Senate

Explanatory Memorandum

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

General outline and financial impact

Australia as a regional financial centre

Amends the Income Tax Assessment Act 1936 (ITAA 1936) to provide for the implementation of the Australia - A Regional Financial Centre component of the Investing for Growth Statement announced by the Government on 8 December 1997.

The legislation was first introduced into Parliament on 2 July 1998 as Schedule 3 to the Taxation Laws Amendment Bill (No. 5) 1998 and lapsed when Parliament was prorogued for the election. The Statement announced that the measures were to apply from the date of introduction of the amending legislation. It is proposed that the legislation continue to apply from 2July1998 to ensure taxpayers are not disadvantaged by the delay in implementation.

The amendments in Schedule 1 relate to the interest withholding tax (IWT) exemption available under section 128F, the offshore banking unit (OBU) regime, the foreign investment fund (FIF) measures, the controlled foreign company (CFC) measures and the thin capitalisation provisions of the ITAA 1936.

Section 128F

The IWT exemption provided under section 128F of the ITAA 1936 will be widened by removing, for debentures issued by companies, the present requirements that they be issued outside Australia and that the interest be paid outside Australia.

The present restriction in section 128F prohibiting the acquisition of debentures by Australian residents will be removed.

The definition of company for the purposes of section 128F will be extended to include a company acting in the capacity of a trustee for an Australian trust, provided the trust is not a charitable trust and that the beneficiaries of the trust are companies for the purposes of section 128F.

A consequential amendment to section 126 will broaden the scope of that section to include holdings of bearer debentures by residents with a permanent establishment (eg. a branch) offshore.

Offshore banking units

The OBU concessions will be expanded to:

•

extend the range of entities eligible to register as OBUs;

•

provide a tax exemption for income and capital gains of overseas charitable institutions managed by an OBU;

•

extend the range of eligible OBU activities to include:

-

custodial services;

-

trading in Australian dollars where the other party to the transaction is an offshore person;

-

trading in gold bullion with offshore persons in any currency;

-

trading in gold bullion with any person other than in Australian dollars;

-

trading in base metals and palladium bullion with offshore persons in any currency;

-

other trading activities (apart from currency trading) in Australian dollars with offshore persons;

-

eligible contract activities in Australian dollars with offshore persons; and

-

hedging in Australian dollars with related offshore persons;

•

remove the current anti-avoidance measure which prevents Australia being used as a conduit to channel loans to other countries;

•

reduce the capital gains tax liability where non-residents dispose of interests in OBU offshore investment trusts;

•

provide a foreign tax credit for foreign tax paid by Australian resident OBUs regardless of whether a Double Tax Agreement applies;

•

remove the requirement that OBUs maintain separate nostro and vostro accounts for OBU transactions; and

•

reduce the rate of OBU withholding penalty tax for breaches of the IWT concession from 300 per cent to 75 per cent.

Thin capitalisation

This measure will relax the effect of the thin capitalisation loan back provisions so that an Australian subsidiary of a foreign bank may raise section 128F IWT exempt funds and on-lend those funds to a related Australian branch without affecting the subsidiaries thin capitalisation position.

Foreign investment funds (FIFs)

Amends Part XI of the Income Tax Assessment Act 1936 (ITAA 1936) to provide an exemption from the FIF measures for interests in certain US FIFs. The exemption is intended to encourage Australian investment funds to be more efficient by exposing them to competition from US funds.

Changes to the calculation method in the FIF measures and consequential amendments to the general provisions for taxing trusts will also be made.

Controlled foreign companies

Amends Part X of Income Tax Assessment Act 1936 (ITAA 1936) to provide an exemption from the CFC measures for interests in US real estate investment trusts (REITs) that derive income or hold assets principally in the US. The exemption is similar to the proposed exemption for FIF interests in REITs in Part 2 of Schedule 1 to Taxation Laws Amendment Bill (No. 2) 1999.

Date of effect: The proposed measures in the package will generally apply from 2 July 1998, the date of first introduction. In relation to the FIF measures the exemption will apply for notional accounting periods of FIFs ending on or after 2 July 1998. The amendments to the calculation method and the consequential amendments will apply in relation to assessments for years of income ending on or after 2 July 1998. The exemption from the CFC measures will apply for statutory accounting periods of CFCs ending on or after 2 July 1998.

Proposal announced: Foreshadowed in the Australia - A Regional Financial Centre component of the Investing for Growth Statement announced by the Government on 8December 1997 and the Treasurers Press Release No. 80 of 13 August 1998. The CFC amendments have not been previously announced.

Financial impact: The package is estimated to cost $22 million in a full year. There may also be an indirect cost to the revenue as a result of the proposed FIF exemption because of increased investment in US FIFs. The cost to the revenue is unquantifiable because the amount of capital transferred to US funds will be dependent on prevailing economic conditions and on the investment strategies of Australian funds managers. The cost to the revenue of the CFC exemption is expected to be minor.

Compliance cost impact: The compliance cost impact is incorporated into the Regulation Impact Statements. The Regulation Impact Statement for the withholding tax, OBU and thin capitalisation measures is at the end of Part 1 of Chapter1 of the Explanatory Memorandum. The Regulation Impact Statement for the FIF measure is at the end of Part 2 of Chapter1 of the Explanatory Memorandum. The exemption from the CFC measures may result in a small decrease in compliance costs for affected taxpayers.

Summary of Regulation Impact Statement - Part 1 of Schedule 1

Interest Withholding Tax Exemption, Offshore Banking Units and Thin Capitalisation

Impact: Low

The objective of the measures is to make Australia more attractive as a regional financial centre. The package endeavours to develop our corporate debt market and increase Australia's competitiveness as an offshore banking regime.

The global financial industry is growing rapidly. These measures provide the Australian financial sector with the opportunity to achieve higher levels of participation in international trade in financial services. The affected groups are financial intermediaries for whom non-residents are a significant client group, primarily banks and funds managers, and non-residents investing in or through Australia.

The proposed amendments represent a package which is aimed at providing greater certainty and reducing compliance costs and tax burdens in relation to financial sector activities.

The proposed legislation is estimated to negatively affect revenue to the amount of $22 million in a full year. However, the package is expected to promote new business in the financial industry. To the extent that new business is generated revenue will increase.

The Treasury and the Australian Taxation Office will monitor these measures as part of the whole taxation system on a continuing basis. Furthermore, a task force within the Financial Sector Advisory Council was established as a consultative forum which will provide ongoing advice on the effect of the measures on Australia's attractiveness as a regional financial centre.

Summary of Regulation Impact Statement - Part 2 of Schedule 1

Foreign Investment Funds

Impact: Low

Main points:

•

The exemption will benefit resident taxpayers who hold interests in US FIFs.

-

The major impact is expected to be on superannuation and investment funds, who between them hold the majority of Australian interests in US FIFs.

•

The exemption is likely to increase Australian investment in US FIFs, particularly US mutual funds, that qualify for the exemption.

-

This investment is expected to be largely at the expense of direct investment in US securities, but also to some extent at the expense of investments in Australia and in other countries.

•

The exemption is likely to result in a minor reduction in compliance costs because the FIF measures will not apply to investments that qualify for the exemption.

•

The cost to the revenue of providing the exemption is expected to be $2 million in the 1998-99 income year and $3 million annually for subsequent income years.

•

Some informal consultation on the exemption has been undertaken with industry and professional associations, in particular, with the Investment & Financial Services Association which represents Australian funds managers.

•

The measure is not controversial to the extent it benefits taxpayers, however, it may be opposed by funds managers who face greater competition.

Summary of Regulation Impact Statement - Part 3 of Schedule 1

Controlled foreign companies

Impact: Low

Main points:

•

The exemption will allow Australian collective investment funds to compete on an equal footing with US real estate investment trusts in attracting Australian investment.

•

The exemption is likely to result in an initial and recurrent reduction in compliance costs because the CFC measures will not apply to investments that qualify for the exemption.

•

The cost to the revenue of providing the exemption is expected to be minor.

•

An Australian collective investment fund was consulted on the proposed exemption.

Commercial debt forgiveness

Amends the Income Tax Assessment Act 1936 to require that:

•

the forgiven amount of a debt be applied, where relevant, to reduce unrecouped net capital losses in respect of all years of income before the forgiveness year of income, rather than the immediately preceding year of income;

•

where a taxpayer incurs a net capital loss in a year of income earlier than the forgiveness year of income, and the loss is reduced by the operation of the debt forgiveness provisions, the loss will also be reduced for the purposes of the capital gains tax provisions.

Date of effect: The amendments will apply to debts forgiven after the date of introduction. [Item 3 of Schedule 2]

Proposal announced: Not previously announced.

Financial impact: There should be no significant impact on revenue as the amendments merely ensure the debt forgiveness rules operate as intended.

Compliance cost impact: There should be no impact on compliance costs as taxpayers have to keep records of prior year net capital losses under the existing law.

Depreciation of plant previously owned by an exempt entity

Inserts new Division 58 into the Income Tax Assessment Act 1997 to set a common base for the depreciation deductions for plant that can be claimed by exempt entities which become taxable and by taxable entities which purchase plant from an exempt entity in connection with the acquisition of a business. The depreciation deductions available to such entities will be taken from a base which is a choice between the notional written down value of the plant at the time it enters the tax net and its undeducted pre-existing audited book value at that time. The amendments include a safeguard measure designed to ensure that, where such plant is on-sold to a subsequent owner, a balancing amount is included in the assessable income or deductions of the first taxable owner to reflect the special depreciation base which applies to that owner and so as to compensate for the effect on the on-sale price of the special depreciation base not applying to the purchaser.

The measure was previously introduced into Parliament but lapsed when Parliament was prorogued. The reintroduced measure contains some technical amendments to correct several potential anomalies which have been identified with the wording of the provisions as previously introduced and their interaction with the capital gains tax provisions. The reintroduced provisions will now more clearly give effect to the measure as originally intended.

Date of effect: Applies to exempt entities which first become taxable on or after 4 August 1997 and to acquisitions of plant by taxable entities from an exempt entity on or after 4 August 1997.

Proposal announced: Treasurers Press Release No. 84 of 4 August 1997.

Financial impact: No additional revenue is expected compared to current Budget estimates. However, failure to implement this measure poses a potentially significant threat to the revenue.

Compliance cost impact: There may be a minimal increase in compliance costs for affected entities.

Franking credits, franking debits and the intercorporate dividend rebate

Amends the Income Tax Assessment Act 1936 to prevent franking credit trading and mis-use of the intercorporate dividend rebate by denying the franking benefit or intercorporate dividend rebate from a dividend where the taxpayer does not satisfy:

•

a holding period rule that, subject to certain exceptions, requires taxpayers to hold shares at-risk for more than 45 days (or 90 days for preference shares); and

•

a related payments rule that requires taxpayers who are under an obligation to make a related payment with respect to a dividend paid on shares to hold the relevant shares at-risk for more than 45 days (or 90 days for preference shares) during the relevant qualification period.

Date of effect: The holding period rule applies generally to shares and interests in shares acquired on or after 1 July 1997 unless the taxpayer became contractually obliged to acquire the shares before 7.30 pm AEST 13 May 1997; special rules affecting certain trusts take effect from 3 pm AEST 31 December 1997. The related payments rule applies to arrangements entered into after 7.30 pm AEST 13 May 1997.

Proposal announced: 1997-98 Budget (13 May 1997). Modifications to the original proposal were announced in Treasurers Press Release No. 89 released on 8 August 1997, and Assistant Treasurers Press Release No.AT/25 released on 31 December 1997.

Financial impact: The holding period and related payments rules will protect the revenue base used for the forward estimates, by removing opportunities for significant future expansion of franking credit trading and mis-use of the intercorporate dividend rebate. The rules are part of a package of measures targeting franking credit trading and dividend streaming. In the absence of the measures, to the extent that the revenue base would not be protected, there would be a significant revenue loss. While it is not possible to provide an exact estimate of the revenue loss that already existed from franking credit trading and dividend streaming, $130 million a year has been factored into the forward estimates for 1998-99 and subsequent years to take account of the effect of the measures on existing activities.

Compliance cost impact: Taxpayers who are required to comply with the rules will incur additional compliance costs. The extent of the compliance costs incurred will vary depending on the facts and circumstances of particular cases. Accordingly, no reliable data on the amount of these costs is available.

Summary of Regulation Impact Statement

Impact: Medium

Main points:

•

Taxpayers who are required to comply with the rules will have to incur additional compliance costs. The extent of the compliance costs which will be incurred by taxpayers will vary depending on the facts and circumstances of particular cases. Accordingly, no reliable data on the amount of these costs is available.

•

Natural person shareholders (ie. shareholders claiming franking rebates of $2000 or less) are exempt from the holding period rule and low-risk taxpayers (eg. superannuation funds) will be able to elect to have a franking credit or rebate ceiling as opposed to applying the holding period rule.

•

Only taxpayers who enter into related payment arrangements will incur costs in complying with the related payments rule.

Policy objective

To prevent franking credit trading by implementing some of the measures announced by the Government in the 1997-98 Budget.

Franking of dividends by exempting companies and former exempting companies

Amends the Income Tax Assessment Act 1936 by introducing a rule that limits the source of franking credits available for trading by:

•

prescribing that franked dividends paid by companies which are effectively wholly owned by non-residents or tax-exempts will only provide franking benefits in limited circumstances; and

•

quarantining the franking surpluses of companies which were formerly wholly owned by non-residents or tax-exempts.

The measure will also ensure that non-resident shareholders in receipt of franked dividends from affected companies will continue to be exempt from dividend withholding tax.

Date of effect: Subject to the transitional measures explained in Chapter5, the rule to limit the source of franking credits available for trading will apply to:

•

companies that are effectively wholly owned by non residents or tax-exempts at 7.30 pm AEST, 13 May 1997;

•

companies that are effectively wholly owned by non residents or tax-exempts at 7.30 pm AEST, 13 May 1997 and cease to be so owned; and

•

companies which become effectively wholly owned by non residents or tax-exempts at 7.30 pm AEST, 13 May 1997.

Proposal announced: 1997-98 budget.

Financial impact: The amendments are part of a package of measures targeting franking credit trading and dividend streaming that will protect the revenue base. In the absence of the measures, to the extent that the revenue base would not be protected, there would be a significant revenue loss. The measures will result in unquantifiable revenue gains to the extent of existing tax minimisation.

Compliance cost impact: There is unlikely to be any significant compliance costs associated with the proposed measures. The rule will not apply to taxpayers unless they are wholly owned by non-residents to tax-exempts or have ceased to be so wholly owned.

Summary of Regulation Impact Statement

Impact: Low

Main points:

•

The measure will impact on companies and their tax advisers (eg. Members of the legal and accounting professions) who are effectively wholly owned, or have, since 13 May 1997, been effectively wholly owned by non-residents or tax-exempts.

•

The measure will also impact on the ATO (in administering the rule, for example, information campaigns), the Government (in that the revenue base will be protected) and non-residents and tax-exempt shareholders (who are no longer able to transfer franking credits).

•

The implementation option adopted avoids the need, for most companies, to create a separate account: this minimises compliance costs for those companies, as well as significantly limiting the number of amendments required to the tax laws.

•

The amendments to the income tax law to implement this option are based on exiting provision of the tax law which are familiar to companies.

•

The alternative option would involve greater compliance costs and complexity without any commensurate additional benefits.

Policy objective: The policy objective is to prevent franking credit trading by limiting the source of franking credits available for trading.

Di stributions to beneficiaries and partners that are equivalent to interest

Amends the Income Tax Assessment Act 1936 to prevent franking credit trading and mis-use of the intercorporate dividend rebate by denying the franking benefit or intercorporate dividend rebate from a trust or partnership distribution attributable to a dividend where the distribution is equivalent to interest.

Date of effect: The amendments apply to trust and partnership interests created or acquired, and finance arrangements entered into, after 7.30 pm AEST 13 May 1997, and to existing arrangements extended after that time.

Proposal announced: The 1997-98 Budget, 13 May 1997.

Financial impact: The amendments will protect the revenue base used for the forward estimates, by removing opportunities for significant future expansion of franking credit trading and mis-use of the intercorporate dividend rebate. The amendments are part of a package of measures targeting franking credit trading and dividend streaming. In the absence of the measures, to the extent that the revenue base would not be protected, there would be a significant revenue loss. While it is not possible to provide an exact estimate of the revenue loss that already existed from franking credit trading and dividend streaming, $130 million a year has been factored into the forward estimates for 1998-99 and subsequent years to take account of the effect of the measures on existing activities.

Compliance cost impact: Taxpayers who enter into relevant arrangements will incur additional compliance costs in determining whether their distributions are equivalent to the payment of interest on a loan. However, the extent of the compliance costs which will be incurred by taxpayers will vary depending on the facts and circumstances of particular cases. Accordingly, no reliable data on the amount of these costs is available.

Summary of Regulation Impact Statement

Impact: Low

Policy objective: To prevent franking credit trading by implementing one of the measures announced by the Government in the 1997-98 Budget.

Menzies Research Centre Public Fund

This measure amends the IncomeTax Assessment Act 1997 to allow deductions for gifts of $2 or more made to the Menzies Research Centre Public Fund.

Date of effect: Gifts made after 2 April 1998 will be tax deductible.

Proposal announced: The proposal was announced in the Treasurers Press Release No.102 of 10 October 1996.

Financial impact: The proposed amendment is not expected to have a significant revenue impact.

Compliance cost impact: None.

Chapter 1 - Australia as a regional financial centre

Overview

1.1 The amendments contained in Schedule 1 to the Bill will amend the Income Tax Assessment Act 1936 (ITAA 1936) to implement a package of measures announced by the Prime Minister on 8 December 1997 as part of the Investing for Growth Statement (the Statement). The amendments also take account of the Treasurers Press Release No. 80 of 13 August 1998. The package is designed to, among other things, further enhance Australia's credentials as a world financial centre. In particular, measures included in the Australia-A Regional Financial Centre component of the Statement are aimed at making Australia a more attractive regional financial centre by building on Australia's existing advantages to ensure its participation in the increasing global trade in financial services.

1.2 Part 1 of Schedule 1 contains amendments that will:

Section 128F interest withholding tax exemption

•

widen the interest withholding tax (IWT) exemption provided under section 128F of the ITAA 1936 by removing, for eligible debentures issued by companies, the present requirements that they be issued outside Australia and that the interest be paid outside Australia;

•

allow issues of debentures or interests in debentures to Australian residents and still attract the IWT exemption under section 128F;

•

ensure that issues of bearer debentures made under section 128F to residents operating a business offshore would be within the scope of section 126;

•

extend the definition of company for the purposes of section 128F, to include a company acting in the capacity of a resident trustee, provided the trust is not a charitable trust and the beneficiaries of the trust are companies (as long as they are not trustee companies) for the purposes of section 128F;

Offshore Banking Units

•

extend the range of entities eligible to register as Offshore Banking Units (OBUs);

•

provide a tax exemption for income and capital gains of overseas charitable institutions managed by OBUs;

•

extend the range of eligible OBU activities to include:

-

custodial services;

-

trading in Australian dollars where the other party to the transaction is an offshore person;

-

trading in gold bullion with offshore persons in any currency;

-

trading in gold bullion with any person other than in Australian dollars;

-

trading in base metals and palladium bullion with offshore persons in any currency;

-

other trading activities (apart from currency trading) in Australian dollars with offshore persons;

-

eligible contract activities in Australian dollars with offshore persons; and

-

hedging in Australian dollars with related offshore persons;

•

remove the current anti-avoidance measure in section 128GB which prevents Australia being used as a conduit to channel loans to other countries;

•

reduce the capital gains tax liability where non-residents dispose of interests in OBU offshore investment trusts;

•

provide a foreign tax credit for foreign tax paid by an Australian resident OBU regardless of whether a Double Tax Agreement (DTA) applies;

•

remove the requirement that OBUs maintain separate nostro and vostro accounts; and

•

reduce the rate of OBU withholding penalty tax for breaches of the IWT concession from 300 per cent to 75 per cent.

Thin Capitalisation

•

relax the effect of the thin capitalisation loan back provisions so that an Australian subsidiary of a foreign bank may raise section 128F IWT exempt funds and on-lend those funds to a related Australian branch without affecting the subsidiaries thin capitalisation position.

1.3 Part 2 of Schedule 1 contains amendments that will:

Foreign Investment Funds

•

provide an exemption from the foreign investment fund (FIF) measures for interests in certain FIFs taxed on a worldwide basis in the United States (US);

•

provide a limited exemption for interests in certain FIFs taxed as conduit entities in the US; and

•

make these exemptions available when determining FIF income under the calculation method.

1.4 Consequential amendments will also be made to ensure:

•

the general trust provisions do not claw back the benefits of providing the exemption; and

•

the trustee of a trust FIF that qualifies for the exemption is taxed on the Australian source income of the trust under the general trust provisions.

1.5 Part 3 of Schedule 1 contains amendments that will:

Controlled Foreign Companies

•

provide an exemption from the controlled foreign company (CFC) measures for interests in US real estate investment trusts that derive income or hold assets principally in the US.

1.6 Regulation Impact Statements for the changes are provided at the end of the explanation for each Part.

Summary of the amendments

Purpose of the amendments

1.7 The purpose of these amendments is to further support the development of the funds management and corporate debt markets and to promote a more effective and competitive offshore banking regime. The measures will accommodate the integration of Australian financial markets into global markets.

1.8 The amendment to the thin capitalisation provisions will make it easier for a foreign bank branch operating in Australia to access loan funds that are exempt from IWT under section 128F. The amendment is required as a result of the interaction between Australia's thin capitalisation regime and IWT regime.

Date of effect

1.9 The legislation was first introduced into Parliament on 2July1998 as Schedule 3 to the Taxation Laws Amendment Bill (No.5) 1998 and lapsed when Parliament was prorogued for the election. The Statement announced that the measures were to apply from the date of introduction of the amending legislation. It is proposed that the legislation continue to apply from 2July1998 to ensure taxpayers are not disadvantaged by the delay in implementation.

Section 128F, Offshore Banking Units and Thin Capitalisation

1.10 Generally, the measures will apply from 2 July 1998.

Foreign Investment Funds

1.11 The exemption from the FIF measures will have effect for notional accounting periods of FIFs ending on or after 2 July 1998. The amendments to the calculation method and the consequential amendments to the general trust provisions will apply in relation to assessments for income years ending on or after 2 July 1998.

Controlled Foreign Companies

1.12 The proposed CFC amendments will apply for statutory accounting periods of CFCs ending on or after 2 July 1998.

Part 1- Withholding tax, Offshore Banking Units and Thin Capitalisation

Overview of Part 1 of the Chapter

1.13 Part 1 of Schedule 1 to the Bill will amend the ITAA 1936 to implement the section 128F, OBU and thin capitalisation measures. These measures are contained in Part 1 of Chapter 1 as follows:

•

Section 1 - section 128F;

•

Section 2 - OBUs; and

•

Section 3 - thin capitalisation.

1.14 An explanation of the dates of application is contained in Section4 and a regulation impact statement for the changes is provided in Section 5 .

Section 1 Section 128F interest withholding tax exemption

Background to the legislation

What is interest withholding tax (IWT)?

1.15 The taxation of Australian sourced interest paid or credited to non-residents, and residents operating through an offshore permanent establishment, (eg a branch) is subject to the provisions contained in Division 11A of the ITAA 1936. These provisions provide, in conjunction with the relevant Rates Act, that the recipient of Australian sourced interest is subject to withholding tax on the gross amount paid or credited. A rate of 10 per cent of the gross amount of the interest is imposed. The obligation for the collection of withholding tax is placed on the person making the payment.

What is the section 128F interest withholding tax exemption?

1.16 Under the current concession, the interest payable on debentures issued offshore is exempt from IWT provided certain conditions are met. Section 128F provides an exemption where a resident company issues debentures outside Australia; the interest payable by the resident company in connection with the debentures is paid outside Australia; the resident company issued the debenture outside Australia for the purpose of raising finance outside Australia; and the issue meets the requirements of the public offer test.

The definition of company in section 128F

1.17 Section 128F currently permits Australian resident companies to issue debentures which are eligible for the exemption. In addition, certain public bodies are treated as Australian resident companies for the purposes of section 128F, which enables them to qualify for the exemption in respect of their debentures issued overseas.

1.18 However, the term,company, is not defined for the purposes of the section 128F exemption and the question has arisen whether the term includes a company acting in the capacity of a trustee.

1.19 The proposed amendments will clarify the definition of company for the purposes of section 128F. The meaning will be extended to include a company acting in the capacity of a resident trustee for an Australian trust provided the trust is not a charitable trust and the beneficiaries of the trust are Australian companies, which are not trustee companies, for the purposes of section 128F.

The public offer test

1.20 There are a number of tests listed under subsections 128F(3) and 128F(4) which are collectively referred to as the public offer test. Companies are required, at the time of issuing debentures, to satisfy at least one of these tests in order to qualify for the section 128F exemption. The purpose of these tests is to ensure that lenders on overseas capital markets are aware that an Australian company is offering debentures for issue.

Loss of eligibility for the exemption

1.21 Currently an issue of debentures will fail the public offer test with a consequential loss of eligibility for the exemption, if at the time of issue, the issuing company is aware that the debentures will be acquired by a resident or an associate of the company.

1.22 The exemption will also be lost where the company issuing the debentures had reasonable grounds to suspect that the debentures would be acquired by a resident or an associate if the company. For example, if the Australian company issuing debentures was aware that a resident of Australia was proposing to acquire the debentures through an interposed overseas entity, the public offer test will not be satisfied for those debentures.

1.23 In order to further integrate the domestic and offshore corporate debt markets, the Government has decided to permit Australian residents, either within Australia or offshore, to acquire debentures or interests in debentures without affecting the eligibility of the issue as a whole for the section 128F IWT exemption.

What is a debenture?

1.24 The term debenture, in relation to a company is defined in section 6 of the ITAA 1936 as including stock, bonds, notes and any other securities of the company, whether constituting a charge on the assets of the company or not. This definition would include promissory notes or bills of exchange.

1.25 Broadly speaking, there are two classes of debentures, bearer and non-bearer. A bearer debenture is a debenture where the interest is payable to the person in possession of the security and details of the holder are not recorded. A non-bearer debenture or registered debenture is a debenture where the ownership of the security is recorded by or on behalf of the issuing company.

Tax treatment of debenture related interest paid to a resident

1.26 Generally, Australian residents who are paid interest in respect of debentures are subject to tax on the interest by assessment. Residents, other than residents who carry on business at or through a permanent establishment in another country, are not subject to interest withholding tax. Therefore, the section 128F exemption has no application for a resident in Australia and under the current law, if a company is aware that the debenture may be acquired by a resident the issue of debentures loses its eligibility for the exemption.

1.27 The proposed amendment will benefit residents who carry on business at or through a permanent establishment in another country as they will be able to acquire debentures which are eligible for the section 128F exemption. They will, however, continue to be liable for tax by assessment on interest.

Anti-avoidance measure

1.28 Under the current law, where interest is paid in respect of a bearer debenture to a person resident in Australia or to a non-resident carrying on business in Australia, section 126 provides that the issuing company will be subjected to tax if it fails to advise the Australian Taxation Office of the name and address of the holder of bearer debentures.The Income Tax (Bearer Debentures) Act 1971 imposes tax on the company at 47 per cent, the top marginal rate of tax for individuals.

1.29 However, if the interest is exempt from withholding tax because of sections 128F and 128GB (which refers to offshore banking units) then section 126 does not apply.

1.30 A consequential amendment to section 126 will broaden the scope of this anti-avoidance measure to include interest paid, in respect of a bearer debenture issued under section 128F, to residents who carry on business at or through a permanent establishment in another country.

Operation of the proposed measures

1.31 In order to encourage the development of the domestic corporate debt market the Government has decided to widen the IWT exemption in respect of debentures issued by companies. It will remove the requirements that these debentures be issued outside Australia for the purpose of raising finance outside Australia and that interest payable must be paid outside Australia.

1.32 The wider exemption will not be available to Commonwealth Government securities or securities issued by State or Territory central borrowing authorities (sovereign issues). However, the existing section 128F exemption applying to offshore issues of debentures will continue to be available to these entities.

1.33 Companies will still need to meet the public offer test in respect of all issues.

1.34 Companies will be permitted to issue debentures in Australia and offshore to residents and non-residents without affecting the overall withholding tax exemption. However, whilst interest payments paid offshore will qualify for the IWT exemption, residents acquiring debentures will be subject to tax on the interest by assessment.

1.35 There will be no restriction placed on where the interest is paid.

1.36 The proposed amendments will permit debentures to be issued simultaneously in Australia and overseas, to residents and non-residents.

1.37 For the purposes of section 128F, the meaning of company will be extended to include a company acting in the capacity of a resident trustee, provided the trust is not a charitable trust and the beneficiaries of the trust are companies, but not trustee companies, for the purposes of section 128F

1.38 Financial institutions involved in securitisation transactions will, therefore, be able to more easily access the section 128F interest withholding tax exemption. This is expected to increase competitive pressures in lending for home buyers and consumers by allowing lenders to access the cheapest funds free of withholding tax.

1.39 Section 126 will now impose a penalty rate of tax of 47% on the issuer of a bearer debenture if the issuer has failed to disclose the names and addresses of the debenture holders to the Australian Taxation Office where the interest is paid or credited to:

•

a resident located in Australia;

•

a resident carrying on a business in a country outside Australia at or through a permanent establishment; or

•

a non-resident carrying on business in Australia at or through a permanent establishment.

Explanation of the amendments

1.40 The proposed amendments to section 128F will remove the requirements that debentures be issued outside Australia and that interest payable must be paid outside Australia. An overview of how section 128F will operate after the amendments is provided at the end of this section in flow chart form.

1.41 The repeal of paragraphs 128F(1)(c) and 128F(1)(d) will allow companies to issue debentures either in Australia or offshore and will no longer restrict where interest payments may be made. [Item27] However, the wider exemption will not apply to sovereign issues.

The public offer test

1.42 Companies will still need to satisfy at least one of the public offer tests in respect of these issues. The existing requirement in paragraph 128F(3)(c) (the third public offer test) that the debentures be accepted for listing by an overseas stock exchange is amended by item 28 . This will remove the current restriction requiring the debentures to be listed on a stock exchange outside Australia and allow debentures to be listed on a stock exchange in Australia.

Acquisition by residents

1.43 An issue of debentures will not fail the public offer test where a resident acquires debentures either within Australia or offshore. This is achieved by the amendment proposed by item 29.

Acquisition by associates

1.44 The existing restriction prohibiting the issue of debentures to associates of the company will continue to apply under subsection 128F(5). The issue will fail the public offer test, with consequential loss of eligibility for the exemption, if the company was aware at the time of issue, that the debentures would be acquired by the issuing companies associate. [Item29]

1.45 Existing subsection 128F(6) will continue to deny the exemption if the issuing company was aware or should have been aware that the interest in respect of the debentures was paid to an associate of the company.

Central borrowing authorities

1.46 New subsection 128F(5A) will make it clear that the exemption will not be available to issues of debentures in Australia by:

•

Australian public bodies as defined in existing subsection 128F(7); or

•

State or Territory central borrowing authorities.

1.47 A central borrowing authority is defined in new subsection 128F(5A) as a body established for the purpose of raising finance for a State or Territory. New subsection 128F(5A) provides examples of central borrowing authorities. [Item 29]

Non-resident subsidiaries of Australian resident companies

1.48 Subsection 128F(8) allows certain fully owned non-resident subsidiaries of Australian resident companies to raise finance for their parents in a country listed in the Income Tax Regulations whilst retaining the exemption. The proposed legislation amends subsection 128F(8) to remove the requirement that interest must be paid outside Australia. [Items 30 and 31]

Interest paid by companies on bearer debentures

1.49 An amendment to paragraph 126(1)(c) will be made by item 23 to include holdings of bearer debentures by residents with a permanent establishment (eg, a branch) offshore.

Definition of company

1.50 Without affecting its meaning elsewhere in this Act, the extended meaning of the term company for the purposes of section 128F will be inserted in subsection 128F(9). (Item32)

Section 2 Offshore Banking Units

Background to the legislation

The offshore banking unit regime

1.51 The term offshore banking broadly refers to the intermediation by institutions operating in Australia in financial transactions between non-resident borrowers and non-resident lenders. It also includes the provision of financial services to non-residents in respect of transactions or business occurring outside Australia.

1.52 Under the present law, declaration as an OBU is confined to certain financial entities being authorised banks subject to the Banking Act 1959, wholly owned subsidiaries of banks which are already registered as OBUs, State banks and other financial institutions that the Treasurer is satisfied are appropriately authorised to carry on business as dealers in foreign exchange: subsection 128AE(2).

1.53 Income derived by an OBU from OB activities is effectively taxed at a concessional rate of 10 per cent. The meaning of an OB activity is set out in sections 121D, 121E and 121EA of the ITAA 1936. For ease of explanation this document refers to OBU activities rather than OB activities.

Operation of the proposed measures

1.54 The proposed amendments extend both the range of eligible entities and eligible activities. The measures will increase the attractiveness of the OBU regime by reducing the compliance burden and widening the concessions available.

Entities eligible to apply for OBU status

1.55 As mentioned above, declaration as an OBU is currently confined to the financial entities listed in subsection 128AE(2). In order to facilitate greater non-bank competition for offshore business, the Government has decided to extend OBU status to:

•

funds managers incorporated under the Corporations Law which are:

-

money market corporations subject to the Financial Corporations Act 1974 or fully owned subsidiaries of these corporations;

-

holders of securities dealers licences under the Corporations Law;

-

holders of investment advisers licences under the Corporations Law;

•

life insurance companies registered under the Life Insurance Act 1995; and

•

other companies, including providers of custodial services, determined by the Treasurer to be OBUs.

Income tax exemption for offshore charities managed by an OBU

Charitable institutions

1.56 Currently, non-resident charitable institutions whose investments are managed by an OBU receive the same tax treatment as other offshore investors. Namely, income and capital gains derived from the offshore assets are exempt. However, income or capital gains derived from Australian assets are not exempt from income tax and are subject to Part IIIA of the ITAA 1936.

1.57 To encourage funds management by OBUs as well as investment in Australia by offshore charities, the Government has decided to exempt all income and gains of overseas charitable institutions where:

•

the investments which give rise to the income or gains are managed by an OBU; and

•

the charitable institution is exempt from tax in its home jurisdiction.

1.58 For the purposes of the measure overseas charitable institutions will be defined as those which would be exempt under item 1.1 of section50-5 of the Income Tax Assessment Act 1997 if they:

•

had a physical presence in Australia and incurred their expenditure and pursued their objectives principally in Australia; and

•

are exempt from income tax in the country in which they are resident.

1.59 The proposal is similar to the existing portfolio investment activity described in subsection 121D(6A) of the ITAA 1936. This activity allows OBUs to manage portfolio investments on behalf of non-residents subject to a 10 per cent limit on Australian assets. However, under the proposed activity there will be no limitation on the proportion of Australian assets which may be held.

The OBUs fee income

1.60 Consistent with the portfolio investment activity under subsection 121D(6A), OBUs will only be eligible for the 10 per cent concessional tax rate on the component of the management fee which relates to the foreign assets. The component relating to the Australian assets will be taxed at the full company rate.

Extension of eligible OBU activities

Custodial services

1.61 The Government has decided to extend the range of OBU activities to allow OBUs to provide custodial services to non-residents.

What are custodial services?

1.62 Custodial service providers (custodians) offer a broad range of services directed at investment related activities. In contrast to fund managers, custodians perform these functions at the direction of their clients. Some common entities providing custodial services as part of their broader activities are global banking groups, funds management groups and insurance companies.

1.63 Custodial services include the following:

•

safe-keeping of assets (the physical security and storage of assets);

•

settlement of transactions (the finalisation of financial matters to the point of settlement);

•

foreign exchange dealings;

•

collection of income (the collection and distribution of interest and dividend income);

•

corporate actions (the notification of and follow-up regarding upcoming corporate events in which clients have an interest);

•

securities management;

•

reporting and advisory services; and

•

tax reclamation (obtaining tax refunds where appropriate).

Implementation of the measure

1.64 Currently OBUs undertaking portfolio investment activities described in subsection 121D(6A) are allowed to make and manage investments on behalf of non-residents. Under this activity OBUs are permitted to invest in Australian assets subject to a 10 per cent limit (by value) on the Australian asset component of each investment portfolio.

1.65 As custodians provide similar services to those provided by fund managers, the new custodial services activity will be included within the existing portfolio investment activity. The amendments will allow OBUs to undertake custodial services at the direction of non-residents.

The OBUs fee income

1.66 Consistent with the portfolio investment activity under subsection 121D(6A), OBUs will only be eligible for the 10 per cent concessional tax rate on the component of the management fee which relates to the offshore assets. The component relating to the Australian assets will be taxed at the full company rate.

Currency trading

1.67 Under the current concessional tax regime OBUs are allowed to trade on their own behalf in spot or forward foreign currency, or options or rights in respect of foreign currency, with any person, but not where the trade involves Australian currency on either side of the transaction: paragraph 121D(4)(e).

1.68 The proposed legislation extends this activity in order to allow transactions in Australian currency where the other party to the transaction is an offshore person. The term offshore person is defined in section 121E and in broad terms means non-residents (excluding Australian branches of non-residents), foreign branches of Australian residents and OBUs. The measures, however, continue to prohibit Australian dollar trading with Australian residents not operating through foreign branches.

Gold trading

1.69 The range of eligible OBU activities also permits OBUs to trade in gold bullion with offshore persons where any money payable or receivable is not Australian currency: paragraph 121D(4)(f).

1.70 The proposed legislation will extend this activity by broadening the parties with which an OBU may trade and removing, in the case of offshore persons, the currency restriction. The proposal is as follows:

•

offshore persons - the existing currency restriction will be removed and OBUs will be permitted to trade in gold bullion with offshore persons where any money payable or receivable under the trade is in Australian currency; and

•

residents and non-residents operating through a permanent establishment in Australia - OBUs will be permitted to trade in gold bullion with residents and Australian branches of non-residents but the existing currency restriction will apply. That is, no Australian dollar transactions will be permitted.

Metals trading

1.71 Trading with an offshore person in silver and platinum bullion, or rights in respect of such bullion, is permitted under the OBU regime, as long as any money payable or receivable is not Australian currency. The measures will remove the currency restriction.

1.72 Currently physical trading in the base metals (aluminium, aluminium alloy, zinc, tin, lead, nickel and copper) is not a trading activity under subsection 121D(4) and, therefore, is not an eligible OBU activity.

1.73 At present, physical trading in palladium bullion is also not an eligible OBU activity. Palladium is a rare element of the platinum group and is traded in the precious metals market.

1.74 Derivative transactions in base metals and palladium bullion, however, are currently eligible contract activities under subsection 121D(5). In order to allow all transactions in an OBUs global commodities book to be eligible OBU activities, the Government has decided to extend trading activities to include physical trading in base metals and trading in palladium bullion with offshore persons in any currency. These measures have been provided as a result of industry representations. They were not included in the Statement.

Other trading activities

1.75 Currently OBUs are permitted to undertake a number of distinct trading activities (apart from currency trading) with offshore persons where any money payable or receivable is not in Australian currency or where the shares, eligible contracts, securities or units traded are not denominated in Australian currency: subsection 121D(4). It is proposed to extend this activity to allow transactions in Australian currency with offshore persons.

Eligible contract activities

1.76 Under the existing concessions OBUs are allowed to enter into a futures contract, a forward contract, an options contract, a swap contract, a cap, collar, floor or similar contract with offshore persons where any money payable or receivable is not in Australian currency: subsection 121D(5). This activity will be extended to allow transactions in Australian currency with offshore persons.

Hedging

1.77 Hedging of interest rates and currency is used to manage exposure to risk from borrowing and lending activities. Hedging is currently permitted with an offshore person in Australian currency as long as the counter-party is not a related person: subsection 121D(8).

1.78 In broad terms, a related person is an associate of the OBU or any permanent establishment of the OBU through which activities other than OBU activities are carried on. The terms related person and associate are defined in section 121C.

1.79 The Government has decided to extend this activity by removing the related person restriction. This will allow OBUs to trade in Australian currency with their associates and offshore permanent establishments (eg. a branch).

Interest paid on offshore borrowings under conduit arrangements

1.80 Section 128GB provides an exemption from IWT on interest or gold fees paid by OBUs to non-residents where the money or gold borrowed is part of a borrowing activity and the money or gold is used to fund other OBU activities. Subsection 128GB(3) is a measure designed to protect another countries tax base by preventing an OBU situated in Australia being used as a conduit to channel the loan. It does this by denying the IWT exemption where an OBU is used as a mere conduit for a loan transaction.

1.81 In order to increase the attractiveness of the concessional tax regime by allowing back-to-back offshore loans through an OBU, the Government has decided to remove this anti-avoidance measure.

Capital gains tax exemption for disposals of interests in OBU offshore investment trusts

1.82 The Government has decided to reduce the capital gains tax (CTG) liability of non-residents disposing of their units in OBU offshore investment trusts. The purpose of the measure is to remove the CTG liability on gains relating to the underlying foreign assets held by these trusts.

What is an OBU offshore investment trust?

1.83 Under subsections 121D(6) and 121D(6A) an OBU may undertake investment activities on behalf of non-residents as trustee or central manager and controller of a trust. The trust is broadly referred to as an OBU offshore investment trust.

The Australian asset percentage

1.84 The portfolio investment activity described by subsection 121D(6A) allows OBUs to invest in Australian assets on behalf of non-residents subject to a 10 per cent limit on the Australian asset component of each investment portfolio. In broad terms, the Australian asset percentage of an investment portfolio is the percentage of Australian assets held in the portfolio.

1.85 In the case of an investment activity under subsection 121D(6), OBUs are not permitted to invest in Australian assets. Therefore, in these cases the Australian asset percentage will be zero.

Capital gains tax implications

1.86 If a non-resident beneficiary of an OBU offshore investment trust disposes of an interest (unit) in the trust a CTG liability may arise. However, this will only be the case where the unit is a CTG asset having the necessary connection with Australia.

1.87 In this context, category number 6 of section 136-25 of the Income Tax Assessment Act 1997 provides that a unit in a unit trust has the necessary connection with Australia if:

•

the unit trust is a resident trust for CTG purposes for the income year in which the CTG event (the disposal of the unit by the beneficiary) happens; and

•

the beneficiary, and their associates, beneficially owned at least 10% of the issued units in the trust at any time during the 5 years preceding the CTG event (the disposal of the units by the beneficiary).

