ASSISTING YOUR SME CLIENTS EXPAND OVERSEAS - WHAT YOU MUST BE AWARE OF Assisting your SME Clients Expand Overseas What you must be aware of

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1 National Division 25 November 2010 Swissotel, Sydney ASSISTING YOUR SME CLIENTS EXPAND OVERSEAS - WHAT YOU MUST BE AWARE OF Assisting your SME Clients Expand Overseas What you must be aware of Written by: Taxation Institute of Australia 2010 Disclaimer: The material and opinions in this paper are those of the author and not those of the Taxation Institute of Australia. The Taxation Institute of Australia did not review the contents of this paper and does not have any view as to its accuracy. The material and opinions in the paper should not be used or treated as professional advice and readers should rely on their own enquiries in making any decisions concerning their own interests.

2 CONTENTS 1 KEY DRIVERS IN OFFSHORE EXPANSION INTRODUCTION TOPIC 1 CORPORATE RESIDENCY Why is residence important? Residence test for companies Voting power TOPIC 2 SOURCE OF COMPANY INCOME Why is source important? How is source determined? Statutory source rules Common law source rules TOPIC 3 ENTITY CHOICES Using Australian companies to expand overseas General Exemption 1: Non-portfolio dividends; s.23aj ITAA Exemption 2: Branch profits; s.23ah ITAA Exemption 3: CGT participation exemption; Div 768 ITAA Meaning of total assets and active asset Other types of entities available for expanding overseas Permanent Establishment/Branch Partnerships and Trusts Fiscally transparent entities TOPIC 4 - FOREIGN INCOME TAX OFFSET ( FITO ) General Conditions for the availability of foreign income tax offsets Foreign income tax Payment of foreign tax Assessable income Exemptions Taxation Institute of Australia 2

3 6.7 Treatment of capital gains Calculation of foreign tax offset Steps in calculating foreign tax offset entitlement Transitional rules TOPIC 5A - THIN CAPITALISATION: General When does Div 820 apply? De-minimis exceptions Application of Div 820 to foreign income Key terms Classifying an entity Outward investing entities ADJUSTED AVERAGE DEBT MAXIMUM ALLOWABLE DEBT Inward investing entities MAXIMUM ALLOWABLE DEBT Safe harbour debt amount Arm s length debt amount Worldwide gearing amount Valuation issues Calculating debt deductions denied TOPIC 5B - TRANSFER PRICING Overview Methods for Determining Arm s Length Consideration Acceptable methodologies Traditional methodologies Contemporaneous Documentation Practical action points to limit transfer pricing risks TOPIC 5C - ATTRIBUTION SYSTEMS (CFCS, TRANSFEROR TRUSTS AND FIFS) Repealed and Rewritten Rules Taxation Institute of Australia 3

4 General Controlled foreign company (CFC) rules Foreign investment fund (FIF) rules Transferor trust measures s99b Proposed Changes Active Business Income Exemption De minimis passive income test Lightly taxed entities Tainted royalties Removal of double taxation Subtractive approach Foreign Accumulation Fund ( FAF ) Rules TOPIC 6 THE IMPACT OF DOUBLE TAX AGREEMENTS (DTAS) How does international double taxation arise? Steps in working with a DTA Contents of a DTA Division of taxing rights Business profits Income from real property TOPIC 7 STAFFING THE OFFSHORE BUSINESS Consider residency of the employee Consider source of income Consider impact of DTA CASE DISCUSSION Taxation Institute of Australia 4

5 1 KEY DRIVERS IN OFFSHORE EXPANSION 1. Getting residency right for domestic and DTA purposes 2. Understanding where income is sourced 3. Structure to fully utilise Foreign Income Tax Offsets in the current year 4. Using exemption provisions efficiently Foreign dividend income Foreign branch income CGT participation exemption 5. Avoiding the three big offshore traps Thin capitalisation stay under $250,000 cap or comply with safe harbour debt test Transfer pricing test pricing and fully document the prices charged highlighting in particular why the price charged is the most appropriate Attribution rules use active income exemption effectively 6. Use Double Tax Agreements efficiently so as to minimise withholding rates and avoid a Permanent Establishment in the source jurisdiction if at all possible 7. Don t get too clever and trigger the application of Part IVA (the general anti-avoidance provision) 2 INTRODUCTION Advising clients in respect of offshore expansion requires some knowledge of the basics of Australian International Tax. If you are not an expert but nonetheless wish to provide some guidance to clients in respect of the possibilities for structuring and financing offshore investments, it is critical that you have a clear understanding of some background fundamental issues and some understanding of the answers to some practical questions which clients are likely to ask you. In these materials we deal with the fundamental International Tax building blocks. In doing so we attempt to answer some of the practical questions clients are likely to ask. We will then separately deal with a sample case study and a case study for review during the session. Dealing first with the fundamental building blocks it seems that there are series of issues which need to be addressed as follows; - 1. How is corporate residency determined under Australian tax law? 2. How is the source of company income determined under Australian tax law? 3. What exemptions are available to Australian companies in respect of their offshore income.? a. How is double tax avoided through the use of Foreign Income Tax Offsets (previously known as Foreign Tax Credits)? b. What is thin capitalisation and why is it important for offshore expansion? c. What is transfer pricing and how does it effect offshore operations? d. What are the attribution rules and how do they impact on offshore expansion? Taxation Institute of Australia 5

