House of Representatives

Explanatory Memorandum

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

Chapter 3 - Modernising the Offshore Banking Unit regime

Outline of chapter

3.1 Schedule 3 to this Bill makes a number of reforms to modernise the Offshore Banking Unit (OBU) regime. The reforms include measures implementing recommendations of the Australia as a Financial Centre - Building on Our Strengths report by the Australian Financial Centre Forum chaired by Mark Johnson. The reforms also include targeted amendments to address a number of integrity concerns with the existing regime.

Context of amendments

3.2 The amendments in Schedule 3 are made to the OBU regime contained in Division 9A of the Income Tax Assessment Act 1936 (ITAA 1936). All legislative references in this Chapter are to the ITAA 1936 unless otherwise specified.

3.3 The regime is designed to provide tax incentives to attract and maintain highly mobile financial sector activities within Australia. These activities broadly include:

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financial intermediation between offshore lenders and offshore borrowers; and

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providing other financial services to offshore investors investing outside Australia.

3.4 Assessable income from eligible offshore banking (OB) activities is effectively subject to a tax rate of 10 per cent, rather than the corporate tax rate of 30 per cent. This is achieved by bringing to account only an 'eligible fraction' of income from OB activities and associated expenses (section 121EG).

3.5 In addition, under Division 11A, interest payments made by OBUs when borrowing from offshore are not subject to interest withholding tax when the borrowed funds are used to carry on eligible OB activities (sections 128GB and 128NB).

Operation of the existing law

3.6 An OBU is a notional division or business unit of an Australian entity that conducts OB activities. To be considered an OBU, an entity must be declared by the Treasurer as an OBU.

3.7 An OBU receives concessional tax treatment in respect of eligible OB activities, provided additional criteria are met. The list of eligible OB activities is provided at paragraph 3.21.

Trading activity

3.8 One kind of eligible OB activity is trading activities (subsection 121D(4)). Amongst other things, trading activities include trading with an offshore person in shares and other membership interests of non-resident entities. As a result, trading in the shares of an offshore subsidiary may constitute an eligible OB activity.

3.9 This has the effect of allowing the conversion of ineligible non-OB activities to eligible OB activities. That is, the offshore subsidiary may undertake ineligible activities and the OBU may claim the same economic benefit as assessable OB income by trading in the shares it owns in the subsidiary.

The choice principle

3.10 A taxpayer that is an OBU may engage in activities that are not eligible OB activities. These activities are said to be undertaken by the taxpayer's domestic banking unit (DBU) - another notional division of the entity. The taxpayer must keep separate accounting records for their OBU and DBU activities (subsection 262A(1A)).

3.11 The Commissioner of Taxation (Commissioner) has expressed the view that a taxpayer is entitled to make the choice, at the time of entering into an eligible OB activity transaction, to treat the activity as if it were ineligible. This treatment can be achieved by the taxpayer recording the transaction in its non-OBU accounting records ( TD 93/135 ). A consequence of this choice is that any income from the transaction is not entitled to concessional taxation as assessable OB income. Similarly, expenses or losses on the transaction are entitled to deductions at the full corporate tax rate.

3.12 As the transaction is treated as not being an OB activity, the associated income does not risk the taxpayer failing the purity test in section 121EH if the activity was financed through non-OB money.

3.13 Furthermore, by choosing to attribute offshore borrowing to its DBU, the taxpayer can avoid a recoupment of exempted withholding tax by not claiming the exemption under section 128GB (see section 128NB of the ITAA 1936, and the Income Tax (Offshore Banking Units) (Withholding Tax Recoupment) Act 1988). This choice is necessary where, for example, the taxpayer intends to apply offshore borrowings to its domestic lending activities.

3.14 In 2007, the Commissioner released a discussion paper that considered the withdrawal of TD 93/135, although the determination has not been withdrawn. The availability of the choice referred to in TD 93/135 enables taxpayers to avoid inadvertent breaches of the purity test and the imposition of withholding tax recoupment penalties. The status of the choice principle as an administrative interpretation creates some uncertainty for participants in the regime.

