TAXATION ISSUES TO CONSIDER WHEN OPERATING OVERSEAS

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1 WA DIVISION 14 July 2005 City West Function Centre, West Perth TAXATION ISSUES TO CONSIDER WHEN OPERATING OVERSEAS Written by/presented by: Marc Worley Director KD Johns & Co. Taxation Institute of Australia 2005 Disclaimer: The material in this paper is published on the basis that the opinions expressed are not to be regarded as the official opinions of the Taxation Institute of Australia. The material should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests. For the Taxwise Professional

2 CONTENTS 1 Introduction Appropriate Foreign Structure Foreign Company Residency Controlled Foreign Companies Foreign non-portfolio dividends Attributable Income Listed Country Tainted Services Income Federal Budget Announcements CFC rule changes Foreign Hybrids Foreign Branch Section 23AH Tax Treaties Operating direct from Australia Financing the Foreign Operations Debt Funding Interest deductibility Australia Thin Capitalisation Debt and Equity rules Interest deductibility - overseas Equity Funding Repatriation of Profits Dividends Interest Royalties Management Fees Disposal of Foreign Operations Sale of Shares Active Foreign Business Assets Determining Asset Values Book value method...16 Taxation Institute of Australia

3 5.1.3 AFBA Percentage of Foreign Groups Sale of Assets Recent developments affecting businesses expanding offshore Conclusion...18 Taxation Institute of Australia

4 1 INTRODUCTION With the ever increasing globalisation of markets, Australian businesses are stepping up to the global stage and expanding beyond our shores. Amongst the many challenges faced by these expanding businesses, the taxation considerations of conducting business overseas are critically important. International tax planning for businesses expanding offshore can be challenging due to the evolving nature and complexity of taxation rules both domestically and in the applicable foreign jurisdictions. In Australia, this has particularly been the case in recent years following the Review of Business Taxation led by John Ralph, its subsequent recommendations and introduction of new legislation. The recent Federal Budget announcements have also provided for further changes in relation to the foreign source income measures. These recent legislative changes will greatly benefit Australian businesses operating offshore by allowing profits to be repatriated and offshore restructures and sales to occur in a more tax effective manner. This paper will examine the following issues that should be considered when establishing, operating and ultimately selling foreign operations: Setting up the appropriate foreign business structure; Interaction of the Australian tax laws with the foreign jurisdiction s tax laws, and impact of Double Tax Treaties; Implications of the Australian Controlled Foreign Company ( CFC ) rules; Financing of the foreign operations; Repatriation of profits to Australia; and The disposal of foreign assets or structures. 2 APPROPRIATE FOREIGN STRUCTURE There are many issues to consider when setting up a foreign structure. These include taxation, legal, eligibility to foreign country business concessions or incentives and the various commercial considerations. From a taxation standpoint, it is important to understand the taxation and regulatory conditions in the foreign countries in which your client is seeking to expand into. This will ensure the most appropriate structure is adopted from a commercial and taxation perspective. Depending on the country in which your client intends to operate, different types of legal entities may be established. Structures available could include: Company Hybrid entity (ie Limited Liability Company, Limited Partnership) Branch Partnership Trust Advice should be sought in the foreign jurisdiction to ensure the structure adopted is appropriate for your client s operations in that location. For example, a corporation may be entitled to certain tax concessions or tax holidays in the foreign country whereas a foreign branch may not. Taxation Institute of Australia

