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13 July 2007 Foreign Source Income Anti-Tax-Deferral Review Board of Taxation Secretariat C/- The Treasury Langton Crescent PARKES ACT 2600

By email: [email protected] Dear Sir/Madam, Submission on the review of the foreign source income anti-tax-deferral regimes The Institute of Chartered Accountants in Australia (Institute) welcomes the opportunity to comment on the discussion paper released by the Board of Taxation titled “Review of the Foreign Source Income Anti-Tax-Deferral Regimes” (the Discussion Paper). The Institute is Australia’s premier accounting body, which represents over 44,000 members who are fully qualified Chartered Accountants working either in the accounting profession providing auditing, accountancy, taxation and business consultancy services or in diverse roles in business, commerce, academia or government. Our submission on the Discussion Paper is attached. Should you have any questions regarding this submission, please do not hesitate to contact, in the first instance, Ali Noroozi, Tax Counsel of the Institute, on (02) 9290 5623. Yours sincerely,

Bill Palmer General Manager Standards & Public Affairs Institute of Chartered Accountants in Australia

mailto:[email protected]

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Submission on the “Review of the Foreign Source Income Anti-Tax-Deferral Regimes” Discussion Paper

TABLE OF CONTENTS

Executive summary................................................................................................................ 5 Chapter 3: Interests and Entities............................................................................................ 8 Q3.1 For discretionary interests, should the attribution rules focus on potential

beneficiaries rather than transferors? If so, why, and how?....................................... 8 Q3.2 What aspects of the current rules create uncertainty in identifying relevant interests? How should those aspects be clarified? .................................................... 9 Q3.3 Are economic interests that are not recognised legally for the purposes of the attribution rules a concern? If not, why?......................................................... 10 Q3.4 To what extent does the Government’s announcement to align the definition of non-portfolio dividend with economic ownership concepts affect your answer to Q3.3? ..................................................................................... 11 Q3.5 How should the attribution rules be modified to ensure that they do not disrupt conduit income arrangements for non-residents? ........................................ 13 Chapter 4: Types of Income ................................................................................................ 15 Q4.1 Is passive income appropriately defined, given the need to strike a balance between compliance costs and integrity? ................................................... 15 Q4.2 Are there examples of income that is currently categorised as passive but should be treated as active? How should such examples be accommodated?....................................................................................................... 15 Q4.3 What other improvements could be made to the operation of the active income and business exemptions to address difficulties and reduce compliance costs?........................................................................................ 20 Q4.4 Are there better alternatives to the CFC approach of positively listing passive income? ............................................................................................ 22 Q4.5 Is it possible to provide an intra-group financing exemption, having regard to integrity and compliance costs?................................................................ 22 Q4.6 How could an intra-group financing exemption be defined, and why is such an approach preferred?................................................................................ 22 Q4.7 Do the base company income rules need to be retained? If not, why?.................... 23 Q4.8 Would the removal of the base company income rules create an unacceptable revenue risk? If not, why?.................................................................. 26 Q4.9 If necessary, in what way could the transfer pricing rules be strengthened to allow the base company income rules to be repealed, or reduced in scope?................................................................................ 26 Q4.10 Would the listed country approach need to be retained if the definition of passive income was narrowed (or active income better targeted)?....................................................................................................... 27 Q4.11 Are there alternative approaches that, either alone or in combination, would obviate the need for a listed country approach? If so, what are the advantages and disadvantages over a listed country approach? ...................... 29 Q4.12 Should the current thresholds for the de minimis tests be adjusted, having regard to the potential tax deferral that could arise by increasing the thresholds? What other improvements should be considered? ......................... 30

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Q4.13 Should the de minimis exemptions operate on a more consistent basis across the regimes? If so, how could this be achieved?................................. 30 Q4.14 Could the exemptions for entities or investment arrangements that pose little or no tax deferral risk be improved? If so, how? ............................... 31 Q4.15 How could the exemptions be modified to ensure greater investment neutrality? .............................................................................................. 32 Q4.16 Are there other exemptions or approaches that could be considered? If so, why? ................................................................................................................ 32 Q4.17 Would a purpose or motivation test meet the policy objectives outlined in Chapter 2? If so, how could such a test apply to provide reasonable certainty in a self assessment environment? ........................................................... 33 Q4.18 For managed funds, how could the rules better target offshore income accumulation? .......................................................................................................... 36 Q4.19 Could any changes for managed funds apply more broadly to cover, for example, companies? If so, why and how? ........................................................ 36 Q4.20 Should a public company exemption be included in the attribution regimes? If so, why? ................................................................................................ 36 Q4.21 Could a more generic approach to defining an accumulation vehicle be used to address neutrality concerns? If so, how? .............................................. 37 Q4.22 Could a foreign public company exemption consistent with that in the FIF regime be applied across the attribution regimes? ............................................ 38 Chapter 5: Method of Attribution.......................................................................................... 39 Q5.1 How could the current attribution methods be improved to resolve the distortions that currently exist (both across the regimes and within the regimes)? ................................................................................................. 39 Q5.2 How could the current branch-equivalent calculation approach be improved? Would the adoption of the FIF calculation method adequately address concerns in relation to complexity and compliance costs? ........................ 39 Q5.3 Which provisions of the Australian tax laws should be excluded from

branch-equivalent calculations and why? ................................................................ 40 Q5.4 How could the market value method be improved? ................................................. 41 Q5.5 How should the deemed rate of return be changed to better approximate returns on foreign investment? To what level and why? .......................................... 41 Q5.6 Could the deemed rate of return method be applied consistently across all the attribution rules? ............................................................................................ 42 Q5.7 What other attribution methods are viable alternatives? Would these methods strike an appropriate balance between compliance, complexity, integrity and neutrality? ............................................................................................ 42 Q5.8 Should taxpayers be permitted to choose which attribution method to apply or should some restrictions apply? ................................................................. 43 Q5.9 How should the percentage of income attributed be determined where the taxpayer has no fixed, legal interest in the foreign entity? ................................. 43 Q5.10 Is it practicable to calculate attributable income on the proportional value of the property or services transferred (rather than attributing all income of the foreign entity)? .............................................................................. 45 Q5.11 Should attributable income be apportioned to reflect part-year ownership of the foreign entity, and how would apportionment apply?.................... 47

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Chapter 6: Design Principles of a harmonised attribution regime........................................ 49 Q6.1 To what extent would harmonising the regimes benefit taxpayers? Would these benefits outweigh the associated transitional costs? .......................... 49 Q6.2 Of the three harmonisation options, which one is preferred and why? Are there different approaches to harmonisation that should be considered? ......... 50 Q6.3 Under the second option, how could the FIF-style active business exemption apply to eliminate the need to replicate the CFC-style active income exemption?............................................................................................................... 51 Q6.4 If the FIF-style active business exemption was extended to what are currently CFC interests, would that produce an unmanageable revenue risk for government? If not, why? ............................................................... 51 Q6.5 Should the transferor trust rules be harmonised with the other attribution rules? If not, why? Is justification on the basis that they target different taxpayers sufficient? What integrity issues could arise if the transferor trust rules were harmonised with the other rules? .......................... 52 Q6.6 What improvements to tax administration would assist taxpayers meet their obligations under the attribution rules? ............................................................ 52 Q6.7 What improvements could be made to the administration of the attribution rules that would reduce compliance costs and complexity, while balancing integrity objectives?...................................................................................................... Q6.8 What transitional issues are likely to arise and how should they be addressed? .............................................................................................................. 53 Q6.9 How should the previously announced transferor trust amnesty be dealt with under harmonised arrangements?.................................................................... 54

