CFC remedials

CFC AND FIF EXEMPTIONS FOR AUSTRALIAN UNIT TRUSTS

(Clauses 75 and 76)

Summary of proposed amendments

Under proposed new rules, Australian Unit Trusts that are not taxed as companies under Australian law will be excluded from the exemptions for Australian controlled foreign companies (CFCs) (section EX 22) and interests in foreign investment funds (FIFs) resident in Australia (section EX 35).

Application date

The amendments will apply from the beginning of the 2014–15 income year.

Background

Before the 2009 international tax reforms, taxpayers did not have to return attributed income in respect of their interest in a CFC if the CFC was resident in a “grey list” country. The grey list comprised eight countries that were thought to have broadly comparable tax systems to our own. Income earned in a grey list country was exempt and income earned in other countries was subject to tax.

When the grey list exemption for CFCs was repealed in 2009 it was replaced by an exemption for active income (the active business test) and an exemption for Australian CFCs. Passive income, which included interest, dividends and some types of rent, would be taxable, while active income, primarily business profits, would be exempt. The active business test granted a full tax exemption to CFCs that had only small amounts of passive income.

While the active business test required CFCs to earn less than 5 percent passive income, the Australian exemption was a broader, simpler test. CFCs had to be resident in Australia (and only resident in Australia) and subject to Australian income tax.

A broader exemption was justified in order to reduce compliance costs for SMEs. Many New Zealand firms looking to expand offshore made their first move across the Tasman and the Australian exemption meant these companies did not need to learn or comply with the attribution rules.

The simpler test is buttressed in two ways. First, Inland Revenue and the Australian Tax Office have a close working relationship which makes it easier to monitor and respond to trends and developments. Secondly, the opportunity for mischief is reduced as companies face similar levels of taxation in Australia to those in New Zealand.

A equivalent exemption for non-portfolio FIFs (that is where a taxpayer holds more than a 10 percent interest in a FIF) was introduced when the FIF grey list exemption was repealed in 2012.

Australian Unit Trusts (AUTs) are generally seen as trusts under Australian tax law but are considered companies under New Zealand tax law.

Under the Australian trust regime only a low rate of tax is withheld from passive income; under the New Zealand CFC or non-portfolio FIF regime that income is exempt. In addition, no Australian tax is paid on non-Australian sourced income to which a New Zealand-resident beneficiary is presently entitled.

This outcome is concessionary and contrary to the policy objectives of the Australian exemption for CFCs. AUTs are unlikely to be used by New Zealand SMEs looking to expand offshore and the level of taxation on passive income is significantly lower in Australia than it would be in New Zealand.

 

REPEAL OF SECTION DB 55

(Clauses 43 and 174)

Summary of proposed amendments

The bill repeals section DB 55 of the Income Tax Act 2007, which allows companies to claim deductions for expenses incurred in deriving exempt foreign dividends. This provision was introduced as exempt foreign dividends were subject to the foreign dividend payment (FDP) rules which were seen as being equivalent to a tax.

The Taxation (International Taxation, Life Insurance, and Remedial Matters) Act 2009 repealed FDP and section DB 55 no longer served a purpose as exempt foreign dividends were no longer subject to the FDP rules.

A “savings” provision is included to preserve assessments based on the current rules if the returns were filed before the date of introduction for this bill.

A retrospective amendment is proposed to remove a potential conflict between section DB 55, which allows deductions against exempt foreign dividends, and the general permission under section DA 1, which precludes deductions against exempt income.

Application dates

The amendment repealing section DB 55 applies from 30 June 2009.

The amendment to section DB 55, and section DB 44 of the Income Tax Act 2004, will apply from 1 October 2005.

 

INDIRECT INTERESTS IN FIFS

(Clauses 78 and 80)

Summary of proposed amendment

The bill clarifies the rules that apply to indirectly held interests in FIFs. Additional FIF income is calculated only if the CFC or FIF holds an interest in a FIF that would be an attributable interest if the person had directly held their indirect interest.

Application date

The amendment will apply from the beginning of the 2014–15 income year.

Background

The current rules apply a formula to determine the amount of income that should be attributed when a person holds an interest in a CFC or FIF which itself holds an interest in another FIF.

For example, a person may hold a 50 percent interest in a CFC which holds a 15 percent interest in a FIF.

The intended effect of these rules was that the person should have FIF income attributed to them on the basis of a 7.5 percent indirect interest holding.

The proposed amendment ensures that a person in the above situation is not able to access the exemption for interest in a FIF resident in Australia (section EX 35) as they only hold an indirect interest of 7.5 percent.

