SENATE

REPLACEMENT Explanatory Memorandum

(Circulated by the authority of the Treasurer the Hon John Dawkins, M.P.)THIS MEMORANDUM TAKES ACCOUNT OF AMENDMENTS MADE BY THE House of Representatives TO THE BILL AS INTRODUCED

Chapter 6 Amendments to the Foreign Investment Fund measures

Section 1 - Introduction

The foreign investment fund (FIF) measures came into effect on 1 January 1993. The measures provide for the taxation, on an accruals basis, of investments held by Australian residents in non-controlled foreign companies, interests held by Australian beneficiaries in non-controlled foreign trusts and investments in foreign life policies (FLPs) by Australian policy holders. Also, as part of these measures, new rules governing the taxation of Australian beneficiaries of foreign trust estates were introduced with effect from the 1992-93 income year.

The FIF measures aim to remove the tax advantage of deferring Australian tax by accumulating income in offshore companies and trusts that are not controlled by Australian residents. They complement the controlled foreign company and transferor trust measures which have been in operation since, generally, the 1990-91 income year.

An ongoing review of the FIF measures has been instituted to put right any anomalies which might arise in the course of the operation of the measures. The review confirms the validity of the measures which have been put in place. However, some amendments to the law are required to fine tune the measures and bed them properly with existing provisions, particularly the controlled foreign company measures.

In addition, amendments to the law are required to give effect to a number of changes to the FIF measures which were announced by the Treasurer in a press release on 9 October 1992. This announcement followed a review of the FIF measures by an independent consultant, Professor Brian Arnold, who was appointed as a consultant to advise the Government on the implementation of the measures.

The proposed amendments will:

•

make changes to the controlled foreign company (CFC) measures to:

•

exclude from the FIF income of a CFC certain dividends paid by a FIF out of comparably taxed profits;

•

provide ordering rules to deal with the interaction of attribution accounts under the CFC measures and attribution accounts under the FIF measures; and

•

clarify that the notional assessable income of a CFC is not to include a distribution paid by a FIF out of profits which have been taxed under the FIF measures;

•

modify the operation of the market value method for determining FIF income to:

•

provide a more equitable basis of taxation where a taxpayer changes from using the deemed rate of return method of calculating FIF income to the market value method;

•

ensure that double taxation of income will not occur in relation to interests in a FIF which are disposed of by a taxpayer during an accounting period of the FIF;

•

enable taxpayers to determine the market value of an interest in a company FIF by reference to the redemption price of the interest; and

•

allow taxpayers to elect irrevocably to compute FIF income and losses for all of their FIF interests on a basis that takes foreign currency gains and losses into account annually;

•

modify the rules which govern when the calculation method for determining FIF income may apply by:

•

preventing taxpayers who cease to use the calculation method for calculating FIF income for interests in a FIF from using the calculation method again in relation to interests in that FIF (including where interests are acquired in the FIF at a future time);

•

enabling taxpayers to use the calculation method for the notional accounting period of a FIF which is in progress at the time the election was made; and

•

allow Regulations to be made to prescribe the amortisation rate for a class of property prescribed for the purposes of subparagraph 570(1)(a)(iii);

•

ensure that amounts which are exempt from tax because they are paid out of profits which have been taxed under the FIF measures are not treated as exempt income for the purposes of calculating capital gains and losses under the capital gains tax provisions;

•

ensure that amounts upon which a beneficiary of a foreign trust estate is taxed under the FIF measures are not taxed again in the hands of a transferor of property to the foreign trust estate or the trustee of the foreign trust estate;

•

ensure that the FIF measures will not apply for the purposes of calculating the taxpayer's share of the net income of a trust estate if the FIF measures do not apply to the beneficiary's interest in that trust estate because of the country fund exemption;

•

ensure that the FIF measures do not apply to a taxpayer who is both a resident of Australia and another country where a double taxation agreement (DTA) treats the taxpayer as a resident solely of that other country;

•

ensure that the exemption for certain FIF interests that are trading stock can apply in relation to all interests in FIFs which would normally be treated as trading stock for the purposes of the Act;

•

provide that the exclusion from passive income of amounts that arise from an asset necessarily held by a taxpayer in connection with an insurance business actively carried on by the taxpayer has effect from the 1992-93 year of income;

•

provide that the amortisation rate in relation to certain buildings and structural improvements for the purposes of the calculation method will be 2.5 per cent; and

•

correct technical problems with the drafting of paragraphs 160AFCK(2)(b), 509(b) and section 523.

A detailed explanation of each of these amendments follows:.

Section 2 - General overview of the FIF measures

The FIF measures apply to Australian resident taxpayers who, at the end of an income year, have an interest in a foreign company or trust. The measures also apply to taxpayers who hold a foreign life policy (FLP) at any time during a year of income.

The FIF measures provide a number of exemptions from FIF taxation. These exemptions are designed to exclude from the FIF measures interests in FIFs which are not the target of the measures. Where an exemption does not apply, the amount of FIF income to be included in a taxpayer's assessable income is determined using one of the following three taxing methods:

(i)

the market value method;

(ii)

the deemed rate of return method; or

(iii)

the calculation method.

In the case of FLPs, the amount of FIF income will be determined under the cash surrender value method or the deemed rate of return method.

Under these methods of taxation, the taxpayer's interest in a FIF is measured in relation to notional accounting periods of the FIF commencing on 1 January 1993 and for subsequent periods. The notional accounting period of a FIF is generally the same as a taxpayer's year of income. However, a taxpayer can elect to use the period for which the annual accounts of the FIF are made.

The assessable income arising under the FIF measures is included in the taxpayer's assessable income for the income year in which the notional accounting period of the FIF ends.

Section 3 - Amendments relating to the CFC measures

Overview

It is possible that a controlled foreign company (CFC) will have an interest in another company or trust which is a FIF. The amendments are designed to align the operation of the FIF measures with the CFC measures.

Background to the CFC measures

Broadly, the CFC measures operate to tax the Australian controllers of a CFC on a current basis when those profits are derived by the CFC, i.e., on an accruals basis. The measures tax the Australian controllers on their share of the passive and other tainted profits (generally, income from transactions with related parties) of the CFC where those profits are not taxed at a rate of tax comparable to that which would have applied if the profits had been taxed in Australia.