6 e. What is the relevance and impact of Double Tax Agreements? f. How should the foreign operations be staffed? We will now consider each of these matters separately. 3 TOPIC 1 CORPORATE RESIDENCY 3.1 Why is residence important? In s 6-5(2) of ITAA 1997, the assessable income of an Australian resident includes ordinary income derived from all sources. Similarly, s 6-10(4) states that the assessable income of an Australian resident includes statutory income from all sources. With respect to a foreign resident, s 6-5(3)(a) includes in assessable income ordinary income from Australian sources. Similarly, s 6-10(5)(a) includes statutory income from Australian sources in the assessable income of a foreign resident. Ordinary income, as well as statutory income that is included in assessable income on some basis other than having an Australian source, are both also assessable to a foreign resident by virtue of s 6-5(3)(b) and s 6-10(5)(b) respectively. A foreign resident is defined in s of ITAA 1997 to be a person that is not a resident of Australia for the purposes of ITAA A non-resident is defined in s 6(1) of ITAA 1936 as a person who is not a resident of Australia. Therefore, residency is one of the means by which Australia exerts its authority to tax. 3.2 Residence test for companies A resident company is defined in s 6(1) of ITAA 1936 as a company (as understood in Australian tax law) that is either: incorporated in Australia, or while not incorporated in Australia - carries on business in Australia, and - has its central management and control in Australia, or while not incorporated in Australia, - carries on business in Australia, and - has its voting power controlled by shareholders who are residents of Australia. Whether or not a company is incorporated in Australia is a formalistic test which may be easily determined. However, the term central management and control is not defined in the legislation and case law may assist in our understanding of the meaning of that term. Carrying on business, and central management and control Whether or not a company carries on business in Australia is a question of fact. Malayan Shipping Co Ltd v FCT (1946) 71 CLR 156 is often quoted as authority for the broad proposition that the place where central management and control is will also be the place where the company carries on business. However, in Taxation Ruling 2004/15 the ATO states clearly that in determining where a business is carried on is a separate matter to determining where a company s central management and control is situated. The Commissioner stated that depending on the characteristics of the business, the place of both may be the same, as in the case of Malayan Shipping. TR 2004/15 distinguishes operational businesses (such as trading and manufacturing, which will be carried on where the operations are Taxation Institute of Australia 6

7 situated) from passive businesses (such as investment in assets, which will be carried on where the decisions regarding the investment are made). The superior or directing authority determines where a company s central management and control is situated, rather than the day-to-day running or operation of the business: De Beers Consolidated Mines Ltd v Howe (1906) AC 455. The place where the directors meet and do the business of the company will be the place of central management and control: Koitaki Para Rubber Estates v FCT (1942) 6 ATD 42. The residency of the directors is also important, as this indicates where the company s central management and control is potentially being conducted outside board of director meetings. Finally, the place where the actual business decisions are made plays a part in the determination. This is despite the fact that the directors who make those decisions may be influenced by advice or suggestions that they receive: Esquire Nominees Ltd v FCT 72 ATC Voting power If, in addition to carrying on a business in Australia, a company has its voting power controlled by shareholders who are themselves Australian residents, the company will be a resident of Australia. Shareholders in this regard are persons who appear, or are entitled to appear, on the company s register of members (refer Patcorp Investments Ltd & Ors v FCT 76 ATC 4225). It is generally assumed that control of voting power requires more than 50 per cent of the voting power of a company. Practice Pointer When dealing with corporate residency, make sure you do not incorporate a company in the US and have the company, managed and controlled and carrying on business in Australia. Such a company would be a resident of the US and a resident of Australia under the respective tax laws of each country. On that basis, it is a dual resident company and, quite uniquely, there is no tie-breaker mechanism for such companies in the Australia / US DTA. In these circumstances the DTA with all its benefits (eg reduced withholding tax rates) will not apply to such a company. 4 TOPIC 2 SOURCE OF COMPANY INCOME 4.1 Why is source important? Broadly speaking, a non-resident of Australia is only subject to tax on Australian-sourced income. For a non-resident taxpayer, the source of income will therefore generally determine whether Australia exerts taxing authority. While a resident of Australia is subject to tax on income regardless of source, there are various exemptions and tax offsets that may be available for income that is foreign-sourced. Both exemptions and foreign tax offsets are discussed later in this paper. Accordingly, determining the source of income for a resident taxpayer is important for the operation of various specific provisions. 4.2 How is source determined? The terms source, Australian source and foreign source are not defined in legislation, and Australian income-tax law contains very few statutory source rules. As such, the source of income is generally determined under common law Statutory source rules Statutory source rules include: royalties for withholding tax purposes royalties that are paid by an Australian resident to a nonresident are deemed to be Australian-sourced under s 6C of ITAA 1936 Taxation Institute of Australia 7

