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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.


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