The amount included in the assessable income of an Australian controller of a CFC is calculated as a share of the attributable income of the CFC based upon the interests held by the Australian controller in the CFC.

The attributable income of a CFC is calculated on the basis that the CFC is a resident of Australia. However, the profits of the CFC which are taken into account for the purposes of this calculation are generally the low-taxed passive and other tainted profits of the CFC. In this regard, the FIF income of a CFC is specifically included in the calculation of the CFC's attributable income.

Summary of proposed amendments

Purpose of amendment: The amendments will:

(i)

exclude from the FIF income of a CFC certain dividends paid by a FIF out of comparably taxed profits;

(ii)

provide ordering rules to deal with the interaction of the operation of attribution accounts under the CFC measures and attribution accounts under the FIF measures;

(iii)

clarify that the income of a CFC is not to include a distribution paid by a FIF out of profits which have been taxed under the FIF measures.

Date of Effect: these amendments will apply from the commencement of the FIF measures, i.e., 1 January 1993.

(i) Treatment of exempt dividends received by a CFC

Background to the legislation

Currently, the FIF income to be included in the assessable income of a resident company because it holds an interest in a FIF is reduced to the extent that the company receives a dividend from the FIF which is exempt under section 23AJ. The exemption under section 23AJ operates to provide relief from double taxation in instances where dividends are paid from comparably taxed profits and the shareholding of the resident company represents a substantial interest in the foreign company rather than a passive investment. Broadly, section 23AJ exempts non-portfolio dividends (i.e., dividends received by a resident company from a foreign company in which it has a 10% or greater voting interest) received by an Australian company which are paid out of profits that:

•

have been comparably taxed in a listed country; or

•

have already been taxed in Australia by assessment at the full corporate rate.

Where a resident company has an interest in a CFC, the income of the CFC that is to be included in the assessable income of the taxpayer under the CFC measures is calculated by taking into account the FIF income of the CFC. Currently, the exemption under section 23AJ does not apply for the purposes of calculating the notional assessable income of a CFC [Section 389] . However, there are a number of provisions in the CFC measures which exempt certain dividends received by a CFC for similar reasons to those for providing the exemption under section 23AJ. For consistency with the treatment of section 23AJ exempt dividends, these exempt distributions will reduce the FIF income which would otherwise be attributed to a CFC as a result of its interest in the FIF paying the dividend.

Explanation of proposed amendments

The amendments will provide that dividends which are treated as exempt income of a CFC under the CFC measures for reasons similar to those for exempting dividends under section 23AJ will reduce the FIF income which would otherwise be included in the assessable income of a CFC under the FIF measures.

This will be achieved with changes to section 530. This section operates to prevent double taxation through reducing FIF income by amounts that have either been included in the taxpayer's assessable income or have been comparably taxed in another country.

Paragraph 530(1)(d) will be replaced with a paragraph that will reduce the amount on which a taxpayer will be assessed under the FIF measures by, not only amounts which are exempt from tax under section 23AJ, but also amounts which are notional exempt income, of a CFC in which the taxpayer has an interest, under paragraphs 402(2)(c), 403(b) or section 404.

(ii) Interaction between CFC and FIF attribution account systems

Background to the legislation

Attribution accounts trace the movement of profits which have been included in the assessable income of a taxpayer under the CFC or the FIF measures so that those profits are not taxed again when they are distributed to the taxpayer. The CFC and FIF measures have their own distinct attribution account systems.

Circumstances may arise where an entity has both profits which have been taxed under the CFC measures and profits which have been taxed under the FIF measures. For instance, this may happen where a foreign company ceases to be a CFC.

The attribution account systems require provisions to address instances where an entity has both profits which have been taxed under the CFC measures and profits which have been taxed under the FIF measures. These provisions are necessary to ensure that the distributions of previously taxed profits under the CFC measures and the FIF measures are traced separately so that double counting does not arise.

Explanation of proposed amendment

The amendments will provide ordering rules to deal with the interaction of the operation of attribution accounts under the CFC measures and attribution accounts under the FIF measures. The ordering rules will treat distributions from an entity as paid firstly from profits which have been taxed under the CFC measures and secondly from profits which have been taxed under the FIF measures.

This will be achieved by reducing the amount which is treated as having been paid from profits which have been taxed under the FIF measures to the extent that the amount is treated as having been paid from profits which have been taxed under the CFC measures [New paragraph 606(2)(b)].

The extent to which an amount is treated as having been paid from profits which have been taxed under the CFC or FIF measures is determined in accordance with section 372 or section 606 respectively. These amounts are referred to as "attribution debits" for the purposes of the attribution account systems.

(iii) Distributions from profits taxed under the FIF measures

Background to the legislation

Distributions paid to a CFC by another business entity are exempt to the extent that the distribution was made out of profits of that entity which have been taxed previously under the CFC measures. It follows that this exemption should also apply where a distribution is paid to a CFC out of profits which have been included in the income of the CFC under the FIF measures.

Subsection 402(3) exempts distributions paid to a CFC to the extent that the payment gives rise to an attribution debit for the paying entity. An attribution debit will arise for the paying entity where it makes a distribution out of profits which have been taxed under the CFC measures.

Presently, however, the terms used in subsection 402(3) do not relate to terminology used in relation to FIF attribution accounts. Consequently, it is not clear that subsection 402(3) operates to exempt distributions paid to a CFC to the extent that the payment gives rise to a FIF attribution debit for the paying entity. A FIF attribution debit arises for the paying entity where it makes a distribution out of profits which have been taxed under the FIF measures.

Explanation of proposed amendments

New subsection 402(4) will clarify that the income of a CFC is not to include a distribution paid to the CFC out of profits which have been included in the notional assessable income of the CFC under the FIF measures. There are three conditions that must be satisfied before the subsection applies.

The first condition is that a "FIF attribution account payment" is made to the relevant CFC during the "eligible period" by a "FIF attribution account entity" [Paragraph 402(4)(a)] . Broadly, these terms have the following meanings:

•

a "FIF attribution account payment" includes:

•

a dividend paid by a company to a shareholder;

•

interest paid on a convertible note to the holder of the note; and

•

amounts included in a taxpayer's assessable income because of an interest in a trust or partnership; [Section 603]

•

the "eligible period" is the statutory accounting period for which the CFC's attributable income is being calculated; [Section 381] and

•

a "FIF attribution account entity" is a non-resident company, a partnership or a trust estate. [Section 601]

The second condition is that there be at least a part of the FIF attribution account payment that would be included in notional assessable income of the CFC for the period if subsection 402(4) were not taken into account [Paragraph 402(4)(b)] . Broadly, the notional assessable income of a CFC comprises those amounts which are taken into account in determining the attributable income of the CFC.

