House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 3 - Friendly society investment products

Outline of chapter

3.1 Schedule 3 to this bill amends the ITAA 1936 and the ITAA 1997 so that, from 1 January 2003, friendly societies will be allowed a deduction for investment income paid or credited to recipients of special purpose investment products (income bonds, scholarship plans and funeral policies) where that income has been included in the assessable income of the friendly society.

3.2 Schedule 3 also clarifies the taxation treatment of distributions paid from these products.

Context of amendments

3.3 Currently, friendly societies are exempt from tax on:

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amounts attributable to special purpose investment products issued before 1 December 1999;

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amounts received before 1 January 2003 that are attributable to income bonds and funeral policies issued between 30 November 1999 and 1 January 2003; and

•

amounts received before 1 January 2003 that are attributable to scholarship plans issued between 30 November 1999 and 1 January 2003 if the friendly society that issued the plan is not carried on for profit or gain to individual members.

3.4 To reduce compliance costs, the current exemption will be extended so that it applies to special purpose investment products issued before 1 January 2003.

3.5 As a result of the removal of the tax exemption, from 1 January 2003, friendly societies will be allowed a deduction for investment income included in their assessable income that is paid or credited to:

•

recipients of special purpose investment products issued on or after 1 January 2003; and

•

recipients of scholarship plans issued before 1 January 2003 where the amounts that are attributable to those plans are not currently exempt from tax.

Summary of new law

3.6 Schedule 3 to this bill will amend the ITAA 1997 so that friendly societies will continue to be exempt from tax on:

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amounts attributable to income bonds and funeral policies issued between 30 November 1999 and 1 January 2003; and

•

amounts attributable to scholarship plans issued between 30 November 1999 and 1 January 2003 if the friendly society that issued the plan is not carried on for profit or gain to individual members.

3.7 In addition, from 1 January 2003, friendly societies will be entitled to a deduction for investment income paid or credited on or after that date to:

•

special purpose investment products issued on or after 1 January 2003; and

•

scholarship plans issued before 1 January 2003 where the amounts that are attributable to those plans are not currently exempt from tax.

3.8 Schedule 3 will also amend the ITAA 1936 and the ITAA 1997 to clarify the taxation treatment of distributions paid from these products.

Detailed explanation of new law

Exempt income of friendly societies

3.9 Currently, paragraph 320-35(1)(f) of the ITAA 1997 exempts friendly societies from tax on:

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amounts attributable to special purpose investment products issued before 1 December 1999;

•

amounts received before 1 January 2003 that are attributable to income bonds and funeral policies issued between 30 November 1999 and 1 January 2003; and

•

amounts received before 1 January 2003 that are attributable to scholarship plans issued between 30 November 1999 and 1 January 2003 if the friendly society that issued the plan is not carried on for profit or gain to individual members.

3.10 Paragraph 320-35(1)(f) will be amended to extend this exemption to:

•

amounts attributable to income bonds and funeral policies issued before 1 January 2003; and

•

amounts attributable to scholarship plans issued before 1 January 2003 provided that those amounts would have been exempt from income tax under section 50-1 if they had been received before 1 July 2001 (that is, if the friendly society that issued the plan is not carried on for profit or gain to individual members).

[Schedule 3, item 1, subparagraphs 320-35(1)(f)(ii) and (iii)]

Deduction for interest credited to income bonds

3.11 Section 320-110 allows friendly societies a deduction for interest credited to income bonds issued after 30 November 1999 where the interest accrues on or after 1 January 2003. This deduction is linked to the removal of the exemption on amounts derived by friendly societies that are attributable to these income bonds. Consequently, section 320-110 is amended to allow friendly societies a deduction for interest credited to income bonds issued on or after 1 January 2003. [Schedule 3, item 3, section 320-110]

Deduction for funeral policy payouts

3.12 As a consequence of the removal of the exemption on amounts derived by friendly societies that are attributable to funeral policies issued on or after 1 January 2003, friendly societies will be allowed a deduction for benefits paid in the income year to recipients of funeral policies issued on or after that date. [Schedule 3, item 5, section 320-111]

3.13 The amount of the deduction will be the benefit paid under the policy reduced by any part of the benefit that the friendly society has claimed, or can claim as a deduction under section 320-75. This part of the benefit represents the capital component of the premium paid in respect of the policy.

