Calculation method using the CFC rules

Overview

Certain attributable taxpayers that use the calculation method to determine their attributable FIF income can choose to base this calculation on the CFC rules for income years commencing on or after 1 July 2008. [section 559A]

In addition, the treatment of a foreign company, as an Australian financial institution subsidiary, will be extended to subsidiaries of Australian financial institutions that choose to calculate FIF income using the CFC rules.

Effectively, these taxpayers will treat their FIF interest as if it were a CFC interest, thereby working out the FIF income that accrues to them based on the active income test and exemptions that relate to the calculation of the notional assessable income and notional allowable deductions of a foreign company that is a CFC.

When can a choice be made to use the CFC rules under the FIF calculation method?

A choice to work out notional income and notional deductions using the CFC rules can only be made once the taxpayer has first elected to apply the calculation method in respect of the interest in the FIF. [section 559A]

The restriction on the use of the calculation method for taxpayers who have previously elected to use the calculation method in respect of a FIF but have not continued to use that method in subsequent years, is relaxed. [subsection 535(4A)]

A choice (within the calculation method of the FIF rules) to work out notional assessable income and notional allowable deductions of a FIF using the CFC rules can only be made if:

• the taxpayer has an interest in a foreign company
• the taxpayer has an attribution percentage (as defined in Part X of the ITAA 1936) of 10% or more in the foreign company, and
• once made in relation to a certain year, such a choice can only be made for a subsequent year if it has been made for each intervening year.

Although the attributable FIF income is worked out using the CFC rules (once this choice is made) the attributable taxpayer is still assessed under Part XI itself (through the operation of sections 529 and 580 of the ITAA 1936). The CFC rules are only used to work out the notional income and notional deductions of the FIF.

What is the effect of making a choice?

Once a taxpayer makes a choice in relation to a FIF under section 559A of the ITAA 1936, certain assumptions are made to ensure that the CFC rules can be applied and interact effectively in working out the FIF income that accrues to that taxpayer under the calculation method, namely:

• the FIF is treated as a FIF that is a CFC
• the taxpayer is treated as an attributable taxpayer under Part X of the ITAA 1936
• the notional accounting period is treated as a statutory accounting period
• the notional income of the foreign company is treated as notional assessable income under Part X
• the notional deductions of the foreign company are treated as notional allowable deductions worked out under Part X, and
• if the taxpayer is an Australian financial institution at a particular time in the year of income, the foreign company in relation to whom the choice is made is treated as an Australian financial institution subsidiary at that time.

To ensure the relevant provisions in Part X dealing with notional assessable income and notional allowable deductions can be applied, the FIF is treated as a FIF that is a CFC. The taxpayer, choosing to apply section 559A, is treated as an attributable taxpayer (within the meaning of Part X) in relation to the FIF. In the case of a first-tier FIF choosing to apply section 559A in relation to a second-tier foreign investment fund, it is the first-tier foreign investment fund that is treated as an attributable taxpayer and the second-tier foreign investment fund is treated as a FIF that is a CFC. [paragraph 559A(2)(a) and (b)]

Further, the calculation of attributable income under the CFC rules relies on the statutory accounting period of the CFC. This is generally each 12-month period finishing at the end of 30 June, but with an option to use some other 12-month period (section 319). Under the FIF rules, FIF income accrues to the taxpayer in respect of a notional accounting period of the FIF. The notional accounting period of the FIF is generally a period that is a year of income of the attributable taxpayer, with the choice of an election for a 12-month period based on the period for which the FIF's accounts are made out. Therefore, the notional accounting period may differ from the statutory accounting period.

The new rules treat the notional accounting period of the FIF as the statutory accounting period. This allows the FIF, in relation to which a choice is made under section 559A, to continue using its actual notional accounting period to determine the notional assessable income and notional allowable deductions under Part X. [paragraph 559A(2)(c)]

Under this approach, when the income is actually attributed under Part XI, the number of days in the notional accounting period throughout which the taxpayer had the FIF interest can continue to be applied. Also if the taxpayer does not choose to apply section 559A of the ITAA 1936 in relation to a FIF in a later year, the FIF can continue to use the same notional accounting period it used when applying section 559A for the earlier period.

