House of Representatives

Explanatory Memorandum

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

Glossary

The following abbreviations and acronyms are used throughout this explanatory memorandum.

General outline and financial impact

Thin capitalisation

Schedule 1 to this bill amends the thin capitalisation provisions in Division 820 of the ITAA 1997 and amends the ITAA 1936 to:

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exclude assets that are used principally for private or domestic purposes and exclude non-debt liabilities that are principally of a private or domestic nature;

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ensure that the Australian assets threshold rule operates as intended;

•

ensure consistent treatment of interest-free loans and prevent manipulation of the thin capitalisation calculations through the use of these loans;

•

clarify the record keeping requirements in relation to the arms length debt amount and arms length capital amount;

•

remove the unintended consequences of the associate entity provisions on the control rules;

•

ensure that associate entity equity, associate entity debt, controlled foreign entity equity and controlled foreign entity debt have their intended meanings; and

•

clarify the operation of the law.

Date of effect: The amendments will apply from the start of a taxpayers first income year beginning on or after 1 July 2001.

Proposal announced: Not previously announced.

Financial impact: The measures will prevent revenue leakage of $50 million in 2002-2003 and $30 million annually from 2003-2004 onwards.

Compliance cost impact: Overall, the amendments will involve a net reduction in compliance costs.

Trust to company roll-over

Schedule 2 to this bill inserts into the ITAA 1997 a CGT roll-over for a trust restructuring into a company. The roll-over is available for the trust and the beneficiaries of the trust. The roll-over is not available for discretionary trusts.

The benefit of the roll-over is reversed if the trust does not cease to exist within 6 months from the time the first asset is transferred to the company. The 6 month period may be extended if the reason for failing to cease to exist was outside the control of the trustee.

Date of effect: Assets disposed of under a trust restructure starting on or after 11 November 1999.

Proposal announced: Treasurers Press Release No. 77 of 5 October 2001.

Financial impact: For trust restructures completed between 11 November 1999 and 4 October 2001 inclusive there will be an insignificant impact on revenue. For trust restructures commencing on or after 5 October 2001 it is anticipated that the additional cost is likely to be small but unquantifiable.

Compliance cost impact: It is estimated that these amendments will not significantly increase the compliance costs for taxpayers.

Summary of regulation impact statement

Regulation impact on business

Impact: This measure will provide greater commercial flexibility for those businesses restructuring to increase efficiency of the business and to take full advantage of its future potential.

Main points:

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The roll-over is optional and available for both the trust and the beneficiaries of the trust.

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Compliance costs for taxpayers that own units or interests in the trust are expected to be minimal. There may be some compliance costs associated with a trust restructure, such as compliance requirements under the Corporations Act 2001 and possible changes to accounting and record keeping systems.

Foreign income exemption for temporary residents

Schedule 3 to this bill amends the ITAA 1936 and the ITAA 1997 to provide certain exemptions from Australian tax for individuals who are considered to be temporary residents of Australia for tax purposes. This measure will:

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define who is considered to be a temporary resident;

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exempt all foreign source income of temporary residents from assets regardless of when they were acquired;

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ensure that no capital gain or loss would arise on the disposal by temporary residents of assets not having the necessary connection with Australia, other than portfolio interests in Australian publicly listed companies and resident unit trusts;

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remove interest withholding tax obligations in respect of liabilities of temporary residents regardless of when incurred; and

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amend the existing exemption from the FIF rules for exempt visitors to remove the 4 year restriction for taxpayers holding temporary entry visas.

Date of effect: The amendments will apply from 1 July 2002.

Proposal announced: This proposal was originally announced in Treasurers Press Release No. 74 of 11 November 1999 (in particular, refer to Attachment G of that Press Release). Changes to the proposal were announced in Treasurers Press Release No. 82 of 15 October 2001.

Financial impact: The revenue cost of this measure is estimated to be between $40 to $50 million per annum.

Compliance cost impact: Overall, the amendments will involve a net reduction in compliance costs.

Summary of regulation impact statement

Regulation impact on business

Impact: This measure providing a foreign income exemption for temporary residents is part of the Governments broad ranging reforms that will give Australia a New Business Tax System. These reforms are based on the recommendations of the Review of Business Taxation that the Government established to consider reforms to Australias business tax system.

For businesses and intermediaries affected by this measure there may be initially a small cost associated with the training of staff and the modification of internal systems that deal with executive remuneration planning. However, given that this is a sought after measure, this is not seen as significant. Also, once any necessary training or changes have been implemented, this measure will also lead to reduced compliance costs for these businesses and intermediaries.

Main points:

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The foreign income exemption for temporary residents is designed to achieve 2 related objectives. The measure seeks to attract internationally skilled mobile labour to Australia. It also seeks to assist in the promotion of Australia as a business location, by reducing the costs to Australian business of bringing skilled expatriates to work in Australia.

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The New Business Tax System will provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings. The measure contained in this bill will contribute to this, reducing the tax burden on people who are considered to be temporary residents of Australia for taxation purposes.

•

Potential compliance, administrative and economic impacts of this measure were considered by the Review of Business Taxation and the business sector. Specific compliance issues raised in relation to the taxation of temporary residents subsequent to the release of A Tax System Redesigned have been considered in implementing this measure.

Effective life of depreciating assets

Under the current capital allowances system, the Commissioner is progressively reviewing, and making updated determinations of, the safeharbour effective lives that taxpayers may choose to use in working out the decline in value of depreciating assets. Under an anticipated Commissioners Determination of effective lives, expected to have effect from 1 July 2002, it is expected that there will be significant increases in the safeharbour effective lives of assets used in gas transmission and distribution, oil and gas production, and for aeroplanes and helicopters.

Schedule 4 to this bill amends the ITAA 1997 to introduce statutory caps that will be the effective life used to calculate the decline in value of those depreciating assets if:

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the taxpayer chooses to adopt the effective life determined by the Commissioner for a particular asset; and

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the cap, if any, that applies to that asset is shorter than the effective life determined by the Commissioner.

Schedule 4 also contains the amendments consequential upon this measure.

Date of effect: This measure will apply to a depreciating asset if its start time is on or after 1 July 2002. In practice, the statutory caps will have effect in relation to revised Commissioner determined safeharbour effective lives that are expected to have effect from 1 July 2002.

Proposal announced: Minister for Revenue and Assistant Treasurers Press Release No. C44/02 of 14 May 2002.

Financial impact: The effect of this measure is to limit the revenue gain arising from the expected revised Commissioners Determinations to around $150 million for the period 2002-2003 to 2005-2006 and $675 million over the 10 year period 2002-2003 to 2011-2012. If these statutory caps were not introduced, taxpayers could be expected to pay an extra $465 million over those 4 years and $2.5 billion over those 10 years as a result of the revised determinations. This is because the statutory caps provide significantly shorter effective lives than the anticipated revised Commissioners Determinations. The proposed statutory effective life caps will, therefore, provide subsidies to affected industries of $315 million for the period 2002-2003 to 2005-2006 and $1.9 billion for the period 2002-2003 to 2011-2012.

Compliance cost impact: Industry will not incur additional compliance costs where a capped life applies to an asset.

Summary of regulation impact statement

Regulation impact on business

Impact: Industry will not incur additional compliance costs where a statutory cap applies to an asset. This is because the cap will be the effective life and will be used in place of the safeharbour effective life determined by the Commissioner.

Main points:

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Only certain industries and assets will be affected by these rules.

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The statutory cap will only apply where the taxpayer chooses to use an effective life determined by the Commissioner and that effective life is greater than the cap. In such cases, the cap will be the effective life.

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If a taxpayer does not wish to use an effective life determined by the Commissioner for a particular depreciating asset or, does not wish to use the statutory cap, they will continue to be able to self-assess an effective life for that asset based on their own circumstances of use under the existing capital allowances system.

Chapter 1 - Thin capitalisation

Outline of chapter

1.1 This chapter explains amendments to the thin capitalisation provisions contained in Division 820 of the ITAA 1997 and amendments to the ITAA 1936. Legislative references are to the ITAA 1997 unless otherwise stated. The amendments ensure that the thin capitalisation regime operates as intended, will improve the integrity of the regime and clarify the operation of the law.

Context of amendments

1.2 Division 820 introduced a new thin capitalisation regime consistent with recommendations of A Tax System Redesigned. The objective of the regime is to ensure that multinational entities do not allocate an excessive amount of debt to their Australian operations. Following implementation of the new rules, a number of amendments are required largely to ensure that the rules operate as intended.

Summary of new law

1.3 This bill will amend the ITAA 1997 and the ITAA 1936 to:

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exclude assets that are used principally for private or domestic purposes and exclude non-debt liabilities that are principally of a private or domestic nature;

•

ensure that the Australian assets threshold rule operates as intended;

•

ensure consistent treatment of interest-free loans and prevent manipulation of the thin capitalisation calculations through the use of these loans;

•

clarify the record keeping requirements in relation to the arms length debt amount and arms length capital amount;

•

remove the unintended consequences of the associate entity provisions on the control rules;

•

ensure that associate entity equity, associate entity debt, controlled foreign entity equity and controlled foreign entity debt have their intended meanings; and

•

clarify the operation of the law.

Detailed explanation of new law

Private use assets and non-debt liabilities of a private or domestic nature

1.4 Assets are an important element in the application of the thin capitalisation regime because the level of acceptable debt funding is calculated by reference to the amount of Australian assets. Assets are also important in the context of the assets threshold rule in section 820-37 as entities which satisfy the rule do not need to comply with the thin capitalisation rules. The value of an entitys non-debt liabilities is also a relevant factor in calculating its acceptable level of debt.

1.5 The existing thin capitalisation provisions do not make a distinction between business and private use assets. Consequently, private use assets are included in undertaking calculations under the regime. Although the term non-debt liabilities is a defined term, the definition does not make a distinction between non-debt liabilities that are of a business nature and those that are of a private or domestic nature.

1.6 The requirement to include private use assets in undertaking the thin capitalisation calculations increases compliance costs especially in the case of individuals. For example, in certain situations the legislation could require an individual to value private use assets such as household items.

1.7 In order to reduce compliance costs the Government has decided to exclude from the application of Division 820 assets that are used wholly or principally for private or domestic purposes. Assets that are held for use wholly or principally for private or domestic purposes are also excluded. This will ensure that assets that are not actually used by an entity but which are held for private or domestic purposes fall within the exclusion. [Schedule 1, item 3, section 820-32]

1.8 Non-debt liabilities that are wholly or principally of a private or domestic nature will also be excluded to ensure consistency between the treatment of assets and the treatment of non-debt liabilities. [Schedule 1, item 3, section 820-32]

1.9 It should be noted that debt capital of a private or domestic nature does not give rise to similar problems because of the definition of adjusted average debt. Adjusted average debt generally only includes debt capital that gives rise to debt deductions. Debt capital of a private or domestic nature is excluded from the regime because it does not give rise to debt deductions under section 8-1.

The assets threshold rule

1.10 The assets threshold test contained in section 820-37 excludes from the thin capitalisation regime Australian entities, which are not foreign controlled, with relatively small overseas investments. The exclusion applies where the foreign assets of an entity and its associates represent 10% or less of the combined total assets. Two issues have been identified which require amendments in order to ensure that the rule operates as intended.

1.11 Firstly, the calculation of an entitys average Australian assets and average total assets can be distorted because of double counting of some assets. Where one entity (A) holds equity in, or lends funds to, an associate (B) there is potential for essentially the same assets to be counted in both entities. For example, the equity interest held by A in B will be counted in calculating As assets. The assets held by B which are funded by As equity interest in B will be counted in calculating Bs assets. This bill amends the definition of average Australian assets and average total assets to prevent such double counting. This is achieved by excluding assets comprised by the equity interests an entity holds in associates and the debt interests it holds which have been issued by associates. [Schedule 1, items 4 and 5, section 820-37]

1.12 The second issue relates to the category of asset which is included in the calculation of average Australian assets for foreign associates of the entity. Under the existing definition all assets of a foreign associate are included in calculating average Australian assets. This distorts the calculation because non-Australian assets are also included. To remove this distortion the term average Australian assets for foreign entities will be defined to mean:

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assets located in Australia;

•

assets attributable to the entitys Australian PEs; or

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equity interests or debt interests issued by Australian entities to the extent that those interests are not attributable to the issuers foreign PEs.

[Schedule 1, items 4 and 6, section 820-37]

Foreign tax credits

1.13 The New Business Tax System (Thin Capitalisation) Act 2001 amended subsection 160AF(8) of the ITAA 1936 to ensure that in determining the amount of allowable foreign tax credits, debt deductions, to the extent that they are not attributable to a taxpayers overseas PE, do not reduce net foreign income. A technical amendment to subsection 160AF(8) is required to ensure that the measure has its intended effect. [Schedule 1, item 43, subsection 160AF(8) of the ITAA 1936]

Arms length debt amount and arms length capital amount

1.14 Section 820-980 provides that an entity must keep records on the arms length debt amount or arms length capital amount that it worked out for the purposes of the thin capitalisation regime. Those records must contain particulars about the factual assumptions and relevant factors that are taken into account. However, the thin capitalisation provisions do not currently specify when these records must be prepared.

1.15 Section 820-980 will be amended in order to clarify the law. An entity relying on an arms length amount will be required to prepare these records before it lodges its tax return for the particular income year [Schedule 1, item 38, subsection 820-980(3)] . Failure to comply with this requirement will render a person liable to prosecution or an administrative penalty [Schedule 1, item 44, paragraph 262A(3)(d) of the ITAA 1936] .

Definition of financial entity

1.16 The thin capitalisation provisions contain special rules for financial entities. In order to apply those rules a definition of the term financial entity is contained in subsection 995-1(1). Paragraph (c) of that definition includes an entity that:

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is a financial services licensee within the meaning of the Corporations Act 2001 whose licence covers dealings in financial products mentioned in paragraphs 764(1)(a), (b) and (j) of that Act;

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carries on a business of dealing in securities; and

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does not carry on that business predominantly for the purposes of dealing in securities with, or on behalf of, the entitys associates.

1.17 The existing definition requires that an entity holds a licence which covers all 3 of the financial products mentioned. However, under the new financial products regime in the Corporations Act 2001 entities may apply for a licence that covers only one financial product. The bill amends the definition so that entities will only need to hold a licence that covers at least one of the financial products referred to in the current definition rather than a licence which includes all of those products. [Schedule 1, item 42, definition of financial entity in subsection 995-1(1)]

The control rules and the associate entity definition

1.18 Division 820 has comprehensive rules which measure control interests held by foreign entities in Australian entities and to determine whether an Australian entity is a controller of a controlled foreign entity. These control interests are referred to as TC control interests. TC control interests measure both direct and indirect interests in an entity as well as direct and indirect interests in an entity held by associate entities. It is the latter situation which is the subject of this amendment.

1.19 The term associate entity is defined in section 820-905. Subsection 820-905(3A) makes 2 entities (e.g. B and C) associate entities of each other if both B and C are associate entities of a third entity (A). The extension of associate entity definition in this way has had unintended consequences for the TC control interest rules.