Example 3.1

Melissa takes out a funeral policy with Natasha Friendly Society on 14 December 2003 and pays a premium of $5,000. The premium includes an entry fee of $200. Therefore, Natasha Friendly Society includes $5,000 in its assessable income under paragraph 320-15(a) and is allowed a deduction for $4,800 under section 320-75.

Melissa dies on 14 September 2010 and Natasha Friendly Society pays $7,000 to Melissa's estate. Natasha Friendly Society can claim a deduction under section 320-111 for $2,200 (i.e. $7,000 - $4,800).

Deduction for scholarship plan payouts

3.14 Friendly societies will include in assessable income:

•

amounts attributable to scholarship plans issued on or after 1 January 2003; and

•

amounts attributable to scholarship plans issued before 1 January 2003 if those amounts are not exempt from income tax under paragraph 320-35(1)(f).

3.15 To avoid double taxation, from 1 January 2003 friendly societies will be allowed a deduction for benefits paid in the income year under a scholarship plan to, or on behalf of, students nominated under the plan. [Schedule 3, item 5, section 320-112]

3.16 The amount of the deduction will be the benefit paid under the plan reduced by any part of the benefit that the friendly society has claimed, or can claim as a deduction under section 320-75. This part of the benefit represents the capital component of the premium paid in respect of the plan.

3.17 If under a scholarship plan the investment income is paid to the nominated student and the capital component is returned to the investor, the friendly society will be entitled to a deduction for the full amount of the benefit paid to a nominated student.

3.18 If a nominated student does not qualify for benefits under a scholarship plan because he or she does not proceed to the specified level of education and some or all of the benefits accrued under the plan are paid back to the investor, the benefits under the plan are not applied for the specified purpose. In these circumstances, the life insurance policy will not qualify as a scholarship plan and the friendly society will not be entitled to a deduction for any part of the benefits paid to the investor.

Taxation of benefits paid from income bonds

3.19 Income bonds are defined in subsection 995-1(1) of the ITAA 1997 to be life insurance policies issued by friendly societies that have bonuses distributed regularly. Therefore, amounts credited to income bonds are non-reversionary bonuses and will continue to be included in the bond holder's assessable income under paragraph 26(i) of the ITAA 1936.

Taxation of benefits paid under funeral policies

3.20 Funeral policies are defined in subsection 995-1(1) to be life insurance policies issued by friendly societies for the sole purpose of providing benefits to pay for the funeral of the insured person.

3.21 Benefits paid in the income year to recipients of funeral policies issued on or after 1 January 2003 will be specifically excluded from being taxed as ordinary life insurance investment policy bonuses. [Schedule 3, item 7, subsection 26AH(1)]

3.22 Rather, benefits paid in the income year to recipients of funeral policies issued on or after 1 January 2003 will be included in assessable income under:

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section 6-5;

•

section 102-5; or

•

section 15-55.

3.23 Section 6-5 includes ordinary income derived directly or indirectly from all sources in the assessable income of a resident of Australia. The full amount of a benefit paid under a funeral policy directly to a funeral director (including benefits paid as an assignee or a nominated beneficiary under the policy) is income according to ordinary concepts. Such amounts represent a payment for services rendered. Consequently, a funeral director will continue to include both the investment and capital component of the benefit paid under a funeral policy in assessable income.

