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

Introduction

In the 2003-2004 Budget, following extensive consultation and a report (International Taxation - A Report to the Treasurer) by the Board of Taxation, the Government announced a package of reforms to international taxation. Following on from a new tax treaty with the United Kingdom, the New International Tax Arrangements Bill 2003, and the New International Tax Arrangements (Participation Exemption and Other Measures) Bill 2004, the measures contained in this bill are a further instalment of those reforms.

Capital gains tax and foreign residents

Schedule 1 to this bill makes changes to the tax treatment of foreign residents who make a capital gain or loss in respect of an interest in an Australian fixed trust. These amendments address the current situation where non-residents investing in Australian assets through an Australian managed fund are taxed more heavily than if they invested directly in those assets or through a non-resident fund. The measures amend the law to provide comparable tax outcomes for foreign residents in Australian managed funds. This will improve the international competitiveness of Australian managed funds, increasing their attractiveness to foreign investors investing in Australia and the region. This gives effect to Board of Taxation Recommendations 4.6(1), 4.7 and 4.8.

Date of effect: These amendments will apply to capital gains and losses on or after the date of Royal Assent.

Proposal announced: This measure was announced in the Treasurer's Press Release No. 32 of 13 May 2003.

Financial impact: The revenue impact of this measure is unquantifiable but is expected to be insignificant.

Compliance cost impact: Additional compliance costs may be incurred by fund managers and trustees in applying these amendments. Fund managers and trustees may need to keep additional records, undertake calculations and modify distribution statements in order to ensure that non-residents are able to take full advantage of the amendments. However this is not likely to be a complex or costly exercise for most fund managers.

Treaty source rules

Schedule 2 to this bill includes amendments to the International Tax Agreements Act 1953. The amendments ensure that generally the source of income derived by widely held unit trusts from funds management activities to which a non-resident beneficiary is presently entitled will be determined in the same manner as it would be determined for the purposes of the Income Tax Assessment Act 1936 and the Income Tax Assessment Act 1997. The amendments will align the tax treatment of foreign residents investing through managed funds that derive some or all of their income from sources outside Australia with the tax treatment that would apply if those foreign residents made such investments directly. In removing Australian tax in these cases the amendments will improve Australia's international competitiveness in providing funds management services to foreign investors. This gives effect to Board of Taxation Recommendation 4.6(2).

Date of effect: These amendments will apply from the year of income of the taxpayer in which Royal Assent is obtained.

Proposal announced: This measure was announced in the Treasurer's Press Release No. 32 of 13 May 2003.

Financial impact: The revenue impact of this measure is unquantifiable but is expected to be insignificant.

Compliance cost impact: This measure will reduce compliance costs for foreign resident investors in Australian managed funds as they will no longer be subject to Australian tax in respect of the foreign source income of managed funds. This measure will also reduce compliance costs for trustees (and fund managers) as they will no longer be required to withhold tax in respect of the foreign source income.

Interest withholding tax

Schedule 3 to this bill implements three distinct amendments that relate to the imposition of interest withholding tax (IWT). They seek to ensure that the IWT provisions operate as intended and are consistent with recent developments in the tax law. The first amendment broadens the range of financial instruments eligible for IWT exemption by adding 'debt interests' as debt for tax purposes. The second amendment treats payments of a non-capital nature made on certain Upper Tier 2 hybrid capital instruments as interest for IWT purposes. The final amendment allows assets and debts to be transferred from Australian subsidiaries of foreign banks to their Australian branches without losing IWT exemptions.

Date of effect: These amendments will take effect from the date of Royal Assent.

Proposal announced: This measure was announced in the Minister for Revenue and Assistant Treasurer's Press Release No. C011/04 of 1 March 2004.

Financial impact: The amendments will have a cost to revenue of $5 million per year.

Compliance cost impact: The amendments are expected to reduce compliance costs for affected taxpayers.

Summary of regulation impact statement

Regulation impact on business

Impact: Exempting from Australian tax foreign source income derived by Australian fixed trusts to which foreign resident beneficiaries are presently entitled, will remove tax barriers to foreign residents investing in assets through Australian fixed trusts, such as managed funds. In turn, this should improve the international competitiveness of Australia's managed funds industry, enabling the industry to attract more offshore funds for investment in Australian and foreign assets.

Ensuring that foreign source income derived by Australian managed funds to which foreign resident beneficiaries are presently entitled is no longer subject to Australian tax will reduce compliance costs for resident investors in Australian managed funds, and for trustees and fund managers who will no longer be required to withhold tax in respect of foreign source income.

The additional compliance costs for trustees and fund managers required to track a fund's underlying assets are expected to be minimal.

Main points:

•

More closely aligning the tax treatment of foreign residents that indirectly invest in assets via Australian fixed trusts with the treatment of foreign residents that invest directly in the assets will remove tax impediments to foreign residents investing in Australian fixed trusts as they will no longer be subject to Australian tax in respect of their foreign source income.

•

Removing tax impediments that discourage foreign residents from investing in Australian trusts, including managed funds, will improve the international competitiveness of Australia's managed funds industry, enhancing the ability of Australian funds to attract foreign investment. This in turn should encourage the development of Australia as a global financial services centre.

•

Providing an exception to CGT event E4 for distributions of foreign source income to foreign resident beneficiaries of Australian trusts will remove an onerous administrative impediment to investment in Australian trusts and is expected to make Australia's managed funds industry more internationally attractive, enhancing the ability of Australian funds to compete internationally.

Chapter 1 - Capital gains tax and foreign residents

Outline of chapter

1.1 Schedule 1 to this bill makes a number of changes to the Australian tax treatment of foreign residents that make a capital gain or capital loss in respect of an interest in a fixed trust.

Context of amendments

1.2 Presently, there are parts of the income tax law that make it less attractive for foreign residents to invest in an Australian resident trust holding assets than it is for them to invest directly in those assets. This makes the Australian funds management industry, which commonly uses trusts to pool funds and manage investments, less competitive and efficient than it would otherwise be. It also discourages foreign investment in Australia more generally.

1.3 The amendments to Schedule 1 to this bill seek to overcome these problems by more closely aligning the tax treatment of foreign residents that invest in fixed trusts on the one hand, with the tax treatment of foreign residents that invest directly in assets (in Australia or abroad) on the other. This will mean that the tax law no longer impedes foreign residents from investing in assets through Australian resident trusts, including managed funds.

1.4 These reforms are consistent with the Board of Taxation's Recommendations on International Taxation of 28 February 2003. Schedule 1 to this bill implements Recommendations 4.6(1), 4.7 and 4.8.

Summary of new law

1.5 Schedule 1 makes three key changes to the income tax law.

1.6 One change is to disregard a capital gain or capital loss made by a foreign resident from a capital gains tax (CGT) event happening to a fixed trust if enough of the underlying assets of the trust are without the necessary connection with Australia. In particular this will apply where a foreign resident disposes of an interest in an Australian fixed trust. This is appropriate because CGT would not apply to a foreign resident that held such assets directly.

1.7 Another change is to disregard a capital gain made by a foreign resident in respect of the taxpayer's interest in a fixed trust if the gain relates to an asset without the necessary connection with Australia. For example, this will apply where the capital gain arises from the disposal by an Australian fixed trust of a portfolio interest in an Australian public company. Again, this is appropriate because a foreign resident would not be assessed on such a gain if the asset were held directly.

1.8 The final change is to provide an exception to CGT event E4 for distributions of foreign source income from the trustee of a trust to a beneficiary that is a foreign resident. CGT event E4 effectively creates a capital gain if a trustee makes a payment to a beneficiary (such as foreign source income) that is not assessable income of the beneficiary. This change is appropriate because foreign residents investing directly in the asset generating foreign source income are, in general, not subject to Australian CGT.

Application to the funds management industry

1.9 These amendments apply to foreign residents that have interests in managed funds (or other fixed trusts) whose assets are without the necessary connection with Australia.

1.10 However, managed funds that invest in assets without the necessary connection with Australia may also have some assets with the necessary connection. This may help a fund to diversify its portfolio or achieve some other commercial objective. To ensure as broad an application as possible, the amendments in Schedule 1 to this bill apply to interests in fixed trusts where 10% or less of the trust's assets (by market value) have the necessary connection with Australia.