Example 1.1

A (a foreign company) has a 100% Australian subsidiary (B) and a 100% foreign subsidiary (C). Under the associate entity rules both B and C are associate entities of A and vice-versa. Additionally, subsection 820-905(3A) deems B and C to be associate entities of each other. The thin capitalisation rules classify B as an inward investor. Under this scenario, the section 820-905(3A) relationship does not impact on the outcome.

1.20 If, in Example 1.1, the foreign subsidiary (C) controls another foreign entity, the Australian subsidiary becomes an outward investor because of the impact of subsection 820-905(3A) on the TC control interest rules. However, the appropriate outcome is for the Australian subsidiary to be an inward investor in both cases. One implication of the current law is that if an Australian authorised deposit-taking institution is classified as an outward investor it will be subject to the thin capitalisation rules. If it is an inward investor it could rely only on the capital adequacy rules issued by the Australian Prudential Regulation Authority and not be subject to the thin capitalisation rules.

1.21 In order to address this issue the bill amends sections 820-815, 820-820 and 820-825 so that the TC control rules do not apply where the:

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entity is an associate entity because of section 820-905(3A); and

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the associate entity is not an Australian entity.

[Schedule 1, items 23 to 27, subsections 820-815(2), 820-820(3) and 820-825(2)]

1.22 To avoid unintended consequences for controlled foreign entity equity and debt from these amendments (and those made earlier because of subsection 820-905(3B)), the definitions of these terms will be amended. They will extend to controlled foreign entities of which an associate entity of the tested entity is an Australian controller. [Schedule 1, item 28, paragraph 820-881(b)]

Transitional rule for hybrid instruments

1.23 Consistent with the general transitional measures in the New Business Tax System (Debt and Equity) Act 2001, the Income Tax (Transitional Provisions) Act 1997 contains thin capitalisation transitional measures in sections 820-35 and 820-40. These measures ensure that the issuer of an interest that changes character from 1 July 2001 as a result of applying the debt/equity rules to the interest is not disadvantaged for a transitional period of up to 4 years. The thin capitalisation transitional rules also ensure that the holder of the interest is not affected for a 4 year transitional period.

1.24 Specific transitional measures are provided in the debt/equity rules at subsection 974-75(4) for at call loans. At call loans issued between 21 February 2001 and 31 December 2002 will be debt interests until 1 January 2003.

1.25 The interaction of the general thin capitalisation transitional measures and the specific transitional measure for at call loans in the debt/equity rules means that at call loans issued on or after 21 February 2001 and before 1 July 2001 are subject to 2 transitional regimes:

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the debt/equity rules at subsection 974-75(4) until 31 December 2002; and

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the thin capitalisation rules from 1 January 2003 until 30 June 2004.

1.26 Industry has requested that only one set of transitional rules apply to at call loans to simplify the law and minimise the compliance burden. Consequently, the Government is amending the law to ensure that the general thin capitalisation transitional rules do not apply to at call loans. This amendment will not affect issuers as the interest would be treated as equity for thin capitalisation purposes from 1 January 2003 under either of the transitional rules.

1.27 However, holders of the interest may be affected as what would have been a debt interest from 1 January 2003 to 30 June 2004 under the thin capitalisation transitional measure will now be an equity interest. This is consistent with the intention of the at call loan transitional provision that such loans would only be treated as debt until 31 December 2002. [Schedule 1, item 45, subsection 820-40(1) of the Income Tax (Transitional Provisions) Act 1997]

Interest free debt

1.28 The term debt deduction is defined in section 820-40. Broadly speaking, a debt deduction is the cost incurred in connection with a debt interest that is deductible, subject to the thin capitalisation rules. These costs include but are not limited to interest payments. Where a debt interest does not give rise to a debt deduction it may be referred to as debt deduction free debt. However, in this chapter for ease of explanation, debt deduction free debt is referred to as an interest free loan. Similarly, the issuer and the holder of a debt interest are referred to as the borrower and the lender, respectively.

1.29 Where an entity has been provided with an interest free loan, that loan is treated as quasi-equity and is generally not included in the calculation of adjusted average debt of that entity for thin capitalisation purposes. This recognises that although the funds are not equity they provide capital to fund the entitys operations for which no debt deductions are claimed.

1.30 The legislation includes a number of integrity measures with respect to interest free loans to ensure that they are not used to manipulate the thin capitalisation rules. For example:

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these loans cannot give rise to debt deductions in any year of income;

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these loans are treated as associate entity equity for the lender; and

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the lender and the borrower must use the same measurement days when calculating average values under the regime (if not the loan is counted as debt for the borrower).

1.31 A number of issues have been identified with respect to interest free loans that produce inappropriate outcomes. These include:

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the inclusion of loans that are interest free because the costs associated with them do not give rise to debt deductions. These loans are not the type of loan that is really interest free and their inclusion distorts a number of calculations;

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the lender of an interest free loan may have to include the loan as associate entity equity although the borrower must treat the loan as debt;

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an interest free loan is always denied quasi-equity treatment where it has been provided by an entity that does not have to undertake thin capitalisation calculations;

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the calculation of the amount of debt deductions to be disallowed does not include an interest free loan as debt where it has been denied quasi-equity treatment;

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inconsistent treatment of interest free loans in the calculation of the premium excess amount; and

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loans that have been denied quasi-equity treatment are included as quasi-equity in calculating the attributable safeharbour excess amount.

1.32 Consequently, a number of amendments are made by this bill to address these problems.

Loans that have costs but the costs are not deductible

1.33 The thin capitalisation provisions treat some types of loans as interest free although they may have interest expenses or other similar types of costs associated with them but these costs do not give rise to debt deductions. This is true, for example, for debt interests of capital nature, or where the costs have been incurred in deriving exempt income. These types of loans will not ordinarily enter the thin capitalisation calculations and their inclusion and treatment as interest free loans distort the calculation of a number of important items such as adjusted average debt.

1.34 Consequently, debt interests that do not give rise to debt deductions because the costs associated with the debt are not allowable deductions will be treated as quasi-equity. These are not the types of loans that would be made to intentionally subvert the operation of the thin capitalisation rules. That is, only certain truly interest free debt will be counted as debt in the calculations.

1.35 Specifically, loans that give rise to costs which are not deductible will not be included in the borrowers adjusted average debt. In addition, these loans will be included in the calculation of the lenders associate entity equity. [Schedule 1, item 8, subsection 820-85(3), item 17, subsection 820-120(2), item 19, subsection 820-185(3), item 21, subsection 820-225(2), item 30, paragraph 820-915(3)(c) and item 37, section 820-946]

Cost-free debt capital

1.36 Broadly, interest free loans that do not have any costs associated with them will be included in adjusted average debt but only where:

•

the lender and the borrower use different valuation days or a different number of valuation days; or

•

the loan is for less than 180 days.

1.37 The effect of treating interest free loans as quasi-equity is that the borrowers assets (other funding remaining unchanged) increase without any corresponding increase to its adjusted average debt. This creates the opportunity for the safeharbour debt amount calculations to be manipulated by providing an interest free loan and then repaying it shortly after the borrowing entitys valuation day.

1.38 An integrity measure operates within the definition of adjusted average debt so that an interest free loan is included as adjusted average debt where the borrower and the lender do not use the same valuation days for thin capitalisation purposes. A valuation day is a day on which an entity measures the value of its assets, liabilities and debt.

1.39 The integrity measure is deficient as it:

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does not capture all lenders that could possibly provide interest free loans;

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denies quasi-equity treatment where an interest free loan has been provided by a lender that does not have valuation days; and

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does not recognise that the costs associated with the loan may not give rise to debt deductions.

1.40 To address this, the integrity measure will now apply to all lenders that could potentially provide interest free loans and introduces the 180 day rule. It is based on the new concept of cost-free debt capital. Where an interest free loan meets the definition of cost-free debt capital it will not be treated as quasi-equity but as adjusted average debt. [Schedule 1, item 8, subsection 820-85(3), item 17, subsection 820-120(2), item 19, subsection 820-185(3), item 21, subsection 820-225(2) and item 41, definition of cost-free debt capital in subsection 995-1(1)]

1.41 Cost-free debt capital is defined in new Subdivision 820-KA [Schedule 1, item 37, section 820-946] . The definition has 3 components. Firstly, it identifies to which borrowers the provision applies. Secondly, it identifies the relevant debt interests of those borrowers. Thirdly, it provides certain conditions that must be met by the borrower and lender or the loan.

The borrower

1.42 Whether cost-free debt capital applies to a borrower depends on the classification of the borrower. Cost-free debt capital may arise for a borrower where:

•

the borrower is an outward investing or inward investing entity (non-ADI);

•

if the borrower is a foreign entity, it holds assets that are attributable to an Australian PE or other assets held to produce its assessable income;

•

the borrower is not an exempt entity; and

•

neither of the threshold tests in sections 820-35 and 820-37 operates to prevent the borrowers debt deductions being disallowed.

[Schedule 1, item 37, subsection 820-946(1)]

Qualifying interest free loans

1.43 Cost-free debt capital comprises the total value of loans that:

•

do not give rise to costs covered by paragraph 820-40(1)(a); when

•

at least one of 3 conditions is satisfied.

[Schedule 1, item 37, subsection 820-946(2)]

1.44 Only loans which are free of costs can qualify as cost-free debt capital. Although these are described as interest free loans in this chapter, the costs covered by the provision are broader than interest. Paragraph 820-40(1)(a) forms part of the definition of debt deduction. Broadly, it covers costs for the use of financial benefits received by the entity under the debt interest arrangement and costs directly incurred in obtaining or maintaining those benefits. It should be noted, however, that paragraph 820-40(1)(a) must be read in conjunction with subsections 820-40(2) and (3) which specify costs that are expressly included and others that are excluded.

1.45 In relation to borrowers that are foreign entities, interest free loans to them are taken into account for the purposes of cost-free debt capital only to the extent that the loans relate to their Australian investments. That is, they must be partly or wholly attributable to assets that are attributable to an Australian PE or other assets held to produce assessable income. This means that part of a debt of a foreign entity may qualify as cost-free debt capital. [Schedule 1, item 37, subsection 820-946(5)]

1.46 The conditions to be met by the borrower and lender, or by the loan, depend on whether subsection 820-946(1) also applies to the lender. That is:

•

the lender is an outward investing or inward investing entity (non-ADI);

•

if the lender is a foreign entity, it holds assets that are attributable to an Australian PE or other assets held to produce its assessable income;

•

the lender is not an exempt entity; and

•

neither of the threshold tests in sections 820-35 and 820-37 operates to prevent the lenders debt deductions being disallowed.

[Schedule 1, item 37, subsections 820-946(3) and (4)]

1.47 Where the lender satisfies these requirements, a loan will be cost-free debt capital only if either of the following is satisfied:

•

the valuation days used to calculate the average value of the lenders assets are different from the valuation days used to calculate the borrowers adjusted average debt; or

•

the number of valuation days used to calculate the average value of the lenders assets is different from the number of valuation days used to calculate the borrowers adjusted average debt.

[Schedule 1, item 37, subsection 820-946(3)]

1.48 In all other cases, a loan will be cost-free debt capital only if the loan has been on issue for less than 180 days. [Schedule 1, item 37, subsection 820-946(4)]

1.49 The following flowchart provides a graphical representation of how cost-free debt capital is determined.

Further amendments resulting from the changes to interest free loans

1.50 These changes to the treatment of interest free loans will have a number of implications. These are discussed in paragraphs 1.51 to 1.58.

Amount of debt deduction disallowed

1.51 Currently, the calculation for determining the amount of deduction disallowed under the thin capitalisation regime does not include interest free loans on the basis that they receive quasi-equity treatment. However, where the interest free loan has been denied quasi-equity treatment (because it is cost-free debt capital and is treated as debt) the exclusion of this debt results in an incorrect outcome. Consequently, the definition of average debt will be amended so that it includes interest free loans where those loans are included in an entitys adjusted average debt. [Schedule 1, item 15, section 820-115, item 18, subsection 820-120(4), item 20, section 820-220 and item 22, subsection 820-225(3)]

Associate entity equity

1.52 In general, interest free loans are treated as associate entity equityfor the lender. This provides for consistency of treatment between the lender and the borrower and prevents the cascading of equity through the use of interest free loans.

1.53 However, where the interest free loan has been denied quasi-equity treatment in the borrowing entity (because it is cost-free debt capital and is treated as debt) there is an inconsistency in treatment between the lender and the borrower. The definition of associate entity equity will be amended so that an interest free loan (or any portion of it) that is cost-free debt capital for the borrower will not be included in the associate entity equity of the lender. [Schedule 1, item 30, subsection 820-915(3)]

Associate entity equity, associate entity debt, controlled foreign entity debt and controlled foreign entity equity

1.54 Under the existing law interest free debt is included in CFE debt and is excluded from CFE equity. This treatment does not recognise that interest free debt is generally treated as quasi-equity and is thus included in associate entity equity. This inconsistency creates a number of anomalies in the application of the thin capitalisation rules. In particular, in calculating the safeharbour debt amount for non-ADIs, interest free loans provided to a CFE are deducted twice from the assets of the taxpayer. Firstly, as associate entity equity and secondly as CFE debt. To ensure consistent treatment, interest free loans will only be included in CFE equity and will be excluded from CFE debt. [Schedule 1, item 28, subsections 820-885(1) and 820-890(1)]

1.55 However, the more substantive issue is to ensure that any equity or debt interest that meets the definition of associate entity equity (or associate entity debt) and CFE equity or CFE debt is not deducted twice from assets in calculating the safeharbour amounts. There are a number of specific provisions in the method statements that seek to ensure that double counting does not take place. However, this may not cover all possible situations as the example in paragraph 1.54 demonstrates. Consequently, to remove any possible overlap:

•

an interest in a foreign entity only qualifies as associate entity equity or associate entity debt to the extent that it is attributable to Australian operations [Schedule 1, item 29, subsection 820-910(4) and item 30, subsection 820-915(4)] ;and

•

an interest in a foreign entity only qualifies as CFE equity or CFE debt to the extent that it is not attributable to Australian operations [Schedule 1, item 28, subsections 820-885(2) and 820-890(2), item 39, definition of controlled foreign entity debt in subsection 995-1(1) and item 40, definition of controlled foreign entity equity in subsection 995-1(1)] .

1.56 This means that an interest free loan to a CFC that operates a PE in Australia (but has no other Australian investments) will be associate entity equity to the extent that the loan is used to fund operations of the PE and CFE equity to the extent that it funds the non-PE operations. For example, a $100 interest free loan to the CFC could be $20 associate entity equity and $80 CFE equity.