5 2.1 Foreign Company It may be appropriate to operate offshore through an overseas company. The question of residency of the foreign subsidiary is then important to ascertain which tax rules apply in each jurisdiction Residency Section 6(1) of the Income Tax Assessment Act 1936 ( ITAA 1936 ) defines a resident for Australian tax purposes to mean: a company which is incorporated in Australia, or which, not being incorporated in Australia, carries on business in Australia, and has either its central management and control in Australia, or its voting power controlled by shareholders who are residents of Australia. It is therefore possible for a subsidiary incorporated overseas to still be a resident of Australia for tax purposes where it satisfies the second limb of the residency definition for companies. It has been suggested that the comments by Justice Williams in Malayan Shipping Co Ltd v FCT (1946) 3 AITR 258 set out a general principle that if a company s central management and control is located in Australia, then this means that the company is also carrying on business in Australia for the purposes of the second limb of the residency definition. The ATO has provided guidelines as to when a foreign company would be regarded as a resident of Australia under the second limb in Taxation Ruling TR 2004/15. Where a company carries on business is a question to be determined based on the relevant facts and circumstances, however the ATO s approach to this factual determination is to draw a distinction between a company with operational activities and a company which is more passive in its dealings. The ATO considers operational activities to mean major trading, service provision, manufacturing or mining activities. For those companies undertaking operational activities, it may be more likely that the place of business is wherever its offices, factories or mines are situated. However, in respect of those companies whose earning outcomes are more dependent on the investment decisions made in respect of its assets, its business is carried on where these decisions are made. This may also be where the company s central management and control is located. Issues can arise however when both Australia and the foreign jurisdiction in which the foreign company is incorporated both treat the company as a resident for the purposes of their respective domestic tax laws. Where however the foreign country has a Double Tax Agreement ( DTA ) with Australia, there will generally be a tie-breaker rule to decide in which country the company will be regarded as being resident of. Where a DTA does not have a residency tie-breaker rule, the consequence of this is a denial of treaty benefits for the affected company. The DTA with the United States is one such Treaty where there is no tie-breaker for dual resident companies. The Government had proposed in the Federal Budget 1 to amend the company residence rules such that companies which are residents under Australia s domestic law but non-residents for the purposes of its DTAs, would be treated as non-residents for all income tax purposes. As at 11 July 2005, there has been no further announcement in relation to this proposal. It therefore follows that if the foreign company is treated as a resident of Australia either under the domestic law or under a DTA, it will be subject to Australian taxation on its income from worldwide sources and to the extent it derives foreign income which attracts foreign tax, foreign tax credits may be available Controlled Foreign Companies Where the foreign company is a non-resident for Australian tax purposes, the CFC attribution rules need to be considered. 1 Treasurer s Press Release No.032, 13 May 2003 Taxation Institute of Australia

6 The CFC rules apply to include in an Australian resident taxpayer s assessable income, on an accruals basis, a share of certain income or gains derived by overseas companies in which they have a controlling interest. Section 340 of the ITAA 1936 defines a CFC at a particular time to mean: a company [that] is a resident of a listed country or of an unlisted country and any of the following paragraphs applies: a. at that time, there is group of 5 or fewer Australian 1% entities the aggregate of whose associate-inclusive control interests in the company is not less than 50%; b. both of the following subparagraphs apply: i. at that time, there is a single Australian entity whose associate-inclusive control interest in the company is not less than 40%; ii. at that time, the company is not controlled by a group of entities not being or including the assumed controller or any of its associates; c. at that time, the company is controlled by a group of 5 or fewer Australian entities, either alone or together with associates (whether or not any associate is also an Australian entity). Should a foreign company be a CFC, it must then be determined whether there is an attributable taxpayer in respect of that company. An attributable taxpayer in relation to a CFC is defined in section 361 of the ITAA Where an attributable taxpayer is identified, the share of the CFC s attributable income that is attributable to the attributable taxpayer is equal to its attribution percentage in the CFC. The attribution percentage of an attributable taxpayer is defined in section 362 of the ITAA 1936 to be the sum of the attributable taxpayer s direct and indirect attribution interests in the CFC at the relevant test time. Once the above has been ascertained, it is then necessary to determine whether there is any attributable income of the CFC as determined under Division 7 of the CFC rules. Different rules then apply depending on whether the foreign company is resident in a listed country or an unlisted country for the purposes of the CFC rules. The table of listed countries for the purposes of the CFC provisions can be found in Schedule 10 to the ITAA The provisions of section 384 are applicable to CFC s that are resident in unlisted countries and the provisions of section 385 are applicable to CFC s that are resident in listed countries. Typically, there will not be any attributable income if the CFC satisfies the active income test, unless the CFC also derives certain other types of attributable income as listed in sections 384 and 285 respectively. The active income test requires the CFC to satisfy the criteria in section 432 of the ITAA A company passes the active income test if: it is in existence at the end of the statutory accounting period; it was resident of a listed or unlisted country at all times during the statutory accounting period; it has kept accounts for the statutory accounting period in accordance with the applicable criteria; the substantiation requirements of section 451 of the ITAA 1936 have been complied with; at all times during the statutory accounting period the company carried on business in the foreign country or through a permanent establishment in that foreign country in which it was resident; and the tainted income ratio of the company for the statutory period is less than 5%. Taxation Institute of Australia