1.88 The proposed legislation reduces the CTG liability to make it proportional to the share of the gain which relates to any underlying Australian assets held by the OBU offshore investment trust under subsections 121D(6) and 121D(6A) where:

•

the OBU offshore investment trust is a unit trust; and

•

the Australian asset percentage is not more than 10 per cent.

OBU income and foreign tax credits

1.89 Under the foreign tax credit system, a foreign tax credit is available only to residents for foreign tax paid on foreign income. A foreign tax credit is not available for offset against Australian tax payable on OBU income because the income is deemed to have an Australian source: section 121EJ. Instead the OBU regime allows a tax deduction: section 121EI.

1.90 Under the terms of a number Dates, however, the source article provides that where foreign tax is paid on income, the source of the income is deemed to be in the foreign country. Where this arises the legislation makes it clear that OBUs cannot claim both a foreign tax credit and a deduction: subsection 121EI(2).

1.91 To provide for greater neutrality in the treatment of OBUs which are residents of Australia, the Government has decided to provide a foreign tax credit for foreign tax paid by these OBUs regardless of whether a DTA applies. As is currently the case, however, an OBU will not be permitted to claim both a foreign tax credit and a deduction.

1.92 OBUs which are non-residents will still be permitted to claim a deduction as they will not be entitled to a foreign tax credit.

Separate nostro and vostro account requirement

1.93 As the law now stands, OBUs are required to maintain a separate pool of funds and to keep separate identifiable records, including separate nostro accounts in respect of OBU activities. These records must be maintained as though the OBU were a bank conducting banking activities with another person: section 262A. Vostro accounts may also be maintained by financial institutions.

1.94 In the context of Australian OBUs,nostro (our) accounts are foreign currency denominated accounts maintained by Australian OBUs with foreign banks for the purpose of settling foreign currency transactions.Vostro (your) accounts are Australian dollar accounts maintained by foreign banks with Australian OBUs for the purpose of settling foreign currency transactions.

1.95 In order to reduce compliance costs, the proposed legislation will remove the requirement to operate separate nostro or vostro accounts. However, an OBU will still need to maintain sufficient records, in accordance with generally accepted accounting principles and section262A, to identify OBU transactions passing through the accounts.

Reduction of OBU withholding penalty tax

1.96 An OBU may be liable under section 128NB of the ITAA 1936 for a special penalty tax where funds, that are subject to the OBU interest withholding tax concession under section 128GB of the ITAA 1936, are dealt with by the OBU in a manner excluded by the legislation. For example, where the funds are lent directly or indirectly to an Australian resident, used for general banking activities or used for other purposes by the financial institution of which the OBU is a part.

1.97 The penalty tax is imposed by the Income Tax (Offshore Banking Units) (Withholding Tax Recoupment) Act 1988 at a rate of 300 per cent on the amount of withholding tax that would have been paid if the concession had not applied.

1.98 The Government has decided that the current level of penalty is excessive. The measure will amend the Income Tax (Offshore Banking Units) (Withholding Tax Recoupment) Act 1988 to reduce the penalty tax from 300 per cent to 75 per cent. The proposed new rate is more in line with penalties applying to breaches of the OBU income tax concessions, however, it will continue to provide a significant disincentive to use funds subject to the IWT concession for general banking activities.

Explanation of the amendments

Entities eligible to apply for OBU status

1.99 Item 24 amends subsection 128AE(2) to extend the range of entities which the Treasurer may declare as OBUs. These are:

•

life insurance companies registered under the Life Insurance Act 1995; [New paragraph 128AE(2)(d)]

•

a company incorporated under the Corporations Law that provides funds management on a commercial basis other than solely to related persons. The company may be either:

1.

registered and included in the category of money market corporations under the Financial Corporations Act 1974; or [New subparagraph 128AE(2)(e)(i)]

2.

a fully owned subsidiary of a corporation in 1 above; or [New subparagraph 128AE(2)(e)(ii)]

3.

a holder of a dealers licence or an investment advisers licence granted under Part 7.3 of the Corporations Law; and [New subparagraph 128AE(2)(e)(iii)]

•

other companies, including providers of custodial services, determined by the Treasurer to be OBUs. [New paragraph 128AE(2)(f) ]

1.100 For the purposes of new paragraph 128AE(2)(f), new subsection 128AE(2AA) will require the company to make a written application to the Treasurer. [Item 25] The Treasurers determination must specify the date when the company commences to be an OBU. [New subsection 128AE(2AB)]

1.101 The determination under new subsection 128AE(2AA) must be made in accordance with written guidelines made by the Treasurer under new subsection128AE(2AD) . These guidelines are disallowable instruments for the purposes of section 46A of the Acts Interpretation Act 1901. Broadly speaking, this means that the disallowable instruments must be laid before both Houses of Parliament and that either House may pass a resolution disallowing any of the instruments. [New subsection 128AE(2AE)]

Income tax exemption for offshore charities

Eligible overseas charitable institutions

1.102 Item 4 will insert a new definition into section 121C in order to define institutions which will be eligible for the exemption. Broadly, the term overseas charitable institution is defined to mean an institution whose income:

•

would be exempt from tax under item 1.1 of section 50-5 of the Income Tax Assessment Act 1997 if the charitable institution had a physical presence in Australia and incurred its expenditure and pursued its objectives principally in Australia ; and

•

is exempt from income tax in the country in which it is resident.

Investment activity Portfolio investment for charitable institutions

1.103 The proposed amendments will insert a new activity which is described in the legislation as investment activity portfolio investment for charitable institutions. For ease of explanation the new activity will be referred to in this document as the charitable investment activity. [Items 5 and 15, new subsection 121D(6B)] The charitable investment activity is similar in concept to the existing portfolio investment activity under subsection 121D(6A).

1.104 The meaning of the term investment activity will be extended to include the managing as a broker, an agent, a custodian or a trustee of a portfolio investment during an investment management period for the benefit of overseas charitable institutions where the portfolio investment was made by the OBU or the overseas charitable institution. [Item 15, new subsection 121D(6B)]

1.105 The new activity will link into the existing definition of portfolio investment in subsection 121DA(1). This definition is to be amended by item 17 to include the management by an OBU as custodian, under a contract or trust instrument, of investments for the benefit of an overseas charitable institution.

Investment management period

1.106 The investment management period means either the whole or a part of a year of income. [New subsection 121D(6B)]

The OBUs fee income

The Australian asset percentage

1.107 Unlike the existing portfolio investment activity under subsection 121D(6A), the charitable investment activity does not place a limit on the proportion of Australian assets which may be held in the investment portfolio. Therefore, the Australian average percentage will not be relevant when determining whether the activity constitutes a charitable investment activity.

1.108 However, from the perspective of the OBUs fee income, the average Australian asset percentage will be relevant when determining the proportion of this income which will be subject to the concessional rate of tax. This percentage is essentially the average, over a defined period, of the monthly Australian asset percentages of the investment portfolio. The calculation of this percentage is shown below.

Monthly Australian asset percentage

1.109 The monthly Australian asset percentage is, in broad terms, the percentage of Australian assets, calculated by reference to the value of the assets, in the investment portfolio for a particular month or part of a month: subsection 121DA(3). The calculation of the monthly Australian asset percentage for part of a month will be necessary where, for example, the OBU commences or ceases to manage an investment portfolio part way through the month.

1.110 The monthly Australian asset percentage must be calculated according to reasonable accounting practice and on the same basis for all months of a year of income. This allows OBUs to use their existing records to calculate the monthly Australian asset percentage. It also provides flexibility in that it does not impose any stringent timing requirements as to when the calculations must be done, as long as it is consistent during the year of income: subsection 121DA(4).

Average Australian asset percentage

1.111 The average Australian asset percentage is the average, over the year of income, of the monthly Australian asset percentages: subsection 121DA(2). Item 18 will amend subsection 121DA(2) which defines the term average Australian asset percentage so that a link is created with the new charitable investment activity under new subsection 121D(6B) .

Assessable OB income

1.112 In broad terms, the income from OBU activities is taxed at a rate of 10 per cent. Rather than providing a special rate of tax for this purpose, the assessable income and allowable deductions are adjusted downwards to achieve the same result. Each amount of income and each amount of allowable deduction is reduced by a fraction referred to as the eligible fraction. The eligible fraction is 10 divided by the general company tax rate applicable to the year of income. As the rate of company tax is currently 36 per cent the fraction is:

10/36


1.113 Item 19 will amend subsection 121EE(3A) in order to reduce the OBUs assessable OBU income (that is, income from eligible OBU activities) by the average Australian asset percentage in respect of the portfolio investment concerned. This will have the effect of taxing the fee income derived from the non-Australian asset component of the investment portfolio at the concessional rate of 10 per cent. The fee income derived from managing the Australian asset component of the portfolio will not be eligible for the concessional tax rate and will be subject to the general company tax rate.

Allowable deductions

1.114 The reduction in the OBUs assessable OBU income (as explained in the previous paragraph) will mean that expenses incurred in managing a charitable investment portfolio will not fall within the definition of exclusive OBU deduction in subsection 121EF(3). The expense will, therefore, relate to both OBU and non-OBU activities and will need to be apportioned as a general OBU deduction: subsection 121EF(4).

Example

1.115 AusOBU managed a charitable investment portfolio for three and a half months during a year of income. The portfolio comprised shares in both resident and non-resident companies. AusOBU produced reports on the portfolio it managed from its records on a monthly basis. It used this information to calculate the average Australian asset percentage.

•

AusOBU derived a fee of AUD57,500 for managing the portfolio.

Assessable OBU income

$57,500 x 94% = $54,050


Therefore, AusOBU would be concessionally taxed on AUD3,450.

The exemptions from income tax and withholding tax

1.116 The income and gains derived by the overseas charitable institution from the assets managed by an OBU under the new charitable investment activity will be exempt from income tax. The form of the exemption will depend on whether the OBU is acting in the capacity of trustee of an OBU offshore investment trust or as custodian, broker or agent of the overseas charitable institution. Additionally, the type of income will also determine the form of the exemption.

1.117 The proposed legislation amends section 121EL to exempt income and gains of the OBU offshore investment trust derived in the course of, or in connection with, an investment activity covered by new subsection 121D(6B) . [Item 21] New paragraph 121ELA(1)(b) will exempt distributions of income from the OBU offshore investment trust to the overseas charitable institution.

Income tax and capital gains derived through OBUs acting as custodian, broker or agent

1.118 Where the investment is managed by the OBU as custodian, broker or agent, income from the charitable investment activity will be derived by the overseas charitable institution. New paragraph 121ELA(1)(a) will provide an exemption for income derived by an overseas charitable institution where:

•

the income is a payment or outgoing from an OBU; and

•

the payment or outgoing was made in relation to the OBUs eligible activities. [Item 22]

Withholding tax exemption

1.119 Item 26 will amend paragraph 128B(3)(a) to provide an exemption from interest, dividend and royalty withholding tax in relation to income derived by an overseas charitable institution where that income is exempt under new subsection 121ELA(1) . [Item 22]

Extension of eligible OBU activities

1.120 As the proposed amendments have extensively widened the range of eligible activities (as described below) that qualify for the concessional tax treatment a summary has been included in Table1 which appears at the end of this section.

Custodial Services

Extending the existing portfolio investment activity

1.121 The measures will extend the scope of the portfolio investment activity by allowing OBUs to make and manage investments as custodian on behalf of non-residents by amending subsection 121D(6A). [Item 13]

1.122 The term portfolio investment is defined in subsection 121DA(1) as one or more investments managed by an OBU (as a broker, an agent or a trustee) under a contract or trust instrument for the benefit of a non-resident. Item 17 will amend the definition of portfolio investment in subsection 121DA(1) to include the management by an OBU as custodian, under a contract or trust instrument, of investments for the benefit of a non-resident.

1.123 After these amendments the portfolio investment activity described in subsection 121D(6A) will allow an OBU to manage (as broker, agent, custodian or trustee) a portfolio investment during an investment management period for non-residents, where:

•

if the investments are shares in non-resident companies, units in non-resident unit trusts, land and buildings outside Australia or other foreign assets the investment is made with a non-resident;

•

if the investments are Australian things the investment is made with either a non-resident or resident;

•

the currency in which investments are made is not in Australian dollars;

•

the investment portfolio comprises more than one Australian thing; and

•

the average Australian asset percentage of the portfolio investment is 10 per cent or less.

1.124 Therefore, the expanded activity will allow OBUs, subject to a 10% per cent limit, to manage as custodian Australian investments (eg. shares in Australian companies, units in Australian unit trusts, land and buildings located in Australia) on behalf of non-residents.

1.125 Existing paragraph 121D(6A)(b) will also be amended to allow the non-resident investor as well as the OBU to make the investment which will be managed by the OBU. This will accommodate the situation arising under custodial services where the client makes the investment, for example purchasing an asset, and the custodian holds and deals with the investment at the direction of the client. [Item 14]

1.126 Consistent with the existing provisions, where the average Australian asset percentage in respect of the portfolio investment held under the custodial arrangement exceeds 10 per cent, the activity will not fall within the definition of a portfolio investment activity in subsection 121D(6A) and the whole of the fee income will be subject to the general company rate of tax.

The OBUs fee income

1.127 As is currently the case, the OBUs assessable OB income from providing the services to the non-resident will be reduced by the average Australian asset percentage in respect of the portfolio investment concerned. An explanation on how this percentage is calculated is shown at paragraphs 1.105 to 1.109. This has the effect of taxing the fee income derived from the non-Australian asset component of the investment portfolio at the concessional rate of 10 per cent. The fee income derived from making and managing the Australian asset component of the portfolio will not be eligible for the concessional tax rate and will be subject to the general company tax rate: subsection 121EE(3A).

Currency trading

1.128 Item 10 inserts new paragraph 121D(4)(ea) which will allow OBUs to trade in any currency with an offshore person.

Gold trading

1.129 Item 11 repeals existing paragraph 121D(4)(f) and substitutes a provision which will apply solely to gold trading activities. New subparagraph 121D(4)(f)(i) will allow trading in gold bullion with an offshore person in any currency. New subparagraph 121D(4)(f)(ii) permits trading in gold bullion, or in options or rights in respect of such bullion, with a person other than an offshore person provided that any money payable or receivable is not in Australian currency.

Metals trading

1.130 New paragraph 121D(4)(g) will be inserted by item11 to allow trading in silver, platinum or palladium bullion or in options or rights in respect of such bullion with an offshore person. This amendments extends the existing concessional activities by allowing trading in silver, platinum and palladium bullion with an offshore person in Australian currency.

1.131 New paragraph 121D(4)(h) expands trading activities to allow base metals trading with an offshore person in Australian currency. [Item11]

Other trading activities

1.132 The proposed amendments to subsection 121D(4) made by items6, 7, 8 and 9 allow trading in securities issued by non-residents, eligible contracts (where amounts payable are payable by non-residents), shares in non-resident companies and units in non-resident trusts with an offshore person to be in any currency.

Eligible contract activities

1.133 Existing subsections 121D(5) is amended by item 12 to extend eligible OBU activities to include eligible contract activities with an offshore person in Australian currency.

Hedging

1.134 Amendments to subsection 121D(8) by item 16 remove the related person restriction.

Interest paid on offshore borrowings under conduit arrangements

1.135 Item 33 repeals subsections 128GB(3) and 128GB(4) to allow back-to-back offshore loans through an OBU.

Capital gains tax exemption for disposals of interests in OBU offshore investment trusts

1.136 The proposed amendments will insert new subsection 121ELA(2) and new section 121ELB to give effect to the Governments decision to reduce the capital gains tax liability of non-residents disposing of their units in OBU offshore investment trusts. [Item 22] The provision applying to the particular disposal will depend on whether the income , profits or gains of the trust came from an investment activity covered by existing subsection 121D(6) or 121D(6A) or new subsection 121D(6B) .

Investment activity under subsection 121D(6)

1.137 In the case of an investment activity under subsection 121D(6), OBUs are not permitted to invest in Australian assets and consequently the Australian asset percentage of the portfolio will be zero. Accordingly, new subsection 121ELB(1) provides that the non-resident makes no capital gain or capital loss from a disposal of a unit in an OBU offshore investment trust. [Item 22]

Investment activity portfolio investment under subsection 121D(6A)

1.138 If the OBU offshore investment trust relates to an investment activity under subsection 121D(6A), the amount of the capital gain or capital loss made by a non-resident disposing of a unit in an OBU investment trust will depend on the average Australian asset percentage of the particular investment portfolio. [Item22 new subsection 121ELB(2)]

1.139 An explanation of the term average Australian asset percentage is at paragraph 1.109. For the purposes of calculating the average Australian asset percentage in relation to an adjustment under new subsection 121ELB(2) , the investment management period of the portfolio investment is deemed to be the 12month period immediately before the disposal. [New subsection 121ELB(3)]

1.140 Where the average Australian asset percentage of an OBU offshore investment trust is 10 percent or less, the capital gain or loss will be adjusted to make it proportional to the average Australian asset percentage of the portfolio. However, if the average Australian asset percentage is greater than 10 per cent, no adjustment will be permitted. [New subsection 121ELB(2)]

Example

1.141 The Happy Retirement pension fund owns 20% of the units in an offshore investment trust (the ABC unit trust). The ABC unit trust holds a portfolio which comprises 92 % foreign assets and the average Australian asset percentage is 8%. The pension fund disposes of its units and makes a capital gain of $10,000.

1.142 Under the proposed measure the capital gain would be reduced to be proportional to the average Australian asset percentage as follows:

$10,000 x 8% = $800


Investment activity portfolio investment for overseas charitable institution under new subsection 121D(6B)

1.143 Consistent with the Governments decision to exempt certain overseas charitable institutions, new subsection 121ELA(2) will provide that an eligible institution makes no capital gain or capital loss from a disposal of its interest in an OBU offshore investment trust. [Item 22]

OBU income and foreign tax credits

1.144 In order to provide a foreign tax credit for foreign tax paid by an OBU item 20 inserts new subsection 121EJ(2) which deems, for the purposes of Division 18, income subject to foreign tax to have a foreign source. The existing section 121EI will continue to:

•

provide a deduction to non-resident OBUs for foreign tax paid (non-residents are not entitled to claim foreign tax credits); and

•

disallow a deduction where an OBU is entitled to claim a foreign tax credit.

Separate nostro and vostro account requirement

1.145 Item 35 removes the requirement that OBUs maintain separate nostro and vostro accounts for OBU transactions by inserting new subsection 262A(1AA) .

Reduction of OBU withholding penalty tax

1.146 Item 38 amends section 7 of the Income Tax (Offshore Banking Units) (Withholding Tax Recoupment) Act 1988 to reduce the penalty tax rate of 300 per cent to 75 per cent.

Consequential amendments

1.147 Items 1, 2, and 3 are consequential amendments to subsection 121B(3) to reflect changes to the OBU regime.

1.148 Items 36 and 37 make consequential amendments to the Income Tax Assessment Act 1997 as a result of the measures.

Table 1. OBU activities that qualify for the concessional tax treatment are summarised in general terms below with relevant currency restrictions

Section 3 - Thin Capitalisation

Background to the legislation

1.149 The thin capitalisation rules of the income tax law, contained in Division 16F of Part III of the ITAA 1936, are anti-avoidance measures aimed at limiting the amount of interest that can be claimed as a deduction in relation to certain foreign controlled entities and investments.

1.150 Thin capitalisation of investments in Australia is influenced by the preferential taxation treatment provided to debt funding relative to equity funding. In relation to the foreign debt of an Australian company, interest paid by the company is deductible against its income and the interest paid to the foreigner is normally only subject to IWT at the rate of 10 per cent. However in relation to foreign equity, dividends paid to the foreign shareholders are generally paid from profits that have been subject to the 36 per cent company rate of tax and, under the imputation system, are not subject to dividend withholding tax. The difference between the treatment of debt funding and equity funding creates the incentive for foreign controllers to maximise the debt funding and minimise the equity funding of their investments in Australia.

1.151 The thin capitalisation rules place a limit, by means of a specified debt-to-equity funding ratio, on the amount of interest expense payable in relation to foreign debt that can be deducted for Australian tax purposes. If a taxpayer exceeds the gearing ratio, deductions for interest paid on the related-party debt are disallowed to the extent of the excess. The ratio of related-party foreign debt-to-equity cannot exceed 6:1 for financial institutions, and 2:1 for other taxpayers. The higher ratio of 6:1 is allowed for financial institutions in recognition of their special funding needs.

1.152 The foreign debt of an Australian resident company is the interest-bearing debt which is owed to foreign controllers or their non-resident associates. For these purposes, a foreign controller is any non-resident that has substantial control of the voting power of the company, or is beneficially entitled to receive at least 15% of any dividends or other distribution of capital.

1.153 The foreign equity of an Australian resident company is equivalent to the paid-up share capital and the opening balances of the accumulated profits and asset revaluation reserves beneficially owned by foreign controllers and their non-resident associates. As an anti-avoidance measure, the foreign equity is reduced by any amounts that have been loaned back to the foreign controller or non-resident associates. Thus, only the net amount will be treated as foreign equity. This is necessary to ensure that the foreign equity cannot be artificially inflated by lending back equity to foreign controllers which could then re-inject the funds into the Australian company as new share capital.

Interaction with Interest Withholding Tax regime

1.154 Interest withholding tax is ordinarily payable on interest paid by businesses in Australia to non-residents, subject to some broad exceptions. The IWT regime contains an exemption for interest paid by Australian resident companies on certain debentures that satisfy a public offer test (section 128F). This exemption is only available to Australian companies - it is not available to an Australian branch of a foreign bank.

1.155 However, foreign banks operating in Australia through branches are entitled to have an associated Australian company raise funds overseas under the section 128F exemption, and then on-lend those funds for use in the Australian branch. Companies established for this purpose are held to be financial institutions for the purposes of the thin capitalisation rules by virtue of the definition provided in section 159GZA, and are therefore entitled to the increased gearing ratio of 6:1. The structure is illustrated in the following diagram.

Explanation of the amendments

1.156 When a financial institution, that is either directly or indirectly owned by a foreign bank, raises section 128F funds and on-lends those funds to a related foreign bank branch in Australia, paragraph 159GZG(1)(d) could apply to reduce the foreign equity of the financial institution. This is because funds that are on-lent to the branch are treated as a loan back to the foreign bank - since the branch is a part of the same legal entity as the foreign bank. The reduction of the financial institutions foreign equity would limit its ability to raise funds from its foreign controller or non-resident associates.

1.157 This amendment will introduce new sub-subparagraph 159GZG(1)(d)(i)(C), which will allow the financial institution, that is either directly or indirectly owned by a foreign bank, to on-lend funds raised under the section 128F exemption to a related Australian bank branch, without reducing the financial institutions foreign equity. In order to prevent the foreign bank from artificially increasing its equity in the financial institution, the amendment is only available where the Australian bank branch can show that the funds made available are for use in its Australian business. [Item 34, new sub-subparagraph 159GZG(1)(d)(i)(C)]

Section 4 - Application - Withholding tax, OBU and thin capitalisation measures

1.158 The amendments made by Part 1 of Schedule 1 apply in relation to transactions entered into after 2 July 1998. However, several specific application provisions are provided by item 39 :

•

Item 20 applies to foreign tax paid after 2 July 1998;

•

New subsection 121ELA(2) and new section 121ELB apply to disposals after 2 July 1998;

•

Items 24 and 25 apply to declarations made by the Treasurer after 2 July 1998;

•

Items 27 to 32 apply to debentures issued after 2 July 1998;

•

Item 33 applies to interest paid by an OBU after 2 July 1998;

•

Item 34 applies in relation to amounts lent to Australian branches after 2 July 1998;

•

Item 35 applies to the year of income before the year of income in which 2 July 1998 occurs and all later years of income; and

•

Item 38 applies to penalties imposed after 2 July 1998.

Section 5 - Regulation impact statement

Part 1 - Withholding Tax, Offshore Banking Units and Thin Capitalisation

Policy objective

1.159 On 8 December 1997 the Prime Minister announced, as part of the Investing for Growth Statement (the Statement), a package of measures which, among other things, are designed to further enhance Australia's credentials as a world financial centre. In particular, measures included in the Australia - A Regional Financial Centre component of the Statement are aimed at making Australia a more attractive regional financial centre by building on Australia's existing advantages to ensure its participation in the increasing global trade in financial services. Additional measures to further extend the IWT exemption available under section 128F of the ITAA 1936 were announced in the Treasurers Press Release No. 80 on 13 August 1998.

Developing Financial Markets

1.160 In order to encourage the development of the domestic corporate debt market the Government announced a widening of the section 128F IWT exemption by removing, for eligible debentures issued by companies, the present requirements that they be issued outside Australia and that the interest be paid outside Australia.

Competitive Offshore Banking Regime

1.161 For several years, Australia has provided a special OBU taxation regime intended to promote the provision of financial services for transactions between offshore parties. The regime exempts certain offshore parties from Australian taxes and provides an effective 10 per cent tax rate on the taxable income of OBUs, the financial intermediaries to these transactions. Most of the new tax measures seek to reduce tax burdens on income from offshore investments made by non-resident investors and on OBUs managing this business. Other measures seek to reduce compliance costs on OBUs undertaking this business from Australia.

Thin Capitalisation

1.162 In order to provide the Australian branches of Foreign Banks greater access to IWT exempt funds, the thin capitalisation measures will be relaxed. This will enable foreign owned financial institutions to raise IWT exempt funds and on-lend those funds to their related Australian bank branches without affecting the financial institutions thin capitalisation position.

Implementation options

1.163 In considering the options available it was decided that the possible option of implementing selective parts of the proposed package was not valid because it would undermine the achievement of the policy objective.

1.164 It is necessary to amend the ITAA 1936 in order to implement the policy objectives outlined in the Statement. The amendments will take effect from 2 July 1998. The following implementation options have been identified:

Section 128F IWT Exemption

(a)

Widen the IWT exemption in respect of corporate issues in relation to eligible debentures to allow:

•

debentures to be issued in Australia; and

•

interest to be paid in Australia.

(b)

Allow Australian residents to acquire bearer and registered debentures without the issue as a whole losing its eligibility for the section 128F IWT exemption (the initiative to include bearer debentures was announced by the Treasurer on 13 August 1998). To maintain consistency with the current requirements of section126 in respect of residents in Australia, the company paying bearer debenture related interest must supply the ATO with the names and addresses of the holders of bearer debentures which are Australian branches offshore. Otherwise the company must deduct a penalty tax of 47% from any interest payments made.

(c)

Widen the meaning of the term company, to ensure that an Australian company acting in the capacity of trustee for an Australian trust is treated as a company for the purposes of section 128F, provided the trust is not a charitable trust and that the beneficiaries of the trust are companies as long as they are not trustee companies, for the purposes of section 128F. The Treasurer also announced this initiative on 13 August 1998.

Offshore Banking Regime

(d)

Expand the range of persons eligible to be an OBU to include:

•

funds managers incorporated under the Corporations Law which are:

-

money market corporations subject to the Financial Corporations Act 1974 or fully owned subsidiaries of these corporations;

-

holders of securities dealers licences under the Corporations Law; or

-

holders of investment advisers licences under the Corporations Law;

•

life insurance companies registered under the Life Insurance Act 1995; and

•

other companies (including providers of custodial services) as determined by the Treasurer.

Broadly speaking, the OBU regime will be extended to include funds managers, life insurance offices and providers of custodial services.

(e)

Exempt from tax all income and gains of offshore charitable institutions where:

•

the investments which give rise to the income or gains are managed by an OBU; and

•

the charitable institution is exempt in its home jurisdiction.

There will be no limitation placed on the proportion of Australian assets that may be held on behalf of the charitable institutions. However, OBUs will only be eligible for the 10 per cent concessional tax rate on the component of the management fee which relates to the offshore assets. The component relating to the Australian assets will be taxed at the full company rate.

(f)

Extend the range of eligible OBU activities to include custodial services provided to non-residents.

(g)

Extend the range of eligible OBU activities to include:

•

trading;

•

eligible contract activities; and

•

hedging activities;

in Australian currency with offshore persons.

(h)

Extend the range of eligible OBU activities in gold trading to include:

•

gold bullion trading with an offshore person in any currency; and

•

gold bullion trading with residents and non-residents operating through a permanent establishment in Australia in any currency other than AUD.

(i)

Allow trading in base metals and palladium in any currency with offshore persons as eligible OBU activities. This measure was not announced in the Statement. The Government has decided to extend the concession following Industry representations.

(j)

Remove the current anti-avoidance measure which prevents Australia being used as a conduit to channel loans to other countries by repealing subsections 128GB(3) and 128GB(4).

(k)

Reduce the capital gains tax (CTG) liability of non-residents disposing of their units in an OBU offshore investment trust. This measure reduces the CTG liability to make it proportional to the share of the gain which relates to any underlying Australian assets where they constitute less than 10 per cent of the investment portfolio.

(l)

Allow Australian OBUs a foreign tax credit where OBU income is subject to foreign taxes regardless of whether DTA applies.

(m)

Remove the current requirement for OBUs to maintain separate nostro and vostro accounts for OBU transactions.

(l)

Reduce the rate of OBU withholding penalty tax from 300 per cent to 75 per cent to bring it more into line with the penalties which apply to breaches of the OBU income tax concession.

Thin Capitalisation measures

(m)

Relax the effect of the thin capitalisation loan back provisions so that an Australian subsidiary of a foreign bank may raise section 128F IWT exempt funds and on-lend those funds to a related Australian branch without affecting the subsidiaries thin capitalisation position.

Assessment of impacts (costs and benefits) of each implementation option

Impact group identification

1.165 The affected groups are financial intermediaries for whom non-residents are a significant client group, primarily banks and funds managers, and non-residents investing in or through Australia. World-wide the financial system has grown significantly over the past three decades. Australia is already participating in the international trade in financial services. Over the six years to 1996-1997 exports of financial services grew by more than 20 per cent. By increasing its role as a financial centre Australia can capitalise on opportunities for export growth.

1.166 The OBU related measures most effect those intermediaries that are eligible, or will under the measures become eligible, to operate as OBUs. Increased use of the OBU concessions may impose some additional administration costs on the ATO. The section 128F measure will be of particular benefit to corporate borrowers. The package will have a relatively small impact on Government revenue.

1.167 All of the measures address issues raised by taxpayers (or their representatives) consulted in the preparation of the package. The measures can therefore be expected to generally be welcomed by taxpayers, although some may consider that more far reaching measures are warranted.

Analysis of the costs and benefits associated with each implementation option

1.168 Quantitative data on the compliance and administrative costs of the measures have not been estimated. The assessment in this section is therefore of a qualitative nature. The measures represent a package which is aimed at providing greater certainty and reducing compliance costs and tax burdens in relation to financial sector activities.

Section 128F IWT Exemption

(a)

Widening the section 128F IWT exemption will simplify the compliance arrangements for corporate issuers wishing to access the concession. Such borrowers will no longer be required to issue offshore in order to access the concession.

(b)

Allowing Australian residents to acquire debentures and interests in debentures which are eligible for the section 128F IWT exemption will further integrate the investors in Australia and overseas. Industry has indicated that the benefits of the concession are likely to outweigh the minor compliance cost due to the requirement to provide names and addresses of holders of bearer debentures (excluding non-residents located outside of Australia) to the ATO.

(c)

Widening the meaning of the term company will ensure that an Australian company acting in the capacity of trustee for an Australian trust is treated as a company for the purposes of section 128F, provided the trust is not a charitable trust and that the beneficiaries of the trust are companies, but not trustee companies, for the purposes of section 128F. Financial institutions involved in securitisation transactions will be able to more easily access the section 128F IWT exemption. This is expected to reduce the cost of capital by allowing lenders to access the cheapest funds free of withholding tax: a benefit which should be passed on to borrowers (eg. home buyers and consumers) given the competitiveness of the Australian financial market.

Offshore Banking Regime

(d)

Expanding the range of entities eligible to be an OBU to include funds managers, life insurance offices and providers of custodial services will allow a broader range of financial market participants access to the concessional OBU tax regime. There is expected to be a small cost to revenue as some existing activities carried out under the standard taxation arrangements are transferred to the concessional regime. To the extent that greater use is made of the concessional regime there may be additional administrative costs for the ATO. However, expanding access to the concessions is expected to result in a deepening of the market and an increase in the amount of business generated, resulting in increased revenue.

(e)

Exempting from tax the income and capital gains of offshore charitable institutions, managed by an OBU and exempt in their home jurisdiction, will provide a source of new business for OBUs. It will also provide scope for offshore charitable institutions, whose general exemptions were recently removed under the anti-avoidance measures relating to charitable trusts, to regain exempt status.

(f)

Extending the range of eligible OBU activities to include custodial services provided to non-resident offshore persons will reduce uncertainty about the scope of eligible OBU activities. This measure will negatively effect revenue to the extent that these activities are currently undertaken within the standard taxation regime without concessional procedures.

(g)

The eligible OBU activities involving trading, eligible contract, hedging and gold trading will all be expanded by the new amendments. Trading in base metals and palladium will also be allowed as eligible OBU activities. These measures will reduce tax burdens and negatively effect revenue to the extent that these activities are currently undertaken outside the concessional regime. Compliance costs may be reduced to the extent that the restrictions on OBU activities are less binding.

(h)

Removing the section 128GB(3) exclusion from the OBU IWT exemption of conduit arrangements will reduce uncertainty as to the provisions application and remove complexity from the tax law.

(i)

Reducing the CTG liability of non-residents disposing of their units in an OBU offshore investment trust will make these vehicles more attractive to non-resident investors. The measure will lower tax burdens on investors in these trusts, but do so at the expense of additional tax law complexity. There may be minor costs associated with OBUs assessing the underlying percentage of Australian assets. This concessional measure will negatively affect tax revenue from existing OBU offshore investment trust sources. However, this could be counterbalanced by the expected rise in new business utilising these financial instruments as a result of the concession.

(j)

Allowing Australian OBUs a foreign tax credit (FTC) where OBU income is subject to foreign taxes, regardless of whether a DTA applies, may allow OBUs to reduce their tax burdens in some circumstances. There may be some increase in compliance costs to the extent that the FTC rules are more onerous to comply with than simply claiming a deduction for foreign tax. This is more than offset by the reduction of the OBUs tax burden achieved by including foreign tax credits instead of a deduction.

(k)

Removing the current requirement for OBUs to maintain separate nostro and vostro accounts will reduce compliance costs for OBUs. There may be additional administrative costs for the ATO. The amendment is revenue neutral.

(l)

The current level of penalties is considered excessive. Reducing the penalty tax from 300 per cent to 75 per cent will more closely align the penalties to those applying to the breaches of the OBU income tax concession. There will not be an additional administrative cost for the ATO.

Thin capitalisation measures

(m)

Relaxing the loan back provisions of the thin capitalisation regime will make it easier for Australian branches of Foreign Banks to access section 128F IWT exempt funds from their related Australian subsidiaries. This measure will reduce the tax burden of the Australian subsidiaries and have a negligible effect on revenue. The amendment will have minimal impact on compliance and administrative costs.

Consultation

1.169 The measures have been developed in close consultation with several tax advisory practices with particular expertise in the financial services sector and with other financial market participants. Consultation with industry bodies following the tabling of the Taxation Laws Amendment Bill (No. 5) 1998 (lapsed) in July 1998 led to the inclusion of additional measures in the package. These amendments were announced in the Treasurers Press Release No. 80 on 13 August 1998.

1.170 As part of the package, a task force within the Financial Sector Advisory Council (FSAC) was established as an ongoing consultative forum which will maintain a focus on the effectiveness of the measures and which will report on further options which could boost Australia's attractiveness as a financial centre.

Conclusion

1.171 The package of measures is the Governments preferred method for achieving the policy objective of making Australia a more attractive regional financial centre. Overall, the package is expected to reduce compliance costs.

1.172 The Treasury and the ATO will monitor this package of measures as part of the whole taxation system on an ongoing basis. Furthermore, the task force within the FSAC will provide advice on the effect of the measures on Australia's attractiveness as a regional financial centre.

Part 2 - Exemption from the FIF measures for interests in certain FIFs resident in the United States (US)

Overview of the FIF measures

1.173 Part 2 of Schedule 1 to the Bill will amend the ITAA 1936 to provide an exemption from the FIF measures for interests in certain US FIFs. The exemption forms part of a package of measures entitled Investing for Growth directed at developing and promoting Australia as a regional financial centre announced by the Government on 8 December 1997.

1.174 The amendments will:

•

provide an exemption from the FIF measures for interests in certain FIFs taxed on a worldwide basis in the US ( Section 1 );

•

provide a limited exemption for interests in certain FIFs taxed as conduit entities in the US ( Section 1 ); and

•

make these exemptions available when determining FIF income under the calculation method ( Section 2 ).

1.175 Consequential amendments will also be made to ensure:

•

the general trust provisions do not claw back the benefits of providing the exemption ( Section 3.1 ); and

•

the trustee of a trust FIF that qualifies for the exemption is taxed on the Australian source income of the trust under the general trust provisions ( Section 3.2 ).

1.176 A regulation impact statement for the changes is provided in Section 4 .

1.177 Unless otherwise stated, references to provisions of the law in Part 2 of this Chapter are references to provisions of the ITAA 1936 and item references are to Schedule 1 to the Bill.

Section 1 - Exemption from the FIF measures

Summary of the amendments

Purpose of the amendments

1.178 The amendments will:

•

provide an exemption from the FIF measures for interests in certain FIFs taxed on a worldwide basis in the US; and

•

provide a limited exemption for interests in certain FIFs taxed as conduit entities in the US.

[Item 42]

Date of effect

1.179 The exemption will apply for notional accounting periods of FIFs ending on or after 2 July 1998 . [Subitem 46(1)]

Background

1.180 The FIF measures (Part XI of the ITAA 1936) apply to Australian residents who have an interest in a foreign company or foreign trust at the end of a year of income. Broadly, the FIF measures operate to approximate a resident taxpayers share of the undistributed profits of a FIF (called FIF income) and assess the taxpayer on those profits. This treatment is directed at preventing deferral of Australian tax where profits are accumulated offshore in a FIF rather than remitted to Australian investors.

1.181 Exemptions from the FIF measures are provided for a wide range of investments in company FIFs engaged in active businesses where the risk of tax deferral is not likely to be significant. FIF investments subject to the controlled foreign company or transferor trust measures are also exempt.

Explanation of the amendments

1.182 The amendments will provide a further exemption from the FIF measures for interests in certain US FIFs. The exemption is intended to encourage Australian investment funds to be more efficient by exposing them to competition from US funds. The substantial similarity of US tax rules to those in Australia will ensure tax deferral opportunities do not arise because of the exemption.

1.183 The exemption will be inserted as Division 8 in Part XI of the ITAA 1936. [Item 42] Division 8 previously contained an exemption from the FIF measures for approved country funds and was repealed with effect for notional accounting periods ^[F1] of FIFs commencing on or after 1 January 1997.

What kinds of FIF interests qualify for the exemption?

1.184 The exemption will be available for FIF interests in:

•

entities that are treated as corporations and are subject to tax on their worldwide income under the US Internal Revenue Code of 1986;

•

regulated investment companies; and

•

real estate investment trusts. [New subsection 513(1)]

Regulated investment companies and real estate investment trusts are fully distributing investment funds used widely in the US as vehicles for managing collective investments.

1.185 A limited exemption will be available for FIF interests in:

•

limited liability companies taxed as partnerships in the US;

•

limited partnerships taxed as partnerships in the US; and

•

common trust funds. [New subsections 513(2), (3), (4) and (5)]

1.186 Note, if a limited liability company or a limited partnership is treated as a corporation and is subject to tax on its worldwide income under the US Internal Revenue Code 1986, it will qualify for the exemption under new subsection 513(1) .

1.187 Limited liability companies and limited partnerships taxed as partnerships in the US and common trust funds are also commonly used as investment vehicles in the US. Only a limited exemption is to be provided for these entities, however, because they are taxed in the US as conduit entities and consequently they are not directly liable for US tax. The US tax liability is instead borne by investors in a conduit entity and Australian investors are generally not subject to tax in the US on non US source income derived through a conduit entity. An unqualified exemption for conduit entities could therefore create a significant risk to the revenue because it would allow Australian investors to hold non US investments through a conduit entity and be exempt from anti tax deferral rules in both Australia and the US.

1.188 The exemption will be available for interests held in the above mentioned conduit entities (referred to below as specified conduit entities) only where those interests are held for the sole purpose of investing directly, or indirectly through other entities, in a business conducted in the US and/or real property located in the US. [New paragraphs 513(3)(a) and (4)(a)] The sole purpose test will be satisfied for an interest held in a specified conduit entity if:

•

the interest is held for the purpose of investing directly, or indirectly through other entities, in a business conducted in the US and/or real property located in the US; and

•

the interest is not held for the purpose:

-

of making other types of investment in the US either directly or indirectly through other entities; or

-

of investing outside the US either directly or indirectly through other entities.

1.189 The types of investment covered by the second dot point will be referred to below as non-qualifying investments.

1.190 It is possible for an interest in a specified conduit entity to satisfy the requirements of the test even though the entity directly or indirectly makes non-qualifying investments. The test could be satisfied, for instance, if a taxpayer were to hold an interest in the entity for the purpose of investing into the US and it is incidental that the entity also has some non-qualifying investments.

1.191 The limited exemption is divided into two parts. [New subsection 513(2)] The first part provides an exemption for interests held in specified conduit entities that do not directly, or indirectly through other conduit entities, have non-qualifying investments. [New subsection 513(3)] There is a low risk of tax deferral benefits arising for investments through these entities because the US will normally tax Australian residents on an amount derived through a conduit entity if the amount arises from the conduct of a US business or from the disposal of real property located in the US.

1.192 The second part provides an exemption for interests held in specified conduit entities that directly or indirectly through other conduit entities, have some non-qualifying investments. [New subsection 513(4)] Tighter rules are required before an exemption can be provided for these interests because amounts derived by Australian residents through a conduit entity from sources outside the US are, for instance, unlikely to be taxed in the US.

1.193 Two ratios are used to limit the extent to which a specified conduit entity can hold non-qualifying investments. The first ratio provides that no more than five percent of certain interests can be in interests that do not satisfy either the requirements for obtaining an unqualified exemption under new subsection 513(1) or the requirements of the first part of the limited exemption under subsection 513(3). [New paragraph 513(4)(b)] The following table summarises an example of FIF interests held by a conduit entity that are to be taken into account in determining the 5per cent limit.

