Foreign income return form guide 2010

A CFC is a non-resident company that satisfies one of three control tests. Whether a company is a resident of a foreign country is determined according to Australian tax law as modified by double taxation agreements with other countries.

The three control tests are the:

• strict control test
• assumed controller test, and
• de facto control test.

Strict control test

A foreign company will be treated as a CFC under the strict control test if a group of five or fewer Australian '1% entities', together with their associates, owns or is entitled to acquire a control interest of at least 50% in the foreign company.

An Australian 1% entity is an Australian entity that, together with its associates, holds an interest of at least 1% in the foreign company.

An Australian entity is an Australian partnership, an Australian trust, or an entity - other than a partnership or trust - that is a Part   X Australian resident. A Part   X Australian resident is a resident of Australia who is not treated solely as a resident of another country under a double taxation agreement between Australia and that country.

The associate-inclusive control interest of an entity is the sum of interests held by the entity and its associates in the foreign company. Interests that the entity and its associates are entitled to acquire are also taken into account.

Example 1

Strict control test

This test will be satisfied if three Australian residents each hold interests of 30%, 10% and 10% respectively in a foreign company.

Assumed controller test

A foreign company will normally be treated as a CFC under the assumed controller test if a single Australian entity owns, or is entitled to acquire, an associate-inclusive control interest of at least 40% in the foreign company. An entity's associate-inclusive control interest in a foreign company is the sum of the interests held in the company by the entity and the associates of the entity. However, a foreign company will not be treated as a CFC under the assumed controller test if the company is controlled by a party or parties unrelated to the single resident or its associates.

Example 2

Assumed controller test

If an Australian entity holds 45% of the interests in a foreign company and the remaining 55% is held by several non-residents, it would be assumed under this test that the Australian entity controls the foreign company.

De facto control test

A foreign company will be treated as a CFC under the de facto control test if a group of five or fewer Australian entities, either alone or with associates, effectively controls the foreign company.

Example 3

De facto control test

If an Australian entity can control the appointment of the directors of a foreign company, the Australian entity will generally be taken to have de facto control of that foreign company.

A statutory accounting period of a CFC is a period of 12   months ending 30   June, unless the CFC makes an election to use another period. The control test is applied at the end of a CFC's statutory accounting period to check whether income of the CFC is to be attributed.

It may also be necessary to measure control at the time a CFC pays a dividend to another CFC or to a controlled foreign trust or at the time a CFC changes residence.

Election to change a CFC's statutory accounting period

A CFC can make an election to change its statutory accounting period only if the accounting period is:

• regularly used by the CFC for complying with the tax law of a foreign country, or
• regularly used by the CFC for reporting to its shareholders.

A CFC may also make a written election, and send it to the ATO, to adopt a statutory accounting period ending on a date other than 30   June if the period is regularly used for complying with the tax laws of the CFC's country of residence or is regularly used for reporting to the CFC's shareholders. You may make this election on behalf of a wholly owned CFC.

A CFC may subsequently elect another statutory accounting period ending on any date, including 30   June, provided the above conditions are satisfied.

Where a CFC chooses another statutory accounting period, it must complete the current statutory accounting period. The intervening statutory accounting period - from the last day of the current period to the beginning of the new period - will be less than 12   months. The new and subsequent statutory accounting periods will be 12   months.

Example 4

Statutory accounting periods

If a company with a statutory accounting period ending 30   June 2002 elected on 30   August 2001 to change to a statutory account period ending 30   September, it would have statutory accounting periods of:

• 1 July 2001 to 30 June 2002
• 1 July 2002 to 30 September 2002
• 1 October 2002 to 30 September 2003, and
• subsequent 12-month statutory accounting periods ending 30   September.

It is not necessary for a CFC to complete the current statutory accounting period before beginning a new period if the election is made when the CFC first comes into existence or when a company first becomes a CFC.

In most cases, an interest in a foreign company will be held in the form of shares. This interest can be held either directly or indirectly through other entities. At a particular time, your interests in a foreign company include the interests you hold in the company as well as the interests you are entitled to acquire.

The interests of your associates in a foreign company are also relevant for determining whether you have an interest in the company.

Direct control interest in a foreign company

Your direct control interest in a foreign company is the greatest of the percentages that you hold, or are entitled to acquire, of the following:

• total paid-up share capital in the foreign company
• total rights to vote, or to participate in any decision making, in relation to
  • the distributions of capital or profits
  • the changing of constituent documents
  • the varying of share capital of the company
• total rights to distributions of capital or profits of the company on winding up
• total rights to distributions of capital or profits of the company other than on winding up.

Example 5

Direct control interest in a foreign company

A foreign company is established issuing 100 ordinary shares. An Australian taxpayer purchases 50 of these shares which entitle the taxpayer to 50% of the income, voting and capital rights of the company. The direct control interest of the Australian taxpayer in the foreign company is 50%.

Example 6

Direct control interest in a foreign company where shares confer different rights

An Australian company has a 50% voting interest and a 75% income interest in a foreign company. The direct control interest of the Australian company in the foreign company is 75%.

How is a direct control interest measured if the test time occurs before the end of an accounting period?

A taxpayer's direct control interest in a company has to be measured at a point in time - referred to as the test time.

However, in some cases it may not be possible to measure the percentage a taxpayer holds of the total rights to the profits of a company, or to a distribution of capital on winding up of the company, before the end of the accounting period of the company.

This would be the case, for example, if some shareholders are entitled to a fixed return of capital or profits.

In these cases, the taxpayer's rights to capital or profits are measured at the end of the accounting period of the company. It is assumed for this purpose that the rights held by the taxpayer at the test time are held at the end of the accounting period of the company.

Exclusion of eligible finance shares

Eligible finance shares are not taken into account in working out an entity's direct control interest in a company. Broadly, these are shares issued under preference share financing arrangements with Australian financial intermediaries - for example, banks - and their subsidiaries. In effect, the shares are issued in place of loans.

