Senate

Revised Explanatory Memorandum

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

Chapter 5 - Tax relief for shareholders in listed investment companies

Outline of chapter

5.1 A capital gain made by a company is not reduced by the CGT discount, a concession that is available to other entities making a capital gain. Similarly, a shareholder receiving a distribution of a capital gain as a dividend does not benefit from the CGT discount that may have been available if the shareholder had made the capital gain directly. The amendments in Schedule 4 to this bill amend Division 115 of the ITAA 1997 by introducing Subdivision 115-D. These amendments enable certain shareholders in LICs to effectively reduce the eligible capital gain component of a dividend by the CGT discount.

Context of amendments

5.2 In the 2001-2002 Federal Budget and Treasurers Press Release No. 33 of 22 May 2001 the Government announced that a shareholder in a LIC will benefit from the CGT discount on assets realised on or after 1 July 2001 by the LIC, providing those assets have been held for at least 12 months.

5.3 Schedule 4 to this bill gives effect to the Governments announcements.

5.4 Under the current law a shareholder in a LIC receiving a dividend attributable to an eligible capital gain made by that company receives a different tax outcome to an investor in a managed fund receiving a similar amount from the managed fund.

Summary of new law

5.5 The addition of Subdivision 115-D will:

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enable certain capital gains made by a LIC to be classified as a notional discount capital gain (LIC capital gain); and

•

allow certain shareholders in a LIC, on receiving a dividend that includes a LIC capital gain amount, a deduction that reflects the CGT discount the shareholder could have claimed if they had made the LIC capital gain directly.

5.6 The amendments to Division 115 will ensure that a LIC capital gain amount, reflected in a dividend paid to a shareholder in a LIC, receives a similar tax outcome to a payment of a similar amount to a member of a managed fund. This outcome is achieved without disturbing the operations of the company tax or imputation systems.

5.7 The amendments will apply to a payment of a dividend including a LIC capital gain amount from capital gains made by a LIC on or after 1 July 2001.

Detailed explanation of new law

Overview of CGT discount rules

5.8 Section 115-25 of the ITAA 1997 allows a capital gain made from a CGT event happening to a CGT asset to be a discount capital gain if the asset has been held for at least 12 months.

5.9 A discount capital gain can only be made by:

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an individual;

•

a complying superannuation entity;

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a trust; or

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a life insurance company in respect of a virtual PST asset.

5.10 The amendments modify the rules in Division 115 to enable a LIC to make a LIC capital gain.

Meaning of listed investment company

5.11 A company is a LIC if:

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it is an Australian resident;

•

it is listed on the Australian Stock Exchange or any other approved Australian stock exchange; and

•

90% or more of the market value of its CGT assets consist of permitted investments.

[Schedule 4, item 10, subsection 115-290(1)]

5.12 A wholly-owned subsidiary of a LIC can itself be treated as a LIC if it satisfies the requirements in paragraph 5.11 (apart from the listing requirement). [Schedule 4, item 10, subsection 115-290(2)]

Permitted investments

5.13 Permitted investments made by a LIC are:

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equity investments which include shares, units, options, rights or similar interests;

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financial instruments which includes loans, debts, debentures, bonds, promissory notes, futures contracts, forward contracts, currency swap contracts and a right or option in respect of a share, security, loan or contract;

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an asset whose main use in the companys business is to derive interest, an annuity, rent, royalties or foreign exchange gains (unless it is an intangible asset and its market value has been substantially altered or the derivation of rent was only temporary); and

•

goodwill.

[Schedule 4, item 10, subsection 115-290(4)]

5.14 A LIC will have permitted investments if it owns:

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a 100% subsidiary, providing the subsidiary is a LIC in its own right;

•

any percent (directly or indirectly) of another LIC; or

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10% (directly or indirectly) of any other company or trust.

[Schedule 4, item 10, subsections 115-290(5) to (7)]

If the LIC exceeds the 10% threshold, those shares or interests will not be permitted investments.