The third condition is that the FIF attribution account payment must result in a FIF attribution debit for the entity making the FIF attribution account payment in relation to the relevant taxpayer [Paragraph 402(4)(c)] . Broadly, a FIF attribution debit will arise in relation to a taxpayer where a FIF attribution account entity makes a FIF attribution account payment to the taxpayer, or to another FIF attribution account entity in which the taxpayer has an interest, out of profits which have been attributed to the taxpayer under the FIF measures. [Section 606]

Where the above conditions are satisfied, a FIF attribution account payment will not be included in the notional assessable income of a CFC to the extent that it does not exceed the grossed-up amount of a FIF attribution debit which arises, in relation to the relevant taxpayer, for the entity making the payment.

The grossed-up amount of a FIF attribution debit is determined in accordance with new section 607A.

Paragraph 607A(b) is relevant for the purposes of determining the grossed-up amount of a FIF attribution debit which arises when a CFC receives a FIF attribution account payment.

Broadly, it provides that the grossed-up amount of a FIF attribution debit is calculated by dividing the amount of the FIF attribution debit which arises for the entity making the FIF attribution account payment by the relevant taxpayer's interest in the CFC receiving the payment.

It should be noted that an amount is increased where it is divided by a percentage which is less than 100%. Hence, because it is not possible to have an interest in excess of 100% in a CFC, the grossed-up amount of a FIF attribution debit will never be less than the FIF attribution debit which gave rise to it.

It is necessary to gross-up a FIF attribution debit for the purposes of calculating the exempt amount received by a CFC because the CFC's attributable income is calculated with regard to the entire profits of the CFC and not just a particular taxpayer's share of those profits.

Section 4 - Changes to the market value method

Summary of the proposed amendments

Purpose of amendment: the market value method for calculating FIF income will be amended to:

(i)

provide an equitable basis of taxation where a taxpayer changes from using the deemed rate of return method of calculating FIF income to the market value method;

(ii)

ensure that double taxation of income will not occur for interests in a FIF which are disposed of by a taxpayer during an accounting period of the FIF;

(iii)

enable taxpayers to determine the market value of an interest in a FIF that is a company by reference to the redemption price of the interest on a similar basis to that presently available for calculating the market value of interests in a foreign trust under subsection 539(3); and

(iv)

allow taxpayers to elect irrevocably to compute FIF income and losses for all of their FIF interests on a basis that takes foreign currency gains and losses into account annually.

Date of Effect: these amendments will apply from the commencement of the FIF measures, i.e., 1 January 1993.

(i) Opening value of a FIF interest under the market value method

Background to the legislation

In determining the amount of FIF income that is to be included in a taxpayer's assessable income, the market value method takes into account the market value (or, in certain cases, the redemption value) of that interest at the beginning and end of the accounting period.

Where the market values or redemption values are not available, the taxpayer may determine FIF income by using the deemed rate of return method. If the deemed rate of return method is used in a year to calculate FIF income, the opening value of the FIF interest to be used in the next year is, subject to adjustments for distributions made by the FIF, the current year's opening value increased by the deemed income for the year. This opening value may differ from the market value of the FIF interest.

Presently, the opening value of a FIF interest for the purposes of the market value method is its quoted price on an approved stock market or, in some cases, the redemption value of the interest. This treatment does not give the correct result where the deemed rate of return method was used to calculate FIF income for the previous accounting period. This is because FIF income was determined for that previous period on the basis of a deemed profit rather than on actual profit.

Explanation of proposed amendments

The amendments will provide for instances where the deemed rate of return method is used to calculate FIF income for a FIF interest for an accounting period and the market value method is used in the next period. In this event, the opening value of the FIF interest in the next period for the purposes of the market value method is to be the same opening value as that which would have been used had the deemed rate of return method applied in that period.

A similar problem may arise where a taxpayer changes from using the deemed rate of return method to the cash surrender value method to determine FIF income for an interest in a FLP. The amendments will provide, in this event, that the opening value of the FLP interest in the next period for the purposes of the cash surrender value method is to be the same opening value as that which would have been used had the deemed rate of return method applied in that period.

New subparagraph 538(2)(c)(ii) will apply where a taxpayer changes from using the deemed rate of return method to the market value method for determining FIF income. Broadly, subparagraph 538(2)(c)(ii) has the effect that the value of an interest in a FIF at the start of the relevant period for the purposes of the calculation of FIF income under the market value method is equal to the value which would have been determined if the deemed rate of return method had applied for that period.

Example

In year 1, a taxpayer uses the deemed rate of return method to calculate FIF income for an interest in a FIF. The FIF interest is valued @ $100 at the beginning of the period. Thus, the taxpayer would be assessed on $14 ($100 x 14% x 365 days / 365 days) FIF income.

In year 2, the taxpayer uses the market value method to calculate FIF income. New subparagraph 538(2)(d)(ii) will provide that the opening value of the FIF interest in year 2 is $114, i.e., the value of the interest which would have been used if the deemed rate of return method had applied in year 2. This will be the case even though the value of the FIF interest on an approved stock exchange at the beginning of year 2 may have been a different amount.

New subparagraph 596(2)(d)(ii) mirrors the above treatment for interests held in FLPs. It will apply where a taxpayer changes from using the deemed rate of return method to the cash surrender value method for determining FIF income for an interest in a FLP. Broadly, subparagraph 596(2)(d)(ii) has the effect that the value of an interest in a FLP at the start of the relevant period for the purposes of the calculation of FIF income under the cash surrender value method is equal to the value which would have been determined if the deemed rate of return method had applied for that period.

(ii) Prevention of double taxation under the market value method

Background to the legislation

Presently, the market value method operates to include amounts in FIF income relating to the increase in value of an interest in a FIF which is disposed of during a notional accounting period of the FIF (i.e., the period for which FIF income is determined) [Paragraph 538(2)(c)] . This has the result that the increase in the value of that interest which arises in the year of disposal is included in FIF income.

