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2002-2003

 

THE PARLIAMENT OF THE COMMONWEALTH OF AUSTRALIA

 

 

 

HOUSE OF REPRESENTATIVES

 

 

 

New International tax arrangements bill 2003

 

 

 

EXPLANATORY MEMORANDUM

 

 

 

(Circulated by authority of the

Treasurer, the Hon Peter Costello, MP)

 



T able of contents

Glossary                                                                                                               1

General outline and financial impact............................................................ 3

Chapter 1           Foreign investment funds................................................... 7

Chapter 2           Interest withholding tax exemption for certain

unit trusts............................................................................. 15

Chapter 3           Attributable income of controlled foreign

companies........................................................................... 21

Chapter 4           Preventing double taxation of royalties subject to withholding tax            25

Chapter 5           Regulation impact statement........................................... 29

Index                                                                                                                  39



The following abbreviations and acronyms are used throughout this explanatory memorandum.

Abbreviation

Definition

ADF

approved deposit fund

A Tax System Redesigned

Review of Business Taxation: A Tax System Redesigned

ATO

Australian Taxation Office

CFC

controlled foreign company

CGT

capital gains tax

Commissioner

Commissioner of Taxation

FIF

foreign investment fund

ITAA 1936

Income Tax Assessment Act 1936

IWT

interest withholding tax

PST

pooled superannuation trust

 



Introduction

In the 2003 Federal Budget, following extensive consultation and a report by the Board of Taxation, the Government announced a package of reforms to international taxation. The measures contained in this bill, along with legislation enacting a new tax treaty with the United Kingdom, are part of the first instalment of these reforms.

Foreign investment funds

Schedule 1 to this bill will:

·          exempt from the FIF rules qualifying superannuation entities and fixed trusts where all of the beneficiaries are complying superannuation entities;

·          increase the FIF balanced portfolio exemption threshold from 5% to 10%; and

·          remove management of funds from the FIF ‘blacklist’ of non-eligible business activities.

Date of effect :  The superannuation exemption and the increase in the balanced portfolio exemption will apply to income years beginning on or after 1 July 2003. The removal of ‘management of funds’ will apply to notional accounting periods of FIFs beginning on or after 1 July 2003.

Proposal announced :  These proposals were announced in Treasurer’s Press Release No. 32 of 13 May 2003.

Financial impact :  The FIF exemption and the increase in the balanced portfolio exemption have a total cost to revenue of $15 million for 2004-2005, $20 million for 2005-2006 and $20 million for 2006-2007. The removal of management of funds will have a negligible impact on revenue over these years.

Compliance cost impact :  These measures are expected to substantially lower compliance costs for affected taxpayers.

Interest withholding tax exemption for certain unit trusts

Schedule 2 to this bill will:

·          remove the need for certain unit trusts to withhold tax on interest payments to non-residents in relation to widely offered debentures; and

·          extend this exemption to foreign eligible unit trusts carrying on business in Australia where the interest would otherwise be subject to IWT.

Date of effect :  The exemption from IWT will apply to all qualifying debentures issued on or after the day of Royal Assent.

Proposal announced :  This proposal was announced in Treasurer’s Press Release No. 32 of 13 May 2003.

Financial impact :  The financial impact of this measure is estimated to be up to $3 million per annum over the forward estimates period.

Compliance cost impact :  The amendments are expected to decrease compliance costs by reducing the need for eligible unit trusts to withhold a portion of interest payments made to foreigners. Furthermore, special purpose companies will not need to be created to enable eligible unit trusts to receive the exemption.

Attributable income of controlled foreign companies

Schedule 3 to this bill amends Part X of the ITAA 1936 to better target certain amounts that are included in the notional assessable income of a CFC resident in a broad-exemption listed country. Certain foreign source amounts will no longer be included in a CFC’s notional assessable income, unless the amounts are also of a kind specified in regulations.

Date of effect :  The amendments apply in relation to the statutory accounting periods of CFCs beginning on or after 1 July 2004.

Proposal announced :  This is part of a proposal announced in Treasurer’s Press Release No. 32 of 13 May 2003, as one component of several reforms to the CFC rules.

Financial impact :  The financial impact of the amendments is expected to be negligible.

Compliance cost impact :  The compliance cost of applying the CFC rules will be reduced.

Preventing double taxation of royalties subject to withholding tax

Schedule 4 to this bill amends the ITAA 1936 to ensure that double taxation does not occur where deductions for royalty payments have been denied as a result of the operation of the transfer pricing provisions.

The amendment enables the Commissioner to determine that royalty withholding tax is not payable by a taxpayer to the extent that the transfer pricing rules have been used to disallow a deduction to the payer of the royalty.

Date of effect :  The amendment made by this Schedule applies to applications of section 136AD of the ITAA 1936 that occur on or after the day of Royal Assent.

Proposal announced :  Federal Budget Measures 2003-2004, Budget Paper No. 2.

Financial impact :  The revenue impact of this amendment is $1 million per annum.

Compliance cost impact :  Nil.

SUMMARY OF REGULATION IMPACT STATEMENT

Regulation impact on business

Impact :  Changes to the FIF rules are designed to better target the FIF rules and reduce compliance costs for affected taxpayers (principally the superannuation and managed fund sectors).

The IWT change will reduce the cost of obtaining offshore finance for certain unit trusts operating in Australia. The change will have greatest impact on the managed funds sector, which typically operates through unit trust structures. This change will ensure the same tax treatment is given to debentures issued by these trusts as is currently given to companies.

The change to the CFC rules is designed to reduce the cost of complying with these rules.

Note, this bill also contains an amendment that was not part of the review of international taxation arrangements. This amendment ensures royalty payments are not subject to double taxation to the extent that the transfer pricing rules have disallowed a deduction to the payer of the royalty. Due to its minor nature no regulation impact statement is required for this amendment.