Exclusion of real estate investment trust shares

Real estate investment trust shares are not taken into account in working out an entity's direct control interest in a United States real estate investment trust that derives income or holds assets principally in the United States. Control interests held through a United States real estate investment trust will still be taken into account in determining whether a subsidiary of the trust qualifies as a CFC. This will attribute income from a real estate investment trust subsidiary where a taxpayer has a direct interest in the subsidiary.

This exemption applies to statutory accounting periods of CFCs ending on or after 2   July 1998.

A taxpayer may hold a direct control interest in an entity - Entity   A - which holds a direct control interest in another entity - Entity   B. In this case, the taxpayer has an indirect control interest in Entity   B.

A taxpayer's indirect control interest in Entity   B is obtained by multiplying the direct control interest of the taxpayer in Entity   A by the entity's direct control interest in Entity   B.

This process of multiplication is continued where there are further entities in the chain.

Indirect control interest may only be traced through a controlled foreign entity

An indirect control interest in a foreign entity can be traced only through controlled foreign entities (CFEs). These are CFCs, controlled foreign partnerships and controlled foreign trusts.

A controlled foreign partnership is a partnership which does not have a resident partner and has at least one CFC or a controlled foreign trust as a partner. A controlled foreign trust is a trust, other than an Australian trust:

If you have an interest in a CFC you must determine if you are an attributable taxpayer. You are only required to include an amount of attributable income from a CFC in your assessable income if you are an attributable taxpayer in relation to the CFC.

You will be an attributable taxpayer if:

• you have an associate-inclusive control interest of 10% or more in a CFC, or
• all of the following rules apply:
  • the CFC is a CFC because of the application of the de facto control test
  • you are an Australian 1% entity, and
  • you are part of a group of five or fewer Australian entities who, alone or with associates - regardless of whether the associates are Australian entities - controls the CFC.

If you are an attributable taxpayer, you may be attributed a share of a CFC's attributable income. Your share is called an attribution percentage and is based on your rights to profits from the CFC.

Your attribution percentage in a CFC is the sum of your:

• direct attribution interest in the CFC, and
• indirect attribution interests in the CFC.

The interests of your associates are not included.

Your direct attribution interest in a CFC is the greatest of the percentages that you hold, or are entitled to acquire, of the following:

• total paid-up share capital in the CFC
• total rights to vote, or to participate in any decision making, in relation to
  • the distributions of capital or profits
  • changing of constituent documents
  • varying of share capital of the CFC
• total rights to distributions of capital or profits of the CFC on winding up
• total rights to distributions of capital or profits of the CFC other than on winding up.

Test time

Your direct attribution interest in a CFC is measured at a point in time called a test time. The test time may occur during the accounting period of a CFC.

In some cases, it may not be possible to measure the percentage you hold of the total rights to the profits of a company or to a distribution of capital on winding up of the company before the end of the company's accounting period.

In these cases, your rights to capital or profits are measured at the end of the accounting period of the company. It is assumed for this purpose that the rights you held at the test time are held at the end of the company's accounting period.

Exclusion of eligible finance shares

In working out your direct attribution interest in a CFC, eligible finance shares in the CFC are not taken into account.

You may hold an attribution tracing interest in an entity - Entity   A - which holds an attribution tracing interest in another entity - Entity   B.

Your indirect attribution interest in Entity B is obtained by multiplying your attribution tracing interest in Entity   A by that entity's attribution tracing interest in Entity   B.

This process of multiplication is continued where there are further CFEs in the chain of entities.

Your attribution tracing interest in a CFC is equal to your direct attribution interest in the CFC - the deemed 100% rule for tracing control does not apply when tracing your attribution percentage.

The attribution tracing interest of a partner in a partnership is the percentage the partner holds, or is entitled to acquire, of the profits of the partnership or of the partnership property. Where the two percentages differ, the attribution tracing interest will be the greater of those percentages.

The attribution tracing interest that a beneficiary of a trust holds in the trust is the percentage of the income or property of the trust representing the share of the income or property to which the beneficiary is entitled, or is entitled to acquire. If the percentage of the income and the percentage of the property differ, the higher percentage is treated as the attribution tracing interest.

A number of exemptions from accruals taxation are provided for amounts taxed in a comparable tax country listed in the Income Tax Regulations 1936.

Sections 1 and 2 asked the following questions:

• Is there a CFC?
• Are you an attributable taxpayer?

If the answer to both of these questions is yes, the next step is to determine whether you must include an amount in your assessable income.

If you were an attributable taxpayer of a CFC resident in an unlisted country and the CFC changed its residence to a listed country or to Australia while you were an attributable taxpayer, you may be subject to attribution on your share of the accumulated profits of the CFC.

If you are an attributable taxpayer of a CFC at the end of the CFC's statutory accounting period, you may need to include the whole or a part of the profits of that period in your assessable income.

This section will tell you whether you need to work out the attributable income of the CFC. A brief description of the calculation follows.

If you are an attributable taxpayer, your assessable income may include a share of the profit, if any, from certain types of income and gains of the CFC. The profit of the CFC is called attributable income and is worked out before taking into account your share of the profit - called your attribution percentage.

You work out attributable income based on the existing rules for working out the taxable income of a resident company. However, not all of the profits of a CFC are taken into account in working out the attributable income of the CFC.

The general rule

Dividends

Passive income includes dividends (within the meaning of section   6) and:

• unit trust dividends received from a corporate unit trust or a public trading trust
• a distribution made by a liquidator which is deemed to be a dividend.

Interest income

Passive income includes tainted interest income, which is all interest income except for interest derived through an offshore banking unit. It also specifically includes:

• amounts in the nature of interest - for example, discounts
• income earned from hire purchase and other property financing transactions
• accrued interest on discounted and other deferred interest securities issued after 16   December 1984
• interest deemed to be derived where a CFC assumes the rights of a lender through the purchase of securities through a secondary market
• factoring income.

