ESTATE PLANNING STRATEGIES FOR OFFSHORE HELD FAMILY ASSETS. By Noé Vicca

Transcription

1 ICCA CHARTERED ACCOUNTANTS ESTATE PLANNING STRATEGIES FOR OFFSHORE HELD FAMILY ASSETS By Noé Vicca It is the responsibility of every resident taxpayer in Australia, whether an individual, partnership trusts or corporate to pay tax in Australia on income derived from all sources worldwide, subject to specific exemptions 1. Whereas for a foreign resident, he/she is only subject to tax in Australia on income from Australian sources. There are 2 main methods by which Governments worldwide apply taxes upon their residents. There are those that apply taxes on worldwide income basis such as UK, USA, Germany, Australia. Then there are those that have a territorial taxation system such as Hong Kong, Malaysia and Singapore in this part of the world wherein taxpayers are only taxable on income generated within their borders. And then, there is the multiplicity of other derivatives of these 2 systems applied by many other countries throughout the world. In order to understand this presentation today we need to understand the basic taxing principal in Australia and have an understanding of Australian Tax Law. The Australian Taxation system of determining a Taxpayers Taxable income is in the main governed by 2 separate Tax Acts, the Income tax Assessment Act 1936 and the Income Tax Assessment Act This is further supported by numerous other Acts and Legislative instruments dealing with amongst other things such as GST, FBT, Tax Rates, DTA s to name a few. Today s presentation will be delivered in 4 parts: 1. The Law 2. Exemptions 3. Examples 4. The real world and Articles and Acknowledgements. 1 Most importantly, s23aj in relation to non-portfolio shareholdings by Australian resident companies in non-resident companies, and s23ah in relation to foreign branch profits of Australian resident companies Liability limited by a scheme approved under Professional Standards Legislation!" # $% & '!($!$&)#(#( * +, -)., #+, $/ /!"#$%&

2 Before going into detail, a number of Big Picture points should be made: 1. If significant foreign tax is going to be incurred on foreign investments, it is usually best to hold them so that foreign tax will be creditable against the ultimate Australian tax liability, otherwise the total taxes paid on these offshore investments (once the income has found its way through to Australian resident individuals), will far exceed the top marginal rate for Australian resident individuals: 46.5% (including Medicare Levy). The price to pay for obtaining the benefit of foreign tax credits, is usually that no Australian tax deferral will be available; 2. If insignificant foreign tax is going to be incurred, then it may be possible to obtain Australian tax deferral; 3. In order to obtain maximum foreign tax credits it will be necessary to for an individual to invest directly (which won t be likely if there is an active business, where liability issues will be important), or invest through a fiscally transparent entity, such as a US LLC, and elect for hybrid tax treatment under Div 830; 4. If insignificant foreign tax is going to be incurred, then it may be possible to obtain Australian tax deferral, which will require investment into opaque entities (usually ordinary companies), with low or no tax in the country of residence, and tax treaty benefits available to limit source country taxation ( treaty shopping ); 5. Sometimes asset protection is far more important that minimizing taxation, which may mean that a foreign asset protection trust in a jurisdiction which specifically caters for them, might be in order, even though there may be no tax saving 2. Sometimes, it is possible to do both, especially where the income is from an active business. PART 1 THE LAW The Australian Taxpayer In Australia, a Taxpayer s taxable income is defined as "assessable income less deductions" (Sec 4-15 ITAA 1997 ). Assessable income consists of "ordinary income and statutory income" (Sec 6-1(1) ITAA 1997 ) but excludes "exempt income" (Sec 6-1(3) ITAA 1997), and non-assessable non-exempt income ( Sec 6-23 ITAA 1997). Tax liability within the ITAA 1997 and the ITAA 1936, may be summarized as follows:. Taxable income = assessable income - deductions for the relevant year.. Basic income tax liability = taxable income applicable tax rate(s).. Income tax owed for the financial year = basic income tax liability - tax offsets. In relation to foreign source income, there are certain exemptions by that particular income being categorized as non-assessable non-exempt income ( NANE income ), with the effect that like exempt income, it is not taxable 3. You will hear a lot about NANE income later in this paper. 2 Refer to the recent paper by Robert Gordon extracted towards the end of this paper, which amongst other things, deals with changes to the bankruptcy and family law which is likely to lead to the use of more offshore asset protection trusts. 3 However, unlike exempt income, NANE income does not offset carry forward losses 2

