Controlled Foreign Companies and Foreign Accumulation Funds: Release of Exposure Draft Legislation

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1 On 17 February 2011, the Assistant Treasurer released exposure draft legislation (ED) for the proposed new Controlled Foreign Company (CFC) and Foreign Accumulation Fund (FAF) rules. The ED also includes draft legislation for the proposed replacement for the existing non-portfolio foreign dividend exemption. The proposed rewrite and modernisation of the CFC rules and the proposed new FAF rule form part of a wider package of reforms to Australia s foreign source income (FSI) attribution rules announced in the Budget. These changes are intended to improve the competitiveness of Australian companies with offshore operations and the attractiveness of Australia as a base for regional headquarters of foreign groups. The first stage of amendments to the FSI attribution rules - namely, the repeal of the foreign investment fund (FIF) rules and the deemed present entitlement rules for foreign trusts - came into effect in and from the income year. The changes arose result from the review of Australia s FSI anti-deferral regimes that began in October 2006, when the then Federal Treasurer announced a review of the CFC, FIF, transferor trust and deemed present entitlement rules to be conducted by the Board of Taxation (Board). There has been no update on the Board s recommendation (accepted by the Government) that the transferor trust rules, currently in Division 6 of Part III of the Income Tax Assessment Act 1936 (Cth) (1936 Act) be updated. It is understood that the Board s recommendation that closely held trusts be brought within the CFC regime will not proceed. The Assistant Treasurer said a further round of consultation will occur before the proposed legislation is introduced into Parliament, given the scale, complexity and importance of these rules. There are as yet no proposed start dates for the new rules. CFC rules The key changes in the proposed new CFC rules (proposed to be in new Part 4-10 of the Income Tax Assessment Act 1997 (Cth) (1997 Act)) are summarised below. What is a CFC? It is proposed that a company will be a CFC if it is not an Australian resident and has at least one attributable taxpayer (proposed s ). By virtue of the definition of attributable taxpayer (see below), this means that: an Australian entity must control, or be an associate of an entity that controls, the foreign company; and The Australian entity must have a direct and/or indirect participation interest in the foreign company of greater than zero. The notion of control is therefore critical in determining whether a company is a CFC, as is the case under the current CFC rules. However, the proposed new control test is quite different from the tests under the current rules, as discussed below. Attributable taxpayer An entity (first entity) will be an attributable taxpayer in relation to another entity (second entity) if: Sydney Perth Melbourne Brisbane Adelaide 1

2 (a) (b) (c) the first entity is an Australian entity (i.e. an Australian resident that is not treated as a resident of another country under a double taxation agreement); either the first entity controls the second entity or is an associate of an entity that controls the second entity; and the first entity holds either a direct participation interest (i.e. the percentage that the first entity holds of the total rights of members to returns on equity interests in the second entity that are distributions of profits, otherwise than on winding up - proposed new s ) or a total participation interest (i.e. direct plus indirect participation interests - s ) in the second entity of greater than zero. (proposed s ). Thus, to be an attributable taxpayer, the taxpayer must be a single controller (or, as noted below, a joint a controller) of the CFC or an associate thereof. This is unlike the current rules, where any Australian entity with an associateinclusive control interest of 10% or more will be an attributable taxpayer (although their attribution percentage will reflect only the taxpayer s own interests in the CFC). The single controller approach is said to focus on taxpayers with the capacity to orchestrate and benefit from inappropriate deferral outcomes through a determining influence over investment decisions of a foreign company, and their Australian associates that can also benefit from those investment decisions. 1 Control test It is proposed that control will be defined by reference to accounting standards (proposed s ). In particular: whether an entity controls another entity will be determined in accordance with accounting standard AASB 127 (or other accounting standard specified by the regulations); if 2 or more entities jointly control another entity, each of them will be treated as controlling the other entity - for this purpose, joint control will be determined in accordance with AASB 131 (or other accounting standard specified by the regulations) and, in addition, 2 entities that each hold 50% of the equity interests in the entity will be treated as having joint control. AASB 127 defines control as the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. It further states that control is presumed to exist when the parent directly or indirectly owns, or has power over more than half of the voting power or has control over the board. AASB 131 defines joint control as the contractually agreed sharing of control over an economic activity, where the strategic financial and operating decisions require unanimous consent of the parties (or joint venturers ) sharing control (unless one venturer is appointed as the operator or manager of the joint venture with power to govern the venture s financial or operating policies, in which case only that joint venturer will have control). 1 Refer the Attachment accompanying the ED (Attachment). Sydney Perth Melbourne Brisbane Adelaide 2

