Australia
Ian Farmer
PricewaterhouseCoopers
Australia
Ian Farmer of PricewaterhouseCoopers points out that the Board of Taxation's recommendations for reform of the foreign source income anti-deferral regimes is the first step in constructing a new, effective tax system
In October 2006, as part of a commitment to ensure that the Australian tax system was operating effectively, the former government announced a review of the foreign source income anti-deferral regimes by the Board of Taxation. At the time, Australia had several anti-tax deferral regimes designed to prevent Australian resident taxpayers from using foreign entities to defer or avoid Australian tax.
Additionally, the business community had raised a number of concerns about the complexity of the existing anti-tax deferral regimes and the resulting compliance and administration costs. In some cases, it was submitted that the regimes were poorly targeted, potentially resulting in adverse impacts on offshore investment decisions that were not motivated by tax deferral reasons.
Against this background, the objectives of the board's review were to:
- reduce the complexity and compliance costs associated with the international anti-tax-deferral regimes; and
- examine whether the anti-tax-deferral regimes struck an appropriate balance between effectively countering tax deferral and not inhibiting unnecessarily Australians from competing in the global economy.
Since the initial announcement in 2006, a new Australian federal government has been elected to office, and the world has witnessed a significant change in the global economy. After almost two years of public and private consultation and submissions, including the release of a discussion paper, a position paper, and several issues papers, the board released its recommendations to the federal government in September 2008.
Release of the Board of Taxation's recommendations
Coinciding with the release of the Australian Federal Budget, on May 12 2009, the government released the board's report to the public and announced its intention to adopt all but one of the reforms the board recommended. The government rejected the board's recommendation that Australian listed public companies be exempted from the attribution rules, subject to recommended integrity thresholds. The proposed reforms will significantly change the tax treatment of investment offshore.
As part of its substantial acceptance of the board's recommendations, the government announced that it will:
- 'modernise' and rewrite the controlled foreign company (CFC) provisions
- repeal the foreign investment fund (FIF) provisions (dealing with portfolio investments by residents in offshore entities) and replace them with a specific narrow anti-avoidance rule
- repeal the deemed present entitlement rules (which apply in respect of certain interests held by residents in offshore trusts), and
- amend the transferor trust rules (which address taxation in respect of offshore trusts to which residents have transferred value) to "enhance their effectiveness and improve their integrity".
The government's favourable response to the board's recommendations was generally welcomed by businesses with investments offshore. In particular, those businesses welcomed the narrowing of the categories of income which will potentially be subject to attribution, and the prospect of relief from the compliance burden created by the FIF rules. However, it is likely that the rejection of the recommendation of an exemption for listed public companies caused disappointment in some quarters.
To clarify the details of the proposed changes, the government released a Treasury discussion paper, outlining the framework for the redesign of the foreign source income attribution rules and seeking submissions from interested parties. The discussion paper also presented a whole new raft of issues for consultation, including a number of surprise proposals which went beyond those originally envisaged. These included a possible change to the non-resident capital gains tax (CGT) rules which could affect the treatment of the disposal of certain instruments held by non-residents in land-rich Australian entities.
The government has indicated that the new measures will apply for income years commencing on or after the date of Royal Assent. It therefore seems likely that the earliest date on which the reforms could take effect would be for income years commencing on or after July 1 2010.
The Board's recommendations
While the federal government, in principle, accepted all but one of the Board of Taxation's recommendations, many of the details will be finalised over the coming months through public consultation and submissions based on the discussion paper. The following is an overview of the Board's recommendations:
Retain the controlled foreign company provisions as the primary set of rules to counter tax deferral
The controlled foreign company (CFC) rules, comprised of Part X of the Income Tax Assessment Act 1936 (ITAA 1936), will be rewritten into the Income Tax Assessment Act 1997 (ITAA 1997). The rewritten rules will extend to closely-held fixed trusts and interests in non-common law entities.