3 Double Tax Agreements Because many countries tax income on a worldwide basis, in order to avoid the risk of double taxation, (i.e. 2 countries taxing an individual or entity on income derived in one country) Governments of the world have developed treaties, known as DTA s. These endeavor to set down the ground rules for allocation of taxing rights amongst countries. Australia currently has treaties with at least 44 countries ranging from Argentina to USA. Australia also has numerous other derivative agreements including Data & Information exchange agreement with non taxing states such as the British Virgin Isles. Treaties generally have a standard layout 4 and deal with taxing and crediting of Dividends, Income from Royalties and Patents, Interest, Rentals, Technical Assistance, Shipping and Aircraft, Business Income etc. Double tax treaty countries have enormous advantages including the following: 1. a residence tie breaking Article which deems dual resident companies to be a resident solely of the Contracting State in which its place of effective management is situated. Without treaty protection, the company is at risk of being a tax resident, and therefore taxable in both, or numerous, States, whereas dual residence companies are protected from taxation in the other Contracting State. 2. Provided the non-resident does not have a permanent establishment (PE) in the other Contracting State: (a) business profits sourced in the other Contracting State are protected from source country tax; (b) Interest, unfranked dividends and royalties are subject to a reduced rate of withholding tax. 3. Dividends distributed from a double tax treaty country are commonly exempt from tax in the hands of corporate shareholders in the Other Contracting State. Investment from Australia is likely to favour the choice of a country that has a DTA with Australia, or if not, has DTAs with suitable conduit countries ( treaty shopping ), to limit the amount of source country tax. Foreign Source Income Current state of play The tax treatment of Australian residents who derive foreign-source income has gone through a number of complex phases over many years. The current position, the most significant of which has been in place since 2004, although still remaining quite complex, can when broken down into segments. In the next part of the paper I will deal with the middle era, otherwise known as Accrual Taxation System. Before 1990, in the absence of anti-deferral (Accruals) legislation, an Australian resident taxpayer was only subject to Australian taxation on income from foreign companies and trusts, when a dividend was declared, or the trust resolved to distribute the trust income to an Australian resident. As early as the 1930s, the USA had already moved to prevent such deferral, and over the years several other countries did likewise, leading to the law change in Australia starting in Under models such as the OECD model 3

4 The Accrual System is comprised of 4 regimes which subject foreign income to accruals taxation in the hands of resident Australian taxpayers: 1. the controlled foreign company (CFC) regime; 2. the transferor trust regime; 3. the foreign investment fund (FIF) regime; 4. and the deemed present entitlement rules. I will also touch on the new Foreign Tax Credit system The Board of Taxation (BOT) has delivered a report to Government to harmonize these 4 antideferral regimes, which report is still confidential. The Global Financial Crises seems to have put that report on the back burner. None the less, it is likely that the BOT s report recommends liberalization of the current regime, rather than tightening. The basic premise of the Part X provisions is to require Australian taxpayers to include in their assessable income, on an "accruals basis" in the current year, a share of income or gains earned by them even though the income or gains are retained by another structure domiciled offshore and that structure has not distributed such income or gains. As the law currently applies, in general, offshore trusts are disadvantaged compared to companies, as there is no active income exemption in relation to trusts. The BOT are likely to have recommended that this be changed. The design of the anti-deferral regime to exclude most active business income of offshore companies, was to preserve the competitiveness of Australian owned non-resident companies, when competing with foreign owned companies which did not bear tax rates as high as Australia. Whilst the BOT is likely to have recommended that a separate trust regime be maintained from that applying to companies, it is most likely that the CFC and FIF regimes will be merged, and the deemed present entitlement rules abolished. Currently the CFC rules are based on the concept that Australian residents control the offshore company, whereas the FIF rules (which were introduced later: 1993) only apply where the Australian resident does not control the offshore entity. At this stage, it is also important to note, that for Australian international tax purposes, and also commonly in DTAs, a shareholding of less than 10% (usually voting) is within the definition of a portfolio shareholding. A shareholding of 10% or more is a non-portfolio shareholding. A dividend received by an Australian resident company from a non-portfolio shareholding in a nonresident company is non-assessable non-exempt (NANE) income under s23aj of the 1936 Act. Non-portfolio dividends are assessable to all Australian non-corporate resident taxpayers, under s44, and a foreign tax credit is available only for foreign withholding tax. If the structure put in place is covered by one of the anti-deferral regimes, it is important that the taxpayer understand the need to disclose its existence in Australian tax returns, even if there is no attributable income, as the failure to disclose alone, may result in a risk of prosecution in extreme circumstances. 4

