Tax Brief. 20 July New International Tax Arrangements Update and Draft Conduit Measures (NITA 5) Summary. NITA Progress Report

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1 Tax Brief 20 July 2005 New International Tax Arrangements Update and Draft Conduit Measures (NITA 5) Summary Update on previous Acts implementing the New International Tax Arrangements (NITA) Conduit foreign income Expansion of foreign income that can be passed through Australian company free of dividend withholding tax but foreign passive income still largely excluded No formal requirement to maintain accounts of foreign income Measure also applies for foreign conduit income passing between Australian companies by way of dividend Anti-streaming rules enforced by administrative penalties Some complexities and uncertainties may be addressed in final Bill Balance of foreign dividend account carried over to new regime which applies to dividends paid on or after date of Royal Assent during the first income year commencing on or after 1 July 2005 NITA Progress Report Four NITA Acts covered in previous Tax Briefs have been passed by Parliament, the most recent receiving Royal Assent on 26 June 2005: New International Tax Arrangements Act 2004 (NITA 1) New International Tax Arrangements (Participation Exemption and Other Measures) Act 2004 (NITA 2) New International Tax Arrangements (Managed Funds and Other Measures) Act 2005 (NITA 3)

2 New International Tax Arrangements (Foreign-owned Branches and Other Measures Act 2005 (NITA 4) NITA 4 Because the last of these Acts received Royal Assent on 26 June, clients should be taking steps to implement the measures in that Act which are detailed in our Tax Brief of 9 May Specifically in terms of transition: Dividends paid to Australian branches of non-residents on or after 26 June 2005 are no longer subject to dividend withholding tax but are included in the assessable income of the branch and in most cases attract imputation credits. Assimilation of Australian branches of non-bank financial institutions to the treatment of Australian branches of foreign banks applies to years of income commencing on or after 26 June Clarification of the international operation of employee option and share schemes applies for shares and options issued on or after 26 June 2005 (or in the case of foreign resident employees, when they become subject to the Australian rules on or after that date). Related FIF changes apply for the income year. NITA 3 In relation to the third Act on managed funds discussed in our tax brief of 23 March 2005 to be found at IFSA (the Investment and Financial Services Association) has received advice from the ATO confirming the transitional position as stated in our tax brief. Under the transitional rule if an Australian fund disposes of an asset that does not have the necessary connection with Australia, then foreign resident unitholders in that fund will be relieved by the Act from tax that otherwise might apply if the foreign resident made the capital gain on or after 21 March The ATO agrees that the unitholder in this case makes the capital gain flowing through the trust on the last day of the income year of the trust. Hence if the income year of the trust ends on or after 21 March 2005, the unitholder is relieved from tax, even if the trust disposed of the asset that generated the gain before 21 March The advice given to IFSA is non-binding and so rulings of appropriate kinds will be necessary if funds or unitholders wish to obtain legally binding advice from the ATO. The 2005 Budget announced that CGT will, after suitable amendments are passed, only apply to foreign residents in respect of land in Australia, assets of a branch in Australia and interests in entities which predominantly hold Australian land. This measure may render some of the amendments made by the third NITA Act redundant or at least of much less relevance. 2New International Tax Arrangements Update and Draft Conduit Measures (NITA 5)

3 NITA 5 On 17 June 2005 the Government released draft legislation and explanatory notes on Conduit Foreign Income, one of the remaining items of business from the 2003 Budget response to the Review of International Taxation. There are still several outstanding items from the announcement of the reforms, as well as a promised more general review of the FIF regime. The rest of this tax brief deals with the recently released draft legislation and its place in the overall treatment of conduit income. The Conduit Income Jigsaw One of the fundamental international tax principles accepted in the 2003 Budget is that Australia should generally not be taxing foreign source income derived by an Australian entity if that income belongs to a foreign resident. Such income is generally referred to as conduit income. Measures that produced this result had been adopted in the past but they were piecemeal and did not cover many cases. Over the course of the NITA process, the principle is being implemented more thoroughly, though not always in an obvious way. For the conduit income to be fully relieved from Australian tax, an effective exemption has to apply both when the income is derived by the Australian entity and then when it is received or realised by the foreign resident owner. This involves effectively three exemptions: 1 exemption from Australian company tax on foreign source income derived by an Australian resident company, including dividends from and capital gains on shares in subsidiaries as well as other foreign income; 2 exemption from Australian dividend withholding tax when this income is repatriated to foreign shareholders in the Australian company; and 3 exemption from Australian CGT when shares in the Australian company are disposed of by the foreign shareholders at least to the extent that the company has retained the foreign income. The draft is concerned with the second exemption. For Australian resident companies, conduit treatment is achieved by a number of measures, some of which also serve other purposes. The broadened exemptions for foreign non-portfolio dividends and income of foreign branches, and the capital gains exemption for non-portfolio share interests in foreign companies with active business assets introduced by NITA 2 are the first step in the solution. These measures also, however, apply to companies wholly owned by Australian residents and are designed to make Australian companies internationally competitive, as well as being one part of conduit relief. A foreign resident shareholder in an Australian company may receive or realise foreign income derived by the company either by a distribution from the company or by disposal of its shares in the company. Under the CGT, Australia currently does not tax the disposal of portfolio interests in Australian public companies by 3New International Tax Arrangements Update and Draft Conduit Measures (NITA 5)