8 interest on loans secured by a mortgage over real property is deemed to be Australian sourced by s 25(2) unless the interest is on debentures issued outside Australia by a company or an eligible unit trust dividends s 44(1)(b) of ITAA 1936 effectively provides a source rule by assessing non-resident shareholders on dividends paid out of company profits to the extent the dividend is paid from profits derived from sources in Australia. It does not matter whether the company paying the dividend is a resident or non-resident of Australia CGT with respect to non-resident taxpayers, CGT does not apply unless the CGT asset is taxable Australian real property as defined in Div 855 of ITAA 1997 for CGT events occurring on or after 12 December Resident taxpayers are subject to CGT on assets no matter where they are situated. Technically this is not a source rule but it serves broadly speaking the same purpose Common law source rules Often quoted but not terribly helpful is Nathan v FCT (1918) 25 CLR 183, where it was stated that the source of income is something which a practical man would regard as a real source of income. However, the body of case law suggests that determining the source of an item of income depends on the particular character of the item of income. Income that comprises remuneration for services rendered is generally sourced where those services are performed (FCT v French (1957) 98 CLR 398). However, in FCT v Mitchum (1965) 113 CLR 401, it was stated that there was no rule of law to say this was always the case. There are circumstances in which the location of entering into a contract may be more important in determining source. In Mitchum s case, although the services were performed in Australia, the contract for services was made outside Australia and the income was determined to be sourced outside Australia. This emphasises the point that was made in Nathan s case that source is not a legal concept but instead it is a practical hard matter of fact. The source of interest income, not determined by statutory rules, can be determined by reference to the place where the contract for the loan is made, the place where the money is lent, the place where the principal and interest are paid, and the place where the borrower carries on business. In Spotless Ltd v FCT (1993) 25 ATR 344, it was found that the place where the contract was made and the place where the money was lent were determinative in giving the interest income a source outside Australia. Example A Flamboyant Co is a company incorporated in the United Kingdom but carries on business in Australia and various other parts of South East Asia. It regularly has its board of directors meetings in Australia to discuss management issues primarily in relation to the South East Asian activities. There are rarely meetings held anywhere outside Australia. It derives income from sources in Australia from business activity carried on here but also derives other South East Asian sourced income through business activity carried on in other areas. 1. Assess the corporate residency status of Flamboyant. 2. Comment on the source of income from business activities and why this might matter. 3. Once you have considered Topic 6 of the Paper, determine what impact, if any, the UK/ Australia Double Tax Agreement might have. Practice Pointers Source is a practical hard matter of fact. In Spotless certain steps were taken to ensure that the interest income was sourced outside Australia. These should include, for example, ensuring that the contract of loan is drafted in a foreign jurisdiction, that the contract is governed by the law of a foreign Taxation Institute of Australia 8

9 jurisdiction and payments, at all times, are made in the currency of a foreign jurisdiction and actual payment is made in the foreign jurisdiction. In relation to personal services income, French s case suggests that the place where the services are performed is the fundamental matter that determines source of income. However, Mitchum s case suggests that the place of contracting to provide the service may be more crucial in some circumstances. This may be where the actual place of performance is relatively unimportant and the contract is entered into by a third party such as a company owned by the principal performer of the duties in question. 5 TOPIC 3 ENTITY CHOICES 5.1 Using Australian companies to expand overseas General Australia s system of exemptions generally removes certain foreign income derived by Australian residents from the burden of Australian tax. Exemption in this way results in the same effective tax rate being levied in the source country, regardless of the taxpayer s residence. Australia generally exempts active income as opposed to income from passive investments, which will usually remain subject to Australian tax. There are a number of exemptions that may be available to Australian resident companies in relation to foreign income. The most significant of these are the exemption for dividends and branch profits resulting from overseas operations, and the more recently introduced participation exemption for capital gains on the sale of shares in foreign companies. These benefits must be weighed against the potentially high income tax rates that companies may be subject to in foreign jurisdictions Exemption 1: Non-portfolio dividends; s.23aj ITAA 1936 Generally speaking, a non-portfolio dividend that is paid by a non-resident company to an Australian resident company is non assessable income non exempt income by virtue of s 23AJ. However, s 23AJ does not apply when the Australian resident company owns the shares giving rise to the dividend income as trustee. A non-portfolio dividend is defined in s 317 as a dividend (other than an eligible finance share dividend or a widely distributed finance share dividend) paid to a company when that company has an interest of at least 10 per cent of the voting power in the company paying the dividend. Voting power for these purposes is defined in s 334A by reference to the maximum number of votes that can be cast on a poll at a general meeting of a company. Practice Pointer Section 23AJ is a critical provision that can be relied upon by Australian resident companies to ensure that no tax will be paid on the receipt of foreign dividends from offshore companies in respect of shareholdings of 10% or more. This however will only be the case if there has been no prior attribution of income under the CFC, FIF or transferor trust rules. Apart from that one rider, the application of 23AJ is broad and all encompassing and relates as much to a dividend received from the United States as it does to a dividend received from the Cook Islands. Where an Australian company borrows to fund an equity acquisition overseas which will itself produce section 23AJ non-assessable, non-exempt dividend income, the deduction will be available in full subject only to the thin capitalisation rules. This is because section ITAA 1997 makes it clear that a deduction can be supported by reference to the receipt of section 23AJ non-assessable, nonexempt income. The consequence of this is that if the total deduction is for an amount less than $250,000 (the thin capitalisation threshold beneath which the TC rules do not apply) and relates entirely to the production of section 23AJ non-assessable non-exempt income, the deduction is available in full. Taxation Institute of Australia 9

