11 March 1996 - 3 December 2007
REVIEW OF INTERNATIONAL TAXATION ARRANGEMENTS
To maintain Australia's status as an attractive place for business and investment, the tax system needs continually to adapt to the increasingly integrated global business environment.
Tonight I am announcing the outcome of the Government's review of Australia's international taxation arrangements, following an extensive consultation process conducted by the Board of Taxation. This review delivers on the Government's election commitment in Securing Australia's Prosperity.
The Board reported to me on 28 February 2003. I would like to thank the Board for this crucial work in reviewing the complex area of international taxation law. I am releasing Volumes 1 and 2 of the Board's report today. Volume 3 summarises submissions provided to the Board on a confidential basis, so will not be released.
The package of reforms announced by the Government will improve the competitiveness of Australian companies with offshore operations. These reforms will reduce the costs of complying with the controlled foreign company (CFC) rules, reduce tax on foreign 'active' business income, and effectively reduce foreign taxes by modernising Australia's tax treaties.
The reforms will encourage the establishment in Australia of regional headquarters for foreign groups and improve Australia's attractiveness as a continuing base for our multinational companies. The reforms will also enhance the competitiveness and reduce the compliance costs of Australian based managed funds.
The main components of the Government's package include:
- simplifying the application of the CFC rules for Australian companies operating in countries where tax arrangements are comparable to Australia's and easing these rules for certain services provided in international markets;
- moving towards a more residence-based treaty policy, consistent with the direction set in the US Protocol, where the overall treaty package is in Australia's national interests;
- exempting Australian companies (and their CFCs) from capital gains tax (CGT) for the sale of certain non-portfolio interests in foreign companies and extending the existing tax exemption for foreign non-portfolio dividends (and certain branch profits). This will assist Australian companies operating offshore, as well as regional headquarter operations based in Australia;
- proceeding with the previously announced foreign income account measure;
- better targeting the foreign investment fund (FIF) rules to reduce compliance costs for Australian managed funds and superannuation entities investing offshore by increasing the balanced portfolio exemption from 5 to 10 per cent for all taxpayers along with exempting complying superannuation funds from the FIF rules;
- revising certain aspects of the cross-border taxation of resident trusts to improve the international competitiveness of Australian managed funds;
- proceeding with the simplified treatment of foreign trusts and the tightening of the transferor trust rules, both previously announced;
- extending aspects of the "separate entity" treatment given to foreign bank permanent establishments to branches of other financial entities. Further, unfranked dividends received by foreign-owned branches generally will be taxed on assessment, instead of being subject to non-resident withholding tax; and
- addressing the double taxation of employee share options. A previously announced measure requiring security from departing residents for deferred CGT liabilities will not proceed.
Further details are supplied in the Attachments to this press release.
Capital gains - conduit relief for regional holding companies
As part of its proposal to provide relief from tax on conduit income and gains, the Board recommended giving up taxing rights over all capital gains on the disposal by non-residents of non-portfolio interests in Australian companies. The Government does not support this recommendation. However, the Government intends to consult with the business community to determine whether a more targeted exclusion of non-residents from the CGT regime for gains or losses to the extent they have an underlying foreign source can be practically developed.
Dividend imputation treatment of foreign source income
The Board recommended the Government provide a 20 per cent tax credit to shareholders on unfranked dividends paid out of foreign source income. It also recommended allowing dividend streaming of foreign source income.
However, after carefully considering the Board's views, the Government does not believe it is appropriate to implement these proposals at this time.
The Board noted that its recommendations reflect an `on balance' judgement and concedes that there could also be negative effects from implementing these proposals.
The imputation system is an important feature of Australia's tax system that enjoys wide support amongst both business and shareholders. The Government does not rule out future consideration of the issues examined by the Board.
The Government has also decided, consistent with the Board's views, that the previously announced franking credit for foreign dividend withholding tax measure should not proceed as relief from foreign dividend withholding tax is occurring through recently negotiated and future tax treaties.
Company residence rules
The company residence rules will be amended so that companies that are residents under domestic income tax law, but are non-residents for the purposes of a tax treaty, are treated as non-resident for all purposes of the income tax law. The Government has deferred consideration of changes to the domestic tests of company residence recommended by the Board pending the release of a draft taxation ruling by the Australian Taxation Office to clarify the operation of those tests.
Timing of changes
These reforms are significant and involve complex legislative change. The Government is mindful that the legislation timetable must be realistic and managed in a way that meets the expectations of business.
To enable public consultation to be undertaken on the design of legislation, including addressing integrity issues, the majority of reforms will not commence until on or after 1 July 2004. Priority will be given to implementing key reforms to the CFC and FIF rules to achieve early commencement where possible.
Commencement dates for measures will be announced progressively in sufficient time for business and the Australian Taxation Office to prepare for the changes. Attachment A provides a summary of the proposed reforms with initial indicative priorities.
Negotiations for a revised tax treaty with the United Kingdom are well advanced. The changes to Australia's tax treaty policy announced as part of this review are expected to enable early finalisation of the new treaty.
The Government is committed to continuing the community consultation in the detailed design of these reforms. I have asked the Treasury to establish a small advisory group of business representatives and tax practitioners to help "road-test" the design of legislation and related products implementing these announcements.
This is a fiscally responsible package of reforms to assist Australian companies to integrate more fully into the international economy. The Government recognises this is part of a continuous process of ensuring that Australia's tax system promotes competitiveness and the international integration of Australian business.