There are three categories of tainted rental income:

• rent from associates
  • income from any leases between a CFC and an associate and any income that arises where rent is paid to the CFC by an associate
• lease of land
  • income from related party lease transactions will be tainted rental income
  • income from leases of land, including fixtures, in respect of land situated in a country other than the CFC's country of residence will be tainted rental income
  • income from leases of land, including fixtures, in respect of land situated in the CFC's country of residence will be tainted rental income unless a substantial part of the income is attributable to the provision of labour-intensive 'property management services' by directors or employees of the CFC in connection with the land
• ships and aircraft
  • income from the lease of ships or aircraft, cargo containers for use on ships or aircraft or plant or equipment for use on board ships, unless the income relates to the provision of operating crew in relation to ships and aircraft or maintenance or management services by the CFC's directors or employees.

Special excluded rental income

An amount of rental income will not be treated as tainted if the following three requirements are satisfied:

• the amount is derived from an associated CFC resident in the same country
• the amount is taxed at the normal company rate of tax in that country, and
• the payment of the amount did not wholly or partly give rise to a notional allowable deduction for the associated CFC.

The second requirement is based on whether an amount has been taxed at the normal company rate of tax in a country. For an amount to be treated as taxed at a country's normal company rate, the amount must be taxed at the same rate applicable to the company's other non-dividend income or at a higher rate. In addition, there can be no entitlement to a credit, offset or tax concession in the taxation of the amount.

For the third requirement, it is assumed that the associated CFC failed the active income test. The requirement will not be satisfied if a payment would have resulted in a notional allowable deduction for an associated CFC if the CFC had been required to work out its attributable income.

Tainted royalty income includes income derived from assigning any copyright, patent, trademark or other like property or right.

Specifically excluded from tainted royalty income are royalties received from unrelated persons in the course of carrying on a business where the CFC substantially develops or improves the property or right for which the royalty is paid. For example, if a CFC develops software and licenses it to an unrelated party, the royalty income is not tainted.

The net gain - that is, the sum of gains less losses - from the disposal of tainted assets is included in passive income.

What is a tainted asset?

Tainted assets include:

• all shares, interests in trusts and interests in partnerships
• most financial instruments - such as loans, forward and futures contracts, swaps, other securities and life assurance policies
• rights or options over any of the above.

An asset will also be tainted if it is held by a CFC to derive tainted rental income. In order to determine whether an asset is used to produce tainted rental income, you must look at the use of the asset over the whole time of ownership. If the purpose changed during that period, the asset will be treated as being used to produce tainted rental income if this was the purpose for the majority of the period of ownership.

Also, an asset will be treated as a tainted asset if it is not trading stock or is not used solely in carrying on business.

Note: the tainted assets referred to in the preceding paragraphs, such as shares, will be tainted assets whether or not they are trading stock or are used in carrying on business.

Exclusion of commodity investments

Commodity investments are not tainted assets. They are treated separately when working out net tainted commodity gains.

Proceeds from trading in tainted assets

Income derived in carrying on a business of trading in tainted assets is included in passive income.

Net tainted commodity gains and losses

The net gain on the disposal of tainted commodity investments is included in passive income.

What is a tainted commodity gain or loss?

A tainted commodity gain or loss arises from the disposal of a tainted commodity investment.

What is a tainted commodity investment?

Commodity investments that are tainted include futures or forward contracts for a commodity - or a right or option on such a contract - unless the company carries on a business of producing or processing the commodity or uses the commodity as a raw material. To be excluded, the contract, right or option must relate to the carrying on of that business and the resultant physical sale of the commodity must not be tainted sales income. The contract must also have been entered into for the sole purpose of eliminating or reducing adverse financial consequences from fluctuations in the price of the commodity.

A net tainted currency gain is the sum of the tainted currency exchange gains less the sum of the tainted currency exchange losses. If this is positive there is a net gain. If not, the amount is ignored.

What is a tainted currency exchange gain or loss?

A gain or loss from a currency exchange fluctuation will be tainted unless it falls within one of the following categories:

• the underlying transaction was for the purchase of goods from an unassociated person
• the underlying transaction was for the purchase or sale of depreciable plant or equipment that was used mainly to produce income that is not passive, tainted sales or tainted services
• the underlying transaction was a hedge for one of the preceding transactions
• the CFC was carrying on business as a currency trader and no other party to the transaction was an associate or an Australian resident.

The tainted sales income of a CFC includes that part of gross turnover that represents sales income where the goods sold were purchased from or sold to:

• an associate who is a Part   X Australian resident, or
• an associate who is not a Part   X Australian resident but carried on business in Australia through a permanent establishment.

Sales which result in tainted sales income

Purchases which result in tainted sales income on sale

Manufacturing exclusion

The main exclusion from tainted sales income is sales where the CFC manufactures, extracts, produces or substantially alters the goods sold. This would include, for example, sales from mining and quarrying operations.

This exclusion will apply only where the goods sold were manufactured, produced or substantially altered by the directors or employees of the CFC. The packaging and labelling of goods is not considered to be a substantial alteration of those goods.

The exclusion will not be available where the CFC subcontracts the manufacture, production or substantial alteration to agents or subcontractors. However, the fact that a CFC subcontracts some operations will not disqualify it from the manufacturing exclusion if directors or employees of the CFC carry out a substantial part of the manufacture, production or substantial alteration.

Hospitality exclusion

Also excluded from tainted sales income are sales that, broadly, arise from the tourism and hospitality industry. These are sales provided in connection with a hotel, motel, guesthouse, restaurant, bar or other place of entertainment or recreation.

Passive income exclusion

Amounts of passive income are excluded from tainted sales income. This prevents double counting.

