House of Representatives

Explanatory Memorandum

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

Glossary

The following abbreviations and acronyms are used throughout this explanatory memorandum.

General outline and financial impact

Introduction

In the 2003-2004 Federal Budget, following extensive consultation and a report (International Taxation - A Report to the Treasurer) by the Board of Taxation, the Government announced a package of reforms to international taxation. Following on from a new tax treaty with the United Kingdom and the New International Tax Arrangements Bill 2003, the measures contained in this bill are a further substantial instalment of those reforms.

Capital gains tax concession: active foreign companies

Schedule 1 to this bill amends the income tax law to ignore capital gains and losses arising from capital gains tax (CGT) events happening to shares in foreign companies which are held either by Australian companies or by controlled foreign companies in certain, specified circumstances. Broadly, the gains or losses will be disregarded to the extent that the foreign company has an underlying active business.

Date of effect: The amendments will apply to the specified CGT events relating to shares in foreign companies occurring on or after 1 April 2004.

Proposal announced: This measure was announced in Treasurer's Press Release No. 32 of 13 May 2003.

Financial impact: The financial impact of this measure is not quantifiable.

Compliance cost impact: Because of the underlying active business requirement and a business desire for the measure not to operate as an all-or-nothing exemption, additional compliance costs will be incurred when applying this measure. However, this was regarded as an acceptable cost of a better measure by business during consultation. Business can choose not to apply the rules so as not to incur these costs but then all of any relevant gain will be taxable or all of a loss will be non-deductible.

Foreign branch income, non-portfolio dividends and listed countries

Schedule 2 to this bill extends the existing exemptions for branch profits earned in, and non-portfolio dividends paid from, certain listed countries to all countries. It also changes the existing classification of countries as broad-exemption listed countries, limited-exemption listed countries or unlisted countries to either listed or unlisted countries.

Date of effect: The broadening of the exemption for non-portfolio dividends will apply to dividends paid after 30 June 2004. The broadening of the branch profits exemption and the changes to the classification of countries will apply to income years or statutory accounting periods of controlled foreign companies commencing after 30 June 2004.

Proposal announced: These measures were announced in Treasurer's Press Release No. 32 of 13 May 2003.

Financial impact: The cost to the revenue of this measure is expected to be $30 million in 2005-2006 and $55 million in 2006-2007.

Compliance cost impact: There should be considerable compliance cost savings for business from this measure. The law will be easier to understand and fewer distinctions between countries will be relevant (e.g. all dividends from foreign subsidiaries will be exempt from tax regardless of where the subsidiary is resident or where its profits have been derived).

Tainted services income

Schedule 3 to this bill amends sections 448 and 450 of the Income Tax Assessment Act 1936 to reduce the scope of tainted services income. Tainted services income will, in general, no longer include income from services provided by a company to a non-resident associate, or the overseas permanent establishment of an Australian resident. The amendments will improve the international competitiveness of Australian companies.

Date of effect: The amendments apply in relation to statutory accounting periods beginning on or after 1 July 2004.

Proposal announced: This measure was announced in Treasurer's Press Release No. 32 of 13 May 2003.

Financial impact: The amendments will have a cost to revenue of $10 million in 2005-2006 and $10 million in 2006-2007.

Compliance cost impact: The amendments are expected to reduce compliance costs for affected taxpayers.

Summary of regulation impact statement

Regulation impact on business

Impact: Providing capital gains tax (CGT) relief for the disposal of non-portfolio interests in a foreign company with an active business will provide Australian companies (and controlled foreign companies) with greater flexibility in corporate restructuring decisions. It could remove Australian tax costs from consideration in making these decisions. Additional compliance costs will be incurred in obtaining those benefits.

The extension of the exemption for non-portfolio dividends and foreign branch profits and the many changes to the legislation that this has prompted will substantially reduce compliance costs for taxpayers while improving their international competitiveness.

The modifications to the tainted services income rules will allow for greater flexibility in dealing with offshore associates.

Main points:

•

The provision of CGT relief for the disposal of non-portfolio interests in a foreign company with an active business will give Australian multinationals greater flexibility in the use of their capital. While this necessarily involves additional compliance costs for taxpayers in order to receive the consequent benefits (to determine whether a business is an active business), these costs have been minimised to the extent possible within integrity concerns. The additional compliance costs were seen as an acceptable cost of obtaining the benefits of the measure by those businesses that were consulted.

•

The extension of the exemption for non-portfolio dividends and foreign branch profits will allow Australian multinationals (and their controlled foreign companies) to compete more effectively in overseas markets by removing the Australian tax liability on active business profits. This too will improve flexibility for companies in their use of capital. Compliance costs for taxpayers will be substantially reduced.

•

Reducing the scope of tainted services income will improve the competitiveness of Australian companies with offshore operations by allowing for greater flexibility in dealing with offshore associates. They will be able to use offshore service centres to provide services to other offshore group companies. The changes will also reduce taxpayer compliance costs.

Although the CGT measure requires the addition of new law, these measures in total have enabled some substantial improvements to the law in this area. It will be more easily understood.

Chapter 1 - Capital gains tax concession: active foreign companies

Outline of chapter

1.1 Schedule 1 to this bill inserts Subdivision 768-G into the Income Tax Assessment Act 1997 (ITAA 1997). The Subdivision will operate to reduce a capital gain or capital loss an Australian company or controlled foreign company makes from specified capital gains tax (CGT) events happening on or after 1 April 2004 to certain interests in a foreign company.

1.2 This chapter explains the measure and outlines how a company determines the extent to which it may reduce its capital gain or capital loss.

Context of amendments

1.3 This measure will provide Australian companies (and controlled foreign companies) with greater flexibility in corporate restructuring decisions where other avenues of CGT relief are not available.

1.4 The current application of Australia's income tax law to disposals of interests in a foreign company is relevant at two levels. First, Australian companies are generally subject to tax on any capital gains made on the disposal of interests in a foreign company. Second, any capital gains made by a controlled foreign company on the disposal of interests in a foreign company may be attributed back to the Australian shareholder under Part X of the Income Tax Assessment Act 1936 (ITAA 1936) as assessable income.

1.5 This measure will allow Australian multinational companies and their controlled foreign companies to compete more effectively in capital markets. Together with the changes discussed in Chapter 2, it may facilitate Australian multinational companies to repatriate the profits of the foreign active businesses to Australia without incurring Australian tax. That will more easily enable them to employ that capital and structure (or in fact restructure) their business in the most efficient manner possible.

1.6 This measure implements the Government's decision on Recommendation 3.10(2) of the Board of Taxation's report to the Treasurer on international taxation. The decision was announced in Treasurer's Press Release No. 32 of 13 May 2003. A secondary aim of the measure is to ensure that similar Australian tax consequences arise from the disposal of non-portfolio interests in a foreign company with an underlying active business as would occur from the sale of the underlying active foreign business assets of that company.

1.7 Australian companies are currently subject to tax on capital gains arising from the disposal of shares in foreign companies. This includes disposals of shares in foreign companies with underlying active businesses. Conversely, where the underlying active business assets of the foreign company are sold, any gain arising on that sale may escape attribution under the accruals regimes and be repatriated to Australia free from Australian tax if it is distributed through a non-portfolio dividend.

Summary of new law

1.8 The measure will reduce the capital gain or capital loss a company makes from several specified CGT events happening to shares (other than eligible finance shares or widely distributed finance shares) in a foreign company to the extent that the foreign company has an underlying active business. This measure will also apply to reduce attributable income arising from the same CGT events happening to shares owned by a controlled foreign company in a foreign company.

1.9 The CGT events to which these amendments apply are CGT events A1, B1, C2, E1, E2, G3, J1, K4, K6, K10 and K11.

1.10 In order to be eligible for this measure, the following conditions must be satisfied:

•

the company held a direct voting percentage in the foreign company of at least 10%; and

•

the requisite interest was held by the company for a continuous period of at least 12 months in the two years before the CGT event.

1.11 The extent to which the foreign company carries on an active business is determined by calculating an active foreign business asset percentage for the company. Broadly, the active foreign business asset percentage is the value of active foreign business assets held by the foreign company as a percentage of the value of all the assets of the foreign company. Certain assets are specifically excluded from this calculation.

1.12 A taxpayer may choose to apply either the market value method or the book value method to value the assets of the foreign company for the purposes of calculating its active foreign business asset percentage.

1.13 Where the taxpayer is unable to, or chooses not to, apply either the market value or book value method to calculate the active foreign business asset percentage of a foreign company, the taxpayer will be required to apply a default rule. Under the default rule, the result is that all of a loss is disregarded where a capital loss has arisen on the happening of the CGT event, or none of a gain is disregarded where a capital gain has arisen.

1.14 With the focus of the measure on the valuation of assets of the foreign company, special rules apply to shares a foreign company has in another foreign company. Although characterised as an active asset, the value of these shares that is used in the calculation of the value of the active foreign business assets is based on the subsidiary's active foreign business asset percentage. An active foreign business asset percentage may only be determined for a subsidiary where the company that disposes of the foreign company, has a direct and indirect voting percentage in the subsidiary company of at least 10%. Further, the foreign company must have a direct voting percentage of at least 10% in the subsidiary company. In other cases, the value of shares in other foreign companies (or in Australian companies) to be included as an active asset in the calculation of the active foreign business asset percentage will be zero.

1.15 In certain circumstances, provided the foreign subsidiary company or companies are 100% owned by the foreign company, the calculation of the active foreign business asset percentage may be undertaken on a consolidated basis.

1.16 Special rules apply to the calculation of the active foreign business asset percentage in relation to Australian financial institution subsidiaries and foreign life insurance and foreign general insurance companies. Certain financial instruments used by Australian financial institution subsidiaries in carrying on a business, where their sole or principal business is financial intermediary business, will be included within the definition of active foreign business asset. Concessionary treatment will also be provided to foreign life insurance and foreign general insurance companies to take into account the special regulatory and solvency requirements in each of those industries.

1.17 The measure will apply to specified CGT events happening on or after 1 April 2004.

Comparison of key features of new law and current law

Detailed explanation of new law

What does this measure do?

1.18 This measure applies to reduce any capital gain or capital loss that arises from certain CGT events happening to certain shares in a foreign company by the active foreign business asset percentage of that foreign company [Schedule 1, item 3, subsection 768-505(2)]. Paragraphs 1.21 to 1.22 discuss shares to which this measure applies. Paragraphs 1.23 to 1.36 discuss the CGT events to which this measure applies. Paragraphs 1.51 to 1.59 discuss the concept of the active foreign business asset percentage.

Who will the measure apply to?

1.19 This measure applies where either an Australian company or a controlled foreign company owns shares in a foreign company. In the case of an Australian company, the rules apply to reduce the capital gain or capital loss arising under Part 3-1 of the ITAA 1997 from certain CGT events that happen to shares in the foreign company (see paragraphs 1.23 to 1.36 for a discussion on the relevant CGT events).

1.20 In the case of a controlled foreign company, the rules will apply in the calculation of the controlled foreign company's attributable income under Part X of the ITAA 1936. In Part X a controlled foreign company is assumed to be an Australian resident for the purposes of calculating its attributable income. This includes applying Part 3-1 dealing with capital gains and losses (as modified by Subdivision C of Division 7 of Part X of the ITAA 1936) and new Subdivision 768-G of the ITAA 1997. Apart from this calculation of attributable income, the measure is not relevant where a foreign company owns shares in another foreign company. For example, it has no effect on the active income test nor on the definition of passive income under Part X.

What shares will be covered by the measure?

1.21 A share (other than an eligible finance share or a widely distributed finance share) in a company that is a foreign resident will be eligible for this measure [Schedule 1, item 3, paragraph 768-505(1)(b)]. Eligible finance shares and widely distributed finance shares are defined in Part X of the ITAA 1936.

1.22 The purpose of excluding such shares from the application of this measure is that the shares are, in substance, the equivalent of a debt rather than an equity investment.

Which CGT events are relevant?

1.23 This measure will only apply for CGT events A1, B1, C2, E1, E2, G3, J1, K4, K6, K10 and K11. [Schedule 1, item 3, paragraph 768-505(1)(c)]

1.24 The measure has been restricted to these CGT events in line with the policy of providing a concession where there has been a disposal or sale of shares in the foreign company and to minimise existing impediments to the ability of corporate groups to restructure their business.

1.25 The remaining CGT events in Division 104 have not been included for the purposes of this measure because:

•

they do not happen to shares and are therefore irrelevant; or

•

they have the primary purpose of maintaining integrity of the CGT provisions, and it would therefore be inappropriate to apply the measure to any capital gain or capital loss arising from those CGT events.

Disposal of a CGT asset

1.26 It is envisaged that CGT event A1 will be the most common CGT event giving rise to the application of this measure as it relates to the disposal of a CGT asset.

Other CGT events

1.27 CGT events other than CGT event A1 have been included in the measure because they are so closely related to an actual disposal under CGT event A1 and inequitable outcomes would result if they were not included.

CGT event B1

1.28 CGT event B1 effectively brings forward the time that a capital gain or capital loss arises under an agreement to pass use and enjoyment of a CGT asset from the time when the actual disposal takes place to the time when the use and enjoyment of the asset is transferred. Without the agreement, CGT event A1 would normally apply. Although it is envisaged that there would be very few, if any, situations in which CGT event B1 would apply to shares in a foreign company, the event has been included because it closely relates to the passing of title in the asset.

CGT event C2

1.29 CGT event C2 happens if the taxpayer's ownership of an intangible CGT asset ends because it is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered, forfeited or expired. The reasons for including this event for the purposes of this measure are two-fold:

•

this event may happen because a genuine transaction takes place in relation to the shares in the foreign company whereby the shareholding company no longer holds any ownership interests in the foreign company (e.g. redemption of shares in a company); and

•

if not included, this event could be used by a company to avoid application of this measure where it has made a capital loss from losing its ownership in the shares of the foreign company.

CGT events E1 and E2

1.30 CGT events E1 and E2 have specifically been included on the basis that they could allow a taxpayer to effectively sell the share in the foreign company without causing CGT event A1 to happen. For example, a company could either create a trust over the share or could transfer the share to an existing trust. In both cases, the company would no longer have beneficial ownership of the share. Although the company may retain legal ownership of the share, the beneficial owner of the share would now be the beneficiary of the trust.

CGT event G3

1.31 CGT event G3, which only gives rise to a capital loss, happens when a liquidator declares in writing that there is no likelihood that the shareholders in the company will receive any further distribution in the course of winding up the company. This event has been included to prevent a taxpayer from avoiding application of this measure where they have made a capital loss on their shares in the foreign company under CGT event G3, rather than under CGT event C2 (when the foreign company is eventually wound up).

CGT event J1

1.32 CGT event J1 happens where a company that holds a CGT asset that was the subject of a roll-over under Subdivision 126-B ceases to be a member of a wholly-owned group.

1.33 CGT event J1 is specifically included in this measure to ensure that the part of the capital gain or loss that may arise on the application of CGT event J1 to a share in a foreign company receives the same treatment as any capital gain or loss that could otherwise arise on the actual disposal of the share in a foreign company.

CGT event K4

1.34 CGT event K4 happens where a CGT asset that is already owned by the taxpayer starts being held as trading stock and the taxpayer elects to have the asset treated as having been sold for its market value. Although this event does not happen in response to a change in the ownership of the asset, it has been included in the measure because it represents a change in the nature of the holding of the asset by the taxpayer and involves a deemed sale of the asset as a CGT asset.

CGT event K6

1.35 Inclusion of CGT event K6 means that any capital gain or capital loss arising on the sale by an Australian company or controlled foreign company of a pre-CGT share in a foreign company will be subject to this measure where that foreign company holds predominantly post-CGT assets. If this CGT event were not included, an Australian company or controlled foreign company would not be eligible for a reduction in their capital gain or loss from the disposal of their interest in a foreign company, even if they satisfied all the other conditions prescribed by this measure. That would clearly be inequitable and opposed to the policy intent of this measure.

CGT events K10 and K11

1.36 CGT events K10 and K11, which relate to foreign exchange gains and losses respectively, have been included as they are incidental to other CGT events that are relevant for the purposes of these measures, such as CGT event A1.

How long is the Australian company or controlled foreign company required to hold the interest?

1.37 Application of this measure is limited to any capital gain or capital loss arising from CGT events happening to a share in a foreign company where the shareholding company held a direct voting percentage of at least 10% in the foreign company for a continuous 12-month period in the two years before the CGT event. [Schedule 1, item 3, paragraph 768-505(1)(a)]

1.38 The requirements in relation to a minimum time and minimum shareholding are included to ensure that the availability of concessions under this measure is limited to structural holdings, that is, those shareholdings that may be considered to be part of the business structure of the shareholder company rather than a mere temporary investment. The intention of this measure is to allow companies to restructure their foreign structural shareholdings without being overburdened by Australian tax considerations.

Direct voting percentage

1.39 The concept of direct voting percentage has been used to ensure that it relates to a voting interest that an entity owns directly in another company. In other words, if there is a trust or a partnership interposed between the shareholding entity and the other company, then the first-mentioned company will be taken to not hold a direct voting percentage in the other company.

1.40 The direct voting percentage that an entity has in a foreign company is equal to the voting interest it holds in that foreign company (within the meaning of section 160AFB of the ITAA 1936) as a percentage of the voting power of that company (within the meaning of that section). [Schedule 1, item 3, subsection 768-550(1)]

1.41 However, the application of section 160AFB is modified for the purposes of this measure to ensure that if a partnership or trust is interposed between the shareholding entity and the company in which the shares are held the direct voting percentage in the company will be zero. [Schedule 1, item 3, paragraph 768-550(1)(b) and subsection 768-550(2)]

1.42 This modification for the purposes of the definition of 'direct voting percentage' is consistent with the application of the non-portfolio dividend exemption in section 23AJ of the ITAA 1936, which is only available in respect of non-portfolio dividends that have been paid to an Australian resident company by a foreign resident company.

Example 1.1

On 1 July 2003 an Australian resident company, Abbey Co, purchased the following shares in foreign-resident company Matt Co:

•

50% of the total number of shares in Matt Co carrying only rights to dividends; and

•

5% of the shares in Matt Co that carry the right to exercise voting power in that company.

On 1 July 2004, Abbey Co disposed of its entire shareholding (i.e. the shares carrying only rights to dividends, and the shares carrying voting rights). Any capital gain or capital loss made by Abbey Co in relation to any of the shares will not be reduced under this measure. This is because Abbey Co did not hold a direct voting percentage of 10% or more at any stage.

If, on the other hand, Abbey Co had initially purchased 10% (rather than 5%) of the shares in Matt Co that carry the right to exercise the voting power in that company, the measure would apply to reduce any capital gain or capital loss made on the disposal of both the shares carrying voting rights and the shares carrying only rights to dividends (provided those shares are not eligible finance shares or widely distributed finance shares).

Minimum continuous shareholding period

1.43 In order to be eligible for the reduction under this measure, an Australian company is required to have a direct voting percentage in a foreign company for a continuous period of at least 12 months in the two years immediately before the CGT event. [Schedule 1, item 3, paragraph 768-505(1)(a)]

1.44 This requirement has been included as an integrity measure that is designed to prevent Australian companies or controlled foreign companies from accessing the reduction in capital gains where they have not recently held the requisite interest in the foreign company for at least a 12-month continuous period. Further, as mentioned in paragraph 1.38, this measure is designed to only apply in relation to shares that are part of the shareholder company's structural business rather than a mere temporary investment of the shareholder company.

1.45 It also allows for companies to sell down their shareholding in stages, provided this is carried out within 12 months of ceasing to hold the requisite voting percentage. This is discussed in further detail in paragraphs 1.47 to 1.49.

1.46 Adoption of the timing requirements is consistent with similar regimes in other jurisdictions.

Staggered sell-down

1.47 This measure may also apply where an Australian company or controlled foreign company holds less than a 10% direct voting percentage in the foreign company at the time of the CGT event. This will be the case where the Australian company or controlled foreign company held at least a 10% direct voting percentage for a continuous 12-month period in the two years prior to the relevant CGT event. In other words, the reduction in the capital gain or capital loss provided under this measure may continue to be available for up to 12 months after the Australian company or controlled foreign company has ceased to hold a direct voting percentage of at least 10% in the foreign company that it held for at least 12 months. [Schedule 1, item 3, paragraph 768-505(1)(a)]

1.48 The purpose of this rule is to allow companies to retain eligibility for the concession under this measure where they sell their shares in foreign companies in instalments.