1.11 The managed funds industry typically operates through layers or chains of trusts. For example, a managed fund will often invest in a wholesale trust, which then invests in real assets. The amendments in this bill are designed to allow taxpayers to 'look-through' fixed trusts to the underlying assets.

1.12 These amendments are not confined to foreign residents with interests in widely held unit trusts. The amendments will apply to interests in closely held trusts and trusts that are not unit trusts. This is to ensure the benefits of the measures apply as widely as possible, irrespective of the trust arrangements through which the foreign resident invests. However, the trust in which the foreign resident has invested and all relevant trusts in the chain must meet the definition of 'fixed trust' in the Income Tax Assessment Act 1997 (ITAA 1997). This is to ensure that there is no discretion available to the trustee to provide benefits to parties who are not beneficiaries of the trust. This is important to the integrity of the amendments.

Comparison of key features of new law and current law

Detailed explanation of new law

What do these amendments do?

1.13 The object of the amendments is to provide comparable tax treatment between direct ownership and indirect ownership (through a fixed trust) by foreign residents of CGT assets without the necessary connection with Australia. [Schedule 1, item 6, section 768-600]

1.14 The amendments provide:

•

a capital gain or capital loss that a foreign resident makes from a CGT event happening to an interest in a fixed trust is disregarded where the assets underlying the interest in the trust do not have the necessary connection with Australia [Schedule 1, item 6, subsection 768-605(1)] ;

•

a capital gain that a foreign resident makes in respect of an interest in a fixed trust is disregarded where the gain relates to an asset without the necessary connection [Schedule 1, item 6, subsection 768-605(2)] ; and

•

an exception to CGT event E4 for a distribution of foreign source income by the trustee of a trust to a foreign resident beneficiary [Schedule 1, item 4, subsection 104-70(9)].

1.15 This will remove an impediment to foreign residents investing in assets through Australian fixed trusts, thereby making the Australian managed funds sector more internationally competitive. This should encourage foreign investors to use Australian funds managers to make investments in Australia and the region.

Disregard a capital gain or capital loss made by a foreign resident from a capital gains tax event happening to an interest in a fixed trust

1.16 A foreign resident makes a capital gain or capital loss from a CGT event happening to an interest in a fixed trust (e.g. disposal of the interest) if the interest is an asset with the necessary connection with Australia. This is the case even if all of the assets underlying the interest are, for example, foreign assets which do not have the necessary connection with Australia.

1.17 There are nine categories of assets with the necessary connection with Australia listed in the table in section 136-25 of the ITAA 1997. Some of the assets listed in the table include land in Australia, shares in an Australian resident private company, holdings of at least 10% of the units in a resident unit trust, an interest (of any size) in any other resident trust, and holdings of at least 10% of the shares in a resident public company.

1.18 Schedule 1 to this bill changes the law so that a capital gain or capital loss made by a foreign resident on an interest in a fixed trust (the 'first trust') will be disregarded if at least 90% (by market value) of the trust's assets are without the necessary connection with Australia. A capital gain or capital loss will also be disregarded if at least 90% of assets held by other fixed trusts in which the first trust has an interest (directly, or indirectly through a chain of fixed trusts) are without the necessary connection with Australia. [Schedule 1, item 6, subsection 768-605(1) and section 768-610]

1.19 This will provide a similar tax outcome to a situation where a foreign resident directly holds assets that do not have the necessary connection with Australia, rather than through a fixed trust. This is consistent with the object of the amendments.

1.20 A number of requirements must be satisfied for a capital gain or capital loss to be disregarded:

•

the taxpayer's asset is an interest in a 'fixed trust'. A fixed trust is a trust in which the beneficiaries have fixed entitlements to all of its income and capital [Schedule 1, item 6, subsection 768-605(1)] ;

•

at the time of the CGT event, the taxpayer is a foreign resident [Schedule 1, item 6, paragraph 768-605(1)(a)] ;

•

the interest in the fixed trust is an asset with the necessary connection with Australia [Schedule 1, item 6, paragraph 768-605(1)(b)] :

-

a unit in a unit trust has the necessary connection if the unit trust is a resident trust and the taxpayer owned at least 10% of the issued units at any time during the five years before the CGT event happens (item 6 in the table in section 136-25 of the ITAA 1997); and

-

an interest in any other trust has the necessary connection if the trust is a resident trust (item 4 in the table in section 136-25);

•

the conditions in section 768-610 are satisfied [Schedule 1, item 6, paragraph 768-605(1)(c)].

1.21 The conditions in section 768-610 are satisfied if at least 90% (by market value) of the first trust's assets are without the necessary connection to Australia when the CGT event happened to the taxpayer's interest in the trust. [Schedule 1, item 6, paragraph 768-610(2)(a)]

1.22 Those conditions are also satisfied:

•

if at least 90% (by market value) of the assets of a fixed trust in which the first trust has an interest (directly, or indirectly through a chain of trusts) do not have the necessary connection to Australia when the CGT event happened to the taxpayer's interest in the first trust [Schedule 1, item 6, paragraph 768-610(2)(b)] ; and

•

at least 90% (by market value) of the assets of the first trust, and each other trust in the chain of trusts, would not have the necessary connection with Australia, if you assumed that any interest the trust holds in another fixed trust in the chain did not have the necessary connection with Australia [Schedule 1, item 6, subsections 768-610(3) and (4)].

1.23 The purpose of the conditions is to treat an interest in a trust as an interest without the necessary connection with Australia if the underlying assets of the trust do not have the necessary connection with Australia.

Diagram 1.1: Capital gain or loss from disposing of an interest in an Australian fixed trust

Example 1.1: Selling an interest in an Australian fixed trust which has interests in other Australian fixed trusts

Leo, a foreign resident, has an interest in Trust A, which has interests in Trusts B and C. Trust B has an interest in Trust D and Trust C has an interest in Trust E. Trust D has Asset 1 and Trust E has Asset 2. Assets 1 and 2 are assets without the necessary connection with Australia.

The trusts referred to in this example are resident fixed trusts and the interests in these trusts have the necessary connection with Australia.

Leo sells his interest in Trust A and makes a capital loss. The capital loss will be disregarded if the conditions in section 768-610 are satisfied. The condition in subsection 768-610(2) is not satisfied for Trust A (because the assets of the first trust (Trust A) have the necessary connection with Australia), but is satisfied for Trusts D and E. This is because more than 90% of the assets of Trust D and more than 90% of the assets of Trust E are without the necessary connection with Australia. This means that the further condition in subsection 768-610(4) must be satisfied for Trust A and for each trust in the chain between Trusts A and D (i.e. Trust B) and the chain between Trusts A and E (i.e. Trust C).

The further condition is satisfied for Trust B because its only asset is an interest in Trust D and this is taken to be without the necessary connection. Similarly, the further condition is satisfied for Trust C because its only asset is an interest in Trust E and this is taken to be without the necessary connection. The further condition is also satisfied for Trust A because its only assets are interests in Trust B (in relation to one chain of trusts) and in Trust C (in relation to the other chain of trusts). Both of these assets are taken to be without the necessary connection.

The overall result is that the conditions in section 768-610 are satisfied and the capital loss is disregarded.

Example 1.2: Selling an interest in an Australian fixed trust which has assets with and without the necessary connection with Australia

Leo, a foreign resident, has an interest in Trust A. The interest is an asset with the necessary connection with Australia. Trust A is a resident fixed trust and has four assets. Asset 1 does not have the necessary connection and accounts for 50% of Trust A's assets (by market value). Asset 2 is without the necessary connection and accounts for 30% of Trust A's assets. Asset 3 does not have the necessary connection and accounts for 11% of Trust A's assets. Asset 4 has the necessary connection and accounts for 9% of Trust A's assets.

Leo sells his interest in Trust A and makes a capital gain. The capital gain will be disregarded if the conditions in section 768-610 are satisfied. The condition in subsection 768-610(2) is satisfied for Trust A as at least 90% of its assets are assets without the necessary connection with Australia. This means that the capital gain is disregarded. There is no need to consider the condition in subsection 768-610(4).

Example 1.3: Selling an interest in an Australian fixed trust with an interest in another Australian fixed trust and assets that do not have the necessary connection with Australia

Leo, a foreign resident, has an interest in Trust A. The interest is an asset with the necessary connection with Australia. Trust A has an interest in Trust B which is an asset with the necessary connection and accounts for 25% of Trust A's assets. Trusts A and B are resident fixed trusts.