Tainted services income, in broad terms, means income derived from the provision of services by a company to:

• a resident (except in connection with a foreign permanent establishment of the Australian resident), or
• a non-resident in connection with the non-resident's Australian permanent establishment.

Tainted services income also includes income derived from services provided indirectly to Australian residents, subject to certain requirements.

Services includes any benefit, right or privilege provided under an arrangement for the performance of work or the provision of facilities - for example, performance of technical, managerial or transport work.

Tainted services income

General exclusions

Tainted services income does not include:

• royalties
• any income in respect of a lease of land
• any income from trading in assets, or
• gains from currency exchange rate fluctuations, commodity investments and assets.

Manufacturing exclusion

There is an exclusion from tainted services income where the service relates to goods manufactured by a CFC - for example, payments for after sales service or income derived under a service contract for equipment manufactured by a CFC.

Hospitality exclusion

Also not included in tainted services income are services that, broadly, arise from the tourism and hospitality industry. These amounts are services provided in connection with a hotel, motel, guesthouse, restaurant, bar or other place of entertainment or recreation.

Passive and tainted services income exclusion

Tainted services income does not include passive income or tainted sales income. This prevents double counting.

Indirect services rule

Income from services provided to an Australian resident or Australian permanent establishment of a non-resident is tainted services income. To prevent avoidance of attribution, income from services provided indirectly to certain Australian residents or Australian permanent establishments will also be tainted services where the following conditions are met:

• services provided by the company to an associated entity are received by another entity that is an Australian resident
• the services are provided under a scheme (as defined in section   995-1 of the ITAA 1997), and
• the income from the services would have been tainted income if they had been provided directly by the company to the ultimate recipient.

The services originally provided by the company have to be the same services that are provided to the ultimate recipient.

Example 14

Architect Co and Plans Co are both members of the same corporate group, and both are CFCs of AustCo, an Australian resident company. Architect   Co provides architectural services (house designs) to Australian customers. Plans   Co also develops building and house plans.

Plans Co provides Architect Co (an entity that is an associate) with a suite of highly specific house designs. Architect   Co markets these into the Australian market, assisting customers in choosing the most appropriate design, but otherwise making no changes. In this case, Plans   Co has indirectly provided services to Australian customers, with the house designs received by those customers the same as those originally provided by Plans   Co to Architect   Co.

Therefore, the application of the indirect services rule means that AustCo may have to include an amount in its assessable income that is tainted services income in relation to the services provided by Plans   Co to Architect   Co.

The active income test is used to determine whether a CFC is predominantly engaged in carrying on an active business. An exemption from accruals taxation is available for certain amounts if the test is satisfied.

To determine whether the CFC is mainly engaged in carrying on an active business, the first step is to determine amounts that are likely to be earned in a low-tax jurisdiction to defer Australian tax. These amounts are compared to the CFC's total income to determine the proportion of potential tax deferral activities. Only if this proportion is less than 5% will the CFC be taken to be mainly engaged in active business activities.

A CFC has to satisfy the following five conditions to pass the active income test.

The tainted income ratio for a CFC is worked out as follows:

Broadly, the gross turnover of a CFC is the sum of the company's net gains and gross revenue. Work out the gross turnover using the following five steps:

1. identify the total gross revenue derived by the CFC
2. exclude certain comparably taxed amounts
3. exclude the proceeds of certain asset disposals
4. add back net gains arising from certain asset disposals
5. add the CFC's share of the gross turnover of each partnership in which it was a partner.

The figures used are mainly drawn from the accounts of the CFC. If the accounts are prepared in a foreign currency, there is no need to convert the amounts to Australian dollars.

Step 1 - Identify total gross revenue

The total gross revenue is the sum of amounts shown in the accounts of a CFC as gross revenue - that is, deductions are not taken into account. Do not include amounts that have not been brought to account in the period. For example, an amount may not be recognised in the accounts because its receipt is extremely doubtful. This amount would not be included in gross revenue. The exclusion of the amount must, however, be in accordance with commercially accepted accounting principles and give a true and fair view of the CFC's financial position.

Step 2 - Exclude comparably taxed amounts

Certain comparably taxed amounts are excluded from the active income test. They are:

• a franked dividend
• an amount included in the CFC's assessable income in any year of income, unless the amount is only subject to dividend or interest withholding tax or is not fully taxed - for example, certain shipping or insurance premiums
• an amount arising from the disposal of an asset that is taxable Australian property
• an amount that is an attribution account payment to the extent that the profits from which the payment was made have been previously attributed to you
• an amount derived through a branch in a listed country if the amount is taxed in that country, and
• a non-portfolio dividend from a foreign company.

Because trust amounts arising to a CFC are attributed regardless of whether the CFC passes the active income test, they are also excluded from the tainted income ratio calculation.

Step 3 - Exclude proceeds from certain asset disposals

Amounts that arise from asset disposals are excluded from the gross revenue. However, this exclusion does not extend to disposals of trading stock. Amounts included in gross revenue from currency exchange rate fluctuations and commodity investments are also excluded.

Step 4 - Add back net gains

The amounts that were excluded under step   3 are brought back into gross turnover as net amounts. There are three separate net amounts:

• the net gain from the disposal of commodity investments
• the net gain from currency exchange rate fluctuations
• the net gain from the disposal of other assets that are not trading stock or commodity investments.

In each case, to determine the net gain, the sum of the individual gains is reduced by the sum of the losses. If there is a net loss, the amount is ignored - it does not reduce the gross turnover. It is important to note that there is a separate calculation of net gain for each of the categories. Do not take comparably taxed amounts into account.

Consideration paid or received for asset disposals must be included at market value. Where an amount has been written down in the accounts, the write-down is to be ignored.