1.57 It also means that an entity cannot have associate entity equity in a foreign entity that has no Australian operations. [Schedule 1, item 30, paragraph 820-915(2)(b)]

1.58 As a consequence of this amendment, the specific steps in the method statements that seek to avoid the double counting will be removed. [Schedule 1, item 7, subsection 820-85(3), item 9, section 820-95, item 10, section 820-95, item 11, subsection 820-100(2), item 12, subsection 820-100(2), item 13, subsection 820-100(3), item 14, subsection 820-100(3) and item 16, subsection 820-120(2)]

Other amendments

Associate entity excess amount

1.59 Associate entity equity is deducted from an entitys assets as an integrity measure to prevent over-gearing from the cascading of equity through chains of entities. The associate entity equity rule can produce harsh outcomes where the value of the associate entity equity is not used to fully leverage debt in the associate. In order to address this, the associate entity excess amount allows excess debt capacity of an associate entity to be carried back to the entity with the equity investment. An amendment will be made to clarify the operation of the associate entity excess amount and recognise that both equity and debt interests can be associate entity equity. [Schedule 1, item 31, subsection 820-920(1), item 32, subsection 820-920(2) and item 33, subsection 820-920(2)]

1.60 The associate entity excess amount is made up of 2 components: the attributable safeharbour excess amount and the premium excess amount.

Premium excess amount

1.61 A premium excess amount arises where the books of account of the investing entity and those of the associate place different values on the assets of the associate. The debt capacity attributable to any such difference is the premium excess amount.

Negative equity

1.62 Where the associate entitys equity capital is less than zero, the premium excess amount can be inflated because a negative amount is deducted in the method statement in subsection 820-920(3). This has the effect of producing a premium excess amount which is greater than the amount deducted for associate entity equity. In order to correct this anomaly, negative amounts of equity capital will be taken to be nil. [Schedule 1, item 34, subsection 820-920(3)]

Interest free loans

1.63 Step 1 of the method statement in subsection 820-920(3) inadvertently includes interest free loans held by the investing entity through the use of the term associate entity equity. This distorts the calculation of the premium excess amount because these loans are not included in the equity capital of the associate entity at step 2. To remove the distortion, step 1 of the method statement will be amended to exclude any debt interests that are included in the calculation of associate entity equity. [Schedule 1, item 34, subsection 820-920(3)]

Equity capital of the associate entity

1.64 In the current legislation, step 1 of the premium excess amount removes CFE equity from the associate entity equity in the calculation of the premium excess amount. As associate entity equity and CFE equity are now mutually exclusive as outlined in paragraph 1.55, the removal of CFE equity is unnecessary in step 1. Consequently the reference to CFE equity will be removed from step 1. [Schedule 1, item 34, subsection 820-920(3)]

1.65 Another consequence of applying the new definition of associate entity equity at step 1 of the method statement is that there will be a mismatch of concepts in step 2 that could lead to erroneous results. The problem is that associate entity equity for a foreign entity is determined on the basis of Australian operations whereas there is no such apportionment for equity capital in step 2. An amendment will be made to step 2 to ensure that equity capital will only relate to Australian operations. This is achieved by ensuring that equity capital in step 2 does not include an amount that is CFE equity for the test entity. [Schedule 1, item 34, subsection 820-920(3)]

Safeharbour excess amount

1.66 As discussed in paragraph 1.60, the associate entity excess amount is comprised of the premium excess amount and the attributable safeharbour excess amount. The attributable safeharbour excess amount allows the carry back of excess debt capacity from an associate entity to an investing entity on the basis of the proportion of total equity the investing entity holds in the associate. In calculating the proportion of equity held in the associate entity, steps 3 and 4 in subsection 820-920(4) include amounts of interest free debt provided on the basis that it will be treated as quasi-equity. However, where an interest free loan meets the definition of cost-free debt capital it should not be included in the calculation as it has lost its quasi-equity status. Consequently, steps 3 and 4 will be amended to ensure that any cost-free debt capital is not included in determining an investing entitys equity in an associate entity. [Schedule 1, item 35, subsection 820-920(4) and item 36, subsections 820-920(5) and (6)]

Associate entity debt

1.67 Where an entity borrows funds and on-lends those funds to an associate entity, the same pool of funds could be tested in both entities when in economic terms there is only one loan transaction. The associate entity debt rule eliminates the debt in the interposed lending entity so that the same pool of funds is not tested twice. A requirement of this rule is that it is only provided to an entity where the debt is tested in another entity.

1.68 However, the current legislation is deficient in a number of respects as it provides associate entity debt treatment where:

•

the loan is interest free and is treated as quasi-equity for the borrower in applying the thin capitalisation rules;

•

the borrower is an exempt entity and the thin capitalisation rules do not apply; and

•

thin capitalisation calculations do not apply because the borrower satisfies the requirements for exemption in sections 820-35 and 820-37.

1.69 In each of these cases the associate entity debt rule provides an unintended advantage to the lender by reducing its tested debt. This outcome can be exploited by tailoring loans to meet the above criteria thus subverting the thin capitalisation rules.

1.70 Consequently, the associate entity debt definition will be amended to ensure that associate entity debt can exist only:

•

where the loan gives rise to debt deductions for the associate entity (i.e. an interest free loan will not be associate entity debt); and

•

the associate entity is not freed from the thin capitalisation rules because of the threshold rules in section 820-35 or section 820-37 or because it is a tax exempt entity.

[Schedule 1, item 29, subsections 920-910(2) and (3)]

1.71 The definition of associate entity debt will also be amended to make it clear that, where a foreign entity is the issuer of the debt interest, the interest is only included to the extent that it is attributable to Australian operations (see paragraph 1.55 for explanation of this amendment). [Schedule 1, item 29, subsection 820-910(4)]

Interests acquired in an associate or controlled foreign entity

1.72 The current definitions of associate entity equity, associate entity debt and controlled foreign entity debt only include some interests if they have been directly issued to the tested entity by its associate entity or the controlled entity. This could have unintended consequences, either advantageous or disadvantageous for taxpayers, if interests have been acquired via another party or on the secondary market. To correct this anomaly, the definitions will be amended to ensure that they apply to interests held by the entity irrespective of how they have been acquired. [Schedule 1, item 28, section 820-885, item 29, section 820-910 and item 30, section 820-915]

Application and transitional provisions

1.73 The amendments made by Schedule 1 will apply from the start of a taxpayers first income year beginning on or after 1 July 2001 when Division 820 began to apply. [Schedule 1, items 46 to 48]

Chapter 2 - Trust to company roll-over

Outline of chapter

2.1 This chapter details amendments to the ITAA 1997 to provide a CGT roll-over where:

•

a trust disposes of all of its assets to a company; and

•

the beneficiaries interests in the trust are exchanged for shares in the company.

The roll-over will be available for both the trust and its beneficiaries.

2.2 The trust will be required to cease to exist within 6 months from the disposal of the first asset to the company. In limited circumstances the 6 month period can be extended. The benefits of the roll-over will be removed if the trust fails to cease to exist within that time. This is achieved by inserting a new CGT event.

2.3 In this chapter:

•

interests refers to units and interests in the trust; and

•

a trust restructure refers to a trust disposing of all of its assets to a company and the beneficiaries interests in that trust are being exchanged for shares in the company.

Context of amendments

2.4 This measure was originally intended as transitional relief for trust restructures undertaken in response to the proposed entities regime. Exposure draft legislation for that regime, including the transitional roll-over, was released on 11 October 2000. Later, Treasurers Press Release No. 8 of 27 February 2001 stated that the entities regime would not proceed as proposed. Treasurers Press Release No. 16 of 22 March 2001 then stated that the proposed transitional roll-over was no longer necessary.

2.5 Subsequently, Treasurers Press Release No. 77 of 5 October 2001 announced a new CGT roll-over to facilitate the transfer of assets from certain trusts to a company from 11 November 1999. The roll-over will increase the commercial flexibility available for a trust in selecting an appropriate business form.

2.6 Schedule 2 to this bill gives effect to the Governments announcement by inserting Subdivision 124-N and a new CGT event J4 into the ITAA 1997.

Summary of new law

2.7 The following are key features of Subdivision 124-N:

•

a trust disposes of all of its assets to a company;

•

CGT event E4 (section 104-70) must be capable of applying to all of the interests in the trust;

•

all the beneficiaries must own shares in the company in the same proportion as they owned interests in the trust;

•

the market value of the beneficiaries interests in the trust and the market value of the shares in the company must be at least substantially the same;

•

generally, the company is a shelf company at the time the asset disposals commence; and

•

the entities involved choose the roll-over.

2.8 The roll-over will defer a capital gain or capital loss made on:

•

a trust disposing of an asset to a company; and

•

a beneficiarys interest in the trust being exchanged for a share in the company.

2.9 Consistent with other same-asset roll-overs in the CGT provisions, the trust will not be able to roll-over an asset that is trading stock of the trust or an asset that is trading stock of the company on acquiring it from the trust.

2.10 Similarly, the roll-over is not available for a beneficiarys interest in a trust that is trading stock of the beneficiary or where the interest is replaced with a share that is trading stock of the beneficiary at the time the beneficiary acquires the share.

2.11 The benefits of the roll-over will be reversed by new CGT event J4 if the trust does not cease to exist within 6 months from when the trust disposed of the first asset to the company, or at the end of an extended period if the reasons for the delay are beyond the trustees control.

Detailed explanation of new law

2.12 As a trusts business develops, it may seek to undertake a trust restructure to increase its efficiency and take full advantage of its future potential. Subdivision 124-N provides a CGT roll-over to facilitate such a restructure.

2.13 In general terms, the CGT roll-over is provided where:

•

a trust disposes of all of its assets to a company; and

•

all beneficiaries interests in the trust are exchanged for shares in the company.

[Schedule 2, item 1, subsection 124-855(1)]

2.14 The CGT roll-over is available where 2 or more trusts restructure into a single company. If more than one trust restructures into the same company the interests in each of the trusts must be owned by the same beneficiaries in the same proportions [Schedule 2, item 1, subsection 124-855(2)] . The requirement that the beneficiaries own their interests in each of the trusts in the same proportions is consistent with the policy that a roll-over is only available where the beneficiaries economic ownership in the assets of each of the trusts remain unchanged on completion of the restructuring of the trust into a single company.

Example 2.1

Simon and Jane each own 50% of the units in the Benarman Unit Trust and Julian Unit Trust. All of the assets of both trusts are disposed of to Ida Pty Ltd. Both Simons and Janes economic ownership of the trusts assets before the restructure and of the companys assets after the restructure is maintained at 50% each. As a result, they may choose to roll-over any capital gain or capital loss in respect of the restructure if the other conditions of the roll-over are satisfied.

Example 2.2

To modify Example 2.1, if Simon and Jane each owned 50% of the units in the Benarman Unit Trust and Simon owned 40% and Jane owned 60% of the units in the Julian Unit Trust the economic ownership will not be maintained. After the trust restructure, Simon owns 45% of the shares in the company and Jane owns 55% of the shares in Ida Pty Ltd. Simon and Jane would not be able to disregard a capital gain or capital loss under the roll-over.

2.15 A condition of the roll-over is that CGT event E4 (capital payment for trust interest) must be capable of applying to all of the interests in the trust [Schedule 2, item 1, paragraph 124-855(1)(b)] . A trust where all the beneficiaries interests have a fixed capital component and a discretionary income component will satisfy this requirement. A trust where all the beneficiaries interests have a discretionary capital component and a fixed income component will not be eligible for roll-over. It follows that the roll-over does not apply where the trust is a discretionary trust.

Subdivision 124-N - requirements for the roll-over

Requirement 1: disposal of trust assets

2.16 All of the CGT assets (other than assets that come to an end) of the trust must be disposed of to the company during the trust restructuring period [Schedule 2, item 1, subsection 124-860(1)] . This allows for a staggered transfer of the assets or a single transfer of all of the assets of the trust. The trust restructuring period starts just before the first asset is disposed of to the company and ends on the last asset being disposed of to the company under the trust restructure. Therefore the assets that must be disposed of are all the assets owned by the trust just before the disposal of the first asset to the company, including any assets acquired by the trust up to and until the last asset is disposed of to the company. Assets disposed of before the start of the trust restructuring period are ignored for the purposes of the roll-over.

Example 2.3

PDB Unit Trust decides to restructure into a company - SGA Pty Ltd. However, the trust owns shares in a listed company, XYZ Pty Ltd, that it does not want to dispose of to SGA Pty Ltd. Therefore, on 15 November 1999 the trust disposes of its shares in XYZ Pty Ltd on market with the existing CGT rules applying. The trust then disposes of the first asset to SGA Pty Ltd on 20 November 1999 under a trust restructure. The start of the trust restructuring period for PDB Unit Trust will be 20 November 1999. The shares in XYZ Pty Ltd will be ignored in testing whether all the assets of the trust are disposed of to SGA Pty Ltd under the trust restructure.

2.17 There is an exception to the requirement that all the assets have to be disposed of to the company. Assets that are specifically retained in the trust for the purposes of discharging existing or expected debts can be ignored for the purpose of determining whether all the assets of the trust have been disposed of to the company. [Schedule 2, item 1, subsection 124-860(1)]

2.18 However, the value of those retained assets are not ignored in testing whether the market value test in paragraph 124-860(6)(b) is satisfied. The market value test requires that the market value of the interests the beneficiaries of the trust own just before the trust restructuring period, be at least substantially the same as the market value of the shares those former beneficiaries own in the company just after the end of the trust restructuring period. As a result, the trust may fail this test if the assets it does not dispose of to the company cause the market value of the shares in the company to be less than the market value of the beneficiaries interests in the trust.

Requirement 2: trust restructuring period

2.19 The start of the trust restructuring period is just before the first asset is disposed of to the company under a trust restructure. That disposal must be on or after 11 November 1999. [Schedule 2, item 1, paragraph 124-860(2)(a) and item 17]

2.20 The trust restructuring period ends just after the last CGT asset is disposed of to the company [Schedule 2, item 1, paragraph 124-860(2)(b)] . Just after this time all the interests in the trust must have been exchanged for shares in the company.

Requirement 3: characteristics of the company

2.21 The company must satisfy the following requirements:

•

it is not an entity exempt from income tax [Schedule 2, item 1, subsection 124-860(3)] ;

•

it has never carried on any commercial activities [Schedule 2, item 1, paragraph 124-860(4)(a)] ;

•

it has no CGT assets other than small amounts of cash, on hand or in a bank account [Schedule 2, item 1, paragraph 124-860(4)(b)] ; and

•

it has no losses of any kind [Schedule 2, item 1, paragraph 124-860(4)(c)] .

2.22 Losses of any kind include capital losses, net capital losses, revenue losses the company may have or any deductions that the company may have claimed or can claim.

2.23 There may be situations in which the trustee of the trust is itself a company (a corporate trustee). Rather than requiring the trust to set up a new company for the purposes of the roll-over, the trust can dispose of its assets to the corporate trustee and be eligible for the roll-over. [Schedule 2, item 1, subsection 124-860(5)]

2.24 The corporate trustee must, in its capacity as the company acquiring the assets from the trust, comply with each of the other requirements in section 124-860 (other than paragraphs 124-860(4)(a) to (c)). If the corporate trustee already owns CGT assets before the start of the trust restructuring period, the proportionate interest test in subsection 124-860(6) may not be satisfied. This is because the value of those assets may be such that the market value of the interests in the trust will be less than the market value of the shares in the company.

