House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon J. B. Hockey MP)

Chapter 2 - Foreign dividends

Outline of chapter

2.1 Schedule 2 to this Bill reforms the exemption for foreign non-portfolio dividends.

2.2 All references in this Chapter are to the Income Tax Assessment Act 1997 (ITAA 1997) unless otherwise specified.

Context of amendments

2.3 Currently, a non-portfolio foreign dividend (that is, a dividend on a voting interest of at least 10 per cent in a foreign resident company) is non-assessable non-exempt (NANE) income when paid to an Australian resident company (see section 23AJ of the Income Tax Assessment Act 1936 (ITAA 1936)).

2.4 The intention of this exemption is to make non-portfolio returns on equity to Australian resident companies exempt of Australian income tax, to remove the Australian tax burden from active business income earned by a foreign subsidiary of an Australian owned company. This helps ensure that the foreign subsidiaries are able to compete on an equal footing with other businesses located in that foreign country.

2.5 However, under the current rules, the exemption can also apply in circumstances where the investment instrument is treated as a debt instrument, for example, in the case of redeemable preference shares. This has led to unintended consequences arising from the interaction of the thin capitalisation rules, the core tax rules for determining what is debt and what is equity (the debt equity rules) and the exemption. This arises in circumstances where an Australian company uses a 'debt instrument' which also qualifies for the exemption to fund an offshore expansion. Offshore acquisitions effected in this way are currently unconstrained by the thin capitalisation rules contrary to the initial policy intent.

2.6 Also, the exemption in section 23AJ of the ITAA 1936 only applies in instances where the dividend is received directly by the Australian company from the foreign company. That is, where a dividend from a foreign company passes through a trust or partnership it is no longer eligible for the exemption. There is, however, no economic difference between holding the equity interests directly or indirectly through a trust or partnership.

Summary of new law

2.7 The exemption for foreign dividends has been modernised and re-written into the Income Tax Assessment Act 1997 (ITAA 1997) to:

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ensure that it applies to returns on instruments treated as 'equity interests' under the debt-equity rules. This is intended to exclude any returns on 'debt interests' from the exemption and also allow the exemption to apply in respect of a broader range of equity-like interests, rather than interests that involve significant voting rights;

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allow it to apply where a distribution flows through interposed trusts and partnerships other than corporate tax entities;

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allow it to apply where it is received by a corporate tax entity, rather than a company; and

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allow it to apply in respect of distributions of a non-share dividend, which is not included in the definition of a distribution.

2.8 In addition, the ability to pool portfolio dividends (that is, where the interest is less than 10 per cent) in an offshore entity in order to qualify for an exemption under section 23AJ of the ITAA 1936 will be removed. This type of arrangement is contrary to the intention of the exemption, which is intended to apply to non-portfolio dividends where the interest is at least 10 per cent.

Comparison of key features of new law and current law

Detailed explanation of new law

Foreign equity distributions on participation interests

2.9 The new exemption for foreign equity distributions on participation interest replaces the existing test in section 23AJ of the ITAA 1936 for non-portfolio dividends.

2.10 If an Australian corporate tax entity holds a participation interest of at least 10 per cent in a foreign company, and receives a foreign equity distribution from the foreign company either directly or indirectly through one or more interposed trusts and partnerships, the distribution is NANE income for the Australian corporate tax entity. [Schedule 2, Part 1, item 4, Subdivision 768-A]

Participation interest test

2.11 As noted above, for the distribution to be NANE income, the Australian corporate tax entity must satisfy the participation test [Schedule 2, Part 1, item 4, paragraph 768-5(1)(b)]. This participation test needs to be satisfied at the time the foreign equity distribution is made [Schedule 2, Part 1, item 4, paragraph 768-5(1)(b)].

2.12 The participation interest includes both direct and indirect participation interests [Schedule 2, Part 1, item 4, section 768-15]. Direct and indirect participation interests are existing concepts which are calculated by reference to rules set out in Subdivision 960-GP.