3 Under the current rules, there are 3 separate control tests, namely: 5 or fewer Australian entities between them have associate inclusive control interests in the company of at least 50%; or One Australian entity has an associate inclusive control interest in the company of at least 40% and no other group controls the entity; or The company is controlled by a group of 5 or fewer Australian entities, either alone or together with associates. A control interest for the purpose of the first 2 tests above is defined as the percentage that an entity holds, or is entitled to acquire, of the total paid up capital or the total rights of shareholders to vote or to receive distributions of income or capital on winding up or otherwise. These are sometimes referred to a bright line tests. Control for the purpose of the third test and the second part of the second test is not defined and is taken to mean de facto control. There is little guidance on what constitutes such de facto control. Apart from the proposed rule that will deem 2 entities that each hold 50% of the equity interests to control the company, there is no equivalent under the proposed new rules of the 2 bright line control tests under the current rules. Attribution percentage Under the proposed new rules, an attributable taxpayer will be assessed on the CFC s attributable income multiplied by the taxpayer s total participation interest in the CFC (see above) at the end of the statutory accounting period, disregarding the participation interest of any other entity that is an attributable taxpayer for the CFC at that time (proposed s 801-5(2) and (3)). Attributable income It is proposed that the only amounts that constitute adjusted passive income will be included in a CFC s attributable income (proposed s (6)). Adjusted passive income is prima facie passive income, as adjusted in accordance with proposed Subdivisions 802-C and 802-D. Prima facie income is passive income (to be defined as returns on debt and equity interests, payments of rent, annuities or royalties, profits from financial arrangements and profits from CGT events in relation to assets that produce passive income) to the extent that it: is attributable to a permanent establishment of the entity in Australia or elsewhere - this requirement was not included in the discussion papers previously circulated and its inclusion was not recommended by the Board. However, it is said to put more context around the requirement for competing in a market, by reference to the activities of the permanent establishment; 2 arises from the entity competing in a market; and arises substantially from the ongoing use of labour by the entity, (proposed Subdivision 960-P). Adjusted passive income will consist of prima facie passive income as defined above, except that: 2 Refer Attachment Sydney Perth Melbourne Brisbane Adelaide 3

4 it does not include rent from real property (including a lease of land) - this exclusion, which was not in the previous discussion papers, is said to be because such income is location specific and cannot be moved around for tax advantage and it is internationally agreed that the right to tax such income rests with the country in which the property is located; 3 it includes any royalty income connected with Australia (i.e. where the royalty is in respect of intellectual property acquired from an Australian resident associate of the entity, where the entity has not substantially developed, altered or improved it with the result of substantially enhancing its market value); it is subject to an integrity rule (where an attributable taxpayer for the CFC or an associate of such attributable taxpayer is entitled to a tax benefit, such as a deduction, tax offset or increase in cost base, referable to the CFC having the amount of prima facie assessable income) - this is intended to ensure that the active income test and AFI subsidiary exemption cannot be used as a device to artificially shelter profits shifted out of Australia s tax net ); 4 it does not include certain intra-cfc group amounts (see below); for a CFC resident in a listed country (of which there are currently only 7), it only includes amounts that are not comparably taxed in a listed country due to a feature specified in the regulations - this maintains the limited attribution approach for listed country CFCs in the current rules; for a CFC that is an AFI subsidiary whose sole or principal business is financial intermediary business, it does not include its excluded AFI income (this is still being developed in consultation with industry) - this is also subject to the integrity rule referred to above. The current CFC rules also target only passive income (other than certain base company income, as discussed below). However, they rely on specific carveouts from the concept of passive income, which has been criticised as outdated and inflexible. Similarly to the current rules, there will be no attribution if less than 5% of the CFC s income, as determined by reference to its financial accounts, is prima facie passive income. CFC groups An amount of prima facie passive income will not be attributable if it is referable to a financial benefit provided to the CFC by another CFC that is a member of the same CFC group, where it does not give rise to a deduction for the other CFC (proposed s ). A CFC group will consist of all entities that are CFCs of a single attributable taxpayer and are controlled by that attributable taxpayer and by no other attributable taxpayer (proposed s ). This is said to allow active income to be passed through a CFC group in a series of transactions without attribution consequences and is based on the principle that dealings between related parties that form part of a single economic group largely amount only to shifting profits within the group. 5 3 ibid 4 ibid 5 ibid Sydney Perth Melbourne Brisbane Adelaide 4

