House of Representatives

Explanatory Memorandum

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

Relief for Foreign Taxes

Introduction

Under the Principal Act, relief from international double taxation is dealt with in two ways:

he income may be included in a taxpayer's assessable income and a credit allowed for the foreign tax under the foreign tax credit system (FTCS); or

he income may be exempt from Australian tax.

This chapter deals with these credits and exemptions. A brief explanation of the FTCS, and the exemptions associated with it, follows. Those readers already familiar with the operation of the existing credits and exemptions in respect of foreign income should go to section two of this Chapter.

Section 1: Background to the FTCS

Under the FTCS, foreign source income derived by Australian residents (apart from certain salary and wages) is generally subjected to Australian income tax. A credit for foreign tax paid, up to the amount of the Australian income tax referable to the foreign income, is allowed against the Australian tax payable. Credit is allowable for foreign taxes imposed by central, state and local governments, provided that the taxes are equivalent in nature to Australia's income tax.

Inter-corporate related company dividends

Where the whole or a part of a dividend received from a non-resident company is included in the assessable income of a resident taxpayer (whether corporate or non-corporate) the taxpayer is entitled to a credit for the direct foreign tax - for example, dividend withholding tax - paid in respect of that dividend. However, an Australian resident company that receives a dividend from a related foreign company is also allowed a credit for the foreign company taxes on that portion of the profits from which the dividends are paid - that is, the underlying foreign tax.

A foreign company is related to an Australian company if the Australian company has a direct voting interest of at least 10 per cent of the voting power of the foreign company. This relationship could extend through any number of tiers of foreign companies if each company in the chain has at least a 10 per cent voting interest in the company in the tier below, and the Australian company has a direct or indirect voting interest of at least 5 per cent in the foreign company.

Relief for foreign tax paid by a trust

Where the assessable income of a beneficiary includes foreign income derived by the trust, the beneficiary is entitled to a credit for the proportionate part of the foreign tax paid by the trustee.

No credit is allowed for underlying foreign taxes paid in respect of a dividend - that is, underlying tax credits do not flow through trusts. This rule applies even where shares in the foreign company are held by the trust as nominee for a resident company which is the sole beneficiary of the trust.

Quarantining of credits

The credit allowable for foreign tax paid on foreign income is calculated separately for:

assive income - which includes dividends, interest, royalties, annuities, rents, commodity gains, certain deemed dividends, attributed income of a controlled foreign company and certain net capital gains;

ffshore banking income - which includes interest, fees, commissions and other amounts derived from the offshore transactions of an offshore banking unit and dividends paid by an offshore banking unit; and

ther income.

Excess foreign tax credits

Prior to the 1990-91 income year, where the amount of foreign tax paid on foreign source income of a class of income exceeded the Australian tax payable on that income, the excess was not available to be carried forward or carried back.

For the 1990-91 and later income years, excess foreign tax credits can be carried forward for 5 years and applied against Australian tax payable on foreign income of the same class.

Excess foreign tax credits can also be transferred within wholly-owned company groups.

The impact of accruals taxation

With the introduction of the CFC measures, the FTCS was modified and certain new exemptions were introduced for the purposes of relief from double taxation.

Credit is available to a resident company for tax paid by a related CFC against any amount of the CFC's attributable income that is included in the resident company's assessable income. The credit is allowed on a similar basis as credit is allowed for taxes paid on dividends received by a resident company from a related foreign company.

Amounts of income of the CFC that have already been taxed in full in Australia - for example, Australian sourced income derived by a branch of the CFC and taxed by assessment in Australia - are excluded from the calculation of the CFC's attributable income.

Attributed income is treated as foreign income. The foreign tax and Australian tax paid by the CFC on that amount are creditable foreign taxes. This effectively allows any Australian withholding tax paid by the CFC to be creditable on attribution for foreign tax credit purposes if the resident taxpayer is entitled to the foreign tax credit.

