House of Representatives

Explanatory Memorandum

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

Exemption for Active Business

Overview

This chapter describes the exemption for interests a taxpayer has in foreign companies principally engaged in eligible active business. The purpose of the exemption is to ensure there is no tax hindrance to portfolio diversification or joint venture participation by Australians who wish to invest directly into a non-resident company that is principally engaged in active business.

Introduction

The active business exemption (ABE) will exempt a taxpayer from taxation under the FIF measures for interests the taxpayer has in foreign companies principally engaged in certain active business, known as eligible activities. [Section 497]

The active business exemption will not apply to any interest in a non-resident trust, even though the trust's underlying investments may be principally active. However, the exemption will apply when calculating the net income of a resident trust estate where the trust estate invests directly in a foreign company engaged in an active business. This is because the trust is treated under subsection 95(1) as a resident taxpayer and qualifies for all the exemptions provided to a resident taxpayer under the FIF measures.

The active business exemption will also apply when calculating the FIF income of a controlled foreign company ( CFC) or a controlled foreign trust ( controlled foreign trust). In this case again, the FIF income is calculated by treating the CFC or controlled foreign trust as a resident taxpayer.

Active business

A company will be considered to be carrying on an active business if it is principally engaged in one or more eligible activities.

Meaning of 'eligible activities'

To satisfy the exemption, the taxpayer must establish that the foreign company was at the test time, principally engaged in one or more eligible activities. [Section 497]

All activities that are not named in Schedule 4 are defined as 'eligible activities' under [subsection 496(1)] and may qualify for the ABE.

The business activities that are not eligible activities for the purposes of the ABE are:

a)

anking and the provision of finance.

b)

inancial intermediation services.

c)

nvestment in tainted assets, or tainted commodity investments, within the meaning of section 317.

d)

ife insurance business.

e)

eneral insurance business.

f)

anagement of funds.

g)

ctivities in connection with real property.

It should be noted that although banking, life insurance, general insurance and real property are listed as non-eligible activities, specific exemptions from FIF taxation in Divisions 4 to 7 will provide limited exemptions for investment in those industry groups.

Schedule 4 will have effect until regulations are made specifying activities that are not eligible for the ABE.

The 'black list' approach in Schedule 4 of specifying non-eligible activities benefits a taxpayer because the scope of the measures are narrowed through specifying activities which are targeted by the FIF measures. Consequently, interpretation issues and compliance costs are kept to a minimum.

Methods to determine whether a foreign company carries on active business

There are two methods by which a taxpayer may establish whether a foreign company is principally engaged in eligible activities:

he stock exchange listing method; and

he balance sheet method.

If both methods are capable of being applied to a particular company the taxpayer must choose the method to be used. The ABE will not be available if it is not possible to satisfy either one of the tests. [Section 498]

Test time

For a taxpayer to qualify for the active business exemption, the foreign company itself must be principally engaged in active business at the test time. [Section 497]

For the stock exchange listing method, the test time is the end of the notional accounting period of the foreign company. This is usually at the end of the taxpayer's year of income (refer to the notes on notional accounting periods in Chapter 2). [Paragraph 497(2)(a)]

For the balance sheet method, the test time is the end of the period for which the company prepares its annual accounts for reporting to its shareholders that falls within the taxpayer's year of income. [Paragraph 497(2)(b)]

Stock exchange listing method

The stock exchange listing method is one method by which a taxpayer may determine if a foreign company is principally engaged in eligible activities. The stock exchange listing method [section 499] may only be used if the taxpayer can establish that, at the test time, the foreign company is listed on either:

n approved stock exchange [Schedule 3] ; or

n approved international sectoral classification system [Schedule 5] ,

under a classification or designation that describes an eligible activity.

There are one hundred and thirteen approved stock exchanges listed in Schedule 3. The approved stock exchanges are spread throughout 48 countries.

Schedule 5 lists five (5) approved international sectoral classification systems namely:

loomberg's Information Systems;

inancial times - Actuaries World Index;

organ Stanley Capital International Index;

alomon Russell Global Equity Index; and

tandard and Poor's Composite Index (S & P 500).

