permitted to invest in Australian assets and consequently the Australian asset percentage of the portfolio will be zero. Accordingly, new subsection 121ELB(1) provides that the non-resident makes no capital gain or capital loss from a disposal of a unit in an OBU offshore investment trust. [Item 22]

Investment activity portfolio investment under subsection 121D(6A)

1.138 If the OBU offshore investment trust relates to an investment activity under subsection 121D(6A), the amount of the capital gain or capital loss made by a non-resident disposing of a unit in an OBU investment trust will depend on the average Australian asset percentage of the particular investment portfolio. [Item22 new subsection 121ELB(2)]

1.139 An explanation of the term average Australian asset percentage is at paragraph 1.109. For the purposes of calculating the average Australian asset percentage in relation to an adjustment under new subsection 121ELB(2) , the investment management period of the portfolio investment is deemed to be the 12month period immediately before the disposal. [New subsection 121ELB(3)]

1.140 Where the average Australian asset percentage of an OBU offshore investment trust is 10 percent or less, the capital gain or loss will be adjusted to make it proportional to the average Australian asset percentage of the portfolio. However, if the average Australian asset percentage is greater than 10 per cent, no adjustment will be permitted. [New subsection 121ELB(2)]

Example

1.141 The Happy Retirement pension fund owns 20% of the units in an offshore investment trust (the ABC unit trust). The ABC unit trust holds a portfolio which comprises 92 % foreign assets and the average Australian asset percentage is 8%. The pension fund disposes of its units and makes a capital gain of $10,000.

1.142 Under the proposed measure the capital gain would be reduced to be proportional to the average Australian asset percentage as follows:

$10,000 x 8% = $800

Investment activity portfolio investment for overseas charitable institution under new subsection 121D(6B)

1.143 Consistent with the Governments decision to exempt certain overseas charitable institutions, new subsection 121ELA(2) will provide that an eligible institution makes no capital gain or capital loss from a disposal of its interest in an OBU offshore investment trust. [Item 22]

OBU income and foreign tax credits

1.144 In order to provide a foreign tax credit for foreign tax paid by an OBU item 20 inserts new subsection 121EJ(2) which deems, for the purposes of Division 18, income subject to foreign tax to have a foreign source. The existing section 121EI will continue to:

provide a deduction to non-resident OBUs for foreign tax paid (non-residents are not entitled to claim foreign tax credits); and
disallow a deduction where an OBU is entitled to claim a foreign tax credit.

Separate nostro and vostro account requirement

1.145 Item 35 removes the requirement that OBUs maintain separate nostro and vostro accounts for OBU transactions by inserting new subsection 262A(1AA) .

Reduction of OBU withholding penalty tax

1.146 Item 38 amends section 7 of the Income Tax (Offshore Banking Units) (Withholding Tax Recoupment) Act 1988 to reduce the penalty tax rate of 300 per cent to 75 per cent.

Consequential amendments

1.147 Items 1, 2, and 3 are consequential amendments to subsection 121B(3) to reflect changes to the OBU regime.

1.148 Items 36 and 37 make consequential amendments to the Income Tax Assessment Act 1997 as a result of the measures.

Table 1. OBU activities that qualify for the concessional tax treatment are summarised in general terms below with relevant currency restrictions

  offshore persons s.121E   Onshore persons
Type of Activity Non-Resident (not a related person) s.121E(a) Permanent Establishment of Resident s.121E(b) Other unrelated OBUs s.121E(c) Related Persons s.121C Branch of non-resident Resident
Borrowing 121D(2)(a) any currency non-AUD any currency non-AUD
Lending 121D(2)(b) any currency non-AUD any currency any currency
Guarantees 121D(3) any currency any currency any currency non-AUD
Trading in currency 121D(4)(e) & (ea) any currency 121D(4)(ea) any currency 121D(4)(ea) any currency 121D(4)(ea) any currency 121D(4)(ea) non-AUD 121D(4)(e) non-AUD 121D(4)(e)
Trading in base metals 121D(4)(h) any currency any currency any currency any currency
Trading in gold 121D(4)(f)(i) & (ii) any currency any currency any currency any currency non-AUD 121D(4)(f)(ii) non-AUD 121D(4)(f)(ii)
Trading in platinum silver, and palladium 121D(4)(g) any currency any currency any currency any currency
Trading on Sydney Futures Exchange 121D(4)(d) non-AUD non-AUD non-AUD non-AUD non-AUD non-AUD
Other Trading 121D(4)(a) (b) & (c) any currency any currency any currency any currency
Eligible Contract Activity 121D(5) any currency any currency any currency any currency
Investment 121D(6) non-AUD If non-resident offshore person - non-AUD
Portfolio Investment includes custodial services 121D(6A) non-AUD If non-resident non-AUD non-AUD
Portfolio investment for overseas charitable institutions This activity can only be undertaken with eligible overseas charitable institution. There are no currency restrictions.
Advising 121D(7) This activity can only be undertaken with offshore persons. Currency is not relevant.
Hedging 121D(8) any currency any currency any currency any currency
Key: A greyed cell means this activity is not available;
All legislative references are to provisions of the Income Tax Assessment Act 1936.

Section 3 - Thin Capitalisation

Background to the legislation

1.149 The thin capitalisation rules of the income tax law, contained in Division 16F of Part III of the ITAA 1936 , are anti-avoidance measures aimed at limiting the amount of interest that can be claimed as a deduction in relation to certain foreign controlled entities and investments.

1.150 Thin capitalisation of investments in Australia is influenced by the preferential taxation treatment provided to debt funding relative to equity funding. In relation to the foreign debt of an Australian company, interest paid by the company is deductible against its income and the interest paid to the foreigner is normally only subject to IWT at the rate of 10 per cent. However in relation to foreign equity, dividends paid to the foreign shareholders are generally paid from profits that have been subject to the 36 per cent company rate of tax and, under the imputation system, are not subject to dividend withholding tax. The 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 Australia.

1.151 The thin capitalisation rules place a limit, by means of a specified debt-to-equity funding ratio, on the amount of interest expense payable in relation to foreign debt that can be deducted for Australian tax purposes. 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 ratio of related-party foreign debt-to-equity cannot exceed 6:1 for financial institutions, and 2:1 for other taxpayers. The higher ratio of 6:1 is allowed for financial institutions in recognition of their special funding needs.

1.152 The foreign debt of an Australian resident company is the interest-bearing debt which is owed to foreign controllers or their non-resident associates. For these purposes, a foreign controller is any non-resident that has substantial control of the voting power of the company, or is beneficially entitled to receive at least 15% of any dividends or other distribution of capital.

1.153 The foreign equity of an Australian resident company is equivalent to the paid-up share capital and the opening balances of the accumulated profits and asset revaluation reserves beneficially owned by foreign controllers and their non-resident associates. As an anti-avoidance measure, the foreign equity is reduced by any amounts that have been loaned back to the foreign controller or non-resident associates. Thus, only the net amount will be treated as foreign equity. This is necessary to ensure that the foreign equity cannot be artificially inflated by lending back equity to foreign controllers which could then re-inject the funds into the Australian company as new share capital.

Interaction with Interest Withholding Tax regime

1.154 Interest withholding tax is ordinarily payable on interest paid by businesses in Australia to non-residents, subject to some broad exceptions. The IWT regime contains an exemption for interest paid by Australian resident companies on certain debentures that satisfy a public offer test (section 128F). This exemption is only available to Australian companies - it is not available to an Australian branch of a foreign bank.

1.155 However, foreign banks operating in Australia through branches are entitled to have an associated Australian company raise funds overseas under the section 128F exemption, and then on-lend those funds for use in the Australian branch. Companies established for this purpose are held to be financial institutions for the purposes of the thin capitalisation rules by virtue of the definition provided in section 159GZA, and are therefore entitled to the increased gearing ratio of 6:1. The structure is illustrated in the following diagram.

