Explanatory Memorandum
(Circulated by the authority of the Treasurer, the Hon John Dawkins, M.P.)deemed rate of return method
Overview
This chapter explains the procedure for determining the amount to be included in the taxpayer's assessable income based on the deemed rate of return method.
This chapter only discusses the application of the deemed rate of return method to an interest in a FIF. The procedure for determining the amount to be included in the taxpayer's assessable income in relation to a foreign life policy is covered in Chapter 19.
Explanation
Introduction
The deemed rate of return method applies if it is not practicable to apply the market value method (see Chapter 16) and the taxpayer has not chosen the calculation method (see Chapter 18). [Section 535(2)]
Using this method there are four steps.
- he first step is to determine the taxpayer's interests in the Foreign Investment Fund ( FIF) and whether any of the interests constitute a group.
- he second step is to determine the opening value of the interests. Different procedures are adopted for determining the opening value at the beginning of the FIF measures and for periods occurring after the first notional accounting period of the FIF measures.
- he third step calculates the movement in the value of interest in the FIF throughout the notional accounting period. This is called the FIF amount.
- he fourth step converts the FIF amount to Australian currency and determines the amount that will be included in the taxpayer's assessable income. This is called the FIF income.
There are two sections in this chapter. The first section explains the steps in the application of the deemed rate of return method. The second section shows how to calculate the opening value for the current year.
Section 1: Application of the deemed rate of return method
The deemed rate of return method is applied separately to each group of interests held by the taxpayer. It is necessary therefore, to determine the group or groups of interests in a FIF held by the taxpayer at the end of the relevant period. [Section 544]
Meaning of a 'group of interests in a FIF'
If a taxpayer had only one interest in a FIF during the notional accounting period that interest is a group. [Subsection 544(2)]
Interests in a FIF that are of the same class (for example, two parcels of A class shares held during the same period) are considered as a group of interests. However, if interests are of different classes (for example, A and B class shares with different rights) then each class would be treated as a separate group. Likewise, shares and options in a FIF would form different groups. [Subsections 544(4) and (5)]
If a taxpayer had two or more interests in a FIF that are not of the same group of interests the deemed rate of return method is applied separately to each group. [Subsection 544(3)]
Step 2 - Calculating the opening value
This step determines the opening value of the interest in the FIF as measured at the beginning of the notional accounting period. There are different procedures to be applied for the beginning of the FIF measures and for periods following the first notional accounting period of the FIF measures. These procedures are explained in detail in the second section.
Step 3 - Calculating the movement in the value of the FIF (the FIF amount)
Once the opening deemed value has been ascertained, the FIF amount, that is, the movement in the value of the FIF for the notional accounting period, is calculated by applying the following formula: [Section 555]
Opening value x (deemed rate of return + 4%) x (Number of days held / 365)
Where:
Opening value means the amount determined in Step 2 of this chapter.
Deemed rate of return means the rate of interest applicable in accordance with section 10 of the Taxation (Interest on Overpayments) Act 1983 for the taxpayer's year of income, increased by 4 percentage points. If there is more than one interest rate the weighted average of those rates is used. The current rate of interest on overpayments is 10 per cent.
Number of days held means the number of days in the notional accounting period in which the taxpayer had the interests in the group.
Example 1
Assume an investor holds 2,000 A class shares and 1,000 B class shares in a Cayman Islands company. Each class of shares is a different group. On 1 July 1993, the parcel of A class shares had a value of $CI200,000 and the parcel of B class shares had a value of $CI100,000. At the end of the FIF's notional accounting period there is no market value for either class of share. Further, assume the deemed rate of return is 10 per cent.
For the first year, under the deemed rate of return method it will be necessary to multiply the opening value by the deemed rate of return for each group as follows.The FIF amounts for the groups will be $CI28,000 and $CI14,000. The opening deemed value of the parcel of A class shares for the following notional accounting period would be $CI228,000 and the opening deemed value of the parcel of B class shares for the following notional accounting period would be $CI114,000.
A class shares: $CI200,000 x (10% + 4%) x 365/365 = $CI28,000
B class shares: $CI100,000 x (10% + 4%) x 365/365 = $CI14,000
Example 2
Assume 1,000 C class shares are acquired 150 days into the FIF's notional accounting period for $CI240,000. Application of the deemed rate of return method for the group constituted by the C class shares would be as follows:
$CI240,000 x (10% + 4%) x (365-150)/365 = $CI19,792
The FIF amount is $CI19,792. The opening deemed value of the C class shares for the following notional accounting period would be $CI259,792 ($CI240,000 + $CI19,792).