However, it was not intended that the FIF measures would apply to a FIF interest disposed of by a taxpayer before the end of a notional accounting period of a FIF. Rather, it was intended that the provisions of the Act relating to the taxation of realised profits and gains (for instance, the capital gains tax provisions) should apply to such a disposal. This treatment is provided because a more precise calculation of profits and gains in relation to an interest in a FIF which is disposed of during the year of income can be obtained by using the general provisions of the Act dealing with the taxation of realised profits and gains than can be obtained by using the FIF measures which apply to approximate a FIF's profits.

Explanation of proposed amendments

The amendments will ensure that FIF income does not accrue under the market value method in relation to interests in a FIF which are disposed of by a taxpayer during a notional accounting period of the FIF.

This will be achieved by removing one of the five steps provided in section 538. Taken together, these five steps determine the movement in the market value of the interest in a FIF. The step to be removed is at paragraph 538(2)(c). This paragraph includes amounts in FIF income which relate to the increased value of an interest in a FIF which has been disposed of during the notional accounting period.

A consequence of removing paragraph 538(2)(c) is the renaming of paragraphs 538(2)(d) and 538(2)(e). That is, former paragraph 538(2)(d) is renumbered as paragraph 538(2)(c) and is changed from being the fourth step to becoming the third step. Similarly, former paragraph 538(2)(e) is renumbered as paragraph 538(2)(d) and is changed from being the fifth step to becoming the fourth step.

It should be noted that it is intended that distributions to a taxpayer from a FIF which are referable to FIF interests which were disposed of during a notional accounting period are to be taken into account when determining FIF income [New paragraph 538(2)(e)] . However, section 530 operates to reduce the taxpayer's FIF income to the extent that these distributions are included in the taxpayer's assessable income.

(iii) Redemption price

Background to the legislation

In order to apply the market value method, a taxpayer must first ascertain the market value of the taxpayer's interests in the FIF [Section 539] . Where this is not possible, a taxpayer cannot use the market value method [Section 535] . In many cases, this would result in a taxpayer having to resort to the deemed rate of return method to calculate FIF income.

Currently, a taxpayer may determine the market value of an interest in a FIF which is a trust by reference to a buy back or redemption price of the interest [Subsection 539(3)] . This option is, however, presently restricted to FIFs which are trusts and cannot be used in relation to company FIFs. Thus, the market value of an interest in a company FIF must be determined by reference to its quoted value on an approved stock exchange. If this value cannot be obtained, the taxpayer cannot use the market value method despite the availability of a redemption price for the interest in the FIF.

Explanation of proposed amendments

The amendments will enable a taxpayer to determine the market value of an interest in a company FIF by reference to the redemption price. This method is to be made available where:

•

the interest in the company is not listed on the relevant day on the stock market of an approved stock exchange (Schedule 3 of the Act lists the approved stock exchanges); and

•

the interest is included in a class of interests for which a buy-back or redemption price is offered, at intervals of not more than 12 months, by the company or an associate of the company; and

•

the buy-back or redemption price:

•

was publicly available and offered to all persons; and

•

was calculated by reference to the market value of the assets of the company; and

•

represents the arm's length valuation of the interest on that day.

This will be achieved by inserting references to companies into subsections 539(3) and (4) so that these provisions may apply equally to both companies and trusts. Subsection 539(3) presently allows a redemption value to be used in certain circumstances to value an interest in a trust. Subsection 539(4) allows certain redemption values for an interest in a trust to be used to ascertain the value of that interest at the commencement of the FIF measures.

In addition, the amendments will extend the circumstances where redemption values can be used to value an interest in a FIF. The amendments will allow the redemption price offered by an associate of a company, or of the trustee or manager of a trust, for the redemption of an interest held by a taxpayer in the company or trust to be used as the buy-back or redemption price for that interest [New paragraph 539(3)(b)] . However, the redemption price has to satisfy all of the conditions referred to previously.

(iv) Foreign currency gains and losses

Background to the legislation

Presently, FIF income under the market value method is determined using the currency in which the value of interests held in the FIF on the last day of the relevant period is expressed [Subsection 538(3)]. If FIF income arises, the amount to be included in a taxpayer's assessable income is converted to the corresponding amount in Australian currency. This treatment effectively delays the realisation of currency exchange gains and losses until the end of the period for which FIF income is being calculated.

However, some taxpayers might prefer to determine FIF income and losses for all of their FIF interests on a basis that takes foreign currency gains and losses into account annually.

Explanation of proposed amendments

The amendments to the law will allow taxpayers to elect irrevocably to compute FIF income and losses for all of their FIF interests on a basis that takes foreign currency gains and losses into account annually.

This will be achieved by allowing taxpayers to elect to express the amounts used to calculate FIF income in Australian currency thereby bringing to account currency exchange gains and losses at the time the transactions and values relevant to the calculation of FIF income occurred [New subsection 538(4)] . New subsection 538(5) will ensure that this election is irrevocable and that it will apply to all of a taxpayer's FIF interests.

Section 5 - Changes to when the calculation method may be used to determine FIF income

Summary of amendments

Purpose of amendment: the Bill seeks to amend the law to:

(i)

prevent a taxpayer who ceases to use the calculation method for calculating FIF income for interests in a FIF from using the calculation method again in relation to interests in that FIF (including where interests are acquired in the FIF at a future time);

(ii)

enable taxpayers to use the calculation method for determining FIF income for the notional accounting period of a FIF which is in progress at the time the election was made; and

(iii)

allow Regulations to be made to prescribe the amortisation rate for a class of property prescribed for the purposes of subparagraph 570(1)(a)(iii).

Date of Effect: The amendments referred to at item (i) above will apply for notional accounting periods of a FIF ending after the date the amending Bill receives Royal Assent. The other amendments referred to will apply from the commencement of the FIF measures, i.e., 1 January 1993.

(i) Restriction upon election to use the calculation method

Background to the legislation

A taxpayer can elect to use the "calculation" method to determine FIF income in respect of the taxpayer's interests in a FIF for a notional accounting period [Subsection 535(3)] . Under this method, FIF income is generally calculated on the basis of the taxpayer's share of the realised profits of a FIF. The other methods for calculating FIF income (the deemed rate of return method and the market value method) take into account both realised and unrealised profits of a FIF.