Trust A has three other assets. Asset 1 does not have the necessary connection and accounts for 25% of Trust A's assets (by market value). Asset 2 does not have the necessary connection and accounts for 25% of Trust A's assets. Asset 3 is without the necessary connection and accounts for 25% of Trust A's assets.

Trust B has three assets. Assets 4, 5 and 6 are assets without the necessary connection with Australia and each accounts for 331/3% of Trust B's assets.

Leo sells his interest in Trust A and makes a capital gain. The capital gain will be disregarded if the conditions in section 768-610 are satisfied. The condition in subsection 768-610(2) is not satisfied for Trust A, but is satisfied for Trust B because at least 90% of its assets are without the necessary connection with Australia. This means that the further condition in subsection 768-610(4) must be satisfied for Trust A. This further condition is satisfied because the interest in Trust B is taken to be an asset without the necessary connection with Australia, which means that at least 90% of Trust A's assets are assets without the necessary connection.

The overall result is that the conditions in section 768-610 are satisfied and the capital gain is disregarded.

Example 1.4: How does Example 1.3 work when one of the assets of Trust B has the necessary connection with Australia?

The facts in this example are the same as Example 1.3, except that in this example Asset 4 has the necessary connection with Australia.

Leo sells his interest in Trust A and makes a capital gain. The condition in subsection 768-610(2) is not satisfied for Trust A. The condition is also not satisfied for Trust B because less than 90% of its assets do not have the necessary connection with Australia. This means that the conditions in section 768-610 are not satisfied and the capital gain is not disregarded. There is no need to consider the condition in subsection 768-610(4).

Disregard a capital gain made by a foreign resident beneficiary in a fixed trust in respect of an asset without the necessary connection with Australia

Background to the new law

1.24 A foreign resident is only subject to CGT on assets having the necessary connection with Australia. The concept of an asset having the necessary connection with Australia is discussed in paragraph 1.17.

1.25 On the other hand, an Australian resident is subject to CGT on all of its assets. A capital gain made by an Australian resident trust on any of its assets is included in its net capital gain, which is then included in its net income. For a beneficiary that is a foreign resident and is presently entitled to a share of that net income, the beneficiary (and usually the trustee) is assessed on the share to the extent that it is Australian sourced. The beneficiary's share of the net income could include capital gains made by the trust on assets without the necessary connection with Australia.

1.26 This difference between the tax treatment of capital gains made directly, and those made indirectly through a trust, discourages foreign residents from investing in Australian resident trusts that hold assets without the necessary connection with Australia, including foreign assets outside Australia.

1.27 Schedule 1 to this bill changes the law so that foreign residents enjoy comparable tax treatment of capital gains made directly by them and capital gains made by fixed trusts in which the foreign residents have an interest. This is achieved by disregarding a capital gain made by a foreign resident arising from an interest in a fixed trust (the 'first trust') if the gain is attributable to:

•

an asset without the necessary connection with Australia; or

•

an interest in another fixed trust (that does have the necessary connection with Australia) where the conditions in section 768-610 are satisfied.

[Schedule 1, item 6, subsection 768-605(2)]

1.28 This amendment also changes the law so that the trustee of a fixed trust is not liable to pay tax on an amount that is disregarded. [Schedule 1, item 6, subsection 768-605(3)]

Diagram 1.2: Capital gain where the underlying asset does not have the necessary connection with Australia

The interaction of the proposed law with the capital gains tax rules affecting trusts with net capital gains

1.29 The amendment relies, in part, on the rules in section 115-215 of the ITAA 1997 to achieve its objectives. Section 115-215 applies to a trust that has a net capital gain for an income year. In respect of a foreign resident beneficiary, section 115-215 effectively applies if the beneficiary is presently entitled to a share of the net income of a trust and that share is attributable to Australian sources.

1.30 Under subsection 115-215(3), a beneficiary of a trust has an 'extra capital gain' if the beneficiary's assessable income includes an amount under paragraph 97(1)(a), subsection 98A(1), if the beneficiary is not a company, or subsection 100(1). The amount of the extra capital gain depends on whether the capital gain made by the trust was a discount capital gain or was reduced by the small business 50% reduction.

1.31 It is the extra capital gains that subsection 768-605(2) is concerned with. The extra capital gain will be disregarded if a number of requirements are satisfied [Schedule 1, item 6, subsection 768-605(2)] :

•

the beneficiary makes a capital gain in respect of its interest in a fixed trust. This is a capital gain arising because the trustee has a net capital gain [Schedule 1, item 6, subsection 768-605(2)] ;

•

the beneficiary is a foreign resident when it makes the gain [Schedule 1, item 6, paragraph 768-605(2)(a)]. This means that the beneficiary must be a foreign resident when its assessable income for an income year includes an amount under a provision specified in subsection 115-215(2);

•

the capital gain relates to an asset [Schedule 1, item 6, paragraph 768-605(2)(b)]:

-

of a fixed trust in which the beneficiary has an interest (the 'first trust'); or

-

of another fixed trust in which the first trust has an interest (directly, or indirectly through a chain of fixed trusts);

•

the asset [Schedule 1, item 6, paragraph 768-605(2)(c)] :

-

does not have the necessary connection with Australia at the time of the CGT event; or

-

is an interest in a fixed trust and the conditions in section 768-610 are satisfied.

1.32 The conditions in section 768-610 are discussed in paragraphs 1.21 to 1.23. The conditions apply in the same fashion whether the CGT event happens to an interest in a fixed trust that is held by a foreign resident or by a fixed trust.

1.33 The beneficiary is allowed a deduction under subsection 115-215(6) of the ITAA 1997. The deduction is equal to the amount that was included in the beneficiary's assessable income under a provision specified in subsection 115-215(2) that is attributable to the net capital gain.

Example 1.5: Interaction with section 115-215 of the Income Tax Assessment Act 1997 when the foreign resident beneficiary is an individual

Leo, a foreign resident at year end, is the sole beneficiary of a resident fixed trust. The trust makes a capital gain of $2,000 from selling an asset without the necessary connection with Australia. The gain is a discount capital gain. In calculating the net income of the trust the trustee applies the CGT discount, resulting in a net income for the trust of $1,000.

The net income has an Australian source and Leo is presently entitled to it.

Step 1 - Leo adds $1,000 to his assessable income under subsection 98A(1) (because the trustee was assessed under subsection 98(4)).

Step 2 - Leo has an extra capital gain of $2,000 under paragraph 115-215(3)(b).

Step 3 - Leo disregards the extra capital gain in step 2 under subsection 768-605(2) because it is attributable to an asset without the necessary connection with Australia.

Step 4 - Leo deducts $1,000 from his assessable income under subsection 115-215(6).

The result is that the effect on Leo's taxable income is nil.

Application to a beneficiary that is a company and a foreign resident at year end

1.34 Section 115-215 does not apply to a beneficiary that is a company and a foreign resident at the end of an income year. These companies do not have any extra capital gains under section 115-215 that would otherwise be disregarded under the new law. (All they have is a share of the net income of the trust, which may include a net capital gain.)

1.35 To ensure that a company that is a foreign resident at year end can benefit from the new law, a deduction is allowed for the amount that would be disregarded for a company under subsection 768-605(2) had section 115-215 applied to it. [Schedule 1, item 6, section 768-615]

Example 1.6: Interaction with section 115-215 of the Income Tax Assessment Act 1997 when the foreign resident beneficiary is a company

The facts in this example are the same as Example 1.5, except that the beneficiary is a company, Leo Ltd, and the capital gain is not a discount capital gain.

Step 1 - Leo Ltd adds $2,000 to its assessable income under subsection 98A(1) (because the trustee was assessed under subsection 98(3)).

Step 2 - Leo Ltd deducts $2,000 from its assessable income under section 768-615. This is the amount that would be disregarded for Leo Ltd under subsection 768-605(2) had section 115-215 applied to it.

The result is that the effect on Leo Ltd's taxable income is nil.

Application to a trustee of a fixed trust

1.36 Currently the trustee of a trust is usually liable to pay tax under section 98 of the ITAA 1936 if a foreign resident beneficiary is presently entitled to a share of the net income of the trust and the share is attributable to Australian sources.

1.37 Under the proposed law, a trustee will not be liable to pay tax in respect of an amount that gives rise to a capital gain that is disregarded for a beneficiary under subsection 768-605(2) [Schedule 1, item 6, paragraph 768-605(3)(a) and subsection 768-605(4)]. In other words, a trustee will not be liable to pay tax on an amount that results in a beneficiary being assessed under a provision specified in subsection 115-215(2) and having an extra capital gain under subsection 115-215(3) which is then disregarded under the new law.

