The expanding offshore client by Cameron Blackwood, ATI, Director, and Chris Aboud, CTA, Senior Associate, Greenwoods & Herbert Smith Freehills

Transcription

1 The expanding offshore client by Cameron Blackwood, ATI, Director, and Chris Aboud, CTA, Senior Associate, Greenwoods & Herbert Smith Freehills Abstract: Australia s tax system contains complex rules for Australian entities that wish to expand offshore. The rules can be a minefield and often present difficulties for tax advisers, particularly where they involve applying Australian tax concepts in foreign jurisdictions. This article is intended to provide an overview of the different rules that can apply to Australian entities expanding offshore. While the focus of the article is on offshore investments via a corporate entity, specific issues regarding investments through non-resident trusts are also discussed. The article opens with discussion of basic concepts, including residency and types of entity. The article then discusses in detail what is involved in expanding offshore through a corporate entity, including discussion of the CFC rules. The article concludes with a briefer examination of expansion offshore through a trust. Overview Australia s tax system contains complex rules for Australian entities expanding offshore. The rules can be a minefield and often present difficulties for tax advisers, particularly where they involve applying Australian tax concepts in foreign jurisdictions. The focus of this article is to provide an overview of the different rules that can apply to Australian entities expanding offshore. While the focus of this article is on offshore investments via a corporate entity, specific issues regarding investments through non-resident trusts are also discussed. It is important to note that this article is not exhaustive and is aimed at merely highlighting relevant provisions to consider when expanding offshore. Some basics Australian residents versus non-residents An Australian resident s assessable income prima facie includes the ordinary income and statutory income from all sources, whether in or out of Australia. 1 In contrast, a non-resident is generally only subject to Australian income tax on ordinary income or statutory income derived directly or indirectly from an Australian source. 2 This is subject to numerous exceptions, exemptions and concessions. For example, an Australian resident who expands offshore: via a permanent establishment (PE) may not be subject to Australian tax on income derived via that PE 3 (PEs are not discussed in any detail in this article); via a non-resident company that does not derive any Australian sourced income may still be subject to Australian tax on an accruals basis under the controlled foreign company (CFC) provisions (see below); and via an offshore trust can be taxed on income derived by that trust via the ordinary operation of the trust taxing provisions in Div 6 of the Income Tax Assessment Act 1936 (Cth) (ITAA36) (ie where presently entitled to income of the trust), on an accruals basis under the transferor trust provisions, or on distribution under s 99B ITAA36 (see below). Types of entities As will be explained in further detail below, classifying the type of entity being used to expand offshore as either a company or a trust from an Australian tax perspective is important. However, it can often be difficult to classify an offshore entity for Australian tax purposes, as it may have no Australian equivalent and exhibit characteristics of both a company and a trust. In this regard, the Board of Taxation noted in its position paper discussing the anti-tax deferral regime that: The Board is concerned that certain kinds of interests, including interests in non-common law entities such as anstalts, foundations and stichlings, can potentially avoid the operation of the attribution regimes. Non-common law entities have no legal equivalent in Australia, having some features like a company and others like a trust. Generally, if these entities are classified as companies for Australian tax law purposes, they may avoid the operation of the attribution laws as the rules require there to be a traceable legal interest, a feature these entities often do not exhibit. (To date, no changes have been made to deal with this issue.) Some brief comments are made in Table 1 on classifying different foreign entities from an Australian tax perspective. Expanding offshore via a company Overview When expanding offshore via a company, the focus is often immediately on whether the CFC provisions apply, which determines whether income of the company is taxed to an Australian resident shareholder on an attribution basis. However, it is important not to forget to consider whether the company is either an Australian resident or whether the income has an Australian source. If the answer to either of these questions is yes, then the CFC provisions may not be relevant. In addition to residency and the CFC provisions, this section will also consider the repatriation of profits, the CGT participation exemption on disposal of the shares, and the potential application of 138 TAXATION IN AUSTRALIA SEPTEMBER 2017

2 Table 1. Classifying foreign entities Entity Company: A company is defined for Australian tax purposes as being a body corporate or any other unincorporated association or body of persons. Trust estate: There is no definition of a trust estate in the ITAA97. Limited partnership and hybrids: A limited partnership is defined as being an association of persons (other than a company) carrying on business as partners or in receipt of ordinary income or statutory income jointly, where the liability of at least one of the persons is limited. Often it will be obvious whether an entity is a company for Australian tax purposes, but sometimes it may not be obvious, depending on the jurisdiction. A critical feature of a company is that it has a separate legal identity to that of its owners and therefore may transact in its own right. For example, in ID 2008/62, the ATO determined that a Dutch Stichting was a company on the basis that it has legal personality under Netherland s law. This ATO view reflects an effective presumption that a separate legal entity will usually be characterised as a company for Australian tax purposes. In ID 2008/2, the ATO referred to Harmer: Trust is not defined in the Income Tax Assessment Act 1936 or ITAA French J in Harmer v FCT (1989) 20 ATR 1461; 89 ATC 5180 stated that a trust is notably a definition of a relationship by reference to obligations. He went on to state that the four essential elements of a trust are: 1. the trustee who holds a legal or equitable interest in the trust property 2. the trust property which must be property capable of being held on trust and which includes a chose in action 3. one or more beneficiaries other than the trustee; and 4. a personal obligation on the trustee to deal with the trust property for the benefit of the beneficiaries, which obligation is also annexed to the property. Interestingly, in contrast to the classification in ID 2008/62, the ATO took the view in ID 2008/2 that a Dutch Stichting should be categorised as a trust for Australian tax purposes as the entity had a personal obligation to deal with the trust property for the benefit of the beneficiaries. The different categorisation highlights the potential difficulties in classifying particular types of offshore entities for Australian tax purposes. A limited partnership is generally taxed as a company unless the foreign hybrid provisions apply. 