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

Distributions to entities connected with a private company and related issues

Schedule 1 to this Bill amends the Income Tax Assessment Act 1997 to remove the automatic debiting of the private company's franking account when a deemed dividend arises under Division 7A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936).

These amendments also provide the Commissioner of Taxation (Commissioner) with a general discretion to disregard the operation of Division 7A where deemed dividends have been triggered by honest mistakes or inadvertent omissions by taxpayers. In addition, other amendments are made to Division 7A to reduce the extent that taxpayers can trigger a deemed dividend inadvertently. The Fringe Benefits Tax Assessment Act 1986 is also amended so that fringe benefits tax (FBT) does not apply to Division 7A compliant loans. Section 108 of the ITAA 1936 is also being repealed.

Date of effect: In the main, the changes take effect from 1 July 2006. However, the Commissioner's general discretion is retrospective and can be utilised in respect of 2001-02 and later income years. The FBT amendments apply from 1 April 2007.

Proposal announced: This measure was announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 089 of 6 December 2006.

Financial impact: The overall cost to revenue of these amendments is unquantifiable but expected to be minimal against the forward estimates.

Compliance cost impact: These amendments will reduce ongoing compliance costs for private companies, though there will be a small transitional cost.

Summary of regulation impact statement

Regulation impact on business

Impact: Overall the amendments are beneficial to taxpayers and will be welcomed by taxpayers and tax practitioners. This measure will reduce ongoing compliance costs for private companies and reduce tax penalties, especially for the many small businesses that use a company structure.

Main points:

•

Removing the automatic debiting of a company's franking account when a deemed dividend arises will reduce the punitive impact of Division 7A.

•

The Commissioner's new general discretion in Division 7A will allow the Commissioner to provide relief for deemed dividends that have arisen because of honest mistakes or inadvertent omissions by taxpayers.

•

A number of mainly technical amendments will reduce the scope for normal business transactions to trigger a deemed dividend inadvertently, provide more certainty and increase flexibility for taxpayers.

•

The FBT amendment for Division 7A compliant loans will reduce compliance costs as companies will no longer need to consider the application of FBT to loans to employee shareholders.

•

There may be a small increase in transitional costs for taxpayers and their tax practitioners as they become familiar with the changes to Division 7A.

Transitional non-concessional contributions cap

Schedule 2 to this Bill amends the Income Tax (Transitional Provisions) Act 1997 to ensure that certain superannuation contributions (such as those made by a friend) made prior to 1 July 2007 are appropriately subject to a contributions cap.

Date of effect: 7 December 2006.

Proposal announced: This measure was announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 037 of 24 April 2007.

Financial impact: Nil; this is a revenue protection measure necessary for the proper implementation of the Simplified Superannuation reforms.

Compliance cost impact: Nil.

Capital gains of testamentary trusts

Schedule 3 to this Bill amends the Income Tax Assessment Act 1997 to allow a trustee of a resident testamentary trust to choose to be assessed on capital gains of the trust. The capital gains would otherwise be assessed to an income beneficiary (or the trustee on behalf of such a beneficiary) who, under the terms of the trust, would not receive the benefit of the capital gains.

Date of effect: These amendments apply to the 2005-06 and later income years.

Proposal announced: These amendments were announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 074 of 17 October 2006.

Financial impact: The financial impact of these amendments is unquantifiable, but is expected to be low.

Compliance cost impact: The implementation compliance costs are expected to be minimal while ongoing compliance costs are expected to be reduced by $335,000.

Taxation of superannuation death benefits to non-dependants of defence personnel and police killed in the line of duty

Schedule 4 to this Bill amends the Income Tax Assessment Act 1997 to align the tax treatment of lump sum superannuation death benefits paid to non-dependants with that applying to dependants, where the deceased was killed in the line of duty as a member of the Australian Defence Force or any Australian police force, or as an Australian Protective Service Officer.

Date of effect: These amendments will apply to lump sum superannuation death benefit payments received in the 2007-08 income year and later income years.

Proposal announced: This measure was announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 032 of 5 April 2007.

Financial impact: These amendments will have a cost to revenue of $0.2 million per year.

Compliance cost impact: Low.

Thin capitalisation

Schedule 5 to this Bill amends the Income Tax (Transitional Provisions) Act 1997 to extend by one year (from three to four years) a transitional period relating to the application of accounting standards under the thin capitalisation rules.

Under the transitional arrangements, taxpayers subject to the rules may elect to use either current or former accounting standards to determine and value their assets, liabilities and capital for thin capitalisation purposes.

Date of effect: This amendment applies from the date of Royal Assent, such that the transitional period will apply to four consecutive income years commencing on or after 1 January 2005.

Proposal announced: This measure has not previously been announced.

Financial impact: Nil.

Compliance cost impact: This measure is expected to result in a minimal increase in compliance costs.

Repeal of dividend tainting rules

Schedule 6 to this Bill amends the Income Tax Assessment Act 1936 and the Income Tax Assessment Act 1997 to repeal the dividend tainting rules and to make consequential amendments that will:

•

ensure that distributions from a share capital account (including a tainted share capital account) continue to be unfrankable; and

•

modify a general anti-avoidance rule that applies in relation to the imputation system so that, when considering whether to apply the rule, the Commissioner of Taxation can take into account whether a distribution is sourced from unrealised or untaxed profits.

Date of effect: These amendments will apply in relation to distributions made on or after 1 July 2004.

Proposal announced: This measure was announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 080 of 9 November 2006.

Financial impact: Negligible.

Compliance cost impact: Nil.

Clarification of exemption from interest withholding tax

Schedule 7 to this Bill amends the Income Tax Assessment Act 1936 to more closely specify which debt interests are eligible for exemption from interest withholding tax (IWT) in sections 128F and 128FA.

These amendments ensure that the IWT exemption remains consistent with the Government's original policy intent that Australian business does not face a higher cost of capital, or constrained access to capital, consequent to the IWT burden being shifted onto the Australian borrower.

These amendments correct an unintended broadening of the exemption. Closer specification of the range of debt interests eligible for the exemption will realign the exemption to the Government's policy intent and enhance the integrity of the tax system.

Date of effect: 7 December 2006.

Proposal announced: This measure has previously been announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 091 of 7 December 2006.

Financial impact: Nil.

Compliance cost impact: Nil.

Investments in forestry managed investment schemes

Schedule 8 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to provide that initial investors in forestry managed investment schemes (forestry schemes) will receive a tax deduction equal to 100 per cent of their contributions and subsequent investors will receive a tax deduction for their ongoing contributions to forestry schemes, provided that at least 70 per cent of the scheme manager's expenditure under the scheme is expenditure attributable to establishing, tending, felling and harvesting trees (direct forestry expenditure or DFE). The new provision retains the existing principle that the managers of forestry schemes must include the investors' contributions in their assessable income in the year in which the deduction is first available to the investor for those contributions.

This Schedule also amends the ITAA 1997 and the Income Tax Assessment Act 1936 (ITAA 1936) to clarify the tax treatment for sale and harvest proceeds that are received by secondary investors in forestry schemes, and payments made by secondary investors in relation to forestry schemes.

Date of effect: This measure applies to amounts paid by a participant under a forestry scheme on or after 1 July 2007, provided that no other amounts were paid by the participant or any other participant under the scheme before 1 July 2007.

Proposal announced: This measure was announced in the Minister for Revenue and Assistant Treasurer's Press Release No. 097 of 21 December 2006.

Financial impact: This measure will have these revenue implications:

Compliance cost impact: These amendments are expected to have a small impact on compliance costs.

Non-resident trustee beneficiaries

Schedule 9 to this Bill amends the Income Tax Assessment Act 1936 and the Income Tax Assessment Act 1997 to ensure that a trustee can be taxed on net income of the trust in relation to a non-resident trustee beneficiary similar to the treatment of non-resident company and individual beneficiaries. This treatment is, in effect, similar to a withholding system because the beneficiary is still assessed on these amounts but can reduce their tax liability by the tax paid by the trustee.

Date of effect: These amendments generally apply to income years starting on or after 1 July 2006. Changes to the conduit foreign income provisions apply from 1 July 2005, which is when those provisions first applied. The conduit foreign income changes favour the taxpayer.

Proposal announced: This measure was announced in the Treasurer's Press Release No. 039 of 9 May 2006 as part of the 2006-07 Budget.

Financial impact: This measure will have these revenue implications:

Compliance cost impact: This measure will result in a small increase in compliance costs for trustees with foreign trustee beneficiaries.

New withholding arrangements for managed fund distributions to foreign residents

Schedule 10 to this Bill amends the income tax law to expand the existing pay-as-you-go withholding system to cover distributions made to foreign residents, of net income by managed investment trusts attributable to Australian sources (either directly or through certain Australian intermediaries). Income consisting of dividends, interest or royalty income is generally excluded from this measure, as are capital gains on assets other than taxable Australian property.

Date of effect: This measure will apply to income years beginning on or after 1 July following Royal Assent.

Proposal announced: This measure was announced in the Treasurer's Press Release No. 039 of 9 May 2006.

Financial impact: This measure is expected to increase revenue by $10 million in the first year of its application. Thereafter, the measure is expected to increase revenue by $15 million per annum.

Compliance cost impact: The new regime for managed fund distributions to foreign residents is estimated to involve medium costs in relation to once-off implementation of systems changes, and a small ongoing compliance cost to manage ongoing record keeping and information collection obligations. However, the new regime will reduce compliance costs by removing the need for withholders to ascertain whether the foreign resident is an individual, company, trustee or foreign superannuation fund.

Summary of regulation impact statement

Regulation impact on business

Impact: The new withholding arrangements for managed fund distributions to foreign residents will provide the Australian property trust industry (the main distributors of the type of income this measure applies to) with compliance savings by having a single rate applied to distributions to different types of entities. This reduces compliance costs associated with ascertaining what type of entity the foreign resident is.

Main points:

The new withholding regime will simplify and clarify withholding obligations for Australian managed funds (particularly Australian property trusts) and Australian custodians.

As a result of this new regime:

•

Australian managed funds and Australian custodians will no longer need to know whether the foreign investor is a company, individual, trustee or foreign superannuation fund information about which they are unlikely to know; and

•

withholding obligations will be clarified for payments made via an Australian custodian. Payments made via Australian custodians are the common method via which distributions from Australian managed funds are made to foreign residents.

Chapter 1 Distributions to entities connected with a private company and related issues

Outline of chapter

1.1 Schedule 1 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to remove the automatic debiting of the private company's franking account when a deemed dividend arises under Division 7A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936).

1.2 These amendments also provide the Commissioner of Taxation (Commissioner) with a general discretion to disregard the operation of Division 7A where deemed dividends have been triggered by honest mistakes or inadvertent omissions by taxpayers. In addition, other amendments are made to Division 7A to reduce the extent that taxpayers can trigger a deemed dividend inadvertently. The Fringe Benefits Tax Assessment Act 1986 is also amended to exempt Division 7A compliant loans from fringe benefits tax (FBT). Section 108 of the ITAA 1936 is also being repealed.

Context of amendments

1.3 Division 7A is an integrity provision aimed at preventing private companies from making tax-free distributions of profits to shareholders (or their associates). In particular, advances, loans and other payments or credits to shareholders or associates are, unless they come within specified exclusions, treated as assessable dividends to the extent that there are realised or unrealised profits in the company.

1.4 When a deemed dividend arises under Division 7A the private company's franking account is debited and the shareholder or associate pays tax on the deemed dividend at their marginal rate of tax.

1.5 These amendments reduce the extent to which taxpayers can trigger a deemed dividend inadvertently. The amendments also reduce compliance costs for taxpayers, especially for small businesses which use a private company structure. Specifically, the amendments will:

•

reduce the double-penalty nature of Division 7A by removing the automatic debiting of the private company's franking account when a deemed dividend arises under the Division. (The nature of the penalty currently applicable is not considered to be in proportion with the tax mischief involved);

•

provide a discretion to the Commissioner to disregard deemed dividends (or allow them to be franked) where they have been triggered by honest mistakes or omissions by taxpayers;

•

provide a discretion to the Commissioner to disregard a deemed dividend where minimum yearly repayments have not been made on a loan because of circumstances beyond the control of the taxpayer;

•

make technical amendments to Division 7A and related areas of the taxation law to provide more flexibility for taxpayers and to reduce the extent to which they can be caught by Division 7A inadvertently;

•

exempt Division 7A compliant loans from FBT; and

•

repeal section 108 of the ITAA 1936.

Summary of new law

1.6 These amendments will remove the automatic debiting of a private company's franking account when a deemed dividend arises under Division 7A of the ITAA 1936. This applies from 1 July 2006.

1.7 Where a deemed dividend arises under Division 7A because of an honest mistake or inadvertent omission by a taxpayer, the Commissioner will have a general discretion to either disregard the deemed dividend subject to conditions being complied with, or allow the private company taken to have paid the dividend, to choose to frank the dividend.

1.8 The Commissioner will be able to use the discretion in relation to the 2001-02 income year and later income years. This will allow the Commissioner to appropriately handle the situation where taxpayers have triggered a deemed dividend inadvertently because of a past mistake or omission.

1.9 In addition, the Commissioner will have a discretion to disregard a deemed dividend where minimum yearly repayments have not been made on a private company loan because of circumstances beyond the control of the recipient of the loan (generally, the shareholder or an associate of the shareholder).

1.10 A range of other amendments will provide more flexibility by reducing the impact of Division 7A on normal business transactions, including allowing the refinancing of some loans and exempting Division 7A compliant loans from FBT.

1.11 Section 108, the predecessor of the Division 7A legislation, is repealed.

1.12 The Commissioner will be given a maximum of three years to make a franking assessment, in cases where an entity is not required to give the Commissioner a franking return for an income year.

Comparison of key features of new law and current law

Detailed explanation of new law

Removal of the automatic debiting of the private company's franking account

1.13 An amendment is being made to item 8 in the table in section 205-30 of the ITAA 1997. This section provides for the debiting of a company's franking account when a deemed dividend arises under Division 7A of the ITAA 1936. The amendment will remove the debiting of the private company's franking account when a deemed dividend arises under Division 7A. [Schedule 1, item 29, section 205-30 of the ITAA 1997]

1.14 Deemed dividends will, however, continue to be included in assessable income as unfranked dividends in the hands of shareholders or their associates. A consequential amendment is also being made to the simplified outline of Division 7A in section 109B of the ITAA 1936 to reflect this change. [Schedule 1, item 1, section 109B of the ITAA 1936]

Allow payments to be converted to loans

1.15 Under the current law, a 'payment' made by a company to a shareholder or an associate of a shareholder can not be treated as a loan unless it is of the kind contemplated by paragraph 109D(3)(c). Paragraph 109D(3)(c) contemplates payments made on account of, on behalf of or at the request of, a shareholder (or their associate) where there is an express or implied obligation to repay the amount to the private company.

1.16 Where paragraph 109D(3)(c) applies the payment is treated as a loan and it must be repaid or put on a commercial footing before the private company's lodgment day in order to escape being treated as a dividend. In all other cases, once the payment is made there is a triggering of section 109C notwithstanding any subsequent desire to repay the amount.

1.17 Under these amendments, a payment not already covered by paragraph 109D(3)(c) may be converted to a loan and the shareholder or associate will have until the lodgment date for the company's tax return to either repay the loan to the company in full, or enter into a written loan agreement with the company meeting the terms of section 109N. Either of these actions will prevent a deemed dividend arising. [Schedule 1, items 2 and 3, note under subsections 109C(3A) and 109D(4) of the ITAA 1936]

Example 1.1

In 2007-08, XYZ Pty Ltd pays the petrol expenses of a vehicle owned by shareholder Sally, who is under no express or implied obligation to repay the amount.

Under the current law a deemed dividend will be taken to arise to Sally under section 109C. Taking into account these amendments, Sally and XYZ Pty Ltd will now have until the lodgment day of XYZ Pty Ltd's tax return (which will be in the 2008-09 income year) to convert the payment into a loan and repay it or enter into a written agreement that satisfies the criteria in section 109N of Division 7A. If the loan is put under a section 109N written agreement, Sally must then make the minimum yearly repayments on the loan in the 2008-09 and following income years by 30 June of each year.

The private company may need to undertake a journal entry in its accounting records to reflect the loan and reverse what may have been recorded as an expense in its financial statements for the 2007-08 income year. If these have been finalised, an adjustment to retained earnings may be required.

Deemed dividend to be the amount of the underpayment

1.18 Under the current law (section 109E), where the amount paid on an amalgamated loan falls short of the minimum yearly repayment, a deemed dividend will arise and the amount of the dividend is taken to be the amount of the amalgamated loan that has not been repaid at the end of the current year of income, subject to section 109Y (ie, there being a distributable surplus at the end of the year of income).

1.19 Taking into account these amendments, a deemed dividend would still arise in the above scenario. However, the amount of the deemed dividend will be the amount of the shortfall in the amount of repayments, not the outstanding balance of the loan. That is, the dividend amount would be the difference between the minimum yearly repayment and the amount paid in the current year. [Schedule 1, items 4, 5 and 9, paragraph 109E(1)(c) and subsection 109E(2) of the ITAA 1936]

1.20 Where minimum yearly repayments have not been made and a deemed dividend arises, the shareholder or the associate will still have the shortfall amount as an outstanding debt with the private company. The shareholder can either make the shortfall payment or ask the company to forgive that amount of the debt. The debt forgiveness of this amount would not trigger a deemed dividend as a result of the new subsections 109G(3A) and (3B). [Schedule 1, items 4, 5 and 9, paragraph 109E(1)(c) and subsection 109E(2) of the ITAA 1936]

1.21 Alternatively, the company could use section 109ZC. A later dividend could be declared and used to offset the deemed dividend (with the agreement of the shareholder). The later dividend will not be included in the shareholder's assessable income to the extent it is unfranked.

1.22 A subsequent change is also made to paragraph (a) in the definition of 'repayments of non-commercial loans' in subsection 109Y(2) of the ITAA 1936 to include any repayments of shortfall amounts previously taken to be dividends under section 109E. [Schedule 1, item 18, subsection 109Y(2) of the ITAA 1936]

Example 1.2

GHI Pty Ltd has made a $100,000 loan to one of its shareholders, Ben. The minimum yearly repayment on the loan is $20,000 reflecting principal of $13,000 and interest of $7,000. Ben, however, only manages to repay $19,000 during the first income year after the loan was made. Under the current law, a deemed dividend would therefore arise equal to the outstanding balance of the loan, which is $88,000. Taking these amendments into account, a deemed dividend would still arise, but the amount will be the amount of the underpayment, which is $1,000 (ie, $20,000 less $19,000).

1.23 Because of these changes, a subsequent amendment is also made to subsection 109G(3) to prevent double taxation when a loan or shortfall amount is subsequently forgiven. If the company forgives the debt, the amount of the deemed dividend that arises because of the debt forgiveness will be reduced by the amount of any shortfalls previously treated as dividends in relation to the loan. [Schedule 1, items 7 and 9, subsections 109G(3A) and (3B) of the ITAA 1936]

Example 1.3

Following Example 1.2, GHI Pty Ltd decides to forgive the outstanding loan in the next income year. Because of the amendment, the amount of the deemed dividend will be only $87,000 (ie, the amount of the actual debt being forgiven, which is $88,000 less the shortfall amount previously treated as a deemed dividend, being $1,000).

Allow refinancing of loans

1.24 Loans that meet the minimum interest rate and maximum term criteria under section 109N do not trigger a deemed dividend. One of the criteria is the maximum term of a loan, which is 25 years if:

•

100 per cent of the value of the loan is secured by a mortgage over real property that has been registered in accordance with a law of a state or territory; and

•

when the loan is first made, the market value of that real property (less the amounts of any other liabilities secured over that property in priority to the loan) is at least 110 per cent of the amount of the loan.

For loans not secured by a mortgage over real property, the maximum term is seven years.

1.25 Subsection 109R(2) provides that a payment must not be taken into account (in regard to determining whether a loan has been repaid in whole or in part in the year in which it was made, or in determining whether a minimum yearly payment has been made) if a reasonable person would conclude (having regard to all the circumstances) that when the payment was made the entity intended to obtain a loan from the private company of an amount similar to or larger than the payment. This provision prevents loans from being continually refinanced, effectively never being repaid and thus avoiding the operation of Division 7A.

1.26 If payments are disregarded, a deemed dividend arises. These amendments will allow some genuine refinancing of loans between a company and a shareholder or an associate of a shareholder without the potential for a deemed dividend to arise.

1.27 Subsection 109R(5) is inserted so that a loan can be refinanced without triggering a deemed dividend under subsection 109R(2) when a private company loan becomes subordinated to another loan from another entity (such as a bank), and the refinancing of the private company loan by the shareholder or associate takes place because of that subordination. The subordination must have arisen because of circumstances beyond the control of the shareholder/associate, and the parties that made the loans must be dealing with each other on an arm's length basis. [Schedule 1, item 12, subsection 109R(5) of the ITAA 1936]

Example 1.4

JKL Pty Ltd has made a loan of $10,000 to a shareholder, Steve. The loan meets the minimum requirements stipulated by section 109N and Steve is making the minimum yearly repayments. Steve also has a loan of $50,000 from MNO Bank, which he defaults on. As a result, MNO Bank requires the loan from JKL Pty Ltd to be subordinated to the loan from MNO Bank. Because of the subordination, the shareholder must make the required payments on the loan with the bank before any repayments can be made on the loan with the private company. Under this amendment, Steve could refinance the loan with the private company to, for example, extend the term and reduce the minimum yearly repayments.

1.28 Section 109N is amended and subsections 109R(6) and (7) are inserted to allow loans to be refinanced in certain circumstances without a deemed dividend being triggered.

1.29 An unsecured loan can be converted to a loan secured by a mortgage over real property with a longer maximum term. The maximum term of such a loan is 25 years, less the period of the term already expired in the old loan. Division 7A operates with the concept of an amalgamated loan (which could comprise of one or more constituent loans with the private company). When the term of an existing loan is simply extended because of a mortgage, a new amalgamated loan is taken to be made in the income year prior to the income year in which the extension takes place. [Schedule 1, items 6, 10 and 12, subsections 109E(3A) and (3B), 109N(3A) and (3B) and 109R(6) of the ITAA 1936]

Example 1.5

DEF Pty Ltd makes an unsecured loan of $10,000 to one of its shareholders, Greg. The term of the loan is seven years. After three years, the old loan is refinanced (ie, the old loan is repaid and a new loan secured by a mortgage over real property is created with the private company). In the written agreement governing the new loan, the maximum term will be 22 years (25 years less 3 years).

Example 1.6

Using the same details as per Example 1.5, DEF Pty Ltd simply agrees to extend the term of the existing loan and a new written agreement is made. The extended maximum term will still be 22 years. For Division 7A purposes the new subsection 109E(3B) treats the varied loan as a new amalgamated loan having been made just before the start of the income year in which the loan term is extended. Therefore, minimum yearly repayments will still be required in that income year calculated in accordance with section 109E.

1.30 A loan secured by a mortgage over real property can be refinanced with an unsecured loan. The maximum term of the new loan can be seven years if the actual term of the old loan to date was less than 18 years. If the secured loan has already been in place for more than 18 years, the maximum term of the new unsecured loan will be reduced so that the total term of the loan (in both its secured and unsecured form) will be no more than 25 years. If the actual term of the old loan up until the time the loan is refinanced exceeds 18 years, the maximum term of the new loan is seven years reduced by the number of years in excess of 18 years. [Schedule 1, items 10 and 12, subsections 109N(3C) and (3D) and 109R(7) of the ITAA 1936]

Example 1.7

Hilda Pty Ltd has made a loan secured by a mortgage over real property to an associate of a shareholder, Sachin. The term of the loan was 25 years. However, after 20 years, the terms of the loan are changed and it is no longer secured by a mortgage over real property. If the expired term of the old secured loan was less than 18 years, the maximum term of the new loan will be seven years. However, in this particular instance, the original secured loan had already been in place for more than 18 years. As a result, in the written agreement governing the new loan, the maximum term of the loan can be five years,

(ie, 7 years - (20 years - 18 years) = 5 years).


The Commissioner's power to disregard the operation of Division 7A or allow a dividend to be frankable

1.31 New section 109RB allows the Commissioner to either disregard a deemed dividend that arises under Division 7A or allow a private company to choose to frank a deemed dividend that it has been taken to pay. [Schedule 1, item 13, section 109RB of the ITAA 1936]

1.32 The provision requires a two stage process. The Commissioner can only act if the failure to satisfy the requirements of Division 7A is the result of an honest mistake or inadvertent omission by any of the following:

•

the recipient (the shareholder or an associate of the shareholder);

•

the private company that makes the payment or loan or that is taken to pay the dividend under Division 7A; or

•

any other entity whose conduct contributed to the deemed dividend arising under Division 7A (this could include, for example, an interposed company or trust that makes a payment or loan to a shareholder or an associate of the shareholder of the private company).

[Schedule 1, item 13, paragraph 109RB(1)(b) of the ITAA 1936]

1.33 Whether or not there is an honest mistake or inadvertent omission is an objective question to be determined by reference to all the circumstances surrounding the failure to satisfy the requirements of Division 7A. In practice, the taxpayer will need to demonstrate to the Commissioner that the failure was the result of an honest mistake or inadvertent omission. [Schedule 1, item 13, paragraph 109RB(1)(b) of the ITAA 1936]

1.34 Once it is established that there is an 'honest mistake or inadvertent omission', the Commissioner is then empowered to make a decision. In considering whether to exercise his power in favour of a taxpayer, the Commissioner must have regard to the following:

•

the circumstances that led to the mistake or omission which caused the deemed dividend to arise;

•

the extent to which the relevant taxpayer(s) had acted to try to correct the mistake or omission, and if so how quickly that action was taken after the mistake or omission was identified;

•

whether Division 7A had operated previously in respect of the relevant taxpayers, and if so, the circumstances in which this occurred, for example, if the Commissioner had previously exercised his power under this provision in relation to the entity that made the mistake or omission; and

•

any other matters that the Commissioner considers relevant, for example, the quantum of sums involved.

1.35 However, in making that decision the Commissioner must consider all of the relevant factors in the context of the particular circumstances of each individual taxpayer. The respective weighting of each factor depends on the actual circumstances of the case. The shareholder or the private company or both may apply to the Commissioner to exercise his power to disregard a deemed dividend. Alternatively, the Commissioner may make a decision under this provision without being asked to do so by the company or shareholder. [Schedule 1, item 13, subsection 109RB(3) of the ITAA 1936]

1.36 An examination of the circumstances that led to a mistake or omission provides an opportunity to consider both the nature and extent of the mistake or omission. There is a very wide range of possible mistakes or omissions that would result in Division 7A deeming there to be a dividend paid to a taxpayer. For example, there may be a complete failure to make any minimum yearly repayment over a long period of time, or there may be a simple miscalculation of the minimum yearly repayment in one year. Likewise, there is a wide spectrum of circumstances in which there might be a failure to satisfy the requirement for a written loan agreement under section 109N. For example, there may be no agreement of any kind, or there may be a written agreement that satisfies all the requirements of the provision other than for an interest rate slightly lower than that required by the law.

1.37 No action by a taxpayer can alter the operation of Division 7A once that Division has deemed a dividend to have been paid to a taxpayer; it is only the Commissioner who can act to undo the deeming. However, a taxpayer can act to correct the mistake or omission that resulted in the deemed dividend. For example, if the relevant mistake was a failure to enter into a written loan agreement, then the company and its shareholder could enter into a loan agreement that satisfies the requirements of section 109N. By way of another example, if the relevant mistake was a failure to pay the full amount of the minimum yearly repayment then the shareholder could repay the outstanding amount, and ensure that the correct amount is repaid in the future.

1.38 The Commissioner may make a decision subject to specified conditions. This will allow the Commissioner to require that the mistake or omission that gave rise to the failure to satisfy Division 7A be corrected within a specified time period. For example, the Commissioner could require that:

•

loan documentation be put in place that meets the criteria in section 109N; and/or

•

if the minimum yearly repayments have not been made by the due date, that the minimum amounts be paid by a later specified date.

[Schedule 1, item 13, subsection 109RB(4) of the ITAA 1936]

1.39 If the conditions are not met then the deemed dividend will not have been disregarded. [Schedule 1, item 13, subsection 109RB(5) of the ITAA 1936]

1.40 If a deemed dividend is disregarded because the Commissioner makes a decision under section 109RB, then had there previously been a debit to the private company's franking account because of the deemed dividend, the private company's franking account can be re-credited by the amount of the debit.

1.41 The Commissioner may make a decision that the private company can choose to frank the deemed dividend in accordance with Part 3-6 of the ITAA 1997. If the private company does frank the dividend, the private company's franking account will be debited as per item 1 in the table in section 205-30 of the ITAA 1997. [Schedule 1, items 13 and 28, subsection 109RB(6) of the ITAA 1936 and subparagraph 202-45(g)(i) of the ITAA 1997]

1.42 The Commissioner's discretion to allow dividends to be franked would apply only where the dividend is made to a shareholder, not to an associate of the shareholder. The Commissioner will not be able to make a decision to permit the franking of a deemed dividend that arose before the 1 July 2002, the commencement of the simplified imputation system. [Schedule 1, subitem 43(4 )]

1.43 Amounts included as if they were dividends in the assessable income of a particular entity under Subdivision 7A-EA are not frankable as the private company is not taken to pay the dividend in these circumstances.

Example 1.8

A private company makes a loan to a shareholder in the 2007-08 income year for $100,000. In making the loan, a written agreement is prepared and the term of the loan is seven years.

However, after the return for the 2008-09 income tax year has been lodged the shareholder discovers that the company had made a mistake and advised the shareholder of the wrong interest rate when calculating the minimum yearly repayment. The shareholder only made minimum repayments of $19,000 in 2008-09 instead of the required $20,000. A deemed dividend has arisen as the repayments were lower than required. Once the shareholder realised the payments were lower than required he corrected that mistake by paying an additional $1,000 in the 2009-10 income year to catch-up on the lower payments. The shareholder also immediately advised the Commissioner that lower repayments had been made and that they would like the Commissioner to exercise the discretion.

In order for the Commissioner to exercise his power under this provision it must be established that the failure to pay the minimum yearly repayment was the result of an honest mistake or inadvertent omission. In determining whether there was such a mistake or omission, evidence of the company and shareholder's attempt to comply with the requirements of Division 7A (eg, by making yearly repayments in respect of the loan) would be relevant, as would evidence as to why the wrong interest rate was used in the calculation of the minimum yearly repayment amount.

In considering whether to exercise his power in favour of the taxpayer, the Commissioner would have regard to the following:

•

that there was a loan agreement in place between the company and the shareholder that satisfied all of the requirements of section 109N;

•

the use of the wrong interest rate to calculate the minimum yearly repayment resulted in a relatively small underpayment;

•

once the shareholder discovered the mistake, the taxpayer took action to promptly advise the Commissioner of the mistake; and

•

the shareholder took steps to correct the mistake and to discharge their legal obligation under the loan agreement to make a minimum yearly repayment of $20,000.

Example 1.9

In the 2007-08 income year, the Commissioner undertakes an audit on ABC Pty Ltd. In the course of the audit, the Commissioner discovers that a loan was made to a shareholder in the 2005-06 income year. There was no documentation supporting the loan but loan repayments were made, albeit at a rate that was less than the benchmark rate for the income year. The company and shareholder both state that they thought loan documentation was not necessary provided the interest charged was commercial in nature.

Since there was no loan agreement and the minimum yearly repayments made in 2006-07 were less than would be required to meet the terms of section 109E, a dividend was deemed to have been paid to the relevant shareholder.

In order for the Commissioner to exercise his power under this provision it must be established that the failure to enter into a loan agreement that satisfies the requirement of section 109N, and the failure to pay the minimum yearly repayment was the result of an honest mistake or inadvertent omission. Again, evidence of the shareholder attempting to comply with the intent of Division 7A (eg, by making yearly repayments in respect of the loan) would be relevant when determining if there had been an honest mistake or omission.

In considering whether to exercise his power in favour of the taxpayer, the Commissioner would have regard to the following:

•

the nature of the two mistakes;

•

the level of interest actually charged by the company on the loan;

•

the actual making of yearly repayments on the loan for each year since the loan was entered into; and

•

whether Division 7A has operated previously in respect of either the private company or the shareholder.

As a condition of exercising his power the Commissioner could require that there be a written loan agreement that satisfied all of the requirements of section 109N and for the shareholder to make additional payments equal to the difference between the actual repayments made and the repayments that would have been made if the shareholder had satisfied the requirements of section 109E.

Example 1.10

A business consists of a private company (ABC Pty Ltd) and XYZ trust. Both entities are controlled by Sam and Mel. The trust's beneficiaries are Sam and Mel and they are also shareholders of the company. The trust owns land and buildings which are mortgaged to a financial institution. The company has a loan with a different financial institution. The interest on both loans is tax deductible as the loans are used for income generating purposes.

In the 2005-06 income year the company and the trustee of the XYZ trust decide to consolidate their debts. The company extends its pre-existing loan facility and pays out the loan that the trust has with its bank.

Since the trust estate is an associate of the shareholders of ABC Pty Ltd, Division 7A will deem a dividend to be paid by the private company to the trustee of the XYZ trust as a deemed shareholder in ABC Pty Ltd. Upon discovering the situation the trustee applied to the Commissioner to exercise his power to disregard the deemed dividend as soon as it became aware that Division 7A deemed a dividend to have been paid.

In order for the Commissioner to exercise his powers under this provision either the company or the trustee will need to establish that the relevant officers and employees of the private company and the trustee made an honest mistake as to the operation of Division 7A to the debt consolidation.

In considering whether to exercise his power in favour of the taxpayer, the Commissioner would have regard to the following:

•

the circumstances surrounding the mistake or omission, including the amount of the deemed dividend;

•

the commercial nature of the transaction between the company and the trust; and

•

that once the taxpayers discovered the problem they brought the matter to the Commissioner's attention.

As a condition of exercising his power the Commissioner could require that there be a written loan agreement that satisfied all of the requirements of section 109N be entered into between the company and the trustee and for the trustee to make catch-up minimum yearly repayments.

Example 1.11

Fred and Jen operated a number of separate businesses through different entities including a private company and a trust. They were the trustees of the trust and the only shareholders and directors of the private company. The beneficiaries of the trust are Fred and Jen and members of their immediate family.

During the 2005-06 income year the trust was incurring substantial losses due to a downturn in business conditions. As no other source of funds were available the private company made loans to the trust for working capital purposes during the year.

There were no qualifying section 109N written agreements put in place before the lodgment day of the private company's 2005-06 tax return and no loan repayments had been made to the private company. However, the loan is recognised in the balance sheets of the private company and the trust and the loan is minuted along with a note that the trust is envisaged to resume profitability by the 2008-09 year at which time loan repayments will commence. Division 7A had not operated previously in relation to the private company or the trustee.

In preparing the 2005-06 income tax returns Fred and Jen considered the application of Division 7A but mistakenly believed that only loans to individual shareholders would be subject to Division 7A. Fred and Jen sought tax advice during the 2006-07 income year and the Division 7A problem in the 2005-06 year was immediately brought to their attention. Fred and Jen promptly advised the Commissioner of the mistake.

In considering whether to exercise his power in favour of the trust, the Commissioner would have regard to the following:

•

the fact that the mistake was the result of a misreading of the legal requirements of Division 7A;

•

the relatively short period of time that has elapsed between the year in which the dividend was deemed to be paid and the notification to the Commissioner;

•

the relatively short period of time that has elapsed between when the mistake was identified and the notification to the Commissioner;

•

whether there was any reasonable prospect that the trust would be able to repay the loan, and if so when;

•

the disclosure of the transaction as a loan in the balance sheets of the private company and trust;

•

the quantum of the sums involved; and

•

that Division 7A had not operated previously in relation to the private company or the trustee.

As a condition of exercising his power the Commissioner could require that there be a written loan agreement put in place that satisfied all of the requirements of section 109N and that the trustee make additional payments equal to the difference between the actual repayments made and the repayments that would have been made if the trustee had satisfied the requirements of section 109E.

