Commonwealth Numbered Regulations - Explanatory Statements

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INCOME TAX REGULATIONS (AMENDMENT) 1994 NO. 412

EXPLANATORY STATEMENT

Statutory Rules 1994 No. 412

Issued by the Authority of the Assistant Treasurer

Income Tax Assessment Act 1936

Income Tax Regulations (Amendment)

The Governor-General may make regulations under section 266 of the Income Tax Assessment Act 1936 (the Act) for the purposes of the Act.

Regulation 152C of the Income Tax Regulations (the Principal Regulations) provides various tests to determine if passive-type income derived by certain foreign companies is concessionally taxed in the company's country of residence.

If the income is concessionally taxed, it may be attributed to an Australian taxpayer who is a shareholder of such a company under the accruals tax measures which apply to foreign source income. In other words, the Australian taxpayer is taxed on that income as though the taxpayer itself had derived that income. A brief summary of the accruals tax measures is at Attachment A.

The Government has decided to amend Regulation 152C to provide an additional test. The new test will ensure that income of a foreign company which is reduced by losses transferred to the company from a foreign branch does not result in that income being concessionally taxed.

Details of the Regulations are as follows.

Regulation 1 provides that the Regulations will commence on 1 July 1989. The accruals tax measures relating to the Principal Regulations commenced at the beginning of the 1990-1991 income year. The Regulations operate retrospectively from 1 July 1989 to cater for Australian companies which have substituted accounting periods with early balancing dates. As these changes will benefit taxpayers, they will not impose any retrospective liability on any taxpayer. Therefore, they will not contravene subsection 48(2) of the Acts Interpretation Act 1901 which prohibits the retrospective operation of regulations which affect the rights of, or impose liabilities on, taxpayers.

Regulation 2 provides that the Regulations will amend the Principal Regulations.

Regulation 3 will, in effect, delete the existing subregulation dealing with the transfer of losses between two foreign companies and insert new subregulations which will permit the transfer of losses between a foreign company and a branch owned by an Australian taxpayer as well as the transfer of losses between two foreign companies owned by the taxpayer. A detailed explanation of Regulation 3 is at Attachment B.

Detailed examples of the practical application of the Regulations are set out in Attachment C.

Attachment A

SUMMARY OF ACCRUALS TAX MEASURES

The Regulations form part of the accruals system of taxing certain foreign source income. This system was introduced into the Act on 1 July 1990. It is commonly known as the controlled foreign company (CFC) measures. These measures were designed to prevent Australian taxpayers from avoiding, or at least delaying, the payment of Australian tax on overseas earnings by retaining those earnings in offshore companies. An offshore company that is subject to these measures is called a controlled foreign company (CFC).

Broadly, the CFC measures attribute the overseas earnings of a CFC to the Australian taxpayers which control the company. That attributed income is included in the taxpayers' income in the year in which it is actually derived by the CFC.

As it is not the purpose of the CFC legislation to discourage normal overseas business enterprise by Australian taxpayers, but to stop tax avoidance, there are concessions incorporated into the legislation to exclude some types of income from attribution. In general, income which is gained from normal business activities is excluded from the CFC measures, as is income which is taxed in a foreign country at a level closely comparable with the Australian rate.

Countries which have tax regimes and tax rates similar to Australia's are specified in Schedule 10 of the Regulations. These countries are called 'listed countries'. Other countries, with tax regimes and rates more widely differing from Australia's are called 'unlisted counties'.

The Principal Regulations seek to protect the Australian revenue from loss through tax concessions offered to CFC's by the tax regimes of listed countries. Regulation 152D details passive-type income (e.g., interest income, royalties, dividends) derived by CFC's which, if concessionally taxed, will be termed 'designated concession income'. This concessionally taxed income is attributed to Australian taxpayers under the CFC measures. Regulation 152C contains various tests which are collectively referred to as the 'subject to a reduction of tax' test to determine whether passive-type income derived by a CFC is concessionally taxed.