Example 1.2

An Australian-resident company, Ken Co, purchased 20% of the shares in a foreign-resident company, Cath Co, on 1 July 2002. The shares carried the right to exercise 20% of the voting power in Cath Co. On 1 July 2004, Ken Co disposed of 11% of the shares in Cath Co, therefore retaining 9% of the shares in Cath Co. Ken Co subsequently disposed of 4% of the shares on 31 December 2004 and its remaining 5% shareholding in Cath Co on 1 July 2005.

The transactions may be illustrated on a timeline as follows:

Based on the above, Ken Co would be eligible to the reduction under this measure for any relevant CGT events happening to its interest in Cath Co from 1 July 2003, that is, at a time when Ken Co had held a direct voting percentage of 10% or more in Cath Co for a continuous period of at least 12 months. Ken Co would then continue to be eligible for the reduction for any relevant CGT events happening until 30 June 2005, despite the fact that Ken Co had a direct voting percentage of less than 10% in Cath Co from 1 July 2004.

On this basis, the disposals that would qualify for a reduction are:

•

the disposal of 11% on 1 July 2004; and

•

the disposal of 4% on 31 December 2004.

The disposal of 5% of the shares in Cath Co on 1 July 2005 would not qualify for the reduction as Ken Co did not hold a direct voting percentage of at least 10% in Cath Co for a continuous period of 12 months in the two years prior to the disposal.

1.49 It is possible that this measure will also apply where a company disposes of shares in the foreign company, where those particular shares have been held by the company for less than 12 months. This situation may occur where the shareholding company sold a direct voting percentage in the foreign company of at least 10% after holding it for a continuous period of at least 12 months. If the shareholding company then reacquired some shares in that foreign company, then it may be eligible to access the reduction provided under this measure if the shares were sold within 12 months of the first disposal.

Example 1.3

An Australian-resident company, Invest Co, acquired shares in a foreign-resident company, Target Co, on 1 January 2005, giving Invest Co a direct voting percentage of 40% in Target Co. On 1 January 2006, Invest Co disposed of the entire interest in Target Co so that, at that date, it no longer held any shares in Target Co. On 1 July 2006, Invest Co acquired 5% of the shares in Target Co, which it subsequently disposed of on 31 December 2006.

The transactions are illustrated in the following timeline.

Based on the above, Invest Co will be eligible for the reduction for the disposal of the shares in Target Co on both 1 January 2006 and on 31 December 2006, despite the fact that Invest Co did not own any shares in Target Co between 2 January 2006 and 31 June 2006. This is due to the fact that Invest Co satisfies both the minimum shareholding requirements and the timing requirements in relation to its shareholding in Target Co from 1 January 2005 to 31 December 2006.

How is the capital gain or capital loss reduced?

1.50 Any capital gain or capital loss that arises from certain CGT events happening to shares in a foreign company is reduced under this measure by the active foreign business asset percentage of that foreign company at the time of the CGT event. [Schedule 1, item 3, subsection 768-505(2)]

What is the active foreign business asset percentage of a foreign company?

1.51 The concept of active foreign business asset percentage has been developed to determine the extent to which the foreign company carries on an active business.

1.52 An assessment of the nature of the assets held by a foreign company is considered to be the most practical representation of the extent to which that company is carrying on an active business. An underlying assumption of this measure is therefore that the assets characterised as active for the purpose of calculating the active foreign business asset percentage are used by the company in carrying on an active business.

1.53 Broadly, the active foreign business asset percentage of a foreign company is the value of active foreign business assets owned by the company as a percentage of the value of total assets owned by the company. [Schedule 1, item 3, subsections 768-520(1) and 768-525(1)]

1.54 One of two methods, market value or book value, may be chosen to value these assets. Paragraphs 1.60 to 1.98 discuss these methods in detail.

1.55 It is important to note that there are modified rules for the application of the active foreign business asset percentage for both foreign life insurance companies and foreign general insurance companies and foreign wholly-owned groups [Schedule 1, item 3, sections 768-530 and 768-535]. More detailed discussion on these modifications is provided in paragraphs 1.178 to 1.213 and 1.214 to 1.223.

1.56 The result of the active foreign business asset percentage calculation is rounded to the nearest whole percentage point. Where the result of the calculation is 90% or more, then the active foreign business asset percentage is taken to be 100%. If the result is less than 10%, the active foreign business asset percentage is taken to be zero. In all other cases, the result of the calculation is equal to the active foreign business asset percentage. [Schedule 1, item 3, step 5 in the method statement in subsection 768-520(1); step 5 in the method statement in subsection 768-525(1)]

1.57 Where the active foreign business asset percentage is less than 10%, all capital gains arising from certain CGT events happening to an eligible interest in a foreign company will be taxable. Similarly, all capital losses that arise from those CGT events happening to an eligible interest in a foreign company will be available to be deducted from any other capital gains or carried forward to be used against future capital gains. The main reason for the threshold at the lower end is that the situation where the overwhelming majority of the company's assets are not active is taken to be reflective of the fact that the business being carried on by the company is itself not of a sufficiently active nature to warrant application of this measure.

1.58 Conversely, where the active foreign business asset percentage is 90% or more, capital gains arising from certain CGT events happening to an eligible interest in a foreign company will be reduced to zero, and therefore exempted from tax. Likewise, all capital losses arising from those CGT events will be disregarded. They will therefore not be available to deduct against any capital gains arising during the income year nor will they be available to be carried forward to be deducted against future capital gains.

1.59 The purpose of including a threshold at the upper end of the active foreign business asset percentage calculation is recognition that a company that is predominantly active may own some non-active assets that are incidental to the operation of the overall business. Further, the presence of the upper end threshold provides symmetry with the threshold at the lower end of the active foreign business asset percentage calculation.

Example 1.4

On 1 July 2004, Chrissy's Clothing Co, an Australian-resident company, disposed of the whole of its interest (a 100% direct voting percentage) in Nick's Pants Co, a foreign-resident company, that it originally acquired on 1 July 2001.

Chrissy's Clothing Co determined that the average value of Nick's Pants Co's active foreign business assets as a percentage of Nick's Pants Co's total assets at the time of the disposal was 91%. Therefore, Nick's Pants Co's active foreign business asset percentage at that time is equal to 100%. Any capital gain made or capital loss realised by Chrissy's Clothing Co on disposal of its interest in Nick's Pants Co will therefore be reduced by 100% to zero.

How are assets to be valued for the purposes of calculating the active foreign business asset percentage of a foreign company?

1.60 A choice in valuation methodologies is provided for identifying the values of total assets and active assets for the purposes of calculating the active foreign business asset percentage of a foreign company. [Schedule 1, item 3, subsection 768-510(1)]

1.61 The choice may be made between:

•

market valuation [Schedule 1, item 3, subsection 768-515(1)] ;

•

book valuation [Schedule 1, item 3, subsection 768-515(2)] ; or

•

no valuations - apply default active foreign business asset percentage [Schedule 1, item 3, subsection 768-510(4)].

1.62 A formal choice is required to adopt market or book valuation. Certain criteria must be met before either method may be applied. [Schedule 1, item 3, sections 768-510 and 768-515]

1.63 The default active foreign business asset percentage, or third choice, is made by:

•

not making the formal choice to apply book or market valuations; or

•

formally choosing book or market valuation but not satisfying the particular criteria for using the chosen method.

1.64 Choice has been provided to ensure that all eligible taxpayers will have access to the reduction in capital gains and losses provided by this measure, regardless of their level of access to information, availability of financial accounts or their ability or willingness to incur the compliance costs associated with the different methods of valuation.

Who may choose the valuation method to be applied?

1.65 The choice to adopt the market value or book value method for calculating the active foreign business asset percentage of a foreign company is to be made by the holding company, that is, the company that holds the interest in the foreign company to which the relevant CGT events happen [Schedule 1, item 3, section 768-515]. Where the holding company is an Australian company, then the choice will be made by that company. However, where the holding company is a controlled foreign company, then pursuant to section 390 of the ITAA 1936, the choice will be made by the eligible taxpayer in relation to that eligible controlled foreign company.

1.66 There is no separate notification requirement that the taxpayer needs to make in relation to its choice regarding the asset valuation method used to calculate the active foreign business asset percentage. Rather, the way the taxpayer prepares its income tax return for the year of income in which the relevant CGT event happens is sufficient evidence of the choice. [Schedule 1, item 3, subsection 768-515(3)]

What are the criteria for applying market value methodology?

1.67 The taxpayer may adopt the market value method for calculating the active foreign business asset percentage for a foreign company if certain conditions are satisfied [Schedule 1, item 3, subsection 768-510(2)]. First, the taxpayer must choose to adopt the market value method [Schedule 1, item 3, paragraph 768-510(2)(a)]. Second, at the time of the CGT event there must be:

•

sufficient evidence of the total market value of all the assets included in the total assets of the foreign company; and

•

sufficient evidence of the total market value of all the active foreign business assets included in the total assets of the foreign company.

[Schedule 1, item 3, paragraph 768-510(2)(b)]

1.68 Regardless of the manner in which the market value of the total assets is ascertained and the methodology employed, it is necessary for there to be sufficient evidence kept of the methodology, the information used and the resulting valuations. The methodology itself must also be considered objectively to provide sufficient evidence of the market value of the assets.

1.69 The values of the assets used for the purposes of calculating the active foreign business asset percentage are to represent the current market values at the time the relevant CGT event happens to the holding company's shares in the foreign company. [Schedule 1, item 3, subsection 768-520(1)]

Sufficient evidence of the market value of all assets included in the total assets of the foreign company

1.70 It may not be necessary to value each asset included in the total assets of the foreign company to work out the market value of all assets included in total assets of the foreign company as required under step 1 in the method statement in subsection 768-520(1).

1.71 Rather, it is envisaged that the market value of the total assets as a whole may be ascertained by reference to the sale price of the shares disposed of. In the simple case where 100% of a company with $100 of liabilities is disposed of (in an arm's-length sale on the open market), the market value of the company will be the disposal price. The market value of the total assets of the foreign company will then be the disposal price (market value of the company) plus $100 (liabilities) less the market value of any assets of the company not included in the definition of total assets.

1.72 Consequently, the following steps may generally be used to ascertain the market value for the total assets of a foreign company:

Step 1 - Market value of the company plus

Step 2 - Market value of the liabilities less

Step 3 - Market value of assets in the company not included in total assets.

1.73 Factors that will affect the calculation of the market value of the company by reference to the disposal price for the shares include:

•

disposal of the shares at a discount or premium;

•

non-arm's-length disposal; and

•

disposal of a specific class of shares where the company has different classes of shares.

1.74 Whilst it is not necessary to ascertain the market value of all assets by reference to the sum of the market value for each asset included in the total assets, it is still permissible to calculate the market value of total assets this way.

Sufficient evidence of the market value of all assets included in the active foreign business assets of the foreign company

1.75 As for total assets it is not always necessary to calculate the market value of all assets included in the active foreign business assets of a foreign company as the sum of the market values of each individual active foreign business asset. [Schedule 1, item 3, subsection 768-520(1)]

1.76 Rather, it is envisaged that in the majority of cases it will be simpler to ascertain the market value of assets included in total assets that are not active foreign business assets (non-active assets). The market value of the active foreign business assets of the company may then be calculated as follows.

Step 1 - Market value of total assets [Schedule 1, item 3, step 1 in the method statement in subsection 768-520(1)] less

Step 2 - Market value of non-active assets.

Sufficient evidence of the market valuation of certain assets

1.77 There may be certain circumstances where the value of an asset as recorded in certain financial accounts of the foreign company may be sufficient evidence of market value.

Example 1.5

An Australian company, Hannah Pty Limited (Hannah Australia), holds shares in a foreign company Hannah New Zealand Pty Limited (Hannah NZ).

A building was purchased by Hannah NZ on 1 July 2003 for $1 million. The transaction had conveyancing costs of $10,000 and other associated costs of $30,000. Therefore, the cost of the building was equal to $1,040,000.

The amount of $1,040,000 is recorded in the books of Hannah NZ on the basis that the conveyancing and other associated costs are incidental costs directly attributable to the acquisition of the building. If Hannah Australia's interest in the foreign company is sold on 1 July 2005, the historical cost figure in the accounts for the building is not acceptable for the purposes of the market value method given that it is historical cost and does not take into account any change in value of the building over the time it was held.

Example 1.6

Following from the facts in Example 1.5, assume that the building increased in value by 15% each year in line with commercial property growth in that area. The value of the building at 1 July 2005 would therefore be:

$1,040,000 + (15% * $1 million) + [15% * ($1 million + 15% * $1 million)]
= $1,040,000 + $150,000 + $172,500
= $1,362,500


This would be represented as the current book value (fair value) of the asset for that year at the time the accounts were prepared.

Given that the value appearing in the books would closely resemble the current value of the building, it would be an acceptable value to use under the market value method.

Example 1.7

Evie Australia Pty Limited (Evie Australia) is a holding company. It holds 100% of the shares in Owens New Zealand Pty Limited (Owens NZ). Owens NZ has only issued one class of shares. Owens NZ manufactures sun tanning equipment. Evie Australia sells 40% of its interest in Owens NZ to a third party at the arm's length market price of $200 million.

The market value of the assets of Owens NZ could be derived from the sale price obtained upon disposal of the shares in the foreign company plus the market value of the liabilities of the company. This method alleviates the need to separately value all assets of a company.

Thus, if in the circumstances of this example:

•

40% of the interests in the company are worth $200 million, then the market value of all interests in the company would be $500 million ($200 million divided by 40%);

•

the market value of liabilities is assumed to be $300 million;

•

the market value of 'passive' assets is $100 million; and

•

all of the assets of Owens NZ are assets included in the total assets under section 768-545,

then the calculation under steps 1 to 4 of subsection 768-520(1) would be:

(($500 million + $300 million) - $100 million) / $800 million = 700 / 800 = 88%


Accordingly, a capital gain or loss on the disposal of the interest in Owens NZ by Evie Australia would be reduced by 88%. The remainder would be left within the CGT rules.

If the 40% interest in Evie NZ had a cost base of $100 million, there would be a gain of $100m ($200 million minus $100 million). This means that $88 million of the gain would be exempt and the remaining $12 million would be included in the calculation of Evie Australia's taxable income.

Example 1.8

Use the facts in Example 1.7 but assume that Evie Australia disposed of some of its interest in Owens NZ so that it now owns 40% of the shares. SMG Pty Ltd (a related Australian entity), which owns 16% of the shareholding in Owens NZ, approaches Evie Australia to sell its interest in Owens NZ. Evie Australia agrees to acquire this interest from SMG Pty Ltd for $100 million. Assume that this is a non-arm's-length price.

If the $100 million consideration were accepted to be representative of the value of a 16% interest in Owens NZ, the value of all interests in Owens NZ would amount to $625 million ($100 million divided by 16%). The market value of the total assets in Owens NZ (the foreign company) under the market value methodology would be the sale price of the shares owned by SMG Pty Ltd in Owens NZ (grossed-up) plus the market value of the liabilities of Owens NZ. If it is assumed that the market value of the disposal of the shares is $625 million, this would result in a market value of the total assets of $625 million plus $300 million (liabilities of Owens NZ) which is equal to $925 million.

However, as the acquisition price is not an arm's-length amount, it cannot be accepted as indicative of the market value of the company.

Given that this amount does not represent the market value of the total assets, a market valuation of assets would need to be undertaken; assuming the same result as in Example 1.7.

Thus, a gain or loss would be reduced by 88%. If the cost base of the shares owned by SMG Pty Ltd in Owens NZ is $50 million then the capital gain is $50 million ($100 million minus $50 million). The amount of capital gain is reduced to $6 million. The remaining $44 million would not be included in the calculation of SMG Pty Ltd's taxable income.

1.78 Note that it is necessary to separately identify the value ascribed to share assets for the purposes of identifying the value attributed to the shareholding under subsection 768-520(2). The actual market value of the shares would be replaced, in determining the market value of the active assets, by the amount determined under subsection 768-520(2). [Schedule 1, item 3, subsection 768-520(2)]

What are the criteria for applying the book value method?

1.79 The taxpayer may adopt the book value method for calculating the active foreign business asset percentage for a foreign company if certain conditions are satisfied [Schedule 1, item 3, subsection 768-510(3)]. First, the taxpayer must choose to adopt the book value method [Schedule 1, item 3, paragraph 768-510(3)(a)]. Second, the taxpayer must have access to recognised company accounts of the foreign company for the relevant periods [Schedule 1, item 3, paragraphs 768-510(3)(b) and (c)].

Recognised company accounts

1.80 The average value of total assets of the foreign company and the average value of active foreign business assets of the foreign company are calculated by using the asset values disclosed in the two most recently available recognised company accounts that represent periods ending at least six months but no more than 18 months apart. [Schedule 1, item 3, subsections 768-525(2) and (3)]

1.81 Recognised company accounts of a foreign company are accounts that are prepared in accordance with:

•

the accounting standards prepared by the responsible body in Canada, France, Germany, Japan, New Zealand, United Kingdom (UK) or United States of America (USA), or the international accounting standards; or

•

commercially accepted accounting principles that give a true and fair view of the financial position of the foreign company.

[Schedule 1, item 17, definition of 'recognised company accounts' in subsection 995-1(1)]

1.82 It is intended that accounts that have been prepared in accordance with the accounting standards of Canada, France, Germany, Japan, New Zealand, UK or USA, or the international accounting standards, would be used in preference to accounts prepared in accordance with commercially accepted accounting principles.

1.83 The second element of recognised company accounts is based on paragraph 432(1)(c) of the ITAA 1936. It is anticipated that, under this option, the foreign company's accounts would be prepared in accordance with the accounting standards that are generally in use in the country in which the foreign company is resident or in which the foreign company carries on its principal business activities. Accepted accounting principles would usually mean the accounting standards developed and enforced by the relevant accounting authority in relation to each country. The ability of a foreign company to choose between different sets of commercially accepted accounting principles is restrained by the requirement that accounts must give a true and fair view of the financial position of the company. [Schedule 1, item 17, definition of 'recognised company accounts' in subsection 995-1(1)]

1.84 It is intended that the most recent recognised company accounts would include completion accounts, that is, those accounts that have been prepared solely for the purpose of the disposal of shares in the foreign company.

Average value of assets

1.85 In working out the active foreign business asset percentage of a foreign company in accordance with the book value method it is necessary to calculate the average values of total assets and active foreign business assets. [Schedule 1, item 3, subsection 768-525(1)]

1.86 Recognised company accounts are prepared on a particular day in relation to the position of the company on a particular day which may or may not correlate with the time of the CGT event to which the measure applies. In short, the recognised company accounts may not represent the position of the foreign company at the time of the CGT event but rather the position of the company at an earlier point in time.

1.87 Rather than use the values in a single set of recognised company accounts (possibly) prepared for a different time to the time of the CGT event, average values using two sets of company accounts are required. The use of two sets of accounts in relation to the two prescribed periods for which accounts were prepared will provide a more balanced view of the overall position of the company. Consequently, the use of average values will produce an active foreign business asset percentage that is more reflective of the active nature of the company throughout the relevant period.

1.88 Further, this approach minimises the potential for manipulation of the active foreign business asset percentage by acquiring active assets for the purposes of a single reporting period. The requirement for average values is also consistent with the integrity rule requiring that the holding company own the eligible interest in the foreign company to which the relevant CGT event happens for a period of at least 12 months prior to the CGT event.

1.89 The relevant periods for which recognised company accounts are required are:

•

the most recent period that ends no more than 12 months before the time that the relevant CGT event happens and for which the foreign company has recognised company accounts; and

•

the most recent period that ends between six months and 18 months before the end of the period mentioned above and for which the foreign company has recognised company accounts.

[Schedule 1, item 3, subsections 768-525(2) and (3)]

1.90 If there are multiple periods for which the foreign company has recognised company accounts it will be the consecutive accounts that are closest to the time immediately prior to the CGT event that end no less than six months and no more than 18 months apart that are required to be used.

1.91 Where the foreign company does not have recognised company accounts for one of the required periods, then the taxpayer will not be able to apply the book value method in relation to that foreign company [Schedule 1, item 3, paragraphs 768-510(3)(b) and (c)]. The taxpayer will be required to choose either the market value method or have the default method apply in relation to calculating the active foreign business asset percentage for that foreign company.

1.92 However, if the foreign company did not exist before the start of the period ending no more than 12 months prior to the CGT event and it does not have more than one set of recognised company accounts, then the values of the assets for the earlier period are taken to be zero [Schedule 1, item 3, subsection 768-525(6)]. In other words, where the foreign company has not been in existence long enough to have more than one set of recognised company accounts, then the taxpayer will still be able to apply the book value method in calculating its active foreign business asset percentage.