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Submission on the “Review of the Foreign Source Income Anti-Tax-Deferral Regimes” Discussion Paper Executive summary The policy behind the accruals taxation of Australian residents is to prevent such taxpayers obtaining significant tax advantages – deferral of Australian taxation – by holding foreign source income offshore in a foreign company or trust. The income and capital gains which have been historically targeted as attributable have been income and gains from passive investments which are considered as being able to be readily moved from one tax jurisdiction to another and certain forms of business income which can be readily diverted to low-tax jurisdictions. Having applied exemptions – particularly relating to the investment in foreign companies predominately carrying on an active business – the methods of calculating attributable income should seek to target only the passive and base company income from non-commercial activities derived in the foreign entity (regardless of the level of investment) unless compliance and complexity would be created. These factors justify the choice of more “broad brush” approaches, such as the use of accounting profits, measurement of the increase in the value of the investment, or a deemed rate of return. Whilst there are some concerns with the existing anti-tax-deferral regimes, there are also positive features which, we believe, would be beneficial to retain in any new regime(s). We understand the focus of this round of consultation is to identify high level design principles and that a further process will occur to settle the details of the reforms. Accordingly, in addressing the questions contained in the Discussion Paper, we have sought to highlight the issues with respect to the current measures and suggest potential solutions for consideration by the Board of Taxation in the design of any new regime(s) which would be subject to further consideration and discussion in the detailed design phase. Our key points and recommendations are: Interests and entities that should be subject to the attribution rules

Whilst we acknowledge that economic interests that are not recognised legally for the purposes of the attribution rules are a concern in situations where it results in an inequitable amount being attributed to the legal owners, a change to an economic interests test should be carefully considered in light of additional compliance issues that could be caused (Recommendation 3.3).

An “asset based” small investor exemption should apply under a harmonised anti-tax-deferral regime with the asset thresholds reviewed (Recommendations 4.12 and 4.13).

For entities that pose little or no tax deferral risks, the current FIF approach to exemptions is preferred in an anti-tax-deferral harmonised regime (Recommendation 4.14).

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Entities that are less likely to structure investment for tax deferral purposes should be excluded from a harmonised anti-tax-deferral regime (eg. complying superannuation funds, widely held managed funds, foreign non-employer sponsored superannuation funds or their equivalent) (Recommendations 4.16 and 4.18).

The active income test should be retained, but with thresholds and the definition of what is tainted income revised so that it does not encompass commercial offshore activity. The base company income should only be treated as tainted to the extent that it is derived in respect of non-commercial offshore activity of related entities (Recommendation 4.7 to 4.9). The calculations necessary under the active income test should continue to be based on information that is easily accessible (Recommendation 4.3.1).

We support the introduction of a purpose test as a complement to the range of exemptions available under the anti-tax-deferral regimes (Recommendation 4.17).

Types of income that the anti-tax-deferral regimes should target

Where it can be established that a particular entity, either directly or in conjunction with other entities, is carrying on an active business, then income associated with that active business (including interest income, royalty income and rental income) should not be attributed (Recommendation 4.2.1).

Passive income and base company income should be redefined so that the concepts do not encompass commercial activity offshore. The following types of income should not be within the attribution rules:

- Related and non-related-party income from commercial activities - Income from legitimate foreign financing activities - Interest income that is incidental to a business - Rental income from the management and ownership of substantial properties

involving multiple tenants - Income received in respect of the use of substantial equipment, conducted

as part of a business activity - Royalty income from associates - Income from foreign infrastructure projects (Recommendations 4.2.2 to

4.2.8).

The listed country exemption must be retained in order to minimise compliance costs. Consideration should be given to expanding the exemptions for listed country entities as well as including additional comparable tax countries in the list. (Recommendation 4.10). The targeting of passive and base company income derived by foreign entities in listed countries to that which has been specifically designated should continue (Recommendation 5.1.2).

Methods of attributing targeted income

Taxpayers should be able to use any attribution method to calculate their attributed income. This approach will allow scope to combine the CFC and FIF measures as well as provide taxpayers with the flexibility to undertake precise CFC calculations where necessary information is available or to use a FIF type calculation method (Recommendation 5.1.1).

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The branch equivalent calculation could be improved by:

- Restricting the sections of the Australian tax law which apply - Making the distinction between passive and base company income versus

active income more appropriate and much clearer - Ignoring intra-group transactions for attribution purposes except where such

transactions have an Australian leg (Recommendation 5.2.1).

The deemed rate of return method should be changed to better approximate returns on foreign investments and not be set at a rate which is, as is currently the case, overly penal (Recommendation 5.5).

Explore the use of the following attribution methods in the Australian context:

- The New Zealand fair dividend rate method - Another possible option is that used in New Zealand which requires the

taxpayer to apply a cumulative return of 5% to the cost of each investment - An accounting profit approach in the CFC context (Recommendation 5.7).

With respect to taxpayers who have no fixed, legal interest in a foreign entity, an alternative option should be available to calculate the attribution amount (Recommendations 5.9.1 to 5.9.3).

Options for harmonising the anti-tax-deferral regimes

Harmonising the regimes would, prima facie, appear to offer some benefits to taxpayers. Important factors such as the need to meet policy objectives, the need for positive aspects of the various regimes to be retained and how issues with the existing regimes can be best addressed should also be borne in mind for any proposed, revised framework (Recommendation 6.1).

Of the three harmonisation options proposed in the Discussion Paper, Option C: merging some regimes (or aspects of regimes) is preferred. Specifically, merging the CFC and FIF rules would be beneficial. We see difficulties in trying to merge the transferor trust regime with the CFC and FIF rules (Recommendation 6.2).

Enhancement and improvement of the current exemptions and greater flexibility provided in the ways in which attributable income is calculated should keep transitional issues to a minimum. We recommend that further consultation with business groups and professional bodies should be undertaken once the high level design features are agreed (Recommendation 6.8).

Our detailed comments are set out below.

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Detailed comments on the Discussion Paper Chapter 3: Interests and Entities Q3.1 For discretionary interests, should the attribution rules focus on

potential beneficiaries rather than transferors? If so, why, and how? This question raises the issue whether the criteria of potential economic interest is more appropriate than the historical transfer of property or services for attribution of income from a foreign discretionary trust. The attribution rules for foreign discretionary trusts are currently based on the historical actions of the transferor. The result is that amounts of foreign income are attributed to a transferor when they may have no beneficial or economic interest in the income and assets of the trust. The attribution to an entity with no fixed or legal interest in the foreign entity is discussed in further detail in Q5.9. It seems unreasonable to impose tax on a taxpayer in respect of a share of the foreign entity’s income in which they have no economic interest. Conversely, it would seem reasonable to impose tax on a taxpayer in respect of a share of the foreign entity’s income in which they have an economic interest. We therefore contend that a taxpayer’s attribution percentage, in relation to attributable income, should be determined by reference to their economic interest in the income. The determination of an attributable transferor adds the requirement of control by the transferor. When an entity is in a position to control a trust is set out in the broadest terms. In practice a high degree of uncertainty exists over what constitutes control and whether control is taken to exist for the application of the attribution rules. The rules for determining a transfer are complex, especially given the requirement to determine a value under subsection 102AAZD(5) when there are multiple transferors and the inherent difficulty in determining market value. The multiple attribution may only be reduced via a Commissioner’s discretion (subsection 102AAZD(3)) and demonstrates the difficulties in working with the transferor provisions. From a practical viewpoint, it is also necessary for practitioners and taxpayers to overcome the difficulty in determining what might be a transfer of property or services. As a system to address discretionary trusts, the attribution rules should be relatively simple and equitable. However, the attribution rules need to take into account the special attributes of a discretionary trust. There may be a number of possible alternative methods of attributing income, however we recognise as part of this submission that all methods considered need to be weighed against compliance costs and equitable solutions. By focusing on potential beneficiaries, the tax burden will more directly fall on those that economically benefit from the trust income and assets. Providing an ability to nominate beneficiaries of the trust (similar to section 97 present entitlement) may provide an opportunity to achieve this. As an anti-avoidance measure, undistributed “net income” could be potentially allocated to the transferor(s) based on principles in section 102AAZD with careful consideration on how to avoid duplicate taxation of income or duplicate taxation of individuals. The taxation of transferors as a last resort could be appropriate where, subject to the introduction of an ability to nominate a beneficiary of a trust, after application of sections

