View full documentView full document Previous section | Next section
House of Representatives

Taxation Laws Amendment (Foreign Income Measures) Bill 1997

Explanatory Memorandum

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

Chapter 1 - General outline and financial impact

Purpose of the bill

Overview

1.1 The Bill contains provisions to amend the Income Tax Assessment Act 1936 (the Principal Act) to give effect to changes to the taxation of foreign source income that were announced in the 1997-98 Budget. The changes were foreshadowed in an Information Paper (IP) released by the Treasurer on 24December 1996 for public consultation.

1.2 Broadly, the amendments will:

·
create two lists of countries for the purposes of:

-
accruals taxation under the controlled foreign company (CFC) and transferor trust measures; and
-
exemptions under the foreign tax credit system (FTCS);

·
give effect to measures to help reduce compliance costs under the CFC measures;
·
make a number of changes to the rules for taxing offshore permanent establishments (ie, "branches") of Australian companies;
·
give effect to a number of consequential changes and transitional rules; and
·
make two changes to the foreign investment fund (FIF) measures.

1.3 An outline of the changes is provided below. There is an overview of the current regime for taxing foreign source income in Chapter 2 (page 13).

1.4 Unless otherwise stated, section references are to provisions of the Principal Act and item references are to provisions in Schedule 1 of the Bill.

Changes to the list of countries

1.5 The amendments will make the following structural changes to the foreign source income measures:

·
a list of seven countries (called "broad-exemption listed countries") will be introduced for the purposes of exempting amounts from accruals taxation under the CFC and transferor trust measures; and
·
a longer list of countries (called "limited-exemption listed countries") will be used together with the list of broad-exemption countries for the purposes of exemptions under the FTCS.

1.6 Countries on either the broad-exemption list or on the limited-exemption list will be called "listed countries".

1.7 These amendments are discussed in Chapter 3 (page 17).

Measures to reduce compliance costs

1.8 The amendments make the following changes which will help reduce compliance costs under the CFC measures:

·
the active income test for CFCs in unlisted countries will be applied to all CFCs;
·
amounts derived by a CFC from an associated CFC resident in the same country will no longer be treated as tainted services or tainted rental income if the amounts are subject to the country's normal company tax and do not reduce the attributable income of the associated CFC;
·
the transfer pricing rules will not apply to transfers between CFCs in the same broad-exemption listed country when calculating the attributable income of a CFC;
·
the thin capitalisation and debt creation rules will no longer apply when calculating the attributable income of a CFC; and
·
the rules for making elections in relation to CFCs will be relaxed.

1.9 These amendments are discussed in Chapter 4 (page 27).

Changes to the treatment of branches

1.10 The amendments are to make the following changes to the treatment under the FTCS of branches of Australian companies in limited-exemption listed countries:

·
the exemption provided under section23AH will generally not be available for branch income that is adjusted tainted income;
·
the passive income of a branch conducting life assurance activities will not be reduced under subsection446(2);
·
a branch and its Australian head office are to be treated as separate legal entities for the purpose of determining whether the branch has derived tainted sales income;
·
branches of Australian financial institutions (AFIs) will be provided with an exemption for banking income broadly consistent with the exclusion from accruals taxation available for AFI subsidiaries; and
·
an active income test concession will be provided to allow branches to derive up to 5% of gross turnover as tainted income and still obtain full exemption under section 23AH for income amounts.

1.11 These amendments are discussed in Chapter 5 (page 39). The treatment of branches in broad-exemption listed countries and in unlisted countries will not change.

Consequential changes and transitional rules

1.12 The amendments will give effect to the following consequential changes and transitional rules:

·
the taxation of a CFC's retained profits under section 457 will be modified in cases where the CFC is treated as changing residence because of changes to the list(s) of countries;
·
taxpayers will have the option of treating states emerging from the dissolution of Czechoslovakia, the USSR and Yugoslavia as listed countries:

-
for statutory accounting periods of CFCs and years of income of transferor trusts commencing before the release of the IP; and
-
prior to the release of the IP for the purposes of applying exemptions under the FTCS and other provisions dealing with taxation on the repatriation of profits;

·
exempting profits will be able to arise for a CFC in the Slovak Republic or a state arising from the dissolution of Yugoslavia or the USSR for the part of a statutory accounting period remaining following the release of the IP;
·
the Czech Republic and Vietnam will be treated as listed countries from the release of the IP for the purposes of applying provisions that ensure low taxed profits are comparably taxed at some point prior to repatriation to Australia (ie, sections 47A, 458 and 459):

-
the Czech Republic will also be treated as a listed country from the release of the IP for the purposes of exemptions from the FTCS;

·
it will be clarified that Hong Kong is still an unlisted jurisdiction following the establishment of the HongKong Special Administrative Region of the People's Republic of China on 1 July 1997;
·
an amount will generally be included in the attributable income of a CFC in:

-
a limited-exemption listed country if the amount was not derived from sources within the country and was not subject to tax in a listed country; and
-
a broad-exemption listed country if the amount is adjusted tainted income, was not derived from sources within the country and was not subject to tax in a broad-exemption listed country;

·
an amount derived by an unlisted country company through a branch in a limited exemption listed country will be an exempting receipt if the amount is not adjusted tainted income and is taxed in a listed country;
·
subsection431(4) will not operate to deny a CFC's prior year losses if the CFC is treated as changing residence solely as a result of changes to the list(s) of countries;
·
a credit is to be available for foreign tax forgone on income subject to accruals taxation under the CFC measures where tax sparing provisions of a double taxation agreement require that a credit be provided;
·
paragraph436(1)(b) will not operate to exclude amounts from the active income test which are derived in a CFC's country of residence; and
·
amendments to the Income Tax Regulations giving effect to the changes to the foreign source income measures will be able to apply from the commencement of the changes to the Principal Act.

1.13 These amendments are discussed in Chapter 6 (page 51).

Changes to the FIF measures

1.14 The following two amendments are to be made to the FIFmeasures:

·
the exemption for approved country funds (section 513) is to be repealed; and
·
the Bogota, Colombo, Zimbabwe and Bratislava stock exchanges are to be added to the list of approved stock exchanges.

1.15 These amendments are discussed in Chapter 7 (page 75).

Commencement date

1.16 The two list approach and measures to reduce compliance costs under the CFC measures (apart from the changes to the rules for making elections) will apply in calculating attributable income for statutory accounting periods of CFCs and years of income of transferor trusts commencing on or after 1 July 1997. The changes to the rules for making elections will apply from the time the Bill receives the Royal Assent. The two list approach will apply from 1July 1997 for the purposes of determining whether amounts derived by a resident company are exempt under the FTCS.

1.17 The repeal of the approved country fund exemption will apply for notional accounting periods of FIFs commencing on or after 1 January 1997. New stock exchanges are to be added to the list of approved stock exchanges with effect from the release of the IP.

1.18 Details of the commencement arrangements are provided in the discussion of each measure.

Financial impact

1.19 The changes made by this Bill are expected to result in a revenue gain of $125million in the 1998-99 financial year and $100million for subsequent years. Further details on the financial impact of the changes are discussed below in the following regulation impact statement (refer in particular to paragraphs 1.39 & 1.40).

Regulation impact statement

Policy objectives

1.20 The main policy objective of the amendments announced in the 1997-98 Budget is to address problems which have arisen because the current list of countries for providing exemptions from accruals taxation under the CFC and transferor trust measures is not suitable for that role.

1.21 These problems have been encountered because there are many countries on the list that do not consistently levy tax on a basis closely comparable to Australia. In this regard, it is important that only closely comparable tax countries are listed for the purposes of providing exemptions from accruals taxation. Amounts subject to accruals taxation arise from investments and arrangements that are most likely to be influenced by taxation considerations and thus the location of those investments are likely to be significantly influenced by more favourable taxation treatment offshore. Accruals taxation of these investments is therefore crucial to ensure investments offshore are not favoured over similar investments in Australia for purely taxation reasons.

1.22 Another policy objective of the amendments is to give effect to changes that will help reduce compliance costs under the CFC measures. These changes are being made to help keep compliance costs for legitimate business operations offshore at a minimum.

1.23 The other amendments are required for the general maintenance of the system for taxing foreign source income. The amendments will:

·
update the current list of countries which will continue to be used for the purposes of providing exemptions under the FTCS;
·
remove the "approved country fund" exemption in the FIF measures which is no longer justified following substantial investment liberalisation in emerging markets; and
·
update the list of stock exchanges that can be used to ascertain the value of FIF interests.

1.24 The regulation impact of the amendments is discussed below.

Implementation

1.25 Problems arising because the current list of countries is unsuitable for providing exemptions from accruals taxation will be addressed by creating a new list of broad-exemption countries which will be prescribed in the Income Tax Regulations. Consequential amendments of the Principal Act will also be required for the purposes of calculating attributable income.

1.26 To avoid the need to calculate attributable income for a part period, amendments giving effect to the broad-exemption list will first apply for statutory accounting periods of CFCs and years of income of transferor trusts commencing after 30 June 1997. In some cases this will defer revenue collected from the changes by up to twelve months. Consequential amendments will also be required for the exemption available under the FTCS for branch profits derived by resident companies in listed countries (ie, section 23AH). These amendments will apply from 1 July 1997 (ie, from the creation of the new list).

1.27 The measures to help reduce compliance costs under the CFC measures are largely made possible by the creation of a new list for providing exemptions from accruals taxation or are being made to ameliorate the additional compliance burden arising from restricting the exemptions to a shorter list of countries. The amendments to the Principal Act giving effect to these changes will therefore apply from the time the new list applies (ie, for statutory accounting periods of CFCs commencing after 30 June 1997). The measures to reduce compliance costs not linked with the creation of a new list will apply prospectively from the time the amending Bill receives the Royal Assent.

1.28 The current list of countries in the Income Tax Regulations will be updated and become a list of limited-exemption countries from 1 July 1997. The list of limited-exemption countries will be used together with the list of broad-exemption countries for the purposes of providing exemptions under the FTCS. Transitional rules in the amending Bill will apply to deal with uncertainty arising from the dissolution of a number of countries on the current list. These rules will operate from the time of dissolution of the countries. The Income Tax Regulations will be amended to remove the countries from the list. Amendments of the Principal Act will also provide rules to reduce the extent to which taxpayers may be disadvantaged by changes to the lists of countries. These rules will apply from 1 July 1997 (ie, from the time countries are to be added to the list of limited-exemption countries).

1.29 The removal of the approved country fund exemption in the FIF measures from 1January 1997 as announced in the IP will be achieved by the repeal of the exemption. The addition of stock exchanges to the list of approved stock exchanges from 24December 1996 will be implemented by amending the Income Tax Regulations.

Assessment of impacts

Creation of a new list of broad-exemption countries

1.30 The creation of a new list of countries for providing exemptions from accruals taxation will improve the effectiveness of the CFC and transferor trust measures. The tightening of exemptions from accruals taxation through the use of a more appropriate list will help ensure that competitive investment opportunities in Australia are not overlooked because of tax deferral opportunities available offshore. It will also help stem the erosion of the Australian tax base that could otherwise occur through payments from Australian profits to foreign subsidiaries (eg, for loans, the use of patents, the provision of services).

1.31 This change will affect Australian residents that control offshore companies and trusts. Taxpayers subject to the changes could broadly be described as Australian based multinationals. Branches of Australian companies in limited-exemption listed countries and some high wealth individuals will also be affected.

1.32 The creation of a separate list for accruals taxation purposes will increase compliance costs in some cases for Australian residents that control companies and trusts in limited-exemption listed countries. The new list will have little impact, however, on companies and trusts resident in broad-exemption listed or unlisted countries. An overall reduction in compliance costs is expected for CFCs in these countries because of measures being adopted to help reduce compliance costs.

1.33 The initial cost of compliance for companies and trusts in limited-exemption listed countries is estimated to be less than $5million. This includes the cost of obtaining external advice for the tax changes, internal training, record keeping and from implementing the changes. The impact of measures to help reduce compliance costs under the CFC measures were also taken into account. It is estimated that 1,000entities will be affected by the changes.

1.34 The recurrent costs of compliance for companies and trusts in limited-exemption listed countries is estimated to be less than $1million. Most of the costs for CFCs are likely to arise for companies that fail the active income test in the CFC measures. The costs will therefore be primarily borne by companies that derive significant amounts of tainted income. The initial and recurrent costs of compliance resulting from the tax changes for branches in limited-exemption listed countries are estimated to be less than $1million.

1.35 An effect of the measures to help reduce compliance costs under the CFC measures is the risk that tax avoidance opportunities may be increased. This risk is reduced by the adoption of a more robust list for providing exemptions from accruals taxation.

Update of the current list for use as a list of limited-exemption countries

1.36 The update of the current list of countries is required for the general administration of the rules for taxing foreign source income and will affect resident companies that have branches or companies in countries added to the list. Compliance costs will decrease for these holdings because of exemptions available under the FTCS for amounts derived in listed countries. The removal from the list of countries that have ceased to exist will not affect taxpayers. The compliance costs of transitional rules to deal with uncertainty arising from the dissolution of listed countries and the rules to reduce the extent to which taxpayers may be disadvantaged by future changes to the list are estimated to be less than $1million.