1.93 The taxpayer will not be able to adopt the book value method where the foreign company has recognised company accounts for the relevant periods but the taxpayer cannot get access to them. This may be the case where the foreign company being disposed of (FC1) has recently purchased shares in a subsidiary foreign company (FC2) in which it has a direct voting percentage of at least 10%. Although FC1 may have some difficulty in getting access to recognised company accounts of FC2 for periods prior to its acquisition, inability to acquire the accounts will mean that the book value method cannot be adopted in relation to FC2 (but it still may be able to be used for FC1).

Example 1.9

An Australian company, Alex Co, disposes of 100% of the shares in a foreign company, Lou Co, on 10 July 2006. Lou Co prepares completion accounts in anticipation of the sale for the period ending on the date of the disposal. The completion accounts are for the period 1 July 2006 to 10 July 2006. Lou Co is a quarterly reporting company in its local jurisdiction (the United Kingdom) and has accounts prepared in accordance with the accounting standards of the United Kingdom for each quarter aligning with a 1 July accounting period.

Consequently there are recognised company accounts available for the following periods:

•

1 July 2006 to 10 July 2006;

•

1 April 2006 to 30 June 2006;

•

1 January 2006 to 31 March 2006;

•

1 October 2005 to 31 December 2005;

•

1 July 2005 to 30 September 2005;

•

1 April 2005 to 30 June 2005, and so on.

The relevant accounts to be used by Alex Co in calculating the active foreign business asset percentage are the accounts for the periods 1 July 2006 to 10 July 2006 and 1 October 2005 to 31 December 2005. The first set of accounts ends on the day of the CGT event and the second set of accounts ends (31 December 2005) more than six months before the end of the first period (10 July 2006).

1.94 The value of an asset of a foreign company at the end of a period is taken for the purposes of the book value method to be the value of the asset as shown in the recognised company accounts of the foreign company for that period [Schedule 1, item 3, paragraph 768-525(5)(a)]. If the value of the asset is not disclosed in the recognised company accounts for that period, then the value of the asset is taken to be zero for the purposes of the book value method [Schedule 1, item 3, paragraph 768-525(5)(b)]. Therefore, assets of the company not recorded in the accounts, such as internally generated goodwill, will be ascribed a zero value.

1.95 The value of an asset will not be zero if its value is not individually recorded in the recognised company accounts but is reflected in the value ascribed to a class of assets. In that case the asset has a value in the accounts.

1.96 Where all assets in a class are included in total assets or active foreign business assets there is no need to individually identify the value for each particular asset. If, however, not all assets included in the class of assets are included in the particular calculation, that is total assets or active foreign business assets, then it will be necessary to deconstruct the accounts to identify the values of the relevant assets that are reflected in that class of assets.

1.97 For example, in working out the sum of values of every asset included in the total assets under step 1 or 2 in the method statement in subsection 768-525(2), it is not necessary to separately identify the value of each asset provided all the assets included in the value of a class of assets are included in total assets. If, however, derivative assets are included in a class of assets along with other assets, the value ascribed to the derivatives in the accounts must be identified and excluded [Schedule 1, item 3, paragraph 768-545(1)(c)]. The same applies for working out the sum of values for every active foreign business asset in accordance with steps 1 and 2 in the method statement in subsection 768-525(3).

1.98 Note that it is necessary to separately identify the value ascribed to share assets for the purposes of identifying the value attributed to the shareholding under subsection 768-525(4). [Schedule 1, item 3, subsection 768-525(4)]

When does the default method apply?

1.99 Where the taxpayer is either not able to apply either the market value or the book value method, or does not make a choice in relation to either the market value or book value method, it will be required to adopt the default method. [Schedule 1, item 3, subsection 768-510(4)]

1.100 The default method prescribes the value of the active foreign business asset percentage. The value of the active foreign business asset percentage under the default method will vary depending on whether it is to be applied to a capital gain or capital loss. In the case of a gain, the active foreign business asset percentage will be 0% and the amount of the gain will be fully taxable. In the case of a loss, it will be 100% and the full amount of the capital loss will be disregarded.

1.101 It is intended that the default method will apply in the cases where, for example:

•

taxpayers cannot get access to the appropriate financial information in relation to a foreign company to use either the market value or book value method; or

•

the taxpayer does not make a choice to use either the book or market value method and is unwilling to incur compliance costs in relation to a foreign company (e.g. where the capital gain or loss that arises from the relevant CGT event happening is small).

1.102 The default rule has been included as an incentive for taxpayers to take all reasonable steps to use either the market value method or the book value method. In particular, the default rule is an integrity measure that aims to prevent a company that has made a capital loss under this measure from gaining a benefit just because it has chosen not to calculate the active foreign business asset percentage.

1.103 It is envisaged that this rule will have two separate applications. The first is the calculation of the active foreign business asset percentage for the foreign company being disposed of. The second application is calculation of the active foreign business asset percentage for subsidiary companies of the foreign company being disposed of. The application of this measure to subsidiary companies of the foreign disposal company is discussed in further detail in paragraphs 1.144 to 1.155.

What are active foreign business assets?

1.104 The definition of active foreign business asset is broadly based on existing definitions in the income tax law of 'tainted asset' in section 317 of the ITAA 1936 and 'active asset' in section 152-40 of the ITAA 1997. It is intended that the proportion of assets owned by the foreign company that satisfy the definition of active foreign business asset provides a reasonable reflection of the extent to which the company is carrying on an active business.

1.105 There are several conditions that must be satisfied in order for an asset to be classified as an active foreign business asset. First, the asset must be an asset included in the total assets of the company, as defined in section 768-545 [Schedule 1, item 3, paragraph 768-540(1)(a)]. This condition has been included to prevent distortions in the active foreign business asset percentage that may occur where assets that are included in the numerator of the calculation are not included in the denominator of that calculation, or vice versa.

1.106 Secondly, the asset must be one of the three kinds of assets. The first kind of asset is an asset that is used, or held ready for use, by the company in the course of carrying on a business [Schedule 1, item 3, subparagraph 768-540(1)(b)(i)]. The purpose of this restriction is to ensure that only business assets have the opportunity to be classified as an active foreign business asset under this measure.

1.107 The second kind of asset is goodwill. Goodwill has been specifically listed as an active foreign business asset on the basis that there may be some doubt as to whether goodwill can be used by a company in the course of carrying on a business [Schedule 1, item 3, subparagraph 768-540(1)(b)(ii)]. For example, in subsection 152-40(1), assets that may be used, or held ready for use, in the course of carrying on a business are distinguished from intangible assets, such as goodwill, that are inherently connected with a business that is carried on. Further, goodwill has been specifically included to avoid the necessity of having to apportion goodwill between active and other assets.

Shares in a company

1.108 The third alternative is a share in a company. Although shares are not normally considered to have an active character, they have been included within the definition of active foreign business assets for the purposes of this measure in order to facilitate the testing of subsidiary foreign companies for the presence of an active business [Schedule 1, item 3, subparagraph 768-540(1)(b)(iii)]. If shares were not treated as active for the purposes of this measure, then the active foreign business asset percentage of subsidiary foreign companies could not contribute to the active foreign business asset percentage of their foreign parent company [Schedule 1, item 3, subsections 768-520(2) and 768-525(4)]. The treatment of shares for the purposes of calculating the active foreign business asset percentage is discussed in more detail in paragraphs 1.143 to 1.160.

CGT asset that has the necessary connection with Australia

1.109 An asset that is a CGT asset that has the necessary connection with Australia is specifically excluded from the definition of active foreign business asset [Schedule 1, item 3, paragraph 768-540(1)(c)]. The definition of 'necessary connection with Australia' provided in section 136-25 of the ITAA 1997 has been modified for the purposes of this measure to include a share or an interest in an Australian resident public company and a unit in an Australian resident unit trust, no matter what the size of the beneficial ownership in the share, interest or unit. This modification has been made to ensure that interests of less than 10% in Australian resident public companies and Australian resident unit trusts are not treated as active assets.

1.110 The purpose of this exclusion is to ensure that similar Australian tax consequences arise from the disposal of a non-portfolio interest in a foreign company, as from the disposal of the underlying active foreign business assets of that foreign company. Without this exclusion, opportunities may arise for an Australian resident company to effectively dispose of 'Australian assets' free from Australian tax where the company disposes of a foreign 'active' subsidiary company through which it holds those Australian assets. The measure was never intended to provide this benefit.

1.111 Similarly, in the case of a controlled foreign company holding CGT assets that have the necessary connection with Australia, the controlled foreign company would be subject to CGT on any capital gain from the disposal of those assets. It would be inconsistent with current Australian tax treatment to allow the shareholders in the controlled foreign company to dispose of their shares free from Australian tax where the gain is, in effect, attributable to the unrealised gain on assets that have a necessary connection with Australia.

Excluded assets

1.112 Certain assets have been specifically excluded from the definition of active foreign business asset for the purposes of this measure [Schedule 1, item 3, paragraph 768-540(1)(d) and subsection 768-540(2)]. These specific exclusions have been broadly based on existing provisions in the income tax law that deal with the distinction between active and not active assets or income. In particular, consideration was given to the definition of 'tainted asset' in section 317 of the ITAA 1936 and the definition of 'active asset' in section 152-40 of the ITAA 1997.

Financial instruments

1.113 The purpose of this exclusion is to characterise those assets that are financial instruments, other than shares or trade debts, as not active [Schedule 1, item 3, paragraph 768-540(2)(a)]. This treatment is generally consistent with both the definition of 'tainted assets' in section 317 of the ITAA 1936 and the definition of 'active assets' in section 152-40 of the ITAA 1997.

1.114 On the basis that the term 'financial instrument' is not specifically defined for Australian income tax purposes, it is intended that this term take on its ordinary accounting meaning. It is envisaged that assets that will come within this exclusion include, but are not limited to loans (including deposits with a bank or financial institution), debenture stock, bonds, debentures, certificates of entitlement, bills of exchange, promissory notes or other securities. Although this includes loans and other financial transactions with related companies, the special rule in relation to wholly-owned groups may apply to these types of transactions. The rules relating to wholly-owned groups are discussed in paragraphs 1.214 to 1.223.

1.115 An exception to the exclusion of financial instruments from active assets is made for trade debts [Schedule 1, item 3, paragraph 768-540(2)(a)]. To the extent that receivables are trade debts, they have been considered to constitute active assets within the meaning of section 152-40 if they are used solely in carrying on a business. It is intended that 'trade debt' takes on its ordinary meaning.

1.116 Derivatives are not covered by this exclusion because they are specifically excluded from assets included in total assets [Schedule 1, item 3, paragraph 768-545(1)(c)]. Derivatives therefore do not satisfy the first condition to be classified as an active foreign business asset [Schedule 1, item 3, paragraph 768-540(1)(a)]. The exclusion of derivatives from the calculation of the active foreign business asset percentage is discussed in paragraphs 1.138 to 1.142.

1.117 Special treatment is provided to Australian financial institution subsidiaries in relation to the characterisation of financial instruments for the purposes of calculating their active foreign business asset percentage [Schedule 1, item 3, paragraph 768-540(3)(a)]. The treatment of Australian financial institution subsidiaries for the purposes of this measure is discussed in more detail in paragraphs 1.161 to 1.177.

Example 1.10

James Co, a foreign-resident company, manufactures tents which it sells domestically and on the export market. As James Co is exposed to exchange rate volatility from fixed price export contracts it enters into derivative arrangements to hedge against foreign exchange movements. Spare cash is accumulated during the year which is invested in bank term deposits or bills of exchange rather than kept in a transaction bank account. Credit is extended to domestic retailers for a period of 120 days, which is the normal period in which stock is sold.

The derivatives are not active assets as they are excluded from total assets. Investments in bills of exchange or term deposits are used to derive interest income in the course of carrying on the business, so are not active assets. The trade debt is a business facilitation mechanism excluded from the definition of a financial instrument, so therefore is an active asset.

Certain types of shares

1.118 The second exclusion from the definition of active foreign business asset relates to shares that are eligible finance shares or widely distributed finance shares [Schedule 1, item 3, paragraph 768-540(2)(b)]. Both 'eligible finance share' and 'widely distributed finance share' are defined in Part X of the ITAA 1936. The reason that these types of shares have been excluded from the definition of active foreign business asset is that they are, in substance, the equivalent of a debt rather than an equity investment. Further, it is intended that this measure provide consistent tax treatment to that provided by the non-portfolio dividend exemption in section 23AJ of the ITAA 1936. This means that it would not be appropriate to 'look-through' these shares to test the nature of the underlying business of the foreign company in which the shares are held as any dividends paid by the foreign company out of profits from the disposal of that business would be subject to Australian tax in full.

Interests in a trust or partnership

1.119 Both an interest in a trust and an interest in a partnership are specifically excluded from the definition of active foreign business asset. [Schedule 1, item 3, paragraph 768-540(2)(c)]

1.120 Characterisation of interests in partnerships and trusts as not active means that these entities will not be looked through for the purpose of calculating the active foreign business asset percentage of a foreign company. Consequently, where the foreign company being disposed of holds an interest in a subsidiary company through a partnership or a trust, the active assets of that subsidiary company will not contribute to the active foreign business asset percentage of the foreign company. Therefore, any interest that the foreign company holds in that subsidiary company through the partnership or trust will effectively be treated as not active as the interest held by the company in the partnership or trust is a non-active asset.

Example 1.11

On 1 July 2004, Aus Co disposed of its entire interest in For Co. In calculating the active foreign business asset percentage for For Co, the whole value of For Co's interest in Partnership will be treated as not active. This means that the assets of any underlying subsidiaries, such as For Sub, will not be taken into account in calculating For Co's active foreign business asset percentage, regardless of the level of the indirect interest that For Co has in For Sub.

1.121 Application of the active foreign business asset percentage of tiers of companies is discussed in greater detail in paragraphs 1.143 to 1.160.

Life insurance policies

1.122 Life insurance policies are the fourth specific exclusion from the definition of active foreign business asset [Schedule 1, item 3, paragraph 768-540(2)(d)]. The exclusion of life insurance policies is recognition of the fact that they are generally considered to be comprised mainly of an investment component, and may therefore be characterised as being like a financial instrument. Rather than attempting to split these assets into active and non-active components, in the interests of simplicity they are to be treated entirely as non-active. This may be contrasted with general insurance policies which tend to have no investment component.

1.123 Note that special treatment is provided to life insurance and general insurance companies in relation to the calculation of the active foreign business asset percentage [Schedule 1, item 3, section 768-530]. The application of this measure to life insurance and general insurance companies is discussed in detail in paragraphs 1.178 to 1.213.

Rights or options to certain assets

1.124 Rights or options to acquire a financial instrument, an interest in a company, trust or partnership, or a life insurance policy are also excluded from the definition of 'active foreign business assets'. [Schedule 1, item 3, paragraph 768-540(2)(e)]

1.125 These types of assets are considered to have a nature that is not active on the basis that the 'underlying' assets are also not active. Further, this exclusion applies to a right or option to acquire an interest in a company, despite the fact that interests in companies receive active treatment under this measure. The main reason is that an interest in a company effectively will not be treated as an active foreign business asset under this measure where there is another person in a position to affect the rights of the interest holder, for example, where the other person has a right to acquire interests in the company.

1.126 In other words, the value of an interest in a company will only be included in the value of active foreign business assets where the foreign company has a direct voting percentage of 10% or more in the subsidiary company. A company has a direct voting percentage in another company if it has a voting interest in the other company within the meaning of section 160AFB of the ITAA 1936 [Schedule 1, item 3, subsection 768-550(1)]. Section 160AFB of the ITAA 1936 provides that a company does not have a voting interest in another company if a person is in a position, or may become in a position, to affect that right, for example, if that person has a right, power or option to acquire that right.

Cash or cash equivalent

1.127 To the extent that cash and cash equivalents do not come within the ordinary meaning of 'financial instruments', they will also be excluded from the definition of active foreign business assets [Schedule 1, item 3, paragraph 768-540(2)(f)]. Cash and cash equivalents are not defined in the ITAA 1936 or ITAA 1997. It is intended that they will adopt their ordinary accounting meanings for the purposes of this measure.

1.128 Special treatment is provided to Australian financial institution subsidiaries in relation to cash or cash equivalents for the purpose of calculating their active foreign business asset percentage [Schedule 1, item 3, paragraph 768-540(3)(a)]. The treatment of Australian financial institution subsidiaries for the purposes of this measure is discussed in more detail in paragraphs 1.161 to 1.177.

Assets deriving passive income

1.129 Assets whose main use in the course of carrying on business is the derivation of passive investment income (namely interest, an annuity, rent, royalties or foreign exchange gains) are specifically excluded from the definition of active assets except where:

•

the asset is an intangible asset and its market value has been substantially enhanced through development, alteration or improvement to the asset; or

•

the main use for deriving rent was only temporary.

[Schedule 1, item 3, paragraph 768-540(2)(g)]

1.130 This treatment is consistent with the definition of 'active asset' in section 152-40 of the ITAA 1997.

1.131 The concept of 'main use' in relation to the derivation of passive investment income will take into account various factors in relation to the asset such as:

•

comparative time of use of the asset for various purposes;

•

comparative level of income derived from different uses of the asset;

•

comparative physical use of the asset (e.g. floor space in a building); and

•

any change in use of the asset over the period the active foreign business asset percentage is being calculated.

No single factor will necessarily be determinative.

1.132 Special treatment is provided to Australian financial institution subsidiaries in relation to assets that derive interest, annuities or foreign exchange gains for the purpose of calculating their active foreign business asset percentage [Schedule 1, item 3, paragraph 768-540(3)(b)]. The treatment of Australian financial institution subsidiaries for the purposes of this measure is discussed in more detail in paragraphs 1.161 to 1.177.

Example 1.12

The active foreign business asset percentage is required to be calculated for Buffalo Co, which owns a five story office building. Buffalo Co uses two floors of the building for carrying on a car valuation business and rents out the remaining three floors to an unrelated company. The rental income from the building represents about 20% of the total income derived by the company.

In this case a substantial, although not a majority, of the floor space of the building is used for the carrying on of a business. However, the income derived from the conduct of the business is 80% of total income (business plus rentals). Having regard to these factors, the main use of the building is not deriving rent income, so therefore the building is not excluded from being an active asset.

1.133 A further example of an asset not being excluded from being an active assets is where an intangible asset has been substantially developed, altered or improved so that its market value has been enhanced.

Example 1.13

A foreign company, For Co, owns the trade name 'Clifthanger', valued at a market value of US$100 million in its balance sheet, which it licences out to derive royalty income. Clifthanger is an adventure sports training system. The trade name was created and developed by the company over a period of time as part of its adventure sports business, increasing its value from US$50 million two years ago. While the intangible asset derives royalty income, it is an active asset because it has been substantially developed and improved by the company so that its market value has been substantially enhanced.

What assets are included in the total assets?

1.134 An asset is included in the total assets of a foreign company if at the time of calculating the active foreign business asset percentage the following conditions are satisfied:

•

the asset is a CGT asset;

•

the foreign company owns the asset; and

•

if the foreign company is not an Australian financial institution subsidiary whose sole or principal business is financial intermediary business, the asset is not a derivative asset.

[Schedule 1, item 3, subsection 768-545(1)]

1.135 An asset that does not satisfy all of the above conditions for inclusion as part of total assets of the foreign company will be excluded from the active foreign business asset calculation. [Schedule 1, item 3, paragraph 768-540(1)(a)]

CGT asset

1.136 A CGT asset is defined in section 108-5 of the ITAA 1997. It is specified as being any kind of property or a legal or equitable right that is not property.

Ownership of assets

1.137 A foreign company is considered to own the CGT asset where it is both the legal and beneficial owner of that asset at that time.

Derivative assets

1.138 Derivative assets are specifically excluded from the definition of 'assets included in the total assets' [Schedule 1, item 3, paragraph 768-545(1)(c)]. This exclusion effectively treats derivative assets as active to the same extent as all remaining assets of the foreign company that are included in total assets.

1.139 Derivatives are excluded from total assets in recognition of their potential use in the active business activities of the company. Derivatives may be assets or liabilities. However, if the derivative is a liability, it falls outside the scope of this measure. The character of a derivative as an asset or liability will vary depending on the market. If the derivative is 'in the money' it is an asset. Otherwise it will be a liability. This position may change daily for some instruments. The approach adopted in this rule prevents the need to make this classification.

1.140 The definition of derivative has essentially been adopted from subsection 761D(1) of the Corporations Act 2001. The main changes from that definition of derivative are that foreign exchange contracts are not excluded and the exclusions under subsection 761D(3) of the Corporations Act 2001 have been added back for the purposes of this measure. This means that arrangements such as the following will be included in the definition of derivative:

•

deliverable forward contracts;

•

contracts for the future provision of services;

•

arrangements covering financial products outlined in subsection 764A(1) of the Corporations Act 2001; and

•

financial instruments excluded by regulation.

