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Tuesday, 16 October 1990
Page: 2956

Mr ROCHER(5.25) —The first point to make about the Taxation Laws Amendment (Foreign Income) Bill and the Taxation (Interest on Non-Resident Trust Distributions) Bill being debated cognately is that a further new concept is to be introduced into our taxation system. This legislation will share that distinction with the capital gains tax and the fringe benefits tax in the Australian context. However, accrual systems, although new in Australia, do exist in other countries.

A justification for these Bills seems to be a need to counter the perceived practice of Australians deriving income through non-resident companies based in low tax jurisdictions. Historically, Australian tax has not been payable until after profits of the type to become affected were paid by way of dividends or other income to Australian shareholders. Unlike domestically generated taxable income, the types of income now to be targeted will be taxed regardless of whether the income has actually been received. The perception is that, because such dividends were infrequently or rarely paid, the revenue has been unfairly deprived.

The objective of the new accruals system seems to ensure that foreign income and capital gains received, or deemed earned, by Australians through foreign companies are taxed at the rate of at least 25 per cent. The exception will be income derived by foreign companies satisfying the active income exemption provisions. So it will transpire that generally, if this income is not taxed at the rate of 25 per cent in an overseas jurisdiction, the accruals system will be activated to tax profits at Australian rates, with credits being allowed if certain taxes are paid overseas.

A matter of great concern, for reasons that I will discuss later, is the effective starting date of 1 July this year. The accruals or attribution concept, being new, is far from straightforward. Attempting to summarise it is fraught with problems; but it should be attempted as both the second reading speech by the Minister for Science and Technology and Minister Assisting the Treasurer (Mr Crean) and the weighty documentation accompanying the measure leave something to be desired.

It seems to boil down to something like this: whenever an Australian resident has a share in a foreign company, the accruals concept has the potential to have application to that person. It will not apply where the Australian shareholder and his associates own less than 10 per cent of a foreign company; this is known as a portable investment; nor will it apply where the foreign company is not a controlled foreign corporation. Basically, a CFC is a foreign company controlled by Australian residents. It will not apply in most instances where the active income exemption has application; nor will it apply where the active income exemption has been failed but there is active income nevertheless. Generally, active income of a CFC will not be attributable income.

Finally, application of the accruals system will not apply in most instances where the foreign company is resident in a listed comparable tax country such as the United States of America or the United Kingdom. The most common exception to this exclusion is income derived in the comparable tax country from a designated tax concession. Only one of the exclusions just mentioned need have application to ensure that there is not an accruals assessment or attribution of income to an Australian resident shareholder. The system is designed to take into account income which flows from one foreign company to another. Examples are CFCs deriving income from non-CFCs and vice versa and CFCs based in comparable tax countries deriving income from foreign companies and branches based in non-listed jurisdictions and vice versa.

Basically, a foreign company will be a CFC if it is controlled by Australian residents. Control is defined for the purposes of the accruals system. A foreign company will be deemed a controlled foreign corporation if it is controlled by five or fewer Australian residents either alone or together with associates. This is said to be a matter of fact to be determined according to the circumstances of each case.

The second control test is based on the assumption that a single Australian resident whose interest in the foreign company is 40 per cent or more will control the company. This assumption is rebuttable if it can be shown that the foreign company is controlled by another entity or group of entities, whether Australian or otherwise, not associated with the 40 per cent or more shareholder. Both the direct and indirect interests of the Australian resident are, I understand, taken into account. The direct and indirect interests of associates of Australian residents are also taken into account. It should be noted that associates are not limited to residents of Australia, the definition of `associate' being very broad.

The measurement of control occurs at the end of the non-resident company's accounting year. This measurement requires a complicated-to the point of being unfathomable for most-aggregating of the direct and indirect interests of both the Australian resident and the associates. Listed countries are those which the Government considers have tax systems and rates generally comparable with our own. Not surprisingly, non-listed countries are not listed. Although there is a presumption that the accruals system will apply to companies resident in non-listed countries, there are exceptions to this rule, the most important being the active income exemption. Other exceptions are income derived in a branch in a listed country and taxed at comparable rates in that country; income already taxed in Australia, including franked dividends; and certain dividend receipts.

The relevance of the distinction between listed countries and non-listed countries includes prima facie income derived by CFCs resident in listed countries which will not be subject to the accrual system. Conversely, income derived by CFCs resident in a non-listed country is prima facie subject to the accrual system, unless the active income exemption applies; and a dividend derived by an Australian company from a company, whether or not a CFC resident in a listed country, is exempt income. This exemption will apply only where the dividend is from a non-portfolio investment-that is, the Australian company has a voting interest of at least 10 per cent.