5 Removal of base company income rules Under the proposed new rules, the so-called base company income rules (under which certain amounts of active income from sales and services, generally between related parties, are included in attributable income) have been removed. Under the current rules, a CFC s attributable income includes tainted sales income (broadly, income from the sale by the CFC of goods sold to, or purchased from, associates in Australia) and tainted services income (broadly, income from the provision of services by the CFC to an Australian resident). The Board of Taxation recommended that the base company income rules be abandoned and replaced by express integrity rules where needed and justified, on the basis that they are at odds with the general position that attribution should not apply to active businesses and that the transfer pricing rules have become sufficiently developed to deal with them. Exemption for lightly taxed entities Certain lightly taxed entities - namely complying superannuation entities and life insurance companies whose interest in the CFC is a complying superannuation/fhsa asset or a segregated exempt asset (which are generally only taxed at the rate of 15%) - will be exempt from attribution under the proposed new rules (proposed Subdivision 804-B). The exemption will also apply if the lightly taxed entity holds an interest in an interposed partnership or trust that is required to include attributable income in its net income. This exemption was recommended by the Board of Taxation. similar exemption in the former FIF rules. Attribution credits There was a The proposed new rules retain the exemption for dividends paid out of previously attributed income but do not set out prescriptive rules for recording attribution credits and debits. It is also proposed that taxpayers will be able to pool attribution credits and use them against any other attributed amount (proposed Division 805). Non-portfolio dividend exemption The key changes to the non-portfolio dividend exemption (currently in s 23AJ of the 1936 Act, which is proposed to be replaced by new s of the 1997 Act) are: the exemption will apply to distributions in respect of equity interests, rather than to dividends ; the exemption will apply if, at the time the distribution is made, the receiving company either: - holds an enhanced ordinary membership interest (being the percentage of ordinary membership interests, or shares, that it holds) in the distributing entity of at least 10%; or - is an attributable taxpayer for the distributing company (which, as noted above, requires that the taxpayer, or its associate, controls the company and has a participation interest of greater than zero); Sydney Perth Melbourne Brisbane Adelaide 5

6 while the exemption will still apply only to companies, it can (unlike the current exemption) apply where the receiving company receives the distribution through one or more interposed partnerships or trusts. FAF rules The proposed FAF rules will include an amount of FAF attributable income in the assessable income of an Australian resident taxpayer (including an Australian partnership or trust) that has an equity interest in a FAF at the end of the FAF statutory accounting period for the FAF, where the FAF is not a CFC for which the taxpayer is an attributable taxpayer at the end of that period. An entity will be a FAF for a FAF statutory account period if the entity: is a company or a fixed trust; and is a foreign resident at the end of the period; and satisfies both an investments requirement and an accumulation requirement for the period. The investments requirement will be satisfied if, at the end of the FAF statutory account period, the market value of all debt interests held by the entity comprises 80% or more of the market value of all assets held by the entity. This test seeks to capture entities that invest to receive low-risk, interest-like returns, as recommended by the Board. The accumulation requirement will be met if the amount that is distributed within the period beginning at the start of the FAF statutory account period and ending 3 months after the end of that period (the distribution period) or, in the case of a trust other than a corporate tax entity, constitutes net income of the trust that is included in the assessable income of one or more beneficiaries, is no more than 80% of the total amount of the realised profits and gains of: the entity in question (the first entity) for the period; and/or another entity that the first entity controls (within the meaning of proposed s , as discussed above, excluding the provision deeming 2 entities that each hold 50% of the equity interests to be joint controllers), to the extent that they are reflected in the first entity s unrealised profits and gains for the period. The provision in the previous exposure draft legislation for the Commissioner of Taxation to make a determination to apply the FAF rules has been abandoned, in view of consultation submissions that the rules should be self-executing. The provisions for calculating the FAF attributable income are not included in the ED but it is proposed that it will be a mark to market calculation, similar to the market value method under the former FIF rules. It is proposed that there will be an exemption for lightly taxed entities as under the proposed CFC rules. It is also proposed that double tax relief will be provided through attribution credits, which will be interchangeable with attribution credits from CFCs. In short, the FAF rules: will apply only in relation to foreign entities that are companies or fixed trusts - that is, they will not apply to discretionary trusts, which will be dealt with solely under the transferor trust rules (given the repeal of the FIF and Sydney Perth Melbourne Brisbane Adelaide 6

7 deemed present entitlement rules). As noted above, there has been no further announcement concerning proposed changes to the transferor trust rules; and will not apply in relation to CFCs for which the taxpayer is an attributable taxpayer - thus, the dividing line between the CFC and FAF rules will be determined by the new control test discussed above. For further information please contact: Jane Trethewey Partner p jane.trethewey@jws.com.au Important Disclaimer: The material contained in this article is comment of a general nature only and is not and nor is it intended to be advice on any specific professional matter. In that the effectiveness or accuracy of any professional advice depends upon the particular circumstances of each case, neither the firm nor any individual author accepts any responsibility whatsoever for any acts or omissions resulting from reliance upon the content of any articles. Before acting on the basis of any material contained in this publication, we recommend that you consult your professional adviser. Sydney Perth Melbourne Brisbane Adelaide 7