Copies of the Board's report can be obtained from its website at www.taxboard.gov.au.
Contact: David Alexander.
Ph: (02) 6277 7340
List of Attachments
Controlled Foreign Company (CFC) rules
3, 3.1(1), 3.1(2), 3.2, 3.3, 3.4
Changes to other international company tax arrangements
3.6, 3.9, 3.10(1), 3.10(2), 3.10(3), 3.11(1) and 3.11(2)
Australia as a global financial services centre
4.1(1), 4.1(2), 4.2, 4.3, 4.4, 4.5, 4.6(1), 4.6(2), 4.7, 4.8, 4.8A, 4.8B and 4.8C
Modernising Australia's tax treaties
3.5, 3.7, 3.8
Improving Australia's tax treatment of foreign expatriates
5.1, 5.2, 5.3, 5.4
4.9, 4.10, 4.11(1) and 4.11(2)
To enable public consultation to be undertaken on the design of legislation, including addressing integrity issues, the majority of reforms will not commence until 1 July 2004 or later. Priority will be given to implementing key `Tranche 1' reforms to the CFC and FIF rules to achieve early commencement where possible.
Commencement dates for measures will be announced progressively in sufficient time for business and the ATO to prepare for the changes. The following summarises the proposed reforms with initial indicative priorities.
- Eliminate attribution of most of the income of a controlled foreign company (CFC) in a broad exemption listed country (BELC).
- Increase the balanced portfolio foreign investment fund (FIF) exemption for all taxpayers from 5 to 10 per cent.
- Exempt complying superannuation funds from the FIF rules.
- FIF rules not to apply to `management of funds'.
- Exempt Australian public unit trusts from interest withholding tax on interest paid on widely distributed debentures issued to non-residents.
- Modify the tainted services income definition to exclude certain income from the provision of services to non-resident associates.
- Extend company tax exemption for foreign non-portfolio dividends and certain branch profits to all countries.
- Exclude from the capital gains tax regime the sale by Australian companies and CFCs of non-portfolio interests in foreign companies with an underlying active business.
- Revise taxation of non-resident beneficiaries on capital gains made by Australian unit trusts.
- Amend application of treaty deemed source rules in respect of non-resident investors in Australian managed funds.
- Exempt non-residents from capital gains tax on gains from the disposal of non-portfolio interests in Australian managed funds.
- Set the rate of tax on rental income distributed by property trusts to non-residents at the company tax rate.
- Extend to other financial entities the treatment given to foreign bank permanent establishments under Part IIIB of the Income Tax Assessment Act 1936 and thin capitalisation grouping rules. Allow grouping of losses for other financial entities.
- Eliminate attribution of the income of non-BELC subsidiaries of BELC CFCs, where the BELC has a closely comparable CFC regime.
- Introduce a foreign income account as previously announced applying to all foreign income.
- Apply the result of a treaty tie-breaker test for companies for all income tax purposes.
- Remove cost base reduction on receipt of foreign source income and gains derived by non-resident investors in Australian unit or other fixed trusts.
- Simplify treatment of foreign trusts.
- Tighten the transferor trusts rules and provide an amnesty.
- Tax unfranked dividends received by foreign-owned branches under the assessment system instead of the withholding tax system.
CONTROLLED FOREIGN COMPANY (CFC) RULES
The CFC reforms will streamline the application of the CFC rules, reducing the informational requirements and compliance costs of those rules and improving the flexibility of Australian companies with operations offshore, without significantly increasing risks to integrity. These changes will help improve the efficiency and competitiveness of outwardly oriented Australian business. They will also make Australia a more attractive place for regional headquarter operations.
The CFC rules are central to Australia's accruals-based attribution regime which helps to tax appropriately the foreign source income earned by Australian residents. These rules affect Australian resident taxpayers with controlling interests in foreign subsidiaries which earn mobile or `tainted' income.
Exemption for CFCs in Broad Exemption Listed Countries (BELCs)
BELCs are countries with similar tax regimes to Australia. There are currently seven BELC countries: Canada, France, Germany, Japan, New Zealand, the United Kingdom and the United States.
The Board proposed exempting from attribution, the income of a CFC sourced in a BELC, or otherwise included in the tax base of a BELC. To limit the compliance burden of dealing with more than one CFC regime, the Board also proposed an exemption from Australia's CFC rules for non-BELC subsidiaries of BELC CFCs, where the BELC's own CFC rules are broadly comparable to Australia's CFC rules.
These recommendations will be addressed in two stages. The first stage will address the income attribution of CFCs resident in BELCs, with the second stage addressing the Board's proposal in relation to non-BELC subsidiaries of BELC CFCs.
CFCs in BELCs
The first stage applies to income that may be attributable to Australian taxpayers because of their interest in a CFC resident in a BELC.
Currently two classes of income are attributed in respect of BELC CFCs. The first is `eligible designated concession income' (EDCI) - subject to an `active income test'. The second class of income (for example, transferor trust and foreign investment fund (FIF) income) is always attributable irrespective of the active income test.
To implement the Board's recommendation, the Government will pare back the classes of tainted income treated as EDCI. The Board recognised that in limited cases, income subject to specific features of a BELC's tax system should remain subject to attribution. Only items which pose significant integrity risks would remain subject to attribution. This more targeted approach should largely eliminate the attribution of a BELC CFC's income.