Main points :

·          Complying superannuation entities are unlikely to bias investments toward the kind of offshore investments that the FIF rules target. A new FIF exemption for qualifying superannuation entities and certain fixed trusts will mean that these taxpayers will no longer be subject to the FIF rules with associated savings in compliance costs. For example, these taxpayers will no longer classify their investments as ‘exempt’ or ‘non-exempt’, determine accrual income or maintain attribution accounts.

·          The increase in the balanced portfolio exemption will lower compliance costs for fund managers and other taxpayers by reducing the practice of ‘selling down’ non-exempt FIF assets at the end of the income year in order to meet the balanced portfolio exemption threshold.

·          The removal of ‘management of funds’ from the FIF ‘blacklist’ will reduce the compliance costs of the FIF rules for those taxpayers that hold investments in offshore funds management companies.

·          The IWT measure will make it easier and less expensive for certain unit trusts, typically in the managed funds industry, to borrow offshore. It will remove a distortion in favour of companies over trusts in relation to offshore borrowing.

·          The CFC measure will reduce the compliance costs for taxpayers with relevant interests in CFCs resident in broad-exemption listed countries. Taxpayers will not be required to obtain information from a CFC as to whether it derives certain foreign source amounts, except those, if any, identified in the regulations.



C hapter 1  

Foreign investment funds

Outline of chapter

1.1         Schedule 1 to this bill includes three amendments to the FIF rules in Part XI of the ITAA 1936. The amendments remove complying superannuation entities (and other eligible entities) from the FIF rules, increase the balanced portfolio exemption threshold from 5% to 10% and remove ‘management of funds’ from the FIF ‘blacklist’ of non-eligible business activities.

Context of amendments

1.2         The FIF rules attribute income to Australian residents from their offshore portfolio investments and investments that fall outside the CFC rules. The offshore investments targeted by the FIF rules are those that earn passive income (such as dividends and interest) which is not distributed and may be subject to zero or low tax rates in the offshore jurisdiction. There is a tax benefit from investing in such entities from deferring the derivation of income and converting income into capital gains. The FIF rules seek to remove these benefits.

1.3         The measures in this bill are designed to better target the FIF rules and reduce compliance costs associated with these rules. This will improve the competitiveness of the Australian managed funds and superannuation industries.

Summary of new law

1.4         The amendments remove complying superannuation entities, virtual PST assets and segregated exempt assets of life insurance companies from the FIF rules, increase the balanced portfolio exemption threshold from 5% to 10% and remove ‘management of funds’ from the FIF ‘blacklist’ of non-eligible business activities. These amendments are consistent with recommendations made by the Board of Taxation.

Comparison of key features of new law and current law

New law

Current law

Complying superannuation entities, virtual PST assets and segregated exempt assets of life insurance companies will be exempt from the FIF rules. Fixed trusts where all the beneficiaries are complying superannuation entities (including some non-complying superannuation entities), virtual PST assets and segregated exempt assets of life insurance companies will be exempt from the FIF rules.

Complying superannuation entities, virtual PST assets and segregated exempt assets of life insurance companies are potentially subject to the FIF rules.

The ‘balanced portfolio exemption’ threshold will be increased so that the exemption applies where not more than 10% of the value of the taxpayer’s interests in FIFs are held in non-exempt FIFs.

A ‘balanced portfolio exemption’ exists for interests in non-exempt FIFs the value of which is not more than 5% of the value of all the taxpayer’s interests in FIFs.

‘Management of funds’ will no longer be included in the ‘blacklist’ of non-eligible business activities in the FIF rules.

‘Management of funds’ is included in the ‘blacklist’ of non-eligible business activities in the FIF rules.

Detailed explanation of new law

Exemption from the FIF rules for complying superannuation entities, certain assets of life insurance companies and certain fixed trusts

1.5         The tax benefits of investing in FIFs (i.e. deferring the derivation of income and converting income into capital gains) are greatest for taxpayers that have high marginal tax rates and can access the 50% CGT discount. The tax benefits of investing in FIFs are much lower for complying superannuation entities that are generally taxed at a flat rate of 15% and can only access a one-third discount on eligible capital gains.

1.6         Currently, complying superannuation entities are potentially subject to the FIF rules in Part XI of the ITAA 1936. Part XI will be amended to exempt complying superannuation entities from the FIF rules. Complying superannuation entities include complying superannuation funds, complying ADFs and PSTs. These entities take their meaning from the Superannuation Industry (Supervision) Act 1993 . [Schedule 1, item 2, section 470; item 8, paragraph 519A(b) and subsection 519B(2)]

1.7         Where a complying superannuation entity becomes non-complying, the FIF exemption will not be available to the entity in relation to each year the entity is non-complying. Whether a superannuation entity is non-complying is determined in accordance with the Superannuation Industry (Supervision) Act 1993 .

1.8         Part XI will be also be amended to exempt the ‘virtual PST assets’ and the ‘segregated exempt assets’ of life insurance companies from the FIF rules. Broadly, virtual PST assets are assets that support the complying superannuation business of life insurance companies. Income derived on virtual PST assets is concessionally taxed. Segregated exempt assets are assets that support the immediate annuity and current pension business of life insurance companies. Income derived on those assets is not taxed. [Schedule 1, item 5, section 470; item 7, section 470; item 7, section 470; item 8, paragraph 519A(a) and subsection 519B(1)]

Fixed trust

1.9         Fixed trusts where all beneficiaries are complying superannuation entities, virtual PSTs or segregated exempt assets of life insurance companies will also be exempted from the FIF rules. [Schedule 1, item 4, section 470; item 8, paragraph 519A(b) and subsection 519B(3)]

1.10       The purpose of this exemption is to ensure that where complying superannuation entities pool their investments through a fixed trust, the investments will not be subject to the FIF rules.

1.11       To qualify for the exemption all members of the trust must be complying superannuation entities (or certain assets of life insurance companies). Membership of the trust is tested at the end of each year. There is a limited concession that allows the FIF exemption to continue to apply where a complying superannuation entity becomes non-complying (explained below). [Schedule 1, item 4, section 470; item 8, paragraph 519B(3)(a)]

What if a member of a trust becomes non-complying?