10 Note that this exemption results in unfranked income in the Australian company which will have to be distributed to its shareholders in the future. Practice Pointer Section 23AJ does not apply to:- a. A dividend when it is paid by a company (not being a Pt X Australian resident) to an Australian resident company which receives it in its capacity as a partner in a partnership, unless the dividend is paid to a partner in a partnership which is part of a consolidated group or a multiple entity consolidated (MEC) group. b. A dividend when it is paid by a company (not being Pt X Australian resident) to the trustee of a trust, even where the trustee then pays an amount attributable to the dividend to an Australian resident company beneficiary. However, s 23AJ will apply to a dividend that is paid to a trust which is part of a consolidated group or a multiple entity consolidated (MEC) group Exemption 2: Branch profits; s.23ah ITAA 1936 In line with the exemption for dividends for foreign companies (s.23aj) and the exemption for capital gains on the sale of shares in a foreign company (Division 768), there is also an exemption that applies to profits and capital gains arising from overseas branches of Australian resident companies. This is an attempt to make the issue of how an Australian resident company structures its overseas affairs neutral from an income tax perspective. This is achieved essentially through two critical sub-sections; Pursuant to s 23AH(2), foreign income derived by a resident company in carrying on a business at or through a permanent establishment (PE) in a listed country or unlisted country is non assessable income non exempt income of the company. This exemption for foreign income is limited by s 23AH(5) through s 23AH(8) to active income and active assets. That is, passive investment income and certain related party sales income from unlisted countries will not be available for exemption and thus will be assessable to tax in Australia. These rules operate in much the same way as the controlled foreign company (CFC) provisions, which apply to foreign companies, by referring to terms used in Part X of ITAA 1936, such as the active income test, passive income and eligible designated concession income (EDCI). These concepts are discussed in more detail later in this paper. Pursuant to s 23AH(3), a capital gain made by a resident company is disregarded if the company used the asset wholly or mainly for the purpose of producing foreign income in carrying on a business at or through a PE of the company in a listed country or unlisted country, and the asset does not have the necessary connection with Australia Exemption 3: CGT participation exemption; Div 768 ITAA 1997 With effect from 1 April 2004, capital gains or losses from certain CGT events relating to an Australian resident company s ownership of shares in a non-resident company are reduced, to the extent that the non-resident company carries on an active business. Ownership percentage Pursuant to s (1)(a), in order to obtain a reduction of the capital gain or loss relating to a share (not being an eligible finance share or widely distributed finance share): the Australian holding company must have a direct voting percentage of at least 10 percent, and Taxation Institute of Australia 10

