House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon. P.J. Keating, M.P.)

MAIN FEATURES

Consequential amendments to superannuation provisions (Clauses 2, 4-12, 17-19, 22-35, 43, 48-50)

On 23 October 1987, the Occupational Superannuation Standards Bill (the Principal Bill) and other related legislation were passed by the Parliament. The Principal Bill is based on the taxation power in the Constitution and thus its operative provisions cannot be brought into effect until the proposed consequential amendments are proclaimed.

The Principal Bill is designed to provide a legislative framework for the operating standards and other relevant conditions with which superannuation funds and approved deposit funds will be required to comply in order to be eligible to receive taxation concessions available to them under the Income Tax Assessment Act 1936. The conditions or standards in question include those announced by the Treasurer in his press statements of 11 June, 30 July and 22 December 1986 as well as those applicable to funds under the existing income tax law. The latter include requirements in relation to the level of benefits eligibility of contributors and security of rights to benefits.

The main purpose of the related legislation is to create an Office of Insurance and Superannuation Commissioner who will be responsible for administering the new supervisory arrangements relating to funds.

This Bill proposes consequential amendments to the superannuation provisions of the Income Tax Assessment Act 1936 to give effect to the hand-over to the Insurance and Superannuation Commissioner of the supervision of those non-assessment supervisory requirements relating to superannuation funds currently administered by the Commissioner of Taxation. The amendments will enable superannuation funds and approved deposit funds which comply with operating standards administered by the Insurance and Superannuation Commissioner to be exempt from tax on their investment income.

These changes will leave the Commissioner of Taxation with only the revenue functions of assessing non-approved funds and any excessive or unauthorised benefits paid to fund members or other persons and of allowing deductions for contributions made to approved funds, or certain non-approved funds in some circumstances. Employer contributions to funds approved by the Insurance and Superannuation Commissioner will generally be deductible if they are made rateably over the period of the individual's projected membership of the fund. This is consistent with the current administrative practice of the Taxation Office.

Amendment of the Income Tax Rates Act 1986 (Clauses 59 and 61)

The Bill will ensure that excessive non-arm's length income derived after 12 January 1987 by an otherwise exempt approved deposit fund is subject to tax at the rate of 50% in the 1986-87 year of income and 49% thereafter.

Amendment of the Occupational Superannuation Standards Act 1987 (Part IV)

This Bill will amend the Occupational Superannuation Standards Act 1987 to:

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modify the definition of dependant to ensure that it includes the de facto spouse of the member of a superannuation fund. The effect of this change will be that a fund will be able to provide superannuation benefits to the de facto spouse of a member in the event of the member's death and still remain eligible for relevant taxation concessions;

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ensure that the Insurance and Superannuation Commissioner can oversight compliance by certain funds with requirements contained in the Income Tax Assessment Act 1936 in relation to that part of the year of income of the fund which occurs before 1 July 1986. Such funds are those with a substituted accounting period for 1986-87 which commenced after 30 November 1985 but prior to 1 July 1986;

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permit the Insurance and Superannuation Commissioner to utilise the prosecution provisions of the Taxation Administration Act 1953 for the purpose of taking action against the current trustees of a superannuation fund or an approved deposit fund in the event of a breach of a requirement under that Act to furnish certain information or documents;

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make certain other technical amendments to facilitable the operation of the Act.

Amendment of the Taxation Administration Act 1953 (Part V)

The Bill will amend the Taxation Administration Act 1953 (Administration Act) to give effect to the proposal that a breach of the requirements under section 10 or 11 of the Occupational Superannuation Standards Act 1987 (Standards Act) by fund trustees will result in liability for prosecution under section 8C of the Administration Act. For this purpose, the amendments will provide that Part III of the Administration Act relating to prosecutions and offences will apply in relation to the Standards Act as if that Act were a taxation law and references to the Commissioner of Taxation were references to the Insurance and Superannuation Commissioner.

Sections 10 and 11 of the Standards Act require the trustees of funds to furnish certain information and documents to the Insurance and Superannuation Commissioner. The proposed amendments will enable the Commissioner to impose sanctions on fund trustees in the event of non-compliance with such requirements rather than penalise a fund (and therefore the members of the fund) through the loss of taxation concessions. This approach will preserve the existing situation under which fund trustees are liable for prosecution if they fail to provide relevant information and documents as required by the Commissioner of Taxation pursuant to the income tax law.

