Tax Brief - 2003-4 Federal Budget - International Tax Measures

Earlier tonight the Treasurer handed down the 2003-4 Federal Budget.

Tax matters related primarily to:

• personal income tax cuts by raising the low income tax offset and raising the income tax rate thresholds;
• reiteration of a number of previously released proposals including the deferral of the TOFA currency proposals to 1 July 2004; and
• reforms to Australia’s international tax system.

This Tax Brief deals solely with the Proposed Changes to the International Tax System.

As a general comment the measures announced are the result of a consultation process announced during the last election campaign.

Most changes will occur with effect from 1 July 2004.

Some changes will occur in tranches, some of which may conceivably occur before 1 July 2004 and some of which will very likely occur well after that date.

There will also be another round of consultation as part of implementing the changes.

Summary Of Proposed Changes

For the reader’s benefit we have set out in the attached table a summary of the Treasury’s International Tax Options, the Board of Taxation’s recommendations and the Government's response.

In the table we have attempted to summarise the relevant international tax measures as recommended by the Treasury and subsequently reviewed in depth by the Board of Taxation which made certain recommendations. The final responses by the Government are also summarised in order to provide readers with a picture of how each international tax measure progressed.

CFC Rules

The Controlled Foreign Company ("CFC") reforms are designed to simplify the application of the CFC rules for Australian companies operating in foreign countries with comparable tax regimes. 

Broad exemption listed countries (BELCs)

There are currently seven BELC countries: Canada, France, Germany, Japan, New Zealand, the United Kingdom and the United States.

The Government proposes that only items of income that are considered to pose "significant integrity risks" would in the future be subject to attribution. This will be achieved by means of an express list of items of tainted income derived by BELC CFCs subject to attribution. For instance, capital gains are likely to be expressly listed where a particular BELC exempts capital gains from taxation (eg New Zealand).

The list of tainted income subject to attribution will be the subject of public consultation. However, whilst the intention is to reduce compliance costs, the Government has hinted that the measures will only be introduced if it is satisfied that a significant detrimental impact on revenue or the integrity of the CFC measures would not arise.

There is currently no proposal to change the treatment of certain other types of income that remain attributable for BELC CFCs such as FIF and certain types of trust income. However, the Government has indicated that such income may also be excluded from attribution in the future after further assessment of the integrity risks associated with such a proposal.

From a compliance viewpoint, it is disappointing that the Government did not see fit to remove BELC CFCs from the CFC regime altogether.

Non-BELC CFCs controlled by BELC CFCs

As part of the "Tranche 3" proposals, it is proposed that non-BELC CFCs controlled by BELC CFCs will be removed from the Australian CFC regime where the BELC CFC is resident in a foreign country that has a CFC regime that is closely comparable to Australia.

To ensure integrity, the CFC regime of a BELC will need to satisfy certain criteria in order to be considered "closely comparable". Any reduction in compliance costs will depend on the parameters of the criteria and the ease they may be satisfied.

Tainted services income

It is proposed that the attribution of tainted services income derived by CFCs will generally only apply in the future to income earned from providing services to Australian residents. That is, income of CFCs earned from providing services to non-resident associates will be generally removed from attribution.

However, integrity measures will be concurrently introduced to ensure that services income earned from non-resident associates can remain attributable if the non-resident associate is a CFC and such payments are a notional allowable deduction in calculating the attributable income of the payer.

BELC list

The Government has indicated its support for the recommendation of the Board of Taxation that criteria for declaring further countries as BELCs be developed and published. The Treasury will thereafter consult in setting priorities for additional countries to be added to the BELC list.

CFC issues register

The Government has committed that CFC issues from the register of CFC policy and technical issues maintained by the Foreign Source Income Sub-Committee of the Australian Taxation Office’s National Tax Liaison Group identified by the Board as "urgent" will be reviewed as a matter of priority.

