Foreign income return form guide

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Chapter 1: Attribution of the current year profits of a controlled foreign company (CFC)

This chapter explains the accruals tax system for residents with interests in foreign companies.

The accruals tax system applies to Australian residents who have a substantial interest in a foreign company controlled by Australians, referred to as a CFC. The system operates to include a taxpayer's share of specified income and gains of a CFC in the taxpayer's assessable income: this is called attribution. Subject to some modifications, the income and gains of CFCs are worked out using the same tax rules that apply for residents.

Part 1

Are you subject to the CFC measures?

Part 2

Does the CFC satisfy the active business test?

Part 3

Working out attributable income and the amount to include in your assessable income

Part 1: Are you subject to the CFC measures?

The accruals tax system may apply to you if you are an Australian resident who has a substantial interest in a CFC. This part explains:

  • when a foreign company is a CFC
  • the types of interests in a foreign company that are taken into account in testing whether that company is a CFC
  • the size of an interest in a CFC you need before you must include an amount in your assessable income
  • how to determine the size of your interest in a CFC
  • whether income of a CFC is to be included in your assessable income for the current income year.

Summary of part 1

Section 1

Is there a CFC?

Section 2

Are you an attributable taxpayer?

Section 3

Is the CFC's income generally exempt from accruals taxation?

Section 4

What types of attribution can apply?

Section 5

Do you have to work out the attributable income of a CFC?

S ection 1: Is there a CFC?

Three control tests

A CFC is a non-resident company that satisfies one of three control tests. Whether a company is a resident of a foreign country is determined according to Australian tax law as modified by double-taxation agreements with other countries.

The three control tests are the:

  • strict control test
  • assumed controller test
  • de facto control test.

Strict control test

A foreign company will be treated as a CFC under the strict control test if a group of five or fewer Australian '1% entities', together with their associates, owns or is entitled to acquire a control interest of at least 50% in the foreign company.

An Australian 1% entity is an Australian entity that, together with its associates, holds an interest of at least 1% in the foreign company.

An Australian entity is an Australian partnership, an Australian trust, or an entity (other than a partnership or trust) that is a Part   X Australian resident. A Part   X Australian resident is a resident of Australia who is not treated solely as a resident of another country under a double-taxation agreement between Australia and that country.

The associate-inclusive control interest of an entity is the sum of interests held by the entity and its associates in the foreign company. Interests that the entity and its associates are entitled to acquire are also taken into account.

Example 1

Strict control test

  • This test will be satisfied if three Australian residents each hold interests of 30%, 10% and 10% respectively in a foreign company.

Assumed controller test

A foreign company will normally be treated as a CFC under the assumed controller test if a single Australian entity owns, or is entitled to acquire, an associate-inclusive control interest of at least 40% in the foreign company. An entity's associate-inclusive control interest in a foreign company is the sum of the interests held in the company by the entity and the associates of the entity. However, a foreign company will not be treated as a CFC under the assumed controller test if the company is controlled by a party or parties unrelated to the single resident or its associates.

Example 2

Assumed controller test

  • If an Australian entity holds 45% of the interests in a foreign company and the remaining 55% is held by several non-residents, it would be assumed under this test that the Australian entity controls the foreign company.

De facto control test

A foreign company will be treated as a CFC under the de facto control test if a group of five or fewer Australian entities, either alone or with associates, effectively controls the foreign company.

Example 3

De facto control test

  • If an Australian entity can control the appointment of the directors of a foreign company, the Australian entity will generally be taken to have de facto control of that foreign company.
When is control measured?

A statutory accounting period of a CFC is a period of 12   months ending 30   June, unless the CFC makes an election to use another period. The control test is applied at the end of a CFC's statutory accounting period to check whether income of the CFC is to be attributed.

It may also be necessary to measure control at the time a CFC pays a dividend to another CFC or to a controlled foreign trust or at the time a CFC changes residence.

Election to change a CFC's statutory accounting period

A CFC can make an election to change its statutory accounting period only if the accounting period is:

  • regularly used by the CFC for complying with the tax law of a foreign country, or
  • regularly used by the CFC for reporting to its shareholders.

A CFC may also make a written election, and send it to the ATO, to adopt a statutory accounting period ending on a date other than 30   June if the period is regularly used for complying with the tax laws of the CFC's country of residence or is regularly used for reporting to the CFC's shareholders. You may make this election on behalf of a wholly owned CFC.

A CFC may subsequently elect another statutory accounting period ending on any date, including 30   June, provided the above conditions are satisfied.

Where a CFC chooses another statutory accounting period, it must complete the current statutory accounting period. The intervening statutory accounting period - that is, from the last day of the current period to the beginning of the new period - will be less than 12   months. The new and subsequent statutory accounting periods will be 12   months.

Example 4

Statutory accounting periods

  • If a company with a statutory accounting period ending 30   June 2002 elected on 30   August 2001 to change to a statutory account period ending 30   September, it would have statutory accounting periods of:
  • 1 July 2001 to 30 June 2002
  • 1 July 2002 to 30 September 2002
  • 1 October 2002 to 30 September 2003, and
  • subsequent 12-month statutory accounting periods ending 30   September.
  • It is not necessary for a CFC to complete the current statutory accounting period before beginning a new period if the election is made when the CFC first comes into existence or when a company first becomes a CFC.
What interests in a foreign company are taken into account in the control tests?

In most cases, an interest in a foreign company will be held in the form of shares. This interest can be held either directly or indirectly through other entities. At a particular time, your interests in a foreign company include the interests you hold in the company, as well as the interests you are entitled to acquire.

The interests of your associates in a foreign company are also relevant for determining whether you have an interest in the company.

Direct control interest in a foreign company

Your direct control interest in a foreign company is the largest of the percentages that you hold, or are entitled to acquire, of the following:

  • total paid-up share capital in the foreign company

     
  • total rights to vote, or to participate in any decision making, in relation to
    • the distributions of capital or profits
    • the changing of constituent documents
    • the varying of share capital of the company
  • total rights to distributions of capital or profits of the company on winding up

     
  • total rights to distributions of capital or profits of the company other than on winding up.

Example 5

Direct control interest in a foreign company

  • A foreign company is established issuing 100 ordinary shares. An Australian taxpayer purchases 50 of these shares, which entitle the taxpayer to 50% of the income, voting and capital rights of the company. The direct control interest of the Australian taxpayer in the foreign company is 50%.

Example 6

Direct control interest in a foreign company where shares confer different rights

  • An Australian company has a 50% voting interest and a 75% income interest in a foreign company. The direct control interest of the Australian company in the foreign company is 75%.

How is a direct control interest measured if the test time occurs before the end of an accounting period?

A taxpayer's direct control interest in a company has to be measured at a point in time, referred to as the test time.

However, in some cases, it may not be possible to measure the percentage a taxpayer holds of the total rights to the profits of a company, or to a distribution of capital on winding up of the company, before the end of the accounting period of the company.

For example, this would be the case if some shareholders are entitled to a fixed return of capital or profits.

In these cases, the taxpayer's rights to capital or profits are measured at the end of the accounting period of the company. It is assumed for this purpose that the rights held by the taxpayer at the test time are held at the end of the accounting period of the company.

Exclusion of eligible finance shares

Eligible finance shares are not taken into account in working out an entity's direct control interest in a company. Broadly, these are shares issued under preference share financing arrangements with Australian financial intermediaries (for example, banks) and their subsidiaries. In effect, the shares are issued in place of loans.

Indirect control interest in a company

A taxpayer may hold a direct control interest in an entity (Entity   A) which holds a direct control interest in another entity (Entity   B). In this case, the taxpayer has an indirect control interest in Entity   B.

A taxpayer's indirect control interest in Entity   B is obtained by multiplying the direct control interest of the taxpayer in Entity   A by the entity's direct control interest in Entity   B.

This process of multiplication is continued where there are further entities in the chain.

Indirect control interest may only be traced through a controlled foreign entity

An indirect control interest in a foreign entity can be traced only through controlled foreign entities (CFEs). These are CFCs, controlled foreign partnerships and controlled foreign trusts.

A controlled foreign partnership is a partnership which does not have a resident partner and has at least one CFC or a controlled foreign trust as a partner. A controlled foreign trust is a trust, other than an Australian trust:

  • that has an eligible transferor , or
  • where five or fewer residents and their associates hold, or are entitled to acquire, 50% or more of the income or capital of the trust.

Deeming rules for tracing an indirect control interest

For determining the indirect control interest in an entity (but not for working out the amount of the income to be attributed to a taxpayer) a resident or an interposed CFC is deemed, in the following specified circumstances, to own a 100% interest in a lower-tier entity.

The control tracing interest of an entity will be treated as 100% if, together with associates, the entity:

  • has an interest of at least 50% in a foreign company
  • satisfies the assumed controller test in relation to a foreign company
  • actually controls the foreign company
  • is a partner in a partnership that is not an Australian partnership
  • is an eligible transferor in relation to a trust, or
  • has an interest of at least 50% in a trust that is not an Australian trust.

Example 7

Indirect control interest

  • A resident company holds a 60% interest in a foreign company, FC1, which holds a 35% interest in another foreign company, FC2. FC2 holds a 60% interest in foreign company FC3. Another resident holds a 20% interest in FC2.
  • The indirect control interest of the resident company in FC3 is:

Resident company

Direct control interest

%

Control tracing

interest

%

FC1

60

100

FC2

35

35

FC3

60

100

The indirect control interest of the resident company in FC3 is worked out as follows:
100% x 35% x 100% = 35%
It is possible to trace interests through FC2 because it is a CFC. FC3 is also a CFC because the resident company has an indirect control interest of 35% in FC3 and another resident has an indirect control interest of 20% in FC3 (that is, 20% in FC2 x 100% interest for tracing control of FC2 in FC3).
Associate-inclusive control interest

Your associate-inclusive control interest in a foreign company is the sum of:

  • your direct control interests in the foreign company
  • your indirect control interests in the foreign company
  • the direct and indirect control interests of your associates in the foreign company.

To avoid double counting, an indirect control interest is not taken into account when determining a direct control interest or another indirect control interest.

S ection 2: Are you an attributable taxpayer?

If you have an interest in a CFC, you must determine if you are an attributable taxpayer. You are only required to include an amount of attributable income from a CFC in your assessable income if you are an attributable taxpayer in relation to the CFC.

You will be an attributable taxpayer if:

  • you have an associate-inclusive control interest of 10% or more in a CFC, or
  • all of the following rules apply:
    • the CFC is a CFC because of the application of the de facto control test
    • you are an Australian 1% entity, and
    • you are part of a group of five or fewer Australian entities who, alone or with associates (regardless of whether the associates are Australian entities) controls the CFC.
What share of the attributable income of a CFC must you include in your assessable income?

If you are an attributable taxpayer, you may be attributed a share of a CFC's attributable income. Your share is called an attribution percentage and is based on your rights to profits from the CFC.

Working out your attribution percentage

Your attribution percentage in a CFC is the sum of your:

  • direct attribution interest in the CFC, and
  • indirect attribution interests in the CFC.

The interests of your associates are not included.

Direct attribution interest in a CFC

Your direct attribution interest in a CFC is the largest of the percentages that you hold, or are entitled to acquire, of the following:

  • total paid-up share capital in the CFC

     
  • total rights to vote, or to participate in any decision making, in relation to
    • the distributions of capital or profits
    • changing of constituent documents
    • varying of share capital of the CFC
  • total rights to distributions of capital or profits of the CFC on winding up

     
  • total rights to distributions of capital or profits of the CFC other than on winding up.

Test time

Your direct attribution interest in a CFC is measured at a point in time called a test time. The test time may occur during the accounting period of a CFC.