1.12       Where a complying superannuation entity becomes non-complying, the FIF exemption may continue to be available to the trust provided:

·          the non-complying superannuation entity was a complying superannuation entity when it became a beneficiary of the trust; and

·          the entitlements of all non-complying superannuation entities are not more than 5% of the market value of the trust.

[Schedule 1, item 8, paragraphs 519B(4)(a) and (c)]

1.13       In relation to the first dot point, it does not matter if a complying superannuation entity is later notified that it was non-complying for the year in which it became a beneficiary of the trust. [Schedule 1, item 8, subsection 519B(5)]

1.14       Allowing the FIF exemption to continue to apply to the trust where the interests of non-complying superannuation entities in the trust are relatively small, will ensure that the majority of members who are complying superannuation entities are not penalised.

1.15       However, should the interests of beneficiaries that are non-complying superannuation entities exceed the 5% threshold, the exemption will not apply to the trust in each year that the threshold is exceeded. In these circumstances, all beneficiaries (including complying and non-complying superannuation entities) will effectively become liable to tax on any FIF income of the trust.

Example 1.1

A fixed trust with 100 units is established on 1 January 2010. In 2010 holders of all units in the trust are complying superannuation entities. The trust’s income year is the calendar year. Consequently, the trust is exempt from the FIF rules in 2010.

In 2011, there was a single non-complying superannuation entity that held four units (4%). The trust will be exempt from the FIF rules in 2011.

In 2012, there were two non-complying super entities: one that held four units (4%) and one that held two units (2%). The fixed trust is not entitled to the FIF exemption for 2012 as the entitlements of non-complying superannuation funds exceed the 5% threshold

(4%  +  2%  =  6%).

In 2013, all unit holders are complying superannuation entities. The fixed trust is exempt from the FIF rules for 2013.

Will the FIF exemption apply to a chain of trusts?

1.16       The FIF exemption can apply to a chain of fixed trusts. A fixed trust whose only beneficiary is a fixed trust that qualifies for the FIF exemption will also qualify for the FIF exemption. [Schedule 1, item 8, subsections 519B(3) and (4)]

1.17       A fixed trust whose beneficiaries comprise fixed trusts that qualify for the FIF exemption, complying superannuation entities (and potentially non-complying superannuation entities entitled to not more than 5% of the assets of the fixed trust) virtual PST assets and segregated exempt assets will also qualify for the exemption. [Schedule 1, item 8, subsections 519B(3) and (4)]

Example 1.2

In the following example each of Trusts A, B and C are fixed trusts. Each beneficiary of Trust C is a complying superannuation fund (CSF). Trust B has only two beneficiaries: Trust C and a CSF. Trust B is the only beneficiary of Trust A. Trusts A, B and C qualify for the FIF exemption.

 

 

 

 

 

 

 

 





If, for some reason Trust C did not qualify for the FIF exemption, neither Trust B nor Trust A would qualify for the exemption. If, for some reason Trust B did not qualify for the exemption, neither would Trust A.

Increase the balanced portfolio exemption threshold from 5% to 10%

1.18       The balanced portfolio exemption in Division 14 of Part XI provides an exemption from the FIF rules where the value of the FIF interests that otherwise would not be exempt is no more than 5% of all the taxpayer’s interests in FIFs (other than interests that are exempted because of Division 2 or 11). This exemption is known as the ‘balanced portfolio exemption’ because it recognises that taxpayers with a balanced portfolio may hold some non-exempt FIF interests . Such taxpayers are not subject to the FIF rules.

1.19       The amendment in this bill will allow taxpayers to qualify for the exemption where the value of the non-exempt FIF interests represents no more than 10% of all the FIF interests . This increase in the threshold recognises that changing investment trends may mean that a 5% threshold is no longer sufficient to allow Australian investors to achieve appropriate offshore portfolio diversification. [Schedule 1, item 9, Division 14 of Part XI (appropriate heading); item 10, section 524; item 11, paragraph 525(1)(c)]

Removal of ‘management of funds’ from Schedule 4 to the ITAA 1936

1.20       Division 3 of Part XI provides an exemption from the FIF rules for interests in foreign companies that carry on an ‘active’ business. Broadly, a FIF interest in a foreign company will qualify for this exemption if the company is taken to be principally engaged in any activities other than the non-eligible business activities that are listed in Schedule 4 to the ITAA 1936. Currently, Schedule 4 lists seven non-eligible activities, including the activity of ‘management of funds’ . Schedule 4 will be amended to remove management of funds from the list. [Schedule 1, item 12, paragraph (f) of Schedule 4]

1.21       The list in Schedule 4 is known as a ‘blacklist’ because it seeks to identify those foreign companies that derive predominantly passive income (or hold passive assets) and therefore are companies that the FIF rules generally seek to target . Management of funds will be removed from the ‘blacklist’ because the activity of managing funds for others is not of itself an activity that involves deriving passive income or holding passive assets (other than on behalf of investors in the funds). Fund managers derive fees for services such as holding and managing assets for others. This should be considered an ‘active’, rather than ‘passive’ income-earning activity.

1.22       In the event that fund managers do hold passive investments (other than on behalf of investors in the funds), these holdings are likely to constitute the activity of ‘investment in tainted assets, or tainted commodity investments, within the meaning of section 317’ . This is a non-eligible business activity under item (c) of Schedule 4.