5 1. CFC Controlled Foreign Companies The CFC provisions Part X of ITAA 1936 attribute to Australian resident taxpayers income derived by foreign companies that they control. The extension in 2004 of the non portfolio dividend exemption under Sec 23AJ and the branch profits exemption under Sec 23AH to all countries has diminished the importance of the 7 "listed" countries (i.e. comparably taxed countries): Canada, France, Germany, Japan, New Zealand, the UK and the US, whereas all other countries are "unlisted" countries. For all CFC s there are certain categories of income there are certain categories of income that are "unconditionally" attributable i.e. income is not subject to the application of an "active income test". Controlled Foreign Corporation -CFC A company is a CFC if it is a non-resident company and any one of the following applies (Sec 340 ITAA 1936). A group of 5 or fewer Australian residents (including Australian partnerships, trusts or other resident entity where together with its associates it controls either directly or indirectly an interest of 1% in the relevant company) hold or are entitled to acquire 50% or more of the interests in the company, referred to as the control test; A single Australian resident whose direct and indirect interests in the company is not less than 40% (as long as the company is not controlled by a group of entities not including the subject Australian resident or any of its associates) referred to as the controller test; The company is in fact controlled by a group of 5 or fewer Australian residents (of any size even with less than 1% interests) either alone or together with their associates, referred to as the de facto control test; Note: For the purpose of the above tests, the interest of an Australian resident entity includes both direct and indirect interests of the resident and its associates, traced through the chain of ownership, referred to as the associate-inclusive control interest: The question of whether the company is a CFC is determined at the end of the relevant statutory accounting period. However to prevent circumvention of these rules, if a company is liquidated, the question is determined immediately before the company ceases to exist Sec 319(6) ITAA To be a CFC, the entity in question must first be a company as that term is defined in Sec of ITAA It must therefore be a body corporate, an unincorporated association or a body of persons, but not a partnership, trust, or non-entity joint venture. In the creative world of international tax planning there are often obscure concepts developed by states to circumvent the various CFC rules of comparable taxing states. Perhaps more importantly, civil law countries have entities such as foundations and anstalts, which are neither companies or trusts, and the ATO has had some difficulty dealing with them under the anti-deferral regimes. Because of the use, more specifically in both the UK and USA, of limited partnerships and limited liability partnerships, Div 830 was enacted. It can treat such arrangements as either Hybrid companies or Hybrid partnerships. The choice can result in major differences in the timing of and the declaration of taxable income by the Australian resident taxpayer. Examples of this will be touched on later in the paper. 5

6 Part X - operative provisions The CFC measures in Pt X of ITAA 1936 require Australian taxpayers to include in assessable income, on an "accruals basis" in the current year, a share of income or gains earned by foreign companies in which they have a controlling interest, even though the income or gains are retained by the controlled foreign company (CFC) and have not been distributed. Under Sec 456 ITAA 1936 an attributable taxpayer is required to include in assessable income a share of the "attributable income" of a CFC. The amount of a CFC's attributable income depends on whether the CFC is a resident of a "listed" country or an unlisted country, and on whether the CFC's activities for the exemption for active business income. For listed country resident companies, only designated concession income is attributable. Broadly, designated concession income is income which is not subject to ordinary tax rates in the listed country. For unlisted country resident companies, all income identified as "adjusted tainted income" derived by a CFC resident in an unlisted country is attributable if the CFC fails the active income test i.e. that income is more than 5% of the gross income. Adjusted tainted income is the addition of passive income and tainted income. Tainted Income can be tainted rental income, tainted sales income, tainted services income, tainted royalty income, tainted currency exchange gain, and tainted commodity gain. An income flow may be tainted when it is earned through an associate or from transactions with Australian residents, related or otherwise. The attribution of tainted income is to prevent deferral of Australian tax on income which is not active business income. Attributable income - calculation The term "passive income", as the words suggest, deals with categories of income and gains that are generated from passive investments (e.g. dividends, royalties, rent), rather than active business. If you were dealing with Active Income from business activities (The active income test being passed where the "tainted income ratio" of a company for the relevant statutory accounting period is less than 5%. The tainted income ratio is calculated under Sec433 by dividing the company's "gross tainted turnover" (essentially the total passive income, tainted sales income and tainted services income etc included in the turnover) by its gross turnover for the relevant period) then special rules apply to the following in determining the attributable income of the CFC, Trading stock Special depreciation rules Transfer pricing rules - Special CGT and special loss rules Thin capitalisation rules Debt/equity measures Second-tier provision and Active income test If therefore you are dealing with a CFC with more than 5% of gross made up of a passive income stream or a tainted income stream it is likely that the accrual tax regime applies. An Australian taxpayer must include in their assessable income, on an "accruals basis" in the current year, a share of income or gains earned by them even though the income or gains are retained by the CFC and not distributed. 6

7 Attribution accounts Attribution accounts are the method by which calculations are made of income that is attributed to an attributable taxpayer, in order to trace the extent to which dividends paid by a CFC (i.e. received by the Attributable resident taxpayer) represent amounts previously attributed ( i.e. declared as income in Australia and tax assessed). The statutory regime provides for specified attribution credits, debits, and the tracking of an attribution surplus. A taxpayer who maintains an attribution account in relation to a particular attribution entity will have an "attribution account percentage" in relation to the entity, made up of the taxpayer's total direct and indirect attribution account interests. Where a CFC pays a dividend after the end of its statutory accounting period (SAP), but before the end of an attributable taxpayer's income year, it will be treated as non-assessable non-exempt income (NANE) under Sec 23AI to the extent that an "attribution debit" arises in the attribution account for the CFC and the account is in surplus. Where a dividend is paid before the end of the Statutory Accounting Period and is included in an attributable taxpayer's assessable income, the CFC's attributable income is reduced accordingly: Determination TD 2003/27. Attributed tax accounts (Sec s 374 to 376 ) - which identify attributed income that has borne foreign tax to assist claims for a foreign tax credit - operate in a similar manner to the income attribution accounts. Note however that since the introduction of the foreign income tax offset provisions which replaced the foreign tax credit regime as from 1 July 2008, attributed tax accounts are no longer required. 7

