House of Representatives

Explanatory Memorandum

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

Chapter 3 - Australian branches of foreign financial entities

Outline of chapter

3.1 Schedule 3 to this Bill extends the existing separate entity treatment under the taxation law, provided to Australian branches (permanent establishments) of foreign banks, to Australian branches of foreign financial institutions (entities). Separate entity treatment entails treating a branch as a separate legal entity from a parent company, as if it is a subsidiary. Extending separate entity treatment to Australian branches of foreign financial entities will improve competition within the financial services sector.

3.2 Unless otherwise stated, all legislative references are to the Income Tax Assessment Act 1997.

Context of amendments

3.3 The amendments are part of the Government's response to the Board of Taxation's report to the Treasurer on international taxation. They will foster competitive neutrality between Australian branches of foreign banks and financial entities (which often provide similar services) by providing a similar tax treatment. This measure, along with taxing dividends received by branches in Australia on an assessment basis (Chapter 1), are further steps in treating Australian branches and subsidiaries on a like basis.

3.4 As a general principle, a branch and its head office are part of the one legal person. Under the law generally, a legal person cannot enter into transactions with themself. This is known as the single entity approach. For income tax law purposes the trend in Australia, and internationally, is to treat branches as separate entities like subsidiaries. Australian branches of foreign banks are already treated as entities separate from the head office of the foreign bank under Part IIIB of the Income Tax Assessment Act 1936 (ITAA 1936), for thin capitalisation grouping purposes and under the transfer of loss provisions.

3.5 The separate entity treatment that is currently available to the branches of foreign banks will be extended to Australian branches of foreign financial entities. The amendments will provide a more consistent income tax treatment of Australian branches of foreign banks and foreign financial entities.

Summary of new law

3.6 This measure will amend the income tax law to provide limited separate entity treatment to Australian branches of foreign financial entities. Transactions between a branch and the relevant foreign financial entity will be recognised, a branch will be able to group with Australian subsidiaries of the foreign financial entity (or foreign bank within a wholly-owned group) and also transfer losses. Financial entities accessing separate entity treatment will be required to keep records by which they can separately account for money used in the activities of their branches in Australia. A similar condition is currently imposed on foreign banks with Australian branches.

3.7 The amendments to Part IIIB of the ITAA 1936 and the thin capitalisation grouping provisions will apply to income years starting on or after the date of Royal Assent. The transfer of loss provisions will apply in relation to losses of Australian branches of foreign financial entities, and of other relevant companies, for income years starting on or after the date of Royal Assent.

Comparison of key features of new law and current law

Detailed explanation of new law

Separate entity treatment for Australian branches of foreign banks

3.8 Presently, Australian branches of foreign banks receive limited separate entity treatment under Part IIIB of the ITAA 1936, which contains provisions assisting the calculation of taxable income derived by a foreign bank through an Australian branch. These provisions essentially recognise intra-bank transactions between the Australian branch of the foreign bank and the foreign bank itself.

3.9 Furthermore, Australian branches of foreign banks are also able to:

•

transfer losses to and from Australian companies of the same wholly-owned group (Division 170), and

•

group for thin capitalisation purposes with certain other Australian resident companies of the same wholly-owned group (Subdivision 820-FB).

Extending separate entity treatment to Australian branches of foreign financial entities

3.10 Branches of foreign financial entities, which will be able to access the limited separate entity treatment, are identified in the amendments as branches in Australia of foreign entities that are financial entities. The terms 'foreign entity' and 'financial entity' are defined by section 995-1. [Schedule 3, item 2, section 160ZZZK; item 7, note to subsection 170-5(2A); item 9, note to subsection 170-105(2A); item 17, subparagraphs 820-597(1)(c)(ii) and 820-599(1)(c)(ii)]

3.11 A foreign entity is an entity that is not an 'Australian entity'. An 'Australian entity' is, in effect, an Australian partnership or trust, or a resident company or individual (but not dual-residents). While an individual may be a foreign entity, they cannot be a financial entity as defined, and so cannot access this measure.

3.12 A financial entity encompasses entities operating within the financial services sector. To fall within this definition, Australian branches of foreign entities would need to provide financial services in Australia. This (implicit) requirement matches the requirement for Australian branches of foreign banks to fall within Part IIIB of the ITAA 1936 (see definition of 'Australian branch' in section 160ZZV of the ITAA 1936).

Extending Part IIIB to branches of foreign financial entities

3.13 The amendments will provide Australian branches of foreign financial entities separate entity treatment under Part IIIB of the ITAA 1936 on a similar basis as for Australian branches of foreign banks. [Schedule 3, item 1, note to subsection 160ZZVA(1); item 2, subsection 160ZZZK(3)]

3.14 Similarly, foreign financial entities will be treated in the same way as foreign banks [Schedule 3, item 1, note to subsection 160ZZVA(1); item 2, subsection 160ZZZK(2)]. For example, certain foreign banks have the option to opt out of Part IIIB for a year of income where the foreign bank is resident of a country with which Australia has a tax treaty (subsection 160ZZVB(2) of the ITAA 1936). This option will also be available to foreign financial entities.