1.194 The calculation of the 5 per cent limit is illustrated by the following example.

Example 1 - Calculation of the 5% limit

Facts

•

A US common trust fund holds interests in FIFs as shown in the following table.

Consequences

In this case, the ratio would be calculated as 0.16 (ie. $2 million (total value FIF interests counted towards the 5% limit) / $12 million (total value of FIF interests))). Expressed as a percentage, a ratio of 0.16 means 16percent of the common trust funds interests in FIFs are in non-eligible FIFs. An interest held in the common trust fund would therefore not qualify for the exemption because the funds interests in non-qualifying FIFs exceed the 5 per cent limit.

1.195 The second ratio provides that no more than five percent of a specified conduit entities assets can produce income from sources outside the US or give rise on disposal to gains from sources outside the US. [New paragraph 513(4)(c)]

1.196 The ratios are to be determined using the value of FIF interests and assets shown in the accounting records of a specified conduit entity. [New subsection 513(5)] The ratios cannot be exceeded at any time during the notional accounting period of the entity. [New paragraphs513(4)(b) and (c)]

1.197 The primary test for availability of the limited exemption is the purposive test, discussed previously, that an interest in a FIF must be held for the sole purpose of investing in the US and/or in real property located in the US. The role of the ratios is to limit the extent to which other investments held through a FIF will be accepted as incidental. A purposive test has been used as the primary test to prevent possible abuse of the limited exemption that could occur if a way were found to manipulate the ratios.

Treatment of interests held in controlled foreign trusts

1.198 The exemption will not be available for interests held in controlled foreign trusts. [New section 512A] These interests are currently exempt from the FIF measures under section 492.

1.199 The consequential amendments to the rules for taxing distributions from foreign trusts where an interest in a foreign trust qualifies for the exemption will therefore not affect the taxation of distributions from controlled foreign trusts.

Summary of the availability of the exemption

1.200 The following table shows the availability of the exemption: YOU ARE HERE

1. The exemption is not available if the FIF interest is in a controlled foreign trust.

Section 2 Modifications to the calculation method for determining notional FIF income

Summary of the amendments

Purpose of the amendments

1.201 The amendments will ensure the exemption from the FIF measures for interests held in certain US FIFs is available when determining FIF income under the calculation method. This treatment will allow taxpayers to invest through up to two tiers of conduit entities that have significant investments in countries outside the US and still obtain the benefit of the exemption for investments held by the entities in US FIFs. [Items 43, 44 and 45]

Date of effect

1.202 The amendments to the calculation method will apply in relation to assessments for income years ending on or after 2 July 1998. [Subitem 46(2)]

Background

1.203 Under the calculation method (one of three methods available for determining FIF income), a FIFs profits are determined using rules similar to (but simpler than) those that apply to determine the taxable income of a resident taxpayer. FIF income arises under this method equal to a taxpayers share of the calculated profit of a FIF. The share is based on a taxpayers interest in the FIF.

1.204 FIF income may notionally be included in the calculated profit of a FIF where the FIF has an interest in another FIF, called a second tier FIF (section576). Notional FIF income can also arise where a second tier FIF has an interest in a third tier FIF and the calculation method is applied to determine the notional FIF income of the second tier FIF (section 579). Exemptions from the FIF measures are currently not available when determining notional FIF income from an interest in a second or third tier FIF (paragraph575(2)(c)).

Explanation of the amendments

1.205 The exemption for interests in certain US FIFs will be available when determining notional FIF income under the calculation method. This will be achieved by amending paragraph 575(2)(c) to allow the exemption to be claimed when notionally applying the FIF rules under sections 576 and 579. Under this approach, sections 576 and 579 will no longer operate to include an amount of notional FIF income from an interest in a second or third tier FIF if the interest qualifies for the exemption. [Item 45]

1.206 The following example demonstrates how providing the new exemption when determining the calculated profit of a FIF will allow taxpayers to invest through up to two tiers of conduit entities that have significant investments in countries outside the US and still obtain the benefit of the exemption for investments held by the conduit entities in US FIFs.

Example 2 Impact of providing the new exemption when determining the calculated profit of a FIF

Facts

•

A resident taxpayer has a 10 per cent interest in a US common trust fund that has the following FIF interests.

The structure is illustrated by the following diagram.

•

The taxpayer elects to use the calculation method to determine:

-

FIF income arising from the common trust fund; and

-

notional FIF income for inclusion in the calculated profit of the common trust fund for the trusts interest in the US limited partnership.

•

No amounts are derived by the common trust fund or the limited partnership.

Consequences

The calculated profit of the common trust fund will not include FIF income from its interests in the US companies because these interests will qualify for the new exemption. FIF income may notionally arise, however, for the interest held in the US limited partnership.

In determining the FIF income that arises from the limited partnership under the calculation method, the interest held by the US limited partnership in the regulated investment company will not give rise to notional FIF income because the interest will qualify for the new exemption. An amount of FIF income is likely to arise, however, for the interests the limited partnership holds in non US FIFs.

The net result is that notional FIF income will arise only for interests in non US FIFs held indirectly by the common trust fund through the limited partnership. The direct interests held by the common trust fund in the US companies and the interest held indirectly in the regulated investment company will be exempt from the notional application of the FIF rules in determining the calculated profit of the FIF.

1.207 Section 564, which excludes from notional income a dividend or distribution derived from another FIF, will generally not apply to dividends or distributions derived from a US FIF that qualifies for the new exemption. [Item 43] The exclusion under section 564 is provided to prevent double taxation that could occur if amounts included in notional FIF income under sections 576 and 579 were again included on distribution from a second or third tier FIF. The exclusion will now generally not be required for distributions from second or third tier FIFs that qualify for the new exemption because interests in these FIFs will not be taxed on an accruals basis.

1.208 The following example shows how an interest held by a FIF in a second tier US FIF that qualifies for the new exemption will be taxed under the calculation method both before and after the changes.

Example 3 - Taxation of second tier FIF interests under the calculation method before and after the changes

Facts

•

A second tier FIF that qualifies for the new exemption has $100 notional FIF income.

•

The second tier FIF distributes an amount of $100 from the profits that gave rise to notional FIF income.

Current treatment

Before the amendments, the $100 notional FIF income from the second tier FIF would be included in the notional income of the first tier FIF under section 576. Section 564 would prevent double taxation by excluding the $100 distribution from the first tier FIFs notional income. The profits that give rise to the notional FIF income of the second tier FIF are therefore taxed on an accruals basis under the FIF measures and are exempt on distribution by the second tier FIF.

Treatment after the changes

After the amendments, no amount will be included in the notional FIF income of the first tier FIF under section576. The $100 distribution would be included in the notional income of the first tier FIF, however, because section 564 will no longer apply to exclude the amount. The profits of the second tier FIF will therefore be taxed at the time the FIF makes a distribution.

1.209 Under new subsection 564(2) , the exclusion under section 564 will continue to be available for distributions from second or third tier FIFs if those distributions are paid from profits that have previously been accruals taxed under the FIF measures. Profits derived by newly exempted FIFs may have been taxed previously if, for instance, notional FIF income arose for a second or third tier FIF in a period prior to the operation of the new exemption. [Item 44]

1.210 The exclusion will be available where a distribution derived by a FIF gives rise to a FIF attribution debit for a taxpayer in relation to the entity that makes the distribution. A FIF attribution debit arises where a distribution is made from profits that have previously been taxed on an accruals basis under the FIF measures. The amount of a distribution excluded under section 564 will equal the grossed-up amount of a FIF attribution debit (section 607A) that arises. The grossed-up amount is calculated by dividing the amount of the FIF attribution debit by a taxpayers attribution percentage in the FIF that receives the distribution.

1.211 The following example shows how to calculate the amount excluded under section 564 where a distribution made by a second tier FIF gives rise to a FIF attribution debit in relation to an attributable taxpayer.

Example 4 - Calculation of the excluded amount where a FIF attribution debit arises for a distribution made by a FIF

Facts

•

A resident taxpayer has a 10% interest in a first tier US FIF.

•

The first tier FIF has a 25% interest in a second tier FIF that qualifies for the new exemption.

•

The second tier FIF has a FIF attribution surplus of $1,000 in relation to the resident taxpayer due to the operation of the FIF rules in a period prior to the introduction of the new exemption.

•

The second tier FIF distributes $100,000 to the first tier FIF the first tier FIF derives no other amounts during the period and has no other FIF interests.

•

The calculation method is used to determine the FIF income to be attributed to the resident taxpayer from the first tier FIF.

Consequences

Section 564 will operate to exclude the distribution made by the second tier FIF from the notional income of the first tier FIF to the extent of the amount of the grossed-up attribution debit that arises in relation to the resident taxpayer. An attribution debit of $1,000 will arise as a result of the distribution (ie. the lesser of the attribution surplus ($1,000) and the amount of the distribution ($100,000) multiplied by the resident taxpayers FIF attribution account percentage in the first tier FIF (10%)). The grossed-up amount of the attribution debit will therefore be $10,000 (ie. the amount of the FIF attribution debit ($1,000) divided by the resident taxpayers FIF attribution account percentage in the first tier FIF (10%)). Accordingly, $10,000 of the $100,000 distribution will be excluded from the notional income of the first tier FIF under section 564.

Section 3 Consequential amendments

1.212 Consequential amendments will be made to ensure:

•

the general trust provisions do not claw back the benefits of providing the new exemption (discussed in Section 3.1 ); and

•

the trustee of a trust FIF that qualifies for the new exemption is taxed on the Australian source income of the trust under the general trust provisions (discussed in Section 3.2 ).

Section 3.1 Exemption from section 97 of the general trust provisions for interests in US trust FIFs that qualify for the exemption

Summary of the amendments

Purpose of the amendments

1.213 The amendments will ensure section 97 of the general trust provisions does not claw back the benefits of providing the exemption from accruals taxation for US trust FIFs. [Item 40]

Date of effect

1.214 The amendments will apply in relation to assessments for income years ending on or after 2 July 1998. [Subitem 46(2)]

Background

1.215 Currently subsection 96A(1) ensures that the deemed entitlement rules in the general trust provisions (sections 96B and 96C) do not apply where an interest in a foreign trust is subject to the FIF measures. These rules operate through section 97 of the general trust provisions to accruals tax Australian beneficiaries on their share of the undistributed profits of a foreign trust. Subsection 96A(1) prevents double taxation by ensuring the deemed entitlement rules under the general trust provisions do not apply to an interest in a foreign trust that is subject to the FIF measures.

1.216 The rules to prevent double taxation in subsection 96A(1) would currently not apply, however, to an interest in a trust FIF that qualifies for the new exemption because subsection 96A(1) only applies to interests in foreign trusts that are subject to the FIF measures. The benefits of providing the exemption could therefore be lost because an interest in a US trust FIF that qualifies for the exemption would become subject to the deemed entitlement rules in the general trust provisions. The potential for benefits of providing the new exemption to be clawed back is demonstrated by the following example.

Example 5 - Potential clawback of the new exemption under sections96B and 96C

Facts

•

A US common trust fund that qualifies for the new exemption is calculated to have net income of $1 million.

•

The trust has one Australian beneficiary who has a 10% interest in the property of the trust.

•

The income of the trust is not distributed to the beneficiary during the year of income.

Consequences

The new exemption is intended to ensure that accruals taxation does not apply to the beneficiaries interest in the trust. Sections 96B and 96C would, however, currently deem the beneficiary to be presently entitled to 10% of the income of the trust ($100,000) due to the beneficiaries interest in the property of the trust. This amount would be accruals taxed under section 97 even though there has been no distribution from the trust and thus the benefit of the exemption from the FIF measures would be lost.

1.217 Significant compliance costs could also arise if section 97 were to apply to interests held in US trusts that qualify for the new exemption. A beneficiary would, for instance, be required to calculate the net income of a trust as if the trustee were a resident of Australia. This calculation could be onerous because it would require a full application of our domestic rules and in some cases the beneficiary may not be able to obtain the necessary information.

Explanation of the amendments

1.218 The amendments will ensure section 97 of the general trust provisions does not apply to interests in US trusts that qualify for the new exemption. Section 97 will continue to apply, however, to interests in controlled foreign trusts because these trusts are not subject to the FIF rules (section 493).

1.219 The exclusion from section 97 for interests in US trusts that qualify for the new exemption will be achieved by amending paragraph96A(1)(c). [Item 40]

1.220 The net result will be that amounts distributed from a US trust that qualifies for the new exemption will continue to be assessable to the extent the amounts are paid from profits not previously taxed in Australia (section99B).

Section 3.2 Taxation of Australian source income of US FIFs that qualify for the exemption

Summary of the amendments

Purpose of the amendments

1.221 The amendments will ensure a trustee of a trust that qualifies for the new exemption is taxed on the Australian source income of the trust under sections 99 or 99A. [Item 41]

Date of effect

1.222 The amendments will apply in relation to assessments for income years ending on or after 2 July 1998. [Subitem 46(2)]

Background

1.223 To avoid double taxation, a trustee is not assessable on Australian source income of a foreign trust to the extent the income is likely to have been included in the FIF income of a beneficiary. This treatment is achieved by subsection 96A(1A) which reduces the amount on which a trustee is taxed under sections 99 or 99A. The amount is reduced to the extent a beneficiary would have been assessable on the net income of the trust if not for the exclusion from section97 that applies where a beneficiary is subject to the FIF measures (subsection 96A(1)).

1.224 The amount on which a trustee is taxed should not be reduced under subsection 96A(1A) in cases where a beneficiaries interest in the trust is exempt from section 97 because of the new exemption for US FIFs. In this case, the Australian source income of the trust could completely escape Australian tax if the amount on which the trustee is taxed were reduced. The potential for Australian source income to escape Australian tax is demonstrated by the following example.

Example 6 - Potential for non-taxation of Australian source income

Facts

•

A common trust fund that qualifies for the new exemption is calculated to have net income of $1 million.

•

The net income is wholly referable to sources within Australia.

•

The trust has a large number of Australian beneficiaries who in total have a 100% entitlement to the property of the trust.

•

The income of the trust is not distributed to the beneficiaries during the year of income.

Consequences

The beneficiaries will not be taxed on the net income of the trust under section97 because of the amendments to paragraph 96A(1)(c). In addition, the trustee will not be taxed on the undistributed income of the trust because subsection 96A(1A) will apply to reduce to nil the amount on which the trustee is taxed under section 99 or 99A. The net income of the trust of $1million will therefore be reduced to nil under subsection 96A(1A) because the beneficiaries would have been assessable on $1million under section 97 if not for subsection 96A(1). In this regard, the beneficiaries would be deemed to be presently entitled to the entire income of the trust under sections 96B and 96C because they have a 100% interest in the property of the trust. The net result would be that neither the beneficiaries nor the trustee would be taxed on the undistributed Australian source income of the trust.

Explanation of the amendments

1.225 The amendments will limit the circumstances where subsection 96A(1A) will reduce the assessable income of a trustee. Normally the assessable income of a trustee is reduced by the amount that, disregarding subsection 96A(1), would have been included in the assessable income of a beneficiary under section 97. The amendments will provide that the reduction is not available if the new exemption applies to a beneficiaries interest in the trust. [Item 41

1.226 Double taxation will not arise on trust distributions made from Australian source income in cases where the trustee has been taxed on the income. In these cases, the distribution assessable under section 99B would be reduced to the extent it was made from amounts that were included in the assessable income of the trustee under section99 or 99A (subparagraph 99B(2)(c)(ii)).

1.227 The new arrangements for taxing the Australian source income of an exempt US trust FIF are shown by the following example.

Example 7 - New arrangements for taxing the Australian source income of an exempt US trust FIF

Facts

•

A common trust fund that qualifies for the new exemption is calculated to have net income of $1 million.

•

The net income is wholly referable to sources within Australia.

•

The trust has a large number of Australian beneficiaries who in total have a 100% interest in the property of the trust.

•

The income of the trust is not distributed to the beneficiaries during the year of income.

Consequences

The beneficiaries will not be taxed on the net income of the trust under section97 because subsection 96A(1) is to be extended to apply to trusts that qualify for the new exemption. The trustee will be taxed on the Australian source income of the trust. In this regard, subsection 96A(1A) will not apply to reduce the amount on which the trustee is taxed under sections 99 or 99A.

Section 4 Regulation impact statement

Part 2 - Exemption for US FIFs and related measures

Policy objective

1.228 The proposed exemption for US FIFs from the FIF measures is intended to encourage Australian investment funds to be more efficient. The exemption was announced by the Treasurer in a press release on 8December 1997 and forms part of the Governments strategy for Australian industry entitled Investing for Growth. The exemption is intended to increase the efficiency of Australian investment funds by exposing them to greater competition from US funds.

1.229 The exemption has been limited to interests in certain US FIFs because the effectiveness of the FIF measures could be compromised if the exemption were to apply to all interests in US FIFs. The exemption will nevertheless provide increased competition for Australian funds managers. Competition will be increased because of the size, liquidity and efficiency of the US funds management industry. The risk to the revenue will not be greatly increased because the US tax rules are sufficiently robust to prevent tax deferral opportunities from arising for investments that qualify for the exemption.

Implementation option

1.230 It is necessary to amend ITAA 1936 to provide an exemption from the FIF measures.

1.231 There are considered to be no alternatives to the structure of the exemption outlined below that would provide increased access to US FIFs without giving rise to significant tax deferral opportunities and increasing the risk to the revenue.

Structure of the new exemption

1.232 An unqualified exemption is being limited to FIFs that are taxed on a worldwide basis in the US. Consequently, an unqualified exemption will apply for most US company FIFs and for trusts treated as regulated investment companies (RICs) or real estate investment trusts (REITs). RICs and REITs are fully distributing investment funds used widely in the US as vehicles for managing collective investments.

1.233 In addition, a limited exemption will be provided for investments in certain companies and limited partnerships taxed as partnerships in the US and also for investments in common trust funds. These entities are commonly used by the funds management sector in the US. The exemption is being limited because these entities are taxed in the US as conduit entities and consequently the entities are not directly liable for tax. The US tax liability is instead borne by investors in the conduit entities and Australian investors are not normally subject to tax in the US on foreign income derived through the entities. Accordingly, an unqualified exemption has not been provided because it would allow Australian investors to hold non US FIFs through a conduit entity and be exempt from the anti tax deferral rules in both Australia and the US.

1.234 The exemption for investments in the abovementioned conduit entities is being limited to circumstances where a taxpayer can demonstrate that the investment was made for the sole purpose of investing within the US. Moreover, the exemption will normally not be available if the conduit entity either directly or indirectly has an interest in amounts derived from sources outside the US. An interest traced through an entity eligible for an unqualified exemption will not be taken into account for the purposes of measuring an indirect interest.

1.235 The exemption will only be available for a conduit entity that has an interest in amounts derived from sources outside the US if the value of the conduit entities interests in non-exempt FIFs and in assets that produce amounts from sources outside the US do not exceed five percent of the total value of the conduit entities interests in FIFs and assets respectively.

1.236 The exemption for US FIFs will also be available when determining FIF income under the calculation method (one of three methods available for determining FIF income). This treatment will allow look-through rules to apply where taxpayers can obtain the information necessary to comply with the method. The look-through rules will enable taxpayers to invest through up to two tiers of conduit entities that have investments in countries outside the US and still qualify for the exemption to the extent the entities have investments within the US.

Consequential amendments

1.237 Consequential amendments to the general trust provisions are required to ensure those provisions do not claw back the benefits from providing the new exemption. In the absence of the consequential amendments, the benefits of providing the new exemption could be lost because an investment in a trust FIF that qualifies for the new exemption would be accruals taxed under the general trust provisions.

1.238 Consequential amendments to the general trust provisions are also required to avoid onerous compliance costs arising where the exemption applies to trust FIFs. Without the amendments, beneficiaries would be required to make a net income calculation for investments in trust FIFs that qualify for the exemption. This calculation can be onerous because it requires a full application of our domestic rules and in many cases beneficiaries may not be able to obtain the information necessary to make the calculation.

Impacts (costs and benefits)

Impact group identification

1.239 The exemption will benefit resident taxpayers who hold interests in US FIFs. The major impact is expected to be on superannuation and investment funds, who between them hold the majority of Australian interests in US FIFs. The exemption will also affect some individual investors. Investments in controlled foreign companies and controlled foreign trusts will not be affected by the exemption because these interests are already exempt from the FIF measures.

1.240 The exemption is likely to increase Australian investment in US FIFs, particularly US mutual funds, that qualify for the exemption. This investment is expected to be largely at the expense of direct investment in US securities, but also to some extent at the expense of investments in Australia and in other countries.

Costs and benefits

1.241 It is estimated that approximately 1,000 taxpayers will directly benefit from the exemption. Approximately 80% of these taxpayers are individuals, partnerships and trusts, 15% are companies and 5% are superannuation funds. This estimate is based on the number of taxpayers returning FIF income in their income tax returns. Other taxpayers may be affected, however, because the exemption is likely to encourage more investment in US FIFs.

1.242 The exemption is likely to result in an initial and recurrent reduction in compliance costs because the FIF measures will not apply to investments that qualify for the exemption. The initial and recurrent reduction in compliance costs is expected to be minor.

1.243 The net effect of the exemption on administrative costs is uncertain because a reduction in existing administrative costs may be offset by other administrative costs. Existing administrative costs are likely to be reduced because it will no longer be necessary to ensure taxpayers are returning income from US FIFs that qualify for the exemption. Other administrative costs are likely to arise, however, because it will be necessary to monitor whether FIFs legitimately fall within the exemption.

Taxation revenue

1.244 The cost to the revenue of providing the exemption is expected to be $2 million in 1998-99 and $3 million annually for subsequent income years.

1.245 There may also be an indirect cost to the revenue as a result of the exemption because of increased investment in US FIFs. The indirect cost to the revenue is unquantifiable because the amount of capital transferred to US funds depends on prevailing economic conditions and on the investment strategies of Australian funds managers.

Consultation

1.246 The measure is in part a response to submissions to the Wallis Inquiry into the Australian financial system. Some informal consultation on the exemption has been undertaken with industry and professional associations, in particular, with the Investment & Financial Services Association which represents Australian funds managers. The measure is not controversial to the extent it benefits taxpayers, however, it may be opposed by funds managers who face greater competition.

Conclusion

1.247 The implementation option is considered the only effective means of achieving the policy objective of providing greater competition for Australian funds managers without giving rise to significant tax deferral opportunities. The option is expected to lead to an overall reduction in compliance costs for taxpayers who hold interests in US FIFs.

Part 3 - Exemption from the CFC measures for interests in US real estate investment trusts (REITs)

Overview of the CFC measures

1.248 Part 3 of Schedule 1 to the Bill will provide an exemption from the CFC measures for interests in certain REITs and interests held through certain REITs. The exemption is being provided as the result of representations from an Australian collective investment fund following the original introduction of amendments to the FIF measures in Taxation Laws Amendment Bill (No. 5) 1998 which lapsed when Parliament was prorogued for the election.

1.249 Unless otherwise stated, references to provisions of the law in this Chapter are references to provisions of the ITAA 1936.

Summary of the amendments

Purpose of the amendments

1.250 The proposed amendments will provide an exemption from the CFC measures for interests in REITs that derive income or hold assets principally in the US. [Item 47]

Date of effect

1.251 The proposed amendments will apply for statutory accounting periods of CFCs ending on or after 2 July 1998. [Item 48]

Background

1.252 The CFC measures (Part X of the ITAA 1936) apply to Australian residents who have an interest in a CFC at the end of a year of income. A CFC is a foreign company controlled by Australian residents. Broadly, the CFC measures operate to tax Australian residents, on a current year basis, on their share of certain undistributed amounts derived by a CFC. This treatment, referred to as accruals taxation, is directed at preventing deferral of Australian tax where profits are accumulated offshore in a CFC rather than remitted to Australian investors.

1.253 It is proposed that an interest in a REIT that is subject to the CFC measures be provided with an exemption from accruals taxation similar to that proposed in the Bill for FIF interests in REITs. An interest in a REIT can be subject to the CFC measures because a REIT may be a company for Australian tax purposes.

1.254 The exemption will ensure that Australian collective investment funds remain competitive with US funds in attracting Australian investment in REITs. If an exemption were not provided, direct investments in REITs could be treated more favourably than investments in Australian collective investment funds that manage REITs. In this regard, an Australian collective investment fund would be subject to the CFC measures if it were to control a company REIT. Accordingly, additional tax and compliance cost burdens associated with accruals taxation under the CFC measures would be passed on to investors in the Australian collective investment fund. These tax and compliance cost burdens would not arise, however, for investors who hold an interest directly in a non-controlled REIT because of the proposed exemption from the FIF measures.

Explanation of the amendments

Exemption from accruals taxation

1.255 The proposed amendments will provide a tightly targeted exemption from accruals taxation under the CFC measures for interests in REITs. The substantial similarity of US tax rules to those in Australia will help ensure that tax deferral opportunities do not arise because of the exemption.

1.256 New subsections 356(4A), (4B) and (4C) will give effect to the exemption for REITs by providing that a taxpayers direct attribution interest in a REIT is to be ignored where the interest satisfies the sole purpose test (refer to the discussion on new paragraphs 513(3)(a) and (4)(a) in Section 1, Part 2, Schedule 1 to this Bill) and:

•

the REIT does not directly or indirectly through other entities have income or investments outside the US; [New subsection 356(4B)] or

•

the REIT does not directly or indirectly through other entities have more than an incidental interest in income or investments outside the US. [New subsection 356(4C)]

[Item 47]

1.257 It should be noted, however, that interests held by a REIT indirectly through a US company, regulated investment company (RIC) or REIT are to be taken into account in determining the REITs interest in income or investments outside the US. It is necessary to have tighter rules for determining a REITs interests for the purposes of the CFC exemption because there is a greater risk of tax deferral where a taxpayer exercises significant control over an entity. [Item 47]

1.258 The effect of ignoring a taxpayers direct attribution interests in a REIT is that these interests will not be taken into account in determining the taxpayers share of the attributable income of the REIT. Moreover, the interests would not be taken into account in determining the taxpayers share of the attributable income of a company held through the REIT (section 357).

Control interests

1.259 Control interests held through a REIT will still be taken into account for the purposes of determining whether a subsidiary belonging to the REIT qualifies as a CFC. The CFC measures will continue to apply, for instance, to attribute income from a CFC that is a subsidiary of a REIT where a taxpayer has a direct interest in the subsidiary.

1.260 The application of the exemption is illustrated by the following example:

Example Application of the exemption for CFC interests in REITs

Facts

•

Aus Co is a company resident in Australia.

•

Coy A is a US company that is a real estate investment trust for the purposes of new subsection 356(4A) .

•

Coy B is a US company that conducts all its business in the US.

•

Aus Co has a direct interest in Coy A of 100% and a direct interest in Coy B of 10%.

•

Aus Cos interest in Coy A satisfies the sole purpose test.

•

Coy A has a 90% direct interest in Coy B.

Consequences

The consequences of providing the exemption in determining Aus Cos share of the attributable income of Coy A and Coy B are discussed below.

Coy A

No amount would be attributed to Aus Co from Coy A because Aus Cos attribution interest in Coy A would be ignored under new subsection 356(4A) . Coy A would, however, be treated as a CFC which may be relevant when determining whether deemed dividends derived by Coy A should be taxed on an accruals basis under section 459. The accruals taxation of these dividends is discussed below in the section on the attribution of deemed dividends.

Coy B

Aus Co would be accruals taxed on a 10% share of Coy Bs attributable income. The indirect interest in Coy B held through Coy A would be disregarded in determining this share because of new subsection 356(4A) . The indirect interest held through Coy A would, however, still be taken into account in determining whether Coy B is a CFC.

Attribution of deemed dividends

1.261 A taxpayers direct attribution interests and indirect attribution tracing interests in a REIT will not be ignored for the purpose of section459 which attributes to a taxpayer a share of a deemed dividend derived by a CFC. [Item 47] This will allow amounts arising under the deemed dividend rules in section 47A to be accruals taxed where profits are shifted from a CFC in an unlisted country to a REIT or one of its subsidiaries.

Attribution accounts

1.262 Existing attribution surpluses held by a REIT will continue to be available to taxpayers for application against profits repatriated to Australia. This will ensure that amounts accruals taxed previously under the CFC measures will not be taxed again on distribution.

Regulation impact statement

Controlled foreign companies

Policy objective

1.263 The proposed exemption from the CFC measures is intended to ensure that Australian collective investment funds remain competitive with US funds in attracting and managing Australian investment in REITs.

Background

1.264 If an exemption were not provided, direct investments in REITs may be treated more favourably than indirect investments in REITs managed by Australian collective investment funds. This is because the indirect investments would continue to be subject to accruals taxation under the CFC measures whereas direct investments are likely to be exempt from accruals taxation following the proposed exemption from the FIF measures for US FIFs. Indirect investments would therefore continue to be subject to additional tax and compliance cost burdens associated with accruals taxation while direct investments in REITs would no longer be accruals taxed under the FIF measures.

1.265 Less favourable treatment of REITs managed by Australian collective investment funds could have a significant impact on their ability to compete. In this regard, direct investments in REITs are a close substitute for indirect investments in REITs managed by Australian funds.

1.266 The proposed exemption from the CFC measures is more tightly targeted than the proposed FIF exemption because there is a greater risk of tax deferral where a taxpayer exercises significant control over an entity. The risk to revenue is not likely to be greatly increased by a tightly targeted exemption from the CFC measures because the US tax rules are sufficiently robust to prevent tax deferral opportunities from arising for investments that qualify for the exemption.

Implementation option

1.267 It is necessary to amend the ITAA 1936 to provide an exemption from the CFC measures.

1.268 There are considered to be no alternatives to the structure of the exemption outlined below that would provide interests in REITs with an exemption from the CFC measures without giving rise to significant tax deferral opportunities and increasing the risk to the revenue.

Structure of the new exemption

1.269 The exemption is being limited to interests in REITs that derive income or hold investments principally in the US where a taxpayer can demonstrate that the investment was made for the sole purpose of investing within the US.

1.270 The exemption would normally not be available if the REIT directly or indirectly has an interest in amounts derived from sources outside the US. The exemption will, however, be available where the REIT has only an incidental interest in assets that produce amounts from sources outside the US. This incidental interest must not exceed five percent of the total value of the assets of the REIT, whether these assets are held directly, or indirectly through one or more other entities. Unlike the exemption from the FIF measures, it will be necessary to look through interests held in US companies, RICs and REITs for the purposes of determining interests held in assets that produce amounts from sources outside the US.

Impacts (costs and benefits)

Impact group identification

1.271 The exemption will affect Australian collective investment funds that manage REITs and investors in those funds.

Costs and benefits

1.272 The exemption will allow Australian collective investment funds to compete on an equal footing with REITs. Resident investors may also be advantaged by having the option of investing indirectly in a REIT managed through an Australian fund.

1.273 The exemption is likely to result in an initial and recurrent reduction in compliance costs because the CFC measures will not apply to investments that qualify for the exemption.

1.274 The effect of the exemption on administrative costs is uncertain but is expected to be minor.

Taxation revenue

1.275 The cost to the revenue of providing an exemption from accruals taxation under the CFC measures is expected to be minor because the US tax rules are substantially comparable to Australia's and therefore prevent most tax deferral opportunities from arising.

Consultation

1.276 An Australian collective investment fund was consulted on the proposed exemption from the CFC measures. The fund made representations for an exemption following the introduction of amendments giving effect to the exemption from the FIF measures in Taxation Laws Amendment Bill (No. 5) 1998. This Bill lapsed when Parliament was prorogued for the election.

Conclusion

1.277 The implementation option is considered the only effective means of achieving the policy objective of ensuring that Australian collective investment funds remain competitive with US funds in attracting and managing Australian investment in REITs without giving rise to significant tax deferral opportunities. The option is expected to lead to an overall reduction in compliance costs for Australian collective funds that manage REITs.

Chapter 2 - Commercial debt forgiveness

Summary of the amendments

Purpose of the amendments

2.1 Schedule 2 to the Bill will amend the commercial debt forgiveness provisions in the Income Tax Assessment Act 1936 (ITAA1936) to ensure that amounts of commercial debt that are forgiven will be applied, where relevant, in reduction of a debtor's prior year net capital losses in respect of all years before the forgiveness year of income, rather than the immediately preceding year of income.

2.2 The Bill will also amend the capital gains tax (CTG) provisions to provide that, where a taxpayer incurs a net capital loss in a year of income earlier than the forgiveness year of income, and the loss is reduced by the operation of the debt forgiveness provisions, then the loss will also be reduced for the purposes of the CTG provisions.

2.3 Both of these amendments are consequential upon amendments contained in Taxation Laws Amendment Act (No. 2) Act 1997 (the No. 2 Act).

Date of effect

2.4 The amendments will apply to debts forgiven after the date of introduction. [Item 3 of Schedule 2]

Background to the legislation

2.5 The commercial debt forgiveness provisions, contained in Schedule 2C of the ITAA 1936, apply to taxpayers who have been forgiven the whole or part of a commercial debt. Under the provisions in the existing law, a net forgiven amount is to be applied, in order, in reduction of the taxpayer's revenue losses, net capital losses, deductible amounts and cost bases of assets.

2.6 Where a net capital loss incurred by a taxpayer in a year of income is reduced by a net forgiven amount, the CTG loss provisions provide that only the reduced amount of the net capital loss is able to be recouped against future capital gains.

2.7 The rules governing the calculation of net capital losses were amended by the No. 2 Act so that net capital losses would attach to the year in which they were incurred. Previously, all prior year net capital losses lost their identity and were absorbed into the taxpayer's current year net capital loss.

2.8 Currently, subsection 245-105(6) of the commercial debt forgiveness provision, which deals with the reduction of net capital losses, provides that the forgiven amount of the debt will be applied in reduction of net capital losses in respect of the year of income immediately preceding the forgiveness year of income.

2.9 Further, subsection 160ZC(4E) of the CTG provisions, which is intended to ensure that only the reduced amount of a net capital loss can be recouped, only applies to a net capital loss which was incurred by a taxpayer in the immediately preceding year of income.

2.10 These provisions do not reflect the general treatment of net capital losses which has applied since the amendments made by the No. 2 Act came into effect. The proposed amendments will bring the commercial debt forgiveness provisions into line with the general net capital loss rules.

Explanation of the amendments

2.11 Amended subsection 245-105(6) will provide that the forgiven amount of a debt is to be applied in reduction of unrecouped net capital losses in respect of all years of income before the forgiveness year of income. [Item2 of Schedule 2]

2.12 Amended subsection 160ZC(4E) will provide that where a taxpayer incurs a net capital loss in a year of income earlier than the forgiveness year of income, and the loss is reduced by the operation of the commercial debt forgiveness provisions, the loss will also be reduced for the purposes of the CTG provisions. [Item 1 of Schedule 2]

2.13 These amendments will ensure that the debt forgiveness rules are consistent with the general net capital loss rules.

Chapter 3 - Depreciation of plant previously owned by an exempt entity

Overview

3.1 Schedule 3 to the Bill will insert a new Division 58 into the Income Tax Assessment Act 1997 (ITAA 1997) to change the way that depreciation is to be calculated on plant previously owned by an exempt entity when that plant enters the tax net. Consequential amendments will also be made to the ITAA 1997, the Income Tax Assessment Act 1936 (ITAA 1936) and to the Income Tax (Transitional Provisions) Act 1997. These amendments will integrate the new measures into the income tax law.

3.2 The measures contained in new Division 58 were announced in the Treasurer's Press Release No. 84 dated 4 August 1997. This announcement was the subject of further clarification in the Treasurer's Press Release No. 2 dated 14 January 1998. Draft legislation and an accompanying explanatory statement were released on 10 February 1998, as announced by the Treasurer's Press Release No. 9 on that day.

3.3 New Division 58 sets out special rules that apply in calculating depreciation deductions and balancing adjustments in respect of plant previously owned or quasi-owned by an exempt entity if the plant:

•

continues to be owned or quasi-owned by that entity after the entity becomes taxable (entity sale); or

•

is acquired, or quasi-ownership of it is acquired, from that entity, in connection with the acquisition of a business, by a purchaser that is a taxable entity (asset sale).

Quasi-ownership under Subdivision 42-I extends the availability of depreciation deductions.

Background to the legislation

3.4 The term entity sale, for the purposes of new Subdivision 58-B , pertains to any transition entity with a transition time on or after 4August1997. The obvious example of such a transition is where a Government Business Enterprise (GBE) (either State or Commonwealth owned) ceases to be exempt when it is wholly or partially transferred to private beneficial ownership. Further examples of an entity transition would include:

•

the circumstance of a Commonwealth GBE becoming taxable as a result of Commonwealth transitional legislation as distinct from a change of ownership; and

•

an entity that is exempt pursuant to sections 50-1 and 50-45 of the ITAA 1997 as having been established for the promotion of sport, losing its exempt status by commencing to be carried on for other, non exempt purposes.

3.5 The long standing view of the Commissioner of Taxation (the Commissioner) is that when an entity changes from exempt to taxable status, its transitional plant is brought into the tax system for the purposes of the depreciation provisions, at its notional written down value (NWDV). The Commissioner has consistently administered section 61 of the ITAA 1936 on this basis and on the assumption that the transitional plant was always used by the entity wholly for the purposes of producing assessable income. The High Court decision in FCT v Anderson (1956)
11 ATD 115 provides strong support for this conceptual approach. This approach is also reflected in the provisions of Division 57 of the ITAA 1936, Division 42 of the ITAA 1997 and the proposed section 61A of the ITAA 1936 contained in Schedule 10 to the Taxation Laws Amendment Bill (No. 2) 1998.

3.6 Certain transition entities may have acquired transitional plant from a predecessor exempt Government entity or from a succession of such entities. In such circumstances, the unit's NWDV at the transition time is determined by applying a 'look back' concept in that the transition entity is assumed to have acquired the unit at the time and for the cost at which it was acquired or constructed by the first exempt Government entity. The transition entity is assumed to have been allowed notional depreciation on this assumed cost from the assumed acquisition date.

3.7 The term asset sale for the purposes of new Subdivision 58-C relates to a purchaser of plant from a tax exempt vendor (TEV) with an acquisition time on or after 4 August 1997 in connection with the acquisition of a business. By contrast with the entity sale (NWDV approach), section 42-65 of the ITAA 1997 provides for such plant to be brought into the tax system as follows:

•

for plant generally, the cost is its cost to the purchaser;

•

for plant the purchaser acquires with, or attached to, other assets without a specific value being allocated to it, the cost is so much of the overall cost as is reasonably attributable to the plant.

3.8 The following example demonstrates how, in the absence of the proposed measures, a taxpayer who acquires the depreciable assets of an exempt entity can generate starkly different taxation treatments based on the manner in which the acquisition is structured.

Example

A State Government department is responsible for distribution of an energy product to consumers throughout the State. On 1 July 1996, the net assets of the energy distribution business (comprising depreciable assets and non-depreciable assets including intangibles) are transferred by the State into a corporatised State GBE. The company is XYZ Ltd and its shares are held by the Minister responsible for the State Government department on behalf of the State.

For ease of explanation, assume the depreciable assets were all acquired by the Government department for a total sum of $1 billion. Also assume that at the transfer date the depreciable assets have a NWDV of $400 million. On 1 January 1998 the NWDV is $250 million. The corporatised entity, XYZ Ltd, is exempt under Division 1AB of the ITAA 1936.

Entity Sale

On 1 January 1998, ABC Pty Ltd (a private company which is a taxable entity) acquires the shares in XYZ Ltd for $2 billion. XYZ Ltd ceased to be exempt upon the transfer of its shares to private beneficial ownership. XYZ Ltd is now a transition entity whose opening value of depreciable plant is its NWDV of $250 million.

Asset Sale

The purchaser could, by arrangement with the vendor, choose not to acquire the shares in the exempt entity but instead acquire the net assets of the energy distribution business. The net assets, comprised of the depreciable assets and non-depreciable assets including intangibles, are acquired for a sum of $2.2 billion on 1 January 1998. As part of this arrangement, the vendor will license the new owner to conduct the energy distribution business as the original licence is statutorily allocated to XYZ Ltd.

The cost of the depreciable assets would not be based on the NWDV but on so much of the $2.2 billion as is reasonably attributable to the plant. The attribution would typically be based on the advice of a valuer engaged by the purchaser and the application of a valuation methodology which in the valuer's opinion was appropriate for the relevant assets.

For the purposes of the example, assume the valuation attributed to the depreciable assets is $900 million.

In any attribution process of this magnitude and complexity, there exists some potential or opportunity for shifting value from the non-depreciable assets including intangibles into the depreciable assets. This risk may be increased where the vendor is, from a taxation perspective, disinterested in the proportion of the total business price which is attributed to the cost or termination value of the depreciable assets as it is of no taxation consequence for the exempt vendor in terms of a balancing adjustment or capital gains tax.

3.9 The acquisition structures referred to in the example effectively reflect the same underlying economic transaction. The same business and depreciable assets have entered the tax net but with a $650 million differential in the opening values for depreciation.

3.10 The proposed measures ensure that where depreciable assets of an exempt entity enter the tax net and that transfer is in connection with the acquisition of a business, the purchaser should obtain the same opening value for depreciation purposes irrespective of whether the transition of the assets into the tax net occurs by way of entity sale or asset sale.

3.11 The proposed measures set out rules which provide consistency of treatment between entity sales and asset sales and provide a choice of opening values for each individual depreciable asset based on NWDV or pre-existing audited book value (PABV). This choice is provided to entity sales under new Subdivision 58-B and asset sales under new Subdivision 58-C .

3.12 New subsection 58-10(1) provides that if:

(a)

a balance sheet, as at the end of an annual accounting period (the balance date), that was prepared as part of an *exempt entity's final accounts for that period showed a unit of *plant (the unit) as an asset of the exempt entity and specified a value of the unit; and

(b)

a qualified independent auditor who was engaged, or was required by law, to undertake an audit of those accounts had prepared and signed, before 4 August 1997, a final audit report on those accounts; and

(c)

the report did not state that the auditor was not satisfied that the specified value fairly represented the value of the unit;

the unit is taken to have had a pre-existing audited book value at the balance date of an amount equal to the specified value.

3.13 The concept of PABV may be better understood by reference to the example in paragraph 3.8.

Assume that the balance sheet of XYZ Ltd. as at 30 June 1997, which was prepared as part of XYZ Ltd's final accounts for the year ended 30 June 1997, disclosed a total value for the depreciable assets of $650 million. A qualified independent auditor, who was required by law to undertake an audit of those accounts, prepared and signed on 28 July 1997, before 4August 1997 on which these measures were announced, a final audit report on those accounts without qualification.