Attachment B

DETAILED EXPLANATION OF REGULATION 3

Subregulation 3.1

This subregulation amends subsection 152C(3) to remove the words 'income or profits mentioned in subregulation 152C(1)' and replace them with the words 'income or profits derived by an entity referred to in subregulation 152C(1)'.

Ibis amendment, together with part of the amendment to 152C(3A), makes clear that the entity referred to in 152C(1) and the entity referred to in 152C(3), is the same entity as is defined in subregulation 152C(3A), namely the entity which makes the profit in the situation being considered . In this Explanatory Statement, this entity is referred to as the profit entity.

Subregulation 3.2

This subregulation amends subregulation 152C(3A). It specifies that, subject to subregulation 152C(3C), a loss transfer does not constitute a 'reduction of tax' in terms of paragraph 152C(1)(g) when the profit entity (ie. the entity to which the loss is transferred to be offset against its income) is now one of the following two entities:

1.       a CFC resident in a listed country (paragraph 152C(3A)(a)); or

2.       an Australian company which has a permanent establishment (branch) in a listed country (paragraph 152C(3A)(b)).

The effect of such a loss transfer not constituting a reduction of tax for the purposes of paragraph 152C(1)(a) is that the income of the profit entity will not be designated concession income for the purposes of Regulation 152D.

Subregulation 3.3

This subregulation replaces paragraph 152C(3C)(a). The new paragraph specifies that new subregulation 152C(3A) applies only if, in a loss transfer situation, the loss entity (ie. the entity which transfers the loss to the profit entity) is now one of the following three entities:

1.       a CFC of the same Australian entity of which the profit entity is also a CFC (subsubparagraph 152C(3C)(a)(i)(A)). A diagram outlining the operation of this provision is set out below.

A graphic exists here. Use Browse to view it

The concept of 'group companies' is discussed at the end of this Attachment.

2.        a CFC of the same Australian entity of which the profit entity is a branch (sub-subparagraph 152C(3C)(a)(i)(B)). A diagram outlining the operation of this provision is set out below.

A graphic exists here. Use Browse to view it

3.       a branch of an Australian entity (subparagraph 152C(3C)(a)(ii)). A diagram outlining the operation of this provision is set out below.

A graphic exists here. Use Browse to view it

Subregulation 3.4

This subregulation inserts new subregulations 152C(3F) and 152C(3G). These new subregulations specify that a profit entity, which is a CFC in a listed country, will only gain the benefit of subregulation 152C(3A) when the loss which is transferred is a loss which is incurred by an Australian resident company carrying on business through a 'permanent establishment' (branch) in the listed country.

It is considered unlikely that this subregulation will often apply to an Australian resident company because it is expected that the tax laws of most listed countries would permit the transfer of branch losses only to a CFC. In other words, it is unlikely that the tax laws of a listed country would permit losses not incurred in connection with a branch to be transferred to a CFC resident in that country. However, should such a situation occur, these provisions would exclude it from the concessions provided by subregulation 152C(3A).

Group companies

A company (1st Company) is a group company in relation to another company (2nd company) if the 1st company is either a parent or subsidiary of the 2nd company, or the lst and 2nd companies are both subsidiaries of another company. In the Principal Regulations, a company is a subsidiary of another company if that other company owns 60% or more of the shares issued by the first company.

Attachment C

Example One: Loss transfer from CFC to branch.

This example sets out how the Australian tax law operates in relation to an Australian company (Austco) where its listed country CFC transfers a loss to Austo's branch situated in the same listed country. Part 1 examines the application of the law prior to the amendment of the Principal Regulations. Part 2 reconsiders the situation in Part 1 under the new Regulations.

Part 1

Austco is an Australian company which operates a branch (foreign-branch), and also controls a subsidiary which is a CFC, in the same listed country. The tax law of the listed country permits the transfer of losses between branches and CFCs in the same group of companies.

