House of Representatives

Explanatory Memorandum

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

TAXATION LAWS AMENDMENT (FOREIGN TAX CREDITS) BILL 1986

Introductory note

The Bill proposes the replacement of the present double taxation relief arrangements of the income tax law with a general foreign tax credit system.

Under the existing income tax law, ex-Australian source income of Australian residents is relieved from double taxation in a variety of ways depending on the type of income concerned and the particular country of source -

Income Tax Assessment Act 1936

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Section 45 taxes foreign dividends received by resident individuals, and allows a credit for foreign tax on them;

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Section 46 effectively frees, by a rebate, foreign dividends received by resident companies. The rebate is available irrespective of the level of the foreign tax paid on the dividends whether or not the dividends are subject to foreign tax;

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Division 18 - income (other than salary and wages) from Papua New Guinea is subject to Australian tax and a credit is allowed for the Papua New Guinea tax paid;

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Paragraph 23 (qa) - exempts salary and wages from Papua New Guinea provided the income is not exempt from income tax under Papua New Guinea law;

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Paragraph 23(q) exempts foreign source income not otherwise mentioned above or hereunder (including salary and wages) from Australian income tax if tax on it is paid in the country of source;

Income tax (International Agreements) Act 1953

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Section 14 of the Income Tax (International Agreements) Act 1953 - dividends, interest and royalties from other countries on which foreign tax is limited in terms of comprehensive taxation agreements that Australia has with those countries - these are subject to Australian tax and a credit is given for the foreign tax.

The amendments outlined in this bill will replace the above provisions and substitute in their place a general world-wide system of foreign tax credit relief which will first apply to assessments in respect of income of the year of income commencing on 1 July 1987.

Under the new system all foreign source income derived by Australian resident individuals (apart from certain salary or wages and remuneration derived by persons working on certain approved projects) and by Australian resident companies will be subject to Australian income tax. Foreign tax paid on foreign income subject to the new system will be allowed as a credit, up to the amount of the Australian income tax payable on the foreign income concerned. Under the Bill, foreign taxes for which credit will be allowed will be those taxes on income and gains that are basically similar in nature to the Australian income tax and credit will not be allowed for unitary taxes.

Under the Bill, an Australian company that has a controlling interest of at least 10 per cent in a foreign company a credit will be allowed for foreign company tax paid by the overseas company - called 'underlying tax' - on the profits from which dividends are paid to the Australian company as well as for any foreign tax imposed directly on such dividends. Credit for underlying tax will be available for unlimited tiers of related companies provided each company in the chain has a 10 per cent controlling interest in the company immediately below it, and the Australian parent directly or indirectly holds at least 5 per cent of the voting shares in each company.

The Bill will not effect the existing provisions of the income tax law that exempts, in certain circumstances, remuneration derived by persons working overseas on approved projects. The Bill will also exempt salary or wages earned overseas that is subject to tax in the country of source, where derived by an Australian resident in performing services overseas for a continuous period of at least 12 months - a proportionate exemption will apply where the period is from 3 to 12 months with a credit being allowed for foreign tax paid on any amount not exempted.

However, under the Bill, salary or wages earned overseas that is to be exempt on the foregoing basis will be taken into account in calculating Australian tax on other income, so that exemption of the salary or wages will not also reduce the tax payable on the other income. The existing provisions mentioned above that exempt the remuneration of persons working on overseas approved projects will be amended by this Bill to the same effect.

The major design features of the proposed foreign tax credit system are discussed briefly below.

Worldwide system

Foreign-source income of Australian residents will be assessed on a world-wide basis. This will enable excess foreign tax credits arising from income in high-tax countries to be offset against the Australian tax due on income from low-tax countries.

Measurement of income

The measurement of business income will depend on the form in which overseas activities and other business activities of a resident overseas, are conducted. For branches, foreign income will be determined in accordance with Australian taxation law. For subsidiaries, published commercial profits will generally be used with scope for adjustment where profits disclosed in the accounts of the company give inappropriate results.

Interest income

As an anti-avoidance measure, certain foreign source interest income is to be assessed separately, with separate tax credits limits, from all other income. As part of this quarantining measure, dividends received from foreign subsidiaries will be traced to determine whether interest income has been recharacterised and repatriated as dividends. Where necessary, dividends will be apportioned into an interest income component and other income, with foreign tax credits being allowed separately on each component. Interest earned in carrying on normal business activities and interest received by banks and other financial institutions will be excluded from the quarantining process.

Excess credits

Excess foreign tax credits will not be allowed to be carried forward or carried back. However, they will be transferable within wholly owned company groups for set-off against Australian tax payable on other non-interest foreign income derived by another group company in the same year.

Ordering of dividends

In order to determine the rate of foreign underlying tax on dividends (mentioned earlier) paid by a foreign subsidiary to its Australian parent, all dividends so paid will be treated as being paid out of a pool of accumulated profits of the subsidiary. This will have the effect of averaging fluctuating foreign tax rates on profits and of which the dividends are paid. This pooling approach will apply only to profits derived by a subsidiary in its accounting periods commencing after the introduction of the foreign tax credit system. Dividends in excess of the accumulated pool of profits will be treated as paid out of profits earned in earlier accounting periods on the basis of last-in-first-out arrangements.

Foreign losses

Where a taxpayer has incurred a loss from a foreign source it will be carried forward for a maximum period of 7 years and set off against any future income from the same foreign source. Only the resulting net amount of that income will be taken into account as assessable income for Australian tax purposes in the later year. Foreign losses of an interest nature will be quarantined so as able to be offset only against interest income from the foreign source.

Domestic losses

At the taxpayer's option domestic losses may be treated as they are under the present law or may be offset against foreign income.

Life insurance companies

Australian life insurance companies will be taxed on income derived by foreign branches, only to the extent it is remitted to Australia.

Notes on the individual provisions of the Bill follow.

PART I - PRELIMINARY

Clause 1 : Short title, & c.

This clause provides for the amending Act to be cited as the Taxation Laws Amendment (Foreign Tax Credits) Act 1986.

In the absence of a specific commencement date, the Act will come into operation on the twenty-eighth day after Royal Assent, by virtue of sub-section 5(1A) of the Acts Interpretation Act 1901. However, by virtue of clauses 32 and 39, the amendments contained in the Bill will only apply to income of the year of income commencing on 1 July 1987 and subsequent income years.

PART II - AMENDMENT OF INCOME TAX ASSESSMENT ACT 1936

Clause 2 : Principal Act

This clause facilitates references to the Income Tax Assessment Act 1936 which, in Part II, is referred to as the Principal Act.

Clause 3 : Foreign income and foreign tax

By this clause, it is proposed to insert two new sections in the Principal Act - sections 6AB and 6AC - which will specify the foreign income to which the new system applies, and set out the various foreign taxes for which credit will be allowed against Australian income tax and the circumstances in which such foreign taxes are to be so creditable.

Section 6AB: Foreign income and foreign tax

Sub-section 6AB(1) provides that a reference to "foreign income" is a reference to income derived from sources in a foreign country or more than one foreign country. It ensures that all income derived from sources out of Australia will be subject to the provisions of the Principal Act. Specific detailed rules have not been included for this purpose, and the source of income will be determined on the same bases as under the existing income tax laws.

Sub-section 6AB(2) specifies in general terms the nature of the foreign taxes in respect of which a resident will be entitled to a credit against Australian tax payable on foreign income subject to those foreign taxes - if the particular foreign income (or gain) is not subject to Australian tax, e.g., because it is specifically exempt in Australia, no credit will be allowable for any foreign tax that has been paid on that foreign income (or gain). The basic requirement is that the foreign tax is one imposed by a law of a foreign country. For this purpose, the word 'law' is defined (see notes on sub-section (6) in a way that will ensure that relevant foreign taxes imposed at a Federal, State or local or other government level in a foreign country will be creditable foreign taxes for purposes of the new system.

By paragraph (2)(a), a foreign tax imposed upon income is to be a creditable foreign tax. A foreign tax will be regarded as income tax only if it is imposed on a basis substantially equivalent to the income tax levied under the Principal Act. In other words, to be considered an income tax, a foreign tax must be directed at the taxpayer's net income or gain, or be an income tax similar to the Australian withholding tax on interest and dividends that is imposed in lieu of a tax on the net amount of such income. Foreign imposts based on receipts, turnover, production and the like will not be treated as a foreign income tax under section 6AB.

Paragraph (2)(b) brings within the scope of foreign taxes for which credit may be allowed, taxes imposed on profits or gains, whether imposed on an income tax or a capital gains tax. By this provision foreign tax imposed on a foreign capital gain of an Australian resident that is also subject to Australian tax, will be creditable against the amount of that Australian tax. Credit will not, however, be allowable for a foreign capital transfer tax or a net wealth tax.

By paragraph (2)(c), foreign tax is to include tax that has been paid by a foreign company on its profits from which a dividend has been paid to its Australian "parent" company, and that is, by virtue of new section 160AFC (see notes on that section), to be deemed to be foreign tax paid by the relevant Australian company.

Paragraph (2)(d) ensures that any tax specified in any of Australia's comprehensive agreements for the avoidance of double taxation and by virtue of which Australia is committed to give relief, is treated as a foreign tax.

The closing words of sub-section (2) specifically exclude from its scope, and therefore effectively deny credit for, a foreign tax that is a unitary tax. A definition of a "unitary tax" is contained in sub-section (6) which is discussed below.

To be entitled to a credit for foreign tax imposed on foreign income under new section 160AF (see later notes on that section), an Australian resident must have been personally liable for, and must have paid, the relevant foreign tax. In situations where the foreign tax is paid directly by the Australian resident, these criteria will normally be met. In other cases, however, those criteria will not be met, e.g., where the foreign tax is paid indirectly, even though it is clearly imposed on the income derived by the taxpayer and is in reality borne by that person.

Sub-section 6AB(3) addresses these latter cases by deeming a taxpayer, for the purposes of the Principal Act, to have been personally liable for, and to have paid, foreign tax, where the taxpayer has derived foreign income but the tax on that income has effectively been paid on the taxpayer's behalf -

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by an agent for the taxpayer under an arrangement for that purpose or by the operation of the relevant tax law of the foreign country concerned (sub-paragraph (a)(i));

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by a trustee of a trust estate in which the taxpayer is a beneficiary (sub-paragraph (a)(ii));

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by a partnership in which the taxpayer is a partner (including a liability imposed on the partnership as a separate entity) (sub-paragraph (a)(iii));

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by deduction (e.g., a withholding tax) from the foreign income (sub-paragraph (a)(iv)); or

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by the taxpayer's spouse, where the foreign country taxes husband and wife as one taxable unit (paragraph (b)).

Sub-section 6AB(4) is to the same general effect as sub-section (3), and deems a taxpayer, for the purpose of the Principal Act, to have been personally liable for, and to have paid, foreign tax where the taxpayer receives foreign income on which foreign tax has already been paid and that income passes to the taxpayer through a trust estate.

Paragraph (4)(a) establishes the general pre-condition for application of the sub-section that a taxpayer has, as a beneficiary in a trust estate or by virtue of any other beneficial interest, derived an amount of foreign income (called the 'derived amount') attributable to another amount (called the 'primary amount') of foreign income. This condition would be met in a case where a taxpayer receives a distribution from a trust estate (the derived amount) that comprises foreign interest (the primary amount) on which a withholding tax was paid before the interest was received by the trustee. (In a case where the primary amount is a dividend received by a trustee as the shareholder, existing sub-section 6b(1) of the Principal Act will continue to attribute that amount to the beneficiary.)

Paragraph (4)(b) requires that foreign tax has been paid in respect of the foreign income by any person either directly or by deduction, as would be the case in the above example.

Paragraph (4)(c) in effect, establishes the amount of foreign tax deemed to have been paid by the taxpayer as the difference between the primary amount and the derived amount.