This measure is designed to reduce the informational requirements and compliance costs business face in applying the CFC rules where BELC CFCs are involved, without a significant impact on integrity or the revenue. Instead of business having to self-assess whether items of tainted income derived by BELC CFCs are attributable, these items will be expressly listed.
Initially, FIF and transferor trust (and other trust) income of a BELC CFC will remain attributable. However, if after further assessment, a BELC's FIF or transferor trust regime raises no integrity risks then this income may also become expressly excluded from attribution.
CFCs in Non-BELCs controlled by BELC CFCs
The second stage applies to the income that may be attributable to Australian resident taxpayers because of their interest in a BELC CFC, which in turn, has a controlling interest in a non-BELC CFC (ie where indirect control of a non-BELC CFC through a BELC CFC exists).
Currently, the income of a non-BELC CFC controlled through a BELC CFC may be attributable under the CFC regimes of both the BELC and Australia. While the law currently makes allowance for the attribution by other CFC regimes, this attribution `duplication' can be compliance-intensive and, where the BELC CFC regime is closely comparable to Australia's, may result in little or no Australian tax being paid.
By removing the Australian CFC regime from applying to the extent that a closely comparable BELC CFC regime also applies (attributing the income of a non-BELC CFC), this measure aims to remove unnecessary compliance effort without a significant impact on integrity or the revenue. In effect it `pushes down' responsibility to the closely comparable BELC CFC regime to ensure income is appropriately attributed and tax is not deferred.
To ensure sufficient integrity, a BELC CFC regime will need to be considered closely comparable in certain key respects, including:
- mechanisms used to determine what countries receive jurisdictional exemptions from attribution;
- the control test, which determines what companies are regarded as CFCs;
- the parameters of any active income test used; and
- the income items that are subject to attribution.
The impact of a BELC's conduit arrangements on attribution will also need to be considered.
Work on this proposal will commence after the first stage is developed.
Capital gains tax (CGT) rollover relief for CFCs
Significant relief from CGT for all CFCs (that are restructuring or otherwise) will be provided by the Government's decision to exempt from attribution gains from the sale of non-portfolio interests in foreign companies with an underlying active business (discussed in Attachment C). This ensures that the gains derived by CFCs selling such interests are not attributed. It also excludes the gains derived by Australian residents selling non-portfolio interests in active CFCs from Australian tax.
Further relief from CGT may be provided for BELC CFCs by the exclusion of capital gains from attribution. This exclusion applies to all types of businesses or assets a BELC CFC may sell. However, where a BELC broadly exempts capital gains from taxation, this income may be expressly listed as remaining subject to attribution.
Further relief from CGT in relation to rollovers and restructuring, as recommended under the Board's recommendations 3.1(1) and 3.1(2), is not considered necessary. These `residual' recommendations would only defer CGT on interests in passive assets. It is not consistent with the objective of the CFC regime to permit the deferral of tax on passive gains.
Better targeting the tainted services income rules
Currently, tainted services income arises if services are provided by a CFC to an associate, whether resident or non-resident, or by a CFC to an Australian resident, whether related or unrelated. Such income may be subject to attribution under the CFC rules.
The Government will reduce the scope of the tainted services income rules to largely exclude from attribution the income of CFCs earned from providing services to their non-resident associates. CFC income from providing services to Australian residents will remain attributable, subject to the active income test.
The change will allow Australian multinationals and regional headquarters that provide services to other group companies and joint ventures through their non-resident associates to better compete in international markets without having to face Australian tax rates on the income derived.
An integrity measure will be designed, and concurrently introduced, to prevent a `post-box' CFC being interposed between a CFC providing services to Australian residents and Australia (where the profits remain with the original CFC) to take advantage of this new exclusion. Subject to further consultation, this will broadly take the form of services income earned from non-resident associates remaining attributable if the non-resident associate is a CFC and such payments for services are an allowable deduction in calculating its attributable income.
Develop and publish BELC criteria and review the BELC list
The Board recommended that criteria for declaring further countries as BELCs be developed and published as soon as practicable. The Government supports this recommendation. This will ensure that the process for reviewing and possibly adding countries to the current BELC list is transparent.
Once the BELC criteria are established, other countries can be considered for addition to the BELC list. The Treasury will consult further in setting priorities for additions to the BELC list.
CFC Issues Register
The Foreign Source Income Subcommittee of the Australian Tax Office's National Tax Liaison Group has maintained a register of CFC policy and technical issues for some time (the Register). The Board commissioned a review of the Register, identifying issues to be addressed as a matter of urgency.
The CFC issues from the Register relating to hybrids and currency conversions have been addressed outside the context of the review and will be legislated separately.
The remaining issues on the Register will be reviewed in consultation with the advisory group of business representatives and tax practitioners being established by the Treasury.
Priority will be given to establishing a policy position on the CFC issues from the Register classified as `urgent' in the Board's report - to the extent that they are not addressed by other CFC initiatives announced under this review.
Other CFC issues from the Register will be resolved as soon as possible thereafter. Consideration of the remaining issues will depend on the final design of the Government's response to the Board's other CFC proposals, along with other legislative priorities.
CHANGES TO OTHER INTERNATIONAL COMPANY TAX ARRANGEMENTS
The Government will introduce a range of measures to improve the ability of Australian companies to compete offshore by reforming the taxation of foreign active business income and gains. These changes are complementary to the reforms to the controlled foreign company (CFC) regime.