This difference between the calculation method and the other methods in bringing to account realised and unrealised profits could be manipulated by taxpayers to obtain tax benefits. For example, a movement from the calculation method to the deemed rate of return method may enable a taxpayer to avoid taxation on a part of the FIF income. The taxpayer may use the calculation method during periods when the FIF derives only dividends and interest income from its investments and opt for the deemed rate of return method for periods where it is anticipated that the FIF would derive large capital profits from the sale of its assets that had appreciated in value.

Explanation of proposed amendments

Complicated adjustments would be required to counter the tax avoidance possibilities that could arise from allowing unfettered movement between the calculation method for calculating FIF income and other methods. Rather than providing these adjustments, the amendments will provide that a taxpayer who changes from using the calculation method of determining FIF income to another method in relation to an interest in a FIF cannot subsequently elect to use the calculation method again in relation to that FIF.

New subsection 535(4) will prevent a taxpayer from electing to use the calculation method to determine FIF income for a notional accounting period of a FIF where the taxpayer has ceased to use the calculation method for a previous notional accounting period of the FIF.

(ii) Timing of election to use the calculation method

Background to the legislation

A taxpayer can elect to use the calculation method to determine FIF income in respect of the taxpayer's interests in a FIF for a notional accounting period [Subsection 535(5)] . A notional accounting period of a FIF is the period for which its FIF income is to be determined.

To make an election to use the calculation method, it is a requirement that the taxpayer also elects to use the period for which the FIF makes out its accounts (i.e., the FIF's accounting period) as its notional accounting period [Subsections 535(3), 535(5) and 486(3)] . This allows the accounts for that period to be used for the purposes of calculating FIF income without having regard to when particular profits were derived by the FIF.

Currently, where an election to use the calculation method is made, the calculation method first applies from the next notional accounting period of the FIF which commences after the time the election was made [Subsection 535(4)] . Hence, it is not possible to use the calculation method in relation to a notional accounting period of a FIF which is in progress at the time the election to use the calculation method was made. This means that, in many instances, taxpayers are unable to use the calculation method for the first notional accounting period of a FIF in which they acquire an interest in the FIF. It also prevents taxpayers from using the calculation method for the notional accounting period of a FIF which commences from the date on which the FIF measures first apply (that is,1 January 1993).

The policy of not allowing the calculation method from applying for a notional accounting period of a FIF, where the election is made during that period to use the calculation method, is to prevent taxpayers from selecting the method for determining FIF income once the trading results of the FIF are known. Otherwise, taxpayers may be able to minimise the effects of FIF taxation measures by selectively taking advantage of timing differences which exist between the calculation method and the other methods for determining FIF income.

To enable a taxpayer to decide which method to use after the trading results of the FIF were known was seen to compound this problem. However, given the restriction upon electing to use the calculation method, as outlined at item (i) above, it is not considered necessary to provide further restrictions on taxpayers with regard to the method they use for determining FIF income. Consequently, the circumstances where a taxpayer can make an election to use the calculation method for calculating FIF income are to be extended.

Explanation of the proposed amendment

An amendment is proposed to extend the circumstances where a taxpayer can make an election to use the calculation method. The amendment will enable a taxpayer to elect, at any time during the taxpayer's year of income, to use the calculation method in relation to any notional accounting period of a FIF:

(i)

which is in progress at the time the election was made; or

(ii)

that ended in the year of income of the taxpayer in which the election was made.

This will be achieved by omitting subsection 535(4). Subsection 535(4) currently provides that the calculation method applies to the first period in respect of which a FIF makes out its accounts that begins after the day on which an election to use the calculation method is made. The availability of the calculation method is still subject, however, to a taxpayer making an election under subsection 486(3) to use notional accounting periods for the FIF which correspond to periods for which the FIF makes out its accounts. It should be noted that a taxpayer may use the calculation method for the truncated notional accounting period which arises because of the election under subsection 486(3).

Example

In the absence of an election under subsection 486(3) to use notional accounting periods for the FIF which correspond to periods for which the FIF makes out its accounts, each period that is a year of income of the taxpayer is a notional accounting period of the FIF. [Subsection 486(2)]. Hence, for most taxpayers, the notional accounting period of a FIF prior to making an election under subsection 486(3) will normally be from 1 July to 30 June each year. There are exceptions to this rule. For instance, the first notional accounting period of a FIF which was in existence prior to 1 January 1993 commences on 1 January 1993 rather than from the commencement of the relevant taxpayer's year of income. [Subsection 486(7)]

Assume that a taxpayer has a 1 July to 30 June year of income. If the taxpayer were to elect on 1 February 1994 to use notional accounting periods for a FIF which correspond to periods for which the FIF makes out its accounts, the first period for which the FIF makes out its accounts that begins during the year of income of the taxpayer in which the election was made, and all later such periods, will be notional accounting periods of the FIF [Paragraph 486(5)(a)] . In addition, the period commencing 1 July 1993 (i.e., the commencement of the taxpayer's year of income) and ending immediately before the new notional accounting period will also be a notional accounting period. [Paragraph 486(5)(b)]

Consequently, if the FIF makes out its accounts for the period 1 January to 31 December each year, the FIF would have a truncated notional accounting period from 1 July 1993 to 31 December 1993 and then notional accounting periods from 1 January to 31 December thereafter. A taxpayer may elect to use the calculation method to determine FIF income for the truncated period (i.e.,1 July 1993 to 31 December 1993).

Amendments are also provided to modify the calculation of FIF income. They are relevant for the first notional accounting period of a FIF for which the calculation method is used if that period does not correspond to the period for which the FIF makes out its accounts. [Paragraphs 580(4A)(a), 580(4A)(b), 582(7A)(a) and 582(7A)(b)]

These modifications serve two purposes. Firstly, they provide that the calculated profit of a FIF is to be determined using the accounts of the FIF for the period which ends at the end of the notional accounting period of the FIF. This is achieved by deeming the period for which the calculated profit of the FIF is to be determined to have commenced at the beginning of the corresponding period for which the FIF makes out its accounts [Paragraphs 580(4A)(c) and 582(7A)(c)] . This allows the FIF's accounts to be used for the purpose of determining the FIF's calculated profit without having to make modifications to identify which profits and outgoings relate to the notional accounting period of the FIF.