In this circumstance, under both the entity sale and asset sale approach, the purchaser would have the choice of opening value for each individual asset based on NWDV or PABV. For ease of explanation, assume the purchaser wants to apply the same NWDV or PABV choice to all the depreciable assets, and that there have been no further acquisitions of depreciable plant in the period 1 July 1997 to 1 January 1998. On this basis, the purchaser would have the same choice of $250 million NWDV or $650 million PABV as the opening value of depreciable assets for taxation purposes under an entity sale or asset sale approach.

3.14 The adoption of PABV as an alternative to NWDV provides a balance between a vendor obtaining a fair price for the assets and the objectives of certainty, ease of administration and consistency of treatment of exempt entity assets that become depreciable for taxation purposes. PABV is considered to be an independent, verifiable valuation of depreciable assets, as it is based on values verified by independent audit before these measures were announced.

3.15 New Division 58 deals with the depreciation of plant previously owned or quasi-owned by an exempt entity. The proposed measures are not intended to be confined in their operation to depreciable plant under Division 42 of the ITAA 1997. Certain units of plant that would ordinarily constitute depreciable plant under Division 42 of the ITAA 1997 may instead qualify for amortisation under the transport capital expenditure provisions in Subdivision 330-H of the ITAA 1997. The deductions available under that Subdivision to a purchaser of such plant under an asset sale structure could be argued to be based on the purchase price and as a consequence undermine the policy intent of the proposed measures. Accordingly, the proposed measures include an amendment to Subdivision 330-H to provide that transport capital expenditure does not include expenditure on a unit of plant to which new Subdivision 58-B or 58-C applies.

3.16 The new measures provide a safeguard for circumstances where the unit is sold to any subsequent owner. This safeguard ensures that the first taxable owner will face deductible or assessable balancing adjustments on a sale to any subsequent owner in such circumstances which can exceed the opening value at which the unit initially entered the tax net under new Subdivision 58-B or 58-C . The assessable balancing adjustment can, in effect, recover both any depreciation deductions allowed to the first taxable owner and the difference between the opening value of the plant for depreciation purposes and its opening CTG cost base.

3.17 The safeguard is necessary as a means to protect the policy intent of the measures in circumstances of subsequent transfers of ownership. Otherwise the measures would be ineffective in prescribing an opening value that is uniform for asset and entity sales, as assets could be immediately on-sold to a purchaser whose opening depreciation value is not affected by the rule.

Date of effect

3.18 The amendments will apply where:

•

an entity becomes taxable on or after 4 August 1997; or

•

on or after 4 August 1997 a purchaser that is a taxable entity acquires ownership or quasi-ownership of depreciable plant from an exempt entity in connection with the acquisition of a business from the exempt entity.

Explanation of the amendments

Interpretation

3.19 New section 58-5 makes it clear that the new Division applies to plant which is quasi-owned.A quasi-owner of plant has the meaning given by sections 42-310 and 42-312 of the ITAA 1997. Those provisions relate to plant which is a fixture on land. Section 42-310 treats the holder of land, under certain rights granted by exempt government agencies as its owner, as the owner of such fixtures. Section 42-312 treats lessors as the owners of plant they lease which is a fixture on someone else's land, essentially as if the lessor of the plant would have been its owner had the plant continued to be a chattel. The new section 58-5 provides that the Division applies to plant of which an entity has been or is, or becomes a quasi-owner in the same way as it applies in relation to a unit of plant that has been or is owned by, or is acquired by an entity.

3.20 Therefore, all references in the Division to ownership, or assumed ownership, of a unit of plant include quasi-ownership of a unit of plant within the meaning of sections 42-310 and 42-312 of the ITAA 1997. For example, the reference in the new subsection 58-20(1) to every unit of plant that was owned by a transition entity at the transition time includes units of plant that the transition entity was a quasi-owner of at the transition time.

3.21 Similarly, all references to the acquisition, or assumed acquisition of a unit of plant include becoming a quasi-owner of a unit of plant as a result of the acquisition of a quasi-ownership right within the meaning of subsection 995-1(1) of the ITAA 1997. For example, the reference in the new paragraph 58-150(1)(a) to an entity that acquires a unit of plant from an exempt entity includes the entity becoming a quasi-owner of a unit of plant as a result of acquiring a quasi-ownership right from the exempt entity.

3.22 New section 58-10 contains the meaning of the term PABV.

3.23 In broad terms, the PABV of a unit of plant is a specified audited value given in respect of the unit in a balance sheet as at the end of an annual accounting period which was prepared as part of the final accounts of an exempt entity. Over a period of time it is reasonable to expect that a unit would have a range of PABVs.

3.24 The last day of the annual accounting period to which the balance sheet relates is termed the balance date. The unit of plant is termed the unit. [new paragraph 58-10(1)(a)]

3.25 A unit of plant is taken to have a PABV equal to its value specified in the balance sheet of an exempt entity as at the balance date where:

•

a qualified independent auditor prepared and signed a final audit report required by law on the exempt entity's final accounts before 4 August 1997; and

•

the report did not state that the auditor was not satisfied that the specified value fairly represented the value of the unit.

[new subsection 58-10(1)]

3.26 New subsection 58-10(2) allows a reasonable attribution of the value of the unit where the balance sheet only specifies a combined value for two or more units.

3.27 Under new subsection 58-10(3) , the latest possible time at which the unit is taken to have had a PABV is termed the test time.

Example:

A State Government Department owns a number of power stations. The annual accounts of the Department included an audited book value of the depreciable plant in those power stations. The audited book value would satisfy the conditions set out in new subsection 58-10(1) . In order to privatise the power stations, the Government Department transfers those power stations to 3 corporatised State Government GBEs. The GBEs are sold to the private sector one month later, before audited accounts are prepared. In this case, the privatised entity may adopt the latest PABV (providing it is before 4 August 1997) of the State Government Department.

Entity Sales: Subdivision 58-B

A. Overview

3.28 New Subdivision 58-B applies to entity sales. It gives the transition entity the choice, on an individual asset by asset basis, to calculate depreciation deductions and balancing adjustments by reference to:

(i)

the NWDV of the unit; or

(ii)

the undeducted PABV (if any) of the unit.

New sections 58-25 and 58-90 provide that Subdivision 57-I of the ITAA1936 (dealing with depreciation deductions) and Subdivision 57-K of that Act (in so far as it deals with depreciation balancing adjustments) do not apply in respect of the unit in relation to a transition entity.

B. Transition Entities

3.29 An entity sale occurs where an entity changes from exempt to taxable status on or after 4 August 1997. [New section 58-15] This will be the case whether the entity was a private or government owned entity. For example:

•

a privately owned entity that is exempt pursuant to sections 50-1 and 50-45 of the ITAA 1997 as having been established for the promotion of sport, might lose its exempt status if it starts to be carried on for other, non-exempt purposes;

•

a GBE (either State or Commonwealth owned) will cease to be exempt when it is wholly or partially transferred to private beneficial ownership.

3.30 An entity whose income becomes to any extent assessable is termed the transition entity. [New paragraph 58-15(c)] The time at which its income becomes to any extent assessable is the transition time. [New paragraph 58-15(d)] . The year of income in which the transition time occurs is called the transition year. [New paragraph 58-15(e)]

3.31 New subsection 58-20(1) provides that the transition entity must choose, for all units of plant owned or quasi-owned by it at the transition time, to calculate depreciation deductions and balancing adjustments by reference to either:

(i)

the NWDV of the unit; or

(ii)

the undeducted PABV (if any) of the unit.

3.32 This choice is made on an individual asset by asset basis. It must be made by the day on which the transition entity lodges its income tax return for the transition year, or within any further period allowed by the Commissioner. [New subsection 58-20(2)]

3.33 Once made, the choice applies to the transition year and all later income years. [New subsection 58-20(3)]

C. Depreciation calculated by reference to NWDV

3.34 New subsections 58-25 to 58-85 operate where the transition entity chooses to calculate depreciation deductions and balancing adjustments in respect of a particular unit of plant owned or quasi-owned by it at the transition time by reference to NWDV.

NWDV equals undeducted cost

3.35 New subsection 58-30(1) provides that the undeducted cost of the unit of plant used in calculating further depreciation is the NWDV of the unit. The undeducted cost limits the actual depreciation deductions allowable to the entity.

3.36 The NWDV of the unit of plant is defined in new section 58-80 as the:

Original cost to the transition entity (or assumed cost where the plant was previously owned or quasi-owned by an exempt Australian government agency (EAGA));

less the sum of :

notional depreciation for the period of ownership or assumed ownership prior to transition time;

actual depreciation deductions allowable to the transition entity after transition time; and

notional depreciation for any period after the transition time when the transition entity used the plant other than for the purpose of producing assessable income.

Original or Assumed cost of the unit of plant

3.37 New section 58-40 provides for two different cost rules: one for plant acquired by a transition entity from a predecessor EAGA and one for all other plant. The cost of the plant is determined in accordance with the ordinary rules of Subdivision 42-B, unless there is a predecessor EAGA, in which case the cost of the plant is its cost to the first such EAGA.

3.38 These costs apply in determining both notional depreciation in respect of the period prior to the transition time and actual depreciation in respect of the period after the transition time.

Cost where transitional plant is not acquired from a predecessor EAGA

3.39 New subsection 58-40(1) ensures that the cost of a unit of plant owned or quasi-owned by the transition entity at the transition time is determined under the ordinary depreciation provisions in Subdivision 42-B of the ITAA 1997. Generally this will mean original cost of the unit to the transition entity.

Cost where transitional plant is acquired from a predecessor EAGA

3.40 In some circumstances a transition entity (that was an EAGA immediately before the transition time) may have acquired transitional plant from a predecessor EAGA. For instance, an item may have been originally constructed or acquired by a Commonwealth Government department and later transferred to a corporatised Commonwealth GBE which is made taxable by Commonwealth legislation at the transition time. In such circumstances, new subsection 58-40(2) requires the transition entity to 'look back' to, and adopt the cost applicable to the first EAGA that owned, or quasi-owned, or constructed the plant.

Notional depreciation for the period prior to transition time

Notional depreciation amount

3.41 New section 58-55 ensures that the cost of transitional plant is notionally written down to reflect the fact that it has been used by the transition entity in the period before the transition time.

3.42 Depreciation for the period prior to the transition time is treated as having been allowed to the transition entity as though it had used the unit wholly for the purposes of producing assessable income. This notional depreciation applies from the date of ownership or assumed ownership of the unit until the transition time.

Date of acquisition

3.43 New section 58-35 determines the date of acquisition for the purposes of new section 58-55 .

3.44 The date will be either an assumed date or the actual date.

3.45 The period of assumed ownership is explained in new subsection 58-35(1) . It applies where the transition entity is an EAGA immediately before the transition time and acquired the unit from another EAGA (or through a chain of earlier predecessor EAGAs). The transition entity is taken to have owned or quasi-owned the unit from the date on which it was constructed or acquired by the first EAGA that owned, or quasi-owned, or constructed the unit.

3.46 The period of actual ownership is explained in new subsection 58-35(2) . It provides that where new subsection 58-35(1) does not apply, the date of acquisition is the date on which the transition entity acquired or constructed the unit of plant.

Effective life

3.47 New sections 58-45 and 58-50 provide for the calculation of effective life. Effective life is used to determine the rate of depreciation at which the transition entity notionally writes down the cost of the unit of plant.

3.48 New section 58-45 provides that the effective life is the period that would have been calculated to be its effective life at the time when it was acquired or constructed or assumed to have been acquired or constructed under new section 58-35 by the transition entity. The transition entity is assumed to have made any choice that had to be made under subsection 42-100(1) of the ITAA 1997, or any election that could have been made under subsection 54A(1) of the ITAA 1936 to adopt any determination by the Commissioner of the unit's effective life. [New section 58-50]

Method of depreciation

3.49 A transition entity can choose either the prime cost or diminishing value method of depreciation. The new section 58-60 ensures that the same method of depreciation is used for the purposes of both notional depreciation and actual depreciation.

Rate of depreciation

Loadings and accelerated rates

3.50 In determining the rate of depreciation for notional depreciation purposes in respect of a year of income, any applicable loadings under the former section 57AG and subsection 55(6) of the ITAA 1936 are taken into account [new paragraphs 58-65(a) and 58-65(b)] , but any applicable accelerated rates under the former section 57AL of the ITAA 1936 are disregarded. [New paragraph 58-65(c)]

Choice of rate

3.51 For plant acquired in the 1998 year of income or later years, subsection 42-120(1) of the ITAA 1997 allows you to choose a lower rate of depreciation than the applicable general prime cost rate or diminishing value rate.

3.52 New subsection 58-70 allows a transition entity to make this choice for notional depreciation purposes. However it limits the choice to a minimum rate equal to the pure effective life rate.

Example:

A unit of depreciable plant is acquired in the 1998 income year with an effective life of 10 years. The prime cost rate is 17% and the diminishing value rate is 23% under section 42-125 of the ITAA 1997. Without the operation of new section 58-70 , the transition entity could adopt any rate lower than those prescribed. However new section 58-70 will ensure that any lower rate of depreciation adopted must not be less than the pure effective life rate. The diminishing value rate chosen must not be less than 15%, and the prime cost rate chosen must not be less than 10%.

3.53 In respect of plant acquired prior to the 1998 year of income, the various forms of subsection 55(8) of the ITAA 1936 provide a taxpayer with similar choices to nominate or elect for lower depreciation rates. New subsection 58-75(1) allows the transition entity to make that nomination or election in respect of such plant for the purposes of calculating notional depreciation before the transition time.

3.54 The current subsection 55(8) of the ITAA 1936 allows a taxpayer to nominate a lower depreciation rate than the general rates providing that rate is equal to or greater than the pure effective life rate. Section 55(8A) of the ITAA 1936 ensures that the nomination, once made, applies to all later income years. New subsection 58-75(1) maintains a transition entity's ability to make this nomination if applicable.

3.55 Subsection 55(8) of the ITAA 1936, as in force immediately before the commencement of section 23 of the Taxation Laws Amendment Act 1993, allowed a taxpayer to nominate a lower depreciation rate for a specified year of income, but did not provide for a minimum rate. New subsection 58-75(2) allows the transition entity to make that nomination providing the rate so nominated is not below the pure effective life rate. The rate nominated will apply to the income year in which it is made and all later income years.

3.56 Subsection 55(8) of the ITAA 1936, as originally enacted, allowed a taxpayer to elect to waive broadbanded rates for a particular year of income. Where this election was made, a pure effective life rate with 20% loadings under the then subsection 55(6) would apply. New subsection 58-75(3) maintains the transition entity's ability to make this election if applicable, but provides that the election, once made, applies for all later income years.

Actual depreciation deductions claimed by the transition entity after transition time

3.57 Actual depreciation deductions and balancing adjustments under this regime are affected by the amended definition of undeducted cost in new section 58-30 . [See new subsection 58-85(1)] .

3.58 New section 58-85 contains the rules applicable for the purposes of calculating actual depreciation deductions. The rules applicable for the purposes of working out notional depreciation before the transition time also apply for the purposes of working out actual depreciation. [New subsection 58-85(2)] Actual depreciation deductions will be calculated using the same depreciation rate as was used for the purposes of the latest calculation of notional depreciation. [New subsection 58-85(3)] .

3.59 Otherwise, the rules contained in Division 42 (except for the pooling provisions in Subdivision 42-L of the ITAA 1997 and sections 62AAB to 62AAV of the ITAA 1936 [new subsection 58-85(4)] ) will have application for the purposes of working out actual depreciation deductions. However, balancing adjustment deductions under section 42-195 will not be apportioned by reference to the period for which the asset was used or held ready before the transition time. [New subsection 58-85(5)]

Balancing Adjustment Assessable Amounts

3.60 Where the unit is subject to a balancing adjustment event, the ordinary calculation of assessable balancing adjustments is modified. New subsection 58-85(7) operates where the old CTG law applies to the balancing adjustment event. New subsection 58-85(8) operates where the new CTG law applies to the balancing adjustment event.

3.61 In calculating balancing adjustment assessable amounts, the cost of the unit for the purposes of determining its written down value under section 42-200 of the ITAA 1997 will be the NWDV at the transition time plus the amount of any subsequent capital improvements. [New subsection 58-85(6)] . The assessable balancing adjustment under section 42-190 of the ITAA 1997 will be any excess of the termination value of the plant over its written down value, up to the excess of the higher of the CTG cost base (with some modifications) of the plant or its cost under new subsection 58-85(6) over its written down value. [New subsections 58-85(7) and (8)] . Together, these provisions ensure that, in effect, assessable balancing adjustments can recover both any depreciation since the transition time and the difference between the plant's opening value for depreciation purposes and its opening CTG cost base.

3.62 For the purposes of these calculations, the CTG cost base of the plant is modified to exclude any amounts of expenditure incurred after the transition time that are included in its CTG cost base but not in its cost for depreciation purposes (for example, the transition entity's incidental costs of disposal of the plant). Where the new CTG law applies, the CTG cost base is further modified to exclude any indexation of its elements.

Example where transition entity chooses to calculate by reference to NWDV

3.63 On 1 July 1989, a Commonwealth Government department acquires a unit of plant at a cost of $100,000. If the Commissioner had made an estimate of the unit's effective life at 1 July 1989, he would have estimated it to be 25 years. On 1 July 1994 the unit is transferred to a corporatised Commonwealth GBE. The Commonwealth disposes of all the shares in the GBE to the private sector on 1 July 1998. The GBE uses the unit wholly for the purposes of producing assessable income in the 1999 year of income. The GBE disposes of the unit on 30 June 1999 to an unrelated party for consideration of $40,000.

3.64 The GBE is a transition entity. [New section 58-15] The GBE is assumed to have acquired the unit on 1 July 1989 [new paragraph 58-35(1)(a)] at an assumed cost of $100,000 [new subsection 58-40(2)] . It is assumed to have been allowed notional depreciation for the period 1July 1989 to 30 June 1998. [New section 58-55] The GBE selects the prime cost method of depreciation for actual depreciation and elects under the former subsection 55(8) to waive broadbanding for notional depreciation purposes. For notional depreciation purposes, the rate of depreciation is:

(a)

4.8% in income years 1990 and 1991 (base rate of 4% + s57AG loadings of 20% of base rate) [new paragraph 58-65(a)] using prime cost method [new section 58-60] and based on an effective life estimate of 25 years [new section 58-45] ;

(b)

4.8% in income years 1992 to 1998 inclusive (election under s55(8) to waive broadbanding rates (of 6% = 5% + 20% loading), applicable to all years [new subsection 58-75(3)] , giving base rate of 4% + s55(6) loadings of 20% of base rate [new paragraph 58-65(b)] );

applied to the assumed cost of $100,000.

The same rate of depreciation that applied in the last year of notional depreciation (1998) is also used by the GBE for actual depreciation purposes for the 1999 year. [New subsection 58-85(3)] The method of depreciation used for notional depreciation purposes will be the method selected for actual depreciation. [New section 58-60]

On disposal of the unit by the GBE, the undeducted cost for the purposes of Subdivision 42-F will be the NWDV. [New sections 58-30 and 58-80] The balancing adjustment deduction is not required to be reduced to reflect the 9 years of non-assessable use in the period the unit was assumed to have been owned by the GBE prior to transition time. [New subsection 58-85(5)]

D. Depreciation calculated by reference to Undeducted PABV

3.65 New subsections 58-90 to 58-145 operate where the transition entity chooses to calculate depreciation deductions and balancing adjustments in respect of a particular unit of plant owned or quasi-owned by it at the transition time by reference to undeducted PABV.

Cost of unit for purposes of calculating actual depreciation

3.66 New section 58-95 provides that the cost of the unit of plant for actual depreciation purposes is taken to be the undeducted PABV.

3.67 The undeducted PABV is defined in new section 58-140 . It will be either:

(i)

where the PABV date is less than one year before the transition time, the actual PABV of the unit plus any capital expenditure incurred in respect of improving the unit after the PABV date but before the transition time; or

(ii)

where the PABV date is one year or more before the transition time, the actual PABV of the unit plus any capital expenditure incurred in respect of improving the unit after the PABV date but before transition time, less notional depreciation. [New sections 58-140 and 58-105]

PABV notional depreciation

3.68 New section 58-120 ensures that the PABV of the transitional plant is notionally written down from the PABV date until the transition time if appropriate. Depreciation for that period is treated as having been allowed to the transition entity as though it had used the unit wholly for the purposes of producing assessable income (PABV notional depreciation).

Date of acquisition for purposes of calculating PABV notional depreciation

3.69 New section 58-100 determines the date of acquisition for the purposes of calculating PABV notional depreciation.

3.70 The date will be either an assumed date or the actual date.

3.71 The assumed acquisition date is explained in new subsection 58-100(1) . It applies where the transition entity is an EAGA immediately before the transition time and acquired the unit from another EAGA (or through a chain of earlier predecessor EAGAs). The transition entity is taken to have owned or quasi-owned the unit from the date on which it was constructed or acquired by the first EAGA that owned, or quasi-owned, or constructed the unit.

3.72 The actual acquisition date is explained in new subsection 58-100(2) . It provides that where new subsection 58-100(1) does not apply, the acquisition date is the date on which the transition entity acquired or constructed the unit of plant.

Cost for purposes of calculating PABV notional depreciation

3.73 New section 58-105 provides that the cost for the purposes of calculating notional depreciation of the PABV will be the sum of:

(i)

the latest PABV for the unit of plant; and

(ii)

any capital expenditure incurred in respect of improving the unit after the PABV date but before the transition time.

Effective life for purposes of calculating PABV notional depreciation

3.74 New sections 58-110 and 58-115 provide for the calculation of effective life. Effective life is used to determine the rate of depreciation for the purposes of calculating PABV notional depreciation of a particular unit of plant.

3.75 New section 58-110 provides that the effective life is the period that would have been calculated to be its effective life at the transition entity's actual or assumed acquisition date under new section 58-100 . The transition entity is assumed to have made any election that could have been available under subsection 54A(1) of the ITAA 1936 to adopt any determination by the Commissioner of the unit's effective life. [New section 58-115]

Method of depreciation for purposes of calculating PABV notional depreciation

3.76 A transition entity can choose either the prime cost or diminishing value method of depreciation. The new section 58-125 ensures that the same method of depreciation is used for the purposes of both PABV notional depreciation and actual depreciation.

Rate of depreciation for purposes of calculating PABV notional depreciation

Loadings and accelerated rates

3.77 In determining the rate of depreciation for PABV notional depreciation in respect of a year of income, any applicable loadings under the former section 57AG and subsection 55(6) of the ITAA 1936 are taken into account [new paragraphs 58-130(a) and 58-130(b)] but any applicable accelerated rates under the former section 57AL of the ITAA 1936 are disregarded. [New paragraph 58-130(c)]

Choice of rate

3.78 The various forms of subsection 55(8) of the ITAA 1936 provide a taxpayer with choices to nominate or elect for lower depreciation rates. New subsection 58-135(1) allows the transition entity to make that nomination or election in respect of such plant for the purposes of calculating the PABV notional depreciation.

3.79 The current subsection 55(8) of the ITAA 1936 allows a taxpayer to nominate a lower depreciation rate than the general rates providing that rate is equal to or greater than the pure effective life rate. Section 55(8A) of the ITAA 1936 ensures that the nomination, once made, applies to all later income years. New subsection 58-135(1) maintains a transition entity's ability to make this nomination if applicable.

3.80 Subsection 55(8) of the ITAA 1936, as in force immediately before the commencement of section 23 of the Taxation Laws Amendment Act 1993, allowed the taxpayer to nominate a lower depreciation rate for a specified year of income, but did not provide for a minimum rate. New subsection 58-135(2) allows the transition entity to make that nomination providing the rate so nominated is not below the pure effective life rate. The rate nominated will apply to the income year in which it is made and all later income years.

3.81 Subsection 55(8) of the ITAA 1936, as originally enacted, allowed a taxpayer to elect to waive broadbanded rates for a particular year of income. Where this election was made, a pure effective life rate with 20% loadings under the then subsection 55(6) would apply. New subsection 58-135(3) maintains the transition entity's ability to make this election if applicable, but provides that the election, once made, applies for all later income years.

Actual depreciation deductions claimed by the transition entity after transition time

3.82 Actual depreciation deductions and balancing adjustments under this regime are calculated by reference to the amended definition of cost in new section 58-95 [see new subsection 58-145(1)] .

3.83 The ownership and effective life rules applicable for the purposes of working out PABV notional depreciation will have the same application for the purposes of working out actual depreciation [new subsection 58-145(2)] . This will be the case irrespective of whether the PABV is notionally written down or not. That is, the ownership and effective life rules in new sections 58-100, 58-110 and 58-115 will apply for actual depreciation purposes even where the PABV used is less than 12 months old.

3.84 The rate used for actual depreciation will depend on whether the PABV is notionally written down or not:

(i)

if the PABV is notionally written down (12 months or older) the rate used in the last income year of PABV notional depreciation applies for the purposes of actual depreciation [new subsection 58-145(6)] ; or

(ii)

if the PABV is not notionally written down (less than 12 months old) the rate used for actual depreciation will be determined by reference to the depreciation regime that was in force at the time when the unit was acquired or assumed to have been acquired by the transition entity.

3.85 In calculating a balancing adjustment deduction, new subsection 58-145(4) provides that the transition entity will not have to reduce any deduction to take account of the use of the unit in any period prior to transition time.

3.84 New subsection 58-145(5) modifies the meaning of undeducted cost for the purposes of determining the total amount of actual depreciation that can be claimed and for calculating any balancing adjustment deduction. It provides that undeducted cost is the undeducted PABV less the sum of:

(a)

actual depreciation deductions allowable to the transition entity after the transition time; and

(b)

notional depreciation for any period after the transition time when the transition entity used the plant other than for the purpose of producing assessable income.

3.86 Otherwise, the rules contained in Division 42 (except for the pooling provisions in Subdivision 42-L of the ITAA 1997 [new subsection 58-145(3)] ) will have application for the purposes of working out actual depreciation deductions.

Balancing adjustment assessable amounts

Where the unit is subject to a balancing adjustment event, the ordinary calculation of assessable balancing adjustments is modified. New subsection 58-145(7) operates where the old CTG law applies to the balancing adjustment event. New subsection 58-145(8) operates where the new CTG law applies to the balancing adjustment event.

In such cases, assessable balancing adjustments under section 42-190 of the ITAA 1997 will recover any excess of the termination value of the plant over its written down value, up to the excess of the higher of the CTG cost base (with some modifications) of the plant or its cost for Division 42 purposes over its written down value. [New subsections 58-145(7) and (8)] . These provisions ensure that, in effect, assessable balancing adjustments can recover both any depreciation since the transition time and the difference between the plant's opening value for depreciation purposes and its opening CTG cost base.

For the purposes of these calculations, the CTG cost base of the plant is modified to exclude any amounts of expenditure incurred after the transition time that are included in its CTG cost base but not in its cost for depreciation purposes (for example the transition entity's incidental costs of disposal of the plant). Where the new CTG law applies, the CTG cost base is further modified to exclude any indexation of its elements.

Example where transition entity chooses to calculate by reference to PABV

On 1 July 1993, a corporatised Commonwealth GBE acquires a unit of plant at a cost of $100,000. The Commissioner has in Taxation Ruling IT 2685 specified the unit's effective life to be 25 years. The Commonwealth disposes of all the shares in the GBE to the private sector on 1 July 1998. The GBE uses the unit wholly for the purposes of producing assessable income in the 1999 and 2000 income years. The GBE disposes of the unit on 30 June 2000 to an unrelated party for consideration of $50,000. The unit has a PABV of $90,000 at the test time, which is 30 June 1996.

The GBE is a transition entity [new section 58-15] and chooses to calculate depreciation and balancing adjustments by reference to the undeducted PABV of the unit [new paragraph 58-20(1)(b)] .

Since the transition time (1 July 1998) is more than one year after the test time (30 June 1996), the PABV of the unit must be notionally depreciated to arrive at the undeducted PABV. [New paragraph 58-140(b)] For the purposes of PABV notional depreciation, the GBE is taken to have acquired the unit on 1 July 1993 [new subsection 58-100(2)] at an assumed cost of $90,000. [New section 58-105] It is assumed to have been allowed PABV notional depreciation for the period 1 July 1996 to 30June 1998. [New section 58-120] The GBE selects the prime cost method of depreciation for actual depreciation which also applies for PABV notional depreciation. [New section 58-125] The GBE is assumed to have elected to adopt the effective life of 25 years specified by the Commissioner. [New section 58-115] The GBE can nominate, under s55(8) of the ITAA 1936, a rate of depreciation for PABV notional depreciation that is less than the general rates (13% prime cost), but not lower than the pure effective life rate (which would be 4%). [New subsection 58-135(1)] The GBE nominates the rate of depreciation of 10%.

For the purposes of actual depreciation, the cost of the unit to the GBE is taken to be its undeducted PABV. [New section 58-95] The same rate of depreciation that applied in the last year of notional depreciation (1998) is also used for actual depreciation purposes for the 1999 and 2000 income years. [New subsection 58-145(6)]

On disposal of the unit by the GBE, the undeducted cost for the purposes of Subdivision 42-F will be the undeducted PABV less actual depreciation allowable in the 1999 and 2000 income years. [New subsection 58-145(5)] The balancing adjustment deduction is not required to be reduced to reflect the 5 years of non-assessable use by the GBE in the period before the transition time. [New subsection 42-145(4)]

Asset Sales: Subdivision 58-C

A. Overview

3.87 New Subdivision 58-C applies to asset sales. It gives the purchaser who acquires ownership or quasi-ownership of plant from an exempt entity the choice, on an individual asset by asset basis, to calculate depreciation deductions and balancing adjustments by reference to:

(i)

the NWDV of the unit; or

(ii)

the undeducted PABV (if any) of the unit.

B. Purchase of unit of plant from tax exempt vendor in connection with acquisition of business

3.88 New subsection 58-150(1) provides a test to work out if new Subdivision 58-C applies to a unit of plant.

3.89 New subsection 58-150(1) applies if at a particular time on or after 4 August 1997 a taxable entity acquires ownership or quasi-ownership of a unit of plant from an exempt entity and the acquisition is connected with the acquisition of a business from the exempt entity [new paragraphs 58-150(1)(a) and (b)] .

3.90 The taxable entity which acquired ownership or quasi-ownership of the unit of plant from an exempt entity is termed the purchaser [new paragraph 58-150(f)] . The exempt entity is the TEV and the time of acquisition of the unit of plant by the purchaser is the acquisition time. [New paragraphs 58-150(1)(c) and (d)]

3.91 Under new paragraph 58-150(1)(e) , the year of income in which the acquisition time occurs is termed the acquisition year.

Meaning of acquisition of unit in connection with the acquisition of a business

3.92 New subsection 58-150(2) outlines a range of circumstances in which the acquisition of ownership or quasi-ownership of a unit of plant from an exempt entity is taken to be acquired in connection with the acquisition of a business from an exempt entity for the purposes of new paragraph 58-150(1)(b) .

3.93 New paragraph 58-150(2)(a) covers situations where the unit was used by the exempt entity in the course of carrying on a business and the unit is then used by the purchaser or other person in the business acquired from the exempt entity.

Example

A private company purchases a printing business operated by an exempt government agency. The sale included the acquisition of units of plant such as printing presses. The company uses the printing presses in carrying on the printing business. The units would be taken to be acquired in connection with the acquisition of a business.

3.94 New paragraph 58-150(2)(b) covers situations where the exempt entity does not carry on a business but performs functions in a business like way and the purchaser or another person continues to perform those functions in a carrying on a business.

Example

A hospital owned and operated by an exempt Government body is sold to a privately owned company. The sale includes units of plant. The company then operates the hospital as a business using the units of plant. Units of plant acquired by the company would be taken to be acquired in connection with the acquisition of a business.

3.95 New paragraph 58-150(2)(c) applies in situations where the acquisition of the unit by the purchaser is connected with the acquisition of another asset by the purchaser or another person, in the nature of a collateral advantage. Such an advantage or right would normally come within the definition of asset under Part IIIA of the ITAA 1936.

3.96 For new paragraph 58-150(2)(c) to apply, the other asset must also give the purchaser or other person rights or impose an obligation to perform functions or engage in activities as part of carrying on a business or confer a commercial advantage or opportunity in connection with performing functions or engaging in activities as part of carrying on a business [new subparagraph 58-150(2)(c)(ii)] .

3.97 Under new subparagraph 58-150(2)(c)(iii) it is also necessary that the unit be used by the purchaser or other person in performing particular functions or business activities flowing from the ownership of the other asset.

Example

An exempt State Government body operates a bus service in an inner city area. It sells off 100 buses surplus to its requirements to a taxable purchaser on terms including that the purchaser will be issued with a licence by that State Government to exclusively operate a bus service in a defined outer suburban area. The State Government issues the exclusive licence to the purchaser.

In terms of new paragraph 58-150(2)(c) , the purchase of the plant (buses) is connected with the acquisition of another asset, being an exclusive licence to run a particular bus service. That other asset enables the purchaser to engage in activities as part of carrying on a business.

The particular units of plant (buses) are used by the purchaser in carrying out those business activities. The units of plant would be taken to be acquired in connection with the acquisition of a business.

3.98 New paragraph 58-150(2)(d) would apply in circumstances where there is no direct connection between the acquisition of a unit and the obtaining of an immediate collateral advantage or other 'CTG asset' but there is an arrangement under which the purchaser or other person will obtain another unit of plant or other 'CTG asset' in such a way that the acquisition of the other asset falls within new paragraph 58-150(2)(a), (b) or (c) .

Example

Under an arrangement between an exempt entity and a purchaser, the assets (including plant) of a business conducted by the exempt entity are sold to a purchaser by way of separate sale agreements staggered over a 4year period. At the end of the 4 year period, the purchaser has effectively acquired the whole of the business previously carried on by the exempt entity.

Choice by Purchaser

3.99 New subsection 58-155(1) provides that the purchaser must choose, for all units of plant, to calculate depreciation deductions and balancing adjustments by reference to either:

(i)

the NWDV of the unit in relation to the TEV; or

(ii)

the undeducted PABV of the unit (if any) in relation to the TEV.

3.100 This choice is made on an individual asset by asset basis. It must be made by the day on which the purchaser lodges its income tax return for the year of acquisition of the unit or within any further period allowed by the Commissioner [new subsection 58-155(2)] . Once made, the choice applies to the acquisition year and all later income years. [New subsection 58-155(3)]

C. Depreciation calculated by reference to NWDV

3.101 New subsections 58-160 to 58-215 operate where the purchaser chooses to calculate depreciation deductions and balancing adjustments in respect of a particular unit of plant by reference to the NWDV of the unit in relation to the TEV. The main effect of these provisions is to limit the total actual depreciation deductions that a purchaser can deduct after the acquisition time in respect of the unit by modifying the cost of the unit to the purchaser for the purposes of Division 42 of the ITAA 1997.

Cost of unit to purchaser

3.102 New subsection 58-160(1) provides that the cost of the unit of plant to the purchaser for actual depreciation purposes is the sum of :

(i)

the NWDV of the unit in relation to the TEV at the acquisition time; and

(ii)

any incidental costs of the purchaser in acquiring the unit.

3.103 The elements of the NWDV in relation to the TEV are contained in new sections 58-165 to 58-205 . [New subsection 58-160(2)]

Calculation of the NWDV of the TEV at acquisition time

NWDV of TEV Defined

3.104 New section 58-210 defines the NWDV in relation to the TEV to mean:

(i)

the cost or assumed cost of the unit to the TEV under new section 58-170 ;

less

(ii)

notional depreciation deductions assumed to have been allowed to the TEV under new section 58-185 .

Cost or assumed cost of the unit to the TEV

3.105 New section 58-170 applies two different cost rules, one for plant acquired from a predecessor EAGA and one for all other plant.

3.106 These cost rules apply in determining the notional depreciation assumed to have been allowed to the TEV in the period prior to acquisition time.

Cost where plant is not acquired from a predecessor EAGA

3.107 New subsection 58-170(1) ensures that the cost of a unit of plant acquired by the TEV is determined under the ordinary depreciation provisions in Subdivision 42-B of the ITAA 1997. Generally this will mean the cost is the original cost of the unit to the TEV.

Cost where plant is acquired by TEV (which is an EAGA) from a predecessor EAGA

3.110 In some circumstances a TEV (that was an EAGA immediately before the acquisition time) may have acquired plant from a predecessor EAGA. For instance, an item may have been originally constructed by a Commonwealth Government department and later transferred to another Commonwealth Government agency . In such circumstances, new subsection 58-170(2) requires the TEV to 'look back' to, and adopt the cost applicable to the first EAGA that owned, or quasi-owned, or constructed the plant.

Notional Depreciation of the TEV

3.111 New section 58-185 ensures that the plant is notionally written down to reflect the fact that it has been used by the TEV in the period before the acquisition date. Notional depreciation is assumed to have been allowed to the TEV on the assumption that the unit was used wholly for the purposes of producing assessable income by the TEV from the date of the unit's ownership or assumed ownership by the TEV until the acquisition time.

Actual or assumed date of ownership of unit of plant for TEV

3.112 New section 58-165 determines the ownership period for the purposes of new section 58-185 .

3.113 The ownership period will be either the assumed ownership period or the actual ownership period.

3.114 The period of assumed ownership is explained in new subsection 58-165(1). It applies where the TEV is an EAGA immediately before the acquisition time and acquired the unit from another EAGA (or earlier predecessor EAGA). The TEV is taken to have owned or quasi owned the unit from the date on which it was constructed or acquired by the first EAGA.

3.115 The period of actual ownership is explained in new subsection 58-165(2). It provides that where new subsection 58-165(1) does not apply the date of ownership is the date on which the TEV acquired or constructed the unit of plant.

Effective life

3.116 New sections 58-175 and 58-180 set out the rules for determining effective life. Effective life is used to calculate the depreciation rate at which the TEV notionally writes down the cost of the unit.

3.117 New section 58-175 provides that the effective life is the period that would have been calculated at the time when it was acquired or assumed to have been acquired under new section 58-165 by the TEV. In making this notional estimate, the TEV is assumed to have made any choice that had to be made under subsection 42-100(1) of the ITAA 1997, or any election that could have been made under subsection 54A(1) of the ITAA 1936 to adopt any determination by the Commissioner of the unit's effective life [new section 58-180] .

Method of Depreciation

3.118 In calculating notional depreciation of the TEV, either the prime cost or diminishing value method of depreciation may be used. The purchaser must select the method of depreciation to be used [new section 58-190] .

Rate of depreciation

Loadings and accelerated rates

3.119 In determining the rate of depreciation for notional depreciation purposes for a year of income, any applicable loadings under the former section 57AG and subsection 55(6) of the ITAA 1936 are taken into account [new paragraphs 58-195(a) and (b)] ,but any applicable accelerated rates under the former section 57AL of the ITAA 1936 are disregarded [new paragraph 58-195(c)] .

Choice of rate

3.120 In determining the rate of depreciation for notional depreciation calculations, special rules apply where the TEV could have made a choice or an election at a particular time before the acquisition time for a lower rate to apply.

3.121 If the TEV could have made a choice under subsection 42-120(1) of the ITAA 1997 (for plant acquired in the 1998 year of income or later year) for a lower rate of depreciation before the acquisition time, the purchaser may make the choice and where the choice is made it is taken to have been made by the TEV [new subsection 58-200(1)]. However, the rate of depreciation chosen must not be less than the pure effective life rate under new section 58-200 .

Example

An asset acquired by the TEV in the 1998 year of income has an effective life of 10 years. The prime cost rate is 17% and the diminishing value rate is 23% under section 42-125. Without the operation of new section 58-200 , the TEV could adopt any rate lower that those prescribed. However new section 58-200 will ensure that any lower rate of depreciation adopted must not be less than the pure effective life rate. The diminishing value rate chosen by the purchaser for the TEV must not be less than 15%, and the prime cost rate must not be less than 10%.

3.122 In respect of plant acquired before the 1998 year of income, the various forms of subsection 55(8) of the ITAA 1936 provide a taxpayer with similar choices to nominate or elect for lower depreciation rates. New subsection 58-205(1) allows the purchaser to make that nomination or election on behalf of the TEV in respect of plant acquired from the TEV for the purposes of calculating notional depreciation to the TEV before the acquisition time.

3.123 If the purchaser makes the nomination or election under subsection 55(8) of the ITAA 1936, it is taken to have been made by the TEV [new subsection 58-205(1)] .

3.124 The current subsection 55(8) of the ITAA 1936 allows a taxpayer to nominate a lower depreciation rate than the general rates providing that rate is equal to or greater than the pure effective life rate. Section 55(8A) of the ITAA 1936 ensures that the nomination, once made, applies to all later income years. New subsection 58-205(1) allows the purchaser to make this nomination under subsection 55(8) if applicable.

3.125 If the purchaser makes a nomination under subsection 55(8) of the ITAA 1936 (as in force immediately before the commencement of section 23 of the Taxation Laws Amendment Act 1993) for a lower depreciation rate to apply for a specified year of income, then the nomination applies for the income in which it is taken to have been made and all later income years in the period to the acquisition time. However, any rate of depreciation nominated by the purchaser, must not be less that the appropriate depreciation rate based purely on the assumed effective life of the unit under new section 58-175 [new subsection 58-205(2)] .

3.126 If the purchaser makes an election under subsection 55(8) of the ITAA 1936 as originally enacted, for broadbanded rates of depreciation to be waived for the particular year of income (viz. normal deprecation rates based on pure effective life with 20 % loadings under the then subsection 55(6) apply), then the election applies for the income year in which it is taken to have been made and for all later income years in the period to the acquisition time [new subsection 58-205(3)] .

Actual depreciation deductions claimed by the purchaser after the acquisition time

3.127 Actual depreciation deductions and balancing adjustments under this regime are calculated by reference to the amended definition of cost in new section 58-160 [see new subsection 58-215] .

3.128 Otherwise, the rules contained in Division 42 of the ITAA 1997 will have application for the purposes of working out actual depreciation deductions.

Balancing adjustment assessable amounts

Where the unit is subject to a balancing adjustment event, the ordinary calculation of assessable balancing adjustments is modified. New subsection 58-215(2) operates where the old CTG law applies to the balancing adjustment event. New subsection 58-215(3) operates where the new CTG law applies to the balancing adjustment event.