Dividends from income previously attributed

A dividend that is paid out of income that has been previously attributed to a resident taxpayer is exempt in the hands of that taxpayer. Direct foreign taxes on such a dividend (for example, dividend withholding taxes) are creditable taxes, notwithstanding that the dividend is exempt from tax.

No credits in respect of foreign tax on certain exempted dividends

Non-portfolio dividends paid to a resident company by a related company resident in a listed country - that is, a country whose taxation system is broadly comparable to Australia's - are exempt from tax in Australia. Any part of a non-portfolio dividend paid to a resident company by a company resident in an unlisted country out of profits that have been taxed by assessment in Australia or in a listed country is also exempt from tax in Australia. No foreign tax credits are allowable on these exempt dividends.

Section 2 - Objectives of the changes to the FTCS - company FIFs

Credits on attribution from corporate FIFs

Credits where the market value method is used

Where the market value method is used to determine the FIF income, no credit will be allowed for foreign tax paid by the FIF. Instead, all taxpayers will be allowed an effective deduction for tax paid by, or accrued to, the FIF. This will occur because the closing market value implicitly takes into account any payment of, or liability for, taxes.

Credits where the calculation method is used

Where a resident company and a FIF are related companies and the resident company has used the calculation method to determine the FIF income for the company's interest in the FIF, a foreign tax credit may be allowed in accordance with the FTCS for a share of the foreign tax paid by the FIF (the first tier FIF) on its income and gains.

Furthermore, a credit for tax paid by the second tier FIF may be given where the resident company has used the calculation method to determine the FIF income of the second tier FIF, and the taxpayer, and the first and second tier FIFs are companies and the taxpayer is related to both the first and second tier FIFs. In this case, a foreign tax credit may be allowed in accordance with the FTCS for a share of the foreign tax paid by the second tier FIF on its income and gains. This foreign tax credit is in addition to any foreign tax credit allowed in relation to an interest in a first tier FIF.

A credit will only be allowed where the resident company and the FIF or FIFs are related companies. This is consistent with the general treatment of foreign taxes paid on underlying income under the FTCS and is also consistent with the CFC measures.

Credits for deemed rate of return method

No credit (or deduction) for foreign taxes will be allowed under the deemed rate of return method.

Credits on distribution from corporate FIFs

The allowance of credits on distribution will follow the credits allowed under the existing FTCS. In addition, a taxpayer will be allowed a credit where the dividend is exempt because the profits out of which the dividend has been paid have been subject to attribution in a previous year. The credit will be allowed on a similar basis to the credit allowed where a dividend is assessable, but will be limited to the amount not already allowed as a credit.

Further, the provisions of the Principal Act which allow for excess foreign tax credits to be carried forward for up to 5 years will also apply where excess foreign tax credits arise in relation to an interest in a FIF and, where appropriate, an indirect interest in a second tier FIF. As under the existing FTCS, there will be no carry back of credits.

How the objectives are achieved in the law

Credits on attribution

calculation method at first tier FIF only

Where an amount of FIF income is included in the assessable income of a resident company, the company may be allowed a credit for the taxes paid by the FIF. The credit will only be allowed where:

he resident company is related to the FIF at the end of the FIF's notional accounting period; and

he resident company used the Calculation Method to determine the amount to be included in its assessable income under the FIF measures.

The credit allowed will be equal to the resident company's share of the taxes paid by the FIF that were allowed as a notional deduction in the calculation of the FIF's calculated profit. The FIF's notional deductions consist of the foreign and Australian taxes paid by the FIF in respect of amounts included in the FIF's notional income (refer to Chapter 18).