Secondly, the modifications apportion the calculated profit of a FIF on the basis of the extent to which the notional accounting period of the FIF corresponds to the period for which the calculated profit was determined. This is achieved by deeming the taxpayer to have acquired at the beginning of that notional accounting period, any interests that the taxpayer had in the FIF immediately before the notional accounting period. [Paragraphs 580(4A)(d) and 582(7A)(d)] Accordingly, the taxpayer is not treated as holding any interest in the FIF prior to the notional accounting period and subsection 580(3) will apply to apportion the taxpayer's share of the calculated profit.

Example

In the previous example, the FIF had a truncated notional accounting period of 1 July 1993 to 31 December 1993. If the taxpayer elected to use the calculation method for that period, the following modifications would be made for the purposes of determining FIF income under that method:

(i)

the period for which the calculated profit would be determined would be the period for which the company makes out its accounts ending on the last day of the FIF's truncated notional accounting period, i.e., for the accounting period 1 January 1993 to 31 December 1993;

(ii)

the taxpayer is treated as not having any interest in the FIF prior to the beginning of the commencement of the FIF's truncated notional accounting period, i.e., prior to 1 July 1993.

If the FIF is determined to have a calculated profit of $100,000 using the FIF's accounts for the period 1 January 1993 to 31 December 1993 and the taxpayer's attribution percentage in the FIF is 5%, the taxpayer's FIF income would be calculated as follows:

Taxpayer's share of FIF income = Calculated profit * Attribution percentage * (Number of days held / Total number of days)
= ($100,000 * 5% * 184 days (i.e., 1/7/93 to 31/12/93)) / 365 days = $2520


(iii) Amortisation of building expenses under the calculation method

Background to the legislation

In certain circumstances, a notional deduction is allowable for the purposes of the calculation method for expenditure incurred by a FIF in the acquisition of:

(i)

plant or articles within the meaning of section 54; or

(ii)

industrial property within the meaning of Division 10B; or

(iii)

any other prescribed class of property.

[Section 570]

Capital expenditure on certain buildings and structural improvements of the type set out in Division 10D of Part III of the Act are to be a prescribed class of property for the purposes of subparagraph 570(1)(a)(iii). Hence, a notional deduction will be available under section 570 in certain circumstances for the amortisation of expenditure incurred in acquiring these buildings and structural improvements. This will be achieved by prescribing all or certain types of Division 10D buildings as a class of property in the Income Tax Regulations.

The amortisation rate of 2.5% in Division 10D is to be maintained for the purposes of determining the notional deduction which may be claimed. Normally, section 570 allows an amount to be calculated as a notional deduction equal to that shown in the accounts of the FIF as relating to the amortisation of the relevant asset if the conditions set out in that section are satisfied.

There is presently no authority in section 570 to modify the rate of amortisation by Regulation. Consequently, an amendment to the law is required to provide an amortisation rate or rates for the classes of property prescribed by Regulation.

Explanation of proposed amendments

The amendments will allow Regulations to be made to prescribe the amortisation rate for a class of property prescribed for the purposes of subparagraph 570(1)(a)(iii). [Subsection 570(1A)]

By specifying a rate of amortisation, the period over which the property is amortised for the purposes of the calculation method may be different to that over which the property will be amortised in the accounts of the FIF. For the purposes of subsection 570(1A), it is a requirement that the accounts of the FIF have at some time included an amount for the amortisation of expenditure incurred in the acquisition of the property. [Paragraph 570(1A)(b)]

Where subsection 570(1A) applies, the accounts of a FIF are treated, for the purposes of subsection 570(1), as having amortised the expenditure on the relevant property on the basis of the rate of amortisation prescribed in the Regulations. Consequently, the condition in subsection 570(1) that the accounts of the FIF include an amount in respect of the amortisation of expenditure on the property can be satisfied even though the expenditure has been written off in the accounts of the FIF in earlier periods because of higher rates of amortisation.

Furthermore, the notional deduction which can be claimed under subsection 570(1) for property to be prescribed by Regulations is limited to amortisation at the relevant rate prescribed in those Regulations.

Example

Assume a FIF acquires property of a class which is prescribed for the purposes of subparagraph 570(1)(a)(iii) for $10,000 and amortises that property in its accounts at a rate of 10%. Also assume that Regulations prescribe that this class of property may be amortised at a rate of 2.5%.

Subsection 570(1A) would operate to apply subsection 570(1) as if the property had been amortised in the accounts of the FIF at a rate of 2.5% rather than 10%. Therefore, if the property was depreciated for a full year, the notional deduction available under subsection 570(1) would be limited to $250 (i.e., $10,000 x 2.5%) even though the amount shown in the accounts of the FIF was $1,000 (i.e., $10,000 x 10%).

Section 6 - Interaction of the capital gains tax provisions with the FIF measures

Summary of proposed amendments

Purpose of amendment: the amendments will ensure that amounts which are exempt from tax solely because they are paid out of profits which have been taxed under the FIF measures will not be treated as exempt income for the purposes of calculating capital gains and losses under the capital gains tax provisions.

Date of Effect: these amendments will apply from the commencement of the FIF measures, i.e., 1 January 1993.

Background of the legislation

Generally, any capital gain arising from the disposal of an asset which was used solely for the purpose of producing exempt income is not taken into account in calculating the amount to be included in assessable income under the capital gains tax provisions. Correspondingly, a capital loss incurred by a taxpayer on the disposal of an asset which was used solely for the purpose of producing exempt income is not taken to have been incurred by the taxpayer.

The FIF measures exclude from assessable income amounts that are paid to a taxpayer by a FIF out of the profits of the FIF which have already been included in the taxpayer's assessable income under the FIF measures [Section 23AK] . These amounts ought not to be treated as exempt income for the purposes of the capital gains tax provisions because the exemption under section 23AK is provided in order to prevent double taxation rather than to entirely exclude the amounts from the tax base.

Explanation of proposed amendment

The amendment will ensure that amounts which are exempt from tax solely because they are paid out of profits which have been taxed under the FIF measures will not be treated as exempt income for the purposes of calculating capital gains and losses under the capital gains tax provisions.

Subsection 160Z(6) provides that a capital gain arising from the disposal of an asset used solely for the purpose of producing exempt income is not included as assessable income under the capital gains tax provisions. Also, subsection 160Z(9) ensures that a capital loss incurred by a taxpayer from the disposal of an asset which was used solely for producing exempt income is not taken to be a capital loss. For these purposes, the meaning of 'exempt income' is modified by subsection 160Z(10). To achieve the proposed amendment subsection 160Z(10) will include a reference to section 23AK. This reference will ensure that amounts exempt from the FIF measures under section 23AK will not be treated as exempt income for the purposes of the capital gains tax provisions.