These measures will also encourage the location of regional headquarters in Australia by reducing `conduit' taxation, being taxation of foreign source income and foreign capital gains non-residents earn through Australian companies. An additional measure to specifically address taxation of conduit income will also be introduced.
Foreign source business income and gains of companies
The Government will extend the company tax exemption for repatriated non-portfolio dividends and branch profits from offshore investment. The Government will also introduce a capital gains tax (CGT) exemption for Australian companies and CFCs, where they dispose of some or all of a non-portfolio interest in foreign companies with an underlying active business.
Extending exemptions for repatriated profits
Currently foreign non-portfolio dividends received by Australian companies are taxed differently depending upon whether those dividends relate to profits derived in a listed or unlisted country. Certain foreign branch profits are similarly taxed. In broad terms, non-portfolio dividends and branch profits that relate to profits earned in listed countries are exempt. By contrast, similar income earned in unlisted countries is taxed, with a credit being available for foreign taxes paid.
Under the new measure, foreign non-portfolio dividends and certain foreign branch profits received by Australian companies and CFCs will be exempt regardless of whether those dividends or branch profits relate to listed or unlisted countries. As a result the list of limited exemption listed countries will be removed from the income tax law.
This measure will reduce compliance costs associated with the foreign source income rules (including the CFC rules) and the complexity of those rules.
Australia's CFC and FIF rules will ensure that passive and other mobile income derived from low tax jurisdictions will continue to be taxed appropriately. Active business income can be repatriated to Australian companies free of Australian tax. Certain passive income earned through offshore branches will remain subject to Australian tax.
CGT exemption for disposals of non-portfolio interests in foreign active business companies
Currently CGT is imposed on the disposal by Australian companies or CFCs of non-portfolio interests in foreign companies with underlying active businesses. In many cases the underlying active business assets of a foreign company can be sold and the gain repatriated to Australia free of Australian tax.
To reduce compliance costs and improve commercial flexibility, the Government will exempt the capital gain (or loss) on the disposal by Australian companies and CFCs, of non-portfolio interests in foreign companies with an underlying active business. This will ensure that similar tax consequences arise from the sale of non-portfolio equity interests in a foreign company as occur from the sale of the underlying active business assets of that company.
The definition of `underlying active business', together with other design details, will be the subject of consultation with the business community.
To further encourage the location of regional headquarters in Australia, the Government will proceed with a foreign income account and further investigate a CGT exemption for disposals by non-residents of their interests in Australian companies that have foreign assets.
Foreign income account
The foreign dividend account currently allows a withholding tax exemption for unfranked dividends paid by an Australian company out of non-portfolio dividends it receives from listed countries. For unfranked dividends paid out of non-portfolio dividends received from unlisted countries, the exemption is available to the extent that foreign tax credits are available. To the extent that Australian company tax is payable on the foreign dividends, an Australian company is able to pay franked dividends which would not attract withholding tax.
The Review of Business Taxation recommended expanding the foreign dividend account to provide a withholding tax exemption for all conduit income an Australian company distributes. Under this recommendation, a `foreign income account' would replace the `foreign dividend account'. The Government announced its agreement to this proposal in 1999, but deferred implementing this measure pending the outcome of this review.
The Government will now proceed with the foreign income account. Under the foreign income account, conduit taxation relief under the existing foreign dividend account will be extended to include branch profits, tax-exempt gains from the sale of an offshore subsidiary with an underlying active business and other foreign income sheltered from Australian tax by the availability of foreign tax credits. This will provide additional relief from the conduit taxation of foreign income amounts that are paid via an Australian company to non-resident shareholders.
The range of foreign income to which the foreign income account will apply is wider than that proposed by the Board's Recommendation 3.11(1). The Board's proposal had two purposes. As well as providing a withholding tax exemption for conduit income flows, it identified the foreign source business income to benefit from its recommended 20 per cent tax credit for foreign source income. As the 20 per cent tax credit is not being adopted, a wider range of foreign source income can be included.
As part of the foreign income account proposal, the Government previously announced the provision of a company tax refund for inter-entity distributions paid by holding companies that are wholly owned by non-residents. This has already been implemented substantively, via section 46FA of the Income Tax Assessment Act 1936.
Further consideration of a specific conduit CGT exemption
Currently, non-residents are subject to CGT on the disposal of non-portfolio interests in Australian public companies and any interests in Australian private companies. This is the case even where the gain (or loss) relates to income, gains or losses with a foreign source.
The Board found that a specific conduit regime would require, among other things, complex integrity rules, and instead recommended wider systemic changes to effectively achieve conduit relief. One of these systemic changes was an exemption for non-residents on all capital gains on disposals of non-portfolio interests in Australian companies. This was to be progressively introduced through revised tax treaties. As discussed further in Attachment E, the Government has not accepted this recommendation.
There is strong business interest in reducing conduit taxation. Accordingly this issue will be further explored.
Specifically, the Treasury will examine the feasibility of a more targeted CGT exclusion for capital gains (and capital losses) on the disposal by non-residents of some or all of their non-portfolio interests in Australian companies to the extent the capital gain (or loss) has an underlying foreign source. However, the design of any exemption will need to address the integrity, complexity and harmful tax practice concerns identified in the Board's report.
CGT and non-resident interposed entities
A non-resident holding Australian assets through a non-resident company can dispose of that company, avoiding Australian tax on any capital gain - even though the gain relates to Australian assets. The Review of Business Taxation recommended addressing this issue but its implementation was deferred pending a review of tax treaty policy by this review.