Example 1.12

In the 2007-08 income year, the Commissioner undertakes an audit of EFG Pty Ltd. In the course of the audit, the Commissioner discovers that an interest-free at call loan was made to a shareholder in the 2005-06 income year. There was no documentation supporting the loan and no repayments have been made. Nor was the loan disclosed in the company's books of account. In addition, the loan was made out of income that was not disclosed in the tax return of EFG Pty Ltd for the 2005-06 income year.

On the basis of the objective evidence, the taxpayer has failed to establish that the deemed dividend was the result of an 'honest mistake or inadvertent omission'. Rather it appears that the company has deliberately ignored the operation of Division 7A and has simply sought to distribute undisclosed profits to a shareholder. In such a situation the prerequisite for the Commissioner to exercise his power in subsection 109RB(2) has not been satisfied.

Example 1.13

In the 2007-08 income year, the Commissioner undertakes an audit on ABC Pty Ltd. In the course of the audit, the Commissioner discovers that a loan was made to a trust that is an associate of a shareholder of the private company in the 2005-06 income year. There was no documentation supporting the loan but loan repayments were made, albeit at a rate that was less than the benchmark rate for the income year. The directors of the company and the trustee believed that loan documentation was not necessary provided the interest charged was commercial in nature.

As there was no loan agreement which met the requirements of section 109N put in place by the required time a deemed dividend is taken to have arisen in the year the loan was made. The amount of the deemed dividend is the balance of the loan outstanding just before the company's lodgment day for the income year.

If there has been an honest mistake or inadvertent omission then, in considering whether to exercise his power in favour of the taxpayer, the Commissioner would have regard to the following:

•

the level of interest charged by the company on the loan; and

•

whether either the private company or the trust had enforcement action undertaken by the Commissioner in respect of any other deemed dividends in the current or earlier years.

As a condition of exercising his power the Commissioner could require that there be a written loan agreement put in place that satisfied all of the requirements of section 109N and that the trustee make additional payments equal to the difference between the actual repayments made and the repayments that would have been made if the trustee had satisfied the requirements of section 109E.

Franking deemed dividends because of a marriage or relationship breakdown

1.44 Under the current law, transfers of property and other 'payments' in respect of marriage or relationship breakdown are caught by Division 7A even though they may be non-voluntary (eg, due to a court order). As such a deemed dividend may arise.

1.45 The amendment provides that deemed dividends arising from 'payments' in respect of marriage or relationship breakdown, may be frankable by the private company taken to pay the deemed dividend. The dividend may be franked irrespective of whether it was made to a shareholder or associate of the shareholder (eg, an ex-spouse). [Schedule 1, items 13 and 28, section 109RC of the ITAA 1936 and subparagraph 202-45(g)(i) of the ITAA 1997]

1.46 The private company may frank the dividend in accordance with Part 3-6 of the ITAA 1997, subject to the dividend being franked at the private company's benchmark franking percentage for the period in which the dividend is taken to be paid, or if no franking percentage exists, at 100 per cent. [Schedule 1, item 13, subsection 109RC(3) of the ITAA 1936]

1.47 If the private company franks the dividend, the private company's franking account will be debited (as per item 1 in the table in section 205-30 of the ITAA 1997).

1.48 The dividend may only be franked in the same circumstances that CGT roll-over relief applies in relation to relationship breakdowns.

1.49 Examples of where deemed dividends (arising because of a 'family law obligation') may be franked under the new law can be found in subsection 126-5(1) of the ITAA 1997. They include (but are not restricted to):

•

a court order under the Family Law Act 1975 or a corresponding foreign law;

•

a maintenance agreement approved by a court under section 87 of that Act or a corresponding agreement approved by a court under a corresponding foreign law; or

•

a court order under state law, territory law or foreign law relating to de facto marriage breakdowns.

[Schedule 1, item 23, definition of 'family law obligation' in section 109ZD of the ITAA 1936]

Example 1.14

Jack and Stephanie divorce. Stephanie owns and controls private company BCD Pty Ltd. The Family Court orders Stephanie to transfer the private company's motor vehicle to Jack as part of the property settlement. This transaction will trigger a deemed dividend under Division 7A. The amendments will allow the dividend to be franked like other dividends that the private company declares in the income year that it transfers the motor vehicle to Jack.

Discretion for the Commissioner to disregard a deemed dividend and extend the time for making minimum yearly repayments.

1.50 New section 109RD provides the Commissioner with a discretion to disregard a deemed dividend where the recipient of a private company loan (ie, the shareholder or an associate of the shareholder) was unable to make the minimum yearly repayments because of circumstances beyond their control. The Commissioner can specify a later time by which the minimum yearly repayments must be made. [Schedule 1, item 13, section 109RD of the ITAA 1936]

1.51 Circumstances that may be outside the control of the recipient of a private company loan could include:

•

the shareholder has been in an accident and hospitalised and can not make the minimum yearly repayments;

•

the shareholder has been hospitalised because of an illness and can not make the minimum yearly repayments;

•

the shareholder is prevented from making the minimum yearly repayments because their assets have been frozen by a court; or

•

the shareholder may have another loan with a third party, for example a bank, and through a subordination of the private company loan, the shareholder is prevented from making any payments on the private company loan.

1.52 This provision does not need to consider whether the recipient will suffer undue hardship as these circumstances are already covered by the Commissioner's existing discretion in section 109Q.

Example 1.15

XYZ Pty Ltd provides its shareholder Bill with a secured loan. Bill also has a loan with ABC bank which was taken out before the private company loan. Because of events outside Bill's control, he defaults on the bank loan and as a result the bank requires Bill's loan with the private company to be subordinated to its loan. As a result of this subordination, the bank prevents Bill from making any repayments on the private company until the bank's loan is brought up to date. By not making the required minimum yearly repayments, a deemed dividend will arise in the relevant income year.

Bill may apply to the Commissioner to exercise his discretion to disregard the deemed dividend and extend the time in which to make the minimum yearly repayments. If the Commissioner is satisfied that the circumstances that led to Bill not being able to make the minimum yearly repayments were beyond his control, he may exercise his discretion to disregard the deemed dividend and extend the time for making the repayments. Bill would need to continue to apply to the Commissioner in each subsequent year if the problem persisted.

Loan guarantees

1.53 Under the current law, where a private company guarantees a loan made by a third party to a shareholder and the private company is required to make a payment to the third party because the shareholder defaults on the loan, the payment is treated as a deemed dividend from the private company to the shareholder. Furthermore, the loan that arises between the company and the shareholder is also a loan (a common law debt) to which Division 7A applies.

1.54 The amendment to section 109UA exempts guaranteed loans where the shareholder (or associate) enters into a loan agreement with the private company and that loan meets the requirements of section 109N. Neither the loan guarantee liability that arises when the guarantor pays on the defaulting loan, nor the common law debt that arises between the private company and the shareholder (or their associate) will trigger a deemed dividend in these circumstances. [Schedule 1, item 14, subsection 109UA(5 )]

Example 1.16

ABC Bank Pty Ltd has made a loan to Mary, who is a shareholder of XYZ Pty Ltd, which guarantees Mary's bank loan. However, Mary defaults on the bank loan and XYZ Pty Ltd becomes liable to make a payment to the bank. This liability, which is not a contingent liability, will cause a deemed dividend to arise, unless XYZ Pty Ltd and Mary enter into a loan agreement (in respect of the common law debt) that meets the minimum interest rate and maximum term criteria in section 109N and minimum yearly repayments are made in subsequent income years.

Loans involving interposed entities

1.55 The current law does not allow a loan made by an interposed entity to a shareholder of a private company to be an excluded loan under section 109N or for any repayments of such a loan to be repayments for the purposes of section 109E. The amendment to subsection 109X(2) and new subsections 109X(3) and (4) have the effect of allowing:

•

a loan agreement between the interposed entity and the shareholder or associate (that meets the criteria of section 109N) to be treated as a loan between the private company and the shareholder or associate for Division 7A purposes; and

•

repayments made by the shareholder or associate against the actual loan with the interposed entity to be taken to be repayments of the notional loan between the private company and the shareholder or associate. Repayments are determined having regard to the amount of the notional loan worked out under subsection 109W(3) of the ITAA 1936.

[Schedule 1, item 15, subsection 109X(4 )]

Example 1.17

DEF Pty Ltd makes a payment to ABC Pty Ltd. Under an arrangement with DEF Pty Ltd, ABC Pty Ltd on loans that amount to one of DEF Pty Ltd's shareholders, that is, Julie. A loan agreement is in place between ABC Pty Ltd and Julie that meets the criteria in section 109N. Under the current law, a deemed dividend would arise under this arrangement as DEF Pty Ltd would have been taken to pay a dividend to Julie (subject to an available distributable surplus). However, the amendments to subsection 109X(2) and new subsections 109X(3) and (4) will treat the loan agreement between ABC Pty Ltd and Julie as the relevant agreement for the purpose of section 109N and a deemed dividend will not arise so long as minimum yearly repayments are made in accordance with section 109E in subsequent income years (item 15 and subsections 109X(2) to (4)).

Calculation of distributable surplus

1.56 Section 109Y of the ITAA 1936 provides a formula for calculating whether the private company has a distributable surplus in the income year that a deemed dividend arises. If a private company has no distributable surplus, then the amount of a deemed dividend will be nil. The amount of the deemed dividend can not exceed the private company's distributable surplus.

1.57 Under subsection 109Y(2), if the Commissioner considers that the company's accounting records significantly undervalue its assets or overvalue its provisions, he may substitute a value that he considers is appropriate. The amendments extend this power so that the Commissioner may also substitute values if he considers that the company's accounting records significantly overvalue its assets or undervalue its provisions. [Schedule 1, items 16 and 17, subsection 109Y(2) of the ITAA 1936]

Payment of an offset dividend not taxable when a deemed dividend arises - technical correction to section 109ZC

1.58 Under the current law, section 109ZC of the ITAA 1936 is designed to prevent double taxation where a later dividend distributed by a private company is offset against an amount already treated as a dividend paid by the company. The later dividend set off (to the extent that it is unfranked) is not assessable income up to the amount of the deemed dividend. However, there is a concern that double taxation may arise if the borrower is not the shareholder of the company, but an associate. These amendments will allow later distributions of dividends to be applied by a shareholder to offset amounts of deemed dividends previously taken to be paid to an associate of a shareholder, but only to the extent of the amount of the deemed dividend previously taken to be paid. [Schedule 1, items 19 and 20, subsection 109ZC(2) of the ITAA 1936]

Example: 1.18

ABC Pty Ltd makes a loan to Mel, who is an associate of one of its shareholders, Ben. Ben has an arrangement with ABC Pty Ltd that any dividends declared are to be put towards repaying the loan that Mel has with ABC Pty Ltd. Mel also makes payments. Mel has defaulted on the loan and a deemed dividend has arisen under Division 7A.

ABC Pty Ltd declares a dividend to shareholders. Under Ben's arrangement with ABC Pty Ltd the full amount of his dividend is applied to reduce the amount of Mel's loan, partially offsetting the amount of the deemed dividend that was previously taken to have been paid to Mel. This later dividend, up to the amount of the deemed dividend previously taken to be paid, will not be treated as assessable income to the extent that it is unfranked.

Division 7A - excluded loans / FBT interactions

1.59 The FBT amendment directly removes the FBT consequences of making a loan to a shareholder who is also an employee, where the loan meets the excluded loan requirements in section 109N of the ITAA 1936. These amendments reduce compliance costs for taxpayers with these types of loan arrangements, because they do not need to consider the application of FBT to the loans. The minimum interest rate requirements in Division 7A provide sufficient integrity around the making of loans by private companies to shareholders.

1.60 These amendments exclude loans that would give rise to deemed dividends, were it not for section 109N of the ITAA 1936, from the definition of 'fringe benefit' in subsection 136(1) of the Fringe Benefits Tax Assessment Act 1986. Basically, this means that any loan that meets the conditions in section 109N of the ITAA 1936 will not be a fringe benefit.

1.61 In the year that a loan is made, two groups of loans are excluded from the definition of 'fringe benefit':

•

loans that give rise to deemed dividends under section 109D of the ITAA 1936 (because of existing paragraph (r) of the definition of 'fringe benefit' in the Fringe Benefits Tax Assessment Act 1986 which excludes anything that gives rise to a deemed dividend under Division 7A); and

•

loans that would give rise to deemed dividends under section 109D, were it not for meeting the requirements of section 109N.

[Schedule 1, items 30 to 32, subsection 136(1), paragraph (s) of the definition of 'fringe benefit' of the Fringe Benefits Tax Assessment Act 1986]

Example 1.19

Zoe, a shareholder and employee of Small Company Pty Ltd, is provided with a loan by Small Company Pty Ltd on 1 August 2007. The loan documents for the loan are finalised on 1 March 2008, and meet the excluded loan requirements in section 109N of Division 7A. No repayments (including interest) are payable on the loan until 1 July 2008.

Loan benefits may arise in the 2007-08 and the 2008-09 FBT years because no interest is paid. However, as the loan meets the requirements to be an excluded loan under section 109N, the loan is not a fringe benefit. The fact that Zoe does not pay interest does not result in an FBT liability for Small Company Pty Ltd.

1.62 In subsequent years, loans that form part of an amalgamated loan under section 109E are not subject to FBT. This is because, under existing paragraph 109E(3)(b), for a loan to be a part of an amalgamated loan under section 109E, the loan must be a loan to which section 109D would have applied, were it not for section 109N. This means that it will be excluded from the definition of 'fringe benefit' under the new provision. [Schedule 1, items 30 to 32, definition of 'fringe benefit' in subsection 136(1) of the Fringe Benefits Tax Assessment Act 1986 and the note in subsection 16(1 )]

Example 1.20

Following from Example 1.19, on 1 July 2008, the loan to Zoe is subject to interest at a rate of 7 per cent for that income year. The benchmark interest rate (for Division 7A) and the statutory interest rate (for FBT) are both 7 per cent at that time. On 1 April 2009, the FBT rate is set to 8 per cent.

For the period 1 April 2009 to 30 June 2009, Zoe is paying less than the rate of interest required to avoid the loan having a taxable value for FBT. However, the loan is not a fringe benefit, because it is a loan that did not give rise to a deemed dividend under Division 7A, but would have done were it not for section 109N.

1.63 In subsequent years, loans that form part of an amalgamated loan will not be subject to FBT, even if the Commissioner exercises the discretion in section 109Q or 109RD to not deem a dividend to have been paid if the amount paid in relation to the loan is less than the minimum yearly repayment required.

1.64 In addition, loans made by trustees that would have given rise to a deemed dividend under section 109XB had they been made by a private company, were it not for section 109N, are not fringe benefits.

Repeal of section 108 from the ITAA 1936

1.65 Section 108 is being repealed. Section 108 is the predecessor of Division 7A and provides that if a private company makes a payment or loan to a shareholder or associate then the amount may be deemed to be a dividend. Unlike Division 7A, it is not self-executing. After nearly 10 years of the operation of Division 7A and in light of the limited amendment periods for the Ausralian Taxation Office (ATO) to adjust income tax returns, section 108 is no longer considered necessary. The effect will be to remove the uncertainty for taxpayers which has been created by having two sets of similar provisions applying to essentially the same set of transactions. [Schedule 1, item 33]

1.66 Section 108 dividends that have arisen in prior years are taken into account in determining whether the private company has a distributable surplus under section 109Y, if the actual loan that triggered the dividend is in the accounts of the company. Consquently, the references to section 108 (or subsections) in the definitions of 'non-commercial loans' and 'repayments of non-commercial loans' are amended to refer to 'former section 108' or 'former subsection 108(2)'. [Schedule 1, items 34 to 36, subsection 109Y(2) of the ITAA 1936]

Time limit for making franking assessments (Schedule 1, Part 3)

1.67 An amendment is made to section 214-60 of the ITAA 1997 to provide the Commissioner with a maximum period of three years to make a franking assessment, in cases where an entity is not required to give the Commissioner a franking return for an income year.

1.68 Generally, the Commissioner will have three years from the later of:

•

the time the entity was required to lodge an income tax return for the income year; and

•

the time when the entity lodged the income tax return for the year of income.

[Schedule 1, item 42, subsection 214-60(1A) of the ITAA 1997]

Application and transitional provisions

1.69 Subject to the following variations, the amendments made by Schedule 1 apply to assessments for the income year in which 1 July 2006 occurred, and later income years. [Schedule 1, subitem 43(1 )]

1.70 The FBT amendment applies to benefits provided in a year of tax that begins on or after 1 April 2007. [Schedule 1, subitem 43(2 )]

1.71 The FBT amendment also applies to all relevant loans from 1 April 2007, if the loan was made prior to this date. This is because, irrespective of whether or not the loan was made before or after 1 April 2007, for the loan to be part of an amalgamated loan under Division 7A, it must have been a loan that did not give rise to a deemed dividend under Division 7A, but would have done were it not for section 109N. This operation is clarified in the application provision. [Schedule 1, subitem 43(3 )]

1.72 To the extent that the amendments relate to section 109RB of the ITAA 1936 (the Commissioner's discretion to either disregard the deemed dividend or allow the private company to frank the dividend), they apply in relation to the 2001-02 income year and later years. [Schedule 1, subitem 43(4 )]

1.73 The Commissioner cannot make a decision to allow a dividend to be franked if the dividend was paid before 1 July 2002, as this period is before the commencement date of the simplified imputation system. [Schedule 1, subitem 43(4 )]

1.74 Where the Commissioner exercises his discretion under section 109RB to disregard a deemed dividend from an earlier year of income, he will be able to amend the private company's franking assessment accordingly. [Schedule 1, subitem 43(4 )]

1.75 The amendments made by Part 3 of this Schedule (Time limit for making franking assessments), applies to franking assessments for the income year in which 1 July 2006 occurred and later income years. [Schedule 1, item 42, subitems 43(4) and (6), subsection 214-60(1A) of the ITAA 1997]

1.76 Section 170 of the ITAA 1936 does not prevent an amendment of an assessment if the assessment was made before the commencement of section 109RB (the Commissioner's discretion) if it is made within four years after commencement of section 109RB and the amendment is made for the purpose of giving effect to a decision of the Commissioner under section 109RB of the ITAA 1936. [Schedule 1, subitem 43(5 )]

Consequential amendments

1.77 Because section 108 of the ITAA 1936 is repealed, there are a number of references to section 108 (or subsection 108(2)) that are either being omitted or the reference is amended to refer to 'former section 108' or 'former subsection 108(2)' where appropriate. [Schedule 1, items 8, 34 and 35, subsection 109Y(2), paragraphs 109G(3)(b), 160AEA(1)(d) and 268-40(5)(b) in Schedule 2F to the ITAA 1936 and paragraph 165-60(5)(b), subparagraph 202-45(g)(ii) and section 10-5 of the ITAA 1997]

REGULATION IMPACT STATEMENT

Policy objective

1.78 The purpose of Division 7A of the ITAA 1936 is to prevent private companies^[1] from making tax-free distributions of profits to shareholders (or their associates) in the form of a payment, loan or forgiven debt. Unless they come within specified exclusions^[2], advances, loans and other credits by private companies to shareholders (or their associates) are treated as assessable dividends to the extent that there are realised or unrealised profits in the company.

1.79 The objective of reviewing the Division 7A provisions was to reduce both the extent to which taxpayers are inadvertently caught by Division 7A and the unduly punitive nature of the provisions. The tax impost resulting from a breach of Division 7A is considered to be out of proportion with the tax mischief involved.

Background

1.80 Division 7A is a self-executing provision that requires taxpayers - the private company and its shareholders and their associates - to be fully aware of all its consequences. Taxpayers must self assess if they are caught by the provisions. If a private company makes a payment or loan to a shareholder (even inadvertently) which is not put on a proper commercial footing, generally by the time the company lodges its tax return, then the private company's franking account is debited and the deemed dividend is taxable in the hands of the shareholder; but without entitlement to an imputation credit to offset the tax paid by the company.

1.81 Advice from both the accounting profession and the ATO indicates that in practice the application of Division 7A is widely misunderstood by taxpayers resulting in inadvertent and frequent breaches of the provisions. It has been described by some tax practitioners as the most commonly encountered problem area for practitioners outside the big four accounting firms. The ATO has identified in its Compliance Program 2005-06 that shareholder loan arrangements are a concern and that the ATO needs to lift awareness of the rules among businesses and their tax agents, to increase compliance with Division 7A.

1.82 Division 7A was introduced with effect from 4 December 1997 because section 108 of the ITAA 1936, which also deemed certain amounts to be dividends, only applied when the Commissioner formed the opinion that an amount loaned, paid or credited represented a distribution of profits. Such opinions could not generally be formed without information which was usually only available after conducting an audit. Division 7A, on the other hand, is intended to operate automatically through self-assessment.

Implementation options

1.83 There are essentially two options to deal with this issue.

Option 1

1.84 Option one would be for the Government to remove the self assessment nature of Division 7A and rely solely on the ATO to identify breaches through audit activity.

1.85 This was not considered feasible for a number of reasons:

•

it would revert to a system that was in place prior to 4 December 1997 that relied on the Commissioner identifying specific tax-avoidance activity. This involved the Commissioner forming an opinion that the amount loaned, paid or otherwise credited, represented a distribution of profits. In order to be in a position to form this opinion, the Commissioner needed to consider many factors and analyse much information, which usually was not available unless the Commissioner conducted an audit. Consequently, many loans which should have been taxable as dividends were not taxed. Against this background, the Government specifically moved away from this system. It is also inconsistent with Government policy on self assessment and the need to provide more certainty for taxpayers. Under the current regime taxpayers self assess other taxes such as the goods and services tax (GST) and the FBT, etc; and

•

taxpayers may be encouraged to avoid tax as the risk of detection through ATO audit activity may be perceived to be small. At present, many private companies use tax agents who are expected to be aware of the requirements of the tax law and who can advise their clients on various aspects of their tax affairs, including Division 7A requirements.

On this basis this option was not assessed further.

Option 2

1.86 The second and preferred option was to make the following changes to provide more flexibility and certainty to taxpayers:

•

reduce the double penalty nature of the provisions by removing the automatic debit to a company's franking account when a deemed dividend arises;

•

provide the Commissioner with an extended discretion in Division 7A to enable him to provide relief for deemed dividends that have arisen because of honest mistakes or inadvertent omissions by taxpayers; and

•

make a range of other mainly technical amendments to reduce the scope for normal business transactions to be inadvertently caught by Division 7A, when there has been no mischief intended and to generally increase its flexibility for taxpayers.

Proposed amendments

Removing the automatic debit to a company's franking account when a deemed dividend arises

1.87 The double penalty tax impost of Division 7A will be reduced by removing the automatic debiting of the company's franking account when a deemed dividend arises. This double penalty is unnecessary and not in proportion with the tax mischief of shareholders not declaring distributions from companies as assessable income. It also penalises all the company's shareholders, not just the shareholder assessed with a deemed dividend. Deemed dividends will, however, continue to be treated as assessable income in the hands of shareholders and associates.

1.88 This will reduce the harshness of Division 7A by taxing shareholders and associates only on the amounts received from the private company. The deterrent effect of the provisions will remain as deemed dividends will be subject to the marginal tax rate of the taxpayer without access to franking credits. This tax outcome still imposes a higher tax burden on genuine tax-avoidance arrangements.

1.89 Should the Commissioner exercise the discretion referred to below (to frank a deemed dividend) then the company's franking account would be debited.

Commissioner's discretion

1.90 The Commissioner's discretion in Division 7A will be extended. Currently Division 7A provides only a very limited discretion to the Commissioner to disregard its application in respect of loans, where he considers it reasonable in cases of undue hardship. The proposed amendments would provide a more general and flexible discretion to the Commissioner to enable him to provide relief for deemed dividends that have arisen under Division 7A because of an honest mistake or inadvertent omission. When considering the use of the discretion, the Commissioner would have regard to a range of factors including:

•

the circumstances that led to the mistake or omission which caused the deemed dividend to arise;

•

the extent to which the relevant taxpayer(s), (eg, the shareholder (or associate), or the private company) had acted to try to correct the mistake or omission, and if so how quickly that action was taken after the mistake or omission was identified; and

•

whether Division 7A had operated previously in respect of the relevant taxpayers, and if so, the circumstances in which this occurred (eg, if the Commissioner had previously exercised his power under this provision in relation to the entity that made the mistake or omission).

1.91 The Commissioner may exercise the discretion to disregard a deemed dividend or allow a deemed dividend that arises under Division 7A to be franked like other dividends.

1.92 The discretion has a retrospective element to enable the Commissioner to appropriately handle taxpayers with past mistakes or omissions; no tax mischief would have been intended in these circumstances. On this basis the Commissioner's discretion will allow him to extend time periods in relation to Division 7A. This has effect from the 2001-02 income year. If the Commissioner was satisfied that a breach of Division 7A requirements was inadvertent, he could use this discretion to extend the time available for taxpayers to rectify problems.

1.93 This discretion allows the Commissioner to appropriately handle cases that have not yet been identified through ATO audit activity. It would also allow those taxpayers that believe they may have inadvertently breached Division 7A to apply to the Commissioner for time to correct genuine errors.

Other mainly technical amendments

Allow payments to be converted to loans

1.94 Changes are made to allow 'payments' to be subsequently converted to a loan (between the company and the shareholder or associate) that can be fully repaid by the lodgment day of the private company's tax return for the year of income, or that meet the terms of section 109N (and thereby avoid the operation of Division 7A). Currently, some payments cannot be treated as loans that meet the terms of section 109N and as such trigger a deemed dividend. The change will reduce the inadvertent triggering of the provisions, increase the flexibility of the provisions by allowing taxpayers to put loans on a footing that meet the terms of section 109N and reduce compliance costs for taxpayers.

Deemed dividend to be the amount of the underpayment

1.95 If the minimum yearly repayments under a loan fall short of the required amount by the due date, the amount of the deemed dividend that arises will only be the amount of the underpayment in the income year, not the full amount of the outstanding loan, as is currently the case. This will have the effect of making the penalty consistent with the mischief committed by the taxpayer. It is inequitable to treat the whole loan as a deemed dividend, when for example, there was minor, unintentional underpayment. It is fairer for only the underpayment to be a deemed dividend in the relevant income year.

Allow refinancing of loans

1.96 Certain loans will be able to be refinanced without triggering a deemed dividend under Division 7A. This includes refinancing of loans between the company and the shareholder when the shareholder's loan with the company becomes subordinated to meet the requirements of a third party such as a bank; or where there is a change in the asset being used as security for the loan. To provide more flexibility for taxpayers and to prevent deemed dividends being triggered inadvertently, unsecured loans may be refinanced with a loan secured by a mortgage over real property and vice versa.

Relationship breakdown - allowing franked dividends

1.97 Transfers of property and payments in respect of marriage or relationship breakdowns are caught by Division 7A even though they may be non-voluntary (eg, by court order). However, while CGT roll-over relief will be available for transfers of CGT assets, income tax will be payable by the spouse (as a shareholder or associate) to the extent that there is a distributable surplus in the company (eg, undistributed after tax profits, or unrealised gains).

1.98 A deemed dividend that arises in these circumstances may be franked like other dividends the private company pays. This recognises that there is no attempt to make a disguised payment to a shareholder or associate for the purpose of tax-avoidance.

1.99 While these payments could be completely removed from being caught by Division 7A this would arguably be providing a tax benefit to these taxpayers which is not the intention of the provisions.

Discretion to extend time for minimim yearly repayments

1.100 The Commissioner will have a discretion to disregard a deemed dividend where the recipient of a private company loan (ie, the shareholder or an associate of the shareholder) was unable to make the minimum yearly repayments because of circumstances beyond their control. The Commissioner can specify a later time by which the minimum yearly repayments must be made. This will ensure that taxpayers will not be unduly penalised when they have made every effort to comply with the law but are unable to do so.

Allow for loan agreements to be made when interposed entities are involved

1.101 Division 7A does not allow loan agreements to be prepared between a private company and the target entity when interposed entities are involved. For example, Company A loans money to Company B and Company B pays that money to Company A's shareholder. At present this would be caught by Division 7A with no opportunity to put things on a commercial footing. Under this proposal, loan agreements that meet the Division 7A minimum interest rate and maximum term criteria in section 109N may be made between the interposed entity and the shareholder of the private company.

Remove the potential for double taxation in respect of guaranteed loans

1.102 Division 7A also applies to arrangements where a private company guarantees a loan made by a third party to a shareholder and the loan is in default. Division 7A will be amended to exempt guaranteed loans where the shareholder enters into a loan with the company that meets the requirements of section 109N (minimum interest rate and maximum term criteria). This will prevent the potential for both the guarantee and the loan to be deemed dividends - removing the potential for double taxation.

Calculation of distributable surplus (used to establish if a deemed dividend arises)

1.103 Section 109Y provides the basis for determining the company's distributable surplus which is used to determine the value of a deemed dividend under Division 7A. The distributable surplus depends in part on the value of the company's net assets (generally assets less the company's present legal obligations and certain provisions). Section 109Y also allows the Commissioner to substitute values where he considers that the company's accounting records significantly undervalue its assets or overvalue its provisions. There is no reason why this should not work both ways, for example assets may be overvalued in a company's accounting records because it has yet to undertake appropriate revaluations. Its provisions may also be understated. Therefore, the Commissioner's powers will be extended to allow him to also substitute values where he considers the company's accounting records significantly overvalue its assets or undervalue its provisions.

Payment of a set off dividend not taxable when a deemed dividend arises - technical correction to section 109ZC

1.104 Currently, section 109ZC is designed to prevent double taxation where a later dividend distributed by a private company can be offset against a dividend deemed to be previously paid by the company. The later dividend as an offset (to the extent that it is unfranked) is not assessable income up to the amount of the deemed dividend. However, instances of double taxation may arise if the borrower is not the shareholder of the company, but an associate. Changes will be made to Division 7A so that later dividends distributed may be applied by a shareholder as an offset against deemed dividends taken previously to be paid to the shareholder's associate.

Interaction between Division 7A and FBT

1.105 FBT may apply to an excluded loan, that is a loan (to a shareholder who is also an employee) that is made under a written agreement and meets the minimum interest rate and maximum term criteria of Division 7A. While Division 7A does not treat it as a deemed dividend, FBT may apply. FBT may also arise in subsequent years because of the different tax years for FBT (1 April to 31 March) and income tax (1 July to 30 June). If the FBT interest rate for employee loans is higher than the Division 7A benchmark interest rate, and the interest rate on the loan in question is lower than the FBT rate, a fringe benefit will arise.

1.106 It is proposed to exclude from FBT, loans that meet the criteria in Division 7A (relating to minimum interest rate, maximum loan term and loan documentation) in the year the loan is made. This also means that, in subsequent years, loans are excluded from FBT irrespective of whether the minimum interest rate requirement is met. This ensures that, if the Division 7A rate of interest is paid, no FBT liability arises.

Repeal section 108 of the ITAA 1936

1.107 Section 108 was the predecessor of Division 7A and likewise provides that if a private company makes a payment or loan out of profits to a shareholder or associate of the company then the amount may be deemed to be a dividend. It primarily applies to payments and loans made before 4 December 1997. If these are varied after that date, then Division 7A has application.

1.108 It is considered that after nearly 10 years of the operation of Division 7A and in light of the limited amendment periods for the ATO to adjust income tax returns (generally four years), section 108 no longer has any real application and, therefore, it is being repealed.

Time limit for making franking assessments

1.109 The time the Commissioner has to make franking assessments will be reduced to three years. At present it can be unlimited in some circumstances. A franking account return is taken to be a franking assessment under section 214-65 of the ITAA 1997. Under section 214-95, the Commissioner can amend a franking assessment at any time during the period of three years after the franking assessment was made. However, franking account returns are not required except in limited circumstances, for example, if there is a liability for franking deficit tax.

1.110 Where no franking account return is required (and therefore the Commissioner has not been taken to have made a franking assessment), the Commissioner will have only three years to issue a franking assessment reviewing the taxpayer's franking liability.

Assessment of impacts

Impact group identification

1.111 The proposals impact on taxpayers, that is, all private companies, and their shareholders and associates. This is considered to be a large number spread across micro, small, medium and large businesses across different industries. According to ATO taxation statistics for the 2003-04 income year, there were approximately 620,000 private companies in the tax system^[3]. Private companies can have as few as one or two shareholders or a much larger number. Therefore there are a large number of individual taxpayers that could be affected by Division 7A. Tax agents will also be affected as they prepare returns on behalf of taxpayers.

1.112 It is not expected that the proposed changes will change the behaviour of taxpayers fundamentally. Private companies will continue to make loans to shareholders and associates on a commercial basis, but the knowledge that honest mistakes can be corrected should lead to taxpayers bringing these to the attention of their tax agents and the ATO.

1.113 The proposal will also impact upon the ATO.

Analysis of costs / benefits

Taxpayers and tax agents

Benefits

1.114 Overall, the proposed changes are beneficial to taxpayers and will be welcomed by taxpayers and tax practitioners. The proposals will reduce ongoing compliance costs for private companies when compared with the costs imposed under the existing provisions. This should lead to a reduction in planning effort (including tax agents' fees) and legislative complexity. However, the most significant benefit for taxpayers will be the reduced tax penalties.

1.115 A number of the changes will provide significant benefits through the reduced penalty tax impost.

1.116 For example, reducing the scope of the application of Division 7A will remove many of the 'inadvertent breaches' of the provisions, which were not meant to be captured. A number of the changes facilitate this, for example:

•

refinancing of loans when security changes (eg, mortgage);

•

allowing all 'payments' to be converted to loans and put on a commercial footing on terms that meet the minimum interest rate and maximum term criteria specified in section 109N of Division 7A;

•

allowing loans agreements between an interposed entity and the shareholder of a private company to qualify as a loan agreement between the private company and the shareholder; and

•

providing a franking credit on payments connected with marriage breakdowns recognising that this is not an attempt to avoid tax in these circumstances.

1.117 In addition, in the event that Division 7A is triggered, taxpayers will no longer have to suffer what is regarded as the 'double penalty' effect of Division 7A as the automatic debit to the company's franking account will be removed. When a deemed dividend is triggered the private company will still have access to its franking credits and therefore not all the shareholders of the private company will be penalised.

1.118 The Commissioner's new discretion will allow the operation of Division 7A to be disregarded in some circumstances (subject to conditions being complied with such as making the minimum yearly repayments on a loan), leading to potentially no penalty tax impost for taxpayers.

1.119 A number of the changes clarify the operation of the law and provide greater certainty for taxpayers, for example:

•

correcting possible double taxation involved with loan guarantees; and

•

where there is an underpayment of a loan repayment, the amount of the underpayment will be the value of the deemed dividend, not the balance of the oustanding loan - this is more equitable for taxpayers.

1.120 While private companies will still be required to self-assess if a deemed dividend arises, the number of tax calculations in respect of franking accounts will be reduced where a deemed dividend arises. For example, at present when a private company establishes that a deemed dividend arises, it is required to make an adjustment to its franking account and advise the shareholder or the associate of the amount of the deemed dividend with no franking credits attached. Under the proposed changes, this will occur less and when it does, the company will not be required to make adjustments to its franking account. Record keeping will therefore be simplified in respect of franking accounts in these circumstances.

1.121 Repealing section 108 removes uncertainty and confusion for taxpayers who currently still have to determine whether section 108 applies to each particular situation (eg, company to company loans which are specifically excluded from the application of Division 7A). In the event that the ATO identifies a transaction which may be considered a tax-avoidance arrangement, it may use the general anti-avoidance provisions (Part IVA of the ITAA 1936). Repealing section 108 will reduce compliance costs for taxpayers and their agents.

1.122 The changes to the FBT laws will provide that Division 7A 'excluded loans' are not fringe benefits. Employers will no longer need to calculate FBT on these loans because of this amendment.

Costs

1.123 There may be a small increase in transitional compliance costs for taxpayers and their agents as they will need to become familiar with the changes to Division 7A. The increase should be minimal as the proposals are changes to existing provisions within the tax laws and therefore, taxpayers and their tax agents should be familiar with the general concepts and framework to be applied.

1.124 Taxpayers will also incur compliance costs in understanding the extent to which the changes will benefit them, including consideration of whether to apply to the Commissioner to use his new discretion.