Requirement 4: proportional interest must be maintained

2.25 Just after the trust restructuring period, the shareholders must have the same proportionate ownership in the company as they owned interests in the trust.

2.26 The test compares the proportionate ownership of interests in a trust just before the trust disposes of its first asset to a company under a trust restructure with the proportionate ownership of shares in the company just after the trust restructuring period. [Schedule 2, item 1, paragraph 124-860(6)(a)]

Example 2.4

Shamsa and Ingrid own 40% and 60% of the interests in Capital Unit Trust respectively just before the trust restructuring period. Just after the trust restructuring period Shamsa must own 40% and Ingrid must own 60% of the shares in the company to satisfy the proportionate interest test.

2.27 Further, the market value of the shares just after the trust restructuring period must be at least substantially the same as the market value of the interests in the trust just before the start of the trust restructuring period. [Schedule 2, item 1, paragraph 124-860(6)(b)]

Exception to proportionate interest tests

2.28 As the company may be a shelf company, a nominal number of shares may be owned by entities other than the beneficiaries in the trust before the first asset is disposed of to the company. It is also a requirement that the entities that own shares in the company just before the start of the trust restructuring period only own up to 5 shares collectively at that time [Schedule 2, item 1, paragraph 124-860(7)(a)] . Those shares initially issued in the shelf company may be ignored for the purposes of the proportionate interest tests if it would be reasonable to treat the beneficiaries of the trust as if they owned all the shares in the company. Those shares can be ignored where the market value of the shares owned in the company before the trust restructuring period is so insignificant that the beneficiaries of the trust, just before the trust restructuring period, can be considered to own all the shares in the company just after the end of that period [Schedule 2, item 1, paragraph 124-860(7)(b)] .

Example 2.5

Felicity owns 2 shares in ESS Pty Ltd (a shelf company) before the trust restructure. Immediately after the trust restructure period, 10,000 shares are issued to the members of the trust that restructured into ESS Pty Ltd. All the shares have equal market value. The shares owned by Felicity can be ignored in applying the proportionate interest test.

Requirement 5: the company must be an Australian resident

2.29 The company into which the trust is restructuring must be an Australian resident. [Schedule 2, item 1, subsection 124-860(8)]

Requirement 6: choosing the roll-over

2.30 Both the trust and the company under the trust restructure must choose the roll-over. [Schedule 2, item 1, section 124-865]

2.31 The beneficiaries of the trust must choose the roll-over to disregard a capital gain or capital loss arising on their interests in the trust being exchanged for shares in the company [Schedule 2, item 1, subsection 124-870(1)] . The trust beneficiaries may choose the roll-over regardless of whether the trust and company choose the roll-over.

2.32 The trust, the company and the beneficiaries of the trust choose the roll-over on an asset by asset basis [Schedule 2, item 1, subsection 124-870(2)] . In addition, where the trust restructuring period occurs over more than one income year, the trust and each beneficiary who chooses roll-over will need to amend their income tax assessments for the years prior to the ending of the trust restructure. Roll-over can only be chosen once the trust restructure is completed.

2.33 A non-resident beneficiary of the trust can only choose to obtain the roll-over if the replacement share in the company they receive in exchange for their interest in the trust has the necessary connection with Australia [Schedule 2, item 1, subsection 124-870(3)] . Section 136-25 of the ITAA 1997 lists which shares have the necessary connection with Australia. For example, a share in a company that is a private company and a resident of Australia will qualify as having the necessary connection with Australia.

Consequences of roll-over for trust and company

Capital gains and losses disregarded

2.34 Where the requirements for the roll-over have been satisfied, the trust can disregard the capital gain or loss from a CGT event A1 happening on the disposal of an asset to the company [Schedule 2, item 1, subsection 124-875(1)] . This roll-over is not negated by CGT event J4 later happening to that asset. CGT event J4 is discussed in paragraphs 2.45 to 2.54.

Cost base is transferred

2.35 The cost base and reduced cost base of the CGT asset for the trust becomes the first element of the cost base or reduced cost base, respectively, of the asset for the company. [Schedule 2, item 1, subsection 124-875(2)]

Pre-CGT assets retain their status

2.36 Consistent with other CGT same-asset roll-overs, the company will be taken to have acquired an asset from the trust before 20 September 1985 if the trust acquired that asset before 20 September 1985 [Schedule 2, item 1, subsection 124-875(3)] . If the trust fails to cease to exist within the required time (generally 6 months from the disposal of the first asset to the company) the company will no longer be taken to have acquired that asset before 20 September 1985 [Schedule 2, item 1, subsection 124-875(4)] .

Roll-over not available for trading stock

2.37 The roll-over provided by Subdivision 124-N applies only to capital gains and capital losses. If the CGT asset is trading stock of the trust or if the CGT asset becomes trading stock of the company on acquisition of the asset, the roll-over in Subdivision 124-N is not available. [Schedule 2, item 1, subsection 124-875(5)]

2.38 The roll-over will apply to a trust asset that is disposed of to the company that is a right or option to acquire an asset. If the right or option is exercised by the company and the company as a result acquires an item of trading stock, then any capital gain or capital loss on the exercise of the right or option will not be disregarded. This rule will be inserted in Division 134-1. [Schedule 2, item 13]

Example 2.6

Chitra Unit Trust runs a horse breeding business. It owns an option to acquire 20 horses. During the trust restructuring period, the option to acquire the horses is disposed of to Lina Pty Ltd. Lina Pty Ltd satisfies the conditions of subsection 124-860(4). Just after the trust restructuring period, Lina Pty Ltd exercises the option. The horses acquired under the option become trading stock of Lina Pty Ltd on exercise of the option. The roll-over will be available for the disposal of the option to Lina Pty Ltd though any capital gain or capital loss on exercise of the option will not be disregarded for Lina Pty Ltd.

Consequences for beneficiaries in a trust receiving shares

Roll-over consequences under Subdivision 124-A

2.39 The consequences for a beneficiary who chooses the Subdivision 124-N roll-over are set out in Subdivision 124-A (replacement-asset roll-overs, general rules) of the ITAA 1997. [Schedule 2, item 1, subsection 124-870(1), note 1]

2.40 The consequences are:

•

the capital gain or capital loss made from the interest in the trust being replaced with a share is disregarded;

•

for interests acquired before 20 September 1985, the shares received in exchange for the interests will also be taken to have been acquired before that date under subsections 124-10(4) and 124-15(4) and (5);

•

if CGT event J4 happens to a share then the pre-CGT status of the share is lost, resulting in the share being acquired after 19 September 1985 under the acquisition rules in Division 109; and

•

the cost base or reduced cost base of interests in the trust acquired after 20 September 1985 are evenly spread across the first element of the cost base or reduced cost base, respectively, of the shares under subsections 124-10(3) or 124-15(3) and (6).

This roll-over is not negated by CGT event J4 later happening to that asset. CGT event J4 is discussed in paragraphs 2.45 to 2.54.

Capital loss not available during trust restructuring period

2.41 The beneficiaries of the trust are prevented from making a capital loss on their interests in that trust during the trust restructuring period. [Schedule 2, item 1, subsection 124-870(4)]

2.42 This integrity measure is intended to prevent any capital losses arising on the cancellation or other CGT event happening to the interests in the trust, while the assets of the trust are being disposed of to the company.

Roll-over not available for trading stock

2.43 The roll-over provided in section 124-870 for the beneficiary applies only to capital gains and capital losses on their interests in the trust. The roll-over is not available where the beneficiarys interest in the trust is trading stock or the share becomes trading stock of the beneficiary acquiring it. [Schedule 2, item 1, subsection 124-870(5)]

2.44 The roll-over will apply to rights or options to acquire units in the trust that are exchanged for rights or options to acquire shares in the company. If the right or option is then exercised and as a result the entity owning the right or option acquires the shares as trading stock, then any capital gain or loss on the exercise of the right or option will not be disregarded. This rule will be inserted in Division 134-1. [Schedule 2, item 13]

Trust fails to cease to exist - CGT event J4

2.45 CGT event J4 will happen where:

•

a roll-over in Subdivision 124-N is chosen for an asset disposed of to a company during the trust restructuring period;

•

the trust fails to cease to exist within a certain time frame (generally 6 months after the first asset transfer); and

•

the company owns the asset when the failure happens.

As a result the effect of the roll-over is reversed. [Schedule 2, item 4, subsection 104-195(1)]

2.46 CGT event J4 will also be triggered where:

•

a Subdivision 124-N roll-over is chosen by a beneficiary of the trust in respect of their interest in the trust that was exchanged for a share under a trust restructure;

•

the trust fails to cease to exist within the required time; and

•

the beneficiary still owns the share in the company.

The effect of the roll-over will also be reversed for the beneficiary. [Schedule 2, item 4, subsection 104-195(2)]

Time frame for trust ceasing to exist

2.47 In most cases, the trust must cease to exist within 6 months after the trust first disposed of an asset to the company under a trust restructure. CGT event J4 may be triggered if the trust fails to cease to exist within this time frame. [Schedule 2, item 4, subparagraphs 104-195(1)(b)(i) and (2)(b)(i)]

2.48 CGT event J4 will happen at the end of the 6 month period. [Schedule 2, item 4, subsection 104-195(3)]

2.49 The 6 month period will be extended where the trust fails to cease to exist and that failure was caused by circumstances that were beyond the control of the trust and the trust then ceases to exist as soon as practicable after that time. If the trust does not cease to exist as soon as practicable after this time CGT event J4 may still be triggered. The time of the CGT event J4 in this case is at the end of the extended period. [Schedule 2, item 4, subparagraphs 104-195(1)(b)(ii) and (2)(b)(ii) and subsection 104-195(3)]

When a company makes a capital gain or capital loss

2.50 If a trust obtained a roll-over for an asset it disposed of to a company under Subdivision 124-N and the company still owns the asset the company, and not the trust, will make a capital gain or capital loss under CGT event J4. The capital gain is the excess of the assets market value at the time the company acquired the asset from the trust over the cost base of the asset at that time. The company will make a capital loss if the market value is less than the assets reduced cost base at the time the company acquired the asset. Division 109 will apply to determine the acquisition time for the asset. [Schedule 2, item 4, subsection 104-195(4)]

When a shareholder makes a capital gain or capital loss

2.51 As with the company, the shareholder will make a capital gain under CGT event J4 if the shares market value at the time the shareholder acquired it under the trust restructure is more than the shares cost base at that time. A capital loss is made if the shares market value is less than the shares reduced cost base at that time. Instead, Division 109 will apply to determine the acquisition time for the share. [Schedule 2, item 4, subsection 104-195(6)]

Cost base of assets

2.52 The first element of the cost base or reduced cost base of the CGT asset for the company or of the share for the shareholder after the application of CGT event J4, will be the market value of the asset or the share respectively at the time it was acquired under the trust restructure. [Schedule 2, item 4, subsections 104-195(5) and (7)]

2.53 If CGT event J4 happens in respect of an asset of the company that was taken to have been acquired before 20 September 1985, that asset will no longer have that acquisition date. Instead, Division 109 will apply to determine the acquisition time for the asset. The same applies for shareholders who have CGT event J4 happen in respect of a share they own in the company that was received in exchange for their pre-CGT interest in the trust. [Schedule 2, items 11 and 12, subsections 124-10(5) and 124-15(7)]

Exception

2.54 If the trust restructuring period ends before Royal Assent is received for this bill, and a trust fails to cease to exist after that date, CGT event J4 will not apply [Schedule 2, item 4, subsection 104-195(8)] . For this exception to apply, everything that was required under Subdivision 124-N must have occurred apart from having made a choice to disregard the capital gain or capital loss. This includes the first asset being disposed of to the company under a trust restructure on or after 11 November 1999, all the assets of the trust having been disposed of to the company and shares in the company being received by the beneficiaries in exchange for all their interests in the trust before Royal Assent is received.

Application and transitional provisions

2.55 The transitional provision allows those trusts that have commenced to restructure into a company on or after 11 November 1999, but before Royal Assent was received for this bill, to amend their income tax assessments for the 1999-2000, 2000-2001 and 2001-2002 income years [Schedule 2, item 16] . For trusts to obtain a Subdivision 124-N roll-over they will need to make a choice within 12 months after the day on which that bill receives Royal Assent before they can amend their respective tax assessments.

2.56 The new Subdivision 124-N roll-over and the new CGT event J4, along with the transitional and consequential amendments, will apply to CGT events happening on or after 11 November 1999. [Schedule 2, item 17]

Consequential amendments

2.57 A signpost is added to section 102-20 to highlight that a capital loss cannot be made on a CGT event happening to a beneficiarys interest in the trust during a trust restructuring period [Schedule 2, item 2] . This is relevant for calculating a capital loss under section 102-20.

2.58 A new item is added to the Guide in section 104-5 to summarise CGT event J4. The summary includes the time of the event and how to calculate a capital gain or loss that is made from that event. [Schedule 2, item 3, section 104-5, item J4 in the table]

2.59 A new CGT event is inserted into Division 104. CGT event J4 is discussed in paragraphs 2.45 to 2.54. [Schedule 2, item 4, Subdivision 104-J]

2.60 Item 8 of section 109-55 will be amended to reflect the acquisition rule for pre-CGT assets in Subdivision 124-N. [Schedule 2, item 5]

2.61 A new item is added to the Guide in section 112-45 to specify the cost base modifications that apply under CGT event J4. [Schedule 2, item 6, section 112-45, item J4 in the table]

2.62 A reference to Division 124 is inserted into the table in section 112-115 listing all the replacement-asset roll-overs. [Schedule 2, item 7, section 112-115, item 14B in the table]

2.63 A reference to Subdivision 124-N is inserted into section 112-140 recognising that the trust to company roll-over is a same-asset roll-over. [Schedule 2, item 8, section 112-140]

2.64 A reference to Subdivision 124-N is inserted into the table in section 112-150 listing all the same-asset roll-overs. [Schedule 2, item 9, section 112-150, item 4A in the table]

2.65 Subsection 124-5(1) (How to find your way around this Division) is amended to include a reference to Subdivision 124-N. [Schedule 2, item 10]

2.66 Subsections 124-10(5) and (7) are inserted to undo the operation of subsection 124-10(4) as a result of a CGT event J4 happening. In the circumstances the normal acquisition rules in Division 109 will apply. [Schedule 2, items 11 and 12, subsections 124-10(5) and (7)]

2.67An exception will be made to subsection 134-1(4) which disregards a capital gain or a capital loss that a grantee of a right makes on exercising that right. This exception will only apply to a right a company acquired as a result of a trust restructure if on exercise of the right the company acquires an item of trading stock. [Schedule 2, item 13]

2.68 A new item is added to the table in section 136-10 to identify when a non-resident makes a capital gain or a capital loss from a CGT event happening during a trust restructuring period. [Schedule 2, item 14, section 136-10, item J4 in the table]

2.69 The definition of a trust restructuring period is to be inserted into the dictionary in subsection 995-1(1). [Schedule 2, item 15, definition of trust restructuring period in the ITAA 1997]

REGULATION IMPACT STATEMENT

Policy objective

2.70 As a business develops, it may seek to restructure to increase its efficiency and take full advantage of its future potential. The policy objective of this measure is to provide a CGT roll-over to increase the commercial flexibility available in selecting an appropriate business structure for the needs of business.