In some cases, it may not be possible to measure the percentage you hold of the total rights to the profits of a company or to a distribution of capital on winding up of the company before the end of the company's accounting period.

In these cases, your rights to capital or profits are measured at the end of the accounting period of the company. It is assumed for this purpose that the rights you held at the test time are held at the end of the company's accounting period.

Exclusion of eligible finance shares

In working out your direct attribution interest in a CFC, eligible finance shares in the CFC are not taken into account.

Exclusion of real estate investment trust shares

Real estate investment trust shares are not taken into account in working out an entity's direct attribution interest in a United States real estate investment trust that derives income or holds assets principally in the United States. Control interests held through a United States real estate investment trust will still be taken into account in determining whether a subsidiary of the trust qualifies as a CFC. This will attribute income from a real estate investment trust subsidiary where a taxpayer has a direct interest in the subsidiary.

This exemption applies to statutory accounting periods of CFCs ending on or after 2 July 1998.

Indirect attribution interest in a CFC

You may hold an attribution tracing interest in an entity (Entity   A) which holds an attribution tracing interest in another entity (Entity   B).

Your indirect attribution interest in Entity B is obtained by multiplying your attribution tracing interest in Entity   A by that entity's attribution tracing interest in Entity   B.

This process of multiplication is continued where there are further CFEs in the chain of entities.

Attribution tracing interests in a CFC

Your attribution tracing interest in a CFC is equal to your direct attribution interest in the CFC. The deemed 100% rule for tracing control does not apply when tracing your attribution percentage.

Attribution tracing interest in a controlled foreign partnership

The attribution tracing interest of a partner in a partnership is the percentage the partner holds, or is entitled to acquire, of the profits of the partnership or of the partnership property. Where the two percentages differ, the attribution tracing interest will be the greater of those percentages.

Attribution tracing interest in a controlled foreign trust

The attribution tracing interest that a beneficiary of a trust holds in the trust is the percentage of the income or property of the trust representing the share of the income or property to which the beneficiary is entitled, or is entitled to acquire. If the percentage of the income and the percentage of the property differ, the higher percentage is treated as the attribution tracing interest.

An eligible transferor has an attribution tracing interest in the controlled foreign trust equal to 100%. See part   1 of chapter   2 to determine whether you are an eligible transferor.

Reduction of the attribution percentage where the total percentage is more than 100%

In some cases, the total of the attribution percentage of all attributable taxpayers may be more than 100%. In these cases, the aggregate is reduced to 100% by reducing proportionately the interest of each attributable taxpayer.

  • Example 8

    Reduction where attribution percentage is more than 100%
  • A foreign company has two classes of shares on issue. Class   A carries the right to vote, but no income rights. Class   B carries the right to income and is non-voting. An Australian resident (Res1) owns 25% of the Class   A shares and 75% of the Class   B shares. Another resident (Res2) owns the remaining shares in each class. The foreign company is a CFC and both residents are attributable taxpayers.

Res1's attribution percentage

(greater of 25% and 75% )

75%

Res2's attribution percentage

(greater of 75% and 25% )

75%

Total interest of residents

150%

  • Each attributable taxpayer's attribution percentage is reduced in proportion, so that the aggregate interests of all attributable taxpayers is 100%.

Res1's reduced attribution percentage

=

                        attribution percentage                        

total interest of attributable taxpayers

 

=

 

  75

150

= 50%

Res2's reduced attribution percentage

=

                        attribution percentage                        

total interest of attributable taxpayers

 

=

 

  75

150

= 50%

S ection 3: Is the CFC's income generally exempt from accruals taxation?

A number of exemptions from accruals taxation are provided for amounts taxed in a comparable tax country listed in the Income Tax Regulations 1936 .

The countries listed in attachment   A of appendix   1 are called listed countries. The countries not listed are called unlisted countries. (A subset of unlisted countries is 'section 404 countries').

Summary of terms used to refer to countries

L isted countries

Listed countries are those listed in Schedule   10 of the Income Tax Regulations 1936 . Amounts taxed at full rates by listed countries are generally exempt from accruals taxation.

Unlisted countries

Unlisted countries are those that are not listed countries. This includes section   404 countries for all purposes of the CFC rules except the application of section   404.

Section 404 countries

Section 404 countries are those listed as 'section 404 countries' in Schedule   10 of the Income Tax Regulations 1936 . The list of section 404 countries is in attachment   A of appendix   1 .

Section 404 excludes from attributable income dividends paid from a company resident in a listed country or section   404 country to a CFC that is also resident in a listed or section   404 country.

When is a CFC a resident of a listed country?

A CFC is treated as a resident of a listed country if:

  • the CFC is not a Part   X Australian resident, and
  • the CFC is treated as a resident of a listed country under the tax laws of that country.
When is a CFC a resident of a section 404 country?

A CFC is a resident of a section 404 country if:

  • the CFC is not a Part   X Australian resident
  • the CFC is treated as a resident of a section   404 country under the tax laws of that country, and
  • the CFC is not treated as a resident of a listed country at that time for the purposes of the tax law of the listed country.
When is a company a resident of an unlisted country?

A company is treated as a resident of an unlisted country if the company is neither a Part   X Australian resident nor a resident of a listed country.

Rules that determine the particular unlisted country of residence

In some cases, it is necessary to determine whether a company is treated as a resident of a particular unlisted country, for example, for determining the active income test.

A company is treated as a resident of a particular unlisted country if:

  • the company is treated as a resident under a tax law of the unlisted country, and
  • the company is not treated as a resident of any other unlisted country under the tax law of that country.

If a company is treated as a resident of more than one unlisted country under the tax laws of those countries and is incorporated in one of those countries, it is treated as a resident in the country of incorporation.

If a company is not treated as a resident under the tax law of any unlisted country, it will be a resident of the unlisted country in which its management and control is solely or principally located.

If a company is not treated as a resident under the tax law of any unlisted country and does not have its central management and control solely or principally in an unlisted country, it will be a resident of the unlisted country in which it is incorporated.

S ection 4: What types of attribution can apply?

Sections 1 and 2 asked the following questions:

  • Is there a CFC?
  • Are you an attributable taxpayer?

If the answer to both of these questions is yes, the next step is to determine whether you must include an amount in your assessable income.

Attribution on change of residence

If you were an attributable taxpayer of a CFC resident in an unlisted country and the CFC changed its residence to a listed country or to Australia while you were an attributable taxpayer, you may be subject to attribution on your share of the accumulated profits of the CFC.

Attribution of current year profits

If you are an attributable taxpayer of a CFC at the end of the CFC's statutory accounting period, you may need to include the whole or a part of the profits of that period in your assessable income.

The attribution of current year profits of a CFC may be reduced if you have been subject to dividend attribution or attribution on change of residence by the CFC. Read chapter   3 and appendix   2 to see whether either of these applies to you.

S ection 5: Do you have to work out the attributable income of a CFC?

This section will tell you whether you need to work out the attributable income of the CFC. A brief description of the calculation follows.

Overview of the calculation

If you are an attributable taxpayer, your assessable income may include a share of the profit, if any, from certain types of income and gains of the CFC. The profit of the CFC is called attributable income and is worked out before taking into account your share of the profit (called your attribution percentage).

You work out attributable income based on the existing rules for working out the taxable income of a resident company. However, not all of the profits of a CFC are taken into account in working out the attributable income of the CFC.

The general rule

The general rule is that only amounts that arise from certain transactions (called tainted income ) which are classified as prone to tax minimisation are taken into account. These will only be taken into account if a CFC is not mainly engaged in genuine business activities, that is, where the CFC fails the active income test.

Exception for a listed country

An exception to the general rule is made for a CFC that is resident in a listed country and derives certain untaxed income or gains (of a kind specified in the Income Tax Regulations 1936 ) from sources outside listed countries. These amounts are taken into account whether or not the CFC passes the active income test.

Exception for trust amounts

Another exception to the general rule is for certain trust amounts derived by a CFC. These will be taken into account whether or not the CFC passes the active income test.

Exception for comparably taxed amounts

Amounts are generally only taken into account if they are not taxed in full in Australia or comparably taxed in a listed country. Amounts arising in a listed country are assumed to be comparably taxed if they do not qualify as eligible designated concession income as described in Schedule   9 of the Income Tax Regulations 1936 and in appendix   1 .

Relevant period

An amount will normally only be included in your assessable income if the CFC's statutory accounting period ends in your income year.

Example 9

Taxpayer with a standard year of income

  • A taxpayer whose income year ends on 30   June has a CFC with a statutory accounting period which also ends on 30   June. For the taxpayer's income year ending 30   June 2007, the taxpayer must include a share of the attributable income of the CFC for the statutory accounting period ending 30   June 2007.

Example 10

Taxpayer who balances early

  • A taxpayer whose income year ends on 31   March has a CFC with a statutory accounting period ending 30   June. For the taxpayer's income year ending 31   March 2007, the taxpayer must include a share of the attributable income of the CFC for the statutory accounting period ending 30   June 2006. The CFC's attributable income for the period 1   July 2006 to 30   June 2007 would not be included in the taxpayer's assessable income until the income year ending 31   March 2008.
Special rule for companies that cease to exist

If a company that was a CFC at the beginning of its statutory accounting period ceases to exist before the end of that period, the end of the company's statutory accounting period is deemed to be immediately before it ceased to exist.

Example 11

Shortened statutory accounting period when a company ceases to exist

  • A CFC elects a statutory accounting period that aligns with its usual accounting period of 1   January to 31   December. The company members pass a resolution to wind up the company on 1   August 2007 and it is finally de-registered on 2   November 2007 in accordance with the corporation law in the company's country of residence. As the company ceased to exist during what was its statutory accounting period, the company's statutory accounting period is taken to be from 1   January 2007 to 2   November 2007.
Conditions to be met before you work out attributable income

You only need to work out attributable income if a foreign company is a CFC at the end of the foreign company's statutory accounting period. In addition, you will only need to work it out if you are an attributable taxpayer at the end of the period.

If you have an interest in a CFC at the end of the CFC's statutory accounting period, you must work out the attributable income of the CFC for the entire period, not just for the time you held the interest.

Example 12

Disposal of a CFC before the end of a statutory accounting period

  • A resident individual with an income year ending 30   June has a CFC with a statutory accounting period that coincides with the individual's income year. On 31   December 2006, the individual disposes of the CFC to an unassociated resident company.
  • In this case, the resident individual will not be an attributable taxpayer for the CFC's statutory accounting period ending 30   June 2007. As a result, the resident individual will not include in their assessable income any of the attributable income of the CFC for the period.

Example 13

Acquisition of a CFC part way through a statutory accounting period

  • Changing the facts from the previous example so that the CFC was acquired (not disposed of) on 31   December 2006, the resident company would be an attributable taxpayer for the CFC's statutory accounting period ending 30   June 2007. As a result, the company would be taxed on the attributable income of the CFC for the entire period, even though the company owned the foreign company for only the second half of that period.
  • An arrangement that is designed to avoid the CFC measures by selling an interest before the end of a CFC's statutory accounting period and acquiring the interest after the end of the period will be treated as if the interest were not sold.

Were you an attributable taxpayer at the end of the CFC's statutory accounting period?

No

You do not need to work out attributable income. You do not need to continue reading this chapter.

Yes

Read on.

Part 2: Does the CFC satisfy the active income test?

Part 2 deals with the operation of the active income test but does not cover the operation of the special rules for banks, other financial institutions and insurance companies in Subdivision F of Division 8 of Part X of the ITAA 1936.

Section 1

Terms used in this part

Section 2

Conditions to be met to satisfy the active income test

Section 3

Is the tainted income ratio less than 5%?

