Section 3: Conditions to be met to satisfy the active income test.

A CFC has to satisfy the following five conditions to pass the active income test:

1. Is it a resident of a foreign country?
2. Does it have a permanent establishment in its country of residence?
3. Does it keep proper records?
4. Can it substantiate your claim that it has met the active income test?
5. Is its tainted income ratio less than 5%?

Condition 1 - Is the CFC a resident of a foreign country?

The CFC must be a resident of a particular country throughout the statutory accounting period. A change of residence of the CFC does not mean that the CFC will fail the active income test. However, it must have been a resident of a particular country both before and after the change.

New companies

If a CFC was in existence for only part of a statutory accounting period, it must be a resident of a particular country throughout the period in which it existed - that is, in the period from incorporation to the end of the statutory accounting period.

Treatment of dormant companies

The term 'in existence' does not include a company that is dormant within the meaning of Part VI of the Companies Act 1981. A CFC that is dormant for the whole of the statutory accounting period will fail the active income test. However, because the CFC is dormant, it will have no income or gains and will have no attributable income.

Is the CFC resident in a particular country?

Yes	Read on.
No	The CFC has failed the active income test. Go straight to part 3.

Condition 2 - Does the CFC have a permanent establishment in its country of residence?

The CFC must carry on business through a permanent establishment in its country of residence for the whole of a statutory accounting period in which it is in existence.

What is a permanent establishment?

The definition of permanent establishment is contained in section 6 of the Act. Broadly, the term includes a place at or through which normal business activities are carried on. However, it specifically excludes a place where a person:

• is engaged in business dealings through a commission agent or broker who is acting in the ordinary course of business and receiving customary rates of remuneration
• is carrying on business through an agent who does not have or does not usually exercise a general authority to negotiate or conclude contracts or to fill orders from stock situated in the country
• maintains the place solely for the purpose of purchasing goods or merchandise.

Partnership with a permanent establishment

Even if the CFC did not carry on business at or through a permanent establishment, the CFC will satisfy this condition if any partnership in which it is a member carried on business at or through a permanent establishment in the country of residence of the CFC.

Did the CFC directly or indirectly through a partnership carry on business through a permanent establishment in its country of residence?

Yes	Read on.
No	The CFC has failed the active income test. Go straight to part 3.

Condition 3 - Does the CFC keep proper records?

The figures used in the active income test are mainly drawn from accounting records and, in general, are not adjusted to comply with tax law concepts. Therefore, the accounts of the company must be properly prepared.

The accounts must be prepared in accordance with commercially accepted accounting principles. Where there are commercially accepted accounting principles in the country of residence of the CFC, it is acceptable if the accounts of the CFC comply with those principles. In other cases, it is acceptable if the accounts of the CFC comply with Australian commercially accepted accounting principles.

The documents you must take into consideration are:

• the profit and loss statement and balance sheet
• any ledgers or journals, and
• any notes, statements or reports that are attached to, or meant to be read with, these accounts.

The accounts of a CFC for a statutory accounting period must give a true and fair view of the financial position of the CFC. If the accounts are prepared in accordance with commercially accepted accounting principles but do not give a true and fair view, the CFC will fail the active income test.

Treatment of partnerships

Where a CFC is a partner in a partnership, the CFC's share of the partnership income must be taken into account. This means that the partnership must also keep proper accounts. If the partnership does not keep proper accounts, the CFC will fail the active income test.

Has the CFC and every partnership in which it was a partner kept proper accounts that give a true and fair view?

Yes	Read on.
No	The CFC has failed the active income test. Go straight to part 3.

Condition 4 - Can the CFC substantiate your claim that it has met the active income test?

A CFC must have, and be able to produce, accounts to substantiate your claim that the CFC has passed the active income test. If the CFC is a partner in a partnership, that partnership must also keep accounts to substantiate amounts derived by the partnership. If the CFC or partnership does not have the accounts, or does not produce them, the CFC is taken to have failed the active income test. See chapter 4 for details of the substantiation requirements and the procedures.

Is the CFC and any partnership in which it is a partner able to substantiate your claim?

Yes	Read on.
No	The CFC has failed the active income test. Go straight to part 3.

Condition 5 - Is the CFC's tainted income ratio less than 5%

To pass the active income test, the tainted income ratio of a CFC for a statutory accounting period must be less than 0.05 - that is, less than 5%. If both the bottom line and the top line of the relevant formula is nil, the CFC is taken to have passed the active income test.