House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer,the Hon Peter Costello, MP)

Chapter 5 - Taxation of income derived from sources outside Australia

Overview

5.1 Part 5 of Schedule 1 of the Bill will amend the Income Tax Assessment Act 1936 (the Act) to:

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ensure that the appointment of a liquidator to a related company does not affect an Australian company's entitlement to underlying foreign tax credit under the foreign tax credit system (FTCS) on dividends paid by related companies;

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make changes to terminology necessary because of amendments to Part IIIA in Taxation Laws Amendment Act (No.2) 1992 (TLAA (No.2) 1992);

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amend the basis on which assessable foreign investment fund income is calculated to ensure that only foreign investment fund income accrued while a taxpayer is a resident is assessable; and

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allow assessable foreign investment fund income accrued from a foreign investment fund (FIF) or a foreign life assurance policy (FLP) to be reduced by assessable distributions from the FIF or FLP that relate to the accrued income, regardless of whether the distribution is made in the same year of income.

Summary of the amendments

Purpose of the amendments

Liquidator appointed to a related company

5.2 The amendments will ensure that an Australian company does not lose its entitlement to a foreign tax credit for underlying foreign tax on dividends paid by a related foreign company when a liquidator is appointed to the related foreign company.

Date of effect

5.3 This amendment will apply to assessments for the 1987-88 year of income - the time of commencement of the FTCS. [Subitem 47(1)]

Modified capital gains tax provisions

5.4 The proposed amendments will amend the modified provisions that apply for taxing foreign source income on an accruals basis to employ terminology consistent with that used in the general provisions (section 160ZZO) following amendments enacted by section 42 of TLAA (No.2) 1992.

Date of effect

5.5 These amendments will apply to disposals of assets after 2 April 1992. [Subitem 47(2)]

Change to the basis of calculating assessable FIF income

5.6 The amendment will ensure that a taxpayer is taxed only on foreign investment fund income from a FIF or a FLP that accrued during the period the taxpayer was a resident of Australia.

Date of effect

5.7 This amendment will apply to assessments for the 1996-97 and later years of income. [Subitem 47(3)]

Reductions of FIF and FLP income for earlier distributions

5.8 These amendments will provide for assessable foreign investment fund income accrued from a FIF or a FLP to be reduced by:

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a distribution made in the previous year of income which relates to accrued foreign investment fund income assessable in the current year; and

•

assessable distributions made by a FLP on the same basis as distributions made by a FIF.

Date of effect

5.9 These amendments will apply from 1 January 1993 - the date of commencement of the FIF measures. [Subclause 2(2)]

Background to the legislation

Appointment of a liquidator to a related company

5.10 Under the FTCS an Australian resident company which receives a dividend from a related foreign company is entitled to a credit for both foreign withholding taxes paid on the dividends received and any 'underlying' foreign company taxes paid on the profits out of which the dividend is paid.

5.11 A foreign company is treated as being related to an Australian company if the Australian company has a 10 per cent voting interest in the foreign company (subsection 160AFB(1)). Where the foreign dividend income is derived through a chain of foreign related companies, the Australian company is related if:

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each company in the chain has at least a 10 per cent voting interest in the foreign company in the tier below; and

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the Australian company has a direct or indirect voting interest of at least 5 per cent in each company in the chain (section 160AFB(2)).

5.12 An Australian company is taken to have a voting interest in a foreign company if the following conditions are satisfied:

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the Australian company is the beneficial owner of shares in the foreign company which carry the right to exercise the voting power in the other company; and

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there is no arrangement in force under which any person is in a position to, or may become in a position to, affect that right (subsection 160AFB(4)).

5.13 A person is in a position to affect a right of a company if that person has a right, power or option:

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to acquire that right; or

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to do an act or thing that would prevent the company from exercising that right or receiving any benefits accruing by reason of that right (subsection 160AFB(5)).

5.14 The voting power is the maximum number of votes that can be cast in a poll at a general meeting of the company, or arising out of a general meeting of the company, in relation to all questions that can be submitted to such a poll (subsection 160AFB(6)).

5.15 When a liquidator is appointed to a company the right to control and administer the company's property vests in the liquidator. The appointment of a liquidator effectively prevents the shareholders from exercising voting rights and can be construed as an arrangement that prevents the shareholders from exercising their voting power (subsections 160AFB(4) and (5)).

5.16 Since the appointment of a liquidator is an arrangement within the meaning of subsection 160AFB(5), the shareholder company ceases to have a voting interest in the company and the companies are no longer related. As the companies are no longer related the effect of the existing law is that the shareholder company is not entitled to a credit for underlying foreign tax, even though the appointment of a liquidator does not alter the essential nature of the relationship between a company and its shareholders.

