Edited version of private advice

Authorisation Number: 1051947105952

Date of advice: 8 February 2022

Ruling

Subject: Controlled foreign company

Question 1

Is Company D Pty Ltd (Company D) a controlled foreign company (CFC)?

Answer

Yes.

Question 2

Is the net income of Company D attributable to you in Australia?

Answer

Yes.

Question 3

Will dividends received from Company D which are less than the surplus in your attribution account be assessable income when received?

Answer

No.

Question 4

Do you receive a foreign tax offset for tax paid by Company D in the Country A?

Answer

No.

Question 5

Does the tax paid by Company D in the Country A reduce your attributed income?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

You and your spouse are both residents of Australia.

You each own over 40% of the issued shares in Company D Pty Ltd.

Company D is a private company limited by shares registered in the Country B.

Neither you nor your spouse are directors of Company D and are not involved in the day to day operations of the company.

Company D owns a rental property in the Country A.

The property is rented to an independent entity who uses it to conduct a business in the Country A.

Company D is not a tax resident of the Country A.

Company D had profits before tax in the year ended 2020 of AUD$ X and paid tax in the Country A of AUD$ Y.

Company D has made no payment of funds in any form to you.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 770-135

Income Tax Assessment Act 1936 Part X

Income Tax Regulations 1936 Schedule 10

Reasons for decision

Section 6-10 of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income includes some amounts that are not ordinary income but are included by other provisions about assessable income, also known as statutory income.

Included in the lists of Statutory Income Provisions contained in section 10-5 of the ITAA 1997 are sections 456 to 459A of the Income Tax Assessment Act 1936 (ITAA 1936) dealing with the attribution of income.

The controlled foreign company (CFC) provisions are contained in Part X of the ITAA 1936. The accruals system applies to Australian residents who have a substantial interest in a foreign company controlled by Australians. 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. This is achieved by attributing tainted income to the Australian resident controllers of the CFC.

There are modifications to the attributable income where the CFC is located in a country that taxes income in a similar way to Australia. The attributable income is also modified where the CFC has significant income from actively carrying on business.

Will Company D be a CFC?

Section 340 of the ITAA 1936 contains the definition of CFC. The determination of the status of a foreign company as a CFC arises from a consideration of the direct and indirect control interests held by Australian entities in the company.

The following factors need to be established in order for a company to be a CFC:

1. Is the entity a company?
2. Is the company a resident of either a listed country or an unlisted country?
3. Is there a group of five or fewer Australian 1% entities, the aggregate of whose associate inclusive control interests in the company, is not less than 50%? (strict control test)

Company D is a private company.

Listed country

Schedule 10 of the Income Tax Regulations 1936 specifies the countries that are listed countries. The countries that are listed countries are Canada, France, Germany, Japan, New Zealand, United Kingdom of Great Britain and Northern Ireland and the United States of America.

Unlisted country

An unlisted country means a foreign country which is not a listed country. Country B is not a listed country; therefore, it is 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.

Subsection 317(1) of the ITAA 1936 defines a Part X Australian resident is a resident of Australia who is not treated solely as a resident of a treaty partner country under a double-taxation agreement between Australia and that country.

Subsection 6(1) of the ITAA 1936 defines an Australian company resident for taxation purposes as a company which is incorporated in Australia, or which, not being incorporated in Australia, carries on business in Australia, and has either its central management and control in Australia, or its voting power controlled by shareholders who are residents of Australia.

Company D is a resident of the Country B, which is an unlisted country.

You and your spouse each over 40% of the shares in Company D

Accordingly, Company D is a Controlled Foreign Company.

Question 2

Section 456 of the ITAA 1936 provides that where a CFC has attributable income for a statutory accounting period in respect of an attributable taxpayer, the taxpayer's attribution percentage of the attributable income is included in the assessable income for the year of income in which the CFC's statutory accounting period ends.

Subsection 361(1) of the ITAA 1936 states that an entity will be an attributable taxpayer in relation to a CFC where the entity:

a)    is an Australian entity whose associate-inclusive control interest in the CFC is at least 10%; or

b)    all of the following apply:

              i.        the CFC is a CFC only because of paragraph 340(c) of the ITAA 1936;

             ii.        the CFC is controlled by any group of 5 or fewer Australian entities; and

            iii.        is an Australian 1% entity and is included in the group of 5 or fewer Australian entities.