Allocation of expenses

3.15 The expenses of a taxpayer with an OBU must be allocated between the taxpayer's DBU and OBU. Deductions for expenses allocated to each unit are deductible at a 30 per cent and 10 per cent tax rate respectively.

3.16 Section 121EF uses a number of concepts to categorise deductions:

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Allowable OB deductions, which include:

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exclusive OB deductions, which relate only to deriving assessable OB income;

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some general OB deductions; or

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some apportionable OB deductions.

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Loss deductions (per Division 36 of the Income Tax Assessment Act 1997 (ITAA 1997)).

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Exclusive non-OB deductions, which relate only to non-OB assessable income.

3.17 General deductions, which do not relate exclusively to assessable OB or assessable non-OB income (and are not loss or apportionable deductions) are allocated to the OBU on the basis of a statutory formula. The formula allocates these deductions according to the proportion of the taxpayer's adjusted assessable income (assessable income less exclusive interest deductions) that consists of adjusted OB income.

3.18 The use of adjusted assessable income is intended to prevent distortions arising from low-margin OB activities (see the explanatory memorandum to the Taxation Laws Amendment Bill (No. 4) 1992, paragraphs 32-33).

3.19 Apportionable deductions, as defined in subsection 6(1), relate to neither assessable OB income nor assessable non-OB income and are allocated according to a separate statutory formula in subsection 121EF(5).

3.20 Section 121EF does not expressly refer to deductions allowable for expenses incurred in deriving non-assessable non-exempt (NANE) income, for example, deductions for interest costs under section 25-90 of the ITAA 1997. As such, the current law treats these deductions as deductions to be allocated according to the existing statutory formula for determining general OB deductions.

The list of eligible OB activities

3.21 The list of eligible activities is contained in section 121D of the ITAA 1936. The current list includes:

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borrowing and lending activities;

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guarantee-type activities;

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trading activities;

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eligible contract activities;

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investment activities;

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advisory activities;

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hedging activities; and

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activities prescribed in the regulations.

3.22 Certain requirements apply before a listed activity is eligible to produce concessional OB income for the OBU. Section 121EA ensures that the OBU undertakes the OB activities within Australia. Furthermore, many of the activities are only eligible when undertaken with counterparties that meet the definition of 'offshore person' in section 121E.

3.23 The list of eligible activities has remained constant since 1998. Furthermore, no regulations have been made prescribing additional activities relevant to modern commercial practice.

Internal financial dealings

3.24 Section 121EB treats the different permanent establishments of an OBU as separate persons in working out if there are eligible OB activities under sections 121D to 121EA. This enables an OBU to deal with its offshore permanent establishment and satisfy the requirement for dealing with an offshore person.

3.25 As a result, the existing law contemplates that an OBU may source funding internally from its own offshore branch operations for the purposes of applying the OB money funding requirements.

3.26 The existing law does not stipulate that the internal dealings are to be priced on an arm's length basis. The transfer pricing rules in Division 815 of the ITAA 1997 may apply to a number of potential transactions involving OBUs. However, the internal dealings within a single entity are not subject to the application of an arm's length requirement under the existing transfer pricing rules.

Summary of new law

3.27 Schedule 3 implements a number of reforms to the OBU regime. These include:

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limiting the availability of the OBU concession in certain circumstances where it could otherwise be used to convert an ineligible activity into an eligible OB activity;

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codifying the choice principle to remove uncertainty for taxpayers;

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introducing a new method of allocating certain expenses between the operations of a taxpayer's DBU and OBU;

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modernising the list of eligible OB activities; and

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treating internal financial dealings (for example, between an entity's DBU and OBU) as if they were on an arm's length basis.

Comparison of key features of new law and current law

Detailed explanation of new law

Part 1: Trading activity

3.28 Part 1 of Schedule 3 limits the eligible trading activity in certain situations.

3.29 Under the existing law, an OBU may trade with an offshore person in the shares and other membership interests it has in an offshore subsidiary (paragraphs 121D(4)(a) and (b)). This trading activity may constitute an eligible OB activity, even if the subsidiary is undertaking ineligible non-OB activities.