8 2. Non Resident Trust Estates Accruals taxation of transferor trusts The object of the transferor trust measures in Div 6AAA Pt III of ITAA 1936 provides for the attributable income of a non-resident discretionary trust to be included in the assessable income of a resident transferor. A transferor includes an entity that: at any time transfers or has transferred value to a non-resident discretionary trust; or after 7.30 pm on 12 April 1989 has transferred value for inadequate or for no consideration to a non-resident non-discretionary trust. Div 6AAA endeavors to capture all direct and indirect transfers of value (including property and services) to a trust, including a transfer which of itself creates the trust. Like the CFC measures, a distinction is drawn between a listed country trust and an unlisted country trust, however, as already noted, there is currently no active income exemption. Attributable taxpayers The rules relating to an attributable taxpayer in Sec 102AAT differ according to whether transfers are made to a non-resident discretionary trust or to a non-resident non-discretionary trust. A "discretionary trust estate" has the wide meaning within Sec 102AAB. The general rule is that an entity is an attributable taxpayer in relation to a non-resident discretionary trust estate where the trust estate is a discretionary trust estate at any time during a current income year (other than a trust that is a public unit trust throughout the income year) and the entity has transferred property or services to the trust at any time before or during the current income year. Note two general exceptions apply where: the transfer is made in the course of carrying on a business, where identical or similar property or services are transferred in the ordinary course of business to ordinary clients or customers under arm's length transactions on similar the transfer is not made in the course of carrying on a business, but is made under an arm's length transaction and the transferor was not in a position at any time after the transfer and before the end of the current year to control the trust estate Exemptions Exemption from the Div 6AAA transferor trust measures is available in certain circumstances: transfers to discretionary trusts which were in existence prior to 12 April 1989, provided the transferor can convince the Commissioner that he or she was in no position to control the trust estate after that date. There was an announcement under the previous Government of the abolition of this exemption, but on referral to the BOT review, no action has been taken; transfers to a non-resident trust that is treated as a non-resident family trust. A non-resident family trust is either (a) a trust where all the beneficiaries of the trust: (i) are named "poor" natural persons; 8

9 (ii) (iii) are non-residents of Australia; and fall within a specified category of relatives of the transferor; or (b) a trust created upon breakdown of marriage where all the beneficiaries of the trust are: (i) non-residents of Australia; and (ii) fall within a specified category of relatives of the transferor created upon the breakdown of marriage; (c.) transfers made by a trustee of the estate of a deceased person under a will or codicil or court order varying a will or codicil however further sub provision conditions may apply. Attributable income - calculation In order to avoid doubling up of taxable income for an attributable Australian taxpayer, the attributable income of a non-resident trust, not resident in a listed country, is the whole of the net income of the trust estate, reduced by amounts that would be subject to full Australian tax (i.e. amounts assessed in the hands of the presently entitled resident beneficiaries or amounts assessed in the hands of the trustee) or tax in a listed country: Sec 102AAU(1)(a). The attributable income of a non-resident trust, resident in a listed country, is so much of the net income of the trust that benefits from designated tax concession, reduced by the amounts that are subject to full Australian tax or tax in a listed country: Sec 102AAU(1)(b) ; The attributable income of a trust, that is a resident of a listed country, is not to be included in the assessable income of a transferor if the aggregate attributable income derived by non-resident trusts to which the transferor has transferred value does not exceed the lesser of (s 102AAZE ):. 10% of the aggregate of the net incomes of the trusts; or. $20,000. Where an Australian resident transfers property or services to the trust in circumstances attracting the transferor provisions the whole of the attributable income of a non-resident trust is included in the assessable income of each Australian resident or CFC. Because of the way these provisions operate, it should be noted that for a transferor trust, if all that it does, is that it holds appreciating property which does not itself produce income directly or indirectly, there is no attribution until the gain is realized, which may provide significant deferral. Section 99B operates in a way not to include the attributable income of a trust estate that has been included in the assessable income of a transferor (other than a company). Where the attributable income of a trust estate has been included in the assessable income of a company transferor, subsequent distributions of that income to that company are exempt from company tax. Additional tax in certain circumstances Sec 99B provides that in reference to distributions, to the extent that a resident beneficiary's assessable income includes a distribution by a nonresident trust estate of income of a previous year, and 9