Extending the transfer of loss provisions to branches of foreign financial entities

3.15 The transfer of loss provisions allow the losses of unprofitable company group members to be offset against the income of profitable group members. Since the inception of the consolidation regime (which generally achieves the same outcome by a different mechanism), these rules only apply in relation to Australian branches of foreign banks, as they cannot consolidate.

3.16 Loss transfers are allowed between the Australian branch of a foreign bank and:

•

the head company of a consolidated group or a multiple entry consolidated group (MEC group), or

•

a company which is not eligible to be a member of a consolidated group.

Both tax losses (Subdivision 170-A) and net capital losses (Subdivision 170-B) can be transferred.

3.17 The amendments will allow Australian branches of foreign financial entities, meeting the same conditions and requirements as for Australian branches of foreign banks, to transfer tax losses and net capital losses to and from relevant members of the same wholly-owned company groups. [Schedule 3, item 7, note to subsection 170-5(2A); item 8, section 170-75; item 9, note to subsection 170-105(2A); item 10, section 170-174]

3.18 Transfer of tax losses and net capital losses will also be possible between Australian branches (of foreign financial entities and foreign banks) within a wholly-owned company group. Two Australian branches have the potential to satisfy the conditions for the transfer, under the transfer of loss provisions, since one of the branches can qualify as either an Australian branch of a foreign bank, or a foreign financial entity, and the other cannot be a member of a consolidatable group. [Schedule 3, item 7, note to subsection 170-5(2A); item 9, note to subsection 170-105(2A)]

3.19 Under Division 170, losses are technically only transferable between resident companies of the same wholly-owned group. However, Part IIIB of the ITAA 1936 treats Australian branches of foreign banks as Australian residents for the purposes of Division 170 (sections 160ZZZG and 160ZZZH of the ITAA 1936). Hence, the amendments to Part IIIB (described above) are also needed to allow Division 170 to operate with respect to Australian branches of foreign financial entities.

Extending grouping for thin capitalisation purposes to Australian branches of foreign financial entities

Background

3.20 The thin capitalisation rules compare the level of debt and equity funding used to finance an entity's Australian operations. Where there is a relatively high level of debt funding of the Australian operations deductions in respect of debt are limited.

3.21 The thin capitalisation rules apply differently depending on whether an entity is:

•

an inward investing entity or an outward investing entity

•

a general entity or a financial entity, or

•

an authorised deposit-taking institution.

3.22 Where an entity is both an inward and outward investing entity, the general classification scheme operates to give priority to the outward investor rules. Where a group consists of a combination of general, financial and authorised deposit-taking institution entities, the authorised deposit-taking institution rules take precedence. Authorised deposit-taking institutions are essentially banks. If the group consists of general and financial entities, but no authorised deposit-taking institution entities, then the financial entity rules apply.

Grouping of Australian branches of foreign banks

3.23 The head company of a consolidated group or MEC group may make a choice to treat an Australian branch of a foreign bank as part of itself for purposes of the application of the thin capitalisation rules, subject to certain conditions (section 820-597). A single company that is an Australian entity, and not part of a consolidated group, consolidatable group or a MEC group, may make a similar choice (section 820-599). Hence, Australian branches of foreign banks can be grouped with wholly-owned Australian subsidiaries of the same foreign bank group when determining the thin capitalisation positions of both the branches and the subsidiaries.

Grouping of Australian branches of foreign financial entities

3.24 Grouping for thin capitalisation purposes will be extended to Australian branches of foreign financial entities. Sections 820-597 and 820-599 are rewritten to apply to foreign financial entities as well as foreign banks within a wholly-owned group that operates in Australia using branches and subsidiaries. Therefore, a relevant head company of a consolidated group or MEC group, or a relevant single company which cannot consolidate, will be able to treat an Australian branch of a foreign bank, or a foreign financial entity, as part of itself for thin capitalisation purposes. This will allow Australian branches of foreign banks, and foreign financial entities, to be grouped with wholly-owned Australian subsidiaries of the foreign parent in determining the thin capitalisation positions of both the branches and subsidiaries. [Schedule 3, item 17, sections 820-597 and 820-599]

3.25 As part of rewriting sections 820-597 and 820-599, the term 'establishment entity' refers to the foreign bank or the foreign financial entity that established an Australian branch or branches [Schedule 3, item 17, paragraphs 820-597(1)(c) and 820-599(1)(c)]. A head company or single company will not be required to group all of the Australian branches within a wholly-owned group [Schedule 3, item 17, subsections 820-597(3) and 820-599(3)]. However, if a head company or single company makes a choice to treat one of the Australian branches, of an establishment entity, as part of itself for the grouping period, it must also make that choice in respect of all of the Australian branches of that establishment entity [Schedule 3, item 17, subsections 820-597(2) and 820-599(2)]. See Example 3.1.

