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Taxation Laws Amendment (Foreign Income Measures) Bill 1997
Date Introduced: 4 September 1997
House: House of Representatives
Portfolio: Treasury
Commencement: Royal Assent
The main effect of the Bill will be to create lists that represent countries with a compatible foreign income taxation system as that operating in Australia and another, more extensive, list of countries that has a taxation system such that tax paid in that country will be eligible to be offset against tax payable in respect of Controlled Foreign Companies payable in Australia. Under the first list, income from Controlled Foreign Companies operating in that country will be treated in such a manner as to ensure that the income is treated more favourably with foreign tax being treated as if Australian tax had been paid. The Bill also contains provisions designed to reduce compliance costs and to take account of changes in the composition of various countries.
As the name of the Bill suggests, the measures contained in the Bill relate to the taxation of Australian residents on income earned overseas. This area of the tax law is very complex due to the large number of methods that can be used to disguise overseas income and to use various overseas entities to channel funds so that the calculation of the actual amount of income and its sources are often very difficult. As a result of the complexity of the various methods that may be used to minimise tax, the legislation is correspondingly complex.
The foreign income taxation scheme depends on a number of key terms:
Accrual taxation:This is a method of calculating the income of a body, usually a trading company, that is deemed to have earned income as it becomes due. This may be contrasted with the system generally applicable to individuals where income is taxed only upon receipt. Using the later method in relation to companies, especially trading companies, would allow the timing of the receipt of income to be manipulated to minimise the tax payable, eg. through delaying the receipt of income to a later financial year when lower income will be received.
Controlled Foreign Company (CFC):A CFC is, as the term implies, a non-resident company in which Australian resident entities have a sufficient interest to be considered to be in control of the CFC. Associated interests are also included in determining the degree of control in certain circumstances. The definition of a CFC contained in section 340 of the Income Tax Assessment Act 1936 (ITAA) provides that in general circumstances control will be taken to be where 5 or fewer Australian entities have control of at least 50% of the interests in the company, or 40% in certain circumstances where there is no other controller of the company. The matters that may be taken into consideration when determining whether an entity has a controlling interest include voting rights in the company, the right to receive the distributions (eg. dividends) from the entity and the right to the capital of the company if it is wound-up. There are also circumstances in which an Australian entity will be deemed to be in control of a foreign company and Part X of the ITAA contains a number of other provisions designed to prevent avoidance of the rules relating to CFCs.
Similar rules will also apply to controlled foreign trusts and partnerships to include such entities in the general regime designed to prevent the use of low tax foreign entities to avoid Australian tax. If such entities were not included in the regime, it would be possible to arrange the flow of funds so that a trust or partnership was used rather than a company to achieve the same results of minimising the amount of Australian tax payable.
Listed Country:In relation to CFCs, the Australian taxation of the entity depends on whether the country in which the CFC resides is a listed or unlisted country. A listed country is one which has been determined to have a taxation regime that in substantially similar to Australia's in regard to the prevention of avoidance by the use of low tax regimes. There are currently approximately 60 countries which are defined to be listed countries, although the list contains a number of countries which have ceased to exist, such as the USSR, and is need of updating. The question of whether all of the countries on the list truly have comparable taxation regimes to Australia in relation to this issue has also been asked and the major amendments contained in the Bill relate to the status of listed countries (see below).
Tainted Income:As noted, the CFC regime is designed to prevent the use of low tax countries to minimise Australian tax. The measures are not directed at normal commercial operations carried out overseas by Australian controlled companies and there is a distinction between active and tainted income, with the CFC regime applying principally to the later type of income. Examples of tainted income include royalties, dividends and rent. As tainted income is generally more portable than active income (ie. it can be directed so that the country in which it is earned can be reasonably easily changed to take advantage of lower tax rates), tainted income is more often used in tax minimisation schemes. The distinction between tainted and active income is particularly important in relation to earnings in unlisted countries, where the income is fully attributed to the Australian controllers except to the extent that it is active income.
Foreign Tax Credits:The foreign tax credits system (FTCS) provides that where foreign source income is included in an Australian residents income, a credit is allowed for the amount of foreign tax, if any, paid on the income overseas. In relation to income from a CFC, depending on the status of the country in which the country is earned and the nature of the income, an amount will be attributed to the Australian resident. The amount of tax payable on the income is then calculated and the amount of tax payable is then reduced by the amount of foreign tax paid. The FTCS does not apply where the foreign source income is specifically exempt under Australian law, which are principally dividend and branch profit income derived in a listed country. The exemption is based on the foreign company having to pay comparable tax as it is derived in a listed country.