7 Broadly, a CFC satisfies the tainted income ratio if the sum of its passive income, tainted services income and tainted sales income is less than 5% of its gross turnover. Gross turnover is defined in section 434 of the ITAA Where a CFC being resident in an unlisted country fails the active income test, its attributable income will be its passive income, tainted services income and tainted sales income (subject to the modifications of Subdivisions A to E within Division 7 of the CFC rules) plus any other types of income that would be attributable (ie FIF income) under section 384. Where however a CFC being resident in a listed country fails the active income test, its attributable income will be its passive income, tainted services income and tainted sales income that is also eligible designated concession income ( EDCI ), plus any other types of income that would be attributable under section 385. EDCI in relation to a listed country is broadly designated concession income (ie concessionally or nontaxed income in a foreign country) that is not subject to tax in another listed country, or is designated concession income in relation to another listed country. The practical effect generally being that most income of listed country companies is not attributable in Australia. From 1 July 2004, a number of changes in relation to the CFC rules came into affect 2. These changes enable Australian companies and their CFC s to obtain more attractive rates of return from their operations in foreign markets, improving their ability to attract capital. These changes to the current exemptions remove an impediment to the distribution of foreign profits to Australia and also remove a deterrent to Australian companies expanding their active business offshore 3. These changes related to: the exemptions for non-portfolio dividends and foreign branch profits for Australian companies; what is attributable income under the CFC rules; the definition of listed country ; reducing the scope of tainted services income Foreign non-portfolio dividends Non-portfolio dividends (being dividends paid to a company where that company has a voting interest, within the meaning of 160AFB of the ITAA 1936, amounting to at least 10% in the company paying the dividend) received by Australian companies are now exempt from Australian tax. Such dividends are nonassessable non-exempt income. Prior to 1 July 2004, only non-portfolio dividends paid from comparably taxed profits were exempt from Australian tax. Division 6 of the CFC rules contained complicated rules for determining whether dividends were sourced from comparably taxed profits. However now that the comparable tax requirement is removed, Division 6 became redundant and was repealed Attributable Income In addition, the CFC rules were aligned more directly with the expanded non-portfolio dividend exemption in section 23AJ of the ITAA All non-portfolio dividends received by CFC s are now no longer included in attributable income and have also been excluded from the active income test so as to not inadvertently lead to the attribution of other tainted income. As a consequence of the above changes, a number of other provisions within the general income tax, CFC and foreign tax credit rules within the ITAA 1936 were either removed or amended. 2 New International Tax Arrangements (Participation and Other Measures) Act Explanatory Memorandum to New International Tax Arrangements (Participation and Other Measures) Act 2004, para s 2.3 and 2.4 Taxation Institute of Australia

8 2.1.5 Listed Country Prior to 1 July 2004, there were two types of listed countries for the purposes of the CFC rules: broadexemption listed countries ( BELCs ) and limited-exemption listed countries ( LELCs ). BELCs are those countries with very similar income tax systems to Australia s, whilst LELCs are considered to have broadly comparable income tax systems to Australia. The broad policy behind this listing system was to provide more favourable tax treatment to listed countries than unlisted countries. The expansion of the non-portfolio dividend exemption to all countries largely removed the necessity to have two separate types of listed countries. Accordingly, those countries previously on the BELC list are now listed countries, and all other countries are now unlisted countries. Those countries previously identified as LELCs are now reclassified as section 404 countries. To ensure section 404 continues to operate as intended, all dividends (including portfolio dividends) paid from a company resident in any listed country or a section 404 country to a CFC that is also resident in a listed country or a section 404 country will continue to be excluded from attributable income Tainted Services Income The scope of the tainted services income definition has been reduced with effect in statutory accounting periods of companies beginning on or after 1 July The new definition now generally excludes income from services provided to non-resident associates, or the overseas permanent establishment ( PE ) of Australian residents. Services provided to Australian customers (Australian residents, other than in respect of their overseas PEs, and non-residents PEs in Australia) will remain part of tainted services income. An indirect services rule has also been inserted to prevent non-resident entities being interposed between a company providing services and its customers in Australia for the purpose of taking advantage of this concession Federal Budget Announcements CFC rule changes The Government announced in the Federal Budget that with the removal of the requirement for taxpayers to quarantine foreign losses, taxpayers that earn attributable income through CFCs will no longer need to quarantine the revenue losses of their CFCs into separate classes. In addition, listed country CFCs will no longer have tainted capital losses excluded from the calculation of eligible designated concession income. However, a CFC s tainted capital losses will continue to be quarantined from its other income. Also, CFC losses will continue to be quarantined in the CFC that incurred them Foreign Hybrids It may be appropriate under the domestic laws of the foreign country to instead operate via a hybrid entity such as a limited or limited liability partnership. Prior to the introduction of the foreign hybrid measures, it was not clear as to the appropriate tax treatment of foreign entities which did not fit the Australian definition of a company, but were taxed as companies under the Australian tax law. This created adverse Australian taxation implications including, attribution of a wider range of income than intended under the CFC rules, increased risk of double taxation and significant compliance costs. Division 830 of the ITAA 1997 was introduced to clarify the tax treatment of such entities, and in particular limited partnerships ( LPs ), limited liability partnerships ( LLPs ), and US Limited Liability Companies ( LLCs ). Such entities are now treated as partnerships for Australian tax law purposes. Accordingly, the CFC and FIF rules do not have application to such entities. 4 Treasurer s Press Release No. 044, 10 May 2005 Taxation Institute of Australia