Private company dividends and excessive non-arm's length income derived by approved deposit funds (Clause 8)

The Bill will give effect to a proposal, announced on 12 January 1987, to subject to income tax certain private company dividends and excessive amounts of non-arm's length income derived after that date by an otherwise exempt approved deposit fund. This is a safeguarding measure against arrangements under which investments in an entity associated with an approved deposit fund depositor have the scope to be used to avoid tax.

The proposed provisions are similar to those which have applied for many years in relation to non-arm's length income derived by certain superannuation funds that are otherwise exempt from tax. Under the amendment, private company dividends derived by an approved deposit fund after 12 January 1987 will not be exempt from tax unless the Commissioner of Taxation considers that it would be reasonable to exempt the dividends. In making his decision the Commissioner will have regard to the manner in which the relevant company shares are acquired by the approved deposit fund and the circumstances surrounding payment of the dividends as well as any other matters considered to be relevant.

Other non-arm's length income derived by an approved deposit fund after 12 January 1987, for example, interest on a loan to a company associated with a fund depositor, will not be exempt from tax if the amount of the income is greater than might have been expected if the transaction had been at arm's length. The rate of tax payable in respect of income of the 1986-87 income year made assessable by this amendment is 50%, and 49% for income of subsequent years.

Gifts (Clause 15)

The Bill will give effect to the proposals announced on 16 June 1987 to extend those provisions of the Income Tax Assessment Act 1936 that authorise deductions for gifts of the value of $2 or more made to specified organisations to include the Ninth Australian Division Memorial of Participation (Alamein) Fund and the Korean and South East Asian and Vietnam War Memorials Anzac Square Trust Fund. In accordance with the announcement, gifts made to those funds after 14 June 1987 and before 1 July 1989 will qualify for deduction.

Satisfaction of common ownership test by shelf companies (Clauses 16, 42, 44 and 45)

The Bill will give effect to the proposal announced on 29 June 1987 to allow a company that has never operated (referred to as a "shelf company"), and which is introduced into a company group in a year of income, to satisfy the 100% common ownership test necessary to establish a group relationship between companies in the year of income. The existence of a group relationship between companies enables the transfer between those companies of losses incurred in deriving income (section 80G), of excess rental property loan interest (section 82KZF), of excess foreign tax credits (section 160AFE) and of net capital losses (section 160ZP), and the rollover of an asset between companies for capital gains purposes (section 160ZZO).

The 100% common ownership test between two companies is met for a year of income if, throughout the year, one of the companies was a subsidiary (as defined) of the other, or each of the companies was a subsidiary of the same parent company. If either or both of the companies was not or were not in existence for part of the year, the ownership test must be satisfied during the part of the year in which both were in existence. A company that was in existence in a year of income before it was acquired by its parent company, that is, it had been incorporated prior to the acquisition, cannot satisfy the common ownership test in respect of the parent or any other company in the group for that income year.

The amendments to be made to the relevant provisions by this Bill will deem a "shelf company" not to have been in existence in the year of income prior to its acquisition by the company group, and thereby enable it to satisfy the common ownership test in that income year.

A company will qualify as a "shelf company" if it was dormant, within the meaning of the Companies Act 1981, throughout the period commencing on the day on which it was incorporated and ending on the day on which all the shares in the company were acquired by the company group.

The amendments will apply in relation to companies acquired in the 1986-87 year of income and all subsequent years of income.

Investment allowance (Clause 20)

The Bill will give effect to the proposal announced on 12 June 1987 to extend by six months (from 1 July 1987 to 1 January 1988) the date before which eligible property must be first used, or installed ready for use, in order to qualify for the investment allowance.

Under this extension eligible property may qualify for the investment allowance of up to 18% of the capital cost where -

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the property was acquired under a contract entered into before 1 July 1985; or

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construction of the property by or for the taxpayer commenced before 1 July 1985;

and the property is first used, or installed ready for use, before 1 January 1988.

Limitation on deductions for rental property loan interest (Clause 21)

The Bill will give effect to the 1987-88 Budget proposal to terminate the operation of the provisions that limit the income tax deduction that may be allowed in a year of income for interest on borrowings for "negative gearing" of rental property investments. The deduction limitation will not apply to interest incurred in or after the 1987-88 year of income. Interest deductions disallowed under these provisions in earlier years and carried forward to the 1987-88 year of income will be allowed without limitation in that later year.

