House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon John Dawkins, M.P.)

Foreign Life Policies

Overview

This chapter explains the application of the Foreign Investment Fund ( FIF) measures to taxpayers who have an interest in a Foreign Life Assurance Policy ( FLP).

The chapter will examine the meaning of a FLP and when a taxpayer is considered to have an interest in a FLP. In order to apply the FIF measures to the interest in a FLP, this chapter will also explain the period over which the interest in the FLP is taxable, the notional accounting period, and the two methods of taxation that are applicable to a taxpayer's interest in a FLP, the cash surrender value method and the deemed rate of return method.

Explanation

Meaning of a 'foreign life assurance policy'

A FLP in relation to a taxpayer for a year of income is a life assurance policy which has been issued by an entity that was a non-resident at any time in that year of income. A FLP does not include an Australian policy issued by a foreign company that is authorised to carry on life insurance business in Australia. [Subsection 482(1)]

A life assurance policy is a policy which provides for the payment of benefits upon death, other than death by accident or specified sickness, or on the happening of a specified event which relates to the ending or continuing of a human life. A life assurance policy also includes an instrument which grants an annuity for a term dependent upon a human life. [Paragraphs 482(2)(a) to 482(2)(d)]

These measures will not apply to certain life policies that are excluded. The three categories of policies to be excluded are:

hose which provide for payment of benefits on death, or death or permanent disability only;

hose policies issued before 1 July 1992 which cannot, after that date, be cancelled, surrendered or redeemed and for which the terms have not, after that date, been altered in a material respect; or

contract of reinsurance between a resident insurer and a non-resident reinsurer in relation to life assurance policies which provide only life cover.[Paragraphs 482(2)(e) and 482(2)(f)]

Policy issued by a non-resident

These measures will only apply to a FLP that was issued by a non-resident. If however, a resident of Australia issues a life policy and then transfers it to a non-resident insurer with a view to avoiding these measures the Commissioner of Taxation may apply the anti-avoidance provisions of Part IVA of the Principal Act to defeat the arrangement.

Meaning of 'an interest in a FLP'

A person will have an interest in a FLP if that person has a legal title to the FLP. [Subsection 483(3)]

Taxpayers whose interest in a FLP will be subject to taxation

A taxpayer's assessable income for the year of income will include foreign investment fund income if the taxpayer had the interest in a FLP at any time during the notional accounting period of the FLP that ends in the taxpayer's year of income and the taxpayer was a resident at any time in that year of income. [Subsection 485(4)]

The measures will not apply to an interest in a FLP if the taxpayer disposes of that interest before 30 June 1993. [Subsection 485(5)]

Treatment of bare trusts

A bare trust arises when a taxpayer has a beneficial interest in the property of a trust and the trustee does no more than hold legal title to the property. Where the property of a bare trust consists of an interest in a FLP, the FIF measures will look through the trust arrangements and the taxpayer will be treated as holding an interest in the FIF. [Section 484]

Exempt visitor to Australia

Provision has been made to exempt from FIF taxation a taxpayer's interest in a FLP if the taxpayer is a short term visitor to Australia for not more than four years - see Chapter 11 for an explanation of this exemption from the FIF measures. [Section 517]

The acquisition and disposal of an interest in a FLP

Effect of change in ownership

If the interest in a FLP undergoes a change in ownership, this change constitutes a disposal by the person who had the interest in the FLP immediately before the change and an acquisition by the person who owns it immediately after the change. For there to be a change in ownership there must be a change in the beneficial ownership of the interest in the FLP in addition to a change in its legal ownership. [Subsections 488(2) and (3)]

A change in the ownership of an interest in a FLP can take place in any of the following ways:

y the execution of an instrument;

y the entering into of a transaction;

y the transfer of the interest in the FLP by the operation of law;

y the doing of any other act or thing; or

y the occurrence of any event. [Subsection 488(4)]