1.125 It needs to be recognised that at present taxpayers incur compliance costs in establishing whether they have met the requirements of Division 7A. When a breach is identified and it is a result of an unintended mistake or error, the taxpayer incurs costs in seeking to obtain relief from the ATO. Under the proposed changes, these costs are expected to be reduced as the ATO will now have more scope to address taxpayer requests for relief.

Australian Taxation Office

Benefits

1.126 The ATO will have more scope to deal with inadvertent technical breaches of Division 7A. At present the ATO has little scope to deal with a taxpayer's request for relief when an inadvertent breach has occurred through an honest mistake or omission. There will be more scope to settle disputes with taxpayers.

1.127 In the longer term, on an overall basis, the proposals should provide benefits to the ATO in terms of administration, as it will result in the ATO having to deal with fewer, largely technical breaches of the provisions.

1.128 Compliance activity may also be reduced as the ATO will not need to pursue transactions that would be breaches, but for these amendments.

Costs

1.129 The introduction of a general discretion will lead to an increase in administration costs for the ATO as taxpayers request the Commissioner to exercise his new discretion and deal with disputes if the discretion is not exercised. There will be some short term increase in workload and administration costs as the Commissioner develops products that give guidance on the factors the Commissioner will consider in exercising his new discretion.

1.130 The discretion will create an increased workload around receiving and processing requests for the Commissioner to exercise the discretion retrospectively and to process the subsequent amendments. Similarly there will also be a need for the Commissioner to develop a view and give guidance on the factors considered in exercising the retrospective discretion.

1.131 The ATO will also need to update publications and make taxpayers and tax practitioners aware of other changes. To this end, there will be minimal costs involved in drafting and issuing documents that assist with interpretation and which assist taxpayers to understand the tax system and law.

1.132 Initial estimates from the ATO indicate that the administrative impact would be between 1.1 to 5.9 full time equivalent (FTE) staff in respect of interpretation and information products and active compliance products. Based on a direct cost of around $100,000 per FTE, the cost would be between $104,000 and $560,000. This would likely be incurred in the short term - over the first 12 months.

1.133 The revenue impact of the changes is unquantifiable but is expected to be minor against the forward estimates. This is because there is some revenue that is being currently collected which is not from intended tax avoidance, but rather technical breaches of the provisions. This will now be forgone. It is also unknown exactly when the Commissioner would exercise his new discretion. On the assumption that the discretion would only be used where tax avoidance was not intended, revenue that was not expected to be collected will be forgone.

Consultation

1.134 These changes have been developed in consultation with major accounting groups (Institute of Chartered Accountants in Australia and the Taxation Institute of Australia) and some tax practitioners. These groups are supportive of the changes. These groups were also consulted on the draft legislation.

Conclusion and recommended option

1.135 The preferred approach is to make the changes outlined in option 2, rather than remove the self-assessment nature of the provisions and rely solely on ATO audit activity to identify breaches of Division 7A.

1.136 The current legislation is fundamentally sound and acts as a significant deterrent to tax avoidance. It encourages private companies to maintain proper financial and tax records for transactions between the company and its shareholders (and their associates).

1.137 The nature of the concerns identified with the operation of Division 7A can be remedied through a range of relatively minor amendments to provide more flexibility for taxpayers.

1.138 The proposed changes will increase taxpayer flexibility with respect to Division 7A and reduce compliance costs for taxpayers whilst maintaining integrity and assist the ATO in its administration of the provisions. These changes are beneficial for taxpayers.

1.139 The proposed amendments generally apply from the year commencing 1 July 2006. However, the Commissioner's new discretion would apply for the 2001-02 income year and later income years. This will enable him to deal with past breaches that may not have been identified by the ATO or taxpayers and that may warrant the use of his discretion.

1.140 The FBT changes are proposed to take effect from the FBT year commencing 1 April 2007.

1.141 Treasury and the ATO will monitor this taxation measure, as part of the whole taxation system, on an on going basis.

Chapter 2 Transitional non-concessional contributions cap

Outline of chapter

2.1 Schedule 2 to this Bill amends the Income Tax (Transitional Provisions) Act 1997 to ensure that certain superannuation contributions (such as those made by a friend) made prior to 1 July 2007 are appropriately subject to a cap.

Context of amendments

2.2 New caps on superannuation contributions were introduced as part of the Simplified Superannuation reforms in the Tax Laws Amendment (Simplified Superannuation) Act 2007 and the Superannuation Legislation Amendment (Simplification) Act 2007.

2.3 From 1 July 2007 the concessional contributions cap limits the amount of concessional (generally assessable for a superannuation entity) contributions that will benefit from concessional tax treatment at a fixed dollar amount per person per year.

2.4 From 10 May 2006 the non-concessional contributions cap limits the amount of non-concessional (generally undeducted) contributions that a person can make into the concessional superannuation environment.

2.5 Contributions made on behalf of someone else are currently included in the assessable income of superannuation entities under section 274 of the Income Tax Assessment Act 1936, and from 1 July 2007 under Subdivision 295-C of the Income Tax Assessment Act 1997 (ITAA 1997).

2.6 From 1 July 2007 assessable contributions will be subject to the concessional contributions cap, including contributions made by friends (ie, contributions made on behalf of someone else but which are not Government co-contributions or contributions made on behalf of a spouse, employee or child).

2.7 During the period 10 May 2006 to 30 June 2007 the concessional contributions cap does not operate. Whilst the non-concessional contributions cap does operate for this period the contributions made by a friend are not covered by this cap.

2.8 As a result, these contributions made by a friend will not be capped during the transitional period and this will allow opportunities for excessive contributions to be made into the concessional superannuation system before 1 July 2007, with only a 15 per cent tax applying to the contribution (if the fund is complying).

2.9 The Treasurer and the Minister for Revenue and Assistant Treasurer issued joint Press Release No. 131 on 7 December 2006 with the introduction of the first Simplified Superannuation Bills into Parliament. This Press Release stated that the Government would act to address any avoidance activities that are undertaken in the Simplified Superannuation system, with the date of effect of any such measures to be backdated to 7 December 2006.

Summary of new law

2.10 Amendments are proposed to section 292-80 of the Income Tax (Transitional Provisions) Act 1997 to include certain contributions made after 6 December 2006 but before 1 July 2007 on behalf of someone else as non-concessional contributions and thus subject to the non-concessional contribution cap.

2.11 This will include contributions made by friends for each other but will not include contributions that are not included in the assessable income of the entity (such as spouse contributions, contributions on behalf of children and Government co-contributions) or contributions on behalf of an employee (as these are, in one way or another, already limited or capped during that period).

Comparison of key features of new law and current law

Detailed explanation of new law

2.12 The definition of 'non-concessional contributions' for the period between 10 May 2006 and 30 June 2007 will be amended to include certain contributions, such as those made by a friend. [Schedule 2, item 1, paragraph 292-80(3)(b )]

2.13 A contribution will be included in the non-concessional contributions for a person if the contribution is made in respect of another person and that other person is not an employee of the entity making the contribution and the contribution is included in the assessable income of the superannuation provider in relation to the plan to which the contribution is made. [Schedule 2, item 2, subsection 292-80(7 )]

2.14 An employee, for the purposes of this measure, is a person that is treated as an employee for the purposes of Division 290 of the ITAA 1997. [Schedule 2, item 2, subsection 292-80(8 )]

Application and transitional provisions

2.15 This is a transitional provision for the purposes of the Simplified Superannuation reforms. These amendments commence immediately after the commencement of Schedule 1 to the Tax Laws Amendment (Simplified Superannuation) Act 2007 however its effect is that it applies to contributions made after 6 December 2006 and before 1 July 2007.

Chapter 3 Capital gains of testamentary trusts

Outline of chapter

3.1 Schedule 3 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to allow a trustee of a resident testamentary trust to choose to be assessed on capital gains of the trust. The capital gains would otherwise be assessed to an income beneficiary (or to the trustee on behalf of such a beneficiary) who, under the terms of the trust, would not receive the benefit of the capital gains.

Context of amendments

3.2 Under the current income tax laws an income beneficiary who is entitled to a share of a trust's income is generally assessed on a similar share of the trust's net (or taxable) income. If the net income includes capital gains, the income beneficiary may be assessed on those capital gains even if, under the terms of the trust, they are not entitled to benefit from the capital gains.

3.3 These amendments will allow the trustee of a resident testamentary trust to choose to be assessed on the capital gains which would otherwise be assessed to an income beneficiary (or the trustee on their behalf).

3.4 The trustee will be able to make the choice if, under the terms of the trust, the income beneficiary cannot benefit from the capital gains.

3.5 These amendments will ensure that, if the choice is made, tax is in effect borne by the capital beneficiaries of the trust who will ultimately benefit from the capital gains.

Summary of new law

3.6 These amendments amend Subdivision 115-C of the ITAA 1997 to allow a trustee of a resident testamentary trust to make a choice that has the effect that the trustee, rather than an income beneficiary, will be assessed on capital gains of the trust.

Comparison of key features of new law and current law

Detailed explanation of new law

3.7 A trust is not a separate taxable entity: either the trustee or the beneficiaries (or a combination of the trustee and the beneficiaries) will be assessed on the 'net income of the trust' (ie, the trust's taxable income).

3.8 If a beneficiary of a trust is presently entitled to a share of the trust income, the beneficiary, and not the trustee, will generally be assessed on that share of the trust's net income.

3.9 Where the net income includes capital gains, the income beneficiary may be inappropriately assessed on an amount from which they will never benefit.

Example 3.1

Assume that Mr Brown's will provides for his assets to be held on trust for Philip, for life with the remainder to Lynette (ie, Lynette will receive the assets on Philip's death).

The trust income for a particular income year is $60,000 interest. Philip is presently entitled to this amount. The net income of the trust is $90,000, which comprises the $60,000 interest income and a net capital gain of $30,000.

Under the current law because Philip is presently entitled to all of the trust income he would be assessed on the entire trust net income including the $30,000 net capital gain. That outcome is inappropriate because, under the terms of the Brown trust, Philip cannot benefit from the $30,000.

3.10 These amendments will allow the trustee of a resident testamentary trust to choose that the capital gains, which would otherwise be assessed to an income beneficiary, are not so assessed. [Schedule 3, item 2, paragraph 115-230(1)(a )]

3.11 In certain circumstances the trustee may be assessed on behalf of an income beneficiary under section 98 of the Income Tax Assessment Act 1936 (ITAA 1936). In these circumstances, these amendments will also allow the trustee to make a choice that they will not be assessed on the capital gains on behalf of the income beneficiary. [Schedule 3, item 2, paragraph 115-230(1)(b )]

Example 3.2

Assume the same facts as in Example 3.1. The trustee of the Brown trust could choose that Philip is not to be assessed on the capital gains that would otherwise be assessed to him. The consequences of making this choice are discussed in paragraphs 3.23 to 3.26.

Trusts for which a choice can be made

3.12 A trustee will only be able to make a choice under these amendments for a trust that resulted from:

•

a will;

•

a codicil;

•

an order of a court that varied or modified the provisions of a will or a codicil;

•

an intestacy; or

•

an order of a court that varied or modified the application, in relation to the estate of a deceased person, of the provisions of the law relating to the distribution of the estates of persons who die intestate.

[Schedule 3, item 2, paragraph 115-230(2)(a )]

3.13 In addition, the trust must also be a 'resident trust estate' (as defined for the purposes of Division 6 of Part III of the ITAA 1936) for the income year in respect of which a choice is made. [Schedule 3, item 2, paragraph 115-230(2)(b )]

3.14 A trust is a resident trust estate in relation to an income year if:

•

a trustee of the trust estate was a resident at any time during the year of income; or

•

the central management and control of the trust estate was in Australia at any time during the income year.

Example 3.3

Nigel (a resident of Australia at all relevant times) is the trustee of a trust estate set up under the terms of a will. The trust will be a resident trust estate because Nigel, the trustee, is a resident. Nigel may be able to make a choice under these provisions.

Example 3.4

Christine (a resident of Australia at all relevant times) declared that she held certain property on trust for her children, for life. Although the trust is a resident trust estate, Christine cannot make a choice under these provisions because the trust was created during her life and not as a result of her will etc.

Example 3.5

Peter's will establishes a trust for his wife for life with the remainder to his children. Nathan, one of his sons, is the trustee of the trust. When Peter died his wife and children resided in Australia.

Nathan subsequently becomes a resident of the United Kingdom. Nathan will be able to make a choice under these provisions in respect of the income year in which he ceases to be an Australian resident. Even though Nathan was a resident for only part of the year, the trust will be a resident trust estate for the whole of that income year.

Nathan will not be able to make a choice for any later income year throughout which he resides in the United Kingdom (assuming that the central management and control of the trust is not in Australia).

Circumstances in which a choice can be made

3.15 The trustee can make a choice in relation to a beneficiary who:

•

does not have a vested and indefeasible interest in trust property representing the gain under the terms of the trust; and

•

has not been paid, or had applied to them, the benefit of that property. [Schedule 3, item 2, subsection 115-230(3 )]

Example 3.6

Marcia is entitled to all the income of a resident testamentary trust for the duration of her life. Under the terms of the trust deed, the trust would be wound up on her death and the corpus distributed to Trevor.

Whilst Marcia is alive, the trustee disposes of some shares in the trust and makes a capital gain. As Marcia is not entitled under the terms of the trust to receive the proceeds from the disposal of the shares, Marcia would not have a vested and indefeasible interest in trust property representing the gain.

Example 3.7

The Jones trust is a resident testamentary trust. Timothy is the sole beneficiary of the trust. However the deed provides that if Timothy dies before he attains the age of 25 years the trust property is to be held for various charities.

The trustee disposes of an investment property and makes a capital gain. The proceeds from the sale are accumulated.

The trustee can make a choice because Timothy (who is currently 23) has a defeasible interest in the corpus of the trust at the time of the trustee making the choice (ie, his interest will be defeated if he dies before turning 25). Timothy does not have a vested and indefeasible interest in the trust property representing the gain from the sale of the property.

3.16 The trustee chooses on a beneficiary-by-beneficiary basis. That is, the trustee may make a choice in respect of one beneficiary but not another. Where an income beneficiary would not pay tax on the gain (eg, if the income beneficiary is an exempt entity), the trustee may decide not to make a choice.

3.17 The trustee cannot make a choice that an income beneficiary is assessed on some of the capital gains of the trust, but not others, that would otherwise be assessed to the income beneficiary. If the trustee makes a choice, the choice must relate to all the capital gains that would otherwise be assessed to the income beneficiary.

Example 3.8

Assume that Sarah is the only income beneficiary of a resident testamentary trust which has made a net capital gain of $50,000. Under the terms of the trust deed, the trust would be wound up on Sarah's death and the corpus distributed to Kate. The $50,000 net capital gain comprises a $30,000 capital gain from the sale of real estate and a $20,000 capital gain from the sale of shares.

If the trustee does not make a choice under these amendments then the $50,000 net capital gain is assessed to Sarah under section 97 of the ITAA 1936.

The trustee cannot make a choice that Sarah is assessed only on the capital gain from the sale of the real estate. The choice must relate to all the capital gains that would otherwise be assessed to her (ie, the capital gains from both the real estate and the shares).

How choice is to be made

3.18 There is no specific requirement as to the form a choice must take nor must the choice be provided to the Australian Taxation Office (ATO). Evidence of the choice having been made should be available if requested by the ATO. Evidence may include:

•

trustee minutes;

•

trustee working papers;

•

tax agent working papers;

•

specific written advice (including electronic) to the beneficiary that the choice was made; or

•

beneficiary's distribution statement.

Example 3.9

Assume that the trustee of a resident testamentary trust makes a choice that subsection 115-230(4) applies in respect of a beneficiary, Mark. The choice is evidenced by a trustee minute which provides that the trustee has chosen to be assessed in respect of $20,000 being Mark's share of the trust capital gains.

Subsequently, the trust net income is increased as a result of an inclusion of an additional capital gain - Mark's share of which is $5,000.

The choice that the trustee made in respect of Mark is not invalidated by the later increase in his share of trust capital gains. Because the trustee's choice can only be made in respect of all of the capital gains for a beneficiary, the minute is taken as evidence of the making of the choice for Mark - it does not matter that the beneficiary's share may change.

3.19 In making a choice, the trustee should take into account their fiduciary duties to both the income beneficiaries and capital beneficiaries of the trust.

3.20 The trustee is required to make any choice within two months from the end of the income year to which the choice relates. A two-month deadline is consistent with the Commissioner of Taxation's (Commissioner's) administrative practice in other areas of the tax law. [Schedule 3, item 2, paragraph 115-230(5)(a )]

3.21 However, the Commissioner may allow further time for the trustee to make a choice in special circumstances. Special circumstances would not extend to the trustee wishing to defer making a choice until the income beneficiary or the trustee lodges their tax return. [Schedule 3, item 2, paragraph 115-230(5)(b )]

3.22 Section 103-25 of the ITAA 1997 is a provision about making choices for the purposes of the capital gains tax (CGT) provisions in Parts 3-1 and 3-3 of the ITAA 1997. It provides that generally a choice must be made by the time a taxpayer lodges their income tax return. Given that the choice in these amendments is required to be made within two months from the end of the income year (or within further time as allowed by the Commissioner), it is appropriate that this choice is excluded from section 103-25 of the ITAA 1997. [Schedule 3, item 1, paragraph 103-25(3)(aa )]

Consequences if the trustee makes a choice

3.23 If the trustee makes a choice in regards to an income beneficiary then the income beneficiary is not assessed on that amount under section 97, 98A or 100 of the ITAA 1936. [Schedule 3, item 2, paragraph 115-230(4)(a )]

3.24 If the trustee would otherwise be assessed on behalf of the income beneficiary, then a choice by the trustee (in their capacity as trustee) will mean that the gain is not assessed to the trustee under section 98 of the ITAA 1936. [Schedule 3, item 2, paragraph 115-230(4)(b )]

3.25 If the trustee makes a choice that the income beneficiary (or the trustee on their behalf) is not assessed on the capital gains then, as a consequence, the trustee will be assessed on those gains. This assessment to the trustee will be made under either section 99 or section 99A of the ITAA 1936 as appropriate. [Schedule 3, item 2, subsection 115-230(4 )]

3.26 These amendments do not modify the Commissioner's discretion to apply either section 99 or section 99A of the ITAA 1936 to the trustee.

Example 3.10

Assume that the Oakroad trust is a resident trust, set up under the terms of Ms Oakroad's will. It has two income beneficiaries, Richard and Kaye, each entitled to 50 per cent of the trust income for their lives. The remainder is held on trust for various charities.

For a particular income year the trust has income of $10,000. Richard is presently entitled to 50 per cent of that income. Kaye is aged 15. Apart from her legal disability (ie, being under 18 years of age), she also would be presently entitled to 50 per cent of the income of the trust. The net income of the trust for an income year is $40,000. This comprises interest income of $10,000 and a net capital gain of $30,000.

The following examples detail the consequences of a trustee's choice on the assumption that the Commissioner exercises their discretion to allow the trustee to be assessed under section 99 of the ITAA 1936.

If the Commissioner did not exercise that discretion, references in the examples to section 99 of the ITAA 1936 should be read as section 99A of the ITAA 1936. If the trustee was assessed under section 99A of the ITAA 1936, then the trustee would be required to reverse the application of the CGT discount in working out the trust's net capital gain.

Example 3.11

The trustee does not make a choice. As a result, the net income of the trust would be assessed as follows:

•

Richard is assessed under section 97 of the ITAA 1936 on $20,000; and

•

the trustee is assessed, on behalf of Kaye, under subsection 98(1) of the ITAA 1936 on $20,000.

Example 3.12

The trustee makes a choice that both Richard and Kaye are not to be assessed on the capital gains of the trust. As a result, the net income of the trust would be assessed as follows:

•

Richard is assessed under section 97 of the ITAA 1936 on $5,000;

•

the trustee is assessed, on behalf of Kaye, under subsection 98(1) of the ITAA 1936 on $5,000; and

•

the trustee is assessed under section 99 of the ITAA 1936, in their capacity as trustee, on $30,000.

Example 3.13

The trustee makes a choice that they (as trustee for Kaye) are not to be assessed on the capital gain. The trustee does not make a choice in relation to Richard. As a result, the net income of the trust would be assessed as follows:

•

Richard is assessed under section 97 of the ITAA 1936 on $20,000;

•

the trustee is assessed under subsection 98(1) of the ITAA 1936, on behalf of Kaye, on $5,000; and

•

the trustee is assessed under section 99 of the ITAA 1936, in their capacity as trustee, on $15,000.

Application and transitional provisions

3.27 These amendments will commence on Royal Assent.

3.28 These amendments will apply to the 2005-06 and later income years [Schedule 3, item 3, subsection (1 )]. A trustee can make a choice in respect of capital gains included in the trust's net income for the 2005-06 and later income years.

Period for making a choice: 2005-06 income year

3.29 The application and transitional rules contain an exception to the general rule in subsection 115-230(5) that a trustee must make a choice within two months after the end of an income year. The exception is that, regardless of when Royal Assent is received, a trustee can make a choice for the 2005-06 income year within two years of these amendments receiving Royal Assent. In special circumstances the Commissioner may provide further time for the trustee to make a choice. [Schedule 3, item 3, subsection (2 )]

Period for making a choice: 2006-07 income year

3.30 Further, if these amendments do not receive Royal Assent until the 2007-08 income year, then a choice for the 2006-07 income year may also be made within two years of these amendments receiving Royal Assent (or within further time allowed by the Commissioner in special circumstances). [Schedule 3, item 3, subsection (3 )]

3.31 If these amendments receive Royal Assent during the 2006-07 income year, then a trustee will only have until 31 August 2007 to make a choice for the 2006-07 income year unless the Commissioner exercises their discretion under paragraph 115-230(5)(b).

The period for amending an assessment to give effect to a choice

3.32 If the trustee makes a choice under these amendments for the 2005-06 income year (and the 2006-07 income year, if the amendments do not receive Royal Assent until the 2007-08 income year) after a beneficiary, or trustee on their behalf, has received an assessment from the ATO (that related to the capital gains in respect of which the trustee choice is made), then the taxpayer may apply to amend their assessment within two years of these amendments receiving Royal Assent. [Schedule 3, item 4, paragraphs (a) and (b )]

3.33 If a taxpayer has a longer period to amend their assessment under section 170 of the ITAA 1936, then they may apply to amend their assessment within this longer time period. [Schedule 3, item 4]

3.34 There may be circumstances when a trustee makes a choice towards the end of this two year period and so an income beneficiary may not be able to apply to amend their assessment within the time limits provided for in these amendments.

3.35 Subsection 14ZW(2) of the Taxation Administration Act 1953 (TAA 1953) allows a person to lodge an out of time objection with a written request to the Commissioner that the objection be treated as if it were lodged within time. Section 14ZX of the TAA 1953 requires the Commissioner to consider whether to agree to the taxpayer's request.

3.36 When deciding whether or not to agree to the taxpayer's request for an objection out of time under these transitional provisions, the Commissioner should have regard to when the trustee made a choice under these transitional arrangements, and in particular whether it was made towards the end of this two year period.

Chapter 4 Taxation of superannuation death benefits to non-dependants of defence personnel and police killed in the line of duty

Outline of chapter

4.1 Schedule 4 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to align the tax treatment of lump sum superannuation death benefits paid to non-dependants with that applying to dependants where the deceased was killed in the line of duty as a member of either the Australian Defence Force (ADF), or any Australian police force, or as an Australian Protective Service Officer.

Context of amendments

4.2 Superannuation death benefits paid to dependants of a deceased person are taxed more concessionally than if they are paid to non-dependants.

4.3 From 1 July 2007, lump sum superannuation death benefits will be tax-free without limit if paid to dependants and taxed concessionally if paid to non-dependants, as a result of the introduction of the Simplified Superannuation reforms.

4.4 This means that non-dependant beneficiaries of defence personnel and police, such as parents and siblings, pay a higher rate of tax on lump sum superannuation death benefits than dependant beneficiaries, such as spouses.

Summary of new law

4.5 Schedule 4 allows non-dependants of ADF personnel, Australian police force members or Australian Protective Service Officers who die in the line of duty to be treated as death benefits dependants for tax purposes.

4.6 The Minister for Revenue and Assistant Treasurer announced in Press Release No. 032 of 5 April 2007 that non-dependants of ADF personnel, Australian Federal Police (AFP), including Australian Protective Service Officers, and state and territory police killed in the line of duty (or as a result of injuries sustained in the line of duty) would receive access to the same concessional tax treatment for lump sum superannuation death benefits as dependants, with effect from 1 January 1999.

4.7 These amendments recognise the valuable role played by defence personnel and police in maintaining the safety and security of the community and the country.

4.8 These amendments take effect from the 2007-08 income year.

4.9 The legislation recognises that the making of ex gratia payments in relation to lump sum superannuation death benefits received in income years prior to the 2007-08 income year by non-dependants of ADF personnel, Australian police force members and Australian Protective Service Officers who died in the line of duty is an appropriate exercise of the Executive Power of the Commonwealth. The Commissioner of Taxation (Commissioner) will make these payments on behalf of the Commonwealth.

Comparison of key features of new law and current law

Detailed explanation of new law

4.10 A superannuation death benefit is a superannuation benefit that is paid as the result of the death of another person.

4.11 Superannuation death benefits paid to dependants of a deceased person are taxed more concessionally than if they are paid to non-dependants.

4.12 Death benefits dependant is defined in the legislation as the deceased's spouse or former spouse, the deceased's child aged less than 18, any person with whom the deceased had an interdependency relationship just before he or she died, or any other person who was a dependant of the deceased person just before he or she died.

4.13 As a result of the Simplified Superannuation reforms, from 1 July 2007 superannuation death benefits will be tax-free without limit if paid to dependants and taxed concessionally if paid to non-dependants (at 15 per cent if paid from a taxed fund and at 30 per cent if paid from an untaxed fund).

4.14 Where a non-dependant receives a lump sum superannuation death benefit in respect of the death in the line of duty, either within or outside Australia, of a member of the ADF, the AFP, a state or territory police force or an Australian Protective Service Officer, the payment is taxed as though it were paid to a dependant of the deceased. [Schedule 4, item 2, subsection 302-195(2 )]

4.15 Circumstances that constitute an individual being killed in the line of duty will be set out in regulations. The circumstances of the death must be covered in the regulations in order for the deceased's non-dependant beneficiaries to qualify for the same tax treatment as a dependant. [Schedule 4, item 2, subsection 302-195(3 )]

4.16 It is intended that the regulations will cover circumstances that are both included and excluded from the definition of 'died in the line of duty'. Excluded circumstances, such as suicide, would override included circumstances, such as participation in an overseas deployment. The intended application will be covered in more detail in the explanatory statement to the regulations.

4.17 In line with the normal record keeping requirements, claimants are required to retain proof of the circumstances surrounding the death. For example, this may take the form of a death certificate, letter from the deceased's employer or a coroner's report.

Ex gratia payments

4.18 Ex gratia payments are considered to be the most effective mechanism to achieve a similar outcome for the non-dependants of ADF personnel, AFP members, Australian Protective Service Officers, and state and territory police force members killed in the line of duty who have received a lump sum superannuation death benefit over the period from 1 January 1999 to 30 June 2007.

4.19 This approach avoids the need to seek an amended tax assessment of the deceased estate, which would be required if the legislation was amended retrospectively.

4.20 The calculation of the ex gratia payments shall be based on the tax treatment that applied at the time the lump sum superannuation death benefit was received. This will ensure that eligible non-dependants achieve a similar outcome to that of a dependant who received a lump sum superannuation death benefit at the same time. For payments received prior to 1 July 2007, lump sum superannuation death benefits paid to dependants were tax-free up to the reasonable benefit limit.

4.21 Ex gratia payments will be made as an exercise of the Executive Power of the Commonwealth and these arrangements will be administered by the Commissioner.

4.22 This is an appropriate exercise of the Executive Power, even though the legislative amendments will apply prospectively. [Schedule 4, item 5]

4.23 Individuals may need to provide substantiating documentation to the Australian Taxation Office (ATO), such as proof of tax paid and the circumstances surrounding death, as part of the assessment process for an ex gratia payment.

4.24 Based on information provided by the individual, the ATO shall apply the circumstances of death to the exhaustive list in the regulations to determine whether a non-dependant beneficiary is eligible for a payment.

Application provisions

4.25 These amendments apply to lump sum superannuation death benefit payments received in the 2007-08 income year and later income years. [Schedule 4, item 4]

Consequential amendments

4.26 The numbering of section 302-195 is changed to reflect the inclusion of a subsection on eligibility for treatment as a 'death benefits dependant'. [Schedule 4, item 1]

4.27 A definition of 'died in the line of duty' is inserted into the Dictionary in Division 995 of the ITAA 1997. [Schedule 4, item 3, definition of 'died in the line of duty' in subsection 995-1(1 )]

Chapter 5 Thin capitalisation

Outline of chapter

5.1 Schedule 5 to this Bill extends by one year a transitional period relating to the application of accounting standards under the thin capitalisation rules.

Context of amendments

5.2 The thin capitalisation rules in Division 820 of the Income Tax Assessment Act 1997 are designed to ensure that both Australian and foreign-owned multinational entities do not allocate an excessive amount of debt to their Australian operations. The rules operate to disallow a proportion of otherwise deductible finance expenses (eg, interest) where the debt used to fund the Australian operations exceeds certain thresholds.

5.3 In calculating its thin capitalisation 'position', an entity is required to determine its assets, liabilities and equity capital.

5.4 Under the thin capitalisation rules, an entity's assets, liabilities and equity capital must be determined and valued in accordance with 'accounting standards', which has the same meaning as in the Corporations Act 2001.

5.5 On 1 January 2005 Australia adopted new accounting standards, known as Australian Equivalents to International Financial Reporting Standards, replacing the previous Australian Generally Accepted Accounting Principles.

5.6 Differences between Australian Equivalents to International Financial Reporting Standards and Australian Generally Accepted Accounting Principles in the recognition and/or valuation of certain assets, liabilities and equity capital items, impact on the thin capitalisation calculations of a number of entities.

5.7 In view of this, the Government legislated a three-year transitional period during which entities can choose, on an annual basis, to use either Australian Equivalents to International Financial Reporting Standards or Australian Generally Accepted Accounting Principles to make calculations required under the thin capitalisation rules.

5.8 The transitional arrangements are set out in section 820-45 of the Income Tax (Transitional Provisions) Act 1997 and apply to an entity from its first income year commencing on or after 1 January 2005.

Summary of new law

5.9 This amendment will extend the transitional period by one year, such that the transitional arrangements will apply to four consecutive income years of an entity beginning on or after 1 January 2005.

Detailed explanation of new law

5.10 The extension of the transitional period means that entities can choose, on an annual basis, to use either Australian Equivalents to International Financial Reporting Standards or Australian Generally Accepted Accounting Principles (and, in the case of Authorised Deposit-taking Institutions, pre-1 January 2005 prudential standards) for four consecutive income years beginning on or after 1 January 2005. [Schedule 5, item 1, subsection 820-45(1 )]

5.11 Therefore, for example, for an entity with an income year commencing on 1 July, the transition period will expire on 30 June 2009, rather than 30 June 2008.

Application and transitional provisions

5.12 This amendment will apply from Royal Assent.

Chapter 6 Repeal of dividend tainting rules

Outline of chapter

6.1 Schedule 6 to this Bill amends the Income Tax Assessment Act 1936 (ITAA 1936) and the Income Tax Assessment Act 1997 (ITAA 1997) to repeal the dividend tainting rules and to make consequential amendments that will:

•

ensure that distributions from a share capital account (including a tainted share capital account) continue to be unfrankable; and

•

modify a general anti-avoidance rule that applies in relation to the imputation system so that, when considering whether to apply the rule, the Commissioner of Taxation (Commissioner) can take into account whether a distribution is sourced from unrealised or untaxed profits.

Context of amendments

6.2 The dividend tainting rules, which are contained in sections 46G to 46M of the ITAA 1936, were introduced in 1995 to prevent corporate taxpayers from taking advantage of the inter-corporate dividend rebate to make tax-free distributions to corporate shareholders or transferring franking credits to shareholders by inappropriate means. The rules operate by preventing distributions debited to certain accounts from being rebatable or frankable.

6.3 The rules also provide a mechanism to ensure that a return of capital from a tainted share capital account is treated as an unfranked distribution for tax purposes.

6.4 Under the simplified imputation system, the inter-corporate dividend rebate has been removed. The gross-up and credit approach now applies to all shareholders.

6.5 As a result of the removal of the inter-corporate dividend rebate and the introduction of the consolidation regime, the schemes that the dividend tainting rules were primarily directed at preventing can no longer be entered into. However, the rules may be inadvertently triggered by accounting entries required under the Australian Equivalent of the International Financial Reporting Standards.

Summary of new law

6.6 The dividend tainting rules (sections 46G to 46M of the ITAA 1936) will be repealed. Consequential amendments will:

•

ensure that distributions from a share capital account (including a tainted share capital account) continue to be unfrankable; and

•

modify a general anti-avoidance rule (section 177EA of the ITAA 1936) that applies in relation to the imputation system so that, when considering whether to apply the rule, the Commissioner can take into account whether a distribution is sourced directly or indirectly from unrealised or untaxed profits.

Comparison of key features of new law and current law

Detailed explanation of new law

Repeal of the dividend tainting rules

6.7 The dividend tainting rules (sections 46G to 46M of the ITAA 1936) will be repealed. [Schedule 6, item 1]

Distributions from a company's share capital account continue to be unfrankable

6.8 Currently, the dividend tainting rules operate to ensure that distributions made from share capital accounts (including tainted share capital accounts) are not frankable.

6.9 Therefore, a consequential amendment to section 202-45 of the ITAA 1997, which lists distributions that are unfrankable, will ensure that a distribution that is sourced directly or indirectly from a company's share capital account (including a tainted share capital account) is unfrankable. [Schedule 6, item 4, paragraph 202-45(e )]

6.10 A distribution will be sourced directly from a company's share capital account if an accounting debit is made to the share capital account for the making of the distribution.

6.11 A distribution will be sourced indirectly from a company's share capital account if, for example, a company transfers an amount from its share capital account into a distributable profits reserve and subsequently makes a distribution to shareholders that is debited against the distributable profits reserve in circumstances where it is reasonable to conclude that the distribution represents the amount transferred from the share capital account.

6.12 Further consequential amendments to the ITAA 1997 will:

•

update section references in the note to subsection 197-50(1), which outlines the consequences of a share capital accounting becoming tainted;

•

modify subsection 375-872(4) to ensure that paragraph 202-45(e) does not operate to treat the return of concessional capital by a film licensed investment company as an unfrankable distribution for the purpose of working out whether certain distributions of capital are taken to be a dividend; and

•

modify section 975-300 of the ITAA 1997, which defines a 'share capital account', to:

-

ensure that, for the purposes of applying paragraph 202-45(e), a tainted share capital account is treated as a share capital account; and

-

remove an obsolete reference to section 46H of the ITAA 1936.

[Schedule 6, items 3, 5, 6 and 7, subsections 197-50(1), 375-872(4) and 975-300(3 )]

Extension of the general anti-avoidance rule

6.13 The general anti-avoidance rule in section 177EA of the ITAA 1936 applies where a scheme involving the disposition of membership interests in a company is entered into with a more than incidental purpose of enabling a taxpayer to obtain an imputation benefit. If the section applies, the Commissioner may make a determination that a franking debit arises in the distributing company's franking account or deny the imputation benefit to the taxpayer.

6.14 Section 177EA applies if, broadly:

•

there is a scheme for the disposition of membership interests in a company;

•

a frankable distribution has been paid in respect of the membership interests, or has flowed indirectly to a person in respect of the membership interests;

•

the distribution was franked and, but for section 177EA, the taxpayer would receive imputation benefits as a result of the distribution; and

•

having regard to the relevant circumstances of the scheme, it would be concluded that a person entered into the scheme or any part of the scheme for a purpose (whether or not a dominant purpose but not including an incidental purpose) of enabling the taxpayer to obtain an imputation benefit.