Section 1: Terms used in this part

Meaning of passive income

Dividends

Passive income includes dividends (within the meaning of section   6) and:

  • unit trust dividends received from a corporate unit trust or a public trading trust
  • a distribution made by a liquidator which is deemed to be a dividend.

Interest income

Passive income includes tainted interest income, which is all interest income except for interest derived through an offshore banking unit. It also specifically includes:

  • amounts in the nature of interest (for example, discounts)
  • income earned from hire purchase and other property financing transactions
  • accrued interest on discounted and other deferred interest securities issued after 16   December 1984
  • interest deemed to be derived where a CFC assumes the rights of a lender through the purchase of securities through a secondary market
  • factoring income.
Tainted rental income

There are three categories of tainted rental income:

  • rent from associates
    • income from any leases between a CFC and an associate and any income that arises where rent is paid to the CFC by an associate
  • lease of land
    • income from related party lease transactions
    • income from leases of land, including fixtures, in respect of land situated in a country other than the CFC's country of residence
    • income from leases of land, including fixtures, in respect of land situated in the CFC's country of residence, unless a substantial part of the income is attributable to the provision of labour-intensive 'property management services' by directors or employees of the CFC in connection with the land
  • ships and aircraft
    • income from the lease of ships or aircraft, cargo containers for use on ships or aircraft or plant or equipment for use on board ships, unless the income relates to the provision of operating crew in relation to ships and aircraft or maintenance or management services by the CFC's directors or employees.

Special excluded rental income

An amount of rental income will not be treated as tainted if the following three requirements are satisfied:

  • the amount is derived from an associated CFC resident in the same country
  • the amount is taxed at the normal company rate of tax in that country, and
  • the payment of the amount did not wholly or partly give rise to a notional allowable deduction for the associated CFC.

The second requirement is based on whether an amount has been taxed at the normal company rate of tax in a country. For an amount to be treated as taxed at a country's normal company rate, the amount must be taxed at the same rate applicable to the company's other non-dividend income or at a higher rate. In addition, there can be no entitlement to a credit, offset or tax concession in the taxation of the amount.

For the third requirement, it is assumed that the associated CFC failed the active income test. The requirement will not be satisfied if a payment would have resulted in a notional allowable deduction for an associated CFC if the CFC had been required to work out its attributable income.

Tainted royalty income

Tainted royalty income includes income derived from assigning any copyright, patent, trademark or other like property or right.

Specifically excluded from tainted royalty income are royalties received from unrelated persons in the course of carrying on a business where the CFC substantially develops or improves the property or right for which the royalty is paid. For example, if a CFC develops software and licenses it to an unrelated party, the royalty income is not tainted.

Net gains on the disposal of tainted assets

The net gain (that is, the sum of gains, less losses) from the disposal of tainted assets is included in passive income.

What is a tainted asset?

Tainted assets include:

  • all shares, interests in trusts and interests in partnerships
  • most financial instruments, such as loans, forward and futures contracts, swaps, other securities and life assurance policies
  • rights or options over any of the above.

An asset will also be tainted if it is held by a CFC to derive tainted rental income. In order to determine whether an asset is used to produce tainted rental income, you must look at the use of the asset over the whole time of ownership. If the purpose changed during that period, the asset will be treated as being used to produce tainted rental income if this was the purpose for the majority of the period of ownership.

Also, an asset will be treated as a tainted asset if it is not trading stock or is not used solely in carrying on business.

The tainted assets referred to in the preceding paragraphs, such as shares, will be tainted assets whether or not they are trading stock or are used in carrying on business. Exclusion of commodity investments

Commodity investments are not tainted assets: they are treated separately when working out net tainted commodity gains.

Proceeds from trading in tainted assets

Income derived in carrying on a business of trading in tainted assets is included in passive income.

Net tainted commodity gains and losses

The net gain on the disposal of tainted commodity investments is included in passive income.

What is a tainted commodity gain or loss?

A tainted commodity gain or loss arises from the disposal of a tainted commodity investment.

What is a tainted commodity investment?

Commodity investments that are tainted include futures or forward contracts for a commodity (or a right or option on such a contract) unless the contract relates to carrying on a business of:

  • producing or processing the commodity, or
  • using the commodity as a raw material in a production process

Where these conditions are not met, the investment can be excluded from being a tainted commodity investment if the contract, right or option relates to a transaction where the resultant physical sale of the commodity will not be tainted sales income. The contract must also have been entered into for the sole purpose of eliminating or reducing adverse financial consequences from fluctuations in the price of the commodity.

Net tainted currency exchange gains and losses

A net tainted currency gain is the total of the tainted currency exchange gains less the total of the tainted currency exchange losses. If this is a positive figure, there is a net gain; if not, the amount is ignored.

What is a tainted currency exchange gain or loss?

A gain or loss from a currency exchange fluctuation will be tainted unless it falls within one of the following categories:

  • the underlying transaction was for the purchase of goods from an unassociated person
  • the underlying transaction was for the purchase or sale of depreciable plant or equipment that was used mainly to produce income that is not passive, tainted sales or tainted services
  • the underlying transaction was a hedge for one of the preceding transactions
  • the CFC was carrying on business as a currency trader and no other party to the transaction was an associate or an Australian resident.
Meaning of tainted sales income

The tainted sales income of a CFC includes that part of gross turnover that represents sales income where the goods sold were purchased from or sold to:

  • an associate who is a Part   X Australian resident, or
  • an associate who is not a Part   X Australian resident but carried on business in Australia through a permanent establishment.

Sales which result in tainted sales income

 

Purchased from

Tainted sales?

Sold to anyone

Associated Australian

Yes

Associated non-resident (via Australian branch)

Yes

Unassociated Australian

No

Associated non-resident (not via Australian branch)

No

Unassociated non-resident

No

Purchases which result in tainted sales income on sale

 

Sold to

Tainted sales?

Purchased from

anyone

Associated Australian

Yes

Associated non-resident (via Australian branch)

Yes

Unassociated Australian

No

Associated non-resident (not via Australian branch)

No

Unassociated non-resident

No

Exclusions from tainted sales income

Manufacturing exclusion

The main exclusion from tainted sales income is sales where the CFC manufactures, extracts, produces or substantially alters the goods sold: for example, this would include sales from mining and quarrying operations.

This exclusion will apply only where the goods sold were manufactured, produced or substantially altered by the directors or employees of the CFC. The packaging and labelling of goods is not considered to be a substantial alteration of those goods.

The exclusion will not be available where the CFC subcontracts the manufacture, production or substantial alteration to agents or subcontractors. However, the fact that a CFC subcontracts some operations will not disqualify it from the manufacturing exclusion if directors or employees of the CFC carry out a substantial part of the manufacture, production or substantial alteration.

Hospitality exclusion

Also excluded from tainted sales income are sales that, broadly, arise from the tourism and hospitality industry. These are sales provided in connection with a hotel, motel, guesthouse, restaurant, bar or other place of entertainment or recreation.

Passive income exclusion

Amounts of passive income are excluded from tainted sales income. This prevents double counting.

Meaning of tainted services income

Tainted services income, in broad terms, means income derived from the provision of services by a company to:

  • a resident (except in connection with a foreign permanent establishment of the Australian resident), or
  • a non-resident in connection with the non-resident's Australian permanent establishment.

Tainted services income also includes income derived from services provided indirectly to Australian residents, subject to certain requirements.

Services includes any benefit, right or privilege provided under an arrangement for the performance of work or the provision of facilities: for example, performance of technical, managerial or transport work.

Tainted services income

Provided to

Tainted services?

Associated Australian

Yes

Associated non-resident (via Australian branch)

Yes

Unassociated Australian

Yes

Associated non-resident (not via Australian branch)

No, subject to indirect services rule

Unassociated non-resident (via Australian branch)

Yes

Unassociated non-resident (not via Australian branch)

No

Exclusions from tainted services income

General exclusions

Tainted services income does not include:

  • royalties
  • any income in respect of a lease of land
  • any income from trading in assets, or
  • gains from currency exchange rate fluctuations, commodity investments and assets.

Manufacturing exclusion

There is an exclusion from tainted services income where the service relates to goods manufactured by a CFC: for example, payments for after-sales service or income derived under a service contract for equipment manufactured by a CFC.

Hospitality exclusion

Also not included in tainted services income are services that, broadly, arise from the tourism and hospitality industry: these amounts are services provided in connection with a hotel, motel, guesthouse, restaurant, bar or other place of entertainment or recreation.

Passive and tainted services income exclusion

Tainted services income does not include passive income or tainted sales income, this prevents double counting.

Indirect services rule

Income from services provided to an Australian resident or Australian permanent establishment of a non-resident is tainted services income. Income from services provided indirectly to certain Australian residents or Australian permanent establishments will also be tainted services income where the following conditions are met:

  • services provided by the company to an associated entity are received by another entity that is an Australian resident
  • the services are provided under a scheme (as defined in section   995-1 of the ITAA 1997), and
  • the income from the services would have been tainted income if they had been provided directly by the company to the ultimate recipient.

The services originally provided by the company have to be the same services that are provided to the ultimate recipient.

Example 14

  • Architect Co and Plans Co are both members of the same corporate group, and both are CFCs of AustCo, an Australian resident company. Architect   Co provides architectural services (house designs) to Australian customers. Plans   Co also develops building and house plans.
  • Plans Co provides Architect Co (an entity that is an associate) with a suite of highly specific house designs. Architect   Co markets these into the Australian market, assisting customers in choosing the most appropriate design, but otherwise making no changes. In this case, Plans   Co has indirectly provided services to Australian customers, with the house designs received by those customers the same as those originally provided by Plans   Co to Architect   Co.
  • The application of the indirect services rule means that AustCo may have to include an amount in its assessable income that is tainted services income in relation to the services provided by Plans   Co to Architect   Co.

Section 2: Conditions to be met to satisfy the active income test

A CFC has to satisfy the following five conditions to pass the active income test:

  • It is a resident of a foreign country .
  • It carries on business at or through a permanent establishment in its country of residence.
  • It keeps proper records .
  • It can substantiate that it has met the active income test.
  • Its tainted income ratio is less than 5%.
Cond ition 1 - the CFC is a resident of a foreign country

The CFC must be a resident of a particular country throughout the statutory accounting period. A change of residence of the CFC does not mean that the CFC will fail the active income test. However, it must have been a resident of a particular country both before and after the change, and must have been in existence at the end of the statutory accounting period.

New companies

If a CFC was in existence for only part of a statutory accounting period, it must be a resident of a particular country throughout the period in which it existed - that is, in the period from incorporation to the end of the statutory accounting period.

Treatment of dormant companies

The term 'in existence' does not include a company that is dormant within the meaning of former Part   VI of the Companies Act 1981 . A CFC that is dormant for the whole of the statutory accounting period will fail the active income test. However, because the CFC is dormant, it will have no income or gains and will have no attributable income.

Is the CFC resident in a particular country?

Yes

Read on.

No

The CFC has failed the active income test. Go straight to part   3 .

Cond ition 2 - the CFC carries on business at or through a permanent establishment in its country of residence

The CFC must carry on business through a permanent establishment in its country of residence for the whole of a statutory accounting period in which it is in existence.

What is a permanent establishment?

The definition of permanent establishment is contained in section 6 of the Act. The term includes a fixed place of business through which the CFC carries on business operations. However, it specifically excludes a place where a person:

  • is engaged in business dealings through a commission agent or broker who is acting in the ordinary course of business and receiving customary rates of remuneration

  • is carrying on business through an agent who does not have, or does not usually exercise, a general authority to negotiate and conclude contracts or to fill orders from stock situated in the country

  • maintains the place solely for the purpose of purchasing goods or merchandise.

Did the CFC carry on business through a permanent establishment in its country of residence?