Changes to the FIF measures

1.37 The repeal of the approved country fund exemption in the FIF measures will remove the tax bias created by the exemption in favour of investing in approved country funds and will affect taxpayers with interests in these funds. The addition of stock exchanges to the list of approved stock exchanges will reduce compliance costs under the FIF measures because taxpayers will be able to use the value of FIF interests quoted on the exchanges for the purposes of calculations under the measures. The change will affect taxpayers with FIF interests quoted on stock exchanges added to the list.

Administrative costs

1.38 The additional administrative costs arising from implementing the above changes to the rules for taxing foreign source income are estimated to be less than $1million. This includes the costs of updating return form material, staff training, responding to enquiries and revising compliance strategies. Many of these costs will be absorbed as part of the ongoing administration of the existing rules for taxing foreign source income.

Financial impact

1.39 The annual revenue gain from the proposed changes and the decision to generally not provide tax sparing in future double taxation agreements (as announced in the IP) is estimated to be $150million in the 1998-99 financial year and for subsequent years. Of this amount it is expected that changes made by this Bill will result in a revenue gain of $125million in the 1998-99 financial year and $100million for subsequent years. The balance of the revenue gain is attributable to the decision to generally not provide tax sparing in future double taxation agreements.

1.40 It is expected that a significant portion of the revenue from measures in this Bill will arise due to changes in investment behaviour and be collected under the general provisions of the Principal Act rather than directly under the CFC or transferor trust measures.

Consultation

1.41 There have been two rounds of public consultation on the changes to the rules for taxing foreign source income. The first round was on policy issues following the release by the Treasurer of the IP on 24December 1996. The views expressed in submissions were taken into account in settling the changes announced in the 1997-98 Budget. The following changes to help reduce compliance costs were adopted after consideration of the submissions:

·
the active income test for CFCs in unlisted countries will be applied to all CFCs;
·
amounts derived by a CFC from an associated CFC resident in the same country will no longer be treated as tainted services or tainted rental income if the amounts are subject to the country's normal company tax and do not reduce the attributable income of the associated CFC;
·
the transfer pricing rules will not apply to transfers between CFCs in the same broad-exemption listed country when calculating the attributable income of a CFC;
·
the thin capitalisation and debt creation rules will no longer apply when calculating the attributable income of a CFC; and
·
the rules for making elections in relation to CFCs will be relaxed.

1.42 The second round of consultation was on legislation giving effect to the changes that was released in draft form on 1 July 1997. One change was made to the draft legislation after this round of consultation. The change corrects a minor technical problem in the active income test for broad-exemption listed country CFCs (the amendment is discussed on page 72).

Conclusion

1.43 The proposed changes will improve the effectiveness of the rules for the accruals taxation of foreign source income and thereby help ensure that investments offshore are not favoured over similar investments in Australia for purely taxation reasons. Improving the effectiveness of the rules will also help stem the erosion of the Australian tax base that could otherwise occur through payments from Australian profits to foreign subsidiaries. The changes are expected to result in a revenue gain of $125million in the 1998-99 financial year and $100million for subsequent years.

1.44 The creation of a shorter list of countries for providing exemptions from accruals taxation is likely to result in some increase in compliance costs for companies and trusts in limited-exemption listed countries. These costs are considered necessary, however, to ensure the policy objectives are met. Most of the additional compliance burden for CFCs will be borne by companies that derive significant amounts of tainted income. These companies are the legitimate target of the CFC measures.

1.45 However, compliance costs will not increase for all CFCs. The changes being made to help reduce compliance costs under the CFC measures are likely to result in an overall reduction in compliance costs for most CFCs in broad-exemption listed countries.

1.46 The Treasury and the Australian Taxation Office will continue to monitor the rules for taxing foreign source income to ensure the rules are operating appropriately.

Chapter 2 - Overview of the foreign source income regime

Overview

2.1 The regime for taxing foreign source income comprises:

(i)
the controlled foreign company (CFC) measures (Part X);
(ii)
the foreign investment fund (FIF) measures (Part XI);
(iii)
the transferor trust measures (Division 6AAA of Part III);
(iv)
other measures in Division 6 of Part III relating to the taxation of interests in non-resident trusts; and
(v)
the foreign tax credit system or "FTCS" (Division 18 of Part III and related provisions).

2.2 The proposed changes impact primarily on the CFC measures and to a lesser extent on the transferor trust measures and the foreign tax credit system. Minor changes are to be made to the FIF measures.

Outline of the CFC measures

Policy objectives

2.3 The objective of the CFC measures is to tax Australian shareholders on their pro rata share of a CFC's tainted income (ie, passive, tainted sales and tainted services income) as it is earned unless the income is comparably taxed offshore or the CFC satisfies an active income test. Broadly, tainted income arises from investments and arrangements that are likely to be significantly influenced by taxation considerations. Examples of tainted income include interest, royalties, dividends and amounts arising from certain related party transactions.

2.4 The CFC measures focus on tainted income because it is the most mobile form of income and is thus readily diverted for tax planning purposes to avoid or defer Australian tax. Transactions involving tainted income are also most easily used to divert income properly sourced in Australia to foreign entities through transfer pricing practices or by giving income an artificial foreign source. The taxation of tainted income as it is earned ensures that investments offshore that produce tainted income are not favoured over similar investments in Australia for purely taxation reasons.

2.5 Active income (ie, income other than tainted income) is generally exempt from accruals taxation under the CFC measures to allow Australian businesses to compete effectively in low tax countries. This exemption is not considered a serious risk to the revenue or the Australian economy because the location of investments that produce active income tend to be primarily influenced by considerations other than tax. It is therefore less likely that these investments will be undertaken offshore for taxation reasons. An exemption is also provided for tainted income where a CFC satisfies an active income test (section 433) in recognition that a CFC may derive small amounts of tainted income that are incidental to an active business.

2.6 A list of countries (Appendix C) is currently used to reduce compliance and administrative costs of the CFC measures. The costs are reduced by providing an exemption for most types of income that have been taxed in a listed country. The exemption is provided on the basis that only limited tax deferral opportunities are available in listed countries and concessions which offer deferral opportunities can be identified and designated in the Income Tax Regulations.

Operation of the current CFC measures

2.7 Under the CFC measures, Australian taxpayers are liable to pay tax, on a current year basis, on income or gains earned by foreign companies in which they have a controlling interest, notwithstanding that the income or gains have not yet been derived by the taxpayers. The Australian controllers of a CFC are called "attributable taxpayers".

2.8 An attributable taxpayer is required to include in assessable income its share of the attributable income of the CFC (section 456). Subject to some modifications, the attributable income of a CFC is calculated using the same tax rules that apply to Australian resident companies. The amount of a CFC's attributable income depends on whether the CFC is resident in a "listed" or "unlisted" country and on whether the CFC's activities are such that it may take advantage of the exemption for active income.

2.9 Generally, all income of a tainted nature derived by a CFC resident in an unlisted country is attributable if the CFC fails the active income test. In contrast, the attributable income of a listed country CFC normally includes only concessionally taxed amounts of narrowly defined tainted income (ie, eligible designated concession income or "EDCI") which is also tainted under the broader definition of tainted income in the CFC measures (ie, "adjusted tainted income"). The rules for determining whether an amount is EDCI are provided in section 317 of the Principal Act and Part 8A of the Income Tax Regulations.

2.10 Appendix A provides a diagrammatic summary of the current CFC measures.

Outline of the transferor trust measures

2.11 The transferor trust measures attribute the income of a non-resident trust to an Australian resident who has, directly or indirectly, transferred value to the trust. Broadly, this treatment will apply if the trust is treated as a resident of an unlisted (ie, low tax) country, or has derived EDCI from a listed country, and the transfer was made:

·
in the case of a discretionary trust, at any time; or
·
in the case of a non-discretionary trust, after 12 April 1989.

Outline of the FIF measures

2.12 The FIF measures apply to Australian resident taxpayers who have an interest in a foreign company or trust at the end of a year of income that is not subject to the CFC or transferor trust measures. The measures also apply to taxpayers who hold a foreign life policy at any time during a year of income.

2.13 Broadly, the FIF measures operate to approximate a resident taxpayer's share of the undistributed profits of a FIF (called FIF income) and to assess the taxpayer on those profits. This treatment is directed at preventing the deferral of Australian tax where profits are accumulated offshore in a FIF rather than remitted to Australian investors.

2.14 Exemptions from the FIF measures are provided for a wide range of investments in active businesses where the risk of tax deferral is not likely to be significant. Exemptions are also available to exclude interests in FIFs that are not the target of the measures (eg, a small investor exemption is provided for individuals who hold investments in FIFs and FLPs not exceeding $50,000 in value).

Outline of the FTCS

2.15 Foreign source income derived by an Australian resident is generally subject to Australian income tax (eg, subsection 25(1)) and a credit for foreign tax paid on the income is allowed against the Australian tax payable under the FTCS. The credit cannot exceed the amount of Australian tax that would otherwise be payable on the foreign income.

2.16 A resident taxpayer can claim a credit for foreign dividend withholding tax paid on an assessable dividend from a foreign company. In addition, a resident company that receives a dividend from a "related" foreign company is allowed a credit for foreign tax paid by the foreign company on profits out of which the dividend was paid (ie, "underlying tax").

2.17 A foreign company is related to an Australian company if the Australian company has a direct voting interest of at least 10% of the voting power of the foreign company. This relationship can extend through any number of tiers of foreign companies.

2.18 An exemption under section 23AJ applies to non-portfolio dividends paid to Australian resident companies from comparably taxed profits. A dividend is a non-portfolio dividend if it is paid to a company that holds at least 10% of the voting power in the company paying the dividend. Broadly, a non-portfolio dividend derived by a resident company will be exempt under section 23AJ if the dividend was:

·
paid by a listed country company out of profits which have not been previously attributed to the taxpayer (section 23AI applies to exempt dividends paid from previously attributed profits); or
·
paid by an unlisted country company out of profits that have been fully taxed in Australia or in a listed country.

2.19 An exemption is provided for dividends paid from profits taxed in listed countries because the potential Australian tax liability on the dividends would be largely offset by a credit for foreign tax. In theory, the exemption under section 23AJ achieves the same result as the FTCS but relieves Australian companies from the compliance burden associated with claiming a credit for foreign tax.

2.20 Section 23AH provides a similar exemption for amounts derived by an Australian company through a branch in a listed country. The exemption is available for foreign income derived by an Australian company from a business conducted through a branch in a listed country where the income is not EDCI and is subject to tax in the listed country. The exemption can also apply to a capital gain on the disposal of land, a building or depreciable property used by the branch in the conduct of its business.

Chapter 3 - Creation of a new list for accruals taxation purposes

Summary of the amendments

Purpose of the amendments

3.1 This Chapter will discuss amendments necessary to create a list of broad-exemption countries. The list, comprising seven countries, will be used to determine whether amounts of tainted income have been comparably taxed and should therefore be exempt from accruals taxation under the CFC and transferor trust measures. A list of limited-exemption countries will be used together with the list of broad-exemption countries for the purposes of exemptions under the FTCS. Countries on these lists taken together will be referred to as listed countries.

Date of effect

3.2 The creation of two lists is to apply in calculating attributable income for statutory accounting periods of CFCs and years of income of transferor trusts commencing on or after 1 July 1997. For other purposes (eg, the taxation of dividends and branch profits) the changes are to apply from 1July 1997. The commencement arrangements are discussed in more detail later in the Chapter.

Background

3.3 Problems have been encountered under the CFC measures because the current list of countries (Schedule 10 of the Income Tax Regulations (Appendix C)) has been used for two distinct purposes that would have been best served by separate lists. The same list has been used:

·
for the purposes of determining when income should be exempt from accruals taxation under the CFC measures; and
·
to determine when dividends and branch profits derived by resident companies should be exempt under the FTCS (sections23AJ and 23AH respectively).

3.4 The countries on the current list have tax regimes sufficiently comparable for the purposes of exemptions under the FTCS. However, a higher degree of comparability is required for the purposes of exemptions from accruals taxation under the CFC measures. It is important that only closely comparable tax countries are listed for the purposes of the CFC measures because the CFC measures deal primarily with the taxation of tainted income. Tainted income arises from investments and arrangements that are most likely to be influenced by taxation considerations and thus the location of those investments are likely to be significantly influenced by more favourable taxation treatment offshore. Accruals taxation of non comparably taxed tainted income is therefore crucial to ensure investments offshore are not favoured over similar investments in Australia for purely taxation reasons.

3.5 A shorter list will also make the task of designating tax concessions more manageable. Broadly, an amount will not be exempt from accruals taxation under the CFC measures (or under the FTCS where derived by a branch) if the amount is EDCI. Efforts to designate tax deferral opportunities in listed countries have had only limited success and are made more difficult by the large number of countries that must be monitored. The risks to the revenue associated with not designating a tax deferral opportunity are significant because tainted income by its nature can easily be diverted to take advantage of the opportunity.

3.6 The list of broad-exemption countries will comprise:

Canada
France
Germany
Japan
New Zealand
United Kingdom of Great Britain and Northern Ireland
United States of America

3.7 These countries will be designated in the Income Tax Regulations as broad-exemption listed countries.

3.8 The list will also apply for the purposes of exemptions from accruals taxation under the transferor trust measures (Division 6AAA of Part III). The following diagram provides a general outline of the treatment of CFCs for accruals taxation purposes under the two list approach.