Sub-section 6AB(5) is complementary to new section 160AFF (that is explained later in these notes) which enables regulations to be made prescribing taxation incentives - in the form of tax holidays or tax reductions - offered by a developing country, to be taken into account in the application of a foreign tax credit system. Where such recognition - called 'tax sparing' - is granted, either by way of regulation or under the terms of a comprehensive taxation agreement, the amount of any tax forgone by the foreign country under the relevant incentive measure will be deemed by sub-section (5) to have been paid by the Australian taxpayer who will, therefore, be eligible for a foreign tax credit under new Division 18 in respect of that amount.

Sub-section 6AB(6) defines two terms used in the section -

'law' in relation to a foreign country, means a law of that country, or any part of, or place in, that country. This definition is relevant to the determination of whether a foreign tax is a creditable tax - see earlier notes on sub-section 6AB(2). In defining 'law' in this way, a foreign tax will be a creditable tax if it is imposed by a national government, a state or province, or at the local or municipal level of government.

'unitary tax' is also relevant to, but is excluded from, the scope of foreign taxes that, by virtue of section 6AB, are to be creditable taxes. The term is effectively defined as a tax imposed on a portion of the global income of a company (and its associates) that is attributed to the taxing state on the basis of the relative levels of business activity (which may be measured by a proportion of global payroll, property and sales) that occurs in that state, rather than on the usual basis of the amount of net income derived by the company in that state. By this definition a tax will not be a unitary tax if the relevant foreign law only takes the matters specified into account, in relation to an associated company, if that company is a resident for the purposes of that law, or for the purposes of granting any form of relief in relation to tax imposed on dividends received by one company from another company.

Section 6AC : Grossing up of foreign income

Section 6AC gives effect to the basic rule of a foreign tax credit system, that the amount of income subject to tax in the country of residence of the recipient is the gross amount of the income before payment of any foreign tax for which credit is to be allowed. Its basic purpose therefore is to provide for the grossing up of net foreign income derived by the amount of any foreign tax paid or deducted from that income for which credit will be allowed in terms of new section 160AF.

Sub-section 6AC(1) ensures that, for the purpose of determining the amount of foreign income to be included in the assessable income of a taxpayer under the Principal Act, the amount of foreign income derived by an Australian resident who has paid foreign tax in respect of that income will be the amount of that income before payment of that tax.

Sub-section 6AC(2) is to the same general effect and will ensure that a dividend paid by a foreign subsidiary company to its Australian parent company will be effectively increased, for assessment purposes, by the amount of any tax that, by new section 160AFC is deemed to have been paid by the parent on that proportion of the profits of the company from which the dividend was paid. This matter is explained in more detail in later notes on section 160AFC.

Clause 4 : Income beneficially derived

By this clause, sub-section 6B(2) of the Principal Act is to be repealed and three new sub-sections - sub-sections 6B(2), 6B(2A) and 6B(2B) - are to be inserted in its place.

Existing sub-section 6B(2) ensures that the amount that is treated as income attributable to a foreign dividend derived by a beneficiary through a trust estate by existing sub-section 6B(1) (which, as indicated in the earlier notes on sub-section 6AB(4) will continue to perform that function), is not to be reduced by the amount of any foreign tax for which the beneficiary or the person deriving the dividend was personally liable. With the insertion in the Principal Act of new section 6AC (by clause 3 of this Bill) under which all foreign income, including dividends, derived by a beneficiary in a trust estate is taken to be the amount of that income before payment of any foreign tax in respect of that income, sub-section 6B(2) is no longer necessary and is being repealed.

New sub-section 6B(2), which is identical in effect to existing sub-section 6B(1), specifies the circumstances in which income derived by a person, being income other than interest income, is to be traced through and deemed to be income attributable to interest income. This tracing mechanism is necessary for the application of the interest income quarantining measures contained in new sub-section 160AF(7) and new section AFA which are discussed later in these notes.

Under paragraph (2)(a) an amount of income derived by a person is to be deemed to be attributable to interest income where that amount is derived by the person by reason of being beneficially entitled to the income.

By paragraph (2)(b), income derived by a person as a beneficiary in a trust estate is deemed to be an amount attributable to interest income where the income arises from interest income derived by the trustee of a trust estate. The paragraph also applies where interest income passes through more than one trust estate before being distributed to a beneficiary.

New sub-section 6B(2A) is also similar in operation to sub-section (2) but specifies basic rules to identify the particular source of income derived by a person in different situations. By this section, that source of income derived by a person will be -

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where the income derived is not attributable to a dividend or interest by virtue of the operation of sub-section 6B(1) or (2):-

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if the income is derived by a person who is beneficially entitled to that income - the same source from which that income is derived (sub-paragraph (2A)(a)(i));

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if the income is derived by a person as a beneficiary in a trust estate by way of a distribution - the same source as the income to which the income comprised in the distribution is attributable (sub-paragraph (2A)(a)(ii)); and

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where the income derived is attributable to a dividend or interest by virtue of the operation of sub-section 6B(1) or (2) - the source of that dividend or interest (paragraph (b)).

Sub-section 6B(2B) makes it clear that the term 'interest income' in this section has the same meaning as in section 160AE which, as explained in the notes on that section, is relevant to the quarantining of foreign interest income.

Clause 5 : Income, & c. to be expressed in Australian currency

Under the foreign tax credit system both foreign income and foreign tax will need to be expressed in Australian currency for the purpose of assessing Australian tax on the foreign-source income and allowing credit for foreign tax paid. Clause 5 proposes the amendment of section 20 of the Principal Act by inserting 4 new sub-sections - sub-sections (2), (3), (4) and (5) - to achieve this purpose.

Sub-section 20(2) will apply where an amount of income of a taxpayer is derived from the carrying on of any business activities in a foreign country, whether at or through a permanent establishment (branch) in that country or otherwise. By paragraph (2)(a), the relevant income is to be expressed in Australian currency at a rate equal to the average of the exchange rates applicable from time to time during the whole of the year or, where the business is carried on only for part of a year, during that part of the year.

By paragraph (2)(b), any amount of foreign tax paid in respect of foreign income derived from the above business activities is to be expressed in Australian currency at the exchange rate applicable at the time when that tax is paid.

Sub-section 20(3) is to apply where an amount of foreign income other than income from the carrying on of a business or income earned in overseas employment is derived during a year of income. Income to which this sub-section applies would include dividends, interest, royalties and rent.

Such foreign income, and any amount of foreign tax paid in respect of it, (including, in the case of dividends received by an Australian company from an overseas subsidiary, "underlying" company tax that the Australian company is, by sub-section 160AFC(4) to be deemed to have paid - see notes on clause 22) is to be expressed in Australian currency at the exchange rate applicable -

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where the whole amount of that income is remitted to Australia in that year - on the day on which it is remitted (paragraph (3)(a));

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where part of the amount of that income is remitted to Australia in that year - on the day on which it is remitted (paragraph (3)(b)); or

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in any other case - at the end of that year (paragraph (3)(c)).

Sub-section 20(4) applies in respect of foreign income earned in overseas employment, including foreign earnings of persons engaged on approved overseas projects, to whom the amendments proposed by clauses 7 and 8 will apply - see notes on those clauses.

Paragraph (4)(a) provides that such foreign earnings are to be expressed in Australian currency at a rate equal to the average of the exchange rates applicable from time to time during the whole or the part of an income year in which the income was earned.

By paragraph 4(b), any amount of foreign tax paid in respect of foreign earnings to which this sub-section applies is to be expressed in Australian currency at the rate applicable at the time when the tax was paid.

Sub-section 20(5) makes it clear that, for the purposes of sub-section (3), income to which that sub-section applies will be taken to be remitted at the time when it is received in Australia. This measure, which will not affect the assessability of income on the basis of the time of its derivation, will ensure that the relevant income and tax paid on it, is generally converted to Australian currency at the exchange rate obtained by the recipient of the income.

Clause 6 : Exemptions

Clause 6 amends section 23 of the Principal Act by omitting paragraphs 23(q) and 23(qa).

As indicated earlier in these notes, paragraph 23(q) exempts many categories of income derived by a resident of Australia from sources outside Australia and Papua New Guinea which would otherwise be assessable by virtue of paragraph 25(1)(a) of the Principal Act where, broadly, the income is not exempt from tax in the country where it is derived.

Existing paragraph 23(qa) also exempts salary, wages and other similar remuneration derived by residents of Australia from sources in Papua New Guinea, where the income is not exempt from Papua New Guinea tax.

Neither paragraph will be required once the foreign tax credit system commences to apply from the commencement of the 1987-88 income year, and both will, by virtue of clause 32 of the Bill (see notes on that clause), case to apply from that time. From that time also, new section 23AG will provide an exemption from Australian tax for salaries and wages earned overseas in certain circumstances - see notes on clause 8.

Clause 7 : Exemption of certain income derived in respect of approved overseas projects

This clause proposes the amendment of section 23AF of the Principal Act which exempts from Australian tax income derived by an Australian resident individual from the performance by that person of personal services outside Australia on an approved project, for a continuous period of 12 months or more, where the income is not taxed in the country where the services are performed. Where the services are performed over a period of between 3 and 12 months, a proportionate exemption is allowed. The balance of income earned in such cases, and all income earned during a period of service on an approved project of less than 3 months, is subject to Australian tax.

Sub-section 23AF(17) identifies categories of income to which the section does not apply. One such category is income which is exempt from Australian tax by reason of paragraph 23(qa) (Papua New Guinea) and paragraph 23(q) (other countries) because the income is effectively taxed in the country of source. Accordingly, paragraph 23AF(17)(a) formally excludes from the exemption provided by section 23AF income that is exempt from Australian tax by application of paragraph 23(q) or 23(qa).

Paragraph (a) of clause 7 will amend paragraph 23AF(17)(a) of the Principal Act by omitting the reference to "paragraph 23(q) or (qa)". This amendment is consequential on the repeal of paragraphs 23(q) and (qa) proposed by clause 6 of this Bill. Foreign income earned in overseas employment will, in certain circumstances, continue to be exempt in terms of new section 23AG proposed to be inserted in the Principal Act by clause 8 - see notes on that clause. It is therefore necessary to substitute a reference to the new section 23AG in lieu of paragraph 23(q) and (qa). Paragraph (a) will also do this.

Paragraph (b) of clause 7 will amend section 23AF by adding two new sub-sections - sub-sections 23AF(17A) and (17B) - to that section.

The purpose of these measures (and of corresponding provisions in new section 23AG (clause 8) relating to the exemption of foreign source salary or wages of Australian residents) is to ensure that any foreign earnings of a person working overseas on approved projects that are exempt from tax will be taken into account in calculating Australian tax on other income derived by the person, so that exemption of the foreign earnings will not also reduce the Australian tax payable on that other income.

Sub-section 23AF(17A) gives practical effect to this measure by specifying that the amount of tax (if any) payable in respect of the other income is to be ascertained by using the formula -

A-B


where -

A

is the amount of tax (if any) that would be payable if, in effect, all of the income of the taxpayer was subject to tax; and

B

is so much of the amount of tax (if any) that would be payable if the exempt amount was assessable income (paragraph (a)), that amount was the only income of the taxpayer (paragraph (b)) and allowable deductions were only made from that amount to the extent they were attributable to deriving that amount (paragraph (c)), as does not exceed A.

At a practical level, the above formula is more simply explained in the following way -

(Tax that would be payable on the amount that would be total taxable income if the exempt amount was assessable income) less (Tax that would be payable on the amount that would be the taxable income if the exempt amount was the only income and was assessable income.)


The practical effect of the formula can be illustrated by a simple example of a taxpayer who qualifies for a full exemption of foreign approved project earnings that amount to $20,000, derives other net income from Australian sources of $4,000, and has no other deductions.

Under the present law the taxpayer would have no Australian tax to pay - the foreign earnings are exempt from tax under section 23AF, and no tax is payable on the Australian source income of $4,000 as it is below the tax-free threshold represented by the zero rate step in the personal income tax rate scale.