Step 5 - Include partnership turnover

A CFC's share of the gross turnover of a partnership must be added to the CFC's gross turnover. This is done for each partnership in which the CFC is a partner. This means that you must go through the same process - steps   1 to 4 - for each partnership.

In working out the total, treat the partnership as if it were a CFC. The partnership is assumed to be a resident of the same country as the CFC.

Result of steps 1 to 5

Add the amounts at steps   2 and 3. Take this total away from the total revenue at step   1. The balance is the gross revenue after exclusions.

Add the totals of steps 4 and 5. This is the CFC's gross turnover.

Gross tainted turnover is the part of the gross turnover that is either passive income, tainted sales income or tainted services income.

Broadly, passive income includes:

• dividends
• tainted interest income
• annuity income
• tainted rental income
• tainted royalty income
• amounts derived as consideration for the assignment in whole or part of any copyright, patent, design, trade mark or other like property or right
• net gains on the disposal of a tainted asset
• income derived in carrying on a business of trading in tainted assets
• net tainted commodity gains
• net tainted currency exchange gains.

Tainted sales income and tainted services income are, broadly, income from certain transactions with, or originating from, associates or Australian residents.

The gross tainted turnover is worked out using the following five steps:

Step 1

Identify the part of gross revenue that is passive income.

Step 2

Add the part of gross revenue that is tainted services income.

Step 3

Add the part of gross revenue that is tainted sales income.

Step 4

Add the part of the gross turnover that is net tainted gains.

Step 5

Add the CFC's share of the gross tainted turnover of each partnership in which it was a partner.

Identify the tainted part of gross revenue (steps 1, 2 and 3)

Identify which parts of the gross revenue are passive income, tainted sales income or tainted services income - that is, determine the tainted part of the result after step   3 of the calculation of gross turnover.

Identify tainted net gains (step 4)

Identify the parts of the net gains that are tainted - that is:

• the part of the net gain from the disposal of commodity investments that is tainted
• the part of the net gain from currency exchange rate fluctuations that is tainted, and
• the part of the net gain from the disposal of assets - other than trading stock or commodity investments - that is tainted.

Each of the net tainted gains is calculated separately and cannot exceed the amount of the net gain to which it relates. To do this you will need, in each case, to calculate the net gain and the net tainted gain. If the net tainted gain is greater than the net gain, use the net gain instead of the net tainted gain.

Identify the CFC's share of a partnership's gross tainted turnover (step   5)

Go through steps 1 to 4 for each partnership in which a CFC was a partner. The CFC's share of the gross tainted turnover of each partnership is then added to the CFC's tainted income that was derived directly.

The tainted income ratio is worked out by dividing the gross tainted turnover of a CFC by the gross turnover of the CFC.

The following is a simple example of how to work out the tainted income ratio.

Example 15

Working out the tainted income ratio

		HK$ (shown in accounts)
Interest - passive		2m
Royalty - passive		1m
Business income - from goods manufactured in Hong Kong		60m
Manufacturing expenses		40m
Tainted income ratio	= gross tainted turnover                   gross turnover = 3m     63m = 4.8% of gross turnover

Therefore, the CFC passes the test.

Is the tainted income ratio less than 5%?

Attributable income is included directly in your assessable income. It is not necessary to aggregate amounts of attributable income as you trace through a chain of CFCs.

Example 16

Attribution directly to taxpayer

Assume you wholly own a foreign company which, in turn, wholly owns another foreign company. Also assume that the first company has $300,000 attributable income and the second company has $200,000 attributable income.

You include an amount in your assessable income as follows:

Attributable income is taxable income

Attributable income is a hypothetical amount. It is the amount that would be the taxable income of a CFC, based on certain assumptions. These are explained below.

Assume the CFC is a resident taxpayer

To work out attributable income it must first be assumed that the CFC is both a resident of Australia and a taxpayer for the whole of a statutory accounting period. You can then work out the attributable income in the same way you work out the taxable income of a resident company. Amounts derived by a CFC from all sources will be taken into account because residents are taxable on their worldwide income and gains.

To distinguish the calculation of attributable income from a 'real' calculation of taxable income, the amounts used to work out attributable income are called notional amounts. Thus, attributable income is the amount by which the notional assessable income is greater than notional allowable deductions. Income that is not notional assessable income is notional exempt income.

The assumption that a CFC is a resident of Australia does not change the nature of the activities of the CFC - that is, events that occur in a foreign country will not be taken to have occurred in Australia.

Modifications in working out the attributable income of a CFC

In applying the Act to work out a CFC's hypothetical taxable income, you will need to read the Act as if certain modifications (dealt with later in this chapter) have been made to it.

In some cases, provisions are ignored because the application is not appropriate. In other cases, provisions have been replaced with similar provisions that are tailored to the way the attributable income is worked out.

In addition, provisions have been included that are not comparable to other provisions of the Act. These modifications are explained later in this part.

Some provisions of the Act clearly cannot apply when working out attributable income - for example, Part   IV, which deals with the making of returns or assessments. Although these provisions of the Act are not specifically excluded from the calculation, for practical purposes they have no effect and can be ignored.

Taxable income is worked out for a period called an income year. To apply the Act, the statutory accounting period of a CFC is assumed to be an income year. The particular income year referred to in working out attributable income will be the income year of the attributable taxpayer in which the statutory accounting period ends.

Example 17

Assume you are working out the amount to be included in assessable income for the year ending 30   June 2007 and the statutory accounting period of the CFC ended on 30   September 2006. The attributable income of the CFC for that statutory accounting period is to be worked out in accordance with the provisions of the Act that applied for the year ended 30   June 2007.

You must work out your attributable income for a CFC separately to other attributable taxpayers. Different taxpayers may work out different amounts of attributable income for a CFC - that is, the amount included in assessable income may be different for each attributable taxpayer even if they have the same attribution percentage in the CFC.

There are differences in working out attributable income depending on whether a CFC is a resident of a listed country or unlisted country.