5 In addition to some limited partnerships, the foreign hybrid provisions will also treat some US and UK limited liability companies as partnerships for Australian tax purposes, on either an automatic basis (where the entity would otherwise be a CFC with an attributable taxpayer) or on an elective basis. Div 7A and s 47A ITAA36. So provisions which often cause grief in a purely domestic context often get taken with you when crossing the border. Residency and source Residency There are two definitions of corporate residency that are important for present purposes (see Table 2). Source If the foreign company is not an Australian resident, it is still possible for the income derived by that company to be subject to Australian taxation outside of the CFC regime. As noted above, a non-resident s Australian assessable income includes income which has an Australian source. Such income is specifically excluded from being attributed under the CFC regime. 10 In this case, the non-resident company is subject to Australian tax rather than the Australian attributable taxpayer. The concept of attributable taxpayer is discussed below. A detailed overview of how source of income is determined is beyond the scope of this article. CFC regime Background Most nations tax residents on both their domestic and foreign income. However, tax on the foreign income of a resident taxpayer may be deferred by interposing a foreign company between the source of income and the resident. Given that the foreign company should be treated as a separate legal entity, potentially, shareholders are not taxed on company profits until distributed (by way of dividend). Accordingly, a shareholder s liability to tax on the foreign income depends on the distribution policy of the company. If the company retains rather than distributes profits, generally there is a deferral of taxation. The first country to attempt to deal with this problem was the United States. The US legislation eliminated deferral of passive income and certain sales and service income from related party transactions (ie deferral was retained in relation to active business income of a foreign company). The legislation introduced by the US to deal with deferral has become known internationally as CFC legislation. Generally, under CFC legislation, domestic controllers of foreign companies are required to pay residence country tax on their pro-rata share of the income of the foreign company. The effect of this is to advance the timing of residence country tax from the time of distribution to the time of derivation by the foreign company. TAXATION IN AUSTRALIA VOL 52(3) 139

3 Table 2. Corporate residency Definition Section 6(1) ITAA36 definition of residency: A company is a resident of Australia if it: (1) is incorporated in Australia; or (2) carries on business in Australia and either: (a) has its central management and control in Australia; or (b) its voting power is controlled by shareholders who are residents of Australia. In the current case, it is the second limb of the definition that will be relevant (ie companies not incorporated in Australia). Often, the critical question is whether the company is actually carrying on business in Australia, particularly where the foreign company is owned by Australian residents. The issue of whether a company is carrying on business in Australia, and what constitutes central management and control (CM&C) being in Australia, was recently considered by the High Court in Bywater Investments Ltd v FCT. 6 In response to Bywater, the ATO has withdrawn TR 2004/15 and released TR 2017/D2 and a decision impact statement. The obvious substantive change is that the ATO now considers that CM&C is always part of a company s business, so if CM&C is in Australia, then the company will be resident here. Previously, the ATO s position was that, depending on the business, these could be two separate things, so CM&C could be in Australia without the company carrying on business here or causing it to be a resident: The approach the Commissioner took in TR 2004/15 in relation to the earlier High Court decision in Malayan Shipping can no longer be sustained. At [57] the majority of the court clearly agreed with Williams J s rejection of the contention that where a company has its central management and control in Australia it must, to be a resident of Australia, in addition also carry on its business operations in Australia. Therefore if a company carrying on business has its central management and control in Australia it will necessarily carry on business in Australia. That is so even when the only business carried on in Australia consists of that central management and control, and trading operations are conducted outside this country. 7 (The ATO s assertion above is not without some doubt, but Bywater may fall into the basket of bad facts making bad law.) Thus, the location of CM&C will then become critical. Here, the key issue then becomes whether the CM&C is only exercised by the directors outside of Australia, and not by an outsider. As the passages below from TR 2017/D2 demonstrate, the question is who is really running the show: 14. Normally, where a company is run in accordance with its constitution and the normal company law rules, its directors will control and direct its operations. 15. The actions of those directors, or others with the legal power and authority to act on behalf of the company, are a useful starting point but not the end of any enquiry. There is no presumption that the directors exercise central management and control unless proved otherwise. 16. All relevant facts and circumstances, including the role of anyone who assumes the directors role in managing and controlling the company s affairs or has a role or any input in the decision-making processes or governance of the company, must be considered. 