House of Representatives

Explanatory Memorandum

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

Chapter 2 - Changes to the controlled foreign companies rules

Outline of chapter

2.1 Schedule 2 to this Bill contains changes to:

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the definition of 'commencing day' as that term is used in the controlled foreign companies rules

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attribution of income under the controlled foreign companies rules when a country is listed as a 'listed country', and

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the definition of 'adjusted distributable profits' for the purpose of attribution under the controlled foreign companies rules when a controlled foreign company changes its residence from an 'unlisted country' to a listed country or Australia.

2.2 Unless otherwise stated, all legislative references are to the Income Tax Assessment Act 1936.

Context of amendments

Commencing day

2.3 The decision to change the definition of commencing day is part of the Government's response to the Board of Taxation's report to the Treasurer on international taxation.

2.4 The definition of commencing day determines the period of time over which capital gains and capital losses on assets without the necessary connection with Australia, that are owned by controlled foreign companies, are calculated.

2.5 The current definition means that, where an Australian taxpayer acquires an interest in a foreign company which has not been controlled from Australia, it cannot make the reasonable assumption that Australian tax will not subsequently be payable on gains which have accrued prior to the time of acquisition by the Australian taxpayer. The definition of commencing day will be changed so that this assumption can be made in these circumstances.

2.6 This amendment will reduce compliance costs associated with acquisitions of overseas groups and restructuring of overseas operations.

Consequences of changing an unlisted country to a listed country under the controlled foreign companies rules

2.7 The decision to change the consequences of a controlled foreign company's country of residence becoming a listed country also arises out of the Government's response to the Board of Taxation's report to the Treasurer on international taxation. This measure is a part of the Government's decision to consider further countries for addition to the listed country list, together with other changes to the law resulting from the Government's response to the Board of Taxation's report.

2.8 Currently, where a controlled foreign company's country of residence is listed as a listed country, attribution of income may occur as a result of that listing if the controlled foreign company was a resident of the country for less than three years prior to the time of residency change. This measure removes the three year requirement, as attribution in this case is no longer appropriate in light of the expansion of the income tax exemption under section 23AJ.

2.9 These amendments will enable further countries to be added to the listed country list without inappropriate consequences.

Adjusted distributable profits

2.10 The decision to change the definition of 'adjusted distributable profits' is intended to ensure that amendments made in the New International Tax Arrangements (Participation Exemption and Other Measures) Act 2004 (NITA Act 2004) have their intended effect.

Summary of new law

Commencing day

2.11 The current definition of commencing day determines the commencing day largely by reference to the date that the eligible controlled foreign company becomes a controlled foreign company. The new definition will mean that the commencing day will instead be largely determined by reference to when there is an attributable taxpayer with a positive attribution percentage in relation to the controlled foreign company.

2.12 In addition the amendments will ensure that, for the purposes of determining the commencing day, an attributable taxpayer can ignore time before the most recent period during which there was no attributable taxpayer with a positive attribution interest in relation to the controlled foreign company.

Consequences of changing an unlisted country to a listed country under the controlled foreign companies rules

2.13 Items 1 to 4 and 9 of Schedule 2 ensure that attribution no longer occurs solely because an unlisted country controlled foreign company becomes a listed country controlled foreign company due to its country of residence being listed.

Adjusted distributable profits

2.14 The change to the definition of adjusted distributable profits will ensure that adjusted distributable profits of previous statutory accounting periods are ignored. This is consistent with the intent underlying the NITA Act 2004.

Comparison of key features of new law and current law

Detailed explanation of new law

Commencing day

2.15 Division 7, Subdivision C of Part X contains modifications to Australia's CGT rules. Amongst other things, these aim to exclude any capital gain or capital loss on assets without the necessary connection with Australia that accrued before either the commencement of the controlled foreign companies rules (30 June 1990), or the date that the company became a controlled foreign company (whichever is later). This date is known as the commencing day. These gains or losses should not be attributed because they either relate to a time that the controlled foreign companies rules did not exist (pre-30 June 1990) or when the company was not in Australia's tax net (which a company supposedly is when it is a controlled foreign company).

2.16 To achieve this, Subdivision C treats a controlled foreign company that owned assets at the end of the commencing day, as having acquired those assets on that day for market value. Further, under section 408A capital losses that arose from CGT events before the end of the commencing day cannot be carried forward.

2.17 There are times, however, when a company becomes a controlled foreign company but the company is not in Australia's tax net. This can arise when Australian residents have foreign associates through which they are taken to be able to exert control upon a foreign company, but do not have any direct or indirect interest in the foreign company.

