Explanatory Memorandum
(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)Chapter 4 - Measures to reduce compliance costs
Overview
4.1 This chapter discusses amendments that will make the following changes to reduce compliance costs under the CFC measures:
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- the active income test for CFCs in unlisted countries will be applied to all CFCs;
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- amounts derived by a CFC from an associated CFC resident in the same country will no longer be classed as tainted services or tainted rental income if the amounts are subject to the country's normal company tax and do not reduce the attributable income of the associated CFC;
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- the transfer pricing rules will not apply to transfers between CFCs in the same broad-exemption listed country when calculating the attributable income of a CFC;
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- the thin capitalisation and debt creation rules will no longer apply when calculating the attributable income of a CFC; and
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- the rules for making elections in relation to CFCs will be relaxed.
4.2 Details of these amendments are discussed below.
Uniform active income test
Summary of the amendments
4.3 The amendments will extend the active income test that currently applies for unlisted country CFCs to all CFCs.
4.4 The changes will apply in calculating attributable income for statutory accounting periods of CFCs commencing on or after 1 July 1997. [Subitem 126(5)]
Background to the legislation
4.5 The active income test (section 432) reduces compliance costs by providing an exemption from accruals taxation for small amounts of tainted income that are incidental to the overall operations of a CFC. Listed country CFCs currently have a different active income test to that for unlisted country CFCs.
4.6 The problem with the test for listed country CFCs is that only amounts of eligible designated concession income (EDCI) are taken into account. Broadly, EDCI is narrowly defined tainted income that has been concessionally taxed in a listed country. The current active income test is determined by dividing a CFC's tainted EDCI by its EDCI (the test is passed if the ratio is less than 0.05). This approach results in the test for listed country CFCs being 'failed' in almost all cases because tainted EDCI and EDCI will normally be the same, leading to accruals taxation of the tainted EDCI. This could occur even though a CFC's tainted income was not significant as a proportion of its primary business income.
4.7 To overcome this problem, the active income test for unlisted country CFCs will be applied to all CFCs. The test for all CFCs will therefore be determined by dividing a CFC's gross tainted turnover by its gross turnover.
Explanation of the amendments
4.8 The amendments will extend the active income test ratio for unlisted country CFCs in subsection433(1) to all CFCs. The ratio for listed country CFCs in subsection 433(2) will be repealed. [Items50 & 51]
Exclusion from tainted services income and tainted rental income
Summary of the amendments
4.9 The amendments will exclude an amount from tainted services or tainted rental income if the amount is derived from an associated CFC in the same country, is subject to the normal company tax rate in that country and does not reduce the attributable income of the associated CFC.
4.10 The changes will apply in calculating attributable income for statutory accounting periods of CFCs commencing on or after 1 July 1997. [Subitem 126(1)]
Background to the legislation
4.11 Services and rental income are generally treated as tainted if derived by a CFC from an associate because there is a significant risk that non-arm's length service and rental payments could be used to shift profits. The accruals taxation of income arising from these arrangements ensures that a CFC's dealings with associates are not undertaken to obtain a tax advantage.
4.12 An exclusion from tainted income is to be provided for certain dealings involving residents of the same country because there is a low risk of tax arbitrage where amounts are derived from arrangements that are covered by the one tax jurisdiction.
Explanation of the amendments
4.13 The rules for determining whether an amount is tainted services income or tainted rental income are in sections 448 and 317 respectively. Broadly, the amendments modify these sections to ensure amounts are not treated as tainted where the following three requirements are satisfied:
- (i)
- the amounts were derived from an associated CFC resident in the same country (the definition of associate is in section 318);
- (ii)
- the amounts are subject to the normal company rate of tax in that country; and
- (iii)
- the payment of the amounts did not wholly or partly give rise to a notional allowable deduction for the associated CFC.
4.14 The second requirement is based on whether an amount has been subject to the normal company rate of tax in a country. The requirement ensures that an arrangement has sufficient connection with a country where a CFC is resident for the country to seek to tax the amount at normal rates.
4.15 There are currently rules in section 325 for determining whether an amount has been subject to the normal company rate of tax in a listed country. Rules are required, however, for amounts derived in unlisted countries. New subsection 325(2) will provide rules for determining whether an amount has been subject to the normal company rate in these countries. [Item 30] The rules will be the same as those that currently apply for listed countries. Consequently, for an amount to be treated as taxed at the normal company rate in a country, it must be taxed at the same rate applicable to a company's other income or at a higher rate. In addition, there can be no entitlement to a credit, rebate or tax concession in the taxation of the amount by the country. It should also be noted that foreign tax will not be treated as paid if:
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- a refund of foreign tax becomes liable to be made to the taxpayer or any other person; or
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- any other benefit becomes liable to be provided to the taxpayer or any other person, where:
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- the amount of the benefit is worked out by reference to the amount of the foreign tax paid by the taxpayer alone; and
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- the benefit does not consist of a reduction of foreign tax payable by the taxpayer or the other person.