Deductions for capital expenditure on new income-producing buildings (Clause 36)

The Bill will give effect to the 1987-88 Budget proposal to reduce the rate of the allowance available for the write-off of capital expenditure on the construction of new buildings (including extensions, alterations and improvements to buildings) that are used for the purpose of producing assessable income. At present, the rate of deduction is 4% per annum of the construction cost of the eligible building, i.e., the cost is written off on a prime cost basis over a period of 25 years.

The proposed amendments will reduce the rate of the deduction to 2 1/2% per annum (i.e., over a 40 year period) for buildings that are commenced to be constructed after 15 September 1987. The 4% rate will continue to apply to any building that is commenced to be constructed after that date under a "qualifying previous commitment".

A qualifying previous commitment will arise where construction of the building (or extension etc) is undertaken pursuant to a contract entered into on or before 15 September 1987. If the construction is undertaken pursuant to a series of contracts, eligibility for the 4% rate will be met if any one of those contracts was entered into on or before 15 September 1987. A qualifying previous commitment will also exist if the whole of any money borrowed to finance the construction was borrowed under a contract or contracts entered into on or before 15 September 1987 for the purpose of financing that construction and the taxpayer has one of the following interests:

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in the case of the construction of a building, the taxpayer was on 15 September 1987 the owner or the lessee of the land on which the building was constructed or, after that date, became the owner or the lessee of the land pursuant to a contract entered into on or before that date; or

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in the case of the construction of an extension, alteration or improvement to a building or to a part of a building, the taxpayer was, on 15 September 1987, the owner or lessee of the building or that part of the building or became the owner or lessee pursuant to a contract entered into on or before 15 September 1987.

Abnormal Income of Artists, Composers, Inventors, Performers, Production Associates, Sportspersons and Writers (Clause 14, 38, 46 and 48)

The Bill also proposes to give effect to the decision announced in the 1986-87 Budget to introduce an income averaging system for the abnormal income of Australian resident performers, production associates and sportspersons, and to bring within that system the abnormal income of authors (which includes artists, composers and writers) and inventors. This new system will replace the existing income tax arrangements for abnormal incomes of authors and inventors.

The new taxing arrangements will operate within the averaging system for capital gains. Liability to tax will be calculated by applying to the aggregate amount of abnormal income and any capital gains the average rate of tax which one fifth of that amount would have borne as the "top slice" of the taxpayer's taxable income. A more detailed outline of these arrangements is given below.

The new scheme requires calculation of a taxpayer's abnormal income. A taxpayer's abnormal income is so much of the amount included in taxable income from the relevant activities in the income year (the "eligible taxable income") over the average of such income in the previous 4 years.

A taxpayer's total taxable income is, therefore, divided into:

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abnormal income, which is the subject of the new averaging arrangements; and

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other income.

Where there is no abnormal income, i.e., eligible taxable income is equal to or less than the average eligible taxable income of the previous four years, tax at ordinary rates will be payable.

In separating eligible taxable income from other taxable income, deductions for expenses incurred in earning income will be allocated according to whether they are attributable to the earning of abnormal income or other income. Where deductions are not attributable to the earning of particular income (for example, deductions allowable under the gift provisions), they will be allocated on a pro rata basis.

A taxpayer will come under the new scheme if he or she has an eligible taxable income in excess of $2,500 in the 1986-87 year of income or any earlier year (referred to as the "qualifying event"). Once so qualifying, the taxpayer will remain eligible under the scheme even though his or her eligible taxable income may not, in subsequent years, exceed that amount.

Special provisions will apply in calculating the abnormal income of an eligible person in the first three years of application of the scheme (i.e., 1986-87, 1987-88 and 1988-89) and these will differ according to whether or not the taxpayer was a resident for tax purposes in the year preceding the year in which the qualifying event occurred. Taxpayers who were residents in that preceding year will, effectively, be treated as having had a NIL eligible taxable income in each of the 2 years prior to the year in which the qualifying event occurred. A resident person newly qualifying as an eligible person in the 1986-87 year or any subsequent year will, therefore, receive the benefit of an abnormal income amount in the first year.