Structure to enable foreign bank branch in Australia to access section 128F IWT exempt funds

Explanation of the amendments

1.156 When a financial institution, that is either directly or indirectly owned by a foreign bank, raises section 128F funds and on-lends those funds to a related foreign bank branch in Australia, paragraph 159GZG(1)(d) could apply to reduce the foreign equity of the financial institution. This is because funds that are on-lent to the branch are treated as a loan back to the foreign bank - since the branch is a part of the same legal entity as the foreign bank. The reduction of the financial institutions foreign equity would limit its ability to raise funds from its foreign controller or non-resident associates.

1.157 This amendment will introduce new sub-subparagraph 159GZG(1)(d)(i)(C), which will allow the financial institution, that is either directly or indirectly owned by a foreign bank, to on-lend funds raised under the section 128F exemption to a related Australian bank branch, without reducing the financial institutions foreign equity. In order to prevent the foreign bank from artificially increasing its equity in the financial institution, the amendment is only available where the Australian bank branch can show that the funds made available are for use in its Australian business. [Item 34, new sub-subparagraph 159GZG(1)(d)(i)(C)]

Section 4 - Application - Withholding tax, OBU and thin capitalisation measures

1.158 The amendments made by Part 1 of Schedule 1 apply in relation to transactions entered into after 2 July 1998. However, several specific application provisions are provided by item 39 :

Item 20 applies to foreign tax paid after 2 July 1998;
New subsection 121ELA(2) and new section 121ELB apply to disposals after 2 July 1998;
Items 24 and 25 apply to declarations made by the Treasurer after 2 July 1998;
Items 27 to 32 apply to debentures issued after 2 July 1998;
Item 33 applies to interest paid by an OBU after 2 July 1998;
Item 34 applies in relation to amounts lent to Australian branches after 2 July 1998;
Item 35 applies to the year of income before the year of income in which 2 July 1998 occurs and all later years of income; and
Item 38 applies to penalties imposed after 2 July 1998.

Section 5 - Regulation impact statement

Part 1 - Withholding Tax, Offshore Banking Units and Thin Capitalisation

Policy objective

1.159 On 8 December 1997 the Prime Minister announced, as part of the Investing for Growth Statement (the Statement), a package of measures which, among other things, are designed to further enhance Australia's credentials as a world financial centre. In particular, measures included in the Australia - A Regional Financial Centre component of the Statement are aimed at making Australia a more attractive regional financial centre by building on Australia's existing advantages to ensure its participation in the increasing global trade in financial services. Additional measures to further extend the IWT exemption available under section 128F of the ITAA 1936 were announced in the Treasurers Press Release No. 80 on 13 August 1998.

Developing Financial Markets

1.160 In order to encourage the development of the domestic corporate debt market the Government announced a widening of the section 128F IWT exemption by removing, for eligible debentures issued by companies, the present requirements that they be issued outside Australia and that the interest be paid outside Australia.

Competitive Offshore Banking Regime

1.161 For several years, Australia has provided a special OBU taxation regime intended to promote the provision of financial services for transactions between offshore parties. The regime exempts certain offshore parties from Australian taxes and provides an effective 10 per cent tax rate on the taxable income of OBUs, the financial intermediaries to these transactions. Most of the new tax measures seek to reduce tax burdens on income from offshore investments made by non-resident investors and on OBUs managing this business. Other measures seek to reduce compliance costs on OBUs undertaking this business from Australia.

Thin Capitalisation

1.162 In order to provide the Australian branches of Foreign Banks greater access to IWT exempt funds, the thin capitalisation measures will be relaxed. This will enable foreign owned financial institutions to raise IWT exempt funds and on-lend those funds to their related Australian bank branches without affecting the financial institutions thin capitalisation position.

Implementation options

1.163 In considering the options available it was decided that the possible option of implementing selective parts of the proposed package was not valid because it would undermine the achievement of the policy objective.

1.164 It is necessary to amend the ITAA 1936 in order to implement the policy objectives outlined in the Statement. The amendments will take effect from 2 July 1998. The following implementation options have been identified:

Section 128F IWT Exemption
(a)
Widen the IWT exemption in respect of corporate issues in relation to eligible debentures to allow:

debentures to be issued in Australia; and
interest to be paid in Australia.

(b)
Allow Australian residents to acquire bearer and registered debentures without the issue as a whole losing its eligibility for the section 128F IWT exemption (the initiative to include bearer debentures was announced by the Treasurer on 13 August 1998). To maintain consistency with the current requirements of section126 in respect of residents in Australia, the company paying bearer debenture related interest must supply the ATO with the names and addresses of the holders of bearer debentures which are Australian branches offshore. Otherwise the company must deduct a penalty tax of 47% from any interest payments made.
(c)
Widen the meaning of the term company , to ensure that an Australian company acting in the capacity of trustee for an Australian trust is treated as a company for the purposes of section 128F, provided the trust is not a charitable trust and that the beneficiaries of the trust are companies as long as they are not trustee companies, for the purposes of section 128F. The Treasurer also announced this initiative on 13 August 1998.
Offshore Banking Regime
(d)
Expand the range of persons eligible to be an OBU to include:

funds managers incorporated under the Corporations Law which are:

-
money market corporations subject to the Financial Corporations Act 1974 or fully owned subsidiaries of these corporations;
-
holders of securities dealers licences under the Corporations Law; or
-
holders of investment advisers licences under the Corporations Law;

life insurance companies registered under the Life Insurance Act 1995 ; and
other companies (including providers of custodial services) as determined by the Treasurer.

Broadly speaking, the OBU regime will be extended to include funds managers, life insurance offices and providers of custodial services.
(e)
Exempt from tax all income and gains of offshore charitable institutions where:

the investments which give rise to the income or gains are managed by an OBU; and
the charitable institution is exempt in its home jurisdiction.

There will be no limitation placed on the proportion of Australian assets that may be held on behalf of the charitable institutions. However, OBUs will only be eligible for the 10 per cent concessional tax rate on the component of the management fee which relates to the offshore assets. The component relating to the Australian assets will be taxed at the full company rate.
(f)
Extend the range of eligible OBU activities to include custodial services provided to non-residents.
(g)
Extend the range of eligible OBU activities to include:

trading;
eligible contract activities; and
hedging activities;

in Australian currency with offshore persons.
(h)
Extend the range of eligible OBU activities in gold trading to include:

gold bullion trading with an offshore person in any currency; and
gold bullion trading with residents and non-residents operating through a permanent establishment in Australia in any currency other than AUD.

(i)
Allow trading in base metals and palladium in any currency with offshore persons as eligible OBU activities. This measure was not announced in the Statement. The Government has decided to extend the concession following Industry representations.
(j)
Remove the current anti-avoidance measure which prevents Australia being used as a conduit to channel loans to other countries by repealing subsections 128GB(3) and 128GB(4).
(k)
Reduce the capital gains tax (CTG) liability of non-residents disposing of their units in an OBU offshore investment trust. This measure reduces the CTG liability to make it proportional to the share of the gain which relates to any underlying Australian assets where they constitute less than 10 per cent of the investment portfolio.
(l)
Allow Australian OBUs a foreign tax credit where OBU income is subject to foreign taxes regardless of whether DTA applies.
(m)
Remove the current requirement for OBUs to maintain separate nostro and vostro accounts for OBU transactions.
(l)
Reduce the rate of OBU withholding penalty tax from 300 per cent to 75 per cent to bring it more into line with the penalties which apply to breaches of the OBU income tax concession.
Thin Capitalisation measures
(m)
Relax the effect of the thin capitalisation loan back provisions so that an Australian subsidiary of a foreign bank may raise section 128F IWT exempt funds and on-lend those funds to a related Australian branch without affecting the subsidiaries thin capitalisation position.

Assessment of impacts (costs and benefits) of each implementation option

Impact group identification

1.165 The affected groups are financial intermediaries for whom non-residents are a significant client group, primarily banks and funds managers, and non-residents investing in or through Australia. World-wide the financial system has grown significantly over the past three decades. Australia is already participating in the international trade in financial services. Over the six years to 1996-1997 exports of financial services grew by more than 20 per cent. By increasing its role as a financial centre Australia can capitalise on opportunities for export growth.