In such cases, assessable balancing adjustments under section 42-190 of the ITAA 1997 will recapture the excess of the termination value of the plant over its written down value, up to the excess of the higher of the CTG cost base (with some modifications) of the plant to the purchaser or its cost for Division 42 purposes over its written down value [new subsections 58-215(2) and (3)] . These provisions ensure that, in effect, assessable balancing adjustments can recover both any depreciation since the acquisition time and the difference between the plant's opening value for depreciation purposes and its opening CTG cost base.

3.131 For the purposes of these calculations, the CTG cost base of the plant is modified to exclude any amounts of expenditure incurred after the acquisition time that are included in its CTG cost base but not in its cost for depreciation purposes (for example, the purchaser's incidental costs of disposal of the plant). Where the new CTG law applies, the CTG cost base is further modified to exclude any indexation of its elements.

Example where purchaser chooses to calculate by reference to NWDV

On 1 July 1998, a Commonwealth Government Department acquires a unit of plant at a cost of $100,000. The Commissioner has, in Taxation Ruling IT 2685, specified the unit's effective life to be 25 years. On 1July2001, a private company acquires the unit from the Government Department in connection with the acquisition of a business from the Government Department for consideration of $85,000. The private company uses the unit wholly for the purposes of producing assessable income in the 2002 and 2003 income years. It disposes of the unit on 30June 2003 to an unrelated party for consideration of $70,000.

The Government department is the TEV [new paragraph 58-150(1)(c)] . The private company is the purchaser [new paragraph 58-150(1)(f)] and chooses to calculate depreciation and balancing adjustments by reference to the NWDV of the unit [new paragraph 58-155(1)(a)] . The cost of the unit to the private company for actual depreciation purposes will be the NWDV of the unit in relation to the Government Department [new section 58-160] .

For the purposes of working out the NWDV of the unit, the Government department is taken to have acquired the unit on 1 July 1998 [new subsection 58-165(2)] at cost of $100,000 [new subsection 58-170(1)] . It is assumed to have been allowed notional depreciation for the period 1July 1998 to 30 June 2001 [new section 58-185] . The private company selects the prime cost method of depreciation for the Government to use for notional depreciation [new subsection 58-190(1)] . It is assumed to have chosen the effective life of 25 years specified by the Commissioner [paragraph 58-180(a)] . The private company chooses for the Government Department to use a lower rate of depreciation under subsection 42-120(1). [New subsection 58-200(1)] It chooses a prime cost rate of 4%, the minimum rate permitted by new subsection 58-200(3) .

For the purposes of actual depreciation, Division 42 applies, subject to new section 58-160 which provides that the cost of the unit to the private company is taken to the NWDV of the unit in relation to the Government Department [new section 58-215] . The company assesses the effective life of the plant to be 28 years [Subdivision 42-C], chooses the diminishing value method of depreciation [subsection 42-25(3)], and uses the general diminishing value rate of 20% based on that effective life [Subdivision42-D].

On disposal of the unit by the private company, the assessable balancing adjustment will be the termination value ($70,000) less the written down value ($56,320) of the unit [paragraph 42-190(2)(b)].

D. Depreciation calculated by reference to undeducted PABV

3.132 New subsections 58-220 to 58-270 operate where the purchaser chooses to calculate depreciation deductions and balancing adjustments in respect of a particular unit of plant by reference to the undeducted PABV in relation to the TEV. The main effect of these provisions is to limit the total actual depreciation deductions that a purchaser can deduct after the acquisition time of the unit by modifying the cost of the unit to the purchaser for the purposes of the application of Division 42 of the ITAA 1997.

Cost of unit for purposes of calculating actual depreciation

3.133 New section 58-220 provides that the cost of the unit of plant to the purchaser for depreciation purposes is taken to be the sum of:

(i)

the undeducted PABV in relation to the TEV; and

(ii)

any incidental costs of the purchaser in acquiring the unit.

3.134 The undeducted PABV in relation to the TEV is defined in new section 58-265 . It will be either:

(i)

where the PABV date is less than one year before the acquisition time the actual PABV of the unit plus any capital expenditure incurred in respect of improving the unit after the PABV date but before the acquisition time; or

(ii)

where the PABV date is one year or more before the acquisition time the actual PABV of the unit plus any capital expenditure incurred in respect of improving the unit after the PABV date but before the acquisition time, less notional depreciation [new sections 58-265 and 58-230] .

PABV notional depreciation of the TEV

3.135 New section 58-245 ensures that the PABV of the unit is notionally written down from the PABV date until the acquisition time, where appropriate. Depreciation for that period is treated as having been allowed to the TEV as though it had used the unit wholly for the purposes of producing assessable income (PABV notional depreciation of the TEV).

Date of ownership for purposes of calculating the PABV notional depreciation of the TEV

3.136 New section 58-225 determines the date of acquisition by the TEV for the purposes of calculating PABV notional depreciation of the TEV.

3.137 The date will be either an assumed date or the actual date.

3.138 The assumed acquisition date is explained in new subsection 58-225(1) . It applies where the TEV is an EAGA immediately before the acquisition time and acquired the unit from another EAGA (or through a chain of earlier predecessor EAGAs). The TEV is taken to have owned or quasi-owned the unit from the date on which it was constructed or acquired by the first EAGA that owned, or quasi-owned, or constructed the unit.

3.139 The actual acquisition date is explained in new subsection 58-225(2) . It provides that where new subsection 58-225(1) does not apply, the date of ownership is the date on which the TEV acquired or constructed the unit of plant.

Cost to TEV for purposes of calculating PABV notional depreciation of the TEV

3.140 New section 58-230 provides that the assumed cost of the unit to the TEV for the purposes of calculating PABV notional depreciation of the TEV will be the sum of:

(i)

the latest PABV for the unit of plant; and

(ii)

any capital expenditure incurred in respect of improving the unit after the PABV date but before the acquisition time.

Effective life for purposes of calculating PABV notional depreciation of the TEV

3.141 New sections 58-235 and 58-240 set out the rules for determining effective life. Effective life is used to determine the rate at which the TEV notionally writes down the PABV (or assumed cost) of the unit of plant.

3.142 New section 58-235 provides that the effective life is the period that would have been calculated to be its effective life at the time when it was acquired or assumed to have been acquired under new section 58-225 by the TEV. In making this notional estimate, the TEV is assumed to have made any election that would have been available under subsection 54A(1) of the ITAA 1936 to adopt any determination by the Commissioner of the unit's effective life [new section 58-240] .

Method of depreciation for purposes of calculating PABV notional depreciation of the TEV

3.143 In calculating PABV notional depreciation of the TEV, either the prime cost or diminishing value method of depreciation may be used. The purchaser must select the method of depreciation to be used. [New section 58-250]

Rate of depreciation for purposes of calculating PABV notional depreciation of the TEV

Loadings and accelerated rates

3.144 In determining the depreciation rate for PABV notional depreciation of the TEV in respect of a year of income, any applicable loadings under the former section 57AG and subsection 55(6) of the ITAA1936 are taken into account [new paragraphs 58-255(a) and (b)] but any applicable accelerated rates under the former section 57AL of the ITAA 1936 are disregarded [new paragraph 58-255(c)] .

Choice of rate

3.145 The various forms of subsection 55(8) of the ITAA 1936 provide a taxpayer with choices to nominate or elect for lower depreciation rates than the rates prevailing at that time. New subsection 58-260(1) allows the purchaser to make that nomination or election on behalf of the TEV in respect of plant acquired from the TEV for the purposes of calculating PABV notional depreciation of the TEV.

3.146 The current subsection 55(8) of the ITAA 1936 allows a taxpayer to nominate a lower depreciation rate than the general rates providing that rate is equal to or greater than the pure effective life rate. Section 55(8A) of the ITAA 1936 ensures that the nomination, once made, applies to all later income years. New subsection 58-260(1) maintains this ability to make this nomination if applicable.

3.147 Subsection 55(8) of the ITAA 1936, as in force immediately before the commencement of section 23 of the Taxation Laws Amendment Act 1993, allowed a taxpayer to nominate a lower depreciation rate for a specified year of income, but did not provide for a minimum rate. New subsection 58-260(2) allows the purchaser to make that nomination providing the rate so nominated is not below the pure effective life rate. The rate nominated will apply to the TEV for the income year in which it is made and all later income years up until the acquisition time.

3.148 Subsection 55(8) of the ITAA 1936, originally enacted, allowed a taxpayer to elect to waive broadbanded rates for a particular year of income. Where this election was made, a pure effective life rate with 20% loadings under the then subsection 55(6) would apply. New subsection 58-260(3) allows the purchaser to make that election if applicable, but provides that the election, once made, applies to the TEV for all later income years up until the acquisition time.

Actual depreciation deductions claimed by the purchaser after acquisition time

3.149 Actual depreciation deductions and balancing adjustments under this regime are calculated by reference to the amended definition of cost in new section 58-220 .(See new subsection 58-270(1) ).

3.150 Otherwise, the rules contained in Division 42 of the ITAA 1997 will have application for the purposes of working out actual depreciation deductions.

Balancing adjustment assessable amounts

Where the unit is subject to a balancing adjustment event, the ordinary calculation of assessable balancing adjustments is modified. New subsection 58-270(2) operates where the old CTG law applies to the balancing adjustment event. New subsection 58-270(3) operates where the new CTG law applies to the balancing adjustment event.

In such cases, assessable balancing adjustments under section 42-190 of the ITAA 1997 will recover the excess of the termination value over the written down value, up to the excess of the higher of the CTG cost base (with some modifications) of the plant to the purchaser or its cost for Division 42 purposes over its written down value [new subsections 58-270(2) and (3)] . These provisions ensure that, in effect, assessable balancing adjustments can recover both any depreciation since the acquisition time and the difference between the plant's opening value for depreciation purposes and its opening CTG cost base.

For the purposes of these calculations, the CTG cost base of the plant is modified to exclude any amounts of expenditure incurred after the acquisition time that are included in its CTG cost base but not in its cost for depreciation purposes (for example, the purchaser's incidental costs of disposal of the plant). Where the new CTG law applies, the CTG cost base is further modified to exclude any indexation of its elements.

Examples where purchaser chooses to calculate by reference to PABV

Example 1:

On 1 July 1989, a Commonwealth Government department acquires a unit of plant at a cost of $100,000. If the Commissioner of Taxation had made an estimate of the unit's effective life at 1 July 1989, he would have estimated it to be 30 years. On 1 July 1994 the unit is transferred to a corporatised Commonwealth GBE for consideration of $92,000. On 1July 1998, a private company acquires the unit from the GBE in connection with the acquisition of a business from the GBE for consideration of $85,000. The private company uses the unit wholly for the purposes of producing assessable income in the 1999 and 2000 income years. It disposes of the unit on 30 June 2000 to an unrelated party for consideration of $84,000. The unit has a PABV of $90,000 at the test time, which is 30 June 1996.

The GBE is the TEV [new paragraph 58-150(1)(c)] . The private company is the purchaser [new paragraph 58-150(1)(f)] and chooses to calculate depreciation and balancing adjustments by reference to the undeducted PABV of the unit [new paragraph 58-155(1)(b)] .

Since the acquisition time (1 July 1998) is more than one year after the test time (30 June 1996), the PABV of the unit must be notionally depreciated to arrive at the undeducted PABV in relation to the TEV [new paragraph 58-265(b)] . For the purposes of PABV notional depreciation of the TEV, the GBE is assumed to have acquired the unit on 1 July 1989 [new paragraph 58-225(1)(a)] at an assumed cost of $90,000 [new section 58-230] . It is assumed to have been allowed PABV notional depreciation for the period 1 July 1996 to 30 June 1998 [new section 58-245]. The GBE is assumed to have elected to adopt the Commissioner's determination of effective life under subsection 54A(1) of the ITAA 1936 [new section 58-240] . The private company selects the prime cost method of depreciation for the GBE to use for PABV notional depreciation [new section 58-250] . The private company elects that the GBE will, under section 55(8) of the ITAA 1936 waive the broadbanded rate of depreciation (6% = prime cost rate of 5% + 20% loading) for PABV notional depreciation. Therefore, the GBE adopts the prime cost rate of 4% (pure effective life rate of 3.33% under s55(1) plus 20% loading under s55(6)). [New paragraph 58-255(b) and subsection 58-260(3)]

For the purposes of actual depreciation, Division 42 of the ITAA 1997 applies, subject to new section 58-220 which provides that the cost of the unit to the private company is taken to be its undeducted PABV in relation to the TEV [new section 58-270] . The company assesses the effective life of the plant to be 28 years [Subdivision 42-C], chooses the diminishing value method of depreciation [subsection 42-25(3)], and uses the general diminishing value rate of 20% based on that effective life [Subdivision 42D].

On disposal of the unit by the private company, the assessable balancing adjustment will be the termination value ($84,000) less the written down value ($52,992) of the unit [paragraph 42-190(2)(b)].

Example 2:

On 1 July 1998 a private company (Company X) acquires a unit of plant from an exempt GBE in connection with the acquisition of a business for consideration of $140,000. At that time the unit has an undeducted PABV of $100,000.

Company X uses the unit wholly for the purposes of producing assessable income in the 1999 and 2000 income years. On 1 July 1999 Company X makes capital improvements to the unit costing $50,000. It disposes of the unit on 30 June 2000 to an unrelated party for consideration of $200,000, and incurs incidental disposal costs of $2,000.

Assume Company X chooses a prime cost depreciation rate of 10% to apply to the unit. Assume also that indexation of the elements of the CTG cost base for the unit amounts to $3,000.

Company X chooses to calculate depreciation deductions and balancing adjustments by reference to the undeducted PABV of the unit [new paragraph 58-155(1)(b)] .

Calculation of depreciation deductions allowable

Calculation of Balancing Adjustment

Modifications to Division 42

3.154 Part 1 of the Schedule makes amendments to Division 42 (which relates to depreciation of plant) of the ITAA 1997 which are necessary to complement the changes made by new Division 58 .

3.155 Item 1 amends section 42-65 to add new Item 15 to the cost table. The amendment ensures that the cost for plant to which new Division 58 applies is calculated under new section 58-40 , 58-95 , 58-160 or 58-220 .

3.156 Item 2 repeals existing paragraph 42-175(d) and substitutes new paragraphs 42-175(d) and (e) and new subsection 42-175(2) .

3.157 New paragraph 42-175(d) applies to units of plant acquired from a transition entity to which new Subdivision 58-B applies in circumstances where Common Rule 1 applies to the acquisition.

3.158 In such circumstances, new paragraph 42-175(d) provides that the amounts to be deducted from the cost of the unit in ascertaining the undeducted cost of plant for the transferee include:

•

the amounts deducted under new paragraphs 58-80(a),(b) and (c) in calculating the NWDV for the transition entity; or

•

the amounts deducted under new paragraphs 58-145(5)(a) and (b) in calculating the undeducted cost for the transition entity

as is appropriate.

3.159 New paragraph 42-175(e) operates in a similar manner to former paragraph 42-175(d) in that it imputes to the transferee the various components deducted in ascertaining the undeducted cost of the unit for the transferor and earlier successive transferors. The new paragraph 42-175(e) includes amounts under the new paragraph 42-175(d) as one of these components.

3.160 New subsection 42-175(2) provides that section 42-175 has effect subject to new Subdivision 58-B for plant that comes within that Subdivision.

3.161 Item 3 inserts new subsections 42-190(4) and (5) . The new subsection 42-190(4) provides that subsection 42-190(2) has effect subject to new subsections 58-85(7) & (8), 58-145(7) & (8), 58-215(2) & (3) and 58-270(2) & (3) - the safeguard provisions which modify the rules for calculating balancing adjustment assessable amounts.

3.162 New subsection 42-190(5) applies where plant to which Division 58 applies is disposed of by a transition entity or purchaser from a TEV in circumstances where Common rule 1 applies to the acquisition by the transferee, or each acquisition by successive transferees. The new subsection 42-190(5) ensures that the special rules for calculating assessable balancing adjustment amounts provided for by new subsections 58-85(7) & (8), 58-145(7) & (8), 58-215(2) & (3) and 58-270(2) & (3) will apply to such transferees in the same way as they would have applied to the transition entity or purchaser from the TEV, as the case may be.

3.163 Item 4 inserts new subsection 42-195(4) .

3.164 New subsection 42-195(4) ensures that subsection 42-195(3) has effect subject to the new subsections 58-85(5) and 58-145(4) in reducing the balancing adjustment deduction allowable to a transition entity.

3.165 Item 5 inserts new subsections 42-200(2) and 42-200(3) .

3.166 New subsection 42-200(2) provides that subsection 42-200(1) has effect subject to new subsection 58-85(6) in calculating the written down value of plant for the purpose of determining whether and what balancing adjustment is to be included in a transition entity's assessable income.

3.167 New subsection 42-200(3) applies where plant to which the new section 58-85 applies is disposed of by a transition entity in circumstances where Common rule 1 applies to the acquisition by the transferee, or each acquisition by successive transferees. The new subsection 42-200(3) ensures that the special rule for determining the written down value of the plant provided for by the new subsection 58-85(6) will apply to such transferees. Under this special rule, the cost of the unit for the purposes of determining its written down value is taken to be its NWDV at the transition time in relation to the transition entity plus the amount of any subsequent capital improvements.

Other matters

A. Amendments to Subdivision 110-B

Items 8 to 11 clarify aspects of the operation of the rules about reduced cost base of a CTG asset contained in Subdivision 110-B in circumstances where new Division 58 applies to the asset.

Item 8 substitutes new paragraph 110-55(3)(a) for the existing paragraph 110-55(3)(a). New subparagraph 110-55(3)(a)(ii) applies in circumstances where an amount is included in assessable income as a result of the operation of the special rules for calculating assessable balancing adjustments provided for by the new subsections 58-85(7) & (8), 58-145(7) & (8), 58-215(2) & (3) and 58-270(2) & (3). New subparagraph 110-55(3)(a)(ii) makes it clear that, in these circumstances, the reduced cost base of the CTG asset includes only that part of the assessable balancing adjustment that is attributable to depreciation deductions that have been allowed in respect of the asset after the transition time or the acquisition time, as the case may be.

Item 10 provides similar clarification in respect of amounts included in the reduced cost base of an entity's interest in a CTG asset of a partnership under section 110-60.

Item 9 inserts references to new paragraphs 58-80(c) and 58-145(5)(b) into existing subsection 110-55(5). This makes it clear that the reduced cost base of a CTG asset does not include amounts of notional depreciation on account of any use of the asset after the transition time which is not wholly for the purposes of producing assessable income.

Item 11 provides similar clarification in respect of amounts not included in the reduced cost base of an entity's interest in a CTG asset of a partnership under section 110-60.

B. Modifications to Subdivision 330-H

3.173 Item 12 inserts new subsections 330-375(4) and (5) .

3.174 New subsections 330-375(4) and (5) alter the meaning of transport capital expenditure for the purposes of Subdivision 330-H. New subsection 330-375(4) excludes any expenditure on a unit of plant to which new Subdivision 58-B or 58-C applies. New subsection 330-375(5) also excludes any expenditure by an entity who has acquired such plant from a transition entity or a purchaser from a TEV in circumstances where Common rule 1 applies to the acquisition by the transferee, or each acquisition by successive transferees. The new subsections 330-375(4) and (5) ensure that, in respect of expenditure on such plant, entities to which Division 58 applies and any later successive Common rule 1 transferees are to claim deductions under the depreciation provisions of Division 42 rather than under the capital allowance provisions of Subdivision 330-H.

C. Dictionary

3.175 Items 13 to 24 of Part 1 of the Schedule incorporate changes arising from the new Division 58 to existing definitions and also includes new definitions in the Dictionary at subsection 995-1(1).

D. Income Tax (Transitional) Provisions Act 1997

3.176 Part 2 of the Schedule inserts a note at the end of existing section 42-175 of the Income Tax (Transitional Provisions) Act 1997 to the effect that those provisions are replaced by other provisions in relation to a transition entity in respect of plant owned or quasi-owned by it.

E. Amendments to Division 3 of Part IIIA of the ITAA 1936

Items 26 to 31 of the Schedule clarify aspects of the operation of the CTG anti-overlap provisions and reduced cost base provisions contained in sections 160ZA and 160ZK of the ITAA 1936 in circumstances where new Division 58 applies to an asset.

Item 26 makes it clear that the full amount of any assessable balancing adjustment included in assessable income as a result of the operation of the special calculation rules provided for by the new subsections 58-85(7) & (8), 58-145(7) & (8), 58-215(2) & (3) and 58-270(2) & (3) is excluded from the CTG relief provided for by subsection 160ZA(4). Such assessable balancing adjustments will not be 'included amounts' for the purposes of paragraph 160ZA(4)(b).

Item 27 provides similar clarification in respect of amounts excluded from the CTG relief provided for by subsection 160ZA(5) in respect of the disposal of an interest in a partnership asset.

Items 28 and 29 add references to new paragraphs 58-80(c) and 58-145(5)(b) into existing paragraph 160ZK(1)(a). This makes it clear that the reduced cost base of a CTG asset does not include amounts of notional depreciation on account of any use of the asset after the transition time which is not wholly for the purposes of producing assessable income.

Items 30 and 31 provide similar clarification in respect of amounts not included in the reduced cost base of a taxpayer's interest in a CTG asset of a partnership under subsection 160ZK(3).

F. Amendment to Division 57 of the ITAA 1936

3.182 Item 32 of the Schedule inserts new Subdivision 57-N of the ITAA 1936 which ensure that existing Subdivision 57-I, and existing Subdivision 57-K in so far as it relates to depreciation balancing adjustments, do not apply to plant covered by new Subdivision 58-B .

Application

3.183 The amendments will apply where:

•

an entity first becomes taxable on or after 4 August 1997; or

•

on or after 4 August 1997 a purchaser that is a taxable entity acquires ownership or quasi-ownership of depreciable plant from an exempt entity in connection with the acquisition of a business from the exempt entity.

Regulation Impact Statement

Policy objectives

The objective is to align the depreciation treatment of exempt entity asset sales with the treatment of sales of shares in the entity in a way that will provide the best balance of certainty, ease of administration and consistency of treatment of exempt entity assets that become depreciable with taxation purposes while ensuring that vendors of exempt entities or their assets realise a fair price on privatisation.

A measure to address this objective was announced by the Treasurer in Press Release No. 84 of 4 August 1997. Further clarification of the measure was made in Treasurer's Press Release No. 2 of 14 January 1998. The Bill was exposed to the public in Treasurer's Press Release No.9 of 10 February 1998.

The measure represents a new treatment giving a common depreciation base for assets following both exempt entity asset sales and sales of shares in exempt entities owning the assets.

Identification of implementation options

Background

In December 1996 the ITAA 1936 was amended to clarify,inter alia, the treatment of depreciable assets of businesses operating through tax exempt entities that entered the Commonwealth tax net after the sale of shares in the entities. The legislation provided that depreciation claims are to be based on the notional written down value (NWDV) of the assets. The provisions did not apply where the business assets of the entities were sold (asset sale) rather than the shares in the entities themselves (entity sale).

Subsequent to that legislation being announced the asset sale technique has been used. This resulted in depreciation claims being based on the purchase consideration attributable to the depreciable assets, rather than the NWDV of the assets. These circumstances provided scope for parties to the Sales to Structure arrangements to gain taxation advantages at a cost to Commonwealth revenue.

Implementation options

Option 1 is to allow the depreciation deductions available for assets following either sale of the exempt owner, or sale of the assets themselves, to a taxpayer to be based on a choice between the NWDV of the plant at the time it enters the tax net and its undeducted pre-existing audited book value at that time. This option would include a safeguard measure designed to ensure that, where such plant is on-sold to a subsequent owner, balancing adjustments are included in the assessable income of the first purchaser of the asset should the first purchaser on-sell the asset for more than its WDV. This will ensure that any increase in depreciation available to the subsequent purchaser, which increases the price the subsequent purchaser is prepared to pay, is off set by an amount taxable to the first purchaser. This prevents on-sales being used to circumvent the measure and preserve its integrity. Subsequent transactions in respect of the asset would be accorded the same treatment as transactions relating to any other asset sales between or by taxpayers (ie. depreciation is available on the basis of purchase price).

An alternative implementation option for achieving the policy objective would be to limit the depreciation deductions that can be claimed by all purchasers (the first and all subsequent purchasers) of the asset to the opening NWDV given to the first purchaser. However this option was not considered acceptable as it would have meant a different taxation treatment would have applied to an asset that was once owned by an exempt entity compared with the taxation treatment that would apply to an identical asset had it always been owned by private taxpayers.

Assessment of impacts (costs and benefits) of implementation option

Impact group identification

The group affected by these measures are purchasers of assets (eg. power stations) formerly owned by tax exempts such as State governments where that purchase is associated with the acquisition of a business; and purchasers of exempt entities. The measures also have implications for Commonwealth revenues.

Assessment of costs

Administration cost to Government

The Australian Taxation Office (ATO) has the responsibility of administering this legislation. It has already allocated resources to deal with privatisation issues and it is not expected that there will be additional staff required as a result of these measures.

Compliance costs to business

The ATO is routinely approached by taxpayers undertaking a transition from exempt to taxable status and by prospective purchasers of assets owned by exempt entities. To date there have been no approaches by small business taxpayers so it is assumed that the impact on small business will be negligible. There may be a minimal increase in compliance costs for affected entities. Some entities will have already undertaken share transactions and will be familiar with the methods being introduced. Others will need to familiarise themselves with the method.

Assessment of benefits

Failure to implement this measure would pose a significant threat to the revenue due to larger potential depreciation deductions available to purchasers of exempt entity assets. Implementation of this measure will ensure a near identical tax treatment is given to exempt entity asset sales and sales of those entities via the sale of shares in the entity owning the asset.

Consultation

The ATO has undertaken extensive consultation with State Governments. It is largely their assets and entities that will be affected by this measure.

Conclusion

The proposed implementation measure achieves the government's policy objective and involves minimal additional compliance costs for those affected. The ATO and Treasury will monitor this legislation to evaluate its effectiveness.

Chapter 4 - Franking credits, franking debits and the intercorporate dividend rebate

Overview

4.1 Schedule 4 to the Bill will amend Part IIIAA of the Income Tax Assessment Act 1936 (ITAA 1936) to prevent franking credit trading and misuse of the intercorporate dividend rebate. The amendments will introduce:

•

the holding period rule which, subject to certain exceptions, requires taxpayers to hold shares at-risk for more than 45 days in order to qualify for a franking benefit or intercorporate dividend rebate from a dividend, or, in the case of certain preference shares, more than 90 days; and

•

the related payments rule which requires taxpayers who are under an obligation to make a related payment with respect to a dividend paid on shares to hold the relevant shares at-risk for more than 45 days (or 90 days for preference shares) during the relevant qualification period in order to qualify for a franking benefit or intercorporate dividend rebate from the dividend.

Summary of amendments

Purpose of amendments

4.2 The purpose of the amendments is to protect the revenue by introducing a holding period rule and related payments rule for shares to curb the unintended usage of franking credits and misuse of the intercorporate dividend rebate by persons who are not effectively owners of shares or who are only very briefly owners of shares. This will counter certain tax avoidance schemes under which franking credits or the intercorporate dividend rebate are made available to such persons.

Date of effect

4.3 The holding period rule is to apply to shares and interests in shares which were acquired on or after 1 July 1997, unless the taxpayer had become contractually obliged to acquire the shares before 7.30 pm AEST, 13 May 1997. [Subitem 25(1)]

4.4 New section 160APHL , which applies special rules for beneficiaries of certain trusts, takes effect at 3 pm AEST, 31 December 1997 and applies to:

•

shares or interests in shares which were acquired by a trust (other than a widely held public share-trading trust) after that time; and

•

widely held public share-trading trusts established after that time. [Subitem 25(6)]

4.5 The related payments rule applies to arrangements entered into on or after 7.30 pm AEST, 13 May 1997. However, shares or interests in shares acquired before that time are not exempt from the measure. Provided the arrangement is entered into after 7.30 pm AEST, 13 May 1997, the measures will apply. For example, if a financial institution issues endowment warrants after that time over shares which it acquired before then, the dividends payable on the shares will be within the measure notwithstanding that the shares were acquired before 7.30 pm AEST, 13 May 1997. [Subitem 25(9)]

Background to the legislation

4.6 One of the underlying principles of the imputation system is that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves: a degree of wastage of franking credits is an intended feature of the imputation system.

4.7 In substance, the owner of shares is the person who is exposed to the risks of loss and opportunities for gain in respect of the shares. However, franking credit trading schemes allow persons who are not exposed, or have only a small exposure, to the risks and opportunities of share ownership to obtain access to the full value of franking credits, which often, but for the scheme, would not have been used at all, or would not have been fully used. Some of these schemes may operate over extended periods, and typically involve a payment related to the dividend which has the effect of passing its benefit in economic terms to a counterparty. The schemes therefore undermine an underlying principle of imputation.

4.8 These or similar schemes also allow companies inappropriate access to the intercorporate dividend rebate, usually in circumstances where, because of a tax deduction against the assessable amount of the dividend, the rebate is not required to relieve the dividend from double taxation, but rather is used inappropriately to reduce tax on other income.

4.9 The Bill introduces a holding period rule and a related payments rule which provides that taxpayers must satisfy certain criteria before they qualify for the benefits of franking and the intercorporate dividend rebate. The measures restore the underlying principle of the imputation system and prevent misuse of the intercorporate dividend rebate.

Explanation of the amendments

Qualification for franking credits, franking rebates and the intercorporate dividend rebate

4.10 Schedule 4 to the Bill inserts new Division 1A in Part IIIAA of the ITAA 1936. The object of this new Division is to set out the circumstances in which a taxpayer is entitled to a franking credit, franking rebate or the intercorporate dividend rebate in respect of a particular dividend, whether received directly or indirectly though a trust or partnership. [Item 8, new section 160APHC]

4.11 To be entitled to a franking credit, franking rebate, or intercorporate dividend rebate in relation to a particular dividend, a taxpayer must be a qualified person in relation to the dividend. Broadly speaking, to be a qualified person in relation to a dividend, a taxpayer must satisfy both the holding period rule (or certain alternative rules) and the related payments rule.

4.12 The paragraphs below explain that a taxpayer is a qualified person in relation to a dividend if the taxpayer satisfies the related payments rule and:

(a)

the taxpayer satisfies the holding period rule in relation to the dividend; [Item 8, new section 160APHO]

(b)

the taxpayer is a particular kind of taxpayer that elects to have a franking credit or franking rebate ceiling applied, calculated according to a prescribed formula; [Item 8, new section 160APHR]

(c)

the taxpayer is a natural person whose franking rebate entitlement for the year is less than $2,000; or [Item 8, new section 160APHT]

(d)

the dividend is paid on certain shares issued in connection with the winding up of a company. [Item 8, new section 160APHQ]

4.13 Where a taxpayer derives dividends through a distribution from a partnership or trust consisting wholly or in part of dividends, the taxpayer needs to determine what component of the trust or partnership distribution is attributable to a particular dividend, and then determine whether, in relation to that dividend, the taxpayer is a qualified person. However, by way of exception, a taxpayer who is a beneficiary of a widely-held trust need only determine whether he or she is a qualified person in relation to the trust distribution itself, rather than the particular dividends it may be comprised of (this is explained below).

4.14 The effect for a taxpayer of not being a qualified person in relation to a dividend or distribution is explained below. Deductions that may be available to certain beneficiaries and partners who are not qualified persons in relation to a trust or partnership distribution are also explained below.

(a) Satisfaction of the holding period and related payments rules

4.15 For the purposes of the holding period rule, a taxpayer who holds shares or an interest in shares on which a dividend or distribution has been paid is a qualified person in relation to the dividend if the taxpayer has held the shares or interest in shares at-risk, not counting the day of acquisition or disposal, for at least 45 days (or 90 days for certain preference shares). [Item 8, new section 160APHO]

4.16 To be a qualified person in relation to a dividend under the related payments rule, a person must be either:

•

at-risk in respect of the relevant shares or interests in shares for the relevant period during a qualification period around the ex-dividend day; or

•

if the taxpayer is not at-risk for the relevant period during the qualification period, the taxpayer or associate must not make a related payment (explained below) in respect of the dividend.

If a taxpayer fails both these requirements, the taxpayer will not be a qualified person, and franking benefits and the intercorporate dividend rebate will be denied.

4.17 In the case of trust or partnership distributions consisting wholly or in part of dividends, the taxpayer must be either be at-risk for the relevant period (during the qualification period) in respect of the taxpayers interest in the shares from which the dividend is derived; or must not make a related payment in respect of that component of the distribution consisting of the dividend, or the distribution as a whole. An exception to this rule is that a taxpayer who is a beneficiary of a widely-held trust need only be either at-risk in respect of the interest in the trust during a qualification period around the trust distribution date; or must not make a related payment in relation to the distribution as a whole, without regard to the particular dividends of which it is comprised. (This exception is discussed in more detail under the heading Beneficiaries of a widely-held trust at paragraphs 4.136-4.138). [Item 8, new section 160APHP]

4.18 However, in these cases where a taxpayer holds shares indirectly through a trust or partnership (or through a chain of trusts or partnerships), if the trustee or partnership is not a qualified person in relation to a dividend, then the taxpayer cannot be a qualified person in relation to the dividend flowing through the trust or partnership. [Item 8, Notes to new subsections 160APHK(1) and 160APHL(1)

4.19 The holding period rule is a once-and-for-all test. It sets an initial threshold which only has to be crossed once. Therefore, once a taxpayer is a qualified person in relation to a dividend or distribution by virtue of the fact that the taxpayer has held the relevant shares or interest for more than 45 days, the taxpayer is taken to be a qualified person for the purposes of the rule in relation to future dividends or distributions paid on those shares or interest.

4.20 For example, if a taxpayer acquires a share on 1 September 1997 and, after holding it continuously at-risk, puts in place a risk diminution arrangement on 1 November 1997, the taxpayer will continue to be a qualified person in relation to the dividends paid on the shares for the purposes of the holding period rule (and therefore entitled to the franking credit and section 46 intercorporate dividend rebate on the dividends) because the taxpayer has held the shares for more than 45days prior to putting the arrangement in place.

4.21 The related payments rule, however, is not a once-and-for-all test. That is, even if a taxpayer is a qualified person in relation to a dividend or distribution by virtue of the fact that the taxpayer has held the relevant shares or interest for more than 45 (or 90) days, the taxpayer is not taken to be a qualified person in relation to future dividends or distributions paid on those shares or interest if the taxpayer or associate is under an obligation to make a related payment in relation to the future dividends or distributions and has not held the shares at risk for the requisite period during the relevant qualification period (ie. if the taxpayer triggers the related payments rule).

What is a share?

4.22 A share includes the interest of a partner in a corporate limited partnership and membership of a company which does not have share capital (eg. companies limited by guarantee). [Item 8, new section 160APHD]

When does an interest in a share arise?

4.23 New section 160APHG provides that when a partnership or trust (other than a widely held trust) holds, acquires or disposes of shares or an interest in shares:

(a)

the relevant partners or beneficiaries (including potential beneficiaries of discretionary trusts) are taken to hold, acquire or dispose of an interest in the shares; and

(b)

the relevant partners or beneficiaries are taken to hold, acquire or dispose of their interests in shares at or during the time the partnership or trust holds, acquires or disposes of its shares or interests in shares.

4.24 Furthermore, when a taxpayer becomes or ceases to be a partner of a partnership or beneficiary of a trust which holds shares or interests in shares, the taxpayer is taken to acquire or dispose of an interest in the shares at the time the taxpayer becomes or ceases to be a partner or beneficiary. [Item 8, new subsections 160APHG(1) to 160APHG(4)]

Note: While a change in beneficiaries will not necessarily result in a new trust, a change in partners is generally considered to result in a new partnership for tax purposes. However, to avoid uncertainty, partnerships as well as trusts are included.

4.25 The amount of the interest in shares held through a partnership is specified in new section 160APHK , while new section 160APHL specifies the amount of a beneficiaries interest in shares held by a trust. [Item 8, new sections 160APHK and 160APHL]

Interests in shares held by widely held trusts

4.26 A beneficiary of a widely held trust is treated as holding an interest in all the shares, or interests, held by the trust as an undissected aggregate, and is only required to satisfy the 45 day rule in relation to his or her interest in the trust as a whole, rather than in relation to each share in which he or she has an interest under the trust. The provisions do not look through the widely held trust to see whether the beneficiary has had an interest for 45 days in each of the underlying shares in the trust estate. This stands in contrast with the position of a beneficiary of an ordinary trust, where such a look through approach is required.

4.27 Where a widely held trust holds shares or interests in shares, and a taxpayer is, becomes or ceases to be a beneficiary of the trust:

(a)

the taxpayer is taken to hold, acquire or dispose of an interest in shares during or at the time the taxpayer becomes or ceases to be a beneficiary of the trust; but

(b)

the interest is not taken to be an interest in the particular shares or interests in shares held by the trust.

Where a widely-held trust which did not previously hold any shares or interests in shares acquires shares or interests in shares:

(a)

the beneficiaries of the trust are taken to acquire an interest in shares, being their interest in the trust, at that time; but

(b)

the interest is not taken to be an interest in the particular shares or interests in shares acquired by the trust.

Similarly, when a widely-held trust which held shares or interests in shares ceases to hold any shares or interests in shares, the beneficiaries of the trust are taken to have disposed of their interest in shares. [Item 8, new subsections 160APHG(5) to 160APHG(8)]

4.28 A beneficiary of a widely held trust will be treated as holding, while a beneficiary, an interest in any shares or interests in shares held from time to time by the trustee, whether or not the shares are held by the trustee during the same period as the period in which the taxpayer is a beneficiary. Thus a beneficiary of a widely held trust who receives dividends from shares previously included in the trust estate will be treated as holding an interest in those shares while he or she continues to hold his or her interest as beneficiary of the trust, even though the shares were disposed of by the trustee before or soon after the beneficiary acquired the interest in the trust. This means that a beneficiary of a widely held trust will not be precluded from franking benefits where a distribution includes dividends paid on shares or interests in shares disposed of by the trustee before or soon after they acquired their interests in the trust, provided that the beneficiary has held its interest in the trust as a whole for the required period of 45 days.

When does a person hold shares for the purposes of the holding period and related payments rules?

4.29 Generally, a taxpayer is taken to hold shares from the time the taxpayer acquires the shares until the time the taxpayer disposes of the shares. For acquisitions and disposals at a fixed price under an unconditional contract, the time of acquisition and disposal is the time of making the contract. [Item 8, new subsection 160APHH(1)]

4.30 This is because a taxpayer will assume the risks and opportunities of share ownership once he or she has an unconditional right and obligation to buy shares at a fixed price. (This would not be true if the share price could change: for example, a contract to buy shares at the market price on a future day would leave risk with the seller until then.)

4.31 For example, if a taxpayer acquires an ordinary share on 1November, the taxpayer would have to hold the share until at least 17December to be a qualified person for the purposes of new section 160APHO .

4.32 The taxpayer is not required to hold shares or an interest in shares for more than 45 days before a dividend is paid to be a qualified person in relation to that dividend: days after the dividend is paid can also be counted (although they must be within the qualifying period explained below).

Special provisions relating to acquisition and disposal

4.33 New section 160APHH outlines several circumstances where a taxpayer may be taken to acquire or dispose of shares at a time other than the actual disposal or acquisition. For example, by virtue of new subsection 160APHH(3) a person who holds an instalment receipt under a trust which converts into an ordinary share (by the cancellation of the instalment receipt and the transfer of an equivalent number of shares to the instalment receipt holder on the payment of the final instalment) will be deemed to have held the ordinary shares from the time the instalment receipt was acquired. This is because the taxpayer has the same economic interest in the shares throughout.

4.34 Similarly, new subsection 160APHH(2) provides that for the purpose of determining when shares are acquired, where shares (bonus shares) are issued in respect of existing shares (original shares):

•

if some part of the bonus shares is or is taken to be a dividend which is included in the assessable income of the taxpayer the bonus shares are acquired when they were issued;

•

if no part is, or is taken to be, a dividend which is included in the assessable income of the taxpayer, the bonus shares are taken for the purposes of this Division to have been acquired when the original shares were acquired, and they are deemed to have been held for the same number of days as the original shares are taken to have been held.

In the first case, the re-investment of the dividend in shares is analogous to a new share purchase; while in the second case, the bonus share issue is like a share split rather than a new acquisition of shares.

4.35 In addition, new subsection 160APHH(10) provides that where a company (the first company) in a wholly-owned group disposes of shares to another company in the same group the holding period of the shares is to include the days on which the first company held the shares at risk. Economically there is no real change of ownership because there is no change in the underlying ownership of the companies.

4.36 Similarly, new subsection 160APHH(8) provides that if a taxpayer disposes of shares or interests under a securities lending arrangement which satisfies subsection 26BC(4) of the ITAA 1936 (and therefore is deemed not to have disposed of the shares or interests for the purposes of the ordinary income or capital gains provisions of the ITAA 1936), then the taxpayer is also treated as not having disposed of the shares for the purposes of new section 160APHO. In such a case, the lender will still be taken to hold the shares for the purposes of determining whether the lender has satisfied the holding period rule in relation to dividends paid on the shares (during the loan period the dividends may, for imputation purposes, be passed back to the lender under section 160AQUA of the ITAA 1936). Again, this is consistent with the underlying economic ownership of the shares.

4.37 New subsection 160APHH(6) provides that if a person transfers shares or an interest in shares to a person to hold as bare trustee for the transferor, the trustee will be treated as having held the shares or interest for the period that the shares or interest were held by the transferor (in addition to the period that the trustee held the shares or interest). New subsection 160APHH(6) provides that this concession will not apply if the trust becomes a widely held trust within 45 days of the transfer if the shares are not preference shares or 90 days if the shares are preference shares.

Roll-over relief

4.38 Other cases where roll-over relief is available are:

•

on the death of a person;

•

where a person becomes subject to a legal disability (eg. on becoming mentally incapacitated); and

•

where there is a mere change of trustee or transfer of an asset between wholly-owned trusts.

[Item 8, new subsections 160APHH(4),(5) and (7)]

Disposals of shares taken to be disposals of related shares or interests

4.39 New section 160APHI ensures that the holding period operates on a last-in, first-out basis (LIFO). This is because shares are fungible assets, and the sale of any one parcel of shares is economically equivalent to any other sale of any other parcel. LIFO prevents circumvention of the holding period rule by taxpayers with portfolios of old shares buying new shares and selling old shares, as well as providing tax neutrality in a decision whether to make economically equivalent disposals of particular parcels of shares.

