House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon. John Howard, M.P.)

Main features

The main features of the Income Tax Assessment Amendment Bill 1982 are as follows:

International tax avoidance (Clauses 19 and 21-23)

This Bill introduces revised measures, announced on 27 May 1981, to counter arrangements that result in avoidance of Australian tax through what are commonly referred to as "transfer pricing" or "profit shifting" arrangements. The new provisions will replace existing section 136, which has appeared in the Principal Act, as set out below, since 1936. An earlier version had been inserted into the income tax law as section 28(1) of the Income Tax Assessment Act 1922. The section now reads -

"136. Where any business carried on in Australia -

(a)

is controlled principally by non-residents;

(b)

is carried on by a company a majority of the shares in which is held by or on behalf of non-residents; or

(c)

is carried on by a company which holds or on behalf of which other persons hold a majority of the shares in a non-resident company,

and it appears to the Commissioner that the business produces either no taxable income or less than the amount of taxable income which might be expected to arise from that business, the person carrying on the business in Australia shall, notwithstanding any other provision of this Act, be liable to pay income tax on a taxable income of such amount of the total receipts (whether cash or credit) of the business as the Commissioner determines.".

As will be seen, the Commissioner of Taxation is empowered under section 136 to determine a taxpayer's taxable income as a proportion of the total receipts of the taxpayer's business, where the conditions identified in the section have been satisfied. In broad terms, the section is intended to give the Commissioner power to reconstruct the taxable income of a taxpayer to whom the section applies, where the taxpayer has shifted profits out of Australia, so reducing or eliminating Australian tax otherwise payable.

For the existing section to apply, it must be established that the taxpayer carries on business in Australia, that there is a control or ownership situation as described in paragraph (a), (b) or (c) of the section and the Commissioner must be satisfied that the business produces no taxable income or less than the amount which might have been expected to arise from that business.

However, one serious deficiency in the rules which allow the section to apply was exposed by the High Court in its decision in F.C. of T. v Commonwealth Aluminium Corporation Ltd (1980) 143 CLR 646.

The majority of the court decided that although a resident Australian company, Commonwealth Aluminium Corporation, was ultimately 90 per cent owned by two non-resident companies, the business was "controlled", in the sense in which that word is used in section 136, by its directors who were resident in Australia. Therefore the relevant basic test of the section - that which requires control by non-residents - was not satisfied.

A control test does not necessarily cover all the situations that may be of relevance in this area - two completely independent parties may well find it in their mutual interests to arrange matters within Australia so as to reduce tax payable here by one of the parties, and, for example, to split the tax avoided by some offsetting deal abroad. The share ownership tests of existing section 136 also have limitations - they may be avoided, for example, by interposing other entities into a chain of ownership.

Proposed Division 13 accordingly does not depend on basic tests of control or share ownership. Instead, the Commissioner of Taxation will be authorised to apply the substantive provisions of the Division, and to adjust income or deductions, where:

(a)

property (including services) is supplied or acquired under an "international agreement", that is, broadly, where it is supplied or acquired by a non-resident of Australia other than in connection with a business carried on by the non-resident through a branch in Australia, or where it is supplied or acquired by a resident of Australia in connection with a business carried on overseas;

(b)

he is satisfied that any 2 or more of the parties to the agreement were not dealing at arm's length with each other in relation to the supply or acquisition of property under the agreement; and

(c)

he is satisfied that the supply or acquisition was at other than an arm's length consideration, that is, the consideration that might reasonably have been expected if the property had been supplied or acquired under an agreement between independent persons dealing at arm's length.

The test that an "international agreement" must exist before the revised Division may apply means that transactions all of the parties to which operate in Australia and are subject to income tax in Australia in respect of the transaction (especially those solely within Australia between Australian residents) will not be affected.

There are a number of other technical deficiencies or potential deficiencies in the existing section 136, particularly -

(a)

the section, in general, only applies to non-residents that engage in international profit shifting and does not set out to deal with Australian residents engaging in such activities;

(b)

the limitation to business income may preclude application of the section to rents, interest, or other transactions not clearly linked to a business;

(c)

the section may only apply to companies and not to other entities such as individuals and trusts;

(d)

the section is inadequate to impute the derivation of income in a transaction which would produce income if it were one between independent parties, such as an interest-free loan to an off-shore associate;

(e)

the section's link with total receipts could be unduly restrictive - it could mean that even where total receipts have been reduced by a tax avoidance arrangement, the Commissioner would be unable to look beyond the reduced amount in determining taxable income.