5.15 In testing levels of equity all forms of equity interest must be considered (including voting, non-voting and participating interests). In applying these ownership tests, any indirect ownership is disregarded if this ownership is through a listed public company or a publicly traded unit trust. Tracing of indirect interests through another LIC (that is not a wholly-owned subsidiary) is only required if the first LIC owns more than 50% of the second LIC. [Schedule 4, item 10, subsection 115-290(8)]

Example 5.1

Banjo Investments has a large portfolio of investments in listed and unlisted securities, cash and short term deposit accounts, and qualifies as a LIC. Half of its portfolio is held via a wholly-owned subsidiary, Snowy River Co. Snowy River Co also satisfies the requirements of paragraphs 115-290(1)(a) and (c) and subsection 115-290(2) and qualifies as a LIC. Both Banjo and Snowy River Co satisfy the 90% permitted investment test in paragraph 115-290(1)(c). Any capital gain made by Banjo or Snowy River Company on assets that are permitted investments may be able to be treated as LIC capital gains.

Breach of LIC requirements

5.16 A company will continue to be regarded as a LIC (discussed in paragraph 5.11) if it fails the 90% permitted investments test because of circumstances beyond its control and the non-compliance is only of a temporary nature [Schedule 4, item 10, subsection 115-290(3)] . This may enable a company to satisfy the definition of a LIC at 1 July 2001, when the measure commenced, and at any later time.

Example 5.2

The Vimera Investment Company Limited, a LIC, owned 9.5% of the shares in Millner Sports Limited. As a consequence of a share buy-back undertaken by Millner, Vimeras shareholding in Millner then represented 10.3% of the LIC equity in that company. Vimera fails the 10% ownership in subsection 115-290(5), and this may also trigger the failure of the 90% test in paragraph 115-290(1)(c).

Vimera sold part of its equity in Millner reducing its ownership of LIC equity to 9.8%. Subsection 115-290(3) would apply to enable Vimera to continue to be treated as a LIC as if the breach had not occurred.

Example 5.3

Latham Limited, a LIC, believed that the price of shares in Booming Technology Limited was likely to rise rapidly. Latham acquired 16% of the shares in Booming Technology and sold them 3 months later when Latham determined the share price had peaked.

In purchasing these shares, Latham failed the 10% ownership test in subsection 115-290(5). These shares are therefore not permitted investments, and this causes Latham to fail the 90% test in paragraph 115-290(1)(c). Latham ceases to be a LIC at the time it purchased the shares. Section 115-290(3) would not apply to ignore the breach as while the breach may have been temporary, it was not beyond Lathams control.

5.17 Administrative guidelines in relation to certain aspects of the LIC measures will be settled between the ATO and industry members. These are likely to include the record keeping requirements and the tests discussed in paragraph 5.16.

Meaning of LIC capital gain

5.18 A LIC capital gain is a capital gain made by a LIC from a CGT event that happened on or after 1 July 2001 to a permitted asset. The gain must also satisfy certain discount capital gain eligibility tests in Subdivision 115-A.

5.19 It is also a requirement that the LIC capital gain be included in both the companys net capital gain and taxable income for the income year in which the capital gain is made. [Schedule 4, item 10, subsection 115-285(1)]

Example 5.4

Sound Investments Limited, a LIC, made a $50,000 capital gain on 23 October 2001 that was a LIC capital gain. The company also made a capital loss of $4,000 on 11 January 2002.

The companys net capital gain for the 2001-2002 income year is $46,000 which is included in its taxable income of $360,000.

The LIC capital gain available to be paid to the companys shareholders is $46,000.

If Sound Investments had carried forward tax losses of $400,000 it would have no taxable income for the income year and no LIC capital gain.

If Sound Investments had carried forward tax losses of $300,000, it could apply those losses against its other income so that a LIC net capital gain of $46,000 was included in its taxable income of $60,000.