Retain and modernise existing legal based passive income rules
One of the primary classes of income caught by the CFC rules is passive income (eg interest, dividends, certain royalties and rent, and capital gains in respect of 'tainted assets') derived by a CFC. As part of the consultation process, the board raised the possibility of determining whether an amount was passive income on the basis of the economic substance of the transaction giving rise to the amount. In its final recommendations, it endorsed retaining the existing tests that are based on the legal form of the amounts received.
However, the board also endorsed a 'modernisation' of the definition of passive income to accommodate modern business practices, including:
- 'updating' concessional provisions in respect of financial intermediaries to encompass additional activities ordinarily undertaken by such entities;
- narrowing the definition of 'tainted rental income' to comprehend less rigid ownership and management structures than those contemplated by the existing provisions; and
- narrowing the definition of tainted royalty income.
Allow a group approach for applying active income test
The existing rules apply a de minimis active income test which will exclude most amounts from the attributable income of a CFC where, among other things, less than 5% of the CFC's turnover arises from passive or tainted amounts. The board recommended the adoption of a group approach in applying this test, where CFCs are consolidated for accounting purposes. This may ensure that only passive income derived from non-group entities will be taken into account in determining whether the CFC passes the active income test. However, the limitations of such grouping, including determining whether it will extend beyond entities resident in a single jurisdiction, is yet to be determined.
Remove base company income rules, subject to express integrity rules
Now, the notional assessable income of a CFC and its tainted turnover, for the purposes of the active income test will, typically, comprise passive income, tainted sales income and tainted services income. The board recommended that base company income (being, tainted sales income and tainted services income) be excluded, for these purposes.
As tainted sales income involves sales to, or acquisitions from, associates who are likely to be subject to Australian income tax, the board took the view that such amounts should be addressed exclusively by the Australian transfer pricing provisions and, thus excluded from the CFC measures.
The focus of tainted services income is on the supply of services to those within the Australian tax net. As such, the policy of the provisions was to discourage the substitution of the provision of services into Australia from offshore for those that might otherwise have been provided from within the Australian tax base. The board recommended exclusion of these amounts from the CFC measures on the basis that their inclusion placed Australian investors at a competitive disadvantage to offshore competitors.
Exemption of complying superannuation entities from the CFC rules
In line with the existing exemption from the FIF measures, for interests in FIFs held by a complying superannuation (pension fund) entity, the board recommended that a similar exemption be available for complying superannuation funds in respect of the CFC rules.
Allow taxpayers a choice of methods in calculating attributable income
Under the CFC rules, an Australian attributable taxpayer must calculate its share of attributable income of a CFC by applying a branch equivalent approach (applying a modified version of Australia's income tax rules to the affairs of the CFC). The board recommended that, in addition to this approach, a taxpayer should be able to calculate its share of the attributable income of a CFC on the basis of changes in the market value of their interest in the CFC, or by applying a compounding deemed rate of return to the market value of their initial investment.
Retain the tax law approach for branch equivalent calculations
As part of the consultation process, the board raised the possibility of calculating attributable income under a branch equivalent approach based on accounting data, rather than the modified application of the Australian income tax laws. The board's final recommendation was to continue with the current modified tax law approach.
Repeal section 404
Under section 404 of the ITAA 1936, a dividend paid by a company resident in a listed country (that is, Canada, France, Germany, Japan, New Zealand, UK and US) or section 404 country (broadly, Australia's tax treaty partners) to a CFC resident in another listed country or section 404 country is notional exempt income of that CFC, and therefore not attributable. The board recommended the repeal of section 404 because the section created a deficiency in the CFC rules, as it allowed an Australian resident company to establish a CFC in an section 404 or listed country, to receive portfolio dividends which would be treated as notional exempt income.
The CFC could then remit the profits received by the Australian resident company as a non-assessable, non-exempt, non-portfolio dividend (that is, where the payee has a voting interest of at least 10% in the company paying the dividend) under section 23AJ of the ITAA 1936. In contrast, if the Australian resident company had derived such portfolio dividends directly, they would have been included in its assessable income.