6.15 Subsection 177EA(17) contains a list of factors that are the relevant circumstances of a scheme. An amendment is being made to subsection 177EA(17) so that a relevant circumstance includes whether a distribution that is made or that flows indirectly under the scheme to the relevant taxpayer is sourced directly or indirectly from unrealised or untaxed profits. [Schedule 6, item 2, paragraph 177EA(17)(ga) of the ITAA 1936]

Application and transitional provisions

6.16 These amendments apply in relation to distributions made on or after 1 July 2004. [Schedule 6, item 8]

6.17 The repeal of the dividend tainting rules with effect from 1 July 2004 will be beneficial for corporate taxpayers:

•

Companies will not inadvertently trigger the dividend tainting rules by posting accounting entries required under the Australian Equivalent of the International Financial Reporting Standards.

•

Compliance costs will be significantly reduced as companies will no longer be required to keep 'disqualifying accounts' and 'notional disqualifying accounts'.

6.18 Some practical consequences may arise for companies that have made distributions since 1 July 2004 that were made unfrankable by the operation of the dividend tainting rules. Some of those distributions may now be frankable. Companies that wish to attach franking credits retrospectively to such distributions (eg, to avoid a breach of the benchmark franking rule in Division 203 of the ITAA 1997) will need to approach the Commissioner for a determination that will allow them to amend the relevant distribution statements.

Chapter 7 Clarification of exemption from interest withholding tax

Outline of chapter

7.1 Schedule 7 to this Bill amends sections 128F and 128FA of the Income Tax Assessment Act 1936 (ITAA 1936) to more closely specify those debt interests that are eligible for exemption from interest withholding tax (IWT).

7.2 These amendments ensure this exemption remains consistent with the Government's original policy, which was to ensure that Australian business does not face a restrictively higher cost of capital, or constrained access to capital, as a result of the IWT burden being shifted from the non-resident lender to the Australian borrower.

7.3 These amendments correct an unintended broadening of the exemption that occurred following the New International Tax Arrangements (Managed Fund and Other Measures) Act 2005 (2005 amendments). Closer specification of the range of debt interests eligible for the exemption realigns the exemption to the Government's policy intent and enhances the integrity of the tax system.

7.4 The amendments specify that non-debenture debt interests that are non-equity shares (including those subject to the related scheme rules in Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)) and syndicated loans are eligible for exemption from IWT. They also introduce a regulation-making power to prescribe further types of eligible debt interests.

7.5 Unless otherwise stated all legislative references are to the ITAA 1936.

Context of amendments

7.6 IWT was first imposed in 1968 to replace an assessment system of taxing interest payments to non-residents that was open to abuse. The view underlying the IWT system was that since IWT levied by Australia would generate a tax credit in the lender's home country, the burden of the tax would fall on foreign revenue collections. Unfortunately, the response of many foreign lenders was to increase interest margins on loans to Australia, shifting the burden of the tax to Australian borrowers.

7.7 To avoid imposing higher capital costs on Australian business, limited exemptions from IWT were introduced in 1971 for certain types of offshore borrowing. The prime objective of the exemptions was, and has remained, to ensure Australian business does not face a higher cost of capital as a consequence of the imposition of IWT. The limitations also recognised that some forms of money raising have the potential to reduce the integrity of Australia's tax system and, consequently, the exemptions were targeted at arm's length arrangements.

7.8 Subsequent amendments circumscribed eligibility for financial instruments to those expected to fulfil an arm's length capital raising function in circumstances where shifting of the tax burden was most likely to occur. The introduction of concepts such as 'wide distribution test' and the 'public offer test' confirmed the original policy intent of restricting exemption to structured capital raisings for business activities while excluding related party transactions and individually negotiated loans.

7.9 Legislative amendments in 2005 extended the exemption from interest on a debenture to interest on a debenture or a debt interest, in order to reflect changes to Australia's debt/equity rules in 2001. The debt/equity rules characterised financing arrangements as debt or equity interest on the basis of economic substance, rather than legal form.

7.10 The purpose of the 2005 amendments was to enable hybrid instruments now characterised as debt interests (under the debt/equity rules) as eligible for the exemption where they performed a capital raising function similar to debentures and also satisfied other legislative requirements (particularly the public offer test).

7.11 However, the 2005 amendments unintentionally resulted in the exemption being potentially available to all debt interests, which was not consistent with the Government's original policy intent, and represented a threat to the integrity of the tax system.

7.12 These amendments specify that debt interests that are non-equity shares (including where the related scheme rules apply) and syndicated loans are eligible for exemption, subject to satisfying the public offer test.

7.13 The inclusion of syndicated loans reflects evidence that this form of loan is an important and less costly substitute for debenture issues in securing large scale infrastructure capital, acquisition and other major financings.

7.14 In recognition of the evolving nature of financial markets and innovation in financial instruments, a regulation-making power has also been included to enable the prescription of other financial instruments as eligible for exemption. It is anticipated that this power will only be used to prescribe financial instruments that are close substitutes for, and perform a similar role to, debentures. Consideration would also be given to the extent to which there is a detrimental impact on access to capital by Australian borrowers.

Summary of new law

7.15 Schedule 7 specifies that only non-debenture debt interests that are non-equity shares (including those subject to the related scheme rules in section 974-15 of the ITAA 1997), and syndicated loans will be eligible for IWT exemption, unless the non-debenture debt interest is prescribed as eligible for exemption by regulation.

7.16 Non-equity shares are shares in a company that are viewed as equity on a legal form assessment, but characterised as debt interests based on economic substance, pursuant to Division 974 of the ITAA 1997. As a consequence, a dividend paid in respect of such a share is deemed to be interest under subsection 128A(1AB), and potentially liable to IWT. As non-equity shares perform a similar capital raising function to debentures it is appropriate that they be eligible for IWT exemption, subject to satisfying the public offer test.

7.17 Syndicated loans are often used for large debt capital raisings as they are a means by which Australian borrowers can access offshore lending in order to benefit from greater liquidity in some of these markets. Being close substitutes for debentures, it is also appropriate that syndicated loans are eligible for the IWT exemption. The exemption is available in respect of the interest paid on a 'syndicated loan' (as defined) that is a debt interest. The syndicated loan must be provided under a 'syndicated loan facility' (also defined) that has satisfied the public offer test.

7.18 The amendments take effect for debt interests issued on or after 7 December 2006. Although the amendments have limited retrospectivity, they provide certainty to the market (particularly in relation to syndicated loans, which constitute a significant source of capital for Australian businesses), thereby outweighing any potential negative effects that may be associated with retrospective legislation.

7.19 It should also be noted that most of the amendments (apart from those applying to syndicated loan facilities) were previously included in Schedule 2 to the Tax Laws Amendment (2006 Measures No. 7) Bill 2006, which was introduced into the House of Representatives on 7 December 2006 and were due to take effect from that date. Although Schedule 2 was removed from the Bill when it came before the Senate for debate on 27 March 2007, industry had been familiar with the Government's policy intentions with regard to the exemption for a considerable time. At the time of removal, it was also made clear that the Government would seek to reintroduce the amendments.

7.20 Transitional rules ensure that taxpayers who entered into written agreements in reliance on the law as it stood following the March 2005 amendments remain eligible for exemption in respect of debt interest resulting from or issued under these arrangements. An integrity provision has also been included to ensure that where such an agreement is altered to extend its term, the transitional rules will cease to apply to the agreement from the date on which it would otherwise have expired.

Comparison of key features of new law and current law

Detailed explanation of new law

What is interest withholding tax?

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

Interest withholding tax exemptions

7.22 Currently, Division 11A provides exemptions from IWT. In the context of these amendments, the following exemptions are relevant:

•

Section 128F provides that where an Australian resident company, or a non-resident company carrying on business at or through a permanent establishment in Australia, issues a debenture or a debt interest and the issue satisfies the requirements of the public offer test contained in

subsection 128F(3) or (4), an exemption from IWT will apply. In the absence of the exemption, IWT would be payable on the interest paid to non-resident holders of the debenture or debt interest.

•

In a similar way to section 128F, section 128FA provides for exemption from IWT for the interest paid to a non-resident by the trustee of certain unit trusts on a debenture or debt interest.

What is the public offer test?

7.23 A public offer test must be satisfied for interest to be exempt from IWT under section 128F or 128FA. In order to satisfy the public offer test, the debenture or debt interest must be offered in at least one of the following ways:

•

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 interests; or

•

to a dealer, manager or underwriter for the purpose of placement of the debenture or debt interest if the dealer, manager or underwriter satisfies one of the previous tests where:

-

the placement occurs under an agreement between the company and the dealer, manager or underwriter; and

-

the placement occurs within 30 days of the original issue of the debenture or debt interest to the dealer, manager or underwriter.

7.24 An issue of a debenture or a debt interest 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 debenture or debt interest would be acquired by associates of the issuing company or the unit trust, 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 on the debentures or non-debenture debt interests is being paid to an associate of the company or trust. There are limited exceptions where the debenture or debt interest is acquired by an associate in the capacity of a dealer, manager, underwriter, clearing house, custodian, funds manager or responsible entity of a registered scheme.

What debt interests are now eligible for exemption?

Closer specification of eligible debt interests

7.25 These amendments have the effect, while retaining the public offer test and other conditions to be met, of specifying more closely the debt interests eligible for IWT exemption.

7.26 The exemption is only available in respect of non-debenture debt interests that are non-equity shares (including those subject to the related scheme rules in section 974-15 of the ITAA 1997), syndicated loans, or prescribed as eligible for exemption by regulation. [Schedule 7, item 1]

7.27 The requirement for the issue of the debenture or debt interest to satisfy the public offer test still applies. For a syndicated loan, it is the invitation to become a lender under the relevant syndicated loan facility that must satisfy the public offer test. [Schedule 7, item 1]

7.28 Identical conditions to those in paragraphs 7.26 and 7.27 apply to interest paid to non-residents by non-resident companies that maintain a permanent establishment in Australia. [Schedule 7, item 2]

7.29 Identical conditions to those in paragraphs 7.26 and 7.27 are inserted to ensure that where the purchase price of an eligible debenture or debt interest is composed in part of interest, that embedded interest is only eligible for IWT exemption if it is on an eligible non-debenture debt interest that is a non-equity share, a syndicated loan or is prescribed by regulation. [Schedule 7, item 3]

Non-equity shares

7.30 Division 974 of the ITAA 1997 may characterise interests in a company that are equity on a legal form assessment as debt interests on the basis of economic substance. The shares then become 'non-equity shares' (section 995-1 of the ITAA 1997). Dividends paid on non-equity shares are treated as payments of interest under subsection 128A(1AB), and therefore potentially liable to IWT. As non-equity shares perform a similar capital raising function to debentures (which are currently eligible for the IWT exemption), the IWT exemption applies to non-equity shares, subject to satisfaction of the public offer test. [Schedule 7, item 1]

7.31 These amendments also specify that debt interests that are 'related schemes' (under section 974-15 of the ITAA 1997) that include non-equity shares should remain eligible for exemption, where the public offer test is satisfied. [Schedule 7, item 1]

7.32 'Related schemes' have the meaning in section 974-155 of the ITAA 1997. Two or more schemes are related to one another if they are related to one another 'in any way' other than merely because one refers to the other or they have a common party. Whether two or more related schemes then give rise to a debt or equity interest depends on the related scheme provisions in either section 974-15 (for a debt interest) or section 974-70 (for an equity interest) being met. Consequently, where the IWT exemption is expressed to apply only to interests that are non-equity shares, the non-equity shares that are part of a notional scheme that passes the debt test may be ineligible for exemption from IWT, which is not a desired policy outcome.

7.33 Where one or more of the related schemes is a non-equity share, the exemption will only apply to the dividends paid in respect of the non-equity share, which are treated as interest pursuant to subsection 128A(1AB). An exception to this rule arises if the other related scheme or schemes would have been eligible for the exemption in isolation. [Schedule 7, item 8]

Example 7.1

Bardy Inc issues redeemable preference shares in United States dollars. Bardy Inc also enters into a foreign currency swap with the market that is not solely used to mitigate its foreign currency risk in relation to the issue price of the redeemable preference share.

In characterising the redeemable preference shares as debt or equity, it is possible that the two schemes would be viewed as related to one another, and, therefore, upon passing the debt test, it would be the related scheme that would be the debt interest. These amendments ensure that even where this is the case, the redeemable preference shares would remain eligible for exemption. The exemption is limited to the dividends paid on the redeemable preference shares (which are treated as interest under subsection 128A(1AB)).

Syndicated loan facilities

Definitions

7.34 A syndicated loan is defined as a loan or other form of financial accommodation that is provided under a syndicated loan facility where that facility has two or more lenders. [Schedule 7, item 6]

7.35 The reference to 'loan or other financial accommodation provided' recognises that although most syndicated loans take the form of a standard loan, this is not the only form they may take. 'Financial accommodation' refers to other financial benefit or assistance to obtain financial benefit that is commonly provided by the market in lieu of a standard loan where the payments for such facilities would normally be considered amounts in the nature of interest. It can include the issuing, endorsing or otherwise dealing in promissory notes, bills of exchange or securities.

7.36 As an example, it has been market practice in the past for the financial accommodation to be provided in the form of a bill acceptance facility, where the lenders agree to accept bills of exchange issued by the borrowers. As the fees for facilities such as bill acceptance facilities would normally be considered amounts in the nature of interest (and deemed to be interest pursuant to subsection 128A(1AB)) and therefore liable to IWT, it is appropriate that they be eligible for exemption from IWT.

7.37 The requirement that there be at least two lenders that are parties to the agreement stems from the fact that the presence of multiple lenders is a defining feature of a syndicated loan. For this reason, for the period that there is only one lender under the syndicated loan facility, the loan or financial accommodation provided will not qualify as a syndicated loan.

7.38 The syndicated loan, being a loan or financial accommodation provided under a facility, can only arise at the time the loan or financial accommodation is provided. As this may occur after the time the public offer is made, it is not appropriate that the syndicated loan be made the subject of the public offer test. Rather, the public offer test applies to the syndicated loan facility under which the syndicated loan is to be made.

7.39 A written agreement is a 'syndicated loan facility' where the agreement describes itself as a syndicated loan facility or syndicated facility agreement. The purpose of including this requirement in the definition of 'syndicated loan facility' is to take advantage of the fact that financial markets will have certain expectations of an agreement that describes itself as a syndicated loan facility (particularly given the documentation to establish syndicated loan facilities is becoming more standardised through the work of organisations such as the Asia Pacific Loan Market Association). These market expectations can act as a deterrent to parties from describing an agreement as a syndicated loan facility or syndicated facility agreement where it is not truly such an agreement. [Schedule 7, items 7 and 8]

7.40 Where a written agreement does not describe itself as a syndicated loan facility or syndicated facility agreement, it would not satisfy the definition of 'syndicated loan facility'. Such an agreement cannot be made the subject of the public offer test, and therefore any loans or financial accommodation provided under the agreement cannot be eligible for exemption. Where an agreement is altered so that it is described as a syndicated loan facility, it is necessary for the public offer test to be satisfied at the time the agreement is properly described. Any earlier purported satisfaction of the public offer test would be invalid. Additionally, it should be noted that the Commissioner of Taxation (Commissioner) does not have the discretion to treat an agreement improperly described as a syndicated loan facility.

7.41 The remainder of the definition of 'syndicated loan facility' seeks to capture those elements commonly associated with syndicated loan facilities. Therefore, a syndicated loan facility must also be an agreement between one or more borrowers and at least two lenders. Additionally, under the agreement each lender must agree to severally, but not jointly, lend money or otherwise provide financial accommodation to the borrower or borrowers. The result is that each lender has a separate claim on the borrower in relation to either the portion of the money or financial accommodation provided, or the amount of obligation it has assumed (where the lender became party to the agreement following an assignment or novation of another lender's interest in the loan). Finally, under the agreement the amount to which the borrower or borrowers will have access at the time the first loan or other form of financial accommodation is to be provided under the agreement must be at least $100 million (or a prescribed amount). [Schedule 7, item 8]

7.42 A written agreement is also a 'syndicated loan facility' where the agreement is between one or more borrowers and one lender but the agreement provides for the addition of other lenders. This recognises that in many cases a borrower may enter into a written agreement with a single lender who then acts as an arranger on behalf of the borrower and seeks out other lenders to become party to the agreement, or the facility is otherwise syndicated to multiple lenders. This definition of 'syndicated loan facility' will enable such an agreement to be the subject of the public offer test. [Schedule 7, items 7 and 8]

7.43 Where the syndicated loan facility has only one lender, it is also necessary that the agreement describe itself as a syndicated loan agreement or syndicated facility agreement, and provide that upon the addition of other lenders, each lender severally, but not jointly, agrees to lend money to, or otherwise provide financial accommodation to, the borrower or borrowers. Finally, under the agreement the amount to which the borrower or borrowers will have access at the time the first loan or other form of financial accommodation is to be provided under the agreement is at least $100 million (or a prescribed amount). [Schedule 7, item 8]

7.44 Even where the public offer test is satisfied in respect of a syndicated loan facility that has only one lender, any loan or financial accommodation provided will not be a syndicated loan until the facility under which it is provided has at least two or more lenders. Broadly, a facility that has one lender is eligible to be made the subject of a public offer, however, an exemption from IWT will only apply to a debt interest issued under the facility once two or more lenders are party to the agreement because it is only upon satisfying that condition that the debt interest will be a syndicated loan.

7.45 It is appropriate that both definitions of a syndicated loan facility are referenced to size. The purpose of the IWT exemption is to facilitate Australian borrowers' access to overseas markets for the purposes of large capital raising. The $100 million sum is to be interpreted as that amount in Australian dollars or the equivalent amount in a foreign currency where the loan is expressed in foreign currency. [Schedule 7, item 8]

7.46 The reference to 'at the time the first loan or other form of financial accommodation is to be provided under the agreement is at least $100 million' is intended to provide eligibility only for those syndicated loan facilities that allow the borrower or borrowers to draw down at least $100 million at the time the loan or financial accommodation is, or is to be, initially provided. A facility that allows the borrower to access an amount of $200 million at the time of the first draw down is eligible for the exemption even if, for instance, the first drawn actually made is for $50 million. A revolving credit facility that allows a borrower to draw down and repay up to $50 million at a time will not qualify. Even though the borrower may borrow (through several draw downs and repayments) amounts in excess of $100 million in total, at the time the loan or financial accommodation is first offered, the borrower only had the ability to access up to $50 million. Where a borrower draws down a loan of $300 million under a facility and makes repayments so that the amount outstanding and available in later years drops to less than $100 million, the facility will continue to satisfy the $100 million threshold because, at the time where the loan or financial accommodation was first provided, the borrower was able to access at least $100 million.

7.47 A regulation-making power has also been included to enable the prescription of a different threshold, should this be more appropriate. [Schedule 7, item 8]

7.48 The September 2005 Reserve Bank Bulletin document issued by the Reserve Bank of Australia indicated that there were 126 syndicated loan deals undertaken in the Australian syndicated loan market for 2004-05. The average size of the loans was $540 million. However, of the 126 loans, 18 were 'jumbo' deals (greater than $1 billion). On the basis of this data, $100 million would appear to be appropriate to accommodate the vast majority of syndicated loans, whilst still 'ring fencing' the exemption so that it applies to large capital raising (consistent with the original policy intent).

7.49 Where there is evidence to suggest that the threshold is not reflective of the syndicated loan market, the regulation-making power will be utilised to prescribe a greater or lower amount.

7.50 The definition of 'syndicated loan facility' is further qualified by the requirement that where a loan or other form of financial accommodation has two or more borrowers all of the borrowers must be members of the same wholly-owned group, parties to the same joint venture or associates of each other. The intention behind this qualification is to avoid situations where a syndicated loan facility is entered into by unrelated borrowers who have clubbed together their borrowing requirements and entered into a syndicated loan facility of at least $100 million. [Schedule 7, item 8]

7.51 Where there is a change in the lenders (including by novation) under a syndicated loan facility, this will not result in a different agreement. This recognises that it is possible for interests in syndicated loan facilities to be traded in a secondary market. Where trading is achieved by novation, legally, a new agreement arises, and there may, therefore, be a question as to whether the new facility (stemming from the new agreement) needs to re-satisfy the public offer test. This uncertainty has the potential to significantly destabilise secondary trading in syndicated loans. This uncertainty has been overcome by specifying that a change of lenders does not result in a different agreement. [Schedule 7, item 8]

7.52 It should be noted that the reference to 'change of lenders' is intended to encompass both an increase and decrease in the lenders under the syndicated loan facility. Further, where an agreement is treated as a syndicated loan facility pursuant to subsection 128F(12), that is, where the agreement is entered into by only one lender, the subsequent addition of other lenders (by a process of syndication) is intended to be treated as a 'change of lenders'. The result is that a different agreement will not result in such circumstances, irrespective of whether the change in lender occurs by novation, assignment or otherwise. [Schedule 7, item 8]

Public offer test and syndicated loan facilities

7.53 In order for the syndicated loan to be exempt from IWT, the syndicated loan facility must satisfy the public offer test. This is necessary because the debt interest, being the syndicated loan, will generally only come into existence upon there being a draw-down under the facility, which could occur after the time the public offer is made. To overcome this an invitation to become a lender under a syndicated loan facility has been made the subject of the public offer test. [Schedule 7, item 4]

7.54 An invitation, by a company, to become a lender under a syndicated loan facility will satisfy the public offer test if the invitation was made:

•

to at least 10 persons each of whom was carrying on a business of providing finance, or investing or dealing in securities, in the course of operating in financial markets, and was not known, or suspected by the company to be an associate of any of the other persons to whom an invitation has been made;

•

publicly, whether in electronic or another form, that was used by financial markets for dealing in debentures or debt interests; or

•

to a dealer, manager or underwriter, in relation to the placement of debentures or debt interests, who, under an agreement with the company, made the invitation to become a lender under the facility within 30 days in either of the two preceding ways listed above.

[Schedule 7, item 4]

7.55 Not all of the public offer tests in subsection 128F(3) have been duplicated because not all the tests are relevant to syndicated loan facilities.

7.56 As is currently the case with debentures and debt interests, there will be circumstances where a syndicated loan facility will be taken to have failed the public offer test.

7.57 An invitation to become a lender under a syndicated loan facility will fail the public offer test if at the time the invitation is made, the company knew or had reasonable grounds to suspect that:

•

an associate of the company is, or will become, a lender under the facility and either:

-

the associate is a non-resident and is not, or would not, become a lender under the facility by carrying on a business in Australia at, or through, a permanent establishment of the associate in Australia; or

-

the associate is a resident of Australia and is, or would become, a lender under the facility in carrying on a business in a country outside Australia at or through a permanent establishment of the associate in that country; and

•

the associate is not, or would not, become a lender under the facility in the capacity of either a dealer, manager or underwriter in relation to the invitation, or a clearing house, custodian, funds manager or responsible entity of a registered scheme.

[Schedule 7, item 5]

Regulation-making power to prescribe additional instruments for exemption

7.58 In recognition of the evolving nature of financial markets and innovation in financial instruments, a regulation-making power has also been included to enable the prescription of other financial instruments as eligible for exemption. [Schedule 7, items 1 to 3]

7.59 It is anticipated that this power will only be used to prescribe financial instruments that are close substitutes for, and perform a similar role to, debentures. Consideration would also be given to the extent to which there is a detrimental impact on access to capital by Australian borrowers.

Debt interests issued by eligible unit trusts

7.60 Under the new law, interest on a non-debenture debt interest issued by an eligible unit trust is eligible for the IWT exemption only if the interest is on a non-debenture debt interest that is a syndicated loan or is prescribed as eligible for exemption by regulation. [Schedule 7, item 9]

7.61 Similarly, the insertion of non-equity share in those provisions making reference to a qualifying security should not be interpreted as implying a non-equity share would necessarily constitute a security under income tax law.

7.62 In order to be eligible for exemption, the relevant debenture or debt interest must satisfy the public offer test. Where the non-debenture debt interest is a syndicated loan, it is the invitation to become a lender under the relevant syndicated loan facility that must satisfy the public offer test. [Schedule 7, item 9]

7.63 The definitions of 'syndicated loans' and 'syndicated loan facilities' in relation to eligible unit trusts is consistent with those applying to companies. [Schedule 7, items 14 and 15]

7.64 Amendments ensure that where the purchase price of an eligible debt interest is composed in part of interest, that embedded interest is only eligible for IWT exemption if it is on an eligible non-debenture debt interest that is a syndicated loan or is prescribed by regulation. [Schedule 7, item 10]

7.65 The public offer test applies to the trustee of an eligible unit trust in respect of an invitation to become a lender under a syndicated loan facility in a corresponding way to how it applies to companies in respect of invitations to become a lender under a syndicated loan facility. [Schedule 7, items 11 and 12]

7.66 In order to facilitate secondary trading in syndicated loans, a change in the lenders under a syndicated loan agreement will not result in a different agreement. This section applies to eligible unit trusts in an identical manner to how it applies to companies. [Schedule 7, item 13]

7.67 It should be noted that the amendments do not enable a non-debenture debt interest issued, that is a non-equity share issued by an eligible unit trust, to qualify for the IWT exemption. Although it is unlikely that such an instrument could be issued directly by a trustee, there may be more limited circumstances that could arise in the context of an offshore subsidiary company (subsection 128FA(5)).

7.68 However, subsection 128FA(5) can only have application where the offshore subsidiary company raises finance in a country specified in the regulations (paragraph 128FA(5)(c)). As no regulations have been made, subsection 128FA(5) currently does not have any effect.

7.69 Should a situation arise where an entity of the type specified in subsection 128FA(5) issues non-debenture debt interests that are non-equity shares, consideration will be given to using the regulation-making power to prescribe such instruments as eligible for exemption.

Application and transitional provisions

Application provisions

7.70 The amendments clarifying the scope of the IWT exemption will apply only to interest paid in respect of debt interests issued on or after 7 December 2006. [Schedule 7, item 16]

7.71 For the most part, these amendments were previously part of Schedule 2 to the Tax Laws Amendment (2006 Measures No. 7) Bill 2006, which was introduced into the House of Representatives on 7 December 2006 and due to take effect from that date. The Schedule was subsequently removed from the Bill when it came before the Senate for debate on 27 March 2007.

7.72 It is anticipated that any potential negative effects that may be associated with retrospective legislation will be minimal. Firstly, due to the very limited retrospectivity of the amendments (five months) and secondly, given the fact the financial markets have been familiar with the Government's policy intentions in this area for a considerable period.

7.73 Schedule 7 does differ in one significant effect to the IWT amendments that were introduced on 7 December 2006 in that the current amendments explicitly provide that debt interests that are syndicated loans are eligible for IWT exemption. It should be noted that although syndicated loans were capable of eligibility for IWT exemption from 21 March 2005, there was uncertainty regarding how the public offer test would apply in the case of draw-downs and novations of syndicated loan facilities. As these issues have now been addressed in the primary legislation (minimising the need for private rulings from the Australian Taxation Office), industry would gain additional benefits from increased certainty where the amendments apply sooner (ie, from 7 December 2006) than later.

Transitional provisions

7.74 A debt interest will be treated as having been issued before 7 December 2006 (the 'start day') if it is issued under, or results from, a written agreement entered into on or after 21 March 2005 but prior to the start day. The transitional provisions ensure that parties that enter into written agreements in reliance on the law as it stood following the 2005 amendments to the IWT exemption continue to benefit from the exemption in respect of those debt interests that are issued under, or result from, the agreement. [Schedule 7, item 16]

7.75 The terms 'is issued under' and 'results from' are intended to apply in situations where a new debt interest arises as a consequence of the draw-down of an existing written agreement. Although the draw-down will technically constitute a new debt interest (subject to passing the debt test), where the draw-down is in respect of a written agreement that was entered into after 21 March 2005 but prior to the start day, the modified transitional arrangements will operate to treat the new debt interest as having arisen prior to the start day.

7.76 The terms 'is issued under' and 'results from' are also intended to apply to situations where a new debt interest arises as a consequence of the novation of an existing written agreement. Where the novation arises in respect of a written agreement that was entered into after 21 March 2005 but prior to the start day, the modified transitional arrangements will operate to treat the new debt interest as having arisen prior to the start day.

7.77 An integrity provision has also been included to ensure that where a written agreement entered into between 21 March 2005 and the start day is altered to extend the term of the agreement, that extended term cannot benefit from the transitional arrangements. The IWT exemption will cease at the point when the agreement was originally due to terminate. [Schedule 7, item 16]

Chapter 8 Investments in forestry managed investment schemes

Outline of chapter

8.1 Schedule 8 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to provide that initial investors in forestry managed investment schemes (forestry schemes) will receive a tax deduction equal to 100 per cent of their contributions and subsequent investors will receive a tax deduction for their ongoing contributions to forestry schemes, provided that at least 70 per cent of the scheme manager's expenditure under the scheme is expenditure attributable to establishing, tending and felling trees for harvesting (direct forestry expenditure or DFE).

8.2 The new provision retains the existing principle that the managers of forestry schemes must include the investors' contributions in their assessable income in the year in which the deduction is first available to the investor for those contributions.

8.3 This Schedule also provides rules governing the taxation consequences of trading forestry scheme interests. These rules are set out in the following chapter (Chapter 9) of this explanatory memorandum.

Context of amendments

8.4 The deductibility of investors' contributions to forestry schemes is currently determined under the general deduction provision contained in section 8-1 of the ITAA 1997. In addition, an immediate deduction may be claimed for funds contributed in one year for 'seasonally dependent agronomic activities' undertaken during the following year (section 82KZMG of the Income Tax Assessment Act 1936 (ITAA 1936)). This special '12-month prepayment rule' is due to expire on 30 June 2008. Where investors take advantage of the 12-month prepayment rule, scheme managers must include the investor's contribution in their assessable income in the year the investor becomes eligible for the deduction (section 15-45 of the ITAA 1997).

8.5 The test in section 8-1 involves considerable uncertainty as to whether specific expenses relating to managed investment schemes will qualify as a deduction, either because the investor may not be carrying on a business or because the investor's interest in the scheme is capital rather than revenue in nature.

8.6 Accordingly, the Government has decided to provide certainty to investors and the forestry industry by providing a specific deduction for contributions to forestry schemes. At the same time, it has decided to maintain the requirement that scheme managers include investors' contributions in assessable income in the year the investor is entitled to the deduction.

Summary of new law

8.7 Schedule 8 creates a new specific deduction provision for contributions to forestry schemes.

8.8 The provision ensures that initial investors in forestry schemes will receive a tax deduction equal to 100 per cent of their contributions and that secondary investors will receive a tax deduction equal to 100 per cent of their ongoing contributions, provided that there is a reasonable expectation that at least 70 per cent of the scheme manager's expenditure under the scheme, at arm's length prices, is expenditure attributable to establishing, tending and felling trees for harvest (DFE).

8.9 The requirements for the deduction are set out in sections 394-10 and 394-15. These include that:

•

the entity claiming the deduction is an investor in a scheme whose purpose is for establishing and tending trees for felling only in Australia;

•

the investor does not have day-to-day control over the operation of the scheme; and

•

the trees intended to be established in accordance with the scheme have all been established within 18 months of the end of the income year in which the first payment is made by an investor.

8.10 The '70 per cent DFE rule' is set out in section 394-35. The rule provides that the amount of DFE under the scheme (the sum of the net present values of all DFE under the scheme) divided by the amount of payments under the scheme (the sum of the net present values of all amounts that participants in the scheme have paid or will pay) must be greater than or equal to 70 per cent. This is an objective test of what is a reasonable estimate of 70 per cent expenditure on DFE, based on the actions that a reasonable person in the scheme manager's position would take in making such an estimate. A market value substitution rule operates where the expenditure differs from market value.

8.11 The notion of a payment under the scheme excludes payments for:

•

financing (borrowing costs and interest and payments in the nature of interest);

•

stamp duty;

•

goods and services tax (GST), where applicable; and

•

processing forestry produce, for example in-field wood chipping or milling of logs, whether in-field or at a static facility.

8.12 'DFE' is defined in broad terms as:

•

amounts spent by the scheme manager (or an associate of the scheme manager) under the scheme that are attributable to establishing, tending, felling and harvesting trees; and

•

amounts of notional expenditure reflecting the market value of land, goods and services provided by the scheme manager that are used for establishing, tending, felling and harvesting trees.

Certain expenses which are clearly not DFE are listed in subsections 394-45(3) and (4).

Definitions of concepts used in the legislation

8.13 The following meanings of words and phrases (and legislatively defined terms) are used in Chapters 8 and 9:

•

amounts paid by investors are referred to as 'contributions' or 'fees', whereas amounts paid by scheme managers (and their associates) are referred to as 'expenditure' or 'expenses';

•

the term 'investor' is used to describe an entity which makes a contribution to a scheme - in the legislation, an investor in the scheme (other than the manager, if the manager invests in the scheme) is referred to as a 'participant';

•

'scheme' is as defined in subsection 995-1(1) of the ITAA 1997;

•

'forestry managed investment scheme', 'manager', 'interest', 'participant' and 'initial participant' are as defined in section 394-15:

-

The forestry managed investment scheme may be registered or unregistered under the Corporations Act 2001,

•

'associate' is as defined in section 318 of the ITAA 1936;

•

'Australia' is as defined in section 17 of the Acts Interpretation Act 1901 and the ITAA 1936; and

•

'payment' is defined in section 394-20 to include constructive payments, such as a payment made to the scheme manager by a financier at the direction of an investor.

Comparison of key features of new law and current law

Detailed explanation of new law

8.14 This measure inserts a specific deduction into the ITAA 1997 to provide initial investors with a tax deduction equal to 100 per cent of their payments under the scheme, provided that there is a reasonable expectation at 30 June in the year in which an amount is first paid under the scheme that at least 70 per cent of that expenditure (using market value) qualifies as DFE. Secondary investors are also entitled to a tax deduction equal to 100 per cent of their on-going contributions under the scheme.

8.15 The specific deduction provisions will be located in Division 394 of the ITAA 1997. If a taxpayer would be eligible for deductions under both section 8-1 and the specific deduction provision, then pursuant to section 8-10 of the ITAA 1997, the taxpayer will be able to claim a deduction only under the provision that is more appropriate. If the taxpayer qualifies under the specific deduction provision, then this would be the most appropriate provision. If a forestry scheme does not qualify under the new Division 394, but may do so under section 8-1, section 8-1 may continue to apply.

8.16 There is no requirement for taxpayers to demonstrate that they are 'carrying on a business' in order to access the deduction or that the amount paid is revenue in nature.

8.17 Interest and borrowing costs paid by an investor will not be covered by the specific deduction provision and will continue to be deductible under the relevant provisions of the ITAA 1936 and the ITAA 1997 (eg, sections 8-1 and 25-25 of the ITAA 1997, respectively), provided the relevant tests for those provisions are met.

Objects clause

8.18 The objects clause is intended to provide guidance as to parliament's precise objectives in enacting these rules and to limit the parameters of the rules.

8.19 The objectives of the legislation is to direct investment to commercial plantation forests, to help achieve the industry's goals as set out in Plantations for Australia: the 2020 Vision:

•

In particular, the intention is to grow trees to be felled. Schemes involving trees that are grown for their produce other than timber (eg, avocadoes, olives or macadamia nuts) do not generally qualify except in a case such as sandalwood which is felled and subsequently exploited for its oil as well as its timber.

8.20 The objective is to be achieved by:

•

ensuring that investors will only qualify for the deduction if certain conditions are met (for instance if there is a reasonable expectation that 70 per cent of their contributions (on a market value basis) will be spent on direct forest expenditure); and

•

allowing secondary market trading of scheme interests whilst minimising tax arbitrage opportunities and providing certainty of taxation treatment for investors.

