House of Representatives

Taxation Laws Amendment (Foreign Tax Credits) Bill 1986

Taxation Laws Amendment (Foreign Tax Credits) Act 1986

Second Reading Speech

The Treasurer, the Hon. P.J. Keating, M.P.

This Bill will give effect to the proposal announced in my 19 September 1985 tax reform statement to replace the present double taxation relief arrangements of the income tax law with a general foreign tax credit system.

Since that statement, detailed consideration has been given to the most appropriate arrangements for a foreign tax credit system in Australia.

In this process, the Government has considered representations from many sources, and held discussions with interested business groups.

In the light of these further deliberations, the details of the system that I will shortly describe differ in some respects from those outlined in my September statement.

These differences generally tend to lessen the tax impact of the proposal on Australian residents.

However, the information gained in this process has confirmed the Government's view that the present manner of treating foreign source income of Australian residents is not consistent with the general equity, neutrality and efficiency objectives of a sound taxation system.

As well, the present treatment encourages Australians to avoid tax by arranging to give their income an artificial overseas source.

The asprey committee, in 1975, recommended the introduction of a foreign tax credit system in the interests of equity and efficiency.

In 1978 the previous government announced that it would introduce such a system but, in the face of criticism from certain quarters, the measure was abandoned.

Such criticism overlooks the fact that foreign tax credit systems are common in developed countries - american, west german and japanese firms, amongst others, have extensive overseas operations despite being subject to such systems in their home countries.

The direct gain to revenue from this measure is estimated at about s60 million per annum at 1985-86 levels of income, with the first revenue gains accruing in 1988-89.

In the longer run, however, the revenue gains could be substantially r greater if followed-up with initiatives against offshore tax avoidance activities which would be based on the foreign tax credit system framework.

I turn now to the details of this measure.

The new system will first apply to assessments in respect of the year of income commencing on 1 July 1987.

Under it, all foreign source income derived by Australian resident taxpayers - apart from certain salary and wages that I will mention shortly - will be subject to Australian tax, and a credit will be allowed against that tax for analogous foreign tax paid on that income.

Except for certain interest income derived overseas, foreign source income will be assessed on a worldwide basis.

This approach will enable excess foreign tax credits from high-tax countries to be offset against Australian tax on income from low-tax countries.

Foreign tax on the foreign income of an Australian company will be creditable against its Australian company tax on that income, but not against compensatory tax that will be payable as part of the proposed imputation arrangements.

Credits for foreign tax will be set against company tax before compensatory tax offsets company tax.

An Australian company receiving dividends from subsidiaries overseas will be allowed credit for underlying foreign company tax on the profits from which the dividends are paid, as well as for any foreign withholding or other tax imposed on the dividends.

The credit for underlying tax will be allowed for unlimited tiers of subsidiary companies provided that each company in the chain has a 10 per cent controlling interest in the company immediately below it, and the Australian parent has a direct or indirect interest of at least 5 per cent in the voting shares of each company.

As part of this mechanism, dividends received by an Australian parent from an overseas subsidiary will be treated as being first paid out of a pool of the subsidiary's accumulated profits.

This pooling approach, which is of an anti-avoidance nature, will apply s on a prospective basis, and any dividends in excess of the pool will be treated as paid out of the subsidiary's profits of earlier years on a last-in-first-out basis.

The measurement of income for overseas branches, or other overseas business, commercial or investment activities of Australian taxpayers will be determined in accordance with Australian income tax law.

For subsidiaries, book profits as disclosed in the accounts of the company will be used, with scope for these to be adjusted where that is appropriate.

Overseas branches of Australian life insurance companies will be taxed, under the new system, only on income remitted to Australia and not on all branch profits.

The Bill contains currency exchange conversion rules that are to apply to convert various categories of foreign income to Australian dollars for Australian tax purposes.