A change in ownership will be taken to have occurred where one of the following occurs:

declaration of trust in relation to the interest in the FLP under which a beneficiary is absolutely entitled to the interest in the FLP rather than the trustee;

he release, discharge, satisfaction, surrender, forfeiture, expiry, abandonment or extinction, at law or in equity, of the interest in the FLP; or

he redemption or buy-back, in whole or in part, or the cancellation, of the interest in the FLP.[Subsection 488(5)]

An issue to a person of a interest in a FLP is treated as an acquisition of the interest in the FLP by that person. [Subsection 488(6)]

The acquisition or disposal of an interest in a FLP does not take place when there has been an exchange of an interest in one FLP for another interest in a FLP of the same value. The crediting of a bonus on a life policy without the payment of consideration is not an acquisition of an interest in a FLP. [Subsection 488(7)]

Time of disposal or acquisition

If an interest in a FLP is acquired or disposed of under a contract, the time of making the contract is the time of acquisition or disposal. If there is no contract, the acquisition or disposal takes place when the change in ownership occurs. [Section 489]

Consideration for the acquisition or disposal of a FLP

Where inadequate or no consideration is given for the acquisition or disposal of an interest in a FLP, the law will deem that consideration equal to the market value of the interest in the FLP has been paid or received as the case may be. Consideration given is not treated as adequate if:

he amount given or received was greater or less than the market value of the interest; and

he acquisition or disposal was not at arm's length.[Section 490]

Distributions by a FLP

A distribution made under a FLP to the FLP policy holder is any amount paid or credited, or any property distributed in relation to the FLP to the person that constitutes income derived, or a receipt of capital by that person. A distribution by a FLP includes any payment to a person of a bonus or a refund of premium in respect of the FLP. [Section 474]

Meaning of ' notional accounting period of a FLP'

The foreign investment fund income (that which is to be included in the taxpayer's assessable income) is calculated for a ' notional accounting period' of the FLP.

A notional accounting period of a FLP will generally coincide with the taxpayer's year of income, being the period of 12 months ending on 30 June. [Subsection 487(2)]

If the FLP existed before 1 January 1993, then the first notional accounting period of the FLP commences on 1 January 1993 and ends on 30 June 1993. If the policy came into existence on or after 1 January 1993 then the first notional accounting period commences on the day on which it came into existence and ends on the following 30 June. [Subsection 487(7)]

Electing a notional accounting period

If the cash surrender values for an interest in a FLP are available on a day during the same month in each calendar year, then the taxpayer may elect that the end of the notional accounting period of the FLP coincides with the end of the month for which the cash surrender value is available on an annual basis. [Subsection 487(3)]

This election will generally need to be made if the taxpayer wishes to apply the cash surrender value method of taxation to the interest in the FLP.

If the taxpayer chooses to align the notional accounting period of the FLP with the end of the month for which the cash surrender values are available on an annual basis, the election will remain in force so long as the taxpayer has an interest in the FLP. [Subsection 487(4)]

When the taxpayer elects to use the period for which cash surrender values for the FLP are available, the first notional accounting period begins immediately after the end of the month in which the first cash surrender value is provided before the election day. The period ends at the end of the same month in the next calendar year being a month in which the next cash surrender value is provided. [Subsection 487(5)]

Example 1

Assume that the issuer of the FLP provides a cash surrender value for the taxpayer's interest in the FLP in October each year.

The taxpayer is able to apply the cash surrender value method of taxation and on 1 April 1993 elects to change the notional accounting period of the FLP from his/her year of income to coincide with the month during which the cash surrender value of the interest in the FLP is provided.

The notional accounting periods of the FLP are:

1)

January 1993 - 30 June 1993;

2)

July 1993 - 31 October 1993;

3)

November 1993 - 31 October 1994 and every year following.

notional accounting period reverting to year of income

If, following the making of an election to change the notional accounting period of a FLP, a cash surrender value is not available for the taxpayer during the appropriate month, the notional accounting period of the FLP will revert to the taxpayer's year of income. The period beginning on 1 July that is before the period of 12 months during which the cash surrender value is not available and ending on 30 June is a notional accounting period as is every following 12 month period. [Subsection 487(6)]

Example 2

Assume the taxpayer in Example 1 is unable to provide a cash surrender value during the month of October 1996. The following are the notional accounting periods of the FLP:

1)

November 1994 - 30 October 1995;

2)

November 1995 - 30 June 1996;

3)

July 1996 - 30 June 1997 and every year following.