4.40 LIFO will apply to shares or interests in shares held by one taxpayer, but also to wholly owned company groups (which are effectively treated as one taxpayer for the purposes of the holding period rule) and to associates acting together under an arrangement. The purpose of the arrangement test is to prevent a taxpayer acting in collusion with an associate in such a way that, in essence, the taxpayer acquires shares or an interest in shares and then, under the arrangement, the associate disposes of substantially identical shares or securities which has a similar effect for the taxpayer as if the disposal had been by the taxpayer.

4.41 To achieve this, new section 160APHI provides that in determining whether a taxpayer has held particular shares or interests in shares (called the primary securities) for the requisite period of time during a qualification period regard must be had to whether a disposal of related securities (defined below) by the taxpayer, an associate of the taxpayer or, if the taxpayer is a company, another company in the same wholly-owned group has occurred. Where such a disposal has occurred the taxpayer may be taken for the purposes of new section 160APHO to have disposed of (and immediately reacquired) the primary securities. However, a disposal of securities within a wholly-owned company group will not be treated as a disposal of identical securities held by a company within the group.

4.42 For example, if on 1 July 1997 a taxpayer acquires 100 ordinary shares in a company and on 1 August disposes of 50 ordinary shares in the same company, irrespective of whether the shares disposed of are the shares acquired in July, the taxpayer will be taken to have disposed of 50 of the July shares. Moreover, if, for example, a person acquires 100 ordinary shares in a company and, under an arrangement with the person, a company controlled by the person disposes of 100 ordinary shares in the same company, the person will be taken to have disposed of the 100 shares.

4.43 Before a related security can be treated as the disposal of a primary security, the related security must provide the taxpayer or associate with a frankable or rebatable dividend or distribution corresponding to the dividend or distribution paid on the primary security (which is the dividend or distribution against which the rule is being applied). As an example, a distribution paid by a trust holding only shares of a particular kind will correspond to a dividend paid on the shares if the distribution is attributable to that dividend. [Item 8, new section 160APHI]

What is a related security?

4.44 New subsection 160APHI(2) defines related securities as being the primary securities, securities which are substantially identical to the primary securities and substantially identical securities disposed of by a connected person (ie. the taxpayer or associate). New subsection 160APHF(1) defines a substantially identical security as being any property that is economically equivalent to (or fungible with) the relevant shares or interests in shares. [Item 8, new subsection 160APHI(2)]

4.45 Accordingly, in relation to shares (the relevant shares), substantially identical securities include but are not limited to:

(a)

shares in the same company that are of the same class as the relevant shares;

(b)

shares in the same company that are of a different class where there is no material difference between the classes or shares that are exchangeable for shares in the same class as the relevant shares;

(c)

shares in another company that predominantly hold shares in categories (a) and (b); or

(d)

shares in another company which are exchangeable for shares in categories (a) and (b). [Item 8, new subsection 160APHF(3)]

4.46 In relation to an interest in the relevant shares, substantially identical securities include an interest in a trust or partnership that predominantly holds the shares in categories (a) and (b) in the previous paragraph. [Item 8, new subsection 160APHF(4)]

4.47 For example, in relation to an ordinary share, a converting preference share with a delta of +0.9 in relation to the ordinary share would be a substantially identical security to the ordinary share (the concept of delta is explained below).

4.48 There will be no double counting of disposals of securities. Therefore, if the disposal of a security triggers the holding period rule in relation to that security, it will not also trigger a disposal of another security, even if it is related. [Item 8, new subsection 160APHI(7)]

4.49 To avoid the need to track disposals of shares which are managed as or in a discrete fund in respect of which an election to adopt a formula-based ceiling is made under new section 160APHR , shares held in such funds are not related securities. [These elections are discussed in more detail under the heading (b) Formula-based ceiling for certain taxpayers at paragraphs 4.103-4.111.] [Item 8, new subsection 160APHI(2)]

When does a person not hold shares for the purposes of the holding period and related payments rules?

4.50 In calculating whether a taxpayer has satisfied the requisite holding period, any days during which there is a materially diminished risk in relation to the relevant shares or interest are not counted. In other words, it is as if the taxpayer did not hold the shares on those days. There would be a material diminution of risk, for example, if a taxpayer has forward sold the shares or has taken a position in derivatives which eliminates the upside and downside risk of holding the shares. [Item 8, new subsection 160APHO(3)]

4.51 To determine whether there has been a material diminution of risk, it is first necessary to understand what is a position, and how a taxpayers net position is determined by reference to long and short positions. These terms are explained below at paragraphs 4.52-4.59.

4.52 New subsection 160APHJ(2) lists some examples of positions which, because they relate to substantially similar or related property, will have a delta in relation to the shares held by the taxpayer (substantially similar or related property refers to property sufficiently resembling the shares to exhibit a correlation in price movements). However, a position in other property could, as a matter of fact, have a delta in relation to shares if changes in its value exhibit a correlation with share price movements, notwithstanding that the property was not similar to the shares. For example, a company which derived most of its profits from the sale of one product might find that its share price was correlated with the price of that product; a derivative in that product could then be used to hedge shares in the company. Also, preference shares which behave like debt can be hedged by debt derivatives, such as bond futures; a purchase or sale of bond futures could therefore be a position in relation to those shares.

4.53 New subsection 160APHJ(2) also includes as possible positions embedded options, non-recourse loans and indemnities and guarantees. An embedded option is not an option, but an aspect of the price of something which behaves as if it were an option. For example, converting preference shares may convert into other shares on terms such as that up to a particular price (a notional strike price) the new shares received on conversion are of the same value as the money originally subscribed for the converting preference share, but above that price the new shares will be worth more than the money subscribed for the converting preference share. Such shares behave like debt with an option to purchase the new shares at the notional strike price, and are therefore said to have an embedded option, with a delta which can be calculated in the same way as for a real option. [Item 8, new section 160APHJ]

4.54 Similarly, a non-recourse loan, that is, a loan which is repayable only up to the value of certain property (eg. shares), effectively contains a put option to sell the shares to the lender, and a delta can be calculated in relation to this notional option. The value to a taxpayer of an indemnity or surety in respect of share losses would also behave like an option to sell shares.

Position in relation to shares or interests

4.55 In the absence of regulations, new subsection 160APHJ(2) provides that a position in relation to shares or an interest in shares is anything that has a delta in relation to the shares or interest. [Item 8, new subsection 160APHJ(2)]

4.56Delta is a well-recognised financial concept that measures the relative change in the price of an option or other derivative for a given small change in the price of an underlying asset. An option with a positive delta indicates that its price is expected to rise and fall with the underlying asset, while a negative delta indicates an inverse relationship.

4.57 For example, if a taxpayer writes or buys a call option over shares in a company, the taxpayer has taken a position in relation to those shares because the obligation or right under the option provides an opportunity for profit or loss by reference to the market value of the shares (ie. the option has a delta in relation to the shares rises and falls in share price will affect the option price).

4.58 New subsection 160APHJ(1) provides that regulations may specify:

•

what is a position;

•

when a position relates to particular shares or interests; and

•

how the delta of a position is to be calculated. [Item 8, new subsection 160APHJ(1)]

Short position

4.59 A short position in relation to shares is a position which has a negative delta in relation to those shares. This would include, for example, a short sale, a futures contract to sell shares, a sold call or a bought put, and a futures contract to sell a particular share index. [Item 8, new subsection 160APHJ(3)]

Long position

4.60 A long position in relation to shares is a position which has a positive delta in relation to those shares. For example, a share purchase, a bought future, a bought call and a sold put, and a futures contract to buy a particular index are long positions. [Item 8, new subsection 160APHJ(4)]

Net position

4.61 The net position of a taxpayer in relation to shares is calculated by adding the sum of the taxpayers long positions to the sum of the taxpayers short positions. [Item 8, new subsection 160APHJ(5)]

4.62 For example, if a taxpayer holds 1,000 shares and buys one call option with a delta of 0.9 and one put option with a delta of -0.4, the taxpayers net equity position would be determined by adding the deltas of the shares with the options:

[1,000 + (1,000 x -0.4) + (1,000 x 0.9)]/1,000 = 1.5


(The delta of the options is multiplied by 1,000 because option contracts are provided over a parcel of 1,000 shares).

Delta of position taken not to have changed

4.63 If a taxpayer acquires shares or interests in shares and takes a position in relation to the shares or interests, provided the taxpayer continues to hold the shares or interests and does not enter into any other positions in relation to the shares or interests, the delta of the position remains the delta of the position on the day on which the shares were acquired or the position was entered into, whichever is the later.

4.64 For example, a taxpayer buys 1,000 ordinary shares and subsequently sells a call option which has a delta of 0.5 on the day the option was sold. Later, the shares increase in price and the delta rises to 0.8. The relevant delta for the purposes of the provision would be 0.5, the delta on the day the option was sold. [Item 8, new subsection 160APHJ(10)]

Certain short positions ignored

4.65 If a taxpayer holds shares in a company whose sole or dominant business is producing, purchasing, consuming, trading or otherwise dealing in certain commodities and a taxpayer is a controller of the company for the purposes of section 160ZZRN, then short positions held by the taxpayer in its shares in the company are disregarded under new subsection 160APHJ(6) if the positions relate to one of the listed commodities and are taken in the ordinary course of the taxpayers business. The relevant commodities are set out in new subsection 160APHJ(7). The purpose of this exception is to prevent the holding period rule applying inappropriately to deny franking benefits and the intercorporate dividend rebate on dividends paid to a company by a wholly-owned mining subsidiary where the parent company has, in the ordinary course of its business, hedged against the commodity being mined.

4.66 If a life insurance company or superannuation fund passes on the full value of any franking rebate to the policy holders or members on whose behalf the relevant shares or interest in shares are held, and no effective tax deduction arises as a result, then any short positions held by the company or fund arising from the fact that the shares or interest are held on behalf of the members or policy holders are disregarded under new subsection 160APHJ(8) . It would be inappropriate for the company or fund to be denied the franking rebate under the holding period rule and related payments rule where the policy holders or members bear all the risks and opportunities of share ownership.

Positions of associates

4.67 Where, under an arrangement, an associate of the taxpayer has entered into a short position in relation to shares held by the taxpayer, the position is deemed to be a position entered into by the taxpayer. For example, if a taxpayer holds 1,000 ordinary shares in company A and, under an arrangement, company B (which is controlled by the taxpayer) writes a call option on ordinary shares in company A, the option position taken by company B will be deemed to be an option position taken by the taxpayer. [Item 8, new subsection 160APHJ(9)]

Material diminution of risk

4.68Regulations may prescribe the circumstances in which a taxpayer is taken to have materially diminished risk with respect to shares or an interest in shares. [Item 8, new subsection 160APHM(1)]

4.69 In the absence of regulations to the contrary, new subsection 160APHM(2) provides that a taxpayer is taken to have materially diminished the risks of loss and opportunities for gain with respect to shares or interests if the net position of the taxpayer results in the taxpayer having less than 30% of the risks and opportunities associated with the shares or interests. [Item 8, new subsection 160APHM(2)]

Examples

4.70 For example, a taxpayer who holds 1,000 shares in a company and writes a call option with a delta of 0.6 in respect of those shares will not have materially diminished risk with respect to the shares because the net position of the taxpayer in relation to the shares would be in excess of 0.3. To determine the net position, the delta of the sold call option is subtracted (because it is a short position) from the delta of the shares (the delta of a share against which the delta of an option or other derivative is calculated is, by definition, +1). Accordingly, the net position of the taxpayer in relation to the shares is:

[(1,000 X 1) - (1,000 x 0.6)]/1,000 = 0.4


4.71 In contrast, a taxpayer who holds 1,000 shares and writes a call option with a delta of 0.9 will have materially diminished risk with respect to the shares because the net position of the taxpayer in relation to the shares is 0.1.

4.72 It is possible to combine several options with a holding of shares to materially diminish risk with respect to those shares. For example, a taxpayer who holds 1,000 shares in a company and writes a call option with a delta of 0.5 and buys a put option with a delta of 0.4 will have materially diminished risk with respect to the shares. To determine the net position, the deltas of the call and put option are subtracted (because they are short positions) from the delta of the shares. Accordingly the net delta of the shares and options is:

[(1,000 x 1) - (1,000 x 0.5) + (1,000 x -0.4)]/1,000 = 0.1


4.73 Derivatives with different deltas should be added on a weighted basis. For example, if, in respect of a particular shareholding, a shareholder buys one call option with a delta of 0.4, two put options with a delta of 0.3 and three put options with a delta of 0.2 then, in respect of the shares, the total delta of the options is:

[(1,000 x 0.4) + (2000 x -0.3) + (3000 x -0.2)]/1,000 = -0.8


Therefore the net position in relation to the shares is:

-0.8 + 1 = 0.2


4.74 Similarly, through the use of various hedging techniques shares and options can be combined to produce a position where the taxpayer is not exposed to risk of loss. For example, a share trader who holds 600 shares in a company and writes a call option with a delta of 0.6 will have materially diminished risk with respect to the shares. This is because the net position of the taxpayer in relation to shares is less than 0.3:

[(600 x 1) - (1,000 X 0.6)]/1,000


4.75 In addition, if a taxpayer has entered into a forward sale of shares or a futures contract to sell shares, the taxpayer will be deemed to have diminished risk with respect to the shares because the taxpayers net position in relation to the shares would be less than 0.3. This is because the delta of the future or forward in relation to the shares would be -1. As a result, the net position of the taxpayer in relation to the shares would be:

[(1,000 x 1) - (1,000 x 1)]/1,000


When do beneficiaries under a trust have a material diminution of risk?

4.76 Some interests in shares held through a trust are inherently risk-less. For example, a potential income beneficiary of a discretionary trust cannot be said to bear the risks of loss or opportunities for gain from shares held by the trust. To prevent such risk-less holdings being used to circumvent the holding period rule, special provisions apply to interests in shares held through trusts.

4.77 New section 160APHL determines how beneficiaries under a trust calculate the extent of their interests. This calculation is required to determine whether the beneficiary is holding the relevant interest at-risk.

4.78 In calculating the extent of a beneficiaries interest, it is necessary to distinguish between the interest of a beneficiary in shares held by a widely-held trust (as defined below), and the interest of a beneficiary in shares held by other trusts. This is because, for beneficiaries of a widely held trust, it is the interest in all the shares held from time to time by the trust that is relevant in determining whether a beneficiary holds an interest at-risk for the requisite period, while for beneficiaries of trusts other than widely-held trusts it is the interest of the beneficiary in particular shares that is relevant. Therefore the interest in shares of a beneficiary of a widely-held trust is taken to be that beneficiaries share of the dividend income from all shares (or interest in shares) held by the trust in respect of which the beneficiary receives a distribution, expressed as a proportion of the total dividend income received by the trust in relation to those shares. On the other hand, the interest of a beneficiary in each share (or interest in shares) held by non-widely held trusts is that beneficiaries share in the income from that share, expressed as a proportion of the total dividend income received by the trust in relation to that share. [Item 8, new subsections 160APHL(5) and (6)]

4.79 For the purposes of calculating a beneficiaries net position under new subsection 160APHJ(5) , the interest in shares calculated in this way is a long position with a delta of +1 in relation to itself (in the same way that direct ownership of a share constitutes a long position in that share). [Item 8, new subsection 160APHL(7)]

4.80 However, this deemed long position is effectively cancelled by a matching short position for beneficiaries of trusts other than family trusts, deceased estate trusts and employee share scheme trusts (all of which are discussed below). After the effective cancellation of the deemed long position, and assuming there are no other positions held by the beneficiary which relate to the trust holding (see below), a beneficiary of these other trusts has a long position in only so much of the beneficiaries interest in the shares held by the trust as is a fixed interest. As a result, if a beneficiary of such a trust does not have a fixed interest and has no other long positions which relate to the trust holding, the beneficiaries net position in his or her interest in the shares held by the trust will be zero, and the beneficiary will have materially diminished risks of loss and opportunities for gain for the purposes of new sections 160APHO and 160APHP . The consequence of having materially diminished risks and opportunities is that days on which this occurs are not counted in determining whether the beneficiaries interest in the shares has been held for the requisite period. [Item 8, new subsection 160APHL(10)]

4.81 For these purposes an interest is fixed if it is vested and indefeasible. An interest may be defeasible if it is redeemable for less than its value, or if its value can be materially reduced by the creation of other interests in the trust (which, in the case of a unit trust, includes the issue of further units). Special provisions apply in determining whether a unit-holder in a unit trust has a vested and indefeasible interest. [Item 8, new subsections 160APHL(12) and (13)]

4.82 Even if an interest is not fixed and indefeasible, the Commissioner may, in appropriate circumstances, deem it to be so. For example, it may be appropriate to exercise this discretion, if necessary, in relation to beneficiaries of certain hardship trusts (eg. trusts established under workers compensation legislation). [Item 8, new subsections 160APHL(14) and (15)]

Definitions of widely-held trusts, family trusts, deceased estate trusts and employee share scheme securities

4.83 New section 160APHD provides a definition of widely-held trust. A trust is a not a widely-held trust if it is a non-fixed trust (as defined in Schedule 2F of the ITAA 1936) or a closely-held fixed trust. A trust is a closely-held fixed trust if 20 entities (which include natural persons) or less (none of whom is an associate of any of the others) have interests in the trust that together entitle them to 75% or more of:

•

the beneficial interests in the income of the trust; or

•

the beneficial interests in the property of the trust.

4.84 In this context, beneficial interests refer to the immediate beneficial interests of beneficiaries of a trust and not the ultimate beneficial interests. For example, a trust with only two superannuation funds as beneficiaries would not be widely-held even though there may be many ultimate beneficiaries of the trust (ie. the superannuation fund members). Also included in the definition of widely held trusts are unit trusts where the trustee is eligible to make an election under subsection 160APHR(1) to apply the benchmark portfolio ceiling approach irrespective of whether the election is actually made. [Item8, new section 160APHD]

4.85 Schedule 2F to ITAA 1936 provides the definition of a family trust used for the purposes of the holding period rule. To ensure that a trust is not precluded from making a family trust election merely because the beneficiaries are unable to control the trustee, the definition in Schedule 2F has been modified by the Bill to include a category of trust where the only group able to benefit under the trust are family members. Thus a damages trust administered for the benefit of a disabled accident victim could be a family trust, even though the beneficiary is not necessarily in a position to control the trust. [Item 24, new paragraph 272-87(g)]

4.86 Deceased estate trusts are estates administered by executors or administrators: they are not trusts created by will. [Item 8, new paragraph 160APHL(10)(b)]

4.87 Employee share scheme trusts are trusts established to provide shares to employees under an employee share scheme for the purposes of Division 13A of Part III of the ITAA 1936, provided that any forfeiture condition relating to the scheme does not extend beyond 10 years. However, for the purpose of the employee share scheme concession under the holding period rule and related payments rule, employee share schemes include schemes where shares are acquired at or above market value. [Item 8, new section 160APHD definition of employee share scheme security]

Other positions

4.88 Apart from the long position mentioned in new subsection 160APHL(7) , and the long position constituted by a beneficiaries fixed and indefeasible interest in the shares held by the trust, in working out whether there has been a material diminution of risk the beneficiaries other long and short positions are also counted.

4.89 In the case of trusts other than widely-held trusts, these other positions include positions of the trustee which are imputed to the beneficiary because they relate to the beneficiaries interest in the shares. A position of the trustee relates to a beneficiaries interest if:

•

the position relates to shares in which the beneficiary has a vested and indefeasible interest; or

•

the beneficiary stands to directly gain a benefit or suffer a loss from the position.

[Item 8, new subsections 160APHL(8) and (9)]

4.90 For example, a closely-held fixed trust established in January 1998 with two beneficiaries entitled to share equally in the trust income and capital (ie. they have equal fixed interests in the corpus) holds 1,000 shares in a company which were acquired at the time of the trusts establishment. In October 1998 the trustee appoints a third beneficiary, who shares in the trust income and capital equally with the original beneficiaries. At the same time the trustee buys a deep-in-the-money put option with a delta of -0.8 as against the shares (so that the risk with regards to the shares is materially diminished).

4.91 In this example, the original beneficiaries will continue to be eligible for franking benefits and the intercorporate dividend rebate in relation to dividends paid on the shares (provided they are not under an obligation to make a related payment) because they have held their interest in the shares at risk for the requisite period. However, the position entered into by the trustee in respect of the shares will be deemed to be a position of the beneficiaries. As a result, the new beneficiary will not be entitled to franking benefits because the beneficiary will not have held an interest in the shares for the requisite period of time to qualify for franking benefits and the intercorporate dividend rebate.

Example of the operation of new section 160APHL

4.92 Assume the trustee of a trust which is not a family trust, deceased estate trust or employee share scheme trust holds 2000 shares and that a beneficiary is entitled to half the dividends from those shares. The beneficiaries interest in those shares will be 50% of the trustees holding, or 1,000 shares. However, this long position is offset by a matching short position under new subsection 160APHL(10) , leaving the beneficiary with a long position of only so much of the beneficiaries interest as is a fixed interest. If the beneficiary does have a fixed interest of 30% or greater in the 1,000 shares (ie. the equivalent of 300 shares), then there will not be a materially diminished risk in respect of the interest in the shares. On the other hand, if the beneficiary has a lesser fixed interest, or no fixed interest, in corpus (eg. because the beneficiary is only a discretionary object of the trust) there would be a material diminution of risk.

When does the 45 or 90 day holding have to take place?

4.93 The relevant holding period has to occur during the qualification period. For the holding period rule the relevant qualification period is the primary qualification period; for the related payments rule it is the secondary qualification period. New section 160APHD defines the primary qualification period as the period commencing on the day after the day the taxpayer acquires the shares or interest, and ends on the 45th day (or 90th day for preference shares) after the day on which the shares or interests become ex-dividend. The secondary qualification period, if the shares are not preference shares,is defined as the period commencing on the 45th day before, and ending on the 45th day after, the day on which the shares or interest become ex-dividend. If the shares are preference shares, the secondary qualification period commences on the 90th day before, and ends on the 90th day after, the day on which the shares or interest become ex-dividend.

4.94 If a taxpayer is not under an obligation to make a related payment in relation to a dividend or distribution, the taxpayer will have to satisfy the holding period requirement within the primary qualification period. If a taxpayer is under an obligation to make a related payment in relation to a dividend or distribution, the taxpayer will have to satisfy the holding period requirement within the secondary qualification period.

4.95 For these purposes, a share or interest becomes ex-dividend on the day after the last day on which the shares or interest in shares can be acquired by a taxpayer so as to become entitled to the dividend or distribution on the shares or interest. For example, if a company declares a dividend on 1 June, to be paid on 30 June, and the dividend can be paid to a shareholder who held shares up until 25 June (but no later), then the ex-dividend day is 26 June. [Item 8, new section 160APHE]

4.96 Therefore, a taxpayer who acquires shares on the day before the ex-dividend day will be a qualified person (for the purposes of the holding period rule) in relation to a dividend for the purposes of new section 160APHO provided the taxpayer immediately thereafter holds the shares for the requisite period.

What is a related payment?

4.97 A taxpayer or associate is taken for the purposes of the provisions to have made a related payment if the taxpayer or associate is under an obligation to pass the benefit of a dividend or distribution to other persons. The requirement that the benefit be passed on means that if the benefit of the dividend or distribution remains with the taxpayer, there will not be a related payment. For example there will not be a related payment merely because a dividend is paid directly into the taxpayers bank account. [New section 160APHN]

4.98 Although new section 160APHN uses the expression related payment it is immaterial whether an actual payment or some other method is used to pass the benefit of the dividend to another person; any method of passing the benefit of a dividend to another person may be a related payment within the meaning of the section. New subsection 160APHN(3) provides the following examples as transactions which may constitute the making of a related payment:

•

any distribution, whether in money or other property, which is equal to, calculated by reference to or approximates the amount of the dividend or distribution;

•

any amounts which are credited or notionally credited (explained below) to a party to the arrangement which are calculated by reference to, equal to or approximates the amount of the dividend or distribution; and

•

any amounts payable to a party to the arrangement which are calculated by reference to, equal to or approximates the amount of the dividend or distribution. [Item 8, new subsection 160APHN(3)]

Notional crediting

4.99 Because a person does not need to receive an actual payment to receive the economic benefit of a dividend, a related payment includes a notional crediting of an amount which is calculated by reference to the amount of the dividend or distribution. A notional crediting of an amount usually involves having the extent of a persons obligation under an arrangement (eg. a futures contract or warrant arrangement) determined by a formula which is calculated by reference to the amount of the dividend. A notional crediting differs from an actual crediting in that the dividend amounts are not actually attributed to the relevant person, that is, the relevant person has no actual rights in relation to the dividend . [Item8, new subsection 160APHN(6)]

4.100 For example, holders of endowment warrants have their obligation under the warrants (ie. price payable on completion of the warrants) reduced by the amount of dividends received by the issuing institution; however, the warrant holders cannot demand payment of the dividends in lieu of having the dividends offset against their obligations. Similarly, the buyer in a futures contract cannot demand that the seller pass on the cash amount of the dividend. The buyer is only able to receive the benefit of the dividend indirectly when the futures contract is settled.

4.101 Accordingly, if the amount payable on maturity of a security is calculated by reference to the amount of the dividend, the specific inclusion of the dividend amounts in the calculation of the amount payable will be a related payment.

Other examples of related payments

4.102 The following will also be related payments, provided they are calculated by reference to the amount of the dividend:

•

amounts which are credited by way of discounts on debt securities;

•

a partial, total or notional offset of interest payable on a loan arrangement; or

•

an amount representing capitalised interest which is payable on the maturity of a security.

4.103 Likewise, where the price paid for a security includes an estimated dividend component, the offset of the interest component by the estimated dividend component will be a related payment. For example, the theoretical price of a share under a futures contract is usually calculated by taking the current market price, adding interest on the outstanding share price for the term of the contract, and subtracting expected dividends: the subtraction from the price of the expected dividends is a related payment.

4.104 Apart from cases where a payment or crediting relates to a particular dividend, there are cases where payments or credits are made in respect of a number of dividends, for example, under index derivatives. Where dividends are received from a number of shares and there is a matching outgoing under an index derivative, there may be a related payment. In some cases the related payment may be calculated in respect of dividends on shares which do not exactly match those held by the taxpayer. However, the match need not be exact for the payment to be a related payment, provided it is substantially the same. This is because small discrepancies in the relevant parcels of shares, particularly those shares with a low weighting in an index, will not necessarily prevent the payment under the derivative from effectively passing the benefit of the dividends to the counterparty. Generally, a correspondence between a share parcel and an index derivative which is sufficiently close to reduce risk materially in a qualification period will, if the index derivative requires a dividend equivalent benefit to pass to the holder of the derivative, also be sufficiently matched with the dividends on the parcel to constitute a related payment.

Share price index (SPI) and other futures

4.105 It is necessary for the related payments rule to apply to Share Price Index (SPI) future transactions where the seller of the future hedges by holding the physical stock (ie. a share portfolio which is closely correlated with the All Ordinaries Index (AOI)) and effectively credits the buyer with the estimated dividends on the shares through the price against which the contract is agreed to be settled. This is because otherwise such transactions could be used to generate inappropriate tax benefits. Such benefits would come about because the tax payable on the dividends is offset by the seller paying less tax on the profit on the futures transaction or generating a greater loss (by virtue of the fact that the seller receives less cash on settlement of the contract). The seller, however, remains in the same economic position because any reduction in cash received on the futures transaction is offset by the dividend income. In this case the profit made (and therefore the tax paid) by the seller on the sale price does not include the amount of the expected dividends so that, when the dividends are received, there has been an effective tax deduction against them. Any rebates attaching to the dividend are therefore used to offset the tax payable on other income. Taxpayers entering into such transactions are indifferent to rises and falls in the price of the shares, because any losses or gains made by the seller on the shares will be offset by equivalent gains or losses on the SPI contract.

4.106 In relation to equity swaps the financial institution which holds the legal title to shares is required to pay the counterparty an amount equivalent to the dividends received by it plus any capital gains under an obligation which is represented by the swap arrangement. The financial institution is under an obligation to make a related payment because under the swap arrangement the institution is obliged to pay the counterparty an amount which is calculated by reference to the amount of the dividend.

Sales of subsidiary companies

4.107 New section 160APHNA provides an exception to the related payments rule for dividends paid within 6 months of the sale of a group company out of profits which it is reasonable to regard as attributable to the period of ownership of the selling company.

4.108 If a parent company, whether resident or non-resident, sells a resident subsidiary company, the risks of ownership and opportunities for gain will generally pass to the buyer because a contract of sale is in place. If the seller is entitled under the contract to cause the subsidiary to distribute dividends to it, and to reduce the sale price accordingly, the reduction in the sale price would be a related payment under the current provisions, and consequently the inter-corporate dividend rebate would be denied. However, this would prevent holding companies from extracting the franking credits attributable to what are, in substance, their own taxed profits from their subsidiaries once a contract of sale was agreed. By deeming such reductions not to be related payments (provided the dividend is paid within six months of the contract to sell), the selling shareholder is afforded a reasonable opportunity to extract its own taxed profits from the company along with the franking credits applicable to them.

(b) Formula-based ceiling for certain taxpayers

4.109 The above paragraphs explained how the related payments rule and the general holding period rule operate. Below is an explanation of special cases where the taxpayer may be a qualified person irrespective of how long the shares or interests in shares are held.

4.110 The Bill provides that certain eligible taxpayers may elect to have franking credit or rebate ceilings applied in accordance with a particular formula on shares or interest in shares managed as or in a discrete fund. These eligible taxpayers are:

•

listed widely-held trusts; [Item 8, new paragraph 160APHR(1)(a)]

•

unlisted very widely held trusts; [Item 8, new paragraph 160APHR(1)(b)]

•

life assurance companies; [Item 8, new paragraph 160APHR(1)(c)] ;

•

general insurance companies; [Item 8, new paragraph 160APHR(1)(d)]

•

friendly societies; [Item 8, new paragraph 160APHR(1)(e)]

•

health insurance funds; [Item 8, new paragraph 160APHR(1)(f)]

•

trustees of complying superannuation funds, other than excluded superannuation funds (which have fewer than five members and are subject to less regulation than larger funds); [Item 8, new paragraph 160APHR(1)(g)]

•

trustees of funds which are complying approved deposit funds (ADFs), other than excluded ADFs; [Item 8, new paragraph 160APHR(1)(h)]

•

trustees of unit trusts which are pooled superannuation trusts; [Item 8, new paragraph 160APHR(1)(i)]

•

any other taxpayers who are declared by regulations to be an eligible taxpayer for the purposes of the election; and [Item 8, new paragraph 160APHR(1)(j)]

•

unit trusts where at least 75% of the units are owned by any of the above entities (or entities unable to benefit from franking or the intercorporate dividend rebate, namely non-residents and tax-exempt entities). [Item 8, new paragraph 160APHR(1)(k) and new section 160APHS]

4.111 These taxpayers are treated differently because they would incur high compliance costs in meeting the requirements of the holding period rule, and because they are considered to be low revenue risk taxpayers. Moreover, their investment activities make comparison with a share index benchmark an appropriate alternative to the holding period rule.

4.112 The regulations can also provide for the inclusion of other low revenue risk taxpayers as eligible for making an election; such taxpayers generally also need to be subject to high compliance costs in applying the holding period rule. In this regard, closely-held investment vehicles and geared funds are likely to be higher revenue risk than low turn-over and fully invested funds, as well as funds owing a high level of fiduciary duties to investors; a high turn-over of shares, investments spread over a number of different funds and frequent use of derivatives are indicia of high compliance costs. [Item 8, new paragraph 160APHR(1)(j)]

4.113 An election to have a franking credit or rebate ceiling applied is irrevocable without leave of the Commissioner.

4.114 An eligible taxpayer who makes such an election is deemed to be a qualified person for the purposes of new section 160APHO in relation to every dividend paid in relation to the shares or interest in shares in respect of which the election is made during the time the election is in force. [Item 8, new subsection 160APHR(8)]

4.115 The election will not apply in relation to shares or interests which are subject to equity swaps or securities lending arrangements attracting the related payments rule. Therefore, if an eligible entity enters into such an arrangement, the entity is taken not to be a qualified person in relation to the dividend or distribution paid on the shares or interest which form the subject of the arrangement. Accordingly, if a superannuation fund enters into an equity swap where the fund is the legal holder of the shares but it is under an obligation to make a related payment with respect to the dividends paid on the shares, the election to have a franking rebate ceiling will not apply in relation to those shares. [Item 8, new subsections 160APHR(3) and 160APHR(4)]

4.116 If the Commissioner has made a determination under subsection 177EA(5) (the general anti-avoidance rule) in respect of dividends or distributions paid on shares or interests in shares, the Commissioner may also determine that the election to apply a franking credit or rebate ceiling made by the relevant taxpayer is effectively revoked. [Item 8, new subsection 160APHR(9)]

4.117 Where the following conditions are satisfied:

•

there is an election in force in relation to shares or interests;

•

the Commissioner is of the opinion that the taxpayer has entered into an arrangement with a third party (eg. the asset overlay manager) or an associate; and

•

pursuant to the arrangement, the third party or associate has taken a position which materially diminishes the risks of loss and opportunities for gain in relation to the shares or interests but is not taken into account when calculating the net equity exposure under new subsection 160AQZF(2) ;

the relevant short positions are taken into account for the purposes of calculating the net equity exposure of the fund or taxpayer, and the Commissioner may determine that the election made by the relevant taxpayer ceases to have effect. [Item 8, new subsection 160APHR(10)]

Calculation of the franking credits ceiling

4.118 The maximum franking credits a taxpayer is entitled to during a year of income from dividends or distributions paid on shares and interests in shares held directly or indirectly by the taxpayer, which are managed by the taxpayer, or on the taxpayers behalf, as or in a discrete fund, is not to exceed the ceiling amount in relation to the fund. If, for example, the taxpayer holds $100 million of shares which are divided into two $50 million funds, one managed by Fund Manager A, the other managed by Fund Manager B, the ceiling amount applies separately in relation to each fund. Where the ceiling amount has been exceeded, a franking debit will arise to reduce a companies total franking credit claim for an income year. [Item 22, new subsection 160AQZE(1)]

4.119 For a particular year of income, unless regulations prescribe otherwise, the ceiling amount in relation to a fund is the notional total credit amount increased by 20%. [Item 22, new subsection 160AQZE(3)]

4.120 The notional total credit amount in relation to a fund is, unless regulations prescribe otherwise, the total amount of franking credits to which the taxpayer would be entitled in respect of dividends on shares which become ex dividend during the year of income on a benchmark portfolio of shares (explained below). [Item 22, new subsection 160AQZE(4)]

4.121 Therefore the total amount of franking credits a taxpayer would be entitled to would depend on the franked dividend yield of the relevant benchmark portfolio. If the taxpayer is a life assurance company paid a class A franked dividend and the company is entitled to a class A franking credit then, in calculating the sum of the franking credits to which the company is entitled under new section 160AQZE , the class A franking credits are converted into equivalent class C franking credits (for other companies, no entitlement to a class A franking credit arises because such credits are converted into class C franking credits under section 160ASI of the ITAA 1936). The benchmark yield is to be the yield calculated for the taxpayers income year. [Item 22, new subsection 160AQZE(2)]

4.122 Where a fund exists for only part of a year of income, the ceiling amounts for franking credits and franking rebates and intercorporate dividend rebates will be calculated on the basis of the shares in the benchmark portfolio which become ex-dividend during that part of the year during which the fund exists. [Item 22, new subsections 160AQZE(5) and 160AQZE(6)]

Calculation of the franking rebate and intercorporate dividend rebate ceiling

4.123 New section 160AQZF provides for the calculation of the maximum franking and intercorporate dividend rebates a taxpayer is entitled to from dividends or distributions paid on shares (and interests in shares) held (directly or indirectly) by the taxpayer, which are managed by the taxpayer, or on the taxpayers behalf, as or in a discrete fund. The ceiling is calculated in an equivalent way to the calculation of the franking credit ceiling for companies (see paragraphs 4.112-4.115 above). [Item22, new section 160AQZF]

Calculation of the ceiling for dividends received through trusts and partnerships

4.124 Trusts and partnerships receiving dividends (directly or indirectly from other trusts or partnerships) are not entitled to franking benefits or the intercorporate dividend rebate, but such benefits can flow through to the ultimate beneficiaries or partners.

4.125 If a trust is of a kind mentioned in new subsection 160APHR(1) , or a partnership is prescribed in regulations as being eligible to make an election under that section, the trust or partnership may elect to have a franking credit or rebate ceiling applied against shares or interests in shares managed as or in a discrete fund. In such a case the flow through of franking benefits or the intercorporate dividend rebate to the ultimate beneficiaries or partners needs to be limited by reference to the ceiling.

4.126 To implement this, new section 160AQZG limits the potential rebate amount flowing through the trust or partnership (ie. the mechanism used in Part IIIAA of the ITAA 1936 to allow franking benefits to flow through a trust or partnership), while new section 45ZB caps the intercorporate dividend rebate available to corporate beneficiaries or partners that receive dividends indirectly through one or more interposed trusts or partnerships. [Item 8, new section 160AQZG, Item 5, new section 45ZB]

Standard benchmark portfolio

4.127 The standard benchmark portfolio applicable in respect of a fund managed by or on behalf of a taxpayer is to be a portfolio comprising the All Ordinaries Index (AOI) equal in value to the net equity exposure of the fund for the relevant year of income. [Item 22, new paragraph 160AQZH(1)(a)]

4.128 Some portfolios will legitimately have a higher franked dividend yield than an equivalent AOI holding. For example, a portfolio that matches the Banks and Finance Index will generally have a higher franked yield than one matching the AOI. To allow for this, taxpayers whose equity portfolio matches, or has a sufficient weighting towards, a recognised share index will be able to benefit from the higher yield such an index provides. In a few cases, the AOI may be inappropriately high; for example, where a fund specialises in low yielding or unfranked stocks. Accordingly, new paragraph 160AQZG(1)(b) allows for the making of regulations providing details of alternative benchmark portfolios. However, until those regulations are made taxpayers will be required to adopt the standard (AOI) benchmark portfolio. [Item 22, new paragraph 160AQZH(1)(b)]

Net equity exposure

4.129 To compare the franked yield from the taxpayers fund with the benchmark portfolio, it is necessary to determine the net equity exposure of the fund for a year. Unless regulations prescribe otherwise, this is to be determined generally by calculating an average for the year based on weekly figures. [Item 22, new subsection 160AQZH(4)]

4.130 In calculating the net equity exposure of a particular fund for the purposes of the holding period rule, any positions which the taxpayer has which are subject to equity swaps or securities lending arrangements where the taxpayer is under an obligation to make a related payment with respect to the relevant dividends are ignored for the purposes of determining the net equity exposure of the fund. Therefore, in calculating the net equity exposure of the fund, the long position comprising the shares and the short position represented by the offsetting obligation are not taken into account when calculating the net equity exposure of the fund. [Item 8, new subsection 160APHR(5)]

4.131 For example, if Fund Manager A (who manages a fund of $50 million) has derivatives which, as against the shares held in the fund, have a delta of -0.1, the net equity exposure of the fund is:

(50 million x 1) + (50 million x -0.1) = 45 million


Example of application of the ceiling

4.132 Suppose a complying superannuation fund (which is not an excluded fund) holds an equity portfolio with an average market value of $100 million and derivatives which, as against the shares, have a delta of minus 0.05 so that the net equity exposure would be $95 million. The AOI has, for example, a 4% yield (70% franked) which would provide a franking rebate on a $95 million portfolio of $1.5 million ($95million 4% 70% 36/64). Therefore the taxpayer will be able to claim a franking rebate of up to $1.5 million plus 20% (ie. $1.8 million). Any rebate above $1.8 million will be denied.

(c) Small shareholder exemption

4.133 Taxpayers who are natural persons (ie. not companies, trusts or partnerships) can also elect to have a franking rebate ceiling applied in relation to a year of income. If a natural person taxpayer makes such an election, the taxpayer is a qualified person for the purposes of the holding period rule in relation to every dividend paid during that year of income. [Item 8, new section 160APHT]

4.134 Under new section 160APHT , all natural persons will be able to elect to apply a franking rebate ceiling instead of satisfying the holding period rules. This ceiling will apply to franked income from all sources, not just from shares held directly by the taxpayer. For example, a franked distribution from a trust is included. [Item 22, new subsection 160AQZJ(1)]

4.135 However, an electing taxpayer will not be taken to be a qualified person in relation to a dividend or distribution if the related payments rule applies to the dividend or distribution.

4.136 New subsection 160AQZJ(1) provides that the sum of the franking rebates claimed by a natural person who has made an election in accordance with new section 160APHT is not to exceed the amount specified in new subsection 160AQZJ(2) . [Item 22, new section 160AQZJ]

4.137 Under new subsection 160AQZJ(2) the maximum franking rebate is calculated by adding all franking rebates to which the relevant person would have been entitled if the taxpayer was a qualified person in relation to all dividends and trust and partnership distributions received in the income year in which the taxpayer has made the election, and subtracting $4 for every $1 of franking rebate in excess of $2,000. [Item 22, new subsection 160AQZJ(2)]

4.138 For example, a taxpayer who has made an election with a franking rebate of $2,001 would not be entitled to the rebate in excess of $2000 and will also have the remaining rebate reduced by $4, leaving an entitlement to a rebate of $1,996.

4.139 Taxpayers must elect to apply the threshold in relation to a particular year. If no election is made the ordinary holding period rule applies. The election need not be in a particular form.

4.140 A deduction is allowable for the gross-up amount of a dividend included in assessable income (eg. under section 160AQT) for which the taxpayer is denied a franking rebate. The maximum deduction allowable is $2,500. [Item 22, new section 160AQZK]

(d) Shares issued in connection with winding up

4.141New section 160APHQ provides that if shares are issued and cancelled in the course of winding up a company and a dividend is paid on those shares, the taxpayer who holds the shares or an interest in the shares is a qualified person in relation to the dividend for the purposes of the holding period rule. However, if, for example, shares are issued in the course of winding up and then within 45 days are disposed of to a third party (as opposed to the issuing company), the taxpayer will not be a qualified person in relation to any dividends paid on the shares (this exception has been created because companies sometimes issue shares in the course of winding up to capitalise debt).