Salary and wages earned overseas by an Australian resident and liable to tax in the country of source are to be fully exempt from Australian income tax where derived in performing service overseas for a continuous period of at least 12 months.

A proportionate exemption will apply where the period is from 3 to 12 months, with a credit being allowed for foreign tax paid on any amount not exempted.

These provisions will not affect persons working overseas on approved projects to whom a specific exemption in the present law will continue to apply.

However, the foreign earnings of such persons, as well as salary and wages earned overseas that is to be exempted on the basis I have just outlined, will be taken into account in calculating Australian tax on other income derived by a taxpayer, so that exemption of the foreign earnings will not also reduce the Australian tax payable on that other income.

In most cases, the taxation treatment of foreign pensions received by Australian residents is governed by the terms of an existing double taxation agreement, and this position will not be altered by the a foreign tax credit system.

The new system will therefore apply only to foreign pension income in the limited number of cases where pensions are derived from non-treaty countries.

As an anti-avoidance measure, certain foreign source interest income is to be assessed separately from other income, with separate tax credit limits.

Because of arrangements that might be designed to avoid this interest quarantining, dividends received from foreign subsidiaries will under certain circumstances be traced to determine whether interest income has been recharacterised and remitted to Australia as dividends.

Where necessary, dividends will be apportioned into an interest income component and other income, with foreign tax credits being allowed separately on each component.

Interest earned in carrying on normal business activities and interest received by banks and other financial institutions will be excluded from the quarantining process.

Although the Government has decided not to treat other forms of passive income in a similar way to interest, the position will be monitored to see whether there is a need to widen the quarantining measures.

Under the Bill, losses incurred in any year in respect of an overseas branch operation or other particular business, commercial or investment activity will not be offset against domestic income in the same year, nor against other foreign source income, but will be available for offset against profits derived in any of the seven succeeding years from the same branch or activity.

Taxpayers will have the option to carry-forward domestic losses for offset against later domestic income as at present or to offset them against foreign income.

Excess foreign tax credits will not be able to be carried forward or back, but will be transferable within wholly owned company groups for set-off against Australian tax payable on other non-interest foreign income derived by another group company in the same year of income.

The Bill also contains measures to recognise selected taxation incentives of a developing country.

In the absence of special measures - called tax sparing relief - a foreign tax credit system can negate incentives in the form of tax holidays or tax reductions offered by developing countries to encourage foreign investment to assist in the development of those countries.

Tax sparing relief is traditionally granted in the context of a comprehensive agreement for the avoidance of double taxation between the two countries concerned.

Australia has followed this approach, but the Bill will also enable tax sparing to be granted on a country by country basis by regulations made for that purpose.

Where tax sparing is granted in respect of income from a particular country, either by way of regulation or under the terms of a comprehensive taxation agreement, the tax forgone by the foreign country under the relevant taxation incentive measure will be deemed to have been paid by the Australian taxpayer before arriving at the income received.

The taxpayer will therefore be entitled to a credit for the foreign tax forgone in respect of the relevant foreign income.

Finally, in giving effect to the general foreign tax credit system, it is also necessary to remove from the income tax law those double taxation relief provisions that the new system will replace.

To this end, the Bill will repeal the existing foreign tax credit provisions that apply to foreign dividends received by individuals, to most classes of income derived from papua new guinea, and to foreign source interest and royalties subject to limited tax rates under Australia's comprehensive tax treaties.

It will also repeal existing provisions that exempt from Australian tax various categories of foreign income that will become subject to the new system.

For the same reason the Bill will withdraw, in relation to foreign source dividends, the rebate provided by section 46 of the income tax assessment Act that now effectively exempts such dividends from l Australian tax.

An issue that the Government has under notice in the light of representations is whether to extend the capital expenditure deductions for mining companies to such expenditures on overseas projects.

A decision will be announced as soon as practicable.

A technical explanation of the provisions of this Bill is contained in an Explanatory Memorandum that will be made available to honourable members.

I commend the Bill to the House.