Yes

Read on.

No

The CFC has failed the active income test. Go straight to part   3 .

C ondition 3 - the CFC kept proper records

The figures used in the active income test are mainly drawn from accounting records and, in general, are not adjusted to comply with tax law concepts; as a result, the accounts of the company must be properly prepared.

The accounts must be prepared in accordance with commercially accepted accounting principles. Where there are commercially accepted accounting principles in the country of residence of the CFC, it is acceptable if the accounts of the CFC comply with those principles. In other cases, it is acceptable if the accounts of the CFC comply with Australian commercially accepted accounting principles.

The documents you must take into consideration are:

  • the profit and loss statement and financial statements
  • any ledgers or journals
  • any notes, statements or reports that are attached to, or meant to be read with, these accounts.

The accounts of a CFC for a statutory accounting period must give a true and fair view of the financial position of the CFC. If the accounts are prepared in accordance with commercially accepted accounting principles, but do not give a true and fair view, the CFC will fail the active income test.

Treatment of partnerships

Where a CFC is a partner in a partnership, the CFC's share of the partnership income must be taken into account. This means that the partnership must also keep proper accounts. If the partnership does not keep proper accounts, the CFC will fail the active income test.

Has the CFC and every partnership in which it was a partner kept proper accounts that give a true and fair view?

Yes

Read on.

No

The CFC has failed the active income test. Go straight to part   3 .

Co ndition 4 - the CFC can substantiate a claim that it has met the active income test?

A CFC must have, and be able to produce, accounts to substantiate your claim that the CFC has passed the active income test. If the CFC is a partner in a partnership, that partnership must also keep accounts to substantiate amounts derived by the partnership. If the CFC or partnership does not have the accounts, or does not produce them, the CFC is taken to have failed the active income test. See chapter   5 for details of the substantiation requirements and the procedures.

Is the CFC and any partnership in which it is a partner able to substantiate your claim?

Yes

Read on.

No

The CFC has failed the active income test. Go straight to part   3 .

Condi tion 5 - the CFC's tainted income ratio is less than 5%

To pass the active income test, the tainted income ratio of a CFC for a statutory accounting period must be less than 0.05; that is, less than 5%. If both the bottom line and the top line of the relevant formula are nil, the CFC is taken to have passed the active income test.

Section 3: Is the tainted income ratio less than 5%?

The tainted income ratio for a CFC is worked out as follows:

gross tainted turnover

gross turnover

Gross turnover

Broadly, the gross turnover of a CFC is the sum of the company's net gains and gross revenue. Work out the gross turnover using the following five steps:

  1. identify the total gross revenue derived by the CFC
  2. exclude certain comparably taxed amounts
  3. exclude the proceeds of certain asset disposals
  4. add back net gains arising from certain asset disposals
  5. add the CFC's share of the gross turnover of each partnership in which it was a partner.

The figures used are mainly drawn from the accounts of the CFC. If the accounts are prepared in a foreign currency, there is no need to convert the amounts to Australian dollars.

Step 1 - Identify total gross revenue

The total gross revenue is the sum of amounts shown in the accounts of a CFC as gross revenue; that is, deductions are not taken into account.

Do not include amounts that have not been brought to account in the period: for example, an amount may not be recognised in the accounts because its receipt is extremely doubtful. This amount would not be included in gross revenue. However, the exclusion of the amount must be in accordance with commercially accepted accounting principles and give a true and fair view of the CFC's financial position.

Step 2 - Exclude comparably taxed amounts

Certain comparably taxed amounts are excluded from the active income test. They are:

  • a franked dividend
  • an amount included in the CFC's assessable income in any year of income, unless the amount is only subject to dividend or interest withholding tax or is not fully taxed: for example, certain shipping or insurance premiums
  • an amount arising from the disposal of an asset that is taxable Australian property
  • an amount that is an attribution account payment to the extent that the profits from which the payment was made have been previously attributed to you
  • an amount derived through a branch in a listed country if the amount is taxed in that country
  • a non-portfolio dividend from a foreign company.

Because trust amounts arising to a CFC are attributed regardless of whether the CFC passes the active income test, they are also excluded from the tainted income ratio calculation.

Step 3 - Exclude proceeds from certain asset disposals

Amounts that arise from asset disposals are excluded from the gross revenue. However, this exclusion does not extend to disposals of trading stock. Amounts included in gross revenue from currency exchange rate fluctuations and commodity investments are also excluded.

Step 4 - Add back net gains

The amounts that were excluded under step   3 are brought back into gross turnover as net amounts. There are three separate net amounts:

  • the net gain from the disposal of commodity investments
  • the net gain from currency exchange rate fluctuations
  • the net gain from the disposal of other assets that are not trading stock or commodity investments.

In each case, to determine the net gain, the sum of the individual gains is reduced by the sum of the losses. If there is a net loss, the amount is ignored and does not reduce the gross turnover. It is important to note that there is a separate calculation of net gain for each of the categories. Do not take comparably taxed amounts into account.

Consideration paid or received for asset disposals must be included at market value. Where an amount has been written down in the accounts, the write-down is to be ignored.

Step 5 - Include partnership turnover

A CFC's share of the gross turnover of a partnership must be added to the CFC's gross turnover. This is done for each partnership in which the CFC is a partner. This means that you must go through the same process (steps   1 to 4) for each partnership.

In working out the total, treat the partnership as if it were a CFC. The partnership is assumed to be a resident of the same country as the CFC.

Result of steps 1 to 5

Add the amounts at steps   2 and 3. Take this total away from the total revenue at step   1. The balance is the gross revenue after exclusions.

Add the totals of steps 4 and 5. This is the CFC's gross turnover.

Gross tainted turnover

Gross tainted turnover is the part of the gross turnover that is either passive income, tainted sales income or tainted services income.

Broadly, passive income includes:

  • dividends
  • tainted interest income
  • annuity income
  • tainted rental income
  • tainted royalty income
  • amounts derived as consideration for the assignment in whole or part of any copyright, patent, design, trademark or other like property or right
  • net gains on the disposal of a tainted asset
  • income derived in carrying on a business of trading in tainted assets
  • net tainted commodity gains
  • net tainted currency exchange gains.

Tainted sales income and tainted services income are, broadly, income from certain transactions with, or originating from, associates or Australian residents.

The gross tainted turnover is worked out using the following five steps:

Step 1

Identify the part of gross revenue that is passive income.

Step 2

Add the part of gross revenue that is tainted services income.

Step 3

Add the part of gross revenue that is tainted sales income.

Step 4

Add the part of the gross turnover that is net tainted gains.

Step 5

Add the CFC's share of the gross tainted turnover of each partnership in which it was a partner.

Identify the tainted part of gross revenue (steps 1, 2 and 3)

Identify which parts of the gross revenue are passive income, tainted sales income or tainted services income; that is, determine the tainted part of the result after step   3 of the calculation of gross turnover.

Identify tainted net gains (step 4)

Identify the parts of the net gains that are tainted; that is:

  • the part of the net gain from the disposal of commodity investments that is tainted
  • the part of the net gain from currency exchange rate fluctuations that is tainted, and
  • the part of the net gain from the disposal of assets (other than trading stock or commodity investments) that is tainted.

Each of the net tainted gains is calculated separately and cannot exceed the amount of the net gain to which it relates. In each case, you will need to calculate the net gain and the net tainted gain. If the net tainted gain is greater than the net gain, use the net gain instead of the net tainted gain.

Identify the CFC's share of a partnership's gross tainted turnover (step   5)

Go through steps 1 to 4 for each partnership in which a CFC was a partner. The CFC's share of the gross tainted turnover of each partnership is then added to the CFC's tainted income that was derived directly.

Working out the tainted income ratio

The tainted income ratio is worked out by dividing the gross tainted turnover of a CFC by the gross turnover of the CFC.

The following is a simple example of how to work out the tainted income ratio:

Example 15

Working out the tainted income ratio

  •  

 

HK$

(shown in accounts)

Interest (passive)

2 million

Royalty (passive)

1 million

Business income - from goods manufactured in Hong Kong  

60 million

Manufacturing expenses  

40 million

Tainted income ratio

= gross tainted turnover

                  gross turnover

= 3 million

      63 million

= 4.8% of gross turnover

 
  • As a result, the CFC passes the test.

Is the tainted income ratio less than 5%?

Yes

The CFC has passed the active income test. Go to part 3 .

No

The CFC has failed the active income test. Go to part 3 .

Part 3: Working out attributable income and the amount to include in your assessable income

This part explains how to work out the attributable income of a CFC. Your share of the attributable income is included in your assessable income.

Even if the CFC passes the active income test, you will still need to read on - passing the test will eliminate many, but not all, types of attributed income and gains.

Summary of part 3

Section 1

General assumptions for working out the attributable income of a CFC

Section 2

General modifications to the law

Section 3

Modifications to the treatment of capital gains and capital losses

Section 4

Quarantining of losses

Section 5

Working out the net income of a partnership

Section 6

Trust amounts

Section 7

Reduction of attributable income because of interim dividends

Section 8

Relief from double accruals taxation

Section 9

How much is included in assessable income

S ection 1: General assumptions for working out the attributable income of a CFC

Attributable income is included directly in your assessable income. It is not necessary to aggregate amounts of attributable income as you trace through a chain of CFCs.

Example 16

Attribution directly to taxpayer

  • Assume you wholly own a foreign company which, in turn, wholly owns another foreign company. Also assume that the first company has $300,000 attributable income, and the second company has $200,000 attributable income.

You include an amount in your assessable income as follows:

Like this

Not like this

Attributable income is taxable income

Attributable income is a hypothetical amount. It is the amount that would be the taxable income of a CFC, based on certain assumptions. These are explained below.

Assume the CFC is a resident taxpayer

To work out attributable income, it must first be assumed that the CFC is both a resident of Australia and a taxpayer for the whole of a statutory accounting period. You can then work out the attributable income in the same way you work out the taxable income of a resident company. Amounts derived by a CFC from all sources will be taken into account because residents are taxable on their worldwide income and gains.

To distinguish the calculation of attributable income from a 'real' calculation of taxable income, the amounts used to work out attributable income are called notional amounts. Attributable income is the amount by which the notional assessable income is greater than notional allowable deductions. Income that is not notional assessable income is notional exempt income.

The assumption that a CFC is a resident of Australia does not change the nature of the activities of the CFC; that is, events that occur in a foreign country will not be taken to have occurred in Australia.

Modifications in working out the attributable income of a CFC

In applying the Act to work out a CFC's hypothetical taxable income, you will need to read the Act as if certain modifications (dealt with later in this chapter) have been made to it.

In some cases, provisions are ignored because the application is not appropriate. In other cases, provisions have been replaced with similar provisions that are tailored to the way the attributable income is worked out.

In addition, provisions have been included that are not comparable to other provisions of the Act. These modifications are explained later in this part.

Some provisions of the Act clearly cannot apply when working out attributable income: for example, Part   IV, which deals with the making of returns or assessments. Although these provisions of the Act are not specifically excluded from the calculation, for practical purposes they have no effect and can be ignored.

Accounting period is the year of income

Taxable income is worked out for a period called an income year. To apply the Act, the statutory accounting period of a CFC is assumed to be an income year. The particular income year referred to in working out attributable income will be the income year of the attributable taxpayer in which the statutory accounting period ends.

Example 17

  • Assume you are working out the amount to be included in assessable income for the year ending 30   June 2007 and the statutory accounting period of the CFC ended on 30   September 2006. The attributable income of the CFC for that statutory accounting period is to be worked out in accordance with the provisions of the Act that applied for the year ended 30   June 2007.
Work out attributable income separately

You must work out your attributable income for a CFC separately to other attributable taxpayers. Different taxpayers may work out different amounts of attributable income for a CFC; that is, the amount included in assessable income may be different for each attributable taxpayer, even if they have the same attribution percentage in the CFC.