The notional assessable income of a CFC includes only amounts that fall into specified categories. All other amounts are treated as notional exempt income.

The excluded amounts depend on whether the CFC passed or failed the active income test.

What if a CFC fails the active income test?

If a CFC fails the active income test, amounts that would be assessable if the CFC were a resident are included in attributable income to the extent they represent the following:

• adjusted tainted income derived by the CFC directly
• adjusted tainted income derived by the CFC indirectly as a partner in a partnership
• trust amounts arising to the CFC directly
• trust amounts arising to the CFC indirectly because the CFC is a partner in a partnership
• transferor trust amounts arising to the CFC directly or indirectly as a partner in a partnership, or
• FIF income derived by the CFC directly or indirectly as a partner in a partnership.

What if a CFC passes the active income test?

If a CFC passes the active income test, amounts that would be assessable if the CFC were a resident are included in attributable income to the extent they represent the following:

• FIF income derived by the CFC directly or indirectly as a partner in a partnership
• trust amounts arising to the CFC directly
• trust amounts arising to the CFC indirectly because the CFC is a partner in a partnership, or
• transferor trust amounts arising to the CFC directly or indirectly as a partner in a partnership.

This section explains a number of general modifications to the taxation law which apply when working out the attributable income of a CFC. There are also modifications to:

• the treatment of gains and losses made by a CFC on the disposal of a capital asset
• the treatment of losses incurred by a CFC, including the quarantining of deductions, and
• the treatment of amounts derived through a partnership.

The operation of the capital gains tax provisions of the tax acts is modified for working out the attributable income for a controlled foreign company (CFC).

Capital gains and losses taken into account in working out attributable income for a CFC are those arising on the disposal of assets, other than capital gains tax (CGT) assets which are taxable Australian property.

(A capital gain or loss on the disposal of a CGT asset which is taxable Australian property is taken into account in working out the actual assessable income of the CFC as a non-resident taxpayer and is therefore excluded from the calculation of the CFC's attributable income).

Note: This exclusion applies even if the relevant asset is not subject to CGT because it was acquired before 20   September 1985.

In determining whether an asset is a CGT asset that is taxable Australian property, the assumption that the CFC is a resident of Australia is ignored. In almost all cases, however, the residency assumption will make no difference.

There are five categories of CGT assets that are taxable Australian property. These five categories are as follows.

1. Taxable Australian real property which is directly held.

This includes:

• real property situated in Australia, and
• mining, quarrying or prospecting rights where minerals, petroleum or quarry materials are situated in Australia.

Where such assets are depreciating assets, then capital gains and losses are disregarded for CGT purposes.

2. Indirect Australian real property interest (other than interests in category   5).

A membership interest held by an entity in another entity where the following two tests are met:

• non-portfolio interest test (broadly where the interest in an entity, whether foreign or Australian, must be at least 10%), and
• principal asset test (where the market value of the entity's assets is principally attributable to Australian real property).

Note: Where an indirect Australian real property interest held on 10   May 2005 was not previously subject to CGT, its cost base is reset to its market value on that day. For the reset to occur, on 10   May 2005 the following must be satisfied:

• the interest was held by a foreign resident (or trustee of a non-resident trust)
• the interest was a post-CGT asset, and
• the membership interest did not have the necessary connection with Australia (within the meaning of the law on 10   May 2005) disregarding the operation of items 5(b) and 6(b) of the table in section 136-25.

As a result, unrealised capital gains and capital losses on 10   May 2005 are not subject to CGT.

3. Business assets used in an Australian permanent establishment of a foreign resident (other than assets in category 1, 2 or 5).
   
    
4. Options or rights over category 1, 2 or 3 assets.
   
    
5. Assets where a CGT gain or loss is deferred when an entity ceases to be an Australian resident.

Note: The specific list of CGT assets which are taxable Australian property are set out in section 855-15 of the ITAA 1997.

Assets used to produce notional exempt income

In working out taxable income, the capital gains tax provisions do not normally apply to the disposal of assets used solely for the production of exempt income. However, in working out attributable income, capital gains or losses on the disposal of assets used to derive notional exempt income can be taken into account.

When applying the capital gains tax provisions in working out attributable income, all CGT assets other than taxable Australian property that a CFC owns are deemed to have been acquired on 30   June 1990 or a later date - being the last day of the most recent period during which there was not an attributable taxpayer with a positive attribution percentage. As such, the exemption for pre-20   September 1985 assets does not apply in working out attributable income.

The cost base of assets owned by a CFC is the market value at the later of:

• the last day of the most recent period during which there was not an attributable taxpayer with a positive attribution percentage in relation to the CFC, and
• 30 June 1990.

This day is called the 'commencing day'.

Example 24

Cost base of asset

A company is a CFC from 31 December 1990. However, there is not an attributable taxpayer with a positive attribution interest until 1   March 1993 at 5.00pm. The CFC acquired an asset on 1   May 1992 and disposes of the asset on 1   October 2006.

Consequences

The asset will be deemed to have been acquired for market value on 1   March 1993. This is the commencing day as it is the last day of the most recent period during which an attributable taxpayer did not have an attribution percentage. The capital gain or capital loss is therefore worked out using the change in the asset's value between 1   March 1993 and 1   October 2006.

You work out the amount to include in a CFC's notional assessable income in broadly the same way as for the usual operation of the capital gains tax provisions. That is, you must determine the excess of a CFC's capital gains over the CFC's capital losses and include that excess - the net capital gain - in the CFC's notional assessable income. A net loss can only be carried forward to be offset against future capital gains. However, there are certain modifications to the CGT provisions that apply when working out attributable income.

An unrealised gain that accumulated on or before the commencing day will not be taxed. Correspondingly, any unrealised loss accumulated up to that date will not be allowed. This is done by valuing the assets on the commencing day and, in general, using that value as the consideration paid.