9 Where a foreign hybrid incurs a loss, the extent to which the loss can be offset against income from sources other than the foreign hybrid may be limited under the loss limitation rules. 2.3 Foreign Branch An Australian business could alternatively operate via a branch or PE in the foreign country Section 23AH Section 23AH of the ITAA 1936 provides that foreign branch income of Australian companies is not assessable income. For income years ending on or prior to 30 June 2004, foreign branch profits were only exempt from Australian tax where those profits were subject to tax in a listed country. Further, that income could not be eligible designated concession income of a BELC or adjusted tainted income of a LELC (unless the active income test was passed in respect of the PE). Foreign branch capital gains and losses were only disregarded where the asset was an active business asset of the PE and not EDCI of a BELC or adjusted tainted income of a LELC. The New International Tax Arrangements (Participation and Other Measures) Act amended the foreign branch profits rules in section 23AH such that most foreign income and gains derived through a foreign permanent establishment in either a listed or unlisted country are now exempt from Australian tax. The new rules now provide for an active income test in relation to PEs in both listed and unlisted countries. Foreign income from a PE will now only be attributable to the Australian resident company where the active income test is failed and the income is adjusted tainted income in the case of unlisted countries and adjusted tainted income that is also EDCI in the case of listed countries.. The active income test in section 23AH does not include net capital gains in the calculation. Also, there is no exclusion for capital gains where a PE passes the active income test. A resident company will include in the calculation of its net capital gains any capital gain or capital loss as a result of a CGT event happening in relation to a tainted asset that is used in carrying on a business through a PE in a listed country where the gain is also EDCI. A capital loss is only included where, if there had been a gain, the gain would have been EDCI. A resident company will include in the calculation of its net capital gains any capital gain or capital loss as a result of a CGT event happening in relation to a tainted asset that is used in carrying on a business through a PE in an unlisted country Tax Treaties In relation to a country with which Australia has a DTA, whether the business profits of an overseas branch or permanent establishment are taxable in that foreign country will depend on the articles of the applicable DTA. Typically, the Business Profits article of a DTA will provide that the business profits of an enterprise of a country will only be taxable in that country unless the enterprise carries on business in the other country through a PE situated therein. If a PE is determined to exist in that other country, the business profits of the enterprise attributable to that PE may then be taxed in that other country. Article 5(1) of the OECD Model Convention on Income and Capital ( OECD Model Convention ) defines a PE mean to mean..a fixed place of business through which a business of an enterprise is wholly or partly carried on. This definition of PE is typically similar in most of Australia s Tax Treaties. The OECD Model Convention also provides that the term PE shall include specifically: a place of management; a branch; Taxation Institute of Australia

10 an office; a factory; a workshop; and a mine, an oil or gas well, a quarry or any other place of extraction of natural resources. In addition to the above specific inclusions, many of Australia s DTAs also include other activities in the meaning of PE, including: An agricultural, pastoral or forestry property; A building site or a construction, installation or assembly project which exists for at least a certain period of time. The business profits (being net of allowable deductions) of the PE in the foreign country shall be those profits that might be expected to be derived in that foreign country as though it were an independent enterprise engaged in the same or similar activities and dealing at arm s length with the enterprise of which it is a PE or dealing with other independent entities. To the extent profits in that foreign country include certain other classes of income such as dividends, interest or royalties (the tax on which is limited by other articles within the applicable DTA), these amounts would typically not be included in the business profits of the PE unless they are effectively connected with the trade or business carried on through the PE. However, to the extent these income types are included in business profits of the PE, then those articles limiting the rate of tax applicable to those income types are disregarded and higher rates of tax may apply. 2.4 Operating direct from Australia Alternatively, it may even be the case that upon examination of your client s business, it can operate directly from Australia without the establishment of an overseas structure or branch. This scenario would provide that a PE does not exist in the foreign country. Whether or not a PE exists in a foreign jurisdiction will however ultimately be a matter of fact. If the intended country of operation has a Double DTA with Australia, the applicable PE Article will define which activities do and do not constitute a PE in that country. For example, Article 4(4) of the Singapore DTA with Australia provides that a PE of an enterprise shall not exist in Singapore merely by reason of: the use of facilities solely for the purpose of storage or display of goods or merchandise belonging to the enterprise; the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage or display; the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise or collecting information, for the enterprise; the maintenance of a fixed place of business solely for the purpose of activities which have a preparatory or auxiliary character for the enterprise, such as advertising, the supply of information or scientific research. Taxation Institute of Australia