There are differences in working out attributable income, depending on whether a CFC is a resident of a listed country or unlisted country.

Modifications for an unlisted country

The notional assessable income of a CFC includes only amounts that fall into specified categories. All other amounts are treated as notional exempt income.

The excluded amounts depend on whether the CFC passed or failed the active income test.

What if a CFC fails the active income test?

If a CFC fails the active income test, amounts that would be assessable if the CFC were a resident are included in attributable income to the extent they represent the following:

  • adjusted tainted income derived by the CFC directly
  • adjusted tainted income derived by the CFC indirectly as a partner in a partnership
  • trust amounts arising to the CFC directly
  • trust amounts arising to the CFC indirectly because the CFC is a partner in a partnership
  • transferor trust amounts arising to the CFC directly or indirectly as a partner in a partnership.

What if a CFC passes the active income test?

If a CFC passes the active income test, amounts that would be assessable if the CFC were a resident are included in attributable income to the extent they represent the following:

  • trust amounts arising to the CFC directly
  • trust amounts arising to the CFC indirectly because the CFC is a partner in a partnership
  • transferor trust amounts arising to the CFC directly or indirectly as a partner in a partnership.

These amounts are explained in section 5 and section 6 . Any other income is notional exempt income.

Diagram 1: Amounts taken into account - unlisted country CFC

What is adjusted tainted income?

Adjusted tainted income is based on the definition of tainted income used for the active income test. Broadly, it comprises amounts that are either passive income, tainted sales income or tainted services income.

The main difference in the definition of tainted income for the active income test and the definition for working out attributable income is that net gains are included in determining the active income test, whereas the entire consideration on disposal of an asset is included when working out attributable income.

Amounts not included

Some amounts that would normally be assessable if derived by a resident company are treated as notional exempt income in working out the attributable income of a CFC. Certain exemptions are also disregarded when working out attributable income. These exemptions have been replaced with similar provisions that are tailored for working out attributable income.

Amounts taxed in Australia

Amounts that have been taxed in full in Australia are not included in notional assessable income. Amounts will be treated as taxed in full if they have been included in a CFC's assessable income: for example, income sourced in Australia from a CFC's branch in Australia would normally be included in the CFC's assessable income in Australia. Amounts that will not be considered fully taxed, although subject to Australian taxation, are:

  • amounts subject to interest or dividend withholding tax, and
  • certain shipping income, film and video tape royalties, and insurance premiums.

Dividends that are franked under the imputation provisions are treated as notional exempt income.

Branch in a listed country

An amount of income or profits derived by a CFC in an unlisted country from carrying on a business through a permanent establishment (for example, a branch) in a listed country is excluded, provided the amount is not eligible designated concession income (EDCI) in relation to any listed country.

Exclusion of dividends

Most dividends paid to a CFC by a foreign company are not included in the notional assessable income of the CFC. The only dividends you may need to include for a CFC that is resident in an unlisted country are dividends that are portfolio dividends paid to the CFC (see chapter   3 ).

Modifications for a listed country

Working out attributable income for a CFC resident in a listed country is similar to working out attributable income for a CFC resident in an unlisted country. However, more exemptions are provided for CFCs in listed countries.

What if a CFC fails the active income test?

If a CFC fails the active income test, amounts that would be assessable if the CFC were a resident are included in attributable income to the extent they represent the following:

  • EDCI that is adjusted tainted income arising to the CFC directly or indirectly as a partner in a partnership
  • low-taxed third-country income arising to the CFC directly or indirectly as a partner in a partnership (only where it is of a kind specified in the Income Tax Regulations 1936)
  • trust amounts arising to the CFC directly that are not subject to tax in a listed country or are subject to tax and are designated concession income
  • trust amounts arising to the CFC indirectly because the CFC is a partner in a partnership, if the amounts are not subject to tax in a listed country or are subject to tax and are designated concession income
  • transferor trust amounts arising to the CFC directly or indirectly as a partner in a partnership.

Any other amounts are notional exempt income.

What if a CFC passes the active income test?

If a CFC passes the active income test, amounts that would be assessable if the CFC were a resident are included in attributable income to the extent they represent the following:

  • low-taxed third-country income arising to the CFC directly or indirectly as a partner in a partnership (only where it is of a kind specified in the Income Tax Regulations 1936)
  • trust amounts arising to the CFC directly that are not subject to tax in a listed country or are subject to tax and are designated concession income
  • trust amounts arising to the CFC indirectly because the CFC is a partner in a partnership, if the amounts are not subject to tax in a listed country or are subject to tax and are designated concession income
  • transferor trust amounts arising to the CFC directly or indirectly as a partner in a partnership.

Any other income is notional exempt income.

Diagram 2: Amounts taken into account - listed country CFC

See Exemption for small amounts for more information concerning the de minimis tests.

Adjusted tainted income

Adjusted tainted income is based on the definition of tainted income used for the active income test. Broadly, it comprises amounts that are either passive income, tainted sales income or tainted services income.

The difference in the definition of tainted income for the active income test and the definition for working out attributable income is that net gains are included in determining the active income test, whereas the entire consideration on disposal of an asset is included when working out attributable income.

Low-taxed third-country income

The notional assessable income of a CFC in a listed country includes amounts derived from sources outside the CFC's country of residence if the amounts are of a kind specified in the Regulations. This rule does not apply to amounts of eligible designated concession income (these amounts may be included if the CFC fails the active income test).

Amounts taxed in Australia

Amounts that have been taxed in full in Australia are not included in notional assessable income. Amounts will be treated as taxed in full if they have been included in a CFC's assessable income. Amounts that will not be considered fully taxed, although subject to Australian taxation, are:

  • amounts subject to Australian interest or dividend withholding tax, and
  • certain shipping income, film and videotape royalties and insurance premiums.

Dividends that have been franked under the imputation provisions are treated as notional exempt income.

Dividends not included

Most dividends paid to a CFC by a foreign company are not included. The only dividends you must include are dividends (other than non-portfolio dividends) paid to the CFC by a company that was a resident of an unlisted country (other than a section   404 country) when the dividends were paid.

These amounts will not be included in notional assessable income if the profits from which the dividends were paid have previously been attributed to you.

Exemption for small amounts

An exemption applies for CFCs in listed countries if the total of:

  • eligible designated concession income (if the active income test was not passed), and
  • low-taxed third-country income (of a kind specified in the Regulations)

is not greater than a threshold amount.

There is no similar exemption for a CFC that is a resident of an unlisted country.

Threshold amount

If the CFC has a gross turnover of $1   million or more, the threshold amount is $50,000; that is, the exemption will only apply if the total of the amounts is $50,000 or less.

If a CFC has a gross turnover of less than $1   million, the threshold amount is 5% of the CFC's gross turnover; that is, the exemption will only apply if the sum of the amounts is less than or equal to 5%.

How does the exemption operate?

If the threshold is not exceeded, a CFC's eligible designated concession income and low-taxed foreign source income are not included in the notional assessable income of the CFC. The general anti-avoidance provisions of the Act may apply where attempts are made to split income among a number of CFCs to take advantage of the exemption.

Section 2: General modifications to the law

This section explains a number of general modifications to the taxation law which apply when working out the attributable income of a CFC. There are also modifications to:

  • the treatment of gains and losses made by a CFC on the disposal of a capital asset
  • the treatment of losses incurred by a CFC, including the quarantining of deductions
  • the treatment of amounts derived through a partnership.

These modifications are dealt with in section 3 , section 4 and section   5 of part   3.

Elections to be made by the taxpayer

You can make most elections on behalf of a CFC in working out its attributable income: you must make the elections when you lodge your tax return. The ATO may extend the time for making the elections.

Lodgment of elections

In the case of companies and superannuation funds, no notice of the election is to be sent to the ATO; only give notice if the ATO requests you to do so.

Exceptions to the rule

An election for rollover relief under the capital gains tax provisions must normally be made by a CFC, although you can make the election for a wholly owned CFC. The rules for making these elections are explained in section   3 of part   3.

Functional currency elections are also an exception to the general rule that allows you to make most elections when working out the attributable income of a CFC: see 'Choice to use functional currency' below.

Foreign currency conversion rules

When calculating attributable income, you must convert all amounts into Australian currency. This conversion is done using the conversion rules under the usual operation of the Act: see Foreign exchange (forex): the general translation rule .

C hoice to use functional currency

You can choose to calculate attributable income in the sole or predominant currency in which the CFC keeps its accounts (ledgers, journals, statements of financial performance). This sole or predominant currency is called the applicable functional currency.

When calculating attributable income in a functional currency, all amounts that are not in the applicable functional currency (including Australian currency amounts) must be converted into the applicable functional currency. This conversion is done using the conversion rules under the usual operation of the Act. However, when applying these rules, the applicable functional currency is taken not to be foreign currency and all other amounts (including Australian currency) are taken to be foreign currency.

Once you have calculated your attributable income, you then convert that amount into Australian currency in accordance with the relevant conversion rules.

The choice of applicable functional currency must be in writing, but you are not required to notify the Commissioner of Taxation (Commissioner). You must keep written evidence of the choice for as long as you are required to keep your tax records.

Generally, the choice will apply to the CFC's statutory accounting period immediately following the one in which you make the choice. However, it will apply to the statutory accounting period in which you make the choice, where you make the choice within 90   days of the beginning of that statutory accounting period.

The choice to use the applicable functional currency applies until you withdraw it. You can only withdraw a choice where the functional currency has ceased to be the sole or predominant currency in which the CFC keeps its accounts. The withdrawal has effect from immediately after the end of the CFC's statutory accounting period in which the choice is withdrawn. The withdrawal must be in writing and retained with your tax records. You may make a new choice applicable to subsequent statutory accounting periods.

Treatment of foreign and Australian taxes

Deduction for taxes

A notional allowable deduction is available for foreign or Australian tax paid on amounts included in the attributable income of a CFC. An Australian tax is defined to be a withholding or income tax. It does not include additional amounts, such as late payment penalties. If the tax is paid in a subsequent year, the earlier year's assessment can be amended to allow a deduction for the tax, subject to the time limits for amendments.

Trading stock provisions

Valuation is cost only

In working out attributable income, you must value trading stock at cost. The normal rules for determining the cost of trading stock apply.

What happens to obsolete stock?

In working out taxable income, a special valuation is allowed for obsolete stock. This valuation is not allowed when working out attributable income.

Depreciation provisions

Basis for depreciation

Generally, the normal depreciation rules apply for working out the attributable income of a CFC. This means you can choose to depreciate assets by the diminishing value method or the prime cost method. In addition, the rates of depreciation that apply for working out taxable income will also apply in working out attributable income.

Example 18

Deduction for depreciation

  • A CFC purchased a depreciable asset on 1   July 2005 and uses it solely for the production of notional assessable income. For the statutory accounting period ended 30   June 2006, depreciation would be worked out as follows, using the diminishing value method:

Base value at 1 July 2005

$20,000

Effective life of asset

7.5 years

Adjustable value at 30 June 2006

$16,000

Notional depreciation for 2005-06

$4,000

The formula for the diminishing value method is:

decline in value

=

Base value

x

days   held

365

x

                      150%                      

asset's effective life

Apportionment for exempt usage

A notional allowable deduction for depreciation must be reduced if an asset is only partially used for the production of notional assessable income. The normal rules apply in working out the reduction.