As the Board proposed giving up relevant capital gains taxing rights (Recommendation 3.11(2)) in tax treaty negotiations it did not support this measure proceeding. It also noted the possible adverse effect upon foreign investors' perception of Australia as a place to invest, and perceived administration concerns.
However, as the Government has decided to continue taxing these capital gains, it may be appropriate to reinforce Australia's ability to tax non-residents disposing of Australian assets. Accordingly, in consultation with the business community, the Government will give further consideration to the Review of Business Taxation recommendation, recognising that any proposal will need to address concerns regarding a possible adverse effect upon foreign investors' perception of Australia as a place to invest, administration and compliance issues.
AUSTRALIA AS A GLOBAL FINANCIAL SERVICES CENTRE
The Government will make changes to remove barriers to Australia's development as a global financial services centre. These changes involve the foreign investment fund (FIF) rules and aspects of the cross-border taxation of trusts under capital gains tax (CGT), tax treaty deemed source and trustee taxation rules.
The Foreign Investment Fund rules
The FIF rules prevent tax avoidance which can occur through the deferral of Australian tax by accumulating passive income offshore and the conversion of passive income to capital gains. Although FIF rules are necessary to maintain the integrity of the tax system, they can impose high compliance costs upon Australian taxpayers and, in particular, Australian managed funds.
The FIF rules will be changed to provide a better balance between integrity and the impact of compliance costs on taxpayers. A more comprehensive review of the FIF rules will be considered in the longer term. It would take into account international developments in this area, together with the effect of the following reforms.
Balanced portfolio exemption
Under the current balanced portfolio exemption, non-exempt FIF interests are nevertheless exempted from the FIF rules where their aggregate value is 5 per cent or less of the total value of FIF investments of a taxpayer.
Initially the law will be changed to increase the current 5 per cent threshold to 10 per cent, reducing compliance costs for these taxpayers.
The Board noted that its consultation process showed strong business support for a new balanced portfolio exemption for Australian managed funds. The Board therefore recommended non-exempt FIF interests of Australian managed funds be exempted where their aggregate value is 10 per cent or less of the total value of their net assets. The Government agrees in principle with this recommendation, subject to the development of an acceptable design.
The Government will consult with the business community to refine the design of the legislation. In particular, the legislation will need to ensure that the exemption is confined to Australian managed funds and that mis-characterisation and double counting of net assets does not occur when assets are held, say, through chains of entities. Valuation issues will also need to be addressed.
Funds registered under the managed investment fund scheme
The Board also recommended an exemption for Australian registered funds with diversified portfolios to address compliance cost issues raised by the FIF rules. This recommendation is not considered necessary in the light of a new balanced portfolio exemption for Australian managed funds. Further, the proposed requirements specified by the Board for this exemption (as set out below) do not sufficiently isolate funds investing in tax deferral vehicles.
- One requirement was that Australian managed funds should be exempt if they are registered under the managed investment scheme legislation. However, that legislation focuses on prudential requirements and does not prevent investments in accumulation funds that the FIF rules are designed to address.
- Another requirement was that Australian managed funds should be exempt if 75 per cent of the fund's portfolio is in investments listed on an approved stock exchange. However, a listed investment itself can invest in accumulation funds that are the target of the FIF rules. Also, there are stock exchanges where the listing of specially structured tax deferral vehicles is not difficult.
The Board recommended an exemption from the FIF rules for `index funds'. This proposal raises complexity and integrity concerns. The increase in the threshold of the balanced portfolio exemption to 10 per cent and, subject to consultation, the introduction of a new balanced portfolio exemption for Australian managed funds sufficiently address compliance cost issues. Accordingly this proposal is not adopted.
Australian superannuation fund exemption
Currently, Australian superannuation entities can be subject to the FIF rules.
Australian complying superannuation entities are to be exempted from the FIF rules so that, while an entity is a complying superannuation entity, any interests of the entity in FIFs will be exempt from the FIF rules. Because complying superannuation entities currently have a low tax rate, their investment decisions are unlikely to be biased towards investment in the kinds of offshore investment vehicles that the FIF rules are designed to prevent.
FIF rules not to apply to 'management of funds'
Currently, the FIF rules apply to the `management of funds.' The law will be changed so that `management of funds', not including activities that involve deriving passive income from the funds being managed, will be removed from the operation of the FIF rules. This activity is being removed because it is unlikely to involve the deferral of tax on passive income.
Taxation of trusts
The Australian managed funds industry predominantly uses trusts as the legal structure through which it manages funds. Certain aspects of the CGT, tax treaty deemed source and trustee taxation rules can detract from the international competitiveness of the Australian managed funds industry because of the manner in which these rules treat Australian trusts.
Exempt non-residents from CGT when selling non-portfolio interests in Australian managed funds
The CGT rules currently impose tax upon the disposal by non-residents of non-portfolio interests in Australian unit trusts even though the unit trust's investments consist of assets without the necessary connection with Australia (ie. those assets for which non-residents are not subject to CGT if held directly).
The Government will exclude disposals by non-residents of some or all of a non-portfolio interest in a `managed fund' from the CGT regime. While the Board proposed this change in the context of tax treaty negotiations, the Government will provide relief under Australia's domestic taxation laws.