[Schedule 8, item 2, section 394-5]

Requirements for the scheme

8.21 The prerequisites for obtaining the deduction are that:

•

the entity claiming the deduction holds an interest in a forestry managed investment scheme [Schedule 8, item 2, paragraph 394-10(1)(a )]:

-

such an entity is referred to in the legislation as a 'participant';

-

'participant' does not include contractors or subcontractors that are engaged by the scheme manager. It also does not include employees of the scheme manager or any contractors engaged to carry out activities under the scheme. However, investors are not denied deductions when they invest separately to their capacity as a contractor, sub-contactors or employee of the scheme manager;

•

the purpose of the scheme is for establishing and tending trees for felling in Australia [Schedule 8, item 2, subsection 394-15(1 )]:

-

this requirement is intended to preclude deductions for horticulture trees that are grown for their produce apart from timber, for example almond and avocadoes;

•

the investor pays an amount under the scheme [Schedule 8, item 2, paragraph 394-10(1)(b )]:

-

this is effectively the time when the cash flows from the investor to the scheme manager. The use of the word 'paid' (rather than 'incurred') denotes this cash concept. The word 'pay' is defined further below; and

-

the acquisition of shares in forestry companies, or units in a forestry unit trust, falls outside the wording of this provision. Accordingly, taxpayers who acquire such shares or units are not entitled to the deduction;

•

the scheme satisfies the 70 per cent DFE rule on 30 June in the income year in which an investor in the scheme first pays an amount under the scheme [Schedule 8, item 2, paragraph 394-10(1)(c )];

•

the investor does not have day-to-day control over the operation of the scheme (whether or not the investor has the right to be consulted or give directions) [Schedule 8, item 2, paragraph 394-10(1)(c )]:

-

the legislative requirement that the investor be a 'participant' in a forestry scheme is wide enough to encompass investors, forestry scheme managers and forestry contractors. The requirement that the investor does not have day-to-day control over the operation of the scheme ensures that managers of forestry schemes cannot access this concession. The preceding requirement, that the investor pays an amount under the scheme, ensures that contractors who supply goods or services to the scheme manager cannot access this concession;

•

at least one of these conditions is satisfied [Schedule 8, item 2, paragraph 394-10(1)(e )]:

-

there is more than one investor in the scheme; or

-

the scheme manager, or an associate of the manager, manages, arranges or promotes similar schemes for other entities;

•

the trees intended to be established in accordance with the scheme have all been established within 18 months of the income year when expenditure was first paid under the scheme by an investor [Schedule 8, item 2, paragraph 394-10(1)(f) and subsection 394-10(4 )]:

-

this ensures that the intent of the specific deduction, to establish trees for felling, is met;

-

this provision is worded in a manner that it is deemed to be fulfilled unless it is subsequently found that the trees are not planted. As a consequence, investors should be able to claim a deduction when they pay their contribution. Should the trees not be planted within 18 months, then the investor's deduction may be denied, in addition to potentially applying the promoter penalty provisions against the scheme manager; and

-

a forestry scheme would meet paragraph 394-10(1)(f) where replanting of unsuccessful seedlings extends past 18 months;

•

the investor is an initial investor that holds the interest under the scheme for four years from the end of the income year in which they first paid an amount under the scheme. (The concept of an initial investor is explained further in Chapter 9 of this explanatory memorandum.) [Schedule 8, item 2, subsections 394-10(5) and (6 )]:

-

a breach of this requirement will result in the investor losing a deduction and being assessed on the proceeds. The investor may also be liable to pay the general interest charge and penalties; and

•

sections 82KZMD and 82KZMF of the ITAA 1936 do not apply to expenditure which qualifies for the new specific deduction. Those provisions relate to the rules which normally govern the period over which prepaid expenditure can be deducted [Schedule 8, item 2, subsection 394-10(7 )].

8.22 The investor claims the deduction for the income year in which the investor pays the amount. [Schedule 8, item 2, subsection 394-10(2 )]

Subsequent investors cannot deduct the costs of acquiring their interest

8.23 An investor who acquires an interest in the scheme from another investor (eg, by purchasing the interest from the initial investor on the secondary market) is specifically prevented from claiming the specific deduction in respect of the market value that they pay to acquire that interest. Given that the objective is to establish trees, secondary investors should not need to obtain a deduction for the establishment costs of trees. [Schedule 8, item 2, subsection 394-10(3 )]

Meaning of 'payment'

8.24 For the purposes of paragraph 394-10(1)(b), 'payment' includes an amount paid at the direction of an investor in the scheme, such as a financial institution paying the scheme manager an amount as part of funding a loan to the investor. [Schedule 8, item 2, section 394-20]

Example 8.1

Investor A instructs Finance Coy to pay Australian Forest Ltd (AFL) $10,000 for an interest in a 2008 pulpwood project. Finance Coy deposits this amount into AFL's account. This satisfies 'pay' for the purposes of paragraph 394-10(1)(b).

Payments under the forestry scheme

8.25 This concept encompasses everything paid by an investor to a scheme manager under a forestry scheme. However, the following payments are excluded from the deduction [Schedule 8, item 2, sections 394-10 and 394-40] :

•

borrowing costs;

•

interest and payments in the nature of interest (such as a premium on repayment or redemption of a security, or a discount on a bill or bond);

•

stamp duty;

•

GST (where applicable); and

•

processing costs.

The first time an amount is paid under the scheme

8.26 'The first time an amount is paid under the scheme' for the purposes of the paragraph 394-10(1)(c) test, will either be when the first amount is paid by an investor to become a participant in the scheme or, if there is a contingency such as a minimum subscription requirement, when the contingency occurs. To determine this question, it will be necessary to examine the terms of the agreement. Under some forestry agreements, this will be the time at which minimum subscription is achieved and the application fee is transformed into an establishment fee. The issue arises because there is a question as to when the first investor actually becomes a participant in the scheme. Many schemes have an application fee that is held in trust until a minimum subscription level is reached, at which point it may then be transformed into an establishment fee.

Example 8.2

Australian Forests Ltd (AFL) issues a product disclosure statement for its 2009 pulpwood project on 31 March 2008. Investor A pays an application fee on 20 June 2008 which is held in trust by AFL until minimum subscription occurs. The issue is fully subscribed on 25 June 2008 and AFL applies the investor's application fee together with an additional establishment fee to establish the 2009 pulpwood project on 25 June 2008.

The scheme must satisfy the 70 per cent DFE rule on 30 June 2008 which is in the income year where the establishment fee was paid. This constitutes the first payment under the scheme.

Meaning of 'establishing'

8.27 The concept of 'establishing' a plantation includes planting, coppicing and grafting activities and other methods of plant propagation that result in a forest being established. Coppicing is a process in which new shoots from the stumps of harvested trees are culled and the selected shoots are managed to produce a new tree crop. 'Establishing' does not include acquiring an immature forest.

8.28 Site preparation costs (such as ground and fence clearing, deep ripping and mounding, pre-planting fertilisation, initial weed control and channel irrigation and road or fire-break creation), which are necessary to enable trees to be established and survive, are included in the concept of establishing.

8.29 In addition, some 'pre-establishment' costs (such as site selection costs) will be able to be claimed to the extent they are attributable to DFE. Such costs may need to be apportioned, for example, where they relate to more than one project covered by the same site selection exercise.

Meaning of 'tending'

8.30 'Tending' includes inspection, measuring and monitoring, pest control, fire hazard reduction and fire management, re-planting, coppice management, fertilising, pruning and thinning, which are all part of tending the forest until harvest.

Meaning of 'felling'

8.31 For the purposes of Division 394, felling trees includes harvesting activities (whether for final harvest or earlier commercial thinnings) such as felling trees, de-limbing or lopping off branches and heads, the removal of bark or the cross-cutting into manageable lengths to facilitate on-site storage or transport. 'Harvesting' trees does not include substantial transformation into a different product such as through in-field chipping or milling. [Schedule 8, item 2, subsection 394-45(4 )]

8.32 Certain 'post-harvesting activities' are excluded from DFE. These are outlined in paragraphs 8.66 and 8.67.

Initial investor's sale and harvest proceeds held on revenue account

8.33 To provide symmetry between the upfront revenue deduction and the proceeds of sale or harvest, where you are an initial participant in the scheme and can deduct or have deducted an amount under Division 394 (or could have done so if you had not disposed of your interest within four years), and a CGT event occurs in relation to your interest, the proceeds arising from the CGT event will be treated as assessable income on revenue account in the income year of receipt. [Schedule 8, item 2, section 394-25]

8.34 This is achieved by requiring the assessable income of the investor to include the market value of the interest when a CGT event happens to your interest under the scheme. A CGT event will happen in relation to your interest if that interest is sold, is extinguished or ceases, or if the CGT event reduces the value of the interest. The market value that is included in your income is the value of the interest just before the event, or if you continue to hold your interest after the CGT event, the amount by which the market value of your interest is reduced. [Schedule 8, item 2, subsection 394-25(2 )]

8.35 Treating the initial investor's interest as capital would result in the initial investor obtaining a double benefit of a 100 per cent deduction (on revenue account) on acquiring the interest and the potential application of concessional CGT treatment, including the CGT discount for individuals and trusts and the application of capital losses to their proceeds on disposal.

Direct forestry expenditure (DFE) and the 70 per cent DFE rule

8.36 To ensure that most of the funds contributed by investors are spent on activities directly related to establishing, tending and felling trees for harvesting, the scheme manager of the scheme must ensure that no less than 70 per cent is spent on 'direct forestry expenditure'. [Schedule 8, item 2, section 394-35]

8.37 The principle will only measure contributions and expenditure that are undertaken under the scheme. For example, supplies that are made by related entities (rather than by the scheme manager) direct to the investor will only be captured if they are within the scheme. Equally, payments by investors must be made under the scheme to be included in the test.

8.38 The concept embodies an objective test of what is a reasonable estimate of 70 per cent expenditure on DFE over the life of the project, using a net present value calculation for past and future expenditure. The deduction is available if there is a reasonable expectation that DFE will be equal to or exceed 70 per cent at 30 June of the income year in which an investor first makes a contribution to the scheme. [Schedule 8, item 2, paragraph 394-10(1)(c) and subsection 394-35(1 )]

8.39 It should be noted that:

•

the standard of reasonableness is that of a reasonable person standing in the shoes of the scheme manager and taking reasonable steps to gather relevant information to establish that the expectation exists; and

•

the scheme manager will need to prepare, for the duration of the project, sufficient evidence to document that this reasonable expectation existed at the required time.

Example 8.3

In year 1 a scheme manager of a 10-year bluegum project has a reasonable expectation that the proportion of DFE under a particular scheme will be 75 per cent. This includes an expectation that the annual rent in net present value terms over the life of the project is $50,000 based on the scheme manager's knowledge of the relevant technology and prevailing economic conditions.

In the subsequent years, the following events occur which have the effect, based on actual data, of reducing the relevant proportion below 70 per cent. However, as the examples illustrate, the actual proportion does not directly impact on whether the expectation was reasonable at the time it was made.

•

The scheme manager estimated that the cost of felling and loading the plantation in 10 years time in net present value terms will be $4,000 per hectare. Subsequent technological advances in the methods for felling that were not foreseeable when the project was planned result in the cost of felling being reduced by 25 per cent to $3,000, which means that the actual DFE on the project during its life would be below 70 per cent of total fees charged to investors. The scheme manager became aware of this in year 8 of the project. The scheme manager could not reasonably have expected such a technological advancement to happen at the time of making the estimate for the purposes of subsection 394-35(1). Therefore the reasonable expectation test in subsection 394-35(1) was met at the time of the estimate.

•

The scheme manager's estimated labour costs for the project based on the future value of current costs of similar size projects, including labour costs for pest control. During the three years prior to the commencement of the project, the use of advanced methods of pest control had increased steadily from 10 per cent of industry projects to 30 per cent. Industry reports in the year before the project commenced indicated the expectation that in the next 10 years this method would spread to all parts of the industry. This method of pest control is adopted in the project from commencement and significantly reduces labour costs below that used in the estimates of DFE. A reasonable estimate of the proportion of DFE based on the use of the advanced pest control method would be below 70 per cent. The scheme manager of the scheme could reasonable have expected that these methods would come to be used in this project during its life. Therefore, the reasonable expectation test in subsection 394-35(1) was never met and the investors in the scheme were never entitled to the specific deduction under section 394-10.

•

As a result of an unexpected drought in the region where the project is located, the growth of trees is substantially less than originally projected and harvest costs are only $2,000 per hectare, which means that the actual DFE on the project during its life would be below 70 per cent of the total fees charged to investors. As this drought was unexpected at the time of making the estimate for the purposes of subsection 394-35(1), therefore the reasonable expectation test in subsection 394-35(1) was met at the time of the estimate and the project continues to meet the test in subsection 394-35(1).

8.40 Once it is found that there was not a reasonable expectation at the relevant time, any participant contributions will not be deductible, subject to the period of review for the participant in respect of relevant income years.

8.41 The amount of DFE under the scheme is the sum of the net present values (at the date of the test) of all DFE under the scheme that the scheme manager has paid or will pay under the scheme. [Schedule 8, item 2, subsection 394-35(2 )]

Example 8.4

On 30 June 2009 the manager spends $2,000 on site selection costs. On 15 March 2010 the first investor's payment under the scheme becomes final. On 30 June 2010, the manager will be required to calculate the net present value of the site selection expenditure using the figure prescribed in subsection 394-35(7) for the purposes of estimating the 70 per cent DFE amount.

8.42 The amount of payments under the scheme is the sum of the net present values of all amounts that participants in the scheme (other than the manager) have paid or will pay under the scheme. [Schedule 8, item 2, subsection 394-35(3 )]

8.43 Expenses are recognised on a 'net cost' basis. For example, where expenditure is undertaken and a grant is received (such as for the costs of training/employing apprentices), only the net expense of the scheme manager is taken into account. [Schedule 8, item 2, subsection 394-35(6)]

Net present value basis

8.44 The amount spent on DFE over the life of the project will be determined in 'net present value' terms. Net present value is a way of converting past and future costs into today's dollars. Discounting is the technique used to make the conversion. Discounting recognises that a dollar today is not worth the same as a dollar in the future because (even in the absence of inflation) today's dollar can be invested.

8.45 This concept applies to both past and future expenditure of the scheme manager under the scheme.

8.46 If:

(Net present value of DFE unde the arrangement / Net present value of fees paid by investor under the arrangment) >= 70%


then it is a qualifying scheme. [Schedule 8, item 2, subsections 394-35(1) to (3 )]

8.47 For the purpose of working out the net present value of an amount paid on or before the day on which the 70 per cent DFE rule is calculated, the amount is to be treated as having been paid on 30 June in the income year in which the amount was actually paid. [Schedule 8, item 2, subsection 394-35(4 )]

8.48 For the purpose of working out the net present value of an amount expected to be paid after the day on which the 70 per cent DFE rule is calculated, the amount is to be treated as having been paid on 1 January in the income year in which the amount was actually paid. [Schedule 8, item 2, subsection 394-35(5 )]

8.49 Present values will be calculated by discounting future expenditures using the yield on Commonwealth Government Securities that are Treasury bonds with the maturity closest to 10 years (as published by the Reserve Bank of Australia). The scheme manager can use the current quoted rate as an approximation of the rate on 30 June. [Schedule 8, item 2, subsection 394-35(7 )]

Example 8.5

On 30 June 2008, a scheme manager is seeking to establish the net present value of future expenditure. The manager consults the Indicative Mid Rates of Selected Commonwealth Government Securities as published by the Reserve Bank of Australia for that day. According to the Reserve Bank, a Treasury Fixed Coupon Bond with a yield of 5.910 per cent will mature in February 2017 and another Treasury Fixed Coupon Bond with a yield of 5.880 per cent will mature in March 2019. No other bonds with a longer maturity are listed. The bond maturing in March 2019 should be chosen as it has the maturity closest to 10 years.

8.50 The yield on Commonwealth Government Securities is a risk-free rate. The rate is chosen for simplicity and to reduce compliance costs. The use of a risk-free rate is balanced by a number of risk-related items being excluded from DFE, such as insurance.

Example 8.6

The following scenarios assume that Australian Forests Ltd (AFL) issues a product disclosure statement for its 2008 project. Investors acquire a one hectare interest in a 10-year plantation. It is assumed that the initial investor holds until harvest. The discount rate specified in the legislation to calculate the net present value of AFL's future expenditure is the interest rate on Commonwealth Government Securities that are Treasury bonds with the maturity closest to 10 years which at 1 January 2008 is 7 per cent per annum. In each scenario the base year is year 1.

Scenario 1

In the first scenario, in year 1 the investor acquires an interest for $10,000. The scheme manager pays $8,000 in DFE. There are no further anticipated or actual expenses or contributions over the life of the project. Applying the formula:

(Net present value of DFE under the arrangment / Net present value of fees paid by the investor under the arrangment)


the relevant figure is: 8000 / 10,000 = 80% (ie, the test is passed).

Scenario 2

In year 1 the investor acquires an interest for $10,000. The scheme manager pays $7,000 in expenses. In year 10 the investor pays a further $1,000 in fees and the scheme manager pays $700 in DFE. The net present value of the investor's fees in year 1 terms is $10,544. The net present value of the scheme manager's expenses is $7,381. Applying the above formula:

the relevant figure is: 7,381 / 10,544 = 70% (ie, the test is passed).

Scenario 3

In year 1 the investor acquires an interest for $10,000. The scheme manager pays $6,000 in expenses. The investor pays no further fees. In year 10 the scheme manager pays $1,000 in DFE (in net present value terms, this is $544). Applying the above formula:

the relevant figure is: 6,544 / 10,000 = 65.44% (ie, the test is failed).

Scenario 4

In year 1 the investor acquires an interest for $10,000. In years 2 to 9 the investor is required to pay an annual fee of $500. In year 10, the investor pays $2,000 in fees. The investor's total outlay in nominal terms is $16,000, the net present value of which is $14,074.

In year 1, the scheme manager outlays $8,000 in DFE. In years 2 to 9 the scheme manager's expenditure on DFE is $300 per annum and in year 10 it is $2,000. The scheme manager's total outlay in nominal terms is $12,400, the net present value of which is $10,879.

Applying the formula:

the relevant figure is: 10,879 / 14,074 = 77.30% (ie, the test is passed).

Recognition of costs of assets used in multiple projects

8.51 There will be no requirement that the scheme manager's expenditure be exclusively revenue. However, capital expenditure will only be able to be counted to the extent that the amount is attributable to establishing, tending, felling and harvesting trees. As a consequence, in carrying out the DFE calculation, capital costs of assets whose effective life is greater than the projects, or which are used in multiple projects, are only to be incorporated to the extent that the assets are used in the relevant project. The same consideration requiring apportionment to the extent that an expense is attributable to DFE also applies to non-DFE expenses, particularly labour costs.

Example 8.7

A scheme manager purchases harvesting equipment for $100,000. The equipment will be used equally on five forestry scheme projects for the whole of its life. $20,000 is allocated to each of the five projects.

Market value substitution rule where expenditure differs from market value

8.52 Where:

•

the scheme manager has paid or will pay amounts under the scheme;

•

the transaction is not at arm's length; and

•

the amount paid is or will be more or less than the market value of what the amount is for,

the market value is to be substituted for the prices actually used in determining the amount of DFE. [Schedule 8, item 2, subsection 394-35(8 )]

8.53 This provision will often be used when a related party of the manager charges an inflated price for a good or service. This provision will operate to reduce the price to the market price.

8.54 It should be noted that a discounted price where parties are dealing at arm's length is a market value price. This includes discounts for volume of purchases, confirmation of advance orders and prompt payment.

Example 8.8

Teak Pty Ltd, a company which manages a forestry scheme which is based in north-western WA, decides to purchase teak seedlings from Unique Teak Ltd (UTL), a wholly-owned subsidiary, for $10,000. UTL is one of a number of suppliers of teak seedlings in Australia.

On investigation, there is evidence that the normal market value for the seedlings is $4,000. For the purpose of calculating the 70 per cent test, the amount of $4,000 is substituted.

8.55 In cases where there is no local market for a good or service, regard should be given to the standards used in comparable industries in Australia or overseas in determining whether an applicable market value should be substituted.

8.56 The arm's length prices for internally provided forestry services (eg, tree felling services) will include the normal profit margin that an arm's length supplier would require. This ensures that there is no distinction between 'in-sourced' and 'out-sourced' services.

Definition of direct forestry expenditure

8.57 DFE under a scheme means, in a general sense:

•

amounts spent by the scheme manager (or an associate of the scheme manager) under the scheme that are attributable to establishing, tending, felling and harvesting trees; and

•

amounts of notional expenditure reflecting the market value of use of land, goods and services provided by the scheme manager that are used for establishing, tending, felling and harvesting trees.

[Schedule 8, item 2, subsection 394-45(1 )]

8.58 Expenditure under the first category includes actual costs, including actual rent paid by the scheme manager for land used to establish trees.

8.59 Expenditure under the second category includes notional expenditure, such as notional rent (where the scheme manager owns the land used to establish trees) or the notional charges for goods or services that the scheme manager provides in-house rather than purchasing the equivalent good or service from an external provider.

8.60 Where DFE relates to notional amounts, the amount is calculated as if it were paid annually for each income year based on the market value of the use of the land, good or service. The day on which the notional amount is taken to be paid is:

•

unless one of the following applies - 1 January in the income year; or

•

if the first time an amount is paid under the scheme is later than the first day of the income year - the last day of the income year; or

•

if the scheme comes to an end on a day before the end of the income year - that day.

[Schedule 8, item 2, subsection 394-45(2 )]

8.61 DFE includes road transport to the first stages of milling or processing. While DFE does not include the cost of in-field chipping, it does include the first leg of transport after in-field chipping to a mill or wharf. This will ensure consistent treatment across forestry operations, where it may be more economical to conduct initial processing on-site prior to road transport. It should be noted that the chipping and other forms of processing are outside of the scheme under section 100.

8.62 The costs of research and development (R&D) that are attributable to establishing, tending, felling and harvesting trees are allowable. Where R&D costs are difficult to apportion, a reasonable apportionment method will be acceptable. For example, where R&D has been undertaken that relates to multiple projects, it is permissible to apportion the cost on a reasonable basis, such as in proportion to the area under plantation or the value of the projects.

8.63 The expenditure is net of recoverable tax (eg, input tax credits under the GST). In relation to GST, it should also be noted that section 960-405 of the ITAA 1997 reduces the market value of an asset at a particular time by the amount of an input tax credit to which the taxpayer would be entitled.

Specific exclusions from DFE

8.64 The legislation provides that the following types of expenditure are expressly excluded from DFE:

•

marketing of the scheme (including expenditure related to advertising, sales, sponsorship and entertainment);

•

insurance, contingency funds or provisions (other than for employee entitlements);

•

financing;

•

lobbying;

•

general business overheads (but not overheads directly attributable to forestry);

•

subscriptions to industry bodies;

•

commissions for financial planners or financial advisers;

•

compliance with requirements related to the structure and operations of the forestry manager of the scheme (including product design and the preparation of product disclosure statements);

•

supervision and auditing of contracts, other than direct supervision of direct forestry activities; and

•

legal fees relating to any matter mentioned in the subsection.

[Schedule 8, item 2, subsection 394-45(3 )]

Examples illustrating activities that are or are not direct forestry activities (and where apportionment is required)

Example 8.9

Greentrees Ltd's sole business is the management of bluegum forestry projects. The costs of an employee of Greentrees Ltd who only carries out the following tasks would be regarded as corporate overheads and not included in DFE: chief executive officer, personnel manager or accounts manager.

Example 8.10

The costs of an employee who only carries out the following tasks would be included in DFE:

•

a 'project coordinator' who undertakes community liaison, education programmes and land purchase;

•

a 'case and systems manager' located at head office who operates Private Plantation Management Information System (PPMIS) allocations, mapping services, geology, planning applications, remote sensing and survival analysis;

•

a 'resource manager' who undertakes harvest scheduling, inventory, survival analysis, mill liaison and in-field project analysis;

•

a 'head of forestry operations' who undertakes final land approval, seedling/cutting strategy, plantation and base design and government and community liaison (noting that there is a specific exception for lobbying); and

•

an 'in-field technical supply officer' who undertakes satellite operations, personal digital assistant (PDA) support, mapping and taping out and reserve monitoring.

Example 8.11

An entity engaged in forestry projects employs a person to supervise its team of foresters and accounting staff. If a scheme manager includes the cost of this supervisor in the calculation of DFE for the 70 per cent rule then it must apportion the costs (including the labour costs of employing the supervisor) between DFE and general overheads. Only the portion directly relating to supervision of the foresters is DFE.

Example 8.12

The cost of legal advice, or wages for legal staff involved in drawing up contracts for forestry and harvesting contractors, is DFE. However, the cost of legal advice, or wages for legal staff in assisting in regulatory compliance, investor relations, and business structuring and financing would not be DFE.

Example 8.13

Wages for accounts-payable staff who deal with both the payment of invoices directly related to forestry and other invoices can be apportioned.

Example 8.14

The cost of compliance with forest certification and/or forestry codes and prescriptions, including the wages of office staff that are paid to monitor compliance with these codes is DFE (and is to be apportioned where appropriate).

8.65 The concept of DFE ends when the earliest of the following activities takes place:

•

sale;

•

transport to a mill within Australia;

•

transport to a wharf within Australia; or

•

processing.

8.66 Harvesting costs do not include:

•

in-field processing such as chipping or milling;

•

marketing;

•

sale costs;

•

stockpiles; or

•

port handling and ship loading.

[Schedule 8, item 2, subsection 394-45(4 )]

8.67 While the concept of harvesting is exclusive of processing, including the costs of 'in-field chipping', a scheme manager may claim costs of transport to a mill or wharf subsequent to in-field chipping (but not the costs of the chipping, or where transport is after the sale).

Examples 8.15: Establishing, tending and felling

The scheme manager of a forestry project engages a 3rd party to fell, delimb and chip logs in the field. For the purposes of Division 394 the amount of the cost that relates to felling and delimbing constitutes DFE. The amount that relates to infield chipping does not constitute DFE.

The scheme manager of a forestry project engages a 3rd party to selectively cull coppice shoots on harvested stumps after previous forestry operations. The cost of coppicing is an establishment or planting cost for the purposes of Division 394.

The scheme manager instructs his forestry employees to use a mobile timber mill to cut timber into slabs as the customer requires the wood for use as dining room tables. The cost of this activity is regarded as processing and does not constitute DFE.

Amounts paid to the scheme manager under a forestry scheme

8.68 Section 15-46 of the ITAA 1997 explains that when a scheme manager (or an associate of the scheme manager) receives an amount from an investor and all the requirements of section 394-10 are satisfied (disregarding subsection 394-10(5)), the amount must be included in the scheme manager's assessable income in the income year in which the participant is first able to claim the corresponding deduction. This is the same principle as is used in section 15-45. [Schedule 8, item 15, section 15-46]

Compliance and administration issues

Notification requirements

8.69 A scheme manager must make a statement to the Commissioner of Taxation (Commissioner) regarding the first amount of income the manager receives that is included in the manager's assessable income under section 15-46. The statement must be in the approved form and must be given to the Commissioner within three months after the end of the income year in which the manager receives the amount. [Schedule 8, item 3, section 394-5 of the Taxation Administration Act 1953 (TAA 1953 )]

8.70 If the 18-month requirement in subsection 394-10(4) is not met, the scheme manager must give the Commissioner a statement in relation to the reasons why the condition was not satisfied. The statement must be in the approved form and must be given to the Commissioner within three months after the end of the 18-month period. [Schedule 8, item 3, section 394-10 of the TAA 1953]

8.71 Both notification requirements apply to managers of schemes whether or not the scheme is covered by a product ruling. These requirements are not limited by whether or not a scheme qualifies as a managed investment scheme, or for registration, for the purposes of the Corporations Act 2001.

Record keeping requirements

8.72 Investors will be required to keep records for five years from the date when a relevant event (eg, the claiming of a deduction under Division 394) occurs. [Schedule 8, item 7, subsection 262A(2AAA) of the ITAA 1936]

8.73 Managers will be required to keep records for the life of the scheme plus five years. The relevant records to be kept must show:

•

the basis of their reasonable expectation at test time for the duration of the project;

•

expenditure on DFE for the duration of the project; and

•

investor fees collected for the duration of the project.

[Schedule 8, item 7, subsections 262A(2AAB) and (2AAC) of the ITAA 1936]

8.74 For the purpose of section 262A, the following definitions are inserted:

•

'associate';

•

'forestry managed investment scheme';

•

'forestry manager'; and

•

'participant'.

Application and transitional provisions

8.75 This measure commences from the date of Royal Assent. It applies to amounts paid by a participant under a scheme on or after 1 July 2007, provided that no other amounts were paid by the participant or any other participant under the scheme before 1 July 2007. [Schedule 8, item 26, subsections 394-220(1) and (2 )]

8.76 Sections 394-150 and 394-160 (and sections 82KZMGA and 82KZMGB) apply to CGT events that happen on or after 1 July 2007. [Schedule 8, item 26, subsections 394-200(3) and (4 )]

8.77 The purpose of the application provision is to ensure that the specific deduction is available to investors from 1 July 2007.

Consequential amendments

8.78 This Schedule amends paragraph (p) of the definition of 'relevant expenditure' in subsection 82KH(1) of the ITAA 1936 to add a reference to a loss or outgoing in respect of the establishment and tending of trees for felling to the extent to which a deduction would, apart from section 82KL, be allowable to the taxpayer under the new specific deduction provision.

•

The definition of relevant expenditure defines those losses or expenditures to which the 'expenditure recoupment' provisions in Subdivision 3-D of Part III of the ITAA 1936 may apply. That Subdivision was enacted to counter various tax avoidance schemes which involve the effective recoupment of an expenditure so that the loss or outgoing is not really suffered.

[Schedule 8, items 4 to 6 and 10B, paragraphs 82KH(1)(pa), 82KH(1G)(pa) and 82KH(1L)(p) of the ITAA 1936]

8.79 This Schedule amends the item 'forestry agreement' in section 10-5 of the ITAA 1997 to indicate that when, a CGT event occurs in relation to an interest in a forestry agreement section 82KZMGB includes an amount in the investor's assessable income. [Schedule 8, item 12, section 10-5]

8.80 This Schedule inserts a new item 'forestry managed investment schemes' in section 10-5 of the ITAA 1997 to indicate that:

•

a special provision (new section 15-46) applies to an amount received as income by a scheme manager where the new specific deduction applies; and

•

when a CGT event occurs in relation to an interest in a scheme for an initial or a subsequent investor, subsections 394-25(2) and 394-30(2) include an amount in the investor's assessable income.

[Schedule 8, item 13, section 10-5]

8.81 This Schedule amends section 12-5 of the ITAA 1997 to indicate that the ITAA 1997 Act contains a specific deduction provision (Division 394) for contributions made under forestry schemes. [Schedule 8, item 14, section 12-5]

8.82 This Schedule amends subsection 995-1(1) of the ITAA 1997 to insert the following definitions in Part 6-5 (Dictionary definitions):

•

'70 per cent DFE rule';

•

'direct forestry expenditure';

•

'forestry managed investment scheme';

•

'incidental forestry scheme receipts';

•

'initial participant';

•

'forestry interest';

•

'forestry manager';

•

'participant' and

•

'total forestry scheme deductions'.

[Schedule 8, items 17 to 25, subsection 995-1(1) of the ITAA 1997]

Chapter 9 Disposals of interests in forestry managed investment schemes

Outline of chapter

9.1 Schedule 8 to this Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) and the Income Tax Assessment Act 1936 (ITAA 1936) to clarify the tax treatment for sale and harvest proceeds that are received by secondary investors in forestry managed investment schemes (forestry schemes), and payments made by secondary investors in relation to forestry schemes.

9.2 These amendments are introduced together with a specific deduction provision for investors in forestry schemes. The specific deduction is explained in the preceding chapter of this explanatory memorandum (Chapter 8).

Context of amendments

9.3 In the previous chapter, the uncertainty regarding the deductibility of investors' contributions to forestry schemes is discussed. This uncertainty extends to whether an investor that disposes of their interest in the scheme prior to harvest had the intention of carrying on a business until harvest. This intention is required to qualify for the deduction under section 8-1 of the ITAA 1997 and relates to section 82KZMG of the ITAA 1936. In practice, this has limited trading of interests in forestry schemes except in cases of hardship. Where interests are disposed of due to reason of hardship, there is also uncertainty as to how an acquiring investor's acquisition costs and proceeds are treated.

9.4 Due to case law developments, the Commissioner of Taxation (Commissioner) has indicated that they will withdraw their previous ruling on the treatment of such investments, taxation ruling TR 2000/8, and has released a reconsidered view in draft taxation ruling TR 2007/D2.

9.5 Accordingly, the Government has decided to provide certainty to investors and industry by providing a specific deduction for investments in forestry managed investment schemes. As investors are no longer required to have an intention to hold the interests until harvest under the specific deduction, this change facilitates secondary market trading of interests.

9.6 The Government supports secondary markets for forestry scheme interests. A secondary market is a market where intangible assets, such as securities, are bought and sold after their initial issue and purchase. Examples of secondary markets are stock exchanges and 'over-the-counter' markets. The existence of secondary markets should increase the financial transparency of forestry scheme investments by introducing pricing information into the market and increasing liquidity. Increased liquidity should also increase the relative attractiveness of forestry investments.

Summary of new law

9.7 Schedule 8 introduces amendments that ensure that secondary investors can obtain deductions for on-going contributions to forestry scheme arrangements under the new deduction provision. Secondary investors cannot obtain a deduction for their acquisition costs under this provision.

9.8 This Schedule also ensures that sale or harvest proceeds received by a secondary investor are assessable income to the extent the proceeds match deductions obtained by the investor under the new deduction provision. Where secondary investors hold the interests on revenue account as trading stock, the balance of the proceeds will be assessable income. Where secondary investors hold the interests on capital account, the proceeds will be subject to a modified capital gains tax (CGT) treatment.

9.9 Proceeds received by initial investors will be treated on revenue account. In order to limit tax arbitrage that may arise from the different treatments and differences in tax rates between investors, this Schedule introduces a pricing rule and a four-year holding period rule for initial investors.

9.10 In addition, aggressive arrangements intended to exploit any opportunities for arbitrage, for instance, through transfers to tax-preferred entities (eg, self-managed superannuation funds or certain non-residents) just before receipt of harvest proceeds, may be subject to the general anti-avoidance rule in Part IVA of the ITAA 1936.

Comparison of key features of new law and current law

Detailed explanation of new law

9.11 This measure inserts rules into the ITAA 1997 and the ITAA 1936 to provide certainty of income tax treatment for investors that acquire interests in forestry schemes through a secondary market and subsequently receive sale or harvest proceeds. In particular, the rules provide for the deductibility of ongoing contributions made by a secondary investor to a forestry scheme and clarify the income tax treatment of sale or harvest proceeds.

9.12 This measure also inserts a four-year holding period rule and a market value pricing rule into the ITAA 1997 for initial investors that dispose of forestry scheme interests prior to harvest.

9.13 In order to facilitate a sufficiently deep market for investment in forestry schemes, trading in interests in existing schemes will also be allowed. Existing forestry scheme interests will also be required to be held for four years after the initial acquisition and a market value pricing rule will apply to the sale proceeds. These requirements are made by inserting sections 82KZMGA and 82KZMGB into the ITAA 1936.

9.14 Throughout this chapter:

•

the term 'investor' is used to refer to a participant in a forestry scheme. A 'participant in a forestry scheme' is defined in subsection 394-15(4) as an entity that holds an interest in the scheme (other than the manager of the scheme); and

•

the term 'scheme manager' includes a 'responsible entity'.

Treatment of sale or harvest proceeds received by secondary investors

9.15 The first part of any sale or harvest proceeds received by secondary investors will be treated as assessable income to the extent that the proceeds represent the value of (or 'match') deductions obtained for ongoing contributions under the new deduction provision. Where investors hold interests on revenue account as trading stock, the balance of the proceeds will be included in assessable income. If held on capital account, the proceeds will be subject to a modified CGT treatment in addition to the matching revenue treatment.

9.16 This seeks to ensure there is matching treatment for investors for amounts that they pay and receive. The initial purchase of the interest for most investors is expected to be on capital account and so the proceeds should also be on capital account. This is only modified to the extent that some deductions have been claimed on revenue account. This is discussed further in paragraphs 9.47 to 9.54 of this chapter.

9.17 The Commissioner's draft taxation ruling (TR 2007/D2) indicates that the preferred view as to the character of investors' contributions in such schemes is that they are payments to acquire an interest in a trust over the scheme property and are thus on capital account. Where secondary investors receive harvest proceeds on revenue account, it may be argued that the investors may either make a capital loss that cannot be offset against the revenue receipt or be unable to make a capital loss due to the operation of the CGT anti-overlap rule. This treatment is not symmetrical and is arguably inequitable.