10 to the extent that the income has neither been attributed to a transferor nor taxed on a current basis to a trustee or beneficiary, the beneficiary is liable to pay additional tax in the nature of an interest charge in respect of that amount: Sec 102AAM. The interest charge is imposed by the Taxation (Interest on Non-resident Trust Distributions) Act 1990 and is payable at the rate applicable under Sec 214A. Deceased Estates: The beneficiary of a deceased estate, the deceased being a person who would otherwise have been assessable under Sec 99B, is exempt from the interest charge if the amounts in question are paid to or applied for the benefit of the beneficiary within 3 years after the death of the deceased person: Sec 102AAM(1B). Such taxpayers are required to prove that the distributions out of accumulated profits of a foreign trust have been comparably taxed offshore before that amount is exempt from the interest charge on attributions above. It should be noted that by Sec 102AAL there is an express exclusion of the attribution of the income of a deceased estate or will trust set up under the will of the deceased, while it is accumulating. and so such a trust that accumulates foreign source income will not be subject to Australian taxation until there is a distribution in favour of an Australian resident beneficiary, under Sec 99B. Further, on the demise of the transferor with respect to an inter vivos trust, the Div 6AAA attribution stops, and so such a trust that accumulates income after the transferor s demise, will not be subject to Australian taxation on foreign source income until there is a distribution in favour of an Australian resident beneficiary, under s99b. 3. Foreign investment funds Foreign investment funds and Foreign Life Policies The foreign investment fund (FIF) regime applies to income and gains accumulating in foreign companies that are not Australian controlled or in foreign trusts that fall outside the transferor trust provisions. It was introduced after the CFC provisions, and as almost all will now acknowledge, was poorly targeted, and did not mesh well with the other provisions, hence, the BOT review. These rules also capture certain foreign life insurance policies (FLP s) that have an investment component, such as life bonds. (The definition of "life assurance policy" in Sec 482 excludes a policy under which a payment is made on death by accident or an expressly named sickness). Ruling TR 2004/3 dealt with foreign life policies marketed by companies resident in tax havens. These policies were designed so as to come within this exclusion. The Tax Office's position is that the exclusion only applies where the payment under such policies only arises upon death. As these products, in order to have an exit strategy generally provided for payment on surrender or maturity (i.e. they have an investment component) (e.g. older whole of life type policies), they will be treated as FLPs. FIF provisions The FIF provisions apply to taxpayers who have an interest in an FIF or a FLP. An interest in a corporate FIF includes a share (other than an eligible finance share, i.e. a share in an Australian Financial Institution refer Sec 327 ) or an option, convertible note or other instrument that confers an entitlement to acquire such a share. An FIF trust interest comprises: an interest in the corpus or income of the trust (including a unit in a unit trust); or 10

11 an option, convertible note or other instrument that confers an entitlement to acquire such an interest. A person has an interest in a FLP if the person has the legal title to a foreign life assurance policy. The FIF provisions apply where a taxpayer has an interest in a FIF at the end of an income year and the taxpayer is a resident at any time during that income year:. The FIF provisions also apply if the taxpayer has an interest in a FLP at any time during the notional accounting period of the FLP that ends in an income year and the taxpayer is a resident at any time in that income year: Sec 529 includes in the assessable income of a resident taxpayer a share of FIF income that is treated as having accrued to the taxpayer. These rules do not apply to a "temporary resident". The FIF income is reduced where interim dividends/distributions have been accrued or received. Under the older provisions the Law required a system of FIF attribution accounts (similar to the CFC attribution accounts) designed to identify amounts included in the assessable income of a taxpayer in relation to a FIF. Under the foreign income tax offset provisions which apply from 1 July 2008, FIFattributed tax accounts are not required. Calculation of FIF income Here is the Crux of why taxpayers and advisors avoid the FIF provision. Basically where none of the FIF exemptions (which are to be discussed later in the paper) apply, the amount of FIF income is determined under one of 3 methods:. the market value method: Sec 535 ;. the deemed rate of return method: Sec s 543 to 557 ; or. the calculation method: Sec s 557A to 583. The assessable income arising under the FIF measures is included in the taxpayer's assessable income for the income year in which the notional accounting period of the FIF ends. The market value method essentially attempts to bring to account as Australian taxable income the change in value of the FIF over the relevant income year. It is only available where there is a market for the shares or units e.g. a stock exchange listing. The deemed rate of return method applies a straight percentage rate (equivalent to the general interest charge less 3 percentage points: to the deemed opening value. The calculation method requires a recalculation of foreign income based on Australian tax principles and it is that amount that is brought to tax. The resulting figure could be less or more than that produced by the other methods but is almost certain to be a truer reflection of the actual income position. Where the interest is an FLP, a taxpayer can only apply the deemed rate of return method or the cash surrender method. 11