4.142 However, new paragraph 160APHQ(c) excludes dividends which attract the related payments rule.

Beneficiaries of a widely held trust

4.143 A taxpayer who holds an interest in shares as a beneficiary of a widely-held trust on which a distribution has been paid will be a qualified person in relation to any dividend paid on the shares from which the distribution is derived if the taxpayer has held the interest in shares during the relevant qualification period in relation to the interest (ie. if the taxpayer or associate is under an obligation to make a related payment with respect to the distribution, the secondary qualification period, and if the taxpayer or associate is not under an obligation to make a related payment, the primary qualification period), not counting the day of acquisition or disposal, for 45 days. [Item 8, new subsection 160APHP(1)]

4.144 Unlike closely-held trusts, where a trustee of a widely-held trust enters into a position with respect to shares or an interest in shares (relevant shares) which form the property of the trust, the beneficiaries of the trust are not deemed to have entered into a proportionate position with respect to their interests in the relevant shares.

4.145 Therefore, beneficiaries of widely-held trusts do not have to be concerned with whether the trustee of the trust has taken a position with respect to the shares in the trust property. Only positions entered into personally by the beneficiary can materially diminish risk in relation to the beneficiaries interest. Provided the beneficiary personally satisfies the holding period requirements, the beneficiary will be a qualified person. [Item 8, new subsection 160APHO(2)]

What is the effect of not being a qualified person in relation to a franked dividend or distribution?

4.146 Where a taxpayer is not a qualified person in relation to a dividend or distribution, the taxpayer will be denied the franking credit (and therefore the franking rebate) and the intercorporate dividend rebate on the dividend or distribution.

4.147 As a result, the Bill will amend:

•

section 160APP so that no franking credits arise upon the receipt of franked dividends if the company in receipt of the dividends is not a qualified person in relation to those dividends; [Item 9, amended subsection 160APP(6)]

•

section 160APQ so that no franking credit arises in respect of a trust or partnership amount included in a companies assessable income if the company is not a qualified person in relation to the relevant dividend (ie. the dividend to which the trust or partnership amount is attributable); [Items 10 and 11, new paragraphs 160APQ(1)(c) and 160APQ(2)(c)]

•

section 160AQT so that no gross-up is made (and hence no entitlement to the franking rebate under section 160AQU arises) upon the receipt of a franked dividend if the taxpayer who receives the dividend is not a qualified person in relation to the dividend; [Items 12 to 16, new paragraphs 160AQT(1)(ba), 160AQT(1AB)(ba), 160AQT(1A)(ba) and 160AQT(1C)(ba)]

•

section 45Z so that, for the purposes of determining whether company beneficiaries or partners will be entitled to the intercorporate dividend rebate, the trust or partnership distribution will not carry the right to an intercorporate dividend rebate if the company is not a qualified person in relation to the relevant dividend; [Items 1 to 4 , new paragraphs 45Z(1)(ca) and 45Z(3)(ca) and new subparagraphs 45Z(2)(c)(iia) and 45Z(4)(c)(iia)]

•

sections 160AQX, 160AQY, 160AQYA, 160AQZ and 160AQZA so that no franking rebate arises in respect of a trust or partnership amount included in a taxpayers assessable income, if the taxpayer is not a qualified person in relation to the relevant dividend; [Items 17 to 21, new paragraphs 160AQX(ca), 160AQY(ba), 160AQYA(1)(ca), 160AQYA(2)(ca) and 160AQZ(ca)]

•

section 46 and 46A so that a company in receipt of a dividend will not be eligible for the intercorporate dividend rebate if the company is not a qualified person for the purposes of Division1A in relation to the dividend. [Items 6 and 7 , new subsections 46(2B) and 46A(5B)]

Adjustments in relation to section 160AQT amounts

4.148 The amendments to sections 160AQX, 160AQY, 160AQYA, 160AQZ and 160AQZA will prevent a beneficiary or partner gaining franking credit benefits from a trust or partnership distribution if the relevant beneficiary or partner is not a qualified person for the purposes of Division 1A .

4.149 However, as section 160AQT requires an amount to be included in the assessable income of the trust or partnership to gross-up the dividend, a beneficiaries or partners share in the net income of the trust or partnership would be inappropriately increased.

4.150 Therefore the Bill will provide a tax deduction for a trust or partnership amount included in a taxpayers assessable income where the taxpayer is not a qualified person for the purposes of Division 1A in relation to the relevant dividend. The amount of the deduction is to be the same as the amount currently allowed under section 160AR, ie. the potential rebate amount. For the purposes of sections 111C, 116CF,116H and 116HB of the ITAA 1936, this deduction relates exclusively to the trust or partnership amount referred to in new paragraph 160ARAB(1)(a) or 160ARAB(2)(a) . [Item 23 , new section 160ARAB]

Regulation Impact Statement: Franking credit trading (Holding period and related payments rules)

Specification of policy objective

4.151 The policy objective is to prevent franking credit trading by requiring that:

•

shares be held at-risk for more than 45 days before a shareholder is entitled to the franking credit and intercorporate dividend rebate (the holding period rule); and

•

shares held by taxpayers who are under an obligation to make a related payment with respect to a dividend paid on the shares be held at-risk for more than 45 days during the relevant qualification period before the shareholder is entitled to the franking credit and intercorporate dividend rebate (the related payments rule).

4.152 These measures form part of a package of measures to prevent franking credit trading which were announced in the 1997-98 Budget. The holding period rule applies from 1 July 1997 and the related payments rule applies from 13 May 1997.

Identification of implementation options

Background

4.153 One of the underlying principles of the dividend imputation system is that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves. Franking credit trading, which broadly is the process of transferring franking credits on a dividend from investors who cannot fully use them (such as non-residents and tax-exempts) to others who can fully use them, undermines this principle. Similarly, franking credit trading transactions can also pose a threat to the revenue where the dividends paid are rebatable under section46 of the ITAA 1936 because they are paid to a company shareholder.

Implementation Option

4.154 The holding period and related payments rules deny franking credits and the intercorporate dividend rebate on dividends paid to holders of shares whose interest in the company is insufficient to justify the receipt of franking and other benefits accorded to true economic owners of shares.

4.155 The holding period rule applies to deny franking credits or the intercorporate dividend rebate where the taxpayer acquires shares or interests in shares and disposes of them (or equivalent shares or interests) within 45 days (or 90 days in the case of preference shares).

4.156 The related payments rule applies to deny franking credits or the intercorporate dividend rebate where the taxpayer is under an obligation to make a related payment in respect of a dividend and the taxpayer has not held the relevant shares at-risk for more than 45 days (or 90 days in the case of preference shares) during the relevant qualification period.

4.157 In determining whether shares or interests are held for the requisite period, days during which there is in place a risk diminution arrangement (eg. if the shareholder has eliminated the risks and opportunities of share ownership by entering into a derivative transaction) are not counted.

4.158 An alternative approach to the holding period rule is available for certain taxpayers (eg. superannuation funds and life companies) who face substantial compliance difficulties under the standard operation of the rule and which represent a relatively low risk to the revenue because of various regulatory and prudential requirements. This approach, referred to as the formula approach, reduces compliance costs by allowing eligible taxpayers to compare the actual franked return on a portfolio with a franked return on a benchmark portfolio consistent with the taxpayers net equity exposure instead of applying the holding period rule. The ratio of franking rebates or credits to equity exposure must be within a specified limit; the taxpayer will not be entitled to any rebates or credits in excess of that allowed by the ratio.

4.159 Individual shareholders (natural persons) entitled to a franking rebate of $2,000 dollars or less annually will also be exempt from the holding period rule, thereby eliminating compliance costs on small individual shareholders.

4.160 Taxpayers electing to apply the alternative approach and individual taxpayers claiming franking rebates of $2000 dollars or less will, however, still be required to comply with the related payments rule. Therefore, if an electing taxpayer is under an obligation to make a related payment in respect of a dividend, the taxpayer will be required to hold the relevant shares for more than 45 days at-risk (or 90 days in the case of preference shares) during the relevant qualification period.

Assessment of impacts (costs and benefits) of each implementation option

Impact group identification

4.161 The holding period rule will affect taxpayers, who buy and sell shares within 45 days, and taxpayers who enter into risk diminution arrangements (eg. derivative transactions) within 45 days of acquiring shares. The related payments rule will affect taxpayers who have diminished risk with regards to their shares during the relevant qualification period and who are under an obligation to make a related payment with respect to a dividend. These taxpayers typically include share traders, options traders, merchant banks and investment companies. The rules will also affect members of the legal and accounting professions who advise these taxpayers.

4.162 The holding period and related payments rules will also have an impact on the ATO (in administering the rule, for example, information campaigns), the Government (in that the revenue base will be protected) and non-residents and tax-exempt shareholders (whose ability to transfer franking credits will be hampered).

4.163 Certain institutional investors such as superannuation funds will not be required to comply with the holding period rule because they will be able to adopt the formula approach. Similarly, as mentioned above, small individual shareholders will also be exempted from the holding period rule.

4.164 It is not possible to provide any numerical data on the numbers of taxpayers in particular stakeholder groups or the extent of their interests. This is because shares are often held through complicated trust, nominee or group company arrangements, or funds are invested by fund managers on behalf of clients. Accordingly, underlying ownership is difficult to trace.

Analysis of the costs and benefits associated with each implementation option

4.165 Certain institutional investors (such as superannuation funds) and natural person taxpayers with franking rebates of less than $2000 have been carved-out of the holding period rule because the policy objective of the rule is to prevent franking credit trading and not to inhibit legitimate risk management or bona-fide share investment. The absence of the carve-out would result in the legislation going beyond the Governments policy objective and attacking commercial transactions that do not have the effect of a franking credit trade.

4.166 The regulatory regime and the prudential requirements placed on entities like superannuation funds and life assurance companies (ie. restrictions on gearing and use of derivatives) make it more difficult for these entities to engage in franking credit trading. In addition, as noted above, these taxpayers have been given a different treatment because they would incur high compliance costs in meeting the requirements of the holding period rule, and because they are considered to be low revenue risk taxpayers. Moreover, their investment activities make comparison with a share index benchmark an appropriate alternative to the holding period rule.

4.167 Natural person taxpayers claiming franking rebates of $2000 or less are unlikely to be engaging in franking credit trading because the transaction costs associated with a franking credit trading scheme would result in the elimination of any tax benefit derived.

4.168 The threshold has been set so that an individual investor with a share portfolio of between $50,000 and $100,000 could be within the exemption (depending on the yield). Accordingly, any investors outside the threshold would not be within the small investor category. Data provided by the Revenue Analysis Branch of the Australian Taxation Office indicates that the number of individual taxpayers claiming franking rebates (imputation credits) of up to $2000 in the 1996 income year was 1,095,000. The numbers of taxpayers claiming rebates ranging from $2001 to $5000 was approximately 115,000. Accordingly, increasing the threshold to $5000 would not benefit a proportionately greater number of taxpayers but may create opportunities for abuse of the exemption. By contrast, the reduction of the threshold would impose unnecessary compliance costs on a large number of small shareholders.

4.169 The advantages of a provision where the Commissioner is not required to make some finding or determination such as the holding period rule are certainty and reduced administrative costs as compared to a test where some avoidance purpose has to be found. This certainty reduces the ATO's administrative costs because the provisions do not have to be applied on a case by case basis. It also reduces compliance costs for taxpayers by reducing uncertainty in the application of the law. However, taxpayers who are required to comply with the rules will have to incur additional compliance costs in tracking their share acquisitions and disposals and their derivative transactions on shares. The extent of the compliance costs which will be incurred by taxpayers will vary depending on the facts and circumstances of particular cases. Accordingly, no reliable data on the amount of these costs is available.

4.170 Taxpayers applying the formula approach generally already have the necessary information to perform the required calculations. Consequently, although there may be some (unquantifiable) costs in applying the formula approach, the approach does not require an extensive gathering of new information. The ATO will work with the ASX to ensure that costs are minimised by, wherever possible, providing taxpayers with any additional information required (eg. yields on relevant indices). No reliable data on the extent of the administrative costs which will be incurred by the ATO is available. However, any costs that do arise for the ATO are not expected to be high and would be met within the ATO's existing budget allocation.

4.171 The related payments rule will only apply to taxpayers who enter into specific arrangements (ie. where taxpayers have diminished risk with respect to their shares and are under an obligation to make related payments with respect to the dividends). This minimises the potential for the measure to apply to genuine commercial transactions and taxpayers compliance costs will be kept to a minimum. Accordingly, the related payments rule should not impose high compliance costs on taxpayers.

Taxation revenue

4.172 The holding period and related payments rules will protect the revenue base used for the forward estimates, by removing opportunities for significant future expansion of franking credit trading and mis-use of the intercorporate dividend rebate. The rules are part of a package of measures targeting franking credit trading and dividend streaming. In the absence of the measures, to the extent that the revenue base would not be protected, there would be a significant revenue loss. While it is not possible to provide an exact estimate of the revenue loss that already existed from franking credit trading and dividend streaming, $130 million a year has been factored into the forward estimates for 1998-99 and subsequent years to take account of the effect of the measures on existing activities.

Consultation

4.173 The ATO and Treasury held extensive consultations with peak bodies representing taxpayers and the investment community (including bodies representing the tax profession, the ASX, merchant banks, superannuation and investment funds) shortly after the Budget announcement on matters relating to the holding period rule. The issues discussed during the consultations concerned tailoring the risk diminution aspect of the holding period rule so that risk reduction strategies not having the effect of a franking credit trade would not be affected, and other issues concerning the general anti-avoidance rule and the specific anti-streaming rule.

4.174 As a result of these consultations, the risk diminution aspect of the holding period rule was tailored to exclude risk reduction strategies that do not have the objective effect of a franking credit trade. In addition, the formula approach was devised to provide institutional investors like superannuation funds an alternative to the holding period rule.

4.175 Details of the formula approach were finalised having regard to further consultations with interested parties (in particular, the general insurance, life and superannuation industries).

Conclusion

4.176 The holding period and related payments rules are important elements of the franking credit trading measures announced in the Budget and they ensure that taxpayers do not gain an undue tax benefit from entering into arrangements involving franking credit trading and mis-use of the intercorporate dividend rebate.

4.177 They implement this policy objective in a way that, as far as possible, minimises administrative and compliance costs while providing taxpayers with certainty (eg. small shareholder exemption and eligible investor carve-out).

4.178 The ATO will monitor developments to detect any emerging possibility of significant revenue loss/deferral or unreasonable compliance costs arising from the rules. In addition, the ATO has consultative arrangements in place to obtain feedback from professional associations and the business community and through other taxpayer consultation forums.

Chapter 5 - Franking of dividends by exempting companies and former exempting companies

Overview

5.1 Schedule 5 to the Bill will amend Part IIIAA of the Income Tax Assessment Act 1936 (ITAA 1936) to prevent franking credit trading. The amendments will limit the source of franking credits available for trading by:

•

prescribing that franked dividends paid by companies which are effectively wholly-owned by non-residents or tax exempt entities will provide franking benefits to resident shareholders in limited circumstances only; and

•

quarantining the franking surpluses of companies which were formerly effectively wholly-owned by non-residents or tax exempt entities.

5.2 The measures will also ensure that non-resident shareholders in receipt of franked dividends from affected companies will continue to be exempt from dividend withholding tax.

Summary of the amendments

Purpose of the amendments

5.3 The purpose of the amendments is to protect the revenue by introducing a measure which limits the source of franking credits available for trading to curb the unintended usage of franking credits through franking credit trading schemes.

Date of effect

5.4 Subject to transitional measures explained below, the measure will apply to:

•

companies that are effectively wholly-owned by non-residents or tax exempt entities at 7.30 pm AEST on 13 May 1997 (exempting companies);

•

companies that are effectively wholly-owned by non-residents or tax exempt entities after 7.30 pm AEST on 13 May 1997 and subsequently cease to be so owned (former exempting companies); and

•

companies which become wholly-owned by non-residents or tax exempt entities at a time after 7.30 pm AEST on 13 May 1997 (these companies will be subject to the measure from that time).

5.5 New subsection 160AQCNI(1) applies where, before 7.30 pm AEST on 13May1997, a taxable resident has become contractually obliged to acquire shares of an exempting company so that the acquisition would result in the company ceasing to be an exempting company. This provision operates so that, although the company will be an exempting company before the acquisition and a former exempting company after the acquisition, the franking surplus or franking deficit of the company will be unchanged by the acquisition. Similarly, franking credits and debits attributable to the period or an event occurring while the company was an exempting company will not be quarantined. [Item 51, new subsection 160AQCNI(1)]

5.6 The above transitional provision will not apply if acquiring the franking credits of the company was a purpose (other than an incidental purpose) of the acquisition of the shares. [Item 51, new subsection 160AQCNI(2)]

5.7 In addition, the measures do not apply to dividends declared, but not paid, by publicly listed companies before 7.30 pm on 13May 1997, and dividends paid after that time that relate to such dividends. An example of where a dividend would relate to another dividend would be where, under a stapled stock arrangement, the declaration of a dividend in one company provides a shareholder in the company with the right to a dividend from another company. [Item 81]

5.8 Companies paying such dividends are to treat the measure as not applying to the extent necessary to allow for the exemption.

Background to the legislation

5.9 One of the underlying principles of the imputation system is that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves.

5.10 In substance, the true economic owner of shares is the person who is exposed to the risks of loss and opportunities for gain in respect of the shares. However, franking credit trading schemes allow persons who are not exposed, or who are only very briefly exposed, to the risks and opportunities of share ownership to obtain access to the full value of franking credits, which often, but for the scheme, would not have been used at all, or would not have been fully used. They therefore undermine an underlying principle of imputation.

5.11 A significant source of credits for trading is to be found in companies which have controlling shareholders for whom franking credits have limited or no value, principally non-residents and tax exempt entities.

5.12 The Bill introduces a measure limiting the source of franking credits available for trading to restore these underlying principles of the imputation system.

Explanation of the amendments

Outline of the amendments

5.13 The ordinary imputation provisions in Part IIIAA of the ITAA 1936 are to apply to companies that are not effectively wholly-owned by non-residents or tax exempt entities and have never been so owned, and to exempting companies (ie. companies that are effectively wholly-owned by non-residents or tax exempt entities) in the same way as they currently apply. However, subject to certain exceptions, franked dividends paid by exempting companies will not provide an entitlement to franking rebates or credits. These dividends will, however, be exempt from dividend withholding tax in the same way as ordinary franked dividends.

5.14 Exempting companies will, therefore, continue to generate franking credits and debits, and be subject to the ordinary provisions in Part IIIAA. However, in most circumstances, dividends paid by exempting companies will only be exempt from dividend withholding tax.

5.15 Former exempting companies (ie. companies that were effectively wholly-owned by non-residents or tax exempt entities but have ceased to be so owned) will need to maintain two franking accounts: a franking account to record franking credits and debits attributable to the period after it ceases to be an exempting company, and an exempting account to record credits and debits attributable to the period during which it was an exempting company. A surplus in the exempting account will be able to be used to pay exempted dividends to certain shareholders. Generally, exempted dividends will only be exempt from dividend withholding tax. Subject to the exceptions explained below, they will not provide an entitlement to franking rebates or credits.

5.16 The legislation, broadly speaking, works as follows:

•

first, it defines the types of taxpayer who have no or a very limited use for franking; these are called prescribed persons.Prescribed persons are defined in a way which includes the entities through which persons who ultimately have no or little use for franking benefits hold their interests in the companies as well those persons themselves;

•

next, the legislation defines what types of shares or interests in shares count in working out who owns a true equity interest in a company; these are called accountable shares or interests; and

•

finally, it defines when a company is effectively owned by prescribed persons by testing whether prescribed persons own 95% or more of the accountable shares or interests in the company, or alternatively, substantially bear the risks and opportunities of owning the accountable shares or interests in the company.

Exempting companies

5.17 New section 160APHBA provides that a company is taken to be an exempting company if the company is effectively wholly-owned by prescribed persons. [Item 42, new section 160APHBA]

Direct ownership by prescribed persons

5.18 For the purposes of new section 160APHBB a company is effectively wholly-owned by prescribed persons if:

•

95% or more of the accountable shares in the company or interests in the accountable shares are held directly or indirectly by prescribed persons; [Item 42, new paragraph 160APHBB(1)(a)] or

•

it would be reasonable to conclude that, having regard to, among other things, any arrangement of which the company is aware with respect to the accountable shares or interests, the risks and opportunities resulting from holding the shares or interests substantially accrue to prescribed persons. [Item 42, new paragraph 160APHBB(1)(b)]

5.19 The purpose of the second of these tests is to ensure that arrangements which in economic substance amount to ownership of a company are also embraced by the rule. This is to deal with the use of derivatives and the like to provide synthetic ownership of equity in companies.

5.20 Where for example, a non-resident owns 70% of an Australian company and an Australian resident owns the remaining 30%, if the Australian resident has transferred the risks and opportunities of ownership of the shares to the non-resident (eg. the resident has forward sold the 30% interest to the non-resident) the Australian company will still be an exempting company notwithstanding that nominally only 70% of the company is held by prescribed persons.

5.21 This test also has regard to unissued shares. This is to prevent the test being avoided by flooding allotments of shares, under which existing shareholdings are diluted to an insignificant proportion by the issue of new shares. For example, if a resident owns two shares, which are the only issued shares, but under an arrangement (eg. an option over unissued shares) a prescribed person or persons will acquire 100 new shares to be issued in the future (which will be accountable shares) the effect may be to place effectively all the risks and opportunities of holding accountable shares into the hands of prescribed persons even though they currently hold no shares.

5.22 New section 160APHBF defines a prescribed person to be a company or natural person who is exempt from tax or a non-resident for the purposes of the ITAA 1936, or a partnership or trust where all the partners or beneficiaries are exempt from tax or non-resident for the purposes of the ITAA 1936. The Commonwealth, States and Territories will also be treated as prescribed persons. [Item 42, new section 160APHBF]

Indirect ownership by prescribed persons

5.23 New section 160APHBG provides that a company, partnership or trust that is not a prescribed person for the purposes of new section 160APHBF , which holds shares in another company, will be taken to be a prescribed person if by applying a look through approach it is determined that a non-resident or tax-exempt holds substantially all of the risks and opportunities of ownership of the shares in the other company. For example, if all the shares of a resident company are held by a trustee of a fixed trust whose beneficiaries are, apart from an inconsequential holding, all non-residents, the company is held by non-residents for the purposes of the measures. Similarly, if there is chain of wholly-owned companies, the measures will apply to each company in the chain if the holding company is within the measure. For example, if foreign company A owns 100% of Australian company B which owns 100% of Australian company C, the measures would apply to both company B and company C. [Item 42, new section 160APHBG]

5.24 New subsection 160APHBG(9) , however, provides that the look through approach will not apply in relation to a company which is itself a prescribed person. Therefore if a resident company is wholly-owned by a non-resident company which has resident shareholders, the resident company is subject to the measures notwithstanding that a look through approach would reveal that the risks and opportunities of ownership lie with residents. [Item 42, new subsection 160APHBG(9)]

Ownership through trusts

5.25 New subsection 160APHBG(4) provides that a trustee of a trust is a prescribed person in relation to a company if one or more prescribed persons controls the trust or all of the beneficiaries actually receiving income are prescribed persons. This test applies to trusts in addition to the risks and opportunities test which applies under new subsection 160APHBG(3) . [Item 42, new subsection 160APHBG(5)]

5.26 However, new subsection 160APHBG(7) provides for the case where a prescribed person controls a trust which holds accountable shares in a company, but some beneficiaries who are not prescribed persons receive distributions comprising dividends paid on accountable shares in the company. New subsection 160APHBG(7) provides that, in this circumstance, the Commissioner may deem that the trust is not a prescribed person in relation to the company if it is reasonable to conclude that persons who are not prescribed persons effectively hold the risks and opportunities of the accountable shares in the company. [Item 42, new subsection 160APHBG(7)]

5.27 In determining whether a person is a controller of a trust, regard is to be had to whether:

•

the person beneficially owns, or is able in any way, whether directly or indirectly, to control the application of the interests in the trust property or in the trust income; [Item 42, new paragraph 160APHBG(6)(a)]

•

the person has the power to directly or indirectly appoint or remove the trustee or beneficiaries of the trust; or [Item 42, new paragraphs 160APHBG(6)(b) and 160APHBG(6)(c)]

•

the trustee of the trust is accustomed or under a formal or informal obligation to act according to the wishes of the person or an associate of the person. [Item 42, new paragraph 160APHBG(6)(d)]

Excluded shares

5.28 In determining whether a company is effectively wholly-owned by non-resident or tax-exempt shareholders, only accountable shares and accountable interests are taken into account. The rules relating to what are accountable shares and accountable interests are concerned with the effective ownership of a company.

5.29 The owner of property, in the economic sense, is the person who bears the risks of loss and has the opportunities for profit arising from that property. In the case of a company, this would mean the person or persons exposed to the performance of the company. However, in the case of a company, the law regards each share in the company as the subject of property, rather than the company itself. It might usually be expected that all the shares in a company in totality will reflect the risks and opportunities of owning the company, but some shares involve their holders in bearing few, if any, risks or opportunities reflecting the performance of the company. For example, some shares carry only rights equivalent to those of creditors; others may have no dividend rights. Often, therefore, the whole of the equity in a company, considered as a matter of substance, is represented by only some of the shares in it. It is therefore necessary to determine which shares, and where there are indirect holdings, which interests in shares, represent the real equity in a company in order to determine who effectively owns it.

5.30 Generally speaking, the clearest case of an owner of a company is the holder of an ordinary share in that company; the standard of ownership is therefore to be found in the rights usually attached to ordinary shares and in the risks and opportunities which flow from such rights. This is the standard adopted by the tests for determining the effective ownership of a company. Shares with different rights, and indirect interests in shares held through trusts and partnerships, are to be judged as relevant or irrelevant to the question of who effectively owns the company according to the extent that they approximate the rights, and participate in the risks and opportunities, from holding such shares.

5.31 Under the rules relating to accountable shares and accountable interests regard must be had, not only to the rights attached to particular shares, but also the rights attached to other shares; both those held by the same shareholder (or associates), and those held by other shareholders. For example, instead of ordinary shares, a company might have different classes of shares carrying only voting rights, only dividend rights, or only rights to capital. Conversely, there might be cases where there are ordinary shares in a company which of themselves appear to represent an ownership interest, but which in fact do not, because there are other super shares with rights that effectively override theirs. The criteria require the relationship between the value of the share or interest and the company to be taken into account, along with the nature of any relationship or connection between holders of shares and interests in shares. The overall position must be taken into account to ensure that the test operates, as intended, as in substance test of ownership.

5.32 The rules which treat holders of accountable shares and interests as prescribed persons if the risks and opportunities of holding those shares lie with prescribed persons (ie. if the real owners of the shares or interests are prescribed persons) extend also to holders of excluded shares and interests. This is because whether some shares or interests are excluded shares or interests may depend on whether they are held by prescribed persons. This will prevent prescribed persons from deliberately structuring their shareholdings so that they are excluded from the definitions of accountable shares and accountable interests.

5.33 New subsection 160APHBC(2) provides that accountable shares are shares which are not excluded shares . New subsection 160APHBC(3) provides that a share is an excluded share if, having regard to the criteria outlined in new paragraphs 160APHBC(3)(a) to 160APHBC(3)(f) , it would be reasonable to conclude that the share should not be taken into account when determining whether the company is effectively wholly-owned by prescribed persons because the share does not involve the holder having to bear any of the risks or opportunities normally associated with share ownership. For example, if resident company A which is wholly-owned by a non-resident issues a negligible amount of Z class non-voting, non-dividend shares to a resident, resident company A will still be an exempting company even though it has a resident shareholder because the type of shareholding indicates that substantially all of the risks and opportunities of ownership of resident company A still lie with the non-resident. [Item 42, new subsection 160APHBC(3)]

5.34 New subsection 160APHBC(5) also provides that finance shares (defined in new subsections 160APHBC(6) and (7) ), dividend access shares (defined in new subsection 160APHBC(8) ), shares without dividend rights and shares issued for the non-incidental purpose of avoiding the application of the measures are to be treated as excluded shares where the shares are held by a person who is not a prescribed person. For example, if all the ordinary shares in resident company A are owned by a non-resident and all the redeemable preference shares are owned by a resident, resident company A will be an exempting company notwithstanding the resident redeemable preference shareholder because the redeemable preference shares are excluded shares. Similarly, if resident company B had two classes of shares, class X which had full voting, dividend and capital rights, and class Y which had only dividend rights, and non-residents held class X shares and residents held class Y shares, resident company B would be an exempting company because the class Y shares would be dividend access shares and therefore excluded. [Item 42, new subsections 160APHBC(5) - 160APHBC(8)]

5.35 New section 160APHBD provides that an accountable interest is an interest in accountable shares which is not an excluded interest . New subsection 160APHBD(3) provides that an interest is an excluded interest if having regard to the criteria outlined in new paragraphs 160APHBD(3)(a) to 160APHBD(3)(g) it would be reasonable to conclude that the interest should not be taken into account when determining whether the company is effectively wholly-owned by prescribed persons because the interest does not involve the holder having to bear any of the risks or opportunities normally associated with ownership of interests in shares. [Item 42, new subsections 160APHBD(2) and 160APHBD(3)]

5.36 In addition, interests issued for the non-incidental purpose of avoiding the application of the measures are also excluded interests. [Item 42, new subsection 160APHBD(5)]

5.37 Therefore, if a trust which holds all the accountable shares in a company and which has non-resident beneficiaries only appoints a resident as a discretionary object, for the purposes of determining whether the trust is a prescribed person in relation to the company, the interest held by the resident may be disregarded if the interest does not involve the holder having to bear any of the risks or opportunities normally associated with ownership of interests in shares.

Effectively wholly-owned group companies

5.38 New section 160APHBI provides that two or more companies are members of the same effectively wholly-owned group if:

•

95% or more of the accountable shares or interests in each of the companies are directly or indirectly held by the same persons; or [Item 42, new paragraph 160APHBI(1)(a)]

•

it would be reasonable to conclude that, having regard to the matters referred to in new subsection 160APHBI(2) , the risks and opportunities resulting from holding accountable shares or interests in each of the companies are borne by or substantially accrue to the same persons. [Item 42, new paragraph 160APHBI(1)(b)]

5.39 Therefore, if companies B and C each hold 50% of company D and company A owns 96% of company B and 96% of company C, for the purposes of new section 160APHI , companies A, B, C and D will form an effectively wholly-owned group notwithstanding that company A only holds 96% of companies B and C.

5.40 The question of whether companies are members of the same effectively wholly-owned group is relevant for the purposes of determining whether certain dividends paid by a former exempting company or exempting company can provide the shareholder with a franking credit benefit.

Eligible continuing substantial shareholders

5.41 New section 160APHBJ provides a definition of eligible continuing substantial shareholder. This is also relevant for the purposes of determining whether certain dividends paid by a former exempting company can provide the shareholder with a franking credit benefit (including an exemption from dividend withholding tax). A shareholder is an eligible continuing shareholder in relation to a dividend paid by a former exempting company if:

•

the shareholder is a non-resident, life company, exempting company or former exempting company, or a partnership or trust having the aforementioned groups as beneficiaries or partners; and

•

the shareholder directly or indirectly holds the prescribed percentage of shares (prescribed percentage is the same percentage as that provided under subsection 708(5) of the Corporations Law dealing with substantial shareholdings); and

•

if the assumptions set out in new subsection 160APHBJ(4) are made the shareholder, beneficiary or partner (if a non-resident) would be exempt from dividend withholding tax or (if a resident) would be entitled to a franking credit or franking rebate in respect of the dividend.

[Item 42, new subsections 160APHBJ(2) and 160APHBJ(3)]

5.42 New section 160APHBJ effectively provides that a shareholder who is a company (first company) who holds a prescribed percentage of accountable shares in a former exempting company (second company) is an eligible continuing substantial shareholder if, when the second company was an exempting company , the first company was able to benefit from franked dividends paid by the second company. For example, if a resident company formerly wholly-owned by non-residents and now owned by taxable residents has a wholly-owned resident subsidiary, both the company and its subsidiary will be former exempting companies and the parent company will be an eligible continuing shareholder of the subsidiary, even if the parent company sells some of its shares in the subsidiary to a third party.

Former exempting companies

5.43 As outlined above, to comply with the measure, exempting companies will not need to modify their franking procedures. However, if a company ceases to be an exempting company so that it becomes a former exempting company, subject to the transitional and short-term ownership provisions explained below, franking surpluses or deficits existing at that time will be quarantined in an exempting account. The exempting account will be used to record franking credits and debits attributable to the period, or to an event taking place, when the relevant company was an exempting company. [Item 42, new section 160APHBE]

5.44 New sections 160AQCNG and 160AQCNH provide that when a company ceases to be an exempting company and becomes a former exempting company the class A or C franking surplus or deficit of the company at that time is to be converted into an equivalent exempting surplus or deficit. For example, if, just before a company became a former exempting company, it had a class A franking surplus (because it is a life company) of $1 million and a class C franking deficit of $2 million, the class A and class C exempting account balances would be, respectively, $1 million surplus and $2 million deficit, and the franking account balances would become zero. The conversion is implemented by:

•

cancelling a franking surplus or deficit by posting an equivalent franking debit or credit (respectively); and

•

posting an exempting credit equal to the amount of the franking surplus, or an exempting debit equal to the amount of the deficit. [Item 51, new sections 160AQCNG and 160AQCNH]

5.45 However, if an exempting company becomes a former exempting company, and franking credits and debits had arisen before that time which are attributable to the period that the company is a former exempting company, the franking surplus or deficit of the company at the time it becomes a former exempting company will be reduced or increased accordingly. The proportion of the franking credits or debits attributable to the period that the company is a former exempting company will not be quarantined: it will continue to be treated as franking credits or debits by the company. [Item 51, new subsections 160AQCNG(3), 160AQCNG(4), 160AQCNH(3) and 160AQCNH(4)]

5.46 To allow former exempting companies to maintain and operate exempting accounts the definitions of franking account terms in the ITAA have been extended to include exempting account terms. Amended section 160APA provides for class A or C exempting deficits, surpluses, debits, credits, account balances and class A or C exempted dividends. [Items 16 to 35, amended section 160APA]

5.47 In addition to the extension of the franking credit and debit terms to equivalent exempting account terms, the amendments will allow the ascertainment of a class A or C exempting surplus or deficit at any particular time during the franking year. This is achieved by providing for the calculation of the surplus and deficit in the same way as the class A and C franking account surpluses and deficits are calculated. [Item 51, new section 160AQCND]

5.48 Because only former exempting companies retain exempting accounts, if a former exempting company reverts to being an exempting company (eg. if a company originally held by non-residents is sold to taxable residents and then sold back to non-residents), the exempting account once again becomes a franking account. Therefore, new sections 160AQCNK and 160AQCNL convert the exempting surplus or deficit of such companies into a franking surplus or deficit. These provisions operate so that, upon becoming an exempting company, the company will receive an exempting debit or credit to cancel an exempting surplus or deficit, and receive an equivalent franking credit or debit. However, franking credits of exempting companies are generally not able to provide franking credit benefits to residents. [Item 51, new sections 160AQCNK and 160AQCNL]

Allocation of credits and debits to the exempting account

5.49 As explained above, exempting companies are to maintain franking accounts which are governed by the current provisions in Part IIIAA, including the provisions of Division 2 providing for the generation of franking credits and franking debits.

5.50 Former exempting companies are also to maintain an exempting account. New sections 160AQCNM and 160AQCNN provide that former exempting companies are to convert franking credits and debits (generated from the payment of company tax or the receipt of a refund of company tax) which are attributable to the period, or to an event taking place, when they were exempting companies into equivalent exempting credits or debits. New subsections 160AQCNM(2) and 160AQCNN(2) provide that the franking credit or debit does not arise if it is attributable to a period when the company was an exempting company and instead an equivalent exempting credit or debit arises to the company. [Item 51, new sections 160AQCNM and 160AQCNN]

5.51 For example, suppose an exempting company paid $360,000 tax at 36%, was sold to a taxable Australian resident and, after the change in ownership, received a full refund of the tax paid. Instead of posting a franking debit under section 160APYBA, the company, now a former exempting company, would post a class C exempting debit of $640,000 ($360,000 64/36).

5.52 As a result of this amendment, if a company becomes a former exempting company during an income year, credits arising from tax instalments paid for that year (see Division 1C of Part VI of the ITAA) will be partly franking credits and partly exempting credits. The pro-rating is to be made on the basis of the proportion of the period during the year that the company was an exempting company (exempting credits) to the remaining period (franking credits). For example, where a June balancing company becomes a former exempting company on 1January in a particular income year, 50% of the credits that arise from company tax instalments relating to that year will be franking credits and 50% will be exempting credits. Similarly, if the above company were to receive a refund in respect of those instalments, 50% of the debits arising from the refund would be franking debits and 50% would be exempting debits.

5.53 Therefore, in the example below of a 30 June balancing large taxpayer (as defined in section 221AZH) which was an exempting company until being sold to residents on 1 October 1997 (when it became a former exempting company), the credits accruing on the 1 December 1997 tax instalment would be exempting credits (because it is the final instalment for the previous income year, during the whole of which it was an exempting company), while the credit accruing on the instalments for the 1997-98 income year (ie. 1 March, 1 June, 1 September and 1December in 1998) would be in the proportions of 25% exempting credits and 75% franking credits. This is because the company is an exempting company for a quarter of the income year.

Payment of dividends by former exempting companies

5.54 Former exempting companies can pay either exempted dividends or franked dividends.

5.55 Former exempting companies will generally pay ordinary franked dividends according to the prevailing balance in their franking account: they will be subject to the required franking rules in Division 4 of Part IIIAA. They will also be able, at their option, to pay exempted dividends to certain shareholders (provided they have the required surplus), including employees under eligible employee share schemes. However, only the unfranked portion of a dividend can be exempted by a former exempting company. Therefore the company must first frank the dividend according to the required franking rules (see Division 4 of Part IIIAA) using its available franking surplus before it can use the balance in its exempting surplus. To do otherwise would be to attract underfranking penalties under section 160APX.

What constitutes franking with an exempted amount?

5.56 Section 160AQF of the ITAA specifies the circumstances in which a dividend may be franked and how it is franked. Broadly, a frankable dividend is franked if a resident company makes a declaration before the reckoning day that the current dividend is a franked dividend to the extent of a certain percentage (not exceeding 100 %).

5.57 The franking rules set out in section 160AQF for franked dividends will be extended to exempted dividends. To determine the exempted amount of a dividend a company needs to make a declaration that a dividend is exempted to the percentage specified in the declaration. [Item 54, new section 160AQFA]

5.58 New subsection 160AQFA(4) provides that a former exempting company may frank a dividend with exempting credits to the extent it is unfranked by franking credits only to the extent the dividend is paid to an eligible continuing substantial shareholder or an employee under an eligible employee share scheme. Where the franked and exempted amounts of the dividend exceeds the amount of the dividend the dividend is taken not to have been franked in accordance with new section 160AQFA . [Item 54, new subsections 160AQFA(3) and 160AQFA(4)]

5.59 New subsection 160AQFA(4) effectively provides that where a former exempting company pays an exempted dividend to a shareholder which is not an eligible shareholder or an employee under an employee share scheme the dividend will not be treated as franked for the purposes of new section 160AQFA . [Item 54, new subsection 160AQFA(4)]

Equal allocation of exempting credits

5.60 To avoid streaming of exempting credits, if a former exempting company opts to pay an exempted dividend to an eligible shareholder (ie. an eligible continuing substantial shareholder or employee under an eligible employee share scheme), it must notionally attach exempting credits evenly across the whole dividend (ie. to all shareholders receiving the dividend). Therefore, if the company exercises the option it will be required when paying a dividend to debit the exempting account to the extent that exempting credits would have gone to all shareholders had they all been eligible to receive exempted dividends. However, notwithstanding this notional allocation of exempting credits, only dividends paid to the shareholders described above will be exempted dividends.

5.61 Moreover, new subsections 160AQFA(5) and 160AQFA(6) provide that a declaration that a dividend is exempted under new section 160AQFA is not effective unless a similar declaration is made in relation to all other dividends paid by the company which are in the same combined class of dividends. [Item 54, new subsections 160AQFA(5) and 160AQFA(6)]

5.62 New section 160AQCNE provides that when a former exempting company pays an exempted dividend there arises to the company an exempting debit equal to the full exempted amount declared under new section 160AQFA .

Example

5.63 Arnold (a non-resident) owns 100% of the shares in Dinkum Ltd (an Australian resident). Therefore, Dinkum Ltd is an exempting company. On 1 January 1998, Arnold disposes of 50% of Dinkum Ltd to Joe (an Australian resident). At that time, Dinkum Ltd ceases to be an exempting company and becomes a former exempting company. On 1March of that year, Dinkum (a June 30 balancing company) pays a company tax instalment of $360 and receives $320 of franking credit and $320 of exempting credit. This is because for half of the relevant income year Dinkum was an exempting company. On 1 April of that year Dinkum pays a $640 dividend to its shareholders. The measures provide that Dinkum is required to exhaust its franking surplus before it can use its exempting surplus. Accordingly, Dinkum pays a partially franked dividend to both Arnold and Joe. The measures also provide that Dinkum is allowed to exempt the unfranked portion of the dividend paid to Arnold because he is an eligible continuing shareholder. However, under the measures, if the exemption of the dividend paid to Arnold is to be effective, Dinkum must notionally exempt the entire dividend, that is, if the dividend to Arnold is exempted, the dividend to Joe must be notionally exempted to the same extent. Accordingly, if Arnold receives a $320 dividend, $160 of the dividend will be franked and $160 will be exempted. However, the dividend received by Joe will only be $160 franked and no part will be exempted (because Joe is not an eligible shareholder). The total exempting debit will be $320.

Obligation to debit exempting account for previously declared dividends

5.64 Circumstances may arise where, before it becomes a former exempting company, a company declares a dividend to be class A or class C franked under section 160AQF based on its current franking surplus, but, because the reckoning day of the dividend is after it becomes a former exempting company, when it comes to pay the dividend it no longer has a franking surplus but instead has an exempting surplus. For example, where an exempting company declares a dividend to be 100% franked and before the dividend is paid it is sold to a taxable resident, the company may not be able to frank the dividend because the franking surplus has been reduced to zero and converted to an exempting surplus.