Calculating the income attributable to a FLP

A taxpayer who has an interest in a FLP is required to calculate the foreign investment fund income from each interest in a FLP using either:

he deemed rate of return method; or

he cash surrender value method.

Electing the cash surrender value method

Generally, the deemed rate of return method will be applicable to a taxpayer's interest in a FLP. However, the taxpayer may elect to apply the cash surrender value method if the deemed rate of return method has not previously been applied to the taxpayer's interest in the FLP in respect of the notional accounting period. [Subsection 536(2)]

Electing for the cash surrender value method will also require the taxpayer to elect a notional accounting period for the FLP to coincide with the period for which the cash surrender values are available. [Subsection 536(3)]

An election to apply the cash surrender value method is irrevocable. [Subsection 536(5)]

It will, however, not be possible to apply the cash surrender value method when the taxpayer cannot provide cash surrender values for the beginning and the end of a notional accounting period. In this situation, the deemed rate of return method is applied as follows.

Method of taxation reverting to deemed rate of return

When reverting to the deemed rate of return method, following the application of the cash surrender value method, the tax treatment differs according to when the interest in the FLP was issued to the taxpayer.

(1) Interest in the FLP issued on or before 3 November 1992

If the FLP was issued on or before 3 November 1992, the deemed rate of return method is applied on the same basis as if the cash surrender value had never been applied for any previous notional accounting periods. The notional accounting period from which the deemed rate of return method is applied is determined according to those measures previously outlined in this chapter (see notional accounting period reverting to year of income). [Subsection 536(8)]

(2) Interest in the FLP issued after 3 November 1992

If the FLP was issued after 3 November 1992, the amount of foreign investment fund income that the taxpayer accrued under the cash surrender value method cannot be less than the amount that would have accrued if the deemed rate of return method had been applied for those periods. Accordingly, the following formula is applied to ascertain the amount, if any, by which the foreign investment fund income accrued to the taxpayer under the cash surrender value method should be increased in the year of change over to the deemed rate of return method. [Subsection 536(9)]

The notional FIF income - The actual FIF income


The notional FIF income means the amount of foreign investment fund income that would have accrued to the taxpayer if the deemed rate of return method had always applied.

The actual FIF income means the amount of foreign investment fund income that accrued to the taxpayer under the cash surrender value method.

Example

Assume a taxpayer accrued foreign investment fund income of $150 (the actual FIF income) from the application of the cash surrender value for an interest in a FLP issued after the date of Introduction. Further, assume that the taxpayer could not provide a cash surrender value and is required to revert to the deemed rate of return. The taxpayer calculates that if the deemed rate of return method had always applied to the interest in the FLP, the foreign investment fund income that would have accrued is $200 (the notional FIF income).

Accordingly, the foreign investment fund income that has accrued to the taxpayer under the cash surrender value method must be increased by $50 (that is, $200 - $150 = $50).

deemed rate of return method

Four steps are used in the deemed rate of return method. [Subdivision 18E]

he first step is to determine the number of 'interests' in a FLP the taxpayer has.

he second step is to determine the opening value of the taxpayer's interest in the FLP. Different procedures are adopted for determining the opening value which applies at the beginning of the FIF measures and for periods occurring after the start of the first notional accounting period.

he third step calculates the movement in the value of the taxpayer's interest in the FLP during the notional accounting period. This is known as 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. The amount included in assessable income is called the FIF income.

