Senate

Explanatory Memorandum

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

Controlled foreign companies and foreign investment funds

Overview

3.1 Part 3 of Schedule 1 of the Bill will amend the Income Tax Assessment Act 1936 (the Act) to:

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ensure that exclusions from the section 47A deemed dividend rules operate correctly;

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ensure that the 'gross turnover' of a controlled foreign company (CFC) for the purposes of the de minimis exemption in subsection 385(4) is not reduced by amounts excluded from the active income test under section 436;

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take account of changes to the Migration Act 1958 which:

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have the effect that temporary entry permits are now called temporary visas; and

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allow citizens of New Zealand to visit Australia without a temporary visa; and

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allow a notional deduction for a loss of a capital nature where a gain of a capital nature would be included in a foreign investment fund's (FIF's) calculated profit.

Application of the deemed dividend rules in section 47A to share acquisitions and payments relating to calls on shares

Summary of the amendments

Purpose of the amendments

3.2 The amendments correct a technical problem in the law which may have the effect that exclusions from the section 47A deemed dividend rules, for certain share acquisitions and payments relating to calls on shares, are not available in cases when they should apply.

Date of effect

3.3 The amendments are to have effect from 3 June 1990 (ie. from the commencement of section 47A). [Subclause 2(2)]

Background to the legislation

3.4 A CFC resident in an unlisted country is deemed in certain circumstances to have paid a dividend where it purchases shares in another company (subsection 47A(8)). This treatment ensures tax is not avoided on a CFC's low taxed profits by the transfer of those profits to another entity in a form other than a dividend.

3.5 There is an exclusion from the deemed dividend rules that allows shares to be purchased by an unlisted country CFC (or by another entity using amounts originating from the CFC's profits) without triggering the rules (subsection 47A(9)). The exclusion is available only if the share purchase is in a company not partly owned by an associate of the purchaser. An exclusion is provided in these circumstances because there is little risk that capital or profits of the company can be diverted by dividend payments or transferred in another form to an associate of the purchaser.

3.6 A technical problem exists in subsection 47A(9) which may have the effect that the above exclusion will not apply in some cases where it should be available. The problem arises because interpreted literally the tests for determining whether the exclusion applies have regard to shares held by the purchaser. It was not intended, however, that this shareholding be taken into account in determining whether the exclusion is available.

3.7 The following example illustrates the problem with the exclusion.

3.8 In the example a purchase by the first company (the provider) of shares in the subsidiary company (the recipient) would constitute the provision of an eligible benefit under subsection 47A(8). This eligible benefit is also a distribution benefit under subsection 47A(3) and therefore may be treated as a deemed dividend under subsection 47A(1).

3.9 Subsection 47A(9) should operate in this case to prevent the eligible benefit from being treated as a distribution benefit because the holding company does not have an eligible equity interest in the recipient other than through the provider of the benefit (ie. the first company). An eligible equity interest includes shares, interests in shares, rights to acquire shares and options to acquire shares in a company (subsection 47A(21)).

3.10 Technically, however, an exclusion under subsection 47A(9) may not be available for the eligible benefit because an associate of the holding company is also the holder of an eligible equity interest in the recipient. In this regard, the first company is an associate of the holding company (paragraph 318(2)(e)) and has an eligible equity interest (shares) in the subsidiary company. The first company therefore will not satisfy the requirements of subsection 47A(9) in relation to the share purchase even though the exclusion was intended to apply.

3.11 There is a similar problem in the exclusion from the deemed dividend rules for certain payments in relation to a call on shares (subsection 47A(12)). The problem also exists in subsection 47A(13) which denies the exclusions if the conditions on which they are provided cease to be satisfied at some point in the future.

Explanation of the amendment

3.12 The Bill amends subsection 47A(9) by inserting the words 'other than the provider' after 'there is no entity' in the opening passage of the subsection [item 17] . This clarifies that the provider of the benefit will not be treated as an associate of its holding company for the purposes of applying the exclusion. The first company in the example above, for instance, would be able to satisfy the exclusion.

3.13 Comparable amendments have been made to subsections 47A(12) and 47A(13). [Items 18 and 19]

Meaning of 'gross turnover'

Summary of the amendments

Purpose of the amendments

3.14 The amendments will ensure that amounts excluded from 'gross turnover' for the purposes of the active income test will not be excluded in determining the de minimis exemption from accruals taxation under the CFC measures.

Date of effect

3.15 The amendments are to have effect from the commencement of the CFC measures (ie. for statutory accounting periods of CFCs commencing on or after 1 July 1990). [Item 21]

Background to the legislation

3.16 The proposed changes will correct a technical problem with the de minimis exemption. The exemption is available for small amounts of tainted income derived by a listed country CFC and is provided to reduce compliance costs. The exemption applies where low taxed tainted income and certain other attributable amounts derived by a CFC do not exceed the lesser of $50,000 or 5 per cent of the CFC's 'gross turnover'.