21. An outsider who merely influences those with legal power to control and direct a company, even if they can and do exert strong influence, is not the relevant decision maker and does not exercise central management and control of the company. However, if an outsider is more than merely influential, and actually dictates or controls the decisions made by the directors, the outsider will exercise central management and control of the company. 22. The distinction turns on what amounts to decision making for the central management and control test. In Bywater, the High Court observed that this turns on whether the people said to make the decisions of the company, actually consider whether to do what they are told, or are advised to do, and make a decision to do it because it is in the best interests of the company. If they do, they are the relevant decision maker and exercise central management and control of the company. If they do not, and merely mechanically implement or rubberstamp company decisions already made by others based on what they are told or advised to do, the person who gave the instruction is the real decision-maker and exercises central management and control of the company. 23. It is relevant to consider whether the directors would refuse to follow advice or directions of outsiders that are improper or inadvisable. If they would, it is more likely the directors are the real decision-makers. If not, it is more likely the outsider who exercises central management and control. 140 TAXATION IN AUSTRALIA SEPTEMBER 2017

4 Table 2. Corporate residency (cont) Definition Part X Australian resident 8 is defined as follows: a resident within the meaning of section 6, but does not include an entity where: (a) there is a double tax agreement in force in respect of a foreign country; and (b) that agreement contains a provision that is expressed to apply where, apart from the provision, the entity would, for the purposes of the agreement, be both a resident of Australia and a resident of the foreign country; and (c) that provision has the effect that the entity is, for the purposes of the agreement, a resident solely of the foreign country. 24. The directors knowledge of the business is also relevant. A lack of knowledge of the business sufficient to enable them to determine if following advice or instructions would be improper or inadvisable, suggests they are not the real decision makers and are more likely rubberstamping or implementing decisions already made by others. Based on the above, the existence of an outsider may not necessarily impact residency so long as directors have sufficient expertise and the ability to reject any proposal put forward by the outsider. As a result, it is imperative that the company keep proper records detailing any decision made by the directors such that the influence of directors can be established. It is noted that the ATO is expected to issue a practical compliance guideline (PCG) dealing with residency. This definition is relevant to the operation of the CFC provisions, as a Part X Australian resident will not be a CFC. 9 The application of Australia s double tax agreements (DTA) is relevant to the definition, and in particular the corporate residency tie-breaker. In short, a company will be a Part X Australian resident if both: (1) it is an Australian resident under s 6(1) (discussed above); and (2) a DTA between Australia and a foreign country does not allocate residency to that foreign country. With effect from 1 July 1990, Australia became the eighth country to introduce CFC legislation. Shortly after the introduction of the CFC regime, the transferor trust measures were introduced (discussed below). The CFC provisions are a good example of how the tax reform process can quickly change. Between 2006 and 2010, there was a push to modernise, and in some cases relax, Australia s CFC regime. This process was overtaken by the OECD s base erosion and profit shifting (BEPS) process so it is fair to say that there will be no changes to the policy framework of the CFC regime any time soon. 11 The CFC regime is complex, mostly as a result of a very prescriptive legislative style. This section will focus on the key concepts. Are you subject to the CFC regime? The three key questions that must be answered to determine whether the CFC regime apples are: (1) Is the foreign company a CFC? (2) Is there an Australian resident attributable taxpayer and what is their attribution interest? (3) What is the CFC s attributable income? If the CFC regime applies, the Australian resident attributable taxpayer will include their attribution interest of the CFC s attributable income in their assessable income. 12 Is the foreign company a CFC? Table 3 outlines the requirements that must be satisfied for an entity to be treated as a CFC for Australian income tax purposes. Attribution interest/attributable taxpayer? To be an attributable taxpayer, the Australian resident must have a 10% or greater attribution interest in the foreign company. 26 In cases where the foreign company is a CFC by virtue of the de facto control test (see above), the Australian resident need only have a 1% interest in the company if it forms part of the group that controls the CFC. 27 The attribution interest determines the percentage of the CFC s attributable income that is included in the attributable taxpayer s assessable income. The attribution interest is determined in a similar, but not identical, manner to the control percentages outlined above that determine whether the foreign company is a CFC in the first place. The most important difference is that the attribution interest is not determined on an associate-inclusive basis. 28 As a direct attribution percentage is determined by reference to the highest of the capital, rights to vote and rights to distributions, the provisions can scale back an attribution interest in scenarios where the sum of all attributable taxpayer s attribution percentage is greater than 100%. 29 Determining attributable income The attributable income of each CFC (even if a CFC is a 100% subsidiary of another CFC) must be determined separately, as there is no grouping for these purposes. Thus, a tax loss in one CFC cannot offset the taxable income in another CFC even if the attributable taxpayer is the same. The attributable income is essentially a notional Australian income tax calculation of the CFC s income, with a number of TAXATION IN AUSTRALIA VOL 52(3) 141

