Fewer taxpayers will be dragged into the attribution net if the proposed simplification of the controlled foreign companies and foreign accumulation funds measures are adopted.
The Australian Government has released draft legislation for the new controlled foreign company (CFC) and foreign accumulation fund (FAF) rules which were foreshadowed in the 2009 Budget.
The simplified narrow base that the proposed regime is built upon is a welcome next step in the reform of Australia's anti-tax deferral regime. Although there are some issues requiring technical and/or drafting clarity prior to enactment, the foundation blocks of the new regime are a definite improvement and should ensure a reduction in compliance costs, general inefficiencies and scope for dispute. There is an increased emphasis on accounting concepts –which may lead to some interpretational issues in marginal cases.
The call for change
Until recently Australian resident taxpayers with interests in foreign entities were subject to four anti-deferral regimes: the CFC, transferor trust, foreign investment fund (FIF) and deemed present entitlement (DPE) regimes. Each regime is/was inefficient, inequitable and exposed taxpayers to significant compliance costs (even if only to conclude that the regimes did not apply).
In October 2006, the Board of Taxation was requested to undertake a review of Australia's foreign source income attribution rules. In September 2008, the Board of Taxation issued its findings. Consistent with these recommendations , the 2009-10 Budget included an announcement that:
the CFC rules are to be rewritten into the Income Tax Assessment Act 1997; and
the FIF rules are to be repealed and replaced with a specific anti-roll-up fund rule; and
the DPE rules are to be repealed.
The FIF and DPE rules were repealed by the Tax Law Amendment (Foreign Source Income Deferral) Act (No. 1) 2010 on 14 July 2010. Consequently, there is no longer a requirement to attribute income for foreign investments held in non-control cases under the FIF rules.
On 17 February 2011 the draft legislation was released for comment. The new regime is to apply to income years on or after royal assent. Although there is no formal indication of when this will be, the rule is expected to take effect from the 2011/2012 income year. Submissions are due by 18 March 2011.
Overview of the proposed CFC rules
- an attributable taxpayer
- for a CFC
is required to include attributable income for a period in its assessable income for that period
with concessions and exemptions for certain taxpayers and relief from double tax.
The term attributable taxpayer is defined to mean an Australian entity which controls a second entity or is an associate of another entity (whether resident or non-resident) that controls the second entity and has a direct participation interest or total participation interest (the interest of the taxpayer through its subsidiaries) in the second entity of greater than zero.
Control is based on Australian Accounting Standards AASB 127 and AASB 131, which deal with the question of control on a sole and joint basis. Under the accounting standards the test is whether an entity has the power to govern the financial and operating policies of another entity so as to obtain benefits from its activities. Thus, control is generally seen to exist if there is a 50% or greater interest in the relevant entity.
However, it can exist where lesser interests are held where there is power to influence policies, the composition of directors or votes. This cedes control of the tax legislation in this respect to the relevant accounting bodies. There may be interesting questions of interpretation which result in cases which are at the margin.
The attributable taxpayer test focuses on the interests held by the entity and its associates. Under this proposal it will no longer be necessary to consider whether an entity is controlled by five or fewer Australian entities – ie. taxpayers do not have to concern themselves with interests held by other Australian entities that they are unconnected with. This is a significant departure from the current legislation, which effectively deems control exists if there is a relevant 10% holding, regardless of whether there is actual control of the entity.
The attributable taxpayer test is applied only at the end of the statutory accounting period. That is, it is not necessary to test an entity throughout the year.
The Board of Taxation's recommendation that Australian listed public companies be exempt from the anti-deferral regimes was rejected by the Government. Accordingly, Australian listed public companies can be attributable taxpayers.
Controlled foreign company
A company is a CFC if it is not an Australian resident and there is at least one attributable taxpayer.
If two entities each hold 50% interest in a company, they are treated as jointly controlling the company (and therefore attributable taxpayers in relation to a CFC). There are many joint venture arrangements where neither party controls the joint venture vehicle. It is expected that this issue will be the subject of submissions in this round of consultation.
Under the current provisions a company can be a CFC even if there is no attributable taxpayer. This change will ensure that many taxpayers will be kept outside the regime.
The attributable income of a taxpayer is to be determined by assuming that the CFC is an Australian resident company for the entire period and adding to assessable income the adjusted passive income.
The following types of income are prima facie passive income:
returns on an equity interest;
returns on a debt interest;
payments of rent (not being rent on real property);
payments of annuity;
payments of royalty;
profits from financial arrangement; and
gains from a CGT event from an asset that could give rise to an amount in previous paragraphs.
Consistent with the current regime, adjusted passive income will not include income that is comparably taxed in listed countries (it is not anticipated that there will be any change to the seven listed countries at this time).
In determining a CFC's taxable income, certain provisions are ignored including in relation to thin capitalisation, consolidation, imputation, transfer pricing and superannuation. However, Division 230 (the TOFA provisions) is no longer ignored.