Example 19

Apportionment of deduction for depreciation

  • A CFC purchased a depreciable asset on 1   July 2006 and used it for the production of income. For the statutory accounting period ended 30   June 2007, only 50% of the usage was for the production of notional assessable income. Notional depreciation, using the diminishing value method, would be worked out as follows:

Base value at 1 July 2006

$20,000

Depreciation to 30 June 2007

$4,000

Adjustable value at 30 June 2007

$16,000

Notional depreciation in 2006-07 (50% of $4,000)

$2,000

Asset used in a non-attributable period

Special rules apply for an asset held by a CFC during a period for which it was either:

  • not necessary to work out the attributable income of the CFC, or
  • not necessary to take depreciation on the asset into account in working out the attributable income of the CFC.

In such cases, the depreciation rules apply as if the asset were held solely for the production of notional assessable income during the period.

Example 20

Deduction for depreciation in non-attributable period

  • A CFC purchased a depreciable asset on 1   July 2004 and used it for the production of income. It was not necessary to work out the attributable income of the CFC for the statutory accounting period ending 30   June 2005. For the statutory accounting period ended 30   June 2006, only 50% of the usage was for the production of notional assessable income. In working out the notional depreciation for the 2005-06 statutory accounting period using the diminishing value method, the first step is to notionally depreciate the asset to the beginning of the income year:

Base value at 1 July 2004

$20,000

Depreciation to 30 June 2005

$4,000

Notional adjustable value at 30 June 2005

$16,000

  • The next step is to determine the depreciation for the 2005-06 income year:

Notional opening adjustable value at 1   July 2005

$16,000

Depreciation to 30 June 2006

$3,200

Notional adjustable value at 30 June 2006

$12,800

  • The last step is to apportion the depreciation because the asset is not used wholly for the production of notional assessable income:

Notional depreciation in 2005-06 (50% of $3,200)

$1,600

Sale of a depreciable asset

Under the normal operation of the Act, a deduction for the difference may be allowed where an asset is sold for less than the notional depreciated value of the asset. This deduction is also allowable in working out the attributable income of a CFC.

Example 21

Deduction on disposal

  • In the next statutory accounting period, the depreciable asset in example   20 was again used for 50% of the time to derive notional assessable income. At the end of the year it was sold for $9,000. The depreciation calculation would be as follows:

Notional opening adjustable value at 1 July 2006

$12,800

Depreciation to 30 June 2007

$2,560

Notional adjustable value at 30 June 2007

$10,240

Proceeds of sale

$9,000

Notional loss

$1,240

Notional depreciation in 2006-07 (50% of $2,560)

$1,280

Notional deduction for loss (50% of $1,240)

$620

An amount may also be included in notional assessable income as a result of the sale of the asset.

Example 22

Notional assessable income on disposal

  • Assume that the asset was sold for $18,000. In this case an amount would be included in notional assessable income as follows:

Base value at 1 July 2004

$20,000

Depreciation allowed

$2,880

Adjustable value at 30 June 2007

$17,120

Proceeds of sale

$18,000

Less adjustable value

$17,120

Notional assessable income on disposal

$880

For more information, phone 13   28   66 .

What about other capital deductions?

There are other provisions of the Act that allow for a deduction of the capital amounts and these may apply when working out attributable income. Where the assets were used in a non-attributable income period, the amount of the deduction allowed or the recoupment included in notional assessable income needs to be determined. However, it is not expected that this will often occur.

For more information, phone 13   28   66 .

Transfer pricing rules

Division   13 of Part   III

The Act contains measures to counter arrangements designed to move profits from one entity to another: these arrangements are commonly called transfer pricing or profit shifting. Broadly, the transfer pricing rules allow the ATO to increase a taxpayer's assessable income or decrease allowable deductions to negate the effect of the arrangement.

Tax treaty

Subdivision 815-A of the ITAA 1997 confirms Australia's ability to assess tax based on the associated enterprises article in Australia's tax treaties. The rules apply only where there is a relevant tax treaty. For the purpose of applying the definitions in such a tax treaty, the CFC is treated as a resident of a foreign country. The result is that the associated enterprises article may apply to arrangements involving the CFC.

Example 23

CFC in an unlisted country

  • Unlist Co1, which you wholly own, is a CFC resident of an unlisted country. In turn, Unlist   Co1 wholly owns another CFC (Unlist   Co2) in an unlisted country. Unlist   Co1 lends Unlist   Co2 $1   million and there is no interest payable on the loan. The market interest rate is 10%.

  • Unlist Co1 will be taken to have received $100,000 on the loan. This amount will be tainted interest income and will be included in the tainted income of the company. If the company fails the active income test, the notional assessable income of Unlist   Co1 will include $100,000.

Application of the transfer pricing rules to non-arm's-length arrangements involving CFCs resident in the same listed country

The transfer pricing rules do not apply to arrangements involving CFCs resident in the same listed country at any time when a tax treaty is in force.

Impact on active income test

The ATO can make adjustments reflecting arm's-length values to amounts used in determining whether a CFC has passed the active income test. An adjustment can be made if, in working out the attributable income of a CFC, the ATO would make a transfer pricing adjustment in relation to the acquisition or supply of property by the CFC.

Requests for rulings

You can request a ruling from the ATO on whether Division   13, as modified, applies to an arrangement.

Compensating adjustments

To avoid double taxation, the ATO may make adjustments in the assessment of another taxpayer to compensate for a transfer pricing adjustment. For example, a compensating adjustment may be made where a transfer pricing adjustment decreases the amount of a royalty payment made to a related company. In this case, a compensatory adjustment could be made to reduce the amount included in the assessable income of the related company as a result of the royalty payment.

As with the usual operation of the transfer pricing rules, where one CFC's notional assessable income or notional allowable deductions are adjusted, the ATO may make a compensating adjustment to:

  • a taxpayer's allowable deductions or assessable income
  • another CFC's notional assessable income or notional allowable deductions, or
  • the attributable income of a transferor trust estate.

Similarly, compensating adjustments may be made to the attributable income of a CFC when the transfer pricing rules have been applied to:

  • a taxpayer's allowable deductions or assessable income, or
  • the attributable income of a transferor trust estate.
Deduction for eligible finance shares

A deduction is not normally available for the payment of a dividend. However, a notional allowable deduction is available for an eligible finance share dividend paid by a CFC. Broadly, this is a dividend paid on a share issued under a preference share financing arrangement with an Australian financial intermediary (for example, a bank) and its subsidiaries. In effect, the issue of eligible finance shares is treated as a type of loan.

Dividends on eligible finance shares are treated as an interest expense. A notional allowable deduction is available for the dividends, to the extent a notional allowable deduction would have been available if the dividends had been an interest outgoing.

Deduction for widely distributed finance shares

A deduction, similar to that provided for eligible finance shares, is available for dividends paid by a CFC on widely distributed finance shares. Widely distributed finance shares include shares issued by a CFC as a public issue under a preference share financing arrangement to persons who are not associates of the CFC and who have provided finance on arm's-length terms. To qualify, the shareholders should have no interest in the CFC apart from ensuring repayment of the funds and regular payment of the dividends in a form which is, in effect, a substitution for interest on a loan.

Diagram 3: Operation of widely distributed finance share measures

members of the public

- >

funds raised by public issue of widely distributed finance shares

- >

CFC   A

- >

funds may be lent

- >

CFC   B

A deduction is available from the attributable income of CFC   A for dividends paid on its widely distributed finance shares. In addition, CFC   B is allowed a deduction for interest paid to CFC   A on the loan from that company.

S ection 3: Modifications to the treatment of capital gains and losses

The operation of the capital gains tax provisions of the tax acts is modified for working out the attributable income for a controlled foreign company (CFC).

Assets included in the calculation

Capital gains and losses taken into account in working out attributable income for a CFC are those arising on the disposal of assets, other than capital gains tax (CGT) assets which are taxable Australian property.

A capital gain or loss on the disposal of a CGT asset which is taxable Australian property is taken into account in working out the actual assessable income of the CFC as a non-resident taxpayer; as a result, it is excluded from the calculation of the CFC's attributable income.

This exclusion applies even if the relevant asset is not subject to CGT because it was acquired before 20   September 1985.

What is a CGT asset which is taxable Australian property?

In determining whether an asset is a CGT asset that is taxable Australian property, the assumption that the CFC is a resident of Australia is ignored. However, in most cases, the residency assumption will make no difference.

There are five categories of CGT assets that are taxable Australian property. They are:

  1. Taxable Australian real property which is directly held.
This includes:
  • real property situated in Australia, and
  • mining, quarrying or prospecting rights, where minerals, petroleum or quarry materials are situated in Australia.
Where such assets are depreciating assets, then capital gains and losses are disregarded for CGT purposes.
  1. Indirect Australian real property interest (other than interests in category   5).
A membership interest held by an entity in another entity where the following two tests are met:
  • non-portfolio interest test (broadly where the interest in an entity, whether foreign or Australian, must be at least 10%), and
  • principal asset test (where the market value of the entity's assets is principally attributable to Australian real property).
Note: Where an indirect Australian real property interest held on 10   May 2005 was not previously subject to CGT, its cost base is reset to its market value on that day. For the reset to occur, on 10   May 2005 the following must be satisfied:
  • the interest was held by a foreign resident (or trustee of a non-resident trust)
  • the interest was a post-CGT asset, and
  • the membership interest did not have the necessary connection with Australia (within the meaning of the law on 10   May 2005) disregarding the operation of items 5(b) and 6(b) of the table in section 136-25.
As a result, unrealised capital gains and capital losses on 10   May 2005 are not subject to CGT.
  1. Business assets used in an Australian permanent establishment of a foreign resident (other than assets in category 1, 2 or 5).

     
  2. Options or rights over category 1, 2 or 3 assets.

     
  3. Assets where a CGT gain or loss is deferred when an entity ceases to be an Australian resident.

     

The specific list of CGT assets which are taxable Australian property are set out in section 855-15 of the ITAA 1997.

Assets used to produce notional exempt income

In working out taxable income, the capital gains tax provisions do not normally apply to the disposal of assets used solely for the production of exempt income. However, in working out attributable income, capital gains or losses on the disposal of assets used to derive notional exempt income can be taken into account.

Removal of exemption of pre-20   September 1985 assets

When applying the capital gains tax provisions in working out attributable income, all CGT assets other than taxable Australian property that a CFC owns are deemed to have been acquired on 30   June 1990 or a later date (being the last day of the most recent period during which there was not an attributable taxpayer with a positive attribution percentage). As such, the exemption for pre-20   September 1985 assets does not apply in working out attributable income.

Cost base of assets

The cost base of assets owned by a CFC is the market value at the later of:

  • the last day of the most recent period during which there was not an attributable taxpayer with a positive attribution percentage in relation to the CFC, and
  • 30 June 1990.

This day is called the 'commencing day'.

Example 24

Cost base of asset

  • A company is a CFC from 31 December 1990. However, there is not an attributable taxpayer with a positive attribution interest until 1   March 1993 at 5.00pm. The CFC acquired an asset on 1   May 1992, and disposes of the asset on 1   October 2006.
  • Consequences
  • The asset will be deemed to have been acquired for market value on 1   March 1993. This is the commencing day, as it is the last day of the most recent period during which an attributable taxpayer did not have an attribution percentage. The capital gain or capital loss is worked out using the change in the asset's value between 1   March 1993 and 1   October 2006.
Working out a gain or loss on disposal

You work out the amount to include in a CFC's notional assessable income in broadly the same way as for the usual operation of the capital gains tax provisions; that is, you must determine the excess of a CFC's capital gains over the CFC's capital losses and include that excess (the net capital gain) in the CFC's notional assessable income. A net loss can only be carried forward to be offset against future capital gains. However, there are certain modifications to the CGT provisions that apply when working out attributable income.