Summary of accruals taxation under a two list approach

Accruals taxed if the active income test is failed

3.9 Countries on the current list have tax regimes sufficiently comparable for the purposes of exemptions under the FTCS because the exemptions apply to amounts derived from investments and arrangements that are less sensitive to taxation considerations. A list of limited-exemption countries, comprising countries on the current list (with minor updating) and excluding broad-exemption listed countries, will be designated in the Income Tax Regulations (AppendixD).

3.10 The list of limited-exemption countries will be used together with the list of broad-exemption listed countries for the purposes of exemptions under the FTCS. The exemptions will therefore generally continue to be available for dividends and branch profits derived from either broad-exemption listed countries or limited-exemption listed countries (ie, from listed countries). The following diagram provides a general outline of the taxation of dividends under the two list approach.

Summary of dividend taxation under a two list approach

Dividends paid from profits that have been taxed on an accruals basis under the CFC measures are exempt under section 23AI.

Explanation of the amendments

Terminology

3.11 The new terms for referring to countries will be defined in section320 which currently defines "listed" and "unlisted" countries. References to the new terms will also be included in section 317. The new terms are summarised below.

Broad-exemption listed countries

3.12 There will be seven broad-exemption listed countries. The term "broad-exemption" reflects that amounts taxed at full rates by countries on the short list are generally exempt from both accruals taxation and taxation on repatriation to Australia. [Items 18 & 26]

Limited-exemption listed countries

3.13 Limited-exemption listed countriesare countries on the longer list of countries. The term "limited-exemption" reflects that amounts taxed at full rates by countries on the longer list are generally exempt from tax on repatriation to Australia. An exemption from accruals taxation will, however, no longer be provided for amounts of tainted income that have been taxed in a limited-exemption listed country. [Items19 & 27]

Listed countries

3.14 Listed countries arecountries on the list of broad-exemption listed countries or on the list of limited-exemption listed countries. [Item28]

Unlisted countries

3.15 Unlisted countries are countries that are not on either list.

Non-broad-exemption listed countries

3.16 Non-broad-exemption listed countries are countries that are not on the list of broad-exemption countries. They comprise unlisted countries or countries on the list of limited-exemption countries. [Items20 & 29]

3.17 Section 332, which currently provides rules for determining whether a CFC is a resident of a listed country, will be repealed. New sections332 and 332A will be inserted to provide rules for determining whether a company is a resident of a broad-exemption listed or a limited-exemption listed country. A company that is resident of both a broad-exemption listed country and a limited-exemption listed country will be treated as a resident of broad-exemption listed country. [Items31 & 32]

Treatment of broad-exemption listed countries

3.18 Only broad-exemption listed countries will be treated as listed for the purposes of provisions in the following table. The provisions deal with the accruals taxation of CFCs and transferor trusts. References to "listed countries" and "unlisted countries" in the provisions will be changed to "broad-exemption listed countries" and "non-broad-exemption listed countries" respectively.

Table of provisions for which only broad-exemption listed countries will be treated as listed
Affected provision Outline of the provision's effect Items making the changes
Division 6AAA (Transferor trust measures) The transferor trust measures attribute the income of a non-resident trust to an Australian resident who has, directly or indirectly, transferred value to the trust 7, 8, 9, 10, 11, 12, 13, 14, 15, 58, 59, 60, 61, 62, 63, 64, 65, 66, 67, 68, 69, 70, 71, 72, 73, 74, 75, 76, 77, 106 & 114
Definition of "accruals tax law" The term is used in section 456A which provides a reduction in attributable income for amounts that have been taxed under an accruals tax law of another country 78
Definition of "designated concession income" (Section 317) "Designated concession income" (DCI) comprises low taxed amounts of narrowly defined tainted income as determined in accordance with rules provided in the Income Tax Regulations. DCI is used for the purposes of the definition of "eligible designated concession income". 79
Definition of "eligible designated concession income" (Section 317) "Eligible designated concession income" (EDCI) comprises amounts of DCI that are not subject to full tax in another listed country. Non-EDCI amounts derived in a listed country are generally exempt from Australian tax. 80
Definition of "tainted rental income" (Section 317) "Tainted rental income" is a component of "passive income" 81, 82, 83, 84, 107, 108, 115 & 116
Sections 384 and 385 (not including sub-subparagraph 385(2)(a)(ii)(C)) Assumptions for calculating the attributable income of unlisted and listed country CFCs respectively 34, 85, 86, 87, 88, 89, 90, 91, 92, 93 & 117
Paragraph 403(a) Exemption from accruals taxation for profits derived by an unlisted country CFC through a branch in a listed country 94
Section 418A Gains on non-taxable Australian assets derived by a CFC that was formerly an Australian company are calculated from the time the company became a CFC 95 & 118
Section 419 Group company rollover relief for calculating capital gains derived by a CFC 45, 96 & 119
Subsection 431(4) Prior year losses are not available for a listed country CFC if they were incurred when the CFC was a resident of an unlisted country. Similarly, prior year losses are not available for an unlisted country CFC if they were incurred when the CFC was a resident of a listed country. 49
Paragraphs 432(1)(b) and (e) Requires that a company must be a resident of a particular country throughout a statutory accounting period to satisfy the active income test 97, 98, 109 & 110
Paragraph 436(1)(b) Excludes profits derived through a branch in a listed country from the active income test 99, 100 & 101
Subparagraph 437(1)(c)(iii) Treatment of partnership income for the purposes of the active income test 102 & 111
Subsection 437(2) Allows a company to satisfy the residency requirement in the active income test where the company is a partner of a partnership that carries on business through a branch in a particular country 103 & 112
Section 456A Reduces attributable income for amounts that have been taxed under an accruals tax law of another country 104

Treatment of listed countries

3.19 References to "listed countries" in provisions outlined in the following table will not change. The provisions will therefore apply toboth broad-exemption listed countries and limited-exemption listed countries. The provisions ensure that low taxed profits derived through companies offshore are taxed in a listed country at some point prior to repatriation to Australia. They also provide exemptions under the FTCS for amounts that have been taxed in a listed country.

Table of provisions for which both broad-exemption listed countries and limited-exemption listed countries will be treated as listed
Affected provision Outline of the provisions effect
Section 23AH (other than paragraphs (1)(c), (6)(f) & (7)(f)) Exemption for certain foreign branch profits of Australian companies
Section 23AJ Exemption for non-portfolio dividends received by resident companies
Section 63D Ensures that a deduction is not allowable for writing off debts of a foreign branch where the income of the branch is exempt under section 23AH
Division 18 of Part III Calculation of a credit that can be claimed for foreign tax
Subsections 160M(12A), (12AB) and (12B) Modifications to the rules for taxing the disposal of assets by a former CFC where the assets were held prior to the company becoming a resident of Australia
Section 160ZFB Reduction of a capital gain derived by a CFC on disposing of a taxable Australian asset to the extent the gain has been taxed previously under section 457
Section 324 Rules for determining whether an amount has been subject to tax in a listed country
Section 325 Rules for determining whether an amount has been taxed at the normal company rate
Subsection 371(8) Election to defer attribution credit for amounts included in assessable income under section 457
Sections 377, 378 and 379 Rules for identifying and tracing profits that can be distributed by unlisted country companies as exempt dividends under section 23AJ
Section 380 Rules for determining the extent to which a dividend paid to an Australian resident company can be exempt under section 23AJ
Paragraph 403(b) Exemption from accruals taxation for a non-portfolio dividend received from a CFC resident in a listed country
Section 404 Exemption from accruals taxation for dividends received from a CFC resident in a listed country
Section 422 Reduction of a capital gain derived by a CFC on disposing of a non-taxable Australian asset to the extent the gain has been taxed previously under section 457
Paragraph 436(1)(e) Exclusion from the active income test for non-portfolio dividends derived from listed country companies
Subsection 456(2) Reduction of attributable income for amounts taxed under section 457
Section 457 Accruals taxation of a CFCs distributable profits where the CFC changes residence from an unlisted country to a listed country or Australia
Section 458 Accruals taxation of non-portfolio dividends paid by an unlisted country CFC to a listed country CFC (or to certain trusts and partnerships) where the dividends are not taxed in the listed country at the normal company tax rate
Section 459 Accruals taxation of deemed dividends under section 47A that are taken to have been paid by an unlisted country CFC to a listed country CFC (or to certain trusts and partnerships)

Interpretative provisions

3.20 References to "listed countries" will also not change in provisions outlined in the following table. These provisions are largely interpretative and have no substantive effect of themselves.

Table of interpretative provisions that refer to listed countries
Affected provision Outline of the provision's effect
Definition of "law" (section 317) The term is used in the definition of tax law
Definition of "tax accounting period" (section 317) Refers to the accounting period used for determining whether tax is imposed or levied under the tax law of a listed country
Definition of "tax law" (section 317) The term is relevant to the definitions of "subject to tax" and "tax accounting period"
Section 321 Each listed and unlisted country is to be treated as a separate country
Section 323 Allows State taxes designated in the Income Tax Regulations to be treated as Federal taxes
Section 333 Rules for determining whether a company is a resident of a listed or an unlisted country
Section 340 Definition of a "CFC"
Section 395 Assumption that attributable income has been calculated in previous years for the purposes of determining whether outgoings are allowable deductions
Section 399 Modifications of net income of partnerships and trusts for the purposes of determining attributable income
Subsection 402(1) Additional notional exempt income

3.21 Definitions of "broad-exemption listed country" and "limited exemption listed country" are also to be inserted into section23AH. [Items 5 & 6]

Commencement

3.22 The two list approach will operate for statutory accounting periods of CFCs and years of income of transferor trusts commencing on or after 1 July 1997 for the purposes of applying the following provisions.

Table of provisions for which the two list approach will apply for statutory accounting periods of CFCs and years of income of transferor trusts commencing on or after 1 July 1997
Affected provision Outline of the provision's effect Items making the changes
Division 6AAA The transferor trust measures attribute the income of a non-resident trust to an Australian resident who has, directly or indirectly, transferred value to the trust. An interest charge is also applied on distributions paid from low taxed profits accumulated in a non-resident trust. Item 123
Provisions in Part X for the purposes of calculating attributable income The Australian controllers of a CFC may be accruals taxed on certain income derived by the CFC Subitem 126(1)
Sections 377 and 378 Rules for identifying and tracing profits that can be distributed by unlisted country companies as exempt dividends under section 23AJ Subitem 126(3)
Provisions in Part X relevant to determining the active income test The active income test ensures that small amounts of tainted income derived by a CFC are exempt from taxation. An exemption is provided from accruals taxation for most amounts derived by a CFC if the test is satisfied. Subitem 126(5)
Section 456A Reduces attributable income for amounts that have been taxed under an accruals tax law of another country Subitems 126(7) & (8)

3.23 The two list approach will operate from 1 July 1997 for the purposes of applying the following provisions.

Table of provisions for which the two list approach will apply from 1 July 1997
Affected provision Outline of the provision's effect Items making the changes
Section 23AH Exemption for certain foreign branch profits of Australian companies Subitems 120(3) & (4)
Section 23AJ Exemption for non-portfolio dividends received by resident companies Subitem 121
Sections 47A and 108 Deemed dividend rules for benefits provided by companies Subitem 122
Division 18 of Part III Calculation of a credit that can be claimed for foreign tax Subitem 124(1)
Subsections 160M(12A), (12AB) and (12B) Modifications to the rules for taxing the disposal of assets by a former CFC where the assets were held prior to the company becoming a resident of Australia Subitem 125(1)
Section 160ZFB Reduction of a capital gain derived by a CFC on disposing of a taxable Australian asset to the extent the gain has been taxed previously under section 457 Subitem 125(2)
Section 380 Rules for determining the extent to which a dividend paid to an Australian resident company can be exempt under section 23AJ Subitem 126(4)
Subsection 456(2) Reduction of attributable income for amounts taxed under section 457 Subitem 126(6)
Section 457 Accruals taxation of a CFCs distributable profits where the CFC changes residence from an unlisted country to a listed country or Australia Subitems 126(9) & (10)
Section 458 Accruals taxation of non-portfolio dividends paid by an unlisted country CFC to a listed country CFC (or to certain trusts and partnerships) where the dividends are not taxed in the listed country at the normal company tax rate Subitem 126(11)
Section 459 Accruals taxation of deemed dividends under section 47A that are taken to have been paid by an unlisted country CFC to a listed country CFC (or to certain trusts and partnerships) Subitem 126(11)

Chapter 4 - Measures to reduce compliance costs

Overview

4.1 This chapter discusses amendments that will make the following changes to reduce compliance costs under the CFC measures:

·
the active income test for CFCs in unlisted countries will be applied to all CFCs;
·
amounts derived by a CFC from an associated CFC resident in the same country will no longer be classed as tainted services or tainted rental income if the amounts are subject to the country's normal company tax and do not reduce the attributable income of the associated CFC;
·
the transfer pricing rules will not apply to transfers between CFCs in the same broad-exemption listed country when calculating the attributable income of a CFC;
·
the thin capitalisation and debt creation rules will no longer apply when calculating the attributable income of a CFC; and
·
the rules for making elections in relation to CFCs will be relaxed.