5 Table 3. Determining whether you are a CFC Issue What is a CFC? What are the control tests? Determining the control percentages Analysis A CFC is a foreign resident company 13 where a control test is satisfied (see below). There are two concepts of control that are relevant to the determination of whether a foreign company is a CFC strict and economic control (comprised of three tests). A foreign company is a CFC if: 14 a group of five or fewer Australian entities holds at least a 50% associate-inclusive control interest in the foreign company; a single Australian entity holds at least a 40% associate-inclusive control interest in the foreign company and a third party does not control the company (the assumed controller test); or it is controlled by a group of five or fewer Australian entities (referred to as the de facto control test). 15 The provisions governing the control percentages and tracing are complex. 16 Importantly, as the control tests operate on an associate inclusive basis, it is not just direct or indirect interests held by Australian residents that are taken into account. Thus, technically, all entities of a foreign parent can be CFCs if there is a single Australian company in the group. The key concepts for determining the control percentages are outlined below. Direct control interest in a company Your direct control interest is the largest of the percentages that you hold, or are entitled to acquire, 17 of the following: (1) total paid-up share capital in the foreign company; (2) total rights to vote, or to participate in any decision making, in relation to: (a) the distributions of capital or profits (b) the changing of constituent documents (c) the varying of share capital of the company; (3) total rights to distributions of capital or profits of the company on winding up; and (4) total rights to distributions of capital or profits of the company other than on winding up. 18 Where a company has different classes of shares, the percentages for each of the above may not be the same, hence the highest is taken. 19 Indirect control interests in a company A taxpayer may hold a direct control interest in an entity (Entity A) which holds a direct control interest in another entity (Entity B). In this case, the taxpayer has an indirect control interest in Entity B. A taxpayer s indirect control interest in Entity B is obtained by multiplying the direct control interest of the taxpayer in Entity A by the entity s direct control interest in Entity B. This process of multiplication is continued where there are further entities in the chain. What entities are traced through? Not all entities are traced through to determine indirect control interests only entities that are controlled foreign entities (or CFEs) are traced through. 20 That is, using the above example, you only trace through Entity A if Entity A is itself a CFE. In addition to a CFC, a CFE includes: Entity Controlled foreign partnership (CFP) Controlled foreign trust (CFT) A partnership with no Australian resident partners, and at least one of the partners is another CFE. The trust is not an Australian trust this means that neither the trustee is an Australian resident nor the CM&C of the trust is in Australia. 21 In addition, there must either be: (1) an eligible transferor in relation to the trust (which is based on similar tests to those in the transferor trust provisions); or (2) a group of five or fewer Australian entities holds at least a 50% associate-inclusive control interest in the foreign trust. 22 Deemed 100% ownership for purpose of indirect tracing rules For the purpose of determining whether a company is a CFC, the tracing interest will be deemed to be 100% in the following scenarios where an entity: 23 has an interest of at least 50% in a foreign company; 142 TAXATION IN AUSTRALIA SEPTEMBER 2017

6 Table 3. Determining whether you are a CFC (cont) Issue When do you determine if an entity is a CFC? Analysis satisfies the assumed control test in relation to the foreign company; satisfies the de-facto control test in relation to the foreign company; is a partner in a partnership that is not an Australian partnership; is an eligible transferor in relation to a CFT; or has an interest of at least 50% in a trust that is a CFT. Generally, it is only at 30 June that it is necessary to determine whether a foreign company is a CFC. 24 This is because a calculation of the attributable income is only necessary if the company is a CFC and there is an attributable taxpayer at that time. 25 This means that, if you are not the attributable taxpayer as at 30 June, no attribution arises (ie there is no pro rata calculation). assumptions and modifications. The key assumptions include: the CFC is a taxpayer and an Australian resident; the year of income is the CFC s statutory accounting period ; 30 the Income Tax Assessment Act 1997 (Cth) (ITAA97) is modified in accordance with the CFC provisions; and additional assumptions are made depending on whether the CFC is a resident of a listed country or an unlisted country. 31 As the Australian income tax calculation is notional, the terminology used is to notional assessable income, notional allowable deductions and notional exempt income. Consistent with the intent of the provisions, it is only meant to be bad income (referred to as adjusted tainted income) that is subject to attribution. The process of determining attributable income can be diagrammatically represented (see Diagram 1). Listed countries. For listed countries, the only types of income that are generally subject to attribution are the income types set out in Table 4 (referred to as eligible designated concession income, or EDCI). 32 Income derived by the CFC or a partnership is only subject to tax if the income is EDCI. However, income derived by the CFC via a trust can give rise to attribution even if it is not EDCI in circumstances where that income is not subject to tax. 33 It is also possible for a listed country CFC s notional assessable income to include income determined under the transferor trust provisions. Diagram 1. Determining attributable income Is the CFC listed or unlisted? LISTED UNLISTED Bad income (EDCI)?* Pass active income test (5%)?* YES NO YES NO Bad income (passive/tainted sales/tainted services) YES NO Possible attribution No attribution No attribution Possible attribution No attribution *Trust income always attributed. Active income/tainted/edci rules apply to a partnership TAXATION IN AUSTRALIA VOL 52(3) 143