The income of a CFC referable to an intra-CFC group transaction is to be excluded from adjusted passive income provided that the other CFC group member does not receive a tax benefit in relation to the transaction. A tax benefit can be a deduction, change in cost base of a CGT asset, or a tax offset.
This exclusion is only to be available if the CFC deriving the income is a member of a CFC group throughout the relevant statutory period (ie. not just at the time the inter-company transactions occur). The term CFC group is defined to mean entities that at a relevant time are CFCs of a single attributable taxpayer and controlled by that attributable taxpayer and not controlled by any other attributable taxpayer.
Thus, a CFC group does not require 100% shareholding; rather it will fall to be determined by accounting concepts (as discussed above).
Active business income exclusion
The new provisions recognise that certain types of income can be passive for some taxpayers but not for others. For example, interest income will often be passive but will be active for financial institutions. Accordingly the following income is to be excluded from attribution:
income that is attributable and has a substantial connection to a permanent establishment of the CFC (whether in Australia or in another country);
arises from the CFC competing in a market; and
arises substantially from the CFC's ongoing use of labour
provided that the source of the income, the market and the labour has a substantial connection with the country in which the permanent establishment is located.
The drafting in these provisions probably opens the greatest scope for future disputes as taxpayers grapple with what is meant by terms such as "competing in a market", "ongoing use of labour" and "substantial connection. It seems that this potential uncertainty has been recognised – hence the introduction of more targeted "bright line" concessions as described below.
Concessions for Australian financial institutions
For Australian financial institutions (including authorised depositary institutions and life insurance companies) who control a CFC, excluded AFI income is not included in the adjusted passive income of the CFC. What constitutes excluded AFI income is yet to be agreed – consultation is continuing on this definition. The CFC's sole or principal business must be a financial intermediary business – that is, either banking business or money-lending business.
Active CFC exemption / de minimis exclusion
The exemption for active CFCs has been updated and simplified to two requirements:
the company must have kept accounts which are prepared in accordance with commercially accepted accounting principles and the accounts give a true and fair view of the company's financial position; and
the company's prima facie passive income is <5% of income for the period based on the financial accounts of the company.
Exemption for lightly taxed entities
Also excluded from the CFC regime are attributable taxpayers who are "lightly taxed entities" including:
complying superannuation entities
life insurance companies where the interest in the CFC is a complying superannuation/FHSA asset or a segregated exempt asset; and
any interposed trust or partnership with lightly taxed entities as members.
Relief of double tax
Attribution credits are available to the extent that certain amounts have been included in a taxpayer's income by reason of the CFC regime. These attribution credits can be used to convert distributions by the CFC or capital proceeds attributable to equity interests in a CFC from assessable income into non-assessable non-exempt income.
An integrity rule will apply where passive income is not attributed because of an exemption and an attributable taxpayer for the CFC or an associate of an attributable taxpayer for the CFC is entitled to a tax benefit (eg. a deduction) referable to the CFC having the amount of prima facie passive income (proposed section 802-215). Under the rule the adjusted passive income includes the passive income that had otherwise been excluded.
Calculating the attributable amount
The amount that an attributable taxpayer is required to include in assessable income in relation to each CFC in respect of which it is an attributable taxpayer is the attributable income of the CFC multiplied by the attributable taxpayer's total participation interest. Broadly, that amount is calculated by reference to issued equity and rights to distributions of profit and capital.
Replacement of foreign branch exemption and non-portfolio dividend exemption rules
Section 23AH (the foreign branch income exemption) and section 23AJ (non-portfolio dividend exemption) are to be repealed and replaced by new exemptions in Subdivision 768-A.
Where a distribution is made by a foreign company to an Australian resident in respect of an equity interest, the income is non-assessable non-exempt income provided the recipient has at least 10% direct ordinary interest in the foreign company or is an attributable taxpayer in respect of the foreign company and the recipient does not receive the distribution in its capacity as a trustee.
The exemption has also been extended to apply to partnerships and trusts where a distribution is paid to the partnership or trust or to interposed partnerships or trusts.
Where an Australian resident company carries on business at or through a permanent establishment in a foreign country, the income is non-assessable non-exempt income for the Australian company except to the extent that there would be attributable income under the new CFC rules if the permanent establishment was deemed to be a CFC and the Australian company was an attributable taxpayer with 100% participation interest in the deemed CFC.
Foreign Accumulation Funds
The proposed anti-roll-up rule is contained in the draft FAF provisions.
A FAF is a trust or company which is not an Australian resident, which has 80% or more of assets which are debt interests, and which distributes less than 80% of its realised gains and profits (as well as realised gains and profits in its subsidiaries) or as prescribed by regulations.
The calculation of attributable income of a FAF is to be determined, but is expected to be based on the change in market value of the interest in the FAF plus any distributions made by the FAF in the period.
As with the CFC regime, there are exemptions for lightly taxed entities and relief for double tax.
The new rules have been a long time coming, and have not yet completely arrived. However, the underlying policy amendments and the simpler drafting style in the draft legislation represent significant advances on the current regimes. A major consequence of the proposals will be that many taxpayers that are currently within the attribution net will be excluded.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.