11 that voting interest of at least 10 per cent must have been held throughout a 12-month period starting 24 months before the CGT event. CGT events By virtue of s (c), a reduction in the capital gain or loss only applies to prescribed CGT events, being A1, B1, C2, E1, E2, G3, J1, K4, K6, K10 and K11. For example, a reduction of a capital gain would not apply in the case of a return of capital that is more than the cost base and which did not result in the cancellation of a share, being CGT event G1. However, a reduction of a capital gain or loss could apply in the case of a reduction of capital that resulted in the cancellation of shares, being CGT event C2. When the above criteria are satisfied, the capital gain or loss is reduced under s (2) by reference to the active foreign business asset percentage at the time of the relevant CGT event. Methods for calculating CGT reduction The active foreign business asset percentage is determined according to s , using one of the following methods: 1. The market value method (s ). This applies on a non-consolidated basis and requires that sufficient evidence exist regarding the market value of assets at the time of disposal of the shares. 2. The book value method (s ). Consolidated accounts may be used for 100 per cent wholly owned groups, providing they are audited or prepared in accordance with commercially-accepted accounting principles. An average of book values at two points in time is used for this method, generally coinciding with the end of an accounting period, although completion accounts should be used if they have been prepared. The first measurement point in time is the end of the most recent period before the CGT event. The second measurement point in time must be at least six months before but not more than 18 months before the first measurement point in time. 3. The default method (s (4)). This method applies when either of the above methods cannot be used, or where the taxpayer does not choose, pursuant to s , to use either of the above methods. Under this method, all capital gains are fully taxable and, all capital losses are reduced to nil. A taxpayer may choose to use the market value method when there is significant internally-generated goodwill that is not recognised in the accounts and hence not reflected in the value of assets using the book value method. Alternatively, a taxpayer may choose to use the book value method to reduce compliance costs associated with determining the market value of assets required for using the market value method. Using the market value or book value methods, the active foreign business asset percentage is generally calculated by comparing the value of active assets of the foreign company with the value of total assets of the foreign company (s and s ). According to Step 5 of the calculation in s and s , if the resultant foreign business asset percentage is 90 per cent or more, the capital gain or loss is reduced to nil. If the percentage is less than 10 per cent, there is no reduction, and if the percentage is between 10 and 90 per cent, the capital gain or loss is reduced by the percentage amount. Meaning of total assets and active asset A foreign company s total assets are defined in s as CGT assets owned by the foreign company. A foreign company s active assets are defined in s as CGT assets owned by the foreign company that are used in carrying on the foreign company s business. Excluded from the definition of active assets in s are: assets that are taxable Australian property (in the case of public companies and unit trusts, there is regard to the percentage of holding which normally requires a holding 10 per cent or more); Taxation Institute of Australia 11

12 financial instruments (other than shares or trade debts); cash or cash equivalents; interests in trusts and partnerships; assets whose main use is to derive interest, annuities or foreign exchange gains; assets whose main business use is to derive royalties, except when the asset is an intangible asset that has been substantially developed, altered or improved by the foreign company to substantially increase its market value; and assets whose main business use is to derive rent, except when this is only a temporary purpose. Taxation Determination TD 2008/23 makes it clear that active assets of a partnership, in which a foreign company is a partner, do not constitute active foreign business assets of the foreign company for the purpose of Division 768-G 5.2 Other types of entities available for expanding overseas Permanent Establishment/Branch Foreign branches are often established when Australian business expand overseas due to the relatively low cost of establishment and ability to use an existing Australian entity. There are exemptions from Australian tax for foreign branch income (s23ah ITAA36). Unfortunately branches expose the Australian head office to the risks of the overseas operations and there can be difficulties in attributing the income to either the branch or head office Partnerships and Trusts Partnerships and trusts are beneficial due to their flexibility of distributions. However, as trusts are a common law concept, they are not understood in all jurisdictions. Partnerships also open both of the partners to joint and several liability. Although trusts are generally not used for investments held by unrelated parties, they do allow FITOs to pass through to the underlying beneficiaries Fiscally transparent entities Fiscally transparent entities, including LLCs and LLPs have the benefits of limited liability and the flow through of FITOs. Unfortunately, there is often complex DTA issues which must be worked through in order to use these entities. 6 TOPIC 4 - FOREIGN INCOME TAX OFFSET ( FITO ) 6.1 General The foreign income tax offset system is one of the many mechanisms provided by tax law to avoid double taxation of the same income. When the assessable income of a resident taxpayer includes income on which foreign tax has been paid by the taxpayer, the resident taxpayer may be entitled to foreign income tax offsets to reduce the Australian tax liability on that income. 6.2 Conditions for the availability of foreign income tax offsets In order to be entitled to foreign income tax offset, each of the following conditions must be satisfied (s of ITAA 1997): the taxpayer has paid foreign income tax the foreign income tax is paid in respect of all or part of an amount included in assessable income for the year Taxation Institute of Australia 12