By the operation of sub-section 23AF(17A), the taxpayer's situation (at 1985-86 rates of tax) would be -

Sub-section 23AF(17B) makes it clear that, for the purposes of the application of the above formula, amounts that would be allowable deductions if the exempt income was assessable income, cannot exceed an amount equal to the exempt amount.

Clause 8 : Exemption of income earned in overseas employment

Clause 8 proposes the insertion of a new section section 23AG - into the Principal Act, the purpose of which is to provide an exemption from Australian tax for salary or wages earned overseas by an Australian resident during a continuous period of service of at least 12 months. A proportionate exemption will apply where the period is from 3 to 12 months, provided in either case that the income is not exempt from tax in the country in which it is derived, and any foreign tax due has been, or will be, paid.

Reflecting the amendment proposed to section 23AF of the Principal Act by clause 7 of the Bill, this exemption will also operate on an "exemption with progression" basis - that is, the exempt amount will be taken into account in determining the Australian tax payable on any other income.

Sub-section 23AG(1) will allow an individual a complete exemption from Australian tax for foreign earnings (as defined in sub-section (7) - see below) where the person has been engaged in foreign service (as also defined in sub-section (7)) for a continuous period of not less than 365 days. It will not be necessary for this period to coincide with an Australian income year.

Sub-section 23AG(2) allows a proportionate exemption in cases where a person has been engaged in foreign service for a continuous period of less than 365 days, but not less than 91 days. In such cases, exemption will apply to a proportion of the foreign earnings equal to the proportion which the number of days of foreign service bears to 365, that is -

((No. of days of foreign service)/(365))*(foreign earnings)


Sub-section 23AG(3) stipulates that foreign earnings are not exempt from tax under this section unless the earnings are, effectively, subject to income tax in the country of source (paragraph (3)(a)), and, if there is a liability for payment of income tax in the country where that income is derived, the Commissioner of Taxation is satisfied that the tax has been or will be paid (paragraph (3)(b)). These tests correspond with those contained in paragraph 23(q) of the Principal Act that have been a longstanding feature of the income tax law.

Sub-sections 23AG(4) and (5) will ensure that any exempt foreign earnings will be taken into account in calculating Australian tax on other income derived by the taxpayer, so that exemption of the foreign earnings will not also reduce the Australian tax payable on that other income. To this end, the formula applied by these sub-sections (and its practical application) is identical to the measure to be introduced into section 23AF of the Principal Act by the amendments proposed by clause 7 of the Bill. The notes and example given in relation to that clause are thus equally relevant to the operation of these sub-sections.

Sub-section 23AG(6) in effect specifies that, for the purpose of determining the length of a period of foreign service on which entitlement to exemption under the section is based, various periods when the person is not actually on the job are to be taken into account. The periods so specified are those during which the person, as authorised -

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is absent on recreation leave, other than -

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leave attributable to employment other than foreign service (sub-paragraph (6)(a)(i));

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long service leave or leave of a similar kind (sub-paragraph (6)(a)(ii));

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leave without pay or on reduced pay (sub-paragraph (6)(a)(iii)); or

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is absent from work because of accident or illness (paragraph (6)(b)).

Sub-section (7) defines several terms used in the section -

'employee' is to have its normal meaning, but will include a person employed by a government, an authority of a government or an international organisation, and a person who is a member of a disciplined force (such as a defence force or peace-keeping force).

'foreign earnings' is defined in the usual way to mean income consisting of earnings, salary, wages, commissions, bonuses or allowances. The term does not include pensions, annuities or superannuation payments which will therefore be subject to the operation of the Australian income tax law, including the foreign tax credit system, but as modified by provisions in Australia's comprehensive agreements for the avoidance of double taxation.

'foreign service' is to mean service in a foreign country as the holder of an office, or in the capacity of an employee, which is itself a defined term - see earlier notes.

Clause 9 : Certain film proceeds included in assessable income

This clause will amend section 26AG of the Principal Act by omitting sub-section 26AG(7).

Section 26AG provides a code for the assessment of receipts from the use or disposal of a film copyright by a taxpayer whose capital expenditure on the film has qualified for deduction under the concessions contained in Division 10BA of Part III of the Principal Act.

Sub-section 26AG(7) applies in a case where a resident taxpayer derives income from a country outside Australia and Papua New Guinea from the exhibition of a film in which the taxpayer has made an eligible investment and where that income is subject to tax in that country.

Under the terms of existing paragraph 23(q), such income would be exempt from tax if it was derived from countries other than Papua New Guinea or those with which Australia has a double tax treaty (to which foreign tax credit arrangements already apply) and foreign tax was paid on that income.

By the operation of sub-section 26AG(7), that exemption is modified, however, so that only income that is attributable to exhibition of the film in an overseas country that taxes the income remains exempt.

With the proposed repeal of paragraph 23(q) by clause 6 of this Bill and its replacement by a foreign tax credit system which will operate in relation to film income to which section 26AG applies, sub-section 26AG(7) will become redundant and is therefore to be omitted.

Clause 10 : Dividends

By this clause it is proposed to amend section 44 of the Principal Act to omit sub-section 44(1A).

Generally speaking, income derived by an Australian resident from sources outside Australia is, by the operation of paragraph 23(q), exempt from income tax in Australia if that income is not exempt from tax in the country where it is derived.

The position is otherwise, however, in the case of income from dividends. Sub-section 44(1A) expressly provides that the operation of sub-section 44(1) (by which, amongst other things, a resident shareholder is assessable on dividends paid by a company out of profits derived by it from any source), is unaffected by paragraph 23(q).

As it is proposed to repeal paragraph 23(q) by clause 6 of this Bill, sub-section 44(1A) will become redundant.

Clause 11 : Repeal of section 45

Clause 11 proposes the repeal of section 45 of the Principal Act which provides unilateral relief for foreign tax paid by a taxpayer on foreign dividends included in the taxpayer's assessable income by the operation of section 44 of the Principal Act.

As the general system of foreign tax credit relief in new Division 18 - see notes on clause 22 - will extend to dividends received by Australian shareholders in foreign companies, section 45 will also become redundant.

Clause 12 : Rebate on dividends

This clause will amend section 46 of the Principal Act to make it inapplicable to dividends received by resident companies from foreign companies.

Subject to certain qualifications not relevant here, the rebate for intercorporate dividends provided by section 46 effectively frees from tax dividend income received by a resident company. The rebate provided by section 46 applies to dividends received by a resident company from both resident and non-resident companies.

By the measures proposed in this Bill, all foreign source income of Australian resident taxpayers, including foreign dividends derived by resident companies, is to be subject to Australian tax, with credit against that tax being allowed for foreign tax paid on the relevant income. To achieve that result in the case of foreign dividends received by resident companies, clause 12 proposes the omission from the Principal Act of existing sub-sections 46(1A) and 46(1) and the substitution of a new sub-section - sub-section (1) - that will ensure that all references to dividends in section 46 refer only to dividends received from resident companies.

Sub-section 46(1) will effect the above change by means of two definitions that, apart from excluding from their scope dividends paid by a non-resident company, effectively re-enact the present definitions of "dividend" and "private company dividend". The new definitions are -

'dividend' which is to mean a dividend paid by a resident company but, except in paragraph 46(3)(a) or (b) (see notes below), does not include a dividend in relation to which section 46A applies; and

'private company dividend' which, in relation to a shareholder that is a private company in relation to the year of income, is to mean a dividend paid to the shareholder by a resident private company in relation to the year of income of that other company in which the dividend was paid. The provisions of paragraphs 46(3)(a) and (b) referred to in the definition of "dividend" are part of the measures in the Principal Act designed to require private companies to make sufficient distributions of their profits to individual shareholders. Section 46A applies in calculating the rebate to be allowed on dividends involved in dividend stripping arrangements. Sections 46 and 46A are mutually exclusive, so that a dividend subject to a rebate under section 46A is not also rebatable under section 46. This definition will ensure that both of these measures continue to have their intended effect.

Clause 13 : Rebate on dividends paid as part of dividend stripping operation

Clause 13 will amend section 46A of the Principal Act in a manner similar to the change to be effected to section 46 by clause 12 of the Bill.

Section 46A applies in determining the intercorporate rebate due to a taxpayer where the dividend in respect of which the rebate is to be allowed was paid in the course of a dividend stripping operation. Under the terms of sub-section 46(1A) the provisions of section 46 do not apply and the taxpayer's right to a rebate is provided by section 46A.

In line with the amendments proposed by clause 12 to section 46 to ensure that the intercorporate rebate applies only to dividends received by resident companies from other resident companies, this clause will effect corresponding amendments to section 46A to make the section inapplicable to dividends derived by an Australian company from a foreign company.

Paragraph (a) of clause 13 will omit sub-section 46A(1) and substitute a new sub-section 46A(1) which, apart from the exclusion from their scope of dividends paid by a non-resident company, effectively re-enacts the definitions of 'dividend' (in existing sub-section 46A(1)) and 'private company dividend' (in existing sub-section 46A(4)). The new definitions are broadly expressed as follows -

'dividend' means a dividend paid by a resident company but, except in paragraph 6(a) or (b), does not include a dividend that was not made in the course of a dividend stripping operation. Paragraphs 46(6)(a) and (b) allow a private company that may be denied a full rebate a further rebate in certain circumstances and those provisions will, by this definition, continue to have their intended effect.

'private company dividend' in relation to a shareholder that is a private company in relation to the year of income, means a dividend paid to the shareholder by a resident private company in relation to the year of income of that other company in which the dividend was paid.

Paragraph (b) of clause 13 will amend sub-section 46A(2) of the Principal Act which sets out the conditions for the operation of section 46A. The amendment, which does not change the effect of the sub-section, is purely technical in nature and is consequential on the change to be made by paragraph (a) of this clause to insert a new definition of 'dividend'.

Paragraph (c) of clause 13 will omit sub-section 46A(4) of the Principal Act which will no longer be necessary because the definition of 'private company dividends' which it contains is being included in new sub-section 46A(1A) that is proposed to be inserted by paragraph (a) of this clause.

Clause 14 : Losses and outgoings

This clause proposes the addition of 2 new sub-sections - sub-sections (6) and (7) - to section 51 of the Principal Act - the general deduction provision that allows deductions for losses and outgoings to the extent they are incurred in gaining or producing assessable income or in carrying on a business for that purpose.

Under the proposed foreign tax credit system (see notes on clause 22 in relation to new section 160AFD), a loss incurred by a taxpayer from a foreign source in relation to a class of income will be able to be carried forward to offset foreign income from the same source in a later year. In other words, the taxpayer will not, in the year of income in which the loss is incurred, be able to deduct the amount of that loss from any domestic or foreign income derived in that year.

Sub-section 51(6) will ensure that, where the amount of a class of foreign income derived by a taxpayer in a year of income from a foreign source is exceeded by certain deductions allowable against that income, the amount of the excess cannot be deducted from assessable income in terms of section 51.

The deductions referred to are -

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any deductions allowable from the assessable income of the taxpayer of the year of income that relate exclusively to the foreign income of that class derived from that source (paragraph (6)(a)); and

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so much of any other deductions allowable from assessable income (other than apportionable deductions) as, in the opinion of the Commissioner of Taxation, may appropriately be related to that foreign income (paragraph (6)(b)).

Sub-section 51(7) is a drafting measure that will give the terms "class of income" and "foreign source" as used in new sub-section 51(6) the same meanings as they have in new section 160AFD - see notes on clause 22.

Clause 15 : Special depreciation on trading ships

This clause, which is consequential on the repeal of paragraph 23(q) of the Principal Act proposed by clause 6, will amend section 57AM of the Principal Act which authorizes special depreciation allowances on eligible Australian trading ships.

Where an eligible ship is used outside Australia, and income from a foreign source is received, the taxpayer is still entitled to the concessions under section 57AM, provided an election is made by the taxpayer under sub-section 57AM(30) that the provisions of paragraph 23(q) will not apply to exempt that income from tax. In such circumstances, Division 18B of the Principal Act operates to allow the taxpayer a credit for foreign tax paid on the relevant income.