1.141 A single future time period, being one business day, will also be used for all derivatives. Presently the Corporations Act 2001 provides foreign exchange contracts with a different time period to that of all other derivatives. [Schedule 1, item 3, paragraph 768-545(3)(b)]

1.142 Due to the complex and fluid nature of financial arrangements, and derivatives in particular, provision for regulations to outline specific inclusions and exclusions has been provided for, if required in the future. [Schedule 1, item 3, subsections 768-545(2) to (4)]

How are share assets to be valued in the case of a tier of companies?

1.143 The extent to which a foreign company is carrying on an active business, and therefore, the extent to which the relevant capital gain or capital loss in relation to that foreign company is reduced under this measure, is based on the active foreign business asset percentage of the foreign company. Paragraphs 1.51 to 1.59 discuss the concept of the active foreign business asset percentage.

1.144 In calculating the active foreign business asset percentage, the value of all active foreign business assets must be determined [Schedule 1, item 3, subsections 768-520(1) and 768-525(3)]. Within this calculation is a requirement that the value of any shares (that are active foreign business assets) in a subsidiary company is modified by the active foreign business asset percentage of that subsidiary company (if certain requirements are met) or is zero (if the requirements are not met). These sufficient interest requirements are discussed in paragraphs 1.149 to 1.155.

1.145 If the subsidiary company itself owns a share (which is an active foreign business asset) in another subsidiary company (the lower tier company), the same rule applies. An interest that the foreign company has in a subsidiary company, and other lower tier companies, may be characterised as an active asset only to the extent of the subsidiary company's active foreign business asset percentage. [Schedule 1, item 3, subsections 768-520(2) and 768-525(4)]

1.146 This rule has the effect that the active foreign business asset percentage of lower tier companies in which the holding company has a sufficient interest may contribute to the active foreign business asset percentage of the foreign company being disposed of by the Australian company or controlled foreign company.

1.147 The purpose of allowing the active foreign business asset percentages of lower tier companies to contribute to the foreign company's active foreign business asset percentage is to determine whether the foreign company has an underlying active business. In other words, where the foreign company has a sufficient interest in a lower tier company, it is arguable that the nature of the business of the lower tier company contributes to the nature of the business carried on by the foreign company. This will be particularly relevant, but not restricted to, foreign holding companies.

1.148 Special rules can apply to companies that are part of a foreign wholly-owned group [Schedule 1, item 3, section 768-535]. Where these rules apply a share owned by one of the companies in the wholly-owned group in another of those companies in the wholly-owned group is effectively ignored [Schedule 1, item 3, subsection 768-535(4)]. The effect of this is that the active foreign business asset percentage of the foreign wholly-owned group is calculated on a group basis, rather than on application at each level in the chain of companies. These grouping rules are discussed in detail in paragraphs 1.214 to 1.223.

What are the sufficient interest requirements?

1.149 The sufficient interest requirements that must be met for the application of the valuation rules for shares held by a foreign company in a foreign subsidiary company are:

•

the foreign company has a direct voting percentage of 10% or more in the foreign subsidiary company; and

•

the company disposing of the share (the holding company) has a total voting percentage of 10% or more in the foreign subsidiary company.

[Schedule 1, item 3, subsections 768-520(2) and 768-525(4)]

1.150 If one or both of these requirements is not met, it will not be necessary to calculate the active foreign business asset percentage for the foreign subsidiary company. The value of the share in that company will be zero when calculating the active foreign business assets of the foreign company. [Schedule 1, item 3, item 2 in the table in subsection 768-520(2) and item 2 in the table in subsection 768-525(4)]

Direct voting percentage

1.151 Each foreign company is required to have at least a 10% direct voting percentage in the immediate foreign subsidiary company in order to limit this measure to companies that have the opportunity to participate to some extent in the business of the subsidiary company. Further, an interest holding of 10% is consistent with the level of interest required for the non-portfolio dividend exemption under section 23AJ of the ITAA 1936. It is also consistent with the level of interest required for the application of the measure to the CGT event in relation to a share in a foreign company, but, unlike that provision, does not require the interest to be held for any particular time.

Total voting percentage in subsidiary company

1.152 In addition, the holding company is required to have a total voting percentage (i.e. direct and indirect voting percentage) of at least 10% in the foreign subsidiary company. The main purpose of this requirement is to ensure that the taxpayer has adequate access to the financial information of the subsidiary company to be able to sufficiently comply with the requirements under this measure. This requirement becomes more important as the active foreign business asset percentage is calculated for subsidiary companies further down the chain, where it may be quite difficult to get access to sufficient information to be able to perform the calculation.

1.153 The reason that interests are traced by reference to the holding company (i.e. the Australian company or controlled foreign company that disposes of a foreign company) rather than by reference to the foreign company being disposed of is to ensure that the taxpayer has sufficient access to information.

1.154 A company has a total voting percentage in a foreign subsidiary company equal to the sum of the company's direct voting percentage and the company's indirect voting percentage in that subsidiary company [Schedule 1, item 3, section 768-560]. A company's indirect voting percentage in a subsidiary company is calculated by multiplying the following:

•

the company's direct voting percentage in an interposed company (the intermediate company); and

•

the sum of:

-

the intermediate company's direct voting percentage in the subsidiary company; and

-

the intermediate company's indirect voting percentage in the subsidiary company.

[Schedule 1, item 3, subsection 768-555(1)]

1.155 If the company's indirect voting percentage in the lowest tier subsidiary company may be traced through more than one chain of subsidiaries, then the result of the calculation above for each separate chain is added together to determine the company's indirect voting percentage [Schedule 1, item 3, subsection 768-555(2)]. In other words, where the entity has a direct voting percentage in more than one subsidiary company, each of which may have a direct or indirect voting percentage in the lowest tier subsidiary company, then the company's indirect voting percentage is to be worked out by tracing through each subsidiary company.

Example 1.14

The total voting percentage that Co A has in Co E is the sum of Co A's direct and indirect voting percentages in Co E. As Co A does not have any direct voting percentage (DVP) in Co E, only its indirect voting percentage (IVP) in Co E is relevant.

The indirect voting percentage that Co A has in Co E is the sum of the indirect voting percentage through Co B and the indirect voting percentage through Co C. The formula would appear as follows:

Where:

•

DVPAB is the direct voting percentage of Co A in Co B;

•

DVPBE is the direct voting percentage of Co B in Co E;

•

IVPBE is the indirect voting percentage of Co B in Co E;

•

DVPAC is the direct voting percentage of Co A in Co C;

•

DVPCE is the direct voting percentage of Co C in Co E;

•

IVPCE is the indirect voting percentage of Co C in Co E.

[Schedule 1, item 3, section 768-550]

In order to work out the indirect voting percentage that Co A has in Co E, it is necessary to first calculate the indirect voting percentage that Co B and Co C each has in Co E. The indirect voting percentage that Co B has in Co E is calculated as follows:

The indirect voting percentage that Co C has in Co E is:

The indirect voting percentage that Co A has in Co E is therefore:

If Co A were to dispose of its shares in Co B, Co E could be tested (i.e. the active foreign business asset percentage calculation can be made for Co E). This is because Co A holds 31% total voting interest in Co E, and Co D (and Co B) has a direct voting percentage in Co E of 10%. Therefore, Co E's active foreign business asset percentage will be relevant for the valuation of both Co D and Co B's shares in Co E. [Schedule 1, item 3, item 1 in the table in subsections 768-520(2) and 768-525(4)]

If in the example above Co A had no shareholding in Co C, the total voting percentage that Co A would have in Co E would instead be 6%. As this is less than 10%, Co E could not be tested, even though both Co B and Co D have a 10% direct voting percentage in Co E. [Schedule 1, item 3, item 2 in the table in subsections 768-520(2) and 768-525(4)]

What is the 'bottom-up' approach in calculating the active foreign business asset percentage?

1.156 Generally, the active foreign business asset percentage is to be calculated for the foreign company and each subsidiary company individually, as though each subsidiary company was the foreign company being disposed of. However, the special rules that can apply to companies that are part of a foreign wholly-owned group (see paragraphs 1.214 to 1.223) may partially (or entirely) eliminate this mechanical approach of going through each subsidiary company individually.

1.157 When calculating the active business percentage for numerous subsidiary companies, it will be necessary to first calculate the percentage for the lowest subsidiary company in which the foreign company and the holding company have a sufficient interest. The active foreign business asset percentage will then be calculated for the preceding subsidiary company, with its interest in the lowest subsidiary company being active to the extent of the active foreign business asset percentage of the lowest subsidiary company. [Schedule 1, item 3, note to subsections 768-520(2) and 768-525(4)]

Example 1.15

Aus Co holds a direct voting percentage in For Co 1 of 50%, For Co 1 holds a direct voting percentage in For Co 2 of 30% and For Co 2 holds a direct voting percentage in For Co 3 of 100%. Aus Co's indirect voting percentage in both For Co 2 and For Co 3 is therefore 15%. The group structure is illustrated in the diagram below.

The active foreign business asset percentage is first calculated For Co 3. If the active foreign business asset percentage of For Co 3 is 70%, then shares in For Co 3 held by For Co 2 will be taken to be 70% active. Only 70% of their value (market or book, as chosen) will be counted as an active asset. [Schedule 1, item 3, item 1 in the table in subsections 768-520(2) and 768-525(4)]

The active foreign business asset percentage is then calculated for For Co 2. Assume the active foreign business asset percentage of For Co 2 is 90% (taking into account that only 70% of the value of the shares in For Co 3 is active). On the basis that the threshold for the active foreign business asset percentage is 90%, shares in For Co 2 held by For Co 1 will be taken to be 100% active. That is, 100% of the value of those shares will be counted as an active asset.

The active foreign business asset percentage is then calculated for For Co 1. Assume that the active foreign business asset percentage of For Co 1 is 80% (taking into account that 100% of its shares in For Co 2 are active).

Therefore, Aus Co's capital gain or capital loss on the disposal of all, or any, of its interest in For Co 1 will be reduced by 80%. [Schedule 1, item 3, subsection 768-505(2)]

What is the effect of not having access to valuation information?

1.158 Where the taxpayer cannot access the appropriate information to be able to adopt either the market value or book value method in relation to a subsidiary company, the active foreign business asset percentage of the subsidiary company will be either 100%, if a capital loss arose to the holding company from the shares in the foreign company, or zero, if a capital gain arose. [Schedule 1, item 3, subsection 768-510(4)]

What is the treatment of interposed partnerships and trusts?

1.159 The calculation of the indirect voting percentage allows tracing through interposed companies to determine the percentage interest that the top entity holds in the lowest tier company. However, calculation of the indirect voting percentage does not allow tracing through partnerships or trusts because of the restriction in the definition of 'direct voting percentage'. [Schedule 1, item 3, subsection 768-550(2)]

1.160 The restriction in relation to tracing through partnerships or trusts for the purpose of determining the indirect voting percentage is consistent with the treatment of interests in partnerships and trusts held by the foreign company as non-active for the purpose of calculating the foreign company's active foreign business asset percentage. [Schedule 1, item 3, paragraph 768-540(2)(c)]

How does the measure apply to financial institutions?

1.161 Certain financial institutions calculate their active foreign business assets using modified definitions of total assets and active foreign business assets.

1.162 The modifications provide for derivative assets to be included in the total assets and certain financial instruments to be included in active foreign business assets.

1.163 The modifications are provided in recognition of the fact that financial institutions hold, trade in and dispose of certain financial instruments as part of their active rather than mere passive investment activities.

1.164 One of the aims of these modifications is to ensure that gains from the disposal of Australian financial institution subsidiaries that hold certain financial instruments are treated commensurately under this measure with the treatment under the controlled foreign companies regime of income and gains from trading in certain financial instruments held by Australian financial institution subsidiaries. Where the trading income or gain is treated as passive income or tainted services income, the asset is not an active asset.

To which financial institutions do the modified definitions of total assets and active foreign business assets apply?

1.165 The financial institutions to which the modified definitions of total assets and active foreign business assets apply are Australian financial institution subsidiaries whose sole or principal business is financial intermediary business. [Schedule 1, item 3, paragraphs 768-540(1)(e) and 768-545(1)(c) and subsection 768-540(3)]

1.166 The meaning of both Australian financial institution subsidiary and financial intermediary business for this measure is the same as the meaning in Part X of the ITAA 1936. The use of these terms to identify the financial institutions to which the special treatment of various financial instruments relates facilitates the symmetrical treatment of both the entities and financial instruments.

What are the modifications to the active foreign business assets of Australian financial institution subsidiaries?

What assets are included in the active foreign business assets of Australian financial institution subsidiaries?

1.167 The active foreign business assets of an Australian financial institution subsidiary include:

•

financial instruments;

•

cash or cash equivalents; and

•

assets whose main use in the course of carrying on the business of the company is to derive interest, annuities or foreign exchange gains.

[Schedule 1, item 3, subsection 768-540(3)]

What assets are excluded from the active foreign business assets of Australian financial institution subsidiaries?

1.168 Although Australian financial institution subsidiaries receive special treatment in relation to financial instruments under this measure, some financial instruments that are owned by Australian financial institution subsidiaries continue to be excluded from the definition of active foreign business asset if certain conditions are satisfied. [Schedule 1, item 3, paragraph 768-540(1)(e)]

1.169 There are two categories of assets that continue to be treated as not active under this measure. The first must satisfy the following conditions:

•

the asset is an asset mentioned in subparagraph 450(4)(b)(i) or (ii) of the ITAA 1936;

•

the asset was acquired from another entity; and

•

either of the conditions mentioned in subparagraphs 450(6)(c)(i) and (ii) was satisfied in relation to the other entity at the time of the acquisition.

[Schedule 1, item 3, paragraph 768-540(4)(a)]

1.170 The assets mentioned in subparagraphs 450(4)(b)(i) and (ii) are as follows:

•

loans (including deposits with a bank or other financial institution); and

•

debenture stock, bonds, debentures, certificates of entitlement, bills of exchange, promissory notes or other securities.

1.171 The conditions in subparagraphs 450(6)(c)(i) and (ii), as changed by the measure discussed in Chapter 3, are that the entity was either:

•

a Part X Australian resident and the acquisition was not in connection with a business carried on by the entity at or through a permanent establishment of the entity in a foreign country; or

•

not a Part X Australian resident, but the acquisition of the asset from that entity was in connection with a business carried on by the entity at or through a permanent establishment of the entity in Australia.

1.172 In other words, where the specified financial asset was acquired from an Australian resident in Australia or from a permanent establishment of a foreign resident in Australia, then it will continue to be excluded from the definition of active foreign business asset.

1.173 The second category of assets that are excluded from the definition of active foreign business asset must satisfy the following conditions:

•

the asset relates to a debt to which factoring income (within the meaning of Part X of the ITAA 1936) of the foreign company relates; and

•

the condition in paragraph 450(8)(b) of the ITAA 1936 is satisfied in relation to the debt.

[Schedule 1, item 3, paragraph 768-540(4)(b)]

1.174 Factoring income is defined in section 317 of the ITAA 1936 to mean income derived from carrying on a business of factoring.

1.175 The condition in paragraph 450(8)(b) of the ITAA 1936, as amended by the measure discussed in Chapter 3, is that the debt to which the factoring income relates was acquired from, or disposed of to, another entity where either of the following conditions is satisfied at the time of the acquisition or disposal:

•

the entity was a Part X Australian resident and the acquisition was not in connection with a business carried on by the entity at or through a permanent establishment of the entity in a foreign country; or

•

the entity was not a Part X Australian resident, but the acquisition or disposal was in connection with a business carried on by the entity at or through a permanent establishment of the entity in Australia.

1.176 Consequently, an asset relating to a debt to which factoring income relates will be treated as not active under this measure where the debt was acquired from, or disposed of to, an Australian resident in Australia or from a permanent establishment of a foreign resident in Australia.

What are the modifications to the total assets of Australian financial institution subsidiaries?

1.177 Total assets of companies that are not Australian financial institution subsidiaries exclude derivatives. For the purposes of calculating the active foreign business asset percentage of an Australian financial institution subsidiary whose sole or principal business is financial intermediary business, derivative assets are included in total assets. Inclusion of derivatives in total assets at this level then provides for them to be treated as active where appropriate under the application of the definition of active foreign business assets. [Schedule 1, item 3, paragraph 768-545(1)(c)]

How does the measure apply to insurance companies?

1.178 The calculation of the active foreign business asset percentage for foreign life and foreign general insurance companies is modified in order to take into account the special regulatory and solvency requirements placed on insurance companies. The modifications are based on the treatment of life insurance and general insurance companies in Part X of the ITAA 1936 in relation to the calculation of the passive income of a controlled foreign company. It is intended that the modifications under this measure mirror the treatment under Part X.

1.179 Although the modifications differ for foreign life and foreign general insurance companies, the result for both is that the active foreign business asset percentage of the foreign life or foreign general insurance company is increased by increasing the amount of active foreign business assets.

What is a foreign life insurance company?

1.180 A foreign life insurance company is a company that is a foreign resident whose sole or principal business is life insurance [Schedule 1, item 15, definition of 'foreign life insurance company' in subsection 995-1(1)]. Life insurance in this definition is to take on its ordinary meaning.

1.181 The definition of foreign life insurance company does not adopt the ITAA 1997 definitions of life insurance company or life insurance business. Life insurance companies, under the ITAA 1997, must be registered under the Life Insurance Act 1995.

1.182 Foreign companies are not eligible to be registered to carry on a life insurance business in Australia. Rather, a foreign life insurance company must incorporate an Australian subsidiary that must then be registered to carry on business of life insurance in Australia. On this basis foreign life insurance companies will never be registered under the Life Insurance Act 1995.

What is a foreign general insurance company?

1.183 A foreign general insurance company is a company that is a foreign resident whose sole or principal business is insurance business [Schedule 1, item 14, definition of 'foreign general insurance company' in subsection 995-1(1)]. Insurance business is defined as for the Insurance Act 1973, that is, the business of undertaking liability, by way of insurance (including reinsurance), in respect of any loss or damage, including liability to pay damages or compensation, contingent upon the happening of a specified event, and includes any business incidental to insurance business as so defined, but does not include certain businesses such as life insurance business.

1.184 In application, the definition of foreign general insurance company reflects the definition of general insurance company in Part X of the ITAA 1936.

What modifications are required in the calculation of the active foreign business asset percentage for insurance companies?

1.185 The calculation of the active foreign business asset percentage for both life insurance and general insurance companies is modified in section 768-530 [Schedule 1, item 3, section 768-530]. The modifications have been made to acknowledge the requirements on insurance companies to hold a certain level of 'non-active foreign business assets' for both regulatory purposes and as part of prudent business activities.

1.186 For life insurance companies, the value of active foreign business assets is modified to include the value of non-active assets held to meet untainted insurance policy liabilities [Schedule 1, item 3, subsections 768-530(3) and (4)]. Untainted insurance policies are insurance policies that do not give rise to tainted services income. The insurance policies that do give rise to tainted services income are those where the owner of the policy is an Australian resident.

1.187 For general insurance companies, the value of active foreign business assets is modified to include the value of non-active assets that relate to untainted outstanding claims of the company [Schedule 1, item 3, subsections 768-530(3) and (4)]. Untainted outstanding claims are so much of the outstanding claims of the company at the end of the statutory accounting period that are referable to general insurance policies that do not give rise to tainted services income of the company of any statutory accounting period.

Choice of market value or book value methods

1.188 In calculating the modified active foreign business asset percentage, insurance companies may still choose to apply the book value or market value method. [Schedule 1, item 3, section 768-515]

Market value method

1.189 If an insurance company chooses to calculate its active foreign business asset percentage using the market value method it will, in practice, use a mixture of market values and book values to calculate the value of its active foreign business assets.

1.190 Market values will be used to calculate the value of assets included in the total assets and active foreign business assets of the foreign company for the purposes of steps 1 and 2 in the method statement in subsection 768-520(1).

1.191 However, the book values recorded in the recognised company accounts for the most recent statutory accounting period ending at or before the CGT event will be used to calculate the amount by which the value of active foreign business assets is to be increased (the amount applicable under subsection 768-530(4)). [Schedule 1, item 3, subsection 768-530(3)]

Book value method

1.192 In applying the book value methodology the insurance company may only use recognised company accounts for its statutory accounting periods [Schedule 1, item 3, subsection 768-530(2)]. The same accounts must be used to calculate the initial value of active foreign business assets and total assets and the amount by which the active foreign business assets will be increased (the amount applicable under subsection 768-530(4)) [Schedule 1, item 3, subsections 768-525(2) and (3) and subsection 768-530(3)].