To achieve this, income under the FIF measures will be treated as foreign income. [Subsection 6AB(1)]

In addition, the resident company will be deemed to have been personally liable for, and to have paid the amount of foreign tax claimed as a credit.[Subsection 6AB(3A), section 160AFCE]

As with the normal operation of the FTCS, the foreign income must be grossed up to include the foreign tax. [Subsection 6AC(6)]

Example 1

An Australian resident company (Ausco) has a 20% interest in a company FIF resident in an unlisted country (Forco). Forco is not a CFC and has never been a CFC. For the notional accounting period, Forco's details were as follows:

Notional income		$200,000
Notional deduction for the tax paid on the notional income	$17,000
Other notional deductions	$30,000	$ 47,000
calculated profit		$153,000
Taxpayer's FIF income (20% x $153,000)		$ 30,600

Ausco is deemed to have paid the following amount of tax on the attributed income:

attribution percentage x notional deduction
= 20% x $17,000 = $3,400


Ausco must gross up its assessable foreign income by this amount - that is, the $30,600 is increased by the $3,400 to $34,000. Ausco can then claim a foreign tax credit for $3,400 (subject to the usual limitation in the law which states that the credit being claimed cannot exceed the Australian tax payable in respect of the foreign income).

Calculation method at the second tier FIF

Where the calculation method is used at the second tier and an amount of second tier FIF income is included in the notional income of a first tier FIF, a resident company may be allowed a credit for a share of the taxes paid by the second tier FIF. The credit will only be allowed where:

he resident company is related to the first tier FIF and the second tier FIF at the end of the second tier FIF's notional accounting period;

he resident company used the calculation method to determine the amount of first tier FIF income to be included in its assessable income under the FIF measures;

he resident company used the calculation method to determine the amount of second tier FIF income to be included in the notional income of the first tier FIF;

n amount of second tier FIF income is included in the notional income of the first tier FIF and an amount of FIF income is included in the assessable income of the resident company; and

n amount of foreign tax is a notional deduction from the notional income of the second tier FIF. [Section 160AFCF]

The credit allowed will generally be equal to the resident company's share of the taxes paid by the second tier FIF that were allowed as a notional deduction in the calculation of the second tier FIF's calculated profit.

The resident company's share of calculated profit of the second tier company FIF is that part of the first tier FIF income included in the resident company's assessable income that relates to an amount of second tier FIF income included in the notional income of the first tier FIF. [Subsection 160AFCF(3)]

The second tier FIF's notional deductions consist of the foreign and Australian taxes paid by the second tier FIF in respect of amounts included in the FIF's notional income (refer to Chapter 18). To achieve this, income under the FIF measures will be treated as foreign income. [Subsection 6AB(1)]

A new provision has been inserted into the law to allow taxpayers to claim a foreign tax credit. The taxpayer is deemed to have been personally liable for, and to have paid an amount of the foreign tax paid by the second tier FIF. [Subsection 6AB(3A) and section 160AFCF]

As with the normal operation of the FTCS, the foreign income must be grossed up to include the foreign tax deemed paid under section 160AFCF. [Subsection 6AC(6)]

Example 2

An Australian resident company (Ausco) has a 20% interest in a company FIF resident in an unlisted country (Forco). Forco is not a CFC and has never been a CFC. Forco in turn has a 30% interest in a second FIF (Secco) that is not a CFC.

For Secco's notional accounting period which ends during the notional accounting period of Forco, Secco's details were as follows:

Notional income		$650,000
Notional deduction for the tax paid on the notional income	$100,000
Other notional deductions	$150,000	$250,000
calculated profit		$400,000
Secco FIF income included in Forco's notional income (30% x 400,000)		$120,000*
The gross deductible amount for taxes paid is $100,000.
* This is included in Notional Income in Example 1.

The calculated profit of Secco is $400,000. The amount of Secco's FIF income included in the notional income of the first tier FIF is $400,000 x 30% =$120,000.

Ausco's share of the calculated profit of Secco is

= $120,000 x 20% = $24,000.


Ausco is deemed to have paid the following amount of tax in respect of Secco:

= Gross deductible amount x (Ausco's share of calc profit of Secco / Calculated profit of Secco)
= $100,000 x $24,000/$400,000 = $6,000


Ausco must gross up its assessable foreign income that is $30,600 (from Example 1) by the amount of foreign tax deemed paid under sections 160AFCE ($3,400) - see example 1 - and 160AFCF($6,000) that is, $9,400. Ausco can then can claim a foreign tax credit for $9,400 (subject to the usual limitation in the law which states that the foreign tax paid cannot exceed the Australian tax payable in respect of the foreign income).