3.30 This makes it possible to convert ineligible non-OB activities to eligible OB activities, by allowing the OBU to undertake ineligible activities through an offshore subsidiary, and trading in the interests of the subsidiary.

Total participation interest of 10 per cent or more

3.31 To address this integrity concern, the amendments limit the scope of the eligible trading activity category. Trading in things, such as shares, that affect the total participation interest in another entity will no longer be an eligible OB activity if the total participation interest is 10 per cent or more just before the trading activity occurred. [Schedule 3, items 1 and 2, paragraph 121D(1)(c), paragraph 121D(4A)(a) and subparagraph 121D(4A)(b)(i) of the ITAA 1936]

3.32 'Total participation interest' is an existing concept used in section 960-180 of the ITAA 1997. It includes both direct and indirect participation interests. However, for the purposes of the new law, any rights that the OBU may have, directly or indirectly, on the winding-up of the entity are disregarded in determining the total participation interest. The rights on winding-up may vary considerably from other interests and can therefore distort the total participation test. [Schedule 3, item 2, subsection 121D(4B) of the ITAA 1936]

3.33 This amendment will ensure that trading in subsidiaries, or other entities where the OBU holds an interest of at least 10 per cent, no longer attracts concessional tax treatment.

Example 3.1: Change in participation interest

On 1 July 2015, AusOBU holds a total participation interest in an offshore company, Forco, of 20 per cent.

On 3 July 2015, AusOBU buys more shares in Forco, taking its total participation interest to 25 per cent. Under the new law, the purchase of the shares will not be an eligible OB trading activity, because AusOBU holds a participation interest of at least 10 per cent.

On 6 July 2015, AusOBU sells some of its shares in Forco, taking its total participation interest to 7 per cent. Under the new law, the sale of the shares will not be an eligible OB trading activity because AusOBU's total participation interest just before the sale was more than 10 per cent.

Example 3.2: No net change in participation interest

On 1 July 2015, AusOBU holds a total participation interest in an offshore company, SJP Ltd, of 20 per cent.

On 3 July 2015, AusOBU buys more shares in SJP Ltd, taking its total participation interest to 25 per cent. Later that day, AusOBU decides to sell some shares in SJP Ltd, so that its total participation interest returns to 20 per cent.

Under the amendments, neither the purchase nor sale of the shares is an eligible OB trading activity. Even though there is no net change in the total participation interest, the new law considers whether the thing (in this case, the shares) affected the total participation interest, rather than whether the trade of the thing affected the total participation interest.

Participation interests not held for trading

3.34 Trading in a thing that affects the total participation interest will not be an eligible OB activity if, just before the trading activity, any of the traded interest the OBU held was not recorded in the OBU's accounting records as held for trading in accordance with the accounting standards. [Schedule 3, item 2, subparagraph 121D(4A)(b)(ii) of the ITAA 1936]

3.35 This rule applies even if the total participation interest is less than 10 per cent just before the trading activity.

3.36 This rule is intended to clarify that the 'trading activity' limb applies to genuine trading activity, as evidenced by the OBU's accounting records.

3.37 This is determined by reference to the accounting standards issued by the Australian Accounting Standards Board. Currently, accounting standard AASB 9 Financial Instruments defines held for trading as a financial asset or financial liability that:

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is acquired or incurred principally for the purpose of selling or repurchasing it in the near term;

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on initial recognition is part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit-taking; or

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is a derivative (except for a derivative that is a financial guarantee contract or a designated and effective hedging instrument).

Example 3.3: Interests not held for trading

AusOBU holds an investment in a Singaporean company, MP Ltd. This investment is not recorded as being 'held for trading' in AusOBU's accounting records. AusOBU's acquired this investment as part of its long-term strategy to increase its exposure to the Singaporean market, rather than for the principal purpose of selling or repurchasing it for short term gains.

Any trading of AusOBU's investment will not be an eligible OB trading activity.

3.38 The amendments in Part 1 only limit the scope of the eligible trading activity. In some circumstances, an activity ineligible for concessional treatment as a trading activity may be eligible as a contract activity, for example.