With the proposed repeal of paragraph 23(q) and the introduction of a general foreign tax credit system, the relevant overseas income will be assessable income. Accordingly, the reference to that paragraph in sub-section 57AM(30) is no longer needed and is to be deleted. As indicated in the notes on clause 24, a corresponding amendment is to be made to Division 18B of the Principal Act mentioned above.

Clause 16 : Domestic losses of previous years

Section 80 of the Principal Act defines a loss incurred by a taxpayer in a year of income, and deals with the manner in which, and the extent to which, the taxpayer can deduct from his or her income of any year of income any losses incurred in previous years.

The first purpose of the amendments proposed to section 80 by this clause is to ensure that its provisions cannot apply to any foreign losses incurred by a taxpayer. The manner in which foreign losses can be offset from subsequent foreign income of the same class is set out in new sub-section 160AFD to be inserted in the Principal Act by clause 22 - see notes on that clause.

If a domestic loss was offset against foreign income of a taxpayer in a year of income, the taxpayer could lose the whole or a part of the credit for foreign tax to which he or she would otherwise have been entitled for that year. This situation would occur where the Australian tax on the foreign income, which places an upper limit on the credit to be allowed for foreign tax paid, has been effectively reduced because it is calculated on the amount of foreign income after deducting the domestic loss.

In order to afford the maximum benefit to a taxpayer in such cases, it is also proposed to amend section 80 of the Principal Act to specify that a domestic loss is not to be offset against foreign income unless the taxpayer, by exercising an election to that effect, chooses to deduct a domestic loss from the foreign income should that be to the taxpayer's advantage.

Paragraph (a) of clause 16 will amend sub-section 80(2) of the Principal Act to stipulate that the deduction permitted under that sub-section for losses incurred in the previous 7 years is subject to the provisions of new sub-section (2B) which will be introduced by paragraph (b) of this clause.

Paragraph (b) of this clause will insert 3 new sub-sections - sub-sections (2B), (2C), and (2D) - in section 80 of the Principal Act.

Sub-section 80(2B) gives effect to the basic rule outlined above that a domestic loss incurred by a taxpayer shall not be allowable as a deduction from any foreign income derived by the taxpayer except as provided in sub-section 80(2C).

Sub-section 80(2C) grants to a taxpayer a right to elect to deduct the entire amount or a part of the amount of the losses referred to in sub-section 80(2) from any foreign income of a year of income, if that loss, but for sub-section (2), could have been deducted from that income under the normal rules relating to the deduction of losses.

By sub-section 80(2D), an election under sub-section 80(2C) is to be made by the taxpayer by notice in writing given to the Commissioner of Taxation. The taxpayer is required to lodge such notice on or before the date of lodgment of the return for the relevant year of income, or within such further period as the Commissioner may allow.

Paragraph (c) of clause 16 relates to the first measure outlined above and will also add new sub-sections - sub-sections (8) and (9) - to section 80 of the Principal Act.

Sub-section 80(8) effectively provides that, in calculating the amount of a loss for a year of income under sub-section 80(1), the amount of any foreign loss shall be disregarded. The amount to be disregarded is that by which the taxpayer's income of a class of income from a foreign source in a year of income falls short of the sum of -

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any deductions allowable from the assessable income of the taxpayer that relate exclusively to the foreign income of that class derived from that source (paragraph (8)(a)); and

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so much of any other deductions allowable from assessable income (other than apportionable deductions) as, in the opinion of the Commissioner, may appropriately be related to that foreign income (paragraph (8)(b)).

Sub-section 80(9) will ensure that, in the application of sub-section 80(8), the phrases "class of income" and "foreign source" have the same meaning as in new section 160AFD - see notes on clause 22.

Clause 17 : Interpretation

This clause will amend section 103 of Division 7 of Part III of the Principal Act.

The purpose of Division 7 is to require a private company to distribute as dividends or pay additional tax on a sufficient proportion of its after-tax income - called "the distributable amount" which is, broadly, the taxable income less income taxes (including foreign taxes) payable on that income and the amount - called "the retention allowance" - that the company is permitted to retain out of that income.

Under the new foreign tax credit arrangements, a company deriving a dividend from an overseas subsidiary will be assessed on the proportion of the subsidiary's profits from which the dividend was paid, but will also be deemed to have paid a corresponding proportion of the tax paid by the subsidiary on those profits. (See notes on clause 22 in relation to new section 160AFC).

Reflecting that situation, clause 17 will amend the definition of "the distributable income" in sub-paragraph 103(1)(b)(iii) to ensure that the reference to foreign tax paid by a private company includes any foreign tax that the company is to be deemed to have paid in the above circumstances.

Clause 18 : Additional period for making sufficient distribution

Clause 18 proposes to insert a new paragraph - paragraph (1)(d) - in section 105AA of the Principal Act.

That section, which is also contained in Division 7 of Part III of the Principal Act (see notes on clause 17), enables the Commissioner of Taxation to extend the time period during which a private company can make additional distributions of dividends to avoid additional tax on its undistributed profits. The relevant period is to be extended in particular circumstances arising as a consequence of the general foreign tax credit system.

Paragraph (a) of clause 18 is a drafting measure to facilitate the insertion of the new paragraph (1)(d) by paragraph (b) of this clause.

Paragraph (b) will insert new paragraph 105AA(1)(d) which will expand the operation of the sub-section to allow the Commissioner to extend the time period prescribed in section 105AA where, after the expiry of that period, the foreign tax credit available to the company is determined or amended and, as a result, the distributable income of the company is greater than it would otherwise have been.

Clause 19 : Exemptions of certain foreign income

By virtue of the operation of paragraph 23(q) of the Principal Act (see notes on clause 6) the profits of overseas branches of life assurance companies are generally exempt from Australian tax if, broadly, income tax is paid in the country of source in respect of those profits. With the introduction of the foreign tax credit system, it is proposed to subject to Australian income tax, income received by overseas branches of life assurance companies only to the extent that such income is remitted to Australia. Clause 19 will effect this result by inserting a new section - section 112B - in Division 8 of Part III of the Principal Act.

Section 112B will exclude from the assessable income of a life assurance company (as defined in section 110 for the purposes of Division 8) so much of its foreign income as is not remitted to Australia. To the extent that branch income is remitted to Australia, it will be subject to Australian tax on the same basis as the company's Australian income, that is, in accordance with the provisions of Division 8, but subject to the allowance of credit for foreign tax paid on that income.

Clause 20 : Deductions in relation to calculated liabilities

Under section 115 of the Principal Act, a life assurance company is entitled to a deduction, from the assessable income of the company, of an amount ascertained by reference to the company's "calculated liabilities", broadly, a percentage of the actuarial valuation of the company's liabilities at the end of the year of income. The deduction otherwise allowable is reduced by sub-section 115(2) where any part of the income from the assets of the relevant insurance fund is exempt from income tax under section 112A.

Section 112B - to be inserted in the Principal Act by clause 19 - will exclude from the assessable income of a life assurance company so much of its foreign income as is not remitted to Australia. As a consequence of that change, clause 20 will amend sub-section 115(2) - by including a reference to section 112B - to ensure that an appropriate adjustment is also made in the calculation of the section 115 deduction where a part of the income derived from assets in an overseas fund is exempt from tax under that new section.

Clause 21 : Reduction in amount of dividends to be taken into account for purposes of section 46

Section 116AA of the Principal Act operates so as to require a proportion of the deductions under section 113 (general management expenses) or section 115 (calculated liabilities) to be set off against dividends in calculating the amount on which a life assurance company is allowed the inter-corporate dividend rebate under section 46 of the Principal Act.

In the case of the section 113 deduction the amount set off against dividends is the amount by which the deduction is increased through treating dividends as assessable income. In the case of the section 115 deduction, the amount set off against dividends for dividend rebate purposes is the amount by which the deduction is increased by the inclusion, in the value of assets producing assessable income, of the value of shares giving rise to the dividends which are included in assessable income.

By the amendment proposed by clause 12 of this Bill, the intercorporate rebate under section 46 will no longer apply to dividends received from non-resident companies, and it is necessary to exclude from the above calculations such dividends and the value of the relevant shares in those companies.

Clause 21 will effect these exclusions by -

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incorporating in sub-paragraph 116AA(1)(a)(i) a reference to dividends paid by a foreign company (paragraph (a)); and

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incorporating in sub-paragraph 116AA(1)(a)(ii) a reference to shares in a foreign company (paragraph (b)).

Clause 22 : Division 18 - Credits in respect of Foreign Tax

This clause proposes the repeal of the present Division 18 (sections 160AE to 160AG) of Part III of the Principal Act - which relates to credits in respect of tax paid under the income tax laws of Papua New Guinea - and its replacement by a new Division 18 - which relates to credits in respect of tax paid under the income tax laws of all foreign countries.

The new arrangements are described in broad outline at the beginning of this memorandum. A brief outline of the structure of the revised Division 18 is given below, in order to assist understanding of the subsequent explanation of each proposed section -

Notes on the proposed provisions of the revised Division 18 being inserted by clause 22 follow.

Section 160AE : Interpretation

Section 160AE contains a number of definitions and interpretative provisions necessary for the operation of the new Division.

Sub-section 160AE(1) defines the following terms, each of which is to have the given meaning unless the contrary intention appears. Apart from certain expressions which are self-explanatory, these are -

'Australian company' means a company that is a resident of Australia. By the definition of 'resident' in section 6 of the Principal Act, this is a company which is incorporated in Australia or which, not being incorporated in Australia, carries on business here and has either its central management and control in Australia, or its voting power controlled by shareholders who are residents of Australia.

'company' is not to include a company in the capacity of a trustee.

'law' of a foreign country is effectively defined so as to include National, State, Provincial, Local or Municipal laws and is relevant to determining whether an amount of foreign tax is one for which credit is to be allowed.

'profits' for general purposes of Division 18 includes gains, whether of an income or capital nature. The term is defined more extensively because of its relevance to the allowance to an Australian parent of credit for underlying company tax paid on the profits out of which a dividend is paid by a subsidiary. For that purpose it is necessary to determine the amount of profits that is available for distribution by the subsidiary, or would be available for distribution but for the requirement to pay foreign tax on those profits. To that end the term 'profits' is to mean in relation to a company the amount of profits derived by the company measured by having regard to -

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the accounts of the company (paragraph (a)); .

any provisions of a law that require the company to maintain statutory reserves - which would be regarded as a reduction of available profits - (paragraph (b)); and

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such other matters as may reasonably be regarded as relevant (e.g., the transfer of profits to reserves or provisions) to the determination of profits derived and properly available for distribution (paragraph (c)).

'underlying tax' is the term used to describe the tax paid by a foreign company on profits out of which a dividend is paid to a related Australian company in terms of new section 160AFB, and which that Australian company is to be deemed to have paid in respect of the dividend.

Sub-section 160AE(2) sets out a general source rule under which a foreign profit of a capital nature will be said to have a source in a foreign country. Broadly, if a profit of a capital nature derived from sources in a foreign country, and in respect of which foreign tax is payable, is included in the assessable income of a taxpayer in a year of income, the amount so included will be deemed to have been derived from sources in that foreign country.

Sub-section 160AE(3) establishes for the purposes of this Division the meaning of "interest income". Such income from sources out of Australia is to be quarantined from all other foreign source income for the purpose of allowing foreign tax credits.

Interest income that is to be dealt with separately is income consisting of interest, or a payment in the nature of interest paid in respect of -

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money lent, advanced or deposited (paragraph (3)(a));

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credit given (paragraph (3)(b)); or

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any other form of debt or liability (paragraph (3)(c)).