The revised Division 13, which this Bill will insert into the Principal Act, is designed to also overcome these difficulties and to provide in the international area a general supplement to the new Part IVA of the Principal Act. Because of policy and technical interrelationships between the two, a number of the now proposed provisions draw on the measures contained in Part IVA.

Once the initial tests in the revised provisions, referred to earlier, permit the Commissioner to make adjustments to an item of income or deduction shown in a taxpayer's return, and the case is one where it is appropriate for the Division to apply, the Commissioner will be required to re-determine the taxpayer's assessable income or allowable deductions, basically by using the internationally accepted "arm's length" principle, a principle relevant under existing section 136. The arm's length principle is also at the base of provisions in each of Australia's comprehensive double taxation agreements that enable the determination of profits attributable to business activities in one or other of the countries concerned.

That arm's length principle is defined in the proposed Division 13 and in essence refers to the consideration that might, on the basis of analysis of all relevant available evidence, reasonably be expected to have passed between independent parties dealing at arm's length with each other in relation to the supply or acquisition of the property or services concerned.

There can be situations, for which both existing section 136 and each of the double taxation agreements make provision, where it is not feasible to ascertain the arm's length consideration that is to be taken as a benchmark. This can happen where the nature of the industry is such that relevant arm's length dealings do not exist, or where information about arm's length dealings is not available to the taxation authorities. The new provisions will, in relation to such situations, enable appropriate re-construction of Australian taxable income arising in international transactions.

Apart from the necessity to determine under the proposed provisions, on the basis of the principles outlined earlier, the amount of consideration that is for Australian income tax purposes to be taken to have been derived or incurred in respect of a supply or acquisition of goods or services, a question may also arise in such international transactions as to how much of it has, or relates to, a source in Australia or in another country. This could occur, for example, where there are successive steps of manufacture in Australia and another country and particularly where operations in one country are conducted through a branch (permanent establishment).

The revised Division 13 contains provisions which authorise the Commissioner to determine these questions, again using the arm's length principle.

The provisions will also expressly provide for situations where there is profit shifting between a head office abroad and its branch in Australia or vice versa. At this level, the profit shifting is of a somewhat different kind to that occurring under an international agreement because essentially it occurs not through actual transactions in goods, merchandise and the like, but through book entries involving, say, the invoicing of goods at excessive prices to a branch in Australia, the charging of an excessive proportion of head office expenses to the branch, or attributing too little of the firm's income to the branch.

In such circumstances, the Commissioner will be empowered to adjust income or deductions, by reference to arm's length guidelines, having regard to the circumstances that might have been expected to exist if the permanent establishment were a distinct and separate entity and its dealing with the taxpayer (i.e., the head office) and other persons were at arm's length.

The proposed Division will also expressly authorise the Commissioner to make any necessary compensating adjustments in favour of the taxpayer, or other taxpayers, where he considers it fair and reasonable to do so as a consequence of his having, in effect, increased the taxpayer's taxable income by applying the arm's length provisions of the revised Division 13.

Where the Division has been applied to increase a taxpayer's liability to income tax by adjusting assessable income or allowable deductions, an amount of additional tax will also be payable. The additional tax will be 10 per cent per annum of the difference between the tax payable upon the application of Division 13 and the tax calculated on the basis that the particulars in the taxpayer's return had been accepted as correct insofar as those particulars were relevant to the operation of the Division. Where a taxpayer's tax liability is increased under corresponding provisions of a double taxation agreement in circumstances where, but for the agreement, the Division would have applied to the same effect, the additional tax will also be payable.

Any such additional tax will be subject to a power of remission by the Commissioner and subject also to a power of review by an independent Taxation Board of Review. Decisions by the Commissioner under the basic provisions of the revised Division will, of course, be subject to the usual rights of objection, review by a Board of Review and appeal to a Court.

Reflecting the position that exists in relation to existing section 136, an assessment may be amended to give effect to the revised Division at any time, so long as the Division has not previously been applied in relation to the same subject matter. Where a double taxation agreement provision operates to reallocate profits, amendment of assessments will be authorised on the same basis. An assessment may also be amended at any time for the purpose of making a compensating adjustment in favour of a taxpayer.

The revised Division 13 is only to apply to income derived or allowable deductions incurred after 27 May 1981, as indicated when the measures were foreshadowed in the House of Representatives on that day. For the income year in which 28 May 1981 occurs, both the existing section 136 and the revised provisions may, therefore, be applicable. However, provision is made to ensure that there can be no possibility of an overlap in the operation of the two measures.