1.166 The OBU related measures most effect those intermediaries that are eligible, or will under the measures become eligible, to operate as OBUs. Increased use of the OBU concessions may impose some additional administration costs on the ATO. The section 128F measure will be of particular benefit to corporate borrowers. The package will have a relatively small impact on Government revenue.

1.167 All of the measures address issues raised by taxpayers (or their representatives) consulted in the preparation of the package. The measures can therefore be expected to generally be welcomed by taxpayers, although some may consider that more far reaching measures are warranted.

Analysis of the costs and benefits associated with each implementation option

1.168 Quantitative data on the compliance and administrative costs of the measures have not been estimated. The assessment in this section is therefore of a qualitative nature. The measures represent a package which is aimed at providing greater certainty and reducing compliance costs and tax burdens in relation to financial sector activities.

Section 128F IWT Exemption
(a)
Widening the section 128F IWT exemption will simplify the compliance arrangements for corporate issuers wishing to access the concession. Such borrowers will no longer be required to issue offshore in order to access the concession.
(b)
Allowing Australian residents to acquire debentures and interests in debentures which are eligible for the section 128F IWT exemption will further integrate the investors in Australia and overseas. Industry has indicated that the benefits of the concession are likely to outweigh the minor compliance cost due to the requirement to provide names and addresses of holders of bearer debentures (excluding non-residents located outside of Australia) to the ATO.
(c)
Widening the meaning of the term company will ensure that an Australian company acting in the capacity of trustee for an Australian trust is treated as a company for the purposes of section 128F, provided the trust is not a charitable trust and that the beneficiaries of the trust are companies, but not trustee companies, for the purposes of section 128F. Financial institutions involved in securitisation transactions will be able to more easily access the section 128F IWT exemption. This is expected to reduce the cost of capital by allowing lenders to access the cheapest funds free of withholding tax: a benefit which should be passed on to borrowers (eg. home buyers and consumers) given the competitiveness of the Australian financial market.
Offshore Banking Regime
(d)
Expanding the range of entities eligible to be an OBU to include funds managers, life insurance offices and providers of custodial services will allow a broader range of financial market participants access to the concessional OBU tax regime. There is expected to be a small cost to revenue as some existing activities carried out under the standard taxation arrangements are transferred to the concessional regime. To the extent that greater use is made of the concessional regime there may be additional administrative costs for the ATO. However, expanding access to the concessions is expected to result in a deepening of the market and an increase in the amount of business generated, resulting in increased revenue.
(e)
Exempting from tax the income and capital gains of offshore charitable institutions, managed by an OBU and exempt in their home jurisdiction, will provide a source of new business for OBUs. It will also provide scope for offshore charitable institutions, whose general exemptions were recently removed under the anti-avoidance measures relating to charitable trusts, to regain exempt status.
(f)
Extending the range of eligible OBU activities to include custodial services provided to non-resident offshore persons will reduce uncertainty about the scope of eligible OBU activities. This measure will negatively effect revenue to the extent that these activities are currently undertaken within the standard taxation regime without concessional procedures.
(g)
The eligible OBU activities involving trading, eligible contract, hedging and gold trading will all be expanded by the new amendments. Trading in base metals and palladium will also be allowed as eligible OBU activities. These measures will reduce tax burdens and negatively effect revenue to the extent that these activities are currently undertaken outside the concessional regime. Compliance costs may be reduced to the extent that the restrictions on OBU activities are less binding.
(h)
Removing the section 128GB(3) exclusion from the OBU IWT exemption of conduit arrangements will reduce uncertainty as to the provisions application and remove complexity from the tax law.
(i)
Reducing the CTG liability of non-residents disposing of their units in an OBU offshore investment trust will make these vehicles more attractive to non-resident investors. The measure will lower tax burdens on investors in these trusts, but do so at the expense of additional tax law complexity. There may be minor costs associated with OBUs assessing the underlying percentage of Australian assets. This concessional measure will negatively affect tax revenue from existing OBU offshore investment trust sources. However, this could be counterbalanced by the expected rise in new business utilising these financial instruments as a result of the concession.
(j)
Allowing Australian OBUs a foreign tax credit (FTC) where OBU income is subject to foreign taxes, regardless of whether a DTA applies, may allow OBUs to reduce their tax burdens in some circumstances. There may be some increase in compliance costs to the extent that the FTC rules are more onerous to comply with than simply claiming a deduction for foreign tax. This is more than offset by the reduction of the OBUs tax burden achieved by including foreign tax credits instead of a deduction.
(k)
Removing the current requirement for OBUs to maintain separate nostro and vostro accounts will reduce compliance costs for OBUs. There may be additional administrative costs for the ATO. The amendment is revenue neutral.
(l)
The current level of penalties is considered excessive. Reducing the penalty tax from 300 per cent to 75 per cent will more closely align the penalties to those applying to the breaches of the OBU income tax concession. There will not be an additional administrative cost for the ATO.
Thin capitalisation measures
(m)
Relaxing the loan back provisions of the thin capitalisation regime will make it easier for Australian branches of Foreign Banks to access section 128F IWT exempt funds from their related Australian subsidiaries. This measure will reduce the tax burden of the Australian subsidiaries and have a negligible effect on revenue. The amendment will have minimal impact on compliance and administrative costs.

Consultation

1.169 The measures have been developed in close consultation with several tax advisory practices with particular expertise in the financial services sector and with other financial market participants. Consultation with industry bodies following the tabling of the Taxation Laws Amendment Bill (No. 5) 1998 (lapsed) in July 1998 led to the inclusion of additional measures in the package. These amendments were announced in the Treasurers Press Release No. 80 on 13 August 1998.

1.170 As part of the package, a task force within the Financial Sector Advisory Council (FSAC) was established as an ongoing consultative forum which will maintain a focus on the effectiveness of the measures and which will report on further options which could boost Australia's attractiveness as a financial centre.

Conclusion

1.171 The package of measures is the Governments preferred method for achieving the policy objective of making Australia a more attractive regional financial centre. Overall, the package is expected to reduce compliance costs.

1.172 The Treasury and the ATO will monitor this package of measures as part of the whole taxation system on an ongoing basis. Furthermore, the task force within the FSAC will provide advice on the effect of the measures on Australia's attractiveness as a regional financial centre.

Part 2 - Exemption from the FIF measures for interests in certain FIFs resident in the United States (US)

Overview of the FIF measures

1.173 Part 2 of Schedule 1 to the Bill will amend the ITAA 1936 to provide an exemption from the FIF measures for interests in certain US FIFs. The exemption forms part of a package of measures entitled Investing for Growth directed at developing and promoting Australia as a regional financial centre announced by the Government on 8 December 1997.

1.174 The amendments will:

provide an exemption from the FIF measures for interests in certain FIFs taxed on a worldwide basis in the US ( Section 1 );
provide a limited exemption for interests in certain FIFs taxed as conduit entities in the US ( Section 1 ); and
make these exemptions available when determining FIF income under the calculation method ( Section 2 ).

1.175 Consequential amendments will also be made to ensure:

the general trust provisions do not claw back the benefits of providing the exemption ( Section 3.1 ); and
the trustee of a trust FIF that qualifies for the exemption is taxed on the Australian source income of the trust under the general trust provisions ( Section 3.2 ).

1.176 A regulation impact statement for the changes is provided in Section 4 .

1.177 Unless otherwise stated, references to provisions of the law in Part 2 of this Chapter are references to provisions of the ITAA 1936 and item references are to Schedule 1 to the Bill.