Implementation options

2.71 This measure was originally announced in Treasurers Press Release No. 74 of 11 November 1999 as part of the entities tax regime, as recommended in the Review of Business Taxation. The original announcement provided for transitional relief for those entities restructuring from a fixed trust to a company. Exposure draft legislation, including the CGT roll-over provisions, was released on 11 October 2000. The Treasurer announced on 22 March 2001 (Press Release No. 16) that the transitional roll-over was no longer necessary following the announcement on 27 February 2001 (Treasurers Press Release No. 8) that the proposed entities tax regime would not proceed.

2.72 Treasurers Press Release No. 77 of 5 October 2001 announced that for asset transfers from 11 November 1999, roll-over would, in general, be available where:

•

a trust (other than a discretionary trust) disposes of all its assets to a company and the trust ceases to exist; and

•

the beneficiaries of the trust have all their interests exchanged for shares in the company and own those shares in the same proportions as they owned interests in the trust.

2.73 The provisions contained in this bill develop the exposure draft legislation. Under the new CGT roll-over the CGT liability that would have otherwise arisen on disposal of an asset from a trust to a company is deferred until a later CGT event happens to the asset. The same cost base is transferred from the trust to the company. Therefore, when the asset is later sold by the company, any increase in value of the asset while it was still in the trust will be captured at the time of the later sale by the company.

2.74 The roll-over will be optional and available for both the trust and for the beneficiaries of the trust.

2.75 The beneficiaries can choose to apply the roll-over regardless of whether the trust and company choose the roll-over on the disposal of the asset to the company. This is equally true for the trust and company who can choose the roll-over independently of whether the beneficiaries choose the roll-over on having their trust interest replaced with a share.

Assessment of impacts

Impact group identification

Trustees of trusts and companies involved in restructure

2.76 The proposed amendments will affect the trustee of a trust. Both the trustee and the company will need to choose the roll-over in respect of assets that are transferred from the trust to the company. The trustee will also be responsible for notifying the members of the trusts about the restructure and of their new interests in the company.

2.77 It is estimated that there are at least 80,000 trusts in Australia that may choose the benefit of the proposed roll-over.

Members of eligible trusts

2.78 The members of eligible trusts will need to be aware of the tax implications of the restructure because they must choose the roll-over in respect of their interests in the trust before they can defer a capital gain or capital loss.

Pure discretionary trusts and their members

2.79 The roll-over is only available to trusts whose members interests have a fixed capital component. Therefore, pure discretionary trusts (i.e. where the beneficiaries have no right to the capital or income of the trust until the trustee exercises its discretion) are excluded. If a discretionary trust decides to undertake a trust restructure, it may incur some CGT liability.

Analysis of costs and benefits associated with each implementation option

Compliance costs

2.80 Taxpayers must choose to take advantage of the roll-over. Where the taxpayer chooses to use the roll-over, this choice is indicated from the amount of capital gains included in their income tax assessment in the particular income year in which the trust restructure takes place. The taxpayer does not have to send any further paperwork to the ATO. This is consistent with the existing choice rules for CGT.

2.81 There will be no increase in record keeping costs for the taxpayers involved as the current substantiation rules continue to apply.

2.82 Taxpayers may require further consultation with their tax agent or legal adviser in the year of the trust restructure. The taxpayer may incur additional costs in obtaining information relating to the roll-over requirements and the Corporations Act 2001 requirements for incorporation of a company.

2.83 As the affairs of each trust vary the exact cost of compliance cannot be quantified. Examples of the types of costs that may be incurred by either the trustee of the trust or the company include:

•

setting up the company structure;

•

changing accounting and record keeping systems to allow for the change from making distributions out of the trust to paying dividends out of the company;

•

providing members with information required for the members to comply with their taxation obligations; and

•

complying with any Corporations Act 2001 requirements.

Administrative costs

2.84 The proposed amendments do not require any systems changes for the ATO.

2.85 The ATO information booklets will need to be modified to include a reference to the proposed roll-over. Also, it is ATO practice to produce information sheets and, where required, update the website to reflect the amendments ahead of printing the new booklets. The ATO is constantly updating information on its website and its booklets, return forms, schedules and guides are updated annually. The administration effects of these amendments will be folded into that process. Therefore, there should be minimal costs to administration in this respect.

2.86 ATO staff will need to be trained on the proposed roll-over in order to deal with any requests for advice. This training will be part of ongoing internal training, therefore administration costs in this respect will be minimal.

Revenue costs

2.87 Those trusts that had restructured using the exposure draft legislation as guidance were required to include any capital gains or capital losses from the restructure in their returns. Depending on the circumstances of the trust, the various CGT concessions may have dramatically reduced the capital gain that would have otherwise been payable. Accordingly, there will be an insignificant impact on revenue as a result of backdating the proposed roll-over to 11 November 1999.

2.88 The proposed roll-over provides a simpler and more flexible way of transferring the assets of a fixed trust into a company than under the current law. To the extent that more trusts may roll-over in response to this more flexible mechanism, the additional cost is likely to be small but unquantifiable.

Economic benefits

2.89 Eligible taxpayers will benefit from a deferral of a CGT liability.

2.90 Taxation will not be an impediment to the restructure of a business from a fixed trust to a company. This is because the potential for a CGT liability on that restructure occurring will now be deferred.

Other issues - consultation

2.91 In the development of this measure, tax practitioners were consulted. In particular, advisers of clients who have restructured or are considering restructuring have been consulted.

Conclusion

2.92 The proposed roll-over will provide greater commercial flexibility for certain trusts disposing of assets to a company. This measure was backdated to 11 November 1999 so as not to disadvantage those entities that undertook restructuring from that date.

Chapter 3 - Foreign income exemption for temporary residents

Outline of chapter

3.1 This chapter details amendments to the ITAA 1936 and the ITAA1997 that will provide certain exemptions from Australian tax for individuals who are considered to be temporary residents of Australia for tax purposes. The chapter explains who the exemptions will apply to and what income or gains will be exempt.

3.2 In addition, it explains changes to the current exemption for exempt visitors from the FIF rules.

Context of amendments

3.3 A Tax System Redesigned noted that the current taxation treatment of foreign expatriates who become temporarily resident in Australia could discourage some multinational enterprises, particularly skill intensive businesses, from locating in Australia.

3.4 The rules were seen as inhibiting attempts to attract key personnel from offshore, especially where taxation of the income from pre-residence investments at the top marginal tax rate could increase the overall tax burden. This additional tax expense is often borne by the Australian business, thereby increasing the cost of doing business in Australia.

3.5 As part of its Stage 2 response to the New Business Tax System, the Government announced changes designed to reduce the tax burden on temporary residents. This would also have the effect of assisting those Australian businesses seeking to attract key personnel to Australia.

3.6 Recommendation 22.18in A Tax System Redesigned that the exemption applies to the foreign source income derived from pre-residence assets and to the interest withholding tax obligations from associated pre-residence liabilities was extended by the Government. The details of this measure were contained in Treasurers Press Release No. 82 of 15 October 2001. The measure will now:

•

exempt all foreign source income of temporary residents from assets regardless of when they were acquired;

•

ensure that no capital gain or loss would arise on the disposal by temporary residents of assets not having the necessary connection with Australia, other than portfolio interests in Australian publicly listed companies and resident unit trusts; and

•

remove interest withholding tax obligations in respect of liabilities of temporary residents regardless of when incurred.

The extension to the Ralph recommendations avoids locking temporary residents into pre-residence investments or financial arrangements for the period of the 4 year exemption.

3.7 In addition, the existing exemption from the FIF rules for exempt visitors is no longer to be restricted to 4 years for taxpayers holding temporary entry visas. Rather, the exemption will apply whilst a taxpayer is the holder of a temporary visa.

Summary of new law

3.8 The measure contained in this bill is directed at people who would normally be considered to be resident of Australia for tax purposes, but who qualify under the temporary resident exemption.

3.9 Temporary residents will generally be first-time tax residents of Australia who are in Australia on temporary entry visas. However, also included are people in Australia on temporary entry visas who have not been a tax resident of Australia for at least the previous 10 years.

3.10 Presently, a person who is a resident of Australia is taxable on income and gains from all sources whether they are Australian or not. This measure provides a tax exemption for all foreign income and capital gains and for interest withholding tax obligations associated with overseas liabilities. The exemption applies to the individuals who are considered to be temporary residents, for a maximum period of 4 years. The exemption will not, however, apply to remuneration received for or associated with employment, or for services performed while a resident of Australia.

3.11 In addition, this bill removes the 4 year limitation on the FIF exemption for all people considered to be exempt visitors for the purposes of the FIF legislation.

Detailed explanation of new law

To whom will the 4 year exemption apply?

3.12 The 4 year exemption from Australian tax on foreign source income and capital gains and from interest withholding tax obligations applies to individuals who are considered temporary residents for the purposes of Australian taxation law.

Who is a temporary resident for the purposes of the 4 year exemption?

3.13 An Australian resident individual is considered to be a temporary resident for taxation purposes if the following conditions are satisfied:

•

the person has not been an Australian resident at any time during the 10 years before last becoming an Australian resident;

•

the person has not been an Australian resident for more than 4 years since last becoming an Australian resident;

•

the person is the holder of a temporary entry visa granted under the Migration Act 1958;and

•

the person has not applied for a permanent visa under the Migration Act 1958 (unless the application, and any review or appeal proceeding in relation to the application, has been finally determined, withdrawn or otherwise disposed of).

[Schedule 3, item 13, definition of temporary resident in subsection 995-1(1)]

The qualification to the application for a permanent visa means that a person may still be considered to be a temporary resident in instances where a permanent visa had been applied for, but subsequently was rejected or withdrawn.

3.14 As New Zealand citizens enter Australia under special visa arrangements, provisions are required to ensure that they have access to the exemption in the appropriate circumstances. An Australian resident who is a New Zealand citizen will be considered to be a temporary resident if, in addition to the timing rules above, the person:

•

would have been required to be the holder of a temporary entry visa if not for the fact that the person is a citizen of New Zealand;

•

is not a protected SCV holder (as defined in section 7 of the Social Security Act 1991); and

•

has not come to live in Australia permanently.

[Schedule 3, item 13, definition of temporary resident in subsection 995-1(1)]

New Zealand citizens who are protected SCV holders (generally those people who arrived in Australia on or before 26 February 2001) (see paragraphs 3.37 and 3.38) are excluded from this measure. Protected SCV holders have rights of entry and access to benefits similar to those that are available to Australian citizens and are therefore not considered to be temporary residents for the purposes of this measure.

3.15 In determining whether a taxpayer is a temporary resident, periods of residence that ended more than 10 years before the commencement of the current period of residency are to be ignored for the purposes of determining whether or not an individual is a temporary resident.

3.16 Whether a person was previously a tax resident of Australia is based on how that person was assessed during their prior period in Australia. The basis of this determination is the domestic definition of who is a resident of Australia for taxation purposes rather than the tie-breaker tests contained in relevant double taxation treaties.

3.17 This 10 year reset rule will allow individuals who were resident in Australia some time ago, for example, people previously here as students or as children of people who came to work in Australia, to qualify for the temporary resident exemption when they return to Australia at a later date.

3.18 The 4 year limitation means that once the 4 year period has lapsed, the individual as a resident taxpayer will be liable to Australian tax on income from all sources. The rule also means that people who re-apply for an additional temporary entry visa to extend their stay in Australia are unable to gain the benefit of the tax exemption beyond the 4 year period.

3.19 When determining compliance with the 4 year period of the exemption and the 10 year reset rule, all times when the person was an Australian resident are taken into account even if they occurred prior to 1 July 2002. [Schedule 3, item 13, definition of temporary resident in subsection 995-1(1)]

Example 3.1

Peter successfully applied for a temporary entry visa and arrived in Australia on 1 September 2001 from the USA to assist XYZ Co in its IT area. Subject to visa requirements, he intends being in Australia for a maximum period of 5 years and has no intention of taking up permanent Australian residency.

Peter previously lived in Australia for 5 years up until August 1990 before moving permanently to the USA.

In this instance, Peter would qualify as a temporary resident as his previous period of Australian residency for tax purposes occurred more than 10 years ago.

Peter would in this instance have access to the exemption for the period 1 July 2002 until 31 August 2005. The period 1 September 2005 to 30 August 2006, being the final year of his intended stay in Australia, would not be covered by the exemption.

To what does the 4 year exemption apply?

Foreign source income

3.20 The first exemption will apply to foreign income derived during the period that a taxpayer is considered to be a temporary resident [Schedule 3, item 9, subsection 51-52(1)] . As mentioned in paragraph 3.10, the maximum period for this exemption is 4 years. It follows that expenses incurred in earning this income are not deductible. The exemption applies to all foreign income that is ordinary or statutory income including amounts otherwise attributable from a CFC or a FIF.

3.21 This exemption, however, does not apply to any income or remuneration that in any way relates to employment or to services performed by the taxpayer while the taxpayer is considered to be a temporary resident of Australia. Such income will continue to be liable to tax in Australia. [Schedule 3, item 9, subsection 51-52(2)]

3.22 Given that foreign source income of an eligible temporary resident is exempt from Australian taxation it is also necessary to exclude these taxpayers from attribution percentage calculations that may be required under the CFC rules and in determining income from a non-resident trust [Schedule 3, items 1 and 3, subsections 96C(6A) and 361(3)] . The effect of this is to relieve temporary residents of the compliance burden associated with these calculations. This change will not affect the determination as to whether or not a CFC exists for other taxpayers, that is, the temporary residents interest may still be counted. This is consistent with the treatment already provided for in the FIF rules for exempt visitors, which would include all temporary residents, who are not required to determine any attribution percentage.

3.23 Where a temporary resident would otherwise include in assessable income an amount, being a gain on employee share options,that is a reward relating to both foreign employment performed before becoming an Australian resident and for employment performed whilst an Australian resident, then the amount is to be apportioned between the relevant countries on the basis of the days of employment exercised in each country. Only the amount that is apportioned to the exercise of employment whilst a temporary resident is to be included as part of assessable income. [Schedule 3, item 9, subsections 51-52(3) to (8)]

Example 3.2

The relevant amount of income is $100,000. Kim, now a temporary resident, exercised 100 days of employment before becoming an Australian resident and 400 days of employment as an Australian temporary resident to earn that amount. Kim would include 4/5 ($80,000) of this amountas being income that is assessable in Australia.

3.24 If the reward that relates to both pre-residence employment and to employment while an Australian resident is taxed as a capital gain in Australia, and the asset does not have the necessary connection with Australia, then the normal CGT rules would apply. This would effectively apportion the relevant gain on the asset between the foreign jurisdiction and Australia.