4.2 Details of these amendments are discussed below.

Uniform active income test

Summary of the amendments

Purpose of the amendments

4.3 The amendments will extend the active income test that currently applies for unlisted country CFCs to all CFCs.

Date of effect

4.4 The changes will apply in calculating attributable income for statutory accounting periods of CFCs commencing on or after 1 July 1997. [Subitem 126(5)]

Background to the legislation

4.5 The active income test (section 432) reduces compliance costs by providing an exemption from accruals taxation for small amounts of tainted income that are incidental to the overall operations of a CFC. Listed country CFCs currently have a different active income test to that for unlisted country CFCs.

4.6 The problem with the test for listed country CFCs is that only amounts of eligible designated concession income (EDCI) are taken into account. Broadly, EDCI is narrowly defined tainted income that has been concessionally taxed in a listed country. The current active income test is determined by dividing a CFC's tainted EDCI by its EDCI (the test is passed if the ratio is less than 0.05). This approach results in the test for listed country CFCs being 'failed' in almost all cases because tainted EDCI and EDCI will normally be the same, leading to accruals taxation of the tainted EDCI. This could occur even though a CFC's tainted income was not significant as a proportion of its primary business income.

4.7 To overcome this problem, the active income test for unlisted country CFCs will be applied to all CFCs. The test for all CFCs will therefore be determined by dividing a CFC's gross tainted turnover by its gross turnover.

Explanation of the amendments

4.8 The amendments will extend the active income test ratio for unlisted country CFCs in subsection433(1) to all CFCs. The ratio for listed country CFCs in subsection 433(2) will be repealed. [Items50 & 51]

Exclusion from tainted services income and tainted rental income

Summary of the amendments

Purpose of the amendments

4.9 The amendments will exclude an amount from tainted services or tainted rental income if the amount is derived from an associated CFC in the same country, is subject to the normal company tax rate in that country and does not reduce the attributable income of the associated CFC.

Date of effect

4.10 The changes will apply in calculating attributable income for statutory accounting periods of CFCs commencing on or after 1 July 1997. [Subitem 126(1)]

Background to the legislation

4.11 Services and rental income are generally treated as tainted if derived by a CFC from an associate because there is a significant risk that non-arm's length service and rental payments could be used to shift profits. The accruals taxation of income arising from these arrangements ensures that a CFC's dealings with associates are not undertaken to obtain a tax advantage.

4.12 An exclusion from tainted income is to be provided for certain dealings involving residents of the same country because there is a low risk of tax arbitrage where amounts are derived from arrangements that are covered by the one tax jurisdiction.

Explanation of the amendments

4.13 The rules for determining whether an amount is tainted services income or tainted rental income are in sections 448 and 317 respectively. Broadly, the amendments modify these sections to ensure amounts are not treated as tainted where the following three requirements are satisfied:

(i)
the amounts were derived from an associated CFC resident in the same country (the definition of associate is in section 318);
(ii)
the amounts are subject to the normal company rate of tax in that country; and
(iii)
the payment of the amounts did not wholly or partly give rise to a notional allowable deduction for the associated CFC.

4.14 The second requirement is based on whether an amount has been subject to the normal company rate of tax in a country. The requirement ensures that an arrangement has sufficient connection with a country where a CFC is resident for the country to seek to tax the amount at normal rates.

4.15 There are currently rules in section 325 for determining whether an amount has been subject to the normal company rate of tax in a listed country. Rules are required, however, for amounts derived in unlisted countries. New subsection 325(2) will provide rules for determining whether an amount has been subject to the normal company rate in these countries. [Item 30] The rules will be the same as those that currently apply for listed countries. Consequently, for an amount to be treated as taxed at the normal company rate in a country, it must be taxed at the same rate applicable to a company's other income or at a higher rate. In addition, there can be no entitlement to a credit, rebate or tax concession in the taxation of the amount by the country. It should also be noted that foreign tax will not be treated as paid if:

·
a refund of foreign tax becomes liable to be made to the taxpayer or any other person; or
·
any other benefit becomes liable to be provided to the taxpayer or any other person, where:

-
the amount of the benefit is worked out by reference to the amount of the foreign tax paid by the taxpayer alone; and
-
the benefit does not consist of a reduction of foreign tax payable by the taxpayer or the other person.
(Subsection 6AB(5A))

4.16 The final requirement is to be determined on the assumption that the associated CFC had failed the active income test. The requirement will therefore not be satisfied if a payment would have resulted in a notional allowable deduction for an associated CFC had the CFC been required to calculate its attributable income.

4.17 The amounts excluded from tainted rental income will be referred to as "special excluded rental income". [Items 21 & 22] New subsection448(6A) will exclude amounts from tainted services income. [Item 55]

Application of the transfer pricing rules to transfers involving CFCs resident in the same broad-exemption listed country

Summary of the amendments

Purpose of the amendments

4.18 The amendments will provide an exclusion from the transfer pricing rules (Division 13 of Part III), in determining the attributable income of a CFC, for transfers involving CFCs resident in the same broad-exemption listed country.

Date of effect

4.19 The changes will apply in calculating attributable income for statutory accounting periods of CFCs commencing on or after 1 July 1997. [Subitem 126(1)]

Background to the legislation

4.20 The transfer pricing rules seek to prevent profit shifting through arrangements involving related parties (a strategy commonly used for tax planning purposes). The risk to the revenue from not applying the transfer pricing rules in calculating the attributable income of a CFC for arrangements involving residents of the same broad-exemption listed country are tolerable because of the protection afforded by the tax regimes of those countries. The countries have their own transfer pricing rules and are also likely to ensure profits derived by their resident companies are ultimately taxed at full rates.

Explanation of the amendments

4.21 Section 400 provides a number of modifications to the transfer pricing rules for the purposes of determining the attributable income of a CFC. The amendments will insert new paragraph 400(aa) which makes a further modification to the transfer pricing rules for arrangements involving CFCs resident in the same broad exemption listed country. [Item44]

4.22 The modification will provide that an international agreement (section136AC) for the purposes of the transfer pricing rules in the CFC measures does not include an agreement where, at all times, all parties to the agreement are CFCs resident of the same broad-exemption listed country. This has the effect of excluding the agreement from the transfer pricing rules because the transfer pricing rules only apply to international agreements.

Removal of the thin capitalisation and debt creation rules in calculating the attributable income of a CFC

Summary of the amendments

Purpose of the amendments

4.23 The amendments will remove the requirement to apply thin capitalisation and debt creation rules in calculating the attributable income of a CFC.

Date of effect

4.24 The changes will apply in calculating attributable income for statutory accounting periods of CFCs commencing on or after 1 July 1997. [Subitem 126(1)]

Background to the legislation

4.25 The thin capitalisation rules and debt creation rules (Divisions16F and 16G of Part III, respectively) are intended to prevent profit shifting.

4.26 The thin capitalisation rules operate to deny an interest deduction where the foreign controllers of a company do not maintain a specified debt to equity ratio. In the absence of these rules, the profits of a company could be reduced by excessive interest deductions and could thereby be effectively transferred to the foreign controllers as interest payments.

4.27 The debt creation rules deny an interest deduction on debt used to finance the transfer of assets from one related company to another where the buyer and seller are at least 50% controlled by a non-resident or a related non-resident. The rules prevent the effective transfer of profits from one company to another through the creation of an interest expense.

4.28 The thin capitalisation and debt creation rules will no longer apply in determining the attributable income of a CFC because the need for the rules will be greatly reduced following the creation of a short list of countries. The short list for accruals taxation purposes will make it more difficult to shift profits to another company without those profits being either taxed at full rates in a broad-exemption listed country or accruals taxed under the CFC measures. There is therefore less opportunity to gain a tax benefit from shifting profits through the use of thin capitalisation or debt creation arrangements. The changes reflect a change in policy and are in no way intended to affect the application of the law prior to the commencement of the changes.

Explanation of the amendments

4.29 Section 389 provides a list of provisions that are not to apply in determining the attributable income of a CFC. The insertion of references to Division 16F and Division 16G of Part III into paragraph 389(a) will have the effect of ensuring the thin capitalisation and debt creation rules do not apply in determining the attributable income of a CFC. [Item43]

Relaxation of the rules for making elections in relation to CFCs

Overview

4.30 The amendments will make three changes to the rules for making elections in relation to CFCs. These changes are discussed below.

(i) Election to vary a CFC's statutory accounting period

Summary of the amendments

Purpose of the amendments

4.31 The amendments will allow an election to vary a CFC's statutory accounting period to take effect immediately if made during the first period that a company becomes a CFC. A statutory accounting period is the period used to calculate a CFC's attributable income (section 319).

Date of effect

4.32 The new rules for making elections will apply from the time the Bill receives the Royal Assent. [Clause 2]

Background to the legislation

4.33 An election to vary a CFC's statutory accounting period can currently only take effect immediately if it is made when a company first comes into existence (subsection319(5)). Normally the first statutory accounting period using the "new day" (ie, the last day of the new statutory accounting period) cannot commence until after the end of the statutory accounting period in which the election is made (subsection 319(4)). The following is an example of the current rules for varying the statutory accounting period of a CFC.

Example If an election to use a new statutory accounting period of 1February to 31January is made during a statutory accounting period of a CFC from 1 July 1996 to 30 June 1997, the first period using the new day could not commence until 1February 1998. This is the first period using the new day commencing after the end of the period ending on 30 June 1997 (ie, the period in which the election was made). The following diagram illustrates this result.

Existing CFC makes election

If, however, the CFC had come into existence on 1 January 1997, it is currently possible to use the new period from 1February 1997 (a full 12months earlier). This is the first period using the new day commencing after the company came into existence (paragraph 319(5)(b)). The following diagram illustrates this result.

New CFC created

Explanation of the amendments

4.34 New subsection 319(4A) will allow a varied period to be adopted on the acquisition of a company to align its statutory accounting period with the period normally used by the company for the preparation of accounts or with the period used for the purposes of complying with the tax laws of another country. These are the only alternative statutory accounting periods permitted (subsection319(3)).

4.35 The first period using the new day will be the period next commencing after the election is made. This treatment is more favourable than the current arrangements whereby the first period using the new day is the period commencing after the end of the statutory accounting period in which the election is made.

Example A foreign company becomes a CFC on 1 January 1997 after being acquired by an Australian company. If the CFC makes an election before 1 February 1997 to use a new statutory accounting period of 1February to 31January, the first period using the new day would commence on 1February 1997 (ie, the first period using the new day next commencing after the election is made). This result is illustrated by the following diagram.

A foreign company becomes a CFC after being acquired by an Australian company and makes an election

4.36 The new arrangements for varying the statutory accounting period of a newly acquired company will not apply if the company was a CFC in a previous statutory accounting period. [Items 23 & 24]

(ii) Elections for wholly owned CFCs

Summary of the amendments

Purpose of the amendments

4.37 The amendments will allow an attributable taxpayer to make an election on behalf of a CFC if the CFC is wholly owned by the taxpayer either directly or indirectly through other entities.

Date of effect

4.38 The new rules for making elections will apply from the time the Bill receives the Royal Assent. [Clause 2]

Background to the legislation

4.39 Most elections can currently be made by an attributable taxpayer on behalf of a CFC under section 390. An attributable taxpayer, however, cannot make an election to vary a CFC's statutory accounting period (subsection 319(2)) or elect for a CFC to take advantage of CGT rollover relief (section 421 and subsection 438(3A)). Currently these elections are to be made by a CFC because the elections must apply equally to all attributable taxpayers. In cases where there is only one attributable taxpayer, the amendments will allow the attributable taxpayer to make the election.

Explanation of the amendments

4.40 A CFC is to be treated as wholly owned by an attributable taxpayer if the taxpayer is the only attributable taxpayer (section 361) and has an attribution percentage (section362) in the CFC of 100%. Where these conditions are satisfied, the attributable taxpayer is to be able to make elections on behalf of the CFC for the purposes of subsection 319(2), section 421 and subsection 438(3A) (new subsections 319(7), 421(1A) and 438(3B) respectively). [Items 25, 47 & 54]

4.41 The term "designated entity" is used to describe the attributable taxpayer in new subsections421(1A) and 438(3B) to distinguish the attributable taxpayer from the CFC and any other entity that may be affected by the CFC's election for rollover relief. The other entity could also be the attributable taxpayer where, for instance, a CFC elects for rollover relief under section 160ZZO (as modified by section 419) on the transfer of an asset to the attributable taxpayer. New paragraphs 421(1A)(c) and 438(3B)(d) provide for the case where the other entity is the attributable taxpayer. The case where the other entity is not the attributable taxpayer is dealt with by new paragraphs 421(1A)(d) and 438(3B)(e).

(iii) Time allowed for a CFC to elect for capital gains tax rollover relief

Summary of the amendments

Purpose of the amendments

4.42 The amendments will extend the time allowed for a CFC to make an election for capital gains tax (CGT) rollover relief.

Date of effect

4.43 The new rules for making elections will apply from the time the Bill receives the Royal Assent. [Clause 2]

Background to the legislation

4.44 An election for rollover relief must currently be made within two months of the end of a CFC's statutory accounting period (section 421 and subsection 438(3A)). This can create problems if an attributable taxpayer does not closely monitor the impact of the capital gains tax rules on a CFC. The attributable taxpayer may not, for instance, become aware that a CFC should make an election until it is time to prepare a tax return. By this time it may be too late for the CFC to make the election. The proposed amendments ameliorate this problem by aligning the time for making an election with the lodgment of tax returns by the attributable taxpayers of a CFC.