5.17 The voting interest of a company in the voting power of another company for the purposes of entitlement to an underlying foreign tax credit (section 160AFB) is the test for determining whether dividends are non-portfolio dividends and exempt from tax (section 23J). A non-portfolio dividend is a dividend paid by a non-resident company to a company which has a 10 per cent or greater voting interest in the company paying the dividend (section 317).

5.18 Under the existing law, the appointment of a liquidator to the company paying the dividend affects the right of the company receiving the dividend to exercise its voting rights in the dividend paying company for the purposes of section 160AFB. The effect of the appointment is that the dividends are no longer non-portfolio dividends and the tax exemption is lost (section 23AJ).

Modified capital gains tax provisions

5.19 Section 419 modifies the application of section 160ZZO (which allows roll-over of assets between group companies in certain circumstances) for the purposes of calculating the attributable income of an eligible controlled foreign company (CFC). In the course of amending section 160ZZO in TLAA (No.2) 1992 certain changes made to the terminology in paragraph 160ZZO(1)(a) were not reflected in modified paragraph 160ZZO(1)(a) which operates by virtue of section 419.

5.20 The effect of section 42 of TLAA (No.2) 1992 is that an 'asset' in subparagraph 160ZZO(1)(a)(i) is now referred to as a 'roll-over asset'. Appropriate amendments were made to the rest of section 160ZZO to refer to 'roll-over' assets. However, amendments were not made to paragraph 160ZZO(1)(a) as modified by section 419. The effect of the failure to amend paragraph 160ZZO(1)(a) as modified by section 419 is that when the modified paragraph is applied with the remainder of section 160ZZO, the meaning of the term 'roll-over asset' is not specified.

5.21 An amendment effected by paragraph 42(d) of TLAA (No.2) 1992 inserted the word 'roll-over' before 'asset' (wherever occurring) in subsection 160ZZO(2D). The effect of this amendment is that a 'taxable Australian asset' incorrectly became a 'taxable Australian roll-over asset'.

Change to the basis of calculating assessable FIF income

5.22 Under the FIF measures the foreign investment fund income of a taxpayer accrued during a notional accounting period is included in the assessable income of the taxpayer for the year of income during which the notional accounting period ended (section 529). It is only foreign investment fund income that accrues while a taxpayer is a resident that should constitute assessable income under the FIF measures.

5.23 The basis for determining whether a taxpayer is assessable in respect of an interest in a FIF or a FLP should be the period of the notional accounting period during which the taxpayer was a resident. However, the basis on which foreign investment fund income accrued from an interest in a FIF or a FLP is assessable under the existing law is the period of the year of income during which the taxpayer was a resident.

5.24 A taxpayer is not assessed on the correct amount of foreign investment fund income accrued from a FIF or a FLP where the notional accounting period of the FIF or FLP does not coincide with the taxpayer's year of income and:

(a)

the taxpayer is a resident for the whole of the year of income but not for the whole of the notional accounting period that ended during that year of income; or

(b)

the taxpayer is a resident for the whole of the notional accounting period but not for the whole of the year of income during which the notional accounting period ended.

5.25 Where paragraph (a) applies, the taxpayer is incorrectly assessed on the whole of the income that accrued during the notional accounting period even though the taxpayer was not a resident for the whole of that period. Where paragraph (b) applies, the taxpayer's assessable foreign investment fund income for the year of income is reduced even though the taxpayer was a resident for the whole of the notional accounting period.

Reductions of FIF and FLP income for earlier distributions

5.26 Foreign investment fund income accrued to a taxpayer in respect of a notional accounting period of a FIF is included in the assessable income of the taxpayer for the year of income during which the notional accounting period ends (section 529). Generally, the notional accounting period of a FIF or a FLP is the year of income of the taxpayer (subsection 486(2) for a FIF and subsection 487(2) for a FLP). However, a taxpayer may make an irrevocable election that the notional accounting period of the FIF will be the accounting period for which the accounts of the FIF are made out (subsections 486(3) and (4)). In the case of an interest in a FLP a taxpayer may make an irrevocable election to adopt the period for which cash surrender values for the FLP are available (subsection 487(4)).

5.27 If a FIF attribution account payment (such as dividends, share of partnership net income or share of the net income of a trust) (section 603) is made during a notional accounting period, and an amount of foreign investment fund income from that FIF is included in the taxpayer's assessable income for that year of income, the amount of assessable foreign investment fund income is reduced by the amount of the FIF attribution account payment that is included in the taxpayer's assessable income for that year of income (section 530).

5.28 If the taxpayer's year of income coincides with the notional accounting period of the FIF, assessable foreign investment fund income will be reduced by all assessable distributions from the FIF. However, if the notional accounting period of a FIF does not coincide with the taxpayer's year of income, and the FIF makes a distribution to the taxpayer during the notional accounting period, but in the year of income prior to that in which the FIF amount is assessable, no reduction is allowable under the existing law for the amount of the distribution included in the taxpayer's assessable income of the previous year.