In a given year, the CFC incurs a net loss of $100,000. Foreign-branch has net interest income of $200,000. The tax law of the listed country. operates as follows:

Listed country tax position for foreign-branch


Interest income
Loss from CFC
Net income
Listed country tax rate 30%     
Listed country tax paid

   $
200,000
100,000
100.000

30,000

Australian tax position for foreign-branch

The foreign-branch is a part of Austco, not a separate legal entity. Therefore the income of the foreign branch needs to be taken into account for Australian tax purposes. The process by which this occurs is set out below:

•       The $100,000 loss transfer reduces the $200,000 interest income for the purposes of determining the amount of taxable income of the foreign branch, under the tax law of the listed country. Under Regulation 152C(1)(g) this has the effect of making the whole of the $200,000 interest income of the branch 'designated concession income' under Regulation 152D(1)(b).

•        That 'designated concession income' is 'eligible designated concession income' within the meaning of that term defined in section 317 of the Act.

•       Therefore section 23AH(1)(c) does not apply to exclude the amount from the assessable income of Austco, the owner of foreign-branch.

•       The income of foreign-branch is therefore dealt with as follows in the hands of Austco under Australian tax law:


Income assessable under s 25
S 6AC(1) uplift
Total assessable income
Australian tax rate 33%
Australian tax payable
Less foreign tax credit (s 160AF)      
Net Australian tax payable

   $
170,000
30,000
200,000

66,000
30,00
36,000

Where, in the current year, the tax loss is transferred by the CFC to the branch, the operation of Regulation 152C(1)(g) as outlined above has the effect that the group as a whole loses the tax benefit of their loss. If the CFC elected not to transfer the loss to the group branch, no eligible designated concession income would arise under the Regulations. However, the CFC would have to defer these losses to be utilised in a subsequent year.

Part 2

In relation to Example One above, under the new Regulations, the Australian tax position for foreign-branch will now be as follows:

The income of foreign-branch will meet the conditions for exclusion from the assessable income of Austco under subsection 23AH(2) of the Act since:

•       it is income derived during or after the year of income commencing on 1 July 1990 (paragraph 23AH(1)(a));

•       the income is derived through a 'permanent establishment' (branch) in a listed country (paragraph 23AH(1)(b));

•       the income is not 'eligible designated concession income' and therefore paragraph 23AH(1)(c) does not apply to negate the exemption;

[Note: The only change made by the amending Regulations is in relation to this point. All the other requirements outlined in the other three dot points are not affected by the amending Regulations.]

•       the income is 'subject to tax' in a listed, country (paragraph 23AH(1)(d)).

[Note: The concept of 'subject to tax' is defined in s 324 of the Act and is to be distinguished from the 'subject to a reduction of tax' test in Regulation 152C.]

Example two: Loss transfer from branch to CFC.

This example sets out how the Australian tax law operates in relation to an Australian company (Austco) where its listed country branch transfers a loss to its CFC resident in the same listed country. Part 1 examines the application of the law prior to the amendment of the Principal Regulations. Part 2 reconsiders the situation in Part 1 under the new Regulations.

Part 1

In a given year foreign-branch makes a net loss of $100,000. The CFC has interest only income of $200,000. The tax law of the listed country operates as follows:

Listed country tax position for the CFC.


Interest income
Loss from foreign-branch
Net income
Listed country tax rate 30%
Listed country tax paid

   $
200,000
100,000
100,000

30,000

Australian tax position for the CFC

•       The $100,000 loss transfer reduces the $200,000 interest income for the purposes of determining the amount of taxable income of the foreign branch under the tax law of the listed country. Under Regulation 152C(1)(g), this has the effect of making the whole of the $200,000 interest income of the CFC 'designated concession income' under Regulation 152D(1)(b).

•       that 'designated concession income' is 'eligible designated concession income' within the meaning of that term as defined in s 317 of the Act;

•       the CFC will fail the 'active income test' as set out in subsection 433(2) of the Act because the tainted income ratio in this example would be 100%. The tainted income ratio is 100% because all of the income derived by the CFC is tainted eligible designated concession income.

•       the attributable income of the CFC is calculated as follows:


Notional assessable income
Notional allowable deductions
(ie tax paid in listed country)
Attributable income

   $
200,000 [s 385(2)]

30.000 [s 393(1)]
170.000 [s 382]

•       the amount of attributable income is included in the assessable income of Austco [s 456];


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