Example 2.1

ForCo Ltd, a non-resident company wholly-owned by non-residents, has two subsidiaries - AusCo Pty Ltd, an Australian resident company, and CFC Ltd, a non-resident company. Because ForCo Ltd is an associate of AusCo Pty Ltd, CFC Ltd is a controlled foreign company because AusCo Pty Ltd is taken to be able to control it through its relationship with ForCo Ltd. This is despite AusCo Pty Ltd (or any other Australian resident) having no attribution percentage in relation to CFC Ltd, and therefore no possibility of any income being attributable in respect of CFC Ltd's activities.

2.18 This causes a problem where some time after the foreign entity becomes a controlled foreign company, an Australian resident obtains a direct or indirect interest in the foreign entity. If the foreign entity then derives a capital gain or capital loss from selling a relevant asset, the asset's cost base is not its market value at the time the Australian resident obtained the direct or indirect interest in the foreign entity (being the time the controlled foreign company has substantively entered into the Australian tax net). Instead, the cost base is that at the time the foreign entity originally became a controlled foreign company. This inappropriately leads to a capital gain or capital loss being included in attributable income that may have accrued during a time when there was no Australian resident with a direct or indirect interest in the controlled foreign company.

2.19 Further, there are situations where a company that was a controlled foreign company, is no longer a controlled foreign company. Where a subsequent Australian resident obtains control of the company (and the company again becomes a controlled foreign company), taxation of gains that accrued while the company was not in the CGT net can arise. This gives rise to problems when Australians conduct due diligence processes whilst acquiring a foreign company - the due diligence process has to discover whether, in the history of the company since 30 June 1990, there was technically any Australian control of the company. This can be an onerous process.

2.20 Item 5 of Schedule 2 to this Bill will change the meaning of commencing day in section 406 of Part X so that:

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instead of the time an eligible controlled foreign company became a controlled foreign company being used to identify the commencing day, the time that there was no attributable taxpayer with a positive attribution percentage in relation to the controlled foreign company will be used, and

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periods of time before the most recent time during which there was not an attributable taxpayer with a positive attribution percentage in relation to the controlled foreign company will be ignored in determining the commencing day.

Example 2.2

Robert purchased all of the shares in Graz Inc at 3.00 pm on 20 October 2004. At the time of purchase there were no other attributable taxpayers. Upon purchase of the shares, Graz Inc becomes a controlled foreign company. From 30 June to 1 April 2002, Graz Inc was a controlled foreign company.

The 'last day of the most recent period during which there was not an attributable taxpayer with an attribution percentage (greater than nil)' is 20 October 2004. This is because up to 3.00 pm on that day, there was no such attributable taxpayer in relation to Graz Inc. Because this is later than 30 June 1990, the commencing day is 20 October 2004.

The period of time from 30 June to 1 April 2002 is not relevant in determining the commencing day, because it is before the 'most recent period during which there was not an attributable taxpayer with an attribution percentage (greater than nil)'.

2.21 Section 408A will continue to, in effect, appropriately deny the carry-forward of capital losses that relate to CGT events that occurred prior to the commencing day.

Consequences of changing an unlisted country to a listed country under the controlled foreign companies rules

2.22 Where a controlled foreign company's country of residence goes from being an unlisted country to being a listed country, section 457 only operates to attribute income if the controlled foreign company was a resident of that unlisted country for less than three years prior to the time of residency change (subsection 457(3)). The income attributed in that case is not intended to include all adjusted distributable profits as unrealised gains on tainted assets are intended to be excluded and then taxed subsequently under paragraphs 385(2)(e) and 384(2)(e).

2.23 The NITA Act 2004 has resulted in the three categories of countries (broad-exemption listed countries, limited-exemption listed countries, and unlisted countries) being narrowed to two (unlisted and listed countries). Broad-exemption listed countries are now known as listed countries (a term that previously included limited-exemption listed countries in its meaning) while unlisted countries and limited-exemption listed countries are now unlisted countries. As a consequence, section 384, which was important in determining the assessable income of an unlisted country or limited exemption listed country controlled foreign company now only applies to unlisted country controlled foreign companies; and section 385 which applied to broad-exemption listed country controlled foreign companies now applies to listed country controlled foreign companies.

2.24 Paragraph 384(2)(e) therefore now only has application to a controlled foreign company that was resident of an unlisted country that became a limited-exemption listed country (eg Argentina in 2000). Following the NITA Act 2004, this paragraph prima facie covers cases where an unlisted country becomes an unlisted country - it therefore no longer has any apparent use. Therefore the use of paragraph 384(2)(e) is only relevant for past cases where the relevant change occurred when the limited-exemption listed country term still applied. In such cases, paragraph 384(2)(e) has the consequence that where a relevant controlled foreign company sells an untainted asset (tainted assets would be subject to attribution under paragraph 384(2)(a)) that it held at residence change time, then any gain is attributable. The underlying rationale for such an outcome would be in respect of maintaining the quarantining of section 23AJ to only limited-exemption listed countries or broad-exemption listed countries.