For a taxpayer in this category in respect of whom the qualifying event occurred prior to 1986-87, calculations under the proposed new arrangements of average eligible taxable income of the taxpayer, will take account of eligible taxable income derived in years prior to 1986-87.

For taxpayers who were not residents for tax purposes in the year preceding the year in which the qualifying event occurred, the eligible taxable income of that year will be treated as the average eligible taxable income.

For the 1986-87 income year only, taxpayers eligible for the existing authors and inventors taxing arrangements will have the option of being taxed under those arrangements or under the new scheme.

Financial instruments in the nature of deferred annuities (Clauses 13, 39, 40, 48 and 49)

This Bill will implement the proposal, as first announced on 19 and expanded on 26 September 1986, to ensure that returns from certain financial arrangements taking the form of annuities, and aimed at achieving substantial tax deferral advantages, will be taxed on an accruals basis rather than on a receipts basis.

Existing provisions of the income tax law which generally govern the taxation of annuities are concessional in their treatment of annuitants through the allocation, on a straight line basis, of the interest component of each annuity payment. This spreads the income evenly over the period during which annuity payments are received whereas, strictly, the bulk of the income accrues in the earlier payment years. For deferred annuities, there is a greater degree of concession in this because the annuitant is not taxed until annuity payments commence. This adds to the deferral element.

However, under Division 16E the income return on deferred interest securities and other "qualifying securities" is taxed annually in the hands of a resident holder on an accruals basis. With some exceptions matching deductions are allowable to issuers of those securities.

The particular financing arrangements at which the proposed amendments are directed are of a kind intended to fall within Division 16E. An argument has been advanced that instead they attract the concessional treatment accorded to genuine annuity contracts. The particular arrangements involve the provision of finance to be repaid, with a gain akin to interest paid either during the loan term or at maturity. To put the matter beyond doubt, such arrangements will by these amendments be specifically designated to be "qualifying securities" for the purposes of Division 16E. This will remove any doubt that the resulting gains are not assessable on the accruals basis applying to other deferred interest securities.

The particular financial arrangements affected by this Bill involve deferred annuities issued on or after 19 September 1986 and immediate annuities issued on or after 29 October 1987.

Technical changes to Division 16E (Clauses 39, 48 and 49)

Some technical deficiencies in the present method of calculating the income accruing under certain "qualifying securities" are being corrected by the Bill. The existing provisions could produce inaccurate results in some circumstances.

The securities affected are ones under which, during the security term, payments other than of periodic interest are made. Such securities are not specifically catered for by the present provisions. The existing legislation also effectively assumes that periodic interest payments will be made at the end of a 6 monthly interval. The proposed amendments will allow the Division to apply appropriately where payments of periodic interest (and other) payments are made at other intervals.

Deductions to issuers (Clauses 40 and 48)

The Bill will implement the proposal announced on 23 April 1987 to preclude the allowance of deductions on an accruals basis in respect of the discount component or other deferred interest component of qualifying securities where the securities are issued in Australia to, or on behalf of, a non-resident associate of the issuer.

The existing law entitles the issuer to deductions calculated on an accruals basis for the deferred yield where qualifying securities, other than bearer securities, are issued in Australia. These amendments deal with issues made in Australia to non-resident associates. Under the present law, such issues could yield allowable deductions for the resident issuer in income years earlier than those in which the non-resident holder's matching income component is taxed (generally by interest withholding tax). The amendments will close this defect by denying the accruals basis of deduction to the resident issuer. Deductions will instead be allowed in the year in which the discount or other deferred yield is paid.

Thin capitalisation (Clauses 41, 48 and 51)

The Bill will implement the proposal, announced on 30 April 1987, to incorporate in the income tax law with effect generally from 1 July 1987 thin capitalisation rules broadly equivalent to those previously imposed administratively under foreign investment policy as a condition for approval of certain foreign investment proposals. Those rules ensured, broadly, that foreign investors having an interest of at least 15% in an Australian business maintained an appropriate balance between the debt the business owed to them and their equity in that business.

Whether an Australian company is controlled as to 15% or more by non-residents will generally be determined according to whether non-residents have a 15% or greater control of voting power, or of dividend entitlements. Similar tests will measure the level of non-resident control of partnerships, trusts and direct investments. In the Bill, non-residents having a 15% or greater degree of control of an Australian enterprise are referred to as "foreign controllers". Interest payments made to foreign controllers by any Australian enterprise they control will be subject to the provisions of the Bill. Portfolio investments not involving such control will not be subject to the statutory requirements.