Application and transitional provisions

1.23       The exemption from the FIF rules for complying superannuation entities (and certain assets of life insurance companies) and the increase in the balanced portfolio exemption will apply to income years beginning on or after 1 July 2003. [Schedule 1, item 13]

1.24       The removal of ‘management of funds’ from Schedule 4 to the ITAA 1936 will apply in relation to notional accounting periods of FIFs beginning on or after 1 July 2003. [Schedule 1, item 13]

Consequential amendments

1.25       A consequential amendment is required to ensure that the deemed present entitlement rules do not apply where a complying superannuation entity (or certain assets of life insurance companies) qualifies for the exemption from the FIF rules. [Schedule 1, item 1, paragraph 96A(1)(c)]

 



C hapter 2  

Interest withholding tax exemption for certain unit trusts

Outline of chapter

2.1         Schedule 2 to this bill provides an IWT exemption for interest paid on certain debentures issued by (the trustees of) eligible unit trusts. In this chapter, this is referred to as an IWT exemption for these unit trusts. A similar exemption is currently available for companies.

Context of amendments

2.2         Generally, entities operating in Australia which have obtained finance abroad must withhold a proportion of their interest payments to non-residents and remit that amount to the ATO. These amounts are withheld as a final tax on interest income sourced in Australia. If entities operating in Australia fail to withhold a proportion of interest payments they will be personally liable for these amounts. Obliging Australian borrowers to withhold amounts from interest paid on debentures held by foreigners tends to shift the tax impact onto the Australian borrowers.

2.3         Companies carrying on a business in Australia are currently able to receive an exemption from IWT on interest payments in relation to widely offered debentures. Other borrowers, including unit trusts, are not similarly exempted from withholding even in relation to interest paid on similar debentures. However, they may effectively obtain the exemption by having an interposed company undertake the borrowing and paying the interest.

2.4         The Board of Taxation recommended that this exemption should be extended to the managed funds industry, which operates through unit trust structures.

Summary of new law

2.5         This bill:

·          removes the requirement to withhold tax on interest paid on widely offered debentures issued by certain Australian unit trusts;

·          allows certain foreign unit trusts operating at or through a permanent establishment in Australia to access the exemption for interest payments in relation to widely offered debenture issues;

·          stipulates the types of unit trusts that may qualify for the exemption; and

·          duplicates all the other conditions for the exemption that currently applies to companies.

2.6         All legislative references are to the ITAA 1936.

Comparison of key features of new law and current law

New law

Current law

Eligible unit trusts and companies carrying on business in Australia will receive an IWT exemption for interest paid on debentures issued under certain conditions.

Companies carrying on business in Australia receive an exemption from IWT for interest paid on debentures issued under certain conditions.

A foreign company or eligible unit trust carrying on business at or through a permanent establishment in Australia will be exempt from IWT for interest paid on debentures issued under certain conditions.

A foreign company carrying on business in Australia at or through a permanent establishment is exempt from IWT for interest paid on debentures issued under certain conditions.

The definition of eligible unit trust incorporates certain public unit trusts, corporate unit trusts and most public trading trusts. Unit trusts will also be able to access the exemption if all their units are held by specified unit holders.

There is no similar provision in the existing law.

Detailed explanation of new law

The exemption

2.7         In order to access the IWT exemption, a unit trust must meet the eligibility requirements when the debenture is issued and when the interest is paid on the debenture. To apply these tests, trusts that are taken to be public unit trusts or certain other trusts for an income year are deemed to be these kinds of trusts for the whole income year. These debenture issues must also satisfy the public offer test by being widely offered [Schedule 2, item 5, subsections 128FA(1), (2) and (9)] . When these requirements are satisfied, interest paid on the debenture will be exempt from withholding tax and the trustee of the unit trust will not have to withhold tax on the interest payments [Schedule 2, item 5, subsection 128FA(3)] .

2.8         All unit trusts operating in Australia that would otherwise be required to withhold tax from interest payments to non-residents may qualify for the exemption. This means that what might be termed a foreign eligible unit trust carrying on business in Australia at or through a permanent establishment will receive the IWT exemption if debentures issued by it satisfy the public offer test. This will place all qualifying unit trusts carrying on a business in Australia on an equal footing with each other and with companies in relation to the taxation of their interest payments. [Schedule 2, item 5, subsection 128FA(1)]

Eligible unit trusts

2.9         The unit trusts that may qualify for the IWT exemption are referred to as eligible unit trusts. This definition refers to unit trusts which at any time in a year of income are public unit trusts, or unit trusts which have all their issued units held by two or more listed eligible unit holders. The objective of this definition is to ensure that eligible unit trusts are directly or indirectly widely held, for integrity reasons. [Schedule 2, item 5, subsection 128FA(8)]

2.10       The public unit trust definition adopted for the purposes of this measure (section 102G) will allow trusts taxed like companies (i.e. corporate unit trusts and most public trading trusts) to receive an exemption from IWT on debentures which meet the public offer test. Not all public trading trusts will be entitled to the exemption because of concerns that some of these trusts may be closely held. [Schedule 2, item 5, subsection 128FA(8)]

2.11       In order to receive the IWT exemption, a unit trust that is not a public unit trust must have all its issued units held by two or more of the following entities:

·          public unit trusts;

·          complying superannuation funds with 50 or more members;

·          PST;

·          complying ADFs;

·          life insurance companies;

·          public companies; or

·          other unit trusts which themselves meet this requirement.

2.12       These entities are included as permissible unit holders of eligible unit trusts on the basis that they are generally widely held. [Schedule 2, item 5, subsection 128FA(8)]

Duplication of provisions applying to companies

2.13       Many of the provisions in section 128FA mirror the existing provisions in section 128F that apply only to companies. This allows eligible unit trusts to receive the same treatment as companies in relation to the borrowing activities of some foreign subsidiary companies, associate requirements, the debenture definition, the public offer test and the issue of global bonds. [Schedule 2, item 5, subsections 128FA(4) to (7)]

2.14       In addition, section 128FA includes a provision to exempt from IWT the deemed interest component of the sale price of a qualifying debenture similar to that provided for companies. Note that this provision applies only in relation to qualifying debentures issued by eligible unit trusts. [Schedule 2, item 5, subsection 128FA(2)]

2.15       For the purposes of the associates requirements in section 128FA, eligible unit trusts are to be regarded as public unit trusts. This enables the trustee of a public unit trust to be treated as if it were a company for the operation of the ‘associates’ definition in section 318 [Schedule 2, item 5, subsection 128FA(8)] . In determining whether the trustee of an eligible unit trust is sufficiently influenced by another entity, regard should only be had to the influence on the trustee acting in that capacity and not in any other capacity. This principle of applying the provisions to the trustee of a unit trust in its capacity as the trustee and not in any other capacity should be adopted generally in applying section 128FA (e.g. in the definition of ‘debenture’ in subsection 128FA(8)).

