Tax Brief. 8 April Participation Exemption and Reform of the CFC Rules. Summary

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1 Tax Brief 8 April 2004 Participation Exemption and Reform of the CFC Rules On April Fools Day the second tranche of legislation arising out of the Review of International Taxation was introduced into Federal Parliament. The timing of the release of the Bill may not have been propitious, but the rules are important and generally welcome. Of course, the terms of the Bill are considerably more complicated than proposed by the Board of Taxation and do not achieve the large scale winding back of CFC and related legislation that the Board had recommended. While simplification of the legislation to the extent hoped may not have been achieved, many of the practical constraints that the CFC legislation currently places on offshore growth by Australian companies, and the restructuring of company groups will be removed. The measures will commence from 1 April and from 1 July Summary In general terms, the key measures in the Bill are designed to: 1 exempt from Australian tax all dividends received from foreign companies where the Australian corporate shareholder has at least 10% of the voting shares in the company; 2 exempt from Australian tax certain capital gains made on transactions with shares in foreign companies where the Australian corporate shareholder has at least 10% of the voting shares in the company; 3 widen the exemption for Australian companies from Australian tax of income and capital gains made through foreign branches; and 4 extend these three exemptions to the CFC regime where a CFC receives such dividends, capital gains or branch profits; 5 narrow the situations where a resident shareholder will be attributed with income derived by a CFC from performing services for offshore associates.

2 Exemption for Non-Profit Dividends Starting with the simplest change and one which will make life easier for many companies non-portfolio dividends paid on 10% or greater voting interests in foreign companies to Australian resident (parent) companies will now be entirely free from tax in Australia. It will no longer be necessary to apply foreign tax credits to the extent that dividends are out of active income from CFCs operating in unlisted countries, for example. This measure allows some consequential changes to be made: The tracking of foreign income within CFCs is simplified and the Division in the CFC rules defining exempting receipts is repealed; Similarly, some of the legislation dealing with foreign tax credits such as the underlying foreign tax credit is repealed or amended; and Save in one minor respect which is under further review (see below), the change also removes one of the two lists in the CFC regime broadexemption listed countries and limited-exemption listed countries. There will be a single list and the listed countries will now be only Canada, France, Germany, Japan, New Zealand, UK and US. The exemption of dividends paid to resident companies is extended to nonportfolio dividends paid by or to CFCs resident in the current list of unlisted countries. This extension is effected by repealing the complex sections that currently include all or part of such dividends in the attributable CFC income of Australian residents. The current exemption for dividends (including portfolio dividends) paid between companies resident in broad-exemption listed countries (to be reclassified as listed countries ) and limited-exemption listed countries (to be reclassified as section 404 countries ) is to be retained (although this is subject to review). As the movement of dividends from offshore companies in unlisted countries is freed up by all these changes, the concern about disguised distributions being used to achieve a tax-free result is considerably reduced. Currently the very broad terms of section 47A of the Income Tax Assessment Act 1936, which deals with deemed dividends from CFCs in unlisted countries, targets disguised distributions. Although the section remains in the legislation, it is effectively gutted by changes that mean that non-portfolio dividends, other than those passing through partnerships or trusts, are effectively removed from section 47A. Its effect will now generally be limited to portfolio interests in unlisted countries. These changes generally take effect on 1 July Participation Exemption and Reform of the CFC Rules