Step 1 - Interests in a FLP

The first step is to ascertain whether the taxpayer had only one interest, or had two or more interests, in the FLP during the notional accounting period. If the taxpayer has two or more interests that were acquired at different times during the notional accounting period, then the deemed rate of return method is applied separately for each such interest for the period from when the acquisition occurred. [Section 585]

Step 2 - Calculating the opening value

This step determines the opening value of the FLP. If the taxpayer had the interest in the FLP at the beginning of the notional accounting period, the opening value is the value on the day before the first day of the period. [Paragraph 586(a)]

If the taxpayer acquired the interest in the FLP during the notional accounting period, the opening value is the value on the day on which the interest was acquired. [Paragraph 586(b)]

There are different methods to be applied for calculating the opening value at the beginning of the FIF measures and for later periods.

Special rule for calculating the opening value at the start of the FIF measures

For the beginning of the FIF measures, the opening value for a FLP is the amount the taxpayer would be given for surrendering the interest in the FLP on the commencement day of the FIF measures. However, the taxpayer may elect for the opening value of the interest in the FLP at the start of the FIF measures to be the cost of acquiring the interest in the FLP. [Section 588]

Calculating the opening value for later periods

When the deemed rate of return method has applied in the immediately previous year, the opening value is calculated as outlined in the following four steps:

Step one

Determine the deemed value of the FLP at the commencement of the previous notional accounting period;

Step two

Add the FIF income for the previous notional accounting period;

Step three

Add the value of any premiums paid during the previous notional accounting period; and

Step four

Deduct any distributions made by the FLP in the previous notional accounting period. [Section 590]

Opening value where the interest in the FLP was acquired during a notional accounting period

If the FLP was acquired during the notional accounting period, the value of the FLP is the cost to the taxpayer of the acquisition if the taxpayer has paid the full consideration for the FLP. In any other case, the value is the amount of the first premium paid. [Section 591]

Step 3 - Calculating the movement in the value of the FLP ( FIF amount)

Once the opening deemed value has been ascertained, the FIF amount (that is, the movement in the value of the FLP for the notional accounting period) is calculated by applying the following formula:

Opening value of interest x Deemed rate of return x (Number of days held / 365)


Opening value means the amount determined in Step 2.

Deemed rate of return means the rate of interest applicable in 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 existing rate of interest on overpayments is 10 percent.

Number of days held means the number of days in the notional accounting period in which the taxpayer had the interest in the FLP.

Example 1

Assume that at the commencement date of the FIF measures an investor holds a FLP to the value of $HK250,000. Further, assume the statutory interest rate 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 as follows.

$HK250,000 x (10% + 4%) x (181/365) = $HK17,356


The FIF amount for the FLP will be $HK17,356.

Example 2

Assume a second premium of $HK10,000 is paid in respect of the FLP in the previous example 200 days into the FLP's first notional accounting period. This premium will be added to the opening value for the previous notional accounting period plus the FIF amount to get the opening value of the FLP for the next period as follows:

$HK250,000 + $HK17,356 + $HK10,000 = $HK277,356


Step 4 - Determining the amount to be included in assessable income ( 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. The rate of exchange that applied at the end of the notional accounting period is used to convert each amount of FIF income to the corresponding amount in Australian currency. [Sections 593 and 594]

Example 3

In the above example assume there is an exchange rate of $A1.00 = $HK5.00.

Accordingly, the FIF income for the FLP would be:

$HK17,356/5 = $A3,471


FIF income is $A3,471.

cash surrender value method

This method of determining whether any foreign investment fund income accrues to a taxpayer from an interest in a FLP is applied by taking into account changes in the cash surrender value of the interest in the FLP.

The amount attributed to the taxpayer under the cash surrender value method is calculated in two steps.

he first step measures the foreign investment fund amount, which takes into account the movement in the cash surrender value of the taxpayer's interest in the FLP.

f there was a cash surrender value increase, the second step calculates the amount to be included in the assessable income of the taxpayer.

The cash surrender value method applies if it is practicable to ascertain the cash surrender value of the interest of a taxpayer in a FLP. [Subsection 595(1)]

Step 1 - Calculating the movement in the cash surrender value of the interest in the FLP

The movement in the cash surrender value of the taxpayer's interest in the FLP, that is, the foreign investment fund amount, is calculated by applying the following five applications. [Section 596]

First application

Determine the cash surrender value of the taxpayer's interests in the FLP at the end of the notional accounting period.