9.18 To ensure that neither an asymmetrical outcome nor a double benefit arises for secondary investors that would otherwise obtain both deductions for ongoing contributions and CGT treatment for the capital gains made on the sale or harvest proceeds, the proceeds received are matched as assessable income to the extent the investor obtained deductions under the specific deduction provision.

9.19 Some modifications are made to the CGT rules to ensure that these rules apply appropriately when secondary investors include some of the proceeds received in assessable income on revenue account.

Initial investor's sale or harvest proceeds treated as on revenue account

9.20 To provide symmetry between the upfront revenue deduction and the proceeds of sale or harvest, where an initial participant in a scheme can deduct or has deducted an amount under section 394-10 (or could have done so if the investor had not disposed of the interests within four years), and a CGT event occurs in relation to the interests, the proceeds arising from the CGT event will be treated as assessable income on revenue account in the income year of receipt. [Schedule 8, item 2, section 394-25]

9.21 This is achieved by requiring the assessable income of the investor to include the market value of the interests when a CGT event happens to the interests under the scheme. A CGT event will happen in relation to the interests if they are sold, bought back by the manager prior to harvest, or harvest proceeds are received, or if the CGT event reduces the value of the interests (eg, a sale of part of the interests or a partial harvest). The market value that is included in the initial investor's assessable income is the value of the interest just before the event, or if the investor continues to hold some of the interests after the CGT event, the amount by which the market value of the interests is reduced. [Schedule 8, item 2, subsection 394-25(2 )]

9.22 Treating the initial investor's interest as capital would result in the initial investor obtaining a double benefit of a 100 per cent deduction (on revenue account) on acquiring the interest and the potential application of concessional CGT treatment, including the CGT discount and the application of capital losses to their proceeds on disposal.

Definition of 'initial investors'

9.23 An initial investor acquires interests in a forestry scheme from a scheme manager and not from another investor in the scheme. The investor's acquisition costs flow through as contributions to the scheme for establishing trees. [Schedule 8, item 2, subsection 394-15(5 )]

9.24 Where a scheme manager buys back interests from investors, neither the manager, nor an investor that subsequently acquires those interests from the manager, is an initial investor.

9.25 If the manager, after the trees have been planted, subsequently issues new interests in the scheme, the acquiring investors will not be initial investors as the acquisition costs will not result in the establishment of trees.

9.26 Where an initial investor obtains deductions for acquisition costs and contributions under section 394-10, all proceeds received will be treated as assessable income on revenue account. [Schedule 8, item 2, section 394-25]

Example 9.1

Helen subscribed to a forestry scheme managed by Australian Forests Limited (AFL) for $9,000 in June 2008. Investors in AFL interests are required to contribute an annual management and services fee of $1,000 in each July starting July 2009.

In October 2012, Helen sells the interests for $11,000.

Helen includes the amount of $11,000 in her assessable income on revenue account for the year ended 30 June 2013 in accordance with section 394-25.

Helen will have also obtained under section 394-10 a deduction of $9,000 for the acquisition costs of the AFL interests in the year of income ended 30 June 2008 and of $1,000 for the annual management and services fee in each income year ended 30 June 2010 to 30 June 2013.

Pricing rule

9.27 To minimise tax arbitrage opportunities (in particular, shifting of a gain from revenue to capital account), an initial investor is taken to receive the market value of the interests when a CGT event happens to the interests. [Schedule 8, item 2, subsection 394-25(2 )]

9.28 Where part of the interests is subject to a CGT event, the investor is taken to receive the amount by which the market value of the interests decreases. This is consistent with the rule in section 108-5 of the ITAA 1997 that a CGT asset includes a part of, or an interest in, a CGT asset. [Schedule 8, item 2, paragraph 394-25(2)(b )]

9.29 To prevent double counting, where an investor receives a different amount from the market value amount, the actual amount received is not included in assessable income nor is it exempt income. [Schedule 8, item 2, subsection 394-25(3 )]

9.30 A 'CGT event' is widely defined and will apply to situations where the interests are sold or are bought back by the scheme manager.

Example 9.2

Following on from Example 9.1, if the market value of Helen's interests in October 2012 is $14,000, Helen instead includes the amount of $14,000 in her assessable income on revenue account for the year ended 30 June 2013 in accordance with paragraph 394-25(2)(a).

Helen does not include the amount of $12,000 she actually received in her assessable income nor is the $12,000 exempt income under subsection 394-25(3).

9.31 Where an acquiring secondary investor holds the interests on capital account, the CGT market value substitution rule applies for the purposes of working out the secondary investor's acquisition costs for the interests (section 112-20 of the ITAA 1997).

Holding period

9.32 Deductions obtained by an initial investor for acquisition costs and contributions to a forestry scheme are denied for the income years the amounts are paid if a CGT event happens to the interests within four years. [Schedule 8, item 2, subsection 394-10(5 )]

9.33 Consistent with the rule in section 108-5 of the ITAA 1997, where a CGT event happens to the interests within four years, but the investor still holds the interests after the event, then the deductions are denied to the extent of the decrease in the market value of the interests.

9.34 An implication of this is that an initial investor is taken to dispose of the interests under the scheme at the time of entering into an agreement for the disposal. This is because some CGT events are subject to this timing rule (see for example subsections 104-10(3) and 104-25(2) of the ITAA 1997 respectively for sales and for when an asset comes to an end). A secondary investor that holds the interests on capital account is taken to acquire the interests at the time of entering into an agreement to acquire the interests (case 1 in the table in subsection 109-5(2) of the ITAA 1997).

9.35 An initial investor's assessment(s) may be amended within two years of the end of the income year that the investor disposed of the interests. This may mean that the initial investor is subject to a longer review period than would normally be the case. [Schedule 8, item 2, subsection 394-10(6 )]

9.36 Where deductions for contributions made by an initial investor are denied in the income year(s) the amounts are paid, the sale or disposal proceeds received will continue to be treated as assessable income on revenue account. [Schedule 8, item 2, subparagraph 394-25(1)(b)(ii) and subsection 394-25(2 )]

Example 9.3

Following on from Example 9.2, if Helen instead sold her interests in August 2010 at a market value of $12,000, then:

•

Helen includes $12,000 in her assessable income on revenue account in the income year ended 30 June 2011 under subsection 394-25(2);

•

the deduction for $9,000 acquisition costs for the year ended 30 June 2008 is denied in accordance with subsection 394-10(5);

•

the deductions for management and services fees of $1,000 in each income year ended 30 June 2010 and 2011 are denied under subsection 394-10(5); and

•

Helen does not make a capital loss due to the operation of the CGT rules and their interaction with provisions about assessable income.

Acquisition costs of secondary investors

9.37 Where a secondary investor acquires an interest in a forestry scheme through secondary market trading, the investor does not obtain a deduction under the new deduction provision for the acquisition costs. [Schedule 8, item 2, subsection 394-10(3 )]

9.38 However, the acquisition costs may be deductible to a secondary investor that holds the interests on revenue account as trading stock under another provision of the income tax laws.

9.39 The costs of acquiring interests from a scheme manager are not deductible under the new deduction provision if the interests replace interests that were previously bought back. This is because the acquisition costs do not relate to the establishment of new trees under the scheme and because the manager is not a participant. [Schedule 8, item 2, subsections 394-10(3) and 394-15(4) and (5 )]

9.40 For secondary investors that hold the interests on capital account, the acquisition costs are included in the cost base or reduced cost base of the interests for CGT purposes when the interests are subsequently disposed of prior to harvest or if harvest proceeds are received. It is expected that most secondary investors are likely to hold the interests on capital account.

Example 9.4

Julian acquires the AFL interests from Helen in August 2012 for $14,000 (at market value). Julian holds the interests on capital account as he does not trade in securities.

Julian does not obtain a deduction for $14,000 paid to Helen in accordance with subsection 394-10(3). Instead, this amount will form part of the cost base or reduced cost base of the interests when Julian later sells the interests or receives harvest proceeds.

Contributions made by secondary investors are deductible

9.41 Contributions made by secondary investors to a forestry scheme will be deductible if the amounts would be deductible if paid by initial investors. [Schedule 8, item 2, subsection 394-10(1 )]

9.42 This reduces the incentive to front-load ongoing fees into the acquisition costs and contributions paid by initial investors.

Example 9.5

Julian may deduct $1,000 in annual management and services fees that he pays AFL in each year of income he pays the fee after acquiring the interests from Helen.

Amounts that are received by investors for thinnings, are assessable income

9.43 Amounts received by initial and secondary investors for thinnings will be assessable income on revenue account. Thinnings are specifically excluded from the CGT treatment for secondary investors that hold interests in a forestry scheme on capital account. [Schedule 8, item 2, paragraph 394-30(1)(c )]

Example 9.6

Julian receives $1,500 for thinnings in December 2015 from AFL. Julian includes this amount in his assessable income for the year of income ended 30 June 2016.

9.44 Thinnings include a selective harvest of immature trees to facilitate better outcomes when mature trees are harvested.

9.45 A clear fell of a percentage of mature trees is not thinnings for this purpose. Instead, amounts received for this are treated as harvest proceeds received over two or more income years. See discussion in paragraphs 9.55 to 9.57.

Example 9.7

Raylee has an interest in one hectare of forest. In 2011, half of the hectare is clear felled. The following half is clear felled in 2012. The proceeds are not considered amounts of thinnings.

9.46 The CGT treatment for secondary investors that sell their interests in either secondary market trading or to the scheme manager prior to harvest, or that receive harvest proceeds, is discussed below.

Sale proceeds received by secondary investors

9.47 A secondary investor that subsequently disposes of forestry scheme interests prior to harvest is treated as receiving assessable income to the extent the investor's sale proceeds match the 'net deductions'. The net deductions are the total forestry scheme deductions (obtained by the investor under the new deduction provision) less incidental forestry scheme receipts. [Schedule 8, item 2, paragraph 394-30(2)(b) and subsections 394-30(3) to (5 )]

Example 9.8

Julian sells the AFL interests to Dana in March 2017 for $20,000 (at market value).

Julian has obtained deductions for annual management and services fees of $1,000 in each income year since the year ended 30 June 2013, a total of $4,000 under section 394-10.

Julian also included $1,500 in his assessable income for thinnings in the income year ended 30 June 2016.

Julian includes $2,500 of the sale proceeds received as assessable income for the income year ended 30 June 2017. This amount is calculated from total forestry scheme deductions of $4,000 Julian has claimed under section 394-10 for the purposes of subsection 394-30(3) less the amount of incidental forestry scheme receipts of $1,500 Julian included in assessable income for thinnings for the purposes of subsection 394-30(4).

The amount of net capital gains that Julian should also include in his assessable income is discussed in Example 9.10.

9.48 However, if the sale proceeds received by a secondary investor are less than the total forestry scheme deductions for the amount of deductions obtained by the investor under the new deduction provision (as reduced by an amount included in assessable income as incidental forestry scheme receipts for thinnings if any) all of the proceeds are assessable income. [Schedule 8, item 2, paragraph 394-30(2)(a )]

Example 9.9

If the market value of the AFL interests in March 2017 was $2,000 and Julian sold the interests to Paul for this amount, the excess of total forestry scheme deductions over incidental forestry scheme receipts for thinnings ($2,500) is more than the proceeds of sale. Julian includes all of the $2,000 in his assessable income for the income year ended 30 June 2017.

The CGT outcomes for Julian in this example are discussed in Example 9.11.

9.49 As secondary investors obtain the benefit of being able to deduct ongoing contributions under the new deduction provision, the matching principle ensures that proceeds received by these investors are not also subject to concessional CGT treatment to the extent the proceeds 'recoup' the deductions.

9.50 The sale proceeds received by a secondary investor that holds the interests on capital account are capital proceeds for CGT purposes. The normal CGT rules are modified to avoid issues that arise from the operation of the CGT anti-overlap rule and its interaction with ordinary income, statutory income, exempt income and non-assessable non-exempt income. [Schedule 8, item 2, subsections 394-30(7) and (8 )]

9.51 The cost base or reduced cost base of the interests is also modified for CGT purposes. The amount of the sale proceeds matched as assessable income under subsection 394-30(2) is included in the cost base or reduced cost base of the interests. No adjustments are made to either the capital proceeds or the cost base or reduced cost base of the interests sold if no part of the proceeds is matched as assessable income (eg, where the amount of total forestry scheme deductions is less than incidental forestry scheme receipts). [Schedule 8, item 2, subsection 394-30(9 )]

Example 9.10

Following on from Example 9.8, Julian has sold his AFL interests to Dana in March 2017 for $20,000 (at market value).

Julian includes $2,500 in his assessable income for the income year ended 30 June 2017. This is made up of total forestry scheme deductions of $4,000 that Julian obtained under section 394-10 less incidental forestry scheme receipts of $1,500 for thinnings that Julian included in his assessable income for the year of income ended 30 June 2016.

Julian's capital proceeds are the sale proceeds of $20,000.

The cost base of Julian's interests is $16,500, made up of the acquisition costs of $14,000 increased by the net amount matched as assessable income of $2,500 under subsection 394-30(9). Julian's capital gain is $3,500. Julian may apply capital losses if any and the CGT discount to the gain in determining the net capital gain to include in his assessable income for the year of income ended 30 June 2017. Julian includes the net capital gain amount in addition to the $2,500 included in assessable income under subsection 394-30(2).

Example 9.11

Following on from Example 9.9, Julian has sold his interests to Paul in March 2017 for $2,000 (at market value).

Julian includes $2,000 in his assessable income for the income year ended 30 June 2017. This occurs as subsection 394-30(2) requires the lesser of the market value of the interests (which is $2,000) or the amount of total forestry scheme deductions claimed less incidental forestry scheme receipts received (which is $2,500, being $4,000 less $1,500) to be included in assessable income.

Julian's capital proceeds are the sale proceeds of $2,000.

The reduced cost base of Julian's interests is $16,000 made up of the acquisition costs of $14,000 and modified under subsection 394-30(9)[0] to include the sale proceeds of $2,000 matched as assessable income in accordance with subsection 394-30(2). Julian makes a capital loss of $14,000[0]. Julian may apply the capital loss to other capital gains made in the income year ended 30 June 2017 or carry the capital loss forward to apply against capital gains in a later income year in addition to the $2,000 included in assessable income under subsection 394-30(2).

9.52 In calculating the capital gain, an approach that could have been taken would have been to reduce the amount of capital proceeds by the amount included in assessable income. This would more directly reflect the concept that the first part of the proceeds is taken to match the deductions claimed on revenue account. However, the legislation achieves the same result by increasing the cost base or reduced cost base rather than decreasing the sale proceeds. This approach requires fewer consequential amendments to achieve the desired policy outcome.

9.53 Where a secondary investor sells or otherwise disposes of part of their interests, the total forestry scheme deductions and incidental forestry scheme receipts are apportioned to the extent of the interests sold or disposed of. The remainder of each of total forestry scheme deductions and incidental forestry scheme receipts that is not matched as assessable income in an income year that partial sale proceeds are received is used for matching purposes in the next income year that sale or harvest proceeds are received. The remainder amounts are reflected in the cost base or reduced cost base in that next income year. [Schedule 8, item 2, subsections 394-30(2) to (6 )]

Harvest proceeds received by secondary investors

9.54 Harvest proceeds received by a secondary investor are treated in the same way as sale proceeds.

Example 9.12

Following on from Example 9.10, Dana acquired the AFL interests from Julian in March 2017 for $20,000. Dana receives gross harvest proceeds in September 2018 of $25,000 and a net amount of $23,500 as AFL was entitled under the terms of the scheme to $1,500 for harvesting and marketing fees.

Dana paid $1,000 in annual management and services fees in each of the income years ended 30 June 2017 and 2018.

Dana has not received any incidental forestry scheme receipts amounts such as for thinnings.

Dana holds the interests on capital account.

For the year of income ended 30 June 2019, Dana:

•

obtains deductions totalling $2,500 for the annual management and services fee of $1,000 and the harvesting and marketing fee of $1,500 under section 394-10;

•

matches as assessable income an amount of $3,500 for total forestry scheme deductions obtained under subsection 394-30(2). This includes deductions of $2,500 in the current year and the annual management and services fee of $1,000 obtained in the year of income ended 30 June 2018; and

•

includes in her assessable income a net capital gain worked out from a capital gain of $1,500 for capital proceeds that are harvest proceeds of $25,000 less a cost base of $23,500 for acquisition costs of $20,000 increased by the matched assessable income of $3,500 under subsection 394-30(9). Dana may offset against her capital gain of $1,500 any 'net capital losses' from previous years and any 'capital losses' from this income year and if entitled may apply the CGT discount.

Harvest proceeds received over two or more income years

9.55 Where a secondary investor receives harvest proceeds over two or more income years then:

•

the amounts matched as assessable income for the total forestry scheme deductions less the total forestry scheme receipts (for deductions obtained under the new deduction provision) are apportioned over the income years that harvest proceeds are received [Schedule 8, item 2, subsections 394-30(2) to (5 )]; and

•

the acquisition costs used in working out the cost base or reduced cost base of the interests for investors that hold the interests on capital account are also apportioned over the income years that harvest proceeds are received (section 112-30 of the ITAA 1997):

-

the relevant proportion is worked out by reference to the proportion that the amount of the reduction in the market value of the interests the investor continues to hold are of the market value of the interests just before the CGT event [Schedule 8, item 2, subsection 394-30(5 )]; and

-

scheme managers will need to notify investors of the proportion of interests to which a harvest relates;

•

any remainder of each amount of total forestry scheme deductions and incidental forestry scheme receipts in an income year in which partial harvest proceeds are received is used in the same manner as discussed for sale proceeds in paragraph 9.53 [Schedule 8, item 2, subsection 394-30(6 )].

9.56 Harvest proceeds may be received over two or more income years under a scheme either because the same plantation is harvested over more than one income year or because two or more plantations subject to the one scheme are harvested in different income years.

9.57 Where a scheme has two or more plantations of different trees, the scheme manager will need to keep records that document the relevant proportion of the scheme to which each plantation relates.

Example 9.13

Following on from Example 9.12, Dana instead receives from AFL partial harvest proceeds in September 2018 of $11,000 and proceeds of $14,000 from the balance of the harvest in September 2019.

Under the terms of the scheme, Dana is not required to pay an annual management and services fee in July 2019. Dana pays harvesting and marketing fees of $660 in the income year ended 30 June 2019 and $840 in the income year ended 30 June 2020.

Dana is advised by AFL that the harvest proceeds of $11,000 she received in September 2018 represent 44 per cent of her interests in the AFL scheme. That is, the market value of Dana's interests has decreased by 44 per cent due to the partial harvest.

For the year of income ended 30 June 2019, Dana:

•

obtains deductions totalling $1,660 for the annual management and services fee of $1,000 and the harvesting and marketing fee of $660 under section 394-10;

•

matches as assessable income an amount of $1,170 for 44 per cent of the total forestry scheme deductions of $2,660 under subsection 394-30(2) that she has obtained under section 394-10 since acquiring the interests. The total amount includes the $1,660 in the current year and the annual management and services fees of $1,000 obtained in the year of income ended 30 June 2018; and

•

includes in her assessable income a net capital gain worked out from a capital gain of $1,030 for capital proceeds that are harvest proceeds. This is calculated as harvest proceeds of $11,000 less a cost base of $9,970. The cost base is the proportion of acquisition costs of $8,800 increased by the matched assessable income of $1,170 under subsection 394-30(9). Dana may offset the capital gain of $1,030 by any 'net capital losses' from previous years and any 'capital losses' from this income year and if entitled may apply the CGT discount.

For the year of income ended 30 June 2020, Dana:

•

obtains a deduction of $840 for the harvesting and marketing fee under section 394-10;

•

matches as assessable income an amount of $2,330 for the current year deduction of $840 and the remainder of previous year deductible contributions not previously matched as assessable income, of $1,490. The amount of $1,490 reflects total forestry scheme deductions not included in Dana's assessable income in the previous income year under subsection 394-30(6); and

•

includes in her assessable income a net capital gain worked out from a capital gain of $470. This amount is equal to harvest proceeds of $14,000 less a cost base of $13,530. The cost base is the proportion of acquisition costs of $11,200 and the matched assessable income of $2,330. Dana may offset against the capital gain of $470 any previous or current year capital losses if any and if entitled by the CGT discount.

Similar outcomes would arise if Dana sold 44 per cent of her interests in September 2018 for $11,000 and either sold the remainder of her interests or received harvest proceeds for $14,000 in September 2019. In the sale situations, Dana would not have obtained deductions for harvesting and marketing fees and so does not match (nor apportion the matching amount) for deductions for this fee.

Example 9.14

Greg acquired interests in the Pine and Blue Gum 2008 scheme (PBG 2008) in secondary market trading in April 2013 for $15,000. Greg holds the interests on capital account and is not entitled to a deduction for the acquisition costs under subsection 394-10(3).

Under the terms of the PBG 2008 scheme, Greg is required to pay an annual management fee in each July of $250. Greg is also required to pay a harvest and marketing fee of 5 per cent of any gross harvest proceeds. In each income year Greg pays an annual management fee or a harvest and marketing fee, the amount of the fee is deductible in the income year paid under section 394-10.

PBG 2008 has two plantations, a blue gum plantation and a pine plantation. The scheme manager's records indicate that the blue gum plantation makes up 40 per cent of the interests that investors hold in the scheme, and the pine plantation makes up 60 per cent of the interests that investors hold in the scheme. The blue gum plantation is to be harvested in January 2016 (representing a decrease in the market value of Greg's interests of 40 per cent at that time) and the pine plantation in January 2018.

In January 2016, Greg receives $9,500 for the harvest of the blue gum plantation. The scheme manager has deducted $500 from gross proceeds of $10,000. In January 2018, Greg receives $14,250 for the harvest of the pine plantation. The scheme manager has deducted $750 from gross proceeds of $15,000.

H&M = harvest and marketing

For the income year ended 30 June 2016, Greg:

•

obtains deductions in accordance with section 394-10 for $750 (for a harvesting and marketing fee of $500 and an annual fee of $250);

•

includes an amount of $500 in assessable income on revenue account (40 per cent of $1,250 being the total of current year fees of $750 and total prior year annual fees of $500) under subsection 394-30(2); and

•

makes a capital gain of $3,500 (capital proceeds of $10,000 less a cost base of $6,500 made up of $6,000 (40 per cent of acquisition costs) and $500 for matched income included by subsection 394-30(9)). Assuming Greg has no capital losses and is entitled to the 50 per cent CGT discount, Greg includes a net capital gain of $1,750 in his assessable income.

For the income year ended 30 June 2018, Greg:

•

obtains deductions in accordance with section 394-10 for $1,000 (for a harvesting and marketing fee of $750 and annual fee of $250);

•

includes an amount of $2,000 in assessable income on revenue account under subsection 394-30(2). This is worked out as the total of current year fees of $1,000 and of fees from prior income years not matched as assessable income of $1,000. The later amount of $1,000 reflects total forestry scheme deductions not included in Greg's assessable income in the year ended 30 June 2016 under subsection 394-30(6); and

•

makes a capital gain of $4,000 (capital proceeds of $15,000 less a cost base of $11,000 made up of $9,000 (remainder of acquisition costs) and $2,000 for matched income included by subsection 394-30(9)). Assuming Greg has no capital losses and is entitled to the 50 per cent CGT discount, Greg includes a net capital gain of $2,000 in his assessable income.

Similar outcomes would arise if Greg sold 40 per cent of his interests in January 2016 for $10,000 and either sold the remainder of his interests or received harvest proceeds for $15,000 in January 2018. In the sale situations, Greg would not have obtained deductions for harvesting and marketing fees and so does not match (nor apportion the matching amount) for deductions for this fee.

Existing forestry scheme interests

9.58 In order to ensure a sufficient depth in the market for forestry scheme interests, the Government will facilitate trading of existing forestry scheme interests.

9.59 An initial investor may dispose of existing interests on or after 1 July 2007. Disposals of existing forestry scheme interests will be subject to the four-year holding period and market value pricing rules, which are identical to those outlined above for new investors. [Schedule 8, item 1, sections 82KZMGA and 82KZMGB]

9.60 Initial investors are assessed on sale or harvest proceeds in the same manner as for initial investors in forestry schemes subject to Division 394. [Schedule 8, item 1, section 82KZMGB]

9.61 Similarly, any amount received for thinnings will be treated on revenue account. [Schedule 8, item 1, paragraph 82KZMGB(1)(d )]

Application and transitional provisions

9.62 This measure commences from the date of Royal Assent. It applies to disposals of interests held in forestry schemes on or after 1 July 2007. [Schedule 8, item 26, section 394-220]

Consequential amendments

9.63 This Schedule amends the table in section 112-97 of the ITAA 1997 to include item 22A to ensure the list of cost base and reduced cost base adjustments includes an adjustment made pursuant to subsection 394-30(9). [Schedule 8, item 16, section 112-97, item 22A]

Chapter 10 Non-resident trustee beneficiaries

Outline of chapter

10.1 Schedule 9 to this Bill amends the Income Tax Assessment Act 1936 (ITAA 1936) and the Income Tax Assessment Act 1997 (ITAA 1997) to ensure that a trustee can be taxed on net income of the trust in relation to a non-resident trustee beneficiary similar to the treatment of non-resident company and individual beneficiaries. This treatment is, in effect, similar to a withholding system because the beneficiary is still assessed on these amounts but can reduce their tax liability by the tax paid by the trustee. This change applies to income years starting on or after 1 July 2006 and later income years.

10.2 The broadening of the taxation of trustees does not apply to Australian managed investment trusts and Australian intermediaries covered by the separate measure in Schedule 10 to this Bill (see Chapter 11).

10.3 Legislative references in this chapter are to provisions in the ITAA 1936 unless otherwise stated.

Context of amendments

10.4 Under the current law, a trustee is liable to pay tax on a beneficiary's share of the net income of the trust if the beneficiary is a non-resident company or individual at the end of the income year and is presently entitled to income of the trust. However, a trustee is not currently liable to pay tax if the beneficiary is a non-resident trustee of another trust. This means the taxation of trustees in relation to non-resident beneficiaries is inconsistent. Further, although a non-resident trustee is liable to pay Australian tax under the current rules in relation to non-resident company or individual beneficiaries, collecting the tax is difficult.

10.5 These amendments ensure a trustee is liable to pay tax in relation to a non-resident trustee beneficiary in a similar way to that in which a trustee is currently liable to pay tax in relation to a non-resident company or individual beneficiary. This means that the taxation of trustees in relation to non-resident beneficiaries is more consistent. These amendments also reduce the difficulty in collecting tax from non-resident trustees.

Summary of new law

10.6 These amendments extend a trustee's liability to be taxed on the net income of a trust to include the case where a trustee beneficiary who is a non-resident at the end of an income year is presently entitled to trust income. The trustee is to pay tax on that beneficiary's share of the net income of the trust attributable to an Australian source.

10.7 The broadening of the taxation of trustees does not apply to Australian managed investment trusts covered by the separate measure in Schedule 10. Similarly, it does not apply to Australian intermediaries covered by Schedule 10 to the extent their income is managed investment trust income (see Chapter 11).

10.8 Transitional provisions implement the exclusion for Australian managed investment trusts and intermediaries from this Schedule until the amendments in Schedule 10 apply. See paragraphs 10.49 to 10.51 for a more detailed explanation of the transitional provisions. Once the amendments in Schedule 10 apply, specific provisions in that Schedule will ensure the exclusion applies for later periods.

10.9 A trustee of a trust in a chain of trusts is not liable to pay tax on an amount included in the net income of that trust if that amount is reasonably attributable to an amount that has already been taxed in the hands of a trustee of a trust earlier in the chain.

10.10 The rate of tax that a trustee pays in relation to a non-resident trustee beneficiary is the top tax rate for a non-resident individual (currently, 45 per cent). There is no change to the tax rates a trustee pays in relation to non-resident individual and company beneficiaries that are not trustees.

10.11 The tax paid by the trustee is not a final tax in that an ultimate individual or company beneficiary is assessed on its share of the net income that is reasonably attributable to an amount on which the trustee was taxed. The ultimate beneficiary is then able to deduct from its tax liability its share of the tax paid by the trustee on that amount. The beneficiary is entitled to a refund of any excess tax.

Comparison of key features of new law and current law

Detailed explanation of new law

When is a trustee liable to pay Australian tax on behalf of a beneficiary?

10.12 Generally, the net income of a trust is taxed to beneficiaries of the trust under section 97. However, section 98 applies in certain cases to tax a trustee in relation to a beneficiary, including where a beneficiary is a non-resident at the end of an income year. Trustees are taxed in relation to non-resident beneficiaries to assist in the collection of Australian tax on relevant income.

10.13 Under the current law, a trustee is liable to pay tax on a non-resident beneficiary's share of the net income of the trust where the beneficiary is a company (under subsection 98(3)) or an individual (under subsection 98(4)), but only if the beneficiary is not acting in the capacity of a trustee.

10.14 The amendments to section 98 do two things. The first is to restate the effect of the current subsections 98(3) and (4). The second is to extend the circumstances in which a trustee is taxed in respect of a non-resident beneficiary to include non-resident trustee beneficiaries.

Restating current subsections 98(3) and (4)

10.15 Subsection 98(2A) will now set out the circumstances in which a trustee is taxed in relation to a non-resident company or individual beneficiary [Schedule 9, item 1, subsection 98(2A )]. Subsection 98(3) will now provide the rules for determining the rates of tax that a trustee pays in relation to the share of the net income of those beneficiaries [Schedule 9, item 1, subsection 98(3 )].

10.16 The rewritten provisions do not change the way a trustee is taxed in relation to non-resident company and individual non-trustee beneficiaries. The trustee is taxed on a non-resident beneficiary's share of the net income of the trust whether attributable to Australian or foreign sources for the period the beneficiary is a resident. The trustee is taxed only on net income of the trust attributable to Australian sources (excluding dividends, interest and royalties) for the period the beneficiary is a non-resident. [Schedule 9, item 1, subsections 98(2A) and (3 )]

Extending the liability of trustees

10.17 These amendments extend a trustee's liability to pay tax to include the case where a non-resident beneficiary is a trustee of another trust and is presently entitled to income of the first trust. The trustee of the first trust is assessed on net income of the trust attributable to Australian sources (other than dividends, interest and royalties) for an income year if a trustee of the other trust is a non-resident at the end of that income year. If the other trust has more than one trustee, the amendments will apply if at least one trustee is a non-resident at that time. [Schedule 9, item 1, subsection 98(4 )]

Dividends, interest and royalties

10.18 A beneficiary is liable, under the withholding tax rules in Division 11A of Part III, for tax on Australian dividends, interest and royalties to which they are presently entitled while a non-resident. The withholding tax is collected from the trustee under the pay as you go withholding rules in the Taxation Administration Act 1953. Income taxed under the withholding tax rules or excluded from those rules is not treated as assessable income and is therefore not taxed again to the trustee or beneficiary under either the current or new rules.

Distributions declared to be conduit foreign income

10.19 If an Australian company makes an unfranked frankable distribution that it declares to be conduit foreign income to a trustee, a trustee is not to be liable to pay tax in relation to a non-resident beneficiary's share of the net income of the trust that is reasonably attributable to all or part of that distribution. The non-resident beneficiary must be presently entitled to the share of the trust income that is reasonably attributable to all or part of that unfranked distribution. [Schedule 9, item 23, subsection 802-17(3) of the ITAA 1997]

10.20 A non-resident beneficiary is not assessed on its share of the net income of a trust to the extent the share of the net income is reasonably attributable to a distribution declared to be conduit foreign income. [Schedule 9, item 23, subsection 802-17(1) of the ITAA 1997]

10.21 The new provision ensures that distributions declared to be conduit foreign income are able to flow through trusts to non-resident beneficiaries free of Australian tax.

Capital gains

10.22 In calculating the net income of a trust, the trustee may be entitled to discount a capital gain by the relevant capital gains tax (CGT) discount percentage (currently, 50 per cent). However, such a discount is in effect reversed under section 115-220 of the ITAA 1997 in determining the amount on which a trustee pays tax in relation to a non-resident company beneficiary not acting in a trustee capacity. Taxing a trustee in this way ensures that a company beneficiary cannot gain access to a CGT discount to which it should not be entitled.

10.23 Similarly, a new provision in effect reverses a CGT discount in determining the amount on which a trustee pays tax in relation to a non-resident trustee beneficiary. [Schedule 9, item 21, section 115-222 of the ITAA 1997]

Example 10.1: Trustee tax - discount capital gain included in net income

(For illustrative purposes, this example uses the tax rates for the 2006-07 income year as in force on 1 July 2006.)

The P Trust has two non-resident trustee beneficiaries, the trustee of the S Trust and the trustee of the H Trust. The trustee of the S Trust is presently entitled to a three-fifths share of the income of the P Trust. The trustee of the H Trust is presently entitled to a two-fifths share of the income of the P Trust.

The net income of the P Trust is $100,000. It is all attributable to Australian sources. A discounted capital gain of $40,000 (the gain before discount having been $80,000) on taxable Australian property was taken into account in working out the net income.

The trustee of the P Trust pays tax of $37,800 in respect of the trustee of the S Trust's interest. The tax includes an extra amount of $10,800 as a result of the operation of section 115-222 of the ITAA 1997. The trustee of the P Trust also pays tax of $25,200 (including an amount of $7,200 as a result of the operation of section 115-222) in respect of the trustee of the H Trust's interest.

Exclusions for certain trustees

Provisions affecting a trustee's tax liability

10.24 Under the existing law, a trustee is generally taxed under subsection 98(1) or (2) in relation to a particular beneficiary where the beneficiary is under a legal disability or is treated as presently entitled to a share of the income of the trust. In such a situation, the trustee is not taxed under the current subsection 98(3) or (4) where the beneficiary is also a non-resident at the end of the income year.

10.25 The amendments to restate the effect of subsections 98(3) and (4) do not change this outcome.

10.26 Beneficiaries acting in a trustee capacity are in effect excluded from the current operation of subsections 98(1) and (2). The amendments do not change this outcome.

10.27 Currently, subsections 98(3) and (4) have the effect that trustees do not pay tax in relation to a beneficiary:

•

to whom section 97A applies; or

•

that is a body, association, fund or organisation to which subsection 97(3) applies.

Again, the amendments to restate the effect of subsections 98(3) and (4) do not change this outcome [Schedule 9, item 1, subparagraphs 98(2A)(a)(iii) and (iv )]. The new subsection 98(4) also does not tax a trustee in relation to a beneficiary to whom subsection 97(3) applies.

Trustees in a chain of trusts

10.28 A chain of trusts exists where a trustee of one trust is a beneficiary in another trust (see the diagram in Example 10.2). A trustee of a trust in a chain of trusts is not liable to pay tax under section 98 (or section 99 or 99A) on an amount included in the net income of that trust to the extent that the share of net income is reasonably attributable to an amount that has already been taxed to a trustee earlier in the chain. [Schedule 9, item 8, section 99E]

10.29 In particular, subsection 98(4) does not apply to a trustee in a chain of trusts if the relevant share of net income is reasonably attributable to an amount on which a trustee earlier in the chain was taxed under subsection 98(4).

Example 10.2: Trustees in a chain of trusts

The trustee of Trust B is the only beneficiary of Trust A and the trustee of Trust C is the only beneficiary of Trust B. The trustee of Trust B is a non-resident at the end of the income year, as is the trustee of Trust C. Trust B is presently entitled to all of the income of Trust A. Similarly, Trust C is presently entitled to all of the income of Trust B. All the income of Trust A has an Australian source and the only income of Trust B and Trust C is that flowing to them from Trust A. There is one non-resident beneficiary presently entitled to all the trust income of Trust C but under a legal disability.

Neither the trustee of Trust B nor the trustee of Trust C is taxed given that the trustee of Trust A is taxed under subsection 98(4). That is, the trustee of Trust B is not taxed under subsection 98(4) in relation to the non-resident trustee of Trust C. Similarly, the trustee of Trust C is not taxed under subsection 98(1) in relation to its individual beneficiary. However, if Trust C had other Australian source income, the trustee would be liable to pay tax under subsection 98(1) on the beneficiary's share of the net income that is attributable to that Australian source income.