Section 1 - Exemption from the FIF measures

Summary of the amendments

Purpose of the amendments

1.178 The amendments will:

provide an exemption from the FIF measures for interests in certain FIFs taxed on a worldwide basis in the US; and
provide a limited exemption for interests in certain FIFs taxed as conduit entities in the US.
[Item 42]

Date of effect

1.179 The exemption will apply for notional accounting periods of FIFs ending on or after 2 July 1998 . [Subitem 46(1)]

Background

1.180 The FIF measures (Part XI of the ITAA 1936) apply to Australian residents who have an interest in a foreign company or foreign trust at the end of a year of income. Broadly, the FIF measures operate to approximate a resident taxpayers share of the undistributed profits of a FIF (called FIF income) and assess the taxpayer on those profits. This treatment is directed at preventing deferral of Australian tax where profits are accumulated offshore in a FIF rather than remitted to Australian investors.

1.181 Exemptions from the FIF measures are provided for a wide range of investments in company FIFs engaged in active businesses where the risk of tax deferral is not likely to be significant. FIF investments subject to the controlled foreign company or transferor trust measures are also exempt.

Explanation of the amendments

1.182 The amendments will provide a further exemption from the FIF measures for interests in certain US FIFs. The exemption is intended to encourage Australian investment funds to be more efficient by exposing them to competition from US funds. The substantial similarity of US tax rules to those in Australia will ensure tax deferral opportunities do not arise because of the exemption.

1.183 The exemption will be inserted as Division 8 in Part XI of the ITAA 1936. [Item 42] Division 8 previously contained an exemption from the FIF measures for approved country funds and was repealed with effect for notional accounting periods [F1] of FIFs commencing on or after 1 January 1997.

What kinds of FIF interests qualify for the exemption?

1.184 The exemption will be available for FIF interests in:

entities that are treated as corporations and are subject to tax on their worldwide income under the US Internal Revenue Code of 1986;
regulated investment companies; and
real estate investment trusts. [New subsection 513(1)]

Regulated investment companies and real estate investment trusts are fully distributing investment funds used widely in the US as vehicles for managing collective investments.

1.185 A limited exemption will be available for FIF interests in:

limited liability companies taxed as partnerships in the US;
limited partnerships taxed as partnerships in the US; and
common trust funds. [New subsections 513(2), (3), (4) and (5)]

1.186 Note, if a limited liability company or a limited partnership is treated as a corporation and is subject to tax on its worldwide income under the US Internal Revenue Code 1986, it will qualify for the exemption under new subsection 513(1) .

1.187 Limited liability companies and limited partnerships taxed as partnerships in the US and common trust funds are also commonly used as investment vehicles in the US. Only a limited exemption is to be provided for these entities, however, because they are taxed in the US as conduit entities and consequently they are not directly liable for US tax. The US tax liability is instead borne by investors in a conduit entity and Australian investors are generally not subject to tax in the US on non US source income derived through a conduit entity. An unqualified exemption for conduit entities could therefore create a significant risk to the revenue because it would allow Australian investors to hold non US investments through a conduit entity and be exempt from anti tax deferral rules in both Australia and the US.

1.188 The exemption will be available for interests held in the above mentioned conduit entities (referred to below as specified conduit entities) only where those interests are held for the sole purpose of investing directly, or indirectly through other entities, in a business conducted in the US and/or real property located in the US. [New paragraphs 513(3)(a) and (4)(a)] The sole purpose test will be satisfied for an interest held in a specified conduit entity if:

the interest is held for the purpose of investing directly, or indirectly through other entities, in a business conducted in the US and/or real property located in the US; and
the interest is not held for the purpose:

-
of making other types of investment in the US either directly or indirectly through other entities; or
-
of investing outside the US either directly or indirectly through other entities.

1.189 The types of investment covered by the second dot point will be referred to below as non-qualifying investments.

1.190 It is possible for an interest in a specified conduit entity to satisfy the requirements of the test even though the entity directly or indirectly makes non-qualifying investments. The test could be satisfied, for instance, if a taxpayer were to hold an interest in the entity for the purpose of investing into the US and it is incidental that the entity also has some non-qualifying investments.

1.191 The limited exemption is divided into two parts. [New subsection 513(2)] The first part provides an exemption for interests held in specified conduit entities that do not directly, or indirectly through other conduit entities, have non-qualifying investments. [New subsection 513(3)] There is a low risk of tax deferral benefits arising for investments through these entities because the US will normally tax Australian residents on an amount derived through a conduit entity if the amount arises from the conduct of a US business or from the disposal of real property located in the US.

1.192 The second part provides an exemption for interests held in specified conduit entities that directly or indirectly through other conduit entities, have some non-qualifying investments. [New subsection 513(4)] Tighter rules are required before an exemption can be provided for these interests because amounts derived by Australian residents through a conduit entity from sources outside the US are, for instance, unlikely to be taxed in the US.

1.193 Two ratios are used to limit the extent to which a specified conduit entity can hold non-qualifying investments. The first ratio provides that no more than five percent of certain interests can be in interests that do not satisfy either the requirements for obtaining an unqualified exemption under new subsection 513(1) or the requirements of the first part of the limited exemption under subsection 513(3). [New paragraph 513(4)(b)] The following table summarises an example of FIF interests held by a conduit entity that are to be taken into account in determining the 5per cent limit.

Table 1 - FIF interests counted towards the 5% limit
Value of FIF interest held in: Counted towards the 5% limit?
Corporations that are subject to tax on their worldwide income under the US Internal Revenue Code of 1986 No
Regulated investment companies No
Real estate investment trusts No
Specified conduit entities that do not have non-qualifying investments (ie. specified conduit entities that satisfy the first part of the limited exemption) No
Specified conduit entities that have non-qualifying investments but satisfy the second part of the limited exemption Yes
Other FIFs Yes

1.194 The calculation of the 5 per cent limit is illustrated by the following example.

Example 1 - Calculation of the 5% limit

Facts

A US common trust fund holds interests in FIFs as shown in the following table.

FIF interests held in: Value ($Million) Counted towards the 5% limit?
Corporations that are subject to tax on their worldwide income under the US Internal Revenue Code of 1986 3 No
Regulated investment companies 5 No
Real estate investment trusts 1 No
Specified conduit entities that do not have non-qualifying investments (ie. Specified conduit entities that satisfy the first part of the limited exemption) 1 No
Specified conduit entities that have non-qualifying investments but satisfy the second part of the limited exemption 2 Yes
Other FIFs 0 Yes

Consequences

In this case, the ratio would be calculated as 0.16 (ie. $2 million (total value FIF interests counted towards the 5% limit) / $12 million (total value of FIF interests))). Expressed as a percentage, a ratio of 0.16 means 16percent of the common trust funds interests in FIFs are in non-eligible FIFs. An interest held in the common trust fund would therefore not qualify for the exemption because the funds interests in non-qualifying FIFs exceed the 5 per cent limit.

1.195 The second ratio provides that no more than five percent of a specified conduit entities assets can produce income from sources outside the US or give rise on disposal to gains from sources outside the US. [New paragraph 513(4)(c)]

1.196 The ratios are to be determined using the value of FIF interests and assets shown in the accounting records of a specified conduit entity. [New subsection 513(5)] The ratios cannot be exceeded at any time during the notional accounting period of the entity. [New paragraphs513(4)(b) and (c)]

1.197 The primary test for availability of the limited exemption is the purposive test, discussed previously, that an interest in a FIF must be held for the sole purpose of investing in the US and/or in real property located in the US. The role of the ratios is to limit the extent to which other investments held through a FIF will be accepted as incidental. A purposive test has been used as the primary test to prevent possible abuse of the limited exemption that could occur if a way were found to manipulate the ratios.

Treatment of interests held in controlled foreign trusts

1.198 The exemption will not be available for interests held in controlled foreign trusts. [New section 512A] These interests are currently exempt from the FIF measures under section 492.

1.199 The consequential amendments to the rules for taxing distributions from foreign trusts where an interest in a foreign trust qualifies for the exemption will therefore not affect the taxation of distributions from controlled foreign trusts.