Explanation of the amendments

4.45 An election that can be made by a CFC for rollover relief during a statutory accounting period is to be valid if made on or before the lodgment of a return by an attributable taxpayer in which the statutory accounting period of the CFC ends (new paragraphs 421(1)(c), 421(1)(d), 438(3A)(c) and 438(3A)(d)). If there is more than one attributable taxpayer, the election will be valid if made before the later of the lodgment dates for the affected tax returns. [Items 46 & 53]

Example Ausco1 and Ausco2 are attributable taxpayers of a CFC and are due to lodge tax returns by 30June 1997 and 31 December 1997 respectively. These returns are affected by a decision of the CFC regarding rollover relief. Under the proposed changes, the election for rollover relief is to be valid if made by the CFC on or before 31December 1997 (ie, the latest of the lodgment dates of the affected tax returns). Ausco1 would be required to lodge an amended tax return if the election was made after 30 June 1997 (ie, after Ausco1 had lodged its tax return).

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

Overview

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

·
the exemption will generally not be available for branch income that is adjusted tainted income;
·
the passive income of a branch conducting life assurance activities will not be reduced under subsection446(2);
·
a branch and its Australian head office are to be treated as separate legal entities for the purpose of determining whether the branch has derived tainted sales income;
·
branches of Australian financial institutions (AFIs) will be provided with an exemption for banking income broadly consistent with the exclusion from accruals taxation available under the CFC measures for AFI subsidiaries; and
·
an active income test concession will be provided to allow branches to derive up to 5% of gross turnover as tainted income and still obtain full exemption under section 23AH for income amounts.

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

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

Summary of the amendments

Purpose of the amendments

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

Date of effect

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

Background to the legislation

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

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

Explanation of the amendments

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

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

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

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

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

Summary of the amendments

Purpose of the amendments

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

Date of effect

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

Background to the legislation

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

Explanation of the amendments

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

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

Summary of the amendments

Purpose of the amendments

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

Date of effect

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

Background to the legislation

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

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

Unassociated foreign entities

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

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

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

Unassociated foreign entities

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

Explanation of the amendments

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

·
the branch were a distinct and separate company (called the PE company) from the head office (called the HQ company);
·
the PE company and the HQ company were engaged in the same or similar activities under the same or similar conditions as the branch and the head office respectively; and
·
the PE company were dealing wholly independently with the HQ company.

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

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

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

Unassociated foreign entities

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

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

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

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

Exemption for branches of AFIs in limited-exemption listed countries

Summary of the amendments

Purpose of the amendments

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

Date of effect

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

Background to the legislation

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

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

Explanation of the amendments

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

Active income test for branches in limited-exemption listed countries

Summary of the amendments

Purpose of the amendments

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

Date of effect

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

Background to the legislation

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

Explanation of the amendments

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

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

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

Table of provisions in the active income test that will not apply to branches
Affected provision Outline of the provision's effect Relevant provision
Paragraph 432(1)(b) Requirement that there is no time during a company's statutory accounting period that it was not a resident of a particular country New paragraph 23AH(10B)(c)
Paragraph 432(1)(e) Requirement that a company has a permanent establishment in its country of residence at all times during a statutory accounting period
Subsection 432(2) Company deemed to be in existence
Subsection 432(3) Rules dealing with dormant companies

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

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

Example A taxpayer with a year of income from 1April to 31March has a branch in a limited-exemption listed country that derived tainted income of $10,000 from 1 April 1997 to 30 June 1997 and $50,000 from 1 July 1997 to 31 March 1998. The branch derived $100,000 in total during the period 1 April 1997 to 30 June 1997 and $900,000 during the period 1 July 1997 to 31 March 1998.In this case, the active income test would be determined with regard only to amounts derived during the period from 1July 1997 to 31 March 1998. The branch's gross tainted turnover would therefore be $50,000 and its gross turnover would be $900,000. The branch would thus fail the active income test because the ratio of tainted income to total income exceeds 0.05. The $50,000 tainted income derived after 30 June 1997 would therefore not be exempt under section 23AH. The $10,000 tainted income derived prior to 1 July 1997 may be exempt under section 23AH providing the income is not EDCI.

Chapter 6 - Consequential changes and transitional rules

Overview

6.1 The amendments will give effect to the following consequential changes and transitional rules:

·
the taxation of a CFC's retained profits under section 457 will be modified in cases where the CFC is treated as changing residence because of changes to the list(s) of countries;
·
taxpayers will have the option of treating states emerging from the dissolution of Czechoslovakia, the USSR and Yugoslavia as listed countries:

-
for statutory accounting periods of CFCs and years of income of transferor trusts commencing before the release of the IP (ie, 24December 1996); and
-
prior to the release of the IP for the purposes of applying exemptions under the FTCS and other provisions dealing with taxation on the repatriation of profits;

·
exempting profits will be able to arise for a CFC in the SlovakRepublic or a state arising from the dissolution of Yugoslavia or the USSR for the part of a statutory accounting period remaining following the release of the IP;
·
the Czech Republic and Vietnam will be treated as listed countries from the release of the IP for the purposes of applying provisions that ensure low taxed profits are comparably taxed at some point prior to repatriation to Australia (ie, sections 47A, 458 and 459):

-
the Czech Republic will also be treated as a listed country from the release of the IP for the purposes of exemptions under the FTCS;

·
it will be clarified that Hong Kong is still an unlisted jurisdiction following the establishment of the HongKong Special Administrative Region of the People's Republic of China on 1 July 1997;
·
an amount will generally be included in the attributable income of a CFC in:

-
a limited-exemption listed country if the amount was not derived from sources within the country and was not subject to tax in a listed country; and
-
a broad-exemption listed country if the amount is adjusted tainted income, was not derived from sources within the country and was not subject to tax in a broad-exemption listed country;

·
an amount derived by an unlisted country company through a branch in a limited-exemption listed country will be an exempting receipt if the amount is not adjusted tainted income and is also taxed in a listed country;
·
subsection431(4) will not operate to deny a CFC's prior year losses if the CFC is treated as changing residence solely as a result of changes to the list(s) of countries;
·
a credit is to be available for foreign tax forgone on income subject to accruals taxation under the CFC measures in circumstances where tax sparing provisions in a double taxation agreement require that a credit be provided;
·
paragraph436(1)(b) will not operate to exclude amounts from the active income test which are derived in a CFC's country of residence; and
·
amendments to the Income Tax Regulations giving effect to the changes to the foreign source income measures will be able to apply from the commencement of the changes to the Principal Act.

Treatment of residence changes arising from changes to the list(s) of countries

Summary of the amendments

Purpose of the amendments

6.2 The amendments will modify the operation of section 457 where an unlisted country CFC is treated as having changed residence to a listed country as a result of the unlisted country becoming listed. In this case, section 457 will not apply to tax the retained profits of a CFC if the CFC was a resident of the newly listed country for three or more years prior to the country becoming listed. Where a CFC has been a resident of a newly listed country for less than three years, section 457 will continue to apply but only to the realised profits of the CFC. Gains on the disposal of assets held at the residence change time will be included in the attributable income of the CFC when they are realised.

Date of effect

6.3 The modifications to section 457 will apply for residence changes occurring on or after 1 July 1997. [Subitem 126(9)]

Background to the legislation

6.4 The Australian controllers of a CFC are normally taxed under section 457 on the CFC's accumulated profits if the CFC changes residence from an unlisted to a listed country. The profits are taxed at the residence change time because they are likely to be low taxed and can be distributed as exempt dividends after the CFC becomes a resident of a listed country.

6.5 Modifications are to be made to ameliorate the impact of section457 where a CFC becomes a resident of a listed country as a result of the country becoming listed (eg, on the listing of the Czech Republic or Vietnam as limited-exemption countries from 1 July 1997). Less stringent rules can be applied to the change of residence of a CFC in these circumstances because the change is involuntary. More robust rules are required for voluntary changes of residence to ensure the changes occur for commercial reasons and not for tax planning purposes.

Explanation of the amendments

6.6 New subsection 457(3) will modify the operation of section 457 where a CFC ceases to be a resident of an unlisted country and becomes a resident of a listed country on the listing of a country (new paragraphs457(3)(a) & 457(3)(b)). The modifications to the application of section 457 on the residence change will depend on the period that a CFC was previously resident of the newly listed country.

6.7 Section457 will not apply in cases where a CFC was a resident of a country for three or more years prior to the country's listing (new paragraph 457(3)(c)). In other cases (ie, where a CFC has been a resident of the country for less than three years), section 457 will apply but only to the realised profits of the CFC (new paragraph 457(3)(d)). There will therefore be no deemed disposal of assets held by the CFC in calculating the amount to which section 457 will apply (new subparagraph 457(3)(d)). [Item56]

6.8 Gains on the disposal of assets held at the residence change time by a CFC that was resident of a country for less than three years prior to the country's listing will be included in the attributable income of the CFC when the gains are realised (new paragraphs 384(2)(e) and 385(2)(e)). These gains are to be included in attributable income even though the CFC may satisfy the active income test. [Items 36, 37, 40 & 41]

6.9 Sections 160ZFB and 422 will not apply on the disposal of assets held at the residence change time if new subsection 457(3) applied at that time. The sections normally operate to make adjustments on the disposal of assets held at the residence change time to prevent taxation under both section457 and PartIIIA of pre residence change gains. These adjustments will be unnecessary where new subsection 457(3) applies because unrealised gains would not be taxed under section 457 at the residence change time. [Items 17 & 48]

Election to treat new states as listed countries

Summary of the amendments

Purpose of the amendments

6.10 The amendments will allow taxpayers the option of treating states emerging from the dissolution of Czechoslovakia, the USSR and Yugoslavia as listed countries prior to the release of the IP.

Date of effect

6.11 The election can be made after the amending Act receives the Royal Assent. [Clause 2] The election will apply:

·
for statutory accounting periods of CFCs and years of income of transferor trusts commencing prior to the release of the IP; and
·
prior to the release of the IP for the purposes of applying exemptions under the FTCS and other provisions dealing with taxation on the repatriation of profits.

[Item 129

Background to the legislation

6.12 The current list of countries requires updating following the unification of Germany and the dissolution of Czechoslovakia, the USSR and Yugoslavia. The unification of Germany only requires the removal from the list of the reference to the German Democratic Republic. The references to Czechoslovakia, the USSR and Yugoslavia are also to be removed. Transitional rules are required because of uncertainty prior to the IP regarding whether the newly formed states should be treated as listed or unlisted countries. Additional rules are required for the Czech Republic which are discussed later in this Chapter(page 56) because the Czech Republic is to be included on the list of limited-exemption countries from 1 July 1997.

Explanation of the amendments

6.13 Technically the states that emerged on the dissolution of Czechoslovakia, the USSR and Yugoslavia are unlisted countries. As a transitional arrangement, the amendments will provide taxpayers with the option of treating the new states as listed countries. The option is to be available for statutory accounting periods of CFCs and years of income of transferor trusts ending after the dissolution of the relevant countries and commencing prior to 24 December 1996 (ie, the release of the IP). Where the option is exercised, the states will also be treated as listed prior to 24December 1996 for the purposes of exemptions under the FTCS (sections 23AH, 23AJ & 380) and other provisions dealing with taxation on the repatriation of profits (sections 47A, 457, 458 and 459). [Item129]

6.14 The following states are designated as countries that emerged from former Czechoslovakia, the former USSR and former Yugoslavia. The states are referred to as "designated countries". [Subitem 129(1)]

Countries emerging from former Czechoslovakia, the former USSR and former Yugoslavia
Armenia Georgia Slovenia Slovak Republic
Azerbaijan Kazakstan Tajikistan Turkmenistan
Belarus Kyrgyzstan Czech Republic Ukraine
Bosnia and Herzegovina Latvia Federal Republic of Yugoslavia Uzbekistan
Croatia Lithuania Former Yugoslav Republic of Macedonia
Estonia Moldova Russian Federation

6.15 An election to treat these countries as listed during the transitional period will only be valid if made in writing. [Subitem129(2)] The election is to be retained by a taxpayer and provided if requested by the Commissioner of Taxation. The election will only be valid for a company taxpayer where all Australian resident companies that are related to the company also make the election. [Subitem 129(3)] A related company for this purpose is defined in section 160G. In broad terms a related company is a wholly owned group company. [Subitem129(9)] Where an election is made it will be irrevocable. [Subitem129(10)]

6.16 The election will operate to treat all designated countries as listed countries during the transitional period. The period prior to the IP will be the transitional period for the purposes of applying the dividend and branch profit exemptions for companies under the FTCS and for other provisions dealing with taxation on the repatriation of profits. [Subitem129(5)] Statutory accounting periods of CFCs and years of income of transferor trusts commencing before 24 December 1996 will be the transitional period for the purposes of determining attributable income under the CFC and transferor trusts measures. [Subitems129(4) & (6)]

6.17 The following table summarises the effect of the election for the Slovak Republic and states formed from the dissolution of Yugoslavia and the USSR. Further transitional arrangements apply in the case of the CzechRepublic which are summarised on page 59.

