House of Representatives

Explanatory Memorandum

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

Chapter 1 - Dividends received by foreign-owned branches

Outline of chapter

1.1 Schedule 1 to this Bill amends the taxation of certain non-residents in respect of Australian branches (permanent establishments) to:

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tax dividends paid to the branches on a net assessment basis, and

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provide tax offsets in relation to franked distributions (franked dividends) received.

1.2 Unless otherwise indicated, all legislative references are to the Income Tax Assessment Act 1936.

Context of amendments

1.3 These amendments are part of the Government's response to the Board of Taxation's report to the Treasurer on international taxation. The amendments will improve tax neutrality between the Australian branches and subsidiaries of non-residents. They are consistent with the general trend to treat branches as entities separate from the non-resident behind them.

1.4 Currently, dividends paid by an Australian resident company (Australian company) to a non-resident are subject to withholding tax. Such dividends are non-assessable non-exempt income in the hands of the non-resident. As the dividends are not included in the non-resident's assessable income, the non-resident is not entitled to deduct relevant expenses against that dividend income.

1.5 Where a non-resident is a resident of a tax treaty partner country, the treaty will generally require all income that is attributable to a branch, including dividends, to be taxed in Australia on a net profit basis. The resulting mismatch with Australia's current domestic law, which applies a final withholding tax to gross dividends, increases compliance and administrative costs. These amendments will better align the domestic law with Australia's tax treaty obligations.

1.6 The main benefits to taxpayers affected by these amendments are:

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increased certainty in legal and administrative outcomes

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reduced compliance costs, and

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improved cash flows.

Summary of new law

1.7 Dividends paid by an Australian company to a non-resident company or individual that are attributable to an Australian branch of the non-resident will no longer be subject to dividend withholding tax. Rather, such dividends will be taxed in Australia on a net assessment basis. Where dividends are franked, the non-resident company or individual may be entitled to claim a tax offset. Consequential amendments provide other benefits consistent with taxation on a net assessment basis.

1.8 These amendments will apply to dividends and like amounts paid on or after the date of Royal Assent.

Comparison of key features of new law and current law

Detailed explanation of new law

1.9 Dividends paid by an Australian company (Australian dividends) to an Australian branch of a non-resident company or individual will be included in the assessable income of the non-resident. Further, where such dividends are franked, the non-resident company or individual may be entitled to claim a tax offset.

How are Australian dividends paid to Australian branches currently taxed?

1.10 Unfranked dividends paid by an Australian company to an Australian branch of a non-resident are taxed on a final withholding basis (section 128B). Those dividends are not assessable income and are not exempt income in the hands of the non-resident (section 128D).

1.11 Franked dividends are currently excluded from withholding tax (paragraph 128B(3)(ga)). However, dividends excluded from withholding tax by reason of being franked are still considered to be non-assessable non-exempt income of the non-resident (section 128D).

1.12 Non-residents are not entitled to deduct any expenses incurred in relation to deriving franked and unfranked dividends, as those dividends are not assessable income of the non-resident (section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)). However, Australia's tax treaties require that relevant expenses be allowed as deductions against dividend income of a non-resident that is attributable to an Australian branch.

How will Australian dividends paid to an Australian branch be taxed?

1.13 Franked and unfranked dividends paid by an Australian company will be included in the assessable income of a non-resident company or individual where those dividends are attributable to a branch of the non-resident that is situated in Australia. Consequently, any expenses incurred in deriving that dividend income may be allowed as a deduction from that income when calculating the taxable income of the non-resident. Further, a non-resident company or individual may be entitled to tax offsets under Division 207 of the ITAA 1997 in respect of franked dividends that are attributable to an Australian branch of the non-resident.

Exclusion from withholding tax

1.14 These amendments will ensure that Australian dividends paid to an Australian branch of a non-resident company or individual are excluded from withholding tax [Schedule 1, item 5, subsection 128B(1); item 6, subsection 128B(3E)]. Consequently, the dividends will no longer be non-assessable non-exempt income of the non-resident pursuant to section 128D, even when the dividends are franked [Schedule 1, item 6, note to subsection 128B(3E)].

