2014 amendment removes an inconsistency in the Australian Unit Trusts rules and ensures the taxation of Australian Unit Trusts is consistent across both countries.
Sections EX 22 and EX 35 of the Income Tax Act 2007
Under the new rules Australian Unit Trusts that are not taxed as companies under Australian law are 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). This change removes an inconsistency in the previous rules and ensures that the taxation of Australian Unit Trusts is consistent across both countries.
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When the grey list exemption for CFCs was repealed in 2009 it was replaced by an exemption for active income (the active business test) and an exemption for Australian CFCs.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.
An equivalent exemption for non-portfolio FIFs (that is, when 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.
Key features
Unit trusts cannot claim the Australian exemptions unless they are taxed under Australian law as companies (sections EX 22 and EX 35).
Application date
The changes apply to income years beginning on or after 1 July 2014.
Repeal of section DB 55
Sections DB 44 of the Income Tax Act 2004 and DB 55 of the Income Tax Act 2007
Section DB 55 of the Income Tax Act 2007 has been repealed. This section allowed 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.
Background
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.
Key features
Section DB 55 has been repealed from the 2008-2009 income year.
A "savings" provision is included to preserve assessments based on the current rules if the returns were filed before the date of introduction of the Taxation (Annual Rates, Employee Allowances, and Remedial Matters) Bill on 22 November 2013, for the 2013 and 2014 income years, if the taxpayer has previously relied on that section.
A retrospective amendment has also been made to resolve a potential conflict between section DB 55 and the general rules governing deductions.
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, applies from 1 October 2005.
Indirect interests in FIFS
Sections EX 50 and EX 58 of the Income Tax Act 2007
The rules that apply to indirectly held interests in FIFs have been clarified. 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.
Background
The previous rules applied 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 those rules was that the person should have FIF income attributed to them on the basis of a 7.5 percent indirect interest holding. The new rules ensure that a person in this situation cannot 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.
Key features
Taxpayers who indirectly hold FIF interests are treated as if they directly held an equivalent interest.
Application date
The changes apply to income years beginning on or after 2014–15.
Active business test for wholly owned groups
Sections EX 21B and EX 21D of the Income Tax Act 2007
Under the previous rules, taxpayers determining whether a CFC met the active business test had 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 have been 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 continues to apply.
Wholly owned groups of companies are not restricted from forming over-lapping test groups by including any one CFC in multiple different test groups.
The changes remove unnecessary restrictions on how these groups can access the active business test.
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.
Key features
The change extends the test grouping rules to CFCs owned by a group of companies.
Application date
The changes apply to income years beginning on or after 1 July 2009.
Negative passive income and accounting standards test for CFC
Section EX 21E of the Income Tax Act 2007
A negative numerator in the formula defined in section EX 21E(5) no longer disqualifies a CFC from passing the active business test. Instead the negative numerator is deemed to be zero. The change removes an unnecessary compliance burden.
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) provided that if the numerator (the top line of the formula) is negative, the CFC would fail the accounting standards test and would 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.
Key features
Negative numerators no longer exclude a CFC from passing the active business test.
Application date
The change applies to income years beginning on or after 1 July 2009.
Foreign exchange gains and losses on liabilities
Section EX 21E of the Income Tax Act 2007
Taxpayers now have 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 accounting standards 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 can now apply the accounting standards test using a combined amount.
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 relieves these companies from the additional compliance costs of separating foreign exchange gains from losses.
Key features
Taxpayers who are unable to readily distinguish the foreign exchange gains and losses on financial assets from those on liabilities are able use a combined amount.
Application date
The change applies to income years beginning on or after 1 July 2009.
Detailed analysis
This change has been made in response to taxpayer submissions which said that foreign exchange amounts are often accounted for together in ledger accounts. Financial arrangements such as intercompany accounts or cash sweep accounts could also change from being financial assets to financial liabilities within a financial year (or vice versa). Depending on the financial reporting system used, the gains and losses on assets may not be readily distinguishable from those on liabilities.