Valuation date for assets owned at the end of the commencing day

An unrealised gain that accumulated on or before the commencing day will not be taxed. Correspondingly, any unrealised loss accumulated up to that date will not be allowed. This is done by valuing the assets on the commencing day and, in general, using that value as the consideration paid.

However, where an asset had decreased in value on or before the commencing day, the gain using the market value as the consideration paid could be bigger than the actual gain. Similarly, where the asset had appreciated in value on or before the commencing day, the loss using the market value as the consideration paid could be greater than the actual loss. In either of these cases, only the actual gain or loss is taken into account. To achieve this result, you must use as the consideration paid for such assets either the market value of the asset at the commencing day or the actual cost base of the asset, whichever produces the smaller gain or loss. That is:

  • in working out a gain, use the greater of the unindexed cost base and the market value on the commencing day
  • in working out a loss, use the lower of the unindexed cost base and market value on the commencing day.
Indexation of the cost base

The cost base of an asset acquired by a company on or before 21   September 1999 may be indexed for inflation. However, the cost base of the asset may only be indexed for inflation up until 21   September 1999 if that asset was held for at least 12   months.

Indexation factor

The indexation factor used is the same as that normally used under the capital gains tax provisions; that is, the consumer price index (CPI).

Adjustment to the cost base

In some cases, the cost base of an asset will need to be adjusted: for example, this would occur where there was a return of capital on shares or a tax-free distribution from a unit trust.

For more information, phone 13   28   66 .

Provisions for profit-making ventures

The provisions of the Act that include in assessable income a capital gain from the disposal of an asset purchased for profit-making by sale or from carrying out a profit-making undertaking or that allow a deduction for a loss; that is, sections   25A and 52 of the ITAA 1936 and sections   15-15 and 25-40 of the ITAA 1997 - do not apply in respect of the disposal of a non-taxable Australian asset of a CFC.

Treatment of a net capital loss under the capital gains tax provisions

In working out taxable income, capital losses are offset against capital gains to determine the net capital gain to include in assessable income. Where there is a net capital loss, you cannot use the loss to reduce assessable income. The same rules apply in working out attributable income.

A CFC cannot use a net capital loss under the CGT provisions to reduce its notional assessable income. It can only carry the loss forward for offset against capital gains in subsequent years.

You cannot transfer a loss: for example, you cannot use the loss of one CFC to reduce the notional assessable income of another CFC or your own assessable income.

In working out attributable income, you cannot take into account a capital loss incurred on the disposal of an asset where the disposal occurred before 1   July 1990.

Where a company becomes a CFC after 30   June 1995, asset disposals made before it became a CFC are not taken into account when working out attributable income.

This ensures that a capital loss is not available where it is incurred before a company becomes a CFC.

Rollover of assets under the capital gains tax provisions

Forced disposals

The capital gains tax provisions allow you to defer working out a capital gain or capital loss where the disposal was:

  • as a result of a breakdown of marriage
  • caused by the loss or destruction of the asset
  • from certain resumptions of property
  • from the disposal of certain mining leases.

These rollover provisions will apply in working out the attributable income because of the assumption that the CFC is a resident.

Most of these provisions require that the person disposing of the asset must make an election. You can make the election on behalf of a wholly owned CFC: for more information, see Procedures for electing that the rollover provisions apply .

Group transfers

The CGT rollover provisions allow companies that have 100% common ownership to defer, in certain circumstances, capital gains or capital losses on assets transferred between companies in the group. In the case of asset transfers between CFCs with 100% common ownership, the circumstances under which the rollover provisions apply are modified. These are set out in the table below:

Residence of CFC

Recipient company residence

Asset requirement

Resident of a listed country

Either a resident of that listed country or an Australian resident

Any asset

Resident of a listed country

A resident of a particular unlisted country

The asset must have been used in connection with a permanent establishment of the CFC in an unlisted country

Resident of an unlisted country

Either a resident of an unlisted country at that time or an Australian resident

Any asset

The assumption that a CFC is a resident of Australia is ignored in determining its residence for the group transfer provisions.

Procedures for electing that the rollover provisions apply

How to elect for rollover relief

If an election for rollover relief is required, a CFC (or in the case of group rollovers, both the transferor and transferee) must elect in writing that the particular rollover provision applies.

The CFC must normally make the election. However, an attributable taxpayer may make an election on behalf of a wholly owned CFC.

Timing of elections

An election must be lodged with the ATO on or before the lodgment of a return by an attributable taxpayer that is affected by the election. If more than one attributable taxpayer is affected, the election will be valid if made on or before the lodgment of the affected tax returns.

Self-assessment - extension of time to make an election

The self-assessment guidelines do not apply to an election by a CFC for rollover relief and Taxation Ruling IT   2624 - Income tax: company self-assessment; elections and other notifications; additional (penalty) tax; false or misleading statement does not authorise an extension of time in which to make the election. If an extension of time is required, the CFC or its agent should approach the ATO. For convenience, the request should go to the ATO office where the tax return of the largest attributable taxpayer is lodged. If this is not readily apparent, the request can be lodged at any ATO office.

Which officer makes the election?

The person who acts for the CFC should make the election. In Australia, that person would normally be the public officer of the company; however, foreign laws may require a different officer to act for the company. Whoever is authorised (whether under the foreign law or, if no law governs this, under the constituent document of the CFC) may make the election.

Election by an agent in Australia

The requirement that a CFC make an election will also be satisfied where an agent makes the election for or on behalf of the CFC, provided that the person is authorised by the CFC to do so: for example, the Australian parent of the CFC or the CFC's tax agent in Australia, if authorised, could make the election.

Re duction of disposal consideration where attributable income is not distributed

An adjustment will be made to the consideration received by a CFC in respect of the disposal of an interest in an attribution account entity if the income or profits of that entity have been attributed to you, but have not been distributed. The adjustment only applies where the consideration is included in working out notional assessable income, whether under the capital gains tax provisions or any other provision.

The adjustment is mandatory and does not depend on any finding that the share price reflects the retained earnings. If you think that it applies to the CFC, you can contact the ATO office where you lodge your return for more information.

CGT concession for active foreign companies

For certain CGT events happening on or after 1   April 2004, a CFC may be able to reduce its capital gains or capital losses arising in relation to its interest in a foreign company, including a CFC. This can be done when:

  • the CFC holds shares in a company that is a foreign resident (excluding eligible finance shares and widely distributed finance shares)
  • a CGT event occurs in respect of the CGT asset that is the share in the foreign company, and
  • the CFC has held a direct voting percentage of at least 10% in that foreign company for a continuous period of 12   months in the 24   months before the time of the CGT event.

The gain or loss resulting from the CGT event is reduced by a percentage - calculated at the time of the CGT event - called the active foreign business asset percentage. The method for calculating the active foreign business asset percentage is explained below.

Active foreign business asset

An asset will be an active foreign business asset if, at the time of the CGT event, it is:

  • an asset included in the total assets of the foreign company, and
  • is used or held ready for use by the foreign company in the course of carrying on a business,

and is not

  • a CGT asset that is taxable Australian property
  • a membership interest in an Australian resident company
  • a membership interest in a resident trust for CGT purposes, or
  • an option or right to acquire a membership interest of the type referred to in the previous two bullet points in this list.

Goodwill of the foreign company is included as an active business asset, but financial instruments (other than shares and trade debts) and certain other assets are not included (section   768-540 of the ITAA 97).

To be included in the total assets of the foreign company, the asset must be a CGT asset that is owned by the foreign company at the time of the CGT event.

Active foreign business asset percentage

You can work out the active foreign business asset percentage of a foreign resident company in relation to the CFC using either the market value method or the book value method. If you do not choose either method, the effect of the default method is that you will not gain any benefit under the concession.

Market value method

The active foreign business asset percentage is worked out under the market value method using the following formula:

market value of all active foreign business assets

market value of the total assets

Book value method

The active foreign business asset percentage is worked out under the book value method using the following formula:

average value of active foreign business assets

average value of total assets

The average value of the active foreign business assets is worked out using the following formula:

value of the active foreign business assets at the end

of the most recent period + the value of the assets of the previous period


2

The average value of the total assets of the foreign company are worked out in a similar way.

After applying the formula under either method, the active foreign business asset percentage is determined as follows:

Result of calculation

Active foreign business asset percentage

Less than 10%

0%

10% to less than 90%

The result of the calculation

90% or more

100%

Foreign wholly owned groups

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

S ection 4: Quarantining of losses

Quarantining

If a CFC's notional allowable deductions are more than the notional assessable income for an accounting period, the excess cannot be claimed against notional assessable income of another CFC. However, the CFC will be able to offset a revenue loss against a net capital gain because of the repeal of subsection   424(2) of the ITAA 1936.

The excess loss incurred by a CFC is carried forward and can be claimed as a notional allowable deduction against the notional assessable income of that CFC in a later year.

Different quarantining rules apply to prior years of income ending on or before 30   June 2008. For more information, see the Foreign income return form guide for that year.

Application of transitional foreign loss rules to CFCs

A CFC with unutilised losses quarantined into the four classes of notional assessable income for an earlier statutory accounting period must convert those losses at the commencement of the statutory accounting period starting on or after 1   July 2008.

What is a convertible CFC loss?

A CFC must convert to one loss bundle any loss in relation to notional assessable income of a particular class that has not yet been taken into account. A CFC will have a loss, for an earlier statutory accounting period, if:

  • it has an undeducted loss in relation to notional assessable income of a particular class
  • the loss was made in any of the most recent 10 statutory accounting periods ending before the commencement period, and
  • a loss remains after disregarding certain amounts.

The amount of the loss is the sum of each loss in relation to notional assessable income of a particular class for the earlier period, after disregarding certain amounts.

How does a CFC reduce a loss of a particular class of notional assessable income?

Before summing together each loss of a particular class of notional assessable income, the CFC is required to reduce each loss according to the conversion rules, using a step-by-step approach.

The first step applies only to a CFC that has an existing loss in respect of the 'all other amounts' class of notional assessable income. The CFC must reduce the loss, except to the extent it is attributable to income that would be its notional assessable income or sometimes-exempt income.

The second step requires a CFC with a loss older than seven years, but not more than 10   years (from the first statutory accounting period starting on or after the 1   July following commencement) to halve the loss that remains after step   1 (where applicable).

The result is the amount of the convertible CFC loss for the earlier statutory accounting period. This removes the classes of notional assessable income, leaving the CFC with a single convertible CFC loss for some or all of the most recent 10 statutory accounting periods ending before 1   July 2008.

What happens to a convertible CFC loss?

A convertible CFC loss will be treated as a loss only for the purpose of applying Part   X to statutory accounting periods beginning on or after 1   July 2008. This ensures that the CFC cannot deduct the convertible CFC loss from notional assessable income in accounting periods prior to commencement.

Deductions for sometimes exempt income loss

You may claim a notional allowable deduction for a 'sometimes exempt income loss'. A sometimes exempt income loss can arise for a CFC in an accounting period if:

  • the CFC passed the active income test for the period, or
  • the CFC gained the benefit of the de minimis exemption for the period, and
  • the CFC has any expenses that are not notional allowable deductions, but would have been if the CFC had not passed the active income test or gained the benefit of the de minimis exemption.
How is the sometimes exempt income loss worked out?

The sometimes exempt income loss is worked out by:

  • assuming that the CFC had passed the active income test and did not have the benefit of the de minimis exemption
  • working out the amounts that would be included in the notional assessable income, called the sometimes exempt income
  • working out notional allowable deductions that would be available if the sometimes exempt income were assessable, called 'sometimes exempt deductions'.

If sometimes exempt deductions are more than the sometimes exempt income, the difference is a sometimes exempt income loss.

How is a sometimes exempt income gain worked out?