Step 4 - Determining the amount to be included in assessable income (the FIF income)
The final step in applying the deemed rate of return method is to determine the amount attributed to the taxpayer, that is, the FIF income. To do this the FIF amount (as calculated in step 3) is converted to the corresponding amount in Australian currency. [Sections 556 and 557]
The rate of exchange that applied at the end of the notional accounting period is used to convert each group of interests to the corresponding amount in Australian currency. If there is only one group of interests, the FIF income will be the amount converted into Australian currency. If there is more than one group, the FIF income will be the sum of the amounts already converted into Australian currency. [Section 556]
Example 3
In the above example assume that an exchange rate of $A1.00 = $CI6.00 operates. The FIF income for the three groups constituted by the A, B and C class shares would be the sum of:
Class A shares: $CI28,000/6 = $A4,667 Class B shares: $CI14,000/6 = $A2,333 Class C shares: $CI19,792/6 = $A3,299 $A10,299
The taxpayer will need to include $A10,299 in assessable income. [Section 529]
Section 2: Calculating the opening value
Special rule for the start of the FIF measures
In the first year of application of the FIF measures, all FIFs will be treated as if their first notional accounting period commenced on 1 January 1993. Accordingly, this will mean that a taxpayer to whom the deemed rate of return method is to apply in the first year will be required to calculate a deemed value for each FIF interest as at that date. This will represent the opening value of the FIF interest.
There will be three methods of calculating the opening deemed value in the first year of the FIF measures. Use of the second method will only be required if the first cannot be used. Similarly, the third method will only be used if the first and second methods cannot applied. [Subsections 547(1) , 548(1) and 549(1)]
(1) Previous quotation on approved stock exchange
The first method of valuation will apply where the FIF interest has been quoted on an approved stock exchange. When two or more approved stock markets provide a quoted price, the taxpayer chooses the stock market from which the opening value will be taken. The list of approved stock exchanges is at Schedule 3. [Subsection 547(5)]
If the FIF interest has been quoted on an approved stock exchange on 1 January 1993 then that quoted price is taken to represent the opening value. [Subsection 547(1)]
If the FIF interest is not quoted on an approved stock exchange on 1 January 1993 but an approved stock market value is available at any time during the preceding 12 months, the valuation on the latest quoted date will be used as the deemed value as at 1 January 1993. [Subsection 547(2)]
In the case of an interest in a trust that was not quoted on 1 January 1993 or during the preceeding 12 months, but for which there was on 1 January 1993 a buy-back or redemption price offered by the trustee or manager of the trust, then that offer represents the opening value. If there was not a buy-back or redemption price on 1 January 1993, the latest price within the preceeding 12 months may be used. [Subsection 547(3)]
(2) Fair market value of investment
The second method of valuation uses a fair market value at 1 January 1993 as the opening value. To take advantage of this method, a taxpayer will use an independent valuation of the FIF interest. The valuation must be within a three month period either side of, and including, 1 January 1993. The valuation supplied will form the basis for the opening value. [Subsection 548(2)]
(3) Initial investment indexed at deemed rate of return
Under the third method of valuation, the initial investment is increased by a deemed rate of return for each year between the acquisition date and the first actual application of the deemed rate of return method. [Section 549]
Calculating the opening value for periods following the start of the FIF measures
There are three methods for determining the opening value of the interest in the FIF in periods following the start of the FIF measures.
(1) Opening value where the deemed rate of return method has applied in the previous year
When the deemed rate of return has applied in the immediately previous year the opening value is calculated as outlined in the following three steps. [Section 551]
Determine the deemed value at the commencement of the previous notional accounting period, and add the value of any interests acquired after the commencement of the previous notional accounting period.
Add the FIF income for the previous notional accounting period.
Deduct any distributions made by the FIF in the previous notional accounting period in relation to the FIF interest.
(2) Opening value where the calculation method or an exemption has applied in the previous year
Where the calculation method (see Chapter 18) or an exemption from FIF taxation applied in the immediately previous year the opening value for the current period will be ascertained by one of two valuation methods. [Subsection 552(1)]
The first method of valuation will apply where the FIF interest has been quoted on an approved stock exchange at some time in the previous notional accounting period, but does not have a market value at the end of that notional accounting period. In order to approximate the closing value, should a market value be available at any time during the previous notional accounting period, that valuation will be used as the deemed value as at the end of that previous notional accounting period. If more than one market value exists, then the latest market value for that notional accounting period is to be used as the deemed value as at the end of the notional accounting period. [Subsection 552(2)]
Under the second method of valuation, the starting point for entry into the deemed rate of return method is ascertained by increasing the initial investment by the deemed rate of return as discussed above. This method will only be used where the first method is not applicable. [Subsection 552(3)]
(3) Opening value where the market value method has applied in the previous year
If the market value method has applied in the immediately previous notional accounting period, then the opening value for the current year will be the market value of the interest in the FIF at the end of the previous notional accounting period. [Section 553]
Opening value where the interests in a FIF were acquired during a notional accounting period
If the interests in a FIF were acquired during the notional accounting period, the value of the interests is the consideration paid or given by the taxpayer for the acquisition. [Section 554]