2.13 However, for the purposes of the new NANE exemption for foreign equity distributions, any rights that the Australian corporate tax entity may have on winding-up are disregarded in determining the participation interest [Schedule 2, Part 1, item 4, section 768-15]. The rights on winding-up may vary considerably from other interests and can therefore distort the participation test.

Foreign equity distribution

2.14 The exemption applies where a foreign resident company makes a foreign equity distribution to an Australian corporate tax entity. [Schedule 2, Part 1, item 4, paragraph 768-5(1)(a)]

2.15 A foreign equity distribution is a distribution or non-share dividend made by a company that is a foreign resident in respect of an equity interest in the company. [Schedule 2, Part 1, item 5, definition of 'foreign equity distribution' in subsection 995-1(1)]

2.16 A key feature of the new law is that the distribution will only be NANE income where the distribution is made in respect of an equity interest [Schedule 2, Part 1, item 4, section 768-5]. This is intended to:

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modernise the exemption by aligning it to the concepts of 'debt interests' and 'equity interests' as defined in Division 974;

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ensure that the exemption is not available in respect of returns on debt interests, such as redeemable preference shares;

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allow the exemption to apply in respect of a broader range of equity interests, not only voting interests; and

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ensure that the deduction under section 25-90 operates as intended, by ensuring that any debt 'on-lent' to an offshore entity will give rise to assessable interest income in Australia, with any funding costs of the Australian company being deductible under the general deduction provision in section 8-1, rather than section 25-90.

2.17 A foreign equity distribution also includes a non-share dividend [Schedule 2, Part 1, item 4, section 768-10], which is a dividend on a non-share equity interest. A non-share equity interest is an equity interest in a company that is not in legal form solely a share in the capital of the company. For example, certain convertible notes may be classified as a non-share equity interest for tax purposes.

2.18 As a non-share equity interest is an equity interest, it is appropriate that returns on this equity interest are included in the definition of a foreign equity distribution and are covered by the exemption for foreign dividends (provided the other relevant requirements are satisfied).

Australian corporate tax entities

2.19 Another feature of the new law is that the exemption will be expanded to apply where the foreign equity distribution is received by an Australian corporate tax entity, whereas previously, the exemption only applied where it was received by an Australian company. [Schedule 2, Part 1, item 4, section 768-5]

2.20 This will allow an Australian public trading trust, corporate unit trust and corporate limited partnership to access the exemption where it satisfies the other requirements for the exemption.

2.21 This will broaden the exemption to other types of entities that are treated as a company for tax purposes.

Interposed trusts and partnerships

2.22 Under the new law, a foreign equity distribution can be NANE income for an Australian company, even if it passes through interposed trusts and partnerships (including trusts that are commonly referred to as 'nominee' or 'custodian' arrangements), provided that the interposed trusts and partnerships are not corporate tax entities. [Schedule 2, Part 1, item 4, subsection 768-5(2)]

2.23 This represents a change from the current law, which allows a dividend to be NANE under section 23AJ of the ITAA 1936 only in instances where the dividend is received directly by the Australian company from the foreign company.

2.24 Allowing the exemption to apply where a foreign equity distribution has flowed through interposed trusts and partnerships is intended to reflect the fact that there is no economic difference between holding equity interests directly or indirectly through a trust or partnership.

2.25 The new law provides that an amount will be NANE income for an Australian beneficiary or partner where:

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the amount is ultimately received by an Australian corporate beneficiary of a trust, or an Australian corporate partner in a partnership;

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the amount would otherwise be included in the trust or partnership's assessable income under Division 5 or 6 of Part III of the ITAA 1936;

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the amount can be attributed, either directly or indirectly through one or more interposed trusts and partnerships that are not corporate tax entities, to a foreign equity distribution;

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at the time distribution is made, the trust or partnership satisfies the participation test explained above; and

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the Australian beneficiary or partner does not receive the distribution in the capacity of a trustee (unless it is received in the capacity of a trustee of a corporate unit trust or public trading trust).