Foreign Investment Fund:A foreign investment fund (FIF) is a non-resident company or trust in which a resident has an interest. Income of the FIF is attributed to the resident based on the interest they hold in the FIF and, as with CFCs, certain types of income, such as active income, are not attributed to the taxpayer. The FIF regime is similar in effect to the CFC regime but applies where the resident does not have a controlling interest in the non-resident entity.
The current status of the foreign income tax rules was examined in an Information Paper, titled Proposed Changes to the Taxation of Foreign Source Income, released by the Treasurer in December 1996. The first matter to be examined was the uses to which the list of countries is put. As noted above, the list is used for both CFC and FTCS purposes and the Information Paper found that this was inappropriate as not all countries on the list had truly comparable tax rates and systems and that the number of countries on the list for CFC purposes should be reduced. It was not considered appropriate to abandon the list as this would increase compliance costs for people showing that they had been comparably taxed overseas.(1) In relation to the use of the list for FTCS, the report states:
Retaining a long list of countries for the purposes of exempting distributions of income from the FTCS is considered acceptable. These exemptions primarily apply to distributions of active income. Providing this income has already been subject to comparable taxation offshore, the risk to revenue and the economy from not subjecting distributions of income to the FTCS is relatively small.(2)
The result of this recommendation will be that the exemption of dividend income for non-portfolio distributions and branch profits will remain for those countries on the extended list (which is substantially the same as the current list but takes into account recent changes in certain countries and areas) while the more liberal CFC rules will continue to apply to a reduced range of listed countries where the taxation system is considered to be truly comparable to Australia's. The use of the lists is, in the opinion of the Information Paper, also designed to continue to allow taxpayers with interests in listed countries to reduce their compliance costs. However, the reduction of the list for CFC purposes will increase compliance costs for those entities resident in a country which has lost its listing status for CFC purposes. The explanatory memorandum to the Bill estimates that: 'The initial costs of compliance for companies and trusts in limited-exemption listed countries [ie. those that are listed for FTCS purposes but not for CFC purposes] is estimated to be less than $5 million.'(3)
The Information Paper proposes that the list of countries for CFC purposes will be Canada, France, Germany, Japan, New Zealand, the United Kingdom and the United States. These countries are considered to have a comparable CFC regime to Australia's and the listing of these countries is also proposed on the basis that while some of these countries have more relaxed rules for some categories of tainted income, 'their listing .... would be justified given the significant amount of Australian investment to those countries.'(4)
In relation to the need to update the list of countries that will continue to apply for dividends and branch profits, the Information Paper foreshadows the renaming of countries to reflect changes in the former Germanys, Soviet Union and Yugoslavia. Transitional provisions were also envisaged to cope with the situation where a country may maintain its listing status as a former component of the Soviet Union or Yugoslavia but its future status is in doubt due to changes in their tax laws since the dissolution of the former countries. It is also envisaged that the larger list will also be amended to include Vietnam and the Czech Republic, with which Australia has recently signed a Double Taxation Agreement (which deals with the rate of tax on a number of sources of repatriated income and allows a degree of confidence that the overseas tax system is compatible in regard to dividends and branch profits).
Part 2 of Schedule 1 of the Bill will amend the ITAA to change references of listed countries to references to broad exemption listed country in the provisions listed in the Part. The amendments are part of the creation of the two-list system with different uses for the two lists as described above. Similarly, Parts 3 and 4 of the Schedule will change references to unlisted countries to non-broad-exemption listed countries.
Part 1 of the Schedule contains general amendments. Section 23AH of the ITAA provides for certain foreign source income to be exempt. This is basically where the income is derived from a business in a listed country where the income is not eligible designated concessional income. Items 1, 2 and 3 will amend this section to provide for different treatment of income from the two lists. The exemption will be removed for income that is not adjusted tainted income, or active income,from limited exemption listed countries.
Items 26 and 27 insert the definition of broad-exemption listed country and limited-exemption listed country. The countries in each group are to be fixed by regulation.
There are also provisions to reduce compliance costs, such as the changes to the active income test, simplified methods for calculating income of associated companies within a listed country and transfer pricing rules will not apply to transfers between CFCs in the same listed country.
Transitional provisions largely relate to the treatment of countries from the former Soviet Union and Yugoslavia and the Czech Republic and Vietnam.
Chris Field
8 December 1997
Bills Digest Service
Information and Research Services
This paper has been prepared for general distribution to Senators and Members of the Australian Parliament. While great care is taken to ensure that the paper is accurate and balanced, the paper is written using information publicly available at the time of production. The views expressed are those of the author and should not be attributed to the Information and Research Services (IRS). Advice on legislation or legal policy issues contained in this paper is provided for use in parliamentary debate and for related parliamentary purposes. This paper is not professional legal opinion. Readers are reminded that the paper is not an official parliamentary or Australian government document.
ISSN 1328-8091
© Commonwealth of Australia 1997
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Published by the Department of the Parliamentary Library, 1997