Example 10.3: Chain of trusts and ultimate company beneficiary

(For illustrative purposes, this example uses the tax rates for the 2006-07 income year as in force on 1 July 2006.)

The Fun Trust has one beneficiary. The beneficiary is the trustee of the NoFun Trust and is a non-resident at the end of the income year. The trustee beneficiary is presently entitled to all the income of the Fun Trust. The net income of the Fun Trust (all attributable to Australian sources) is $100,000. The trustee of the Fun Trust pays $45,000 tax on the trustee of the NoFun Trust's share (100 per cent) of the net income under subsection 98(4).

The NoFun Trust has a non-resident company beneficiary that is presently entitled to a one-half share of the income of the NoFun Trust. The net income of the NoFun Trust is $120,000 ($100,000 being included as a share of the Fun Trust's net income plus an extra $20,000 from Australian investments). The trustee of the NoFun Trust pays tax of $3,000 (50 per cent of 30 per cent of $20,000) in relation to $10,000 of the non-resident company beneficiary's share of the net income of the NoFun Trust under paragraph 98(3)(b), being that share attributable to the income derived by the trust from its Australian investments. The trustee does not pay tax on the remainder of the non-resident company's share of the net income ($50,000) as it is reasonably attributable to an amount on which the trustee of the Fun Trust paid tax under subsection 98(4) (see section 99E).

Example 10.4: Chain of trusts and no ultimate beneficiary

(For illustrative purposes, this example uses the tax rates for the 2006-07 income year as in force on 1 July 2006.)

The D Trust has two beneficiaries, the trustee of the F Trust and the trustee of the G Trust. Both trustee beneficiaries are non-residents at the end of the income year. The trustee of the F Trust is presently entitled to a three-fifths share of the income of the D Trust. The trustee of the G Trust is presently entitled to a two-fifths share of the income of the D Trust.

The net income of the D Trust (all attributable to Australian sources) is $100,000. Under subsection 98(4), the trustee of the D Trust pays $27,000 tax on the trustee of F Trust's share of the net income and $18,000 tax on the trustee of G Trust's share of the net income. The F Trust's net income is $80,000 ($60,000 from the D Trust and $20,000 from other Australian investments). The G Trust's net income is $35,000 as the trustee incurred expenses relating to the income from the D Trust.

There are no beneficiaries presently entitled to the income of either the G Trust or the F Trust. The trustee of the G Trust has no further Australian tax liabilities (see section 99E). The trustee of the F Trust is liable to pay tax under section 99A (if it is not unreasonable that this section applies) on the net income not reasonably attributable to the amount on which the trustee of D Trust paid tax (ie, tax under section 99A on $20,000).

What are the tax rates for a trustee?

10.30 There is no change to the tax rates a trustee pays in relation to non-resident individual and company beneficiaries that are not trustees of other trusts. Those rates continue to be:

•

if the beneficiary is a company - the company tax rate (currently 30 per cent) [Schedule 9, items 1 and 27 to 29, paragraph 98(3)(b), and sections 5 and 28 of the Income Tax Rates Act 1986] ;

•

if the beneficiary is an individual - the trustee is assessed as though an individual and not entitled to any deductions [Schedule 9, item 1, paragraph 98(3)(a )].

10.31 The tax rate for trustees assessed in relation to non-resident trustee beneficiaries as a result of these amendments is the non-resident individual top marginal tax rate (currently, 45 per cent). [Schedule 9, items 1 and 27 to 29, subsection 98(4) and sections 5 and 28 of the Income Tax Rates Act 1986]

How are ultimate company and individual beneficiaries treated?

10.32 The tax paid by the trustee in relation to a non-resident beneficiary is generally not a final tax. Ultimate company and individual non-trustee beneficiaries are entitled to a credit for the tax paid by the trustee on an amount to which their share of the net income is reasonably attributable. The beneficiary is entitled to a refund if the tax paid by the trustee is greater than the beneficiary's tax liability.

Ultimate beneficiary (trustee assessed under subsection 98(3))

10.33 There is no change to the way a non-resident company or individual non-trustee beneficiary is treated where a trustee is taxed on the beneficiary's share of the trust's net income. The non-resident company or individual beneficiary includes in their assessable income their share of the amount of the trust's net income on which the trustee was taxed (see subsection 98A(1)).

10.34 The beneficiary can deduct from their tax liability the amount of tax the trustee paid in relation to the beneficiary's interest in the net income of the trust. If the tax paid by the trustee in relation to the beneficiary's interest is greater than the tax liability of the beneficiary, the company or individual beneficiary is entitled to a refund of the difference (see subsection 98A(2)). As under the current law, the Commissioner may use the amount to offset any other tax liabilities of the beneficiary.

Ultimate beneficiary (trustee assessed under subsection 98(4))

10.35 If a trustee is taxed on the net income of the trust in relation to a non-resident trustee beneficiary under subsection 98(4), a later trustee in a chain of trusts is not taxed again on that income under section 98, 99 or 99A. However, an amount attributable to that net income may be taxed to the ultimate individual or company non-trustee beneficiary under subsection 98A(3), section 97 or section 100.

Subsection 98A(3)

10.36 A non-resident individual or company non-trustee beneficiary (including an individual under a legal disability) presently entitled to income of a trust, includes in assessable income their share of the trust net income that is reasonably attributable to an amount of net income previously taxed under subsection 98(4) to a trustee earlier in the chain. [Schedule 9, item 4, subsection 98A(3 )]

10.37 A new provision ensures an ultimate non-resident beneficiary is not assessed on the same share of the trust net income under both subsections 98A(1) and 98A(3). Subsection 98A(3) operates in preference to subsection 98A(1) where both may otherwise have applied. This prevents the same amount being included twice in the beneficiary's assessable income. [Schedule 9, item 4, subsection 98A(4 )]

Section 97

10.38 A resident individual or company non-trustee beneficiary presently entitled to the income of a later trust includes in their assessable income the share of the net income of the later trust under section 97, provided Part XI (about foreign investment funds) does not apply. Some of that amount may be reasonably attributable to an amount on which a trustee earlier in the chain paid tax under subsection 98(4).

Section 100

10.39 A resident or non-resident beneficiary who is under a legal disability or who is treated as being presently entitled under subsection 95A(2) and who derives income from more than one trust estate may be assessed under subsection 100(1).

10.40 A new provision is being inserted into section 100 to ensure a resident who is a beneficiary in only one trust estate, and is either under a legal disability or is treated as being presently entitled under subsection 95A(2), is assessed under the section to the extent their interest in the net income is reasonably attributable to an amount on which the trustee was taxed under subsection 98(4). [Schedule 9, item 11 subsection 100(1B )]

10.41 A new provision ensures an ultimate non-resident beneficiary is not assessed on the same share of the trust net income under both section 100 and subsection 98A(3). Subsection 98A(3) operates in preference to section 100 where both may otherwise have applied. This prevents the same amount being included twice in the beneficiary's assessable income. [Schedule 9, items 4, 9 and 10, subsection 98A(4) and subsection 100(1), note 2]

Deduction from tax liability for tax paid by a trustee under subsection 98(4)

10.42 An ultimate beneficiary who includes an amount in their assessable income under section 97, subsection 98A(3) or section 100 can deduct from their tax liability a proportion of the tax paid under subsection 98(4) by a trustee earlier in the chain [Schedule 9, item 5, section 98B] . The tax paid by the trustee includes the tax paid under section 115-220 or 115-222 of the ITAA 1997 that relates to a capital gain [Schedule 9, item 5, paragraph 98B(2)(c )].

10.43 A beneficiary who includes an amount in their assessable income because of the operation of section 100 cannot reduce their tax liability under subsection 100(2) by reference to the tax paid by a trustee under subsection 98(4), to the extent section 98B allows the beneficiary a deduction from tax liability for the tax paid. [Schedule 9, item 12, subsection 100(3 )]

10.44 A beneficiary who is entitled to a deduction from tax liability under section 98B calculates the amount they can deduct from their tax liability having regard to:

•

the amount on which they are assessed under section 97, subsection 98A(3) or section 100;

•

the extent to which the amount relates to a share of the net income of a trust on which a trustee paid tax under subsection 98(4); and

•

the amount of tax the trustee paid on that share of the net income.

The amount of the deduction is the same proportion of the tax paid as the proportion of that share that gave rise to the amount on which the beneficiary was assessed [Schedule 9, item 5, subsection 98B(3 )]. The total amount that all relevant beneficiaries entitled to a section 98B credit can deduct cannot exceed the total of the tax paid by the trustee on the net income of the trust under subsection 98(4).

10.45 If the amount the beneficiary is able to deduct from their tax liability is greater than their tax liability, they are entitled to a refund of the difference. [Schedule 9, item 5, subsection 98B(4 )]

10.46 If an ultimate beneficiary does not include an amount in assessable income that is reasonably attributable to net income on which a trustee has paid tax under subsection 98(4) (eg, because expenses and losses have been offset against that amount as it flows through the chain of trusts), the beneficiary is not entitled to a deduction for the tax the trustee paid. Similarly, if there is no individual or company beneficiary presently entitled to the trust income of the trust at the end of a chain of trusts in an income year, any tax paid by an earlier trustee on the net income of the trust does not give rise to a deduction from tax liability for any beneficiary.

Effect on a beneficiary of a discount capital gain included in trust net income

10.47 If a beneficiary is assessed on an amount of trust net income that is attributable to a capital gain, the CGT provisions in effect treat the beneficiary as having made that capital gain. If the trust capital gain was a discount capital gain, the beneficiary is treated as if they had made a capital gain double that included in their share of the trust net income. [Schedule 9, item 16, subparagraphs 115-215(2)(b)(ii) and (iii) of the ITAA 1997]

10.48 A beneficiary offsets their capital losses and carry-forward net capital losses against the trust capital gain and applies the appropriate discount percentage to the gain. A company beneficiary is not entitled to a CGT discount.

Example 10.5: Net income includes a discount capital

gain - beneficiary assessment and credit (S Trust)

(This example follows on from Example 10.1. For illustrative purposes, it uses the tax rates for the 2006-07 income year as in force on 1 July 2006.)

The S Trust has one beneficiary and that beneficiary is presently entitled to all of the income of the S Trust. The beneficiary, John, is a non-resident individual.

The net income of the S Trust is $60,000 as it has income only from the P Trust. This amount includes $24,000 in relation to the capital gain (having applied the CGT discount). The trustee of the S Trust is not required to pay tax in relation to John as all the net income of the trust is reasonably attributable to the amount on which the trustee of the P Trust paid tax.

John includes $60,000 in his assessable income (ie, his interest in the net income of the S Trust that is reasonably attributable to a part of the net income of the P Trust on which the trustee of the P Trust paid tax under subsection 98(4)). Under subparagraph 115-215(2)(b)(ii), John is treated has having made an extra capital gain of $48,000. John is entitled to a deduction of $24,000 under subsection 115-215(6).

Assuming John has no capital losses or carry forward net capital losses, the total amount included in John's assessable income is $36,000 trust income and net capital gain of $24,000.

John's tax liability is $17,750 less the relevant share of the tax paid by the trustee of the P Trust on a part of the net income (namely, the tax paid on the trustee of S Trust's share of the net income ($60,000)). The relevant amount of the tax paid by the trustee of the P Trust is $37,800 (including the amount under section 115-222), which means that John is entitled to a refund of $20,050 ($37,800 - $17,750).

Example 10.6: Net income includes a discount capital gain - beneficiary assessment and credit (H Trust)

(This example also follows on from Example 10.1. For illustrative purposes, it uses the tax rates for the 2006-07 income year as in force on 1 July 2006.)

The H Trust has one non-resident company beneficiary, Duffy Pty Ltd.

The net income of the H Trust is $40,000 as it only has income from the P Trust. This amount includes $16,000 in relation to the capital gain (having applied the CGT discount). The trustee of the H Trust is not required to pay tax in relation to Duffy Pty Ltd as all the net income of the trust is reasonably attributable to the amount on which the trustee of the P Trust paid tax.

Duffy Pty Ltd includes $40,000 in its assessable income (ie, its interest in the net income of the H Trust that is reasonably attributable to a part of the net income of the P Trust on which the trustee of the P Trust paid tax under subsection 98(4)). Under subparagraph 115-215(2)(b)(ii), Duffy Pty Ltd is treated as having made an extra capital gain of $32,000. Duffy Pty Ltd is entitled to a deduction of $16,000 under subsection 115-215(6).

Assuming Duffy Pty Ltd has no capital losses or carry forward net capital losses, the total amount included in its assessable income is $24,000 trust income and net capital gain of $32,000 (no CGT discount).

Duffy Pty Ltd's tax liability is $16,800 less the relevant share of the tax paid by the trustee of the P Trust on a part of the net income (namely, the tax paid on the trustee of H Trust's share of the net income ($40,000)). The relevant amount of the tax paid by the trustee of the P Trust is $25,200 (including the amount under section 115-222). Duffy Pty Ltd is entitled to a refund of $8,400 ($25,200 - $16,800).

Example 10.7: Comprehensive example

(For illustrative purposes, this example uses the tax rates for the 2006-07 income year as in force on 1 July 2006.)

The following is a comprehensive example demonstrating the calculation for different types of ultimate beneficiaries of the amount they can deduct from their tax liability as a credit for tax paid by a trustee under subsection 98(4) where there is a chain of trusts.

The Fun Trust

The Fun Trust has three beneficiaries, ForCo A Pty Ltd (a company) and the trustees of D Trust and NoFun Trust. The beneficiaries are non-residents for the whole of the 2007-08 income year and are presently entitled to all the income of the Fun Trust in equal proportions (one-third each).

The income of the Fun Trust is $150,000, comprising $120,000 of Australian source income and $30,000 of foreign source income. This is also the net income of the trust.

The trustee of the Fun Trust is assessed under paragraph 98(3)(b) on ForCo A Pty Ltd's share of the net income of the trust attributable to an Australian source (ie, on $40,000). The trustee is also assessed under subsection 98(4) on the share of the net income of each trustee of the D Trust and the NoFun Trust attributable to an Australian source. The trustee of the Fun Trust pays a total of $48,000 tax (30 per cent of $40,000 plus 45 per cent of $80,000).

The D Trust

The only income for D Trust is its share of Fun Trust's net income, which is $50,000. This is also the net income of the trust. There are no beneficiaries presently entitled to the income of D Trust for the 2007-08 income year. The trustee of the D Trust does not pay any Australian tax under section 99 or 99A as the net income of the trust attributable to an Australian source is reasonably attributable to an amount on which an earlier trustee (ie, the trustee of the Fun Trust) paid tax under subsection 98(4) (section 99E). The trustee of the D Trust is not liable for tax on the net income of the trust attributable to a foreign source.

ForCo A Pty Ltd

ForCo A Pty Ltd has no Australian source income other than from its investment in the Fun Trust. Its taxable income is $40,000 (subsection 98A(1)) and tax payable on that income is $12,000. However, ForCo A Pty Ltd's tax liability is nil ($12,000 less $12,000 tax paid by the trustee of the Fun Trust on ForCo A Pty Ltd's share of the net income of the Fun Trust (subsection 98A(2)).

The NoFun Trust

The net income of the NoFun Trust includes a share of the net income of the Fun Trust of $50,000 and an amount of foreign source income of $25,000. The NoFun Trust had deductible expenses relating to its investment in the Fun Trust of $5,000, which means the total net income of the NoFun Trust is $70,000. The amount of the net income attributable to Australian sources is $36,000,

(ie, $50,000 - $10,000 minus four-fifths of $5,000).

The NoFun Trust has two beneficiaries, the trustee of the Sea Trust and ResidentCo Pty Ltd. The trustee of the Sea Trust is presently entitled to four-fifths of the income of the NoFun Trust. ResidentCo Pty Ltd is presently entitled to one-fifth of the income. ResidentCo was a resident for the whole of the 2007-08 income year, and the trustee of the Sea Trust was a non-resident at the end of that income year.

The trustee of the NoFun Trust does not pay Australian tax on either of its beneficiaries' share of the net income. The trustee of the NoFun Trust would not pay tax in relation to ResidentCo Pty Ltd as a trustee does not pay tax in relation to resident company beneficiaries. The trustee of the NoFun Trust would not pay tax in relation to the Sea Trust under subsection 98(4) because the trustee of the Sea Trust's share of the net income attributable to an Australian source is reasonably attributable to an amount on which an earlier trustee (ie, the trustee of the Fun Trust) paid tax under subsection 98(4) (section 99E).

Assume the rules dealing with foreign investment fund income in Part XI do not apply to ResidentCo Pty Ltd. Assume also that ResidentCo Pty Ltd has $10,000 income from its Australian investments. ResidentCo Pty Ltd includes the $10,000 in its assessable income. The company also includes in its assessable income (because of section 97) $14,000, being its share of the net income of the NoFun Trust (one-fifth of $70,000). It has no deductible expenses.

ResidentCo Pty Ltd's taxable income is $24,000. ResidentCo Pty Ltd's tax liability is $7,200 less $3,600. The $3,600 is the tax paid on that portion (one-fifth) of the trustee of the NoFun Trust's share of the net income of the Fun Trust as gave rise to an amount included in ResidentCo's assessable income. That is, $3,600 is one-fifth of $18,000. The $3,600 is available as a deduction because of subsection 98B(3).

The Sea Trust

The Sea Trust has two beneficiaries, ForCo B Pty Ltd and Geoff (an adult individual). Both beneficiaries are non-residents for the whole of the 2007-08 income year and are presently entitled to equal shares in the income of Sea Trust.

The net income of the Sea Trust includes a share of the net income of the NoFun Trust of $56,000 (four-fifths of $70,000) and net rental income from an Australian building of $30,000. The Sea Trust's total net income is $86,000. However, the net income attributable to an Australian source is only $58,800 (four-fifths of $36,000 plus $30,000 of rental income).

The trustee of the Sea Trust pays Australian tax in relation to both its beneficiaries but only on their share of the net income that is attributable to an Australian source and on which (because of section 99E) an earlier trustee was not taxed under subsection 98(4). That is, the rental income of $30,000. The trustee pays tax of $8,750 (29 per cent of $15,000 (ie, $4,350) in relation to Geoff under paragraph 98(3)(a) plus 30 per cent of $15,000 (ie, $4,500) in relation to ForCo B Pty Ltd under paragraph 98(3)(b)).

ForCo B Pty Ltd includes $29,400 in assessable income. An amount of $15,000 is included under subsection 98A(1) as a result of the trustee of Sea Trust's being taxed on ForCo B's share of the $30,000 net rental income, and $14,400 is included under subsection 98A(3), being the amount of the company's share of the net income of the Sea Trust as is reasonably attributable to an amount on which an earlier trustee paid tax (ie, the tax paid by the trustee of the Fun Trust under subsection 98(4)).

ForCo B Pty Ltd has no other Australian source income or expenses, which means its taxable income is $29,400. ForCo B Pty Ltd's tax liability is $8,820 less $4,500 (tax paid by the trustee of the Sea Trust (see subsection 98A(2)) reduced further by $7,200 (tax paid by the trustee of the Fun Trust under subsection 98(4) on that portion (four-fifths of one-half) of the trustee of the NoFun Trust's share of the net income of the Fun Trust as gave rise to the $14,400 included in ForCo B's assessable income (see subsection 98B(3)). ForCo B is entitled to a refund of $2,880 as a result of the operation of subsections 98A(2) and 98B(4).

Geoff includes $29,400 in assessable income. An amount of $15,000 is included under subsection 98A(1) as a result of the trustee of the Sea Trust being taxed on Geoff's share of the $30,000 net rental income and $14,400 is included under subsection 98A(3), being the amount of Geoff's share of the net income of the Sea Trust as is reasonably attributable to an amount on which an earlier trustee paid tax (ie, the tax paid by the trustee of the Fun Trust under subsection 98(4)).

Geoff has no other Australian source income or expenses, which means his taxable income is $29,400. Geoff's tax liability is $8,570 less $4,350 (tax paid by the trustee of the Sea Trust (see subsection 98A(2)) reduced further by $7,200 (tax paid by the trustee of the Fun Trust under subsection 98(4) on that portion (four-fifths of one-half) of the trustee of the NoFun Trust's share of the net income of the Fun Trust as gave rise to the $14,400 included in Geoff's assessable income (see subsection 98B(3)). Geoff is entitled to a refund of $2,980 as a result of the operation of subsections 98A(2) and 98B(4).

The total of the tax paid by the trustee of the Fun Trust was $48,000. Ultimate beneficiaries were able to claim $30,000 of the tax paid. No non-trustee individual or company was entitled to a deduction from tax liability for the remaining $18,000 of the tax paid by the trustee of the Fun Trust because there were no ultimate beneficiaries in the D Trust.

Application and transitional provisions

10.49 Generally, amendments made by this Schedule apply to income years starting on or after 1 July 2006. The changes made to the conduit foreign income provisions apply from 1 July 2005, which is when those provisions first applied. [Schedule 9, item 30]

10.50 The new rule that taxes a trustee in relation to a non-resident trustee beneficiary (subsection 98(4)) does not apply for an income year that starts on or after 1 July 2006 for trustees of Australian managed investment trusts that are to be covered by the separate measure in Schedule 10 (see Chapter 11). There is a similar exclusion for that period applicable to trustees who are intermediaries covered by Schedule 10 to this Bill, but only in so far as their income is managed investment trust income. Until the separate measure comes into force, this result is achieved by transitional provisions. The conditions in these transitional exclusions are modelled on the eligibility provisions in Schedule 10. [Schedule 9, items 32 and 33]

10.51 Once Schedule 10 is in force, new section 99G will ensure that, as an ongoing rule, subsection 98(4) will not apply to managed investment trusts and intermediaries.

10.52 A transitional provision ensures that the new subsection 98(4) does not apply to a trustee of a trust that ceased to exist before the date on which this Bill was introduced into the House of Representatives. This exclusion extends, for example, to a testamentary or other trust that was wound up before this date. [Schedule 9, item 31]

Example 10.8

(For illustrative purposes, this example uses the tax rates for the 2006-07 income year as in force on 1 July 2006.)

The P Trust is a widely-held Australian managed investment trust with an income year that starts on 1 July 2006. The P Trust is an Australian resident trust estate for the 2006-07 income year. A beneficiary in the P Trust is the trustee of the S Trust, who is a non-resident during both the 2006-07 and 2007-08 income years. The trustee beneficiary is presently entitled to a 1 per cent share of the income of the P Trust. The net income of the P Trust for the 2006-07 income year is $1 million and does not include any capital gains. The trustee of the P Trust does not pay tax under subsection 98(4) on S Trust's share of the net income of the trust.

The S Trust has a single non-resident company beneficiary (Forco Pty Ltd) presently entitled to all the income of the trust. The net income of the S Trust is $10,000 for the 2006-07 year. The trustee of the S Trust is assessed and is liable to pay tax of $3,000 on ForCo Pty Ltd's share of the net income of the trust.

If this Bill receives Royal Assent on or before 30 June 2007, the new measure in Schedule 10 applies to the trustee of the P Trust for the income year that commences on 1 July 2007. The net income of the P Trust for the 2007-08 income year is the same as it was for the previous income year. During the year, the trustee of the P Trust makes a payment of $10,000 to the trustee of the S Trust. On the basis that the conditions in Schedule 10 are satisfied, the trustee of the P Trust withholds $3,000 from the amount of $10,000 it pays to the trustee of the S Trust. The trustee of the S Trust does not pay any further tax in relation to the $10,000 (being Forco Pty Ltd's share of the net income of the trust).

Consequential amendments

10.53 Amendments to Division 855 of the ITAA 1997 are being made (and a transitional rule included in relation to its predecessor in Subdivision 768-H of the ITAA 1997) as a consequence of the changes to subparagraph 115-215(2)(b)(ii) of the ITAA 1997 (discussed in paragraph 10.47). Other amendments are being made to Division 855 (and a further transitional rule included for Subdivision 768-H) because of the expanded taxation of a trustee in relation to a non-resident trustee beneficiary. [Schedule 9, items 24 to 26, subsections 855-40(3) and (4) of the ITAA 1997]

10.54 Subdivision 768-H was rewritten as Division 855 of the ITAA 1997 (as part of the Tax Laws Amendment (2006 Measures No. 4) Act 2006). Subsection 855-40(9) replaced section 768-615. Both provisions relate to capital gains and losses made by a beneficiary of a fixed trust if the beneficiary is a foreign resident company. The changes to subparagraph 115-215(2)(b)(ii) mean neither provision is now needed.

10.55 Subsection 855-40(9) is being repealed for an income year that starts on or after 1 July 2006 [Schedule 9, item 26] . Section 768-615 of the ITAA 1997 was repealed in relation to CGT events that happened on or after 12 December 2006. To ensure consistency with the changes to subparagraph 115-215(2)(b)(ii) that apply to income years commencing on or after 1 July 2006, a transitional rule dealing with the application of former section 768-615 has been included. This transitional rule prevents the operation of former section 768-615 in relation to income years commencing on or after 1 July 2006 [Schedule 9, item 34] .

10.56 The repeal of subsection 855-40(9) and the earlier repeal of section 768-615 do not affect the ability of a company beneficiary of a fixed trust to disregard capital gains and losses made by them in respect of trust assets that are not taxable Australian property. These companies now gain access to this concession through subsection 855-40(3) or subsection 768-605(3) (whichever is relevant) as a result of these amendments.

10.57 The table of particular deductions in section 12-5 of the ITAA 1997 is amended to reflect the fact that subsection 855-40(9) has been repealed. [Schedule 9, item 14, section 12-5 of the ITAA 1997]

10.58 Minor amendments are being made to subsections 98A(1) and (2) to reflect the structure of the new law. [Schedule 9, items 2 and 3, subsection 98A(1) and paragraph 98A(2)(a )]

10.59 Two minor amendments are being made to section 99B. One amendment is made because of the expanded taxation of a trustee in relation to a non-resident trustee beneficiary. The other amendment is made as a result of the new section 802-17 of the ITAA 1997 inserted by this Schedule that relates to the conduit foreign income rules. [Schedule 9, items 6 and 7, section 99B]

10.60 A new reference is being added under the heading 'trusts' in the check list of tax offsets in section 13-1 of the ITAA 1997. The new reference reflects that a beneficiary in a foreign trust may reduce their tax liability under section 98B. [Schedule 9, item 15, section 13-1 of the ITAA 1997]

10.61 Minor amendments are being made to section 115-220 of the ITAA 1997 to reflect the changes made to Division 6. [Schedule 9, items 17 to 20, section 115-220]

10.62 Minor amendments are being made to section 5 of the Income Tax Rates Act 1986 to reflect the structure of the new law. [Schedule 9, items 27 and 28, section 5 of the Income Tax Rates Act 1986]

10.63 Minor amendments are being made to subparagraph 207-50(3)(b)(ii) of the ITAA 1997 to reflect the new structure of sections 98A and 100. [Schedule 9, item 22, subparagraph 207-50(3)(b)(ii )].

Chapter 11 New withholding arrangements for managed fund distributions to foreign residents

Outline of chapter

11.1 Schedule 10 to this Bill amends the Taxation Administration Act 1953 (TAA 1953) to implement a new withholding regime for distributions to foreign residents of net income of managed investment trusts attributable to Australian sources (either directly or through certain Australian intermediaries). Income consisting of dividends, interest or royalty income is generally excluded from this measure, as are capital gains on assets other than taxable Australian property.

11.2 Consequential amendments are made to the Income Tax Assessment Act 1936 (ITAA 1936) and the Income Tax Assessment Act 1997 (ITAA 1997). Legislative references in this chapter are to provisions in the TAA 1953 unless otherwise stated.

Context of amendments

11.3 Under the current law, as proposed to be amended by Schedule 9 to this Bill, a trustee of a managed investment trust would be liable to pay tax on a beneficiary's share of the net income of the trust if the beneficiary is a foreign resident at the end of the income year and is presently entitled to income of the trust. The rate at which tax is payable depends on whether the foreign resident is a company, individual or trustee. This means that trustees of Australian managed investment trusts need to have regard to whether the foreign resident beneficiary is a company, individual or a trustee of a trust to determine the correct amount of tax payable.

11.4 In practice, most distributions made from Australian managed investment trusts to foreign residents are made through one or more Australian intermediaries. There is uncertainty about the nature of the legal relationship between Australian intermediaries, managed investment trusts and foreign resident investors, which could vary depending upon the terms and conditions of the arrangement under which the intermediary provides its services. This creates uncertainty about taxation obligations in terms of both the requirement to pay tax and the rate of tax payable.

11.5 The arrangements in this Schedule will simplify the existing tax collection mechanisms and avoid the complexities and uncertainties that could otherwise occur. They will do this by requiring withholding at a single rate for affected payments by managed investment trusts and intermediaries to foreign resident investors, regardless of the identity of the foreign resident or the relationship between the foreign resident investor and the intermediary.

Summary of new law

11.6 These amendments require trustees of managed investment trusts, that make certain payments directly to foreign residents, to withhold from the payments at the company tax rate. Provided relevant notices are provided by payers, payments made from managed investment trusts indirectly through one or more Australian intermediaries are also subject to the withholding regime. In this situation, the Australian intermediary making the payment to the foreign resident will withhold at the company tax rate.

11.7 Payments covered by this measure are, broadly speaking, payments of income of a managed investment trust to the extent they form part of the net income of the trust, excluding dividends, interest, royalties, foreign source income and capital gains on assets that are not taxable Australian property. Dividends, interest and royalty payments are generally excluded because they are already ordinarily subject to their own withholding tax arrangements in Division 11A of Part III of the ITAA 1936. Foreign source income and capital gains on assets that are not taxable Australian property are excluded because these are generally not taxable in the hands of foreign residents.

11.8 Because, at the time of payment, the trustee of the paying managed investment trust or intermediary is unlikely to know whether the payee is a foreign resident or the actual component of the distribution that will form a part of net income, the arrangements allow for certain estimates and assumptions to be made about these facts.

11.9 The ultimate beneficiary is taxed on the relevant portion of their share of net income which is reasonably attributable to an amount that is subject to withholding. An appropriate portion of the amount withheld is available to the ultimate beneficiary as a credit.

Comparison of key features of new law and current law

Detailed explanation of new law

When is the trustee of a managed investment trust liable to withhold?

11.10 These amendments ensure that certain payments made in relation to an income year - referred to in the amendments as 'fund payments' - by the trustee of a trust that qualifies as a managed investment trust, are subject to withholding if paid to a foreign resident (or someone the trustee believes to be a foreign resident).

Which trusts qualify as 'managed investment trusts'?

11.11 To qualify as a managed investment trust for an income year, three requirements must be satisfied at the time of the making of the first fund payment:

•

the trust has a relevant connection with Australia;

•

the trust satisfies certain Corporations Act 2001 requirements pertaining to the management of investments; and

•

the trust is either listed or is widely held.

Testing at the time of the first fund payment

11.12 These amendments test a trust at the time of the first 'fund payment' in relation to an income year to determine whether it qualifies as a managed investment trust for the whole income year. This is to provide certainty in determining whether payments made by the trust are subject to withholding during the income year.

Connection with Australia

11.13 The first requirement is that the trust must be an 'Australian' trust, in that it has a sufficient connection with Australia. This connection must exist at some time during the income year up to and including the time of making the first fund payment, and can be established in two ways. First, the connection with Australia can be established by the trustee of the trust being an Australian resident at a relevant time. Alternatively, the connection with Australia can be established by the trust's central management and control being in Australia at a relevant time. [Schedule 10, item 1, item 1 in the table in paragraph 12-395(1)(b )]

The Corporations Act 2001 requirements to manage investments

11.14 The second requirement is that the trust must satisfy certain conditions concerning the management of investments. To meet this requirement, the trust must, at the time of making the first fund payment for the income year, be a 'managed investment scheme' and be operated by a 'financial services licensee' whose licence covers operating such a managed investment scheme. The terms 'managed investment scheme' and 'financial services licensee' are defined in the Corporations Act 2001. [Schedule 10, item 1, item 2 in the table in paragraph 12-395(1)(b )]

Requirement of listing or of being widely held

11.15 The third requirement is that the trust must be listed or widely held in the sense that the trust has at least 50 members (ignoring objects of a trust) at the time it makes the first fund payment for the income year. These amendments allow look-through of some entities, so that the 50 member requirement is met if at least one specified entity (in general, entities that hold investments collectively for their clients and have at least 50 members themselves) is a member of the trust or indirectly holds interests in the trust through one or more trusts that themselves are Australian managed investment schemes. [Schedule 10, item 1, item 3 in the table in paragraph 12-395(1)(b) and subsection 12-395(2 )]

11.16 The requirement that the trust has 50 members (or can establish the relevant connection with an entity that itself has 50 members) aims to reduce the compliance costs associated with an unlisted trust determining whether it holds investments on behalf of a sufficient number of investors. If the trust does not have 50 members, nor can it establish the relevant connection with an entity that itself has 50 members, it cannot satisfy this requirement. This is the case even if, say, the trustee could establish the relevant connection between the trust and two or more entities, which together have more than 49 members.

Concentration test - substantial interests of foreign residents

11.17 To ensure the ownership of units in a managed investment scheme are not concentrated in a few foreign members (or even one foreign member) despite the 50 member test being satisfied, a trust is not considered to be widely held if one or more foreign resident individual members have, directly or indirectly, a 10 per cent or more interest in the trust. [Schedule 10, item 1, subsection 12-395(3 )]

Start-up and wind-up phases of a managed investment trust

11.18 In recognition that the listing and widely held requirements may be difficult to satisfy when the managed investment scheme is starting or winding up, these amendments provide a dispensation in certain circumstances from the requirement to be widely held or listed applicable to the income year in which the trust is created or is wound down.

Start-up phase

11.19 A trust is treated as a managed investment trust for the year in which the trust is created if it has the relevant connection with Australia and fulfils the Corporations Act 2001 requirements identified above at the time of the first 'fund payment' for the income year. The listed or widely held requirement does not have to be satisfied for this income year. [Schedule 10, item 1, subsection 12-395(4 )]

Wind-up phase

11.20 A trust is also treated as a managed investment trust for the year in which the trust ceases to exist if it has the relevant connection with Australia and fulfils the Corporations Act 2001 requirements identified above at the time of the first 'fund payment' for the income year, provided it also qualified as a managed investment trust for the preceding income year. This is so whether or not the trust is widely held or listed at the time it makes the first fund payment for the year in which the trust ceases to exist. [Schedule 10, item 1, subsection 12-395(5 )]

11.21 In determining whether the trust satisfies the requirement to be a managed investment trust for the preceding year, the trust cannot rely on the start-up rule. This means the wind-up phase rule can only apply in the wind-up year if the trust was a managed investment trust in the preceding year because it was actually listed or widely held at the relevant point of time during that year - a trust cannot qualify as a managed investment trust for two successive income years by having the start-up phase and wind-up phase rules applying successively in the respective years. [Schedule 10, item 1, paragraph 12-395(5)(b )]

What payments qualify as 'fund payments'?

11.22 A three-step process needs to be followed to work out how much of a payment made by a trustee of a managed investment trust is a 'fund payment'. The objective of the process is to identify how much of the payment represents, in effect, a distribution of net income (adjusted by ignoring 'excluded amounts' and related deductions) such that the total of fund payments made by the managed investment trust equals, as nearly as practical, the net income of the trust (suitably adjusted) for the income year [Schedule 10, item 1, subsection 12-400(1 )]. This process requires an estimation at the time of payment of what the adjusted net income of the trust for the year will be and what other fund payments will be made by the trust relating to the year.

11.23 The first step is to reduce the payment by that portion of the payment attributable to:

•

interest, dividend or royalty income, subject to (or exempted from) withholding under Division 11A of Part III of the ITAA 1936;

•

any capital gain on a CGT asset that is not taxable Australian property; or

•

amounts that are not from an Australian source.

These exclusions are called 'excluded amounts'. The payment so reduced is the step 1 amount. [Schedule 10, item 1, step 1 in the method statement in subsection 12-400(2)]

11.24 Dividends, interest and royalty payments are generally excluded in calculating the step 1 amount because they are already ordinarily subject to their own withholding tax arrangements in Division 11A of Part III of the ITAA 1936. Foreign source income and capital gains on assets that are not taxable Australian property are excluded because these are generally not taxable in the hands of foreign residents.

