House of Representatives

Explanatory Memorandum

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

Chapter 2 - International shipping and airline profits

Outline of chapter

2.1 Schedule 2 to this Bill corrects an unintended outcome resulting from recent changes to the tax laws that expanded the foreign branch income exemption. In summary, the correction ensures that an Australian company continues to include in its assessable income, foreign branch income and capital gains derived from the operation of ships or aircraft in international traffic.

Context of amendments

2.2 The exemptions for foreign branch profits and non-portfolio dividends were expanded by the New International Tax Arrangements (Participation Exemption and Other Measures) Act 2004. An unintended outcome of this expansion was that foreign branch profits derived by an Australian company from the operation of ships or aircraft in international traffic would not be taxed in Australia or the country in which the company operates.

2.3 Australia has exclusive rights under most of its tax treaties to tax an Australian company's foreign branch profits from the operation of ships or aircraft in international traffic. This is different to the tax treatment of other business profits derived through a foreign branch. The different tax treatment for those profits reflects the practical difficulties in allocating the income and expenses between countries in determining the profits from the operation of ships or aircraft in international traffic. The expansion to the foreign branch profits exemption meant that Australia would not tax those profits derived through foreign branches in treaty countries.

2.4 The amendment to section 23AH reinstates the way Australian companies, with certain types of foreign branch profits, were taxed prior to the implementation of the New International Tax Arrangements (Participation Exemption and Other Measures) Act 2004. This avoids the unintended effect of income and capital gains from the operation of ships or aircraft in international traffic from not being taxed in Australia or by the country in which the company operates.

Summary of new law

2.5 The amendment in Schedule 2 to this Bill ensures that certain foreign branch income and capital gains of an Australian company are included in its assessable income. This is implemented through a change to the foreign branch income exemption in section 23AH of the Income Tax Assessment Act 1936 (ITAA 1936).

2.6 The change to the foreign branch income exemption means the exemption does not apply to foreign branch income and capital gains from the operation of ships or aircraft in international traffic. This means that such amounts will be included in an Australian company's assessable income. This outcome supports Australian tax treaty policy on the taxation of profits from the operation of ships or aircraft in international traffic. Most of Australia's tax treaties provide exclusive taxing rights to Australia over such income if it is derived by Australian companies through foreign branches in the treaty country.

Comparison of key features of new law and current law

Detailed explanation of new law

2.7 An exemption is provided to Australian companies under section 23AH of the ITAA 1936 for most income and capital gains derived from an active business, through a permanent establishment (foreign branch) in a foreign country. Those amounts may be derived directly or indirectly and are treated as non-assessable non-exempt income. However, the amendment to section 23AH results in an exclusion from the exemption for income and capital gains from the operation of ships or aircraft in international traffic derived by an Australian company through a foreign branch. This means such amounts continue to be included in the Australian company's assessable income. [Schedule 2, item 2, paragraph 23AH(14A)(a)]

2.8 The amendment to section 23AH preserves the way some Australian companies with foreign branches were taxed prior to the implementation of the New International Tax Arrangements (Participation Exemption and Other Measures) Act 2004. That Act applied to income years starting on or after 1 July 2004. This amendment will also apply from that time to ensure that income and capital gains derived by an Australian company from the operation of ships or aircraft in international traffic through a foreign branch do not escape taxation. [Schedule 2, item 3]

2.9 The amendment to section 23AH does not affect compliance costs for an Australian company. The company will continue to allocate its expenses from operating ships or aircraft in international traffic in the way it did before the operation of the expanded foreign branch income exemption.

2.10 The amendment applies to the income and capital gains derived through foreign branches in all foreign countries. That is, there is no distinction between listed and unlisted countries, treaty or non-treaty countries or whether or not tax was paid on the amounts in any foreign country. The Australian company may be entitled to foreign tax credits under section 160AF of the ITAA 1936 for foreign tax paid.

Operation of ships or aircraft in international traffic

2.11 The foreign branch income exemption does not apply to an Australian company that derives foreign branch income and capital gains from the operation of ships or aircraft in international traffic. [Schedule 2, item 2, paragraph 23AH(14A)(a)]

2.12 The phrase 'operation of ships or aircraft in international traffic' is incorporated into most of Australia's tax treaties. The phrase is used in Article 8 of Australia's treaties, and also in Article 13 where treaties were negotiated after the introduction of tax on capital gains. The purpose of those Articles is to allocate the right to tax income and capital gains from the operation of ships or aircraft in international traffic. Australia has the exclusive taxing right, under those Articles, to tax those amounts when they are derived by an Australian resident company.

2.13 In Australia's tax treaties, there is a separate and different tax treatment for the foreign branch amounts from the operation of ships or aircraft in international traffic and from the operation of other types of businesses. The different treatment is because of the practical difficulties in allocating the income and expenses between treaty countries in determining the profits from the operation of ships or aircraft in international traffic.

2.14 The definition of 'operation of ships or aircraft in international traffic' is based on concepts in Australia's tax treaties. The meaning of 'international traffic' is the important part of that phrase. An Australian company operates a ship or aircraft in international traffic if the company transports passengers or goods by ship or aircraft from one place in a particular country to a place in a different country [Schedule 2, item 2, subsection 23AH(14B)]. A ship or aircraft that is used to transport passengers or goods solely between places within a particular country (including Australia) does not constitute the operation of a ship or aircraft in international traffic.