1.38 A beneficiary that is a company and is a foreign resident at year end does not make extra capital gains under section 115-215 (and does not disregard capital gains under the new law). In respect of these beneficiaries, a trustee is not liable to pay tax in respect of an amount that gives rise to a deduction for the company under section 768-615. [Schedule 1, item 6, paragraph 768-605(3)(b) and subsection 768-605(4)]

Example 1.7: Capital gain made in respect of an interest in an Australian fixed trust that sells assets with and without the necessary connection with Australia

For this example, refer to the diagram in Example 1.2.

Leo, a foreign resident, has an interest in Trust A which is an asset with the necessary connection with Australia. Trust A is a resident fixed trust. Trust A has four assets. Assets 1 and 3 are without the necessary connection with Australia. Assets 2 and 4 have the necessary connection.

Scenario 1

Trust A sells Asset 1 and makes a capital gain. The capital gain is included in the trust's net income to which Leo is presently entitled. Leo adds an amount to his assessable income under subsection 98A(1) (because the trustee was assessed under subsection 98(4)) and he has an extra capital gain under subsection 115-215(3). The extra capital gain will be disregarded under subsection 768-605(2) because it is attributable to an asset without the necessary connection with Australia.

Scenario 2

Trust A sells Asset 1 and makes a capital gain of $100. It also sells Asset 2 and makes a capital gain of $200. The net capital gain of $300 is included in the trust's net income to which Leo is presently entitled. Leo adds $300 to his assessable income under subsection 98A(1) and he has an extra capital gain of $300 under subsection 115-215(3). The extra capital gain of $100 will be disregarded under subsection 768-605(2) because it is attributable to an asset that does not have the necessary connection with Australia.

Scenario 3

Trust A sells Asset 1 and makes a capital gain of $100. It also sells Asset 2 and makes a capital loss of $40. The net capital gain of $60 is included in the trust's net income to which Leo is presently entitled. Leo adds $60 to his assessable income under subsection 98A(1) and he has an extra capital gain of $60 under subsection 115-215(3). The extra capital gain will be disregarded under subsection 768-605(2) because it is attributable to an asset without the necessary connection with Australia.

Example 1.8: Interest in an Australian fixed trust which has an interest in another fixed trust

For this example, refer to the diagram in Example 1.3.

Leo, a foreign resident, has an interest in Trust A. Trust A has an interest in Trust B. Trust B has three assets. Asset 4 is without the necessary connection and accounts for 50% (by market value) of Trust B's assets. Asset 5 is without the necessary connection and accounts for 41% of Trust B's assets. Asset 6 is with the necessary connection and accounts for 9% of Trust B's assets.

Trusts A and B are resident fixed trusts and the interests in them are assets with the necessary connection with Australia.

Scenario 1

Trust B sells Asset 4 and makes a capital gain of $700, which is included in its net income. Trust A is presently entitled to that net income and Leo is presently entitled to Trust A's net income ($700).

Leo adds $700 to his assessable income under subsection 98A(1) (because he is a beneficiary described in subsection 98(4)). Leo will have an extra capital gain of $700 under subsection 115-215(3), which will be disregarded under subsection 768-605(2) because it is attributable to an asset without the necessary connection with Australia.

Scenario 2

Trust A sells its interest in Trust B and makes a capital gain of $2,000. This is included in Trust A's net income to which Leo is presently entitled. Leo will add $2,000 to his assessable income under subsection 98A(1) and he will have an extra capital gain of $2,000 under subsection 115-215(3).

The extra capital gain will be disregarded under subsection 768-605(2) if the conditions in section 768-610 are satisfied. The condition in subsection 768-610(2) is satisfied for Trust B because at least 90% of its assets are without the necessary connection. There is no need to satisfy the condition in subsection 768-610(4).

Exception to CGT event E4 for distributions of foreign source income to foreign resident beneficiaries

1.39 No liability to tax arises under Division 6 of the ITAA 1936 where a foreign resident beneficiary of a trust is presently entitled to a share of the trust's net income and that share is not Australian sourced. However, when this amount is distributed to the beneficiary, the distribution may be a non-assessable amount for the purposes of CGT event E4 in section 104-70 of the ITAA 1997. CGT event E4 reduces the cost base of a taxpayer's unit or interest in a trust and it may result in a capital gain.

1.40 An exception to CGT event E4 is provided so that it does not apply to a payment that is reasonably attributable to income that is not Australian sourced. This will ensure that income of a trust that is foreign sourced can flow through the trust to a foreign resident beneficiary without having adverse CGT consequences. [Schedule 1, item 4, subsection 104-70(9)]

1.41 There is no specific exception to CGT event E4 for a distribution of an amount that is disregarded under subsection 768-605(2). This is because income to which subsection 768-605(2) relates is added to the assessable income of a foreign resident (although not in its taxable income because of the deduction allowed under subsection 115-215(6) or section 768-615) (see Examples 1.5 and 1.6). The fact that the amount has been added to the foreign resident's assessable income means that CGT event E4 does not happen when the amount is distributed.

Record keeping

1.42 The requirement to keep records in Division 121 of the ITAA 1997 will apply in relation to capital gains and capital losses that are disregarded under the new Subdivision 768-H. [Schedule 1, item 5, subsection 121-30(2)]

Application provisions

1.43 The new Subdivision 768-H of the ITAA 1997 applies to capital gains and capital losses made on or after the day on which this bill receives Royal Assent:

•

a capital gain or capital loss will be disregarded under subsection 768-605(1) where the gain or capital loss is made by the beneficiary on or after the day of Royal Assent; and

•

the interaction of subsection 768-605(2) and section 115-215 of the ITAA 1997 means that a capital gain will be disregarded under subsection 768-605(2) if, on or after the day on which this bill receives Royal Assent, a beneficiary's assessable income includes an amount under a provision specified in paragraph 115-215(2)(b).

[Schedule 1, subitem 7(1)]

1.45 The amendment to section 104-70 of the ITAA 1997 applies to payments made on or after the day on which this bill receives Royal Assent. [Schedule 1, subitem 7(2)]

Consequential amendments

1.46 A reference to the deduction allowed to a foreign resident that is a company and a beneficiary of a fixed trust is added to the table of specific deductions in section 12-5 of the ITAA 1997. [Schedule 1, items 1 to 3, section 12-5]

Chapter 2 - Treaty source rules

Outline of chapter

2.1 Schedule 2 to this bill includes amendments to the International Tax Agreements Act 1953 (the Agreements Act). The amendments ensure that the source of income derived by widely held unit trusts from funds management activities to which a non-resident beneficiary is presently entitled will generally be determined under the normal rules for determining source for the purposes of the Income Tax Assessment Act 1936 (ITAA 1936) and the Income Tax Assessment Act 1997 (ITAA 1997).

Context of amendments

2.2 Income derived by a resident of a treaty partner country that may be taxed in Australia in accordance with the provisions of Australia's tax treaties, is deemed to have a source in Australia under source of income provisions in those treaties or equivalent provisions of the Agreements Act. For example, Article 21 of the 2003 United Kingdom convention provides:

"Income or gains derived by a resident of the United Kingdom which, under any one or more of Articles 6 to 8 and 10 to 16 and 18, may be taxed in Australia shall for the purposes of the laws of Australia relating to its tax be deemed to arise from sources in Australia."

2.3 Where business profits are attributable to a permanent establishment (generally a branch) operated in Australia by a resident of a treaty partner country, the treaties provide that those profits may be taxed in Australia. In the case of a funds management trust, income from the investment of funds outside Australia may be attributable to activities carried on by the trustee through a permanent establishment in Australia.

2.4 Australia's treaties (and subsection 3(11) of the Agreements Act in respect of treaties pre-dating the subsection) also provide that where business is carried on by a trustee through a permanent establishment in Australia, a non-resident beneficiary who is presently entitled to the income of the trust will be deemed to carry on that business through that permanent establishment. These provisions were introduced to ensure that non-resident beneficiaries of business trusts operating in Australia would be taxed in accordance with the principles of the Business Profits Article in our tax treaties.