Section 7 - Prevention of double taxation of the income of a foreign trust

Summary of proposed amendments

Purpose of amendment: the amendments will ensure that amounts upon which a beneficiary of a foreign trust estate is taxed under the FIF measures are not taxed again in the hands of an eligible transferor in relation to the foreign trust estate or the trustee of the foreign trust estate.

Date of Effect: These amendments will apply from the commencement of the FIF measures, i.e., 1 January 1993.

Background to the legislation

Taxation of the beneficiaries of a foreign trust

Presently, no amount will be included in a beneficiary's assessable income under section 97 where the FIF measures apply to a beneficiary in relation to a non-resident trust estate [Subsection 96A(1)] . Section 97 includes in a beneficiary's assessable income, the share of the net income of a trust estate based upon the share of the income of the trust estate to which the beneficiary is presently entitled. Broadly, the net income of a trust estate is calculated on the basis that the trustee is a resident taxpayer.

Amounts paid by a foreign trust estate to an Australian resident beneficiary will still be included in a beneficiary's assessable income under section 99B. This includes distributions by the foreign trust estate which are made out of current year income which, prior to the FIF measures, would have been assessable to the beneficiary under section 97 as amounts to which the beneficiary was presently entitled. However, double taxation under the FIF measures is avoided because the FIF income arising from the beneficiary's interest in the foreign trust estate is reduced to the extent that the beneficiary is assessable on a distribution from the trust. [Section 530]

Taxation of the trustee of a foreign trust estate

The trustee of a foreign trust estate may be assessable on that part of the net income of the trust which is not included in the assessable income of a beneficiary under section 97. [Subsections 99(4), 99(5), 99A(4B) and 99A(4C)]

There is no reduction of the trustee's assessable amount where an amount has been included in the assessable income of a beneficiary under section 99B. Thus, where an amount relating to the current year income of a trust estate is included in the assessable income of a beneficiary under section 99B, it is possible for both the beneficiary and the trustee to be assessed on the same amount. The amendments will ensure that a trustee will not be assessed on these amounts.

Taxation of transferors

Broadly, the assessable income of a taxpayer who has transferred property to a foreign trust estate may include a share of the net income of the foreign trust estate. The amount to be included in the assessable income of the transferor is reduced by, amongst other things, amounts included in the assessable income of a beneficiary under section 97.

There is no reduction of the transferor's assessable amount where an amount has been included in the assessable income of a beneficiary under section 99B. Thus, where an amount relating to the current year income of a trust estate is included in the assessable income of a beneficiary under section 99B, it is possible for both the beneficiary and the transferor to be assessed on the same amount. The amendments will ensure that a transferor will not be assessed on these amounts.

Explanation of proposed amendments

The amendments will ensure that amounts upon which a beneficiary of a foreign trust estate is taxed under the FIF measures are not taxed again in the hands of an eligible transferor in relation to the foreign trust estate or the trustee of the foreign trust estate.

This will be achieved by treating amounts which would, but for subsection 96A(1), be included in a beneficiary's assessable income under section 97 to have been included in the beneficiary's assessable income under section 97 for the purposes of taxing the trustee or a taxpayer who has transferred property to the trust estate [Subsection 96A(1A)] . Thus, the amount upon which the trustee or transferor is taxed will be reduced to the extent that a beneficiary would have been taxed under section 97 if not for subsection 96A(1). [Paragraphs 99(4)(a), 99(5)(b), 99A(4B)(a), 99A(4C)(b) and sub-subparagraph 102AAU(1)(c)(i)(A)]

Section 8 - Country fund exemption

Summary of proposed amendments

Purpose of amendment: the amendments will ensure that the FIF measures do not apply for the purposes of calculating a beneficiary's share of the net income of a trust estate where the FIF measures do not apply to the beneficiary's interest in that trust estate because of the country fund exemption.

Date of Effect: these amendments will apply from the commencement of the FIF measures, i.e., 1 January 1993.

Background to the legislation

A taxpayer is exempt from the FIF measures in respect of interests held in an approved foreign trust [Section 513]. The list of approved foreign trusts is in Schedule 6 of the Act. Presently, the list consists of certain trusts established in India, the Republic of Korea and Taiwan.

Where this exemption from the FIF measures applies to a taxpayer's interest in an approved foreign trust, the taxpayer is assessed under the general provisions of the Act dealing with the taxation of trust beneficiaries. Of particular relevance is section 97 which includes in a beneficiary's assessable income, the share of the net income of a trust estate based upon the share of the income of the trust estate to which the beneficiary is presently entitled.

Broadly, the net income of a trust estate is calculated on the basis that the trustee is a resident taxpayer. Consequently, the FIF measures apply for the purposes of calculating the net income of an approved foreign trust. This means that where an Australian beneficiary is presently entitled to a share of the net income of an approved foreign trust, the amount to be included in the beneficiary's assessable income under section 97 will include a share of the trust's FIF income. It also means that the active business and other exemptions from the FIF measures will need to be applied separately for each FIF interest of an approved foreign trust for the purposes of determining the FIF income which is to be included in its net income.

The proposed amendments will ensure that the FIF measures do not apply for the purposes of calculating the net income of an approved foreign trust. These amendments are being made because, in compiling the list of approved foreign trusts, the investments of these trusts were examined. The trusts are approved for listing only if the investments made by the trusts are substantially not investments to which the FIF measures would apply. Consequently, it is not considered necessary to require the beneficiaries to determine whether the FIF investments of an approved foreign fund satisfy one of the exemptions from the FIF measures.

Explanation of proposed amendments

The amendments will ensure that the FIF measures do not apply for the purposes of calculating a beneficiary's share of the net income of a trust estate where the FIF measures do not apply to the beneficiary's interest in that trust estate because of the country fund exemption (i.e., Division 8 of Part XI). [Subsection 485A(3)]

Section 9 - Exclusion from FIF measures of certain dual residents who are treated under a DTA as a residents solely of another country

Summary of proposed amendments

Purpose of amendment: the amendments will ensure that the FIF measures do not apply to a taxpayer who is both a resident of Australia and another country where a double taxation agreement treats the taxpayer as a resident solely of that other country.