1.193 In applying the book value methodology it is necessary to calculate the average active foreign business assets and average total assets of the insurance company using recognised company accounts for two statutory accounting periods. The value of the active foreign business assets and the additional amount is calculated under each set of accounts and then averaged.

Calculation of the active foreign business asset percentage

1.194 In practice, an insurance company must first value all total assets and active foreign business assets using the chosen valuation methodology [Schedule 1, item 3, sections 768-520 and 768-525]. This first valuation does not include the modification to the value of active foreign business assets.

1.195 The difference between the two values, total assets and unmodified active foreign business assets is the value of non-active foreign business assets.

1.196 The proportion of active insurance amount to total insurance assets must then be calculated. [Schedule 1, item 3, subsection 768-530(4)]

1.197 The proportion of active insurance amount to total insurance assets is then applied to the value of the non-active foreign business assets. The result of the calculation is the amount by which the active foreign business assets of the insurance company is increased. [Schedule 1, item 3, subsections 768-530(3) and (4)]

1.198 The active insurance amount and total insurance assets will differ for life insurance companies and general insurance companies.

Life insurance companies

1.199 The active insurance amount of a life insurance company is the amount of the company's untainted policy liabilities as defined in subsection 446(2) of the ITAA 1936 [Schedule 1, item 3, subsection 768-530(4)]. Broadly speaking, this definition identifies the amount of the company's policy liabilities as is referable to life assurance policies that do not give rise to tainted services income of the company of any statutory accounting period. That is, the amount of the total policy liabilities of the company that relate to life insurance policies owned by foreign residents.

1.200 The total insurance assets of a life insurance company are the total assets as defined in subsection 446(2) of the ITAA 1936 [Schedule 1, item 3, subsection 768-530(4)]. That is, the average of the total assets of the company for the statutory accounting period. Note that this does not mirror the assets included in the total assets of the life insurance company used in calculating the active foreign business asset percentage.

1.201 In identifying the ratio of untainted policies to total insurance assets, the sum of all assets of the company is required. This would normally be determined by including all the assets disclosed on the company's balance sheet for the statutory accounting period.

1.202 The value ascribed to total insurance assets may be a different amount to the value of assets included in total assets under section 768-545 as certain assets, including derivatives, are excluded from the definition of assets included in the total assets for life insurance companies. [Schedule 1, item 3, paragraph 768-545(1)(c)]

General insurance companies

1.203 The active insurance amount of a general insurance company is calculated using the following formula:

total general insurance assets - net assets - tainted outstanding claims + solvency amount


[Schedule 1, item 3, subsection 768-530(5)]

1.204 Broadly speaking, this formula identifies the foreign business assets that actually relate to untainted outstanding claims of the company.

1.205 Total general insurance assets are the total assets of the company at the end of the statutory accounting period as defined in subsection 446(4) of the ITAA 1936.

1.206 Net assets means the excess at the end of the statutory accounting period of the total assets of the company over the total liabilities as defined in subsection 446(4).

1.207 Solvency amount has the same meaning as that in subsection 446(4). The solvency amount is added to the calculation in recognition of the fact that the amount of net assets related to policies giving rise to tainted services income is greater than the amount of assets held to support the outstanding claims on those policies.

1.208 Tainted outstanding claims of the general insurance company are so much of the outstanding claims of the company at the end of the statutory accounting period as are referable to general insurance policies that give rise to tainted services income of the company of any statutory accounting period (as defined in subsection 446(4)).

1.209 General insurance policies that give rise to tainted services income are defined in paragraphs 448(1)(d) to (f), as amended, as policies where:

•

the insured person is an associate of the company or an Australian resident;

•

the insured property, at the time of making the contract, was situated in Australia;

•

the insured event is one that can only happen in Australia;

•

the risks of an Australian resident insurer from its Australian business are being reinsured by the company; or

•

the risks of a foreign insurer from its Australian business are being reinsured by the company.

1.210 An outstanding claim is an amount that the company would, at the end of the statutory accounting period, based on proper and reasonable estimates, need to set aside and invest in order to meet liabilities of the company that have arisen or will arise:

•

under general insurance policies (including reinsurance policies, but not including life assurance policies); and

•

in respect of events that occurred during or before the period.

1.211 The total general insurance assets of the general insurance company are also defined in subsection 446(4). They are the total assets of the company at the end of the statutory accounting period. Again, note that this does not mirror the assets included in the total assets of the general insurance company used in calculating the active foreign business asset percentage.

How do the grouping provisions apply to life insurance companies and general insurance companies?

1.212 Life and general insurance companies may be members of a wholly-owned group formed in accordance with section 768-535 under a top foreign company (see paragraphs 1.214 to 1.223). If the holding company chooses to form a wholly-owned group that contains an insurance company, the nature of the insurance company, and modifications for calculating the active foreign business asset percentage, are ignored. The active foreign business asset percentage, including its modifications, is only calculated in relation to the top company of the group. The top company will never be a life or general insurance company. [Schedule 1, item 3, subsection 768-530(1) and subparagraphs 768-535(1)(b)(ii) and (iii)]

1.213 The active foreign business asset percentage is only calculated in relation to the top company of the group. Therefore to allow a life or general insurance company to be the top company would apply the modified calculation of the active foreign business asset percentage in relation to the assets of any non-insurance entities included in the group. Consequently, neither life nor general insurance companies can be the top company of a wholly-owned group.

What modifications are made for foreign wholly-owned groups?

1.214 In certain circumstances where the determination of the active foreign business asset percentage involves a tier of foreign companies the calculation may be done on a consolidated basis for wholly-owned companies comprising or within that tier of companies. This removes the need to determine the active foreign business asset percentage for each individual company in the tier where those companies are considered part of the wholly-owned group. Rather, one calculation is performed for the top foreign company in the wholly-owned group that also covers all its 100% owned foreign subsidiary companies.

1.215 The use of consolidated amounts reflects the principle that within a wholly-owned group, internal transactions, and particularly internal debt and equity funding, should not affect the extent to which the foreign company being disposed of is considered to have an underlying active business.

1.216 It is the holding company that makes the choice to calculate the active foreign business asset percentage of the top foreign company on a consolidated basis as part of determining the foreign company's active foreign business asset percentage [Schedule 1, item 3, subsection 768-535(2)]. This choice will be reflected by the way the taxpayer prepares its income tax return [Schedule 1, item 3, subsection 768-535(3)]. There is no requirement that the Commissioner of Taxation be advised of this choice.

1.217 At the time of the CGT event a consolidated approach may be used to calculate the active foreign business asset percentage provided that:

•

the top foreign company of the wholly-owned group is not:

-

an Australian financial institution subsidiary (within the meaning of Part X of the ITAA 1936);

-

a foreign life company; or

-

a foreign general insurance company;

•

the top foreign company and one or more of the other foreign companies are part of the same wholly-owned group; and

•

each of the subsidiary foreign companies is a 100% subsidiary of the top foreign company.

[Schedule 1, item 3, subsection 768-535(1)]

1.218 Although the top foreign company cannot be a foreign life company or a foreign general insurance company these entities are still able to be part of a wholly-owned group. Foreign life companies or foreign general insurance companies that are included as part of the wholly-owned group are, however, unable to use the modifications set out in section 768-530 as the foreign company referred to in that section is the top foreign company.

1.219 Though not compulsory, if the choice is made to consolidate, all companies:

•

for which the active foreign business asset percentage is otherwise required; and

•

which can form a wholly-owned group,

must be included in the group that is dealt with as a single entity.

1.220 In this way, the group is comprised of a single top foreign company and the other companies are the subsidiary foreign companies. Therefore, the top foreign company will be the only company in that group that is not a 100% subsidiary of another company in the group. [Schedule 1, item 3, paragraph 768-535(1)(c)]

1.221 Where a choice has been made to use a consolidated approach, each 100% owned subsidiary company of the top foreign company is treated as if it were a part of the top foreign company, rather than being a separate entity [Schedule 1, item 3, subsection 768-535(4)]. That is, both the active foreign business assets and the total assets of the top foreign company are calculated on a consolidated basis [Schedule 1, item 3, subsection 768-535(5)]. All intra-group assets and liabilities are effectively ignored, including shares held by one company in another group company or debt owed by one company to another group company.

1.222 Where a subsidiary foreign company is not 100%-owned, then a separate active foreign business asset percentage calculation is still required for that company in order to determine the active value of the shares that the wholly-owned group holds in that company. Similarly, if a company in the tier has less than a 100% interest in the wholly-owned group it must undertake a separate active foreign business asset percentage calculation once it has determined the value of its shares in the top foreign company of the wholly-owned group.

Example 1.16

In the above example, Aus Co is disposing of its interest in For Co 1. If Aus Co wishes to access the CGT concession it must determine the active foreign business asset percentage of For Co 1.

For Co 2, For Co 3, For Co 4, For Co 5 and Aust Sub are members of a wholly-owned group. However, the only group that may be formed for the purposes of this measure must consist of all of the following companies: For Co 2, For Co 3, For Co 4 and For Co 5.

Aust Sub is excluded from the group as it is not a company for which the active foreign business asset percentage must be calculated as the interest in that company is not an active asset in accordance with the exclusion in paragraph 768-540(1)(c).

The top company in the group is For Co 2. A sub-group cannot be formed under For Co 3 as the top company then would itself be a foreign subsidiary company that is, itself, a 100% subsidiary of another member of the wholly-owned group. The group is comprised only of one unique top company and 100% subsidiaries of that top company.

Separate calculations are required for For Co 6 and for For Co 1. For Co 3's 50% interest in For Co 6 is deemed to be held by For Co 2 as top company of the wholly-owned group.

1.223 Where the holding company has made the choice to consolidate several foreign companies, the recognised consolidated accounts of the top foreign company and its subsidiary are treated as being the recognised company accounts of the top company [Schedule 1, item 3, subsection 768-535(6)]. The market value method can also be applied on a consolidated basis by adopting the principle in subsection 768-535(4).

Application of measures to consolidated groups

1.224 The measures discussed above generally relate to a resident company, other than one that is a trustee of a trust. However, in some circumstances a company may be a trustee of a corporate unit trust or public trading trust that is a head company of a consolidated group under Subdivision 713-C of the ITAA 1997. The new measures apply to a company in the capacity of a trustee of a corporate unit trust or public trading trust that is the head company of a consolidated group.

Application and transitional provisions

1.225 This measure will apply to specified CGT events happening on or after 1 April 2004. [Schedule 1, item 1]

1.226 Commencement on this date ensures that taxpayer behaviour remains unaffected by the start date of this measure.

Consequential amendments

1.227 An item is included in the table in section 102-30 of the ITAA 1997 referring to special rules in Subdivision 768-G about capital gains and capital losses. [Schedule 1, item 2]

1.228 References to statutory accounting period in the ITAA 1997 have been amended in line with the addition of 'statutory accounting period' to the dictionary in Division 995 of the ITAA 1997. [Schedule 1, items 4 to 9]

1.229 Several other definitions of terms used in Subdivision 768-G are inserted into the dictionary in Division 995 of the ITAA 1997. [Schedule 1, items 10 to 20]

Chapter 2 - Foreign branch income, non-portfolio dividends and listed countries

Outline of chapter

2.1 Schedule 2 to this bill contains changes to:

•

the exemptions for non-portfolio dividends and foreign branch profits for Australian companies;

•

what is attributable income under the controlled foreign companies rules;

•

the underlying foreign tax credit provisions for Australian companies; and

•

the definition of 'listed country'.

2.2 Unless otherwise stated, all legislative references are to the Income Tax Assessment Act 1936 (ITAA 1936).

Context of amendments

2.3 The decision to expand the current exemptions for foreign non-portfolio dividends and foreign branch profits received by Australian companies is part of the Government's response to the Board of Taxation's report to the Treasurer on international taxation. This decision was announced in Treasurer's Press Release No. 32 of 13 May 2003. The amendments enable Australian companies and their controlled foreign companies to obtain more attractive rates of return from their operations in foreign markets, improving their ability to attract capital. This gives them greater flexibility in the allocation of capital in conducting their business operations.

2.4 The changes to the current exemptions remove an impediment to the distribution of foreign profits to Australia. This removes a deterrent to Australian companies expanding their active business offshore. Any passive or highly mobile income shifted to those offshore investments will continue to be taxed in Australia under controlled foreign company rules. Moreover, imputation credits are only available where company tax is paid in Australia. Any company choosing to relocate Australian operations offshore to take advantage of the expanded exemption for foreign dividends would forgo the benefit of being able to frank distributions of the profits from its business. Consequently, it is not expected that these changes will lead to a displacement of those Australian operations merely for tax purposes.

2.5 The expansion of the foreign non-portfolio dividend and foreign branch profits exemptions simplifies the foreign source income rules. As well as making the law easier to understand, this enables the cost of compliance for Australian companies which operate through foreign branches or foreign companies to be reduced.

2.6 This measure along with that in Schedule 1 to this bill also forms part of a systematic solution to the treatment of conduit income for Australian companies that have foreign shareholders. The exemption for foreign non-portfolio dividends and foreign branch income, where those amounts accrue to foreign shareholders, is a necessary step for Australia to become an attractive base for holding companies. Further measures to enhance the attractiveness of Australia as the base for conduit operations as well as providing significant opportunities to establish operations in Australia, will be implemented in later bills.

Summary of new law

2.7 Foreign non-portfolio dividends received by Australian companies are no longer included in assessable income. Similar amounts received by a controlled foreign company will no longer be attributed to an Australian entity.

2.8 The foreign branch profits exemption is expanded to cover branch profits derived in all foreign countries. This will allow all foreign branch income, with the possible exception of passive income, derived by Australian companies to be exempt from Australian tax. A similar outcome is achieved for the foreign branch operations of controlled foreign companies.

2.9 The current provision that provides foreign tax credits for underlying foreign company tax is repealed along with certain other specific foreign tax credit provisions for attributed foreign income. These provisions have been repealed because as a general rule the foreign income for which the foreign tax credits would have been provided will no longer be included in assessable income.

2.10 The provisions that currently attribute income and gains when a controlled foreign company changes residence from an unlisted country to a listed country or to Australia have been modified. This ensures non-tainted income and gains on non-tainted assets are no longer attributed when a change of residence occurs. This includes unrealised gains on non-tainted assets when a controlled foreign company changes residence to a listed country.

2.11 The categorisation of foreign countries has been greatly simplified. Limited-exemption listed countries become unlisted countries (together with those already classified as unlisted countries) and countries currently classified as broad-exemption listed countries are referred to as listed countries.

2.12 The expansion of the foreign non-portfolio dividend exemption limits the need to attribute deemed dividends. The specific provisions which deal with attribution of deemed dividends where they are paid directly or indirectly between controlled foreign companies are repealed and instead any Australian taxation depends on other, more general Australian tax rules (e.g. the general controlled foreign company attribution rules).

Comparison of key features of new law and current law

Detailed explanation of new law

Foreign non-portfolio dividends

2.13 Non-portfolio dividends paid from a company resident in a listed country are currently not included in the assessable income of resident company recipients. Some dividends paid by a company resident in an unlisted country may also not be included where the dividend is paid out of profits that were taxed in a listed country.

2.14 The previous policy was to exempt comparably taxed profits upon distribution to a resident company. Division 6 of Part X (about exempting receipts, profits and profits percentage) provided a mechanism for this, particularly for dividends paid by companies resident in unlisted countries. The Treasurer's announcement in Press Release No. 32 of 13 May 2003 meant that the comparable tax requirement was removed, allowing an exclusion from assessable income for all non-portfolio dividends.

2.15 Some of the profits of a foreign company might be taxed in Australia under Part X or Part XI but, apart from that, they are able to be repatriated to a resident company non-portfolio shareholder free of Australian company tax. This measure is principally aimed at removing the Australian company tax burden from active business income earned by a foreign subsidiary company resident in any foreign country. As a result of this policy change, section 23AJ now applies more simply to all non-portfolio dividends paid by foreign companies [Schedule 2, item 4, section 23AJ]. The policy change also means Division 6 is no longer required and is repealed [Schedule 2, item 57].

Foreign branch profits

2.16 Currently, resident companies do not include in assessable income certain foreign branch income and certain capital gains derived from a business carried on through a permanent establishment in a listed country. The amounts are not assessable and are not exempt income under section 23AH. A resident company may be a partner in a partnership or beneficiary of a trust that has a permanent establishment in a foreign country (there may also be several interposed partnerships and trusts between the resident company and the partnership or trust). In such circumstances, similar amounts of foreign branch income and capital gains, derived from a business carried on through the permanent establishment, are also exempt to the extent of the company's indirect interest in that income or those gains.

2.17 One of the main conditions for the current exemption is that the foreign income must be subject to tax in a listed country. Income taxed in a listed country generally means that the foreign income is considered to have been comparably taxed to income derived in Australia. Currently, listed countries are broad-exemption listed countries and limited-exemption listed countries. Broad-exemption listed countries are countries with very similar income tax systems to Australia while limited-exemption listed countries are countries with broadly comparable income tax systems to Australia. These definitions are to be repealed and the listed country definition will have a different meaning. These changes are discussed in more detail in paragraphs 2.99 to 2.104.

2.18 Currently, if the listed country is a broad-exemption listed country, the foreign income must not be eligible designated concession income in relation to any broad-exemption listed country for the exemption to apply. Eligible designated concession income is income that a particular country does not tax at all (such as dividends) or taxes at reduced rates to attract particular forms of business or financial activity. There is no active income test for a permanent establishment in a broad-exemption listed country by which all its income could be exempt.

2.19 If the listed country is a limited-exemption listed country, the foreign income must not be adjusted tainted income of the permanent establishment. Alternatively the permanent establishment must pass the active income test. Adjusted tainted income is broadly defined as passive income, tainted sales income and tainted services income. The foreign income must also have been subject to tax in a listed country for the exemption to apply.

2.20 Foreign branch capital gains and losses are disregarded where the gain or loss relates to a disposal of particular assets that are used wholly or principally to produce foreign income in carrying on a business in a listed country. The particular assets are land, buildings or depreciating assets, which are not Australian assets. Further, the gain must not be eligible designated concession income for a permanent establishment in a broad-exemption listed country or adjusted tainted income for a permanent establishment in a limited-exemption listed country.

2.21 The current section 23AH has been substituted with a new section 23AH. The new section provides an exemption to a resident company for most foreign income and gains (the exceptions are discussed below) derived through a foreign permanent establishment in either a listed or unlisted country. The exemption will also continue to be available to resident companies that are partners in a partnership or beneficiaries of a trust (or where there are several interposed partnerships and trusts). The exemption applies to the extent of the company's indirect interest in the amounts derived through the permanent establishment.

2.22 The amounts that continue to form part of assessable income of the resident company as a result of the new section 23AH more closely match the income that would be attributed under Part X from a controlled foreign company resident in the same foreign country as the permanent establishment.

No 'subject to tax' test

2.23 The 'subject to tax in a listed country' test in the current section 23AH has been omitted in the new section. There is no longer a concern with the level of foreign tax paid on either the profits from which a non-portfolio dividend is paid or the profits derived through a permanent establishment of a resident company. [Schedule 2, item 1, subsections 23AH(2) and (3)]

2.24 The removal of the subject to tax test is implicit in the existing decision for the non-portfolio dividend exemption in relation to the controlled foreign company case and was intended in the branch case. Retention of the requirement that the income be subject to tax in a listed country in the branch case would have been inconsistent with the stated policy of ensuring that active business income earned offshore would be free of Australian company tax.

Active income test

2.25 An active income test is currently provided for a company that has a permanent establishment in a limited-exemption listed country. However, an active income test is not available under the current rules for a permanent establishment in either a broad-exemption listed country or an unlisted country. To more closely mirror the controlled foreign company rules the new section 23AH provides an active income test for a permanent establishment in either a listed country (current broad-exemption listed countries) or an unlisted country (current limited-exemption listed countries and others). [Schedule 2, item 1, subsections 23AH(5) and (7)]

2.26 The active income test used in the new section 23AH is based on the active income test in section 432 of Part X. The section 432 active income test is used with some appropriate assumptions and certain modifications to make those provisions and other provisions that feed into that section work in a permanent establishment case. In particular, one assumption is to treat the permanent establishment as a separate entity from the company, trust or partnership entity to work out whether the entity has passed the active income test. [Schedule 2, item 1, subsection 23AH(12)]

2.27 Now that an active income test can be applied in relation to a permanent establishment in a listed or unlisted country, only where the permanent establishment fails the active income test would any foreign income be taxable in Australia to a resident company. That is, if the permanent establishment is predominantly deriving what is regarded as active income, all its income is exempt from Australian company tax.