13 When the above conditions are satisfied, the taxpayer s entitlement to a foreign income tax offset is subject to a limit calculated under s of ITAA This limit is effectively the greater of a $1,000 de-minimis cap and the Australian tax payable on assessable income that is double taxed and/or not Australian sourced. This is discussed further below. 6.3 Foreign income tax Foreign income tax is defined in s as a tax imposed by a law other than an Australian law that is a tax on income, profits or gains (whether or not of an income or capital nature) or any other tax imposed under a double tax agreement. It is essentially a tax imposed on income or gain derived by the taxpayer by a foreign country or confederation (eg, European Union). It does not include taxes that are imposed based on the taxpayer s turnover. A foreign tax offset is also not available for an amount of unitary tax or a credit absorption tax (s (5) and defined in s770-15(2) and (3)). Unitary tax is essentially a tax imposed by a foreign country on income derived from the sources of that country but is determined based on the company s worldwide income, losses, outgoings or assets. In other words, it is a tax based on the level of activities in that country relative to the company s global operation rather than based on sources derived from the country less deductions attributable to it. A credit absorption tax is a tax that is imposed by the foreign country only if the taxpayer is entitled to a credit in Australia for the tax paid. 6.4 Payment of foreign tax In order to be entitled to foreign tax offset, a taxpayer must also have paid the foreign income tax as determined under subdivision 770-C. A taxpayer is deemed to have paid foreign tax under s where the tax is paid by another entity under an arrangement with the taxpayer or under the law relating to the foreign income tax. This general deeming rule is intended to replicate the former specific deeming rules and thus should cover tax paid by: deduction or withholding; a trust in which the taxpayer is a beneficiary; a partnership in which the taxpayer is a partner; or the taxpayer s spouse. Other than this, it is important to note that if tax is paid by a company, the shareholders are not eligible to a FITO. 6.5 Assessable income The taxpayer must have paid the foreign tax in respect of an amount, all or part of which is included in the assessable income of the taxpayer (s ). This requires that the foreign income tax offset is only available if the income on which the foreign income tax has been paid is assessable to the taxpayer. This requires a material connection or nexus between the tax paid and assessable income. 6.6 Exemptions Income that is non-assessable non-exempt income due to specific exemptions (as discussed above for individuals and companies) will not meet this requirement and thus any foreign tax would not give rise to an offset and would be a permanent cost to the taxpayer. Example B Taxation Institute of Australia 13

14 An Australian resident company receives a dividend of $900 (net of 10 percent dividend withholding tax) from its US resident 100% owned subsidiary. The Australian company borrowed to enable it to fund the equity investment into the US company. Question 1 Is the dividend taxable on receipt in Australia? Answer No. The dividend income is non-assessable non-exempt income under s 23AJ of ITAA Question 2 Is there a FITO for tax paid in the USA? Answer No. The dividend withholding tax will not give rise to a foreign income tax offset. This is because the dividend income is not assessable. Question 3 Is a deduction available for interest paid? Answer Yes. S25-90 subject to Topic 5A 6.7 Treatment of capital gains It is important that foreign capital gains that have been subject to foreign income tax be included in the amount of any net capital gain that is assessable income of the taxpayer. Thus, to ensure maximise availability of foreign income tax offsets, Australian sourced capital losses should be utilised first against Australian sourced capital gains and then against foreign capital gains on which no foreign tax has been paid. If a capital gain is subject to foreign tax, no foreign income tax offset will be available in circumstances where there is no net capital gain due to use of capital losses. Also note, if you utilise the 50% CGT discount on your foreign gain, only 50% of the FITO will be available. 6.8 Calculation of foreign tax offset Steps in calculating foreign tax offset entitlement The following steps should be followed when calculating a taxpayer s entitlement to foreign tax offset: Step 1: Convert the assessable income and foreign tax paid into Australian currency. Subdivision 960-C and 960-D contain the relevant provisions dealing with conversion of foreign currencies. Step 2: Calculate the sum of foreign income tax paid in respect of amounts included in assessable income. Step 3: Calculate the amount of any pre-commencement excess foreign income tax. This relates to excess foreign tax credits that may be available under the transitional measures within s of ITTPA Step 4: Apply the de-minimis limit of $1,000 of foreign income tax offset under s775-75(2)(a). This is a compliance saving measure, such that no further calculations would be required. Taxation Institute of Australia 14

15 Step 5: If Step 4 is not applied, calculate the amount of the foreign income tax offset limit. This is explained in more detail below. Step 6: If the actual foreign tax paid is more than the foreign income tax offset limit under Step 4 or 5, the excess offset is permanently lost. Foreign income tax offset limit The foreign tax offset limit is calculated either as a fixed maximum entitlement of $1,000 or by reference to the following formula in s770-75(2)(b) of ITAA 1997: Tax payable for income year Less: Tax payable for the income year assuming that: a. the assessable income did NOT include: i. any assessable income on which the taxpayer has paid foreign tax ii. any amounts of ordinary or statutory income from a source other than Australian source (effectively, foreign income); and b. there was no entitlement for deductions that are: i. debt deductions for overseas permanent establishments ii. deductions reasonably related to income covered by (a). Broadly, the net effect of the above calculation is to set a cap on the foreign income tax offset entitlement by reference to the Australian tax payable on double taxed amounts and other assessable amounts that are not Australian sourced. The limit effectively includes all assessable income that is foreign sourced, even if no foreign tax has been paid on that income. This allows for greater averaging of high and low or no taxed foreign income in setting the foreign income tax offset limit. There is a difficulty in determining what deductions are reasonably related to the Australian sourced income compared to the foreign income. The Explanatory Memorandum provides that the approach must be objective and a number of factors may be relevant in making this objective factual determination, including the nature and size of the taxpayer s business, the type of income concerned and the accounting methods used by the taxpayer. 6.9 Transitional rules The transitional rules introduced along with the new foreign income tax offset rules provide a mechanism to utilise any excess foreign tax credits arising under the former foreign tax credit rules, subject to limited exceptions. The excess credits still retain their history and thus remain subject to a five year carry forward time limit as was the case under the former rules. Further, the excess credits can only be utilised if there is capacity under the foreign income tax offset limit. Practice Pointers The foreign income offset rules operate on a use-it or lose-it basis. That is, if it is not used in the year in which the foreign income to which the FITO relates arises it is forever lost to the taxpayer. This creates a strong tax planning motivation to ensure that any highly taxed foreign income is matched with lowly taxed foreign income in the same year so as to ensure the average is such that it sits under the amount of Australian tax that would be payable in respect of the foreign income. Taxation Institute of Australia 15