Gains from overseas assets

3.25 Temporary residents will also be exempt from Australian tax for a maximum period of 4 years on any gain that arises from the disposal of overseas assets. Any loss from such a disposal will be ignored. With 2 exceptions, overseas assets for the purposes of this exemption are assets that are not considered to have the necessary connection with Australia [Schedule 3, item 11, subsection 118-575(1)] . Section 136-25 of the ITAA 1997lists those assets that do have the necessary connection to Australia. The 2 exceptions are portfolio interests (holdings of less than 10%) held in Australian public companies or resident unit trusts as these assets are considered to be Australian assets for the purposes of this measure. [Schedule 3, item 11, subparagraph 118-575(1)(b)(i)]

3.26 The exemption also covers gains/losses that result from creating contractual or other rights under CGT event D1 or from the creation of future property under CGT event D9 where the gain/loss is considered to have been derived from other than an Australian source. [Schedule 3, item 11, subparagraphs 118-575(1)(b)(ii) and (iii)]

3.27 Consistent with the exemption for foreign source income, the exemption does not apply to any gain/loss that is made which results from employment undertaken, or to services performed, while a temporary resident. [Schedule 3, item 11, subsection 118-575(2)]

3.28 To ensure consistency with the treatment of gains/losses resulting from the actual disposal of assets, temporary residents are also to be excluded from the operation of the deemed disposal rule, being section 104-160 of the ITAA 1997 [Schedule 3, item 10, subsection 104-165(1A)] . That section seeks to determine a notional gain/loss on assets not having the necessary connection with Australia at the time a person ceases to be an Australian resident. This exclusion means that, in general, assets without the necessary connection to Australia acquired by a temporary resident during the 4 year period of their stay will not be subject to tax in Australia when the temporary resident ceases to be an Australian resident at or before the end of 4 years.

3.29 Subsection 104-165(1) already provides an exemption from the deemed disposal rule for short-term residents when they cease to be an Australian resident where they were resident for less than 5 years during the previous 10 years. The exemption applies to relevant assets acquired before last becoming a resident or which were acquired because of someones death after last becoming a resident.

3.30 Section 104-165 will still be relevant for temporary residents even though the temporary resident exemption removes the restriction on overseas assets acquired after becoming an Australian resident. For example, a person may remain a resident for longer than 4 years permitted under the temporary resident exemption. Also, the exclusion provided by subsection 104-165(1) applies to all assets not considered to have the necessary connection with Australia that were held prior to last becoming a resident of Australia.

3.31 As with realised gains and losses, this exemption does not cover portfolio interests held in Australian public companies or resident unit trusts [Schedule 3, item 10, subsection 104-165(1B)] . Nor does it apply to unrealised gains/losses that result from employment undertaken or from services performed while a temporary resident [Schedule 3, item 10, subsection 104-165(1C)] .

Interest withholding tax obligations

3.32 For the duration of the 4 year exemption period a temporary resident will be exempt from all interest withholding tax obligations. [Schedule 3, item 2, paragraph 128B(3)(i)]

3.33 While withholding tax would otherwise be a liability of the overseas lender, it is generally the case that such institutional lenders require the Australian resident to compensate them for the additional expense incurred in lending money to an Australian resident. Therefore, this measure not only reduces compliance costs for the temporary resident, it also indirectly reduces their Australian taxation costs.

What are the changes to the exempt visitor exemption in the FIF rules?

3.34 The exemption for exempt visitors from the FIF rules will no longer be limited to 4 years. Rather the exemption will now apply for the period that a taxpayer is the holder of a temporary entry visa granted under the Migration Act 1958, provided the person has not applied for a permanent visa under that Act [Schedule 3, item 4, paragraph 517(2)(b)] . Those who qualify as temporary residents for the above income and gains exemptions will qualify as exempt visitors.

3.35 The removal of the time limit for exempt visitors will eliminate anomalies for people who are not permanent residents of Australia where the accruing benefits are often not accessible until retirement age. Presently, where the temporary visa holders period of residence exceeds 4 years, they will be taxable in Australia on a yearly basis on the increase in their accumulated retirement benefits in non-employer sponsored superannuation funds in their home country. This means that they will be taxed in Australia on an increase in benefits that may not be available to them until they reach their eligible retirement age. Also, double taxation may arise because a credit may not be given in the home jurisdiction, when tax is paid on realisation at a later date, for Australian tax paid on the previously accrued increase.

3.36 The FIF exemption will continue to be available to people who are not New Zealand citizens for as long as they are considered to be exempt visitors to Australia for the purposes of the FIF rules. However, the provisions for when a citizen of New Zealand is considered to be an exempt visitor are being amended as a result of the Governments announcement on 26 February 2001 that requirements for New Zealand citizens seeking access to Australias social security system have changed.

3.37 Resulting from that announcement, people who are not considered to be protected SCV holders, essentially New Zealand citizens that come to Australia after 26 February 2001, are now required to show that they intend to become permanent residents of Australia before they can access the social security system. For protected SCV holders, essentially those New Zealand citizens here prior to 26 February 2001, there is no such requirement.

3.38 Section 7 of the Social Security Act 1991 defines who is considered to be a protected SCV holder, with the 26 February 2001 being the relevant date in that determination. New Zealanders in Australia on the 26 February 2001 as SCV holders are considered to be protected SCV holders. The section also contains other circumstances based on that date when a person will be considered to be a protected SCV holder. For example, a person outside Australia on that date, but who had spent an aggregate of at least 12 months in Australia in the 2 years immediately prior to that date would be a protected SCV holder if the person returned to Australia.

3.39 As mentioned in paragraph 3.14, protected SCV holders will continue to have similar entry rights and access to benefits as would be available to a permanent resident of Australia. Given this, protected SCV holders are not considered to be exempt visitors for the purposes of this measure. However, a transitional rule is provided so that no New Zealand citizen is disadvantaged by the change in eligibility requirements. Therefore, the existing requirements for a citizen of New Zealand to be an exempt visitor for the purposes of the FIF rules, including the 4 year limitation, will apply to those people who are protected SCV holders (i.e. generally those people who arrived in Australia before 26 February 2001) [Schedule 3, item 5, subparagraphs 517(4)(a)(iii) and (iv)] . In effect, protected SCV holders who were eligible for the FIF exemption as at 30 June 2002 can continue to access the remaining period of their current 4 year exemption. Once that period has lapsed, or the person ceases to be a resident, a protected SCV holder will no longer be considered to be an exempt visitor [Schedule 3, item 6, subsection 517(5)] .

Example 3.3

Sue, a New Zealand citizen, arrived in Australia on 1 July 2000. Sue meets all the requirements of subsection 517(4), including being a protected SCV holder. In this instance, providing her circumstances do not change in relation to becoming a permanent resident of Australia, she will be considered to be an exempt visitor until 30 June 2004.

After that date, as a protected SCV holder, Sue will no longer be able to access the temporary visitor exemption from the FIF rules.

3.40 Where a citizen of New Zealand is not a protected SCV holder (i.e. generally a person who arrived here after 26 February 2001), that person will be considered to be an exempt visitor and be able to access the FIF exemption provided that the person has not applied for a permanent visa or has not come to live permanently in Australia [Schedule 3, item 6, subsection 517(6)] . Whether a person is considered to have come to live permanently in Australia will depend on the facts and circumstances of each case, in a similar manner to that which applied when the exempt visitor exemption was limited to 4 years.

3.41 Like citizens of other countries, these New Zealanders will be exempt from the FIF rules for as long as they qualify as exempt visitors, without any 4 year limitation.

Application and transitional provisions

3.42 Subject to the following 2 paragraphs, the measure dealing with the taxation of temporary residents applies for the 2002-2003 income year and all later income years. [Schedule 3, subitem 14(1)]

3.43 The amendment to exclude temporary residents from withholding tax obligations applies to payments of interest made on or after 1 July 2002. [Schedule 3, subitem 14(2)]

3.44 The amendments exempting temporary residents from the operation of the CGT provisions apply if the CGT event happens on or after 1 July 2002. [Schedule 3, subitem 14(3)]

Consequential amendments

3.45 As a result of the introduction of the measure to exempt certain foreign income of taxpayers considered to be either temporary residents or exempt visitors, there will be consequential amendments to the ITAA 1997.

Updating of checklist tables

3.46 Section 11-15 of the ITAA 1997 includes a checklist that refers to provisions covering ordinary or statutory income which is exempt if it is derived by certain entities. This bill necessitates a consequential amendment to include a reference to the exemptions for temporary residents in section 51-52. References are to be included under 2 item headings, these being foreign aspects of income taxation and superannuation or related business. [Schedule 3, items 7 and 8, section 11-15]

Definition of foreign income

3.47 A consequential amendment is required to include the definition of foreign income contained in subsection 6AB(1) of the ITAA 1936 in the Dictionary. [Schedule 3, item 12, definition of foreign income in subsection 995-1(1)]

REGULATION IMPACT STATEMENT

Policy objective

The objectives of the New Business Tax System

3.48 The measure in this bill is part of the Governments broad ranging reforms which will give Australia a New Business Tax System. The reforms are based on the recommendations of the Review of Business Taxation, instituted by the Government to consider reform of Australias business tax system.

3.49 The Government instituted the Review of Business Taxation to consult on its plan to comprehensively reform the business income tax system, as outlined in the Governments tax reform document: Tax Reform: not a new tax, a new tax system. The Review of Business Taxations recommendations to the Government were designed to achieve a simpler, stable and durable business tax system.

3.50 The New Business Tax System is designed to provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings, as well as providing a sustainable revenue base so the Government can continue to deliver services to the community.

3.51 The New Business Tax System also seeks to provide a basis for more robust investment decisions. This is achieved by:

•

using consistent and clearly articulated principles;

•

improving simplicity and transparency;

•

reducing the cost of compliance through principled tax laws that are easier to understand and comply with; and

•

providing fairer, more equitable outcomes.

3.52 The measure dealing with the taxation of temporary residents of Australia contained in this bill is part of the legislative program implementing the New Business Tax System. Other bills have been introduced and passed already and are summarised in Table 3.1.

Table 3.1: Earlier new business tax legislation

The objectives of the measure in this bill

3.53 The exemption for temporary residents measure is designed to achieve 2 related objectives. The measure seeks to attract internationally skilled mobile labour to Australia. It also seeks to assist in the promotion of Australia as a business location, by reducing the costs to Australian business of bringing skilled expatriates to work in Australia.

3.54 The measure is directed at people who are temporary residents of Australia. While the extension of the exemption from the FIF rules applies to all exempt visitors to Australia, the remaining concessions only apply to those people who are considered to be temporary residents of Australia.

3.55 The temporary resident measure provides a mechanism that reduces the cost of labour for industries and firms that engage people who are considered to be temporary residents. However, the concession is not limited to the actual cost burden imposed on employers of foreign expatriate staff. That is, all people who meet the requirements of being a temporary resident may access the concessions, irrespective of whether or not they are employees.

Implementation options

3.56 The temporary resident measure arises directly from recommendations of the Review of Business Taxation. Those recommendations were the subject of extensive consultation. The implementation options that form the basis of these measures can be found at Recommendation 22.18 of A Tax System Redesigned.

3.57 Subsequent to this, the Government announced that the measure was to be expanded and clarified. As a result, the exemption for temporary residents will now apply to:

•

all foreign source income of eligible temporary residents from assets regardless of when they were acquired;

•

ensure that no capital gain or loss would arise on the disposal by eligible temporary residents of assets not having the necessary connection with Australia, other than portfolio interests in Australian publicly listed companies. (This bill also treats portfolio interests in resident unit trusts in the same manner as portfolio interests in Australian publicly listed companies.); and

•

interest withholding tax obligations in respect of liabilities regardless of when incurred.

3.58 In addition, the existing exemption for exempt visitors from the FIF rules is no longer to be restricted to 4 years for taxpayers holding temporary entry visas. Rather, the exemption will apply whilst a temporary visa is held.

Assessment of impact

3.59 The potential compliance, administrative and economic impacts of this measure were considered by the Government, the Review of Business Taxation and the business sector. The Review of Business Taxation focused on the economy as a whole in assessing the impacts of its recommendations and concluded that there would be net gains to business, government and the community generally from business tax reform. Submissions received during consultation did not indicate significant concerns about compliance issues.

3.60 Specific compliance issues raised in relation to the taxation of temporary residents subsequent to the release of A Tax System Redesigned have been considered in implementing this measure.

Impact group identification

Temporary residents

3.61 The measure will impact on people holding a temporary visa granted under the Migration Act 1958 who are in receipt of income from foreign sources or who hold foreign assets. It will also affect New Zealand citizens temporarily resident in Australia, who are subject to special visa arrangements.

3.62 A reference to temporary visa holders includes people who enter Australia under the economic, international and social/cultural visa streams. Also included will be people in Australia on student visas as well as New Zealanders who do not intend to stay permanently in Australia. However, many of these temporary visa holders will either not be affected by this measure as they are either non-residents for taxation purposes (and so Australia does not tax their foreign income) or because they are not considered to be temporary residents.

3.63 As previously mentioned in paragraph 3.54, the FIF exemption will apply to all holders of a temporary visa, with the remaining concessions only being available to people considered to be temporary residents of Australia.

Business

3.64 Businesses that employ or are run by people who qualify for this exemption may receive an indirect benefit as a result of this measure. This will occur in instances where businesses make normalisation payments to compensate their employees for the potential increase in their overall taxation costs that can occur as a result of their coming to Australia for a short-term period.

3.65 Business will also benefit as key personnel from overseas may now be more willing to come to Australia as a result of the change in their Australian tax obligations.

3.66 The measure will also impact on intermediaries, such as accounting firms, that act on behalf of taxpayers or businesses affected by this measure.

ATO

3.67 The ATO will be required to administer the new arrangements.

Analysis of costs/benefits

Compliance costs

Temporary residents

3.68 Temporary residents affected by this measure will have their compliance costs significantly reduced. Such taxpayers will only be required to declare for Australian tax purposes income derived from Australian sources or gains that result from assets that have a connection with Australia. Information in relation to foreign income and gains would no longer be required for Australian tax purposes, provided that income or gain was not related to Australian employment.

3.69 Similarly, providing an exemption from interest withholding tax obligations will also, where applicable, result in reduced compliance costs for these taxpayers in relation to their Australian tax obligations.

3.70 The removal of the 4 year limit from the FIF exemption for exempt visitors will also reduce compliance costs as affected taxpayers will always be eligible for the exemption irrespective of the length of their temporary stay in Australia.

Business

3.71 For businesses and intermediaries affected by this measure there may be initially a small cost associated with the training of staff and the modification of internal systems that deal with executive remuneration planning. However, given that this is a sought after measure this is not seen as significant. Also, once any necessary training or changes have been implemented this measure will also lead to reduced compliance costs for these businesses and intermediaries.

Administration costs

3.72 There will be administrative impacts on the ATO with the introduction of this measure. These centre on the need to interpret the new law as well as ensuring instructional material and return forms and associated instructions reflect the new law. The ATO will also need to deal with computer system changes and compliance issues to ensure that the measure is working as intended.

3.73 The cost of these administrative changes, however, is not considered to be significant and will be absorbed as part of business as usual.