Part 2: The choice principle

3.39 Part 2 of Schedule 3 codifies the choice principle articulated in TD 93/135.

3.40 A taxpayer may choose to treat a transaction that is an eligible OB activity as if it was ineligible. The choice must be made when the transaction is entered into. Once made, the choice is irrevocable and effective for all purposes. [Schedule 3, item 6, subsection 121EAA(1) of the ITAA 1936]

3.41 A taxpayer may evidence this choice by entering the transaction in their non-OB accounting records rather than the OB accounting records maintained under subsection 262A(1A). [Schedule 3, items 4 and 6, section 121C and subsections 121EAA(2) and (3) of the ITAA 1936]

3.42 In relation to certain eligible OB activities, the OBU may not 'use money' in the sense required for the transaction to be eligible for entry into the entity's OB accounting records (see subsection 262A(1A) and TD 93/214 ). Where the entity has no choice but to record the transaction in its non-OB accounting records, recording the transaction in this way will not be evidence of a choice. If a choice is made in these circumstances to treat an activity as if it were ineligible, the choice should be recorded in some other way to satisfy paragraph 262A(2)(b).

Example 3.4: Evidencing a choice where no money is used

An OBU undertakes eligible portfolio management activities for a non-resident. The OBU does not 'use money' for the purposes of subsection 262A(1A) when managing the portfolio.

The OBU necessarily records its fee income earned from the activity in its non-OB accounting records. This will not be taken as evidence of a choice by the OBU to treat the activity as an ineligible activity.

The OBU will remain eligible for the concessional treatment of the fee income.

If the OBU wished to exercise the choice, it would need to make a specific record of that choice (paragraph 262A(2)(b)).

3.43 Regardless of how the choice is recorded, the record should be made as soon as practicable after the taxpayer enters into the transaction. This is consistent with the existing interpretation of the obligation to maintain records generally (section 262A and TR 96/7 , paragraphs 49 and 50).

3.44 Once made, the choice is irrevocable. However, the recording of a choice (including a choice to treat the activity as an eligible activity) may be corrected if the record was made by mistake. That is, the record may be altered only where the recording was inadvertent and did not give effect to the actual intent of the taxpayer at the time the transaction was entered into.

3.45 The choice principle is not applicable to ineligible activities. An OBU must record a transaction that is not an eligible OB activity in its non-OB accounts.

Grouping of transactions

3.46 Making the choice in relation to one transaction will have an impact on the treatment of other transactions if the transactions are part of the same scheme. If a taxpayer choses to treat a particular transaction that is an eligible OB activity as if it were ineligible, all other transactions within the same scheme are treated as if they are ineligible. [Schedule 3, item 6, subsection 121EAA(4) of the ITAA 1936]

3.47 Transactions will be considered to form a single scheme where it is reasonable to do so. This is a question of fact and degree. The question can be determined by having regard to a number of factors. These factors draw on the factors used to group rights and obligations into arrangements under section 230-55 of the ITAA 1997. [Schedule 3, item 6, subsections 121EAA(4) to (6) of the ITAA 1936]

3.48 To determine whether a number of transactions arise under one or more schemes, regard is to be given to the:

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nature of those transactions, when considered separately and in combination (including having regard to the substance and character of the rights obligations created);

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terms and conditions of the transactions, including having regard to the legal terms of the rights and obligations created in their economic context, including those relating to the amount and timing of the consideration to be paid or received, and the pricing of those rights and obligations relative to what would otherwise be expected of such rights and obligations, when considered separately and together;

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circumstances surrounding the entering into of the transaction and the proposed exercise or performance of rights and obligations created, (including what can reasonably be seen as the purposes of one or more of the parties involved), when the rights and obligations are considered separately and when considered in combination;

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whether the rights and obligations created can be dealt with separately or whether they must be dealt with together (for example, the separate interests that comprise a stapled security cannot be dealt with separately);

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normal commercial understandings and practices in relation to the transactions when considered separately and when considered in combination, including whether commercially they are regarded as separate things or as a group or a series that forms a whole; and

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objects of the OBU regime.

Example 3.5: Asymmetric swap scheme

A taxpayer enters into an asymmetric swap scheme with an offshore counterparty. The scheme comprises of two swaps that take opposite positions on an underlying commodity.