However, certain interest will not be within the scope of the phrase "interest income" and will thus be excluded from the quarantining measures. This exclusion will apply to -

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interest derived by a person from a transaction directly related to the active conduct of a trade or business - such as interest charged on debtors' accounts (paragraph (3)(d));

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interest derived by a person from carrying on a banking business, or any other business the income of which is principally derived from the lending of money (paragraph (3)(e)); or

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interest received by a person during a year of income from a company, where -

• .

at any time during the year of income, the company was "related" (in terms of new section 160AFB) to that person or would, if that person was an Australian company, be so related (sub-paragraph (3)(f)(i)); and

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during the year of income, or the preceding year of income, the company has not derived an amount of interest income in excess of 10 per cent of its total profits during the same year (sub-paragraph (3)(f)(ii).

Paragraph (f) is designed to exclude interest from the definition of interest income where normal commercial loans have been made between related entities.

Section 160AF : Credits in respect of foreign tax

This section is the general operative provision of Division 18. It authorises the granting of credits in respect of eligible foreign tax, as defined in section 6AB (see notes on clause 3), and establishes the procedure for ascertaining the amount of the credit that is to be allowed.

Sub-section 160AF(1) entitles an Australian resident taxpayer to a credit for foreign tax paid on income having a foreign source against and up to the amount of, the Australian tax payable on the foreign income.

The basic tests to be satisfied in this regard are that -

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the assessable income of a year of income of a resident taxpayer includes foreign income (paragraph (1)(a));

and the taxpayer has paid foreign tax in respect of that foreign income (paragraph (1)(b)).

Where those tests are met a credit is to be allowed of the lesser of -

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the amount of that foreign tax, reduced in accordance with any relief (as defined in sub-section 160AE(1)) available to the taxpayer (paragraph (1)(c)); or

the amount of Australian tax payable in respect of the foreign income (paragraph (1)(d)).

For these purposes, the relevant credit will by virtue of section 6AB (proposed by clause 3), extend to tax paid on the income in any country outside Australia. If, for example an Australian branch situated in country A derived income from country B, credit would be available for the tax paid in respect of that income in country A and for the tax paid in country B after allowance of any credit already allowed by country A in respect of tax paid in country B.

Sub-section 160AF(2) ensures that if a taxpayer is entitled to have the foreign tax paid reduced, by electing to have tax deducted at source reduced on an assessment basis, then, even if the taxpayer has not taken advantage of that reduction, credit will only be allowed for the notional reduced foreign tax (if any).

Sub-section 160AF(3) establishes the basis for ascertaining the Australian tax payable on foreign income against which, in accordance with sub-section (1), credit for foreign tax paid on the income is to be allowed. The Australian tax payable for this purpose is to be calculated by -

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applying "the average rate of Australian tax" - broadly the gross tax on taxable income divided by the amount of taxable income - to "the adjusted net foreign income" - broadly, the foreign income reduced by deductions allocated to that income - (both of these terms are defined in sub-section (8) and explained later in these notes) (paragraph (a)); and

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deducting therefrom any rebates relating exclusively to foreign income to which the taxpayer is entitled, other than a rebate allowable under a Rates Act for the year of tax (paragraph (b)).

Sub-section 160AF(4) modifies the calculation of the amount of Australian tax payable on foreign income in accordance with sub-section (3) where the taxpayer is a private company and additional tax under Division 7 of Part III has been paid or is payable on the company's undistributed income of the year of income. In these cases, the amount of Australian tax payable in respect of foreign income is the sum of -

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the amount ascertained in accordance with sub-section (3) (paragraph (a)); and

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a proportion of the additional tax under Division 7, being an amount ascertained by applying the rate of the additional tax (50 per cent) to, broadly, so much of the adjusted net foreign income as is included in the undistributed income of the company of the year of income (paragraph (b)).

Sub-section 160AF(5) provides for the determination of the amount of Australian tax payable in cases where a taxpayer is liable to pay tax under section 94 of the Principal Act - an uncontrolled partnership income - (paragraph (5)(a)), or under section 102 of that Act - by a trustee on income of revocable trusts and certain trusts for minors (paragraph (5)(b)).

Those sections are of an anti-avoidance nature under which, in certain circumstances, a higher rate of tax is payable on income to which they apply. Where an assessment is made under one or other of these sections, the Commissioner of Taxation is empowered under sub-section (5) to determine the part of the Australian tax payable that is reasonably attributable to the foreign income. The amount so determined will form the basis for determining the credit to be allowed for foreign tax on the affected income.

Sub-section 160AF(6) will ensure that where only a part of any income earned in overseas employment is exempt in terms of section 23AG because the foreign service was for a continuous period of less than 365 days (see notes on clause 8) (paragraph (6)(a)), and the remaining part of that income is included in the taxpayer's assessable income (paragraph (6)(b)), credit will be allowed for only a proportion of the foreign tax paid in respect of those foreign earnings.

In such cases, the limited amount of creditable foreign tax will be calculated in the same proportion as the amount of assessable foreign earnings income bears to the total foreign earnings.

A corresponding provision is not required in relation to foreign income derived by a person working overseas on an approved project that is not exempt from Australian tax in accordance with section 23AF of the Principal Act (see also notes on clause 7) because the person was not engaged on the project for a continuous period of 365 days or more, as that section only applies where the foreign income is exempt from tax in the country of source.

Sub-section 160AF(7) operates to quarantine certain foreign interest income (see earlier notes on sub-section (1)) from other foreign income for the purpose of allowing foreign tax credits. Interest income subject to this measure is to be assessed separately from all other income with a separate foreign tax credit applying to it. As is indicated earlier in these notes, the quarantining mechanism is directed at what may be broadly described as passive interest income which, in the absence of this measure, could be freely generated for the purpose of offsetting excess foreign tax credits which would otherwise be lost. An associated measure in section 160AFA (see later notes on that section) will deem foreign dividends to be interest income and subject those dividends to quarantining rules to the extent that those dividends comprise passive interest income and are paid by a foreign company to a related person in Australia.

Sub-section 160AF(8) contains definitions of three terms used in this section -

'adjusted net foreign income' is a term used in sub-sections (3) and (4) for the purpose of determining the Australian tax payable on foreign income against which credit for foreign tax is to be allowed. The definition must be read in conjunction with the provisions of sub-section (7) which, as indicated above, addresses cases in which a taxpayer has both foreign interest income and other foreign income and in respect of which separate calculations of the credit available in respect of interest income and in respect of other income are required. Against that background -

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paragraph (a) of the definition of 'adjusted net foreign income' applies where sub-section (7) does not operate to quarantine interest income, and the 'net foreign income' (also a defined term - see notes below) exceeds the sum of the taxpayer's taxable income of the year of income and the apportionable deductions (as defined in section 6 of the Principal Act). In these circumstances the adjusted net foreign income would be taken as being equal to the taxable income;

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paragraph (b) of the definition applies where sub-section (7) operates to quarantine foreign interest income and the combined net foreign income - that is, interest income and other income - exceeds the sum of the taxpayer's taxable income and the apportionable deductions. In such a case the principle of paragraph (a) is followed and the taxable income is divided proportionately into the adjusted net foreign income from interest and the adjusted net foreign income from other income;

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paragraph (c) of the definition applies where the net foreign income does not exceed the sum of the taxpayer's taxable income and the apportionable deductions. In these cases a proportion of the apportionable deductions, equal to the proportion that the net foreign income bears to the sum of the taxable income and the apportionable deductions, is set off against the net foreign income. In a case where sub-section (7) applies this is done separately in relation to interest income and other income;

'average rate of Australian tax' is a term used in sub-section (3) to calculate the Australian tax payable on foreign income for the purpose of allowing credit for foreign tax paid on that income, by applying this rate to the amount of the adjusted net foreign income. The term is defined to mean an amount per dollar on the sum of -

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the income tax that would be payable by the taxpayer if the taxpayer were not entitled to any rebate (other than a rebate under sub-section 23AB(7) or section 79A or 79B (zone and certain overseas service rebates) or Subdivision A of Division 17 of Part III (concessional rebates), or under an Act imposing income tax for the year of tax) or credit (paragraph (a)); and

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in the case of a company, any additional tax on undistributed income which may be payable under Division 7 (paragraph (b)),

divided by the number of whole dollars in the taxable income;

'net foreign income' is, as indicated earlier, the term used to determine the "adjusted net foreign income" which is relevant to the calculation of Australian tax payable on foreign income. It means the part of a taxpayer's assessable income that is foreign income, reduced by the total of -

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the allowable deductions that relate exclusively to foreign income (paragraph (a));

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the amount of any domestic loss incurred in a year of income which the taxpayer has elected, under sub-section 80(2C) - see notes on clause 16 - to deduct from his or her foreign income of that year (paragraph (b)); and

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so much of any other allowable deductions (other than apportionable deductions) as, in the opinion of the Commissioner of Taxation, may appropriately be related to foreign income (paragraph (c)).

The amount ascertained by means of the definition of the 'net foreign income' is not a final determination of the taxable income attributable to foreign sources because "apportionable deductions" are not taken into account. This further stage in the process of estimating the taxable income attributable to foreign sources is effected by means of the definition of the 'adjusted net foreign income' discussed earlier.

Section 160AFA - Certain dividends deemed to be interest income

Foreign interest income of the type described in sub-section 160AE(3) (see earlier notes) is to be treated as a separate class of income with a separate foreign tax credit limit applying to it. It is quite possible, however, to alter the character of foreign interest income simply by incorporating a foreign company to receive the interest income and then effectively converting it to dividends paid to the Australian taxpayer.

The purpose of new section 160AFA is to ensure that the intended operation of the quarantining measure in sub-section 160AF(7) (also see earlier notes) has its intended operation and is not avoided by arrangements of the kind described above. To this end, and in broad terms, dividends received by Australian residents from related foreign companies will be subject to tracing rules, so as to treat as interest income foreign dividends paid out of interest income in specified circumstances.

Sub-section 160AFA(1) stipulates that the provisions of this section apply in relation to a foreign company where the company derives net interest income amounting to at least 10 per cent of the total profits of the company during the first accounting period of the company that ends after 30 June 1987 or in any subsequent accounting period - referred to as the relevant period.

Sub-section 160AFA(2) provides that the sum of any amount of net interest income derived by the company during a period consisting of the relevant period and any subsequent period, reduced by the amount of any dividends treated as interest income under sub-section (3), shall constitute a pool of interest income.

Sub-section 160AFA(3) is the operative provision that specifies that a dividend paid by a foreign company to a taxpayer in the year of income commencing on 1 July 1987, or in any subsequent year of income, is to be treated as interest income of the taxpayer to the extent that the dividend is paid out of the amount standing in the interest pool of the company at the time the dividend was paid.

By virtue of paragraph (3)(b), this quarantining measure will only operate to treat a dividend paid by a foreign company as interest income if, at any time in the year of income in which the dividend was paid, the taxpayer receiving the dividend was an Australian company related to the foreign company, or was a person who would have been related to that foreign company if that person was an Australian company, e.g., an individual having a controlling interest of 10 per cent or more in the foreign company.

Sub-section 160AFA(4) defines the term 'net interest income' used in this section in relation to a foreign company in respect of an accounting period of such a company. It means the interest income as defined in sub-section 160AE(3) - see earlier notes - derived by the company during an accounting period, reduced by -

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any deductions allowable under any law from the income of the company for that period which relate exclusively to the interest income (paragraph (4)(a)); and

•

so much of any other deductions allowable under any law from the income of the company as, in the opinion of the Commissioner, may appropriately be related to the interest income (paragraph (4)(b)).

Section 160AFB : Related foreign companies

Under the proposed foreign tax credit system, an Australian resident company, which receives a dividend from a related foreign company, will be allowed a credit for both foreign withholding taxes on the dividends received and for the "underlying" foreign company taxes on that portion of the profits out of which the dividend is paid. This section will define related companies for this purpose, as well as for the purpose of applying the interest quarantining measures.

Section 160AFB specifies the conditions that are required to be satisfied for companies to qualify as related foreign companies. At base, a foreign company is treated as related to an Australian company if the Australian company has a 10 percent controlling interest in the foreign company. This relationship also applies to relationships through any number of tiers of foreign companies provided that -

•

each company in the chain has at least a 10 percent controlling interest in the company in the tier below; and

•

the Australian company has a direct or indirect interest of at least 5 per cent in the voting shares of each foreign company that is a member of the chain.