11 Similarly, a permanent establishment also does not exist in Singapore if the Australian enterprise carries on business in Singapore through a broker, general commission agent, or any other agent of an independent status, where such broker or agent is acting in the ordinary course of that person s business. 5 Any income derived by the Australian enterprise from such activities as described above may be regarded as foreign sourced income. Section 6-5(3) of the Income Tax Assessment Act 1997 ( ITAA 1997 ) provides that income from worldwide sources is included in assessable income for Australian resident entities. Accordingly, such income would be subject to Australian tax and to the extent any foreign tax is paid in respect of the income, a foreign tax credit may be available 6. 3 FINANCING THE FOREIGN OPERAT IONS There are a number of taxation issues applicable to the various ways in which businesses can finance their foreign operations. Generally, financing would include equity and/or debt. 3.1 Debt Funding Debt funding for the foreign operations may be sourced in Australia or overseas Interest deductibility Australia Should loan funding be obtained in Australia to finance the foreign operations, several taxation issues should be considered. Prior to 1 July 2001, interest expenses could not be deducted when incurred for the purpose of deriving exempt foreign dividend income, or was quarantined under the foreign income rules to the extent it exceeded assessable foreign income. Section of the ITAA 1997 was introduced with effect from 1 July 2001 to allow Australian entities to deduct costs in relation to debt interests (ie including interest expenses) where the amount is incurred in deriving income from a foreign source and the income is exempt (from 30 June 2003 non-assessable non-exempt income) under sections 23AI, 23AJ or 23AK of the ITAA Various amendments were also made to the foreign income rules to ensure that debt deductions (to the extent not attributable to an overseas PE) were no longer foreign income deductions and hence not quarantined under section 79D of the ITAA However, to the extent debt deductions relate to an overseas PE of the borrower, the income of which is not assessable under section 23AH, the amount is then not deductible in Australia. Care must also be taken where the Australian investing entity is a member of a consolidated group or a group intending to consolidate. Prior to the introduction of the tax consolidation regime, should an Australian company have borrowed funds to capitalise or lend to an Australian subsidiary towards that subsidiary s investment in a foreign PE, those borrowed funds would generally have been deductible to the parent company (where incurred in the expectation of deriving assessable dividend income from the subsidiary). However, if that group consolidates for tax purposes, the single entity rule operates to deem the parent company (assuming it being the Head Company) to be operating the PE for tax purposes. Therefore to the extent the subsidiary does not operate any other assessable income generating activities, the borrowing by the parent would relate only to the derivation of non-assessable non-exempt income under section 23AH from the foreign PE. A deduction for the interest expense would therefore not be permitted under section 8-1 of the ITAA Article 4(6) Australian/Singapore DTA 6 ITAA 1936, Section 160AF Taxation Institute of Australia

12 3.1.2 Thin Capitalisation Interest deductibility could be impacted by the thin capitalisation rules. The thin capitalisation rules operate to limit the deductibility of debt deductions on borrowings by Australian entities financing their overseas operations or investments. A general exemption from the thin capitalisation rules applies where the total debt deductions of the Australian entity and all of its associates for the applicable year do not exceed AUD$250,000. A debt deduction is broadly a cost incurred in relation to a debt interest that could, apart from the operation of the thin capitalisation rules, be deducted in Australia from the applicable entity s assessable income 7. For outbound investing entities, a further exemption from the thin capitalisation rules is applicable where assets of the applicable entity and its associates are predominantly Australian assets. Section of the ITAA 1997 sets out this 90% asset threshold test. Should the thin capitalisation rules still then apply, interest deductions of an outbound investing entity will then be disallowed to the extent debt funding exceeds the maximum allowable debt (calculated under either the safe harbour, arm s length or worldwide gearing methods) Debt and Equity rules Australia introduced debt and equity rules with effect from 1 July 2001 whereby interest expense is not deductible unless it is incurred in respect of a debt interest. To the extent the interest expense is incurred in respect of an equity interest that is not also a debt interest, the interest expense will not be deductible Interest deductibility - overseas Should loan funding be obtained overseas, it is necessary to determine the interest deductibility in the foreign location. In addition to general deduction rules for interest expense in the foreign country, the foreign country may also have thin capitalisation and or debt/equity rules that may further limit the deductible interest expense. Should loan funding be obtained overseas but from a different jurisdiction to the country of operations, there may also be applicable withholding tax and transfer pricing issues that require consideration. 3.2 Equity Funding When considering equity funding of a foreign subsidiary, the Australian entity should have regard to whether the rate of withholding tax on dividends is more favourable than the applicable withholding rate on interest. There may also be certain restrictions in the foreign country in relation to re-accessing the equity in the foreign company. It may often be the case that a mixture of debt and equity is required to optimise returns from the foreign operations. 4 REPATRIATION OF PROFITS There are a number of ways to repatriate profits from the foreign operations to Australia. Ways in which profits can be repatriated to Australia include: Dividends Interest 7 ITAA 1997, section Taxation Institute of Australia