16 7 TOPIC 5A - THIN CAPITALISATION: 7.1 General Broadly speaking, Australia s thin capitalisation rules impose restrictions on the deductibility of interest based on a taxpayer s debt to equity ratio. The thin capitalisation rules aim to prevent the allocation of excessive interest bearing, tax deductible debt to Australian operations. The thin capitalisation rules are contained in div 820 of ITAA 1997 and apply from 1 July The provisions operate to disallow certain debt deductions where an entity is thinly capitalised. Put simply, Australia has imposed a 3:1 debt to equity ratio, meaning that at least 25 per cent of an asset s value should be financed with equity and no more than 75 per cent of that value should be financed with debt. The distinction between debt and equity for thin capitalisation purposes is drawn from the definitions in div 974 of ITAA The thin capitalisation provisions contain a variety of rules that depend on whether the entity is: an authorised deposit-taking institution (ADI) (which are not covered in this paper); or foreign controlled, or alternatively controls a foreign entity. A guide to thin capitalisation and associated ATO guides are available at provide step-by-step instructions and worked examples for many of the calculations required by the thin capitalisation provisions. 7.2 When does Div 820 apply? The thin capitalisation rules apply to entities which include individuals, companies, trusts and partnerships. However, in order for the thin capitalisation rules to apply the entity must be either an inward investing or an outward investing entity De-minimis exceptions Where the thin capitalisation provisions would otherwise apply, there are two general exceptions: 1. Pursuant to s820-35, the thin capitalisation provisions do not operate in relation to a taxpayer for an income year where the aggregate debt deductions of the taxpayer and all of the taxpayer s associate entities for that year are $250,000 or less. Note that this related to all debt deductions and not solely those in relation to the foreign operations. 2. Provided the taxpayer is not foreign controlled, the thin capitalisation provisions will also not apply, by virtue of s , for an income year in which the average Australian assets of the taxpayer, together with those of each of the taxpayer s associates are at least 90 per cent of the average total assets of the taxpayer together with those of each of its associates Application of Div 820 to foreign income The deductibility of interest relating to foreign income is dealt with by s of ITAA 1997 which provides that an Australian entity can deduct an amount of loss or outgoing from its assessable income if: the amount is incurred in deriving foreign income; the income is exempt under s 23AI, s 23AJ, or s 23AK of ITAA 1936; and the loss or outgoing is a cost in relation to a debt interest covered by paragraph (a) of the definition of debt interest in s of ITAA Taxation Institute of Australia 16

17 Due to the link to Div 820, the thin capitalisation provisions generally govern the deductibility of debt deductions relating to foreign income. It should be noted that this is not the case for foreign branch income where debt deductions will continue to be denied for listed and unlisted branches Key terms The thin capitalisation provisions are quite mechanical and, as can be seen from the introductory paragraphs above, rely on a number of specific definitions. The central definitions follow. Debt deduction While interest is generally used when discussing thin capitalisation, it is important to note that these provisions operate with respect to debt deductions and not interest. The term debt deduction is defined in s and is much broader than interest. Debt deduction also includes bill discounts, fees and stamp duty and deemed interest under hire purchases and certain leases. Debt deduction does not include hedging costs or currency losses on debt repayments. Associate entities Subdivision 820-I sets out the rules that apply in determining whether one entity is an associate entity of another entity for thin capitalisation purposes and also contains the various method statements for calculating associate entity debt associate entity equity and associate entity excess amount which are used in calculating the safe harbour debt amount (discussed further below). An associate entity is defined in s Under the first step in determining whether an entity is an associate entity (the first entity) of another entity, the first entity must be an associate pursuant to s318 of ITAA Section 318 contains a broad definition of associate, including the concept of the entity being sufficiently influenced by another. The second step is for the other entity to have an associate interest of at least 50 per cent in the first entity, or for the first entity to act in accordance with the directions, instructions or wishes of the other entity in respect of the first entity s financial affairs. Associate interest for a company is defined in s (4) to be the direct control interest that is held, which follows the definition of such an interest in the controlled foreign company (CFC) provisions of Part X of ITAA 1936 (covered later in this paper). There are similar provisions for determining an associate interest in a trust or partnership. 7.3 Classifying an entity The thin capitalisation provisions have different rules for determining whether an entity is thinly capitalised depending on its classification. The main classification is to determine whether the entity is: an outward investing entity (defined and governed by subdiv 820-B); or an inward investing entity (defined and governed by subdiv 820-C). Where an entity is classified as both an outward investing entity and an inward investing entity, the entity will be treated as an outward investing entity. However, such an entity will not be able to access all of the tests that would otherwise apply to an outward investing entity, notably the worldwide gearing test Outward investing entities Classification An outward investing entity is defined in s820-85(2) and is an Australian resident entity that: is an Australian controller of an Australian controlled foreign entity ; Taxation Institute of Australia 17