Once the taxpayer elects to use the calculation method in relation to a FIF and makes a choice to base the calculation on the CFC rules, the taxpayer will determine the FIF income that accrues to them by working out the notional assessable income and notional allowable deduction rules under Part X instead of using the provisions in Part XI.

Therefore, the notional income and notional deduction rules under the calculation method in Part XI of the ITAA 1936 are effectively 'turned off' and, instead, the notional assessable income and notional allowable deduction rules in Part X of the ITAA 1936 apply.

Modification rules

There are five modification rules that alter the treatment of notional income and notional deductions where a choice is made.

Three of these rules reapply certain provisions in Part XI (the FIF rules) to ensure that the choice of the notional controlled foreign company calculation within the calculation method only deals with an interest in a first-tier FIF, and with an interest a first-tier FIF may have in a second-tier FIF.

The first rule applies where a FIF has an interest in a second-tier FIF, or where a second-tier FIF has an interest in a third-tier FIF. In these cases, the existing rules in sections 575 to 579 of the ITAA 1936 apply in relation to the actual attributable taxpayer with effect that a choice to use the notional CFC calculation method is not available in relation to a third-tier FIF. This is despite the assumptions under subsection 559A(3) of the ITAA 1936. [subsections 559A(6), 559A(7) and 559A(8)]

The second and third rules apply to 'turn off' the rules in Part X of the ITAA 1936 that also calculate any FIF income accruing under Part XI of that Act in order to ensure there is no double counting of income accruing to a first-tier or second-tier FIF from any second-tier and third-tier FIF, respectively. As sections 576 and 579 of the ITAA 1936 apply in relation to a second-tier and third-tier FIFs, paragraphs 384(2)(ca) and 385(2)(ca) (which ordinarily deal with notional assessable income of a CFC from an interest in a FIF under Part XI of the ITAA 1936) are disregarded. [paragraph 559A(7)(a) and subparagraph 559A(8)(b)(i)]

Example

At the end of year one, an Australian taxpayer, South Co, holds a 10% direct shareholding in foreign company West Co and a 5% direct interest in foreign company North Co. West Co has a 50% interest in North Co as indicated in the following diagram.

Assume the direct shareholding percentages equate to direct attribution interest percentages under Part X of the ITAA 1936.

Under the FIF calculation method, South Co elects, to use the notional controlled foreign company calculation to work out the notional income and notional deductions of West Co. In the process of determining the notional income of West Co, the notional income of North Co must also be determined. This is ascertained by applying section 576 and not paragraph 384(2)(ca) or 385(2)(ca) of the ITAA 1936 which are normally relevant to the calculation of notional assessable income under the CFC rules.

In determining the notional income of North Co in respect of West Co's 50% interest, section 575 of the ITAA 1936 applies and West Co can make the choice to use the CFC rules to work out the notional income and notional deductions of North Co, as South Co's attribution percentage in North Co is 10% (5% direct and 5% indirect attribution interest).

South Co must make a separate election for its 5% direct interest in North Co. This is a separate process to the election that it makes in relation to West Co's interest in North Co. However, the indirect attribution interest held in North Co through West Co ensures South Co meets the 10% attribution percentage requirement. [paragraph 559A(1)(b)]

If, at the end of year two, South Co's interest in West Co dropped to 5% it would not be able to make a choice in relation to either West Co or North Co in relation to year two because the 10% attribution percentage requirement is not met. In subsequent years, South Co is not able to make a choice in relation to its interest in West Co or North Co.

Note that the choice cannot be made in relation to a third-tier FIF. This is consistent with the operation of section 579 of the ITAA 1936 and the fact that the calculation method can only ever be used in relation to a first-tier and second-tier FIF of a taxpayer. [subparagraph 559A(8)(b)(ii)]

The remaining two modification rules relate to the calculation of capital gains and the utilisation of prior-year losses of the FIF.