The lists in Schedules 3 and 5 will have effect until regulations are made for the purpose of listing approved stock exchanges and international sectoral classification systems. [Section 470 and sub-subparagraph 499(2)(a)(ii)(B)]

A foreign company is not considered to be principally engaged in eligible activities if at the test time it is classified or designated by each approved stock exchange and international sectoral classification system which it is listed as engaged in a class of activities of an 'unclassified' or 'miscellaneous' kind. [Subsection 499(3)]

However, where a company is designated or classified by a stock exchange or an international sectoral classification system under a heading similar to 'conglomerate' or 'multi-industry', the company will not be considered to be listed as engaged in a class of activities of an 'unclassified' or 'miscellaneous' kind.

Balance sheet method

The balance sheet method is the second method for a taxpayer to establish whether a company is principally engaged in eligible activities. [Section 500]

It tests whether a company was principally engaged in eligible activities by reference to the foreign company's balance sheet and if appropriate, the balance sheets of its subsidiaries. [Subsection 500(1)]

A company is principally engaged in eligible activities if, at the test time, 50 per cent or more of the gross value of the company's assets were for use in eligible activities (50% assets test). [Subsection 500(2)]

This percentage is calculated as follows:

(the gross value of the company's assets used in eligible activities / the gross value of all of the company's assets) x (100/1)


The gross value of an asset of the company is the value shown in the balance sheet of the company prepared at the test time for reporting to the shareholders on an annual basis. The balance sheet test cannot be used if the balance sheet for the company was not prepared in accordance with commercially accepted accounting principles or if it does not give a true and fair view of the financial position of the company. [Subsection 500(9)]

In calculating the gross value of the company's assets for use in eligible activities, the gross value of assets which are not for use solely in eligible activities must be reduced proportionally to the extent that those assets were for use for other purposes [Subsection 500(11)]

The gross value of the company's assets for use in eligible activities includes assets of the company which are for use by:

he company's employees or directors in eligible activities; and

he assets for use by sub-contractors or other persons engaged in active business on behalf of the company under a contract or arrangement. [Subsection 500(13)]

Balance sheet method - 'look-through' rule extended to lower-tier companies

An offshore holding company may not satisfy the active business exemption in its own right under the balance sheet test since such companies frequently would not have any active business of their own. To prevent this result, the ABE allows the first-tier foreign holding company to look through to the underlying assets of certain subsidiaries. Only companies in which the first tier foreign holding company holds directly, indirectly or directly and indirectly 50 per cent or more of the paid up share capital are treated as subsidiaries for this purpose.[Subsections 500(3) and (6)]

Where a first-tier foreign holding company has a 50 per cent or greater interest in the paid-up share capital of a lower-tier company, the 'look-through' rule will allow the first-tier foreign holding company to 'look-through' to its share of the underlying assets of the second-tier company.[Subsection 500(3) and (6)]

The first-tier foreign holding company will treat its share of the underlying assets of the lower-tier company as its own in order to assist it to pass the 50 per cent assets test. [Subsection 500(2)]

There is no limit to the number of tiers that a first-tier foreign holding company may 'look-through', provided the first-tier foreign holding company has an effective interest of 50 per cent or greater in the lower-tier company.

A company's indirect interest in another company will be measured by rules provided in section 501. The 'look-through' rule will aggregate any direct interest determined under [subsection 501(3)] with any indirect interest calculated by section 501 and included in the aggregate interest by subsection 500(6).

The following diagram and table illustrate which subsidiaries a first-tier foreign holding company may 'look-through' to and use the underlying assets of the subsidiary to assist it to pass the 50 per cent assets test.

How to determine the gross value of a subsidiary's assets

Once it has been determined if a first-tier foreign holding company may 'look through' to a lower-tier company the following formulas in [subsection 500(3)] are used to determine the amount to be included in:

he gross value of the holding company's total assets; and

he gross value of the holding company's assets for use in eligible activities.

The gross value of the holding company's assets for use in eligible activities includes the amount which is calculated as follows:

Gross value of subsidiary's eligible assets x (Interest in share capital / Total share capital)


The gross value of all the holding company's assets includes an amount which is calculated as follows:

Gross value of all of subsidiary's assets x (Interest in share capital / Total share capital)


In the above formulas:

Gross value of subsidiary's eligible assets means the gross value at the test time of the subsidiary company's assets for use in one or more eligible activities (i.e., assets for use in active business);

Gross value of subsidiary's assets means the gross value at the test time of all the subsidiary company's assets;

Interest in share capital means the amount of the share capital of the subsidiary company that was directly or indirectly owned by the holding company;

Total share capital means the total amount of the issued share capital of the subsidiary company.

X% = the percentage of the paid up share capital held by the higher-tier company in the immediate succeeding lower-tier company.