Under the new law, the taxpayer must make the same choice in respect of both swaps. That is, the taxpayer cannot choose to treat one swap as an eligible OB activity, and the other swap as an ineligible activity.

Example 3.6: Loan facilities

A taxpayer operates an OBU and a DBU. The taxpayer secures a loan facility from a third-party lender. The taxpayer draws down funds on behalf of its OBU and DBU under the facility.

The taxpayer chooses to treat the drawdown of funds for the DBU as though it was not an eligible OB activity. The creation of the facility, the drawdown of funds for the DBU and the drawdown of funds for the OBU are each separate schemes.

The choice made with respect to the DBU funding does not prevent the borrowing for the OBU being an eligible OB activity.

Example 3.7: Umbrella trading arrangements and hedging

A taxpayer enters into an umbrella trading arrangement with an offshore person. The arrangement covers a broad range of transactions.

The taxpayer hedges a number of eligible OB trading activities. The hedging is not an eligible OB activity. Consequently, the taxpayer chooses to treat the hedged trading activities as ineligible activities.

The umbrella arrangement also covers a number of eligible OB trading activities that are not hedged through ineligible transactions. The grouping rules do not apply to treat these transactions as ineligible activities. It is not a normal commercial practice to understand the two trading activities, one hedged by ineligible activities and the other not, as comprising a single scheme.

3.49 Further examples, relevant to the interpretation of section 230-55 of the ITAA 1997, on which these amendments draw, are contained in the explanatory memorandum to the Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008. Regard may be had to these examples when interpreting the present amendments. It is important to note, however, that the objects of the Taxation of Financial Arrangements rules are different to the object of the OBU regime and the relevant provisions assess different things (for example, transactions rather than rights and obligations).

3.50 The grouping rules do not apply merely because one or more transactions, being eligible OB activities, are associated with one or more ineligible transactions. No choice can be made in relation to ineligible transactions.

Example 3.8: Ineligible activities

An OBU creates a loan facility for a corporate group. The parent company of the group is an offshore person but the group contains an Australian subsidiary. Under the facility, all members of the group can drawdown funds from the taxpayer.

Lending to the Australian subsidiary is an ineligible activity. No choice can be made under subsection 121EAA(1). The grouping rules in subsections 121EAA(4) to (6) are not engaged. The lending to the offshore persons within the group remains an eligible OB activity.

Part 3: Allocation of expenses

3.51 Part 3 of Schedule 3 sets out a new framework for allocating deductions that relate to both OB and non-OB income, such as rent on a building used for both OBU and DBU activities, between the taxpayer's OBU and DBU.

3.52 Under the current law, certain deductions must be apportioned using a statutory formula, which is based on adjusted income allocated to the taxpayer's OBU and DBU.

3.53 The effect of the amendments is to replace the statutory formula with a rule that the unallocated deduction is allocated to the taxpayer's OBU to the extent that it relates to OB income. This is achieved by amending the definition of a general OB deduction. The new rule draws on the apportionment principles applicable to the general deduction provision in section 8-1 of the ITAA 1997. [Schedule 3, item 15, subsection 121EF(4) of the ITAA 1936]

3.54 The definition of a general OB deduction under the new law requires that the deduction relate to OB income, rather than 'assessable' OB income. This is intended to cater for deductions that relate to expenses incurred in deriving NANE income, as well as assessable income.

3.55 For example, deductions claimed under section 25-90 of the ITAA 1997 could be apportioned using this new rule. Section 25-90 deductions relate to interest and other similar expenses incurred in deriving dividends that are NANE income under section 768-5 of the ITAA 1997.

3.56 To support the new definition of a general OB deduction, the new law inserts a definition of 'OB income' and modifies the current definition of 'assessable OB income'. [Schedule 3, items 13 and 14, section 121EDA and subsection 121EE(2) of the ITAA 1936]

3.57 The definition of 'OB income' is based on the existing definition of 'assessable OB income', with appropriate modifications. The definition of 'assessable OB income' has been modified to be so much of OB income as is assessable.