2.5 The interaction of the deemed source rules and the permanent establishment rules for beneficiaries of business trusts can have the effect that income derived by non-resident beneficiaries from funds management activities of the trust is deemed to have an Australian source even though the income arises from funds invested offshore. The amendments proposed by this bill will ensure that, where such income has a source outside Australia under the ordinary rules for determining source of income for domestic law purposes, the income will continue to have a foreign source.

Summary of new law

2.6 The amendments provide that the Source of Income Articles in Australia's tax treaties (and similar provisions in the Agreements Act) will not apply to income from funds management activities (as defined) where a non-resident beneficiary is presently entitled to that income through one or more interposed trusts and the beneficiary has a fixed entitlement to the income through those trusts.

Comparison of key features of new law and current law

Detailed explanation of new law

2.7 The amendments insert section 3AA into the Agreements Act. The section will provide that in specified circumstances, the deemed source rules included in Australia's treaties (usually in a Source of Income Article) or the Agreements Act will not apply in relation to managed funds. The alteration of the deemed source rules will apply to funds management activities undertaken through a trust where the trust satisfies the provisions of the section and carries on business in Australia through a permanent establishment in Australia. [Schedule 2, item 1, paragraphs 3AA(2)(a) to (c)]

2.8 The amendments address concerns that the current law discourages the use of Australian expertise in funds management as a result of the interaction between the Business Profits Articles as modified by subsection 3(11) of the Agreements Act, or as provided for in the Business Profits Articles of treaties concluded after the introduction of subsection 3(11), and the deemed source of income provisions in their application to business trusts. The effect of subsection 3(11) and later provisions of Business Profits Articles is to deem a business carried on by a trust through a permanent establishment of the trustee to be a business carried on through a permanent establishment by a non-resident beneficiary who is presently entitled through one or more interposed trusts to the business profits arising from the trustee's operations.

2.9 Section 3AA provides for a limited modification of the deemed source rules that find their expression in Australia's tax treaties.

Background

2.10 Under the current law the Business Profits Articles of Australia's treaties provide for the taxation in Australia of income attributable to a permanent establishment of an enterprise of the treaty partner country in Australia. Attributable income can include income that might normally be considered to be sourced outside Australia. The source rules applicable to Australia's treaties provide that where Australia has a taxing right over that income of a resident of the treaty partner country under the treaty, that income is deemed to have an Australian source.

2.11 Where the trustee of a managed fund has a permanent establishment in Australia under the treaty (and regardless of whether the trustee is an Australian resident or not) and in the course of carrying on a business of funds management through that permanent establishment, it invests funds offshore, the income from such investments will be attributable to that permanent establishment. This income is currently deemed to be sourced in Australia and will be subject to tax in Australia.

2.12 The deemed permanent establishment rules for non-resident beneficiaries mean that this result also applies to the beneficiaries.

Impact on funds management activities

2.13 Section 3AA will operate to ensure that the source of such offshore income from funds management activities will be determined in accordance with Australia's normal domestic law source rules rather than the treaty deemed source rules. As funds management involves highly mobile forms of income that can be managed anywhere in the world, the deemed source rules have the effect of subjecting to Australian tax, profits that would not be subject to tax in Australia if a non-resident investor made those investments directly. [Schedule 2, item 1, subsection 3AA(2)]

2.14 The following conditions need to be met before the deemed source rules in the treaty cease to apply to funds management income:

•

the beneficiary must be a beneficiary in a widely held unit trust, or, indirectly, a beneficiary through one or more interposed trusts. The term 'widely held unit trust' is defined by reference to the trust loss measures in Schedule 2F of the ITAA 1936 (section 272-105). The amendments are confined to widely held unit trusts in recognition of the fact that the unit holders in such trusts are generally not carrying on business through these trusts [Schedule 2, item 1, subsection 3AA(1)] ;

•

the beneficiary must be a treaty resident of the other country. In dual residency cases the beneficiary will be a treaty resident of the country to which the tie-breaker rules in the treaty allocate sole residence [Schedule 2, item 1, paragraph 3AA(1)(a)] ;

•

the beneficiary needs to be presently entitled to the income of the widely held unit trust either directly or indirectly through interposed trusts [Schedule 2, item 1, paragraph 3AA(1)(b)] :

-

where the beneficiary is presently entitled to funds management income through interposed trust estates those trusts do not have to be widely held but the beneficiary has to have a fixed entitlement to the income through each interposed trust estate [Schedule 2, item 1, paragraph 3AA(1)(b)] ;

-

the term 'fixed entitlement' has the same meaning as it has for purposes of the ITAA 1997 and the tests necessary to determine fixed entitlement contained in Schedule 2F of the ITAA 1936 will apply. The requirement for fixed entitlements in the funds management trust or interposed trusts will operate to minimise the opportunities for streaming foreign sourced income away from resident beneficiaries to non-resident beneficiaries [Schedule 2, item 1, paragraph 3AA(1)(b)] ;

•

the trustee of the widely held unit trust must carry on business;

•

the business must be carried on in Australia through a permanent establishment as defined in the relevant agreement [Schedule 2, item 1, subsection 3AA(4)] ;

•

the business carried on must be one of funds management with funds management activities being defined [Schedule 2, item 1, subsection 3AA(4)].

2.15 Funds management activities are any activities carried on by the trustee of:

•

a widely held unit trust that is a managed investment scheme under the Corporations Act 2001; or

•

a closely held trust that is a managed investment scheme and that is closely held by either:

-

a managed investment scheme that is a widely held unit trust;

-

a complying superannuation entity;

-

a life insurance company; or

-

any combination of these.

[Schedule 2, item 1, subsection 3AA(4)]

2.16 'Closely held' will be interpreted by reference to Schedule 2F to the ITAA 1936 (section 272-105). 'Complying superannuation entity' and 'life insurance company' will take their meaning from the ITAA 1936.

Example 2.1

In the above example David, a non-resident beneficiary of Trust A, is presently entitled to 50% of the income from that trust. Trust A carries on a manufacturing business through a permanent establishment in Australia and exports its manufactures to Malaysia. Trust A also has discretionary beneficiaries who are entitled to be considered by the trustee in the distribution of the 50% of income to which David is not entitled.

Trust A holds 10% of the units in Widely Held Trust 1. This is a fixed entitlement to 10% of the income and capital of Widely Held Trust 1. Widely Held Trust 1 is a managed investment scheme which carries on business in Australia through a permanent establishment in Australia. It derives offshore income from placing funds in overseas markets and managing those funds.

In calculating the trustee's tax liability on behalf of David under subsection 98(4) of the ITAA 1936, section 3AA will mean that the deemed source rules in the treaty between Australia and country X, of which David is a resident, will not apply with respect to the offshore income of Widely Held Trust 1. Where the offshore income has a source outside Australia under the normal rules applicable to domestic law, the income will not be included in assessable income.

Any non-resident discretionary beneficiaries of Trust A, resident in country X, who become presently entitled to the income of the trust will be assessed on the offshore income of Widely Held Trust 1 that is attributable to its permanent establishment in Australia, as such beneficiaries do not have a fixed entitlement to the income of Trust A.

The amendments will not affect the source of income from activities other than fund management activities. Accordingly, David and any non-resident discretionary beneficiaries resident in country X becoming entitled to the income of the trust will be taxed on the Malaysian income attributable to Trust A's manufacturing permanent establishment in Australia. The income is attributable to the permanent establishment of Trust A as Trust A's salespeople market and conclude contracts for its manufactures during quarterly trips to Malaysia of two weeks duration. This income is taxed under subsection 98(4).

The liability to tax arises because those beneficiaries are, under subsection 3(11) (country X is a pre-subsection 3(11) treaty), deemed to have a permanent establishment in Australia (the permanent establishment of Trust A) and to carry on business through that permanent establishment (the business of Trust A). The Malaysian income is attributable to the permanent establishment and the Source of Income Article in country X's treaty with Australia provides that income that can be taxed in Australia under the treaty is deemed to have a source in Australia for both treaty and domestic law purposes..

Example 2.2

Trust A has a fixed entitlement to the income of Widely Held Trust 2 (a unit trust and managed investment scheme). Widely Held Trust 2 has a fixed entitlement to 20% of the income of Closely Held Trust (a managed investment scheme). Widely Held Trust 2, in the course of carrying on its business of funds management through a permanent establishment in Australia, receives offshore income from funds management activities of Closely Held Trust.