The ratio of debt to equity generally required under the previous administrative controls under foreign investment policy strictures was 3:1, i.e., for every 3 dollars the foreign investor lent to the Australian business in which that investor held at least a 15% interest, the investor had to hold or inject one dollar of equity. For banks and non-bank financial intermediaries the ratio was 6:1. The imposition of the debt/equity ratio protected against the avoidance of Australian tax through the use of 'in house' loans. Such loans could otherwise be used to effectively shift profits to the foreign investor in the form of tax deductible interest payments instead of as non-deductible dividends, with the only offsetting Australian tax being the usual 10% withholding tax on interest.

Since 1 July 1987, foreign investment policy administration is no longer applied to control thin capitalisation of foreign investments. The thin capitalisation rules under the Bill will instead achieve a comparable result by effectively imposing statutory debt/equity ratios, in relation to funding of non-arm's length foreign investments exceeding a 15% threshold, of 3:1 (6:1 for financial institutions). By these rules, the funded entity will be denied deductions for Australian income tax purposes for relevant interest payments to the extent that these ratios are exceeded. Entities that are "financial corporations" within the meaning of that term in the Financial Corporations Act 1974 will attract the 6:1 ratio.

The new rules will affect only certain types of foreign borrowing. They will not apply to interest-free debt, arm's length debt or parent-guaranteed debt. Australian investors in Australian enterprises will not be affected by the Bill, i.e., the overall gearing ratios of Australian controlled enterprises will not be subject to the tax controls. Nor will debt to a non-resident company having Australian investments exceeding the 15% threshold be subject to the measures against thin capitalisation if that company is itself controlled to the extent of at least 85% by Australian residents.

The new provisions will apply on and after 1 July 1987 to investments made before that date that are the subject to a standard debt/equity ratio undertaking under the former foreign investment controls and to all new borrowings on and after that date. Foreign investors whose investments were not subject to tax conditions imposed prior to 1 July 1987 under the former administrative controls will have until the earlier of maturity of their existing financial arrangements or 30 June 1988 to restructure their in-house financing to bring them within the new statutory ratio requirements. Mineral exploration companies that were not required to give a debt/equity undertaking under previous investment policy will have until the earliest of:

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the first derivation of assessable income;

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the commencement of production (after 30 June 1987);

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30 June 1988; or

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the re-financing of their investment,

to comply with the 3:1 ratio.

For a few cases where funding by other than a 3:1 or 6:1 ratio was approved under the former controls, the new statutory rules will not apply to the funding arrangements for so long as any undertakings given by the foreign investor as a condition of investment approval continue to be adhered to. However, as any such non-standard ratio approved loans mature, are extended or are refinanced (e.g., by loan rollover), the Australian enterprise will be required under the new provisions to comply with the standard ratios or suffer disallowance of deductions for the excess interest.

The Bill provides that, in measuring foreign debt for debt/equity ratio purposes, regard will generally be had to the highest point of foreign debt owed during the income year to a foreign controller(s). For all entities except companies, the balance at the end of the income year will generally be the yardstick. For companies, subject to special transitional measures, equity will generally be measured at the start of the income year for the accumulated profit/loss and asset revaluation reserve components and at the end of the income year for the issued capital and share premium components. Thus, if the level of foreign debt exceeds the applicable debt/equity ratio during the year, there will be no loss of entitlement to interest deduction provided sufficient equity is injected by year end to restore compliance with the ratio. Anti-avoidance provisions of the Bill will guard against the manipulation of equity levels to produce artificial or temporary compliance with the required ratio. The foreign controller may, of course, prefer to forgo interest on the excess debt rather than introduce further equity.

Australian resident companies in foreign-controlled company groups with 100% common ownership will not generally be subject to individual ratio testing. The direct equity of the foreign controller will be measured against the total foreign debt of all members of the group to ascertain whether the group as a whole satisfies the applicable debt/equity ratio. Where the ratio is not satisfied, an adjustment will be made against the foreign debt interest of each member of the resident company group. Separate calculations will be required where there are 2 or more onshore companies controlled directly by a foreign controller(s) rather than through a chain.

A more detailed explanation of the provisions of the Bill is contained in the following notes.