Zone allowance arrangements (Clauses 3, 10 and 11)

The Bill will give effect to changes to the income tax zone allowance arrangements that were foreshadowed in the 1981-82 Budget Speech, details of which were announced on 15 November 1981. The changes flow from consideration of the report of the Public Inquiry into Income Tax Zone Allowances.

Broadly, under the arrangements that will apply from 1 November 1981, the part of the zone rebate that is based on the rebates in respect of a taxpayer's dependants will increase from 25 per cent of the relevant rebate amount to 50 per cent for people in Zone A, and from 4 per cent to 20 per cent for those in Zone B. Also from 1 November 1981, a special basic rebate of $750, in lieu of the ordinary basic rebate of $216 for Zone A and $36 for Zone B, will be available for people residing or spending the required period of time in especially isolated areas in either zone, that is, at places in excess of 250 kilometres by the shortest practicable surface route from the centre of the nearest population centre of 2,500 or more (based on 1976 census data).

In addition, the existing test for determining whether a person qualifies for a zone rebate - broadly that the person resides or is actually present in a zone for more than half of a year of income - will be modified in two respects. First, a person who resides or spends the required period of time in a zone (not including any such time prior to 1 January 1981) over a period of two consecutive income years but who, at present, does not satisfy the test in relation to either income year concerned is to receive a rebate in the latter income year. Second, a person who resides in a zone for a continuous period of up to five income years (not including a period prior to 1 January 1981) but who, at present, does not satisfy the test in the first and last of the income years concerned will be entitled to a rebate in the last year, provided the period in the first income year combined with that in the last income year exceeds 182 days.

In line with the increase in the dependant component of the Zone A rebate from 25 per cent to 50 per cent, the Bill also provides for a similar increase in the dependant component of the comparable rebates available to certain persons serving overseas with a United Nations' armed force, and to Defence Force members serving in certain overseas localities. Since their inception, these rebates have been set at levels corresponding with the prevailing Zone A rebate.

Assessable income from short-term property transactions (Clause 4)

An amendment to section 26AAA of the Principal Act is proposed to remedy a defect in the income tax law which may allow profits made on certain short-term property transactions to escape tax.

As presently framed, section 26AAA taxes profits arising from the sale of property within 12 months of its purchase by the taxpayer. However, the intention of the law may be avoided by arranging for a private company to purchase property and then, within 12 months, selling controlling shares in the company at a price which reflects the increase in value of the underlying property. The technique could be varied by using a trust as the vehicle for the purchase and sale of assets, or by holding an interest in property through a chain of companies, or through interposed companies, partnerships or trusts.

To remedy the defect, the amendment will specify that a taxpayer is to be assessed to tax where he sells shares in a private (unlisted) company or an interest in a private trust estate if, at the time of the sale, the company or trustee owns property that was purchased by it within the preceding 12 months and the value of which is not less than 75 per cent of the net worth of the company or trust estate.

In those circumstances, the taxpayer's assessable income will include so much of the sale price of the shares or the interest in the trust estate as reflects an increase in the value of the underlying property from the time it was purchased to the time when the shares or interest were sold by the taxpayer. An appropriate allowance will be made in respect of any additional expenditure incurred in relation to the property during that period.

Similar rules will apply where a taxpayer sells shares in a company or an interest in a trust estate or partnership which in turn has a proprietary interest through one or more interposed companies, trusts or partnerships in property purchased within the preceding 12 months.

Section 26AAA will be further amended so as to apply where a taxpayer sells property received as part of a distribution in specie by a company or trustee of a trust estate, the property having been purchased by the company or trustee within the preceding 12 months. In those circumstances, the taxpayer will be deemed to have purchased the property at the time it was purchased by the company or trustee, and for the same price. Where the taxpayer sells the property within 12 months of its purchase by the company or trustee, the amount by which the sale price exceeds the earlier purchase price, less any related expenses, will be included in the assessable income of the taxpayer.

Underlying property in the nature of trading stock, depreciable plant or property purchased for sale at a profit will generally be outside the scope of the amendments. However, safeguarding provisions will apply to prevent taxpayers exploiting their exclusion.

The amendments are to generally apply in relation to underlying property purchased after 10 September 1981.