Date of Effect: these amendments will apply from the commencement of the FIF measures, i.e., 1 January 1993.

Background to the legislation

It is possible for a taxpayer to be treated as a resident of Australia under our tax law and as a resident of a foreign country under its tax laws. Our double taxation agreements (DTAs) contain provisions to allocate the residency status of a taxpayer, who is treated as a resident of both Australia and the treaty partner country, to one of those countries for purposes of applying the DTA.

It was intended that the FIF measures should only apply to residents of Australia. The amendments will clarify that the measures do not apply to a dual resident where Australia has agreed in a DTA to treat that resident as a resident solely of the treaty partner country for the purposes of the agreement.

Explanation of proposed amendments

The amendments will ensure that the FIF measures do not apply to a taxpayer who is both a resident of Australia and another country where a DTA treats the taxpayer as a resident solely of that other country. This will be achieved limiting the FIF measures so that they only apply to Part XI Australian residents.

A Part XI Australian resident is currently defined by reference to a resident within the meaning of section 6. Section 6 defines the term resident for the purposes of the Act unless a contrary intention to that meaning is expressed in a particular provision. However, a Part XI Australian resident does not include an entity if:

(a)

there is a DTA in force in respect of a foreign country; and

(b)

that DTA contains a provision that is expressed to apply if, apart from the provision, the entity would, for the purposes of the DTA, be both a resident of Australia and a resident of the foreign country; and

(c)

that provision has the effect that the entity is, for the purposes of the DTA, a resident solely of the foreign country. [Section 470]

A difficulty with this approach is that the residency assumption for the purposes of calculating the net income of a partnership or trust estate does not make the hypothetical taxpayer (e.g., the trustee) a resident within the meaning of section 6 and hence, a "Part XI Australian resident". Accordingly, the amendments will make it clear that the FIF measures apply for the purposes of calculating the net income of a trust or partnership. [Subsection 485A(2)]

Section 10 - Definition of trading stock

Summary of proposed amendments

Purpose of amendment: the amendments will ensure that the exemption under section 521 for certain FIF interests that are trading stock can apply in relation to all interests in FIFs which would normally be treated as trading stock for the purposes of the Act.

Date of Effect: these amendments will apply from the commencement of the FIF measures, i.e., 1 January 1993.

Background to the legislation

The FIF measures do not apply to FIF interests which are trading stock where a taxpayer elects to use the market value to value those interests for the purposes of the trading stock provisions [Section 521] . This treatment is provided because the increase in the value of those FIF interests are effectively taxed under the trading stock rules.

A technical difficulty has arisen because the meaning of "trading stock" is modified for the purposes of the FIF measures such that it does not include securities within the meaning of the Corporations Law [Section 470] . Hence, trading stock would not include, amongst other things, shares held in a FIF. It was not intended that the meaning of "trading stock" be limited in this way for the purposes of the trading stock exemption.

The modified meaning of trading stock given by section 470 is correctly used for the purposes of section 568 of the calculation method. Section 568 provides that a taxpayer who uses the calculation method of computing FIF income can deduct the cost of acquiring trading stock. The restricted definition of trading stock in section 470 has the correct effect in denying a deduction under section 568 for the acquisition of securities within the meaning of the Corporations Law which are trading stock.

Explanation of proposed amendments

The amendments will ensure that the exemption under section 521 for certain FIF interests that are trading stock can apply in relation to all interests in FIFs which would normally be treated as trading stock for the purposes of the Act.

This will be achieved by omitting the definition of "trading stock" from section 470. Hence, the term "trading stock" will have the meaning given to it by subsection 6(1) where it is used in the FIF measures unless a contrary intention is expressed. It will therefore have its normal meaning for the purposes of section 521.

The restricted definition of trading stock for the purposes of section 568 will be maintained by making it clear that the term "trading stock" does not include securities within the meaning of the Corporations Law where it is used in that section.

Section 11 - Definition of passive income

Summary of proposed amendments

Purpose of amendment: the amendments will provide that the exclusion from passive income of amounts that arise from an asset necessarily held by a taxpayer in connection with an insurance business actively carried on by the taxpayer has effect from the 1992-93 year of income;

Date of Effect: these amendments will apply from the commencement of the Income Tax Assessment Amendment (Foreign Income) Act 1992 .

Background to the legislation

Under the current law, foreign tax credits and foreign losses are calculated separately for each class of foreign income [Division 18 of Part III and section 79D] . In broad terms, the classes of foreign income are interest income, modified passive income (i.e., passive income other than interest), offshore banking income and all other income. The classes of interest income and modified passive income are combined into one class, which is called "passive income", for the purposes of calculating foreign tax credits.

The FIF measures contained provisions to exclude from passive income, amounts that relate to assets necessarily held by a taxpayer in connection with an insurance business actively carried on by the taxpayer. This change was made because these amounts are more correctly characterised as being derived from carrying on a business activity than as being derived from passive investments.

Explanation of proposed amendments

The Income Tax Assessment Amendment (Foreign Income) Act 1992 which excluded from passive income amounts that relate to assets necessarily held by a taxpayer in connection with an insurance business actively carried on by the taxpayer will be amended to clarify that the exclusion applies for the 1992 -93 and later years of income only.

Section 12 - Technical amendments

Summary of proposed amendments

Purpose of amendment: the amendments correct technical problems with the drafting of paragraphs 160AFCK(2)(b), 509(b) and section 523.

Date of Effect: These amendments will apply from the commencement of the FIF measures, i.e., 1 January 1993.

Background to the legislation

Section 523

Section 523 is intended to exempt a taxpayer from taxation in respect of foreign investment fund income that would otherwise be taken to accrue from a foreign company that engages in active business (section 522). Presently, however, section 523 sets out the conditions required for the exemption but does not specifically provide for the grant of the exemption. Accordingly, section 523 requires amendment to provide the exemption.

Paragraph 509(b)

Paragraph 509(b) refers to subparagraph (a)(i). The reference should be to paragraph 509(a).

Paragraph 160AFCK(2)(b)

Paragraph 160AFCK(2)(b) refers to the "notional assessable income" of a taxpayer". The reference should be to the "assessable income" of the taxpayer.

Explanation of proposed amendments

The amendments correct technical problems with the drafting of paragraphs 160AFCK(2)(b), 509(b) and section 523.