- (Subsection 6AB(5A))
4.16 The final requirement is to be determined on the assumption that the associated CFC had failed the active income test. The requirement will therefore not be satisfied if a payment would have resulted in a notional allowable deduction for an associated CFC had the CFC been required to calculate its attributable income.
4.17 The amounts excluded from tainted rental income will be referred to as "special excluded rental income". [Items 21 & 22] New subsection448(6A) will exclude amounts from tainted services income. [Item 55]
Application of the transfer pricing rules to transfers involving CFCs resident in the same broad-exemption listed country
Summary of the amendments
4.18 The amendments will provide an exclusion from the transfer pricing rules (Division 13 of Part III), in determining the attributable income of a CFC, for transfers involving CFCs resident in the same broad-exemption listed country.
4.19 The changes will apply in calculating attributable income for statutory accounting periods of CFCs commencing on or after 1 July 1997. [Subitem 126(1)]
Background to the legislation
4.20 The transfer pricing rules seek to prevent profit shifting through arrangements involving related parties (a strategy commonly used for tax planning purposes). The risk to the revenue from not applying the transfer pricing rules in calculating the attributable income of a CFC for arrangements involving residents of the same broad-exemption listed country are tolerable because of the protection afforded by the tax regimes of those countries. The countries have their own transfer pricing rules and are also likely to ensure profits derived by their resident companies are ultimately taxed at full rates.
Explanation of the amendments
4.21 Section 400 provides a number of modifications to the transfer pricing rules for the purposes of determining the attributable income of a CFC. The amendments will insert new paragraph 400(aa) which makes a further modification to the transfer pricing rules for arrangements involving CFCs resident in the same broad exemption listed country. [Item44]
4.22 The modification will provide that an international agreement (section136AC) for the purposes of the transfer pricing rules in the CFC measures does not include an agreement where, at all times, all parties to the agreement are CFCs resident of the same broad-exemption listed country. This has the effect of excluding the agreement from the transfer pricing rules because the transfer pricing rules only apply to international agreements.
Removal of the thin capitalisation and debt creation rules in calculating the attributable income of a CFC
Summary of the amendments
4.23 The amendments will remove the requirement to apply thin capitalisation and debt creation rules in calculating the attributable income of a CFC.
4.24 The changes will apply in calculating attributable income for statutory accounting periods of CFCs commencing on or after 1 July 1997. [Subitem 126(1)]
4.25 The thin capitalisation rules and debt creation rules (Divisions16F and 16G of Part III, respectively) are intended to prevent profit shifting.
4.26 The thin capitalisation rules operate to deny an interest deduction where the foreign controllers of a company do not maintain a specified debt to equity ratio. In the absence of these rules, the profits of a company could be reduced by excessive interest deductions and could thereby be effectively transferred to the foreign controllers as interest payments.
4.27 The debt creation rules deny an interest deduction on debt used to finance the transfer of assets from one related company to another where the buyer and seller are at least 50% controlled by a non-resident or a related non-resident. The rules prevent the effective transfer of profits from one company to another through the creation of an interest expense.
4.28 The thin capitalisation and debt creation rules will no longer apply in determining the attributable income of a CFC because the need for the rules will be greatly reduced following the creation of a short list of countries. The short list for accruals taxation purposes will make it more difficult to shift profits to another company without those profits being either taxed at full rates in a broad-exemption listed country or accruals taxed under the CFC measures. There is therefore less opportunity to gain a tax benefit from shifting profits through the use of thin capitalisation or debt creation arrangements. The changes reflect a change in policy and are in no way intended to affect the application of the law prior to the commencement of the changes.
Explanation of the amendments
4.29 Section 389 provides a list of provisions that are not to apply in determining the attributable income of a CFC. The insertion of references to Division 16F and Division 16G of Part III into paragraph 389(a) will have the effect of ensuring the thin capitalisation and debt creation rules do not apply in determining the attributable income of a CFC. [Item43]
Relaxation of the rules for making elections in relation to CFCs
4.30 The amendments will make three changes to the rules for making elections in relation to CFCs. These changes are discussed below.
(i) Election to vary a CFC's statutory accounting period
Summary of the amendments
4.31 The amendments will allow an election to vary a CFC's statutory accounting period to take effect immediately if made during the first period that a company becomes a CFC. A statutory accounting period is the period used to calculate a CFC's attributable income (section 319).
4.32 The new rules for making elections will apply from the time the Bill receives the Royal Assent. [Clause 2]
Background to the legislation
4.33 An election to vary a CFC's statutory accounting period can currently only take effect immediately if it is made when a company first comes into existence (subsection319(5)). Normally the first statutory accounting period using the "new day" (ie, the last day of the new statutory accounting period) cannot commence until after the end of the statutory accounting period in which the election is made (subsection 319(4)). The following is an example of the current rules for varying the statutory accounting period of a CFC.
Example
If an election to use a new statutory accounting period of 1February to 31January is made during a statutory accounting period of a CFC from 1 July 1996 to 30 June 1997, the first period using the new day could not commence until 1February 1998. This is the first period using the new day commencing after the end of the period ending on 30 June 1997 (ie, the period in which the election was made). The following diagram illustrates this result.