Summary of the availability of the exemption

1.200 The following table shows the availability of the exemption: YOU ARE HERE

Table 2 - Availability of the exemption from the FIF measures for interests in US FIFs
FIF interests held in: Treatment
Corporations that are subject to tax on their worldwide income under the US Internal Revenue Code of 1986 Exempt1
Regulated investment companies Exempt1
Real estate investment trusts Exempt1
Limited liability companies taxed as partnerships in the US Limited exemption1
Limited partnerships taxed as partnerships in the US Limited exemption1
Common trust funds Limited exemption1
Other US FIFs Not exempt

1. The exemption is not available if the FIF interest is in a controlled foreign trust.

Section 2 Modifications to the calculation method for determining notional FIF income

Summary of the amendments

Purpose of the amendments

1.201 The amendments will ensure the exemption from the FIF measures for interests held in certain US FIFs is available when determining FIF income under the calculation method. This treatment will allow taxpayers to invest through up to two tiers of conduit entities that have significant investments in countries outside the US and still obtain the benefit of the exemption for investments held by the entities in US FIFs. [Items 43, 44 and 45]

Date of effect

1.202 The amendments to the calculation method will apply in relation to assessments for income years ending on or after 2 July 1998. [Subitem 46(2)]

Background

1.203 Under the calculation method (one of three methods available for determining FIF income), a FIFs profits are determined using rules similar to (but simpler than) those that apply to determine the taxable income of a resident taxpayer. FIF income arises under this method equal to a taxpayers share of the calculated profit of a FIF. The share is based on a taxpayers interest in the FIF.

1.204 FIF income may notionally be included in the calculated profit of a FIF where the FIF has an interest in another FIF, called a second tier FIF (section576). Notional FIF income can also arise where a second tier FIF has an interest in a third tier FIF and the calculation method is applied to determine the notional FIF income of the second tier FIF (section 579). Exemptions from the FIF measures are currently not available when determining notional FIF income from an interest in a second or third tier FIF (paragraph575(2)(c)).

Explanation of the amendments

1.205 The exemption for interests in certain US FIFs will be available when determining notional FIF income under the calculation method. This will be achieved by amending paragraph 575(2)(c) to allow the exemption to be claimed when notionally applying the FIF rules under sections 576 and 579. Under this approach, sections 576 and 579 will no longer operate to include an amount of notional FIF income from an interest in a second or third tier FIF if the interest qualifies for the exemption. [Item 45]

1.206 The following example demonstrates how providing the new exemption when determining the calculated profit of a FIF will allow taxpayers to invest through up to two tiers of conduit entities that have significant investments in countries outside the US and still obtain the benefit of the exemption for investments held by the conduit entities in US FIFs.

Example 2 Impact of providing the new exemption when determining the calculated profit of a FIF

Facts

A resident taxpayer has a 10 per cent interest in a US common trust fund that has the following FIF interests.

FIF interests held in: Value ($Million) Exempt?
Corporations that are subject to tax on their worldwide income under the US Internal Revenue Code of 1986 3 Yes
A wholly owned US limited partnership that holds FIF interests outside the US of $1.5 million and FIF interests in regulated investment companies of $0.5million 2 No

The structure is illustrated by the following diagram.

Example 2  Impact of providing the new exemption when determining the calculated profit of a FIF - Diagram

The taxpayer elects to use the calculation method to determine:

-
FIF income arising from the common trust fund; and
-
notional FIF income for inclusion in the calculated profit of the common trust fund for the trusts interest in the US limited partnership.

No amounts are derived by the common trust fund or the limited partnership.

Consequences

The calculated profit of the common trust fund will not include FIF income from its interests in the US companies because these interests will qualify for the new exemption. FIF income may notionally arise, however, for the interest held in the US limited partnership.

In determining the FIF income that arises from the limited partnership under the calculation method, the interest held by the US limited partnership in the regulated investment company will not give rise to notional FIF income because the interest will qualify for the new exemption. An amount of FIF income is likely to arise, however, for the interests the limited partnership holds in non US FIFs.

The net result is that notional FIF income will arise only for interests in non US FIFs held indirectly by the common trust fund through the limited partnership. The direct interests held by the common trust fund in the US companies and the interest held indirectly in the regulated investment company will be exempt from the notional application of the FIF rules in determining the calculated profit of the FIF.

1.207 Section 564, which excludes from notional income a dividend or distribution derived from another FIF, will generally not apply to dividends or distributions derived from a US FIF that qualifies for the new exemption. [Item 43] The exclusion under section 564 is provided to prevent double taxation that could occur if amounts included in notional FIF income under sections 576 and 579 were again included on distribution from a second or third tier FIF. The exclusion will now generally not be required for distributions from second or third tier FIFs that qualify for the new exemption because interests in these FIFs will not be taxed on an accruals basis.

1.208 The following example shows how an interest held by a FIF in a second tier US FIF that qualifies for the new exemption will be taxed under the calculation method both before and after the changes.

Example 3 - Taxation of second tier FIF interests under the calculation method before and after the changes

Facts

A second tier FIF that qualifies for the new exemption has $100 notional FIF income.
The second tier FIF distributes an amount of $100 from the profits that gave rise to notional FIF income.

Example 3 - Taxation of second tier FIF interests under the calculation method before and after the changes - Diagram

Current treatment

Before the amendments, the $100 notional FIF income from the second tier FIF would be included in the notional income of the first tier FIF under section 576. Section 564 would prevent double taxation by excluding the $100 distribution from the first tier FIFs notional income. The profits that give rise to the notional FIF income of the second tier FIF are therefore taxed on an accruals basis under the FIF measures and are exempt on distribution by the second tier FIF.

Treatment after the changes

After the amendments, no amount will be included in the notional FIF income of the first tier FIF under section576. The $100 distribution would be included in the notional income of the first tier FIF, however, because section 564 will no longer apply to exclude the amount. The profits of the second tier FIF will therefore be taxed at the time the FIF makes a distribution.

1.209 Under new subsection 564(2) , the exclusion under section 564 will continue to be available for distributions from second or third tier FIFs if those distributions are paid from profits that have previously been accruals taxed under the FIF measures. Profits derived by newly exempted FIFs may have been taxed previously if, for instance, notional FIF income arose for a second or third tier FIF in a period prior to the operation of the new exemption. [Item 44]

1.210 The exclusion will be available where a distribution derived by a FIF gives rise to a FIF attribution debit for a taxpayer in relation to the entity that makes the distribution. A FIF attribution debit arises where a distribution is made from profits that have previously been taxed on an accruals basis under the FIF measures. The amount of a distribution excluded under section 564 will equal the grossed-up amount of a FIF attribution debit (section 607A) that arises. The grossed-up amount is calculated by dividing the amount of the FIF attribution debit by a taxpayers attribution percentage in the FIF that receives the distribution.

1.211 The following example shows how to calculate the amount excluded under section 564 where a distribution made by a second tier FIF gives rise to a FIF attribution debit in relation to an attributable taxpayer.

Example 4 - Calculation of the excluded amount where a FIF attribution debit arises for a distribution made by a FIF

Facts

A resident taxpayer has a 10% interest in a first tier US FIF.
The first tier FIF has a 25% interest in a second tier FIF that qualifies for the new exemption.
The second tier FIF has a FIF attribution surplus of $1,000 in relation to the resident taxpayer due to the operation of the FIF rules in a period prior to the introduction of the new exemption.
The second tier FIF distributes $100,000 to the first tier FIF the first tier FIF derives no other amounts during the period and has no other FIF interests.
The calculation method is used to determine the FIF income to be attributed to the resident taxpayer from the first tier FIF.

Example 4 - Calculation of the excluded amount where a FIF attribution debit arises for a distribution made by a FIF - Diagram

Consequences

Section 564 will operate to exclude the distribution made by the second tier FIF from the notional income of the first tier FIF to the extent of the amount of the grossed-up attribution debit that arises in relation to the resident taxpayer. An attribution debit of $1,000 will arise as a result of the distribution (ie. the lesser of the attribution surplus ($1,000) and the amount of the distribution ($100,000) multiplied by the resident taxpayers FIF attribution account percentage in the first tier FIF (10%)). The grossed-up amount of the attribution debit will therefore be $10,000 (ie. the amount of the FIF attribution debit ($1,000) divided by the resident taxpayers FIF attribution account percentage in the first tier FIF (10%)). Accordingly, $10,000 of the $100,000 distribution will be excluded from the notional income of the first tier FIF under section 564.