Sub-section 160AFB(1) sets out the circumstances under which a company is treated as a member of a group of companies. Where an Australian company has a voting interest in a foreign company of at least 10 per cent of a voting power of a foreign company, both companies are treated as a member of a group of companies (paragraph (1)(a)). Where the foreign company, in turn, has a voting interest in another foreign company amounting to at least 10 percent of the voting power of the second foreign company, the Australian company and the two foreign companies are treated as members of a group of companies (paragraph (1)(b)). This concept of a group of companies is extended to include other foreign companies which are similarly connected (paragraph (1)(c)).

Sub-section 160AFB(2) specifies the circumstances under which a foreign company that is a member of a group on the basis contained in sub-section (1) is treated as related to an Australian company for the purposes of Division 18. This relationship will exist where both companies are members of a group of companies and the Australian company has a voting interest (see notes on sub-section (4)) amounting to at least 5 per cent of the voting power of the foreign company. The Australian company may hold the voting interest either directly or through one or more companies, whether or not those companies are also members of the group.

Sub-section 160AFB(3) contains the formula for calculating the voting interest of the first company in the third company in a chain, where the first company has a voting interest in the second company which, in turn, has a voting interest in the third company. The formula is expressed as

(A*B)/(C)


where -

A

is the amount of the voting interest of the first company in the second company;

B

is the amount of the voting interest of the second company in the third company; and

C

is the total amount of the voting power (as defined in sub-section (6)) of the second company.

Thus, if the voting power of each of three companies A, B and C was 100 shares, and A owned 50 of those shares in B and B owned 10 of those shares in C, application of the above formula would be as follows -

(50*10)/(100) = 5


In other words, A would possess the required voting interest in C to make those two companies, together with B, related companies.

The voting interest is traced down a chain of companies in the same manner.

Sub-section 160AFB(4) establishes the circumstances under which a company will be taken to have a voting interest in another company. One company is taken to have such an interest in another company if -

•

the first company is the beneficial owner of shares in the other company that carry the right to exercise any of the voting power in that other company (paragraph (4)(a)); and

•

there is no arrangement (as defined in sub-section (7)) in force under which any person is in a position to, or may become in a position to, affect that right (paragraph (4)(b)).

The extent of the voting interest is the total number of votes that by virtue of that right, could be cast on a poll at, or arising out of, a general meeting of company B.

Sub-section 160AFB(5) specifies the circumstances in which, in applying paragraph (4)(b), a person will be taken to be in a position to affect a right of a company if that person has a right, power or option -

•

to acquire that right; or

•

to do an act or thing that would prevent the company from exercising that right or receiving any benefits accruing by reason of that right.

For these purposes, the right, power or option may exist by virtue of any provision in the constitutent document of a company, or by reason of any agreement or instrument or otherwise.

Sub-section 160AFB(6) defines what is meant by the term voting power used in this section. Voting power is the maximum number of votes that can be cast on a poll at a general meeting of a company, or arising out of a general meeting of the company, in relation to all questions that can be submitted to such a poll.

By sub-section 160AFB(7), an 'arrangement' includes any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether legally enforceable or not (paragraph (7)(a)). The term also includes any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise (paragraph (7)(b)).

Section 160AFC : Foreign underlying tax

An Australian company, which derives a dividend from a related foreign company as determined in accordance with section 160AFB, will be entitled to credit for foreign withholding or other taxes paid on that dividend. Entitlement to credit also extends to the underlying foreign company tax paid by the company by which the dividend is paid on that portion of the profits of that company from which the dividends are paid.

The underlying tax paid procedure is to be traced down a chain of related companies. Where a foreign company pays a dividend to a related Australian company, and has itself received a dividend from another related foreign company, the first foreign company is to be deemed to have paid, in addition to its own underlying tax, a portion of the underlying tax paid by the second related foreign company on its profits out of which it paid the dividend to the first foreign company.

Dividends received by an Australian company from a foreign related company will be treated as paid firstly out of a pool of the related company's profits for its first accounting period commencing after 30 June 1987, and subsequent accounting periods. The foreign underlying tax attributable to a dividend paid out of the pooled profits will therefore be the average rate of foreign tax imposed on those profits over the period during which they are accumulated.

Dividends in excess of the pool of accumulated profits will be treated as paid out of the profits of earlier accounting periods of a related foreign company on a last-in-first-out basis, and the foreign underlying tax attributable to such dividends will be calculated accordingly.

Sub-section 160AFC(1) specifies the circumstances in which the provisions of this section will apply, namely, where one or more of the following tests is met -

•

an Australian company receives a dividend from a foreign company which, at the time when the dividend was received, was related to the Australian company (paragraph (1)(a));

•

the foreign company had, in turn, previously received a dividend from another foreign company which was related to the Australian company when the dividend was received (paragraph (1)(b));

•

that other foreign company, at an earlier time, had received a dividend from another company which was related to the Australian company, or there was a series of companies receiving dividends in this manner (paragraph (1)(c)).

Where those tests are met, the following conditions which are necessary for the application of this section will flow -

•

each company is treated as a member of a dividend series in relation to those dividends (paragraph (1)(d));

•

the company paying the dividend is referred to as the 'paying company' and the company receiving the dividend as the 'receiving company' in relation to each dividend (paragraph (1)(e));

•

the taxpayer is taken to be the higher or the highest, as the case may be, in the dividend series. The other member or members shall be taken to be lower or successively lower, as the case may be (paragraph (1)(f));

•

the same company may be a member of two or more dividend series (paragraph (1)(g)).

Sub-section 160AFC(2) deals with a situation where there is only one pair of companies in the dividend series, and the company which pays the dividend has paid an amount of underlying tax in respect of the profits out of which the dividend has been paid. It stipulates that, in such a case, the company which receives the dividend is to be deemed to have paid, in respect of the dividend, and to have been personally liable for, an amount of foreign tax calculated in accordance with the formula -

(A*B)/(C)


where -

A

is the amount of the dividend;

B

is the amount of the underlying tax; and

C

is the number of whole dollars in the amount by which the profits (as defined in sub-section 160AE(1) - see earlier notes) out of which the dividend has been paid, exceeds B.

The foreign tax determined in this manner is to be deemed to have been paid by the company receiving the dividend in the year of income in which it receives the dividend so that a credit for foreign tax may be available in that year.

Sub-section 160AFC(3) operates in conjunction with sub-section (4), and provides for circumstances where there are two or more pairs of companies in a dividend series. It specifies that, in such a case, the formula contained in sub-section (4) will apply successively in relation to each pair of companies in the series.

Sub-section 160AFC(4) deems a company that has received a dividend to have paid, and to have been personally liable for, an amount of foreign tax in respect of that dividend. The amount of the foreign tax is calculated using the formula -

(A*(B+C))/(D)


where -

A

is the amount of the dividend;

B

is the amount (if any) of the underlying tax paid by the company which pays the dividend on the profits out of which the dividend has been paid;

C

is the amount, if any, of the underlying tax deemed to have been paid by the company which pays the dividend, by any other application of this sub-section, on any dividend received by that company;

D

is the number of whole dollars in the amount by which the profits out of which the dividend referred to in A was paid, exceeds B.

Sub-section 160AFC(5) provides that, where the Australian company referred to in sub-section (4) is the company which receives the dividend, the foreign tax deemed by that sub-section to have been paid by that company in respect of that dividend, will be taken to have been paid in the year of income in which the dividend was received. The foreign tax would, therefore, be taken into account in determining the credit for foreign tax to be granted to the Australian company in the year of income in which the dividend received forms part of its income.

Sub-section 160AFC(6) specifies the order in which the profits of a foreign company are to be treated as distributed as a dividend to which this section applies.

The dividend is treated as paid first out of the profits accumulated during the first accounting period (as defined in sub-section (10)) of the company commencing after 30 June 1987, and subsequent accounting periods (paragraph (6)(a)).

If the dividend exceeds those profits, the excess is treated as paid out of the profits of the accounting period preceding the first accounting period of the company commencing after 30 June 1987 (paragraph (6)(b)).

If the dividend exceeds those profits also, the excess is treated as paid out of the profits of the immediately preceding accounting period, and so on (paragraph (6)(c)).

Sub-section 160AFC(7) provides that, for the purposes of sub-section (6), in determining the profits out of which a particular dividend is paid, all profits distributed by the company before that sub-section commenced to apply are to be disregarded (paragraph (7)(a)). Similarly, profits which are treated as having been distributed in accordance with the provisions of sub-section (6) in relation to any dividend distributed previously are also to be disregarded (paragraph (7)(b)).

Sub-section 160AFC(8) specifies that, for the purposes of this section, underlying tax paid by a company is the amount of that tax after the deduction of any relief (as defined in sub-section 160AE(1)) available to the company under the law of the foreign country which imposes that tax.

Sub-section 160AFC(9) stipulates that, in calculating the foreign tax deemed to have been paid in respect of a dividend by a company receiving the dividend, the dividend paid shall be increased by the amount of any foreign tax deducted from that dividend, e.g., a withholding tax.

Sub-section 160AFC(10) defines an 'accounting period' in relation to a foreign company as the accounting period used by the company in terms of the law of the foreign country which imposes underlying tax on the company. The relevant foreign country is that in which the company is treated as a resident company for purposes of taxation.

The following example illustrates the operation of section 160AFC.

EXAMPLE

Facts

Ausco owns 100% of Firsco, Firsco owns 50% of Secco and Secco owns 50% of Thirco. In 1985 Thirco pays a dividend of $550 to Secco. In 1986 Secco pays a dividend of $900 to Firsco and on 1 August 1987 Firsco pays a dividend of $3000 to Ausco. Each of the subsidiaries use a calendar year as the income year, Ausco uses the normal Australian income year. For simplicity, dividend withholding taxes have been ignored in this example, and it has been assumed that the net dividends received by Secco and Firsco are subject to full company tax.

Section 160AFD: Losses of previous years

This new section will enable a resident taxpayer to deduct from a class of income derived from a foreign source in a year of income, any overall foreign loss incurred in relation to the same class of income from that same foreign source.

For these purposes, interest income is treated as a separate class of income from all other income. Further, a business carried on by a taxpayer at or through a permanent establishment in a foreign country, or any other business, commercial or investment activity carried on by a taxpayer in a foreign country, will each constitute a separate foreign source of income.

The effect of the new section is that a business loss incurred in a year of income by a taxpayer in relation to a permanent establishment of the taxpayer in a foreign country can be offset only against subsequent profits of the same permanent establishment. Similarly, a loss incurred in a foreign country in a year of income in respect of a business, commercial or investment activity carried on in that country by a taxpayer other than through a permanent establishment can also be offset only against subsequent profits from the same business, commercial or investment activity. As interest income is to be quarantined by other measures outlined earlier, a loss from any foreign activity cannot offset foreign interest income.

To qualify for deduction from income of a year of income, the loss must have been incurred in any of the seven preceding years of income. Foreign losses incurred prior to the commencement of the foreign tax credit system will be subject to the same rules as losses incurred in a year of income commencing after 1 July 1987.

A more detailed explanation of section 160AFD is given in the notes that follow.

Sub-section 160AFD(1) provides for the deduction of an "overall foreign loss" as defined in sub-section (5). In determining the amount of the foreign loss which can be deducted from income in any year of income, the overall foreign loss incurred in respect of a class of income derived from a foreign source (i.e., each separate activity), is to be reduced by any amount of that loss which had been deducted from income of an earlier year of income derived from a activity (paragraph (1)(a)). The amount of the foreign loss from any particular activity which can be deducted in any year of income is limited to the amount of the income of that year from the same activity (paragraph (1)(b)). The foreign income of a year of income can be reduced by any overall foreign loss in this way only if the loss was incurred in any of the preceding seven years of income.

Sub-section 160AFD(2) will apply where a taxpayer's income from a particular activity of a year of income is reduced by foreign losses incurred in two or more years of income. In such cases, the losses will be taken into account in the order in which they were incurred.