David has a fixed entitlement to the income of Widely Held Trust 2 from funds management activities. Accordingly, section 3AA applies in respect of that income and any offshore income from sources outside Australia will not be included in the assessable income of the trustee attributable to David.

Profit shifting adjustments

2.17 The deemed source rules will continue to apply even in circumstances where the conditions of subsection 3AA (1) (see paragraph 2.14) are satisfied if the profits of the trust carrying on the funds management activities are adjusted under provisions of the applicable treaty that ensure that the profits of a permanent establishment are determined as if the permanent establishment were an independent entity dealing independently with other parts of the entity and with associated enterprises (arm's length dealing). Such adjustment can be made by the taxpayer themselves (where arm's length prices are used instead of the contracted prices), a debit amendment initiated by the taxpayer or by the Commissioner of Taxation (Commissioner). The deemed source rules will operate to the extent of the adjustment. This will ensure, that even though the profit being attributed to the permanent establishment in Australia may be considered to have its notional source in the treaty partner country, it will be deemed to have a source in Australia and to be taxable in the hands of a non-resident beneficiary here. [Schedule 2, item 1, subsection 3AA(3)]

Example 2.3

A united States (US) funds management trust (US Trust) has a permanent establishment in Australia through which it carries on fund management activities. The permanent establishment borrows $10 million from sources in Australia. The interest rate for this loan is 9.25% (p.a.).

The funds are made available to the head office of the trust in the US which lends the $10 million to Associate Fund. The interest rate on this loan is 9.3% p.a. and the loan is entered into in New York.

Associate Fund lends this $10 million to an unassociated US company at an arm's length rate of 9.4% (p.a.).

US Trust has calculated its taxable profit in Australia on the basis that if its permanent establishment was a distinct and separate enterprise it would have lent the funds at an arm's length interest rate of 9.28% (p.a.). This gives a taxable profit of $3,000 (0.03% of $10 million (per year)).

However, the Commissioner considers that the arm's length interest rate for a loan to an independent party in the circumstances is 9.31% (p.a.). This results in a profit of $6,000 (0.06% of $10 million (per year)). An argument could be raised that part of the Australian permanent establishment's adjusted profit of $6,000 is sourced in the US (the loan funds having been contracted for in the US and the funds made available from accounts in the US). However, as the $6,000 profit is attributable to the permanent establishment in Australia the deemed source rules in our treaties would ensure that the arm's length profit would for assessment purposes be sourced in Australia.

Where a beneficiary is a resident of a treaty partner country and is presently entitled to the income of the trust (in this case all the income of the trust), the adjustment to the trust's income will have an Australian source and be included in the beneficiary's Australian assessable income.

Application and transitional provisions

2.18 The amendments will apply from the beginning of a taxpayer's year of income in which this bill receives Royal Assent and for later years of income. In most instances this will be the year of income commencing on 1 July 2004. However, some taxpayers with substituted accounting periods may not have the amendments apply until their 2005-2006 year of income.

Chapter 3 - Interest withholding tax

Outline of chapter

3.1 Schedule 3 to this bill amends the taxation law relating to interest withholding tax (IWT). It contains three distinct amendments that relate to the imposition of IWT.

•

The first set of amendments broadens the range of financial instruments eligible for IWT exemption by including debt interests.

•

The second amendment treats payments of a non-capital nature made on certain Upper Tier 2 hybrid capital instruments as interest for IWT purposes.

•

The final amendment allows assets and debts to be transferred from Australian subsidiaries of foreign banks to their Australian branches without losing IWT exemptions.

Context of amendments

3.2 The amendments explained in this chapter seek to ensure that the IWT provisions operate as intended in view of other recent developments in the tax law.

3.3 The first set of amendments arises as a consequence of the introduction of the debt/equity rules in 2001. While the concept of interest in the IWT provisions was partially aligned with the new debt/equity rules in 2001, the concepts of 'debenture' and 'offshore borrowing' need to be similarly updated to make the IWT provisions work as intended. This current measure will ensure that payments on financial instruments now treated as debt for tax purposes - including certain redeemable preference shares - will also be exempt from IWT (provided certain conditions are met) if those payments qualify as interest.

3.4 The second amendment complements the Government's decision announced in the Minister for Revenue and Assistant Treasurer's Press Release No. C012/03 of 4 March 2003, to introduce regulations to treat certain Upper Tier 2 capital instruments issued by authorised deposit-taking institutions that are banks as debt for taxation purposes. This amendment ensures that non-capital payments on such instruments are interest for IWT purposes. This change, together with the first set of amendments, will ensure that these payments are exempt from withholding tax in the appropriate circumstances.

3.5 In 2001, changes were made to the IWT legislation to allow non-resident companies (including foreign banks) carrying on business through permanent establishments in Australia to issue debentures that qualify for exemption from IWT. However, the legislation allowing debentures issued after 18 June 1993 to be transferred from Australian subsidiaries of foreign banks to their branches without the loss of IWT exemption was not amended. Therefore, the banks' subsidiaries could not transfer debentures issued after that date to their branches and then wind up their subsidiaries without the loss of the exemption. The final amendment ensures that the IWT exemption is not lost if IWT-exempt instruments are transferred from an Australian subsidiary of a foreign bank to a branch. This will facilitate the transfer of all business from foreign banks' Australian subsidiaries to their Australian branches, if they wish.

Summary of new law

3.6 This bill amends the IWT provisions in Division 11A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936) to:

•

update the references to 'debenture' and 'offshore borrowing' for IWT purposes by adding 'debt interest'; and

•

treat payments made in respect of certain financial instruments - Upper Tier 2 capital - as 'interest' for IWT purposes.

3.7 This bill also amends the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 so that debentures issued after 18 June 1993 that are transferred from Australian subsidiaries of foreign banks to their Australian branches will retain eligibility for the IWT exemption.

Comparison of key features of new law and current law

Detailed explanation of new law

What is interest withholding tax?

3.8 The taxation of Australian sourced interest paid or credited to non-residents, and residents operating through offshore permanent establishments, is dealt with in the IWT provisions contained in Division 11A of Part III of the ITAA 1936. These provisions provide, in conjunction with the Income Tax (Dividends, Interest and Royalties) Withholding Tax Act 1974, that the recipient of Australian sourced interest is subject to withholding tax on the gross amount paid or credited. A rate of 10% of the gross amount of the interest is imposed. The obligation for collecting the IWT is placed on the person making the payment. The provisions define 'interest' and stipulate when an amount of interest is subject to withholding tax.

Interest withholding tax exemptions

3.9 Under certain circumstances, Division 11A of Part III of the ITAA 1936 provides exemptions from IWT. In the context of these proposed amendments the following exemptions are relevant:

•

section 128F of the ITAA 1936^[F1] provides an exemption from IWT where an Australian resident company, or a non-resident company carrying on business at or through a permanent establishment in Australia, issues debentures and the issue satisfies the requirements of the public offer test contained in subsection 128F(3) or (4). In the absence of the exemption, IWT would be payable on the interest paid to foreign debenture holders;

•

a new parallel provision, section 128FA, is being inserted by the New International Tax Arrangements Bill 2003 to provide an exemption in respect of the interest on debentures issued by certain unit trusts, similar to that provided for the interest on debentures issued by companies (by section 128F);

•

section 128GB provides an exemption from IWT on interest paid by offshore banking units on offshore borrowings including interest consisting of gold paid in respect of offshore borrowings.

What is the public offer test?

3.10 As mentioned in the preceding paragraph, a public offer test must be satisfied for interest to be exempt from IWT under section 128F or the proposed section 128FA. The issue of debentures will need to satisfy one of five tests. These tests are satisfied if a debenture is offered:

•

to at least 10 persons who were each carrying on the business of providing finance, or investing or dealing in securities, as participants in financial markets;

•

to at least 100 investors who have acquired debentures in the past or could reasonably be likely to be interested in acquiring debentures;

•

as a result of being accepted for listing on a stock exchange, where the company or trustee of the unit trust had previously entered into an agreement with a dealer, manager or underwriter, requiring the company or trustee to seek such listing;

•

as a result of negotiations being initiated publicly in electronic form, or in another form, that was used by financial markets for dealing in debentures or debt interest; or

•

to a dealer, manager or underwriter for the purpose of placement of the debenture if the dealer, manager or underwriter satisfies one of the previous tests.