18 carries on business at or through an overseas permanent establishment as defined in s 6 of ITAA 1936; or is an associate entity of an entity that is an outward investing entity. An Australian controller is defined in s and depends on whether the foreign entity is a CFC because of the de facto control test (ie. where five or fewer Australian residents control the company), or the control tracing rules (ie. a 40 per cent interest unless there is another controller or a 50 per cent control interest). Where there is de facto control, each of the five or fewer Australian entities that control the CFC will be an Australian controller. In all other situations, an entity that holds a control interest of 10 per cent or more in the CFC will be an Australian controller. An Australian controlled foreign entity is defined in s as a CFC, a controlled foreign trust (CFT) or a controlled foreign corporate limited partnership. A CFC and CFT are determined by applying definitions under Part X of ITAA 1936 which are covered later in this paper. Limitation on debt deductions The legislation requires an outward investing entity to calculate its adjusted average debt and compare this to its maximum allowable debt. If the adjusted average debt exceeds the maximum allowable debt there is a proportionate denial of the debt deduction otherwise available to the entity. 8 ADJUSTED AVERAGE DEBT Adjusted average debt is calculated by reference to the method statement in s (3) and is basically the average value of all of the entity s debt that gives rise to debt deductions for that year, excluding the average value of debt owed to it by any controlled foreign entity. 9 MAXIMUM ALLOWABLE DEBT The maximum allowable debt of an outward investing entity is defined in s as the greatest of: the safe harbour debt amount the arm s length debt amount, or the worldwide gearing amount (note that this is not available for an entity that is also an inward investing entity) Inward investing entities Classification An inward investing entity is defined in s (2) and is: any non-resident entity, and any foreign controlled Australian resident entity, determined by provisions that in essence mirror the CFC tests in s 340 of ITAA Limitation on debt deductions The limitation on an inward investing entity is calculated in the same manner as for an outward investing entity, although the definition of maximum allowable debt for these purposes is more restrictive. 10 MAXIMUM ALLOWABLE DEBT Pursuant to s the maximum allowable debt of an inward investing entity is defined as the greater of: Taxation Institute of Australia 18

19 the safe harbour debt amount, or the arm s length debt amount. Notably, the worldwide gearing amount is not available for an inward investing entity Safe harbour debt amount The safe harbour debt amount is defined in s for an outward investor and s for an inward investor. Generally speaking, the safe harbour debt amount is 75 per cent of the average value of the entity s assets for the income year. While this may sound reasonably straightforward, there is a detailed method statement in the respective sections for determining this amount which can be complex to apply in practice. The method statement for an outward investor in s is as follows: Step 1: determine assets. The term assets is undefined and readers are referred to discussion under valuation issues. Step 1A: reduce the result of step 1 by the average value, for that year, of all the excluded equity interests in the entity. Step 2: deduct associate entity debt. This effectively results in loans to associate entities having no effect on the calculation. Step 3: deduct associate entity equity. Step 4: deduct controlled foreign entity debt. Step 5: deduct controlled foreign entity equity. This is intended to result in debt deductions limited by reference to Australian assets, that is, those producing assessable income. Step 6: deduct non-debt liabilities. The term liabilities is similarly undefined and readers are again referred to the discussion under valuation issues. Step 7: multiply the amount remaining after Step 6 by ¾. Step 8: add the associate entity excess amount. This is determined under s The method statement for an inward investor in s is similarly constructed, but omits Steps 4 and 5 relating to controlled foreign entities Arm s length debt amount The arm s length debt amount is defined in s for an outward investing entity and s for an inward investing entity. The arm s length debt amount is determined by conducting an analysis of the entity s activities and funding to determine a notional amount that represents what the entity could reasonably be expected to have borrowed on an arm s length basis during the period. The Commissioner s views on the application of the arm s length test are set out in Taxation Ruling TR 2003/1 Income tax: thin capitalisation applying the arm s length debt test and expects that a taxpayer is able to provide evidence that a third party lender would have lent funds to the entity unsupported by the parent up to the deductible amount claimed by the taxpayer Worldwide gearing amount The worldwide gearing amount is only relevant for an outward investing entity and is defined in s The worldwide gearing test is available when the safe harbour debt amount has been exceeded. The test allows an Australian multinational enterprise with controlled foreign investment to gear its Australian operations by up to 120 per cent of the gearing of its worldwide operations. Taxation Institute of Australia 19