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529 and 97 there still existed the result that no beneficiary includes the income of the trust in their assessable income. It is not considered that the beneficiary would need to be resident in Australia or, as required in section 102AAU, a listed country. Recommendation 3.1 We recommend that the attribution percentage of a transferor should be reduced to the extent that others have an ascertainable economic interest in the attributable income (eg. because the foreign entity has already distributed income in respect of the attribution accounting period). Appropriate attribution can be achieved by providing an ability to nominate beneficiaries of the trust and may provide an opportunity to match tax liabilities with economic benefit. As an anti-avoidance measure, undistributed “net income” could be potentially allocated to the transferor(s) based on principles in section 102AAZD with careful consideration on how to avoid duplicate taxation of income or duplicate taxation of individuals. The taxation of transferors as a last resort could be appropriate where, subject to the introduction of an ability to nominate a beneficiary of a trust, no beneficiary includes the income of the trust in their assessable income. There also should be an unlimited power to amend an assessment in respect of attributed income if others ultimately benefit from the attributable income (eg. because, in a future income year, the foreign entity distributes the accrued income to someone else). Q3.2 What aspects of the current rules create uncertainty in identifying

relevant interests? How should those aspects be clarified? Further certainty and economic reasonableness is required in identifying relevant interests whilst “interest” remains the basis of attributing foreign income. A number of clearly defined interests such as control interest, fixed interest, and legal interest, are used in the current anti-tax-deferral rules. The question is whether these are the most appropriate basis for determining the income to be attributed to any taxpayer. There are a number of difficult issues in identifying relevant interests. Some issues arise from uncertainty and some from inequity. This question asks how the current rules create uncertainty. In our view, potential inequity is a more relevant issue. For those interests where attribution currently arises, uncertainty can exist in what constitutes an interest under section 483 and particularly what constitutes an interest in a foreign trust. The simplest example is that of a foreign non-employer sponsored pension fund which is essentially a discretionary trust. The FIF provisions make a resident assessable on a deemed amount which is neither income nor capital if the individual has an interest in the foreign trust. In our opinion, the interest would need to entitle the individual to more than a contingent entitlement to interest and corpus. To attribute income on the basis of a contingent interest could result in multiple discretionary beneficiaries being subject to tax on the same deemed amount.

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A regular challenge arises in determining whether there has been a transfer to a trust under Division 6AAA for the purpose of determining an attributable taxpayer and the proportion to attribute under section 102AAZD. An example of the uncertainty applies to how to treat the granting of an arm’s length loan. This uncertainty should be addressed in any simplification of the anti-tax-deferral regimes. Uncertainty also occurs in relation to the application of sections 322 and 475 to a number of interests and arrangements. The inclusion in a control interest of the “contingent entitlement to acquire” test is an area of uncertainty. Similarly, the treatment of rights attaching to different classes of shares and the potential absence or lack of information for indirect control interests affect the certain application of section 350. Recommendation 3.2 There needs to be a careful review of integrity provisions that provide broad based principles which are used for all interests. Such rules can create uncertainty unless they are properly tested. A move to an “economic interests” test should be carefully considered to ensure that the provisions can be practically applied, without additional compliance, and in circumstances where the correct outcome is achieved in almost all cases. Q3.3 Are economic interests that are not recognised legally for the purposes

of the attribution rules a concern? If not, why? Control test and economic interests We believe that the response to this question is partly dependent on the role and purpose of the “control test” under any new proposed anti-tax-deferral regime. That is, paragraph 3.30 of the Discussion Paper states that:

“3.30 Second, for some taxpayers the level of their investment is not properly recognised for attribution purposes. Currently, although taxpayers may hold, in substance, a significant interest in a foreign entity it does not qualify for treatment under the CFC rules. The consequence is that the interest is taxed under the FIF rules and the CFC exemptions, that may have otherwise been available, have no application. This outcome occurs because entry into the CFC rules turns on the legal notion of control, a concept that is not recognised in many non-common law countries.” [emphasis added]

However, where Option C (for example) is ultimately chosen as the desired design structure, or where the “control test” is not used as a decisive factor in determining whether a particular calculation method or exemptions would apply to a taxpayer, then the comments at paragraph 3.30 may not seem all that relevant in respect of a proposed new regime. Accordingly, where the control test is not to be a relevant test under a proposed regime, “interests” held by a taxpayer in a foreign entity would only appear to be relevant for the purpose of calculating amounts attributable to a taxpayer, for example under section 356 or section 581.

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Attribution tests and economic interests One of the purposes of the attribution calculation and methodology contained in Part X and Part XI is to attribute back a reasonable amount to a taxpayer based on their relevant economic interest in the underlying target income. It is noted that sections 356 and 581 (in part) already use some concepts of economic ownership, by taking into account not only legal interests that are owned, but also those interests that a taxpayer is “entitled to acquire” at a relevant test time. This is determined through the application of sections 322 and 475, and has been the subject of Taxation Ruling TR 2002/3 in respect of contingent entitlements, pre-emptive rights, call options and put options. However, it is acknowledged that the tests in sections 356 and 581 do not properly take into account the economic owner of an entity in certain arrangements, for example where there is a total return swap in respect of the shareholding in a relevant CFC. In such examples, the provisions (using legal concepts) can act to include an amount of attributed income in the entity that does not bear the economic risks and rewards in respect of the underlying entity, which is ultimately an inequitable result. Our concern, however, in using an economic interest test would be two fold. Firstly it would require an increase in the level of complexity in determining whether a holder has an economic interest in an entity (as compared to a legal interest). Secondly, where the provisions continue to trace through multiple CFC/FIF entities, this could prove to be a difficult exercise based on the types of interests held in such entities, and the access to information. Accordingly, while we acknowledge that an economic interest test could provide for more equitable outcomes under a revised anti-tax-deferral regime, we highlight that such a proposal would need to be considered in light of any additional compliance issues that it may create or cause. Recommendation 3.3 Whilst we acknowledge that economic interests that are not recognised legally for the purposes of the attribution rules are a concern in situations where it results in an inequitable amount being attributed to the legal owners, we recommend that a change to an economic interests test should be carefully considered in light of additional compliance issues that could be caused. Q3.4 To what extent does the Government’s announcement to align the

definition of non-portfolio dividend with economic ownership concepts affect your answer to Q3.3?

The response to this question is dependent on the ultimate purpose and expected effect of the Government’s announcement. The announcement in question stated that:

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“The Government will [be] … making some consequential amendments to the definition of non-portfolio dividend, including aligning it with economic ownership concepts.”

It is understood that announcement was mainly to be used in respect of the definition of “non-portfolio dividend” for the purpose of determining the application of section 23AJ. The definition of non-portfolio dividend only refers to legal ownership concepts in three ways:

The test currently refers to a concept of “voting power” and does not bear reference to entitlements to distributions of income or capital of the entity. Accordingly this would be an issue for legal form shares that do not bear such rights.

Section 160AFB does not appear to allow one to take into account “voting power” held via non-equity shares.

The concept of non-portfolio dividend only takes into account “dividends” as defined in subsection 6(1) and does not appear to take into account non-equity share distributions (such as returns on convertible notes that are treated as an equity interest under Division 974). Accordingly this would be an issue for economic interests that are held under Division 974.

There may be different purposes for the proposed amendment, and it is uncertain whether the proposal is intended to correct issues with legal form shares (i.e. dot point one above) or expand the application to economic forms of equity (i.e. dot points two and three). However, whether this proposed amendment should impact the “attribution rules” is a question that needs to be analysed with reference to the purpose of section 23AJ and the definition of a non-portfolio dividend. Due to the removal of the requirement that a section 23AJ dividend be an “exempting receipt”, section 23AJ was extended to all dividends paid where a non-portfolio interest is held by the relevant taxpayer. The intention of the amendment is stipulated in the explanatory memorandum to the amendment to section 23AJ contained in New International Tax Arrangements (Participation Exemption And Other Measures) Act 2005:

2.14 The previous policy was to exempt comparably taxed profits upon distribution to a resident company. Division 6 of Part X (about exempting receipts, profits and profits percentage) provided a mechanism for this, particularly for dividends paid by companies resident in unlisted countries. The Treasurer’s announcement in Press Release No. 32 of 13 May 2003 meant that the comparable tax requirement was removed, allowing an exclusion from assessable income for all non-portfolio dividends.