The definition of `managed fund' in this context will target those funds that have assets without the necessary connection with Australia. The Board noted integrity concerns could arise if funds were to be used for non-portfolio investment purposes and the underlying investment would be subject to CGT if held directly by the non-resident (for example, Australian land or a non-portfolio interest in a public company or unit trust). Consultation with the business community will be conducted to address these issues.
Exempt non-resident beneficiaries on non-Australian gains of Australian unit or other fixed trusts
The CGT rules together with the trust taxation rules can currently result in CGT being payable by non-residents in respect of assets without the necessary connection with Australia.
The law will be changed so that capital gains and losses derived by Australian unit or other fixed trusts on assets without the necessary connection to Australia will be ignored to the extent a non-resident is presently entitled to the net capital gains of the trust. In ascertaining whether an asset has the necessary connection to Australia, the law will look at the trustee's interest in the asset rather than the non-resident beneficiary's interest in the underlying asset.
Remove cost base reduction on receipt of foreign source income and gains derived by non-resident investors in Australian unit or other fixed trusts
The CGT rules currently reduce the `cost base' and `reduced cost base' of a non-resident beneficiary's interest in a unit or other fixed trust where the beneficiary is paid foreign source income by the trust. This can give rise to CGT on the foreign source income when the non-resident disposes of the interest.
Under this measure, the receipt of foreign source income (or net capital gains the subject of the change described immediately above) by a non-resident beneficiary of a unit or other fixed trust will not reduce the beneficiary's `cost base' or `reduced cost base' for CGT purposes. This will remove the potential imposition of CGT upon the income (or gain) when the interest in the unit or fixed trust is disposed of.
Change treaty source rules to exempt non-resident beneficiaries on non-Australian income and gains of Australian managed funds
Source rules included in Australia's tax treaties can deem the foreign source income of Australian managed funds to have an Australia source. This could result in Australian tax being imposed on foreign source income derived by non-residents through Australian managed funds.
The law will be changed so that income and capital gains sourced outside Australia and earned by non-resident investors through Australian managed funds will retain their foreign source. The definition of `Australian managed funds' in this context, and other law design issues will be the subject of further consultation.
Setting the rate of tax on rental income distributed by property trusts to non-residents at the company tax rate
The trust level taxation of rental income that non-residents derive through Australian property trusts can cause compliance costs for the property trust industry. This complexity arises because of the difference in the tax rates imposed upon distributions to non-resident investors including the imposition of progressive rates of tax imposed on non-resident individuals.
To reduce these compliance costs, the rate of tax imposed on trustees of Australian `property trusts' in respect of all rental distributions made to non-residents will be set at the company tax rate. Defining a `property trust' in this context, together with other aspects of the design of the legislation, will be the subject of consultation with the business community.
Other trustee taxes
The Board also recommended that trustee taxation of income distributed by Australian unit trusts to non-residents be removed (except for net rent, interest, dividend and royalty income). This recommendation is not accepted because it raises integrity concerns in relation to the collection of tax from non-residents in respect of these kinds of income.
Exempt from withholding tax interest on widely distributed debentures issued by Australian widely-held public unit trusts
Currently interest paid by companies on debentures widely distributed to non-residents can be exempt from withholding tax. Interest paid by widely-held public trusts on debentures issued in similar circumstances is not similarly exempt, which increases the borrowing costs of trusts relative to companies.
To reduce these borrowing costs, interest paid on certain debentures issued by Australian widely held public unit trusts will be made exempt from interest withholding tax. The exemption will be available where the circumstances of the issue is consistent with the requirements of section 128F of the Income Tax Assessment Act 1936 (apart from the requirement that the issuer be a company). The definition of `Australian widely held public unit trusts', and other law design issues, will be the subject of further consultation.
MODERNISING AUSTRALIA'S TAX TREATIES
Tax treaties govern the allocation of residence and source taxing rights between two countries. They aim to facilitate cross-border trade, investment and movements of people by preventing the double taxation of income arising from those activities. Provisions facilitating exchange of information between countries also help prevent fiscal evasion and assist with tax administration.
The review considered three aspects of Australian tax treaty policy and practice:
- Australia's future treaty practice;
- Australia's future treaty negotiation programme; and
- improving consultation arrangements.
Australia's future treaty practice
The Board of Taxation recommended a move towards a more residence-based treaty policy in substitution for the treaty model based on the source taxation of income.
The Government broadly supports such a move. A key element in achieving this would involve reducing withholding tax rate limits consistent with the direction set in the US Protocol and further aligning Australia's treaty practice with the OECD Model Tax Convention, where the overall treaty package is in Australia's national interests.
However, the Government does not support the Board's recommendation, made in the context of conduit tax relief, to give up Australia's source country taxing rights over capital gains made by non-residents on the disposal of shares comprising non-portfolio interests in Australian companies. This proposal goes beyond what is needed for specific conduit relief for non-residents holding foreign assets through Australian companies. Given the treaty proposals in relation to reduced withholding tax rate limits, the Government considers that giving up these capital gains taxing rights would not provide a balanced treaty outcome for Australia.
Details of Australia's future tax treaty practice will be refined in consultation with the Tax Treaties Advisory Panel (see discussion below).
Australia's future treaty negotiation programme
As recommended by the Board, Australia's future treaty programme will have a particular focus on ensuring that treaties with key investment partner countries remain relevant to evolving business directions. From time to time, however, there may be other reasons to negotiate a new tax treaty, such as strengthening Australia's relationship with a particular country.