 

ACTIVE BUSINESS TEST FOR WHOLLY OWNED GROUPS

(Clauses 72, 73 and 74(1))

Summary of proposed amendments

Under the current rules, taxpayers determining whether a CFC meets the active business test have the option of grouping multiple CFCs together into a test group and working out the ratio of active to passive income based on the consolidated accounts of that group.

Amendments are being made to allow companies that are part of wholly owned groups to form test groups which include any interest in a CFC held by a member of the wholly owned group. The same-jurisdiction rule will continue to apply.

A further amendment is being made to ensure that wholly owned groups of companies are not able to form over-lapping test groups by including any one CFC in multiple different test groups.

Application date

The amendments will apply for income years beginning on or after 1 July 2009.

Background

Taxpayers determining whether their CFCs meet the active business test have the option of grouping multiple CFCs together into a test group and working out the ratio of active to passive income based on the consolidated accounts of the test group. The CFCs must be resident in the same country and the taxpayer must hold an income interest of more than 50 percent in each CFC.

It is not uncommon for CFC interests to be held by different members of a wholly owned group. The current rules place unnecessary restrictions on how those groups can access the active business test given that the group effectively has control over all of the CFC holdings.

 

NEGATIVE PASSIVE INCOME AND ACCOUNTING STANDARDS TEST FOR CFCS

(Clauses 74(2), (3) and (4))

Summary of proposed amendments

Under the proposed new rule, a negative numerator in the formula defined in section EX 21E(5) will no longer disqualify a CFC from passing the active business test. Instead the negative numerator will be deemed to be zero.

Application date

The amendments will apply for income years beginning from 1 July 2009.

Background

The formula for the accounting standards active business test is defined in subsection EX 21E(5) as below:

reported passive + added passive – removed passive
reported revenue + added revenue – removed revenue

Subsection EX 21E(3) provides that if the numerator (the top line of the formula) is negative, the CFC will fail the accounting standards test and will need to perform the default test (EX 21D).

CFCs that are demonstrably active CFCs, that is they receive very little, if any, passive income, may fail the accounting standards if they hold foreign currency (that is, currency other than the currency in their home jurisdiction) and that currency loses value, resulting in a foreign exchange loss.

Requiring these CFCs to undertake the more demanding default test is considered to be an undue compliance burden.

 

FOREIGN EXCHANGE GAINS AND LOSSES ON LIABILITIES

(Clauses 74(5), (6), (7), (8) and (9))

Summary of proposed amendments

The proposed rules give taxpayers the option to include foreign exchange gains and losses on both financial assets and liabilities when applying the accounting standards test (section EX 21E).

Under the current test, the ratio of passive income to active income takes into account foreign exchange gains and losses from financial assets and not from financial liabilities.

Taxpayers who are unable to readily distinguish the foreign exchange gains and losses on financial assets from those on liabilities will be able to apply the accounting standards test using a combined amount.

Inland Revenue will publish further information in the Tax Information Bulletin following enactment of the legislation on how the term “readily distinguishable” will be interpreted.

Application date

The amendments will apply for income years from 1 July 2009.

Background

It is not unusual for companies to produce financial accounts that provide a single rolled up figure of foreign exchange gains and losses from both financial assets and liabilities.

The amendment has been proposed to relieve these companies from the additional compliance costs of separating foreign exchange gains from losses. 

 

APPORTIONED FUNDING INCOME

(Clauses 70 and 71)

Summary of proposed amendments

The bill relocates the provisions relating to apportioned funding income from section EX 20C (Net attributable CFC income or loss) to section EX 20B (Attributable CFC income).

The specific effects of the provisions are unchanged. Taxpayers can exclude a portion of income from financial liabilities (that is, foreign exchange gains on loans taken out by the company) based on the percentage of the company’s assets (the asset fraction) used to generate active income.

Moving the provisions into section EX 20B will mean that taxpayers will be able to take this adjustment into account when applying the active business test under section EX 21D.

Application date

The amendments will apply for income years beginning on or after 1 July 2009.

Background

Section EX 20B contains the rules defining how a CFC calculates its attributable CFC amount. This is broadly equivalent to the CFC’s gross attributable income.

Section EX 20C contains the rules which define what deductions can be taken against that gross attributable income to derive the CFC’s net attributable income or loss.

The current subsection EX 20C(3) includes an adjustment which excludes some of the income that was previously included in the gross attributable income (apportioned funding income).

As this adjustment is an exclusion of income rather than a deduction against income, it is better situated in section EX 20B.

Moving the provision to section EX 20B will also provide more accurate calculations of a CFC’s active-to-passive income ratio as the current rules do not take the adjustment for apportioned funding income into account.