3.17 Broadly, the 'gross turnover' of a CFC is the sum of net gains and gross revenue shown in the CFC's recognised accounts (section 434). The 'gross turnover' is reduced for the purposes of determining the active income test by amounts that have been comparably taxed in a listed country or have been taxed in Australia and therefore fall outside consideration under the CFC rules (section 436). The active income test is used to determine whether the tainted income derived by a CFC is incidental to the conduct of an active business and an exemption is provided from accruals taxation if the test is satisfied.

3.18 Problems may currently arise because amounts excluded from the 'gross turnover' of a CFC should be excluded only for the purpose of applying the active income test. These amounts should be included in the 'gross turnover' for the purposes of applying the de minimis exemption.

Explanation of the amendments

3.19 The amendments will make it clear that 'gross turnover' for the purposes of the de minimis exemption is not reduced by amounts excluded from the active income test. This will be achieved by new subsection 385(5) which modifies 'gross turnover' to include amounts normally excluded under section 436. [Item 20]

Changes to the temporary visitor exemption from the foreign investment fund (FIF) measures

Summary of the amendments

Purpose of the amendments

3.20 The amendments ensure that the temporary visitor exemption from the FIF measures will apply to persons with temporary visas and will continue to apply to persons with temporary entry permits. The amendments also ensure the temporary visitor exemption can apply to citizens of New Zealand who are permitted to visit Australia without a temporary visa.

Date of effect

3.21The amendments are to have effect from the commencement of section 3 of the Migration Reform Act 1992 (ie. from 1 September 1994). [Subclause 2(4)]

Background to the legislation

3.22 Broadly, the temporary visitor exemption (section 517) is available to persons visiting Australia for a period not exceeding four years. These short term visitors may be treated as residents of Australia for taxation purposes and thus, in the absence of a specific exemption, may be subject to accruals taxation under the FIF measures. An exemption from the FIF measures has been provided for short term visitors because it is unlikely their foreign investments are held to defer Australian tax.

3.23 The terminology used in the temporary visitor exemption requires updating because temporary visas are now issued in place of temporary entry permits following recent changes to the Migration Act 1958 (the Migration Act). The references to temporary entry permits in the temporary visitor exemption should therefore now be to temporary visas.

3.24 Another change to the Migration Act is that citizens of New Zealand can visit Australia without a temporary visa. This may create problems because the temporary visitor exemption is available only if a visitor holds a temporary entry permit (now called a temporary visa). One possible interpretation of the existing law is that citizens of New Zealand who visit Australia without a temporary visa cannot claim the temporary visitor exemption.

Explanation of the amendment

3.25 The amendments replace paragraphs 517(2)(a) and (b) with new paragraphs that refer to temporary visas [item 22] . Subsection 517(3) is added to ensure that the exemption will continue to apply to persons with 'temporary entry permits' issued prior to changes to the Migration Act [item 23] .

3.26 New subsection 517(4) allows visitors from New Zealand who are not required to obtain a temporary visa to qualify for the temporary visitor exemption. A citizen of New Zealand who does not have a temporary entry visa can satisfy the exemption if he or she:

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has been a resident of Australia for a continuous period not exceeding four years;

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would have been required to hold a temporary visa if not a citizen of New Zealand; and

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has not come to live in Australia permanently.

[Item 23]

Treatment of capital losses under the calculation method

Summary of the amendments

Purpose of the amendments

3.27 The amendments will allow a notional deduction under the calculation method for determining FIF income where a FIF incurs a net capital loss.

Date of effect

3.28 The amendments are to have effect from the commencement of the FIF measures (ie. from 1 January 1993). [Subclause 2(3)]

Background to the legislation

3.29 The calculation method relies on information in the accounts of a FIF to determine the profit the FIF has derived for a particular period (called a notional accounting period). The calculated profit is determined using simplified rules to reduce the compliance burden.

3.30 Problems may currently arise under the calculation method because a notional deduction cannot be claimed for a loss on the disposal of an asset unless the loss relates to a gain or profit of a revenue nature (section567). This treatment is inequitable because a gain on the disposal of an asset is included in a FIF's calculated profit (section 560).

3.31 The calculated profit of a FIF should be reduced for net losses of a capital nature to ensure FIF income does not arise for profits which do not exist. The reduction can be achieved by allowing a notional deduction for net losses of a capital nature.

Explanation of the amendments

3.32 The amendments will provide a notional deduction for net capital losses incurred by a FIF during a notional accounting period (new subsection 567A(1)). They will also ensure that an amount cannot be deducted twice (subsection 567A(2)). In this regard, the net amount brought to account will exclude any amount previously allowed as a notional deduction (paragraph567A(2)(a)). It will also exclude amounts that would have been allowed as a notional deduction if the calculation method had applied in a previous period (paragraph 567A(2)(b)). This will be relevant, for instance, if it was not necessary to calculate FIF income in an earlier period because of an exemption from the FIF measures. [Item 24]