Accordingly, due to the abovementioned amendment, the exemption test contained in section 23AJ currently operates with a different purpose to that of the “attribution rules” contained in the CFC provisions in Part X, without having regard to the underlying income being distributed to the shareholder. Therefore, while the Government’s announcement in respect of the definition of non-portfolio dividends is not entirely clear (with respect to what is proposed to be amended), we do not at this point see why a change in section 23AJ would need to be consistently applied to the attribution rules in the proposed anti-tax-deferral regime.

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Recommendation 3.4 The Government’s announcement to align the definition of non-portfolio dividend with economic ownership concepts does not impact our answer to Q3.3 (although we appreciate that full details of the proposal are not as yet available). Q3.5 How should the attribution rules be modified to ensure that they do not disrupt conduit income arrangements for non-residents? The question raised has been phrased around “conduit income” rules associated with subsection 99A(4A), and the ATO’s interpretation contained in ATO Interpretive Decision (ATO ID) 2005/200 in respect of discretionary trusts and the attribution of FIF income. While the question has a limited focus, we believe that the Board of Taxation should review responses in respect of two issues related to this question Conduit arrangements consisting of trusts If the ATO’s view contained in ATO ID 2005/200 is correct, then this represents a “systemic” issue that is contained in Division 6 in respect of trusts, and is not an issue that is limited to conduit trust arrangements. The systemic issue occurs in circumstances where a trust derives net income (or taxable income) but does not have trust law income that can be distributed to the beneficiary. This issue was recently demonstrated by the decision in Cajkusic & Anor v FC of T (No 2) 2006 ATC 4752, where a resident trust derived net income, but was found to have no trust law income. The issue could be addressed by correcting the present entitlement provisions in Division 6 for this scenario. That is, where a trust derives “net income” but does not derive “trust law income” for a year of income, then the issue could be resolved by providing a mechanism to ensure attribution/distribution of taxable income to the beneficiaries of the trust in such circumstances. One method that could be used to achieve this outcome would be to provide an alternative to sections 99 and 99A, which could allow an entity to “distribute” net taxable income to a beneficiary of a trust in circumstances where there is no “trust law income” for the relevant year. Conduit arrangements consisting of companies The question of conduit arrangements for companies raises the issue of the role of Division 802 of the Income Tax Assessment Act 1997 (ITAA 1997) in respect of the attribution rules. Currently, Division 802 does not treat attributed income as conduit foreign income, as such income is taxed at the company level in Australia, and therefore can effectively be paid as a franked dividend to foreign shareholders. However, one needs to question whether Division 802 is fully achieving its purpose in respect of being a conduit for certain types of income. The attribution rules contained in Part X and Part XI are used to attribute foreign income to Australia in order to tax such income in Australia. However, we request that the Board of Taxation consider Division 802 in the context of the following example:

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Division 802 and conduit foreign income

Non-resident Shareholder

100%

Ausco

(1) Attributed

income

(2) Payment of dividends

100%

CFC

For a true conduit regime the attributed income should theoretically not be taxed in Australia where (a) the company is 100% foreign owned, and (b) the underlying income is distributed to the non-resident shareholder via the Australian conduit. In the alternative, if the non-resident shareholder had invested directly into the CFC, no amount would have been taxed in Australia.

Therefore, exempting 100% foreign owned Australian conduit companies from attribution under the anti-tax-deferral regime, where dividends are subsequently flowed through to the ultimate non-resident shareholders should be considered. The distribution of such income (being subsequently subject to section 23AJ) would then automatically fall within Division 802. Recommendation 3.5 We recommend that the Board of Taxation review the conduit foreign income rules applicable to both trusts and companies in the context of the anti-tax-deferral rules to ensure that objectives, such as not dissuading foreign investment through Australia, are met.

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Chapter 4: Types of Income Q4.1 Is passive income appropriately defined, given the need to strike a

balance between compliance costs and integrity? Passive income is no longer appropriately defined given the involvement of Australia and its businesses in the globalised economy. Since the anti-tax-deferral regimes were developed based on 1980s perceptions and business practices, Australian businesses have become much more strongly engaged in business activities globally. The business activities, conducted in many countries, no longer represent merely exports from Australia but involve supply chains within single company groups and within networks of unrelated companies, including jointly owned activities and entities involving related and unrelated parties. Further, Australia’s funds management industry operates globally, with significant internationally-recognised skills and investments in foreign properties, infrastructure projects and investments generally, managing the savings of Australian and foreign investors. With the changed nature of globalised Australian business, there is greater:

splitting of functions into various companies for commercially driven reasons including optimal funding and risk management, compliance with individual country regulatory regimes and others activities undertaken by Australian businesses and investors in many different jurisdictions, which all have their own tax rules.

The active:passive income boundaries in the Australian anti-tax-deferral rules operate inappropriately. As discussed below, the boundaries are inappropriate in relation to their treatment of:

activities involving related entities offshore and onshore activities involving income which in the 1980s was considered passive income but which now forms part of normal international business activities, particularly in a knowledge-intensive economy international funds management activities for legitimate commercial investment purposes.

Q4.2 Are there examples of income that is currently categorised as passive

but should be treated as active? How should such examples be accommodated?

Some key issues which need attention in relation to the active:passive income divide are as follows. (a) Accommodating the examples: a generic business active-income

classification

With the increased globalisation of legitimate business activity by Australian businesses and taxpayers, the time is right for a more strategic targeting of what should be passive income subject to the anti-tax-deferral rules, in 2007 and beyond.

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There are numerous scenarios where the conduct of active business activities and active investment activities overseas, in a legitimate manner, causes problems under the current active:passive income divide. These are mentioned below. While these can be addressed by specific exemptions, one element in the solution is a generic business-income classification, which might reduce some of the requirements for individual exemptions. Recommendation 4.2.1 We recommend that consideration should be given to an exemption from passive income characterisation in relation to income which is generated pertaining to an active business conducted by the relevant CFC or FIF, or by the CFC or FIF in conjunction with other related CFCs or FIFs. In other words, where it can be established that a particular entity, either directly or in conjunction with other entities, is carrying on an active business, then income associated with that active business should not be characterised as passive. In particular, income associated with that business which might include interest income, royalty income and rental income should not be attributed back to Australia. The definition of “business” for this purpose can distinguish between income from activities not related or integrated into the overall business, namely, interest income generated from a purely passive long term investment of funds by that entity in a manner which is not integrated into the business activity. The definition of a business activity might draw on case authority but a better approach would be a legislative definition for the anti-tax-deferral rules. We emphasise that this definition must be developed so as to recognise that certain otherwise passive categories of income, which are associated with the conduct of a business by the relevant entity or its associates, should be treated as active. We note that the rule would need to deal with income which is generated in the conduct of a business which is:

• • •

currently carried on intended to be carried on1 or has been carried on within the last designated number of years (say two years).

Such a business-related approach has some relationship to a purpose test, which is discussed in our analysis of Q4.17.