3.24 Section 102-5 includes net capital gains in assessable income. However, section 118-300 prevents capital gains or losses made from the disposal, cancellation or transfer of an interest in a funeral policy from being taxed under the CGT provisions provided the gain or loss is made by:

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the original beneficial owner of the policy; or

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an entity that acquired the interest in the policy for no consideration.

3.25 Consequently, if a person pays an amount of money or other consideration to a previous owner to acquire rights or an interest in a funeral policy, the CGT provisions will continue to apply to any subsequent disposal of those rights or interest.

3.26 Section 15-55 will include benefits paid in the income year to recipients of funeral policies issued on or after 1 January 2003 where those benefits are not included in assessable income under section 6-5 or section 102-5. For example, the trustee of a policyholder's estate will include benefits paid under a funeral policy in the estate's assessable income under section 15-55. [Schedule 3, item 10, section 15-55]

3.27 The amount included in assessable income under section 15-55 will be the benefit paid by the friendly society reduced by any part of that benefit that reasonably relates to:

•

the return of the premiums paid by the policyholder in respect of the policy; and

•

any fees and charges deducted under the policy that are included in the friendly society's assessable income under paragraph 320-15(k).

[Schedule 3, item 10, section 15-55]

3.28 This will ensure that the amount included in assessable income is net of capital and fees paid under the policy.

Example 3.2

Melissa takes out a funeral policy with Natasha Friendly Society on 14 December 2003 and pays a premium of $5,000. The premium includes an entry fee of $200. Melissa dies on 14 September 2010 and Natasha Friendly Society pays $7,000 to Melissa's estate. The trustee of Melissa's estate will include $2,000 in the estate's assessable income (i.e. $7,000 - $5,000).

If Melissa had assigned her funeral policy to a funeral director, the trustee of Melissa's estate would not include any amount payable under the policy in the estate's assessable income. Instead, the funeral director would include the full amount received under the funeral policy (i.e. $7,000) in assessable income under section 6-5.

Taxation of benefits paid under scholarship plans

3.29 Scholarship plans are defined in subsection 995-1(1) to be life insurance policies issued by friendly societies for the sole purpose of providing benefits to help in the education of nominated beneficiaries. That definition will be amended to ensure that a life insurance policy will only qualify as a scholarship plan if it is not used as security for a loan on or after 1 January 2003. Scholarship plans issued on or after 1 January 2003 must contain a provision prohibiting the use of the plans as security for a loan. [Schedule 3, item 12, subsection 995-1(1)]

3.30 Benefits paid on or after 1 January 2003 in the income year under a scholarship plan to, or on behalf of, a student nominated under the plan will be included in the nominated student's assessable income. The amount included in assessable income will be the benefit paid by the friendly society reduced by any part of that benefit that reasonably relates to:

•

the return of the premiums paid by the investor in respect of the plan; and

•

any fees and charges deducted under the plan that are included in the friendly society's assessable income under paragraph 320-15(k).

[Schedule 3, item 10, section 15-60]

3.31 This will ensure that the amount included in assessable income is net of capital and fees paid under the plan.

3.32 A benefit will be paid under a scholarship plan on behalf of a student nominated under the plan if, for example:

•

the benefit is paid to the nominated student's parents or legal personal representative to reimburse education expenses incurred in relation to the nominated student; or

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the benefit is paid directly to an educational institution to pay for education expenses of the nominated student.

3.33 Division 6AA of Part III of the ITAA 1936 essentially applies to ensure that unearned income derived by children under 18 years of age in excess of $416 is taxed at the highest marginal rate. Where a benefit is paid from a scholarship plan to, or on behalf of, a nominated student under 18 years of age, the amount of the benefit included in assessable income is subject to Division 6AA.