Part 4: Eligible activities

3.58 Part 4 of Schedule 3 modernises the existing list of eligible OB activities in section 121D of the ITAA 1936. This ensures that the OBU regime operates as intended by attracting mobile financial sector activity.

Creation of lending facilities

3.59 The list of eligible activities includes lending money to an offshore person. To this, the amendments add the activity of making a commitment to lend money, even where the commitment is not funded. [Schedule 3, items 18 and 22, section 121C and paragraph 121D(2)(b) of the ITAA 1936]

3.60 A commitment to lend money is where an OBU makes funds available to an offshore person but the funds are not drawn down, or are yet to be drawn down. Income in the form of fees for making the credit facility available is mobile income and will be treated accordingly as assessable OB income.

3.61 The new element of the activity will be subject to the existing currency restrictions in paragraph 121D(2)(b).

Syndicated lending activities

3.62 A syndicated lending arrangement involves a number of financial institutions lending to a borrower. Syndicated arrangements are common in large capital raisings. In addition to committing to lend their own capital, an OBU may be involved in arranging contributions from a syndicate of other lenders. The OBU may also be involved in underwriting some of the credit risk. The OBU will earn a fee for these services.

3.63 The position of arranger within a syndicate is highly mobile. An amendment is made to include undertaking the services of an arranger in the list of eligible OB activities. This amendment ensures that any such service is an eligible OB activity regardless of whether it also falls within the scope of paragraph 121D(3)(c). [Schedule 3, item 23, paragraph 121D(2)(e) of the ITAA 1936]

Guarantee activities and connections with Australia

3.64 Subsection 121D(3) lists four guarantee activities as eligible OB activities. Three of the activities are restricted to (relevantly) activities that are conducted wholly outside Australia, property located outside Australia and events that can only happen outside Australia.

3.65 These strict restrictions limit the application of the concession and are inappropriate where the connection between Australia and the relevant activities is not significant. Accordingly, an amendment is made to require only that the activity not relate, to a material extent, to a place within Australia. [Schedule 3, items 18, 24 and 25, section 121C and subsection 121D(3) of the ITAA 1936]

3.66 The materiality threshold requires a comparison between, for example, the activities undertaken in Australia and those conducted elsewhere. In relation to property, the comparison is between the intended use of the property, either in Australia or elsewhere. Similarly, in the case of events, it is necessary to consider the likelihood of the event occurring in Australia.

3.67 This materiality threshold means that activities occurring predominantly outside Australia but with a slight or theoretical connection to Australia can be treated in the same way as activities conducted wholly outside Australia.

Example 3.9 : Material connections to Australia

An OBU underwrites a risk for an offshore person in relation to the insurance of an aeroplane. The aeroplane spends the majority of its time flying international routes. This includes international flights to and from Australia. The aeroplane does not fly any domestic routes within Australia. The aeroplane's connection to Australia is not material.

The insurance covers property that is used within Australia and elsewhere and includes coverage for risks that could occur in either Australia or elsewhere. However, the likelihood of an insured event occurring within Australia is not material in the context of the scope of the policy, nor is the use of the property within Australia material. The underwriting is an eligible OB activity.

Trading in commodities and entering into commodity derivative contracts

3.68 Subsection 121D(4) provides that certain trading activities are eligible OB activities. Trading activities include trading with offshore persons in a number of precious metals, or in options or rights in respect of those metals.

3.69 An amendment is made to provide that trading in any commodity with an offshore person is an eligible OB activity where it is incidental to an eligible contract activity. The activity includes trading in rights or options in the commodity. [Schedule 3, item 27, paragraph 121D(4)(i) of the ITAA 1936]

3.70 The purpose of this amendment is to allow certain commodity trading activities to be eligible OB activities where they are undertaken to hedge positions in commodity derivatives.

