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Taxation of interests in foreign investment funds



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TREASURER

EMBARGO 3.00 PM 20 AUGUST 1991

STATEMENT BY THE TREASURER, JOHN KERIN HP TAXATION OF INTERESTS IN FOREIGN INVESTMENT FUNDS

As announced in the 1991-92 Budget, the Government has determined the broad design features of new measures to tax the income of Australian residents in respect of their interests in foreign investment funds (FIFs).

The FIF regime was foreshadowed by the Government in its April 1989 Information Paper, 'Taxation of Foreign Source Income'. The new arrangements will operate from the 1992-93 income year, and will complement the foreign source income

(FSI) measures contained in the Taxation Laws Amendment (Foreign Income) Act 1990.

The FSI measures are a major part of the Government's efforts to close off avenues for offshore tax avoidance. The FIF measures will continue the Government's crackdown in this area.,

The Need For FIF Measures

The ability of Australian residents to defer Australian tax . on passive foreign income such as dividends, interest and royalties until it is remitted to Australia provides significant scope for tax avoidance. Passive income can readily be transferred between tax jurisdictions and thus can be sheltered from Australian tax in low-tax jurisdictions or

in countries whose tax systems treat certain types of investment income more generously than does Australia.

The FSI measures commenced from the 1990-91 income year. They tax on a current (ie, accruals) basis most non-active (passive and other tainted) income sheltered offshore by Australian resident owners of Australian-controlled foreign

companies (CFCs) and certain trusts.

The FSI measures apply only where foreign companies are controlled by Australian residents, and only to the extent that individual residents have a substantial interest in those companies. The FSI measures were designed with the

intention that FIF measures would be introduced to counter offshore tax avoidance where Australian residents hold non-controlling interests in foreign entities generating principally passive income.

COMMONWEALTH PARLIAMENTARY LIBRARY MICAH

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Coverage

In designing the FIF measures, the Government has targeted those non-controlling interests in foreign entities that provide the greatest scope for offshore tax avoidance. The new measures will generally not apply to interests held

directly by Australian residents in foreign companies engaged principally in active business operations. Direct investments of this nature provide limited scope for offshore tax avoidance.

However, many investment funds generating passive income that are marketed or otherwise available to Australian taxpayers provide scope for tax avoidance. Because of difficulties in explicitly defining all targeted entities, the Government has decided that income and gains from all interests in offshore entities should be subject to Australian tax on a current basis under the FIF measures unless those interests satisfy

one of the following specific exclusions.

. To ensure that only substantial holdings are targeted, natural persons with aggregate interests in foreign entities not greater than $20,000 will be excluded from the provisions. This 'de minimis· exclusion will reduce compliance and administrative costs in respect of relatively small holdings. Safeguarding measures may be required to prevent splitting of interests to

exploit the threshold.

. . Interests in foreign entities in respect of which Australian residents are attributable taxpayers under existing FSI measures (and are thus assessable on a current basis) will also not be subject to the FIF measures. This exclusion, which will be subject to .

appropriate safeguards against accumulation of income in lower tier foreign entities, is to be provided on the basis that the existing FSI measures tax appropriately the offshore investments to which they apply.

. Interests in companies engaged principally in "active business" will be excluded from the FIF measures along the following lines:

- portfolio interests (investments of less than 10 per cent), will be excluded where they are in companies that are listed on an approved stock exchange. Stock exchange disclosure requirements would facilitate determination of whether

companies are engaged principally in active or passive business activity; and

- non-portfolio interests (investments of 10 per cent or more) will not need to meet a listing requirement because such larger investors will generally have information sufficient to demonstrate the principal business activity of their investment.

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Special provisions will also be developed to exclude holding companies whose subsidiaries are principally engaged in active business activity.

At this stage, it is intended that companies will be considered to be engaged in active business where they are engaged in the following activities:

. agriculture, forestry or fishing;

. manufacturing or processing;

. exploration and development of mineral resources, including energy;

. wholesaling and retailing the product of any of the above activities;

. approved banking; and

. the provision of certain services (eg, architectural, engineering and other professional services).

In addition to the above exclusions, the Government is prepared to examine special cases identified during the consultative process.

Methods of Taxing FIF Interests

The multi-tiered structure of many FIF investments (with the potential for accumulation of income and capital gains in lower level entities) and the lack of control by the investor - and hence limited access to information - make it

impractical to calculate the income and gains in respect of a FIF interest on the same basis as for resident taxpayers and under the existing FSI measures.

Consequently, the Government has decided that the income to be attributed to a resident taxpayer will be calculated by the aggregate change in the market value of taxpayers' FIF interests over the income year - with appropriate allowance

for losses.

The market value will generally approximate the income and gains being made at all levels of the FIF structure, regardless of the number of tiers of foreign entities. It therefore avoids the substantial problems of tracing income and gains through complex structures.

In most cases the market value of an investor's interest in a foreign entity should be able to readily be obtained and verified. Where investors are unable to obtain market value information, income for tax purposes will be determined by

applying to the Australian resident's interests a factor representing a deemed rate of return on the investment. This approach has been adopted under the FSI measures in relation to the taxation of closely held non-resident trusts of Australian residents in circumstances where income cannot be determined on an accruals basis. The Government will be

announcing the deemed rate to apply in due course.

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Where distributions are made to taxpayers in respect of interests taxed under either the market value or deemed income approach iuch distributions will continue to be separately taxat when available to Australian investors but with appropriate relief to avoid double taxation.

Jurisdictional Coverage

The FSI measures distinguish between investments in comparable-tax (listed) and low-tax (unlisted) countries (including tax havens). Thus, in general terms, the FSI measures adopt a jurisdictional approach. Under a

jurisdictional approach, taxpayers need to be able to trace interests held in foreign entities through to their underlying source to establish attributable income. This need for tracing does not impose heavy compliance and administrative costs where taxpayers hold substantial controlling interests and have access to the necessary

information.

However, the jurisdictional approach becomes impractical where taxpayers hold small non-controlling interests in offshore entities and do not have such information access. For this reason, the Government has decided that the FIF measures will apply on a world-wide basis. This approach has been adopted by other countries with FIF regimes.

Consultation

The Government is committed to continuing the consultative process that has been in place throughout the development and introduction of the FSI measures.

The Government will consider submissions received in response to today's announcement before introducing legislation into the Parliament in the Autumn 1992 sittings. Submissions should be sent by 18 October 1991 to:

First Assistant Secretary Taxation Policy Division Department of the Treasury

Parkes Place PAPKES ACT 2600

CANBERRA 20 August 1991

Contact Officers

Treasury:

Mr P. Robinson (06) 263 3905 Mr J. Griffiths (06) 263 2995

Australian Taxation Office:

Mr W. Fulton (06) 275 1161 Mr M. Nugent (06) 275 2363