Government revenue

3.74 The revenue cost of the measures dealing with the taxation of temporary residents is estimated to be between $40 to $50 million per annum.

Economic benefits

3.75 The New Business Tax System will provide Australia with an internationally competitive business tax system that will create the environment for achieving higher economic growth, more jobs and improved savings. The economic benefits of these measures are explained in more detail in the publications of the Review of Business Taxation, particularly A Platform for Consultation and A Tax System Redesigned.

3.76 The measure dealing with the taxation of temporary Australian residents will contribute to these broader economic goals by removing impediments that will assist in attracting internationally mobile labour to Australia. It will also have the effect of reducing business costs where foreigners are employed temporarily in Australia. Australia should then benefit from the dynamic effects of having business located here, as well as from the expenditure, profits and local employment that such businesses may generate. In addition, the bringing to Australia of foreign executives and skilled expatriates will facilitate the transfer of new management techniques and information and skills to the Australian economy.

3.77 While this measure will provide a benefit there is no reliable data available as to the size of that benefit.

Other issues - consultation

3.78 The consultation process began with the release of the Governments tax reform document: Tax Reform: not a new tax, a new tax system in August 1998. The Government established the Review of Business Taxation in that month. Since then, the Review of Business Taxation published 4 documents about business tax reform, in particular A Platform for Consultation and A Tax System Redesigned, in which it canvassed options, discussed issues and sought public input.

3.79 Throughout that period, the Review of Business Taxation held numerous public seminars and focus group meetings with key stakeholders in the tax system. It received and analysed 376 submissions from the public about reform options. Further details are contained in paragraphs 11 to 16 of the Overview of A Tax System Redesigned. In analysing options, the published documents frequently referred to, and were guided by, views expressed during the consultation process.

3.80 The measure dealing with the taxation of temporary residents to Australia was accepted by the Government in their Stage 2 response to the New Business Tax System that was announced on 11 November 1999.

3.81 A consultation workshop was held in May 2000 in relation to the initial announcements made by the Government. In addition, the Department of the Treasury has also received further submissions dealing with the taxation of temporary residents in Australia. As a result of this further consultation process, the Government announced on 15 October 2001 an expansion of the measures beyond what was included in the Stage 2 response. There was also further consultation in April 2002 on the final package of measures.

3.82 Discussions have also taken place with the Department of Immigration and Multicultural and Indigenous Affairs in relation to the visa requirements for people seeking to enter Australia. The Department of Education, Training and Youth Affairs was also consulted in relation to people in Australia on student visas.

Conclusion

3.83 This proposal dealing with the taxation of temporary Australian residents is expected to address some of the issues concerning the employment of skilled temporary residents in Australia. The introduction of this measure will therefore help promote Australia as a business location.

Chapter 4 - Effective life of depreciating assets

Outline of chapter

4.1 This chapter explains the amendments to the ITAA 1997 to insert statutory caps (referred to as capped lives) for certain depreciating assets. These caps will be the effective lives for those assets where certain conditions are met.

4.2 This chapter also explains the amendments consequential upon this measure.

Context of amendments

4.3 The capital allowances system allows a taxpayer a deduction equal to the decline in value of a depreciating asset during an income year. That decline in value is worked out with reference to the effective life of the asset. Broadly, the effective life of an asset is the length of time over which an entity could reasonably be expected to use the particular asset for taxable purposes or for the purpose of producing exempt income. Currently, a taxpayer may choose to use a safeharbour effective life determined by the Commissioner for an asset where there is one in force. However, where a taxpayer chooses not to use a safeharbour effective life, or there is none in force, the taxpayer must self-assess the effective life of the asset.

4.4 Under the current capital allowances system, the Commissioner progressively reviews, and makes updated determinations under section 40-100 of the ITAA 1997 of the safeharbour effective lives used to calculate deductions for depreciating assets. The Commissioners Determinations must be based on an estimate of the period the asset can be used by any entity for a taxable purpose or for the purpose of producing exempt income. The Commissioner cannot take into account national economic implications and the impact on affected industries.

Summary of new law

4.5 Under the new law, the Commissioner will continue to review the effective lives of depreciating assets and make determinations based on the period that the asset could be used by any entity for a taxable purpose or for the purpose of producing exempt income. Taxpayers will continue either to use the safeharbour effective life that the Commissioner has determined for an asset or to self-assess the assets effective life. Where the taxpayer has chosen to use an effective life determined by the Commissioner, that effective life may be affected by a capped life. If a capped life applies to an asset and is shorter than the effective life determined by the Commissioner, the effective life of the asset will be the capped life.

4.6 Diagram 4.1 illustrates the method of working out if capped life applies to an asset.

Diagram 4.1: Working out if a capped life applies to an asset

Detailed explanation of new law

Capped life of certain depreciating assets

4.7 The effective life of a depreciating asset will be the capped life that applies to the asset if the conditions set out in paragraphs 4.9 to 4.13 are satisfied. As a consequence, the decline in value of the depreciating asset will be worked out over a shorter period of time. This will give the taxpayer a greater deduction in any one income year than would otherwise have been the case. [Schedule 4, item 5, subsection 40-102(1)]

When the capped life applies

4.8 Four conditions must be met if the effective life of a particular depreciating asset is to be the capped life. [Schedule 4, item 5, subsection 40-102(2)]

4.9 First, the taxpayer must choose, under existing paragraph 40-95(1)(a) of the ITAA 1997, to use an effective life determined by the Commissioner for the asset. [Schedule 4, item 5, paragraph 40-102(2)(a)]

4.10 The capped life will not apply where the taxpayer has chosen to self-assess the effective life of an asset. This ensures that a taxpayer is still able to self-assess the assets effective life if this provides them with an effective life more appropriate to their circumstances of use.

4.11 Secondly, the taxpayers choice to use an effective life determined by the Commissioner must have been limited to a determination that was in force at the time mentioned in paragraph 40-95(2)(a) or (c) of the ITAA 1997. Effectively, this means that a capped life cannot apply where a taxpayer entered into a contract to acquire an item of plant, otherwise acquired the plant or started to construct it before 21 September 1999. This is because accelerated depreciation rates apply to these items of plant and they are not affected by any upward revision of effective lives determined by the Commissioner. For such an item of plant, the choice to use a Commissioner determined effective life is limited to one in force at the time specified in paragraph 40-95(2)(b). [Schedule 4, item 5, paragraph 40-102(2)(b)]

4.12 Thirdly, there must be a capped life that applies to the depreciating asset which is in force at the relevant time. The meaning of capped life and relevant time is discussed in paragraphs 4.15 to 4.22. [Schedule 4, item 5, paragraph 40-102(2)(c)]

4.13 Fourthly, the capped life must be shorter than the Commissioners determined effective life chosen by the taxpayer that is referred to in the first condition and discussed in paragraph 4.9. If the capped life is not shorter than the effective life determined by the Commissioner, the taxpayer will use the effective life determined by the Commissioner. [Schedule 4, item 5, paragraph 40-102(2)(d)]

Third condition - capped life and relevant time

4.14 Under the third condition outlined in paragraph 4.12, there must be a capped life and it must be in force at the relevant time. Paragraphs 4.15 to 4.22 explain the meaning of these terms.

Working out the capped life

4.15 Certain depreciating assets will have a capped life regardless of the industry in which they are used. These assets are set out in the table in subsection 40-102(4). Where the asset corresponds exactly to the description in column 2 of that table, the capped life is the period specified in column 3. It should be noted that the capped life of an asset may vary depending on the use to which it is put. For example, an aeroplane predominantly used for agricultural spraying or dusting will have a capped life of 8 years, whereas an aeroplane used for general aviation will have a capped life of 10 years. [Schedule 4, item 5, subsection 40-102(4)]

4.16 Taxpayers using a capped life set out in the table in subsection 40-102(4) will have identified the effective life determined by the Commissioner using Table B of the relevant Commissioners Determination. That table sets out the effective lives of generic assets that may be used in more than one industry.

4.17 Other assets will have a capped life only if they are of a particular kind and used in a particular industry. These assets are set out in the table in subsection 40-102(5). Where the asset is of a kind described in column 2 and, is used in the industry specified in column 3, the capped life is the period specified in column 4 of the table. For example, an asset that is a gas transmission asset and used in the gas supply industry will have a capped life of 20 years. [Schedule 4, item 5, subsection 40-102(5)]

4.18 It should be noted that not all assets within an industry mentioned in the table in subsection 40-102(5) will have a capped life. Further, not all depreciating assets within a class of asset to which a capped life applies will necessarily have an effective life determined by the Commissioner that is greater than the capped life. The effective lives determined by the Commissioner for assets within a class, may vary both above and below the capped life. However, for those assets where the capped life is shorter than the effective life determined by the Commissioner, the capped life will be the effective life where the other conditions set out in subsection 40-102(2) are met. See discussion at paragraphs 4.9 to 4.13.

4.19 Taxpayers using a capped life set out in the table in subsection 40-102(5) will have identified the effective life determined by the Commissioner using Table A of the relevant Commissioners Determination. That table sets out the effective lives of assets specific to a particular industry or for which a special effective life applies because of the use to which those assets are put by the industry.

4.20 A new definition of capped life will be inserted into the Dictionary so that it has the meaning given by new section 40-102. [Schedule 4, item 13, definition of capped life in subsection 995-1(1)]

Working out the relevant time

4.21 Once a taxpayer has worked out that there is a capped life for an asset, it is necessary for them to establish that it is in force at the relevant time. The relevant time is generally the assets start time (i.e. when the asset is first used or installed ready for use for any purpose). However, the relevant time will be the time specified in existing paragraph 40-95(2)(a) if paragraph 40-95(2)(a) applied to the taxpayers circumstances and either:

•

the capped life in force at the time specified in paragraph 40-95(2)(a) is both different from and shorter than the capped life in force at the assets start time; or

•

there is no capped life in force at the assets start time but there is a capped life in force at the time specified in paragraph 40-95(2)(a).

[Schedule 4, item 5, subsection 40-102(3)]

4.22 Paragraph 40-95(2)(a) is often referred to as the 5 year rule. The paragraph applies when a taxpayer enters into a contract to acquire a depreciating asset, otherwise acquired it or started to construct it if the assets start time occurs within 5 years of that time. It ensures that a taxpayer is not disadvantaged if the effective life determined by the Commissioner is revised between the time they contract for the asset and the time they start to use the asset, provided that they start to use it within 5 years.

Application and transitional provisions

4.23 The amendments to give effect to the statutory caps will apply to a depreciating asset if the start time for that asset occurs on or after 1 July 2002. [Schedule 4, subitem 15(1)]

4.24 This means, for example, that section 40-102 may apply a capped life where:

•

paragraph 40-95(2)(a) applies to a taxpayers circumstances;

•

the time specified in paragraph 40-95(2)(a) is before 1 July 2002 but the start time of the asset is after 1 July 2002; and

•

the capped life at the assets start time is less than the effective life determined by the Commissioner that applies at the time specified in paragraph 40-95(2)(a) (i.e. the capped life is to the benefit of the taxpayer).

However, section 40-102 has no application where the assets start time occurs before 1 July 2002.

4.25 The consequential amendments to Division 58 of the ITAA 1997 discussed at paragraphs 4.40 to 4.46 will apply to a privatised asset held on or after 1 July 2002. [Schedule 4, subitem 15(2)]

Consequential amendments to the ITAA 1997

Division 40 and Dictionary definitions

4.26 Existing subsection 40-95(1) is the provision under which a taxpayer can choose an effective life either by self-assessing that life or by choosing the effective life determined by the Commissioner. A note will be inserted after that subsection to alert the reader to the fact that a capped life may apply where a taxpayer chooses to use an effective life determined by the Commissioner. [Schedule 4, item 1, note to subsection 40-95(1)]

Associate rules

4.27 Under the existing law certain integrity rules apply when a taxpayer acquires an asset from:

•

an associate; or

•

an entity (former holder) who continues to be the user of the asset after the taxpayer becomes the holder of it.

Amendments to these rules will ensure that a taxpayer cannot access a capped life that is not appropriate to the use of the asset when that taxpayer starts to hold it.

4.28 In particular, the amendments require a taxpayer, who acquires a depreciating asset from an associate or former holder to whom a capped life applied, to decide whether the use of the asset when they start to hold it satisfies the appropriate use requirements, (if any), for that capped life.

4.29 The possible outcomes that can arise in those circumstances are set out in Table 4.1. Table 4.1: Outcomes of associate rules

[Schedule 4, items 2 and 3, subsections 40-95(4B), (4C), (5B) and (5C)]

Example 4.1

A taxpayer acquires a helicopter from an associate on 1 July 2003 and uses it for general purposes (e.g. visiting cattle properties). The associate from whom they acquired it used the helicopter predominantly for mustering and held it for one year. The relevant time for the associate was the helicopters start time which was 1 July 2002.

The effective life used by the associate was the 8 year capped life that applies to helicopters used predominantly for mustering. The associate used the prime cost method to work out the decline in value of the helicopter for the 2002-2003 income year.

At the relevant time for the associate (i.e. the helicopters start time) there was another capped life in force of 10 years for helicopters used for general purposes.

Subsection 40-95(4B) will require the taxpayer to use an effective life of 9 years (i.e. 10 years less the one year that it was held by the associate).

Example 4.2

A taxpayer acquires a gas transmission asset from an associate on 1 July 2007 and does not use it within the gas supply industry. However, the associate from whom they acquired that asset had held it for 5 years and used it in the gas supply industry. The relevant time for the associate was the gas transmission assets start time which was 1 July 2002.

The effective life used by the associate was the 20 year capped life that applies to gas transmission assets used in the gas supply industry. The associate used the prime cost method to work out its decline in value.

The taxpayer does not satisfy the same capped life satisfied by the associate and, at the relevant time for the associate (i.e. the gas transmission assets start time):

•

there is no other capped life that applies to the asset; and

•

the effective life determined by the Commissioner that the associate would otherwise have used is 30 years.

Subsection 40-95(4C) will require the taxpayer to use an effective life of 25 years (i.e. 30 years less the 5 years that it was held by the associate).

Example 4.3

The facts are as per Example 4.2. However, there is a capped life that could apply to the use of the asset in the hands of the taxpayer when it was acquired from the associate but it was not in force at the relevant time for the associate.

Subsection 40-95(4C) will require the taxpayer to use an effective life of 25 years (i.e. 30 years less the 5 years that it was held by the associate).

4.30 If the asset has passed through the hands of more than one associate or former holder, the provisions apply having regard to the relevant time of the first associate or former holder.

4.31 There is a series of amendments that arise consequentially upon the amendments discussed in paragraphs 4.27 to 4.30.

4.32 First, 2 new subsections make it clear that subsections 40-95(4) and (5) do not apply if subsection 40-95(4B), (4C), (5B) or (5C) respectively apply. [Schedule 4, items 2 and 3, subsections 40-95(4A) and (5A)]

4.33 Secondly, subsection 40-95(6) will be amended. That subsection currently operates as an exception to subsection 40-95(5). It requires a taxpayer to use an effective life determined by the Commissioner if:

•

the taxpayer cannot readily find out which effective life the former holder was using; or

•

the former holder did not use an effective life.