13 Royalties Management fees When considering repatriation strategies, the bias of the Australian tax system against the derivation of foreign income should be considered. The Australian imputation system does not allow Australian companies to credit their franking accounts for foreign taxes or withholding taxes paid. Accordingly, resident shareholders do not receive imputation credits in respect of dividends paid out of foreign sourced profits. It may therefore be preferable to either derive or repatriate foreign income that is taxable in Australia such that tax credits can be passed on to shareholders where it is necessary to return profits to shareholders regularly. In addition, it is also preferable to minimise the extent to which withholding taxes are applicable to income flows to Australia so as to reduce the overall tax burden to shareholders. 4.1 Dividends As discussed above, all non-portfolio foreign dividends received by Australian companies after 1 July 2004 are now exempt from tax. Accordingly, Australian companies should seek to reduce the extent to which withholding taxes are applicable on dividend flows to Australia. It may be appropriate to interpose a holding company resident in another jurisdiction between Australia and the proposed foreign country of operations to take advantage of reduced or nil withholding tax rates under the applicable DTAs. Many DTAs however contain limitation of benefits articles whereby the reduced rates of withholding tax on dividends and other income ca be denied where non-residents of the treaty partner uses the partner s country to reduce taxes in the source country. Therefore, care must be taken with respect to such treaty shopping. With the recent amendments to the US and UK DTAs, and depending on the profile of the taxpayer, the withholding tax rate on dividends may be reduced from 15% to either 5% or nil, there may be less incentive to interpose intermediary holding companies between the US or UK and Australia. 4.2 Interest As discussed above, the payment of loan interest can be tax deductible in the foreign country thereby reducing the level of taxable profits in the foreign jurisdiction giving rise to assessable income and franking credits in Australia. To the extent foreign withholding tax is applicable to the interest paid, a foreign tax credit should be available however will not give rise to franking credits. As discussed above, care is required of relevant debt/equity and thin capitalisation rules that may impact the deductibility of such interest expense. Where such debt financing is intra-group, it will also be necessary to consider the transfer pricing rules to ensure the interest charge reflects an appropriate arms-length price. 4.3 Royalties The foreign operations may require the access or use of copyrights, patents, trademarks, commercial knowledge or other such intellectual property. Payment of royalties can also be tax deductible in the foreign country thereby reducing the level of taxable profits in the foreign jurisdiction. To the extent foreign withholding tax is applicable to the royalties paid, a foreign tax credit should be available however will not give rise to franking credits. Taxation Institute of Australia