`Designated tax concessions' is a colloquial term given to certain concessions granted by listed countries within their own taxation system, which the Australian Government will not allow to escape the net of the Australian revenue. The correct term as per the draft regulations is `designated concession income' being profits from certain tax concessions. The tax concessions in listed countries' jurisdictions which are unacceptable to the Australian Government have been dealt with in two ways involving a general description of the types of income and capital gains, which are either not taxed or are taxed at a reduced rate, and a specific reference to a certain country and a precise description of the offending concession.

Briefly, if a listed company does not tax income or a capital gain at a rate of at least 25 per cent, there is an extremely high probability that it will be designated concession income. Whether it is then subject to attribution will be determined by the nature of the income or capital gain. If active, it will not be subject to attribution. Inclusion of the active income exemption provisions was a significant concession won by business after the proposed introduction of an accrual system was first announced way back in 1988. Initially, the exemption was only to apply on an entity basis. However, after further submissions from the business community the concept has been expanded to exempt all active income.

`Active income' is effectively defined, but by default. Basically, active income is any income which is not tainted income. As might be expected, `tainted income' is extensively defined. I quote from page 7 of the introduction to the explanatory memorandum of the draft Bill:

Tainted income includes the types of income that are readily susceptible to being shifted to foreign tax jurisdictions. In very broad terms, tainted income will consist of passive income (e.g. dividends, interest, royalties and most kinds of gains on the disposal of assets) and business income from transactions with related parties and Australian residents.

Of most concern is the inclusion of business income from transactions with related parties and Australian residents.

For instance, there is tainted sales income which refers to the goods which are purchased from or sold to an associate in turn having a relevant connection with Australia. Profits made from sales will be excluded from tainted sales income in two situations, the first where the goods are created or produced by the company and the second where the character of the goods is substantially changed by the company. Packaging is not considered to change substantially the character of goods.

Tainted services income includes income derived from the provision of services to an associate of the company, to a resident of Australia or in connection with a branch in Australia. The performance of technical, managerial, engineering, architectural, scientific, industrial, transport, commercial agency or other professional or similar work would generally qualify as services.

There are three main requirements for the passing of the active income test. The first stipulates that a CFC must have a permanent establishment in its country of residence; then the CFC must have kept accounts and complied with substantiation requirements in respect of those accounts prepared in accordance with commercially accepted accounting principles; and finally, the CFC's tainted income must be less than 5 per cent of its total income. If a CFC passes the stated tests with the exception of certain trust income, none of its income will be subject to attribution.

An area of much concern again, given the wide definition of `tainted income' is that many commercially active operations will not satisfy the active income exemption test. This will be despite legitimate attempts to establish overseas operations. For example, many countries offer the facility of a free trade zone. Such zones are ideally suited for packaging and distribution activities because of the availability of labour at a cheaper rate than in Australia. The nature of a packaged product may not allow for any further activity to be carried out in Australia. So, by definition, the profits generated from such activity will not be active income. Such a tight definition of tainted income effectively defeats the so-called political reason for the inclusion of the active income exemption-and that is to enable Australians to compete effectively in low tax jurisdictions.

Given that a CFC fails the active income exemption, it is not necessarily the case that all of its income will be subject to attribution. Basically, however, its active income will be excluded from attribution. With two major exceptions, the existing system will continue to apply to dividends received by Australian residents from foreign companies. One exception arises where a dividend received by an Australian resident company from a foreign company-whether or not a CFC-resident in a listed country is exempt income where the investment in the foreign company is a non-portfolio investment. A non-portfolio investment, as I think I might have indicated earlier, is where the Australian company has a voting interest of at least 10 per cent.

A second exemption occurs when a dividend is received by an Australian resident from the income of a CFC that has been attributed to the taxpayer under the accrual system. There is a complex system of recording the information to enable this exemption to be calculated.

The treatment of foreign branches of Australian companies has been modified to bring them into line with the treatment of foreign companies. Basically, the profits of a resident company derived in carrying on a business at or through a permanent establishment located in a listed company will be exempt income with effect from 1 July 1990. As might be expected, any such profits which have not been taxed by a listed company will not be exempt income. This might occur where the income or profits have benefited from a designated tax concession.

Having said all that, it is at best only a brief summary of the proposed amendments which intend to tax foreign source income. The legislation is voluminous, complex and detailed. Given the introduction of self-assessment for companies and other taxpayers, the ability to recognise a situation where there is attributable income becomes essential. In reality the administration required to comply with the provisions is prohibitive. Compliance and administration requirements will act as a major disincentive for Australians to become involved in a CFC. This comes at a time when many Australian businesses are seeking to expand their operations into overseas markets. Inevitably, they will become involved with the accrual system, even if it is only to determine whether the active income exemption has some application. This in itself is no easy task.

It should also be noted that not included in this outline of the Bills are the intricate rules relating to overseas trusts or to the practical problems of complying with the legislation and the associated calculations required. Furthermore, the associated issues of tax sparing, the operation of the foreign tax credit system, and international tax treaties are beyond the scope of this discussion.