4.34 Subsection 40-95(6), as amended, will also require the taxpayer to use an effective life determined by the Commissioner where a capped life applied to the former holder and the taxpayer cannot readily find out:

•

the effective life the former holder would have used if a capped life had not applied to the asset; or

•

the relevant time that applied to the former holder.

[Schedule 4, item 4, paragraph 40-95(6)(a)]

4.35 Thirdly, subsection 40-140(1) will be amended. That section requires an associate to pass on certain information to a taxpayer where the taxpayer has acquired an asset from the associate. The information that must be passed on relates to the method used to calculate the decline in value of the asset and the effective life used by the associate.

4.36 Subsection 40-140(1), as amended, provides that the taxpayer can require an associate to tell them the following information where a capped life applied to an asset held by the associate:

•

the effective life the associate would have used if the capped life had not applied to the asset; and

•

the relevant time that applied to the associate as worked out under new subsection 40-102(3). See explanation of relevant time at paragraphs 4.21 and 4.22.

[Schedule 4, item 9, paragraph 40-140(1)(c)]

Recalculation of effective life

4.37 Section 40-110 of the existing law sets out when a taxpayer may, or is required to, recalculate the effective life of an asset. Subsection 40-110(2) requires a recalculation of the effective life in certain circumstances where the taxpayer has chosen to use an effective life determined by the Commissioner for a particular asset or the effective life of an asset has been determined under the existing associate rules. That subsection will be amended to provide that the taxpayer is also required to recalculate an effective life in an income year where:

•

the taxpayer is using an effective life worked out under new subsection 40-95(4B), (4C), (5B) or (5C) or new section 40-102; and

•

the cost of the depreciating asset is increased by at least 10% in the relevant year.

[Schedule 4, items 6 to 8, subparagraphs 40-110(2)(a)(ii) and (iii) and paragraph 40 - 110(3)(a)]

Effective life definition

4.38 The current definition of effective life refers the reader to provisions under which the effective life of an asset is worked out - namely sections 40-95, 40-100, 40-105 and 40-110 of the ITAA 1997.

4.39 The definition will be amended to add a reference to section 40-102 to ensure that it also deals with the case where the effective life of an asset is the capped life. [Schedule 4, item 14, definition of effective life in subsection 995-1(1)]

Division 58

4.40 Division 58 sets out special rules that apply in calculating deductions for the decline in value of depreciating assets and balancing adjustments for assets which were held by an exempt entity and are subsequently held by a taxable entity. The consequential amendments to the Division will provide that a capped life cannot apply to reduce the first element of cost (i.e. the amount used to work out the decline in value) for a privatised asset of a transition entity (i.e. the entity in an entity sale situation that was exempt from income tax and subsequently becomes taxable) unless:

•

the capped life could have applied had the transition entity always been taxable; and

•

the transition entity chooses to apply the capped life for the purposes of working out both their notional depreciation deductions and their actual depreciation deductions.

4.41 In particular, a capped life will not apply to a privatised asset unless all of the following conditions are met:

•

it is an entity sale situation;

•

a capped life applies to the asset at both the assets start time and the transition time (i.e. the time when the transition entitys ordinary income or statutory income becomes to any extent assessable income); and

•

the transition entity chooses to apply the capped life for the purposes of working out the notional written down value.

[Schedule 4, item 10, paragraphs 58-75(5A)(a), (b) and (c)]

4.42 Where the transition entity chooses to apply the capped life, they must apply section 40-102 using certain assumptions and modifications. First, the transition entity disregards paragraphs 40-102(2)(a) and (b). (This means that it is not necessary for the transition entity to have chosen an effective life determined by the Commissioner or for that choice to have been limited to a Commissioner Determined effective life in force at a particular time.) Secondly, the transition entity must use the capped life in force at the transition time. The effective life of the asset will then be the capped life if it is shorter than the effective life determined by the Commissioner. [Schedule 4, item 10, subsection 58-75(5A)]

4.43 A capped life cannot apply for the purposes of Division 58 when:

•

it is an asset sale situation;

•

it is an entity sale situation and the assets start time was prior to the day on which the capped life took effect;

•

it is an entity sale situation and the assets start time is on or after the day on which the capped life took effect but the transition entity chooses not to apply the capped life; or

•

it is an entity sale situation but the effective life determined by the Commissioner is shorter than the capped life.

However, a capped life can apply to work out actual depreciation deductions in an asset sale situation where the requirements in section 40-102 are met by the purchaser of the asset.

4.44 Where the capped life applied in working out the notional written down value of the asset, they will also apply the capped life that is in force at the transition time in working out the decline in value of the asset for their actual deduction. [Schedule 4, item 12, paragraph 58-90(2)(a)]

4.45 However, where the capped life did not apply in working out the notional written down value of the asset or they choose to use the undeducted pre-existing audited book value of the asset, they cannot apply the capped life in working out the decline in value of the asset for their actual deduction. [Schedule 4, item 12, paragraph 58-90(2)(b)]

4.46 It should be noted that a capped life will not apply to an asset where the pre-existing audited book value method is used in working out notional depreciation deductions. This is because the effect of existing paragraph 58-85(1)(b) is that the assets start time will be before 1 July 2002. Consequently, a capped life cannot apply as the taxpayer is unable to satisfy the conditions set out in subsection 40-102(2). That is, they will not satisfy paragraphs 40-102(2)(a) or (b) because of the existing assumptions in subsection 58-80(6). A note will be added to subsection 58-80(6) to alert the reader to the fact that a capped life will not apply where section 58-80 applies. [Schedule 4, item 11, note to subsection 58-80(6)]

REGULATION IMPACT STATEMENT

Policy objective

4.47 The establishment of statutory effective life caps aims to address the broader national interest where large increases in safeharbour effective lives resulting from the review of the existing effective life determination would have a significant effect on investment in industries with national economic implications.

Background

4.48 The Commissioner is progressively revising the safeharbour effective life schedule so that it better reflects the income producing (or effective) lives of depreciable assets. This is in accordance with the Review of Business Taxations recommendation to update the existing effective life schedule.

4.49 The Commissioners reviews are based solely on the consideration of factors relating to an assets effective life and do not take into account wider policy implications. Therefore, the Commissioners Determinations of effective lives do not address issues such as the impact on investment decisions or broader economic impacts.

4.50 It is therefore possible, even likely, that the Commissioner may determine significant increases in the safeharbour life of assets where those increases could have significant adverse impacts on the affected industries with flow on implications to other sectors of the economy.

4.51 To date, over 20 revisions to the existing effective life schedule have been implemented. Most determinations have either provided safeharbour effective lives for the first time, or made relatively minor amendments to existing safeharbour determinations.

4.52 However, there are a number of current reviews where it is expected that the Commissioner will shortly determine significant increases in safeharbour lives which would have wider national economic implications. The Commissioner is expected to make determinations in relation to these reviews by 1 July 2002.

Identification of implementation options

4.53 The policy measure that was announced in the Governments 2002-2003 Federal budget establishes a statutory cap on the safeharbour effective lives for particular asset classes. Under this approach, the safeharbour lives that the Commissioner sets for taxpayers to use to calculate the decline in value of depreciating assets within the relevant asset classes can not exceed the statutory cap. For those assets where the revised effective life is less than the statutory cap, the Commissioners effective life will continue to apply. In addition, the introduction of the statutory caps does not negate the ability of taxpayers to self-assess an appropriate effective life for their assets based on their own circumstances.

4.54 The Government considered cases where significant increases in revised safeharbour effective life determinations would have a significant effect on forthcoming investment projects with significant economic impacts, particularly in large capital intensive industries.

4.55 Following consideration of the broader national interest in this context, the Government decided to establish effective life statutory caps to ensure appropriate capital allowances deductions remain available for aeroplanes, helicopters, gas transmission and distribution assets, oil and gas production assets and assets used to manufacture condensate, crude oil, domestic gas, LNG or LPG.

4.56 Table 4.2 shows the current safeharbour effective lives for these asset classes, together with the effective lives likely to be determined by the Commissioner and the statutory effective life caps under the measure announced by the Government.

Table 4.2: Effective lives for the major sensitive asset classes under review

Alternative options

4.57 A number of alternative options were considered, but were determined to be either inferior or unworkable. The option of applying statutory caps as a transitional arrangement while moving to the Commissioners Determinations in the longer term was considered, as it might have better retained the integrity of the effective life review process. This option, however, would have continued to provide considerable medium and long term uncertainty to industry about the effective life that would apply to projects, particularly if the statutory cap was phased up to the Commissioners Determination. A fixed time for removing the cap would have also risked sub-optimal investment resulting from the incentive to ensure that a taxpayers capital allowances deduction is based on the statutory cap. In addition, such a transitional measure would not only have limited the benefits of the policy measure, but would have also introduced further complexity and uncertainty to the administration of tax law in relation to capital allowances. Transitional arrangements were therefore considered to be inappropriate.

4.58 The option of establishing a mechanical process that considers changes in effective lives and applies detailed prescribed criteria accounting for specific increases in effective lives was thought to be inflexible and complex to administer. A number of rigorous tests would have been needed under this approach and it was considered to be unworkable.

4.59 The use of a purely statutory write-off, rather than statutory caps, was also considered, but it would have undermined the integrity of the effective life based capital allowance system. For this reason, such a process was considered to be unwise.

Assessment of impacts (costs/benefits)

Impact group identification

4.60 The primary impact of establishing statutory effective life caps is the provision of support for taxpayers who would otherwise be adversely affected by substantial increases in the effective lives used for calculating the decline in value of their assets. Firms operating in the airline, gas transmission and distribution, and oil and gas production industries, as well as industries that manufacture condensate, crude oil, domestic gas, LNG and LPG, will be the primary beneficiaries of the measure.

4.61 The main impact of the measure will therefore be to provide significant benefits to the affected industries, estimated at $1.9 billion over 10 years, compared to the Commissioners expected revised determinations of safeharbour effective lives (see Table 4.2).

4.62 Indirect beneficiaries of this measure will be consumers of goods and services produced by the affected industries. This will occur because the affected industries costs will be lower than had the higher effective lives applied, but only to the extent that these lower costs are passed on through lower prices. This is dependent, to some extent, on the specific competition regulation applying to each of the industries.

4.63 To the extent that the statutory caps maintain the existing value of the capital allowances deductions for the affected industries, there could be competitive pressure felt by those industries that produce similar goods and services without the benefit of a statutory cap. A major competitor to the industries covered by the measure is considered to be the electricity generation industry, which competes with some sectors of the gas transmission and distribution industry.

Compliance costs

4.64 The affected industries will not incur additional compliance costs because the statutory effective life caps will simply be used in place of the safeharbour lives that are expected to be determined by the Commissioner.

4.65 The safeharbour lives are provided to assist taxpayers in determining the appropriate capital allowances deductions to claim for their assets. Although taxpayers have the option to self-assess an appropriate effective life for their assets based on their own circumstances, in general they prefer to use safeharbour lives because of the compliance cost savings and the certainty they provide.

Administrative costs

4.66 Government agencies such as the Department of the Treasury, the Department of Industry, Tourism and Resources and the ATO will not incur significant additional costs implementing the proposed measure.

4.67 The Governments willingness to consider statutory caps, where national economic considerations require, may entail unquantifiable costs incurred in public administration and by private representations to bring to the Governments attention all of the factors that may be relevant.

Revenue impact

4.68 The effect of this measure, as announced in the 2002-2003 Federal budget, is to limit the revenue gain arising from the Commissioners revised determinations in excess of the statutory cap to around $150 million over the forward estimates period.

4.69 Had the statutory caps not been implemented the Commissioners likely determinations would have raised an estimated $465 million over the forward estimates and $2.5 billion over the next 10 years.

4.70 The statutory cap will, in a number of cases, shorten the effective life that taxpayers can use to calculate the decline in value of an asset relative to the Commissioners likely effective life determinations for those assets.

4.71 These estimates are based on the statutory caps presented in Table 4.1, and the likely level of investment in the airline, gas transmission and distribution, and oil, gas and LNG production industries over the next decade.

4.72 The estimated revenue impacts are based on the assumption that these higher effective lives will not detract from the investment assumed to occur under the Governments measure. To the extent that investment is discouraged, revenue collections could be lower.

Tax savings to industry

4.73 The Governments statutory caps provide subsidies to the relevant industries by allowing faster depreciation of their assets than that which would have been available under the longer Commissioner determined effective lives that are expected to apply from 1 July 2002. That said, the statutory caps will provide a slightly slower decline in value (or lower effective lives) than available, in some cases, under the existing Commissioner determined safeharbour effective lives. As noted in the revenue impact section, the increased tax that industry would have paid under the likely Commissioners determined effective lives amounts to $465 million over 4 years and $2.5 billion over 10 years. The additional tax that industry will pay under the proposed caps is estimated at $150 million over 4 years and $675 million over 10 years. This represents approximately only 30% of the increased tax payable under the likely Commissioners determined effective lives. The statutory caps will result in savings to industry of around $315 million over 4 years and $1.9 billion over 10 years, compared to the effects of the Commissioners expected safeharbour effective lives.

Impact on investment

4.74 Currently, $48 billion of planned investment is expected in these industries over the next 10 years. The statutory cap will, relative to the Commissioners likely effective life changes, allow businesses to claim an additional $1.9 billion in capital allowances deductions on this investment. This impact could be sufficient to ensure that the relevant industries commit to this level of investment.

4.75 If the Commissioners likely effective life changes were implemented, it is likely that some of these planned investments would not proceed. However, it is difficult to assess the extent to which investment in these projects will occur at the expense of other investment projects throughout the rest of the economy.

Benefits to the economy

4.76 The economy wide impacts of the measure depend on the extent to which investment projects that would not have proceeded under the Commissioners likely effective life changes will proceed under the statutory caps. The impacts then depend on the extent to which other investment projects in the economy do not proceed as a result of this additional investment (as well as the relative rates of return of these investments). To the extent that the recommended statutory caps on effective lives have a net positive impact on investment, there will be flow-on effects in the economy through employment and national production. Some of the investment will also impact on trade flows, particularly those projects that are export-oriented.

Consultation

4.77 The ATO has undertaken extensive consultation with industry during the review of the safeharbour effective life schedule. These consultations are on technical aspects of the effective life project. However, the ATO has kept the Department of the Treasury constantly informed regarding any broader issues relating to the effective life project and any industry views on the impacts of revisions to the safeharbour effective life schedule.

4.78 There have been a number of submissions from industry to Government, and a number of meetings between industry and Government, regarding revisions to the safeharbour effective life schedule.

Conclusion and recommended option

4.79 It was concluded that the measure to cap statutory effective lives for certain depreciating assets is the most efficient and transparent method of achieving the desired policy outcome. The measure provides for the most appropriate balance of interests between meeting the needs of the specific industries and maintaining the integrity of the Governments effective life capital allowances system.

4.80 The measure involves minimal compliance costs, as the new statutory caps will simply replace the existing safeharbour effective lives, and provide significant benefits to those industries concerned.