Senate

Revised Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Scott Morrison MP)

Chapter 3 - OECD hybrid mismatch rules: Other effects of foreign income tax deductions

Outline of chapter

3.1 Schedule 2 to this Bill amends the ITAA 1997 to implement part of the OECD hybrid mismatch rules by:

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denying imputation benefits on franked distributions made by an Australian corporate tax entity if all or part of the distribution gives rise to a foreign income tax deduction; and

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preventing certain foreign equity distributions received, directly or indirectly, by an Australian corporate tax entity from being non-assessable non-exempt income if all or part of the distribution gives rise to a foreign income tax deduction.

3.2 All references in this chapter are to the ITAA 1997 unless otherwise stated.

Context of amendments

3.3 In the 2016-17 Budget, the Government announced that it would implement the recommendations made in the OECD Action 2 Report, taking into account the recommendations made by the Board of Taxation (see Chapter 1). These recommendations include modifications to the domestic income tax law to:

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deny imputation benefits on franked distributions made by an Australian corporate tax entity if all or part of the distribution gives rise to a foreign income tax deduction; and

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prevent certain foreign equity distributions received, directly or indirectly, by an Australian corporate tax entity from being non-assessable non-exempt income if all or part of the distribution gives rise to a foreign income tax deduction.

3.4 These modifications are consistent with Recommendation 2 of the OECD Action 2 Report.

3.5 In the 2017-18 Budget, the Government further announced that it would eliminate hybrid tax mismatches that occur in cross border transactions relating to Additional Tier 1 regulatory capital. Transitional rules for Additional Tier 1 capital instruments issued before 9 May 2017 were also announced.

Summary of new law

3.6 Consistent with the OECD Action 2 Report and the Board of Taxation recommendations, Schedule 2 to this Bill makes amendments to:

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deny imputation benefits on franked distributions made by an Australian corporate tax entity if all or part of the distribution gives rise to a foreign income tax deduction; and

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prevent a foreign equity distribution from a foreign company that is received, directly or indirectly, by an Australian corporate tax entity that holds a participation interest of at least 10 per cent in the foreign company from being non-assessable non-exempt income if all or part of the distribution gives rise to a foreign income tax deduction.

3.7 Transitional rules apply to Additional Tier 1 capital instruments issued by ADI's, general insurance companies and life insurance companies before 9 May 2017. Under these transitional rules, the amendments to deny imputation benefits do not apply in relation to distributions on the instrument that are made before the first available call date of the instrument that occurs on or after 9 May 2017.

Comparison of key features of new law and current law

Detailed explanation of new law

Denial of imputation benefits

3.8 Consistent with the OECD Action 2 Report and the Board of Taxation recommendations, Schedule 2 to this Bill makes amendments to deny imputation benefits on franked distributions made by a corporate tax entity that give rise to a foreign income tax deduction.

3.9 Under the company imputation system, when an Australian corporate tax entity distributes profits to its members, the entity has the option of passing credit for income tax paid by the entity on those profits to those members. This is done by franking the distribution.

3.10 When the Australian corporate tax entity makes a franked distribution, the entity must make a debit to its franking account (section 205-30). The amount of the debit is equal to the amount of the franking credit on the distribution.

3.11 If a member of an entity receives a franked distribution:

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an amount equal to the amount of the franking credit is generally included in the member's assessable income (in addition to the amount of the distribution); and

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the member is generally entitled to a tax offset equal to the amount of the franking credit.

3.12 The amendments operate to deny these imputation benefits if the distribution gives rise to a foreign income tax deduction. [Schedule 2, items 1 to 3, paragraph 207-145(1)(db), paragraph 207-150(2)(eb) and section 207-158]

3.13 Subject to transitional rules, these amendments address the announcement in the 2017-18 Budget relating to the application of the OECD Hybrid Mismatch Rules to Regulatory Capital (even though the amendments are not limited to regulatory capital).

Foreign equity distributions assessable

3.14 Consistent with the OECD Action 2 Report and the Board of Taxation recommendations, Schedule 2 to this Bill makes amendments to ensure that foreign equity distributions that are entitled to a foreign income tax deduction are included in a corporate tax entity's assessable income.

3.15 In this regard, a foreign equity distribution from a foreign company that is received by an Australian corporate tax entity, either directly or indirectly through one or more interposed trusts or partnerships, is non-assessable non-exempt income if the Australian corporate tax entity holds a participation interest of at least 10 per cent in the foreign company (Subdivision 768-A).