Living-away-from-home allowance (Clause 6)

A technical amendment is proposed to the existing law so that members of the Defence Force are clearly able to enjoy the benefit of a provision under which, in broad effect, living-away-from-home allowances received by employees are taxable to the extent of a maximum of $2 per week.

The amendment will ensure that certain allowances received by Defence Force personnel serving overseas are taxed to the same extent as similar allowances received by civilians, as has hitherto been the case.

Special depreciation on property used for basic iron and steel production (Clauses 5, 7 and 8)

Special depreciation provisions will authorize a 20 per cent prime cost rate of depreciation for new and second-hand plant used primarily and principally in the production of basic iron and steel products, or a 331/3 per cent prime cost rate where, under existing law, such plant would attract a rate of more than 20 per cent. The accelerated rates will be available for eligible plant that is acquired under a contract entered into after 18 August 1981 and before 1 July 1991, and is first used or installed ready for use before 1 July 1992. Eligible plant constructed by the taxpayer will qualify on the same basis where construction commenced within the 18 August 1981 to 1 July 1991 period.

For the purposes of the special depreciation rates, basic iron and steel products will, broadly, be those products included in the definition used for the purposes of the 1980 Report of the Industries Assistance Commission into the iron and steel industry. These include pig iron, ingots, blooms, billets and slabs, rerolling coils, universal plates, rails, bars and rods (excluding bright bars), angles and hot rolled strip, sheet and plate (unworked or simply polished). Similar forms of low alloy or high carbon steel will also be included among the products attracting eligibility, as will sponge iron.

Plant eligible for the accelerated rates will include direct production plant such as furnaces, continuous casting plant and hot rolling mills used to form the basic iron and steel products, together with associated pollution and quality control plant, maintenance plant and plant for trimming and packing the basic products.

Plant used by the producer in related activities within the basic iron and steel production premises will also qualify for the accelerated rates. Plant used by the producer in the preparation or production of raw materials and other products consumed in the basic iron and steel production process will qualify on this basis. Eligible plant in this category will include coke ovens, sinter plant, lime kilns, materials blending plant and energy and gas production plant.

Also eligible on this basis will be plant, including wharves, used for materials storage and transport and plant used for the production of plant components, such as rolls, moulds and stools, that are necessary for the basic iron and steel production process. Plant used in the training of apprentices will similarly qualify. Road vehicles ordinarily used to transport persons or deliver goods will not qualify for the accelerated rates.

Taxpayers will be able to elect to have normal rates of depreciation apply to individual plant items instead of the special 20 per cent or 331/3 per cent rates if they so wish. Such an election ordinarily will need to be made at the time of lodgment of the income tax return in which depreciation is first claimed for the plant or machinery. Once made, an election will be irrevocable.

Gifts (Clause 9)

Amendments proposed by clause 9 will extend the gift provisions of the income tax law under which deductions for gifts of the value of $2 or more are available where gifts are made to specified funds, authorities or institutions in Australia.

The first of the amendments will make tax deductible gifts of the value of $2 or more made after 5 February 1982 to a State or Territory branch of the Royal Society for the Prevention of Cruelty to Animals. A second amendment will authorise a deduction for such gifts made during the current financial year to the Help Poland Live Appeal conducted by the Australian National Committee for Relief to Poland, the Australian Red Cross Poland Appeal or the World Vision of Australia Poland Emergency Appeal.

Further amendments will modify the operation of the taxation incentives for the arts scheme. Under the scheme, gifts of works of art and other cultural property for inclusion in the collections maintained by The Australiana Fund, a public art gallery, library, or museum or Artbank qualify for deduction - generally, by reference to the value of the property at the time the gift was made.

By amendments proposed by clause 9, the amount of the deduction will be limited to the lesser of that value and the amount paid for the property by the donor where the property is donated within 12 months of its acquisition by the donor. The amount of the deduction will be similarly limited without reference to the period for which the donor owned the gifted property if it was acquired by the donor for the purpose of being donated, or was acquired subject to an agreement or understanding that it would be donated. The amendments will apply in respect of gifts made after 14 October 1981. Deductions in respect of gifts of property inherited by the donor will not be affected.

Another amendment proposed by clause 9 will formalise arrangements for the appointment of valuers under the taxation incentives for the arts scheme. Under these arrangements responsibility for approval of valuers will rest with the Secretary to the Department of Home Affairs and Environment. Guidelines for the approval of valuers are also to be placed in the law.