7 Table 4. Examples of EDCI Country US UK Canada New Zealand France Germany Japan What can give rise to EDCI? Tax-exempt government bonds or regulated investment companies. Companies with underlying Australian assets or income subject to the tonnage tax. International banking centres or mutual funds. Capital gains in respect of tainted assets. A company that operates as a SICAV or income subject to the tonnage tax. Passive income derived via a PE of the CFC outside of Germany, capital gains from sale of shares in a company or income subject to the tonnage tax. Income derived via Japanese government bonds. The discussion on the active income test and key modifications to the ITAA97 are discussed below in the context of unlisted countries. Finally, simply having a listed country CFC as a holding company is not a general get out of jail card preventing attribution arising for any unlisted county CFC subsidiaries. Rather, attribution is only prevented for income that has itself been subject to attribution under that listed country s CFC regime. 34 Unlisted country. All other countries that are not listed countries are unlisted countries. The key types of bad income, and an overview of the active income test, are outlined in Table 5. Table 5. Categorisation of income for CFC purposes Concept Active income test The active income test allows a CFC s income to include up to 5% of bad income without being subject to attribution. Thus, a CFC carrying on what is otherwise an active business can derive some bad income (such as interest income). Key requirements In order to be able to access the active income test, the CFC must: keep accounts that are prepared in accordance with commercially accepted principles and give a true and fair view of the financial position of the company; comply with the CFC substantiation requirement; and at all times, must carry on business in its country of residence through a PE in that country. 35 5% tainted income ratio The ratio is determined as follows: gross tainted turnover gross turnover Passive income Gross turnover is the gross revenue from the CFC s accounts, with the following modifications: 36 certain asset disposals are included on a net, rather than gross, basis; transfer pricing adjustments and amounts arising from CGT event J1 (claw-backs associated with transfer of CGT assets within a corporate group) are included; and income taxed in Australia, certain income derived via a listed country PE, trust income, franked distributions and non-portfolio dividends (among others) are excluded. If the accounts are prepared in a foreign currency, there is no need to convert the amounts to Australian dollars. 37 Gross tainted turnover consists of passive income, tainted sales income and tainted services income that is included in the gross turnover. These are the categories of bad income that can give rise to attributable income. Additional rules apply for income derived via partnerships and foreign currency gains and losses, which are not considered further. Passive income consists of the following: dividends (within the meaning of s 6 and s 47 ITAA36); interest; annuities; tainted rental income including rental income from the lease of land, ship or aircraft (subject to certain exceptions); tainted royalty income which constitutes all royalty income derived by the CFC excluding royalties that are: (1) derived in the course of a business carried on by the company; (2) not derived from an associate; and (3) arise from IP that has been generated/developed by the CFC; 144 TAXATION IN AUSTRALIA SEPTEMBER 2017

8 Table 5. Categorisation of income for CFC purposes (cont) Concept Tainted sales income 38 Tainted services income 39 Notional Australian tax calculation an amount derived as consideration for the assignment of any copyright, patent, design, trade mark or other like property or rights; income derived from trading in, or from the disposal of, tainted assets (discussed below); tainted commodity gains; and tainted currency exchange gains (which should not include gains related to an active income transaction ). A tainted asset is defined as meaning: financial assets (loans/debentures/shares/trust/partnership/futures contract/forwards/interest rate and currency swaps/forward exchange and interest rate swaps/any similar financial instrument); assets used for tainted rent; or any asset other than trading stock or an asset used solely in carrying on a business. Tainted sales income of a CFC includes that part of gross turnover that represents sales income where the goods sold were purchased from or sold to: an associate who is a Part X Australian resident; or an associate who is not a Part X Australian resident but carried on business in Australia through a PE. Thus, a key requirement is that the Australian resident/pe who is buying or selling goods must be an associate of the CFC. An exclusion can apply if employees/directors of the CFC manufacture, extract, produce or substantially alter the relevant goods. Tainted services income, in broad terms, means income derived from the provision of services by a company to: a resident (except in connection with a foreign PE of the Australian resident); or a non-resident in connection with the non-resident s Australian PE. In contrast to the tainted sales income requirements, there is no requirement for the Australian resident/pe to be an associate of the CFC. An exclusion can apply where the services relate to goods sold by the CFC. Regard should be had to the indirect services rule in s 448(1A) ITAA36, which is intended to capture structures that interpose a foreign company between Australian resident customers and the CFC providing the service. The relevant extrinsic material explained the rationale of the provision as follows: 40 The indirect service rule is intended to prevent a non-resident entity or entities being interposed between a company providing services and its customers in Australia. The interposed entity or entities may be pre-existing or newly created, and include an overseas PE of an Australian resident. Without this rule, the company actually generating the services would not have tainted services income, as it provides the services to a non-resident or overseas PE of an Australian resident. The interposed entity itself could have tainted services income in respect of the services it contracts to provide to Australian customers. However, as it would be allowed a deduction for the services it purchased, it would have little net income to be taxed. The ATO is currently allocating compliance resources to offshore procurement hubs that receive services from a related offshore entity in the circumstances outlined in TA 2015/5. Where an unlisted country fails the active income test, the income that can give rise to attributable income is the bad income (ie passive income, tainted sales and tainted services) outlined above. 