1.15 For franked dividends, section 128D will no longer apply, even though franked dividends are still potentially covered by paragraph 128B(3)(ga). Section 128D only includes franked dividends in the non-assessable non-exempt income of a non-resident where that income would have been subject to withholding tax but for paragraph 128B(3)(ga). However, new subsection 128B(3E) will ensure that relevant franked dividends will not otherwise be subject to withholding tax. Consequently, section 128D will not prevent those dividends from being included in assessable income.

Example 1.1

NZ Co, a company resident in New Zealand, is paid a fully franked dividend by an Australian company. The dividend is attributable to NZ Co's Australian branch.

New subsection 128B(3E) will exclude those dividends from withholding tax on the basis that the dividend is attributable to NZ Co's Australian branch. Consequently, section 128D will not apply to make that income non-assessable and non-exempt in the hands of NZ Co on the basis that withholding tax would not be payable on the dividends, even in the absence of paragraph 128B(3)(ga).

Attributable to an Australian branch

1.16 For the new exclusion from withholding tax to apply, the dividends must be attributable to an Australian branch of the non-resident company or individual [Schedule 1, item 6, paragraph 128B(3E)(b)]. This ensures that only dividends paid to a non-resident through a branch situated in Australia will be included in the assessable income of the non-resident.

1.17 It is intended that the term 'attributable to' will adopt its ordinary meaning.

Example 1.2

US Co, a company resident in the United States, which has a branch in Australia, is paid unfranked dividends by an Australian resident company, Aus Co. US Co's interest in Aus Co is held independently of US Co's Australian branch. Further, the dividends are paid into a bank account maintained in the United States by US Co.

Although US Co carries on business through a branch in Australia, the unfranked dividends paid to it by Aus Co will be subject to withholding tax as they are not attributable to the branch (section 128B). Further, the dividends will be non-assessable non-exempt income of US Co (section 128D).

Definition of permanent establishment (branch)

1.18 A definition of 'permanent establishment' will be introduced specifically for the purpose of these amendments [Schedule 1, item 2, subsection 44(7); item 6, subsection 128B(3F); item 8, paragraph 115-280(1)(b) of the ITAA 1997; item 10, paragraph 207-75(2)(c) of the ITAA 1997]. Under this definition, where a non-resident is subject to a tax treaty, the relevant treaty definition of permanent establishment will apply. Conversely, where there is no relevant tax treaty, the domestic law definition of permanent establishment will apply.

1.19 The primary reason for including this definition is to avoid a gap, and hence any unintended consequences, that may arise because of the differences in the definition of permanent establishment in Australia's domestic tax law and in Australia's various tax treaties.

Restriction to non-resident companies and individuals

Application to partnerships

1.20 A partnership is not a separate and distinct legal entity for either income tax or general law purposes. As a consequence, partners are taxed on their individual interest in the income of the partnership. Similarly, the existence of a partnership is ignored for the purpose of these amendments. Therefore, where dividends are paid by an Australian company to a partnership with a partner that is a non-resident company or individual, and the dividends are attributable to an Australian branch of the partnership, that partner will be exempt from withholding tax. The partner will instead be taxed on its individual interest in those dividends on a net assessment basis.

Application to trusts

1.21 These amendments will not apply to dividends paid to Australian branches of non-resident trusts. [Schedule 1, item 6, paragraph 128B(3E)(c)]

1.22 The current tax treatment of trusts is based primarily on the residence of the beneficiaries of those trusts. Non-resident beneficiaries deriving Australian dividend income through resident and non-resident trusts are therefore generally subject to the same tax. Not applying the amendments to non-resident trusts maintains this position.

1.23 For instance, a beneficiary that is presently entitled to an Australian dividend paid to a non-resident trust will be taken to have derived income consisting of that dividend at the time when the beneficiary became so entitled (subsection 128A(3)). A non-resident beneficiary will therefore be subject to withholding tax on that dividend (section 128B), and benefit from any relevant exclusions, regardless of whether the trust that derived the income is a resident of Australia or not.

1.24 However, the impact of tax treaties must be considered, especially in relation to the application of subsection 3(11) of the International Tax Agreements Act 1953 and equivalent articles in subsequent tax treaties.