FIF Rules

After much hope from business, the changes proposed by the Budget to the FIF rules are somewhat of a disappointment. Hope still exists that "a more comprehensive review of the FIF rules" will in fact take place in the future.

The proposals in the Budget include:

• increasing the 5% balanced portfolio exemption to 10%;
• for Australian managed funds, the basis of measuring the new 10% balanced portfolio exemption will be calculated on the total value of the net assets. This will be subject to legislative design which will be conducted in consultation with industry. Double counting and valuation issues will be addressed in this process;
• an exemption from the FIF rules for Australian complying superannuation entities; and
• the "management of funds" activities (other than derivation of passive income) will be excluded from the FIF rules.

For most corporates with FIF investments and for most managed funds, this should result in a significant reduction in compliance costs. Complying superannuation entities are clear winners.

Of particular interest will be the development of the rules for managed funds. Clearly, the move away from measuring the "base" on an entity basis could result in additional systems and compliance costs. This could possibly be achieved by either excluding interests in lower tier funds or taking a proportional interest approach and subtracting that from the lower tier funds’ calculations.

Global Financial Services Centre - Taxation of Trusts

Withholding from distributions to non-resident beneficiaries

Despite a recommendation by the Board of Taxation, the much anticipated removal of ss.98(3) and 98(4) which operate to assess trustees on behalf of non-resident beneficiaries in respect of Australian source income (with the exception of interest and dividend income) has been rejected by the Government. The funds management industry had argued that the revenue collected by these measures was out of line with the compliance costs incurred in calculating and withholding the tax, especially as it relates to non-corporate beneficiaries.

By contrast it seems that the property trust industry has been able to argue a better case, with the Government announcing that the rate of tax imposed on rental income distributed by property trusts will be set at the company tax rate irrespective of the nature of the beneficiary. Thus, once the measure is implemented there will no longer be a need to apply the marginal tax rates when withholding from distributions of this type of income to non-resident non-corporate beneficiaries.

CGT and non-Australian source income flowing to non-resident beneficiaries

Non-resident beneficiaries will also benefit from several measures related to capital gains tax.

• The current exemption from CGT for the disposal of portfolio interests in Australian unit trusts will be bolstered by a new exemption for the disposal of portfolio interests in Australian "managed funds". It seems that "managed funds" in this context will somehow be defined as funds with assets without the necessary connection with Australia. The Options paper suggested that the necessary connection should be judged by treating the trustee as a non-resident. It will be interesting to see what will happen when this rule is formulated.
• While the measure referred to above affects the taxation of the non-resident beneficiaries interest in the Australian trust, the Government has also announced the complementary measure that capital gains flowing through an Australian trust from the disposal of assets without the necessary connection with Australia will be ignored to the extent that a non-resident is presently entitled to the gain. This means that, for example, gains on portfolio investments in Australian companies, held by Australian trusts, should not result in non-resident beneficiaries effectively being subject to Australian CGT.
• It seems that CGT Event E4 and the convoluted provisions dealing with adjustments to the cost base of interests in a fixed trusts will also be amended so that foreign source income, including capital gains from non-Australian assets referred to in the measure above, flowing through a trust to a non-resident beneficiary will not give rise to a cost base reduction. Such reductions could operate to defeat the purpose of exempting the income flowing through the trust if the disposal of the units is within the Australian CGT net (i.e. non-portfolio interests).

Important Exemption of s.128F Exemption

The Government has also announced that the s.128F interest withholding tax exemption will be made available to widely held public unit trusts, allowing certain trusts to decrease their borrowing costs, putting them on an equal footing with companies. As with most measures in relation to trusts, the design of the law will be subject to further consultation.

Other Measures

In other measures, it seems that s.3(11) of the International Agreements Act will be amended to ensure that non-Australian source income flowing through Australian managed funds to non-residents will retain its foreign source.