41 The modified ITAA97 is then applied to determine the attributable income. Australian residency assumption As outlined above, the CFC is assumed to be an Australian resident. This means that provisions of the ITAA97 that are only enlivened for an Australian resident can be applied by the CFC. A common example is the application of the CGT participation exemption in Subdiv 768-G ITAA97 (discussed below). To engage the operative provision in s ITAA97, the company must be an Australian resident. The CFC Australian residency assumption allows the CFC to access this CGT exemption. This is important, as the sale of shares by a CFC will constitute the disposal of a tainted asset (see above), and will therefore give rise to attributable income, subject to the other CGT participation exemption requirements being satisfied. Another common example is the dividend participation exemption in Subdiv 768-A ITAA97 (also discussed below). Combined with s 404 ITAA36, a dividend that is otherwise assessable passive income may be eligible for the dividend participation exemption (and therefore not be subject to attribution). Disregarded provisions A number of provisions are disregarded in undertaking the notional income calculation, including DTAs, s 23AH ITAA36 (although s 403 ITAA36 exempts income derived by a unlisted country CFC via a listed PE), the taxation of financial arrangements (TOFA) provisions in Div 230 ITAA97, the thin capitalisation provisions, and Div 974 ITAA97 and associated provisions (but switched back on for the purposes of the dividend participation exemption only). cont TAXATION IN AUSTRALIA VOL 52(3) 145

9 Table 5. Categorisation of income for CFC purposes (cont) Concept Modified provisions A number of modifications are then made to the ITAA97, including: taxes paid by the CFC are a notional allowable deduction 42 (but a foreign income tax offset (FITO) may arise for an Australian corporate attributable taxpayer); the transfer pricing provisions are switched off for dealings between CFCs of the same listed country only; 43 a number of modifications are made to the CGT provisions, including: giving a market value basis for CGT assets held by a foreign company at the time it first becomes a CFC with an attributable taxpayer; 44 and modifying the circumstances where the inter-corporate group CGT roll-over in Subdiv 126-B ITAA97 is available; 45 a number of modifications are made to the company loss rules thankfully, the complex loss provisions in Subdivs 165-CC and 165-CD ITAA97 are disregarded; and the commercial debt forgiveness provisions do not apply. 46 Other issues There are various provisions within the law to ensure that double taxation of attributable income does not arise. These provisions are considered in Table 6. Distributions by the CFC Distributions by the CFC as a dividend will prima facie be assessable income for the Australian resident attributable taxpayer unless an exemption applies (see Table 7). Sale of interests in the CFC A number of exemptions can apply to reduce or disregard a gain realised on disposal of interests in a CFC. These are outlined in Table 8. Table 6. Rules to prevent double taxation Issue Preventing double taxation when previously attributed CFC income FITOs Functional currency provisions Change in residence of a CFC Given the CFC rules can attribute income on an accruals basis, rules are necessary to ensure that double taxation is avoided when either previously attributed income is distributed as a dividend (see s 23AI ITAA36) or the attributable taxpayer sells their interest in the CFC and the attributed income has not been distributed (see s 461 ITAA36 which reduces the disposal proceeds). In some cases, where an assessable dividend is paid prior to CFC attribution arising, s 387 ITAA36 reduces the otherwise attributable income by the dividend. 47 All of this is managed by quite prescriptive, and complicated, provisions governing attribution accounts, attribution credits and attribution debits. 48 An Australian attributable taxpayer that is a company with an attribution percentage of at least 10% may be entitled to a FITO for any tax paid by the CFC for which a deduction was claimed under s 393 ITAA A FITO for dividend withholding tax should also be available when it arises in respect of a dividend that is exempt under s 23AI (whether received by a company or not). This is on the basis that the foreign tax really arises in respect of an amount that has been included in the attributable taxpayer s assessable income. 50 However, no FITO is available if the dividend is exempt under the dividend participation exemption in Subdiv 768-A (discussed below which is only relevant for Australian corporate attributable taxpayers). Thus, while the dividend may be exempt for the Australian company, it is not entitled to a FITO for any foreign dividend withholding tax. Despite the dividend being exempt, the inability to get a FITO for the foreign dividend withholding tax may result in the overall effective tax rate being higher for the Australian group. An attributable taxpayer is able to make a functional currency election in respect of each CFC by reference to the pre-dominant currency by which the CFC keeps its accounts. A functional currency choice can allow the CFC s attributable income to be determined using the functional currency rather than Australian currency. The two-step translation rule in s ITAA97 will apply to the relevant CFC. A change in residence of a CFC from an unlisted country to either a listed country or to Australia can cause attributable income to arise under s 457 ITAA36. This provision has a number of technical challenges. 146 TAXATION IN AUSTRALIA SEPTEMBER 2017

10 Table 7. Dividend exemptions Exemption Previously attributed income Attributable taxpayer is a company As noted above, complicated provisions operate to ensure double taxation is avoided. Section 23AI (in broad terms) is designed to operate to ensure that dividends paid in respect of previously attributed income is exempt, thereby avoiding double taxation. It operates by reference to an attributable taxpayer s attribution account and is quite prescriptive: 51 (1) an attribution credit arises where a taxpayer is taxed on a CFC s attributable income under the CFC provisions, and the credit is equal to the amount assessed (s 371 ITAA36). Importantly, the credit only arises at the end of the accounting period; (2) an attribution debit arises when the CFC makes a dividend payment to the attributable taxpayer (s 372 ITAA36, definition of attribution account payment in s 365 ITAA36). The debit is equal to the lesser of the attribution surplus or the attribution account payment; (3) the dividend is exempt to the extent a debit arises in the attribution account (s 23AI). Attribution credits cannot be pooled by a taxpayer, ie attribution credits referable to CFC A cannot be used to exempt a dividend paid by CFC B. Where a dividend is paid to a non-corporate attributable taxpayer before the end of the CFC s substituted accounting period, s 387 may apply to provide that no attributable income arises. Rather, the dividend is assessable this is explained in TD 2003/27 (and is a result of the very prescriptive nature of these rules). The attributable taxpayer may be entitled to the dividend participation exemption in Subdiv 768-A to treat the dividend as non-assessable non-exempt (NANE). TD 2006/51 provides that former s 23AJ ITAA36 (the predecessor to Subdiv 768-A) does not apply to the extent the dividend is exempt under s 23AI. This ensures that attribution credits are utilised appropriately. Note: The dividend exemption should now be available where the dividend is derived via a trust or a partnership. Thus, an Australian corporate beneficiary of a discretionary trust may be entitled to the exemption for dividends received via that trust. 