Section 3 Consequential amendments

1.212 Consequential amendments will be made to ensure:

the general trust provisions do not claw back the benefits of providing the new exemption (discussed in Section 3.1 ); and
the trustee of a trust FIF that qualifies for the new exemption is taxed on the Australian source income of the trust under the general trust provisions (discussed in Section 3.2 ).

Section 3.1 Exemption from section 97 of the general trust provisions for interests in US trust FIFs that qualify for the exemption

Summary of the amendments

Purpose of the amendments

1.213 The amendments will ensure section 97 of the general trust provisions does not claw back the benefits of providing the exemption from accruals taxation for US trust FIFs. [Item 40]

Date of effect

1.214 The amendments will apply in relation to assessments for income years ending on or after 2 July 1998. [Subitem 46(2)]

Background

1.215 Currently subsection 96A(1) ensures that the deemed entitlement rules in the general trust provisions (sections 96B and 96C) do not apply where an interest in a foreign trust is subject to the FIF measures. These rules operate through section 97 of the general trust provisions to accruals tax Australian beneficiaries on their share of the undistributed profits of a foreign trust. Subsection 96A(1) prevents double taxation by ensuring the deemed entitlement rules under the general trust provisions do not apply to an interest in a foreign trust that is subject to the FIF measures.

1.216 The rules to prevent double taxation in subsection 96A(1) would currently not apply, however, to an interest in a trust FIF that qualifies for the new exemption because subsection 96A(1) only applies to interests in foreign trusts that are subject to the FIF measures. The benefits of providing the exemption could therefore be lost because an interest in a US trust FIF that qualifies for the exemption would become subject to the deemed entitlement rules in the general trust provisions. The potential for benefits of providing the new exemption to be clawed back is demonstrated by the following example.

Example 5 - Potential clawback of the new exemption under sections96B and 96C

Facts

A US common trust fund that qualifies for the new exemption is calculated to have net income of $1 million.
The trust has one Australian beneficiary who has a 10% interest in the property of the trust.
The income of the trust is not distributed to the beneficiary during the year of income.

Example 5 - Potential clawback of the new exemption under sections96B and 96C - Diagram

Consequences

The new exemption is intended to ensure that accruals taxation does not apply to the beneficiaries interest in the trust. Sections 96B and 96C would, however, currently deem the beneficiary to be presently entitled to 10% of the income of the trust ($100,000) due to the beneficiaries interest in the property of the trust. This amount would be accruals taxed under section 97 even though there has been no distribution from the trust and thus the benefit of the exemption from the FIF measures would be lost.

1.217 Significant compliance costs could also arise if section 97 were to apply to interests held in US trusts that qualify for the new exemption. A beneficiary would, for instance, be required to calculate the net income of a trust as if the trustee were a resident of Australia. This calculation could be onerous because it would require a full application of our domestic rules and in some cases the beneficiary may not be able to obtain the necessary information.

Explanation of the amendments

1.218 The amendments will ensure section 97 of the general trust provisions does not apply to interests in US trusts that qualify for the new exemption. Section 97 will continue to apply, however, to interests in controlled foreign trusts because these trusts are not subject to the FIF rules (section 493).

1.219 The exclusion from section 97 for interests in US trusts that qualify for the new exemption will be achieved by amending paragraph96A(1)(c). [Item 40]

1.220 The net result will be that amounts distributed from a US trust that qualifies for the new exemption will continue to be assessable to the extent the amounts are paid from profits not previously taxed in Australia (section99B).

Section 3.2 Taxation of Australian source income of US FIFs that qualify for the exemption

Summary of the amendments

Purpose of the amendments

1.221 The amendments will ensure a trustee of a trust that qualifies for the new exemption is taxed on the Australian source income of the trust under sections 99 or 99A. [Item 41]

Date of effect

1.222 The amendments will apply in relation to assessments for income years ending on or after 2 July 1998. [Subitem 46(2)]

Background

1.223 To avoid double taxation, a trustee is not assessable on Australian source income of a foreign trust to the extent the income is likely to have been included in the FIF income of a beneficiary. This treatment is achieved by subsection 96A(1A) which reduces the amount on which a trustee is taxed under sections 99 or 99A. The amount is reduced to the extent a beneficiary would have been assessable on the net income of the trust if not for the exclusion from section97 that applies where a beneficiary is subject to the FIF measures (subsection 96A(1)).

1.224 The amount on which a trustee is taxed should not be reduced under subsection 96A(1A) in cases where a beneficiaries interest in the trust is exempt from section 97 because of the new exemption for US FIFs. In this case, the Australian source income of the trust could completely escape Australian tax if the amount on which the trustee is taxed were reduced. The potential for Australian source income to escape Australian tax is demonstrated by the following example.

Example 6 - Potential for non-taxation of Australian source income

Facts

A common trust fund that qualifies for the new exemption is calculated to have net income of $1 million.
The net income is wholly referable to sources within Australia.
The trust has a large number of Australian beneficiaries who in total have a 100% entitlement to the property of the trust.
The income of the trust is not distributed to the beneficiaries during the year of income.

Example 6 - Potential for non-taxation of Australian source income - Diagram

Consequences

The beneficiaries will not be taxed on the net income of the trust under section97 because of the amendments to paragraph 96A(1)(c). In addition, the trustee will not be taxed on the undistributed income of the trust because subsection 96A(1A) will apply to reduce to nil the amount on which the trustee is taxed under section 99 or 99A. The net income of the trust of $1million will therefore be reduced to nil under subsection 96A(1A) because the beneficiaries would have been assessable on $1million under section 97 if not for subsection 96A(1). In this regard, the beneficiaries would be deemed to be presently entitled to the entire income of the trust under sections 96B and 96C because they have a 100% interest in the property of the trust. The net result would be that neither the beneficiaries nor the trustee would be taxed on the undistributed Australian source income of the trust.

Explanation of the amendments

1.225 The amendments will limit the circumstances where subsection 96A(1A) will reduce the assessable income of a trustee. Normally the assessable income of a trustee is reduced by the amount that, disregarding subsection 96A(1), would have been included in the assessable income of a beneficiary under section 97. The amendments will provide that the reduction is not available if the new exemption applies to a beneficiaries interest in the trust. [Item 41

1.226 Double taxation will not arise on trust distributions made from Australian source income in cases where the trustee has been taxed on the income. In these cases, the distribution assessable under section 99B would be reduced to the extent it was made from amounts that were included in the assessable income of the trustee under section99 or 99A (subparagraph 99B(2)(c)(ii)).

1.227 The new arrangements for taxing the Australian source income of an exempt US trust FIF are shown by the following example.

Example 7 - New arrangements for taxing the Australian source income of an exempt US trust FIF

Facts

A common trust fund that qualifies for the new exemption is calculated to have net income of $1 million.
The net income is wholly referable to sources within Australia.
The trust has a large number of Australian beneficiaries who in total have a 100% interest in the property of the trust.
The income of the trust is not distributed to the beneficiaries during the year of income.

Example 7 - New arrangements for taxing the Australian source income of an exempt US trust FIF - Diagram

Consequences

The beneficiaries will not be taxed on the net income of the trust under section97 because subsection 96A(1) is to be extended to apply to trusts that qualify for the new exemption. The trustee will be taxed on the Australian source income of the trust. In this regard, subsection 96A(1A) will not apply to reduce the amount on which the trustee is taxed under sections 99 or 99A.