Credits on dividends received where there was attribution

Where a resident receives a dividend from a foreign company the following may occur:

ll or a part of the dividend may be exempt because there was previous attribution to the taxpayer in respect of the FIF; and

f the resident is a company, all or part of the dividend may be exempt because the profits from which the dividend was paid were comparably taxed in a listed country.

The part of the dividend which is assessable may qualify for a foreign tax credit under the existing FTCS. That credit will continue to be available.

In addition, a taxpayer may be allowed a credit for the foreign tax paid on that portion of the dividend that is exempt because of previous attribution under the FIF measures.

As under the existing FTCS, no credit will be available for foreign taxes that relate to that part of a dividend that is exempt because the underlying profits were comparably taxed.

The rest of this section discusses the credit in greater detail.

Taxpayers other than resident companies

Where a resident taxpayer receives a dividend from a foreign company, the resident is usually only allowed a credit for foreign taxes paid by the resident or on the resident's behalf. Taxes paid by the company on the profits from which the dividend was paid are not allowed as a credit. This will continue to be the rule under the FIF measures.

Foreign tax credits are usually allowed only where the dividend is included in assessable income. As with dividends that are exempt because there has been attribution under the CFC measures, an exception will be made to this rule where the dividend is exempt because there has been attribution under the FIF measures. [Section 160AFCJ]

However, section 160AFCJ will only operate where a taxpayer receives a dividend which is exempt under [section 23AK] . The formula that determines the credit is as follows:

(EP x DT) + (AEP x UT) - AT.


The only components of the formula that are relevant to a taxpayer other than a company are the EP x DT parts, since the rest of the formula will always equal nil (the rest of the formula is explained under the next heading). The EP x DT component of the formula allocates the direct tax paid by the taxpayer evenly over the part of the dividend that is exempt and the rest of the dividend. In effect, it allows all of the direct tax to be claimed as a credit.

Example 3

A resident individual (J Smith) has 20% of a company FIF (Forco) which is resident in an unlisted country. Forco is not a CFC and has never been a CFC. Forco had distributable profits of $153,000 on which it has paid foreign tax of $17,000. J Smith has a FIF attribution credit balance in relation to Forco of $30,600.

On 1 August 1993, Forco pays a dividend of $30,600 to J Smith. The unlisted country levies dividend withholding tax at the rate of 10%.

J Smith will not need to include the dividend in assessable income as it was paid out of previously attributed income. Despite this, J Smith is deemed to have included the dividend in assessable income for the purpose of granting a foreign tax credit for the dividend withholding tax. J Smith can claim a credit for EP x DT = 100% x $3,060 = $3,060.

This credit is subject to the usual limit of the Australian tax payable, and can only be claimed if J Smith has other foreign income. If not, J Smith can carry the amount forward to claim a credit in a future year.

Example 4

Assume the same facts as in the previous example except that:

he distributable profits of Forco are $200,000; and

n 1 August 1993, Forco paid a dividend of $40,000.

Because J Smith was previously taxed on $30,600, an exemption will be allowed up to that amount. The excess of the dividend over $30,600 (that is, $9,400) will need to be included in his assessable income.

To work out the foreign tax credit J Smith will apply the formula as follows:

EP = $30,600 / $40,000
EP x DT = 76.5% x $4,000 = $3,060


J Smith would be allowed a credit for the rest of the dividend withholding tax ($940) in accordance with the existing provisions of 160AF. In total, the credit is $4,000; the same amount that would be allowed if the dividend were wholly assessable.

Resident companies

In general, resident companies will be treated the same as other taxpayers. However, there is one exception to this rule. The exception is where the resident company receives a non-portfolio dividend from a related foreign company.

As with other dividends, a non-portfolio dividend received by an Australian resident company from a related foreign company will be exempt to the extent that the dividend has been paid out of previously attributed income, and the company will be allowed a credit for the foreign dividend withholding tax paid.