52 Table 8. Exemptions on sale of a CFC interest Exemption Previously attributed income Disposal by an Australian company attributable taxpayer Where attributable income has arisen for a CFC and it has not been distributed to the attributable taxpayer, then the disposal proceeds from a sale of interests in the CFC can be reduced. 53 An Australian resident attributable taxpayer that has held a 10% stake in the CFC for at least 12 months may be able to reduce any capital gain (or loss) by the active foreign business asset percentage (AFBAP). This is known as the CGT participation exemption. The AFBAP is determined using either a book value or market value method by reference to the assets of the foreign company. The test for what is an active asset or a passive asset is determined under s ITAA97 (and is similar to the delineation used in the CFC rules). However, assets that give rise to bad CFC income (such as contracts that underpin tainted sales or tainted services income) will not necessarily be a passive asset for these purposes. Also, the 10% stake test is no longer aligned with that used for the dividend participation exemption following the repeal of s 23AJ and the enactment of Subdiv 768-A. For example, an interposed partnership or trust will result in the CGT participation exemption being lost. 54 There is no policy rationale for this difference. 55 Loans and deemed dividends Section 47A. An often forgotten, and very complex, integrity rule that can apply in respect of a CFC is the extremely opaque s 47A. Section 47A is similar in operation to Div 7A, but contains a number of important differences. The intent of s 47A is explained by the Commissioner in TR 2002/2 as follows: 10. The intent of section 47A is to prevent the avoidance of the accruals regime (and tax) by the shifting of profits from unlisted countries to Australia or to listed countries as disguised dividends ( eligible benefits ). The transfer may be made direct to the taxpayer or indirectly to the taxpayer or an associated entity through an arranger. 11. The types of transactions that are intended to be caught by the legislation are covered by specific subsections within section 47A. Subsection 47A(7) deals with loans. 12. Where section 47A applies, the relevant amount is, subject to conditions, deemed to be a dividend. However, the deemed dividend cannot exceed the amount of profits held by the relevant CFC in an unlisted country. The deemed dividend is treated as a dividend for all purposes of the ITAA The key issues under s 47A are discussed in Table 9. Interaction between Div 7A, s 47A and the CFC provisions. The interaction TAXATION IN AUSTRALIA VOL 52(3) 147

11 Table 9. Key issues under s 47A Issue What happens when s 47A applies? Who must receive the distribution benefit? Who must provide the distribution benefit? What types of transactions are caught? When s 47A applies, the recipient of the distribution benefit is deemed to have received a dividend for the purposes of the ITAA97 out of profits as a shareholder in the CFC. If a taxpayer does not prepare their tax return and notify the Commissioner that s 47A applies, then the taxpayer will lose access to both the FITO provisions in Div 770 ITAA97 and the ability to reduce the deemed dividend to nil under s 23AI for any previously attributed income. 56 A s 47A dividend that otherwise satisfies the dividend participation exemption in Subdiv 768-A should be NANE. Care should be taken in this regard, because in determining eligibility for the dividend participation exemption for a particular dividend, the 10% participation interest does not include indirect interests held via other companies. 57 Thus, if a corporate taxpayer is deemed under s 47A to have derived a dividend in a CFC in which it does not have a direct interest in, it may not be entitled to the exemption. The distribution benefit must be received by an associated entity of the CFC, which will be either the shareholder in the CFC or an associate of the shareholder. Importantly, where the associated entity is itself a CFC, the s 47A dividend is never included in a CFC s notional assessable income. 58 Thus, s 47A should generally only be relevant for an Australian resident. The distribution benefit must be provided by either an unlisted country CFC, or an arranger where the unlisted country CFC has transferred property or services to the arranger in order to provide the distribution benefit to the recipient. The relevant types of transactions that are caught are summarised below. 59 We further consider the loan transaction, as it contains a number of contrasts to the application of Div 7A to a loan: Type of benefit When does deemed dividend arise? Amount of deemed dividend Waiver of a debt by the CFC owed by another When debt waived Amount waived entity 60 Non-arm s length loan granted by CFC 61 Loan (whether arm s length or not) granted by CFC to facilitate payment of dividend that is NANE under s ITAA97 62 Loan granted by CFC to facilitate granting of other types of distribution benefits 63 When loan made Amount of loan Transfer of property or services by the CFC for nil consideration or for consideration that is less than market value. 64 CFC subscribes for shares in a company or units in a trust (and rights/options) (the CFC company/ trust) if the shareholder or associate of the shareholder of the CFC holds, or later acquires, a direct equity interest in the CFC company/trust 65 When property or services transferred When subscription occurs The difference between the market value of the property or services, and the amount of the consideration Subscription amount When is a loan non-arm s length? How are profits determined? Section 47A operates if the parties to the loan are not at arm s length with each other in relation to the loan. 66 The ATO concluded in TR 2002/2 that s 47A(7) should be interpreted as relating to the nature of the dealing, rather than the relationship, between the parties to the loan. However, the ATO goes on to conclude that even if the interest rate is arm s length, s 47A may still apply: Even if the interest rate applicable to the loan is an arm s length interest rate, it is still necessary to determine whether independent parties would have entered into the loan at all. (And, as the recent Chevron 67 litigation has demonstrated, pricing related party debt is not straightforward.) Further, as is evident from the provision and made clear by the ATO, s 47A applies to deem the amount of the loan (and not the interest rate differential) as being a dividend. A deemed dividend only arises to the extent the unlisted country CFC has profits. This is generally determined immediately before the deemed dividend arises. 68 However, this is modified depending on the manner in which the deemed dividend arises. For example, where a deemed dividend arises from the transfer of property or services, the profit will assume that the property or services were transferred for market value TAXATION IN AUSTRALIA SEPTEMBER 2017