If, however, the CFC had come into existence on 1 January 1997, it is currently possible to use the new period from 1February 1997 (a full 12months earlier). This is the first period using the new day commencing after the company came into existence (paragraph 319(5)(b)). The following diagram illustrates this result.
Explanation of the amendments
4.34 New subsection 319(4A) will allow a varied period to be adopted on the acquisition of a company to align its statutory accounting period with the period normally used by the company for the preparation of accounts or with the period used for the purposes of complying with the tax laws of another country. These are the only alternative statutory accounting periods permitted (subsection319(3)).
4.35 The first period using the new day will be the period next commencing after the election is made. This treatment is more favourable than the current arrangements whereby the first period using the new day is the period commencing after the end of the statutory accounting period in which the election is made.
Example
A foreign company becomes a CFC on 1 January 1997 after being acquired by an Australian company. If the CFC makes an election before 1 February 1997 to use a new statutory accounting period of 1February to 31January, the first period using the new day would commence on 1February 1997 (ie, the first period using the new day next commencing after the election is made). This result is illustrated by the following diagram.
4.36 The new arrangements for varying the statutory accounting period of a newly acquired company will not apply if the company was a CFC in a previous statutory accounting period. [Items 23 & 24]
(ii) Elections for wholly owned CFCs
Summary of the amendments
4.37 The amendments will allow an attributable taxpayer to make an election on behalf of a CFC if the CFC is wholly owned by the taxpayer either directly or indirectly through other entities.
4.38 The new rules for making elections will apply from the time the Bill receives the Royal Assent. [Clause 2]
Background to the legislation
4.39 Most elections can currently be made by an attributable taxpayer on behalf of a CFC under section 390. An attributable taxpayer, however, cannot make an election to vary a CFC's statutory accounting period (subsection 319(2)) or elect for a CFC to take advantage of CGT rollover relief (section 421 and subsection 438(3A)). Currently these elections are to be made by a CFC because the elections must apply equally to all attributable taxpayers. In cases where there is only one attributable taxpayer, the amendments will allow the attributable taxpayer to make the election.
Explanation of the amendments
4.40 A CFC is to be treated as wholly owned by an attributable taxpayer if the taxpayer is the only attributable taxpayer (section 361) and has an attribution percentage (section362) in the CFC of 100%. Where these conditions are satisfied, the attributable taxpayer is to be able to make elections on behalf of the CFC for the purposes of subsection 319(2), section 421 and subsection 438(3A) (new subsections 319(7), 421(1A) and 438(3B) respectively). [Items 25, 47 & 54]
4.41 The term "designated entity" is used to describe the attributable taxpayer in new subsections421(1A) and 438(3B) to distinguish the attributable taxpayer from the CFC and any other entity that may be affected by the CFC's election for rollover relief. The other entity could also be the attributable taxpayer where, for instance, a CFC elects for rollover relief under section 160ZZO (as modified by section 419) on the transfer of an asset to the attributable taxpayer. New paragraphs 421(1A)(c) and 438(3B)(d) provide for the case where the other entity is the attributable taxpayer. The case where the other entity is not the attributable taxpayer is dealt with by new paragraphs 421(1A)(d) and 438(3B)(e).
(iii) Time allowed for a CFC to elect for capital gains tax rollover relief
Summary of the amendments
4.42 The amendments will extend the time allowed for a CFC to make an election for capital gains tax (CGT) rollover relief.
4.43 The new rules for making elections will apply from the time the Bill receives the Royal Assent. [Clause 2]
Background to the legislation
4.44 An election for rollover relief must currently be made within two months of the end of a CFC's statutory accounting period (section 421 and subsection 438(3A)). This can create problems if an attributable taxpayer does not closely monitor the impact of the capital gains tax rules on a CFC. The attributable taxpayer may not, for instance, become aware that a CFC should make an election until it is time to prepare a tax return. By this time it may be too late for the CFC to make the election. The proposed amendments ameliorate this problem by aligning the time for making an election with the lodgment of tax returns by the attributable taxpayers of a CFC.
Explanation of the amendments
4.45 An election that can be made by a CFC for rollover relief during a statutory accounting period is to be valid if made on or before the lodgment of a return by an attributable taxpayer in which the statutory accounting period of the CFC ends (new paragraphs 421(1)(c), 421(1)(d), 438(3A)(c) and 438(3A)(d)). If there is more than one attributable taxpayer, the election will be valid if made before the later of the lodgment dates for the affected tax returns. [Items 46 & 53]
Example
Ausco1 and Ausco2 are attributable taxpayers of a CFC and are due to lodge tax returns by 30June 1997 and 31 December 1997 respectively. These returns are affected by a decision of the CFC regarding rollover relief. Under the proposed changes, the election for rollover relief is to be valid if made by the CFC on or before 31December 1997 (ie, the latest of the lodgment dates of the affected tax returns). Ausco1 would be required to lodge an amended tax return if the election was made after 30 June 1997 (ie, after Ausco1 had lodged its tax return).