2.25 Previously, when a controlled foreign company in a listed country sold an untainted asset and paid a non-portfolio dividend to the parent in Australia, section 23AJ would exempt the payment from tax as it exempted non-portfolio dividends from listed countries (at the time, broad-exemption listed countries and limited-exemption listed countries). As a result of the NITA Act 2004, the exemption has been extended to all non-portfolio dividends whether they come from an unlisted country or a listed country. As a result, when a controlled foreign company from any country sells an untainted asset and pays non-portfolio dividends to its parent in Australia, section 23AJ will exempt these. Paragraph 384(2)(e)'s attribution of any gains from selling an untainted asset is therefore no longer justified.

2.26 In contrast to paragraph 384(2)(e), paragraph 385(2)(e) has an ongoing role in respect of future listed country additions (putting aside the technical error in paragraph 457(3)(d) that currently renders it redundant). However, controlled foreign companies located in listed countries are generally only attributed on the tainted income that is eligible designated concession income. Eligible designated concession income is income that is specified in regulations as having received concessional tax treatment in the listed country. However in paragraph 385(2)(e) cases, attribution will occur in respect of realised gains on tainted assets, even when they are not eligible designated concession income. It is difficult to see the rationale for this outcome. If gains on such assets are taxed concessionally, they should be eligible designated concession income. If not, then the intention of listed country status is to reduce compliance costs for taxpayers in respect of sufficiently comparably-taxed amounts by removing them from attribution.

2.27 The current operation of section 457 in these circumstances is no longer justified given the extension of section 23AJ (as discussed above) to all countries, listed or unlisted.

Removing attribution when a country is listed

2.28 This measure provides an exemption from section 457 where an unlisted country controlled foreign company becomes a listed country controlled foreign company due to its country of residence being listed, without a three year prior-residence requirement. Also, there is no attribution under paragraphs 385(2)(e) and 384(2)(e) as these have been repealed.

2.29 In a general sense, the changes ensure:

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that under the controlled foreign companies rules, no inappropriate consequences to taxpayers (under sections 384, 385, and 457) arise from a country becoming, or having become, a listed country, and

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that there is consistency with the policy behind the expansion of section 23AJ.

Adjusted distributable profits

2.30 Section 457 is currently intended to attribute tainted income that relates to the period from the end of the most recent statutory accounting period to the time the company changed residence. Also, any unrealised gain on 'tainted assets' (assets whose gains and losses are potentially subject to attribution) is also generally attributed by section 457 at that time.

2.31 The definition of adjusted distributable profits substituted by the NITA Act 2004, however, did not ignore previous statutory accounting periods. Hence, adjusted tainted income from previous periods (that will have already been attributed to taxpayers under section 456) is arguably part of adjusted distributable profits, and so attributable again under section 457.

2.32 Items 6 to 8 and 10 of Schedule 2 change the definition of adjusted distributable profits to ignore previous statutory accounting periods. However, in calculating the unrealised gains on tainted assets held by the controlled foreign company at the time it changed residence, previous statutory accounting periods remain relevant.

2.33 For tainted income that consists of the proceeds of the disposal of an asset, it is intended that the cost of the asset is included in the profit calculation by virtue of clauses such as (a)(iii) and (b)(ii).

Application and transitional provisions

Commencing day

2.34 The new definition of commencing day will, for most purposes, apply to CGT events occurring on or after the 1 July that next occurs after Royal Assent. For the purposes of determining whether carried forward losses relating to CGT events or disposals occurring before a commencing day as determined under this new definition are available, the new definition will apply to statutory accounting periods starting on or after Royal Assent.

2.35 The above application date is intended to ensure that section 408A applies appropriately, that is, to not allow net capital losses that arose before the commencing day as determined under the proposed definition of commencing day. However, the application date is not intended to require taxpayers to recalculate net capital losses or net capital gains that arise as a result of a different commencing day as determined under the proposed definition.

Consequences of changing an unlisted country to a listed country under the controlled foreign companies rules

2.36 The removal of inappropriate consequences that follow listing of a country will apply from the day after this Bill receives Royal Assent.

Adjusted distributable profits

2.37 The correction of the deficiency relating to the attribution of prior statutory accounting periods' adjusted distributable profits is to apply for income years and statutory accounting periods starting on or after 1 July 2004.

2.38 The new definition is intended to align with the changes made to section 457 by the NITA Act 2004. These latter changes were meant to apply for income years and statutory accounting periods on or after 1 July 2004.