Income of trusts and of dependent minors (Clauses 12-18)

These measures relate to changes which were made in 1980 to the basis of taxing the income of trust estates and of dependent children. The amendments proposed by this Bill are intended to clarify the provisions enacted in 1980 in two areas where, it has been claimed, the law is deficient. A tax avoidance scheme has been developed in reliance upon the existence of one of these claimed deficiencies.

Under existing provisions of the income tax law, trust income to which a beneficiary is presently entitled is either liable to tax in the hands of the beneficiary, or the trustee of the trust estate pays tax on such income at individual rates on behalf of the beneficiary. Trust income to which no beneficiary is presently entitled (broadly, accumulating income) is generally taxed in the hands of the trustee at higher rates.

However, special arrangements were made in 1980 for those cases where a beneficiary of a trust estate, although technically not presently entitled to trust income, has a vested and indefeasible interest in the accumulating trust income. In such a case, the beneficiary of the trust estate is by the 1980 changes deemed to be presently entitled to that trust income and the trustee of the trust estate is assessed and liable to pay tax on that income as if it were the income of an individual. This means that the zero rate of tax applies (1981-82) to the first $4,195 of income and if the beneficiary has no other income the only tax (if any) is that payable by the trustee.

In relation to a scheme devised in this context, it is being contended that this provision operates where the beneficiary deemed to be presently entitled is a beneficiary other than an individual (e.g., a company or a beneficiary in the capacity of a trustee of a further trust estate). Accordingly, the scheme involves the multiple use of such trusts, each with an indefeasible vested interest below the tax threshold arising from the zero-rate, and thus claimed to be entirely tax-free. The amendments proposed by this Bill will clarify the law so as to ensure that this proposition is no longer tenable, the basic legislative response being that where a beneficiary with simply an indefeasible vested interest in trust income is a person other than an individual entitled to the income on his or her own account, the income is to be taxed as if it were income that the beneficiary is presently entitled to, i.e., at tax rates appropriate to the status of the beneficiary.

Turning to the other amendment under this heading, the system for taxing the income of dependent children, which was introduced in 1980, applies so that, subject to important exceptions, income derived by a minor, either directly or through trusts, is taxed at the minimum rate of 46 per cent, subject to a lower tax threshold of $1,040. One category of income that is excepted from this system is employment income of a minor, including payments for services rendered by the minor, to which the ordinary individual rates and tax threshold apply.

It has been claimed in some quarters that income that is derived by a trust estate from carrying on a business of providing services performed by its employees, to which a minor beneficiary is entitled, is employment income of the minor and, as such, is not liable to the higher rate of tax that would otherwise apply if the arrangements for taxing the income of dependent children were applicable. This contention - which is technically based on provisions included in the law to except from the higher tax income derived by a minor from his or her own employment, and the definition of such income adopted in the law - is contrary to the intention of the 1980 amendments. It is proposed to put the matter beyond doubt by indicating expressly that the exception from the higher rate of tax is not applicable to income that a child receives through a trust from the provision of services by others.

The proposed amendments were announced on 27 August 1981 and will apply in relation to trust income derived after that date. The amendments contain provisions to that end.

The Bill will also make two other minor safeguarding amendments that are consequential on the foregoing changes. One (clause 12) will ensure that the amendments to the trust provisions outlined above to deal with the tax avoidance scheme involving multiple trusts as beneficiaries cannot be circumvented by replacing the trustees of those trusts with persons who are under a legal disability. The other amendment (clause 16) will make it clear that the existing safeguards relating to the exception from the higher rates of tax for income derived by a minor from a business carried on either alone or in partnership with others will apply to income derived from the carrying on of a business of providing services. These changes will, in practical effect, only apply to arrangements that might be entered into on or after the date of introduction of the legislation.

Medical expenses (Clause 20)

A general concessional rebate of tax is allowable under the present income tax law of an amount equal to 32 cents in the dollar for each dollar by which the sum of the taxpayer's rebatable expenditures exceeds $1,590. Medical expenses are one of the items of rebatable expenditure.

The law is to be amended so that medical expenditures of the kind that presently qualify as rebatable amounts for this purpose, where payment is made to a legally qualified person who has provided the relevant service, will also be treated as rebatable where the payment is made in respect of a professional service provided by a qualified person but where the payment is made to a corporate or other unqualified employer of that person.

This amendment, which gives recognition to recent developments in rules relating to professional practice, will apply to payments made on or after 1 July 1981.

The Bill is explained in more detail in the notes that follow.