Application and transitional provisions

2.16       The amendments in the Schedule will apply to debentures issued on or after the day of Royal Assent. [Schedule 2, item 6]  

Consequential amendments

2.17       The consequential amendments to the ITAA 1936 ensure that the operation of the withholding tax provisions is not compromised. These consequential amendments ensure like treatment is provided to debentures issued by companies and eligible unit trusts. [Schedule 2, items 1 to 4, subsection 25(2), paragraph 128AAA(2)(b), subparagraph 128B(3)(h)(iv) and section 128D]



C hapter 3  

Attributable income of controlled foreign companies

Outline of chapter

3.1         Schedule 3 to this bill amends Part X of the ITAA 1936 to better target those amounts that are included in the notional assessable income of a CFC resident in a broad-exemption listed country. Certain amounts will no longer be included in a CFC’s notional assessable income, unless the amounts are also of a kind specified in the regulations. This chapter explains the amendments.

Context of amendments

3.2         The CFC rules include in the taxable income of an Australian taxpayer, the taxpayer’s share of specified income of non-resident companies in which they have a controlling interest. The income that is targeted for attribution to taxpayers is income that can readily be shifted by taxpayers to non-resident companies to take advantage of any lower overseas taxation.

3.3         For CFCs resident in broad-exemption listed countries (currently Canada, France, Germany, Japan, New Zealand, the United Kingdom, and the United States of America) a narrower range of income is attributable. These countries have comparable income tax regimes to Australia, which significantly reduces the scope to avoid tax.

3.4         While a narrower range of income is attributable for CFCs in broad-exemption listed countries, various general categories of income (e.g. royalties and certain foreign source amounts) remain attributable subject to the application of various tests. These categories and tests were introduced in 1991, when the number of countries treated like broad-exemption listed countries was over 60. The large number of countries made precise identification of attributable income difficult.

3.5         As part of the Government’s response to the Board of Taxation’s report to the Treasurer, the Government will amend the ITAA 1936 and the Income Tax Regulations 1936 to further reduce the categories of income attributable in respect of CFCs resident in broad-exemption listed countries. This will be done by more precisely identifying the types of income that give rise to significant revenue risk. While this will primarily be achieved by future changes to the regulations (not covered in this bill), the amendments in Schedule 3 complement those intended changes. The changes will reduce compliance costs and improve the commercial flexibility of CFCs resident in broad-exemption listed countries.

Summary of new law

3.6         The amendments in this Schedule reduce the scope of income attributable in respect of CFCs resident in broad-exemption listed countries, subject to a safeguard that allows amounts to remain attributable if identified in the regulations.

3.7         The amendments apply to statutory accounting periods of CFCs beginning on or after 1 July 2004.

Comparison of key features of new law and current law

New law

Current law

The notional assessable income of a CFC resident in a broad-exemption listed country is calculated taking into account certain foreign source amounts only if those amounts are of a kind specified in regulations .

The notional assessable income of a CFC resident in a broad-exemption listed country is calculated taking into account certain foreign source amounts.

Detailed explanation of new law

3.8         A CFC’s attributable income is calculated on a notional basis using the rules for calculating the taxable income of an Australian resident company, subject to some modifications and exemptions. The notional assessable income of a CFC depends on whether the CFC is resident in a broad-exemption listed country or elsewhere.

3.9         If a CFC is resident in a broad-exemption listed country, a greater range of otherwise notional assessable income is exempt from attribution. One category of notional assessable income that remains subject to attribution relates to foreign source amounts that are not eligible designated concession income and pass certain tests, whether derived directly or through a partnership (subparagraphs 385(2)(a)(ii) and (d)(ii)).

Limiting the inclusion of foreign source amounts in attributable income

3.10       While these foreign source amounts can potentially give rise to attributable income in a wide range of circumstances, in practice this is unlikely to occur. For example, even where a CFC resident in a broad-exemption listed country derives a relevant foreign source amount, it is not attributable if subject to certain foreign taxes. However, taxpayers can still incur compliance costs to confirm that there is no such attributable income. The amendments remove the need for taxpayers to consider such amounts, except those, if any, specified in regulations. [Schedule 3, item 1, subparagraphs 385(2)(a)(ii) and (d)(ii)]

3.11       The ability to identify in regulations income amounts that should still be attributable is a revenue safeguard (e.g. in the case where a broad-exemption listed country changes its tax system in a way that opens up tax avoidance opportunities for Australian taxpayers). In most cases, though, income of concern is likely to be attributable under other provisions (e.g. as eligible designated concession income under subparagraphs 385(2)(a)(i) and (d)(i)).

Application and transitional provisions

3.12       The amendments apply to statutory accounting periods of CFCs beginning on or after 1 July 2004. [Schedule 3, item 2]

3.13       The statutory accounting period of a CFC is, in general, each 12-month period ending 30 June. However, a CFC can elect for its statutory accounting period to end on a different date. The attributable income of a CFC, in respect of a particular statutory accounting period, is included in the assessable income of relevant Australian taxpayers in the year of income in which the statutory accounting period ends.



C hapter 4  

Preventing double taxation of royalties subject to withholding tax

Outline of chapter

4.1         Schedule 4 to this bill amends the ITAA 1936 to ensure that double taxation does not occur where deductions for royalty payments have been denied as a result of the operation of the transfer pricing provisions.