As you and your spouse both own over 40% of Company D you will each be an attributable taxpayer.

Attributable Income

Attributable income is calculated based on the same rules used 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 is that only amounts that arise from certain transactions (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.

Section 432 of the ITAA 1936 provides the active income test. A CFC has to satisfy the following five conditions to pass the active income test:

•         the CFC is a resident of a foreign country;

•         it carries on a business at or through a permanent establishment in its country of residence;

•         the CFC keeps proper records;

•         it can substantiate that it has met the active income test;

•         its tainted income ratio is less than five percent.

The definition of permanent establishment is contained in section 6 of the ITAA 1936. 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 an independent 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 on behalf of the person;

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

Company D is a resident of a foreign country but does not have a business on the Country B, it owns a rental property in Country A which is rented to a third party. Company D provided no other service to the tenant.

It does not carry on a business through a permanent establishment

Company D's income is from rent of a property in another country and meets the definition of tainted rental income in section 317 of the ITAA 1936.

tainted rental income (other than special excluded rental income), in relation to a company, in relation to a statutory accounting period, means income derived by the company in the statutory accounting period by way of rent in respect of any of the following:

(a) a lease to which an associate of the company was a party at the time the income was derived;

(b) a lease where any or all of the rent was paid or given by an associate of the company;

(c) a lease of land, except where the following conditions are satisfied:

(i) the land is situated in a listed country or in an unlisted country;

(ii) at all times during the period when the income accrued, the company was a resident of that country;

(d) a lease of land where the following conditions are satisfied:

(i) the land is situated in a listed country or in an unlisted country;

(ii) at all times during the period when the income accrued, the company was a resident of that country;

(iii) it is not the case that a substantial part of the income is attributable to the provision of labour-intensive property management services in connection with the land, being services provided by directors or employees of the company;

As the property is in the Country A and Company D is not then paragraph (c) above means the rental income is tainted rental income.

All of Company D's income is tainted rental income and as it fails the active income test all its income forms part of attributable income and you will be assessable on your share of the attributed income.

Question 3

When a dividend is paid to an attributable taxpayer out of a CFC's income or profits that have been previously subject to tax on attribution, section 23AI of the ITAA 1936 treats the dividend as non-assessable non-exempt income. This is how double taxation is avoided. For a dividend to be treated as non assessable non-exempt income under section 23AI several requirements must be satisfied:

•         there needs to be an 'attribution account entity';

•         the attribution account entity must make an 'attribution account payment'; and

•         an 'attribution debit' must arise for the attribution account entity making the payment.

An attribution account entity includes a CFC. This CFC makes the payment to the attributable taxpayer

An attribution account payment includes a dividend, a share of partnership net income, a share of the net income of a trust estate and a distribution from a trust.

An attribution debit will arise when an attribution account entity makes an attribution account payment and there is an attribution surplus. The amount of the debit cannot exceed the attribution surplus

An attribution surplus is the excess of the attribution account entity's attribution credits arising in relation to the attributable taxpayer over attribution debits arising in relation to the attributable taxpayer at a given time.

An attribution credit will arise for an attribution account entity in relation to the attributable taxpayer where, broadly, an amount is included in the assessable income of the taxpayer by virtue of it being attributed to the taxpayer under Part X of the ITAA 1936.

For a dividend to be wholly or partly non-assessable non-exempt income under section 23AI of the ITAA 1936 when received by the attributable taxpayer, there must be an attribution surplus for the CFC at the time of the payment in relation to that taxpayer. For there to be any attribution surplus, there must be an earlier credit to the attribution account for the CFC in relation to the attributable taxpayer.

Questions 4 and 5

In calculating attributable income, section 393 of the ITAA 1936 allows a deduction for foreign tax and Australian tax paid by a CFC that relates to the eligible period, whether paid before, during or after the eligible period.

A foreign income tax offset (FITO) may also apply to a company (other than a CFC) that is an attributable taxpayer which is assessed under the CFC rules, in order to prevent double taxation. Section 770-135 of the ITAA 1997 deals with foreign tax paid by a CFC and allows a FITO only when the attributed entity is a company.

Your attributable income is reduced by the tax paid by Company D but you are not a company, so no foreign income tax offset is allowable against the attributable income.