Inclusion in assessable income

1.25 Dividends paid to Australian branches of non-residents that are to be exempted from withholding tax will be included in the assessable income of those non-residents. [Schedule 1, item 1, paragraph 44(1)(c)]

1.26 Inclusion in assessable income is achieved by expanding the scope of subsection 44(1). Paragraph 44(1)(b) will continue to apply to dividends paid to an Australian branch of a non-resident company or individual out of profits from an Australian source. The amendments will ensure that all other Australian dividends are included in the assessable income of a non-resident with an Australian branch by applying to Australian dividends paid out of a foreign source. [Schedule 1, item 1, paragraph 44(1)(c)]

1.27 A consequence of including Australian dividends in the assessable income of a non-resident company or individual is that those dividends will be taxed on a net basis. This means that relevant expenses will be allowed as deductions to reduce the taxable income of the non-resident.

Application to non-share and non-unit dividends

1.28 These amendments will also apply in relation to non-share dividends [Schedule 1, item 1, subparagraph 44(1)(c)(ii)]. This is consistent with the current treatment of non-share dividends paid to a non-resident for withholding tax purposes. In particular, dividend withholding tax applies to a non-share dividend in the same way as it applies to a dividend (subsection 128AAA(1)).

1.29 A non-unit dividend that is paid out of corpus of a corporate unit trust will be taken to be derived from a source outside Australia to the extent to which it is attributable to a source outside Australia [Schedule 1, item 3, subsection 102L(21A)]. Similarly, a non-unit dividend paid out of corpus of a public trading trust and that is attributable to a source outside Australia will, to that extent, be taken to be derived from a source outside Australia [Schedule 1, item 4, subsection 102T(22A)]. These amendments reflect the general treatment of such trusts as companies.

Tax offsets available for franked dividends

1.30 Generally, if a corporate tax entity makes a franked distribution to a member, the assessable income of the member may include an amount equal to the franking credit on the distribution (Division 207 of the ITAA 1997). Further, the member is entitled to a tax offset equal to the amount of the franking credit on the distribution. That entitlement depends, among other conditions, on the member being an Australian resident at the time the distribution is made (section 207-75 of the ITAA 1997).

1.31 To provide access to franking tax offsets, a non-resident company or individual (foreign resident) will be treated as satisfying the residency requirement for franked dividends that are attributable to a branch they have in Australia [Schedule 1, item 9, subsection 207-75(1) of the ITAA 1997; item 10, subsection 207-75(2) of the ITAA 1997]. If the non-resident receives a franked dividend that is not attributable to a branch in Australia, then they will not satisfy the residency requirement and so will not be entitled to a tax offset. However, such franked dividends will not constitute assessable income in any case (section 128D).

1.32 The non-resident company or individual will still be required to meet the other conditions apart from residency to benefit from the franking tax offset.

Excess franking tax offsets

Conversion into tax losses

1.33 Where a corporate tax entity has excess franking tax offsets that it is not able to use in a year of income, the entity may, subject to certain conditions, convert those excess franking tax offsets into tax losses (section 36-55 of the ITAA 1997). The tax losses may then be carried forward for consideration as a deduction in a later year of income.

1.34 The excess franking tax offset conversion provisions will apply to a non-resident company that is eligible for the franking tax offset. However, the non-resident company will still be subject to the normal rules governing the deduction of tax losses (Division 36 of the ITAA 1997).

Refundable tax offset rules

1.35 These amendments will ensure that a non-resident individual who has excess franking tax offsets cannot obtain a refund of those tax offsets under Division 67 of the ITAA 1997. [Schedule 1, item 7, subsection 67-25(1DA) of the ITAA 1997]

1.36 In practice, denying a refund will have few consequences given the personal income tax rates applying to non-residents.

Application and transitional provisions

1.37 These amendments will commence on the date of Royal Assent [Clause 2]. This means that the amendments will apply to dividends, non-share dividends, non-unit dividends and distributions paid on or after the date of Royal Assent.

Consequential amendments

Tax relief for shareholders in listed investment companies

1.38 These amendments will enable non-resident individuals to access the deduction provided under Subdivision 115-D of the ITAA 1997. [Schedule 1, item 8, paragraphs 115-280(1)(b) and (ba) of the ITAA 1997]

1.39 An Australian resident individual may deduct an amount for a dividend paid to them by an Australian listed investment company where all or some part of the dividend is reasonably attributable to certain capital gains made by a listed investment company. The deduction effectively reduces the eligible capital gain component of a dividend by the capital gains tax discount.

1.40 Allowing a non-resident individual access to the deduction ensures consistent treatment with Australian resident individuals that are paid dividends from Australian listed investment companies.