14 The recent amendments to the US and UK DTAs have also resulted in the royalty withholding tax rate reducing from 10% to 5%. The transfer pricing rules should also be considered when setting the price for royalty charges. 4.4 Management Fees It may be appropriate that certain management fees or head office allocations be charged to the foreign operation. Whether a deduction for such expenditures is permitted in the foreign country will depend on its domestic laws. Care must be taken to ensure such management fees are not in fact royalties and hence subject to royalty withholding tax. For example, payments for services that ancillary to enabling relevant technology, information, know-how, copyright or machinery or equipment to be transferred or used will be regarded as royalty payments. The transfer pricing rules should also be considered when setting the price for such management fees. The transfer pricing rules require that related parties deal with each other at arm s length in respect of overseas transactions so as to minimise international tax avoidance through various profit shifting techniques. Acceptable pricing methodologies for determining an appropriate arm s length price for overseas transactions include: Comparable uncontrolled price method Cost plus method Resale price method Profit split method Transactional net margin method When setting prices, taxpayers should create contemporaneous documentation supporting the appropriateness of the prices set for its overseas transactions. To assist, there are a number of ATO rulings which explain the various transfer pricing guidelines and safe-harbours. In March 2003, the ATO also announced the creation of standardised pricing documentation for companies doing business in Australia, Canada, Japan and the US which may assist taxpayers to reduce their costs of transfer pricing compliance. 5 DISPOSAL OF FOREIGN OPERATIONS In the case of a foreign subsidiary, the taxpayer can either sell the shares in the foreign subsidiary (or the shares in any intermediary holding company) or the business assets of the foreign operating subsidiary or enterprise. 5.1 Sale of Shares Prior to 1 April 2004, Australian companies were subject to CGT on the disposal of shares in foreign subsidiaries and capital gains of CFCs could be attributed back to the Australian shareholder as assessable income. Subdivision 768-G of the ITAA 1997 was introduced by the New International Tax Arrangements (Participation Exemption and Other Measures) Act 2004 to reduce a capital gain or loss an Australian company or CFC makes from certain CGT events happening to certain interests in a foreign company. These measures reduce the capital gain or capital loss a company makes from several specified CGT events happening to shares (other than eligible finance shares or widely distributed finance shares) in a foreign company to the extent the foreign company has an underlying active business. The measures also apply to reduce attributable income arising from the same CGT events happening to shares owned by a CFC in a foreign company. Taxation Institute of Australia

15 To be eligible for relief under this measure, the following conditions must be satisfied: The company held a direct voting interest in the foreign company of at least 10%; and The requisite interest was held by the company for a continuous period of at least 12 months in the two years before the CGT event. The applicable capital gain or capital loss is reduced by the active foreign business asset ( AFBA ) percentage of that foreign company at the time of the CGT event. Broadly, the AFBA percentage of a foreign company is the value of AFBAs owned by the company as a percentage of the value of total assets owned by the company. The value of assets can be determined under either the market value (if certain conditions are satisfied) or book value methods. Where the result of the AFBA percentage is 90% or more, then the active foreign business percentage is taken to be 100%. Accordingly, the relevant capital gain or capital loss is reduced to zero, and therefore exempted from tax. However where the active foreign business percentage is less than 10%, the active foreign business percentage is taken to be zero. In all other cases, the result of the calculation is equal to the AFBA percentage. A default method applies where neither the market value or book value method is chosen. In which case, the AFBA percentage in respect of a gain is taken to be zero and the AFBA percentage in respect of a loss is taken to be 100% Active Foreign Business Assets There are several conditions that must be satisfied in order for an asset to be classified as an AFBA: 1. the asset must be an asset that is included in the total assets of the company; 2. the asset must be one of 3 kinds of asset a. an asset that is used, or held ready for use by the company in the course of carrying on a business b. goodwill c. shares in a company 3. the asset is not a CGT asset that has the necessary connection with Australia; 4. the asset is not an excluded asset; and 5. the asset is not a financial instrument (where the foreign company is an AFI subsidiary). 8 An excluded asset is: 1. a financial instrument (other than a share or trade debt); 2. eligible finance shares or widely held distributed finance shares; 3. an interest in a partnership or trust; 4. a right or option to acquire a financial instrument; 5. cash or cash equivalents; 6. a right or option to acquire an interest in a partnership or trust; and 8 Section of the ITAA 1997 Taxation Institute of Australia

16 7. an asset whose main use is to derive interest, an annuity, rent, royalties or foreign exchange gains unless: a. the asset is an intangible asset and has been substantially developed, altered or improved by the foreign company so that its market value has been substantially enhanced; or b. its main use for deriving rent was only temporary Determining Asset Values Book value method Where the book value is adopted, the taxpayer must have access to recognised company accounts of the foreign company for the relevant periods. Recognised company accounts of a foreign company are accounts that are prepared in accordance with the accounting standards prepared by the responsible body in Canada, France, Germany, Japan, New Zealand, the UK or US, or the international accounting standards; or commercially accepted accounting principles that give a true and fair view of the financial position of the foreign company. In working out the AFBA percentage, it is necessary to calculate the average values of total assets and AFBAs. Accordingly, the use of two sets of accounts is necessary to determine the average values. The relevant periods for which recognised company accounts are required are: 1. the most recent period that ends no more than 12 months before the time that the relevant CGT event happens and for which the foreign company has recognised company accounts; and 2. the most recent period that ends between six months and 18 months before the end of the period mentioned above and for which the foreign company has recognised company accounts. If the foreign company did not exist before the start of the period ending no more than 12 months prior to the CGT event and it does not have more than one set of recognised company accounts, then values of the assets for the earlier period are taken to be zero. 9 For a taxpayer to adopt the book value method, at the time of the CGT event there must be sufficient evidence of the total market value of all the assets included in the total assets of the foreign company and sufficient evidence of the total market value of all the AFBAs included in total assets of the foreign company. The Explanatory Memorandum to the New International Tax Arrangements (Participation Exemption and Other Measures) Act 2004 at paragraphs 1.70 to 1.78 provide that the market value of the total assets as a whole may be ascertained by reference to the sale price of the shares disposed of as follows: Step 1 Step 2 Step 3 Market value of the company plus Market value of the liabilities less Market value of assets in the company not included in total assets. The market value of the AFBAs of the company may be calculated as follows: Step 1 Step 2 Market value of total assets less Market value of non-active assets AFBA Percentage of Foreign Groups If a foreign subsidiary itself owns shares in another foreign subsidiary, those shares are characterised as an active asset to the extent of the lower subsidiary s AFBA percentage. 9 Section of the ITAA 1997 Taxation Institute of Australia