3.71 Commodity trading can be undertaken through commodity exchanges or over-the-counter facilities.

Securities lending and repurchase agreements

3.72 Amendments are made to the definition of eligible contract activity to include entering into securities lending and repurchase agreements in the list of eligible OB activities. [Schedule 3, items 17, 18, 19 and 32, sections 121C and 121DB, and paragraph 121D(1)(d) of the ITAA 1936]

3.73 Repurchase arrangements involve the sale and repurchase of securities. In most cases, the repurchase price will be higher than the sale price or forward value of the securities. The increase reflects the cost (repo rate) of the original purchaser providing credit to the original owner. Securities lending arrangements, in contrast, are often motivated by the borrower wishing to use the securities in another arrangement, for example short-selling, in return for a fee to the lender.

3.74 Repurchase arrangements share many of the commercial features of a secured loan, where the securities sold act as collateral. Similarly, securities lending has many of the commercial features of lending and trading in securities. This amendment will provide certainty for these arrangements.

3.75 The terms 'securities lending agreement' and 'repurchase agreement' are intended to have their ordinary commercial meaning.

Non-deliverable forward foreign currency contracts

3.76 Paragraph 121D(4)(e) includes trading in non-Australian currencies, or related options and rights, with any person (including Australian residents) as an eligible trading activity. This facilitates trading in forward foreign currency contracts, including as a hedging mechanism.

3.77 A non-deliverable forward foreign currency contract is an instrument that may be used to hedge foreign exchange exposures. The contract works in a similar way to a standard forward foreign currency contract, except the obligations are settled in another currency (settlement being the difference between an agreed notional exchange rate and the forward exchange rate). This is necessary where the relevant currency is not widely traded.

3.78 Under the contract, no rights are created with respect to the foreign currency, which means that the activity is outside the scope of the existing currency trading activity ( ID 2011/27 ). A non-deliverable forward foreign currency contract, therefore, is currently only an eligible OB activity where it is entered into with an offshore person (subsection 121D(5)).

3.79 An amendment is made to allow trading in these contracts with any person to be an eligible OB activity. This will align the tax treatment of non-deliverable forward foreign currency contracts with equivalent foreign exchange contracts. [Schedule 3, item 26, paragraph 121D(4)(aa) of the ITAA 1936]

3.80 A further amendment is made to allow OBUs to treat entering into such a contract with any person as an eligible OB activity. [Schedule 3, items 17, 28 and 32, sections 121C and 121DB, and subsection 121D(5) of the ITAA 1936]

Portfolio investment and funds management activities

3.81 Subsection 121D(6A) includes managing a portfolio investment in the list of eligible OB activities. That is, an OBU that manages a fund on behalf of a non-resident may be entitled to concessional tax treatment of management fees received.

3.82 A fund may invest in both Australian things (for example shares in Australian resident companies) and things that are not Australian things. Under the existing law, the entire fund management activity may be an eligible OB activity (subject to some requirements).

3.83 Only that portion of the assessable OB income that relates to investments in things that are not Australian things is eligible to receive the concessional tax treatment. This treatment is achieved through subsection 121EE(3A), which reduces the amount of assessable income treated as OB assessable income by the average Australian asset percentage of the fund. The percentage is worked out by reference to the value of Australian things as a proportion of a fund's total value (section 121DA).

3.84 Paragraph 121D(6A)(f) restricts the capacity of OBUs to manage funds that contain investments in Australian things where the average Australian asset percentage for the fund exceeds 10 per cent.

3.85 Unlike the reduction achieved through subsection 121EE(3A), this requirement operates to render the entire fund ineligible for concessional tax treatment if the 10 per cent threshold is exceeded.

3.86 The requirement limits the accessibility of the activity and the concession, preventing some OBUs from marketing suitable funds to offshore counterparties. Movements in the value of a fund's assets may inadvertently tip the fund above the 10 per cent threshold, making the entire fund ineligible as an OB activity.

3.87 The limitation is unnecessary to achieve the object of limiting the availability of the OBU concession to offshore investments. This objective can be achieved through reliance on the apportionment of income achieved through subsection 121EE(3A).

3.88 Amendments are made to remove the requirement in paragraph 121D(6A)(f). [Schedule 3, items 29 and 30, paragraphs 121D(6A)(e) and (f) of the ITAA 1936]

Advice on disposal of investments

3.89 Subsection 121D(7) makes the giving of investment or financial advice an eligible activity. A limitation applies in the case of advice relating to the making of an investment. In those circumstances, the advice must relate to an investment that is outside Australia. Other advice is not limited in this way. However, there has been uncertainty in the interpretation of this provision with respect to advice provided in relation to the disposal of investments.