The difference is that in the case of a non-portfolio dividend paid by a related foreign company, a credit will also be allowed for the tax paid by the foreign company on the profits out of which the dividend was paid (that is, the foreign underlying tax), but only to the extent that underlying tax has not yet been allowed as a credit at the attribution stage.

This exception is also achieved by [section 160AFCJ] . However, in addition to the EP x DT part of the formula the taxpayer would use the (AEP x UT) part of the formula. This part of the formula allocates the tax paid by the company out of which the dividend was paid to the part of the dividend that is exempt because of previous attribution under the FIF measures.

Where the taxpayer has not claimed a credit under [section 160AFCE or 160AFCF] , the AT component will be nil (the operation of the AT component is shown in the second example).

Example 5

Ausco owns 20% of a foreign company (Forco) which is resident in an unlisted country and derived only unlisted country income. Forco is not a CFC and has never been a CFC. Forco had distributable profits of $153,000 in respect of which it has paid foreign tax of $17,000. Ausco did not have sufficient information to use the calculation method and relied on the market value method to determine the FIF income. The amount of the attribution surplus on 31 July 1993 is $30,600.

On 1 August 1993, Forco pays a dividend of $30,600 to Ausco. The unlisted country levies dividend withholding tax at the rate of 10%.

The dividend will be exempt from tax for Ausco as it was paid out of previously attributed income. At the attribution stage, Ausco received no credit for the foreign tax paid by Forco.

Again, even though the dividend is not included in assessable income of Ausco, it is deemed to be so included for the purpose of granting a foreign tax credit. Ausco can claim a credit for the dividend withholding tax and for the underlying tax as though the dividend was paid from income that had not been attributed to Ausco.

The EP x DT component is calculated as for other taxpayers - that is, it is $3,060 (refer to Example 3 for non-company taxpayers). The rest of the credit is calculated as:

AEP x UT = 100% x $3,400 = $3,400


The total foreign tax credit allowed is $6,460 ($3,060 + $3,400).

Example 6

Assume the same facts as in Example 5 except that:

he taxpayer used the calculation method to determine the FIF income; and

he FIF income was $30,600 and, the attribution surplus on 31 July 1994 was $30,600.

The EP x DT component would be the same. However, there would now be an amount that was previously allowed as a foreign tax credit (20% x $17,000 = $3,400). Ausco would use the rest of the formula as follows:

(AEP x UT) - AT = 100% x $3,400 - $3,400 = 0


The credit allowed would be $3,060 only.

Credit for accruals taxes of foreign countries

Other countries may also impose accruals type taxes. These will be treated in the same manner as other foreign taxes. That is, where an Australian company is allowed a credit for underlying taxes paid by the company FIF, the accruals type tax will be allowable as a foreign tax credit.

Dividends exempt under section 23AJ

Section 23AJ of the Principal Act may exempt from tax a non-portfolio dividend received by a resident company. Broadly, the exemption applies where the profits out of which the dividend is paid are taxed in a listed (comparable tax) country. The FIF measures will not deny the existing section 23AJ exemption (see Chapter 24).

Objectives of the changes to the FTCS - trust FIFs

Credits on attribution from trust FIFs

Under the FTCS, the treatment of foreign taxes paid by the trustee of a foreign trust is different to that of companies, since the beneficiary of the trust is deemed to have paid the foreign tax paid by the trustee. In general, this distinction will be maintained for taxpayers with an interest in a trust FIF.

Credits where the calculation method is used at first tier

Consistent with the treatment of company FIFs, where the taxpayer has used the calculation method of calculating attributable income of a trust FIF a foreign tax credit will be allowed for the foreign tax paid by the trustee of the trust on the income and gains of the trust FIF. The calculation will be made in the same way as for a related company FIF.

Credits where the calculation method is used at second tier

Where the taxpayer has used the calculation method for the second tier trust FIF a foreign tax credit will be allowed for the foreign tax paid by the trustee of the trust on the income and gains of the trust FIF. The calculation will be made in the same way as for a related company FIF.