2.28 If the permanent establishment fails the active income test, the only amounts of foreign income that may be included in the resident company's assessable income are amounts that are adjusted tainted income. The 'adjusted tainted income' definition is based on the same definition in Part X with appropriate assumptions and certain modifications to make those provisions and other provisions that feed into that section work in a permanent establishment case. [Schedule 2, item 1, subsection 23AH(13)]

2.29 A number of assumptions and modifications are the same for both the 'active income test' and the adjusted tainted income definition. The common assumptions are contained in subsection 23AH(14). [Schedule 2, item 1, subsection 23AH(14)]

2.30 The active income test and the adjusted tainted income definition in the new section 23AH are very similar to the active income test and the adjusted tainted income definition in the old provision. The main differences are as a result of the changes to the definition of tainted services income and the impact that those changes have on services provided to offshore entities. Generally, any income from the provision of services to non-residents or to the foreign permanent establishments of Australian residents will not be tainted services income. The active income test and adjusted tainted income definition in the old section 23AH would have been equally impacted by the tainted services income changes. Those changes are discussed in Chapter 3.

Foreign income

Permanent establishment in a listed country

2.31 Where a permanent establishment in a listed country fails the active income test, the foreign income that continues to be taxable is only foreign income that is adjusted tainted income and which is also eligible designated concession income. This concept is slightly narrower than that used in the old provision but more closely matches the income that would be attributed under Part X from a controlled foreign company resident in a listed country. [Schedule 2, item 1, subsection 23AH(5)]

Permanent establishment in an unlisted country

2.32 Where a permanent establishment in an unlisted country fails the active income test, the foreign income that continues to be taxable is only foreign income that is adjusted tainted income. This closely matches the income that would be attributed under Part X from a controlled foreign company resident in an unlisted country. [Schedule 2, item 1, subsection 23AH(7)]

Capital gains and capital losses

2.33 The active income test in subsection 23AH(12) does not include net capital gains in the calculation. Also, there is no exclusion for capital gains where a permanent establishment passes the active income test. This intentionally mirrors the policy in the old provisions that treated capital gains and capital losses separately without taking into account whether or not the permanent establishment passed the active income test.

2.34 Any gains or losses from capital gains tax (CGT) events that occur in relation to Australian assets (i.e. assets that have the necessary connection with Australia under section 136-25 of the Income Tax Assessment Act 1997 (ITAA 1997)) of a permanent establishment continue to be included in the resident company's net capital gains. The new section 23AH is not intended to provide any exemption for capital gains made in relation to the disposal of Australian assets by a resident company.

2.35 A capital loss that results from a CGT event happening to a tainted asset used in carrying on business through a permanent establishment may be included in the calculation of the resident company's net capital gains. A capital loss is included only where, if there had been a gain in relation to the CGT event, the gain would have been included in the calculation of the resident company's net capital gains. [Schedule 2, item 1, subsection 23AH(4)]

Permanent establishment in a listed country

2.36 A resident company includes in the calculation of its net capital gains any capital gain or capital loss as a result of a CGT event happening in relation to a tainted asset that is used in carrying on a business through a permanent establishment in a listed country where:

•

the gain is also eligible designated concession income; or

•

there is a loss but if there had been a gain, the gain would have been eligible designated concession income.

[Schedule 2, item 1, subsection 23AH(6)]

Permanent establishment in an unlisted country

2.37 A resident company includes in the calculation of its net capital gains any capital gain or capital loss arising as a result of a CGT event happening in relation to a tainted asset that is used in carrying on a business through a permanent establishment in an unlisted country. [Schedule 2, item 1, subsection 23AH(8)]

Interposed partnerships and trusts

2.38 The new section 23AH also provides an exemption to a resident company that is a beneficiary of a trust or a partner in a partnership (or where there are several interposed partnerships or trusts). The trust or partnership derives income through carrying on business through a permanent establishment in a listed or unlisted country. The amount that is not assessable and not exempt income under section 23AH depends on the resident company's indirect interest in the trust or partnership income.

2.39 The general principle is that the amounts that are included in assessable income of a resident company are the amounts that would have been included had the business of the permanent establishment been carried on directly by the resident company taking into account the company's actual portion of the income. Further, the net income of a trust or partnership in relation to a resident company will not include the permanent establishment income that would not have been assessable nor exempt income if the company had derived that permanent establishment income directly.

Foreign income

2.40 Firstly, in considering the permanent establishment as though it were a separate entity, determine whether it passes the active income test. If it does, then the resident company's share of the net income of a trust operating through the permanent establishment does not include any foreign income derived through the permanent establishment. Similarly, the resident company would not include in assessable income its interest in the partnership's net income to the extent any amount relates to the foreign income derived through the permanent establishment of the partnership. [Schedule 2, item 1, subsection 23AH(10)]

2.41 A resident company's interest in a partnership loss is calculated without taking into account foreign branch income that would have been non-assessable non-exempt income had the permanent establishment income been derived directly through the company's permanent establishment, where the permanent establishment passes the active income test. That is, if the foreign permanent establishment derived income that would not be assessable if a resident company's permanent establishment had derived the income, and in ignoring that foreign income the partnership had a partnership loss, then the resident company is entitled to its share of the partnership loss. [Schedule 2, item 1, subsection 23AH(10)]

2.42 Where the permanent establishment fails the active income test and it is in a listed country, the resident company's share of the net income of the partnership or trust, or its share of a partnership loss, includes a portion of the foreign branch income that is adjusted tainted income and eligible designated concession income. Similarly, where the permanent establishment is in an unlisted country, the resident company's share of the net income of the partnership or trust (or of a partnership loss) includes a portion of the foreign branch income that is adjusted tainted income. The amount included in the resident company's assessable income arising out of the permanent establishment operations would be the amount that the company would have derived if it had carried on business through the permanent establishment directly, to the extent of its actual interest. [Schedule 2, item 1, subsection 23AH(10)]

Capital gains and capital losses

2.43 Where a CGT event occurs in relation to a tainted asset used in carrying on a business through a permanent establishment of a trust in an unlisted country resulting in a capital gain, then so much of the resident company's share of the gain will be included in its share of the net income of the trust. Similarly, where the permanent establishment is in a listed country, then so much of the resident company's share of the gain that is eligible designated concession income will be included in its share of the net income of the trust. However, nothing is included in the net income of the trust for a gain on an asset that is not a tainted asset, as far as the resident company beneficiary is concerned. [Schedule 2, item 1, subsection 23AH(11)]

2.44 Where a capital loss results but an amount would have been included in the calculation of the resident company's share of the net income of the trust if there had been a gain in relation to the CGT event then the loss can also be included in the calculation. [Schedule 2, item 1, subsection 23AH(11)]

2.45 Partners in a partnership hold a proportionate share in the assets of a partnership. Where a CGT event occurs in relation to a tainted asset of the partnership that is used in carrying on business through a permanent establishment in an unlisted country, then a resident company partner includes in its calculation of net capital gains the amount of the capital gain or capital loss in relation to the tainted asset. [Schedule 2, item 1, subsection 23AH(11)]

2.46 If the tainted asset of the partnership is used in carrying on business through a permanent establishment in a listed country then the capital gain must also be eligible designated concession income. A capital loss can be used in calculating net capital gains of a partner if instead of a loss there was a gain that would also be eligible designated concession income. [Schedule 2, item 1, subsection 23AH(11)]

2.47 The provisions also operate through several interposed partnerships or trusts and relate only to the resident company's share of the foreign income, capital gains or capital losses.

Example 2.1

Aust Co is a 50% partner in a partnership, For Co is the other partner. The partnership carries on a mining business through a permanent establishment in an unlisted country. The partnership's income year starts on 1 July as does Aust Co's income year.

In the 2006-2007 income year, the income from the mining business is $100, another $150 is net tainted rental income from leasing some equipment to another entity. This is the only income of the partnership. The equipment that was leased is sold in December 2006. The total capital gain is $20. Each partner's share of the gain is $10.

The amount that Aust Co includes in its assessable income is 50% of the $150 of tainted income and $10 of the capital gain from the disposal of the tainted asset.

Certain dividends and foreign branch profits not included in attributable income

2.48 The controlled foreign companies rules in Part X generally provide for income to be attributed to Australian resident taxpayers where they have a controlling interest in a foreign company. Section 389 specifically excludes the operation of sections 23AH and 23AJ for the purposes of calculating the amount to be attributed (the controlled foreign company's attributable income). However, similar provisions essentially replicate those sections within the controlled foreign companies rules. The current provisions dealing with non-portfolio dividends and foreign branch profits in a similar way are paragraphs 402(2)(c) and (d), section 403 and to some extent section 404.

Non-portfolio dividends received by a controlled foreign company

2.49 The expanded section 23AJ makes all non-portfolio dividends non-assessable non-exempt income. The controlled foreign companies rules will be aligned more directly with this approach. This alignment will be achieved by removing from section 389 the reference to section 23AJ [Schedule 2, item 5, paragraph 389(a)]. This will allow the section 23AJ expanded exemption to apply to the calculation of attributable income and removes the need for paragraphs 402(2)(c), (d) and 403(b). Section 404 is discussed further in paragraph 2.104 [Schedule 2, item 6; item 7, section 403].

2.50 Since all non-portfolio dividends received by a controlled foreign company will no longer be included in its attributable income, they are also excluded from the active income test. This is to prevent their inclusion in the test from leading to the attribution of other tainted income. [Schedule 2, item 70, paragraph 436(1)(e)]

Removing section 458

2.51 Section 458 also deals with non-portfolio dividends and directly includes in the assessable income of a resident attributable taxpayer a non-portfolio dividend paid from one controlled foreign company to another controlled foreign company or to a controlled foreign trust or an interposed partnership or trust. This section is no longer appropriate for dividends paid by one controlled foreign company to another because all non-portfolio dividends received directly or indirectly by a controlled foreign company are to be exempt from attribution.

2.52 The current operation of section 458 is generally restricted to cases where non-portfolio dividends are paid by a controlled foreign company in an unlisted country to one in a listed country that does not subject the dividend to normal taxation. This was partly because of the previous policy of restricting the exemption for non-portfolio dividends paid to resident companies to dividends paid out of comparably taxed profits. Since this is no longer the policy, another rationale for the current provision is removed. Therefore section 458 is repealed. [Schedule 2, item 8]

2.53 Although the section is repealed, those non-portfolio dividends would be included in the net income of a trust or partnership where they are paid to a controlled foreign trust, an Australian trust or a partnership. This could lead to an amount being included in the attributable income of a controlled foreign company that is a beneficiary of the trust or a partnership. The same outcome would also occur where a non-portfolio dividend is deemed to be paid as a result of section 47A.

2.54 As well as reducing the payment of Australian tax and so removing a possible barrier to the more efficient use of capital, the removal of section 458 will also considerably reduce compliance costs and complexity.

Foreign branch profits of a controlled foreign company

2.55 A similar provision in Part X, paragraph 403(a), replicates the purpose of section 23AH in relation to a controlled foreign company resident in an unlisted country that carries on business through a permanent establishment in a broad-exemption listed country. This notional exemption is more generous than the current exemption in section 23AH as paragraph 384(2)(a) starts with an amount that is adjusted tainted income. The notional exemption in paragraph 403(a) ensures the amount is also eligible designated concession income. The section 23AH exemption only excludes income that is not eligible designated concession income whether or not the income was adjusted tainted income.

2.56 The provision in section 23AH that exempts certain foreign income derived through a permanent establishment in a limited-exemption listed country is not mirrored in Part X for a controlled foreign company resident in an unlisted country. However, the normal operation of paragraph 384(2)(a) ensures that amounts derived by that controlled foreign company from a permanent establishment in a limited-exemption listed country that would be attributed to a resident entity are similar to the amounts that would be assessed to a resident company.

2.57 Where a controlled foreign company is resident in a limited-exemption listed country, paragraph 384(2)(aa) provides a similar result to section 23AH in relation to a controlled foreign company that carries on business through a permanent establishment. Paragraph 384(2)(aa) includes certain amounts in attributable income that are not adjusted tainted income, where those amounts have not been subject to tax in a listed country. Where a controlled foreign company is resident in a broad-exemption listed country and carries on business through a permanent establishment in any foreign country, the normal operation of paragraph 385(2)(a) achieves the desired result.

2.58 The policy behind the introduction of the new sections 23AH and 23AJ is mirrored in the Part X provisions by repealing paragraph 384(2)(aa) and amending section 403. This ensures there is no longer a 'subject to tax' test for income derived by a controlled foreign company where that income is not adjusted tainted income. [Schedule 2, item 58; item 7, section 403]

2.59 The new section 403 provides for an additional notional exempt income amount where a controlled foreign company resident in an unlisted country carries on business through a permanent establishment in a listed country. The range of situations to which this will apply has been changed because of the changed meaning of listed and unlisted countries as discussed in paragraphs 2.99 to 2.104.

Section 47A and section 459 changes

Section 47A

2.60 The current section 47A deems certain distributions from controlled foreign companies in unlisted countries to be dividends. If a resident entity treats the amount as a dividend then the amount is treated as a dividend for all purposes of the ITAA 1936 and the ITAA 1997. If the amount is not treated as a dividend but should have been, the deemed dividend is included in assessable income. No foreign tax credits are allowed and the dividend is not treated as non-assessable non-exempt income under section 23AI or section 23AJ.

2.61 Section 47A will still operate to deem amounts to be dividends and, in some cases, that amount will be included in assessable income of a resident under section 44. With the change to section 23AJ, all non-portfolio dividends will be exempt, including deemed dividends under section 47A paid from a controlled foreign company resident in an unlisted country to a shareholder with a non-portfolio interest. This change means the penalty provision in section 47A that causes concern to resident companies will not be applied to prevent the application of section 23AJ. To the extent a deemed dividend is paid to a resident company and it meets the definition of a non-portfolio dividend the resident company will exclude it from the calculation of assessable income in the preparation of its income tax return. [Schedule 2, item 17, subsection 47A(2)]

2.62 The repeal of section 458 and Division 6 of Part X also impact on the application of section 47A which has been amended to take account of those changes. [Schedule 2, items 16 to 19, subsections 47A(2), (7) and (16)]

Section 459

2.63 Section 459 interacts with section 47A to ensure profits transferred from a controlled foreign company in an unlisted country to another controlled foreign company (or to a controlled foreign trust or an interposed partnership or trust) are included in a resident attributable taxpayer's assessable income. Both controlled foreign companies have to have a common attributable taxpayer. Section 458 may also have operated in this situation but section 459 only operated where section 458 did not apply (i.e. where the deemed dividend would not be a non-portfolio dividend).

2.64 Similar arguments discussed in paragraphs 2.51 to 2.54 for the repeal of section 458 apply equally to section 459 which is also repealed [Schedule 2, item 8]. This is intended only to remove the special direct attribution of the dividend amounts to the attributable taxpayer.

2.65 Amounts that are deemed to be dividends by section 47A may be included in attributable income of a controlled foreign company with the repeal of paragraph 402(2)(da) [Schedule 2, item 6]. An amount that is a deemed dividend and is a portfolio dividend may be included in an attributable taxpayer's assessable income under section 456. In a similar way to where section 458 could have applied to a deemed dividend, an amount could also be included in the attributable income of a controlled foreign company via the net income of an interposed partnership or trust. Whether the deemed dividend paid to a resident or non-resident associate of the controlled foreign company is taxable will depend on the general assessment or Part X provisions.

Section 423

2.66 Section 423 has been amended to reflect the fact that a deemed dividend may now be included in attributable income which will be assessable to a resident taxpayer under section 456 rather than via section 458 or section 459 [Schedule 2, item 69, paragraph 423(2)(d)]. A deemed dividend may be taxed to a resident attributable taxpayer where an asset has been transferred by their controlled foreign company for less than market value to another of their controlled foreign companies. A capital gain may arise where the asset is later disposed of by the second controlled foreign company. Section 423 prevents double taxation where any amount of the capital gain relates to the previously taxed deemed dividend. The capital gain amount is reduced by the amount on which the attributable taxpayer has paid tax.

2.67 Section 116-85 of the ITAA 1997 is a provision that essentially achieves the same purpose as section 423 for a resident entity disposing of an asset. Item 3 in the table in subsection 116-85(1) has been rewritten and the whole of subsection 116-85(3) has been repealed. Subsection 116-85(3) was repealed because it was no longer needed to explain how a capital gain was calculated for a resident company which is automatically calculated under Parts 3-1 and 3-3 of the ITAA 1997 anyway. Item 3 in the table in subsection 116-85(1) was rewritten because part of it is no longer required. [Schedule 2, item 81, item 3 in the table in subsection 116-85(1) of the ITAA 1997; item 82]

Section 457 changes

2.68 Section 457 currently attributes an amount directly to an attributable taxpayer in a controlled foreign company that changes residence from an unlisted country to a listed country or to Australia. This was to ensure that amounts that had not been attributed from the unlisted country controlled foreign company could not be repatriated to Australia free of the tax that would normally be paid on a non-portfolio dividend from that controlled foreign company. The amount that was attributable was the taxpayer's share of the distributable profits of the controlled foreign company at the time it changed residence plus net unrealised gains on the controlled foreign company's assets. The amount could be reduced to the extent that those profits could have been distributed free of tax under section 23AI because of earlier attribution of income from the controlled foreign company.

2.69 With the extension of the exemption for non-portfolio dividends to all countries, this provision is not required to the same extent. In particular, there is no need to tax the distributable profits of past statutory accounting periods. The removal of the attribution of these amounts at the time of the residence change reflects the policy that Australian tax should only be paid, if at all, when these profits are distributed to resident shareholders or under the general controlled foreign companies rules. Along with that change, there is also no need to avoid possible double taxation by deducting the taxpayer's attribution surplus in the controlled foreign company. All the references to attribution surplus have been removed. [Schedule 2, items 71 and 73]

2.70 The amount to be attributed under section 457 is principally the amount that would be attributed for the period since the end of the preceding statutory accounting period of the controlled foreign company if it had remained a resident of the unlisted country. Non-portfolio dividends received by the controlled foreign company in that period will not be included in the calculation under section 457 because they will no longer be included in attributable income. [Schedule 2, item 72, subsection 457(2), definition of 'adjusted distributable profits']

2.71 As is currently the case, there is an adjustment to that basic amount for unrealised gains on its assets in the case where the controlled foreign company becomes a resident of a listed country. However, now those unrealised gains are limited to those on the tainted assets of the controlled foreign company because Australian tax is not to be imposed on gains on the disposal of its 'active' assets, even on distribution to a non-portfolio shareholder. The reference to adjusted tainted income in this case picks up the modifications to the cost bases of what are called 'commencing day assets' in Subdivision C of Division 7 of Part X. Where some of those tainted assets are shares in other foreign companies, the measure discussed in Chapter 1 may be applicable to reduce the notional gain or loss arising from the assumed disposal of those shares. [Schedule 2, item 72, subsection 457(2), definition of 'adjusted distributable profits']

Foreign tax credits

2.72 Foreign tax credit provisions were introduced in Division 18 of Part III to prevent international double taxation. A foreign tax credit is generally provided where a resident entity includes foreign income in its assessable income and foreign tax was paid on the foreign income (section 160AF). Where a resident company receives a foreign dividend from a foreign related company, foreign tax credits are also available for the foreign tax paid on the profits from which the dividend was paid (section 160AFC). For this to occur, the dividend must be included in assessable income (section 160AF).

2.73 With the introduction of the new measures, all non-portfolio dividends will be excluded from assessable income. This means that foreign tax credits would not be required to prevent double taxation in relation to non-portfolio dividends. In particular, foreign tax credits for underlying foreign company tax will not be required, which allows section 160AFC to be repealed. [Schedule 2, item 37]

2.74 The repeal of section 160AFC impacts on several other provisions but generally the foreign tax credit facilitated by section 160AFC was only available if a resident company received a non-portfolio dividend. The impact on other provisions is discussed below.

2.75 Section 160AFC was the mechanism for calculating the foreign tax credit to be allowed for underlying company tax when a company received an assessable foreign dividend from a related company. The conditions for a dividend paid from a related company (as defined in section 160AFB) are similar to the conditions for a non-portfolio dividend.

2.76 Dividends paid by a related foreign company to a resident company may not always be non-portfolio dividends and thus are included in the assessable income of the company receiving them. With the repeal of section 160AFC, foreign tax credits for underlying foreign company tax will no longer be available for those related company dividends that are included in assessable income of a resident company. However, the resident company will still be entitled to foreign tax credits for foreign tax paid on the dividends.