3.11 An issue of debentures will always fail the public offer test, with consequential loss of eligibility for the exemption, if at the time of issue the company or trustee was aware or suspected that the debentures would be acquired by the issuing company's or unit trust's associates, other than associates acting in the capacity of a dealer, manager or underwriter. The exemption is also denied if the issuing company or trustee is aware or suspects that the interest in respect of the debentures is being paid to an associate of the company or trust.

Update references to debenture and offshore borrowing

3.12 Part 1 of Schedule 3 introduces the term 'debt interest' into section 128F and the proposed section 128FA so that non-equity shares such as redeemable preference shares and other debt interests may qualify for an IWT exemption (provided certain conditions are met). The use of 'debt interest' reflects the use of 'debt interest' in the Income Tax Assessment Act 1997 (ITAA 1997) and the changes to the meaning of interest following the debt/equity amendments of 2001. [Schedule 3, items 7, 8, 10, 11, 12, 14, 15, 19, 20, 21, 23, section 128F; items 25 to 28, 30 and 31, proposed section 128FA]

3.13 While not all payments on debt interests are classified as interest, the exemptions still only apply to amounts that are interest. Even if made in respect of a debt interest, a payment that is not interest will not qualify for the exemption. In any case, it is unlikely that such payments are subject to withholding tax in the first instance.

3.14 As some debentures pay interest but may not fall within the proposed definition of 'debt interest', the term 'debenture' has been retained. No change to the treatment of interest paid on a debenture is intended by the amendments.

3.15 In order to give effect to the changes to section 128F, the term 'debt interest' has been included in the provisions relating to the deeming of a number of debentures to be a single loan and those relating to global bonds. The definition of security has also been amended to include debt interests. [Schedule 3, item 3, paragraph 128A(5)(a); item 4, subsection 128AE(1); item 24, subsection 128F(10)]

3.16 The modified definition of 'qualifying security' has been amended to include debt interest. This will ensure that where transfers of debentures and debt interests that are qualifying securities give rise to interest, the interest may be exempt from IWT. This amendment is not intended to bring within the IWT provisions debt interests that do not give rise to the payment of interest. [Schedule 3, item 2, subsection 128A(1B)]

3.17 The inclusion of debt interest in the definition of security will update the concept of 'offshore borrowing' in relation to offshore banking units because the definition of 'borrow' in section 128AE includes the raising of finance through the issue of a security. This will make it clear that interest paid on any type of debt interest, including non-equity shares, may qualify for the IWT exemption under section 128GB. It will also clarify the scope of section 128NB.

3.18 The provisions relating to the public offer test, which provide the basis for IWT exemptions for debentures issued by companies and eligible unit trusts, have been amended to include debt interests. The provisions relating to the issue of debentures that always fail the public offer test have been broadened to include interests in debentures or debt interests. [Schedule 3, item 13, subsection 128F(3); item 16, paragraph 128F(5)(a); item 17, subparagraphs 128F(5)(b)(i) and (ii); item 18, paragraph 128F(5)(c)]

3.19 Subsection 128F(8) sets out the conditions that must be satisfied before interest paid on debentures issued through a foreign subsidiary can qualify for the IWT exemption. It provides that, in order to qualify for exemption, the parent company must own all of the issued shares in the subsidiary. An equivalent rule applies to the trustee of an eligible unit trust in subsection 128FA(5). As non-equity shares, such as redeemable preference shares, are treated as debt interests in the IWT exemption provisions, an amendment to this provision is required to ensure that the subsidiary can issue eligible preference shares without losing the IWT exemption. [Schedule 3, item 22, paragraph 128F(8)(a); item 29, proposed paragraph 128FA(5)(a)]

3.20 Where possible the concept of 'debenture' has been broadened to include 'debt interest' in section 128F and the proposed section 128FA. However, some provisions have required modification to this approach to apply 'debt interest' correctly. [Schedule 3, item 6, subsection 128F(1); item 9, subsection 128F(1A)]

Expand the definition of interest to include payments made on capital instruments which are debt interests under regulations

3.21 For prudential purposes, Australian banks have to differentiate their capital between Tier 1 and Tier 2 capital. Upper Tier 2 capital is of a lower quality than Tier 1 capital and is essentially permanent in nature. It includes asset revaluation reserves, general provisions for doubtful debts and certain hybrid capital instruments approved by the Australian Prudential Regulation Authority such as cumulative redeemable shares, mandatory convertible notes and perpetual subordinated debt.

3.22 The Government proposes that Upper Tier 2 capital instruments issued by banks will be treated as debt for taxation purposes. Regulations are to be made to do this. This would mean that returns on this type of instrument paid on or after 1 July 2001 would qualify as tax deductions for the banks.

3.23 The payments on certain types of Upper Tier 2 instruments do not fall within the meaning of interest for withholding tax purposes, nor are they dividends. Therefore, withholding tax would not be payable when the payments were made from Australia to non-residents. To ensure that the payments are subject to IWT they have been included within the meaning of interest for IWT purposes. In the appropriate circumstances, those payments would also qualify for an IWT exemption (e.g. under section 128F) because they are made on debt interests. [Schedule 3, item 45, subsection 128A(1AB)]

The transfer of debentures from Australian subsidiaries of foreign banks to their Australian branches

3.24 Amendments to the IWT provisions in 2001 allowed the branches of foreign banks to issue debentures under section 128F which would be free of IWT. The amendments were intended to remove the costs of operating special Australian subsidiaries that were used to gain access to the exemption, and to avoid double taxation under the thin capitalisation rules when funds raised under section 128F are on-lent by a subsidiary to a branch.

3.25 However, the legislation was not amended to allow debentures that were issued by Australian subsidiaries of foreign banks after 18 June 1993 to be transferred to a branch without forgoing any IWT exemption. Consequently, these debentures were effectively locked into the subsidiary. The amendments in this bill allow IWT-free debentures to move from a subsidiary of the foreign bank to a branch without losing the exemption.

3.26 These amendments are made to the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 which is legislation that fosters the Government's policy of encouraging foreign bank branches in Australia by facilitating the transfer of assets and liabilities from Australian subsidiaries of foreign banks to their Australian branches. The Act achieves this by ignoring the tax effects of the transfers, including preserving the exemption from IWT for borrowings that were exempt from IWT under section 128F prior to their transfer.

3.27 The relevant IWT provisions are contained in section 23 of the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 which operates to modify the operation of section 128F. By it, interest paid by a foreign bank, rather than by its Australian subsidiary, on a liability transferred from the subsidiary will qualify for exemption from IWT when the other requirements of the section continue to be met.

3.28 Presently, section 23 is limited to debentures issued on or before 18 June 1993. This bill extends the IWT exemption to debentures issued after this date by amending paragraphs 2(ca), (cb), (cc) and (cd) of section 23 of the Financial Corporations (Transfer of Assets and Liabilities) Act 1993, to remove the restriction to debentures issued on or before 18 June 1993 and to interest paid after that date. Consistent with the first set of amendments, a reference to debt interests as well as debentures is also included. [Schedule 3, item 46, paragraph 23(2)(ca) of the Financial Corporations (Transfer of Assets and Liabilities) Act 1993]

Application and transitional provisions

3.29 The amendments made by this Schedule (except Part 3) apply to:

•

interest paid on debentures or debt interests issued on or after Royal Assent; and

•

payments made on the relevant capital instruments issued on or after Royal Assent.

3.30 The amendment made by Part 3 of the Schedule applies to debentures or debt interests issued after 18 June 1993 which are transferred on or after Royal Assent. [Schedule 3, item 47]

Consequential amendments

Arising from amendments to section 128F and proposed section 128FA

3.31 As the amendments to section 128F and the proposed section 128FA allow for the returns on certain redeemable preference shares to be exempt from IWT, it is necessary to amend the provisions relating to offshore banking units to ensure that their subsidiaries which issue redeemable preference shares may apply for offshore banking unit status. [Schedule 3, item 5, paragraph 128AE(2)(ba)]

3.32 The definition of 'security' in the provisions relating to offshore banking units has been amended to ensure consistency with that contained in the IWT provisions. [Schedule 3, item 1, section 121C]

3.33 Four sections of Division 820 in the ITAA 1997 (dealing with thin capitalisation) need amending to accommodate the introduction of the concept of debt interest into the IWT provisions. [Schedule 3, items 32 to 35, subsection 820-570(1) of the ITAA 1997; items 36 to 39, subsections 820-591(1) and (2) of the ITAA 1997; item 40, section 820-595 of the ITAA 1997; items 41 to 44, subsections 820-617(1) and (2) of the ITAA 1997]

Chapter 4 - Regulation impact statement

Background

4.1 This bill is a further instalment of reforms announced by the Government following the review of international taxation arrangements. Earlier instalments include the New International Tax Arrangements Bill 2003 and the New International Tax Arrangements (Participation Exemption and Other Measures) Bill 2004, both of which are currently before the Parliament.