International Company Tax

Outbound

Australian companies are to benefit from:

• an extension of existing tax exemptions for certain foreign branch profits and dividends from non-portfolio shareholdings in foreign companies; and
• a new CGT exemption for disposals of non-portfolio interests in foreign companies with active businesses.

The existing dividend and foreign branch profits exemptions do not apply, broadly speaking, to profits derived in "unlisted" countries. The proposed extension will remove that restriction.

The new CGT exemption corrects a distortion which exists under the current law. It is intended that a tax exemption for Australian companies should apply to the disposal of non-portfolio foreign shareholdings, whether the disposal is by way of sale of shares in the foreign company, the foreign company selling a non-portfolio shareholding, or by a foreign company selling its active business assets and paying a dividend.

Australian Conduit – Foreign Dividends

The "foreign dividend account" regime facilitates amounts received by an Australian company by way of foreign dividend being paid by that Australian company to foreign shareholders free of withholding tax. That regime is to be replaced by a similar regime applying not only to foreign dividends but to a variety of foreign income and gains. This will, for example, remove a distortion by which foreign shareholders investing through an Australian company would be subject to more Australian tax if that Australian company had profits in a foreign branch than if it had dividends from a foreign subsidiary.

Australian Conduit – CGT

The Government has not provided an exemption where foreign shareholders realise their interest in the Australian company’s foreign profits not by dividend, but by selling their shares in the Australian company. The proposal has not been rejected, but it has been deferred while "integrity, complexity and harmful tax practice concerns" are examined.

There would seem, therefore, to be an Australian tax advantage in such foreign shareholders taking the relevant profits by way of dividend, rather than sale of shares in the Australian company.

In-bound

The Government "will give further consideration" to attempting to impose tax on a sale by a non-resident of non-Australian entities which are substantially merely holding vehicles for Australian assets. (It recognises that any such proposal may have "a possible adverse effect upon foreign investors’ perception" of investment in Australia.)

Taxation Of Foreign Trusts

The Government has decided to simplify the tax treatment for Australian investors in foreign fixed trusts and to strengthen the application of taxing provisions for certain foreign discretionary trusts. In doing so, it is substantially implementing recommendations of the Ralph Review of Business Taxation ("RBT") of July 1999 more recently referred to in Review of International Tax Arrangements. In particular:

Foreign Fixed Trusts

Foreign fixed trusts with only Australian beneficiaries will be subject to the FIF rules alone. Where a foreign fixed trust has Australian and foreign beneficiaries, the FIF measures will apply to resident beneficiaries, however, resident transferors of property or services to the foreign trust will be subject to taxation under the current transferor trust measures on amounts not taxed under the FIF measures.

Based on the relevant RBT recommendation, it is considered that only the transferor trust measures would provide effective protection from tax deferral where a resident has made a transfer to a foreign trust with foreign beneficiaries. This is because the trust could be only one component in a broader scheme involving distributions of trust profits to foreign beneficiaries who then provide gifts or other benefits to the transferor or associates of the transferor.

Foreign Discretionary Trusts

The Government has recognised that the current transferor trust rules allow for taxpayers migrating to Australia to transfer assets to a foreign discretionary trust prior to coming to Australia and not be subject to any tax in Australia on the accumulating income in the trust. This consequence only arises where it cannot be said the transferor controls the trust. The same outcome arises if the relevant transfer was made before the original transferor trust measures were announced.

The Government has recognised that these exemptions from the transferor trust measures provide possible opportunities for deferral, as it is difficult to prove "control". Accordingly, the Government has announced that it will no longer be a requirement that the transferor controls the trust. It is not clear what tests will be substituted for such trusts. In the meantime, an amnesty will be available to taxpayers to wind up the trusts with distributions only taxed at 10%.

Deemed Present Entitlement Rules

As a consequence of the changes referred to above, certain deemed present entitlement rules will be removed from the tax legislation. Based on the RBT recommendations, this is because interests held in a foreign fixed trust can be more equitably treated under the FIF measures and the deemed present entitlement rule cannot be made to operate appropriately for non-fixed interests.