Example 2.1

Aust Co is an airline company with a foreign branch that conducts operations in New Zealand. Aust Co provides transport for passengers both domestically and internationally. During the Rugby World Cup, Aust Co's foreign branch in New Zealand offers special flights departing from Auckland and Wellington and arriving in Sydney. The flight departing from Wellington stops in Auckland before continuing on to Sydney.

Sharon, a New Zealand resident, purchases a ticket from the New Zealand airline office and travels from Wellington to Auckland and then on to Sydney. Sharon does not stop off at Auckland which means the entire trip (including the Wellington to Auckland leg) is classed as an international flight.

Belinda, also a New Zealand resident, purchases a ticket from the New Zealand airline office for travel from Wellington to Auckland and on to Sydney. Upon arrival in Auckland, Belinda attends a business meeting. Belinda then resumes her trip to Sydney. In this situation, only the Auckland to Sydney leg of the trip is treated as an international flight.

Aust Co will include in its assessable income the whole amount from Sharon's ticket but will only include the amount that related to the Auckland to Sydney leg for Belinda's ticket.

Things ancillary to the operation of ships and aircraft

2.15 An Australian company may derive foreign branch income and capital gains from activities other than from the direct transport of passengers or goods by ships or aircraft. Activities that are closely related to but form a minor part of the operations of ships or aircraft in international traffic are things that are ancillary to those operations. Income and capital gains from ancillary operations through a foreign branch are also excluded from the foreign branch income exemption. [Schedule 2, item 2, paragraph 23AH(14A)(b)]

2.16 Income and capital gains derived by an Australian company from leasing a ship or aircraft fully equipped, crewed and supplied are treated in the same way as income and gains from transporting passengers and goods. That is, such amounts of income and capital gains derived by an Australian company through a foreign branch will be excluded from the foreign branch income exemption [Schedule 2, item 2, paragraph 23AH(14A)(a)]. An Australian company would include those amounts in its assessable income.

2.17 Income and capital gains from the lease of a ship or aircraft on a dry lease or bare boat charter basis through a foreign branch will often be treated under the business profits article of an Australian tax treaty. However, where those leases are a very minor part of the operation of ships or aircraft or an occasional source of income, they are ancillary operations. The income and capital gains from those ancillary operations through a foreign branch are excluded from the foreign branch income exemption. Consequently, those amounts are included in an Australian company's assessable income.

Example 2.2

Aust Co is an Australian airline company that transports passengers and goods internationally. Aust Co's foreign branch in India has excess aeroplanes for its current operations. The foreign branch uses its aeroplanes to fly passengers and goods from India to other countries in the region. The foreign branch leases five aeroplanes (five per cent of the foreign branch's fleet) to Aparna Co (a foreign company) for a period of three months. There are two lease agreements. One agreement is for three aeroplanes to be leased without crew or other supporting services (on a dry lease). The other two aeroplanes are leased fully crewed (on a wet lease).

The foreign branch income and capital gains derived under both lease agreements will be included in Aust Co's assessable income as the leases are ancillary to the main operations of the foreign branch.

2.18 An Australian company's income and capital gains from the transportation of passengers or goods by types of transport other than ships or aircraft may also be excluded from the foreign branch income exemption. This occurs where that transportation is connected and incidental to (ie is ancillary to) the operation of ships or aircraft in international traffic through a foreign branch. The income and capital gains from those ancillary operations will be included in the Australian company's assessable income. [Schedule 2, item 2, paragraph 23AH(14A)(b)]

Example 2.3

Aust Co is an airline company offering international and domestic flights through a foreign branch in Canada. In order to boost awareness in regional centres, Aust Co introduces a bus service connecting regional towns in Canada with its international airport terminal. The bus service provides access to and from the airport to the passengers of its international flights.

Income and capital gains from the operation of the bus service are regarded as ancillary to the operation of ships or aircraft in international traffic. Consequently, Aust Co will include those amounts in its assessable income.

2.19 Other things included in ancillary operations where those things relate to the operation of ships or aircraft in international traffic are:

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the sale of tickets at a foreign branch on behalf of other companies where that branch usually sells tickets for the transportation of passengers on ships or aircraft that it operates in international traffic

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advertising at a foreign branch

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the provisions of goods and

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the provisions of services by engineers, ground and equipment maintenance staff, cargo handlers, catering staff and customer services personnel.

Application and transitional provisions

2.20 The amendment to section 23AH of the ITAA 1936 in Schedule 2 to the Bill applies to income years starting on or after 1 July 2004 [Schedule 2, item 3]. The amendment has a retrospective application date so that it operates from the time the expanded foreign branch income exemption applied. The expanded foreign branch income exemption was implemented by the New International Tax Arrangements (Participation Exemption and Other Measures) Act 2004. It is necessary to have this amendment apply from the time the expanded foreign branch income exemption applied to ensure no unintended outcomes arise for some Australian companies following the application of that Act.

2.21 The amendment means that Australian companies will continue to be taxed on their foreign branch income from the operation of ships or aircraft in international traffic as they were before the expansion of the section 23AH exemption.