Credits for market value or deemed rate of return methods

No credit will be allowed on attribution under the market value or deemed rate of return methods. This is consistent with the treatment of company FIFs.

Credits on distribution from trust FIFs

The allowance of credits on distribution will be similar to the credits under the existing FTCS. Broadly, this means that, if the amount of the distribution is included in assessable income, both companies and other taxpayers will be allowed a credit for foreign taxes paid:

irectly by the taxpayer (for example, a withholding tax on a dividend); and

y the trustee of the trust (including accruals type taxes in respect of lower tier entities).

In addition to the normal operation of the FTCS, a taxpayer will be allowed a credit where the trust distribution is exempt because it has been subject to attribution in a previous year. This will be limited to the amount not already allowed as a credit where the calculation method was used.

How the objectives are achieved in the law

Credits on attribution

First tier foreign trust

Where a resident trust used the calculation method to determine the amount to be included in its assessable income under the FIF measures the trust may be allowed a credit for the taxes paid by the FIF.

The credit allowed will be equal to the resident trust's share of the taxes paid by the FIF that were allowed as a notional deduction in the calculation of the FIF's calculated profit. The FIF's notional deductions consist of the foreign and Australian taxes that were paid by the FIF in respect of amounts included in the FIF's notional income. [Section 160AFCG]

Second tier foreign trust

Calculation method at the second tier FIF

Where the calculation method is used at the second tier and an amount of second tier FIF income is included in the notional income of a first tier foreign trust, the taxpayer may be allowed a credit for a share of the taxes paid by the second tier FIF. The credit will only be allowed where:

he taxpayer used the calculation method to determine the amount of first tier FIF income to be included in its assessable income under the FIF measures;

he taxpayer used the calculation method to determine the amount of second tier FIF income to be included in the notional income of the first tier FIF;

n amount of second tier FIF income is included in the notional income of the first tier foreign trust and an amount of FIF income is included in the assessable income of the taxpayer; and

n amount of foreign tax is a notional deduction from the notional income of the second tier foreign trust. [Section 160AFCH]

The credit allowed will generally be equal to the resident company's share of the taxes paid by the second tier FIF that were allowed as a notional deduction in the calculation of the second tier FIF's calculated profit.

The taxpayer's share of calculated profit of the second tier foreign trust is that part of the first tier FIF income included in the taxpayer's assessable income that relates to an amount of second tier FIF income included in the notional income of the first tier FIF. [Subsection 160AFCH(3)]

The second tier FIF's notional deductions consist of the foreign and Australian taxes paid by the second tier FIF in respect of amounts included in the FIF's notional income (refer to Chapter 18). To achieve this, income under the FIF measures will be treated as foreign income. [Subsection 6AB(1)]

New provisions have been inserted into the law to allow taxpayers to claim a foreign tax credit. The taxpayer is deemed to have been personally liable for, and to have paid the amount of foreign tax claimed as a credit.[Subsection 6AB(3A) , section 160AFCG and section 160AFCH]

As with the normal operation of the FTCS, the foreign income must be grossed up to include the foreign tax. [Subsection 6AC(6)]

Credits on distribution from trust FIFs

In addition to the normal operation of the FTCS, a taxpayer will be allowed a credit where the trust distribution is exempt because it has been subject to attribution in a previous year. This will be limited to the amount not already allowed as a credit where the calculation method was used. [Section 160AFCJ]

Clauses making the amendments

Clause 3: Amends section 6AB to include FIF income in foreign income and to treat certain taxes paid by a FIF as foreign tax.

Clause 4: Amends section 6AC to provide for grossing-up of foreign income for the purpose of allowing a foreign tax credit.

Clause 13: Inserts additional definitions into section 160AE which are relevant to the calculation of foreign tax credits under the FIF measures.

Clause 15: Inserts sections 160AFCE, 160AFCF, 160AFCG, 160AFCH and 160AFCJ to enable taxpayers subject to FIF attribution to claim a foreign tax credit on attribution of FIF income and distributions made to them by the FIF.