(b) Active:passive distinction should have regard to entities within groups

The treatment of passive income in the current rules focuses to a significant extent on the activities or functions of a particular entity, that is, an individual company CFC or a company, trust or other interest which is a FIF. If the entity operates within a corporate or trust group, and performs one function in the overall business activities of the entire group,

1 Section 40-880 of the ITAA 1997, which deals with “blackhole expenditure”, uses this concept.

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the classification of the entity or of its income under the active:passive income divide leads to inappropriate outcomes. In essence, the anti-tax-deferral rules discriminate against multiple-entity foreign activities as distinct from singe-entity foreign activities. Example 4.2 in the Discussion Paper illustrates this problem, where a group involved in property development and rental operations splits out its property management activity into a separate entity to the property owner (a CFC) and as a result, rental income of the CFC is treated as passive. A similar example arises in relation to in-house finance companies, or in-house technology licensing companies which might be stand-alone entities for particular legal, credit or commercial reasons. The recommended approach is for the Australian anti-tax-deferral rules to deal with grouping, for purposes of all the tests which characterise the activities of a particular group, to ensure that functions performed by other CFC-like entities are taken into account. So, in Example 4.2, the management activities undertaken by an associated CFC would be taken into account in characterising the nature of the subject CFC and whether its income was active or passive. The precedent is a US style treatment2 of related party income which is discussed in the context of intra-group financing exemptions and Q4.5 to Q4.6 in the Discussion Paper. We emphasise that the US exemption is applicable not merely to intra-group financing arrangements but to intra-group related-party income generally. Recommendation 4.2.2 We recommend the broader adoption of an exclusion of related-party income for the purposes of determining passive income. The recommended approach is for the Australian anti-tax-deferral rules to deal with grouping, for purposes of all the tests which characterise the activities of a particular group. Another approach to recognising the multiplicity of entities in larger international groups would be to adopt concepts of group companies and quasi-consolidation, but that approach might involve more complex drafting than a related-entity exclusion from passive income. (c) Classification of interest income as passive, apart from the related-party issue The treatment of interest income is inappropriate from a number of perspectives: i. Foreign financing business

Example 4.1 in the Discussion Paper highlights that, under current CFC rules, a subsidiary of an Australian financial institution which is a CFC (an AFI subsidiary) is permitted to generate interest income while a CFC involved in financing arrangements which is not owned by an AFI has the relevant income treated as passive. This example

2 Section 954(c)(6) of the Internal Revenue Code.

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highlights the appropriate treatment of various categories of foreign hitherto-passive income as being passive in today’s global environment.

Recommendation 4.2.3 We submit that the continued limitation of foreign financing activities only to AFI subsidiaries is no longer appropriate in a competitive global economy. In our view there should be the ability for legitimate foreign financing business activities to be treated as being active income rather than passive income. If it is considered that, for integrity purposes, there will need to be some minimum scale of foreign activity, this can be accommodated in the consultation process. However, such measures will also need to deal with current commercial practice.

ii. Foreign interest income incidental to business

Interest income, currently treated as tainted interest income, can arise in various legitimate business situations:

•

•

•

Development phase of a business

Example 4.3 in the Discussion Paper notes the situation of a company which is capitalised and, for a temporary period prior to spending its funds on acquisition or operating a business, generates interest income and fails the active income test.

The wind down phase of a business A company which has been carrying on an active business and disposes or ceases its active business, may find that the foreign country prevents the repatriation of capital for a period of time. The capital “lock in” may result in the generation of interest income in circumstances where it is inappropriate to treat such business-related interest income as being passive.

In the interval period between a CFC selling one investment and acquiring another

A CFC, conducting an active business activity, might sell the active business and generate proceeds which (pending their reinvestment to acquire another business) are temporarily deposited in an interest bearing account. In this case, the CFC can easily fail the active income test.

These examples illustrate that the characterisation of interest income as passive may be inappropriate in certain circumstances.

Recommendation 4.2.4 We submit that interest income arising from the above situations should not be treated as passive income. This can be dealt with: • •

By way of individual exclusions Under a purpose-based test as discussed below or

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• Using the active business exemption noted above. (d) Rental income The treatment of rental income is inappropriate where the taxpayer possesses a substantial commercial property intended for multiple tenants, as well as for rental income from related parties, which would be dealt with under the US-style exclusion of income from related parties, as discussed above. The modern business of property and asset management and ownership is very different to the passive flow of income from a single property. A significant property development and investment activity involves substantial management, selection and rotation of tenants, presentation of the relevant properties, marketing of the properties in the relevant environment, possible marketing of the brand name of the property chain (particularly for retail property where the name of the ownership chain is relevant to the position and presentation of the property) and other activities. This management and ownership of substantial properties involving multiple tenants is not a passive activity and should not be characterised as such. If the Board of Taxation considered that there were integrity issues involved, we would welcome the opportunity to engage in consultation on how to distinguish legitimate substantial property management and rental activities from passive rental of the type thought to be targeted by the anti-tax-deferral rules. We suspect, however, that the volume of rental income derived from CFC and FIF interests which could properly be classed as purely passive would not be substantial. Recommendation 4.2.5 We submit that rental income from management of ownership of substantial properties involving multiple tenants should not be treated as passive. Rental income from related parties should be dealt with under the US-style exclusion of income from related parties. (e) Royalty income from rental of chattels, know-how or licensing activity

Currently, the CFC rules provide a very limited concession for foreign royalty income. As that concession is very limited in scope, the outcomes are problematical: i. Businesses which make substantial equipment (ie. chattels) available to others will find

that the income from that substantial equipment is classified as passive, being either rental or alternatively royalty income.

Recommendation 4.2.6 We submit that the income from the rental of substantial equipment, conducted as part of a business activity, should not be classified as passive income under either the rental or royalty category

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ii. Where a group receives royalty income from overseas ownership of intellectual property from an associate, the income is currently classed as being passive income irrespective of the activities of the CFC and even if the income is received from a non-associate, further conditions apply3. Royalty income might be generated from associated entities, where a group might choose (for purposes of protection of its brand names or technical knowledge from potential commercial risk, or for banking or other commercial reasons) to have that intellectual property reside in a stand alone company. Such royalty income may not satisfy the ‘substantial development’ condition to be excluded from being tainted income. Additionally, this does not properly reflect modern international business activity involving strategic relationships with foreign investors which might result in associated entities being involved. It means that Australian companies developing IT internationally as a natural part of their business activities, including where the technology is licensed to non-wholly owned associates, are disadvantaged compared with competitors from other countries, and compared with foreign providers of such know-how.

Recommendation 4.2.7 The policy and the treatment of royalty income should allow for the exclusion of royalty income from associates in the above cases. This might be achieved using the purpose test, or by bright line exclusions for royalty income from related parties, similar to the US-style exclusion mentioned above.

(f) Infrastructure projects leading to licensing revenue

Foreign infrastructure projects involving investment and operation by FIFs or CFCs associated with Australian investors or operators also give rise to the issues discussed above. Recommendation 4.2.8 The category of passive income should also be reviewed to ensure that it does not capture, inappropriately, infrastructure projects with toll income, licence fees from the use of property and others, which in our view should be assimilated to active income. Q4.3 What other improvements could be made to the operation of the active

income and business exemptions to address difficulties and reduce compliance costs?

The active income exemption was, in the main, settled at a time when attribution under the CFC measures was to be on an entity basis. The intention at the time was to determine

3 See definition of tainted royalty income in section 317.

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whether a CFC, as a whole, was an ‘active’ company. It is not clear whether there was any substantial reconsideration of the development of the active income exemption after the attribution under the CFC measures was changed to its present transaction basis. When applied in the context of an entity basis for attribution, the exemption recognised that a certain amount of income and gains that are correctly categorised as passive income or tainted income will be derived as an incident of the active trade or business of a CFC and should not cause the CFC to be categorised as a ‘passive’ company. That is, it was recognised that active companies do derive passive income. When applied on a transaction basis, since the categorisation of the CFC as active or passive is not relevant, the exemption operates on one of two bases, being:

(1) It recognises that certain passive income is not, in the context of a particular business, passive income. This implies that the definition of passive is imprecise.

(2) Where only a relatively small amount of passive income is derived by the CFC,

the compliance and administrative costs imposed under the CFC measures would outweigh any integrity concerns.

Recommendation 4.3.1

We submit that the active income test should be retained and that the calculations necessary under the active income test must continue to be based on information that is already easily accessible. However, we submit that the active income test should not be used as a substitute for a more precise definition of the active:passive income divide. From a compliance perspective, the primary concern with the application of the active income test under the CFC measures is that the taxpayer will not have the necessary information readily available to perform the active income test. For example, difficulties arise in the following circumstances: a) The application of the active income test to a distributor can be difficult where there is

a mix of Australian suppliers and foreign suppliers, since this requires a bifurcation of the sales where this information would not be readily available from the accounts.

b) In our view, the current CFC exemption of 5% of the relevant income is quite uncommercial. Further, given the volatility of trading income and interest income in various commercial situations, a focus purely on income is inappropriate.