3.16 The amendments ensure that, if the foreign equity distribution gives rise to a foreign income tax deduction, then the distribution will not be non-assessable non-exempt income. [Schedule 2, items 6 to 8, paragraph 768-5(1)(d), paragraph 768-5(2)(f) and subsection 768-7(1)]

3.17 Consequently, in this event, foreign equity distribution will be included in the assessable income of the Australian corporate tax entity.

3.18 However, these amendments do not apply to a foreign equity distribution if:

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the foreign income tax deduction arises because the company that made the distribution is recognised under a law of a foreign country in which the deduction arises as being used for collective investment; and

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foreign income tax or a withholding-type tax was payable in respect of the distribution.

[Schedule 2, item 8, subsection 768-7(2)]

3.19 The reason for this exception is to ensure consistent treatment for Australian investors in collective investment vehicles that are established under the laws of different countries which may utilise different tax mechanisms for achieving the same overall outcome for the same types of specific investment.

3.20 In this regard, different models are used around the world to permit investors to collectively invest in vehicles that own real property and be subject to taxation in a manner that is akin to a direct investment - that is the investor is required to pay tax on their share of the vehicle's income and the vehicle does not pay entity level corporate tax. Some countries achieve the shift in taxation of the vehicle's income from the entity to the investor by exempting a portion of the vehicle's income from taxation. Other countries achieve the same outcome by allowing the vehicle a deduction from its assessable income in respect of dividends paid to its shareholders.

3.21 The exception ensures that, for example, an Australian corporate investor does not lose the benefit of receiving a tax exempt dividend from a foreign real estate investment trust where the foreign jurisdiction has a dividends paid deduction.

3.22 In addition, the paragraph 768-5(1)(d) is disregard for the purposes of calculating the attributable income of an eligible controlled foreign corporation if:

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the eligible controlled foreign corporation receives, either directly or indirectly through one or more interposed trusts or partnerships, a foreign equity distribution; and

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at the time the distribution is made, both the eligible controlled foreign corporation and the company are residents of the same listed country or unlisted country.

[Schedule 2, items 4 and 5, subsection 404(2) of the ITAA 1936]

Example 3.1 : Deductible foreign equity distributions

Aus Co holds a profit participating loan in Foreign Co. The profit participating loan is treated as:

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an equity interest for Australian income tax purposes under Division 974; and

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an ordinary loan for Country B purposes.

The interest payments on the profit participating loan are foreign income tax deductions and are therefore ineligible for the participation exemption in Australia.

Application and transitional provisions

Denial of imputation benefits

3.23 Subject to transitional rules for regulatory capital of ADI's, general insurance companies and life insurance companies, the amendments to deny imputation benefits apply to distributions made on or after 1 January 2019. [Schedule 2, subitem 9(1)]

3.24 However, the amendments do not apply unless the foreign income tax deduction to which all or part of the distribution gives rise arises in a foreign tax period ending on or after 1 January 2019. [Schedule 2, subitem 9(3)]

3.25 Transitional rules for regulatory capital apply if:

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before 9 May 2017, either:

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an ADI issued an Additional Tier 1 capital instrument (within the meaning of the prudential standards determined by APRA under section 11AF of the Banking Act 1959, as in force at the time that this Schedule commences);

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a general insurance company issued an Additional Tier 1 capital instrument (within the meaning of the prudential standards determined by APRA under section 32 of the Insurance Act 1973, as in force at the time that this Schedule commences); or

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a life insurance company issued an Additional Tier 1 capital instrument (within the meaning of the prudential standards determined by APRA under section 230A of the Life Insurance Act 1995, as in force at the time that this Schedule commences); and

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the instrument is callable, and there is a scheduled call date of the instrument on or after 9 May 2017.

[Schedule 2, subitem 10(1)]

3.26 In these circumstances, the amendments do not apply in relation to a distribution on the instrument if:

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at the time the distribution is made, the instrument is an Additional Tier-1 capital instrument within the meaning of the applicable prudential standards as in force at that time; and

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the distribution is made on or before the first scheduled call date of the instrument that occurs on or after 9 May 2017.

[Schedule 2, subitem 10(2)]

3.27 In determining for the purposes of paragraph 10(2)(b) whether a call date is the first scheduled call date occurring on or after 9 May 2017, disregard a call date if:

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the ADI, general insurance company or life insurance company sought prior written approval from APRA to exercise the call option; and

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the prior written approval was not received.

[Schedule 2, subitem 10(3)]

Foreign equity distributions assessable

3.28 The amendments to make foreign equity distributions assessable apply to foreign equity distributions made on or after 1 January 2019. [Schedule 2, subitem 9(2)]

3.29 However, the amendments do not apply unless the foreign income tax deduction to which all or part of the foreign equity distribution gives rise arises in a foreign tax period ending on or after 1 January 2019. [Schedule 2, subitem 9(3)]