4.2 This bill also includes a minor amendment to the interest withholding tax exemption provisions, which was not part of the review of international taxation arrangements. Due to its minor nature, a regulation impact statement is not required for this amendment.

Policy objective

4.3 The reforms in this bill will more closely align the tax treatment of foreign residents that invest in Australian fixed trusts (which then invest in assets) on the one hand, and the treatment of foreign residents that invest directly in the assets, on the other.

4.4 This is intended to remove tax barriers to foreign residents investing in assets through Australian fixed trusts, such as managed funds. In turn, this should improve the international competitiveness of Australia's managed funds industry, enabling the industry to attract more offshore funds for investment in Australian and foreign assets.

Implementation

4.5 The measures in this bill amend aspects of Australia's tax rules that make it unattractive for foreign residents to invest in Australian fixed trusts that derive foreign source income or invest in assets that do not have the necessary connection with Australia. This is because foreign residents that invest in these trusts are currently taxed on a broader range of income and gains than if they had invested directly in the assets.

4.6 The measures in this bill:

•

exempt from tax foreign resident beneficiaries of Australian fixed trusts that are presently entitled to capital gains from assets that do not have the necessary connection with Australia;

•

amend the deemed source rules in Australia's tax treaties so that foreign source income derived by Australian managed funds, to which foreign resident beneficiaries are presently entitled, is not taken to have an Australian source;

•

disregard capital gains and losses made by foreign residents in respect of interests in Australian fixed trusts where the trust's underlying assets do not have the necessary connection with Australia; and

•

provide an exception to CGT event E4 for distributions of foreign source income to foreign resident beneficiaries of Australian trusts.

4.7 The measures addressed in this regulation impact statement arise directly from the recommendations made by the Board of Taxation as part of the review of international taxation arrangements. The implementation options for these measures can be found in the Board of Taxation's report, International Taxation - A Report to the Treasurer (the Board's Report) and the Treasury's consultation paper, Review of International Taxation Arrangements (Consultation Paper).

4.8 Table 4.1 shows where the measures, and principles underlying them, are discussed in the Board's Report and the Consultation Paper.

4.9 Where the Board's Report and the Consultation Paper do not address details in this bill, the implementation options are set out in Table 4.2. The table also sets out options endorsed by the Board of Taxation that were not adopted by the Government in this bill.

Assessment of impacts

4.10 The potential compliance, administrative and economic impacts of the measures in this bill have been carefully considered, by the Board of Taxation and the Government, in consultation with the business community.

Impact group identification

4.11 The measures in this bill will affect foreign resident beneficiaries in Australian fixed trusts, many of which are widely held managed funds. The legal duties of trustees to their beneficiaries, as well as the nature of the funds management industry, mean that trustees and fund managers will also be affected.

4.12 Currently, there are around 2,500 Australian trusts that have one or more non-resident beneficiaries. There is no reliable estimate of how many foreign resident beneficiaries in Australian trusts exist in total. It is expected that the number of foreign resident beneficiaries in Australian trusts will grow once the measures in this bill are operative.

Analysis of costs / benefits

Compliance costs

Exempt from tax foreign resident beneficiaries in Australian fixed trusts that are presently entitled to capital gains from assets that do not have the necessary connection with Australia

4.13 This measure will create for fixed trusts a new category of capital gain, and is expected to impose some additional compliance costs on trustees (and fund managers). These additional compliance costs may include making changes to computer systems - to track and classify the new category of capital gain - and modifying distribution statements provided to investors.

4.14 Although the tracking/classifying obligation is an ongoing one, it is not expected to have a significant impact on fund managers' compliance costs. For example, the Investment and Financial Services Association (IFSA), the peak industry body representing fund managers, said the following in its submission to the Board of Taxation:

"Th[is] option ... can be implemented by fund managers with very little change to existing systems - IFSA members tend to have sophisticated accounting systems, so tracking and classifying the underlying fund assets is a simple exercise."

Amend the deemed source rules in Australia's tax treaties so that foreign source income derived by Australian managed funds, to which foreign resident beneficiaries are presently entitled, is not taken to have an Australian source

4.15 This measure will reduce compliance costs for foreign resident investors in Australian managed funds as they will no longer be subject to Australian tax in respect of the foreign source income of managed funds. The measure will also reduce compliance costs for trustees (and fund managers) as they will no longer be required to withhold tax in respect of the foreign source income.

Disregard capital gains and losses made by foreign resident beneficiaries in Australian fixed trusts (in respect of an interest in the trust) where the trust's underlying assets do not have the necessary connection with Australia

4.16 This measure disregards a capital gain or loss a foreign resident makes in respect of an interest in an Australian fixed trust where the underlying assets of the trust do not have the necessary connection with Australia. This will require trustees (or fund managers) to track the fund's underlying assets. However, as noted above, this is not a complex or costly exercise for most fund managers.

Provide an exception to CGT event E4 when foreign resident beneficiaries in Australian trusts receive distributions of income and gains that are not attributable to foreign sources

4.17 This measure will reduce compliance costs for foreign resident beneficiaries in Australian trusts, in respect of foreign source income, as these taxpayers will no longer be required to undertake cost base reductions and perform other complex calculations required by CGT event E4.

Administration costs

4.18 The Australian Taxation Office (ATO) may incur, as a result of these measures, some initial costs in making changes to its publications and other communication materials and educating its staff about the measures. It may also incur costs in providing advice to taxpayers by public and private rulings. However, none of these costs is likely to be significant.

Revenue costs

4.19 The revenue cost of the tax exemption for foreign resident beneficiaries on capital gains from assets that do not have the necessary connection with Australia is insignificant and has been rounded down to nil for each year from 2004-2005 to 2007-2008.

4.20 The nature of the other three measures in this bill is such that a reliable revenue estimate cannot be provided. However, none of these measures is expected to have a discernible effect on revenue.

Economic benefits

4.21 The reforms in this bill are aimed at removing tax impediments that discourage foreign residents from investing in Australian trusts, including managed funds. This is expected to make Australia's managed funds industry more internationally competitive, enhancing the ability of Australian funds to attract foreign investment. If, as expected, this results in an increased flow of funds into Australian funds it will increase scale and efficiencies in the Australian managed funds industry. This will put downward pressure on the cost of managed fund services which will benefit all investors in Australian managed funds.

Consultation

4.22 As discussed in paragraph 4.7 , the measures contained in this bill arise directly from the recommendations of the Board of Taxation. Those recommendations were the subject of extensive consultation, which began with the release of the Consultation Paper in August 2002. The Board of Taxation consulted widely with the business community (in relation to the options contained in the Consultation Paper) and presented its recommendations to the Government in February 2003.

4.23 Since it announced its response to the Board of Taxation's recommendations in May 2003, the Government has worked closely with industry representatives, tax practitioners and the ATO to develop the measures contained in this bill. This has involved the establishment of an advisory group constituted by members of industry and professional bodies to assist in designing the legislation. The more technical issues and the details of the measures were referred to a particular sub-group including representatives of the managed fund industry, wider business community and practitioners. In addition, direct discussions with taxpayers affected by these measures were undertaken as necessary.

4.24 The ATO and external representatives have had a substantial input on the CGT measures contained in this bill. During the consultation process, it became clear that it is common practice for fund managers to pool their funds and invest in wholesale trusts, which then invest in real assets. This led to the Government making changes to the design of the exemptions to ensure that this industry structure is adequately accommodated.

Conclusion

4.25 The measures in this bill are a further instalment of reforms to implement the Government's response to the review of international tax arrangements. The measures are consistent with the Government's policy objectives of enhancing the competitiveness of Australian based managed funds and removing barriers to Australia's development as a global financial services centre.

4.26 While the measures in this bill may impose some additional compliance and administration costs, the costs are not significant when compared with the expected benefits provided by the measures.

Index

Schedule 1: CGT and foreign residents

Schedule 2: Treaty source rules

Schedule 3: Interest withholding tax