Example 3.1

US Securities (1), US Securities (2) and US Bank, and their respective branches and subsidiaries, are part of the same wholly-owned group. US Bank Subsidiary is a single Australian resident company which cannot consolidate. Under the new section 820-599, US Bank Subsidiary could make a choice to group with:

(a)

both the US Securities (1) Branches

(b)

both the US Securities (2) Branches

(c)

US Bank Branch, or

(d)

any or all of (a) to (c).

US Bank Subsidiary does not have to make a choice to treat all the Australian branches (of US Bank, US Securities (1) and US Securities (2)) as part of itself for the grouping period.

Once US Bank Subsidiary makes a choice to treat one of the Australian branches of an establishment entity as part of itself for the grouping period, it must choose to group all of the branches of that establishment entity. That is, once US Bank Subsidiary makes a choice to group one of the US Securities (2) Branches, it must choose to group all of US Securities (2) Branches. If US Bank Subsidiary does not choose to group any of US Securities (2) Branches, but one of the US Securities (1) Branches, it must choose to group all of US Securities (1) Branches.

Consequences of grouping

3.26 The consequences of making a choice to group under sections 820-597 and 820-599 are set out in sections 820-601 to 820-617. The rules which follow from the making of the choice will be extended to Australian branches of foreign financial entities. [Schedule 3, items 18 to 21 and 23 to 26]

3.27 The rules set out the effect of making a choice to group Australian branches, of foreign financial entities or foreign banks, on the classification of the head company or single company (section 820-609). The appropriate thin capitalisation rules that will apply to the head company or single resident company depend upon the classification given to the head company or single company based on the general classification scheme described in paragraphs 3.21 and 3.22.

3.28 If a single company prior to grouping with an Australian branch, of a foreign financial entity or foreign bank, was both an inward investment vehicle (general or financial) and an outward investor (financial or general), then the outward investing entity rules will apply. [Schedule 3, item 27, paragraph 820-609(4)(a) and subsection 820-609(6)]

Thin capitalisation classifications - authorised deposit-taking institution

3.29 The amendments will retain the current classifications in cases involving banks only. Where an Australian branch of a foreign financial entity is grouped with an authorised deposit-taking institution group, the authorised deposit-taking institution rules will take precedence.

3.30 If the head company or single company, prior to the inclusion of an Australian branch of a foreign financial entity or foreign bank, was an outward investing entity (authorised deposit-taking institution), the head company or single company will remain an outward investing entity (authorised deposit-taking institution) [Schedule 3, item 27, paragraph 820-609(1)(a)]. An inward investing entity (authorised deposit-taking institution) is a foreign bank that carries on banking business in Australia through a branch. Under Subdivision 820-FB, an Australian branch can only be grouped with a company. Therefore, the classification scheme does not cater for grouping of Australian branches without the presence of an Australian company.

3.31 Where an Australian branch of a foreign bank is grouped with a financial entity group, the authorised deposit-taking institution rules will take precedence. If the head company or single company, prior to the inclusion of an Australian branch of a foreign bank, was an outward investing entity (non-authorised deposit-taking institution) and an outward investor (general or financial), the head company or single company will be an outward investing entity (authorised deposit-taking institution). [Schedule 3, item 27, paragraph 820-609(1)(b)]

3.32 If the head company or single company, prior to the inclusion of an Australian branch of a foreign bank, was an inward investment vehicle (general or financial), the head company or single company will be an inward investing entity (authorised deposit-taking institution). [Schedule 3, item 27, subsection 820-609(4)]

3.33 If the single company was a foreign controlled Australian authorised deposit-taking institution exempt from the thin capitalisation regime prior to the inclusion of an Australian branch of a foreign financial entity or foreign bank, the single company will apply the outward investing entity (authorised deposit-taking institution) rules following the inclusion of the Australian branch [Schedule 3, item 27, subsection 820-609(3)]. Similarly, if a head company was exempt from the thin capitalisation regime prior to the inclusion of an Australian branch of a foreign financial entity or foreign bank, the head company will apply the outward investing entity (authorised deposit-taking institution) rules following the inclusion of an Australian branch [Schedule 3, item 27, subsection 820-609(2)]. That is, a foreign controlled Australian authorised deposit-taking institution will no longer be exempt from the thin capitalisation regime when it groups with an Australian branch of a foreign financial entity or foreign bank, which are not supervised by the Australian Prudential Regulation Authority (APRA).