Whatever the merits of what is intended, this legislation has had an agonising gestation period. It was first foreshadowed way back in 1988 and was revived in April 1989. A draft Bill became available last December. Consultations ensued, with many suggestions to either simplify the measures proposed or remove the disincentives which militate against Australians doing business overseas.

Another draft Bill followed, available in late June, and the amended version is now before the House. Involving as it does a further 236 pages of amendments to the principal Act, the Income Tax Assessment Act 1936, 416 pages of explanatory memorandum, press statements announcing new and conflicting details and the Minister's second reading speech, it is hardly surprising that the main Bill is neither brief nor in an understandable form. Much of the hyperbole and propaganda reported in the financial press from April 1989 until now also left a great deal to be desired.

The terms of the Bill itself and press briefings of one kind or another are and were intended to mislead and paint a rosy picture of what will be achieved. There is more than a suggestion that considerable thought and effort has gone into manipulating public perceptions. Take as an example the references to tax havens in virtually every newspaper article prior to and since that initial announcement. Those references blatantly insinuated to all but the very well informed that the measures proposed are mainly aimed at income derived by Australians from business channelled through notorious tax havens.

But it will not just be income through tax havens which will be caught in this net; it will go far, far wider. In many cases it will not even be income in any accepted sense of the word `income' which will be taxed. In many cases we will assess and collect taxes from entities and individuals which and who have not received the income taxed and might not receive it for months or even years, if ever.

Then there is the description in the Bill of certain income as tainted. The use of the term `tainted income' ranks alongside `tax haven' as terminology intended to appeal to the emotions rather than to logic or reason. The simple truth is that a new category of taxable income is to be created, and that in normal parlance is hardly tainted income. That adjective is most inappropriate and connotes illegality and even criminality when used as it is to describe income.

A major sticking point is that the legislation is to have effect from 1 July, while it is still here before the Parliament. Our concern is compounded by the certain knowledge that compliance costs will be considerable, as well as the fact that a reasonable degree of knowledge about the Bill's provisions was not possible before introduction only a month ago.

The Minister's claim in his second reading speech when he said that the Bill is essentially the same as the June draft Bill is also misleading. There are at least 18 changes and possibly more. That number of changes might be insignificant to the Minister but in a Bill of great complexity, comprising 60 or 70 clauses, those 18 changes have to be absorbed, understood and ultimately complied with.

The second draft Bill was issued on only 28 June or thereabouts, as were draft regulations. Not without good reason, there is some nervousness about the proposed regulations and the near certainty that they will be varied also. With the June draft available only a few days before the proposed legislation is to have effect and with subsequent changes, both confirmed and likely, the Government will force exporters, bankers and accountants to comply with a parcel of laws which many had not even seen on 1 July. The complications and uncertainty it has created by its own legislative incompetence must be obvious, even to this Government.

The Bill, having grown like topsy since the December 1989 version was issued-from 118 pages to 230-odd today-still fails to attract support. Admittedly, outright opposition is equally difficult to identify, but that is more the product of a sense of general futility as well as ignorance about the full implications of the measures than any implied support for the Bill.

One particularly offensive aspect of the proposed legislation surrounds the intention to insert a new section 264 in the principal Act. The Australian Taxation Office (ATO) is to be given access to documentation held overseas that might be considered relevant for the purpose of establishing a liability or otherwise under these provisions. So far, so good. But it transpires that if the information demanded is not made available, whether due to a failure of the potential taxpayer or because of legal restraints imposed by the country where an investment resides, the taxpayer is to be prevented from using in evidence documents not provided on demand by the ATO but which may subsequently become available in any ultimate court action. That is very heavy-handed stuff. Apart from the potential to deny natural justice to taxpayers it goes to the very heart of the separation of government, in this case represented by its agency, the ATO, from the institution that is our system of law courts.

There remain other matters of concern which a lack of time will prevent my canvassing today. These include, but are not necessarily limited to, the following matters. There is to be common treatment of banks with other enterprises. This is to come about despite separate domestic laws for banks and a whole host of case law. There is a decided lack of commercial reality in the requirements as they will affect the banking industry. Also, there is no assurance that double taxation generally will not or cannot occur. Then there are the control and attribution tests for those Australian shareholders and trust beneficiaries who may be unaware of control by other Australian residents. There is also the prospect of this legislation inhibiting genuine enterprise. Such an outcome, at a time when the Government's economic mismanagement has caused immense national indebtedness and massive balance of payments deficits, would again demonstrate this regime's foolhardiness. The irony is that while the measures are aimed at reducing tax avoidance, a consequential effect will be to discourage export earning enterprise.

There is much about the legislation which gives cause for serious disquiet, but because the concept has been around for some years, consultations with business have taken place and there has been an absence of outright opposition to the provisions, the coalition will not oppose the legislation. While the Government deserves to be hoist on its own petard, unfortunately it is likely that the revenue and all Australians will be the ultimate losers once again.