4 foreign shareholders. The 2005 Budget announced as noted above that nonportfolio shareholdings of foreign residents in Australian companies will also be exempted from CGT (unless the company primarily holds Australian land). Legislation to that end should be in place by 30 June Hence conduit treatment will be achieved to the extent that such gains reflect foreign income of the company, but again the measure goes further because the exemption also applies to capital gains arising because the company has retained Australian source income. The final part of the jigsaw is dividends paid by Australian companies to foreign shareholders out of foreign source income. To the extent that no Australian tax has been paid on such income, it will emerge as an unfranked dividend and would be subject to dividend withholding tax in the absence of any relief from that tax. There already is some relief from this withholding tax under treaty and domestic law. Under the 2001 Protocol to the Australia US tax treaty and the 2003 Australia UK tax treaty, there is no dividend withholding tax payable if among other tests, a US or UK parent company holds 80% or more of an Australian subsidiary. Like the CGT measures referred to above, this exemption achieves a measure of conduit relief but goes further and covers dividends out of Australian source income. Currently there is specific conduit relief for foreign dividends received by Australian companies through the foreign dividend account. This mechanism provides an exemption from dividend withholding tax on the unfranked part of dividends paid to foreign residents out of certain foreign income. The relief only applies in respect of non-portfolio foreign dividends received by the Australian company, not other income, and is not effective outside consolidated groups if the dividends pass through another Australian company before being paid offshore. Draft Legislation The draft legislation expands the coverage of foreign income that is relieved from dividend withholding tax, alters the mechanism used to achieve the exemption and deals with dividends out of foreign income passing between Australian companies. Notwithstanding the changes, a number of features of the draft legislation reflect the current rules for the foreign dividend account. The measures apply to limited partnerships, corporate unit trusts and public trading trusts taxed as companies but the discussion below is focussed on companies. Income Covered The income covered by the measures is initially worked out by asking if the income would not have been assessable income if the Australian resident company receiving it were a foreign resident. This indirect way is used for identifying foreign source income as Australia does not have a consistent set of source rules that apply in all cases. 4New International Tax Arrangements Update and Draft Conduit Measures (NITA 5)

5 A number of adjustments are then made to this initial amount. First, and at first sight bizarrely, any amount that is actually assessable income of the Australian company is excluded. There are two keys points to be made about this apparent oddity. One is that much foreign income of an Australian resident company will not be assessable income, such as foreign non-portfolio dividends and most foreign branch income. The other is that most of the rest of the foreign income of the Australian company (such as foreign interest income) will be passive income of various kinds. This income will be assessable and subject to a foreign tax credit to the extent it is subject to foreign tax. A separate provision treats such income as conduit foreign income to the extent that the overall foreign tax on the income is equivalent to the Australian corporate tax rate. For example, if a company had foreign net income of 100 and a foreign tax credit of 21 in respect of that income, then the foreign conduit income is treated as [21 x 0.7/0.3] or 49 which is 70 net foreign income less 21 foreign tax on that income (70 taxable income is the amount that would produce tax of 21 calculated at the 30% Australian corporate tax rate). Australia does not provide the remaining 30 net foreign income with conduit relief. The reason, which does not appear in the Explanatory Notes, is presumably to avoid Australia becoming a haven for such passive income of foreign residents and attracting the ire of the OECD for engaging in harmful tax practices. The net foreign income thus bears Australian tax to the extent that tax exceeds the foreign tax and the part of the foreign income subject to Australian tax will emerge as a franked dividend which means that no withholding tax applies if it is paid to a non-resident. Because foreign tax credits are determined on an income year basis, this amount is added to foreign conduit income in the following income year, rather that the year in which the credit arose. It is not apparent why such a following year basis is justified for foreign tax credits when a current year basis is used for capital gains and losses as noted below. This approach is likely to cause confusion among taxpayers and increase compliance costs. The second adjustment is that dividends from foreign companies are not included in foreign conduit income if the underlying income is taxed in Australia under the CFC or FIF measures. Again this will generally be passive income. It will also emerge as a franked dividend because of the payment of Australian tax. Presumably Australia does not want to become a haven for such income by exempting it from Australian tax when it flows through Australia to a foreign resident. Under the third adjustment, expenses that relate to the foreign conduit income reduce the amount of that income unless the expenses are deductible for Australian tax purposes. The exception for deductible expenses recognises that debt deductions covered by the thin capitalisation regime (which disallows deductions above the relevant ceilings but allows deductions below the ceilings) do not depend on deductions relating to particular income. Fourthly, there are special rules for capital gains. Gains exempt under the new participation or branch exemptions introduced by NITA 2 reduced by capital 5New International Tax Arrangements Update and Draft Conduit Measures (NITA 5)