3 Exemption for Certain Capital Gains on Non-Profit Shares The corollary to the exemption for non-portfolio dividends which is being introduced is the proposal to exempt from Australian tax any capital gains made on transactions with non-portfolio share interests in non-resident companies. The basic idea is that if non-portfolio dividends are exempt, then so should capital gains on the shares as both dividends and capital gains equally reflect profits at the company level. However, the capital gains tax exemption is more limited than the dividend measure. The problem relates to tainted assets which may be held by the foreign company. Currently, income from tainted assets in unlisted countries is captured as attributable income by the CFC rules and so is any capital gain made on selling such assets. If a blanket exemption were given for capital gains on nonportfolio shares in a foreign company, it would be possible to indirectly realise gains on tainted assets by putting them in a foreign company and then selling the shares in the company. The main limits on the removal of CGT on non-portfolio share interests in foreign companies are: the non-portfolio share interest must be held throughout a 12 month period within the 24 months before the CGT event (this way of expressing the time requires more than a temporary holding of the shares while allowing an orderly sell down of the non-portfolio interest); the CGT is generally removed only to the extent of the active foreign business asset percentage of the foreign company; the new treatment does not apply to eligible finance shares or widely distributed finance shares. (a)active Foreign Business Assets The main issue will be the calculation of the active foreign business asset percentage. Active foreign business assets are generally assets used or held ready for use in the course of carrying on the company s business (including goodwill). The following assets are effectively excluded: assets having the necessary connection with Australia (and so directly taxable under the CGT in the hands of the non-resident); a financial instrument other than a share or trade debt; eligible finance shares or widely distributed finance shares; interests in trusts or partnerships; life insurance policies; 3 Participation Exemption and Reform of the CFC Rules

4 cash or equivalent; assets whose main use is to produce interest, annuity, rent, royalties or foreign exchange gains. These exceptions reflect a combination of elements from the CFC rules and the active asset test in the small business CGT exemptions. They are modified for financial institutions. Financial instruments, cash and assets producing interest, annuities or foreign exchange gains will be active business assets of a subsidiary of an Australian financial institution whose sole or principal business is banking or lending money. On the other hand, loans and similar assets acquired from Australian businesses by such a subsidiary will not be active business assets. The precise scope of some of the exceptions outlined above is clearly likely to be a problem; the need for others is questionable. In particular, loans between related companies will not qualify as active business assets which will often reduce the exemption, unless the 100% related group rule referred to below is available. (b)valuing Active Foreign Business Assets To calculate the percentage that these assets constitute of the total assets of the company two elective methods are provided, the market value method or book value method. If neither method is elected the election is made by the way in which the tax return is prepared then any capital gain is taxed in full but capital losses are disallowed in full. For both methods, if the active foreign business asset percentage worked out is 90% or more, the gain or loss is fully exempt, and if the percentage of active foreign business assets is less than 10%, the capital gain is fully taxable or the loss fully usable. Between 10-90%, the capital gain or capital loss is reduced by the percentage calculated. The market value method raises the familiar problems of valuation experienced in the corporate consolidation regime in recent times. The Explanatory Memorandum indicates some acceptable shortcuts for the new rules such as adding the company s liabilities to the market value of all the shares in the company based on the sale price of the shares and subtracting the market value of assets which are not active foreign business assets. The book value method generally requires the average of the values of the relevant assets in the two most recent sets of financial accounts of the company (including completion accounts in relation to the relevant transaction, if any). There are constraints on the age of the accounts and the standards which they must meet. The accounts must comply with international accounting standards, the standards of the seven listed countries or be prepared in accordance with commercially accepted accounting principles (provided in this case they give a true and fair view of the financial position of the company). 4 Participation Exemption and Reform of the CFC Rules