Even after the adjustments recommended above to currently passive income, we think that a significant lifting of the active income test percentages would be appropriate.

Recommendation 4.3.2 The current CFC exemption of 5% of the relevant income is quite uncommercial and a focus purely on income is inappropriate.

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•

•

We recommend that the exemption should be structured with income and assets legs. As a suggestion for further consultation:

The income exemption could be lifted to the lesser of say 25% of the income of the foreign entity or $250,000.

To deal with disparities of income, which often cause significant problems, the active income test could be supplemented by an active assets test. This would provide that, if more than 50% of the gross assets of the relevant entity were used in the conduct of a business either by that entity or by related entities, then the relevant entity would not have any income subject to attribution.

Q4.4 Are there better alternatives to the CFC approach of positively listing

passive income? We have mentioned earlier the possibility of crafting a general exclusion from the category of passive income in respect of income which is associated with a business undertaking. In other words, if a CFC is involved with business activities in a foreign jurisdiction, even if they involve associated parties, then that business should not have to deal with the intricacies of tainted services and sales income. It should instead be able to be excluded from such categories of passive income by virtue of its business activities. A business income exemption from the passive income test would require a focus on the definition of business activities. A statutory definition of a business may be necessary for this purpose. This business income exemption would need to accommodate the three situations noted above. These are: • Current business activities • Activities involving preparation for a business (with an appropriate lead time) • Activities relating to a business previously carried on (with an appropriate lead time).

Recommendation 4.4 We recommend a general exclusion for business income from the category of passive income.

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Q4.5 Is it possible to provide an intra-group financing exemption, having regard to integrity and compliance costs?

and Q4.6 How could an intra-group financing exemption be defined, and why is

such an approach preferred? We support the legislative approach, mentioned in the Discussion Paper, of an exclusion for income from related entities, along the lines of the US-style exclusion. This should not be limited to merely interest income and is discussed in our response to Q4.2 Q4.7 Do the base company income rules need to be retained? If not, why? The policy intent of the base company rules was, broadly stated, to place taxpayers expanding overseas on the same footing as taxpayers who trade only in Australia, such that any tax savings gained overseas are negated in certain narrow circumstances. Deemed tainting of otherwise active income was employed to ensure that if the active income test was failed then the deemed tainted income would be classed as passive and thus attributed back to Australian shareholders with a controlling interest. (a) Income from the sale of goods Under the base company rules, income from sale of goods by an Australian resident company to foreign associates or for sale of goods by a foreign associate to an Australian resident for ultimate sale to third parties, is tainted. In effect the foreign associate is treated as not existing in the value chain if it fails the active income test and its tainted profit is attributed back to Australia less any local tax paid (so as to mimic the income out of which a dividend would be paid). The following examples illustrate this issue. Example 4.7.1

If the foreign associate is a subsidiary of an Australian head office company and it only purchases goods from associates in Australia to sell in its country of incorporation and possibly wider into that region, then its income is tainted and it will fail the active income test. The base company rules do allow for an exception under the substantial alteration test, the substantial manufacture test and the substantial production test but these are extremely limited in their commercial application. They do not allow for the situation of the subsidiary being a regional logistics centre that employs a significant number of people and assets but does not alter or “manufacture” the goods handled by it.

Example 4.7.2

If the foreign subsidiary manufactures goods, its income from the sale of goods to Australian associates may be tainted if this is the only active income it derives and the manufacturing exclusion does not apply. It passes the substantial alteration or manufacture tests (“substantial” is not defined and so opens to uncertainty in its application) if this is performed by directors or employees of the foreign subsidiary company. This does not match the current commercial reality of creating goods via the use of contract manufacturers in countries such as China or India for at least part of the assembly process. A foreign subsidiary based in Singapore may contract a significant part of the creation of goods to a third party in China then complete the manufacturing process in Singapore before transporting them to Australia. As “substantial” is not defined, this otherwise commercial active income value chain becomes “tainted”.

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Example 4.7.3

An Australian company may source raw materials in Australia and elsewhere and send them to a foreign subsidiary in, for example, Thailand for manufacture and the finished goods are then sold back to the head office or associated companies in Australia for sale to third parties. The sale of the goods made from the raw materials is tainted unless the substantial manufacture test is passed. The Thailand subsidiary however may sub-contract out various sub assembly tasks and only assemble the final good using its employees. This could be a failure of the substantial manufacture test and to gain certainty, a prudent advisor would recommend a private binding ruling application to the ATO. This could also involve significant time and cost to investigate the activity particularly if the sub assembly decisions were made by local directors and not influenced by controlling shareholders in Australia. Only a taxpayer prepared to pay professional fees or deal with the ATO in this way has certainty in preparing an income tax return in the current self-assessment environment.

(b) Income from the provision of services This two-way deeming is not carried through to services. Services sold by a foreign associate to an Australian resident are tainted and there is no exclusion rule if the activity is undertaken by employees of the foreign subsidiary. The following examples illustrates some practical issues with this rule. Example 4.7.4

An Australian software company establishes a foreign subsidiary in the Netherlands to employ software programmers who input code devised by them into a server owned by the Australian company. The Australian company also employs programmers who input code and the end product is a piece of software for sale by the Australian company. The Dutch company was established for strictly commercial reasons to form a team of employees who would not otherwise contract their time to other contractors. The sale of this service to the Australian parent is its only income and is thus tainted services income. It fails the active income test and its after tax profit is attributed to the Australian parent company. The pricing of the service charge has been set at arm’s length for transfer pricing purposes but does not leave a significant profit in the Netherlands which would be attributed. This places a significant compliance cost on the Australian parent as it must calculate the profit under the branch equivalent rules applying Australian tax principles to Dutch accounts and it must also comply with Australian and Dutch transfer pricing rules.

Example 4.7.5

The above company decides to pay a dividend and pays dividend withholding tax. This dividend is now non-assessable non-exempt and thus not subject to Australian tax in the hands of the Australian parent. The parent cannot claim a foreign tax credit for the withholding tax so that it becomes a “cost” of doing business outside Australia. If the dividend is not paid and attribution applies then the income that would have been the dividend is taxed in Australia. Where the Australian parent passes on the section 23AJ dividend to individual Australian shareholders, no franking credits are available and the receiving individual shareholder pays more tax than if the second scenario occurred and the Australian parent paid tax on the attributed income and passed on the income as a franked dividend. This represents bias in the system that is considered to be inequitable.

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Example 4.7.6

If the Dutch subsidiary in the above example were in fact a UK (or other listed country resident) subsidiary doing the same service function then the tainted service income would not be attributed notwithstanding the active income test is failed. This is because only designated concessional income of the UK subsidiary as listed in the regulations would be attributed. The corporate tax rates in the Netherlands and the UK however are similar so that an unfair bias is present in the system which does not accept or recognise the Australian parent company’s right to incorporate in a particular country for commercial reasons. The cost of compliance if the UK is chosen in this example is therefore significantly less than if the Netherlands is chosen. This is not equitable across taxpayers.

The tainted services provision is wide ranging and applies to:

Services inbound to Australia as defined in section 317 – what are generally considered to be professional type activity but which could be for other activities involving employees as described in the example above

Contracts of insurance – specifically attacking offshore self insurance or reinsurance arrangements

An arrangement for or in relation to the lending of money – broadly an offshore associate company lending money to an Australian associated company - which arguably is also covered by the FIF rules.