2.77 If certain finance share dividends (which cannot be non-portfolio dividends) were paid to a resident company, section 160AO specifically restricted the amount of the foreign tax credit that may otherwise arise. The underlying company tax amounts were excluded from the meaning of foreign tax paid by the company by subsection 160AO(4). Repealing section 160AFC ensures underlying foreign tax credits are no longer available for finance share dividends and means that section 160AO can be simplified (as well as not having to consider or remember its application). [Schedule 2, item 44]

Foreign tax credits in relation to attributable income

2.78 Section 160AFCA ensures a foreign tax credit can arise for a resident company where foreign tax is paid on an amount that is included in assessable income under section 456. It no longer provides underlying foreign tax credits.

2.79 Section 160AFCA relies in part on a notional deduction being available under section 393. Under section 393 foreign or Australian taxes paid by a controlled foreign company in relation to amounts included in notional assessable income are notional allowable deductions. This provision also includes in the amount of foreign tax, the amount calculated under section 160AFC in relation to non-portfolio dividends paid to controlled foreign companies that are included in notional assessable income (subsection 393(2)). There is no further requirement for this notional deduction as a controlled foreign company will no longer include a non-portfolio dividend in notional assessable income.

2.80 Subsections 393(2) and 393(3) are repealed with the extension of the exemption for all non-portfolio dividends. [Schedule 2, item 67]

2.81 Section 160AFCB ensures a foreign tax credit can arise where foreign tax is paid on an amount that is included in assessable income under section 457 because of a change of residence of a controlled foreign company. It also provides a foreign tax credit for underlying foreign company tax amounts if a non-portfolio dividend is included in the amount attributed under section 457 to a resident company.

2.82 Amounts may continue to be attributed under section 457 but this provision has been modified to ensure non-portfolio dividends are not attributed. (The modifications to section 457 are discussed in paragraphs 2.69 to 2.71.) Section 160AFCB has been rewritten to remove the references to non-portfolio dividends and section 160AFC. [Schedule 2, item 38, section 160AFCB]

2.83 Section 160AFCC ensures a foreign tax credit can arise where foreign tax is paid on an amount that is included in assessable income under section 458. In the future no amounts are included in assessable income under section 458 as the provision is repealed. (The repeal of section 458 is discussed in more detail in paragraphs 2.51 to 2.54.) This means that section 160AFCC can also be repealed. [Schedule 2, item 39]

Foreign tax credits for previously attributed income

2.84 Double Australian taxation could arise when previously attributed foreign income is repatriated. However, this is avoided by providing an exemption under section 23AI for dividends paid from a controlled foreign company out of previously attributed income. A similar exclusion is provided for dividends paid from a foreign investment fund under section 23AK. Nevertheless, an entity may have paid foreign tax on the distributed income after attribution as well as Australian tax when the income was attributed. This means, to some extent, there could continue to be double taxation on the distributed amounts. However, sections 160AFCD and 160AFCJ ensure an entity is entitled to foreign tax credits for foreign tax paid on amounts that are not included in assessable income because of sections 23AI and 23AK, respectively.

2.85 The foreign tax credits available under sections 160AFCD and 160AFCJ relate to the direct withholding tax paid on the dividend. A further credit to a resident company may also be available under these sections for underlying foreign tax that was paid in relation to the foreign income from which the non-portfolio dividend was paid to the resident company. The current meaning of underlying tax in those provisions includes an amount of foreign tax calculated under section 160AFC to pick up this latter credit.

2.86 The repeal of section 160AFC means that the definition of 'underlying tax' contained in sections 160AFCD and 160AFCJ cannot be applied. However, to ensure underlying foreign tax credits will continue to be available, a new definition of underlying tax has been inserted into those provisions. [Schedule 2, item 41, subsection 160AFCD(2); item 43, subsection 160AFCJ(4)]

Non-portfolio dividends and underlying tax credits - section 160AFCD

2.87 A number of conditions in the new definition of underlying tax are similar to the old requirements. The new definition of underlying tax in section 160AFCD applies where:

•

an attribution account payment which is a non-portfolio dividend is paid to a resident company;

•

that attribution account payment includes an amount that is not assessable because of section 23AI; and

•

foreign tax has been paid in relation to the attribution account payment. The foreign tax can include foreign tax paid on the profits from which the non-portfolio dividend was paid.

2.88 An attribution account payment which is a non-portfolio dividend may ultimately be paid to a resident company through a chain of interposed foreign companies. In such circumstances, foreign tax credits may be available for foreign underlying tax paid by the interposed foreign companies. However, the tax credits are limited to the foreign tax paid on the profits from which the non-portfolio dividend was paid to the resident company to the extent that it relates to the exempt section 23AI part.

2.89 If the conditions in paragraph 2.87 are satisfied, the amount of the underlying tax the resident company is entitled to claim as a foreign tax credit is:

•

the amount of foreign tax paid by the company making the attribution account payment (the non-portfolio dividend) on the profits from which the dividend was paid; and

•

where non-portfolio dividends are paid through a chain of interposed companies, the amount of foreign tax paid on the profits from which those dividends were paid and any withholding tax paid on them.

2.90 The amount of the credit is limited to that portion of the underlying tax that relates to the proportion of profits that were actually distributed and which can be traced to previously attributed income. It is the amounts by which the section 23AI part of the dividend would have been greater if there had been no foreign tax paid [Schedule 2, item 41, subsection 160AFCD(2), definition of 'underlying tax']. This is best illustrated by Example 2.2.

Example 2.2

Aust Co is an attributable taxpayer in relation to all three companies, B Co, C Co and D Co, in this example. The statutory accounting periods and income years are 1 July to 30 June. Aust Co keeps attribution accounts in relation to B Co, C Co and D Co to enable it to claim a non-assessable non-exempt amount under section 23AI.

Assumptions

B Co earns income of $100 that is attributed to Aust Co on 30 June 2005. On 1 July 2006 B Co pays C Co a non-portfolio dividend of $100.

The non-portfolio dividend is C Co's only income. C Co pays company tax of $2 on its income of $100. On 1 July 2007 C Co pays D Co a non-portfolio dividend of $98.

Country C imposes a withholding tax of 5% ($4.90) on the dividend paid to D Co by C Co. The non-portfolio dividend is D Co's only income. D Co does not pay any further company tax on its income.

On 1 August 2008 D Co pays Aust Co a non-portfolio dividend of $93.10. Country D imposes a withholding tax of 2% ($1.86) on the payment of that dividend.

Calculation of the underlying tax

The underlying tax component according to the definition of the underlying tax in section 160AFCD would consist of:

•

the tax paid by C Co - $2 of company tax; and

•

the tax paid by D Co - $4.90 of dividend withholding tax.

The underlying tax amount is $6.90. If this amount of foreign tax hadn't been paid, the section 23AI exempt part would have been that much greater.

Calculation of underlying tax where only part of the attribution account surplus is paid

If D Co had chosen to distribute only part of the profits that formed the attribution account surplus in D Co's attribution account then only part of the credit for underlying tax paid would be provided. For example, if D Co had paid Aust Co a $50 dividend on 1 August 2008 the amount of underlying tax credit would be:

50 / 93.1 * 6.90 = $3.71


Credit for direct taxes

The withholding tax of 2% imposed by country D on the payment of the non-portfolio dividend to Aust Co is taken into account as the direct tax component in the formula in paragraph 160AFCD(1)(b).

Non-portfolio dividends and underlying tax credits - section 160AFCJ

2.91 Section 160AFCJ also contains a definition of 'underlying tax' which operates in much the same way as the underlying tax definition explained in relation to section 160AFCD (see paragraphs 2.87 to 2.90).

2.92 A resident company is able to claim a foreign tax credit in relation to a foreign investment fund attribution account payment that is exempt under section 23AK. The amount of a credit for foreign underlying tax is calculated in relation to a foreign investment fund attribution account payment which is a non-portfolio dividend. As discussed in relation to section 160AFCD the amount of the credit is the amount by which the section 23AK part of the dividend would have been greater if there had been no foreign tax paid. [Schedule 2, item 43, subsection 160AFCJ(4), definition of 'underlying tax']

2.93 The amendments to the underlying tax definition in section 160AFCJ have not affected the meaning for underlying tax that currently relates to an entity that is deemed to have paid tax under subparagraph 6AB(3)(a)(ii).

Changes to attribution account credits and debits

2.94 Attribution accounts are the mechanism used by resident attributable taxpayers to keep track of attributed foreign income that has been included in their assessable income. The accounts also keep track of attribution account balances as they are moved via distributions of profits from the controlled foreign company, whose income was previously attributed, directly or indirectly to the attributable taxpayer.

2.95 A resident attributable taxpayer is able to claim an amount as exempt under section 23AI to the extent of the attribution account payment (usually a dividend) or the amount of the attribution surplus for the entity making the payment, whichever is the lesser amount. Separate attribution accounts are kept for each interposed company in the chain. The successive credits and debits to those attribution accounts enable the tracing of attribution account balances until the payment to the resident. As discussed above, foreign tax credits are available for amounts exempt under section 23AI. The attribution accounts are also used to trace amounts paid between interposed companies in working out the amount of underlying foreign tax that relates to an exempt section 23AI part of a non-portfolio dividend.

2.96 Section 371 defines circumstances that give rise to a credit to the attribution account (an attribution credit). In particular, an attribution credit arises where an amount is included in the assessable income of a taxpayer because of section 458. Amounts are no longer included in the assessable income of a taxpayer under section 458. This means an attribution credit is no longer required and paragraph 371(1)(c) and the related subsection 371(3) are repealed. [Schedule 2, items 51 and 52]

2.97 Section 372 defines circumstances that give rise to a debit to the attribution account (an attribution debit). Subsection 372(3) reduces an attribution debit where a company resident in an unlisted country pays a non-portfolio dividend to the attributable taxpayer or to an interposed company. The purpose of this provision is to maximise the amount of the dividend that would be exempt under the old section 23AJ (or the equivalent for an interposed controlled foreign company). The amount of the attribution debit was then determined by the balance of the attribution account and the remaining amount of the dividend.

2.98 The treatment for dividends from listed countries was different. The attribution debit was determined largely by the attribution account balance. Any remaining amount of the dividend would always be exempt under the old section 23AJ (or the equivalent provision for a controlled foreign company). Since non-portfolio dividends from all countries are to be exempt there is no longer a need to have this special ordering rule and therefore subsection 372(3) is repealed. [Schedule 2, item 55]

Changing the definitions of listed and unlisted country

2.99 A further consequence of the extended exemption for non-portfolio dividends is the modification of the listing of countries. There are currently two types of listed counties in Schedule 10 of the Income Tax Regulations 1936: broad-exemption listed countries in Part 1 and limited-exemption listed countries in Part 2.

2.100 The seven countries on the broad-exemption listed country list are considered to have income tax systems very similar to Australia's. More than 50 countries on the limited-exemption listed country list have income tax systems considered to be broadly comparable to Australia's, but not to the same extent as for broad-exemption listed countries. Most countries with which Australia has a double tax agreement are listed countries on either the broad-exemption listed country or the limited-exemption listed country list.

2.101 The purpose of this system is to provide more favourable tax treatment to listed countries that tax comparably to Australia than to unlisted countries which generally don't have a comparable tax system to Australia. The profits of companies resident in a broad-exemption listed country are treated most favourably. For example, a limited range of income is attributable under the controlled foreign companies rules. Currently, for companies resident in limited-exemption listed countries, the main aspect of the favourable tax treatment is an exemption for non-portfolio dividends.

2.102 This expansion of the non-portfolio dividend exemption to all countries largely removes the purpose of the limited-exemption listed country list and makes it unnecessary to have two separate types of listed countries. The current broad-exemption listed country and limited-exemption listed country definitions will be repealed as those terms will no longer be used. [Schedule 2, items 85 and 86]

2.103 More favourable tax treatment is still available to the seven broad-exemption listed countries. These countries will be reclassified as listed countries [Schedule 2, item 87, subsection 320(1)]. This change will result in all other countries, including the current limited-exemption listed countries, falling within the category of unlisted countries. All countries will have the same treatment for non-portfolio dividends, rather than the current case which only applies to broad-exemption listed countries and limited-exemption listed countries. This is the Government's announced intention.

2.104 The list of countries currently designated as limited-exemption listed countries will remain relevant for one purpose. Section 404 excludes from attributable income all dividends (including portfolio dividends) paid from a company resident in any listed country to a controlled foreign company that is also resident in a listed country. To allow this treatment to continue to apply, in particular for portfolio dividends, the current limited-exemption listed countries will be reclassified as section 404 countries [Schedule 2, item 89, subsection 320(1), definition of 'section 404 country'; item 90, section 404]. The necessary changes to the regulations to reflect these new names for the lists of countries will be made as soon as possible.

Application of measures to consolidated groups

2.105 The measures discussed above generally relate to a resident company, other than one that is a trustee of a trust. However, in some circumstances a company may be a trustee of a corporate unit trust or public trading trust that is a head company of a consolidated group under Subdivision 713-C of the ITAA 1997. The new measures apply to a company in the capacity of a trustee of a corporate unit trust or public trading trust that is the head company of a consolidated group.

Application provisions

2.106 The expanded exemption for non-portfolio dividends and related changes contained in Part 2 and 3 of Schedule 2 to this bill apply to dividends paid after 30 June 2004. It is irrelevant when the profits were earned to pay those dividends. It is also irrelevant in which income year or statutory accounting period the dividend is paid as long as it is after 30 June 2004.

2.107 The expanded exemption for foreign branch profits and the consequential change to the restriction for deductions for certain bad debts applies to income years starting on or after 1 July 2004.

2.108 The changes contained in Part 4 (about changes to the classification of countries and the definition of a listed country) and Part 5 of Schedule 2 to this bill (consequential changes in relation to the changes to the classification of countries) apply to income years of a resident entity starting on or after 1 July 2004. Where the changes in Parts 4 and 5 relate to calculating the attributable income of a controlled foreign company, the changes apply to statutory accounting periods starting on or after 1 July 2004.

Consequential amendments

2.109 Consequential amendments have been made to several provisions to remove references to provisions that have been repealed. For example, all references to sections within Division 6 of Part X, sections 160AFC, 458 and 459 have been removed from all provisions as those sections have been repealed.

2.110 The repeal of the definitions of broad-exemption listed country and limited-exemption listed country has resulted in consequential amendments to several provisions to remove references to those names. Generally, where the term 'broad-exemption listed country' is used the term 'listed country' has replaced that term.

2.111 Other consequential amendments of a more substantial nature are discussed below or have already been discussed.

Section 63D

2.112 The changes to section 23AH impact on section 63D which restricts the amount of a deduction for a bad debt incurred in a money lending business where the income would have been exempt under section 23AH. Section 63D has been modified to take account of the fact that this provision can now apply to branches in all foreign countries. [Schedule 2, item 2, subsection 63D(1); item 3, subsection 63D(2)]

Changes to the foreign dividend account provisions

2.113 The current foreign dividend account measure in Subdivision B of Division 11A of Part III was introduced to enable certain foreign source dividends paid to a resident company to be paid to non-resident shareholders free from dividend withholding tax to the extent that Australian company tax is not paid on the foreign dividends. The measure related to non-portfolio dividends either exempt under section 23AJ or which were included in assessable income but for which a foreign tax credit reduced the Australian tax payable.

2.114 The exemption from dividend withholding tax is provided where a resident company pays an unfranked dividend from the foreign dividend account. Broadly, the foreign dividend account is credited with foreign non-portfolio dividends and is debited with expenses, including Australian tax, that relate to those dividends. A debit also arises where a dividend is paid to foreign shareholders free of dividend withholding tax.

2.115 The change to expand the operation of section 23AJ impacts on the foreign dividend account rules which can now be simplified. Non-portfolio dividends will no longer be included in assessable income which means the foreign dividend account provisions dealing with assessable non-portfolio dividends can be repealed. The only credit to a foreign dividend account is where a resident company receives a non-portfolio dividend that is not assessable and not exempt income under section 23AJ [Schedule 2, item 25, subsections 128TA(1) and (2)]. There will no longer be a requirement for debits to the foreign dividend account that relate to Australian tax paid [Schedule 2, items 27 and 28].

Chapter 3 - Tainted services income

Outline of chapter

3.1 Schedule 3 to this bill amends sections 448 and 450 of the Income Tax Assessment Act 1936 (ITAA 1936) to reduce the scope of tainted services income. Tainted services income will, in general, no longer include income from services provided by a company to a non-resident associate, or the overseas permanent establishment of an Australian resident. The amendments will improve the international competitiveness of Australian companies.

3.2 Unless otherwise stated, all legislative references are to the ITAA 1936.

Context of amendments

3.3 The amendments are part of the Government's response to the Board of Taxation's report to the Treasurer on international taxation. Reducing the scope of tainted services income will improve the competitiveness of Australian companies with offshore operations, and reduce their compliance costs.

3.4 The controlled foreign companies rules include in the taxable income of an Australian taxpayer, the taxpayer's share of the specified income (known as attributable income) of a non-resident company in which they have a controlling interest. The income targeted for attribution is income that can readily be shifted offshore by taxpayers to non-resident companies that they own or control, to take advantage of any lower tax rates offshore. An equivalent approach is applied to the offshore permanent establishments (branches) of Australian companies.

3.5 One category of attributable income is called tainted services income. Tainted services income is, in general, income from services provided by a company to an Australian resident or to an associate of the company (including non-resident associates). It also includes income from services provided to a non-resident in connection with a business carried on by the non-resident through a permanent establishment in Australia.

3.6 Australian company groups with offshore operations often have a dedicated company provide particular services (e.g. computing services) to other group companies. Australian companies using such service centres are subject to the controlled foreign companies rules. Income earned by the service centres is currently tainted services income, with attendant tax and compliance costs. This, and the application of the rules in other cases involving offshore associates, puts Australian companies at a disadvantage against competitors not subject to equivalent rules.

3.7 This bill amends tainted services income to exclude income from services provided to non-resident associates, or the overseas permanent establishments of Australian residents. The changes will allow Australian companies to compete better internationally, with negligible risk to the tax base. They also provide a generally more neutral treatment between services provided to group companies by offshore service centres (currently attributable) as against the internal generation of those same services within each offshore group company (currently not attributable).

3.8 Services provided to Australian customers (Australian residents, other than in respect of their overseas permanent establishments, and non-residents' permanent establishments in Australia) will remain part of tainted services income. The amendments include a provision designed to prevent the amendments being misused to allow services to be provided to Australian customers in a way that falls outside of tainted services income.

Summary of new law

3.9 The amendments in this Schedule generally reduce the scope of tainted services income. In general, tainted services income will now only include income from providing services to an Australian resident (other than in respect of an overseas permanent establishment), or to a non-resident in respect of a permanent establishment in Australia. Income from services provided indirectly to Australian residents, or the Australian permanent establishment of a non-resident, will be included in tainted services income, subject to certain requirements.

3.10 The amendments will apply to statutory accounting periods of companies beginning on or after 1 July 2004.

Comparison of key features of new law and current law

Detailed explanation of new law

3.11 The new law generally reduces the scope of tainted services income. It does not otherwise alter the existing use of the tainted services income concept, which is:

•

the tainted services income of a company that is a controlled foreign company may be attributed to Australian taxpayers with an attributable interest in that controlled foreign company (Part X); and

•

the tainted services income of an overseas permanent establishment of an Australian resident company may be included in the assessable income of the company (section 23AH).

3.12 Currently, tainted services income includes income from providing services to an associate or to a 'Part X Australian resident' (referred to herein as a 'resident') (paragraph 448(1)(a)). Tainted services income also includes income (other than premium income) from providing services to an entity that is not a Part X Australian resident (a 'non-resident') in connection with a business carried on at a permanent establishment of the entity in Australia (paragraph 448(1)(b)).

3.13 Premium income in respect of providing insurance is treated separately from other services income (paragraphs 448(1)(c) to (e)). Certain income and gains of a company that is an Australian financial institution subsidiary are also included in tainted services income (subsections 450(6) to (8)).

Services provided to non-resident associates no longer give rise to tainted services income

3.14 The amendments have the effect of generally removing from the scope of tainted services income, the income a company derives from providing services to non-resident associates. [Schedule 3, item 1, paragraph 448(1)(a)]

3.15 The removal of services provided to non-resident associates is applied consistently to the treatment of insurance premium income and relevant Australian financial institution subsidiary income. [Schedule 3, item 2, paragraph 448(1)(c); item 3, subparagraph 448(1)(d)(i); item 4, paragraphs 448(1)(e) and (f); item 7, subparagraph 450(6)(c)(i); item 8, subparagraph 450(7)(d)(i); item 9, subparagraph 450(8)(b)(i)]

3.16 The existing same-country exemption (subsection 448(6A)) is repealed as removing services provided to non-resident associates makes it redundant. (Under the existing exemption, income from services provided by a controlled foreign company to another controlled foreign company that is an associate and resident in the same overseas country is not included in tainted services income, subject to certain conditions.) [Schedule 3, item 6]

A more consistent treatment of permanent establishments

3.17 The amendments provide for a more consistent treatment of income from services provided by a company to an entity in connection with a business carried on by that entity at a permanent establishment in Australia or in another country.