5.20 A company that became a LIC after 1 July 2001 can only make a LIC capital gain from a CGT event happening to a CGT asset acquired on or after the day it became a LIC. [Schedule 4, item 10, subsection 15-285(2)]

5.21 An integrity rule ensures that in certain situations where an asset is taken to have been acquired after a company became a LIC, because of the operation of another provision of ITAA 1997, the asset will be treated as having been acquired before that time [Schedule 4, item 10, subsection 115-285(3)] . This rule ignores the freshening up of the date of acquisition of the asset that would otherwise occur (e.g. because of certain rollover provisions).

Example 5.5

In December 2001, Beejay Investments restructured its portfolio of investments to meet the LIC requirements in section 115-290. As part of this process it determines that certain assets in its trading portfolio will no longer be held as trading stock. Instead those shares in listed companies will be held for dividend flows and longer term growth.

Section 70-110 applies at that time and Beejay Investments is treated as having acquired those shares at cost at that time.

Subsection 115-285(3) means that any capital gain arising on the happening of any future CGT event to those shares cannot be a LIC capital gain.

Deduction for certain dividends - impacts for LICs

5.22 Under the current law a payment of a capital gain amount made by a LIC to a shareholder may be a franked or unfranked dividend. These amendments do not disturb the operation of the dividend or imputation systems when a LIC capital gain amount is paid to a shareholder as part of a dividend.

5.23 These amendments enable certain shareholders in LICs to claim a deduction if they receive a dividend that includes a LIC capital gain amount (the attributable part).

5.24 A formula is provided to enable a LIC to work out the attributable part [Schedule 4, item 10, subsection 115-280(3)] . This formula requires the LIC to determine the part of the original LIC capital gain included in its taxable income for the income year.

5.25 A LIC must maintain appropriate records so it can advise its shareholders of their share of the attributable part included in each dividend it pays to its shareholders. [Schedule 4, item 10, section 115-295]

5.26 The attributable part can include amounts from 2 sources:

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a LIC capital gain made by the LIC that pays a dividend to its shareholders; and

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an attributable part included in a dividend received by a LIC from:

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another LIC; or

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a 100% subsidiary that would be a LIC other than it not being listed on an approved stock exchange,

that it passes on to its own shareholders as a dividend.

[Schedule 4, item 10, paragraphs 115-280(1)(c) and (d)]

5.27 These amounts can only be determined after the income year in which the LIC capital gain was made or the dividend was paid because of the requirement that they must be included in the taxable income of the LIC for that income year (see paragraph 5.19).

5.28 There is no mechanism to allow for incorrect or over-allocation of LIC capital gains to shareholders. If the company miscalculates or requires an amendment, the attributable part for each shareholder may alter. If so, the LIC must advise the shareholders of the corrected details as soon as possible.

Deduction for certain dividends - impacts for LIC shareholders

5.29 A resident shareholder receiving a dividend with an attributable part is eligible to claim a deduction if they are:

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an individual;

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a trust;

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a partnership;

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a complying superannuation entity; or

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a life insurance company (where the attributable part is part of a dividend paid in respect of shares that are virtual PST assets).

[Schedule 4, item 10, paragraphs 115-280(1)(a) and (b)]

5.30 The amount of the deduction allowed to the shareholder is:

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50% of the attributable part if the shareholder is an individual, a trust or a partnership; or

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331/3% of the attributable part if the shareholder is a complying superannuation entity or a life insurance company.

[Schedule 4, item 10, subsection 115-280(2)]

5.31 The deduction is allowed in the income year in which the dividend is paid.

Example 5.6

On 25 August 2002, Gomez received a fully franked dividend of $210 from a LIC. The dividend notice stated that Gomezs share of the attributable part paid to shareholders was $110.

In completing his income tax return for the 2002-2003 income year, Gomez included in his assessable income a franked dividend of $210 and imputation credit of $90. Gomez also claimed a deduction of $55, being 50% of the $110 attributable part.