3.34 If a nominated student does not qualify for benefits under a scholarship plan because he or she does not proceed to the specified level of education and some or all of the benefits accrued under the plan are paid back to the investor, the benefits under the plan are not applied for the specified purpose. In these circumstances, the life insurance policy will not qualify as a scholarship plan and benefits paid under the policy will be taxed under section 26AH of the ITAA 1936 as ordinary life insurance investment policy bonuses. That is:

•

for plans held for 8 years or less, recipients will include bonuses in assessable income and receive a 30% rebate;

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for plans held for 9 years, recipients will include two-thirds of the bonuses in assessable income and receive a 30% rebate in respect of the two-thirds taxable portion;

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for plans held for 10 years, recipients will include one-third of the bonuses in assessable income and receive a 30% rebate in respect of the one-third taxable portion; and

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for plans held for more than 10 years, recipients will be exempt from tax on bonuses paid on the policy.

Application and transitional provisions

3.35 The amendments apply from 1 January 2003. [Schedule 3, items 2, 6, 11 and 13]

Consequential amendments

Deductibility of claims paid

3.36 Section 320-80 of the ITAA 1997 allows life insurance companies (including friendly societies) a deduction for the risk component of claims paid under life insurance policies. Subsection 320-80(3) prevents life insurance companies from claiming a deduction for any other component of claims paid under life insurance policies.

3.37 Special purpose investment products of friendly societies qualify as life insurance policies. Therefore, consequential amendments will ensure that subsection 320-80(3) does not prevent friendly societies from claiming a deduction for benefits paid from special purpose investment products. [Schedule 3, items 4 and 5, subsections 320-110(2), 320-111(2) and 320-112(4)]

Guide material in the ITAA 1997

3.38 Section 10-5 contains a list of provisions about assessable income to assist users to find relevant sections of the income tax law. Consequential amendments will add references to section 15-55 and section 15-60 to that list of provisions. [Schedule 3, items 8 and 9, section 10-5]

Regulation impact statement

Background

3.39 Currently, friendly societies are generally exempt from tax on amounts attributable to special purpose investment products - that is, income bonds, scholarship plans and funeral policies.

3.40 The Review of Business Taxation recommended that, to ensure comparable tax treatment with other investment products, the current exemption applying to special purpose investment products issued by friendly societies be removed. To avoid double taxation, the Review of Business Taxation also recommended that an imputation system apply to benefits paid from these products.

3.41 Consistent with this recommendation, the current exemption applying to special purpose investment products issued by friendly societies has been removed from 1 January 2003. However, following concerns raised by industry about applying the imputation system to benefits paid from these products, the Government considered alternative options.

Policy objective

3.42 The policy objective is to ensure that there is no double taxation as a result of the removal of the friendly societies' tax exemption (i.e. to ensure that tax is not payable by both friendly societies and benefit recipients).

Implementation options

3.43 Two implementation options were considered.

3.44 Option 1 allows friendly societies a deduction for investment income paid or credited to special purpose investment products issued on or after 1 January 2003 and to scholarship plans issued before 1 January 2003 where the amounts that are attributable to those plans are not currently exempt from tax.

3.45 Holders of income bonds will continue to include investment income credited in their assessable income.

3.46 Where a nominated student qualifies for benefits under a scholarship plan, the student will include investment income paid under the plan in assessable income. Where a nominated student does not qualify for benefits under a scholarship plan, the policy will be treated for taxation purposes as an ordinary life insurance policy. Amounts paid in these circumstances will be taxed as follows:

•

for policies held for 8 years or less, recipients will include bonuses in assessable income and receive a 30% rebate;

•

for policies held for 9 years, recipients will include two-thirds of the bonuses in assessable income and receive a 30% rebate in respect of the two-thirds taxable portion;

•

for policies held for 10 years, recipients will include one-third of the bonuses in assessable income and receive a 30% rebate in respect of the one-third taxable portion; and

•

for policies held for more than 10 years, recipients are exempt from tax on bonuses paid on the policy.

3.47 If the recipient of the proceeds of a funeral policy is the trustee of the policyholder's estate, the trustee will be assessable on the investment return at the time of receipt. If the recipient is a funeral director, the whole of the proceeds (i.e. the capital and the investment component) will be included in the funeral director's assessable income.