5 The meaning of asset for the purpose of these calculations is the tax meaning rather than accounting. Derivatives are generally excluded from the total assets of the company in the calculation, except for subsidiaries of Australian financial institutions. There are tracing rules where some of the assets of the relevant company consist of non-portfolio share interests in other companies. The shares in the other companies are effectively treated as active business assets to the extent that the assets of those companies are active business assets (which can necessitate several levels of calculation where there are several tiers of companies). Although shares are active business assets, their value is set at zero for the purpose of the active business asset calculation to the extent that they do not qualify under this rule. For tracing to occur, there must be an immediate 10% voting interest between each tier of companies, and a 10% voting percentage held by the company making the capital gain and the company s whose assets are being used to calculate the active business percentage. However, it is not possible to trace through to the assets of a lower tier company if a partnership or trust is interposed between the relevant company and the lower tier company. Where a trust or partnership is interposed in such circumstances the assets of the lower tier company will not be included in the active business assets of the relevant company. For these purposes, partnerships will include US LLCs and limited partnerships that are treated as partnerships for Australian tax purposes under the foreign hybrid measures (once they are enacted). It is possible in the case of 100% related groups of offshore companies to do the calculation using consolidated accounts on a group basis (other than for financial institutions). Special rules apply to insurance companies. The insurance rules are drawn by analogy with existing CFC rules. The problems of those rules for life companies are in effect projected into the CGT exemption. The exemption is also effectively applied to cases where a CFC disposes of a non-portfolio share interest in another foreign company. This is because the new rules are applied when working out the attributable income of the CFC. These changes take effect on 1 April 2004 rather than 1 July 2004 to prevent manipulation of the rules. For example, in the absence of such a rule, it would be possible to realise capital losses on non-portfolio shares before the effective date and defer gains until after the effective date so that they are exempt. As always there will be losers from the transitional rule. If an Australian company has had income attributed to it under the CFC rules and then sells at a loss a non-portfolio interest in the CFC which qualifies for the CGT exemption, the loss is denied. As a matter of policy, it is arguable that, as the seller has been taxed on underlying income of the CFC, it should get the loss to that extent. 5 Participation Exemption and Reform of the CFC Rules

6 Exemption for Income and Capital Gains of Foreign Branches To bring the treatment of foreign branches of Australian companies into line with the new exemption approach for non-portfolio dividends and share interests in foreign companies outlined above, the current exemption for branches is considerably broadened. In future, all income and capital gains of a foreign branch of an Australian company in the seven listed countries will be exempt except where: the branch does not pass the active income test; the income or gain is eligible designated concession income; and the income is adjusted tainted income or the capital gain is on a tainted asset. All income and capital gains of a foreign branch of an Australian company in unlisted countries will be exempt except where: the branch does not pass the active income test; and the income is adjusted tainted income or a capital gain is made on a tainted asset. Corresponding branch losses are not available for use by the company. Rules are provided for tracing the exemption where the foreign branch is owned through interposed partnerships and trusts. There is no longer any subject to tax test in applying the exemption. The enlarged exemption applies to income years commencing on or after 1 July Once again the exemption is projected into the CFC regime so that such branch income is no longer attributed in relation to a CFC in one foreign country with a branch in another foreign country. Tainted Services Income Currently tainted services income includes income arising from services provided by a CFC to its associates or to Australian residents. This considerably constrains the offshore organisation of corporate groups and restricts, for example, having the treasury or IT operations for the offshore group of CFCs concentrated in one foreign subsidiary which services the other group companies. The rule is to be changed to eliminate the reference to associates and to limit it to services provided to Australian residents. For example, if an Australian company has a subsidiary in India perform call centre functions for it in relation to its Australian operations, the income of the 6 Participation Exemption and Reform of the CFC Rules

7 subsidiary will be tainted services income and may be attributed to the Australian parent under the CFC rules. The same situation will apply if the Indian subsidiary provides such services to unrelated Australian companies for their Australian operations. If, however, the Indian subsidiary provides call centre services to other foreign subsidiaries of the Australian parent, the income received will not be tainted services income under the new rules. There is an anti-avoidance exception to the rule which prevents the services being provided indirectly to Australia. Suppose in the example just given, the call services provided by the Indian subsidiary were contracted for by an unrelated company in India who for a very small margin on-supplied them to the Australian parent (effectively a back-to-back service arrangement). The exception would apply so that the income in the hands of the Indian subsidiary would still be tainted services income. The Explanatory Memorandum also warns that Part IVA might be applied to other arrangements which have a similar effect. These changes take effect for CFC accounting periods beginning on or after 1 July Participation Exemption and Reform of the CFC Rules

8 For further information, please contact Sydney Ernest Chang Jane Michie Jane.Michie@gf.com.au G&F document ID _15.docx These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN ) Sydney ANZ Tower, 161 Castlereagh Street, Sydney NSW 2000 Australia Ph , Fax Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph Fax Perth QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph Fax Participation Exemption and Reform of the CFC Rules