6 losses of the same kind enter the amount of conduit foreign income as at the end of the income year in which the relevant CGT events occur. This means that other assessable or non-assessable capital gains (such as gains on pre-cgt foreign assets) are not included in conduit foreign income even though they are foreign. Hence there is no conduit relief in respect of such gains. This result is deliberate. The Explanatory Notes maintain that it would be very complex to extend relief to such cases and that the measure is about new investments rather than existing investments. It is hard to accept the new investment argument which is not applied elsewhere in the draft. Relief Mechanism Relief is achieved by granting an exemption from dividend withholding tax on the unfranked part of a frankable dividend to the extent that it is declared to be conduit foreign income. Rather than requiring the formal keeping of a foreign conduit income account, the draft legislation is set up in such a way that an Australian company can keep a running account if it wishes, but equally it can apply the measure to specific conduit foreign income without keeping an account. Companies which wish to rely on the measure regularly for their dividend payments will find it easiest to maintain a running account. Naturally once particular foreign conduit income has been the subject of one declaration that it is conduit foreign income, it cannot be the subject of a later declaration. As with the foreign dividend account, anti-streaming rules are included to prevent foreign conduit income being streamed to foreign residents. Effectively any conduit foreign income declaration has to relate to all membership interests (that is, shares but excluding those that are debt interests) other than interests which do not have any entitlement to distributions other than on winding up. If this is not done and there is insufficient conduit foreign income to support such a declaration, there is an administrative penalty levied. To the extent the membership interests are held by residents, the penalty rate is 30% (the Australian corporate rate) of the deficiency. To the extent membership interests are held by non-residents, the penalty rate is 15% of the deficiency which is designed to reflect the dividend withholding tax that would otherwise have been paid on the dividend. The rate of such tax can vary between zero and 30%, depending on the treaty situation, and 15% is chosen as a typical rate. There are no special rules dealing with trading in the shares of companies with conduit foreign income. For example, a non-resident could purchase from resident shareholders all the shares in an Australian company pregnant with foreign income and declare a conduit foreign income unfranked dividend. Presumably reliance will be placed on general anti-avoidance rules to deal with such cases. 6New International Tax Arrangements Update and Draft Conduit Measures (NITA 5)

7 Dividends Passing Through Other Australian Companies If an Australian resident company receives an unfranked part of a dividend declared to be conduit foreign income, this amount is conduit foreign income of the recipient and also non-assessable non-exempt income of the recipient company to the extent it is on-distributed. That is, the receiving company must itself pay an unfranked dividend declared to be conduit foreign income before the due date for the tax return of the income year the dividend was received. If the on-paying company has expenses related to the dividend it received, the amount that is conduit foreign income and non-assessable non-exempt income is reduced proportionately. In this way it is possible to pass conduit foreign income between Australian companies before it is distributed offshore. If the two companies are part of a consolidated group the same result is achieved differently. The single entity rule means that the conduit foreign income is effectively treated as income of the head company of the group, not of the subsidiary that actually receives it. Any dividend that passes the income from the subsidiary to another member of the consolidated group, including the head company, is ignored for tax purposes under the single entity rule. Adjustments are to be made to the consolidation rules so that the conduit foreign income is also treated as that of the head company not the subsidiary (just as head companies currently maintain the foreign dividend account). Complexity and Uncertainties It will be evident from the above discussion that the conduit foreign income exposure draft is complex, despite its relative brevity of 14 pages. As a result there may be some technical difficulties with the measures. The measures are also silent on an issue that has bedevilled a number of NITA measures, the treatment of income derived through trusts and partnerships. It is understood that Treasury is aware of a number of these issues and that at least some of them are likely to be addressed in the final version of the Bill. Transition The new system is intended to apply for income years starting on or after 1 July 2005 but as the Act was not passed as at that date, the transition is somewhat complicated. If an income year for a company starts on or after 1 July 2005 and before the Act incorporating the measure receives Royal Assent, then the current foreign dividend account continues to operate to the day before Royal Assent. Any surplus in that account as at the day of Royal Assent is converted to conduit foreign income on that day. A company can only make a declaration that a dividend is conduit foreign income as from the date of such Assent. 7New International Tax Arrangements Update and Draft Conduit Measures (NITA 5)

8 If the first income year starting on or after 1 July 2005 commences after the Act receives Royal Assent, then the foreign dividend account rules are kept in operation up to the start of that year despite their repeal and any surplus is converted to conduit foreign income as at the start of that income year. In either event, the rule which treats assessable foreign income subject to a foreign tax credit as conduit foreign income does not commence until the next income year because that measure, as explained above, operates on a following year basis. For further information, please contact Sydney Mark Ferrier Mark.Ferrier@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 New International Tax Arrangements Update and Draft Conduit Measures (NITA 5)