12 4. Deemed present entitlement rules Interests in non-resident trust Sections 96B and 96C ITAA 1936 combine to provide practitioners with the of the general trust provisions for entitlement and add at times an unnecessary additional dimension to the Attribution provisions. The general effect of Sec 96B is fairly straight forward Extract ITAA B(1) [Purpose of section] If at any time during the year of income or a later year of income a taxpayer had an interest (including an interest that is to arise at a future time or is contingent on the happening of an event) in a non-resident trust estate in relation to the year of income In the application of Sec s 96B and 96C, none of the exclusions referred to in the CFC/FIF/transferor trust regimes appears to be reflected in these sections. Consider the position wherein an Australian resident individual who has an interest in a trust that was created upon the death of a non-resident. There are exclusions for this type of situation in the transferor trust and FIF regimes but no equivalent provision in Sec 96B or Sec 96C. Similarly, there is no equivalent provision for the scheduled trust exemption in the FIF regime.. This is by far the most complex and at times ambiguous section of the Attribution rules effecting offshore interest as it at times seems to capture what other provisions exempt or concessionally treat. FOREIGN INCOME TAX OFFSET SYSTEM The New Foreign income tax offset system On the 1 st July 2008, the foreign income tax offset (FITO) system replaces the former class categorized foreign tax credit system. An FITO arising under Div 770 ITAA 1997 is a non-refundable tax offset (i.e. cannot create a tax refunding the hands of the Australian taxpayer). A taxpayer's entitlement to a FITO arises in the year that an amount upon which a foreign income tax that has been paid is included in the taxpayer s assessable income. In ATO ID 2008/135, the ATO affirmed there must be a nexus between the payment of the foreign income tax and the tax liability of the taxpayer, however it was not necessary for the foreign income tax to be paid in the same income year that the amount is included in the taxpayer's assessable income. An available FITO will reduce the gross amount of an Australian taxpayers tax payable on foreign income by the amount of the foreign income tax paid. However this is subject to certain rules and pre conditions set out herein. Conditions for an entitlement to foreign tax credits/offsets Where an Australian resident taxpayer includes foreign income in his/her assessable income and the taxpayer has paid foreign tax in respect of that foreign income the taxpayer is prima facia entitled to a foreign tax credit/offset equal to the lesser of: 12

13 (a) the amount of the foreign tax (reduced in accordance with any relief available to the taxpayer under the law relating to that tax); and (b) the amount of Australian tax payable in respect of that foreign income. Essential pre conditions of (a) and (b) are that:. the taxpayer must be a resident;. the taxpayer's income must include "foreign income. the taxpayer must have paid "foreign tax" and. the foreign tax must be a tax for which the taxpayer was "personally liable" Examples of taxes paid subject to an FTC - Withholding tax - Individual taxes paid on the income - Branch company tax paid Examples of taxes not available for an FTC - CFC company tax paid - Trust taxes paid excepting specifically in relation to the distribution Foreign income tax offset entitlement (FIFO) Specific FITO rules apply in respect of: 1. foreign income tax paid on an amount that is non-assessable non-exempt income under Sec 23AI or Sec 23AK (ITAA 1936): Sec (2) ITAA 1997; 2. foreign income tax, Australian income tax and withholding tax paid by a foreign company where an amount is attributed to a resident taxpayer under the CFC measures: Sec (2) ITAA foreign income tax, Australian income tax and withholding tax paid by a FIF in which the taxpayer holds a direct interest, is available provided the taxpayer uses the calculation method to determine the FIF's attributable income: Sec (5) and (6) ITAA 1997; and 4. no FITO entitlement is available where a taxpayer receives a refund of foreign income tax or a benefit from the foreign country or state Sec ITAA Where the total foreign income tax paid by a taxpayer is less than or equal to $1,000, the taxpayer is not required to calculate the FITO, the taxpayer will simply receive an FITO entitlement equal to the foreign income tax paid on amounts included in the taxpayer's assessable income. It is important to note that where s23aj applies (which is NANE income) i.e. to non-portfolio dividends paid to an Australian resident company (in its own right, not as trustee), no credit is available for underlying company tax paid by the company paying the dividends, nor for foreign withholding paid on the dividend received. 13

14 For example, if an Australian individual owns all the shares in an Australian company that owes all the shares in a UK company that pays 30% UK tax, and the after tax profit is paid as a dividend to the Australian company, and then to the individual, the total tax paid will be as follows: UK profit 100 UK tax (@30%) 30 Dividend from UK 70 UK withholding tax 0 Australian company tax 0 Dividend from Austco 70 Australian individual tax (@46.5%) Net return after all taxes Total taxes paid 62.55% The problem isn t overcome by getting rid of the Australian company. For example, if an Australian individual owns all the shares in a UK company that pays 30% UK tax, and the after tax profit is paid as a dividend to the individual, the total tax paid will be as follows: UK profit 100 UK company tax (@30%) 30 Dividend 70 Australian individual tax (@46.5%) Net return after all taxes Total taxes paid 62.55% 14