Modification rule for capital gains

Profits or gains of a capital nature are determined on the basis of the period that would have been used under Part XI of that Act instead of applying the special rules in Part X of the ITAA 1936. [subsection 559A(5)]

This rule ensures that any choice in relation to a FIF will not:

• refresh the cost base of assets that are held by the FIF
• change the time of acquisition of an asset held by a FIF, or
• impact on the events that result in a capital gain being ignored.

Modification rule for prior-year losses

In working out the notional deductions of the FIF, sections 429 and 431 of Part X of the ITAA 1936 are ignored [paragraph 559A(4)(a)].

The effect of disregarding these sections is that the main operative provisions in Part X of the ITAA 1936 will not apply in relation to the FIF. There will be no need to calculate the sometimes-exempt-income gain or loss because the provisions where those calculations apply (sections 429 and 431) are disregarded in working out the notional allowable deductions of the FIF.

Instead, notional deductions (if any) as worked out under section 572 are included in working out the FIF's notional allowable deductions. Section 572 deals with notional deductions for calculated losses for prior periods.

Where a taxpayer makes a choice to work out the notional income and deductions of a FIF using the CFC rules a calculated loss may arise in respect of that FIF (that is, where the notional allowable deductions exceed notional assessable income) under subsection 559(4) of the ITAA 1936. This loss feeds into section 572 of that Act which provides its own rules for working out the amount of past calculated losses that are treated as notional deductions under section 559(2) in determining the FIF income that accrues to a taxpayer in relation to a future income year.

Section 578 of the ITAA 1936 ensures that any calculated loss of a second-tier FIF as determined by section 572 will be taken into account in determining the notional deductions of the first-tier FIF. [subsection 559A(6) and paragraph 559A(4)(b)]

Certain foreign companies treated as an Australian financial institution subsidiary

Where a taxpayer, that makes an election for this new calculation method treatment in relation to a foreign company, is an Australian financial institution the rules now provide that the foreign company will be treated as an Australian financial institution subsidiary for the purposes of working out the notional income and deductions [paragraph 559A(3)(c)]

This ensures the CFC rules concerning Australian financial institution subsidiaries may then apply in determining attributable income of the company if the foreign company is carrying on a banking business whose income is principally derived from the lending of money.

The rule to treat the FIF as an Australian financial institution subsidiary applies to both first-tier and second-tier FIFs. [paragraph 559A(3)(c) and (8)(a)] Consistent with the current FIF calculation method rules, it is not possible for a third-tier FIF to be treated as an Australian financial institution subsidiary.

As a consequence of these foreign companies being afforded treatment as an Australian financial institution subsidiary, an amendment has been made to the participation exemption rules in Subdivision 768-G of the ITAA 1997. This amendment provides for similar 'active' treatment in relation to the assets of the foreign company.

The approach of 'superimposing' the controlled foreign company calculation of attributable income on the foreign investment fund calculation method means that the foreign company is not actually a CFC as defined in Part X of the ITAA 1936. Therefore, if a taxpayer chooses to use the CFC rules within the FIF calculation method, the equity interest in the FIF will not be a 'controlled foreign equity entity' for thin capitalisation purposes under Division 820 of the ITAA 1997.

Example

Oz Bank, an Australian financial institution, holds a 20% FIF interest in Sing Co which in turn holds a 50% interest in Malay Hold Co, which in turn holds a 100% interest in Malay Co.

Oz Bank makes a choice under section 559A of the ITAA 1936 in relation to its interest in Sing Co. As Oz Bank is an Australian financial institution, Sing Co is treated as an Australian financial institution subsidiary for the purposes of working out its notional income and notional deductions.

Oz Bank's attribution percentage in relation to Malay Hold Co is 10%, therefore the choice to apply the CFC rules can also be made by Sing Co in relation to Malay Hold Co.

Malay Hold Co itself is treated as an Australian financial institution subsidiary for the purposes of working out its notional income and notional deductions.

Although Oz Bank has an attribution percentage of 10% in Malay Co, as Malay Co is a third-tier FIF a choice to use the calculation method cannot be made by Malay Hold Co. [subparagraph 579(b)(ii)]