4.2         The amendment enables the Commissioner to determine that royalty withholding tax is not payable to the extent that the transfer pricing rules have disallowed a deduction to the payer of the royalty.

Context of amendments

4.3         Australia’s domestic transfer pricing provisions and the Associated Enterprises Article of Australia’s tax treaties authorise the adjustment of profits between related parties to reflect an arm’s length profit for taxation purposes.

4.4         Where all or part of a payment is disallowed as a deduction under these rules and the payment is subject to withholding tax, double taxation occurs. The amount is effectively taxed once in the hands of the Australian payer, by reason of a disallowance of the deduction, and again by way of withholding tax in the hands of the recipient. The recipient is usually not an Australian resident.

4.5         Subsection 136AF(3) of the ITAA 1936 operates to remove this double taxation for interest payments. It enables the Commissioner to determine that withholding tax should not have been paid by the (non-resident) recipient, to the extent that the interest amount has been disallowed as a deduction to the Australian payer.

4.6         However, no similar compensating provision applies in relation to royalty payments that have been subject to withholding tax. This was noted in Recommendation 22.14 of A Tax System Redesigned , which recommended that appropriate consequential adjustments be available to avoid double taxation arising from Australian transfer pricing adjustments.

Summary of new law

4.7         Under the proposed amendment, the Commissioner will be able to determine that royalty withholding tax is not payable by a (non-resident) taxpayer to the extent that the transfer pricing rules have disallowed a deduction to the payer of the royalty.

Comparison of key features of new law and current law

New law

Current law

Where there has been a transfer pricing adjustment, the Commissioner may determine that amounts of withholding tax should not have become payable in respect of certain interest or royalty payments.

Where there has been a transfer pricing adjustment, the Commissioner may determine that amounts of withholding tax should not have become payable in respect of certain interest payments. No such determination can be made in relation to royalties.

Detailed explanation of new law

4.8         Schedule 4 amends the income tax law so that, following a transfer pricing adjustment, the Commissioner is now able to consider whether royalty withholding tax would have been payable if the property had been supplied or acquired between independent parties dealing at arm’s length. [Schedule 4, item 1, paragraph 136AF(3)(b)]

4.9         The amendment will align the treatment of royalty payments to that which currently applies in relation to interest payments where withholding tax has been paid in relation to a transaction that has been subject to a transfer pricing adjustment.

4.10       Therefore, if following a transfer pricing adjustment, the Commissioner considers that an amount of royalty or interest withholding tax should not have been payable, subsection 136AF(3) will authorise the Commissioner to take the appropriate action to give effect to this determination and ensure that there is no double taxation.

Application and transitional provisions

4.11       The amendment made by this Schedule applies to applications of section 136AD of the ITAA 1936 that occur on or after the date of Royal Assent. [Schedule 4, item 2]



C hapter 5  

Regulation impact statement

Policy objective

Review of international taxation arrangements

5.1         This bill is the first instalment of the Government’s legislative programme implementing the package of reforms following the review of international taxation arrangements.

5.2         The outcomes of the review will improve the competitiveness of Australian companies with offshore operations. In particular the reforms will reduce the commercial constraints and compliance costs arising from the CFC rules, reduce tax on foreign ‘active’ business income, and effectively reduce foreign taxes by modernising Australia’s tax treaties. The reforms will also enhance the competitiveness and reduce the compliance costs of Australian based managed funds.

The objectives of the measures in this bill 

5.3         Changes to the FIF rules are designed to reduce compliance costs for affected taxpayers and better target the FIF rules to entities most likely to engage in avoidance activities.

5.4         The change to the IWT rules is designed to reduce the cost of obtaining offshore finance for certain unit trusts operating in Australia. This change will ensure the same tax treatment is given to debentures issued by these trusts as is given to companies.

5.5         The change to the CFC rules is designed to reduce the cost of complying with the CFC rules, and complements changes that are to be made to the Income Tax Regulations 1936.

5.6         Note, this bill also contains an amendment that was not part of the review of international taxation arrangements. This amendment ensures royalty payments are not subject to double taxation to the extent that the transfer pricing rules have disallowed a deduction to the payer of the royalty. Due to its minor nature no regulation impact statement is required for this amendment.

Implementation options

5.7         The measures addressed in this regulation impact statement arise directly from the review of international taxation arrangements. Those recommendations were the subject of extensive consultation. The implementation options for these measures can be found in the Board of Taxation’s report, International Taxation - A Report to the Treasurer (the Board’s Report) and the Treasury’s consultation paper, Review of International Taxation Arrangements (Consultation Paper). Table 5.1 shows where the measures, and principles underlying them, are discussed in these publications.

Table 5.1:  Options for implementing measures in this bill arising directly from the Board’s Report and the Consultation Paper



Measure

The Board’s Report

Consultation Paper

Exempting complying superannuation entities from the FIF rules.

Recommendation 4.4, pages 121 and 122

Option 4.4, pages 64 and 65

Increasing the balanced portfolio FIF exemption threshold from 5% to 10%.

Recommendation 4.2, pages 119 to 121

Option 4.2, pages 61 to 63

Removing ‘management of funds’ from the non-eligible activities in the FIF rules.

Recommendation 4.5, page 122

Option 4.5, pages 65 and 66

IWT exemption for certain unit trusts.

Recommendation 4.8C, pages 129 and 130

Not applicable

Paring back attributable income of CFCs resident in broad-exemption listed countries.

Recommendation 3, page 82

Pages 33 to 37



5.8         Where the Board’s Report and the Consultation Paper do not address details in this bill, the implementation options are set out in Table 5.2.

Table 5.2:  Implementation options for details not explicitly addressed in the Board’s Report or the Consultation Paper



Measure

Implementation options

Exempt fixed trusts from the FIF rules where the beneficiaries of the trust are complying superannuation entities.

Superannuation funds typically invest offshore through trusts. The measure ensures that such trusts can also receive the FIF exemption. The exemption will also apply to a chain of trusts. In the absence of the latter rule, the measure would have a more limited application.