The currency used for the cash surrender valuation on this first application is to be used for the amount ascertained in each of the following four applications.[Subsection 596(3)]

Second application

Add the amount or value of each distribution (if any) for the interest in the FLP that was made to the taxpayer during the notional accounting period.

Third application

If the taxpayer disposed of any interest in the FLP during the notional accounting period, add the value of any distributions by the FLP in respect of the interests andthe proceeds of any interests in the FLP which the taxpayer disposed of during the notional accounting period.

Fourth application

Deduct the opening cash surrender value of the interests at the commencement of the notional accounting period (this is the same as the value at the end of the previous notional accounting period).

Fifth application

Deduct the cost of any interests in the FLP which the taxpayer acquired during the notional accounting period.

The aggregate of these five applications will give the foreign investment fund amount.

Example 1

Assume the opening cash surrender value of an interest in a FLP was HK$50,000, and at the end of the notional accounting period the closing value of the interest was HK$53,000. There were no acquisitions, disposals or distributions during the notional accounting period. The increase in cash surrender value, the FIF amount, would be HK$3,000.

Example 2

Assume the opening value of a FIF interest was HK$50,000, and at the end of the notional accounting period the closing value of the interest was HK$45,000. There were no acquisitions, disposals or distributions during the accounting period. The decrease in cash surrender value, the FIF amount, would be a FIF loss of HK$5,000.

Gross FIF income

If the foreign investment fund amount is positive, the amount represents the gross foreign investment fund income. [Section 598]

FIF loss

If the foreign investment fund amount is negative a FIF loss has occurred. [Section 599]

This FIF loss may be used to offset assessable income of the taxpayer but only to the extent that the taxpayer has previously been subject to foreign investment fund taxation from the income of that FIF. [Section 533]

Special rule for determining the cash surrender value at the start of the FIF measures

At the start of the FIF measures, 1 January 1993, a cash surrender value for the day preceding the first day (31 December 1992) may not be available.

If this is the case, the taxpayer must use as the opening value for the notional accounting period the average of two cash surrender values. These two values must not be greater than 12 months apart and refer to the values on:

he latest day on which a cash surrender value is available prior to 31 December 1992; and

he earliest day on which a cash surrender value is available after 31 December 1992.[Section 597]

Step 2 - Calculating the amount included in assessable income

The second step is to determine the amount to be included in the assessable income of the taxpayer- the FIF income. [Subsection 600(1)]

The FIF income is calculated by subtracting from the gross FIF income the total of any 'unapplied previous FIF losses'. [Subsection 600(2)]

If the result is positive the FIF income is converted to Australian dollars at the rate of exchange applicable at the end of the notional accounting period and that FIF income is included in the taxpayer's assessable income. [Subsections 600(3) and (4) ]

Meaning of 'unapplied previous FIF losses'

The meaning of any 'unapplied previous FIF losses' is the amount by which the undeducted amount of a foreign investment fund loss exceeds the sum of any gross FIF income applying to a taxpayer's interest in a FLP, regardless of whether the operative provision did not apply because of any of Divisions 2 to 9 and 11 to 15. [Subsection 600(5)]

In calculating the unapplied previous FIF losses, the undeducted amount of a FIF loss is so much of a FIF loss that has not been allowed as a deduction from the assessable income of the taxpayer. [Subsection 600(6)] Once a FIF loss has been used in ascertaining if there was, for any notional accounting period, an unapplied previous FIF loss, then that loss cannot be taken into account again for the purposes of ascertaining an unapplied previous FIF loss for later notional accounting periods. [Subsection 600(7)]

Also, in determining the gross FIF income that is used in calculating the unapplied previous FIF losses, only that gross FIF income accruing after the notional accounting period in which the loss was incurred and before the current notional accounting period in which the taxpayer has a gross FIF income is applied. [Subsection 600(6)]

Record keeping

For an explanation of the procedure to be followed for keeping records see Chapter 23.