5.29 For example, if the taxpayer's year of income is 1 July to 30 June and the notional accounting period of the FIF is 1 January to 31 December, any distribution made by the FIF between 1 January 1996 and 30 June 1996 would be included in the assessable income of the taxpayer for the 1995-96 year of income. The foreign investment fund income accrued during that period would be included in the taxpayer's 1996-97 year of income - the year of income in which the FIF's notional accounting period ended. Under the existing law, no reduction would be made to the amount of foreign investment fund income assessable to the taxpayer for the 1996-97 year of income for the distribution included in the assessable income of the 1995-96 year of income. The effect of the existing law is that in those circumstances the taxpayer is taxed twice on the amount of foreign investment fund income that is equal to the distribution.

5.30 An oversight appears to have occurred in the original FIF legislation in that no reduction was provided for assessable FIF attribution account payments made by a FLP to a person who has an interest in the FLP. A payment made by the person who issued a FLP to a person who has an interest in the FLP is a FIF attribution account payment (paragraph 603(g)). If the payment constitutes assessable income, the amount of a taxpayer's interest in the FLP that is assessable on an accruals basis for that notional accounting period should be reduced by the amount of the distribution from the FLP that constitutes assessable income.

Explanation of the amendments

Appointment of a liquidator to a related company

5.31 The proposed amendment will apply in determining whether an Australian company is related to a foreign company and entitled to a credit for underlying foreign tax paid on the profits from which dividends were paid to the Australian company. The appointment of a liquidator is to be disregarded in determining whether the company has a voting interest in another company, and the extent of the voting interest. [Item 38 - new subsection 160AFB(5A)]

Modified capital gains tax provisions

5.32 The Bill will amend subparagraph 160ZZO(2D)(b)(ii) to replace the term 'taxable Australian roll-over asset' with 'taxable Australian asset'. [Item 39]

5.33 The Bill will also amend subparagraph 160ZZO(1)(a)(i) which applies in calculating the attributable income of an eligible CFC (section 419(a)). The amendments to this paragraph will change references to an 'asset' to a 'roll-over asset' which will result in the use of terminology that is consistent with the terminology used in the remainder of section 160ZZO following the amendment enacted by TLAA (No.2) 1992. [Item 40]

5.34 Other provisions of paragraph 160ZZO(1)(a) as modified by section 419 to be amended to insert 'roll-over' before 'asset' are:

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sub-subparagraph (a)(i)(C) [item 41] ; and

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subparagraph (a)(ii) [item 42] .

Change to the basis of calculating assessable FIF income

5.35 The Bill will amend the operative provision of the FIF measures in Part XI (section 529) to change the basis on which foreign investment fund income accrued from an interest in a FIF or a FLP constitutes assessable income of a year of income. The amount of assessable income will be calculated on the basis of the period of the notional accounting period that the taxpayer was a resident of Australia. [Item 43]

5.36 This amendment will ensure that where a taxpayer changes residence only foreign investment income accrued during the period that the taxpayer was a resident will constitute assessable foreign investment fund income.

5.37 Where a taxpayer changes residence the amount of assessable foreign investment fund income for a year of income will be calculated according to the number of days in the notional accounting period of the FIF or FLP that ended during the year of income that the taxpayer was a resident of Australia. This amendment will affect the amount of assessable foreign investment fund income accrued from a FIF or a FLP where the notional accounting period of the FIF does not coincide with the taxpayer's year of income.

Reductions of FIF and FLP income for earlier distributions

5.38 The Bill proposes three amendments to section 530. The first amendment will extend the entitlement for a reduction from accrued foreign investment fund income assessable in a year of income to FIF attribution amount payments made by a FLP to a FLP. This amendment will place reductions for FIF attribution payments made by a FLP on the same basis as those made by a FIF. [Item 44]

5.39 The second amendment will amend paragraph 530(1)(b) to recognise that foreign investment fund income accrued from an interest in a FLP during a year of income will be able to be reduced by FIF attribution account payments made by a FLP. [Item 45]

5.40 The third amendment will apply where the taxpayer's year of income and the notional accounting period of the FIF or FLP do not coincide. The amount of foreign investment fund income accrued from a FIF or a FLP that is assessable in a year of income will be able to be reduced by a distribution from the FIF or FLP that was assessable in the earlier year of income where certain conditions are present. [Item 46 - new paragraph 530(1)(ca)]

5.41 These conditions are:

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a FIF or a FLP makes a FIF attribution account payment during a notional accounting period;

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the year of income in which the FIF attribution account payment was made and in which it constituted assessable income is earlier that the year of income in which the notional accounting period ends; and

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the amount of foreign investment fund income that accrued during that notional accounting period is assessable in the later year of income.