IWT exemption for certain unit trusts.

The measure ensures that certain unit trusts that operate in Australia are eligible for an IWT exemption on widely offered debentures.

The Board’s Report recommended that the exemption be available to widely held unit trusts. The primary example of such trusts are public unit trusts.

The exemption is extended to unit trusts that are not widely held but have all their units held by eligible unit holders (which are themselves widely held). Trusts with these characteristics are a commonly adopted structure in the investment industry that borrow to fund investments.

Assessment of impacts

5.9         The Government, the Board of Taxation and the business sector have carefully considered the potential compliance, administrative and economic impacts of the measures in this bill.

Impact group identification

5.10       The measures in this bill specifically impact on those taxpayers identified in Table 5.3.

Table 5.3:  Taxpayers affected by measures in this bill



Measure

Taxpayers affected

Exempting complying superannuation entities from the FIF rules.

Qualifying superannuation entities such as complying superannuation funds, complying approved deposit funds, PSTs and virtual PSTs of life companies. Fixed trusts where the beneficiaries are complying superannuation entities.

Increasing the balanced portfolio FIF exemption threshold from 5% to 10%.

Around 180 entities are currently paying tax due to the application of the FIF rules. However, due to the practice of selling down and because many taxpayers do not have attributable income (though they must still perform steps to determine this conclusion), many more entities than 180 will be affected by this change. A significant number of these entities are domestic managed funds.

Removing ‘management of funds’ from non-eligible activities in the FIF rules.

Due to the practice of ‘selling down’ (described in paragraph 5.15) and because many taxpayers do not have attributable income, an indeterminate number of entities (though many more than 180) will be affected by this change. A significant number of these entities are domestic managed funds.

IWT exemption for certain unit trusts.

Trusts taxed like companies, other public unit trusts and unit trusts with all beneficial interests held by prescribed unit holders. This measure will apply to approximately 600 unit trusts.

Paring back attributable income of CFCs in broad-exemption listed countries.

Around 2,000 taxpayers, predominantly companies, have reported interests in CFCs. This equates to around 5,000 CFCs (and controlled foreign trusts) resident in broad-exemption listed countries.

Note: No other data relating to taxpayers affected by measures in this bill are available.

Analysis of costs / benefits

Compliance costs

Exempting complying superannuation entities from the FIF rules

5.11       Exempting complying superannuation entities from the FIF rules will ensure that such entities do not have to comply with the FIF rules. There will be a significant reduction in compliance costs for such entities as they will no longer need to classify their FIF investments, determine accrual income or maintain attribution accounts. Also, they will not need to undertake the practice of ‘selling down’ (as described below).

5.12       However, there is insufficient data to produce worthwhile estimates of the magnitude of these compliance cost impacts.

Increasing the balanced portfolio FIF exemption threshold from 5% to 10%

5.13       The balanced portfolio exemption was initially introduced so that taxpayers do not incur substantial compliance costs where non-FIF exempt activities are a minor part of their FIF investments. Increasing the threshold from 5% to 10% will ensure that more taxpayers are exempted from the FIF rules. This will reduce compliance costs for such taxpayers as they will not have to determine attributed income or maintain attribution accounts. However, taxpayers will still have to classify their FIF interests to determine whether their non-exempt FIF interests are no greater than 10%.

5.14       There are particular compliance cost savings for the managed fund industry. When the FIF rules were developed in the early 1990s, it was considered that a managed fund generally would have less than 5% of their FIF investments in non-FIF exempt activities. Since then companies that hold financial assets, which broadly constitute non-exempt FIF investments, now comprise a greater proportion of the global investment market. Anecdotal evidence now suggests that managed funds generally hold between 5% and 10% of their FIF investments in non-FIF exempt activities.

5.15       In order to qualify for the balanced portfolio exemption, managed funds ‘sell down’ their non-exempt FIF interests at the end of the income year to ensure that they meet the 5% threshold and repurchase those interests at the commencement of the new income year. This involves substantial transactional compliance costs. Increasing the balanced portfolio exemption from 5% to 10% will reduce the need for managed funds to sell down, thus reducing compliance costs.

5.16       There is insufficient data to produce worthwhile estimates of the magnitude of these compliance cost impacts.

Removing ‘management of funds’ from non-eligible activities in the FIF rules

5.17       Removing ‘management of funds’ from the list of non-eligible business activities will reduce the scope of non-exempt FIF investments of taxpayers. This will reduce the compliance costs associated with determining accrual income and maintaining attribution accounts for these investments.

5.18       There is insufficient data to produce worthwhile estimates of the magnitude of these compliance cost impacts.

IWT exemption

5.19       The extension of the IWT exemption to certain unit trusts is expected to eliminate compliance costs for these trusts. Currently special purpose companies may be created by unit trusts in order to access the existing IWT exemption, but in some cases this may involve prohibitive costs.

5.20       There is insufficient data to produce worthwhile estimates of the magnitude of these compliance cost impacts.

CFC measure

5.21       The CFC measure will reduce the compliance costs for taxpayers with relevant interests in CFCs resident in broad-exemption listed countries. A taxpayer will not be required to obtain information from a CFC as to whether it derives certain foreign source amounts, except those, if any, identified in the regulations.

5.22       There is insufficient data to produce worthwhile estimates of the magnitude of these compliance cost impacts.

Administration costs

Exempting complying superannuation entities from the FIF rules

5.23       A reduction in the information available to the ATO on the FIF interests of self-managed superannuation funds may require the development of a compliance strategy and the independent collection of information from such entities, in order for the ATO to administer the Superannuation Industry (Supervision) Act 1993.

5.24       There is insufficient data to produce worthwhile estimates of the magnitude of administration cost impacts.

Increasing the balanced portfolio FIF exemption threshold from 5% to 10%

5.25       The administrative cost of this measure is expected to be minimal.

Removing ‘management of funds’ from the list of non-eligible activities in the FIF rules

5.26       The administrative cost of this measure is expected to be minimal. There is insufficient data to produce worthwhile estimates of the magnitude of these administration cost impacts.

