Senate

Revised Explanatory Memorandum

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

Chapter 6 - Imputation treatment of exempting entities

Outline of chapter

6.1 The Imputation Bill introduced into Parliament on 30 May 2002 contained core rules for the new simplified imputation system. As a result of the introduction of that bill, certain consequential amendments are required to other areas of the imputation system not covered by those rules. This bill provides consequential amendments to the provisions currently referred to in the taxation laws as the 'exempting and former exempting company provisions'. The amendments explained in this chapter are contained in Schedule 13 to this bill.

6.2 Broadly speaking, these provisions are concerned with limiting franking credits available for trading by:

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prescribing that franked distributions paid by corporate tax entities, which are effectively owned by non-residents or tax exempt entities, will provide franking benefits to members in limited circumstances only; and

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quarantining the franking surpluses of corporate tax entities which were formerly effectively owned by non-residents or tax exempt entities.

6.3 Non-residents and tax-exempt entities generally obtain less benefit from franking credits than other resident members. These provisions ensure that entities effectively owned by non-residents and tax-exempt entities cannot trade the benefits of the franking credits.

Summary of new law

6.4 As a result of the introduction of core rules for the new simplified imputation system, certain consequential amendments are needed to other areas of the imputation provisions, including the exempting and former exempting company provisions.

6.5 The consequential amendments will:

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update references and processes in the exempting and former exempting company provisions so that they are consistent with the new terms and processes introduced in the new simplified imputation system; and

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relocate the exempting and former exempting company provisions from the ITAA 1936 to the ITAA 1997 using clearer and more accessible drafting techniques developed in the tax law improvement project.

Application of exempting entity rules to consolidated groups

6.6 Further rules are to be introduced into the consolidations regime relating to the application of the exempting entity rules to consolidated groups.

6.7 These rules will allow for the pooling of exempting account surpluses of joining subsidiaries. The operation of the rules will be substantially similar to the franking credit pooling rules introduced in the Consolidation Bill on 16 May 2002 and will ensure that groups are able to pass on the benefit of pre-consolidation exempting credits of joining entities to eligible shareholders.

6.8 In addition, further rules will be introduced to test whether or not a consolidated group is an exempting entity or a former exempting entity as the case may be. Broadly speaking, the tests will apply in a manner consistent with the exempting entity provisions introduced in this bill. These rules will ensure that franking benefits arise for the group's shareholders only in appropriate circumstances.

Detailed explanation of new law

Scheme of the legislation

6.9 The legislation, broadly speaking, works as follows:

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first, it defines the types of taxpayer who have no, or a very limited, use for franking credits - these are called prescribed persons (essentially non-residents and tax-exempt entities). Prescribed persons are defined in a way which includes the entities through which persons, who ultimately have no or little use for franking benefits, hold their interests in the original corporate tax entity as well those persons themselves;

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next, the legislation defines what types of interests in entities count in working out who owns a true interest in an entity - these are called accountable interests ; and

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finally, it defines when an entity is effectively owned by prescribed persons by testing whether prescribed persons own 95% or more of the accountable interests in the entity or, alternatively, substantially bear the risks and opportunities of owning the accountable interests in the entity.

6.10 Where a corporate tax entity is effectively owned by prescribed persons it is taken to be an exempting entity . Franked distributions made by exempting entities only confer limited benefits to recipients as follows:

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an exemption from dividend withholding tax for non-resident members;

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a tax offset entitlement for franked distributions made to members holding eligible employee shares, or other corporate tax entities in certain cases; and

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a franking credit arising in the franking account of a recipient exempting entity in certain cases.

6.11 Where an exempting entity ceases to be effectively owned by prescribed persons, it is taken to be a former exempting entity . In these cases the franking account is converted into an exempting account and the entity establishes a new franking account. The exempting account is then quarantined so that distributions franked with exempting credits only confer a franking benefit for eligible continuing substantial shareholders or members holding eligible employee shares.

Consequential amendments

6.12 The consequential amendments will update references and processes in the exempting and former exempting company provisions so that they are consistent with the new terms and processes introduced in the simplified imputation system. Broadly speaking, this will mean that references in the ITAA 1936 to the terms 'company', 'shareholder', and 'dividend' will be changed to 'corporate tax entity, 'member', and 'distribution' respectively. Furthermore, consistent with the rules that apply to ordinary companies, the franking and exempting account balances of exempting and former exempting entities will be maintained on a tax paid basis.

6.13 The amendments will also relocate the existing exempting and former exempting company provisions contained in the ITAA 1936 and insert them, in a rewritten form, into Division 208 of the ITAA 1997.

6.14 Table 6.1 provides references to which provisions in the ITAA 1997 replace the equivalent provisions in the ITAA 1936.

Table 6.1: Translation of the ITAA 1936 provisions into equivalent ITAA 1997 provisions

Application and transitional provisions

6.15 The exempting and former exempting company provisions contained in the ITAA 1936 cease to apply to events arising after 30 June 2002 [Schedule 3, item 1, section 160AOAA of the Imputation Bill] . The new exempting and former exempting entity provisions contained in the ITAA 1997 apply to events arising on or after 1 July 2002 [Schedule 1, item 1, section 201-5 of the Imputation Bill] .