Taxation Of Australian Branches

Branches of Foreign Non-Bank Financial Institutions

This proposal will align the treatment of Australian branches of foreign-owned non-bank financial institutions with Australian branches of foreign owned banks.

In particular, the Australian branches of foreign owned non-bank financial institutions will be treated as separate entities for thin capitalisation and grouping of new losses. This treatment will also be extended to other matters such as withholding tax and interest deductibility as set out in Part IIIB of the Income Tax Assessment Act 1936.

Taxation of Unfranked Dividends Received by Branches

These dividends will be subject to tax by assessment rather than withholding tax in line with the separate entity treatment referred to above. This proposal will apply to all branches of foreign companies.

Double Tax Treaties

Residence of Companies

A company which is a dual resident but which is treated by a tax treaty as a resident of the country other than Australia will be treated for the purposes of the Australian domestic law as a non-resident of Australia. The Budget does not spell out the transitional position and affected companies may be treated as having disposed of many of their assets when this rule comes into force.

Other

In line with OECD trends the Treasurer has committed the Government to more of a ‘residence’ bias – less reliance on source - in allocating taxing rights between Australia and our major trading partners.

In practical terms this means progressive renegotiation of Australia’s tax treaties to restrict withholding taxes on dividends. The Government has conceded long held business community views that the excessive source bias, manifested in withholding taxes, is impeding foreign investment in Australia.

This new approach is already evident in the protocol to the US/Australia tax treaty which came into force yesterday.

A separate tax brief will issue on the US Protocol.

The US protocol eliminates withholding tax on unfranked dividends paid by an 80% owned subsidiary, and reduces to 5% withholding tax on unfranked dividends paid by a 10% owned company. Franked dividends are already free of withholding tax.

The one notable exception to the OECD norm is the express reservation of Australia’s right to tax capital gains on a ‘source’ basis. Gains realised on Australian assets (including company shares, except where the ‘portfolio’ exemption already applies for listed public company shares) will remain subject to Australian CGT. Again, this position is reflected in the US/Australia protocol. Australia’s other older treaties will presumably also be revised in time to reflect that position. Post implementation this will create a clear imperative to repatriate dividends prior to sale of Australian companies.

In accordance with a desire to avoid unnecessary tax burdens on non residents though, the Government will consider limited relief for capital gains on non portfolio investments relating to underlying foreign assets.

A number of countries have ‘Most Favoured Nation’ status in their treaty relationship with Australia, and the Government is committed as a first priority to extending these countries the same benefits as the US protocol. The Netherlands, France, Switzerland, Italy, Norway, Finland, Austria and the republic of Korea have MFN status on withholding tax rates with Australia.

There is no indication that the Government will go so far as to adopt the OECD residence bias to the extent of eliminating withholding tax on royalties. Australia’s position as a significant net importer of intellectual capital may prevent that, though the US Protocol reduces the rate from 10% to 5%.

Foreign Executives in Australia and Australian Executives Overseas

To make Australia a more attractive destination to foreign executives, the Government has announced a 4 year exemption for first-time temporary residents for most foreign source income and foreign capital gains (measure previously released in Taxation Laws Amendment Bill (No. 2) 2003);

The Government will review the taxation of employee shares and rights where employees are resident in more than one country over the life of the employee share/right. Some countries tax the share/right on grant, some on vesting, some on exercise and some on disposal of the share/right. This creates the risk of multiple (or no) taxing points. The OECD has released a paper suggesting principles by which the appropriate taxing point(s) may be determined. The Government is disposed to adopt these rules, subject to consultation.

In light of this, the Government has "put back on the table" the prospect of taxing an Australian executive leaving Australia on his accumulated share plan benefits at the time of his departure.

However, the Government has taken "off the table" the idea of residents departing Australia having to provide security for unrealised capital gains tax.

Please see attached Table below showing International Taxation Options, Recommendations and Responses.