Inclusion of assessable income in certain cases

5.32 These amendments provide tax relief to shareholders in a LIC. If a shareholder is a trust or a partnership, a beneficiary or partner that is an individual will receive the full benefit of the deduction allowed to the trust or partnership because it is reflected in the calculation in the net income of the trust or partnership. A beneficiary or partner that is a complying superannuation entity or a life assurance company, will receive a lesser benefit. A beneficiary or partner that is a company, trust or partnership will receive no benefit. In all cases the benefit for the beneficiary or partner is the equivalent to the benefit that would have been obtained if the beneficiary or partner has owned the asset directly. The concession is connected with the payment of a dividend and does not pass through a series of trusts or partnerships. [Schedule 4, item 10, subsection 115-280(4)]

5.33 The mechanism to reduce or deny the benefit of the deduction allowed requires certain beneficiaries or partners to include an amount in their assessable income. The amount included is:

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that part of the deduction allowed to the trust or partnership that is reflected in the share of the net income of a beneficiary or partner that is a company, trust or partnership; or

•

one-third of that part of the deduction allowed to the trust or partnership that is reflected in the share of the net income of a beneficiary or partner that is a complying superannuation entity or life insurance company.

[Schedule 4, item 10, subsection 115-280(5)]

5.34 The amount is included in the beneficiary or partners assessable income for the income year in which the dividend is paid to the trust or partnership shareholder.

Example 5.7

The Robbie Partnership received a $210 fully franked dividend from a LIC that also contained an attributable part of $180.

The partnership has 3 equal partners, Joe Robbie, Robbie Limited and the Robbie Superannuation Fund, a complying superannuation entity.

The partnership claimed a deduction of $90 in respect of the attributable part in working out its net income of $12,000, including the $210 dividend. Each partners share of the net income is $4,000 and their reduction amount is $30 (one-third of $90)

Each partner includes $4,000 in their assessable income. The partners must also include the following additional amounts in their assessable income:

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Joe Robbie - nil. Joe is an individual partner in the partnership;

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Robbie Limited - $30 (the reduction amount); and

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Robbie Superannuation Fund - $10 (one-third of the reduction amount).

Application and transitional provisions

5.35 The amendments made by Schedule 4 apply to LIC capital gains made by a LIC on or after 1 July 2001. [Schedule 4, item 15]

Consequential amendments

5.36 A reference to the amount included in the assessable income of certain beneficiaries or partners because the trust or partnership is a shareholder in a LIC is added to the table of particular kinds of assessable income in section 10-5 of the ITAA 1997. [Schedule 4, item 1]

5.37 A reference to the deduction allowed to a shareholder in a LIC is added to the table of specific types of deductions in section 12-5 of the ITAA 1997. [Schedule 4, item 2]

5.38 A note is added to subsection 102-3(2) that a shareholder in a LIC can effectively receive the benefit of the CGT discount on capital gains made by a LIC. [Schedule 4, item 3]

5.39 A new exception to CGT event E4 is provided for a payment attributable to a LIC capital gain. This ensures that the benefit of the LIC concession claimed by the trustee is not inappropriately clawed back on distribution to certain beneficiaries. [Schedule 4, items 4 and 5]

5.40 A new item is added to the table in subsections 110-25(8) and 114-5(2) as the choice of working out a capital gain using indexation is now relevant for a LIC. [Schedule 4, items 6 and 7]

5.41 A new paragraph has been added to the Guide material in section 115-1 about the new CGT concession for a shareholder in a LIC. [Schedule 4, item 8]

5.42 A note is added to subsection 115-20(1) that a LIC capital gain must be calculated without reference to indexation. [Schedule 4, item 9]

5.43 A new paragraph is added to subsections 320-205(3) and (4) to support the application of this measure to a life insurance company in respect of its virtual PST assets. [Schedule 4, items 11 and 12]

5.44 Definitions of listed investment company and LIC capital gain are added to the dictionary in subsection 995-1(1) of the ITAA 1997. [Schedule 4, items 13 and 14]

5.45 Certain other consequential amendments are necessary to ensure that shareholders in LICs receive a comparable tax outcome compared with investors in managed funds. These amendments will be contained in a later bill.

REGULATION IMPACT STATEMENT

Policy objective

5.46 The policy objective is to provide shareholders in LICs with comparable tax treatment to investors in managed funds. This will assist investors to access the benefits of portfolio diversification without adverse tax consequences.