Sub-section 160AFD(3), in effect, sets out the manner in which the amount of credit for foreign tax paid in respect of income derived by the taxpayer from a particular activity in a year of income will be computed where his or her assessable income from the same activity has been reduced, by virtue of the operation of sub-section (1), by the amount of a foreign loss. It requires the amount of the foreign tax for tax credit purposes, to be calculated on the foreign income as so reduced.

Sub-section 160AFD(4) stipulates that the provisions relating to the deduction of foreign losses will have effect whether or not the country in which the losses were incurred permits the taxpayer's income of the one year to be reduced by losses incurred in previous years.

Sub-section 160AFD(5) defines an overall foreign loss in respect of a particular activity in a year of income. An overall foreign loss is calculated separately for each class of income from each source of income in each foreign country, and it is the amount by which the sum of -

•

any deductions allowed or allowable from assessable income of the taxpayer that relate exclusively to the taxpayer's income of a particular class of income from a source in a foreign country for a year of income (paragraph (5)(a)), and

•

so much of the other deductions allowed or allowable from the taxpayer's assessable income (other than apportionable deductions - defined in section 6 of the Principal Act) which are, in the opinion of the Commissioner, attributable to that income (paragraph (5)(b)),

exceeds that income.

Sub-section 160AFD(6) provides that interest income constitutes a single class of income (paragraph (6)(a)), separate from all other income (paragraph (6)(b)).

Sub-section 160AFD(7) defines "foreign source", in relation to a taxpayer, to mean a business carried on by the taxpayer at or through a permanent establishment in a foreign country (paragraph (6)(a)). Each other business, commercial or investment activity carried on by a taxpayer in a foreign country is also treated as a separate "foreign source" (paragraph (6)(b)).

Section 160AFE: Transfer of excess credits within company group

Section 160AFE will allow a resident company which has an excess credit (referred to as the 'credit company') in relation to a class of income for a year of income to transfer the excess credit to another resident company (referred to as the 'income company') for the same year of income where there is 100 percent common ownership between the companies in that year of income. To ensure that the interest quarantining measures apply in this area also, there will be only 2 classes of income - one comprising interest income as defined for purposes of the Division by new sub-section 160AE(3) (see earlier notes on section 160AE), and the other comprising all other income.

A company will have an excess credit in relation to a class of income for a year of income where the amount of the foreign tax paid by that company in respect of that class of income for that year, reduced in accordance with any relief available to the company under the law relating to that foreign tax, exceeds the amount of the Australian tax payable by the company in respect of its foreign income of the same class for that year.

The basic rules relating to the allowance of foreign tax credit will be applicable to both the credit company and the income company. The foreign tax credit to which the credit company is entitled will be calculated in the same manner as for any other company. Any excess credit of the credit company for a year of income relating to a class of income will be available as credit to the income company as if the income company had itself paid that amount as foreign tax in that year of income.

A credit will be allowable to the income company only if that company satisfies the normal criteria for the allowance of foreign tax credit for the same class of income.

As part of the formal mechanism for transfer, the credit company and the income company must give written notice to the Commissioner of Taxation stating that the whole or a specified part of the excess credit should be transferred to the income company in the year of income.

An explanation of section 160AFE is given in the notes which follow.

Sub-section 160AFE(1) is the operative provision of section 160AFE. It sets out the basis on which a company that has an excess foreign tax credit may transfer the excess credit (or a part of the excess credit) to another company with which it has the necessary group relationship. The excess credit will be deemed to be foreign tax of the transferee company for the purposes of section 160AF.

Paragraph (1)(a) requires a company (the credit company) to have an excess credit in relation to a class of income in respect of a year of income, i.e., that the foreign tax exceeds the Australian tax on a class of income.

Paragraph (1)(b) specifies that the transferee company (the income company) must have the same class of foreign income, and that section 160AF applies in relation to that class of income in respect of the same year of income.

Paragraph (1)(c) will require the credit company and the income company to furnish to the Commissioner of Taxation a notice specifying that the right to either the whole or a specified part of an excess credit is to be transferred to the income company in the year of income. The notice to be given to the Commissioner for this purpose is to be in writing, signed by the public officers of both companies, and furnished on or before the date of lodgment of the relevant return of income of the income company, or within such further time as the Commissioner allows.

Sub-section 160AFE(2) specifies two tests, either of which must be satisfied if, in relation to a year of income, an excess credit is to be transferable between two companies. These tests are that, throughout the year of income, one of the companies was a subsidiary of the other company (paragraph (2)(a)), or each of the companies was a subsidiary of the same parent (paragraph (2)(b)). The relevant test must be satisfied during the whole of the year of income or, if either or both of the companies was not or were not in existence for part of the year, it must be satisfied during that part of the year in which both companies were in existence. For these purposes, by virtue of subsection 160AFE(6), a company will be treated as coming into existence during the year if it was incorporated during the year. The provisions will not extend to an existing company that was acquired or disposed of by the company group during the year.

Sub-section 160AFE(3) specifies the circumstances in which a company is to be taken to be a subsidiary of another company (termed the 'holding company') for the purposes of section 160AFE during a whole or a part of the year of income ("the relevant period") as required to satisfy sub-section (2). Under sub-paragraph (3)(a)(i) this relationship is established if all the shares in the subsidiary company were beneficially owned by the holding company at all times during the relevant period.

Sub-paragraph (3)(a)(ii) establishes the relationship if all the shares in the subsidiary company were beneficially owned during the relevant period by a company that is, or by two or more companies each of which is, a subsidiary of the holding company. By sub-paragraph (3)(a)(iii) the necessary relationship will also exist if all the shares in the subsidiary company were owned during the relevant period by the holding company and by a company that is, or two or more companies each of which is, a subsidiary of the holding company.

Paragraph (3)(b) imposes the further requirement that during the relevant period there was no arrangement in force by virtue of which any person was in a position, or would become in a position after the relevant period, to affect rights of the holding company, or of another subsidiary of the holding company in relation to the particular subsidiary company. This is a safeguard against the possibility of any collateral arrangement being used to circumvent the intended operation of the provisions.

Sub-section 160AFE(4) extends the operation of sub-sections (2) and (3) by establishing a qualifying group relationship between companies which are part of a wholly owned chain of subsidiaries of a holding company. Thus, in a corporate structure under which all of the shares in a subsidiary are owned by one or more wholly owned companies that are interposed between a holding company and the end subsidiary company, a qualifying group relationship will be found between each of those companies.

Sub-section 160AFE(5) qualifies sub-section (3). It specifies for the purposes of paragraph (3)(b) the circumstances in which a person is to be regarded as being in a position at a particular time to affect the rights of one company in relation to another company. A person will be in that position if he or she has at the particular time a right, power or option to acquire any of the rights of the first company in its subsidiary or to prevent that company from exercising rights in the subsidiary for its own benefit or receiving any benefit accruing by reason of those rights.

The practical effect of sub-section 160AFE(6), when taken together with sub-section (2), is that a company which was not a group company for the whole of the year of income will only be regarded as such if it was a company that was incorporated during the year and was, in practical effect, wholly owned for the remainder of the year by another company. Where either an existing group company is disposed of, in whole or in part, during a year, or a company which was not previously a group company is wholly acquired during a year, neither of those companies can be a group company for excess credit purposes in relation to that particular year of income. However, where a company is acquired during a year of income, that company would be a group company for these purposes in subsequent years if the specified 100 percent common ownership rule continues to be met.

Sub-section 160AFE(7) ensures that the amount available for excess credit transfer by a company will be the amount by which its foreign tax in relation to a class of income exceeds the Australian tax payable on that income.

Paragraph (7)(a) first requires that the basic tests contained in section 160AF are met in relation to the particular income, i.e., that it is foreign income on which foreign tax has been paid.

By paragraph (7)(b), the amount of the excess credit in respect of the particular income is determined by reference to the amounts of the foreign tax and the Australian tax in paragraphs 160AF(1)(c) and (d).

Sub-section 160AFE(8) specifies that, for the purposes of section 160AFE -

•

interest income constitutes a single class of income (paragraph (8)(a)); and

•

all other income constitutes another class of income (paragraph(8)(b)).

By sub-section 160AFE(9) the term 'arrangement' as used in sub-section (3) is given an extended meaning, common to other provisions of the Principal Act, so as to include any agreement, arrangement, understanding, promise or undertaking, or any scheme, plan, proposal, action, course of action or course of conduct.

Sub-section 160AFE(10) defines the term "company" for the purposes of section 160AFE to mean an Australian company. Proposed new sub-section 160AE(1) defines an Australian company as a company that is a resident of Australia.

Section 160AFF: Tax sparing

The purpose of this section is to enable regulations to be made, where appropriate, which recognise the investment incentives of certain developing countries aimed at encouraging foreign investment in those countries. Such incentives usually take the form of a reduction or waiver of taxes and, in the absence of special measures, an Australian resident who derives income liable to Australian tax, from that country would be entitled to reduced credit or no credit for foreign tax foregone by that country. The tax incentive offered by that country would, thus be negated. Until now, tax sparing has been provided only in the context of a comprehensive double tax treaty. This section will provide a facility to supplement that approach.

Sub-section 160AFF(1) enables regulations to be made specifying that the provisions of section 6AC (which grosses-up the amount of foreign income by the amount of foreign tax paid in respect of that income for assessment purposes), and this Division providing for the allowance of credit in respect of foreign tax, will apply to income derived from sources in a particular country, subject to such modifications as may be set out in the regulations. In broad terms, such regulations would operate to the same general effect as existing tax sparing provisions in Australia's comprehensive taxation agreements and, in either situation would, in conjunction with proposed sub-section 6AB(5) (see notes on clause 3) operate to treat, for credit purposes, foreign tax foregone as tax paid

Sub-section 160AFF(2) requires the Minister to review regulations made in accordance with this section at the end of each period of five years after their commencement.

By sub-section 160AFF(3), 'modifications' as used in sub-section (1) is defined to include additions, omissions and substitutions.

Sub-section 160AFF(4) provides that any regulation prescribed under this section after 1 July 1987 may take effect from a date earlier than that on which it was made, but not earlier than 1 July 1987. This will enable tax sparing to be applied in relation to a particular country from the date of commencement of the foreign tax credit system, even though the regulation may be made after that date.

Clause 23 : Credits in respect of overseas tax paid on certain film income

Section 160AGA of the Principal Act provides for the allowance of a credit for overseas taxes paid on certain film income arising outside Australia, where that income is liable to Australian tax under section 26AG. The credit is subject to an upper limit of the Australian tax payable on the overseas income.

Because of its special purpose and the way in which it operates in particular situations, the section is to be retained. However, clause 23 will amend section 160AGA as a consequence of the proposed repeal of paragraph 23(q) of the Principal Act (by clause 6), sub-section 26AG(7) of that Act (by clause 9), and section 15 of the Income Tax (International Agreements) Act, 1953, (by clause 38).

Paragraph (a) of this clause will delete the reference, in paragraph 160AGA(1)(b), to paragraph 23(q), while paragraph (b) will delete the reference to sub-section 26AG(7).

Paragraph (c) will replace present sub-section 160AGA(4), which specifies the method of calculation of the Australian tax on the foreign income to which the section applies by reference to the method provided in section 15 of the Income Tax (International Agreements) Act 1953, with a new subsection (4) to provide for the calculation of that tax in the manner set out in the proposed new section 160AF - see notes on clause 22.

Clause 24 : Credits in respect of overseas tax paid on certain shipping income

Section 160AGB of the Principal Act provides for the allowance of a tax credit for overseas taxes paid on certain shipping income which is liable to Australian tax under sub-section 57AM(30). The credit for overseas tax paid is subject to an upper limit of the Australian tax paid in respect of the overseas income.