[Schedule 2, Part 1, item 4, subsection 768-5(2)]

2.26 The distribution will not be NANE where it flows through an interposed trust or partnership that is a corporate tax entity [Schedule 2, Part 1, item 4, paragraph 768-5(2)(c)], as a corporate tax entity is not a flow-through vehicle.

Interaction with rules about controlled foreign companies

2.27 Currently, section 389A of the ITAA 1936 provides that the debt and equity rules contained in Division 974 are to be disregarded in calculating the attributable income of an eligible controlled foreign corporation (CFC).

2.28 However, given the new foreign distribution exemption relies on the concept of an equity interest, as defined in Division 974 of the ITAA 1997, the law has been clarified to provide that section 389A of the ITAA 1936 is to be disregarded for the purpose of applying the new foreign distribution exemption in Subdivision 768-A. [Schedule 2, Part 2, item 6, section 404 of the ITAA 1936]

2.29 Section 389A of the ITAA 1936 is only to be disregarded for the purposes of applying the foreign distribution exemption in Subdivision 768-A, and not more broadly. This ensures that CFCs can continue to access the foreign distribution exemption.

Repeal of portfolio dividend exemption for controlled foreign companies

2.30 The initial policy rationale for section 404 of the ITAA 1936 was to allow certain dividends to remain NANE income if they did not meet the requirements in section 23AJ of the ITAA 1936. This situation might arise where, for example, the regulatory requirements in some foreign jurisdictions limit the voting interests able to be held by foreigner investors because those jurisdictions do not attach voting rights to equity (and therefore the test in section 23AJ of the ITAA 1936 would not be satisfied).

2.31 However, the need for section 404 of the ITAA 1936 has diminished, given the exemption for foreign equity distributions (explained above) will no longer rely upon the concept of voting rights.

2.32 In addition, section 404 of the ITAA 1936 poses an integrity risk. Currently, the operation of section 404 of the ITAA 1936, and its interaction with section 23AJ of the ITAA 1936, can result in Australian taxpayers paying no Australian tax on dividends derived from their (in substance) foreign portfolio share holdings when received through an interposed CFC.

2.33 This occurs where a CFC receives portfolio dividends from its offshore investments that can be pooled together and repatriated back to Australia as a non-portfolio dividend, which is currently NANE income under section 23AJ of the ITAA 1936. This result arises because all dividends (both portfolio and non-portfolio) paid to a CFC resident in a listed or section 404 country are treated as being exempt if the paying entity is also a resident of a listed or section 404 country.

2.34 In contrast, dividends received directly from foreign portfolio holdings are taxable in Australia.

2.35 To address these issues, section 404 of the ITAA 1936 will be repealed, together with the associated regulations which set out the section 404 countries. [Schedule 2, Part 2, item 6, section 404]

2.36 Section 404 will be replaced with a requirement that is intended to ensure that CFC's continue to have access the foreign dividend exemption - see paragraphs 2.27 to 2.29 above.

Consequential amendments

2.37 Several consequential amendments have been made to:

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update various cross-references to section 23AJ of the ITAA 1936, and replace these with references to the new revised exemption in section 768-5 [Schedule 2, Part 3, items 7 to 9 and 14 to 22]; and

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remove various cross-references to section 404 of the ITAA 1936, given it will be repealed [Schedule 2, Part 3, items 10, 12 and 13].

Application provision

2.38 The amendments apply to distributions and non-share dividends made after the day the Act receives Royal Assent. [Schedule 2, Part 4, item 23]

STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Tax and Superannuation Laws Amendment (2014 Measures No. 4) Bill 2014 - Foreign dividends

2.39 This Bill is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011.

Overview

2.40 This Bill reforms the exemption for foreign non-portfolio dividends.

Human rights implications

2.41 This Bill does not engage any of the applicable rights or freedoms.

Conclusion

2.42 This Bill is compatible with human rights as it does not raise any human rights issues.