12 between Div 7A and s 47A has been raised in consultation, and flagged by the Board of Taxation, as an area regarding clarification unfortunately, no changes have been made. A basic understanding of Div 7A has been assumed. The key issues are discussed in Table 10. So what does this mean? Watch out for non-arm s length transactions involving the CFC and an Australian resident. Particularly as some of the safeguards that are available under Div 7A are not present in s 47A. Expanding offshore via a trust The authors have kept this section brief, as the taxation of trusts and the application of the transferor trust rules have been covered in numerous other articles. Taxation of non-resident trust estate beneficiaries under Div 6 In broad terms, Div 6 will assess a resident beneficiary on: a share of the net income for tax purposes whenever they are presently entitled to a share of the trust income and are not under a legal disability; and amounts distributed to them or applied for their benefit which represents, in broad terms, previously untaxed income (see s 99B discussion below). While Div 6 has a concept of a resident trust estate and a non-resident trust estate, it is clear that an Australian resident beneficiary can be taxed under Div 6 for both. Transferor trusts The transferor trust rules are complex. The object of the Division is to attack trusts (both discretionary and non-discretionary) in low-tax jurisdictions that accumulate income free of Australian tax until the amounts were brought back into Australia. In broad terms, the transferor trust rules can be triggered where an Australian resident transfers property or services to: a non-resident discretionary trust estate; or a non-resident trust estate that is a non-discretionary trust for either no consideration or for less than arm s length consideration. For the purposes of this article, the authors have not discussed the features of a discretionary trust estate and non-discretionary trust estate. Table 10. Interaction of Div 7A, s 47A and the CFC provisions Issue Can a Div 7A deemed dividend be included in a CFC s notional assessable income? Can Div 7A apply to a foreign company? Interaction between s 47A and Div 7A Differences between Div 7A and s 47A There is no express carve-out from the CFC provisions from Div 7A. However, as discussed above, the ATO has ruled that a CFC s notional assessable income does not include a dividend that is deemed to arise under s 47A. The rationale for this is that the CFC provisions only provided that a dividend within the meaning of s 6 or a distribution deemed to be a dividend under s 47 is bad income that is subject to CFC attribution. The same rationale should equally apply to the extent a CFC was capable of being taken to have been deemed to have received a dividend under Div 7A. Similar to s 47A, the relevant provision (s 109Z) doesn t deem the dividend to be a dividend as defined in s 6. Thus, a Div 7A dividend (to the extent one is capable of arising) should not be included in a CFC s notional assessable income. Section 109BC ITAA36 was introduced to clarify that Div 7A can apply to a payment, loan or debt forgiveness where the private company involved in the arrangement is a foreign resident and the shareholder (or their associate) is an Australian resident. 70 However, s 109BC has not put the matter beyond doubt, but has rather caused more confusion. One of the aims of s 109BC is to ensure that references to lodgment day for the income year (an Australian tax concept) works appropriately for foreign companies. It seeks to do this by referencing the lodgment date of the foreign company s tax accounting period, which in turn is defined in the CFC rules (s 317 ITAA36) as follows: in relation to an entity, in relation to a foreign tax imposed by a tax law of a listed country, means the accounting period used by the entity for the purposes of determining the tax base under that law. (emphasis added) That is, the definition only refers to listed (and not unlisted) countries. This issue has been noted by the Board of Taxation, but it has not as yet been resolved. 71 The underlying assumption appears to be that s 47A is aimed at companies that are resident in unlisted countries, and that s 47A is relevant for non-resident companies that are not subject to the CFC regime. 72 In considering the potential interaction between s 47A and Div 7A, the provisions could apply to treat the same transaction (such as a loan) as an assessable dividend. To resolve any potential double taxation, s 109L ITAA36 in Div 7A provides that a deemed dividend does not a rise under Div 7A to the extent that the dividend is assessable under another provision of the ITAA97. But does s 47A not apply if the amount would otherwise be a dividend (such as under Div 7A)? Given the amendment to Div 7A to attempt to make it apply to foreign companies, it would appear that that s 47A is redundant and can be repealed so much so was acknowledged by Treasury when s 109BC was enacted. But, again, this has not occurred. There are some fundamental differences to Div 7A, notably: there is no apparent equivalent to s 109N ITAA36, which exempts Div 7A complying loans. Such loans, if not on arm s length terms, will automatically be caught by s 47A; under s 109G(3) ITAA36, the forgiveness of a debt does not give rise to a dividend if the making of the loan (that gave rise to a debt that is forgiven) was a dividend already under Div 7A. Again, there is no equivalent exception for a debt that is forgiven where the making of the loan gave rise to a dividend under s 47A. This may result in double taxation; and s 47A does not contain a discretion for the Commissioner to disregard the application of the provision, unlike Div 7A which provides the Commissioner to disregard deemed dividends in certain circumstances. TAXATION IN AUSTRALIA VOL 52(3) 149