IWT exemption

5.27       Administration costs may increase because a new class of borrowers is eligible for the exemption, subject to certain conditions. Determining whether a trust is an eligible unit trust may involve tracing through certain unit holders. This increase, however, is likely to be negligible because the taxation of the income of these trusts already requires a certain amount of tracing through the relevant unit holders.

CFC measure

5.28       The administration cost of this measure is expected to be minimal. Some ongoing monitoring of broad-exemption listed country tax systems will be required to determine if specific foreign source amounts should be identified in the regulations.

Government revenue

5.29       The financial impact of these measures will be a loss to the revenue over financial years as outlined in Table 5.4.

Table 5.4:  Financial impact of the measures in this statement



 

2003-2004

2004-2005

2005-2006

2006-2007

Exempting complying superannuation entities from the FIF rules

 

-$9 million

-$9 million

-$10 million

Increasing the balanced portfolio FIF exemption

 

-$15 million

-$20 million

-$20 million

Removing ‘management of funds’ from the FIF blacklist

*

*

*

*

IWT exemption

 

-$1.5 million

-$3 million

-$3 million

CFC measure

..

..

..

..

Notes:

1.     Increasing the balanced portfolio FIF exemption : revenue estimates for this measure represent an upper bound estimate of the loss of revenue resulting from the change. This assumes a full-take up of the measure by all entities affected by the FIF rules. Data is not available to provide a reliable estimate of the number of entities that are currently failing to access the balanced portfolio FIF exemption that would qualify for the exemption under the measure.

2.     As increasing the balanced portfolio FIF exemption represents the upper bound of potentially exempting all FIF income, the costs of this measure and exempting complying superannuation entities from the FIF rules is not additive. The cost to revenue estimates above reflects the cost to revenue if each were separately enacted to the exclusion of the other. In the event that both are enacted the revenue impact for the increasing the balanced portfolio FIF exemption would subsume the exempting complying superannuation entities from the FIF rules costing .

Key:

*     a reliable estimate cannot be provided for the measure.

..     negligible impact.

Economic benefits

5.30       By reducing the tax compliance costs of the funds management and superannuation industries the FIF measures and the IWT exemption will improve the international competitiveness of these sectors. Importantly the IWT exemption will also remove a distortion in favour of companies over trusts in relation to offshore borrowing. There is an economic benefit from any compliance cost reduction associated with the CFC measure, to the extent that, where CFCs have foreign source income, CFC consequences (if any) will be more specifically identified in regulations.

Consultation

5.31       Business, legal and accounting representatives and the ATO have been consulted extensively and have actively assisted in developing these initiatives . This involved the establishment of an advisory group constituted by members of industry and professional peak bodies to help in the design of legislation. Some of the more technical issues, or those that affect a specific interest group, were referred to particular sub-groups . In addition, direct discussions with taxpayers affected by these measures were undertaken as necessary.

5.32       On the IWT exemption measure, consultation substantially shaped the meaning of the unit trusts that would be eligible for the exemption. However, those consulted suggested that the legislation allow investors (e.g. individuals and private companies) other than those prescribed in the law to hold units in the unit trusts (that are not public unit trusts) that may qualify for the exemption. This went beyond the Government’s policy in relation to this measure and so was not adopted.

Conclusion

5.33       The measures in this bill are the first instalment of reforms announced following the review of international taxation arrangements. This bill focuses on measures designed to streamline the FIF regime as well as reduce the cost of obtaining offshore finance for certain unit trusts operating in Australia. Reduced compliance costs associated with the FIF and IWT changes, will improve the international competitiveness of Australia’s funds management and superannuation sectors. The IWT change will remove a distortion in favour of companies over trusts in relation to offshore borrowing.



I ndex         

Schedule 1: Foreign investment funds

Bill reference

Paragraph number

Item 1, paragraph 96A(1)(c)

1.25

Item 2, section 470

1.6

Item 4, section 470

1.9, 1.11

Item 5, section 470

1.8

Item 7, section 470

1.8

Item 8, paragraph 519A(a) and subsection 519B(1)

1.8

Item 8, paragraph 519A(b) and subsection 519B(2)

1.6

Item 8, paragraph 519A(b) and subsection 519B(3)

1.9

Item 8, subsections 519B(3) and (4)

1.16, 1.17

Item 8, paragraph 519B(3)(a)

1.11

Item 8, paragraphs 519B(4)(a) and (c)

1.12

Item 8, subsection 519B(5)

1.13

Item 9, Division 14 of Part XI (appropriate heading)

1.19

Item 10, section 524

1.19

Item 11, paragraph 525(1)(c)

1.19

Item 12, paragraph (f) of Schedule 4

1.20

Item 13

1.23, 1.24

Schedule 2: Interest withholding tax exemption for certain unit trusts

Bill reference

Paragraph number

Items 1 to 4, subsection 25(2), paragraph 128AAA(2)(b), subparagraph 128B(3)(h)(iv) and section 128D

2.17

Item 5, subsection 128FA(1)

2.7, 2.8

Item 5, subsection 128FA(2)

2.7, 2.14

Item 5, subsection 128FA(3)

2.7

Item 5, subsections 128FA(4) to (7)

2.13

Item 5, subsection 128FA(8)

2.9, 2.10, 2.12, 2.15

Item 5, subsection 128FA(9)

2.7

Item 6

2.16

Schedule 3: Attributable income of controlled foreign companies

Bill reference

Paragraph number

Item 1, subparagraphs 385(2)(a)(ii) and (d)(ii)

3.10

Item 2

3.12

Schedule 4: Preventing double taxation of royalties subject to withholding tax

Bill reference

Paragraph number

Item 1, paragraph 136AF(3)(b)

4.8

Item 2

4.11