15 The same result followed because the UK company tax is not available as an offset, as the UK company is opaque. If a UK operator could have established an LLP and it was elected to be transparent for Australian purposes under Div 830, the result would be as follows: UK profit 100 UK tax on partner (@40%) 40 Distribution 60 Gross up for foreign tax 40 Taxable in Australia 100 Australian individual tax (@46.5%) 46.5 Credit for foreign tax 40 Tax payable 6.5% Net return after all taxes 53.5 Total taxes paid 46.5% As observed at the outset, if significant foreign tax is going to be incurred on foreign investments, it is usually best to hold them so that foreign tax will be creditable against the ultimate Australian tax liability, or else the total taxes paid on investments (once the income has found its way through to Australian resident individuals), will far exceed the top marginal rate for Australian resident individuals: 46.5% (including Medicare Levy). The price to pay for obtaining the benefit of foreign tax credits, is usually that no Australian tax deferral will be available. Finance Cost Interest expense of an Australian resident taxpayer to buy shares in a foreign company was traditionally quarantined so that interest was only deductible up to the extent of the foreign assessable income (Sec 79D ITAA 1936), and any excess could carry forward to offset only against that type of income. Interest expense in relation to deriving exempt income was not deductible. However, since 2001, interest expense in relation to non-portfolio dividends under s23aj, has been deductible (s25-90 ITAA 1997), and able to offset assessable income (if any), that the Australian company may have, subject to the limitations of the thin capitalization provisions (Div 820 ITAA 1997), which from 2001, have applied to outbound, as well as inbound investment. Where the dividends are portfolio i.e. less than 10% of the voting rights, the dividends will be assessable, and since 2007 (at the same time the new Foreign Tax Offset rules became effective), the only limitation on deductibility of interest are the thin cap rules. 15

16 PART 2 - EXEMPTIONS Exemptions from the accruals system Now that you have an understanding of the basic attribution categories and rules relative thereto, what options exist to avoid the accruals system. We will firstly start by looking at the boarder exempting CFC provisions. It is easy to see from these concessions why a Corporate holding structure in a CFC is by far the preferred structure for bona fida offshore business operations. Older broader exempting provisions The provisions are generally carried forward from earlier applications of the Law - Foreign non-portfolio dividends (i.e. a corporate interest of 10% or more) derived by a resident company from a foreign company are non-assessable non-exempt (NANE) income (Sec 23AJ ITAA 1936); Note carefully the importance of this is to a resident company s interest in an offshore company that has minimal tainted income from its offshore operations. This is because, if the offshore company had mainly attributable income, it would have already paid tax on it under the CFC provisions, and necessarily, the dividend would be NANE income: s23ai. - Foreign branch income derived by a resident company is non-assessable non-exempt (NANE) income Sec 23AH ITAA 1936); Note the litigation risk of a Branch operation verses an offshore subsidiary to an Australian holding company generally defeats the benefit of this provision. It is also less likely that a foreign equity holder could be introduced into the structure, as most foreign resident investor would rather invest directly in to a neutral tax company offshore to invest in a foreign business, and not via an Australian company. Newer exempting provision - Capital gain or loss that a resident company makes from the disposal of shares in a foreign company is reduced to the extent that the foreign company operated an underlying active business (Div 768G ITAA 1997): In this case the capital gain is treated as non-assessable non-exempt income. The structural preconditions of this generous concession are - Australian Corporate Structure, (i.e. not a trust) held >10% interest in the Foreign Company - Company is not a Part X entity, (i.e. CFC wherein 5 Australians or less control not less than 50% OR 1 Australian controls not less than 40%) - Australian Corporate Structure (i.e. holding entity has a Voting % of not less than 10% throughout a preceding 12 mth period - The holding company shareholding is not a Part X finance share - The event is an approved CGT event (e.g. - Disposal of a CGT asset, company rollover event) - Active Foreign Asset % determines the reduction to the capital gain on the sale of the share in the foreign company (use either Market Value Method, Book Value Method or Default method) - Active foreign assets are covered by a set of rules as is the direct voting % 16

17 FOREIGN HYBRIDS LLCs LLPs DIV 830 A foreign limited liability company (LLC), even if its members are treated for tax purposes as thought they were partners in a partnership in the country of formation, are treated as a foreign company, and so CFC and FIF provisions applied to its members, unless Div 830 of the 1997 Act applies. Div 830 first came into operation on 30 June, Foreign Limited Liability Partnerships (LLPs) are also treated as though they are companies by Div 5A of Part III of the 1936 Act, even though they were in the form of partnerships in the country in which they were formed, and treated as such for tax purposes in that country, unless Div 830 applies. For example, most US LLPs are unincorporated, but UK LLPs are incorporated under the Limited Liability Partnership Act UK LLPs are in wide-spread use in the professions and the venture capital industry. Initially Div 830 was expressly limited in application to US formed LLCs and LLPs, with scope to expand its operation to such entities formed in other countries, by regulations. UK LLPs have recently been added to Div 830 by regulation ( ). Under s830 the Australian resident members with a non-portfolio interest (i.e.>10%) in a US LLP or LLC, or a UK LLP, which are not taxed as a resident entity in any foreign country, are taxed in Australia as partners rather than shareholders in a foreign company. Accordingly, they will not have CFC interests in the LLP or LLC as such. 1. Foreign hybrids are treated for taxation purposes as partnerships. Therefore, the normal "flow-through" taxation treatment under Div 5 Pt III ITAA 1936 applies whereby tax is levied on the partners or shareholders of the hybrid rather than the hybrid itself (e.g. see ATO ID 2006/18). 2. There are limitations on the losses of a foreign hybrid which can be deducted by a partner or shareholder of the foreign hybrid against income from other sources. The limits are based on the limited partner's or shareholder's contributions to the foreign hybrid. The limit is adjusted annually for additional contributions or withdrawals and for previous losses taken into account. There are similar limitations on the capital losses that are allowed to partners and shareholders in foreign hybrids. The principle that underlies this treatment is that limited partners and shareholders in a foreign hybrid should not be able to claim deductions for tax losses to which they are not exposed economically because of their limited liability. 3. Transitional rules transfer asset values from the foreign hybrid to the partners or shareholders (or vice versa) when an entity becomes or ceases to be a foreign hybrid. This value transfer does not give rise to a taxable event and is necessary to ensure coherent CGT treatment - assets of the foreign hybrid are treated for CGT purposes as assets of the partners or shareholders of the foreign hybrid, not the assets of the hybrid itself. 4. Were it not for this provision where a taxpayer's interest in a foreign limited partnership or US limited liability company (LLC) would otherwise be a FIF interest rather than an interest in a CFC, the taxpayer has the right to choose whether the "flow-through" partnership tax treatment under Div 5 Pt III will apply: In short you get the litigation benefit of a company in an LLC/LLP, but not the negative Sec23AJ tax treatment relative to company taxes paid at source, with no flow through Foreign Tax Credits. And where otherwise the FIF provisions could have applied you can elect out of the reporting requirements and you also get the CGT benefits of the underlying asset being an asset of the Partner not the Hybrid 17