3.90 An amendment is made to clarify that advisory activities includes the provision of advice in relation to the disposal of an investment, regardless of its location. [Schedule 3, items 18, 20, 31 and 32, sections 121C and 121DC, paragraph 121D(1)(f), and subsection 121D(7) of the ITAA 1936]

Leasing activities

3.91 Amendments are made to add leasing activities involving offshore persons to the list of eligible OB activities. [Schedule 3, items 18, 21 and 32, section 121C, paragraph 121D(1)(ga) and section 121DD of the ITAA 1936]

3.92 The addition of leasing activities is intended to give greater flexibility to OBUs in recognition of the fact that many leasing arrangements have similar commercial features to existing OB activities such as lending.

3.93 An OBU may enter into a leasing activity as either a lessor or a lessee (or a sublessor or a sublessee). The activity covers both operating leases and finance leases.

3.94 Using the concept of lease from section 51AD of the ITAA 1936, a lease is any arrangement that includes the owner of property granting another person a right to use the property. A lease also includes a sublease where a lessee subleases the property to a sublessee.

3.95 The activity will not apply to hire-purchase arrangements that are recharacterised under division 240 of the ITAA 1997 as notional sale and loan arrangements. Notional loan arrangements may nevertheless be eligible OB activities under subsection 121D(2).

3.96 The leased property must not be used to a material extent within Australia. The materiality condition is intended to align with that discussed in paragraph 3.66 and Example 3.9.

Example 3.10 Leasing Offshore Property

A second OBU leases and subleases the aeroplane referred to in Example 3.9. The leasing activity is an eligible OB activity.

Part 5: Internal financial dealings

3.97 Part 5 of Schedule 3 treats the internal financial dealings of an OBU as being on an arm's length basis.

3.98 Under the existing law, an OBU may source funding internally from another branch of the same entity (section 121EB). Because of the scope of this rule, there are gaps in the application of Australia's transfer pricing rules (Division 815 of the ITAA 1997) to an OBU's internal dealings.

3.99 To address this, the new law provides that the OBU's OB income or allowable OB deductions are treated as being those amounts that would be included or allowed, were the internal parties dealing with each other at arm's length. [Schedule 3, item 33, subsection 121EB(4) of the ITAA 1936]

3.100 In determining the arm's length conditions, taxpayers should have reference to the guidance materials available under Australia's transfer pricing rules in Division 815. [Schedule 3, item 33, subsection 121EB(5) of the ITAA 1936]

Consequential amendments

3.101 Amendments are made to references to 'OB activity' that are consequential to the codification of the choice principle in Part 2. [Schedule 3, items 3, 5 and 7, paragraph 121B(2)(a), subsection 121D(1) and subsection121EB(1) of the ITAA 1936]

3.102 Amendments are made that are consequential to the allocation of expenses in Part 3. [Schedule 3, items 8, 9, 10, 11, 12 and 16, subsection 6(1), paragraphs 121B(2)(b) and 121EH(a), and sections 121C and 121E of the ITAA 1936]

Application provision

3.103 The amendments made by Schedule 3 generally apply in relation to income years starting on or after 1 July 2015. [Schedule 3, subitem 34(1)]

3.104 However, the codification of the choice principle in Part 2 of the Schedule applies to activities entered into on or after 1 July 2015. [Schedule 3, subitem 34(2)]

STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS

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

Modernising the Offshore Banking Unit Regime

3.105 This Schedule 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

3.106 Schedule 3 makes a number of reforms to modernise the Offshore Banking Unit regime. The reforms include measures implementing recommendations of the Australia as a Financial Centre - Building on Our Strengths report by the Australian Financial Centre Forum chaired by Mark Johnson. The reforms also include targeted amendments to address a number of integrity concerns with the existing regime.

Human rights implications

3.107 This Schedule does not engage any of the applicable rights or freedoms.

Conclusion

3.108 This Schedule is compatible with human rights as it does not raise any human rights issues.