The Government will also be addressing the `most favoured nation' obligations that arise when the US Protocol enters into force. `Most favoured nation' clauses in some of Australia's existing tax treaties require Australia to enter into negotiations with a view to providing to the other treaty partner similar withholding tax outcomes to those agreed in the US Protocol.
Finalising current negotiations will also be a priority, noting that a revised tax treaty with the United Kingdom is well advanced and German negotiations are progressing.
Improving consultation arrangements
The Government considers that effective consultation arrangements are important in achieving successful and timely treaty negotiations and in improving the transparency and effectiveness of the current processes.
In recent years formal consultation has mainly been through the Tax Treaties Advisory Panel. This Panel includes representatives from industry and the tax professions. This will continue to be the key forum for consultation on tax treaty issues.
In addition consultation processes similar to domestic tax legislation will be adopted wherever possible, including direct consultation with key industry stakeholders and seeking submissions from the public on forthcoming negotiations. However, these processes will be adapted to reflect the fact that treaties represent a negotiated outcome between two governments and must work within the broad framework of established treaty practice.
It is not proposed to publish an Australian model tax treaty. Such models can rapidly become out of date and publication also reduces flexibility.
IMPROVING AUSTRALIA'S TAX TREATMENT OF FOREIGN EXPATRIATES
The Board noted in its report that countries around the world are boosting efforts to attract highly educated and skilled workers. Australian companies need access to skilled labour to maintain efficient domestic operations and compete internationally. The availability of labour is also a crucial factor in retaining and attracting regional headquarters and service centres. The Government has no intention of favouring foreign expatriates over permanent residents but recognises that Australia's tax system should not inhibit attempts to attract key personnel from offshore.
Foreign source income exemption for temporary residents
The centrepiece of the Government's efforts to attract foreign expatriates is a series of measures which provide, in particular, a four-year exemption to first-time temporary residents for most foreign source income including capital gains. These measures are currently before the Parliament. A first-time temporary resident is a person residing in Australia on the basis of a visa, who has not resided here within the last ten years. The exemption is confined to the foreign source income of temporary residents, and does not apply to expatriates' Australian source income, or generally to salary and wages.
The measures will provide Australia with a competitive system of taxing foreign expatriates. An expatriate moving to Australia could face an extra tax burden from the application of top marginal tax rates on their overseas investments, in addition to standard income tax on all Australian source income. This occurs even when the overseas investments were purchased prior to the expatriate arriving in Australia. This additional tax burden is often borne by Australian employers, increasing costs for Australian located businesses. Implementation of these measures should have the effect of assisting those Australian businesses seeking to attract key personnel to Australia.
The Board of Taxation conducted its Review against the background of these measures, recognising that to compete globally Australia must attract skilled labour to fill shortages and access new ideas. The Board argued that the current taxation rules discourage companies from locating expatriates in Australia, and recommended further reform of the tax treatment of expatriates. The Government has accepted the following measures:
- working towards eliminating double taxation of employee share options (ESOs) by consulting on possible changes to the domestic law, and through treaty negotiations;
- not proceeding with the Review of Business Taxation (RBT) proposal to secure deferred CGT liabilities of departing residents; and
- establishing an ATO specialist cell to provide comprehensive advice to employers on tax administration issues concerning their foreign expatriates.
Addressing double taxation and non-taxation of employee share options for individuals moving between countries
The OECD has highlighted the current unsatisfactory taxation treatment of ESOs for individuals moving between countries as an important issue requiring international resolution.
In the Australian context, under Division 13A of the Income Tax Assessment Act 1936 share option discounts are assessed in the year in which the options are acquired, for example upon grant. Where certain conditions are met, taxpayers may defer assessment of this liability or elect to have the discount assessed in the year of acquisition and benefit from an exemption for the first $1,000 of the option discount. Where assessment is deferred (a maximum of 10 years) discounts are assessable when a cessation time occurs, generally upon exercise of the option.
For employees who are resident in more than one country during the lifetime of the option, the Australian tax treatment of the ESO is more complicated. For example, an employee who is not an Australian resident at the time of grant of the option will not be able to make an election to be taxed at that point. The position may also be modified by the operation of a tax treaty.
Countries have adopted different approaches to the range of possible taxing points for ESOs. ESOs may be taxed when granted, on vesting (becoming free to exercise the option) after a period of service, when exercised at some later time, or on disposal of the shares acquired by exercising the option. These differences create uncertainty and may result in double taxation. For example, an ESO may be taxed in Australia on grant, and in another jurisdiction upon exercise without a credit for the Australian tax paid. Similarly, a move from one jurisdiction to another could result in no tax on an ESO.
The OECD has released a Discussion Paper, which proposes pro rata taxing rights based on the period of employment. A treaty partner's source taxing right is limited to the proportion relating to the period of employment in that country. The country in which the individual resides may also tax the benefit of an ESO, provided a credit is given for tax paid in the source country. The OECD has also suggested principles for determining whether an ESO relates to past or future service.
The OECD is expected to finalise its views this year. As recommended by the Board, it is timely for Australia to adopt this general approach in treaty negotiations, and to consider possible changes to domestic law to align it with the tax treaty approach finally adopted. The Government will consult Australian business on any proposed changes.
Ceasing to be an Australian resident as a cessation time for Division 13A purposes
In consulting on possible changes to align the domestic law on ESOs with the approach that is finally adopted by the OECD, further consideration will be given to the RBT recommendation to treat ceasing to be an Australian resident as a cessation event for the purposes of Division 13A.