Amend non-portfolio dividend treatment to allow equity-like features to be taken into account and preclude debt-like interests
Relief under section 23AJ of the ITAA 1936 is available for (and limited to) legal form dividends paid to a resident company for a non-portfolio (10% voting) interest comprising legal form shares in a non-resident company. The board recommended that, where a minimum 10% interest threshold was met, relief under section 23AJ of the ITAA 1936 should be available for distributions for all interests issued by a foreign company with equity-like features. The test for such interests would look at rights to dividends, and capital and returns upon winding up. The board also recommended that the relief should not be available for distributions in respect of debt-like interests. In the discussion paper, Treasury suggested that the concepts of equity interest and debt interest, contained in Australia's existing tax debt/equity rules could be applied for this purpose.
Repeal FIF rules and replace with specific anti-roll-up fund measure
The board recommended that the FIF rules be repealed and that the provisions be replaced with a much narrower, anti-avoidance regime, targeting interests in non-resident accumulation funds that do not satisfy the control tests in the CFC rules.
Repeal the deemed present entitlement rules
The deemed present entitlement rules represent one of three overlapping regimes, addressing the taxation of residents for non-resident trusts (the others being the transferor trust rules and the FIF rules). The repeal of these provisions had been accepted by the former government following the recommendation of the Ralph Review of Business Taxation in 1999. The board's recommendation to repeal these rules effectively endorses that decision.
Remove the control requirement for pre-commencement and pre-resident transferor trusts
The transferor trust rules exclude taxpayers who transferred amounts to a non-resident trust estate before the transferor trust measures commenced, where the taxpayer was not in a position to control the affairs of the trust after the commencement of the measures.
A similar exemption existed for taxpayers who transferred amounts to a non-resident trust estate before they became a resident, where the taxpayer was not in a position to control the affairs of the trust after the taxpayer became a resident.
The board recommended the removal of both of these exemptions. However, it conceded that further changes may be required to ameliorate the impact of their removal.
Base attributed income for transferor trusts with multiple transferors on value of property or services transferred
For foreign entities with multiple transferors, the board recommended the amount of income to be attributed to each transferor should be based on the respective value of the property or services they transferred to the foreign entity. Where it is not possible to determine this amount, the transferor would be deemed to hold a 100% interest in the foreign entity for the purposes of such attribution.
The reality of implementing the reforms
There is little doubt that the reforms to the foreign source income anti-tax deferral regimes, announced in May 2009, will have a significant impact on investment offshore. To address the details of the measures, the government commenced consultation with the community by releasing the Treasury discussion paper. As noted above, the discussion paper presented a whole new raft of issues for consultation. Some of the more significant issues highlighted in the discussion paper include:
- application of an equity test for determining ownership interests in controlled foreign entities
- the adoption of a uniform substantial ownership test as the threshold for the application of a number of international tax regimes (including the rewritten CFC rules)
- adoption of a de facto control test as the primary test for determining whether a foreign company or trust is if a controlled foreign entity
- adoption of standard timing rules for attribution, the non-portfolio dividend exemption and the capital gains tax participation exemption
- redefinition of passive income to fit the concept of active foreign business in the existing participation exemption rules, and
- the interaction of the Taxation of Financial Arrangements (TOFA) and attribution rules.
While the government may have changed since the Board of Taxation's announcement of the review in 2006, the need to address the complexity and costs of the tax system has not. In fact, establishing a globally competitive, streamlined and efficient taxation system has become a primary focus for the government. The announcement in 2008 of the Australia's Future Tax System Review, chaired by Ken Henry, was a further step in working towards an effective Australian tax system.
As the government finalises the details, and addresses the issues that have arisen out of the board's review of foreign source income anti-tax deferral regimes, those who have investments offshore look forward to the final implementation of the resulting reforms.
Ian Farmer (ian.farmer@au.pwc.com) is managing partner – tax & legal of PricewaterhouseCoopers in Australia