Summary of the treatment of the Slovak Republic and states formed from the dissolution of Yugoslavia and the USSR
  Period
Treatment Prior to dissolution Dissolution - 23 Dec 1996 24 Dec 1996 - 30 Jun 1997 From 1 Jul 1997
For the purposes of determining attributable income for statutory accounting periods of CFCs and years of income of transferor trusts commencing during the period Listed Listed if an election is made. Unlisted if no election is made. Unlisted Unlisted
For the purposes of exemptions under the FTCS (sections 23AH, 23AJ & 380) Listed Listed if an election is made. Unlisted if no election is made. Unlisted Unlisted
For the purposes of provisions dealing with taxation on the repatriation of profits (sections 47A, 457, 458 & 459) Listed Listed if an election is made. Unlisted if no election is made. Unlisted Unlisted

Exempting profits for CFCs in successor states

Summary of the amendments

Purpose of the amendments

6.18 The amendments will ensure that exempting profits can arise for a company in the Slovak Republic or a state arising from the dissolution of Yugoslavia or the USSR for the part of a statutory accounting period remaining following the release of the IP. The affected states are designated in new subitem129(1) and are referred to as "designated countries" (a list of the countries is provided on page 56).

Date of effect

6.19 The transitional arrangements will only apply if an election was made to treat states emerging from the dissolution of Czechoslovakia, the USSR and Yugoslavia as listed countries prior to the release of the IP. The election can be made after the amending Act receives the Royal Assent. [Clause 2] If the election is made, the transitional arrangements will apply to amounts derived by a company on or after 24December 1996 (ie, from the release of the IP) until the end of the accounting period in which that date occurs. [Subitem 129(5)]

Background to the legislation

6.20 Transitional arrangements are required for exempting profits derived by companies in designated countries because there may be a period where a company is treated as a resident of a listed country for accruals taxation purposes and as an unlisted country for the purposes of the dividend exemption under section 23AJ. This can only occur during the part of a statutory accounting period remaining following the release of the IP and then only if a taxpayer elects to treat a designated country as a listed country prior to the release of the IP. Exempting profits (Division6 of Part X) are profits that have been taxed in Australia or a listed country and can be distributed as exempt dividends by a company in an unlisted country.

6.21 In the absence of transitional rules, exempting profits could not arise for a company in a designated country for the portion of a statutory accounting period remaining following the release of the IP if an election was made to treat the designated country as a listed country. This is because exempting profits can only arise for an unlisted country company whereas the election will result in the designated country being treated as a listed country for accruals taxation purposes. The net result would be that the company could not distribute comparably taxed profits derived during the remaining part of a statutory accounting period following the release of the IP as exempt dividends. This result is illustrated by the following example.

Example A CFC resident in the Russian Federation has a statutory accounting period from 1 July to 30 June. If an attributable taxpayer elects for the CFC to be treated as a resident of a listed country, dividends paid by the CFC will cease to be exempt from 24 December 1996 (ie, from the release of the IP) even though for accruals taxation purposes the CFC will not be treated as unlisted until 1 July 1997 (ie, after the end of the statutory accounting period in progress when the IP was released).Subsection378(3) would provide that profits derived by the CFC on or before 24 December 1996 are exempting profits and can therefore be distributed as exempt dividends (section 23AJ and paragraph 380(b)). Exempting profits could not arise, however, for amounts derived during the part of a statutory accounting period remaining following the release of the IP because the CFC will be treated as a resident of a listed country. There is no problem after the end of the statutory accounting period (ie, 30June 1997) because the CFC will be treated as a resident of an unlisted country for accruals taxation purposes and can therefore derive exempting profits.

Explanation of the amendments

6.22 The transitional rules will only apply in cases where a company is affected by an election to treat a designated country as a listed country. The amendments will ensure that exempting profits can arise for a company during the part of a statutory accounting period remaining following the release of the IP even though the company may be treated as a resident of a listed country for accruals taxation purposes during the period [Subitem129(4)] . This will be achieved by treating the company as a resident of an unlisted country for the purposes of applying Division 6 of Part X during the part of a statutory accounting period remaining following the release of the IP. [Subitem129(5)]

Transitional rules for the listing of the Czech Republic and Vietnam

Summary of the amendments

Purpose of the amendments

6.23 The amendments will provide transitional arrangements for the listing of the CzechRepublic and Vietnam from 1 July 1997 as limited-exemption countries. The Czech Republic is also to be treated as a listed country from the release of the IP until 30 June 1997 for the purposes of exemptions under the FTCS (sections 23AH, 23AJ and 380).

Date of effect

6.24 The transitional arrangements will treat:

·
the Czech Republic and Vietnam as listed countries from the release of the IP until 30 June 1997 for the purposes of applying sections 47A, 458 and 459; and
·
the Czech Republic as a listed country from the release of the IP until 30 June 1997 for the purposes of applying sections 23AH, 23AJ and 380. [Subitem 128(1)]

Background to the legislation

6.25 Transitional arrangements are required to prevent the exempt transfer of low taxed profits to CFCs resident in Vietnam and the Czech Republic that could occur to take advantage of the imminent listing of those countries. In the absence of these rules, low taxed profits could be transferred to the Czech Republic or Vietnam and distributed as exempt dividends under section23AJ after the countries are treated as listed for the purposes of exemptions under the FTCS. This result would be inappropriate because the exemptions should only be available for amounts that have been taxed in a listed country.

6.26 Transitional arrangements will also operate to provide continuity in the application of exemptions under the FTCS for amounts derived in the Czech Republic. In the absence of transitional rules, the Czech Republic could be treated as a listed country prior to 24 December 1996 (if a taxpayer makes an election under item 129), as an unlisted country from 24 December 1996 to 30June 1997 and then as a limited-exemption listed country from 1 July 1997. Under the transitional arrangements, the Czech Republic will be treated as a listed country for the purposes of exemptions under the FTCS during the period 24 December 1996 to 30June 1997.

Explanation of the amendments

6.27 The amendments provide that the Czech Republic and Vietnam will be treated as listed countries from the release of the IP until 30 June 1997 for the purposes of applying sections 47A, 458 and 459. These provisions operate to accruals tax amounts derived by a listed country CFC from sources outside that country if the amounts have not been taxed in a listed country. [Subitems128(1) & (2)]

6.28 The amendments also provide that the Czech Republic is to be treated as a listed country from the release of the IP until 30 June 1997 for the purposes of applying sections 23AH, 23AJ and 380. These provisions provide an exemption under the FTCS for certain profits derived through a branch in a listed country and an exemption for dividends derived by resident companies from listed country subsidiaries. [Subitem 128(3)]

6.29 The following tables summarise the treatment of Vietnam and the Czech Republic under the transitional arrangements.

Summary of the treatment of Vietnam
  Period
Treatment Prior to 24 Dec 1996 24 Dec 1996 - 30 Jun 1997 From 1 Jul 1997
For the purposes of determining attributable income for statutory accounting periods of CFCs and years of income of transferor trusts commencing during the period Unlisted Unlisted Unlisted
For the purposes of exemptions under the FTCS Unlisted Unlisted Listed (limited-exemption listed)
For the purposes of applying provisions which ensure that low tax profits are comparably taxed at some point prior to repatriation to Australia (sections 47A, 458 and 459) Unlisted Listed Listed (limited-exemption listed)

Summary of the treatment of the Czech Republic
  Period
Treatment Prior to 1 Jan 1993 1 Jan 1993 - 23 Dec 1996 24 Dec 1996 - 30 Jun 1997 From 1 Jul 1997
For the purposes of determining attributable income for statutory accounting periods of CFCs and years of income of transferor trusts commencing during the period Listed Listed if an election is made. Unlisted if no election is made. Unlisted Unlisted
For the purposes of exemptions under the FTCS Listed Listed if an election is made. Unlisted if no election is made. Listed Listed (limited-exemption listed)
For the purposes of applying provisions which ensure that low tax profits are comparably taxed at some point prior to repatriation to Australia (sections 47A, 458 and 459) Listed Listed if an election is made. Unlisted if no election is made. Listed Listed (limited-exemption listed)

Treatment of Hong Kong from 1 July 1997

Summary of the amendments

Purpose of the amendments

6.30 Amendments will be made to the Income Tax Regulations to clarify that Hong Kong is still an unlisted jurisdiction following the establishment of the Hong Kong Special Administrative Region of the People's Republic of China on 1 July 1997.

Date of effect

6.31 The amendments are to apply from 1 July 1997. [The Income Tax Regulations are to be amended]

Background to the legislation

6.32 Many submissions received on the IP commented on uncertainty regarding the status of Hong Kong for taxation purposes following its return to China's sovereignty on 1 July 1997. Some taxpayers are concerned that Hong Kong could be treated as part of a "listed country" (as defined in subsection 320(1)) from 1 July 1997 after becoming part of China (Hong Kong was formerly treated as an "unlisted country"). This change in status could potentially result in the taxation of the accumulated profits of a CFC in Hong Kong under section 457 because the CFC could be treated as having changed residence from an "unlisted" to a "listed country".

6.33 The proposed changes are being made to remove uncertainty regarding the treatment of the Hong Kong Special Administrative Region from 1 July 1997. The Commissioner's view of the current law is that the Hong Kong Special Administrative Region is not a "listed country" (Draft TD 97/D6).

Explanation of the amendments

6.34 The amendments to the Income Tax Regulations will clarify that the Hong Kong Special Administrative Region is not to be treated as part of a "listed country" as defined in subsection 320(1).

Accruals taxation of low taxed amounts derived offshore by a CFC in a listed country

Summary of the amendments

Purpose of the amendments

6.35 The amendments will include an amount in the attributable income of a CFC in:

·
a limited-exemption listed country if the amount is not derived from sources within the country and has not been subject to tax in a listed country; and
·
a broad-exemption listed country if the amount is adjusted tainted income (other than eligible designated concession income (EDCI)), is not derived from sources within the country and has not been subject to tax in a broad-exemption listed country.

Date of effect

6.36The changes will apply in calculating attributable income for statutory accounting periods of CFCs commencing on or after 1 July 1997. [Subitem 126(1)]

Background to the legislation

6.37 An amount is currently included in the attributable income of a listed country CFC if it is not EDCI, is not derived from sources within the listed country and has not been subject to tax in a listed country (subparagraph 385(2)(a)(ii)). Broadly EDCI is narrowly defined tainted income designated in the Income Tax Regulations that has been concessionally taxed in a listed country. Subparagraph 385(2)(a)(ii) does not apply to amounts of EDCI because these amounts are included in the notional assessable income of a CFC under subparagraph 385(2)(a)(i). A summary of the current operation of subparagraph 385(2)(a)(ii) is provided by the following diagram.

Current treatment of CFCs in listed countries under subparagraph 384(2)(1)(ii)

6.38 The accruals taxation of low taxed amounts derived by a listed country CFC from sources outside its country of residence protects the integrity of the dividend exemption under section 23AJ by ensuring the amounts are taxed at some point prior to repatriation to Australia. Similar rules are required to protect the dividend exemption for profits derived by CFCs in limited-exemption listed countries.

6.39 Modifications are also required to the rules for CFCs in broad-exemption listed countries to ensure that subparagraph 385(2)(a)(ii) can apply to amounts of adjusted tainted income that have only been taxed in a limited-exemption listed country. These tainted amounts should be included in attributable income because they have not been taxed by a broad-exemption listed country.

Explanation of the amendments

Treatment of CFCs in limited-exemption listed countries

6.40 The attributable income of a CFC in a limited-exemption listed country is to be determined according to the assumptions in section 384 that currently apply for unlisted country CFCs. New paragraph 384(2)(aa) will provide a further assumption for amounts derived by a CFC resident in a limited-exemption listed country from sources outside that country. The assumption will provide that an amount derived by the CFC will be included in notional assessable income if the amount is not adjusted tainted income, is not derived from sources within the CFC's country of residence and is not subject to tax in a listed country. [Item 34]

6.41 A summary of the operation of new paragraph 384(2)(aa) is provided by the following diagram.

Treatment of CFCs in limited-exemption listed countries

6.42 This treatment will also apply for amounts derived by a CFC in a limited-exemption listed country through a partnership (new subparagraph 384(2)(d)(ia)). [Item 35]

Treatment of CFCs in broad-exemption listed countries

6.43 The amendments will ensure that subparagraph 385(2)(a)(ii) can apply to amounts of adjusted tainted income derived by a CFC in a broad-exemption listed country if the amounts have only been taxed in a limited-exemption listed country. This will be achieved by replacing the current exclusion from subparagraph 385(2)(a)(ii) for amounts that have been taxed in a listed country (sub-subparagraph 385(2)(a)(ii)(C)) with an exclusion based on whether the amounts satisfy a test provided by new subsection 385(2A). Amounts that pass the test will generally be included in notional assessable income under subparagraph 385(2)(a)(ii). [Item 38]

6.44 The test in subsection 385(2A) will be passed for amounts that:

·
are not subject to tax in a listed country (new paragraph 385(2A)(a)); or
·
are adjusted tainted income and are not subject to tax in a broad-exemption listed country (new paragraph 385(2A)(b)).

6.45 The net effect of the test is that non-tainted amounts will be excluded from subparagraph 385(2)(a)(ii) if they are taxed in a listed country. Amounts of adjusted tainted income will only be excluded if they have been taxed in a broad-exemption listed country. [Item 42]

6.46 A summary of the operation of subparagraph 385(2)(a)(ii) following the changes is provided by the following diagram.