Subsection 448(1A) is an anti-avoidance provision covering services rendered under a scheme. It is a standalone provision but, in our view, should be part of the general anti- avoidance provisions to give consistency across tax issues and taxpayers. Recommendation 4.7.1 If the base company rules are to be carried into any new CFC provisions, specific clarity of what the rules apply to is recommended rather than a blanket application with carve out if specific tests are passed. Clearly the use of “post-box” distributors as seen in the San Remo case is a specific example of an activity that should not be accepted. However the carve out rules that have been enacted create bias as the commercial world changes and activities that have commercial validity under functions, assets and risk benchmarking, are seen as “tainted”. The insertion of a commercial reality test is recommended. The test could mirror transfer pricing tests that review functions, assets and risks. Recommendation 4.7.2 If the base company rules are to continue, the differential between goods and services needs to be redefined to allow for value added service activity sold by overseas associated entities to Australian residents. This would fit better with Australia being seen by the world as a regional headquarters centre and provide an exclusion for commercial trade through a foreign service provider. Recommendation 4.7.3 The 5% passive income threshold in the active income test that triggers attribution

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under the base company provisions is arbitrary and in our view does not sit with deeming otherwise active income, as “tainted”. In our view if the active income test is to prevail then the exclusion tests in the base company provisions in section 447 require significant review (i.e subsections 447(2), 447(4), 447(4A) and 447(4C)) in order to allow generally accepted commercial activity in both the trade of goods AND services to be removed from tainting such that a wider cross-section of trade activity is not defined as “tainted” in the active income test. Q4.8 Would the removal of the base company income rules create an

unacceptable revenue risk? If not, why? The complete removal of the base company rules would create an unacceptable risk unless either a specific application test is used to cover recognised non commercial behaviour or transfer pricing rules are more rigorously applied to cover the risk so that “post-box” activity deemed unacceptable is price adjusted under Division 13 such that profit shifted offshore is clawed back to an Australian supplier or purchaser of both goods and services. See comments in regard to Q4.9 below. Recommendation 4.8.1 The base company rules should remain only in respect of non commercial offshore activity of related entities. It is recommended that the tainting exclusion provisions in section 447 be redrafted to allow generally accepted commercial trade in goods and services to be excluded and thus removed from the active income test as tainted income. Distinctions and bias of treatment between goods and services activity should also be removed in this redrafting. Recommendation 4.8.2 Currently only Part B of Schedule 25A allows placement of data that would allow risk to be monitored by the ATO. The data is at the option of the taxpayer and would appear to be insufficient for risk monitoring unless all taxpayers are required to provide base data on overseas activities. How the system is monitored would appear to be part of a wider issue facing the tax system. Q4.9 If necessary, in what way could the transfer pricing rules be

strengthened to allow the base company income rules to be repealed, or reduced in scope?

In our view, the base company approach of Part X overlaps with the transfer pricing approach to income shifting adopted in Division 13 but for different reasons and outcome. If both Part X and Division 13 were applied to a particular taxpayer for a year of income then substantial compliance costs would be present with an uncertain outcome that would require judgement calls by the taxpayer and the ATO, and possibly a foreign country Competent Authority if the Mutual Agreement Procedure (MAP) process is invoked.

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Part X operates to capture specific profit as a deemed dividend if certain tests are not passed and sets out how that captured profit is calculated. Div 13 captures profit shifting via transactions that are not seen as priced at arm’s length and the Commissioner may substitute an arm’s length amount. The Part X approach has little room for subjective ATO application (apart from how to notionally apply Australia tax computation rules to foreign books of account) with the prime burden of compliance on the Australian attributed taxpayer. Division 13, however, requires considerable work by the ATO based on an audit of documentation prepared by the taxpayer or creation of such documentation by the ATO as evidence of its decision if the taxpayer does not produce it in the first instance. If a double tax treaty is present between the contracting party’s country of residence and Australia, then any transfer pricing adjustment also requires a MAP process to avoid double taxation. Relief from double tax is recognised in Part X but via a simple treatment that any foreign tax paid is deemed an allowable deduction when calculating the attributable income subject to Australian tax. Recommendation 4.9

Where an Australian company and its related foreign associate sell goods and services from / to Australia then the profits of the foreign associate could be treated as not tainted by application of the transfer pricing rules on the basis that the underlying arm’s length review as documented by the Australian company focuses on a fair reward for the functions performed, the assets used and the risks taken by each party to the transaction. A simple test would be that the holding of transfer pricing documentation prepared for the purpose of Division 13 would automatically remove tainting of goods and services for Part X purposes.

If a taxpayer does not produce transfer pricing documentation then base company rules could apply but adjusted as discussed above.

Q4.10 Would the listed country approach need to be retained if the definition

of passive income was narrowed (or active income better targeted)? The largest savings in compliance costs for Australian taxpayers with CFCs or affected by the transferor trust rules comes about as a result of the concessional treatment of listed countries. We consider that even if income to be attributed was to be better targeted, retaining the concept of listed country is likely to remain an important compliance cost saving measure under any revised anti-tax-deferral regime. The Board of Taxation has already accepted that the compliance savings from a listing approach are significant (see paragraph 4.52 and Chapter 3 of the RITA Report). Narrowing of the range of tainted income would be positive for compliance (especially tainted sales). However, that change alone will not change the annual compliance process that is currently necessary for unlisted country CFCs versus listed country CFCs. Put simply, for a listed country CFC it is necessary only to identify the income which has been designated in the Income Tax Regulations 1936 (eligible designated concession income (EDCI)), and the transferor trust and FIF rules. For an unlisted country CFC in addition to the transferor trust income and the FIF income, it is necessary to identify whether the

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income is tainted, whether the tainted income is from a branch in a listed country, apply the transfer pricing rules, etc – leading to significant compliance costs. As noted at paragraph 4.40 of the Discussion Paper, most of Australia’s direct investment offshore is located in the seven listed countries, which reinforces the compliance cost savings (and also removes the complexity of some of the anti-tax-deferral regimes). In the case of the transferor trust measures, if it is a listed country trust estate, only the trust’s EDCI is taken into account when working out the net income. The balance of the income of the trust estate is treated as exempt income. Again, this represents a saving in compliance costs. We appreciate that having the listed company rules places a burden on the tax administration to ensure that changes in the tax systems of listed countries that pose an unacceptable integrity risk are identified, but in our view, this is an administration cost of having anti-tax-deferral regimes. As observed in the Discussion Paper, if these costs are not met by the tax administration in maintaining the listed country rules, they are arguably transferred to each and every taxpayer in respect of each and every jurisdiction that they operate in. The Discussion Paper notes at paragraph 4.49 the comparable tax exemption based on the level of foreign tax paid on CFC income compared to the domestic level of income adopted in some jurisdictions. The United Kingdom is given as an example. In this regard, we note that the United Kingdom still has an excluded companies exemption in its rules, which requires the maintenance of a list of excluded countries. Please refer to the following webpage: http://www.hmrc.gov.uk/manuals/intmanual/INTM203130.htm It should be noted that HM Treasury and HM Revenue & Customs have just released a discussion document (June 2007) entitled “Taxation of the Foreign Profits of Companies” where a participation exemption for dividends is being explored together with review of the CFC rules (including consideration of targeting passive income rather than relying on the current comparable tax basis). Consultation is currently underway with submissions due in September. We also note that as part of the 2007 Budget, the New Zealand government announced that changes would be made to its CFC rules – including introducing an active business test to exempt all CFCs with less than 5% of passive income4. It is stated that this test will be designed to replace the current “grey list” exemption. What form the final legislation will take (expected in 2008) and whether the proposed removal of the grey list will in fact occur (in the face of compliance cost concerns in for instance having to apply an active income test) remains to be seen.

Recommendation 4.10 We recommend that the listed country exemptions should be retained, even if the definitions of passive income (or active income) are better targeted, in order to minimise compliance costs for taxpayers operating in these jurisdictions.