Section 4 Regulation impact statement

Part 2 - Exemption for US FIFs and related measures

Policy objective

1.228 The proposed exemption for US FIFs from the FIF measures is intended to encourage Australian investment funds to be more efficient. The exemption was announced by the Treasurer in a press release on 8December 1997 and forms part of the Governments strategy for Australian industry entitled Investing for Growth . The exemption is intended to increase the efficiency of Australian investment funds by exposing them to greater competition from US funds.

1.229 The exemption has been limited to interests in certain US FIFs because the effectiveness of the FIF measures could be compromised if the exemption were to apply to all interests in US FIFs. The exemption will nevertheless provide increased competition for Australian funds managers. Competition will be increased because of the size, liquidity and efficiency of the US funds management industry. The risk to the revenue will not be greatly increased because the US tax rules are sufficiently robust to prevent tax deferral opportunities from arising for investments that qualify for the exemption.

Implementation option

1.230 It is necessary to amend ITAA 1936 to provide an exemption from the FIF measures.

1.231 There are considered to be no alternatives to the structure of the exemption outlined below that would provide increased access to US FIFs without giving rise to significant tax deferral opportunities and increasing the risk to the revenue.

Structure of the new exemption

1.232 An unqualified exemption is being limited to FIFs that are taxed on a worldwide basis in the US. Consequently, an unqualified exemption will apply for most US company FIFs and for trusts treated as regulated investment companies (RICs) or real estate investment trusts (REITs). RICs and REITs are fully distributing investment funds used widely in the US as vehicles for managing collective investments.

1.233 In addition, a limited exemption will be provided for investments in certain companies and limited partnerships taxed as partnerships in the US and also for investments in common trust funds. These entities are commonly used by the funds management sector in the US. The exemption is being limited because these entities are taxed in the US as conduit entities and consequently the entities are not directly liable for tax. The US tax liability is instead borne by investors in the conduit entities and Australian investors are not normally subject to tax in the US on foreign income derived through the entities. Accordingly, an unqualified exemption has not been provided because it would allow Australian investors to hold non US FIFs through a conduit entity and be exempt from the anti tax deferral rules in both Australia and the US.

1.234 The exemption for investments in the abovementioned conduit entities is being limited to circumstances where a taxpayer can demonstrate that the investment was made for the sole purpose of investing within the US. Moreover, the exemption will normally not be available if the conduit entity either directly or indirectly has an interest in amounts derived from sources outside the US. An interest traced through an entity eligible for an unqualified exemption will not be taken into account for the purposes of measuring an indirect interest.

1.235 The exemption will only be available for a conduit entity that has an interest in amounts derived from sources outside the US if the value of the conduit entities interests in non-exempt FIFs and in assets that produce amounts from sources outside the US do not exceed five percent of the total value of the conduit entities interests in FIFs and assets respectively.

1.236 The exemption for US FIFs will also be available when determining FIF income under the calculation method (one of three methods available for determining FIF income). This treatment will allow look-through rules to apply where taxpayers can obtain the information necessary to comply with the method. The look-through rules will enable taxpayers to invest through up to two tiers of conduit entities that have investments in countries outside the US and still qualify for the exemption to the extent the entities have investments within the US.

Consequential amendments

1.237 Consequential amendments to the general trust provisions are required to ensure those provisions do not claw back the benefits from providing the new exemption. In the absence of the consequential amendments, the benefits of providing the new exemption could be lost because an investment in a trust FIF that qualifies for the new exemption would be accruals taxed under the general trust provisions.

1.238 Consequential amendments to the general trust provisions are also required to avoid onerous compliance costs arising where the exemption applies to trust FIFs. Without the amendments, beneficiaries would be required to make a net income calculation for investments in trust FIFs that qualify for the exemption. This calculation can be onerous because it requires a full application of our domestic rules and in many cases beneficiaries may not be able to obtain the information necessary to make the calculation.

Impacts (costs and benefits)

Impact group identification

1.239 The exemption will benefit resident taxpayers who hold interests in US FIFs. The major impact is expected to be on superannuation and investment funds, who between them hold the majority of Australian interests in US FIFs. The exemption will also affect some individual investors. Investments in controlled foreign companies and controlled foreign trusts will not be affected by the exemption because these interests are already exempt from the FIF measures.

1.240 The exemption is likely to increase Australian investment in US FIFs, particularly US mutual funds, that qualify for the exemption. This investment is expected to be largely at the expense of direct investment in US securities, but also to some extent at the expense of investments in Australia and in other countries.

Costs and benefits

1.241 It is estimated that approximately 1,000 taxpayers will directly benefit from the exemption. Approximately 80% of these taxpayers are individuals, partnerships and trusts, 15% are companies and 5% are superannuation funds. This estimate is based on the number of taxpayers returning FIF income in their income tax returns. Other taxpayers may be affected, however, because the exemption is likely to encourage more investment in US FIFs.

1.242 The exemption is likely to result in an initial and recurrent reduction in compliance costs because the FIF measures will not apply to investments that qualify for the exemption. The initial and recurrent reduction in compliance costs is expected to be minor.

1.243 The net effect of the exemption on administrative costs is uncertain because a reduction in existing administrative costs may be offset by other administrative costs. Existing administrative costs are likely to be reduced because it will no longer be necessary to ensure taxpayers are returning income from US FIFs that qualify for the exemption. Other administrative costs are likely to arise, however, because it will be necessary to monitor whether FIFs legitimately fall within the exemption.

Taxation revenue

1.244 The cost to the revenue of providing the exemption is expected to be $2 million in 1998-99 and $3 million annually for subsequent income years.

1.245 There may also be an indirect cost to the revenue as a result of the exemption because of increased investment in US FIFs. The indirect cost to the revenue is unquantifiable because the amount of capital transferred to US funds depends on prevailing economic conditions and on the investment strategies of Australian funds managers.

Consultation

1.246 The measure is in part a response to submissions to the Wallis Inquiry into the Australian financial system. Some informal consultation on the exemption has been undertaken with industry and professional associations, in particular, with the Investment & Financial Services Association which represents Australian funds managers. The measure is not controversial to the extent it benefits taxpayers, however, it may be opposed by funds managers who face greater competition.

Conclusion

1.247 The implementation option is considered the only effective means of achieving the policy objective of providing greater competition for Australian funds managers without giving rise to significant tax deferral opportunities. The option is expected to lead to an overall reduction in compliance costs for taxpayers who hold interests in US FIFs.

Part 3 - Exemption from the CFC measures for interests in US real estate investment trusts (REITs)

Overview of the CFC measures

1.248 Part 3 of Schedule 1 to the Bill will provide an exemption from the CFC measures for interests in certain REITs and interests held through certain REITs. The exemption is being provided as the result of representations from an Australian collective investment fund following the original introduction of amendments to the FIF measures in Taxation Laws Amendment Bill (No. 5) 1998 which lapsed when Parliament was prorogued for the election.

1.249 Unless otherwise stated, references to provisions of the law in this Chapter are references to provisions of the ITAA 1936.

Summary of the amendments

Purpose of the amendments

1.250 The proposed amendments will provide an exemption from the CFC measures for interests in REITs that derive income or hold assets principally in the US. [Item 47]

Date of effect

1.251 The proposed amendments will apply for statutory accounting periods of CFCs ending on or after 2 July 1998. [Item 48]

Background

1.252 The CFC measures (Part X of the ITAA 1936) apply to Australian residents who have an interest in a CFC at the end of a year of income. A CFC is a foreign company controlled by Australian residents. Broadly, the CFC measures operate to tax Australian residents, on a current year basis, on their share of certain undistributed amounts derived by a CFC. This treatment, referred to as accruals taxation, is directed at preventing deferral of Australian tax where profits are accumulated offshore in a CFC rather than remitted to Australian investors.

1.253 It is proposed that an interest in a REIT that is subject to the CFC measures be provided with an exemption from accruals taxation similar to that proposed in the Bill for FIF interests in REITs. An interest in a REIT can be subject to the CFC measures because a REIT may be a company for Australian tax purposes.