Treatment of CFCs in broad-exemption listed countries

6.47 This treatment will also apply for amounts derived through a partnership by a CFC in a broad-exemption listed country (new sub-subparagraph 385(2)(d)(ii)(C)). [Item 39]

Exempting profits derived through a branch in a listed country

Summary of the amendments

Purpose of the amendments

6.48 The amendments will provide that an amount derived by an unlisted country company through a branch in a limited-exemption listed country will be an exempting receipt if the amount is not adjusted tainted income and is also taxed in a listed country.

Date of effect

6.49 The changes will apply for accounting periods of companies commencing on or after 1 July 1997. [Subitem 126(2)]

Background to the legislation

6.50 Currently, an unlisted country company can distribute profits derived through a branch in a listed country as exempt dividends under section 23AJ providing the profits are not EDCI and are subject to tax in a listed country (paragraph 377(1)(a), subsection 378(1) and section 380). The concept of EDCI will not be applicable, however, for branches in limited-exemption listed countries. Rules are to be introduced to allow dividends paid from non-tainted profits derived by an unlisted country company through a branch in a limited-exemption listed country to be exempt if the profits are taxed in the limited-exemption listed country. This exemption is consistent with the general policy that non-tainted amounts that have been taxed in a listed country can be distributed as exempt dividends.

Explanation of the amendments

6.51 New subparagraph 377(1)(a)(ia) will allow exempting receipts to arise for amounts derived by an unlisted country company in carrying on a business through a branch in a limited-exemption listed country. [Item 33 Exempting receipts are amounts that can be distributed by an unlisted country company as exempt dividends under section 23AJ. Subparagraph 377(1)(a)(ia) will allow exempting receipts to arise for amounts derived by an unlisted country company through a branch in a limited-exemption listed country if the amounts are not adjusted tainted income and are subject to tax in a listed country. Non-tainted amounts derived through a branch in a limited-exemption listed country can therefore be distributed as exempt dividends if the amounts are taxed in a listed country.

Residence requirement for losses

Summary of the amendments

Purpose of the amendments

6.52 The amendments will preserve a CFC's prior year losses if the CFC is treated as changing residence solely as a result of changes to the list(s) of countries.

Date of effect

6.53 The changes will apply in calculating attributable income for statutory accounting periods of CFCs commencing on or after 1 July 1997. [Subitem 126(1)]

Background to the legislation

6.54 Losses from a previous year can currently only be offset in calculating the attributable income of a listed country CFC if the CFC was a resident of a listed country in the previous year. Corresponding treatment applies for CFCs in unlisted countries (subsection 431(4)). Transitional rules are required to ensure that CFCs are not affected by subsection 431(4) if they change residence solely as a result of the adoption of a two list approach or because of future changes to the list of broad-exemption listed countries.

Explanation of the amendments

6.55 New subsection 431(4) will provide rules for determining whether losses incurred in a statutory accounting period commencing before 1 July 1997 can be offset in a statutory accounting period commencing after that time. The general rule will be that carry forward losses arising in a statutory accounting period commencing before 1 July 1997 by a CFC in a broad-exemption listed country can be offset if the CFC was a resident of a listed country when the losses were incurred (new subparagraph 431(4)(a)(ii)). Losses arising in a statutory accounting period commencing before 1 July 1997 by a CFC in a non-broad-exemption listed country can be offset if the CFC was a resident of an unlisted country when the losses were incurred (new subparagraph 431(4)(b)(ii)).

6.56 Modifications to the general rule apply to deal with cases where a company remains a resident of the same country and is treated as changing residence from a listed country to an unlisted country or vice versa as a result of changes to the list(s) of countries or political developments (eg, as a result of the dissolution of a country). In these cases, the losses incurred by a CFC in an earlier period will not be denied under subsection 431(4) solely because the listing status of a CFC's country of residence changes (new subsections 431(4A), (4B) and (4C)). Carry forward losses will not be available, however, if the losses were denied in an earlier statutory accounting period because of a previous application of subsection 431(4) (new subsection 431(4D)). [Item 49]

6.57 The following table summarises the impact of new subsections 431(4), (4A), (4B), (4C) & (4D) on the availability of a CFC's carry forward losses from previous statutory accounting periods.

Impact of new subsections 431(4), (4A), (4B), (4C) & (4D) on carry forward losses
Scenario CFC's current country of residence Availability of losses for statutory accounting periods commencing after 1 July 1997
Losses incurred by a listed country CFC in a statutory accounting period commencing before 1 July 1997 Broad-exemption listed country Allowable* (subparagraph 431(4)(a)(ii))
Non-broad-exemption listed country Generally not allowable (subparagraph 431(4)(b)(ii)); Allowable* if the non-broad-exemption listed country arises from the dissolution of the listed country (subsection 431(4B)); Allowable* if the non-broad-exemption listed country is the same country as the listed country (subsection 431(4C))
Losses incurred by an unlisted country CFC in a statutory accounting period commencing before 1 July 1997 Broad-exemption listed country Generally not allowable (subparagraph 431(4)(a)(ii)); Allowable* if the broad-exemption listed country is the same country as the unlisted country (subsection 431(4A)) - this is unlikely to occur but is theoretically possible
Non-broad-exemption listed country Allowable* (subparagraph 431(4)(b)(ii))
Losses incurred by listed country CFC in a statutory accounting period commencing before 1 July 1997. The CFC subsequently changes residence to another listed country in a statutory accounting period commencing before 1 July 1997. Broad-exemption listed country Allowable* (subparagraph 431(4)(a)(ii))
Non-broad-exemption listed country Generally not allowable (subparagraph 431(4)(b)(ii)); Allowable* if the non-broad-exemption listed country arises from the dissolution of the last mentioned listed country (subsection 431(4B)); Allowable* if the non-broad-exemption listed country is the same country as the last mentioned listed country (subsection 431(4C))
Losses incurred by an unlisted country CFC in a statutory accounting period commencing before 1 July 1997. The CFC subsequently changes residence to a listed country in a statutory accounting period commencing before 1 July 1997. Broad-exemption listed country Not allowable because the losses would have been denied previously under subsection 431(4) (subsection 431(4D))
Non-broad-exemption listed country Not allowable because the losses would have been denied previously under subsection 431(4) (subsection 431(4D))
Losses incurred by a listed country CFC in a statutory accounting period commencing before 1 July 1997. The CFC subsequently changes residence to an unlisted country in a statutory accounting period commencing before 1 July 1997. Broad-exemption listed country Not allowable because the losses would have been denied previously under subsection 431(4) (subsection 431(4D))
Non-broad-exemption listed country Not allowable because the losses would have been denied previously under subsection 431(4) (subsection 431(4D))
Losses incurred by a broad-exemption listed country CFC in a statutory accounting period commencing after 1 July 1997 Broad-exemption listed country Allowable* (subparagraph 431(4)(a)(i))
Non-broad-exemption listed country Generally not allowable (subparagraph 431(4)(b)(i)); Allowable* if the non-broad-exemption listed country arises from the dissolution of the broad-exemption listed country (subsection 431(4B)); Allowable* if the non-broad-exemption listed country is the same country as the broad-exemption listed country (subsection 431(4C))
Losses incurred by a non-broad-exemption listed country CFC in a statutory accounting period commencing after 1 July 1997 Broad-exemption listed country Generally not allowable (subparagraph 431(4)(a)(i)); Allowable* if the broad-exemption listed country is the same country as the non-broad-exemption listed country (subsection 431(4A));
Non-broad-exemption listed country Allowable* (subparagraph 431(4)(b)(i))
(*) The losses will not be available if subsection 431(4) has applied previously to deny the losses (subsection 431(4D)).

Credit under tax sparing arrangements for foreign tax forgone

Summary of the amendments

Purpose of the amendments

6.58 The amendments will ensure that a credit is available for foreign tax forgone on income subject to accruals taxation under the CFC measures in circumstances where tax sparing provisions of a double taxation agreement require that a credit be provided.

Date of effect

6.59 The changes will apply in determining foreign tax credits available against attributable income for statutory accounting periods of CFCs commencing on or after 1 July 1997. [Subitem 124(2)]

Background to the legislation

6.60 Tax sparing occurs where tax forgone by a country in providing certain tax concessions to Australian investors is deemed to be paid for the purposes of the FTCS. Tax sparing is currently only provided under Australia's double taxation agreements although there is also a regulation making power in section160AFF that could be used to provide tax sparing outside of an agreement. In the absence of the recognition of tax sparing, tax concessions provided by other countries could be negated because the FTCS normally only allows a tax credit for foreign tax actually paid. Additional Australian tax would therefore be paid in place of the foreign tax forgone.

6.61 There is currently no need to provide a credit against attributable income for foreign tax forgone under tax sparing arrangements because tax sparing has only been provided for listed countries. Moreover, tax spared amounts derived in a listed country are exempt from accruals taxation because they are excluded from EDCI by regulation 152H. This exclusion will cease to operate for limited-exemption listed countries because the concept of EDCI will generally not be relevant in determining the attributable income of CFCs resident in the countries.

Explanation of the amendments

6.62 Section 393 currently provides a deduction in calculating attributable income for foreign tax paid by a CFC. Where the attributable taxpayer is a company, foreign tax is deemed to be paid under section 160AFCA equal to the taxpayer's attribution percentage of the deduction available under section 393. The amendments will extend this treatment by deeming foreign tax to have been paid for foreign tax forgone under tax sparing arrangements. The amount of foreign tax taken to have been paid will be equal to the taxpayer's attribution percentage of the total of:

·
the section 393 amount; and
·
the amount of foreign tax not actually paid because of a particular provision of a law of a listed country that is deemed to have been paid under a double tax agreement or section 160AFF.

[Item 16]

Treatment of amounts derived in a CFC's country of residence for the purposes of the active income test

Summary of the amendments

Purpose of the amendments

6.63 The amendments will clarify that paragraph436(1)(b) does not operate to exclude amounts from the active income test which are derived in a CFC's country of residence.

Date of effect

6.64 The changes will apply in calculating the active income test for statutory accounting periods of CFCs commencing on or after 1 July 1997. [Subitem 126(1)]

Background to the legislation

6.65 An active income test provides an exemption from accruals taxation for small amounts of tainted income that are incidental to the overall operations of a CFC. In this regard, amounts derived in carrying on a business at or through a branch in a broad-exemption listed country are generally excluded from the active income test (paragraph 436(1)(b)).

6.66 Modifications are required to the exclusion following the extension of the active income test for CFCs resident in unlisted countries to all CFCs. The modifications are required to ensure the exclusion does not apply to amounts derived by a CFC in a broad-exemption listed country from carrying on a business in that country. The exclusion of these amounts would not be appropriate because it would distort the active income test.

Explanation of the amendments

6.67 The amendments will ensure that amounts derived in carrying on a business in a CFC's country of residence are not excluded from the active income test under paragraph436(1)(b). This will be achieved by inserting the phrase "(other than a broad-exemption listed country of which the company is a resident)" at the end of the paragraph. [Item 52]

Operation of the Income Tax Regulations

Summary of the amendments

Purpose of the amendments

6.68 The amendments will ensure that changes to the Income Tax Regulations necessary to give effect to the changes to the foreign source income measures can apply from the commencement of the changes to the Principal Act.

Date of effect

6.69 The amendments will apply to the first regulations made giving effect to the changes to the taxation of foreign source income. [Item127]

Background to the legislation

6.70 Subsection 48(1) of the Acts Interpretation Act 1901 provides that regulations take effect from the date of their notification in the Commonwealth Gazette, or an earlier date if specified in the regulations. Subsection 48(2) limits the circumstances where regulations can operate from an earlier date to instances where they do not disadvantage anyone. Modification is required to the general rule in subsection48(2) if the two list approach is to apply from 1 July 1997 because the two list approach could disadvantage some taxpayers and it will not be possible to make the amendments to the Income Tax Regulations before this time.

Explanation of the amendments

6.71 The amendments will provide transitional arrangements to allow changes to the Income Tax Regulations to take effect prior to the date they will be notified in the Gazette even though the changes may operate to the disadvantage of some taxpayers. These arrangements will not be affected by the Legislative Instruments Act 1997 which will deal with the application of regulations. [Item 127]

Chapter 7 - Changes to the FIF measures

Summary of the amendments

Purpose of the amendments

7.1 The amendments will make the following two changes to the foreign investment fund (FIF) measures:

·
the exemption for approved country funds (section 513) is to be repealed; and
·
the Bogota, Colombo, Zimbabwe and Bratislava stock exchanges are to be added to the list of approved stock exchanges used for the purposes of obtaining market values for FIF interests.

Date of effect

7.2 The country fund exemption (ie, section 513 of the Principal Act and Schedule 11 of the Income Tax Regulations) is to be repealed with effect for notional accounting periods of FIFs commencing on or after 1January 1997. [Item 5 of Schedule 2]

7.3 The Bogota, Colombo, Zimbabwe and Bratislava stock exchanges are to be added to the list of approved stock exchanges in Schedule 12 of the Income Tax Regulations effective from the release of the IP (ie, 24December 1996). [The Income Tax Regulations are to be amended]

Background to the legislation

Approved Country Funds

7.4 A specific exemption from the FIF measures is provided for investments in approved country funds to allow portfolio diversification in emerging markets that do not allow direct investment by Australian residents. Australian investors can therefore invest in these emerging markets through an approved fund without being subject to the FIF measures. The list of approved country funds is prescribed in Schedule 11 of the Income Tax Regulations. There is also a list of approved country funds in Schedule 6 of the Principal Act that applied when the FIF measures were first introduced.