3.18 The current law includes in tainted services income, income (other than premium income) from services provided to a non-resident entity in connection with a business carried on by the entity at a permanent establishment in Australia. That is, the Australian permanent establishment of a non-resident is treated like a resident. The amendments extend this approach to premium income from providing reinsurance. [Schedule 3, item 4, paragraph 448(1)(f)]

3.19 The above approach is not formally extended to income from providing life and general insurance. In the life insurance case, a reference to a permanent establishment is unnecessary as it would have no practical application. In relation to general insurance, premium income from insuring property situated in Australia or events that can only happen in Australia is currently included in tainted services income. In effect, this current treatment already captures most general insurance that would be provided to the Australian permanent establishment of a non-resident.

3.20 The amendments also introduce an equivalent treatment for services provided to the overseas permanent establishments of residents compared with services provided to non-residents. That is, in general, income from such services will not be included in tainted services income. This achieves a symmetrical treatment between Australian permanent establishments (treated like residents) and overseas permanent establishments (treated like non-residents). [Schedule 3, item 1, subparagraph 448(1)(a)(ii); item 3, subparagraph 448(1)(d)(i); item 4, subparagraph 448(1)(e)(ii); item 7, subparagraph 450(6)(c)(i); item 8, subparagraph 450(7)(d)(i); item 9, subparagraph 450(8)(b)(i)]

Services provided indirectly that give rise to tainted services income - indirect services rule

3.21 Income from services provided by a company to a resident (other than in respect of an overseas permanent establishment) or the Australian permanent establishment of a non-resident, is to remain tainted services income. To prevent these amendments being used to avoid that result, income from such services provided, in effect, indirectly by a company will also be tainted services income in certain circumstances. [Schedule 3, item 4, paragraph 448(1)(g); item 5, subsection 448(1A)]

Reason for the indirect services rule

3.22 The indirect service rule is intended to prevent a non-resident entity or entities being interposed between a company providing services and its customers in Australia (see Diagram 3.1). The interposed entity or entities may be pre-existing or newly created, and include an overseas permanent establishment of an Australian resident. Without this rule, the company actually generating the services would not have tainted services income, as it provides the services to a non-resident or overseas permanent establishment of an Australian resident. The interposed entity itself could have tainted services income in respect of the services it contracts to provide to Australian customers. However, as it would be allowed a deduction for the services it purchased, it would have little net income to be taxed.

Diagram 3.1

3.23 An indirect services rule was previously unnecessary as the income from a company providing services to a non-resident associate or overseas permanent establishment of an Australian resident (the interposed entity) was tainted services income. The indirect services rule achieves the same outcome, subject to certain requirements being met. The rule does not limit the generality of other provisions in sections 448 and 450 that include amounts in tainted services income. More specifically, tainted services income may be derived by a company, even though it has arranged for the services to be provided by another entity (e.g. by using a subcontractor or agent to carry out the work). The general anti-avoidance rule in Part IVA would also continue to apply, in particular to cases involving non-associate interposed entities.

Main elements of the indirect services rule

3.24 Application of the indirect services rule is conditional on meeting certain requirements. A number of these requirements are intended to prevent the indirect services rule applying in cases where the provision of services indirectly is inadvertent or unintended (when viewed objectively). The requirements, which are discussed in more detail below, are:

•

services provided by the company to an associated entity are received by another entity (i.e. an Australian customer);

•

the services are provided by the company under a scheme with the relevant purpose; and

•

the income from the services would have been tainted services income if provided directly.

Services provided by the company to an associated entity are received by another entity

3.25 The indirect services rule looks at whether:

•

the company provides services to an entity, where that entity is an associate of the company; and

•

another entity receives those services. That is, they have been provided to that other entity by the company, through one or more interposed entities (the first of which is an associate); and

•

that other entity was an Australian customer - either a resident, other than in respect of an overseas permanent establishment, or the Australian permanent establishment of a non-resident.

[Schedule 3, item 5, paragraphs 448(1A)(a) to (d)]

3.26 Importantly, the services originally provided by the company need to be the services received by the Australian customer, and not merely a service of the same kind. If the service received is a different service or a service so modified or transformed as to have lost its original character (in substance rather than form), then the rule does not apply. However, where particular services are simply bundled with other services or goods before final sale to an Australian customer, those particular services would still have been received by the customer.

Example 3.1

Archi Co and Plans Co are both members of the same corporate group, and controlled foreign companies. Archi Co provides architectural services (house designs) to Australian customers. Plans Co also develops building and house plans.

Case A: Plans Co provides Archi Co (an entity that is an associate) with a suite of highly specified house designs. Archi Co markets these into the Australian market, assisting customers in choosing the most appropriate design, but otherwise making no changes. In this case, Plans Co has indirectly provided services to Australian customers, with the house designs received by those customers the same as those originally provided by Plans Co to Archi Co.

Case B: Plans Co provides Archi Co with a suite of highly specified house designs. Archi Co uses these designs as a technical reference and source of ideas, but otherwise provides custom-designed house plans to Australian customers to suit their individual preferences. In this case, the services provided by Plans Co are not those received by Archi Co's Australian customers, even though services of the same kind were received.

Example 3.2

TelCo, a controlled foreign company, provides international telecommunication services using satellites. The marketing and sale of these services is undertaken exclusively through two associated non-resident group companies, TelPac and TelUSA.

TelPac purchases telecommunications services from TelCo and retails and distributes them into the Asia-Pacific, including a significant proportion to Australia. Australia is a major focus of TelPac's marketing. TelUSA purchases similar telecommunications services from TelCo, but (consistently with the business plans of both TelCo and TelUSA) retails and distributes them exclusively into the United States.

In retailing and distributing telecommunications services purchased from TelCo, TelPac adds billing, other customer-related administrative services, and incidental technical services to the telecommunications services it on-sells to its customers.

The telecommunication services provided by TelCo to TelPac (an associated entity) are the services received by TelPac's Australian customers, notwithstanding the billing and other incidental services provided by TelPac. The telecommunications services sold by TelPac have not lost their original character from the telecommunications services purchased by TelPac from TelCo.

The services are provided by the company under a scheme with the relevant purpose

3.27 The services provided by the company need to be provided under a scheme. The scheme must have been entered into or carried out for a purpose, other than an incidental purpose, of providing those services to Australian customers. [Schedule 3, item 5, paragraphs 448(1A)(a) and (f)]

3.28 'Scheme' is defined in subsection 995-1(1) of the Income Tax Assessment Act 1997. It has a broad scope and means any arrangement, or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise. It would encompass, for example, a common business structure in which a corporate group has a retail company interposed between the group company actually producing the service and the group's customers.

3.29 Whether a purpose of the scheme is to enable Australian customers to receive those services is to be objectively determined. That is done by considering whether a reasonable person, looking at the available information, would conclude that the scheme's purpose was to enable Australian customers to receive those services. It is unnecessary to show that an actual intention of the party or parties to the scheme was to provide those services to Australian customers. Subsection 448(1A) does not require that a purpose of the scheme was to obtain a tax benefit.

3.30 It is enough that a reasonable person would conclude that a purpose of the scheme was to enable those services to be received by Australian customers. That purpose does not have to be the sole or dominant purpose, but an incidental purpose is disregarded. A purpose will be incidental if it is a minor purpose. It may also be incidental if it occurs fortuitously or subordinate to another purpose of the scheme, or merely follows that other purpose as its natural incident.

Example 3.3

Further to Example 3.2, the course of conduct between TelCo and TelPac constitutes a scheme. A reasonable person would, given the facts, conclude that the scheme was entered into or carried out for a purpose of providing services to Australian customers. The purpose is not merely an incidental purpose.

However, a reasonable person would conclude - looking at the arrangement between TelCo and TelUSA, their business plans and the actual sales pattern of TelUSA - that TelCo did not have the required purpose under a scheme involving TelUSA. This would still be true if TelUSA did in fact occasionally provide a few services to Australian customers and this pattern did not change significantly over time.

Example 3.4

Design Co is a controlled foreign company that designs machines for making precision tools. Under an agreement, an associated non-resident group company, Sales Co advertises and sells Design Co's services to the Australian market exclusively.

Under that agreement, when Sales Co contracts with an Australian customer to provide a particular machine design, it then contracts with Design Co to produce the actual design which Sales Co forwards on.

Income from the machine design services provided by Design Co to Sales Co, is income from services provided to an entity that is an associate (Sales Co), and that are received by other entities that are Australian customers.

The use by Design Co of Sales Co to market its machine design services and act as the legal interface with customers is a scheme. Given that Design Co uses Sales Co, a related group company, to market its services exclusively to Australian customers, a reasonable person would conclude that the scheme was entered into or carried out for the requisite purpose.

The income from the services would have been tainted services income if provided directly

3.31 There is a further requirement for the indirect services rule to apply. It must be the case that if the relevant service had been (directly) provided by the company to an Australian customer, then the income from doing so would have constituted tainted services income to the company under another part of section 448 or section 450 (and taking into account the exceptions in subsections 448(2) to (6)). Without this additional requirement, in certain cases income from services provided indirectly (e.g. general insurance) could constitute tainted services income, whereas, if the same services were provided directly, the income from providing the services would not be tainted. [Schedule 3, item 5, paragraph 448(1A)(e)]

Example 3.5

Insure Co, a non-resident company, provides general insurance to Australian based customers. All of Insure Co's insurance policies are reinsured by Reinsure Co, a controlled foreign company and non-resident member of the same corporate group.

Insure Co provides general insurance to the Australian permanent establishment of Foreign Co, an unrelated party. One general insurance policy is for a property of the permanent establishment situated in Australia, and another policy is for an event that could happen outside of Australia.

Assuming that the other requirements of the indirect services rule are met, would the services Reinsure Co provides indirectly to Foreign Co be tainted services income if provided directly?

Reinsure Co directly providing insurance to Foreign Co in respect of the Australian situated property of Foreign Co's permanent establishment would be tainted services income under subparagraph 448(1)(d)(ii). Indirectly providing such insurance (i.e. by reinsuring the policies) would therefore also be tainted services income.

Reinsure Co directly providing insurance to Foreign Co's permanent establishment in Australia in respect of an event that could happen outside of Australia would not be tainted services income under subparagraph 448(1)(d)(iii). Hence, even if all other requirements are met, income relating to this reinsurance is not tainted services income.

Repeal of current provisions applying to the indirect provision of reinsurance

3.32 Current provisions relating to income from providing reinsurance indirectly in certain cases are repealed. The indirect services rule will now cover these cases. [Schedule 3, item 4]

Application and transitional provisions

3.33 The amendments apply to statutory accounting periods of companies beginning on or after 1 July 2004. To avoid doubt, it is expressly stated that these statutory accounting periods include years of income that are assumed to be statutory accounting periods for the purposes of section 23AH. [Schedule 3, item 10]

3.34 The statutory accounting period of a controlled foreign company is, in general, each 12-month period ending 30 June. However, a controlled foreign company can elect for its statutory accounting period to end on a different date. The attributable income of a controlled foreign company, in respect of a particular statutory accounting period, is included in the assessable income of relevant taxpayers in the year of income in which the statutory accounting period ends.

3.35 Tainted services income is also relevant to section 23AH, which operates with respect to the year of income of a taxpayer. Section 23AH (both as it currently is, and as replaced by Schedule 2 to this bill) provides that, in determining adjusted tainted income (which includes tainted services income) and applying the active income test for the purposes of section 23AH, the taxpayer's statutory accounting periods are the same as its years of income.

Chapter 4 - Regulation impact statement

Policy objective

Review of international taxation arrangements

4.1 This bill is a further instalment of the legislative program implementing the reforms the Government announced last year following the review of international taxation arrangements.

4.2 The reforms in this bill will improve the international competitiveness of Australian companies with offshore operations, and will reduce their compliance costs. The reforms will make Australia a more attractive location as a base for regional headquarters for overseas companies, as well as a continuing base for Australian multinational companies.

The objectives of the measures in this bill

4.3 Providing capital gains tax (CGT) relief for the disposal of non-portfolio interests in a foreign company with an active business will provide Australian companies (and their controlled foreign companies) greater flexibility in corporate restructuring decisions. Similar tax consequences will result from the sale of a non-portfolio interest in a foreign company as currently result where the foreign company sells its active foreign business assets and distributes those profits as a dividend.

4.4 The extension of the exemption for non-portfolio dividends and certain foreign branch profits will allow Australian multinationals (and their controlled foreign companies) to compete more effectively in overseas markets by removing the Australian tax liability on active business profits. This will improve flexibility for companies to use capital profits. The measure is also part of a systematic solution to the treatment of conduit income of Australian companies.

4.5 The modifications to the tainted services income rules are designed to improve the competitiveness of Australian companies with offshore operations, by allowing for greater flexibility in dealing with offshore associates, including using service centres to provide services to other offshore group companies. The modifications will also reduce taxpayer compliance costs.

Implementation options

4.6 The measures addressed in this regulation impact statement arise directly from the review of international taxation arrangements. Those recommendations were the subject of extensive consultation. The implementation options for these measures can be found in the Board of Taxation's report, International Taxation - A Report to the Treasurer (the Board's Report) and the Treasury's consultation paper, Review of International Taxation Arrangements (Consultation Paper). Table 4.1 shows where the measures, and principles underlying them, are discussed in these publications.

4.7 Where the Board's Report and the Consultation Paper do not address details in this bill, the implementation options are set out in Table 4.2. The table also sets out options endorsed by the Board of Taxation (the Board) that were not adopted by the Government in this bill.

Assessment of impacts

4.8 The Government, the Board and the business sector have carefully considered the potential compliance, administrative and economic impacts of the measures in this bill.

Impact group identification

4.9 The measures in this bill specifically impact on those taxpayers identified in Table 4.3.

Note: No other data relating to taxpayers affected by measures in this bill are available.

Analysis of costs / benefits

Compliance costs

CGT relief for disposal of a non-portfolio interest in a foreign company with an active business

4.10 For taxpayers seeking the benefits of the CGT exemption, the requirement to calculate the 'active foreign business asset percentage' will impose some new compliance costs on Australian companies (and their controlled foreign companies) that dispose of non-portfolio interests in foreign companies. However, this bill seeks to minimise these costs by allowing taxpayers the choice of using either market value or book value. The way the taxpayer prepares its income tax return for the year of income in which the relevant CGT event happens under this measure is sufficient evidence of the choice.

4.11 Taxpayers may also incur some additional compliance costs if they require advice from the Australian Taxation Office (ATO) and tax professionals in respect of the measure. Taxpayers have the option of forgoing any reduction in a capital gain or ignoring a capital loss so as to avoid these compliance costs.

Extend exemption for non-portfolio dividends and certain foreign branch profits to all countries

4.12 The measure will result in substantial compliance cost savings for companies, with a reduction of over 20 pages of legislation and improvements to the readability of the legislation.

4.13 Australia exempts from company tax non-portfolio dividends (and certain branch profits) received from 63 listed countries. Non-portfolio dividends from companies in listed countries currently comprise around 95% of all foreign non-portfolio dividends received. However, Australian companies with non-portfolio holdings receiving foreign dividends, or with a permanent establishment offshore, must examine income to determine whether an exemption applies. The extended exemption will significantly reduce costs associated with monitoring these amounts.

4.14 The changes will also reduce compliance costs for taxpayers with controlled foreign company interests because it will become unnecessary to track the payment of non-portfolio dividends through offshore companies.

Modified application of the tainted services income rules

4.15 The measure will generally reduce compliance costs for Australian companies, and their offshore subsidiaries, joint-ventures and branches, where those offshore entities provide services to non-resident associates. Compliance costs will be reduced as income from providing such services will no longer need to be attributed to, or (for branches) be included in the assessable income of, the Australian company.

4.16 The removal of services provided to non-resident associates from tainted services income may mean more offshore entities pass the active income test. This may completely remove a small number of offshore entities from the controlled foreign company regime, or (for branches) mean that their income is not assessable income.

Administration costs

CGT relief for disposal of a non-portfolio interest in a foreign company with an active business

4.17 As a result of this measure, the ATO may incur some initial costs in making changes to its material and educating its staff about the measure. It may also incur costs in providing advice to taxpayers, including by public and private rulings. However, none of these costs is likely to be significant.

Extend exemption for non-portfolio dividends and certain foreign branch profits to all countries

4.18 The expanded exemption for dividends received from all countries and for certain foreign branch profits will require changes in ATO administration systems. An education campaign for taxpayers will also be necessary.

4.19 There may also be a slight increase in administration costs to monitor potential avoidance under the new rules. On the other hand, the simplified law will also have administrative benefits.

Modified application of the tainted services income rules

4.20 The administration cost impact of this measure should be minimal. Administration of a new rule dealing with services provided indirectly to Australian residents may require interpretation products such as rulings. Potential behavioural response to the modified rules could require the ATO to develop new audit products and practices.

Government revenue

4.21 The financial impact of these measures will be a loss to the revenue over financial years as outlined in Table 4.4.

Economic benefits

CGT relief for disposal of a non-portfolio interest in a foreign company with an active business

4.22 This measure will align more closely the tax treatment of selling an interest in a foreign company (that has an active business) with the tax outcome that would result if the foreign company disposed of its active foreign business assets and distributed those profits to its shareholders. In other words, there will be no liability to Australian tax if an Australian company (or its controlled foreign company) sells a non-portfolio interest in a foreign company or if the Australian company (or its controlled foreign company) procures the foreign company to sell its active assets and distribute those profits as a dividend.

4.23 This will increase flexibility in corporate restructuring decisions, and will provide an exemption to Australian companies similar to what is currently available in many European countries. This will ensure that Australian companies are not at a competitive disadvantage when they seek to invest offshore, and will encourage foreign groups to establish a regional headquarters in Australia.

Extension of the exemption for non-portfolio dividends and certain foreign branch profits to all countries

4.24 The measure will assist Australian companies investing in foreign countries to be more competitive with foreign counterparts, as they will not be required to pay additional Australian tax on foreign active business income. It will also remove income tax impediments for companies who distribute profits from countries not currently eligible for an exemption, but who will benefit from the extended exemption.

4.25 The substantial compliance cost savings for companies will also provide economic benefits.

Modified application of the tainted services income rules

4.26 The measure will allow Australian multinationals to better compete internationally, with negligible risk to the tax base. It will also provide a more neutral treatment of services provided to group companies by offshore group service centres. Achieving these outcomes will increase Australia's ability to retain and attract multinationals and regional headquarter operations.

Consultation

4.27 Business, legal and accounting representatives and the ATO have been consulted extensively and have actively assisted in developing these initiatives. This involved the establishment of an advisory group constituted by members of industry and professional peak bodies to help in the design of legislation. The more technical issues and the details of the measures, or those that affect a specific interest group, were referred to particular sub-groups. In addition, direct discussions with taxpayers affected by these measures were undertaken as necessary.

4.28 Suggestions on the legislative details of the measures made by working group members were adopted where they were consistent with the intended policy objectives and the integrity of the measures. The consultative groups have been supportive of the consultation process and of the final form of the measures.

Conclusion

4.29 The measures in this bill are a further instalment of reforms to implement the Government's response to the review of international tax arrangements. The measures are consistent with the Government's policy objectives of improving the international competitiveness of Australian companies (and their controlled foreign companies) while maintaining the integrity of Australia's international tax rules.

4.30 The provision of CGT relief for the disposal of non-portfolio interests in a foreign company with an active business will give Australian multinationals greater flexibility in the use of their capital. While this necessarily involves some compliance costs to be incurred by taxpayers in order to receive the consequent benefits, these costs have been minimised to the extent possible within integrity concerns. The extension of the exemption for non-portfolio dividends and certain foreign branch profits will substantially reduce compliance costs for taxpayers while improving their international competitiveness. Reducing the scope of tainted services income will improve the competitiveness of Australian companies with offshore operations, and reduce their compliance costs. Apart from the addition of new law for the CGT measure, these measures have enabled some substantial improvements to the law in this area. It will be more easily understood.

Index

Schedule 1: CGT concession: active foreign companies

Schedule 2: Foreign branch income, non-portfolio dividends and listed countries

Schedule 3: Tainted services income