18 FIF Exemptions It is important at this point to remember why the FIF exemptions are also very important and often overlooked. Where an exemption does not apply, the amount of FIF income is determined under one of 3 methods:. the market value method: Sec 535 ;. the deemed rate of return method: sis 543 to 557 ; or. the calculation method: sis 557A to 583. Active business exemptions Sections 495 to 501 endeavor to provide a platform whereby there is no tax hindrance to portfolio diversification or joint venture participation by Australians who wish to invest directly into a foreign company that is principally engaged in active business. A direct investment in a foreign company principally engaged in one of the listed business activities does not attract the application of the FIF rules. Examples of non-active business activities are pure holding vehicles and companies that engage in activities such as financial services. There are 2 methods for whether or not a foreign company is an active business and is therefore exempt from the FIF measures. The stock exchange listing method uses stock exchange categorization or international sectoral classifications to establish a company's principal activity. Banking If the interest is in a company that is authorized to carry on banking business in its place of residence and is principally engaged in carrying on that business, the FIF rules do not apply if the shares are both listed and widely held and actively traded on the stock market of an approved stock exchange (see Sch 12 to the ITR for a list of approved stock exchanges Life insurance companies An interest in a foreign company that is principally engaged in carrying on life insurance business (listed, widely held and actively traded) is not subject to the FIF rules. (i.e. similar exemption to that of holding companies in banking applies). General insurance business Interests in a company that conducts general insurance business (i.e. shares are listed, widely held and actively traded) are not subject to the FIF regime. (i.e. similar exemption to that of holding companies in banking applies). Commercial real estate activities Interest in a foreign company that was principally engaged in the act of carrying on commercial real estate activities, (e.g. construction and development of real property through capital improvement) and the shares are listed, widely held and actively traded on the stock market of an approved stock exchange, the FIF rules do not apply. (i.e. similar exemption to that of holding companies in banking applies). 18

19 Interests in certain US entities Under Div 8 of Part XI, where a US corporation, LLP, LLC, Regulated Investment Company, Real Estate Investment Trust (REIT), or common trust fund is subject to full US tax i.e. to be treated as opaque, an Australian resident entity with a membership interest is exempt from FIF attribution, subject to certain conditions. Those conditions are that the taxpayer s interest in the US entity is held for the sole purpose of investing in a business conducted in the US, or real property located in the US, and the total value of non US source income and gains, non-resident US FIF interests, and real property located outside the US does not exceed 5% of the total value of all interests. This exemption has been referred to as politically motivated, in that it has been extended to the US only, when other countries may have suitable low deferral regimes. It has been said that the concession was extended as part of the build up to the Australia/US free trade agreement. Multi-industry companies Where a taxpayer has an interest in a foreign company listed on an approved stock exchange and undertakes 2 or more types of business activities, an exemption applies if the principal activities of the company are not "blacklisted" activities: Sec 523. Extract Sec 523 Exemption i) shares in the foreign company that were included in that class were widely held, and actively traded on a regular basis, on a stock market of an approved stock exchange; and (ii) the foreign company was engaged in the active carrying on of any 2 or more of the following activities: (A) (B) construction; development of real property through capital improvement; (C) receipt of rental income from commercial real property owned by the company, being property in respect of which the management, maintenance and security services were principally provided by directors or employees of the company or by a wholly-owned subsidiary of the company that was principally engaged in carrying on the business of providing those services through directors or employees of that subsidiary; (D) provision of management services in respect of real property by directors or employees of the company; (E) acting as agent in connection with the sale or purchase of commercial real property; (F) general insurance business of a kind that the company was authorised under the law of its place of residence to carry on; (G) life insurance business of a kind that the company was authorised under the law of its place of residence to carry on; (H) eligible activities within the meaning of Division 3; 19