5.65 Ordinarily, section 160AQF declarations cannot be varied (subsection 160AQF(2)). However, to prevent companies being obliged to frank their dividends by more than the available franking surplus, new subsection 160AQF(3) allows declarations to be varied where the declaration was made before a company becomes a former exempting company but the dividend to which the declaration relates (or at least one of the dividends if there is more than one) has a reckoning day after that time. In these cases, the declaration can be varied to take into account the new franking surplus. [Item 53, new subsection 160AQF(3)]

5.66 In addition, new section 160AQCNJ allows for the avoidance of an underfranking debit if a former exempting company pays a frankable dividend and:

•

although paid afterwards, the reckoning day of the dividend is before the company became a former exempting company; or

•

subsection 160AQE(3) applies (ie. the current dividend was a committed future dividend in respect of an earlier dividend and the earlier dividend was over-franked thus requiring the current dividend to be franked to the same extent as the earlier dividend); or

•

subsection 160AQE(4) applies (ie. the current dividend is paid on the same day as another dividend but is paid under a different resolution and the other dividend is over-franked).

5.67 Under new section 160AQCNJ an exempting debit arises equal to the difference between the amount by which the dividend is franked and the amount to which the required franking rules requires it to be franked. The dividend is then deemed to be franked to the required extent, but only for the purposes of determining whether an underfranking debit arises under section 160APX. To prevent a double debiting, the exempting debit arising under new section 160AQCNJ is reduced by the amount of any actual exempting debit arising under new section 160AQCNE . [Item 51, new section 160AQCNJ]

Tax treatment of dividends paid by exempting companies and former exempting companies

5.68 As explained above, all franked dividends paid by exempting companies are generally exempt from dividend withholding tax only, while former exempting companies can pay exempted dividends to certain shareholders only. Broadly speaking only employees under certain employee share schemes, or continuing substantial shareholders who were able to benefit from franked dividends paid when the relevant company was an exempting company (eg. a life assurance company shareholder which is part of the same company group).

5.69 Other than for the exceptions explained below, exempted dividends paid by former exempting companies and franked dividends paid by exempting companies are for all intents and purposes unfranked dividends in the hands of residents.

5.70 For non-resident shareholders, however, such dividends will carry the same entitlement to an exemption from dividend withholding tax as ordinary franked dividends. Accordingly the measures provide that where a former exempting company pays an exempted dividend to a shareholder, the dividend is exempt from dividend withholding tax for that portion of the dividend that has been declared to be exempted in the same way it would have been had it been franked in the ordinary way. [Item 10, amended paragraph 128B(3)(ga)]

Dividends paid to individuals and life assurance companies

5.71 Under section 160AQT of the ITAA, resident individual shareholders who receive franked dividends are required to include in their assessable income the amount of the imputation credit together with the amount of the dividend (ie. the grossed-up amount of the dividend). The shareholder is then entitled to a franking rebate equal to the amount of the imputation credit under section 160AQU. This rule is affected by the measures when the company paying the dividend is an exempting company or a former exempting company.

5.72 New subsection 160AQTA(1) provides that section 160AQT does not apply in relation to franked dividends paid by an exempting company. Therefore, with the exception of certain employee share schemes and life assurance companies (explained below), franked dividends paid by exempting companies (and exempted dividends paid by former exempting companies) to residents are to be treated as unfranked dividends for the purposes of section 160AQT (ie. shareholders do not gross-up the dividend and therefore are not allowed a rebate under section 160AQU). [Item 61, new subsection 160AQTA(1)]

Dividends paid to life assurance companies

5.73 Unlike other corporate shareholders, section 160AQT(1A) and (1C) provide that a gross-up amount is included in the assessable income of a life assurance company (and therefore a franking rebate is available) where a franked dividend is paid on its statutory fund assets.

5.74 To ensure that this treatment can continue where the life assurance company is an exempting company or former exempting company and it receives a dividend from a subsidiary (ie. a franked dividend paid by an exempting company or an exempted dividend paid by a former exempting company), new sections 160AQTA and AQTB provide for an exception to the general rule preventing resident shareholders receiving a franking benefit from an exempted dividend or a franked dividend paid by an exempting company. The exception applies where such a dividend is paid to a life assurance company and, in relation to the dividend-paying company, the life assurance company and the dividend-paying company are members of the same effectively wholly-owned group, or the life assurance company holds substantially all the risks and opportunities associated with more than 5% of the shares in the dividend-paying company. In these circumstances, new subsection 160AQTA(2) provides that section 160AQT does apply in relation to the franked dividend paid by the exempting company, while new subsection 160AQTB(1) provides that an exempted dividend paid to a life company is to be treated as franked for the purposes of subsections 160AQT(1A) or 160AQT(1C). [Item 61, new sections 160AQTA and 160AQTB]

5.75 Consistent with the application of section 160APP in relation to franking credits, new sections 160APPA and 160AQCNF provide that where a life assurance company receives a franked dividend from an exempting company, or an exempted dividend, on shares held in its statutory fund the credit arising is reduced by 80%.

5.76 To prevent life companies acquiring exempting companies or former exempting companies as a means of effectively converting exempting credits and unusable franking credits into franking benefits, new subsections 160AQTA(4) and 160AQTB(2) limit the life company concession to credits generated during the time when the life company held shares in the other company: only credits attributable to that period will be able to confer a franking benefit. [Item 61, new subsections 160AQTA(4) and 160AQTB(2)]

Employee share schemes

5.77 New subsection 160AQTA(5) provides that where a franked dividend is paid by an exempting company on shares issued to employees under an employee share scheme (ESS), section 160AQT applies in relation to the dividend. New subsection 160AQTB(3) provides that where an exempted dividend is paid by a former exempting company on shares issued to employees under an ESS the exempted dividend is to be treated as a franked dividend. [Item 61, new subsections 160AQTA(5) and 160AQTB(3)]

5.78 A taxpayer will be taken to acquire a share in a company under an eligible ESS if:

•

the share is acquired by the taxpayer in respect of, or for, or in relation directly or indirectly to, any employment of the taxpayer;

•

the taxpayer is an employee of the company or of a subsidiary company of the company;

•

all the shares available for acquisition under the scheme are ordinary shares or preference shares with substantially the same rights attached to them as ordinary shares;

•

immediately after the acquisition of the shares, the taxpayer does not hold a legal or beneficial interest in more than 5 per cent of the shares of the company; and

•

immediately after the acquisition of the shares, the taxpayer is not in a position to cast, or control the casting of, more than 5 per cent of the maximum number of votes that might be cast at a general meeting of the company. [Item 42, new section 160APHBH]

Intercorporate dividends

5.79 New subsection 160APP(1AAA) provides that franked dividends paid by exempting companies to corporate shareholders will generally not result in a franking credit arising to the company under section 160APP. Moreover, amended subsection 46F(2) applies so that generally franked dividends paid by exempting companies to a private company shareholder will be treated in the same way as an unfranked dividend for the purposes of determining eligibility for a rebate of tax under section 46. [Item 3 and Item 4, amended subsection 46F(2) and new subsection 160APP(1AAA)]

5.80 However, new section 160APPA provides that where an exempting company (first company) pays a franked dividend to another exempting company (second company) a franking credit equal to the franked amount of the dividend will arise to the second company if:

•

both the relevant companies are members of the same effectively wholly-owned exempting company group; or [Item 44, new paragraph 160APPA(1)(b)] having regard to any arrangement with respect to the relevant shares as stated in new subsection 160APPA(3) , the risks and opportunities associated with holding more than 5% of the shares (other than finance shares, dividend access shares and shares which do not carry the right to receive dividends) in the first company substantially accrue to the second company. [Item 44, new paragraph 160APPA(1)(b) and new subsection 160APPA(3)]

5.81 New subsections 160APPA(4) to (6) are equivalent to the provisions in section 160APP. Therefore, for example, no franking credit arises to the second company if the dividend paid by the first company is wholly exempt income of the second company, and no franking credit arises if the dividend was paid as part of a dividend stripping operation. [Item 44, new subsections 160APPA(4)-(6)]

5.82 Similarly new section 160AQCNF provides that where an exempting company receives an exempted dividend there arises to the company a franking credit equal to the exempted amount of the dividend. New section 160AQCNF also provides that when a former exempting company receives an exempted dividend there arises to the company an exempting credit equal to the exempted amount of the dividend. Therefore, if a former exempting company receives a $100 dividend from its continuing wholly-owned subsidiary which is franked to 80% and exempted to 20% it will credit its franking account with $80 and its exempting account with $20. [Item 51, new sections 160AQCNE and 160AQCNF]

Trusts and partnerships

5.83 Division7 of Part IIIAA contains provisions designed to ensure that franked dividends received indirectly through partnerships and trusts are treated in the hands of partners and beneficiaries in the same way that such dividends would have been treated if received directly. In other words where a partnership or trust derives franked dividends, that income retains its character when it is distributed to a partner or beneficiary.

5.84 To provide for residents who, contrary to the general rule, can gain franking benefits from exempted dividends and franked dividends paid by exempting companies (certain exempting company and former exempting company shareholders, life companies, and certain employees), new sections 160AQZC and 160AQZB allow credits to be passed through a trust or partnership holding shares on behalf of such persons. To the extent that distributions representing such dividends are then made to the beneficiary or partner, the tax treatment will be the same as if the dividends were paid directly to the beneficiary or partner. [Item 63, new sections 160AQZC and 160AQZB]

5.85 Provisions corresponding to those in Division 7 to allocate the credits attached to the dividends have not been included because those provisions require the trustee or partnership to gross-up franked dividends received and thereby receive higher assessable income: this would not be appropriate if not all the beneficiaries would be entitled to receive franking benefits from the exempted dividends and dividends paid by exempting companies.

5.86 Accordingly new sections 160AQZC and 160AQZB treat exempting company franked dividends and exempted dividends paid to a trust or partnership as unfranked dividends. However, where the assessable income of a beneficiary or partner includes an amount attributable to the dividends, the beneficiary or partner is deemed, for the purposes of determining whether they are entitled to a franking rebate, a franking credit or an exempting credit, to have been paid directly so much of the dividends as their assessable income from the trust or partnership is attributable to. The beneficiary or partner is also deemed to hold the share in respect of which the dividend was paid, which will allow a franking rebate to flow through to, for example, an employee of a company where a share issued under an eligible employee share scheme is held by a trustee on the employees behalf.

5.87 All beneficiaries or partners are treated as being eligible to benefit from the relevant dividend in proportion to their respective interests in the total income of the trust or partnership. Therefore, the assessable income of each beneficiary or partner is deemed to be attributable to the relevant dividend to the extent of their share of the total income of the trust or partnership. For example, suppose there are two beneficiaries of a trust who are each entitled to half the net income of the trust (say, $5,000). If the trust receives an exempted dividend of $1,000 then each beneficiary is deemed to receive a $500 exempted dividend for the purpose of determining their entitlement, if any, to a franking credit or rebate or exempting credit, irrespective of how the trustee purports to distribute it. [Item 63, new subsections 160AQZB(4) and 160AQZC(4)]

Payment of franking deficit tax, franking additional tax and deficit deferral tax by former exempting companies

5.88 Section 160AQJ of the ITAA imposes a liability to franking deficit tax (FDT) on a company where its franking account balance is in deficit at the end of its franking year. Sections 160AQJA (applicable to life assurance companies) and 160AQJC (applicable to other companies) impose a liability to deficit deferral tax (DDT) where an instalment of tax paid in the income year is refunded in the following franking year and a franking deficit would have arisen if the refund had occurred at the end of the previous franking year.

5.89 New section 160AQCNO provides that a deficit in the exempting account at the end of the franking year results in a nil balance in that account and a franking debit of the deficit amount in the franking account of the company. Therefore, a deficit in an exempting account at the end of a franking year (or, for DDT purposes, a deficit that would have arisen if the refund had been received before the end of the year) effectively gives rise to the same taxes and penalties as an equivalent deficit in a franking account. [Item 51, new section 160AQCNO]

Exempting account: records and information

5.90 Division 12 of Part IIIAA contains provisions that require companies to keep relevant records for a period of five years. The records include documents relevant for the purpose of ascertaining a companies franking account balances (paragraph 160ASC(b)).

5.91 Amended paragraph 160ASC(b) provides references to the exempting account balance that is to be maintained by former exempting companies. [Item 64, amended paragraph 160ASC(b)]

Special measures for Commonwealth owned bodies

5.92 New section 160AQCNP provides the Treasurer with a discretion which effectively allows former exempting companies which were formerly wholly-owned by the Commonwealth to use their exempting credits to pay ordinary franked dividends. [Item 51, new section 160AQCNP]

5.93 New subsection 160AQCNP(2) stipulates that in deciding whether to exercise the discretion in favour of a company, the Treasurer will have regard to:

•

whether the discretion is necessary to allow the company to pay fully franked dividends after the company is sold (ie. if the discretion were not applied would the relevant company have or accrue sufficient franking credits to fully frank its dividends); [Item 51, new paragraph 160AQCNP(2)(a)]

•

whether the ability to pay franked dividends is central to achieving a successful sale; [Item 51, new paragraph 160AQCNP(2)(b)]

•

whether the cost to the revenue from exercising the discretion is expected to be largely offset by the increase in the sale price; [Item 51, new paragraph 160AQCNP(2)(c)] and

•

any other factors the Treasurer considers relevant. [Item 51, new paragraph 160AQCNP(2)(d)]

5.94 The exercise of the discretion by the Treasurer in favour of a company may be made conditional upon compliance by the relevant company with certain stipulated conditions. For example, receiving a written commitment from the relevant company that:

•

it will not vary its forecast dividend paying policies (ie. the amount of the dividends, the frequency of dividends and the proportion of profits it pays out as dividends) in the post-sale period; and

•

its tax payments will be in accordance with the tax law. [Item 51, new subsection 160AQCNP(6)]

5.95 New subsections 160AQCNP(4) and 160AQCNP(5) provide that when exercising the discretion in favour of a company, the Treasurer will specify, after the end of the relevant franking year, the value of exempting credits that can be transferred to the franking account. This transfer is deemed to have taken place immediately before the end of the year. The prevailing balance in the exempting account provides the upper limit on the amount that can be transferred. [Item 51, new subsections 160AQCNP(4) and 160AQCNP(5)]

Short-term ownership by non-residents or tax exempt entities

5.96 New subsection 160APHBE(2) provides that if a company becomes effectively wholly owned by prescribed persons and, within 12months, there is a change in ownership so that it ceases to be so owned, then that change in ownership does not result in the company becoming a former exempting company. In determining whether a company has been an exempting company for less than 12 months, any relevant periods before the commencement of the measure will be taken into account. [Item 42, new subsection 160APHBE(2)]

5.97 Similarly, new subsections 160AQCNI(3) to 160AQCNI(5) provide that if a former exempting company becomes an exempting company for less than twelve months, upon its reversion to a former exempting company, instead of converting the whole of its franking surplus or deficit to an equivalent exempting amount, the company will be able to retain the franking surplus or deficit it would have had if it remained a exempting company instead of becoming an exempting company for the relevant period: the remainder is to be converted to an exempting amount. [Item 51, new subsections 160AQCNI(3) to 160AQCNI(5)]

Dividend statements

5.98 Section 160AQH provides that companies paying dividends to shareholders need to give a dividend statement specifying the extent to which a dividend is franked or unfranked. Amended section 160AQH requires that dividend statements provided to shareholders of former exempting companies set out, in addition to the other information specified by section 160AQH, the exempted amount of the dividend. [Items 56 to 59, amended section 160AQH]

5.99 Exempting companies are required to give a statement to their shareholders advising them that only certain shareholders (eg. eligible life assurance companies or employees under an eligible employee share scheme) are entitled to the franking benefits on a dividend paid by the company. [Item 59, new subsection 160AQH(2)]

5.100 As with the current section 160AQH, companies will also be required to provide such other information as is set out in the approved form (see paragraph 160AQH(c)).

5.101 For exempting companies and former exempting companies that paid dividends after announcement of the measures but before introduction of this Bill into Parliament, the Commissioner is given a discretion to ratify dividend statements notwithstanding that they fail to comply with the provisions of amended section 160AQH . This will ensure that companies that have made a genuine attempt to comply with the dividend statement requirements will not be penalised. [Item 80]

Amendments relating to dividend streaming and schemes to confer a franking benefit

5.102 The Bill makes various amendments to allow the anti-streaming rule in proposed section 160AQCBA to apply to exempting credits in an equivalent way to the way it applies to franking credits. [Items 45 to 50, new paragraph 160AQCBA(3)(a), new subsections 160AQCBA(8) to 160AQCBA(12) and new subsections 160AQCBA(16) and 160AQCBA(17)]

5.103 Similarly, the general anti-avoidance rule in proposed section 177EA will be amended so that it applies to schemes where one of the purposes (other than an incidental purpose) of the scheme is to obtain a tax advantage in relation to exempted dividends. [Items 65 to 72, new paragraph 177EA(5)(a), new subsections 177EA(10), 177EA(16), 177EA(18) and 177EA(20)]

Consequential amendments

5.104 Various other consequential amendments are made to the ITAA1936 to take account of the fact that dividends can now be franked under section 160AQF or new section 160AQFA . [Item 7, Item 62 and Items 73 to 79]

TITLE OF PROJECT: Franking credit trading: Limiting the source of franking credits

Regulation Impact Statement

1. Specification of policy objective

5.105 The policy objective is to prevent franking credit trading by limiting the source of franking credits available for trading.

2. Identification of implementation options

Background

5.106 One of the underlying principles of the dividend imputation system is that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use the franking credits themselves. Franking credit trading, which broadly is the process of transferring franking credits on a dividend from investors who cannot use them at all or relatively little (including non-residents and tax exempt entities) to others who can use them or have a relatively greater use for them, undermines this principle.

5.107 A significant source of credits for trading is to be found in companies which have controlling shareholders for whom franking credits have limited or no value, principally non-residents and tax exempt entities.

5.108 Accordingly, among the measures aimed at preventing franking credit trading announced in the 1997 Budget, the Government announced a measure preventing such companies passing on franking credits or rebates from 13 May 1997.

Implementation Options

5.109 The measure prevents companies that are effectively wholly-owned by non-resident or tax-exempt shareholders providing franking credits or rebates to residents and quarantines the franking surpluses of companies which were formerly wholly-owned by non-residents or tax exempt entities.

5.110 Option One would be to provide that companies subject to the measure would continue to frank their dividends with franking credits according to the required franking rules contained in Division 4 of Part IIIAA. However, subject to certain exceptions relating to employee share schemes and life companies, a franked dividend paid to a resident by a company subject to the measure would not carry an entitlement to any franking rebate or franking credit. Non-resident shareholders receiving franked dividends from such companies will be relieved from dividend withholding tax to the extent that they would have been so relieved had the dividend been a franked dividend paid by a company not subject to the measure. Companies which were formerly wholly-owned by non-residents or tax exempt entities would be required to quarantine their franking surpluses or deficits in an exempting account.

5.111 Exceptions relating to employee share schemes and life companies are necessary because the policy objective of the measures is to prevent franking credit trading and not to inhibit legitimate employee share schemes and disadvantage life assurance policy holders. The absence of the exceptions would result in the legislation going beyond the Governments policy objective.

5.112 Option Two would require that companies subject to the measure have their franking accounts cancelled and in its place the company would create a balance of the same amount in an equivalent exempting account. Companies subject to the measure would therefore frank their dividends with exempting credits just as they currently frank dividends with franking credits. Dividends received by residents franked with exempting credits would have no tax effects for such shareholders. Dividends received by non-residents franked with exempting credits would provide a dividend withholding tax-exemption.

3. Assessment of impacts (costs and benefits) of each implementation option

Impact group identification

5.113 The measure will impact on companies who are effectively wholly-owned, or have, since 13 May 1997, been wholly-owned by non-residents or tax exempt entities, and their tax advisers (eg. members of the legal and accounting professions).

5.114 The measure will also impact on the ATO (in administering the rule, for example, information campaigns), the Government (in that the revenue base will be protected) and non-residents and tax-exempt shareholders (whose ability to transfer franking credits will be limited).

5.115 It is not possible to provide any data on the numbers of taxpayers in particular stakeholder groups or the extent of their interests. This is because shares are often held through complicated trust, nominee, or group company arrangements where the underlying ownership is difficult to trace.

Analysis of the costs and benefits associated with each implementation option

5.116 Option One is preferred because the measure can be implemented more simply without the need, for most companies, to create a separate exempting account: this minimises compliance costs for those companies, as well as significantly limiting the number of amendments required to the ITAA 1936.

5.117 Option Two would involve greater compliance costs and complexity than Option One without any commensurate additional benefits.

5.118 Companies which are required to comply with the measures (ie. companies which are wholly-owned by non-residents or tax exempt entities) will not incur additional compliance costs because they will be franking their dividends in accordance with Part IIIAA. These companies will, however, incur some administrative costs as they will be required to change their dividend statements to reflect that the dividends do not give rise to a franking credit or rebate but only provide a dividend withholding tax-exemption. Reliable data on the extent of these costs is not available but they will not be significant.

5.119 In addition, some costs may be incurred in determining whether a company is subject to the measure. However, these costs would be one-off and not significant. Reliable data on the extent of these costs is also not available.

Taxation revenue

5.120 The measure will protect the revenue base used for the forward estimates, by removing opportunities for significant future expansion of franking credit trading and mis-use of the intercorporate dividend rebate. In the absence of the measure, to the extent that the revenue base would not be protected, there would be a significant revenue loss compared to the forward estimates. The measure will assist in preventing this loss to the revenue. No reliable data on the amount by which this revenue loss would be reduced is available. However, extrapolating from cases known to the ATO, the loss is likely to be significant.

5.121 Reliable data on the size of the franking credit trading market, the extent of revenue loss and the amounts of revenue involved in particular franking credit trading transactions is not available because franking credit trading transactions are often hidden amongst commercial transactions and conducted during the course of ordinary share trades.

Consultation

5.122 The ATO and Treasury held extensive consultations with peak bodies representing taxpayers and the investment community (including bodies representing the tax profession, the ASX, merchant banks, superannuation and investment funds) shortly after the Budget announcement on matters relating to the holding period rule. Issues relating to limiting the source were also raised at these consultations. Following from these discussions the exemptions for life insurance companies and eligible employee share schemes were developed.

5. Conclusion

5.123 The measure limiting the source of franking credits available for trading is an important element of the franking credit trading measures announced in the 1997-98 Budget.

5.124 By choosing Option One this policy objective is implemented in a way that, as far as possible, minimises administrative and compliance costs while providing taxpayers with certainty (through a self-executing provision).

5.125 The ATO will closely monitor developments to detect any emerging possibility of significant revenue loss/deferral or unreasonable compliance costs arising from the rule. In addition, the ATO has consultative arrangements in place to obtain feedback from professional associations and the business community and through other taxpayer consultation forums.

Chapter 6 - Deductions for gifts

Overview

6.1 Schedule 6 to the Bill amends the Income Tax Assessment Act 1997 (ITAA 97) to allow income tax deductions for gifts made to the Menzies Research Centre Public Fund.

Explanation of the amendments

6.2 Items 1 and 2 of Schedule 7 to the Bill amend the ITAA 97 to allow deductions for gifts of $2 or more made to the Menzies Research Centre Public Fund after 2April 1998. This is the date after which this measure was intended to operate when it was first introduced into the previous Parliament.

6.3 This will be done by including the Menzies Research Centre Public Fund in the table to subsection 30-40(2) of the ITAA 97. [Item 1] The index to the gift provisions, found in the table to subsection 30-315(2) of the ITAA 97, will also be amended by including the Menzies Research Public Fund as topic number 72A. [Item 2]

6.4 This amendment will result in gifts to the Menzies Research Centre Public Fund being tax deductible as follows:

Chapter 7 - Distributions to beneficiaries and partners that are equivalent to interest

Overview

7.1 Schedule 7 to the Bill will amend section 45Z and other provisions of the Income Tax Assessment Act 1936 (ITAA 1936) to prevent trust or partnership distributions which are equivalent to the payment of interest on a loan from providing an entitlement to the intercorporate dividend rebate, franking credits or franking rebate.

Summary of amendments

Purpose of amendments

7.2 The purpose of the amendments is to ensure that certain trust or partnership distributions which consist of dividends, but are effectively in the nature of interest, do not inappropriately carry franking benefits or receive the inter-corporate dividend rebate. The amendments will apply to taxpayers who hold a debt-like interest in shares indirectly through a trust or partnership; that is, to taxpayers who, under a trust or partnership, are effectively creditors rather than share owners. The amendments will curb the unintended usage of franking benefits and the inter-corporate dividend rebate by preventing the holders of indirect interests in shares from receiving those benefits for trust or partnership distributions consisting of dividends in the same circumstances in which direct holders of shares are denied those benefits for dividends. This will make the taxation treatment of such distributions consistent with the treatment of debt-dividends under existing section 46D of the ITAA 1936.

Date of effect

7.3 The amendments apply to interests created or acquired, and finance arrangements entered into, after 7.30 pm AEST on 13 May 1997, and to existing arrangements extended after that time.

Background to the legislation

7.4 Under existing section 46D, dividends (debt dividends) which may reasonably be regarded as equivalent to interest on a loan are not eligible for the inter-corporate dividend rebate; nor are debt-dividends frankable dividends (section 160APA provides that debt dividends are not frankable). This prevents arrangements to pay effectively tax-free dividends in lieu of interest. It also reflects a basic principle of imputation that company tax should only be imputed to owners of true equity interests in companies, and not to persons who are effectively creditors. Such persons do not bear the economic risk of holding shares to the same extent as shareholders.

7.5 Existing section 45Z generally extends the availability of the intercorporate dividend rebate to dividends derived indirectly through trusts and partnerships. An exception is where, as between the company paying the dividend and the trustee or partnership, the payment of the dividend is equivalent to the payment of interest on a loan. This exception does not, however, cover all cases where trust or partnership distributions consisting of dividends are equivalent to interest; for example, where the beneficiary or partner is receiving a distribution equivalent to interest, but the trustee or partnership is not. The Bill brings the taxation treatment of these cases into line with the existing treatment of other trust and partnership distributions of dividends which are interest-like in the hands of the trustee or partnership.

Explanation of the amendments

7.6 Schedule 9 of the Bill inserts new section 45ZA to deny the intercorporate dividend rebate in certain circumstances. Broadly speaking, this provision applies if a distribution is made to a taxpayer in respect of an interest in a trust or partnership, or under a finance arrangement, and, having regard to the way in which the amount was calculated, the conditions applying to the payment of the amount and any other relevant matters, that amount may reasonably be regarded as equivalent to the payment (or crediting or application) of interest on a loan. [Item 2, new section 45ZA]

7.7 The key elements of the new section are that

•

an amount must be included in the assessable income of a taxpayer; [Item 2, new paragraph 45ZA(1)(a)]

•

the whole or part of that amount must represent a dividend; and [Item2, new paragraph 45ZA(1)(b)]

•

the amount, or part of it, must be equivalent to interest on a loan. [Item2, new paragraph 45ZA(1)(d)]

7.8 In order to be captured by the new section the amount must also be either:

•

paid under a finance arrangement entered into after the commencing date; or

•

paid in respect of an interest created or acquired after the commencing date. [Item 2, new paragraph 45ZA(1)(c)]

7.9 Similarly, amended section 160APQ provides that where partnership or trust distributions are equivalent to interest, franking credits do not flow to the relevant corporate partners or beneficiaries. [Item 5, new section 160APQ]

7.10 For beneficiaries and partners that are not companies:

•

amended section 160AQX (franking rebate for beneficiaries of a trust who are resident individuals or registered organisations);

•

amended section 160AQY (franking rebate for certain trustees who are beneficiaries of a trust);

•

amended section 160AQYA (franking rebates for trustees of superannuation funds, approved deposit funds and pooled superannuation trusts who are beneficiaries of a trust or partners in a partnership);

•

amended section 160AQZ (franking rebate for certain partners);

•

amended section 160AQZA (franking rebate for certain life assurance companies who are beneficiaries of a trust or partnership);

provide that if the distribution from the trust or partnership is equivalent to the payment of interest on a loan, then no franking rebate or credit is to be allowed.

When is a distribution equivalent to interest on a loan?

Loan

7.11 For a distribution to be equivalent to interest on a loan there must be something analogous to a loan.Loan is defined broadly to include the provision of credit or any other form of financial accommodation, and thus includes financing arrangements not strictly loans at law, such as:

•

forbearing to collect payment of a debt which has fallen due;

•

the discounting of bills of exchange or promissory notes; or

•

the giving of a guarantee or surety.

It will therefore include cases where the party accommodated is not the party liable, or primarily liable, to repay the funds advanced, nor even the party liable to make payments in the nature of interest in respect of the accommodation. In particular, it will include cases where, under a financial arrangement, the person receiving financial accommodation is an associate of the trust or partnership making the distribution, or the company paying the dividend (and cases where the person receiving the distribution is an associate of the person providing the financial accommodation). [Item 2, new subsection 45ZA(4)]

7.12 Therefore the loan, or its equivalent, need not subsist between the taxpayer receiving the distribution, and the trust, partnership or company making it, for new section 45ZA and associated provisions to apply. However, to be equivalent to interest on that loan the distribution must be made in respect of it.

7.13 The relationship in the nature of a loan need not be an actual relationship of debtor and creditor as long as it is substantially equivalent to one. New section 45ZA is designed to deal with cases where the commercial and economic substance of a debt relationship has been replicated by obligations which do not amount in law to debt. For example, the right to receive a distribution in money or property at a later point in time equivalent in value to money or property supplied at an earlier point of time, or to call or put property at an agreed price equivalent to an amount paid previously for the property, may be equivalent in substance to a loan. Essentially anything which has the commercial effect of providing the borrower or accommodated party with the use of capital for a term may be equivalent to a loan; that is, anything equivalent to the hiring of money. [Item 2, new subsection 45ZA(4)]

7.14 Accordingly new section 45ZA and associated provisions encompass repayments by way of a provision for the repayment of the capital by a redemption, buy-back, distribution of capital, collateral payback or otherwise, including by way of understanding, guarantee, letter of credit or any other enforceable security.

7.15 Moreover, new subsection 45ZA(2) allows events occurring before or after the payment of the distributed amount which tend to indicate an equivalence to interest on a loan to be taken into account as other relevant matters under new paragraph 45ZA(2)(c) .

7.16 For example, if an instrument (such as a convertible redeemable unit in a unit trust) appeared to be redeemable only at the option of the issuer (the trustee) but statements are made by the issuer upon the announcement of the issue that a buyback is contemplated (eg. to avoid dilution of the ordinary shareholders equity), the provision would apply.

7.17 Similarly, if an announcement is made upon the issue of the units that a buyback of the shares allotted upon conversion of the units will be bought back, the provision would also apply.

7.18 Also, where the terms of the issue are such that a rational issuer would be commercially obliged to repurchase the units the arrangement may be effectively equivalent to a loan. It is a question of fact in each case whether, under an arrangement, temporary or permanent capital has been raised.

Interest

7.19 Having determined that there is something analogous to a loan, it must be determined whether the distributed amount is equivalent to interest on the loan (or other form of financial accommodation). Interest refers to a reward for the use of money over time. Where a financing arrangement not amounting to a loan in the strict sense of the word (though falling within the extended definition of loan) is involved, interest will refer to a reward in the nature of interest for that provision of credit or financial accommodation. As in the case of section 46D, whether or not a distribution is paid (the distributed amount), in effect, in substitution for payments of interest under financing arrangements will be determined having regard to a number of specific criteria and any other relevant matters: new subsection 45ZA(2) . The specific criteria are:

•

the way in which the distributed amount was calculated; and

•

the conditions applying to the payment of the distributed amount.

These criteria invite consideration of whether the distribution has been calculated in a manner analogous to the manner in which interest is calculated, that is, as a rate over time in respect of a principal sum; and similarly, whether the conditions under which the distribution is made, are analogous to the terms and conditions under which interest is payable on a loan, or equivalent financial arrangement.

7.20 In determining whether a distribution is equivalent to the payment of interest on a loan regard would be had, for example, to whether:

•

the distribution is for a fixed or variable percentage of a capital sum provided to some person;

•

the distribution is cumulative; and

•

directly, or by means of a collateral arrangement, the investment of the beneficiary or partner, can be redeemed or effectively recovered.

7.21 For example, if the distributed amount is calculated as a percentage of the sum subscribed for the interest of the partner or beneficiary in the trust or partnership at a rate fixed at the time of subscription, so that the manner of calculation of the distributed amount corresponds with the calculation of interest, that would be a factor pointing clearly to equivalence to the payment of interest. (Similarly, if the distributed amount were calculated as a rate on a sum provided under a finance arrangement to an associate of the partnership or trust, that too would point to equivalence to interest.) Thus if a taxpayer subscribed money to a unit trust, and was entitled after 5 years to have his units redeemed for the amount subscribed (or bought at an equivalent price), and in the interim to receive distributions consisting of dividends at a certain rate with respect to the amount subscribed, it would be concluded that the distributed amount was equivalent to interest on a loan.

7.22 On the other hand, if a taxpayer subscribed money for units in a unit trust, which then invested the money in shares, and the unit holder was entitled to redeem or sell the unit at any time for a sum or price varying with the changing value of the shares, and until then to receive distributions of the dividends payable on those shares according to the beneficiaries proportionate interest in the trust, there would not, absent other factors, be an equivalence between the distributed amount and interest on a loan. [Item 2, new subsection 45ZA(2)]

Finance arrangement

7.23 New subsection 45ZA(4) provides that a finance arrangement is any arrangement (as defined) carried out for a purpose which includes enabling a trustee, partnership or company (or an associate of the trustee, partnership or company) to obtain finance or to obtain an extension of an existing finance arrangement. Finance may be raised, for example, by the issue of shares or the creation of an interest in a trust or partnership.

7.24 Whether one of the purposes of any particular arrangement was to enable the trustee, partnership or company (or an associate) to obtain finance is a decision that must be made objectively in each case, taking into account the surrounding circumstances. For example, the issue of an interest in the trust or partnership that is redeemable may fall within the definition of a finance arrangement. On the other hand, an interest which was not redeemable generally would not come within the scope of new section 45ZA unless circumstances existed to indicate that the interest is to be, or was likely to be, effectively redeemed or extinguished in future.

Associate

7.25 New subsection 45ZA(4) provides that associate for the purposes of the provisions has the meaning given by section 318 of the ITAA, but that it also includes controllers of trusts and members of wholly-owned company groups.

Controller of a trust

7.26 A person is a controller of a trust if:

•

the person beneficially owns, or is able in any way, whether directly or indirectly, to control the application of more than 50% of the interests in the trust property or in the trust income;

•

the person has the power to appoint or remove the trustee of the trust;or

•

the trustee of the trust is accustomed or under a formal or informal obligation act according to the wishes of the person. [Item 2, new subsection 45ZA(4)]

7.27 For the purposes of the associated provisions (ie. amended sections 160AQX, 160AQY, 160AQYA, 160APQ and 160AQZA ) the definitions of associate and finance arrangement are the same as the definitions outlined in new section 45ZA.

Interests in discretionary trusts

7.28 New subsection 45ZA(4) provides that, for the purposes of these provisions, an interest in a trust will include the right of a discretionary object to receive, at the trustees discretion, benefits under the trust. Accordingly, beneficiaries of a discretionary trust hold an interest in the trust if it holds shares and they can benefit from those shares (eg. because the trustee can distribute dividend income to them).

When is a partnership or trust amount paid?

7.29 For the purposes of these measures, a trust or partnership amount is paid where an amount is included in, or allowed as a deduction from, a taxpayers assessable income. Therefore, a distribution from a trust or partnership which is attributable to a dividend will be paid if the amount of the distribution will be included in the taxpayers assessable income. [Item 2, new subsection 45ZA(4)]

7.30 The reference to allowable deduction is intended to deal with the case where a partnership makes a net loss. Each partner will be entitled to a deduction for their share of the loss. If the partnership derives dividends or other franked distributions the amount of the loss will be reduced. The reduced deduction thus effectively includes the dividend in the partners assessable income.

Non-residents

7.31 If a partner or beneficiary is a non-resident, any interest-like distribution from the trust or partnership to which the measures apply will be subject to dividend withholding tax in the same way as if the relevant dividend had been unfranked. [Item 3, new subsection 128B(3A)]

Deduction where franking rebate disallowed

7.32 The amendments made by items 6 to 11 prevent partners and beneficiaries receiving a franking rebate for distributions to which the measures apply. However, because of the operation of the section 160AQT gross-up to the assessable income of the trust or partnership, the partners or beneficiaries assessable income would include a grossed-up amount for which they do not receive a franking rebate. To prevent this, a tax deduction is allowed which removes so much of the beneficiaries or partners share in the net income of the trust or partnership as relates to the gross-up. [Item 12, new section 160ARAC]

Regulation Impact Statement

1. Specification of policy objective

7.33 The policy objective is to prevent the unintended use of franking credits and the intercorporate dividend rebate by amending the ITAA 1936 to provide that if a distribution from a trust or partnership which is attributable to dividends is equivalent to the payment of interest on a loan, the relevant beneficiaries or partners will not be entitled to the intercorporate dividend rebate or franking benefits attaching to the distribution.

7.34 This measure forms part of a package of measures to prevent franking credit trading and dividend streaming which was announced in the 1997-98 Budget. The amendments apply from 13 May 1997.

2. Identification of implementation options

Background

7.35 One of the underlying principles of the imputation system as introduced in 1987 is that the benefits of imputation should only be available to the true economic owners of shares, and only to the extent that those taxpayers are able to use franking credits themselves. Franking credit trading, which broadly is the process of transferring franking credits on a dividend from investors who cannot fully use them (such as non-residents and tax-exempts) to others who can fully use them, undermines this principle. Similarly, dividend streaming (ie. the distribution of franking credits to select shareholders) undermines the principle that, broadly speaking, tax paid at the company level is imputed to shareholders proportionately to their shareholdings.

7.36 Trust and partnership structures can be set up that allow the streaming of franking credits to a third party; such structures can effectively allow the third party to receive interest-like returns that are fully franked. In contrast, investors who receive interest-like returns directly from a company are denied franking credits and the intercorporate dividend rebate under section 46D of the ITAA.

7.37 It is anomalous that equity benefits should flow to beneficiaries or partners who essentially have debt interests in the relevant trust or partnership holding shares while equity benefits are denied where the taxpayer holds a debt-like interest directly in the company. The proposed amendments to section 45Z and related provisions ensure that the treatment of such interests are consistent irrespective of whether they are held directly in a company or indirectly through a trust or partnership.

Implementation Option

7.38 The amendments to the ITAA ensure that, consistent with the operation of section 46D, where:

•

the beneficiary of a trust becomes presently entitled to a share of the income of a trust estate or a partner in a partnership receives a share of the partnership income;

•

that share is attributable, wholly or partly, to dividends; and

•

the entitlement of the beneficiary to its share of the trusts income or the entitlement of the partner to its share of the partnerships income is equivalent to an entitlement to interest on a loan;

no entitlement to the intercorporate dividend rebate, franking credits or franking rebate will arise in respect of the distribution.

7.39 The amendments to section 45Z and related provisions are the only option for implementing the Governments policy objective.

Assessment of impacts (costs and benefits) of the implementation option

Impact group identification

7.40 The proposed amendments will only affect those taxpayers (ie. beneficiaries or partners) who receive distributions which are equivalent to interest on a loan. Therefore, only those taxpayers that enter into such arrangements, and their tax advisers (eg. members of the legal and accounting professions), need to put their mind to the operation of the amended provision. It is unlikely that taxpayers will inadvertently trigger the operation of the provisions because the relevant arrangements are readily identifiable.

7.41 The proposed amendments will also impact on the ATO (in administering the rule), the Government (in that the revenue base will be protected) and non-residents and tax-exempt shareholders (whose ability to transfer franking credits will be hampered).

7.42 It is not possible to provide any numerical data on the numbers of taxpayers in particular stakeholder groups or the extent of their interests. This is because shares are often held through complicated trust, nominee or group company arrangements or funds are invested by fund managers on behalf of clients. Accordingly, underlying ownership is difficult to trace.

Analysis of the costs and benefits associated with the implementation option

7.43 The rule will only apply to taxpayers who enter into specific arrangements. This advantage will ensure that there will be minimal impact on genuine commercial transactions and taxpayers compliance costs will be kept to a minimum. Accordingly, the proposed amendments should not impose high compliance costs on taxpayers.

7.44 Taxpayers who enter into relevant arrangements will incur additional compliance costs in determining whether their distributions are equivalent to the payment of interest on a loan. However, the extent of the compliance costs which will be incurred by taxpayers will vary depending on the facts and circumstances of particular cases. Accordingly, no reliable data on the amount of these costs is available.

7.45 No reliable data on the extent of the administrative costs which will be incurred by the ATO is available, however, any costs that do arise are not expected to be high and would be met within the ATO's existing budget allocation.

7.46 As mentioned above, section 46D currently does not apply to trust or partnership distributions which are equivalent to interest on a loan. It is anomalous that, while section 46D prevents streaming directly to third parties, it is possible under the current law to achieve exactly the same effect if the third party invests in shares indirectly through a trust or partnership rather than directly in the company. It would therefore be more equitable to ensure that the same rules apply to beneficial owners of shares through trusts and partnerships as apply to direct shareholders.

Taxation revenue

7.47 The amendments will protect the revenue base used for the forward estimates, by removing opportunities for significant future expansion of franking credit trading and mis-use of the intercorporate dividend rebate. The amendments are part of a package of measures targeting franking credit trading and dividend streaming. In the absence of the measures, to the extent that the revenue base would not be protected, there would be a significant revenue loss. While it is not possible to provide an exact estimate of the revenue loss that already existed from franking credit trading and dividend streaming, $130 million a year has been factored into the forward estimates for 1998-99 and subsequent years to take account of the effect of the measures on existing activities.

Consultation

7.48 The ATO and Treasury held extensive consultations with peak bodies representing taxpayers and the investment community (including bodies representing the tax profession, the ASX, merchant banks, superannuation and investment funds) shortly after the Budget announcement of the franking credit trading and dividend streaming measures.

Conclusion

7.49 The proposed amendments are an important element of the franking credit trading and anti-streaming measures announced in the Budget and they ensure that taxpayers do not gain an undue tax benefit from entering into arrangements involving franking credit trading and dividend streaming.

7.50 They implement this policy objective in a way that, as far as possible, minimises administrative and compliance costs while providing taxpayers with certainty. This is because as stated above only taxpayers which enter into particular arrangements need to comply with the measures.

The ATO will closely monitor developments to detect any emerging possibility of significant revenue loss/deferral or unreasonable compliance costs arising from the rules. In addition, the ATO has consultative arrangements in place to obtain feedback from professional associations and the business community and through other taxpayer consultation forums.