However, where an asset had decreased in value on or before the commencing day, the gain using the market value as the consideration paid could be bigger than the actual gain. Similarly, where the asset had appreciated in value on or before the commencing day, the loss using the market value as the consideration paid could be greater than the actual loss. In either of these cases, only the actual gain or loss is taken into account. To achieve this result, you must use as the consideration paid for such assets either the market value of the asset at the commencing day or the actual cost base of the asset, whichever produces the smaller gain or loss. That is:

• in working out a gain, use the greater of the unindexed cost base and the market value on the commencing day
• in working out a loss, use the lower of the unindexed cost base and market value on the commencing day.

The cost base of an asset acquired by a company on or before 21   September 1999 may be indexed for inflation. However, the cost base of the asset may only be indexed for inflation up until 21   September 1999 if that asset was held for at least 12   months.

Indexation factor

If a CFC's notional allowable deductions are more than the notional assessable income for an accounting period, the excess cannot be claimed against notional assessable income of another CFC. However, the CFC will be able to offset a revenue loss against a net capital gain because of the repeal of subsection   424(2) of the ITAA 1936.

The excess loss incurred by a CFC is carried forward and can be claimed as a notional allowable deduction against the notional assessable income of that CFC in a later year.

Note: Different quarantining rules apply to prior years of income ending on or before 30   June 2008. Further details are provided in the relevant Foreign income return form guide for that year.

A CFC with unutilised losses quarantined into the four classes of notional assessable income for an earlier statutory accounting period will be required to convert those losses at the commencement of the statutory accounting period starting on or after 1   July 2008.

A CFC will be required to convert to one loss bundle, any loss in relation to notional assessable income of a particular class that has not yet been taken into account. A CFC will have a loss, for an earlier statutory accounting period, if:

• it has an undeducted loss in relation to notional assessable income of a particular class
• the loss was made in any of the most recent 10 statutory accounting periods ending before the commencement period, and
• a loss remains after disregarding certain amounts.

The amount of the loss is the sum of each loss in relation to notional assessable income of a particular class for the earlier period, after disregarding certain amounts.

Before summing together each loss of a particular class of notional assessable income, the CFC is required to reduce each loss according to the conversion rules using a step by step approach.

The first step applies only to a CFC that has an existing loss in respect of the 'all other amounts' class of notional assessable income. The CFC must reduce the loss, except to the extent it is attributable to income that would be its notional assessable income or sometimes-exempt income.

The second step requires a CFC with a loss older than seven years, but not more than 10   years (from the first statutory accounting period starting on or after the 1   July following commencement), to halve the loss that remains after step   1 (where applicable).

The result is the amount of the convertible CFC loss for the earlier statutory accounting period. This removes the classes of notional assessable income, leaving the CFC with a single convertible CFC loss for some or all of the most recent 10 statutory accounting periods ending before 1   July 2008.

A convertible CFC loss will be treated as a loss only for the purpose of applying Part   X of ITAA 1936 to statutory accounting periods beginning on or after 1   July 2008. This ensures that the CFC cannot deduct the convertible CFC loss from notional assessable income in accounting periods prior to commencement.

You may claim a notional allowable deduction for a 'sometimes exempt income loss'. A sometimes exempt income loss can arise for a CFC in an accounting period if:

• the CFC passed the active income test for the period, or
• the CFC gained the benefit of the de minimis exemption for the period, and
• the CFC has any expenses that are not notional allowable deductions but would have been if the CFC had not passed the active income test or gained the benefit of the de minimis exemption.

The sometimes exempt income loss is worked out by:

• assuming that the CFC had passed the active income test and did not have the benefit of the de minimis exemption
• working out the amounts that would be included in the notional assessable income - called the sometimes exempt income
• working out notional allowable deductions that would be available if the sometimes exempt income were assessable - called 'sometimes exempt deductions'.

If sometimes exempt deductions are more than the sometimes exempt income, the difference is a sometimes exempt income loss.

In contrast, a sometimes exempt income gain will arise where the amount of sometimes exempt income is more than the sometimes exempt deductions. The sometimes exempt income gain reduces a CFC's loss. Losses in the current period are reduced before losses carried forward from a previous period.

You are allowed a notional deduction for a previous year's loss only if the CFC was a CFC when the loss was incurred and at the end of each period until the loss is claimed.

In working out the CFC's previous years' losses you must assume that you were always an attributable taxpayer who was required to work out attributable income. Therefore, it is possible to carry forward a loss from a period when you were not an attributable taxpayer.

You cannot take into account any loss incurred in a statutory accounting period that commenced before 1   July 1983.

A loss that was incurred in a previous statutory accounting period is only allowable if the CFC was a CFC at the end of that statutory accounting period in which the loss arose and at the end of each of the following statutory accounting periods before the eligible period.

In addition, certain residency requirements must be met before the loss may be applied against the notional assessable income in the eligible period. If these are not satisfied the loss will not be taken into account.

Modifications to the general rule deal with cases where a company:

• remains a resident of the same country, but
• is treated as changing residence from a listed country to an unlisted country or vice versa as a result of changes to the lists of countries or political developments - for example, as a result of the dissolution of a country.

In these cases, the losses incurred by a CFC in an earlier period are not denied solely because the listing status of a CFC's country of residence changes.

The following table summarises the availability of losses incurred in previous statutory accounting periods.

Note: Losses are not allowable if they were denied in an earlier statutory accounting period.

The notional assessable income of a CFC includes the CFC's share of the net income of a partnership. You work out the net income of the partnership in accordance with the partnership provisions of the Act. However, it is assumed that:

• the partnership derived only certain income and gains
• the operation of the Act is modified.

The assumptions made for amounts derived by a partnership mirror the assumptions made for working out the income and gains of a CFC (except where the assumption applies only to companies). The amounts taken into account in working out the net income of the partnership depends on whether the CFC passes the active income test. The amounts also depend on whether the CFC is a resident of a listed country or an unlisted country.