The published accounts of the group show that the assets of the foreign holding company (FHC), and Subsidiaries Nos 1 and 2 but not including FHC's investments in Subsidiaries Nos 1 and 2 are:

The gross value of the first-tier foreign holding company's (FHC) assets for use in eligible activities includes an amount calculated as follows because of its interest in subsidiary companies Nos 1 and 2:

Subsidiary No 1

Gross value of subsidiaries eligible assets x (Interest in share capital / Total share capital)
= $10M x (100 / 100) = $10M


Subsidiary No 2

Gross value of subsidiary's eligible assets x (Interest in share capital / Total share capital)
= $15M x (60 / 100) = $9M


Foreign Holding Company

(Gross value of subsidiary's No. 1 & 2 eligible assets + Gross value of FHC eligible assets) x (100 / 1)
= (($10M + $9M) + $0M x 100) / ((($12M x 100) / 100) + ($20M x 60 / 100)) + $2M 1)
= ($19M / $26M) x (100/1) = 73%


Therefore, in this example, the first-tier foreign holding company passes the 50 per cent assets tests and a taxpayer who holds an interest in FHC is exempt from taxation under the FIF regime under the ABE through the balance sheet method.

Balance sheet test - intercompany indebtedness

Wherever the 'look- through' rule applies under Division 3 any intercompany indebtedness in relation to the assets that are taken into account are to be disregarded. [Subsection 500(5)]

In the case where a debt or amount is payable to a company by a lower-tier company the debt or amount is to be disregarded to the extent of the company's notional interest in the underlying assets of the lower-tier company.

In the reverse situation when an amount or debt is payable to a lower-tier company by a company that has an interest in the paid-up share capital of the lower-tier company, the extent to which the indebtedness is to be disregarded is 100 per cent.

Application of 'look-through' rule to Australian subsidiaries

The 'look-through' rule may be applied to an Australian subsidiary of a foreign company or a subsidiary in a different jurisdiction to the first-tier foreign holding company. [Subsection 500(7)]

Balance sheet test - partnership

Where a company is a partner in a partnership, the gross value of the company's assets includes the gross value of the company's interest in each of the assets of the partnership instead of the company's net interest in the partnership. [Subsection 500(8)]

The 'look-through' rule for a partnership is different from the 'look-through' rule for companies in subsections 500(3) and (6).

Where the 'look-through' rule is applied to a company the second and lower-tier company's assets are disregarded where the first-tier foreign holding company's interest in the lower-tier company is less than 50 per cent.

By contrast, where the 'look-through' rule is applied to a partnership it treats the partnership as a conduit entity. In all cases, where a foreign company has an interest in a partnership, the company is considered to own its share of the underlying assets of the partnership, regardless of the size of the company's interest in the partnership.

Therefore, where a foreign company has any interest in a partnership, the gross value of the partnership assets proportional to the interest the company has in the partnership is included in the gross value of all the first-tier foreign holding company's assets.

In addition, where the partnership has assets for use in eligible activities, the gross value of those assets proportional to the interest the company has in the partnership is included in the gross value of the first-tier foreign holding company's assets for use in eligible activities.

The gross value of a asset in which a company has an interest as a partner in a partnership is the value of the asset shown in the balance sheet of the partnership at the test time. The balance sheet must be prepared in accordance with commercially accepted accounting principles and give a true and fair view of the financial position of the partnership. [Subsection 500(10)]

The 'look-through' rule for partnerships benefit a taxpayer who has:

n interest in a foreign company which has an interest in a partnership; or

n interest in a first-tier foreign holding company which has a 50 per cent interest in another lower-tier company which in turn has an interest in a partnership that uses a majority assets in eligible activities.

Balance sheet method - asset valuation

The measurement of assets under the balance sheet method is undertaken in the currency in which the company's balance sheets are prepared. Where accounts of a subsidiary or partnership are prepared in a currency different from the company being tested, the value of assets of the subsidiary or partnership must be converted, at the rate of exchange prevailing at the test time, to the currency used by the first-tier foreign holding company at its balance date. [Subsection 500(12)]

The value of the assets of a subsidiary or partnership are to be determined by a balance sheet of the subsidiary or partnership prepared as at the balance day of the first tier foreign holding company.

Clauses making the amendments

Clause 27: Inserts Part XI containing the Foreign Investment Fund measures.

Clause 28: Inserts Schedules 3 to 6 which list the approved stock exchanges, ineligible business activities and country fund trusts, respectively, for the purpose of the FIF measures.