Meaning of "readily distinguishable"
Whether this information is readily distinguishable will depend on the facts and circumstances in each case. Taxpayers should use their own judgement about whether their systems readily distinguish between the gains or losses on assets and liabilities.
Consistency
If information is or is not readily distinguishable in one year then it is reasonable to assume that it will or will not be readily distinguishable in future years unless there has been a change to the taxpayer's financial reporting system.
Similarly it is expected that if a taxpayer's financial reporting systems do or do not readily distinguish between the gains or losses on assets and liabilities for the interests in one CFC, they will or will not do so for all of the CFC interests under those financial reporting systems.
The policy intent behind this change is to provide a compliance concession to taxpayers who would otherwise have to incur undue costs to meet their obligations. It is not intended that taxpayers will be able to switch between the two options on a regular basis, or apply different approaches for different CFC interests, depending on the tax outcome.
Apportioned funding income
Sections EX 20B and EX 20C of the Income Tax Act 2007
The provisions relating to apportioned funding income have been moved 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 means taxpayers can take this adjustment into account when applying the active business test under section EX 21D.
The change is intended to provide a CFC with a more accurate calculation of its active-to-passive income ratio.
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 also provides 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.
Key features
The specific effects of the provisions are unchanged.
Moving the provisions into section EX 20B means taxpayers can take this adjustment into account when applying the active business test under section EX 21D.
Application date
The change applies to income years beginning on or after 1 July 2009.
Test groups for CFCs with offshore branches
Sections EX 21D and EX 21E of the Income Tax Act 2007
Taxpayers can now form test groups for the active business test that include CFCs with offshore branches. The CFC must be able to pass the active business test in its own right and any active income attributed to the offshore branch is excluded from the test group active business test calculation.
Background
It is not unusual for an operating company to have an offshore branch in another jurisdiction which may, for example, comprise a small sales team. The rules determining whether a branch exists are not clear cut, and can vary from country to country, so it is possible that a CFC may unintentionally establish an offshore branch and unexpectedly fall outside of the test group rules.
The CFC rules allow taxpayers to group multiple CFCs together for the purposes of calculating the active business test. There are rules which limit the CFCs that can be included in the group, one of which is that each CFC must have a "taxed CFC connection" with the same country or territory.
The "taxed CFC connection" essentially requires that the CFC is taxed and resident in the country it is based in and not taxed or resident in any other country. Under the previous rules, this had the effect of barring any CFC that has an offshore branch from being included in a test group. This had a disproportionate effect on CFCs that have minor business presences in other countries.
Key features
CFCs with permanent establishments are able to join test groups.
However, these CFCs must be able to pass the active business test in their own right.
Active income from the permanent establishment is excluded from the test group calculation.
Application date
The change applies for income years beginning on or after 1 July 2009.
Extending the on-lending concessions and exemptions for group funding
Sections EX 20C and EX 20D of the Income Tax Act 2007
The CFC rules have been amended so that the on-lending concession and exemptions that apply to certain interest payments also apply to those dividends that are taxed like interest payments. The measure is intended to align the treatment of dividends from deductible and fixed-rate shares with the treatment of interest.
Background
The CFC rules generally treat dividends from certain types of shares (deductible and fixed-rate shares) in the same way as interest on debt. This is because these shares have debt-like characteristics and are highly substitutable for debt.
Under the CFC rules, a CFC that borrows money and then lends that money on to an associated CFC is able to claim a full deduction of any expenses incurred (the on-lending concession). There is also an exemption for interest income that a CFC receives from lending money to an associated active CFC that is located in the same country.
These rules did not apply to fixed rate foreign equity or shares giving right to a deductible foreign equity distribution. In some instances this led to the same income being taxed twice.
Key features
Dividends that are treated like interest under the normal tax rules are given access to the same exemptions that apply to interest under the CFC rules.
This applies to fixed rate foreign equity or shares giving right to a deductible foreign equity distribution.
Application date
The change applies to income years beginning on or after 1 July 2009.