5.47 Currently, investors in a managed fund are able to benefit from the CGT discount on eligible capital gains received from the fund. This benefit is not available to investors in a LIC.

Implementation options

5.48 A number of options were considered for the implementation of this concession.

Option 1 - Allow a deduction to the shareholder on receipt of a dividend comprising of an eligible capital gain

5.49 This option would allow the shareholder a deduction that reflects the value of the CGT discount that applies to an eligible capital gain contained within a dividend received from the LIC. An eligible capital gain is a capital gain that would, in the hands of the shareholder if received directly, qualify for the CGT discount.

Option 2 - Allow the LIC to reduce its eligible capital gains

5.50 This option would allow a LIC to reduce an eligible capital gain by the CGT discount.

Option 3 - Provide the shareholder with a franking rebate

5.51 This option would allow the shareholder a franking rebate when a LIC pays an eligible capital gain amount to its shareholders.

Option 4 - Use a similar approach as that applicable to managed funds

5.52 The mechanism that applies when a managed fund distributes a discount capital gain to its members requires the members to gross up the discount capital gain received from the managed fund and after offsetting any capital losses apply the appropriate CGT discount.

Assessment of impacts

Impact group identification

Investors

5.53 The proposed amendments will affect persons investing in LICs. Industry estimates there are at least 100,000 shareholders in LICs. By providing appropriate access to the CGT discount on capital gains made by LICs, more taxpayers may choose to invest in these entities.

Listed investment companies

5.54 Currently, there are approximately 20 known LICs in Australia. The proposed amendments will also affect compliance costs incurred by LICs. The level of investments in these companies is likely to increase.

ATO

5.55 The proposed amendments will also impact on the ATO who will administer the new concession.

Analysis of costs/benefits

Economic benefits

5.56 There may be some expansion in the level of investment in LICs. There also may be some increase in the number of LICs as other companies seek LIC status so as to provide the benefit of CGT discount to their shareholders. Overall there will be an increase in the level of competitiveness within the investment industry.

5.57 Taxation will not be an impediment to how an investor chooses to make indirect passive investments because one of the major differences in the taxation treatment of capital gains made by LICs and managed funds is now removed.

Other issues - consultation

5.58 The ATO and Department of Treasury held consultation meetings with peak bodies representing the LICs and managed funds industries and representatives of companies and funds in those industries. Draft legislation was provided to those representatives for their comment.

5.59 Concerns were raised as to the eligibility rules for LICs and their investments. These concerns have been addressed and the legislation reflects an appropriate balance between industry practices and the policy supporting the concession.

5.60 The amendments have industry support.

Conclusion and recommended option

5.61 The proposed amendments will provide a comparative tax outcome for persons investing in LICs and managed funds on discount capital gains made by these investment vehicles. The compliance costs associated with this change in the law will be minimal for the investor. There will be some increase in compliance costs for LICs associated with this concession. The increase in costs will be minimised by adopting the most cost-effective mechanism to provide the concession.

5.62 The measures to provide shareholders in LICs with the benefit of the CGT discount should be adopted because:

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the increased incentive for investment in LICs will outweigh the costs to industry; and

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the proposal provides for diversification of investment for Australians who wish to invest.

5.63 The analysis of the merits of each option concluded that option 1 is the most appropriate mechanism for providing the concession. Option 1 does not require significant changes to the imputation system and other provisions of taxation law. It is the simplest method of providing the concession, which makes it easier to understand and implement. The other options were not supported for the following reasons.

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Option 2 would have reduced the tax paid by the LIC and enabled the company to accumulate this after-tax income. Generally managed funds are unable to accumulate income. Complex rules would have been required to give the appropriate tax outcome to shareholders when the company paid an eligible capital gain amount to its shareholders.

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Option 3 would have required significant changes to the imputation provision with complicated amendments introducing unnecessary complexity to the law.

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Option 4 would have added an unnecessary level of complexity to providing the concession and changed the nature of the payment by the LIC from a dividend to a capital gain.