3.48 Under option 2, the proposals recommended by the Review of Business Taxation would be implemented. That is, from 1 January 2003 friendly societies would maintain a separate franking account for special investment products that are subject to the new tax treatment. They would:

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credit this account with the amount of tax they pay on investment income received on or after 1 January 2003 that is attributable to these products; and

•

debit this account and attach refundable imputation credits when they credit or pay this investment income to recipients.

3.49 Recipients would include the investment income, grossed-up by imputation credits, in assessable income when the income is credited or paid. Tax payable by recipients would be partly or fully offset by refundable imputation credits attached to the investment income depending on the marginal tax rate of the recipients.

Assessment of impacts

Impact group identification

3.50 The proposals will impact on friendly societies that offer special investment products, financial planners, income bond holders, students nominated under a scholarship plan, funeral directors, trustees of deceased estates and the ATO.

Analysis of costs / benefits

Option 1

Compliance costs

3.51 The compliance costs associated with this option would be minimal. Friendly societies will need to make minor system changes to allow deductions for investment income when they are paid or credited to recipients of affected policies.

3.52 In addition, because the Government previously announced that option 2 would apply to these products, friendly societies will incur some compliance costs notifying recipients of the changes to the taxation treatment of their product.

3.53 In relation to financial planners, income bond holders, recipients of scholarship plans and funeral policies, this option generally represents a continuance of the current taxation treatment.

Administrative costs

3.54 The administration costs for the ATO would be minimal. In addition, legislation to implement this option would be relatively simple.

Government revenue

3.55 Friendly societies will pay tax on investment income in relation to these products in the year it is derived but may not get a deduction until it is paid or credited to recipients in a later year. Consequently, there will be a small, unquantifiable bring forward of revenue.

Option 2

Compliance costs

3.56 Compliance costs associated with this option would be substantially higher than under option 1.

3.57 Friendly societies would have to develop new systems to set up and maintain franking accounts and run a significant education program to ensure financial planners and recipients were aware of the changes.

3.58 Friendly societies would also incur additional on-going costs tracking tax paid on investment income that relates to affected products and passing the appropriate amount of franking credits to recipients. In addition, because the taxation treatment under this option is complex, both friendly societies and financial planners would receive and need to respond to more requests for advice than under option 1.

3.59 In relation to income bond holders, recipients of scholarship plans and funeral policies, this option involves significant change to the current taxation treatment and would be more difficult to explain and understand. Recipients would also incur additional on-going costs to comply with their tax obligations. Low marginal rate taxpayers would need to apply to the ATO for a refund of excess imputation credits.

Administrative costs

3.60 The administration costs for the ATO would be substantially higher under this option. The ATO would need to run a significant education program to ensure friendly societies, financial planners, recipients and tax agents were aware of the changes. In addition, because the taxation treatment under this option is complex, the ATO would receive and need to respond to more requests for advice than under option 1.

3.61 Legislation to implement this option would be substantially more complex compared to option 1 as significant changes would need to be made to the existing imputation provisions. For example, new provisions would be needed to allow friendly societies to retain and allocate franking credits to affected products. In addition, additional provisions would be needed to apply the imputation system to recipients.

Government revenue

3.62 The revenue impact of this option is the same as under option 1.

Consultation

3.63 The Australian Friendly Societies Association and affected friendly societies have been consulted in relation to the changes to the taxation treatment of special purpose investment products. The parties consulted unanimously agreed that the costs involved in complying with option 2 would be significant and that option 2 would be substantially more complex and difficult to understand than option 1.

Conclusion and recommended option

3.64 Option 1 is clearly the preferred option for implementing this measure. This option would be significantly easier for friendly societies and recipients to comply with and for the ATO to administer. Both compliance costs and administration costs are minimal compared to option 2.