7.5 The country fund exemption is no longer justified following recent reforms in emerging markets that have resulted in substantial investment liberalisation. The exemption can therefore be repealed.

Approved Stock Exchanges

7.6 The list of approved stock exchanges serves two purposes. First, the value of FIF interests quoted on an approved stock exchange can be used as a valuation method for the market value method, one of three methods allowed under the FIF measures for determining FIF income. Secondly, the sectoral classifications provided by approved stock exchanges offer a simple method of qualifying for the active business exemption in the FIF measures. The list of approved stock exchanges is prescribed in Schedule12 of the Income Tax Regulations.

Explanation of the amendments

7.7 The provisions in the Principal Act dealing with the country fund exemption are to be repealed. [Items 1, 2, 3 & 4 of Schedule 2] Amendments to the Income Tax Regulations adding further exchanges to the list of approved stock exchanges and repealing the list of approved country funds are still to be drafted.

Appendix A

Diagrammatic summary of the present CFC measures

Note
- Active income not subject to tax in a listed country and derived by a CFC resident in a listed country from sources outside that country is taxed on an accruals basis under the CFC measures to ensure that low taxed profits are not repatriated to Australia as exempt dividends.

Appendix B

Diagrammatic summary of the reformed CFC measures

Note
- Active income not subject to tax in a listed country and derived by a CFC resident in a listed country from sources outside that country is taxed on an accruals basis under the CFC measures to ensure that low taxed profits are not repatriated to Australia as exempt dividends. Amounts of adjusted tainted income derived by a CFC resident in a broad-exemption listed country from sources outside that country will also be taxed on an accruals basis if they are not subject to tax in a broad-exemption listed country.

Appendix C

Countries currently listed in Schedule 10 of the Income Tax Regulations

Austria Myanmar
Bangladesh Netherlands
Belgium New Caledonia
Brazil New Zealand
Brunei Norway
Bulgaria Pakistan
Canada Papua New Guinea
China Philippines
Czechoslovakia Poland
Denmark Portugal
Fiji Romania
Finland Saudi Arabia
France Singapore
French Polynesia Solomon Islands
German Democratic Republic Spain
Germany, Federal Republic of Sri Lanka
Greece Sweden
Hungary Switzerland
Iceland Taiwan
India Thailand
Indonesia Tokelau
Ireland Tonga
Israel Turkey
Italy Tuvalu
Japan Union of Soviet Socialist Republics
Kenya United Kingdom of Great Britain and
Kiribati Northern Ireland
Korea, Republic of United States of America
Luxembourg Western Samoa
Malaysia Yugoslavia
Malta Zimbabwe

Appendix D

Countries to be included on the list of limited-exemption listed countries

Austria Myanmar
Bangladesh Netherlands
Belgium New Caledonia
Brazil Norway
Brunei Pakistan
Bulgaria Papua New Guinea
China Philippines
Czech Republic Poland
Denmark Portugal
Fiji Romania
Finland Saudi Arabia
French Polynesia Singapore
Greece Solomon Islands
Hungary Spain
Iceland Sri Lanka
India Sweden
Indonesia Switzerland
Ireland Taiwan
Israel Thailand
Italy Tokelau
Kenya Tonga
Kiribati Turkey
Korea, Republic of Tuvalu
Luxembourg Vietnam
Malaysia Western Samoa
Malta Zimbabwe

Appendix E

Countries to be included on the list of broad-exemption listed countries

Canada
France
Germany, Federal Republic of
Japan
New Zealand
United Kingdom of Great Britain and
Northern Ireland
United States of America

Appendix F

Summary of the changes to the treatment of foreign branch income

The table below summarises the treatment of foreign branches of Australian companies before and after the changes to the foreign source income measures.

Location of the branch Treatment of branch income derived before 1 July 1997 Treatment of branch income derived after 1 July 1997
Listed country Exempt under section 23AH if not EDCI and subject to tax in a listed country. If broad-exemption listed country: No change; Exempt under section 23AH if not EDCI and subject to tax in a listed country.
If limited-exemption listed country: Exempt under section 23AH if not adjusted tainted income and subject to tax in a listed country. Amounts of adjusted tainted income (not including gains or profits of a capital nature) will also be exempt if the branch satisfies an active income test and the income is subject to tax in a listed country.
Branches of Australian financial institutions (AFIs) will be provided with an exclusion from adjusted tainted income for banking income broadly consistent with the exclusion available under the CFC measures for AFI subsidiaries.
Unlisted country Not exempt under section 23AH, FTCS applies. No change: Not exempt under section 23AH, FTCS applies.

Glossary of terms

Accruals taxation

Accruals taxation is the taxation of Australian residents on profits derived through a foreign company or trust as they are earned by the company or trust. Normally the profits would not be taxed in Australia until they are distributed to the taxpayer as a dividend or trust distribution.

Active income test

The active income test ensures that small amounts of tainted income derived by a CFC are exempt from taxation. An exemption is provided from accruals taxation for most amounts derived by a CFC if the test is satisfied.

Current test : The test for a CFC resident in an unlisted country is that the gross tainted turnover of the CFC must be less than 5% of its gross turnover (excluding certain specified amounts). In the case of a listed country CFC, the tainted eligible designated concession income of the CFC must be less than 5% of its eligible designated concession income.
New test : The test for all CFCs is that currently applied to unlisted country CFCs.

Adjusted tainted income

Adjusted tainted income is the basis of the attributable income of a CFC. It comprises passive, tainted sales and tainted services income.

Approved country fund

An approved country fund is a fund listed in Schedule 11 of the Income Tax Regulations. Investment in these funds are exempt from the FIF measures. This exemption was introduced to ensure that the FIF measures do not unreasonably hinder the portfolio diversification of Australian investors in emerging markets with restrictive investments rules.

Associate

Broadly, an associate of a company is:

·
a partner of the company or a partnership in which the company is a partner;
·
a trustee of a trust in which the company holds a beneficial interest;
·
any controllers of the company; and
·
any company controlled by the original company (subsection318(2)).

Attributable income

Amounts taxed on an accruals basis under the CFC, transferor trust or FIF measures.

Attributable taxpayer

An attributable taxpayer is an Australian entity who is liable to pay tax on attributable income.

Attribution

The process by which income is taxed on an accruals basis under the CFC, transferor trust or FIF measures.

Attribution percentage

The attribution percentage is the pro rata share of a CFC's attributable income that will be attributed to a particular taxpayer's assessable income.

AFI subsidiary

An AFI subsidiary is a subsidiary of an Australian financial institution (section 326).

Australian financial institution (AFI)

Broadly, an AFI is an Australian bank or financial institution (section317).

Branch

See permanent establishment.

Broad-exemption listed country

A country listed in the Income Tax Regulations as a broad-exemption country. The list of broad-exemption countries will be used for the purposes of exemptions from accruals taxation under the CFC and transferor trust measures. The list comprises Canada, France, Germany, Japan, NewZealand, the United Kingdom and the United States. These countries are also treated as listed for the purposes of exemptions under the FTCS.

CFC measures

The CFC measures deal with the accruals taxation of Australian residents that have a controlling interest in a foreign company.

Controlled foreign company (CFC)

Broadly, a CFC is a company that is not a resident of Australia and is controlled by five or fewer residents (section 340).

Debt creation rules

Debt creation rules deny an interest deduction on debt used to finance the transfer of assets from one related company to another where the buyer and seller are at least 50% controlled by a non-resident or a related non-resident. The rules ensure that profits are not effectively transferred from one company to another through the creation of an interest expense.

Designated concession income (DCI)

Income or profits of a kind specified in the Income Tax Regulations that are not comparably taxed because of a specified feature in the tax law of:

·
a listed country (currently); or
·
a broad-exemption listed country (after the changes).

Double taxation agreement (DTA)

A double taxation agreement is an agreement made between the Australian Government and another State under the International Tax Agreements Act (1953).

Eligible designated concession income or EDCI

Currently eligible designated concession income is designated concession income from a listed country that is not subject to full tax in any other listed country.

After the changes eligible designated concession income will be designated concession income from a broad-exemption listed country that is not subject to full tax in any other broad-exemption listed country.

Exempting profits

The total of the exempting receipts held as distributable profits by a company resident in an unlisted country.

Exempting receipt

Exempting receipts are, generally, amounts earned by a company resident in an unlisted country that can be distributed as exempt dividends.

FIF measures

The FIF measures deal with the accruals taxation of Australian residents that have a non-controlling interest in a foreign company or foreign trust.

Financial intermediary business

A banking business or a business whose income is principally derived from the lending of money.

Foreign investment fund (FIF)

A FIF is any foreign company or foreign trust (other than a deceased estate).

Foreign life policy (FLP)

Generally a FLP is a life assurance policy issued by an entity that is not a resident of Australia.

Foreign Tax Credit System (FTCS)

Under the FTCS, foreign source income derived by Australian residents (apart from certain salary and wages) is generally subject to Australian tax. A credit for foreign tax paid is allowed against the Australian tax payable, up to the amount of the Australian income tax referable to the foreign income.

Limited-exemption listed country

A country listed in the Income Tax Regulations as a limited-exemption country. These countries will basically comprise the current list of countries in Schedule 10 of the Income Tax Regulations, excluding broad-exemption listed countries. The list will be updated by adding the CzechRepublic and Vietnam, and removing countries which no longer exist.

Listed country

A country listed for the purposes of dividend and branch profit exemptions under the FTCS. Prior to the changes, listed countries were designated in Schedule 10 of the Income Tax Regulations. Following the changes, listed countries comprise those countries on either the list of broad-exemption countries or limited-exemption countries.

Non-broad-exemption listed country

A country that is either a limited-exemption listed country or an unlisted country.

Non-portfolio dividends

Broadly, non-portfolio dividends are dividends paid to a company where that company has a 10 per cent or greater voting interest in the company paying the dividend.

Notional accounting period

A notional accounting period is the period used to determine the attributable income of a FIF or a FLP.

Notional assessable income

The assessable income of a CFC for the purposes of determining the CFC's attributable income.

Passive income

Passive income includes certain types of dividend, interest, royalty, annuity, and rental income (section 446). It also includes gains on the disposal of assets that produce passive income or that are not used solely in carrying on a business.

Permanent establishments

A permanent establishment is widely defined in subsection 6(1). Generally it can be described as a place through or at which an entity in Australia conducts its business in another country. A permanent establishment has been referred to as a branch in this explanatory memorandum.

Related foreign companies

Generally, an Australian company is related to a foreign company for the purposes of the FTCS when:

·
the companies are both group companies; and
·
the Australian company has a voting interest (direct or indirect) of at least 5% in the foreign company (section 160AFB).

For these purposes, a company is a group company when the Australian parent has a voting interest of at least 10% in the foreign company. If the foreign company has an equivalent interest in a second foreign company, then that second foreign company will also be a group company. This result will continue to apply through any number of tiers of companies.

There is also a definition of related company in section 160G of the capital gains tax provisions that will apply for the purposes of determining whether a valid election has been made by a resident company to treat states arising from the dissolution of Czechoslovakia, Yugoslavia and the USSR as listed countries. A related company for the purposes of section160G is broadly a wholly owned group company.

Special excluded rental income

Rental income derived from an associated CFC in the same country that is subject to normal company tax and is not deductible to the associate (section 317).

Statutory accounting period

A statutory accounting period is the period used to determine the attributable income of a CFC.

Successor states

These are countries formed after the dissolution of the USSR, Czechoslovakia and Yugoslavia.

Tainted eligible designated concession income

Tainted eligible designated concession income is tainted income that is also eligible designated concession income.

Tainted income

Tainted income includes passive income, tainted sales income and tainted services income.

Tainted rental income

Tainted rental income includes rental income of a CFC where:

·
land is leased to an associate, or the rent is paid by an associate; or
·
land is leased by a company not resident in the same country.
It can also include rental income from particular leases on ships, aircraft, or cargo containers.

Tainted sales income

Tainted sales income is income of a CFC from the sale of goods purchased from or sold to:

·
an associate who is an Australian resident; or
·
an associate who is not an Australian resident but carries on business in Australia through a permanent establishment.

Tainted services income

Tainted services income is income derived from the provision of services by a CFC to:

·
an associate of the CFC;
·
a resident of Australia; or
·
in connection with a permanent establishment in Australia.

Tax sparing

Tax sparing deems tax forgone by a foreign country in providing a specified concession to an Australian resident to be foreign tax paid for the purposes of Australia's foreign tax credit rules. The Australian resident may therefore be entitled to claim a credit for the tax forgone by the foreign country.

Thin capitalisation

The thin capitalisation rules deny an interest deduction where the foreign controllers of a company do not maintain a specified debt to equity ratio.

Transfer pricing rules

Transfer pricing rules are contained in Division 13 Part III. This Division seeks to impose 'arms-length' consideration on agreements for the sale of property between Australians and non-residents when there is a possibility that the agreement effectively moves income from Australia.

Transferor trust

A non-resident trust to which a resident has made, or is deemed to have made, a transfer of property or services (Division 6AAA of Part III).

Transferor trust measures

The transferor trust measures deal with the accruals taxation of Australian residents who have directly or indirectly transferred value to a non-resident trust. Broadly the rules operate to accruals tax the undistributed income of the trust.

Unlisted country

An unlisted country is a country which is not on either list of countries.


View full documentView full documentBack to top