If a CFC is resident in an unlisted country and it:

• passes the active income test, then the only amounts taken into account in determining the net income of the partnership are trust amounts (including transferor trust) arising for the partnership and amounts of FIF income
  
   
• fails the active income test, then only the following amounts are taken into account in determining the net income of the partnership:
  • adjusted tainted income
  • trust amounts (including transferor trust) arising for the partnership, and
  • FIF income.

If a CFC is resident in a listed country and it:

• passes the active income test, then only the following amounts are taken into account in determining the net income of the partnership:
  • low-taxed third-country income of a kind specified in the Regulations
  • FIF income
  • trust amounts arising for the partnership that are not subject to tax in a listed country or are subject to tax and are designated concession income, and
  • transferor trust amounts arising for the CFC as a partner in a partnership
• fails the active income test, then only the following amounts are taken into account in determining the net income of the partnership:
  • eligible designated concession income that is adjusted tainted income,
  • low-taxed third-country income of a kind specified in the Regulations
  • FIF income
  • trust amounts arising for the partnership that are not subject to tax in a listed country or are subject to tax and are designated concession income, and
  • transferor trust amounts arising for the CFC as a partner in a partnership.

The notional assessable income of a CFC may include certain trust amounts arising for the CFC in the statutory accounting period. There are three types of trust amounts:

• amounts derived as a beneficiary of a trust estate where the CFC is presently entitled to a share of the net income of the trust estate
• other amounts paid to, or applied for the benefit of, the CFC by the trustee of a trust estate, and
• amounts attributed to the CFC under the transferor trust measures.

The attributable income of a CFC is reduced if you are taxed on a dividend paid by the CFC out of current year profits and you would be assessable on those profits under the CFC rules at the end of the statutory accounting period of the CFC.

An interim dividend is considered to have been paid out of the attributable income of the current statutory accounting period only if there are no earlier profits available out of which the dividend could have been paid. When there are such earlier profits, the dividend is considered to have been paid out of those profits. Any balance of interim dividend is considered to have been paid out of the attributable income of the current statutory accounting period.

If an amount of income or gain is to be included in your assessable income as a result of tracing control through a foreign entity and that foreign entity has also been taxed on that amount under the accruals tax laws of another country, you may reduce your assessable income by an amount calculated as follows:

Your indirect attribution interest through a controlled foreign entity is your attribution interest in a CFC traced through the controlled foreign entity.

The foreign accruals-taxed attributable income is that part of an amount of income or gain derived by a CFC on which an interposed controlled foreign entity has been taxed under an accruals tax law of a listed country. The income or gain must be taxed at that country's normal company rate of tax and during a tax accounting period which commences or ends either in your year of income or the statutory accounting period of the CFC.

Only countries listed in the Income Tax Regulations 1936 as having accruals tax laws are recognised for the purpose of granting this relief. They are:

• Canada
• France
• Germany
• Japan
• New Zealand
• United Kingdom of Great Britain and Northern Ireland
• United States of America.

Example 28

Reduction of an otherwise assessable section 456 amount

Scenario

Ausco owns 50% of the share capital of US Co - a company resident in the United States - which in turn owns 50% of the share capital of a company that is a resident of an unlisted country. Ausco also holds a direct interest of 25% of the unlisted country company.

Because of the interests Ausco holds in US Co and the unlisted country company, both foreign companies are CFCs.

For the 2004-05 period, the unlisted country CFC's only item of income was interest income. The amount of this interest income was determined to be $8,000 under Australia's income tax laws.

The United States taxed US Co on an accruals basis on the item of interest income derived by the unlisted country CFC. US Co's interest in the unlisted country company was 50%. Therefore, only half of the item of interest income was attributed to US Co by the United States.

Australia applied the transfer pricing provisions to an interest-free loan which the unlisted country company provided to a related CFC. Consequently, another $2,000 interest income was included in the unlisted country CFC's attributable income under Australia's accruals tax laws. This amount was not included in the unlisted country CFC's attributable income under the accruals tax laws of the United States.

Working out the amount to be attributed to Ausco

Step 1 - Determine Ausco's otherwise assessable amount

Ausco's attributed percentage of the attributable income of the unlisted country CFC is:

direct attribution interest	25%
indirect attribution interest	25%
Attribution percentage	50%

Ausco's otherwise assessable amount is $5,000 (50% attribution percentage) x   ($8,000 interest income   +   $2,000 interest income), arising from the application of the transfer pricing provisions.

Step 2 - Determine Ausco's indirect attribution interests through US Co

Ausco's indirect attribution interest in the unlisted country CFC through US Co is 25% - that is, Ausco's 50% direct interest in US Co multiplied by US Co's 50% interest in the unlisted country CFC.

Step 3 - Determine the unlisted country CFC's foreign accruals-taxed attributable income

The unlisted country CFC's foreign accruals-taxed attributable income worked out under Australian accruals tax rules equals $8,000. This amount is referable to the item of interest income included in the attributable income of the unlisted country CFC under the United States' accruals tax laws. It is important to note that the amount is not necessarily the same as the amount worked out under the United States' accruals tax laws.

Step 4 - Determine the amount by which Ausco's otherwise assessable amount is to be reduced

Reduce the otherwise assessable amount by $2,000 - that is, step   2 multiplied by step   3.

Step 5 - Determine Ausco's assessability in respect of the unlisted country CFC's attributable income

Ausco's assessability for the unlisted country CFC's attributable income is $3,000 - that is, step   1 minus step   4.

You need to work out how much of the attributable income of the CFC to include in your assessable income. Multiply your attribution percentage in the CFC at the end of the statutory accounting period by the attributable income of the CFC. Include the result in your assessable income.

ATO references:
NO NAT 1840