17 This rule has the effect that the AFBA of lower subsidiaries in which the holding company has a sufficient interest may contribute to the AFBA of the foreign company being disposed of by the Australian company or CFC. A foreign company has a sufficient interest in a foreign subsidiary if: the foreign company has a direct voting percentage of 10% or more in the foreign subsidiary; and the company disposing of the share (the holding company) has a total voting percentage (being direct and indirect voting interests) of 10% or more in the foreign subsidiary. If the above requirements cannot be satisfied, the value of the shares in that subsidiary will be zero when calculating the AFBAs of the foreign company. Where there are multiple tiers of foreign subsidiaries, the process must commence from the lowest tier and work up the chain. Where however the determination of the AFBA percentage involves a tier of foreign companies, the calculation can be undertaken on a consolidated basis for wholly-owned groups. 10 Where a choice is made to use the consolidated approach, each 100% subsidiary of the top foreign company is treated as if it were a part of the top foreign company rather than being a separate entity. Therefore, all intra-group assets and liabilities are ignored. Where the modified rules for wholly-owned groups can be applied, it would be prudent to also perform the AFBA percentage calculations under the ordinary rules and then choose the method which gives rise to the best CGT outcome. 5.2 Sale of Assets To the extent the foreign operations are conducted through a PE of an Australian company, the extent to which any capital gain or capital loss is made will be subject to the operation of section 23AH of the ITAA As discussed above, a resident company will include in the calculation of its net capital gains any capital gain or capital loss as a result of a CGT event happening in relation to a tainted asset that is used in carrying on a business through a PE in a listed country where the gain is also EDCI. A capital loss is only included where, if there had been a gain, the gain would have been EDCI. A resident company will include in the calculation of its net capital gains any capital gain or capital loss as a result of a CGT event happening in relation to a tainted asset that is used in carrying on a business through a PE in an unlisted country. Tax may also be payable in respect of the asset disposal in the country in which the PE is situated. To the extent the assets of a foreign company are sold, tax may be payable by the foreign company in that foreign country. Any capital gain on sale may also be attributable to the Australian shareholder under the CFC rules. 6 RECENT DEVELOPMENTS AFFECTING BUSINESSES EXPANDING OFFSHORE New International Tax Arrangements (Foreign-owned Branches and Other Measures) Act 2005 contains various technical amendments to the CFC rules and commencement dates for items in New International Tax Arrangements (Participation Exemption and Other Measures) Act The Government released an Exposure Draft in relation to Conduit Income for comment. The proposed new rules will allow an Australian company that receives foreign income on which no Australian tax is payable to pay dividends to foreign shareholders free of Australian tax Section of the ITAA Assistant Treasurer s Press Release No.055, 17 June 2005 Taxation Institute of Australia

18 The Government announced in the Federal Budget that it will remove the requirement for taxpayers to quarantine foreign losses as they arise from domestic income and the ability of taxpayers to quarantine domestic prior-year losses from foreign income. It will also remove the need for these taxpayers to quarantine their foreign losses and FTCs into separate classes CONCLUSION Expanding business operations offshore introduces a number of additional taxation issues that need to be considered. This paper has identified the Australian tax issues applicable from the initial establishment of a foreign investment structure through to ultimate sale in the future and the recent changes to the Australian international tax provisions. As outlined above, the changes to the Australian international tax provisions should encourage further expansion offshore. In addition to the various exemption and concessions discussed, the ongoing maintenance of an offshore structure should now be less complicated from a taxation perspective. 12 Treasurer s Press Release No.044, 10 May 2005 Taxation Institute of Australia