1.254 The exemption will ensure that Australian collective investment funds remain competitive with US funds in attracting Australian investment in REITs. If an exemption were not provided, direct investments in REITs could be treated more favourably than investments in Australian collective investment funds that manage REITs. In this regard, an Australian collective investment fund would be subject to the CFC measures if it were to control a company REIT. Accordingly, additional tax and compliance cost burdens associated with accruals taxation under the CFC measures would be passed on to investors in the Australian collective investment fund. These tax and compliance cost burdens would not arise, however, for investors who hold an interest directly in a non-controlled REIT because of the proposed exemption from the FIF measures.

Explanation of the amendments

Exemption from accruals taxation

1.255 The proposed amendments will provide a tightly targeted exemption from accruals taxation under the CFC measures for interests in REITs. The substantial similarity of US tax rules to those in Australia will help ensure that tax deferral opportunities do not arise because of the exemption.

1.256 New subsections 356(4A), (4B) and (4C) will give effect to the exemption for REITs by providing that a taxpayers direct attribution interest in a REIT is to be ignored where the interest satisfies the sole purpose test (refer to the discussion on new paragraphs 513(3)(a) and (4)(a) in Section 1, Part 2, Schedule 1 to this Bill) and:

the REIT does not directly or indirectly through other entities have income or investments outside the US; [New subsection 356(4B)] or
the REIT does not directly or indirectly through other entities have more than an incidental interest in income or investments outside the US. [New subsection 356(4C)]

[Item 47]

1.257 It should be noted, however, that interests held by a REIT indirectly through a US company, regulated investment company (RIC) or REIT are to be taken into account in determining the REITs interest in income or investments outside the US. It is necessary to have tighter rules for determining a REITs interests for the purposes of the CFC exemption because there is a greater risk of tax deferral where a taxpayer exercises significant control over an entity. [Item 47]

1.258 The effect of ignoring a taxpayers direct attribution interests in a REIT is that these interests will not be taken into account in determining the taxpayers share of the attributable income of the REIT. Moreover, the interests would not be taken into account in determining the taxpayers share of the attributable income of a company held through the REIT (section 357).

Control interests

1.259 Control interests held through a REIT will still be taken into account for the purposes of determining whether a subsidiary belonging to the REIT qualifies as a CFC. The CFC measures will continue to apply, for instance, to attribute income from a CFC that is a subsidiary of a REIT where a taxpayer has a direct interest in the subsidiary.

1.260 The application of the exemption is illustrated by the following example:

Example Application of the exemption for CFC interests in REITs

Facts

Aus Co is a company resident in Australia.
Coy A is a US company that is a real estate investment trust for the purposes of new subsection 356(4A) .
Coy B is a US company that conducts all its business in the US.
Aus Co has a direct interest in Coy A of 100% and a direct interest in Coy B of 10%.
Aus Cos interest in Coy A satisfies the sole purpose test.
Coy A has a 90% direct interest in Coy B.

Example  Application of the exemption for CFC interests in REITs

Consequences

The consequences of providing the exemption in determining Aus Cos share of the attributable income of Coy A and Coy B are discussed below.

Coy A

No amount would be attributed to Aus Co from Coy A because Aus Cos attribution interest in Coy A would be ignored under new subsection 356(4A) . Coy A would, however, be treated as a CFC which may be relevant when determining whether deemed dividends derived by Coy A should be taxed on an accruals basis under section 459. The accruals taxation of these dividends is discussed below in the section on the attribution of deemed dividends.

Coy B

Aus Co would be accruals taxed on a 10% share of Coy Bs attributable income. The indirect interest in Coy B held through Coy A would be disregarded in determining this share because of new subsection 356(4A) . The indirect interest held through Coy A would, however, still be taken into account in determining whether Coy B is a CFC.

Attribution of deemed dividends

1.261 A taxpayers direct attribution interests and indirect attribution tracing interests in a REIT will not be ignored for the purpose of section459 which attributes to a taxpayer a share of a deemed dividend derived by a CFC. [Item 47] This will allow amounts arising under the deemed dividend rules in section 47A to be accruals taxed where profits are shifted from a CFC in an unlisted country to a REIT or one of its subsidiaries.

Attribution accounts

1.262 Existing attribution surpluses held by a REIT will continue to be available to taxpayers for application against profits repatriated to Australia. This will ensure that amounts accruals taxed previously under the CFC measures will not be taxed again on distribution.

Regulation impact statement

Controlled foreign companies

Policy objective

1.263 The proposed exemption from the CFC measures is intended to ensure that Australian collective investment funds remain competitive with US funds in attracting and managing Australian investment in REITs.

Background

1.264 If an exemption were not provided, direct investments in REITs may be treated more favourably than indirect investments in REITs managed by Australian collective investment funds. This is because the indirect investments would continue to be subject to accruals taxation under the CFC measures whereas direct investments are likely to be exempt from accruals taxation following the proposed exemption from the FIF measures for US FIFs. Indirect investments would therefore continue to be subject to additional tax and compliance cost burdens associated with accruals taxation while direct investments in REITs would no longer be accruals taxed under the FIF measures.

1.265 Less favourable treatment of REITs managed by Australian collective investment funds could have a significant impact on their ability to compete. In this regard, direct investments in REITs are a close substitute for indirect investments in REITs managed by Australian funds.

1.266 The proposed exemption from the CFC measures is more tightly targeted than the proposed FIF exemption because there is a greater risk of tax deferral where a taxpayer exercises significant control over an entity. The risk to revenue is not likely to be greatly increased by a tightly targeted exemption from the CFC measures because the US tax rules are sufficiently robust to prevent tax deferral opportunities from arising for investments that qualify for the exemption.

Implementation option

1.267 It is necessary to amend the ITAA 1936 to provide an exemption from the CFC measures.

1.268 There are considered to be no alternatives to the structure of the exemption outlined below that would provide interests in REITs with an exemption from the CFC measures without giving rise to significant tax deferral opportunities and increasing the risk to the revenue.

Structure of the new exemption

1.269 The exemption is being limited to interests in REITs that derive income or hold investments principally in the US where a taxpayer can demonstrate that the investment was made for the sole purpose of investing within the US.

1.270 The exemption would normally not be available if the REIT directly or indirectly has an interest in amounts derived from sources outside the US. The exemption will, however, be available where the REIT has only an incidental interest in assets that produce amounts from sources outside the US. This incidental interest must not exceed five percent of the total value of the assets of the REIT, whether these assets are held directly, or indirectly through one or more other entities. Unlike the exemption from the FIF measures, it will be necessary to look through interests held in US companies, RICs and REITs for the purposes of determining interests held in assets that produce amounts from sources outside the US.

Impacts (costs and benefits)

Impact group identification

1.271 The exemption will affect Australian collective investment funds that manage REITs and investors in those funds.

Costs and benefits

1.272 The exemption will allow Australian collective investment funds to compete on an equal footing with REITs. Resident investors may also be advantaged by having the option of investing indirectly in a REIT managed through an Australian fund.

1.273 The exemption is likely to result in an initial and recurrent reduction in compliance costs because the CFC measures will not apply to investments that qualify for the exemption.

1.274 The effect of the exemption on administrative costs is uncertain but is expected to be minor.

Taxation revenue

1.275 The cost to the revenue of providing an exemption from accruals taxation under the CFC measures is expected to be minor because the US tax rules are substantially comparable to Australia's and therefore prevent most tax deferral opportunities from arising.

Consultation

1.276 An Australian collective investment fund was consulted on the proposed exemption from the CFC measures. The fund made representations for an exemption following the introduction of amendments giving effect to the exemption from the FIF measures in Taxation Laws Amendment Bill (No. 5) 1998. This Bill lapsed when Parliament was prorogued for the election.

Conclusion

1.277 The implementation option is considered the only effective means of achieving the policy objective of ensuring that Australian collective investment funds remain competitive with US funds in attracting and managing Australian investment in REITs without giving rise to significant tax deferral opportunities. The option is expected to lead to an overall reduction in compliance costs for Australian collective funds that manage REITs.


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