11.25 The second step requires the trustee to work out, based on their knowledge at the time of payment, the amount that it is reasonable to expect will be the net income of the trust for the current year, disregarding excluded amounts, expected excluded amounts, and deductions related to either of these amounts. This estimate of adjusted net income is the step 2 amount. This process of determining a reasonable estimate of the net income of the trust is necessary because net income is an amount that can only be ascertained at the end of a trust's income year. [Schedule 10, item 1, step 2 in the method statement in subsection 12-400(1), subsection 12-400(3 )]

11.26 Excluded amounts are disregarded in calculating the step 2 amount for the same reason they are disregarded in calculating the step 1 amount.

11.27 In undertaking this second step, the trustee of a managed investment trust must ignore the CGT discount in estimating the net income of the trust. The trustee does this by doubling any amount that it is reasonable to expect will be included within the net income of the trust as a discount capital gain. [Schedule 10, item 1, paragraph (b) of step 2 in the method statement in subsection 12-400(2 )]

11.28 The amount of any such discount capital gain is required to be doubled because these amendments do not require the trustee, in assessing its own tax obligations, to make a determination of the identity of the foreign resident recipient as an individual or company, or whether the individual or company is acting in the capacity of a trustee. The rule ensures that a company beneficiary cannot access a CGT discount to which it is not entitled. However, this rule does not prevent the foreign resident, if eligible, from claiming the CGT discount in their Australian tax return.

11.29 The third and final step in ascertaining how much of a payment is a fund payment involves a conclusion as to how much of the payment may reasonably be considered a distribution of net income (suitably adjusted) having regard to:

•

the object of the three-step process;

•

the step 1 amount;

•

amounts of earlier fund payments that have been made during the year (disregarding excluded amounts); and

•

expected amounts of any later fund payments to be made during the year (again disregarding excluded amounts).

[Schedule 10, item 1, step 3 in the method statement in subsection 12-400(2 )]

11.30 Whether it is reasonable to conclude a specific portion of the payment is a fund payment is to be determined on an objective basis. That is, the test is whether a reasonable person would consider that that portion could be expected to form a part of the net income (suitably adjusted) of the trust at the end of the income year.

Example 11.1: Calculation of fund payments

The Jervis Managed Fund, a managed investment trust, makes three distributions per annum. At the time of its first distribution, a reasonable estimation of its net income (net of excluded amounts and deductions relating to those amounts) based upon the knowledge of the trustee of the Fund at that time is as follows:

Income/Expense	July to Oct	Nov to Feb	March to June	Total
Dividends ( A )	$200	$200	$200	$600
Interest income ( B )	$50	$50	$50	$150
Rental income ( C )	$250	$250	$285	$785
Rental expenses ( D )	($0)	($300)	($135)	($435)
Other assessable income ( E )	$500	$0	$0	$500
Other deductions ( F )	($350)	($0)	($200)	($550)
Capital gains from taxable Australian property (gross) ( G )	$0	$850	$0	$850
Other distributable amounts (eg, tax preferred amounts) ( H )	$100	$150	$100	$350
Total (I = A + B + C - D + E - F + G + H)	$750	$1,200	$300	$2,250
Total (net of excluded amounts) ( J = I - A - B )	$500	$950	$50	$1,500
Net income (net of excluded amounts) ( K = J - H )	$400	$800	($50)	$1,150

The Fund decides to pay an amount of $750 as its first distribution, $250 of which is attributable to interest and dividend income received by the Fund.

The Jervis Managed Fund would calculate how much of the $750 payment is a fund payment as follows:

Step 1: The amount of the payment net of 'excluded amounts' (being the $250 of interest and dividend income to which the payment is attributable) is $500.

Step 2: Based on the trustee's knowledge at the time of the payment, it is reasonable to expect that the net income of the trust for the year, net of excluded amounts and deductions relating to those amounts (assuming none of the deductions relate to excluded amounts), will be $1,150.

Step 3: The Fund expects, as at the time of making its first distribution, that the two other distributions it will make for the income year will total $1,500 ($1,000 when excluded amounts are disregarded). As such, the amount of the first payment that is a fund payment is that portion of $1,150 (the adjusted net income) as is reasonable having regard to the present (adjusted) payment of $500 and the expected (adjusted) future payments of $1,000.

As the Fund expects to pay $1,500 in (adjusted) distributions over the year and as the expected (adjusted) net income of the trust for the year is expected to be $1,150, it is reasonable to conclude that the portion of the present payment that is a fund payment is the result of multiplying the fraction (1,150/1,500) x $500, that is $383.33. If the $750 payment is made to a foreign resident, the trustee should withhold 30% x $383.33, equalling $115.00.

If, however, there was significant uncertainty at the time of payment about the future, it may be reasonable to conclude that the portion of the payment that is a fund payment is different to $383.33.

For example, if there is sufficient uncertainty about amounts that could be paid in future as fund payments as well as net income, it may be reasonable to treat $400 as the fund payment. If there were sufficient uncertainty about amounts that could be paid in future as fund payments but it was expected that the net income of the year may approach total (adjusted) payments for the year, it may be appropriate to treat a greater amount than $400 as a fund payment. However, the maximum portion of the payment that can be recognised as a fund payment is $500 (ie, the step 1 amount for the payment).

Example 11.2: Calculation of fund payments

Assume, in contrast to Example 11.1, that at the time of the first distribution, Jervis Managed Fund instead estimates its net income for the year to be as follows:

Income/ Expense	July to Oct	Nov to Feb	March to June	Total
Dividends ( A )	$200	$200	$200	$600
Interest income ( B )	$50	$50	$50	$150
Rental income ( C )	$250	$250	$200	$700
Rental expenses ( D )	($0)	($400)	($150)	($550)
Other assessable income ( E )	$500	$0	$0	$500
Other deductions ( F )	($350)	($0)	($300)	($650)
Capital gains from taxable Australian property (gross) ( G )	$0	$400	$0	$400
Other distributable amounts (eg, tax deferred amounts) ( H )	$100	$100	$100	$300
Total (I = A + B + C - D + E - F + G + H )	$750	$600	$100	$1,450
Total (net of excluded amounts) ( J = I - A - B )	$500	$350	($150)	$700
Net income (net of excluded amounts) ( K = J - H )	$400	$250	($250)	$400

The first payment

The Jervis Managed Fund decides to distribute $500 as its first distribution, $250 of which is attributable to interest and dividend income received by the Fund.

The Jervis Managed Fund would calculate how much of the $500 payment is a fund payment as follows:

Step 1: The amount of the payment net of 'excluded amounts' (being the $250 of interest and dividend income to which the payment is attributable) is $250.

Step 2: Based on the trustee's knowledge at the time of the payment, it is reasonable to expect that the net income of the trust for the year, net of excluded amounts and deductions relating to those amounts (assuming none of the deductions relate to excluded amounts), will be $400.

Step 3: The Fund expects, as at the time of making its first distribution, that the two other distributions it will make for the income year will total $950 ($450 when excluded amounts are disregarded). As such, the amount of the first payment that is a fund payment is that portion of $400 (the adjusted net income) as is reasonable having regard to the present (adjusted) payment and expected (adjusted) future payments of $700.

As the Fund expects to pay $700 in (adjusted) distributions over the year and as the expected (adjusted) net income of the trust for the year is expected to be $400, it is reasonable to conclude that the portion of the present payment that is a fund payment is the result of multiplying the fraction (400/700) x $250, that is $142.86. If the $500 payment is made to a foreign resident, the trustee should withhold 30% x $142.86, equalling $42.00.

On this basis, the possible break-down of the distribution of $500 could be as follows:

Interest and dividends	$250.00
Fund payment	$142.86
Tax deferred amount	$107.14
Total distribution	$500.00

As discussed earlier, depending upon expectations about the future, it may be reasonable to treat a greater portion than $142.86 of the payment as a fund payment. However, the maximum portion of the payment that can be recognised as a fund payment is $250 (the step 1 amount).

The second payment

At the time of making its second distribution, the Jervis Managed Fund makes a larger distribution than it originally planned to make. It now makes a second distribution of $900, $350 of which is attributable to interest and dividend income received by the Fund. At the time of making its second distribution, the fund estimates its net income for the year to be as follows:

Income/ Expense	July to Oct	Nov to Feb	March to June	Total
Dividends (A)	$200	$300	$300	$800
Interest income (B)	$50	$50	$50	$150
Rental income (C)	$250	$450	$600	$1,300
Rental expenses (D)	($0)	($400)	($150)	($550)
Other assessable income (E)	$500	$0	$0	$500
Other deductions (F)	($350)	($0)	($100)	($450)
Capital gains from taxable Australian property (gross) (G)	$0	$400	$1,000	$1,400
Other distributable amounts (eg, tax deferred amounts) (H)	$100	$100	$100	$300
Total (I = A + B + C - D + E - F + G + H )	$750	$900	$1,800	$3,450
Net income (net of excluded amounts) ( K =- J - H )	$500	$550	$1,450	$2,500
Total (net of excluded amounts) ( J = I - A - B )	$400	$450	$1,350	$2,200

The Jervis Managed Fund would calculate how much of the $900 payment is a fund payment as follows:

Step 1: Amount of payment net of 'excluded amounts' (being the $350 of interest and dividend income to which the payment is attributable) is $550.

Step 2: Based on the trustee's knowledge at the time of the payment, it is reasonable to expect that the net income of the trust for the year, net of excluded amounts and deductions relating to those amounts (assuming none of the deductions relate to excluded amounts), will be $2,200.

Step 3: The Fund expects, as at the time of making its second distribution, that the final distribution it will make for the year will be $1,800 ($1,350 when excluded amounts are disregarded). The Fund has already made a distribution of $500 ($250 when excluded amounts are disregarded). As such, the amount of the second payment that is a fund payment is that portion of $2,500 (the adjusted net income) as is reasonable having regard to the present payment, the prior and (expected) future fund payments.

As the Fund calculated $142.86 of the first payment as representing a payment of net income, and as the Fund expects to pay $1,450 in (adjusted) distributions for the remainder of the year, it is reasonable to conclude that the portion of the present payment, that is a fund payment, is the result of multiplying the fraction

(($2,500 - $142.86) / ($1,450 + $550)) by $550, that is $648.21. However, as this is greater than $550 (the step 1 amount), it is reasonable to conclude that the whole payment of $550 is a fund payment.

Indeed, if the possibility or likelihood of a revision upwards in expected net income was known at the time of the first payment, it may have been reasonable to treat a larger amount of the first payment as a fund payment.

If it was reasonable to treat the entire amount of $550 as a fund payment, the break-down of the distribution of $900 would be as follows:

Interest and dividends	$350
Fund payment	$550
Total distribution	$900

It should be noted that the Fund is unable to over-withhold, that is, it is unable to withhold more than $165 (30% of $550) from a fund payment of $550. The Fund is, however, when making a determination as to what portion of the distribution it is paying constitutes a fund payment, able to take into account expected future income in the year so long as it would be reasonable to do so.

Timing of payments

11.31 In addition, for an amount to qualify as a 'fund payment', it must be paid during the income year to which the payment relates or three months after the end of the income year [Schedule 10, item 1, subsection 12-400(4 )]. This includes payments made constructively (under section 11-5).

11.32 However, this base period of time in which a fund payment is to be made if it is to qualify as a fund payment may be extended by the Commissioner of Taxation (Commissioner) by an additional period of up to three months (starting immediately after the end of the base period), if the Commissioner is of the opinion the trustee was unable to make a payment within the base period because of circumstances beyond the influence or control of the managed investment trust [Schedule 10, item 1, subsection 12-400(5 )]. An example of this would be where a non-associated trust, in which the trustee of the managed investment trust has made an investment, has not provided sufficient information about the constituent parts of a distribution made to the managed investment trust, despite all reasonable efforts by the trustee of the managed investment trust to gain that information.

The obligation on managed investment trusts to withhold

11.33 Where the trustee of a managed investment trust has made a fund payment to a foreign resident (or a recipient the trustee believes or has reasonable grounds to believe to be a foreign resident), the trustee must withhold an amount equal to:

The amount of the fund payment x the company tax rate.
[Schedule 10, item 1, subsection 12-385(2 )]

Often, the trustee of the managed investment trust will not have sufficient information to determine whether a recipient is a foreign resident for Australian tax purposes. Accordingly, the amendments allow the trustee of the managed investment trust to make the assumption that the recipient is a foreign resident in certain cases. This outcome is identical to that provided in other withholding arrangements contained in the TAA 1953. [Schedule 10, item 1, section 12-410]

When is an intermediary liable to withhold?

11.34 These amendments also ensure that fund payments made by trustees of managed investment trusts to certain intermediaries, who then pay amounts to foreign residents (or someone believed to be a foreign resident), are subject to withholding. In these circumstances, however, it is the intermediary that is obliged to make the withholding.

Which entities qualify as an 'intermediary'?

11.35 To qualify as an intermediary in respect of a payment, three requirements must be satisfied at the time of receipt of that payment:

•

the entity has a relevant connection with Australia;

•

the entity satisfies certain Corporations Act 2001 requirements pertaining to the conduct of an intermediary business; and

•

the entity must have received a notice relating to the payment.

Connection with Australia

11.36 The first requirement is that the entity must be an 'Australian' entity, in that the entity must have a sufficient connection with Australia. This connection can be established in two ways. First, the connection can be established by the entity being a resident. Where the recipient is a trustee of a trust, either the trustee of the trust must be a resident, or the trust's central management and control must be in Australia, at the time of receipt of the payment. Second, and alternatively, the connection can be established if the business that satisfies the Corporations Act 2001 requirements (see below) is carried on through a permanent establishment in Australia at the time of receipt of the payment. [Schedule 10, item 1, paragraph 12-405(1)(d) and subsection 12-405(2 )]

Corporations Act 2001 requirements to provide intermediary services

11.37 The second requirement is that the entity is, at the time of receipt of the payment, carrying on a business consisting predominantly of providing 'custodial or depository services' pursuant to an 'Australian financial services licence'. The terms 'custodial or depository services' and 'Australian financial services licence' are both defined in the Corporations Act 2001 [Schedule 10, item 1, paragraph 12-405(1)(a )]. Further, the receipt of the payment must be in the course of this business [Schedule 10, item 1, paragraph 12-405(1)(b )].

11.38 A 'business' can mean something that is a part of a larger business, provided the putative business can itself be meaningfully considered a business when viewed as a stand alone venture.

11.39 In addition, the business need only predominantly consist of providing 'custodial or depository services'. Where the business consists of other activities, provided their extent is not such that the provision of custodial or depository services could not be considered to be the dominant activity of the business, the business conducted by the entity may still be considered to be predominantly consisting of providing custodial or depository services.

The entity has received a notice

11.40 An entity can only qualify as an intermediary in respect of a payment it receives if it has received a notice in respect of that payment on or before the time of receipt of the payment. [Schedule 10, item 1, paragraph 12-405(1)(c )]

11.41 The notice will set out information about the payment that will enable the intermediary to calculate the amount the intermediary will need to withhold if it on-pays the amount received to a foreign resident, such as how much of the payment would have been required to be withheld if the payer had made the payment directly to a foreign resident rather than the intermediary. It will also set out the income year of the paying managed investment trust to which the relevant fund payment relates, which is relevant to determining the income year in which the beneficiary should return assessable income. [Schedule 10, item 1, subsection 12-415(2 )]

11.42 It is not mandatory for a payer to give a notice, and the failure to provide a notice to an entity will simply mean the withholding arrangements in this Schedule will not apply to the entity when it on-pays the payment in respect of which a notice has not been provided. A consequence of this is that the withholding obligation may rest with another entity or, in certain situations, other taxing regimes may operate instead.

11.43 Importantly, a notice can only be provided by a trustee of a managed investment trust or an intermediary. [Schedule 10, item 1, subsection 12-415(1 )]

11.44 This is because a notice may only be given by an entity making a payment from which an amount would have been required to be withheld had the payment been made by the entity to a foreign resident. However, the withholding arrangements in this Schedule only impose withholding obligations on managed investment trusts and intermediaries.

11.45 No notice can be provided by an intermediary in respect of a constructive payment (ie, a payment is deemed to have been made). This is to prevent multiple withholding in the rare case that a fund payment is made through two or more entities that would, but for the notice requirement, satisfy the definition of 'intermediary'. Without this prohibition on the provision of notices, an intermediary could make a constructive payment by dealing with a fund payment it receives (eg, by placing the fund payment on deposit on the instruction of another party). At a later time, if the fund payment were on-paid to the other party and the other party were able to satisfy the definition of intermediary (as it could do if it could be provided with a notice in respect of the payment), then a second withholding obligation may be raised if the other party itself made an on-payment to a foreign resident. [Schedule 10, item 1, subsection 12-415(3 )]

Intermediaries acting as agents for their clients

11.46 Entities that act as agents for their clients (as principals) are treated as a separate entity for the purposes of the new withholding arrangements if they meet the definition of 'intermediary'. [Schedule 10, item 1, paragraph 12-420(2)(a )]

11.47 In addition, the mere act of receipt of a payment by an intermediary acting in the capacity of an agent is not a constructive payment [Schedule 10, item 1, paragraph 12-420(2)(b )]. Rather, any subsequent dealing in the fund payment on behalf of the principal will be taken to be a constructive payment. Examples include depositing the fund payment into an interest-bearing account (whereby the principal becomes entitled to interest) or discharging an obligation of the principal by making payment to another party.

Which payments by intermediaries are subject to withholding?

11.48 An intermediary is obliged to withhold from a payment it makes under the amendments if the payment is made to a foreign resident (or a recipient the intermediary believes or has reasonable grounds to believe to be a foreign resident), and the payment is attributable to an earlier payment that would have been subject to withholding had it been made to a foreign resident instead of the intermediary. [Schedule 10, item 1, subsection 12-390(1 )]

The obligation on intermediaries to withhold

11.49 Where an intermediary has received a payment attributable to a fund payment and in turn makes a payment to a foreign resident (or person the intermediary has a reasonable belief is a foreign resident), the intermediary must withhold an amount equal to:

The amount of the payment made to the foreign resident attributable to that part of the payment received that is covered by the notice provided in relation to the payment x the corporate tax rate. [Schedule 10, item 1, subsection 12-390(2 )]

Similarly to trustees of managed investment trusts, intermediaries are entitled to determine whether a recipient is a foreign resident based upon an application of the same tests as apply to managed investment trusts discussed in paragraph 11.33.

Example 11.3: Fund payment made through an intermediary

The Pyke Managed Fund is a trust that satisfies the requirements for being a 'managed investment trust'. The trustee of the Fund gives a notice that satisfies the relevant requirements to Cassandra Custodian Services, an Australian resident company. The trustee of the Fund then makes a payment, a part of which is a 'fund payment' and which is specified by the notice as an amount which, if paid to a foreign resident, would have been subject to withholding. The receipt by Cassandra Custodian Services is in the course of a business that predominantly consists of providing custodial or depository services pursuant to a financial services licence.

Cassandra Custodian Services then on-pays the full amount to Tony, a foreign resident individual.

As Cassandra Custodian Services satisfies all the necessary requirements, it is an intermediary. As a result, the trustee of Pyke Managed Fund is not required to withhold from the payment to Cassandra Custodian Services.

As Cassandra Custodian Services is an intermediary in relation to the fund payment, it will be required to withhold an amount from the payment to Tony to the extent that the payment is attributable to the earlier payment received from, and covered by the notice provided by, Pyke Managed Fund.

Remittance of amounts withheld

11.50 Remittance obligations for amounts withheld will be similar to remittance obligations for other withholdings based on the withholder status of the payer as a small, medium or large withholder.

Credits for amounts withheld

11.51 The pay as you go (PAYG) withholding provisions provide rules to allow for credits for amounts withheld. These rules are in Division 18 of Schedule 1 to the TAA 1953. A new crediting rule, pertaining to managed investment trust withholding, has been inserted into Division 18. The rule specifies the circumstances in which a credit entitlement arises.

11.52 The credit arises if the entity is the beneficiary of a trust and the assessable income of the entity includes an amount that is reasonably attributable to a payment from which an amount was withheld. As is the case for the other withholding rules, it is necessary for an assessment to have been made before the credit entitlement arises. This ensures that a specific time can be established for when the credit arises. [Schedule 10, item 2, section 18-50]

11.53 Credits are also available if the entity is a trustee of a trust, an amount is included in the entity's assessable income under section 99 or 99A of the ITAA 1936, and the amount is reasonably attributable to a 'fund payment' from which an amount was withheld under these amendments. [Schedule 10, item 2, section 18-50]

11.54 However, credits are not available if the entity is a trustee and the assessable income of the trust includes an amount under section 97, except where the trustee is a trustee of either a complying superannuation trust, corporate unit trust or public trading trust. [Schedule 10, item 2, subsections 18-50(5) and (6 )]

11.55 The amount of the credit is so much of the amount withheld multiplied by the 'attributable part of the payment' divided by the amount of the withholding payment. The attributable part of the payment is so much of the 'assessable amount' (which, for this purpose, includes capital gains included in the assessable income of the beneficiary because of subsection 115-215(3) of the ITAA 1997) as is represented by or reasonably attributable to the withholding payment. [Schedule 10, item 2, subsection 18-50(4 )]

11.56 The crediting rule discussed above will not apply in addition to existing crediting rules in section 18-15 or 18-25. This will prevent multiple credit entitlements arising from amounts withheld under the new managed investment trust provisions. [Schedule 10, items 27 and 28, subsections 18-15(3) and 18-25(9 )]

11.57 The PAYG withholding system provides for refunds of amounts to taxpayers where withholding has occurred in error. These rules are in sections 18-65 and 18-70 of Schedule 1 to the TAA 1953. Under the managed fund withholding arrangements, there may be circumstances where the amount withheld by a managed investment trust is subsequently determined to have been different to the amount that would have been withheld if the payer was in possession of information about the net income of the trust or subsequent distributions that was not available to it at the time of payment. An amount will not have been withheld in error in these circumstances simply because the withholding amount would have been different. It is intended that, in working out how much to withhold from a payment, a trustee of a managed investment trust is to work out the expected net income of the trust and expected amounts of future payments on the basis of the trustee's knowledge at the time of the payment. To be an error of a kind engaging the operation of section 18-65 or 18-70, the error must be one that was made at the date of payment having regard to the information that was known to the payer at that time.

Example 11.4: Calculation of credit

The Vo Managed Fund is a trust that satisfies the requirements to be a managed investment trust. The trustee of the Fund makes a fund payment of $3,000 to Hunter Custodian Services, an intermediary, representing the entire share of the net income of the Vo Managed Fund that relate to the interests held by Hunter Custodian Services. Hunter Custodian Services on-pays the entire amount to Nguyen Trust, a non-resident trust estate. Withholding tax of $900 (30% x $3,000) arises in respect of this payment. Nguyen Trust has no other income.

Nguyen Trust has two beneficiaries: Sheela and Nameeta. Sheela is an Australian resident beneficiary, while Nameeta is a foreign resident beneficiary. Sheela and Nameeta are presently entitled to the trust income of Nguyen Trust.

Nguyen Trust's net income of the year of income is $3,000, being the trust's individual interest in the share of the net income of the Vo Managed Fund. The Trust makes payments of $1,800 and $900 to Sheela and Nameeta, respectively. The trustee of the Nguyen Trust is not subject to any tax in respect of these payments as the payments represent income to which the beneficiaries are presently entitled and are reasonably attributable to an amount from which withholding was required by Hunter Custodian Services.

Sheela is a beneficiary that is presently entitled to a share of the trust income of Nguyen Trust and is not a beneficiary in the capacity of a trustee of another trust estate. She is therefore assessed on her interest in the net income of the Trust, which is $2,000. On a similar basis, Nameeta is assessed on an amount of $1,000.

Both Sheela and Nameeta are entitled to credits for an appropriate proportion of the $900 withheld attributable to the fund payment of $3,000.

Sheela's credit is calculated as follows:

(Attributable part of payment ($2,000) / Amount of withholding payment ($3,000)) x Amount withhelf ($900) = $600


Nameeta's credit is calculated as follows:

(Attributable part of payment ($1,000) / Amount of withholding payment ($3,000)) x Amount withheld ($900) = $300


Application and transitional provisions

11.58 The new arrangements will apply to income years beginning on or after 1 July following Royal Assent. [Schedule 10, item 32]

Consequential amendments

Consequential changes to the ITAA 1936

Liability of the ultimate beneficiary

11.59 These amendments ensure that a foreign resident beneficiary that is not a trustee beneficiary is assessed on their share of the net income of the trust where that share is represented by or reasonably attributable to an amount subject to withholding under this measure. [Schedule 10, item 6, section 99F of the ITAA 1936]

Exclusion of Division 6 assessment of trustees where withholding has been made

11.60 The amendments made by this Schedule exclude assessment of the net income of a trust under sections 98, 99 or 99A of the ITAA 1936 in the hands of the trustee to the extent that net income represents income to which a beneficiary is presently entitled and is represented by or reasonably attributable to an amount subject to withholding. The purpose of this is to ensure the operation of Division 6 of Part III of the ITAA 1936 to tax the trustee of a managed investment trust is excluded insofar as withholding by the trustee under these rules is required. [Schedule 10, item 6, section 99G of the ITAA 1936]

11.61 Similarly, in the case of an intermediary that is a trustee, sections 98, 99 and 99A of the ITAA 1936 will not apply to assess the trustee on a share of the net income of the trust to the extent that net income represents income to which a beneficiary is presently entitled and is represented by or reasonably attributable to an amount where withholding was required. As with managed investment trusts, the purpose of this amendment is to ensure the operation of Division 6 of Part III of the ITAA 1936 to tax a trustee intermediary is excluded insofar as withholding by the trustee under these rules is required. [Schedule 10, item 6, section 99G of the ITAA 1936]

11.62 Also, where an amount that is subject to withholding flows through other trust estates, sections 98, 99 and 99A of the ITAA 1936 will not apply to effectively tax the amount again in the hands of a subsequent trustee. Thus, sections 98, 99 and 99A will also not apply to assess the trustee of a share of the net income of the trust to the extent that net income represents income to which a beneficiary is presently entitled and is represented by or reasonably attributable to an amount where withholding was required. [Schedule 10, item 6, section 99G of the ITAA 1936]

Payments made too late to be 'fund payments'

11.63 As discussed in paragraphs 11.31 and 11.32, in order to qualify as a fund payment and, therefore, be eligible for withholding, it is necessary the payment be made (including constructively made) within three months of the end of the income year or within such later period as allowed by the Commissioner. If a foreign resident beneficiary is presently entitled to a share of the income of the trust and that share of the net income is not paid within this period, the trustee will be assessed as if no-one was presently entitled to the share of income. The trustee of the managed investment trust will then be assessed on the share under section 99A of the ITAA 1936. The purpose of this is to deter trustees from accumulating income within the managed investment trust. [Schedule 10, item 6, section 99H of the ITAA 1936]

Beneficiaries under a legal disability

11.64 Where a beneficiary is under a legal disability, the trustee will be liable to tax under subsection 98(1) of the ITAA 1936. Section 100 of the ITAA 1936 operates to ensure that beneficiaries under a legal disability are also assessed on their share of income of the trust estate with a credit for any tax paid by the trustee. However, section 100, as a general rule, only applies where the beneficiary is a beneficiary in more than one trust estate or also derives income from another source. To prevent double taxation, the operation of section 100 has been extended to cover the situation where part of the net income of a non-resident beneficiary is reasonably attributable to a payment from which an amount was required to be withheld under this measure. [Schedule 10, item 7, subsection 100(1C) of the ITAA 1936]

Deemed quotation of a tax file number withholding where withholding has been made

11.65 Section 202EE of the ITAA 1936 provides that a tax file number is deemed to have been quoted by a non-resident in relation to certain investments. The section is amended to include in the category of non-residents who are deemed to have quoted a tax file number those taxpayers receiving payments from which an investment body is required to withhold under the new managed fund withholding provisions. [Schedule 10, item 8]

Deemed quotation of a tax file number withholding where withholding has been made under Subdivision 12-H

11.66 Section 255 of the ITAA 1936 provides that the Commissioner may require a person receiving money on behalf of a non-resident to pay the income tax payable by the non-resident. The section is amended to exclude from the operation of the section money due to a non-resident from which amounts must be withheld under Subdivision 12-H. [Schedule 10, item 9]

Consequential changes to the TAA 1953

11.67 Section 10-1 of Schedule 1 to the TAA 1953 summarises in a table the payments subject to PAYG withholding. The table is amended to list two new withholding payments as specified in sections 12-385 and 12-390. [Schedule 10, item 14]

11.68 Section 12-5 of Schedule 1 prescribes the priority with which particular PAYG withholding provisions are to be applied if more than one withholding provision covers a payment. The new withholding arrangements for managed investment trust payments are to be applied in priority to all other withholding provisions. A new item has been inserted into the table in subsection 12-5(2) to specify this priority. [Schedule 10, item 15]

11.69 Section 15-15 of Schedule 1 provides that the Commissioner may vary the amount required to be withheld from a withholding payment. These variation rules will not apply to the new withholding arrangements for managed investment trusts, trustee intermediaries and agent intermediaries as the standard rate of withholding will be the company tax rate. It is intended that this rate will apply to all payments subject to these new withholding arrangements. [Schedule 10, items 16 to 18]

11.70 Entities required to withhold under the new withholding arrangements are required to report to the Commissioner on the amounts withheld on an annual basis. The time of the report is later than the standard annual report under PAYG withholding as payments that are subject to withholding may be made after the end of a year. The reports will be required to be given to the Commissioner not later than 14 days after the end of six months after the end of the income year of the managed investment trust or within a longer period allowed by the Commissioner. The longer period for reporting reflects the extension of time that the Commissioner may grant for making fund payments. [Schedule 10, item 19, subsection 16-153(4 )]

11.71 Entities required to withhold under the new arrangements will be required to provide a statement each year to the payees. The statement must detail the amounts of the payments from which withholding has occurred and the amounts withheld from those payments. The statement must be provided within 14 days after the end of six months after the end of the managed investment trust's income year. The statement may be provided in electronic form and a copy will not be required to be given to the payee. The standard payment summary rules do not apply to the new withholding arrangements. Instead, specific payment summary requirements apply to managed investment trust payments. [Schedule 10, items 20 to 24]

11.72 The existing penalty for failure to provide a payment summary will be extended so that it applies where a payer fails to supply a payment summary as required under the amendments in this Schedule. Extending the existing penalty ensures that the same penalty applies for failure to provide a payment summary under both existing and the new withholding regimes. [Schedule 10, items 25 and 26]

11.73 It will be an offence to claim a credit for an amount withheld under the new managed fund withholding provisions by providing a statement that has not been duly provided to the taxpayer. Section 20-35 is amended to apply this offence to the managed fund withholding rules. [Schedule 10, items 29 to 31]

REGULATION IMPACT STATEMENT

Policy objective

11.74 The purpose of this measure is to improve the efficiency of the managed funds industry in respect of the collection of tax from distributions to foreign residents.

11.75 This measure implements the Government's decision announced in the Treasurer's Press Release No. 39 of 9 May 2006 to simplify the tax collection mechanism for taxable income distributed to foreign residents by Australian managed funds (and custodians which are an integral part of this industry). This was one of several changes to the tax arrangements for trusts designed to clarify obligations and reduce reporting requirements while maintaining the integrity of the system.

The objectives of this measure

11.76 This measure aims to provide certainty and simplicity for both the managed funds industry and the Australian Taxation Office (ATO) on how tax should be collected from distributions of Australian source income, other than dividends, interest or royalties, by Australian managed funds to foreign residents (including distributions made through Australian intermediaries).

Implementation options

11.77 This measure is the result of the complexity that would otherwise have occurred as a result of different tax outcomes depending upon whether the foreign residents were an individual, company, trustee or superannuation fund. Because of the common use of custodian, nominees and other intermediaries, Australian managed investment trusts and Australian intermediaries are unlikely to know these details. Accordingly, they would not be able to manage their obligation to withhold tax effectively.

11.78 As a result of this measure, there would be one withholding outcome for distributions of income (other than dividend, interest and royalty income) by Australian managed investment trusts and Australian intermediaries - withholding at the company tax rate - regardless of whether the foreign resident is an individual, company, trustee or foreign superannuation fund.

Assessment of impacts

11.79 The potential compliance, administration and economic impacts of this measure are likely to be as follows.

Impact group identification

11.80 The main groups to be affected by this measure are Australian managed investment trusts (particularly Australian property trusts) and Australian intermediaries. It is estimated that there are around 50 entities that would meet the definition of 'intermediary', and around 4,000 entities that would meet the definition of 'managed investment trust'.

11.81 In turn, their clients would also be affected. These are entities such as foreign resident individuals, foreign resident companies (hedge funds, financial institutions such as banks and life insurance companies), foreign resident superannuation funds (assessable as non-complying funds) and other foreign resident trusts (includes foreign or global custodians and potentially other nominee entities).

Analysis of costs and benefits

Compliance costs

11.82 This measure is estimated to involve medium costs in relation to once-off implementation of systems changes, and a small ongoing cost to manage ongoing record keeping and information collection obligations for Australian managed funds and custodians. Against this, this measure will reduce compliance costs by removing any need for these entities to ascertain whether the foreign resident investor is an individual, company, trustee or foreign pension fund in determining their withholding obligations, and any doubt about whether the correct rate of withholding is made.

Administration costs

11.83 It is estimated that there will be a small administrative impact on the ATO. In particular, it is estimated that there will be minimal impact upon the creation of interpretation and information products (products which assist in the interpretation and understanding of the law, respectively), and low impact on active compliance products (activities that maximise compliance).

Government revenue

11.84 This measure will have these revenue implications:

Economic benefits

11.85 This measure will remove the need for managed investment trusts and intermediaries from having to classify the nature of the foreign investor as individual, company, trustee or foreign superannuation fund. Consequently, the measure will also reduce the uncertainty regarding the obligations of managed investment trusts and intermediaries to withhold amounts from distributions to foreign residents. This in turn would improve Australian property trusts as a destination for foreign capital.

11.86 These compliance cost savings and reduced uncertainty would have the effect of increasing the efficiency of the Australian managed funds industry in providing funds management services to foreign residents. This results in a greater ability of the Australian managed funds industry to compete against foreign managed fund industries for the management of the investment of foreign residents' savings.

Consultation

11.87 Business, legal and accounting representatives and the ATO have been consulted extensively and have actively assisted in developing this measure. The more technical issues and the details of the measure were considered on a confidential basis by a working group of representatives from the following bodies:

•

Investment and Financial Services Association;

•

Australian Custodial Services Association;

•

Tax Institute of Australia;

•

Institute of Chartered Accountants in Australia; and

•

Property Council of Australia.

11.88 Meetings took place in November 2006 and March 2007. The main aspects of the measure covered included the definitions of 'managed investment trust', 'trustee intermediary' and 'agent intermediary', as well as the determination of amounts upon which withholding would be made.

11.89 Suggestions made by representatives on the legislative details of this measure were adopted where consistent with the policy objectives and the integrity of this measure.

11.90 The consultation group has been supportive of the consultation process.

Conclusion

11.91 This measure would provide the Australian property trust sector with compliance savings by having a single rate applied to distributions to different types of entities. This reduces compliance costs associated with tracing different types of income and different types of recipients of that income.

11.92 Treasury and the ATO will monitor this taxation measure, as part of the whole taxation system, on an ongoing basis.

Index

Schedule 1: Distributions to entities connected with a private company and related amendments

Schedule 2: Transitional excess non-concessional contributions

Schedule 3: Capital gains of testamentary trusts

Schedule 4: Superannuation of deceased military and police

Schedule 5: Thin capitalisation

Schedule 6: Repeal of dividend tainting rules

Schedule 7: Interest withholding tax

Schedule 8: Forestry managed investment schemes

Chapter 8

Schedule 8: Forestry managed investment schemes

Chapter 9

Schedule 9: Non-resident trustee beneficiaries

Schedule 10: Distributions to foreign residents from managed investment trusts