Thin capitalisation classifications - non-authorised deposit-taking institution

3.34 Where the authorised deposit-taking institution rules do not apply, and where a head company or single company makes the choice to include an Australian branch of a foreign financial entity as part of itself, the head company or single company will be classified as either:

•

an outward investing entity (non-authorised deposit-taking institution) and outward investor (financial), or

•

an inward investing entity (non-authorised deposit-taking institution) and inward investment vehicle (financial).

[Schedule 3, item 27, subsections 820-609(5) and (6)]

3.35 If the head company or single company, prior to the inclusion of the Australian branch of a foreign financial entity, was an outward investing entity (non-authorised deposit-taking institution) and an outward investor (general or financial), the head company or single company will remain an outward investing entity (non-authorised deposit-taking institution). Further, as the group consists of a financial entity, the outward investor (financial) rules apply (Subdivision 820-B). [Schedule 3, item 27, subsection 820-609(5)]

3.36 If the head company or single company, prior to the inclusion of an Australian branch of a foreign financial entity, was an inward investing entity (non-authorised deposit-taking institution) and an inward investment vehicle (general or financial), the head company or single company will remain an inward investing entity (non-authorised deposit-taking institution). Further, as the group consists of a financial entity, the inward investment vehicle (financial) rules apply (Subdivision 820-C). [Schedule 3, item 27, subsection 820-609(6)]

3.37 The calculations under Subdivisions 820-D and 820-E are based on the APRA rules and need to be modified where an authorised deposit-taking institution group contains entities which are not supervised by APRA (sections 820-613 and 820-615). The same concern does not exist for financial entities applying Subdivisions 820-B and 820-C. Consequently, the calculations for financial entities can apply without modification. Modified subsections 820-603(3) and (4), in conjunction with Subdivisions 820-B and 820-C, will produce the appropriate outcome since the head company or single company (treated like a head company) will be taken to include the Australian branch of a financial entity.

Financial entities that choose to be treated as authorised deposit-taking institutions

3.38 Under the current rules, certain financial entities, which are not authorised deposit-taking institutions, can choose to apply the thin capitalisation rules as authorised deposit-taking institutions (Subdivision 820-EA). Where a group consists of an Australian branch of a foreign financial entity (but no authorised deposit-taking institutions or Australian branches of foreign banks), not only can that entity access the grouping provisions, it will also be able to choose (subject to meeting the relevant conditions) to apply the authorised deposit-taking institution rules. Consequently, a head company or a single company that chooses to group and that is classified as an outward investor (financial) or inward investment vehicle (financial) may, if it satisfies the existing conditions in Subdivision 820-EA, choose to be treated as an outward investing entity (authorised deposit-taking institution). Further, it can also use the modified calculations under section 820-613. [Schedule 3, item 27, note to subsection 820-609(7); item 29, note to subsection 820-613(1); item 30, subsections 820-613(3) and (4)]

Application and transitional provisions

3.39 The amendments to Part IIIB of the ITAA 1936 and the thin capitalisation grouping provisions will apply to income years starting on or after the date of Royal Assent. [Clause 2; Schedule 3, items 4 and 39]

3.40 The transfer of loss provisions will apply in relation to losses of Australian branches of foreign financial entities, and of other relevant companies, for income years starting on or after the date of Royal Assent. [Clause 2; Schedule 3, item 11]

Consequential amendments

Requirement to keep records

3.41 A taxpayer carrying on a business is required to keep records that record and explain all transactions and other acts engaged in by the taxpayer that are relevant for any purpose of the ITAA 1936 (section 262A of the ITAA 1936).

3.42 Under Part IIIB of the ITAA 1936, certain transactions between foreign banks and their Australian branches, which would otherwise not be recognised for taxation purposes, are recognised. Accordingly, foreign banks are also required to keep accounting records in respect of any branches in Australia through which they carry on banking business (subsection 262A(1B) of the ITAA 1936). The accounting records provide a means by which the foreign bank can separately account for money used in the activities of a branch in Australia. A similar condition will be imposed on foreign financial entities which have Australian branches. [Schedule 3, item 3, subsection 262A(1BA)]

Updated references, headings and checklists

3.43 Section 12-5 contains a checklist of the specific types of deduction which are affected by statutory provisions. Each entry in the checklist is cross-referenced to the relevant statutory provisions. The checklist will be updated to include references to deduction provisions affecting foreign financial entities' branches. [Schedule 3, item 5; item 6]

3.44 These amendments also update various cross-references within the tax legislation, legislative notes and headings to correspond with the substantive changes to the taxation provisions. [Schedule 3, items 12 to 16, 22, 28 and 31 to 38]

3.45 Subsection 820-445(4) of Subdivision 820-EA is repealed as it is redundant because of subsection 820-609(7). [Schedule 3, item 13, subsection 820-445(4); item 27, subsection 820-609(7)]