In very limited situations the section could provide a credit for foreign tax paid beyond that to be available under new Division 18, and is therefore to be retained. However, clause 24 will amend section 160AGB as a consequence of the proposed repeal of paragraph 23(q) of the Principal Act (by clause 6), and of section 15 of the Income Tax (International Agreements) Act 1953, (by clause 38).

Paragraph (a) will delete the reference, in paragraph 160AGB(1)(b), to paragraph 23(q).

Paragraph (b) will replace the present sub-section 160AGB(4) which provides for the calculation of the Australian tax on the foreign income to be calculated in accordance with the procedure now contained in section 15 of the Income Tax (International Agreements) Act 1953 (that is to be repealed), with a new sub-section (4) under which that calculation will be made on the basis provided in new section 160AF - see notes on clause 22.

Clause 25 : Definitions

Clause 25 will delete the definition of "non-Australian tax" in section 160AH in Division 19 of Part III of the Principal Act (Miscellaneous Provisions with Respect to Credits) which is no longer required. A new definition of foreign tax is contained in new section 6AB which is proposed to be inserted in the Principal Act by clause 3 of the Bill.

Clause 26 : Amendments of determinations

Clause 27 : Information for credit to be furnished within 3 years

The amendments to be made by these clauses to sections 160AK and 160AM (also contained in Division 19) of the Principal Act are consequential on the proposed deletion, by clause 25, of the definition of "non-Australian tax" and its replacement with the term "foreign tax".

Clause 28 : Maximum credits

The omission of sub-section 160AO(1) (also contained in Division 19) of the Principal Act, which brings within the scope of section 160AO relating to maximum credits, credit allowable under section 45 of the Principal Act, is consequential on the repeal of section 45 proposed by clause 11.

Clause 29 : Amount of instalment of tax

Clause 30 : Estimated income tax

Clause 31 : Reduction of provisional tax

These clauses amend sections 221AE, 221AG and 221YDC of the Principal Act respectively, to delete reference they each contain to section 45 which is proposed to be repealed by clause 11 of the Bill.

Clause 32 : Application of amendments

By this clause, which will not amend the Principal Act, the amendments proposed by Part II of the Bill will apply to assessments in respect of income for the year of income commencing on 1 July 1987, and in respect of income of all subsequent years of income.

Clause 33 : Transitional provisions - trading stock

Clause 33 which will not amend the Principal Act, proposes transitional measures in respect of trading stock of a foreign business of a taxpayer the profits of which first become liable to Australian tax in the year of income commencing on 1 July 1987 due to the operation of the amendments proposed by Part II of the Bill.

Sub-clause 1 specifies that the provisions of this clause apply to the valuation of trading stock on hand at the commencement of the first taxable year (defined by sub-clause (7) as the year of income commencing on 1 July 1987), where the trading stock consists of the whole or a part of a business carried on in a foreign country (paragraph (a)), and the income derived from that business in that year would have been exempt income (i.e., by virtue of paragraph 23(q) of the Principal Act) if the amendments proposed by Part II were not made (paragraph (b)).

Section 28 of the Principal Act provides that, where a taxpayer carries on a business, the value of all trading stock on hand at the beginning of the year of income and at the end of that year shall be taken into account in ascertaining whether or not the taxpayer has a taxable income. Sub clause (2) of this clause provides that, in the case of trading stock other than live stock, the value will be, at the option of the taxpayer, its cost price, its market selling value or the price at which it can be replaced (paragraph (a)). Where the stock is live stock, the value to be taken into account at the beginning of the first taxable year will be, at the option of the taxpayer, its cost price or its market selling value (paragraph (b)).

Sub-clause (3) requires any option under sub-clause (2) to be exercised by notice in writing lodged with the Commissioner of Taxation before 1 September 1987, or such later date as the Commissioner allows.

Sub-clause (4) provides that, if a taxpayer does not exercise an option relating to particular trading stock within the time and in the manner specified in sub-clause (3), the cost price of the trading stock will be adopted as the value of that stock.

Section 33 of the Principal Act specifies that a taxpayer shall not, except with the leave of the Commissioner, adopt a basis of valuation of his or her livestock at the end of the year of income which is different from the basis on which the valuation of his or her livestock was made at the end of the immediately preceding year of income. The proposed new sub-clause (5) provides that, notwithstanding section 33, a taxpayer who exercised an option under the proposed sub-clause (2), may exercise a further option in respect of the trading stock on hand at the end of the first taxable year.

The further option in relation to the value of stock may be exercised under section 31 of the Principal Act in respect of trading stock which is not livestock (paragraph (a)) and under section 32 of that Act where the trading stock is livestock (paragraph (b))

Sub-clause (6) specifies that, where a taxpayer adopts cost price as the basis of valuation, under sub-clause (5), in relation to any trading stock at the end of the year of income, the value at which that trading stock was taken into account under sub-clause (2) at the beginning of that year of income will be treated as the cost price of that trading stock.

Sub-clause (7) defines the 'first taxable year' as the year of income commencing on 1 July 1987.

Clause 34 : Transitional provisions - depreciation

This clause, which will not amend the Principal Act, provides for the ascertainment of the amount to be treated as the cost of a unit of property for the purposes of allowing a deduction for depreciation, under section 54 of the Principal Act, against income of a foreign business of a taxpayer first liable to Australian tax for the year of income commencing on 1 July 1987 due to the operation of the amendments proposed in Part II of the Bill.

Sub-clause (1) specifies that this section applies to property in respect of which depreciation is allowable under section 54 of the Principal Act, being property which was owned by the taxpayer on 1 July 1987, and used, or installed ready for use, by the taxpayer for the purposes of producing income which would have been exempt income but for the amendments proposed by Part II, i.e., the repeal of paragraph 23(q) of the Principal Act.

Sub-clause (2) provides that, for the purposes of calculating depreciation allowable under the Principal Act, the cost of a unit of property will be an amount which would have been the depreciated value ascertained under section 62 of the Principal Act of that unit on 1 July 1987. The depreciated value is ascertained as if the unit had been used by the taxpayer during the whole of the period from the time of its acquisition by the taxpayer to 1 July 1987 wholly for the purpose of producing assessable income, and depreciation had been allowed to the taxpayer, during that period, by way of a percentage of the depreciated value of the unit at the beginning of each year of income.

Clause 35 : Transitional Provisions - losses

This clause, which will not amend the Principal Act, provides for the ascertainment of the amount of any overall foreign losses in respect of a class of income of a foreign source which could be taken into account for the purposes of the proposed new section 160AFD for the year of income beginning on 1 July 1987 (referred to as the first taxable year). For this purpose, the rules it specifies are essentially the same as those contained in new section 160AFD for determining the deduction for foreign losses incurred after 1 July 1987.

Sub-clause (1) provides that any overall foreign loss incurred by the taxpayer in any year of income before the first taxable year in respect of a class of income derived from a foreign source or the total of overall foreign losses of more than one year from a class of income from that source, shall be reduced by the amount of any overall profits in respect of that class of income of that source derived by the taxpayer in one or more years of income before the first taxable year, but after the earliest year in which the loss was incurred.

Only the loss as so reduced will be taken into account for the purposes of new section 160AFD.

Sub-clause (2) provides that a taxpayer is to be taken to have made an overall profit, in respect of a class of income from a foreign source, for a year of income, of an amount equal to the excess of the taxpayer's income from that class of income from that source, for that year, over the sum of the allowable deductions from that income. The allowable deductions from that income are -

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any deductions allowable from the assessable income of the taxpayer of the year of income that relate exclusively to the taxpayer's class of income of the year of income derived from that source (paragraph (a)); and

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so much of any other deductions allowable from that assessable income, (other than apportionable deductions) as, in the opinion of the Commissioner, may appropriately be related to the taxpayer's class of income of the year of income derived from that source (paragraph (b)).

Sub-clause (3) specifies that, in this clause, "class of income", "foreign source" and "overall foreign loss" have the same meanings as in the proposed new section 160AFD - see notes on clause 22.

By sub-clause (4), in this section "first taxable year" means the year of income commencing on 1 July 1987.

PART III - AMENDMENT OF INCOME TAX (INTERNATIONAL AGREEMENTS) ACT 1953

The provisions contained in Part III of the Bill make certain amendments to the Income Tax (International Agreements) Act 1953, referred to as the Principal Act in this Part, in the context of the introduction of the general foreign tax credit system. The rules contained in Part II of the Bill, relating to the allowance of a credit for foreign tax paid, will also apply to the calculation of credits to be allowed in accordance with the comprehensive taxation agreements for the avoidance of double taxation entered into between Australia and other countries. Certain provisions relating to the allowance of foreign tax credit contained in the Principal Act to give effect to the terms of those agreements are no longer necessary and are to be repealed, while other provisions are to be amended in minor respects as a consequence of the introduction of the general foreign tax credit system.

Clause 36 - Principal Act

This clause facilitates references to the Income Tax (International Agreements) Act 1953, which is referred to as the 'Principal Act' in Part III of the Bill.

Clause 37 - Interpretation

This clause will omit sub-sections 3(5) and 3(6) of the Principal Act and replace them with a new sub-section (5).

The Principal Act contains measures to allow credit for foreign tax paid at limited rates on dividends, interest and royalties in accordance with the comprehensive taxation agreements to which the Act gives the force of law in Australia. Under those arrangements, credit is allowed for foreign tax paid on the income concerned on a class of income per country basis. To give effect to those limitations, sub-section 3(5) of the Principal Act specifies the classes of income and, sub-section 3(6) of that Act groups those classes of income on a per country basis. As the foreign tax credit mechanism provided by the Principal Act is to be replaced by the general system proposed by clause 22 of the Bill, these provisions are no longer relevant.

The new sub-section 3(5) specifies that all interest income, within the meaning of section 160AE, of the Income Tax Assessment Act 1936, as proposed to be inserted in that Act by clause 22 of the Bill, will constitute one class of income (paragraph (5)(a)), apart from all other income (paragraph (5)(b)).

Where an amount of income is deemed to be attributable to interest income to which section 160AE of the Income Tax Assessment Act 1936 applies, that amount will be treated as within the class of interest income to which paragraph (a) applies. An amount of income deemed to be attributable to other income will be treated as income of that class (paragraph (c)).

The replacement of sub-section 3(5) in this way brings that sub-section in line with the concept of classes of income contained in the proposed new Division 18 of the Assessment Act introduced by clause 22.

Clause 38 - Repeal of sections 12 to 15

Sub-section 12(1) of the Principal Act provides that the exemption of certain foreign income under paragraph 23(q) of the Income Tax Assessment Act 1936, does not apply to interest and royalty income derived from a country with which a comprehensive taxation agreement is in force and under which the rate of tax on that income is limited in the other country. The exemption also does not apply to income attributable to any such interest or royalties. The repeal of paragraph 23(q) by clause 6 makes this provision unnecessary.

Sub-sections 12(2) and 12(3) of the Principal Act ensure that amounts treated as being attributable to interest, royalties and dividends derived from sources in the United Kingdom, and liable to tax in Australia, are not diminished by any United Kingdom tax paid directly or by deduction on the interest, royalties or dividends to which such amounts are attributable. Section 13 provides for the taxation in Australia on a gross income basis of interest, royalties and dividends directly derived by the taxpayer from the United Kingdom. As corresponding provisions of general application to the allowance of all credits for foreign tax paid are proposed by clause 3 of the Bill, sections 12 and 13 are to be repealed by clause 38.

Section 14 of the Principal Act relates to the determination of the credit allowable, under an agreement, for foreign tax paid or payable by a person in respect of any income. Section 15 prescribes the basis for ascertaining the Australian tax for the purpose of the limitation on the amount of credit allowable. As corresponding provisions for the allowance of credits for foreign tax paid on all income are contained in new Division 18 of the Income Tax Assessment Act 1936, proposed to be inserted in that Act by clause 22, this clause will repeal sections 14 and 15.

Clause 39 - Application of amendments

This clause, which will not amend the Principal Act, specifies that the amendments made by Part III of the Bill apply to assessments in respect of the year of income commencing on 1 July 1987, and in respect of income of all subsequent years of income.