In contrast, a sometimes exempt income gain will arise where the amount of sometimes exempt income is more than the sometimes exempt deductions. The sometimes exempt income gain reduces a CFC's loss. Losses in the current period are reduced before losses carried forward from a previous period.

Conditions before a loss is allowed

You are allowed a notional deduction for a previous year's loss only if the CFC was a CFC when the loss was incurred and at the end of each period until the loss is claimed.

In working out the CFC's previous years' losses, you must assume that you were always an attributable taxpayer who was required to work out attributable income. It is possible to carry forward a loss from a period when you were not an attributable taxpayer.

You cannot take into account any loss incurred in a statutory accounting period that commenced before 1   July 1983.

Residency requirement for losses

A loss that was incurred in a previous statutory accounting period is only allowable if the CFC was a CFC at the end of that statutory accounting period in which the loss arose and at the end of each of the following statutory accounting periods before the eligible period.

In addition, certain residency requirements must be met before the loss may be applied against the notional assessable income in the eligible period. If these are not satisfied the loss will not be taken into account.

Modifications to the general rule deal with cases where a company:

  • remains a resident of the same country, but
  • is treated as changing residence from a listed country to an unlisted country, or vice versa, as a result of changes to the lists of countries or political developments: for example, as a result of the dissolution of a country.

In these cases, the losses incurred by a CFC in an earlier period are not denied solely because the listing status of a CFC's country of residence changes.

The following table summarises the availability of losses incurred in previous statutory accounting periods:

CFC's country of residence at end of eligible period

CFC's country of residence at end of the substituted accounting period in which loss arose

Consequence

Listed

Listed

Allowable

Listed

Unlisted

Generally not allowable unless the unlisted country:

  • arose from the dissolution of the listed country, or
  • is the same country as the listed country.

Unlisted

Unlisted

Allowable

Unlisted

Listed

Generally not allowable unless the listed country is the same as the unlisted country.

Losses are not allowable if they were denied in an earlier statutory accounting period.

S ection 5: Working out the net income of a partnership

The notional assessable income of a CFC includes the CFC's share of the net income of a partnership. You work out the net income of the partnership in accordance with the partnership provisions of the Act. However, it is assumed that:

  • the partnership derived only certain income and gains
  • the operation of the Act is modified.
Assumption about income and gains

The assumptions made for amounts derived by a partnership mirror the assumptions made for working out the income and gains of a CFC, except where the assumption applies only to companies. The amounts taken into account in working out the net income of the partnership depends on whether the CFC passes the active income test. The amounts also depend on whether the CFC is a resident of a listed country or an unlisted country.

If a CFC is resident in an unlisted country and it:

  • passes the active income test, then the only amounts taken into account in determining the net income of the partnership are trust amounts (including transferor trust) arising for the partnership
  • fails the active income test, then only the following amounts are taken into account in determining the net income of the partnership:
    • adjusted tainted income
    • trust amounts (including transferor trust) arising for the partnership.

If a CFC is resident in a listed country and it:

  • passes the active income test, then only the following amounts are taken into account in determining the net income of the partnership:
    • low-taxed third-country income of a kind specified in the Regulations
    • trust amounts arising for the partnership that are not subject to tax in a listed country or are subject to tax and are designated concession income, and
    • transferor trust amounts arising for the CFC as a partner in a partnership
  • fails the active income test, then only the following amounts are taken into account in determining the net income of the partnership:
    • eligible designated concession income that is adjusted tainted income,
    • low-taxed third-country income of a kind specified in the Regulations
    • trust amounts arising for the partnership that are not subject to tax in a listed country or are subject to tax and are designated concession income, and
    • transferor trust amounts arising for the CFC as a partner in a partnership.
Assumption about modifications to the Act

The modifications that apply in working out the net income of a partnership are similar to those that apply for working out notional assessable income and notional allowable deductions of a CFC: see section   3 , section   4 and section   5 .

Additional modifications to the Act

Three additional modifications are made in working out the net income of a partnership:

  1. The partnership is treated as a resident of the same country as the CFC.
  2. A dividend will not be notional exempt income of a partnership unless the dividend is paid out of previously attributed income.
  3. The capital gains tax provisions apply to assets acquired by a partnership after 19   September 1985 (the deemed acquisition of assets on 30   June 1990 for CFCs does not apply to assets held by partnerships).

S ection 6: Trust amounts

The notional assessable income of a CFC may include certain trust amounts arising for the CFC in the statutory accounting period. There are three types of trust amounts:

  • amounts derived as a beneficiary of a trust estate where the CFC is presently entitled to a share of the net income of the trust estate
  • other amounts paid to, or applied for the benefit of, the CFC by the trustee of a trust estate
  • amounts attributed to the CFC under the transferor trust measures.
CFC a beneficiary of a trust - present entitlement

Where the CFC is presently entitled to a share of the net income of a trust estate, the CFC must include the share of the net income in notional assessable income. The calculation of the net income of the trust estate is made under the existing trust provisions of the Act. The modifications that apply in working out the net income of a trust are similar to those that apply for working out notional assessable income and notional allowable deductions of the CFC: see section   3 , section   4 and section   5 .

Additional modifications that apply when working out the net income of a trust are outlined below.

Trust is a resident of the same country as the CFC

A trust estate is treated as a resident of the same country as the CFC.

Dividends

A dividend will not be notional exempt income of a trust unless the dividend is paid out of previously attributed income.

Trust is treated as a resident trust estate

A trust is treated as a resident trust estate or a resident unit trust for the purposes of the capital gains tax provisions.

Modifications to capital gains tax provisions

The modifications to the capital gains tax provisions (see section   4 ) that provide for the removal of the exemption for assets acquired before 20   September 1985 do not apply in working out the net income of a trust. As a result, the capital gains tax provisions apply to assets acquired by a trust after 19   September 1985.

Transferor trust measures

The transferor trust measures apply in working out the attributable income of a CFC: see chapter   2 to determine whether the CFC will have an amount attributed to it.

Section 7: Reduction of attributable income because of interim dividends

The attributable income of a CFC is reduced if you are taxed on a dividend paid by the CFC out of current year profits and you would be assessable on those profits under the CFC rules at the end of the statutory accounting period of the CFC.

An interim dividend is considered to have been paid out of the attributable income of the current statutory accounting period only if there are no earlier profits available out of which the dividend could have been paid. When there are such earlier profits, the dividend is considered to have been paid out of those profits. Any balance of interim dividend is considered to have been paid out of the attributable income of the current statutory accounting period.

Taxation Determination TD   2003/27 - Income tax: how is double taxation avoided in the following situations where a Controlled Foreign Company (CFC) pays a dividend to an attributable taxpayer provides further guidance on how the attributable income of a CFC is reduced in these circumstances.

Working out the reduction

Dividend paid to an attributable taxpayer

If the dividend is paid to you, the amount of the reduction in attributable income is worked out as follows:

            amount of the dividend assessed          

your attribution percentage in the CFC

Example 25

Dividend paid wholly out of attributed income

  • A taxpayer has a 50% attribution percentage in a CFC resident of an unlisted country. The CFC has no profits from previous years, and $1   million current year profits are distributed as a dividend. The dividend was paid wholly from profits referable to the attributable income of the CFC. The $500,000 received by the taxpayer is included in the taxpayer's assessable income.
  • The amount by which the attributable income would be reduced is worked out as follows:

$500,000

50%

=

$1 million

Example 26

Dividend paid partly out of attributed income

  • A taxpayer has a 50% attribution percentage in a CFC resident of an unlisted country. The CFC has an accumulated profit of $2   million; it pays total dividends of $2.2   million. The dividend would be taken to have been paid out of the accumulated profits first. The whole of the $200,000 component of the dividend paid from current year profits is referable to the attributable income of the CFC.

The reduction would be:

$100,000

50%

=

$200,000

Example 27

Dividend is exempt

  • A resident company has a 50% interest in a CFC resident of a listed country. The CFC has no profits from previous years and distributes all of the current year profits as an exempt dividend.
  • There is no reduction of attributable income in this case because the dividend was not assessable income.

Section 8: Relief from double accruals taxation

If an amount of income or gain is to be included in your assessable income as a result of tracing control through a foreign entity, and that foreign entity has also been taxed on that amount under the accruals tax laws of another country, you may reduce your assessable income by an amount calculated as follows:

Indirect attribution interests through a controlled foreign entity

x

Foreign accruals-taxed attributable income

Your indirect attribution interest through a controlled foreign entity is your attribution interest in a CFC traced through the controlled foreign entity.

The foreign accruals-taxed attributable income is that part of an amount of income or gain derived by a CFC on which an interposed controlled foreign entity has been taxed under an accruals tax law of a listed country. The income or gain must be taxed at that country's normal company rate of tax and during a tax accounting period which commences or ends either in your year of income or the statutory accounting period of the CFC.

Only countries listed in the Income Tax Regulations 1936 as having accruals tax laws are recognised for the purpose of granting this relief. They are:

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

Example 28

Reduction of an otherwise assessable section 456 amount

  • Scenario
  • Ausco owns 50% of the share capital of US Co (a company resident in the United States) which in turn owns 50% of the share capital of a company that is a resident of an unlisted country. Ausco also holds a direct interest of 25% of the unlisted country company.
  • Because of the interests Ausco holds in US Co and the unlisted country company, both foreign companies are CFCs.
  • For the 2004-05 period, the unlisted country CFC's only item of income was interest income; the amount of this interest income was determined to be $8,000 under Australia's income tax laws.
  • The United States taxed US Co on an accruals basis on the item of interest income derived by the unlisted country CFC. US Co's interest in the unlisted country company was 50%: as a result, only half of the item of interest income was attributed to US Co by the United States.
  • Australia applied the transfer pricing provisions to an interest-free loan which the unlisted country company provided to a related CFC: as a result, another $2,000 interest income was included in the unlisted country CFC's attributable income under Australia's accruals tax laws. This amount was not included in the unlisted country CFC's attributable income under the accruals tax laws of the United States.
  • Working out the amount to be attributed to Ausco
  • Step 1 - Determine Ausco's otherwise assessable amount
  • Ausco's attributed percentage of the attributable income of the unlisted country CFC is:

direct attribution interest

25%

indirect attribution interest

25%

Attribution percentage

50%

  • Ausco's otherwise assessable amount is $5,000 (50% attribution percentage) x   ($8,000 interest income   +   $2,000 interest income), arising from the application of the transfer pricing provisions.
  • Step 2 - Determine Ausco's indirect attribution interests through US Co
  • Ausco's indirect attribution interest in the unlisted country CFC through US Co is 25%; that is, Ausco's 50% direct interest in US Co, multiplied by US Co's 50% interest in the unlisted country CFC.
  • Step 3 - Determine the unlisted country CFC's foreign accruals-taxed attributable income
  • The unlisted country CFC's foreign accruals-taxed attributable income worked out under Australian accruals tax rules equals $8,000. This amount is referable to the item of interest income included in the attributable income of the unlisted country CFC under the United States' accruals tax laws. It is important to note that the amount is not necessarily the same as the amount worked out under the United States' accruals tax laws.
  • Step 4 - Determine the amount by which Ausco's otherwise assessable amount is to be reduced
  • Reduce the otherwise assessable amount by $2,000; that is, step   2 multiplied by step   3.
  • Step 5 - Determine Ausco's assessability in respect of the unlisted country CFC's attributable income
  • Ausco's assessability for the unlisted country CFC's attributable income is $3,000: that is, step   1 minus step   4.

Section 9: How much is included in assessable income

You need to work out how much of the attributable income of the CFC to include in your assessable income. Multiply your attribution percentage in the CFC at the end of the statutory accounting period by the attributable income of the CFC; include the result in your assessable income.

ATO references:
NO NAT 1840

Foreign income return form guide
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