The Board recommended against proceeding with this measure. However, as Australia will be working to find an internationally acceptable method of apportioning taxing rights on ESOs, it is not appropriate at this stage to rule out any options as to how the domestic law should deal with the taxing right assigned to Australia.
Deferred CGT liabilities of departing residents
The Government will not proceed with the RBT recommendation that residents departing Australia provide security for deferred capital gains tax liability.
Proceeding with this measure would involve considerable compliance, complexity and enforcement burdens for little revenue gain. The Government recognises that this would be inconsistent with the general direction the Government is now moving in providing a competitive taxation environment for foreign expatriates.
The measure is also inconsistent with the direction the Government is moving in tax treaty negotiations. For example, the recent protocol to the US treaty will generally have the result that deferred capital gains tax liabilities will not arise for Australian residents who become residents of the US, removing the need for a security.
Australian Taxation Office specialist cell
The Board noted that the Australian Taxation Office has generally sought to establish Centres of Expertise when dealing with international tax issues, and that a specialist cell could be established to deal with expatriate taxation. The Government agrees that establishing a specialist cell within the Australian Taxation Office will assist in clarifying expatriate taxation issues.
The Commissioner of Taxation has advised that he is looking at the best way to establish a specialist cell to assist employers with expatriate tax matters. An announcement will be made when the cell is created.
The Board of Taxation examined a number of issues relating to the taxation of foreign trusts and the taxation of foreign-owned branches in Australia:
- the role of the deemed present entitlement rules;
- the coverage of the transferor trust rules;
- separate entity treatment for branches of foreign banks and non-bank financial institutions; and
- branch dividend taxation.
Foreign trusts - deemed present entitlement rules
The current regimes for taxing foreign trusts - foreign investment fund (FIF) rules, deemed present entitlement rules, and transferor trust rules - are complex and potentially overlapping. Exemptions from accruals taxation given under one set of rules - for example, the FIF rules - may be "clawed back" under the deemed present entitlement rules. There is a strong case for the rationalisation of the rules for taxing foreign trusts.
To simplify the taxation of foreign trusts, and as announced previously following the Review of Business Taxation, the Government will remove the deemed present entitlement rules (sections 96B and 96C of the Income Tax Assessment Act 1936). FIF rules alone will apply to foreign fixed trusts unless there are foreign beneficiaries, in which case the transferor trust rules will also have application. Transfers to foreign discretionary trusts will continue to be subject to the transferor trust rules.
Transferor trust rules
The transferor trust rules are intended to prevent Australian residents from deferring tax on income earned in offshore trusts. However, transfers made to an offshore discretionary trust are not subject to the rules if the transfer was made before the transferor came to Australia or before the original transferor trust measures were announced, provided the transferor does not control the trust. These exemptions provide possible opportunities for deferral, as it is difficult to prove "control".
To strengthen the transferor trust rules, and as announced previously following the Review of Business Taxation, transferors will no longer need to control the trust for accruals taxation to apply to these transfers. The design phase of the legislation may allow the measure to more precisely target anti-avoidance cases. As previously announced in response to the Review of Business Taxation, an amnesty will also be provided to allow foreign trusts affected by the removal of the exemptions to be wound up with distributions from those trusts to be taxed at 10 per cent. The amnesty will enable taxpayers to regularise their affairs, consistent with the offering of an amnesty in 1991 for those taxpayers affected by the introduction of the transferor trust rules.
Branches of foreign financial institutions
Foreign-owned branches of non-bank financial institutions in Australia do not receive a separate entity treatment, and consequently cannot group for thin capitalisation purposes or transfer losses between the branch and a wholly-owned Australian subsidiary of the same company. In contrast, foreign-owned bank branches in Australia receive separate entity treatment in certain areas, including in respect of grouping of losses and for thin capitalisation purposes. (Separate entity treatment refers to treating the branch, which is not at law an entity separate from the owner of the branch, as a subsidiary of the owner for one or more purposes of the law.)
A consistent treatment is needed to foster competitive neutrality between foreign-owned branches of foreign banks operating in Australia, foreign-owned branches of non-bank financial institutions and Australian financial institutions. It is appropriate, where reasonable, that the Australian tax system not discriminate, on the basis of ownership and entity structure, between financial institutions performing essentially similar operations in Australia.
The Government will extend the existing tax treatment of foreign bank branches to foreign-owned branches of other financial institutions in relation to thin capitalisation and grouping of new losses. It will also provide similar separate entity treatment to non-bank branches of foreign financial institutions as foreign bank branches receive under Part IIIB of the Income Tax Assessment Act 1936. As previously announced in response to the Review of Business Taxation, the Government in principle supports rewriting the law over time to permit, in appropriate circumstances, separate entity treatment for branches. This approach will continue, and the adoption of a separate entity treatment in relation to dividends received by branches is outlined below.
Taxation of dividends received by branches
Currently, unfranked dividends received by branches are subject to dividend withholding tax while unfranked dividends received by a foreign-owned subsidiary are taxed on an assessment basis.
The Government will tax unfranked dividends received by foreign branches in Australia on an assessment basis. This will further align the treatment of branches with that of subsidiaries. The treatment of franked dividends received by branches raises more complex issues, and the Government will give further consideration to their treatment, in consultation with the business community.