4 Presumably, this was modelled to some extent on the Australian rules in terms of the 5% passive income limit.

http://www.hmrc.gov.uk/manuals/intmanual/INTM203130.htm

http://customs.hmrc.gov.uk/channelsPortalWebApp/channelsPortalWebApp.portal?_nfpb=true&_pageLabel=pageLibrary_ConsultationDocuments&propertyType=document&columns=1&id=HMCE_PROD1_027592

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In addition, exploration of whether there are any other comparable tax countries that could be included in the list of listed countries (as also raised by the Board in its report on the Review of International Tax Arrangements) should be undertaken. We also recommend that approaches to expand the applicability of the listed country rules to other parts of any proposed anti-tax -deferral regime should be investigated. As an example, for FIFs currently, only certain entities resident in the United States benefit from an exemption. In terms of the burden on the tax administration, we would suggest that opportunities for a co-operative approach to maintaining a comparable country list with overseas revenue departments be explored (e.g. with the United Kingdom). Consideration of OECD initiatives (such as its work on harmful tax practices) may also prove useful. Further compliance cost saving measures, such as expanding the exemptions for listed county entities, should also be considered - for example, by resurrecting the approach announced by the Treasurer in May 2003 in relation to the Board of Taxation’s proposal to provide an exemption from Australia's CFC rules for non-BELC subsidiaries of BELC CFCs, where the BELC's own CFC rules are broadly comparable to Australia's CFC rules. Q4.11 Are there alternative approaches that, either alone or in combination,

would obviate the need for a listed country approach? If so, what are the advantages and disadvantages over a listed country approach?

The listed country approach is attractive as it excludes from attribution income of the relevant CFC (except for EDCI) so that no further calculations (e.g. active income percentage, etc) need to be performed. This represents a major compliance cost saving for taxpayers. It is also well understood. We do not support a ‘black list’ approach for the reasons given in Reform of Australia’s CFC Rules by Lee Burns.5 We are concerned that any possible alternative approach would push an undue level of the compliance burden back on the taxpayer. Recommendation 4.11 We recommend that the use of a listed country exemption (for comparable tax countries) be incorporated in any anti-tax-deferral regime. We have been unable to identify an approach that would obviate this need. Q4.12 Should the current thresholds for the de minimis tests be adjusted,

having regard to the potential tax deferral that could arise by increasing the thresholds? What other improvements should be considered?

and

5 (2006) 21 Australian Tax Forum pp191-2

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Q4.13 Should the de minimis exemptions operate on a more consistent basis across the regimes? If so, how could this be achieved?

De minimis exemption for listed country CFCs The de minimis thresholds exist to exempt investors with small investments from the compliance burden of complying with the CFC and FIF measures. A de minimis exemption applies so that where the combined amount of: (i) eligible designated concession income; (ii) income from sources outside the listed country that is either not taxed in a listed country or adjusted tainted income not taxed in a listed country; and (iii) FIF income accruing to the CFC, does not exceed certain levels (see below), such income is not included in the attributable income of a listed country CFC (subsection 385(4)). For a listed country CFC with a gross turnover of less than $1m, the exemption applies where the sum of the three amounts does not exceed 5% of the gross turnover. Where a listed country CFC has a gross turnover of more than $1m, it applies where the sum of the three amounts does not exceed $50,000. FIF Exemption Small investor exemption There is an exemption from the FIF rules for the taxpayer for interests in all FIFs where the value of FIF and FLP interests held by an individual (non-trustee) taxpayer (and associates) does not exceed $50,000. Balanced portfolio exemption There is an exemption from the FIF rules for the taxpayer for interests in all FIFs where the value of a taxpayer's non-exempt FIF interests does not exceed 10% of the total value of all of the taxpayer's FIF other than those which are exempt under sections 493 and 519. Summary The CFC regime has a $50,000 income ceiling on the availability of the exemption. The FIF regime is an asset base of $50,000. The CFC exemption is more generous than the FIF exemption as more than $50,000 in assets would be needed to generate $50,000 in income, say, $500,000 - $1,000,000. In the USA the equivalent exemption is the lessor of 5% of gross income or $1,000,000 (IRC (US) 954(6)(3)(A)(ii). Recommendation 4.12 We recommend that there should be an adjustment of thresholds for the CFC/FIF measures. The de minimis thresholds for the CFC/FIF measures have not been increased since their introduction in 1990/1993 respectively. The inflation adjusted level on Reserve Bank of Australia inflation figures would be approximately $75,000. In the USA, the equivalent exemption in the USA CFC rules is the lesser of 5% of gross income or $1,000,000 [Internal Revenue Code (USA) s954 (6)(3)(A)(ii)].

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The restriction of the CFC de minimis exemption to listed countries is unnecessary and inhibits business development in emerging markets. Austrade figures on exports illustrate that South East Asian economies attract the second highest level of exporters exceeding the UK, USA and Japan. We suggest a harmonisation of thresholds to asset bases with thresholds appropriately increased on a periodic basis to reduce unnecessary compliance and allow businesses to invest in start-up foreign enterprises. In view of this, we would recommend a $500,000 de minimis exemption. An “asset based” small investor exemption should apply under an anti-tax-deferral harmonised regime with the asset thresholds reviewed. The balanced portfolio exemption is particularly relevant to the managed funds industry and should be retained in an anti-tax-deferral harmonised regime and this threshold should be reviewed. Q4.14 Could the exemptions for entities or investment arrangements that pose

little or no tax deferral risk be improved? If so, how? The CFC regime exempts the income derived by the CFC rather than the entity itself. The FIF regime exempts the entity itself (Division 3-15 of Part IX). This is because the FIF regime adopts surrogate income measures to determine the attributed income – the market value method or deemed rate of return method. Income is not measured so there is no opportunity to exempt particular items of income. The FIF measures include the following exemptions:

•

• • • • • • • •

Foreign company engaged in eligible activities using the stock exchange listing method balance sheet method Foreign bank Foreign life insurance company Foreign general insurance company Foreign real property company US entities Employer sponsored superannuation funds Trading stock Two or more eligible activities

Recommendation 4.14 Anti-deferral tax legislation should be targeted at businesses established to generate passive income with tax deferral as their dominant purpose. The CFC regime applies an income test of 95% non-tainted income. If it fails the active income test only its tainted income is attributed. The FIF regime adopts a more liberal ‘principally engaged in active business’ activities test based on the assets used in that active business. If it passes the test it is exempt, if it fails all income is taxable. However, if an all or nothing approach is adopted the key question is the level of the threshold whether that be an income test or an asset based test. The USA Passive Foreign Investment Company (PFIC) rules use income and asset

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thresholds as alternatives: 75% or more of the gross income of the corporation for the year is passive income or 50% or more of the value of the corporations assets are held for the production of passive income. The active income exemption should apply to all foreign entities. The FIF approach to exemptions is the preferred approach in a harmonised regime provided that if an entity fails the exemptions, they can then rely upon branch equivalent, meaning they will only be taxed on passive and base company income. Q4.15 How could the exemptions be modified to ensure greater investment

neutrality? The varying approaches in the CFC and FIF regimes to determine what income or activity is excluded create uncertainty. The differences can result in vastly different outcomes for attributable entities. Recommendation 4.15 An extended public company exemption could be provided. Entry based exemption based on PFIC style thresholds, increasing thresholds to say $200,000. The potential for differing outcomes should be removed by coordinating approaches used to exempt income from attribution. Q4.16 Are there other exemptions or approaches that could be considered? If

so, why? Although not a new issue and although there appears good justification for the exemptions in the FIF regime, the exclusion of non-employer sponsored superannuation/pension funds in light of the domestic taxation environment is hard to fathom.

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Recommendation 4.16 The exemptions should be expanded to foreign non-employer sponsored superannuation funds (or their equivalent) to reflect the domestic tax environment on superannuation funds and for distributions from funds.

•

•

• •

Q4.17 Would a purpose or motivation test meet the policy objectives outlined in Chapter 2? If so, how could such a test apply to provide reasonable certainty in a self assessment environment?

We support the introduction of a purpose test as a useful complement in the array of exemptions and legislation targeting the focus of the anti-tax-deferral rules and their outcomes. However, we would be concerned if the potential inclusion of a purpose test was seen as a justification for less precision in the development of other exemptions from and modifications to the CFC measures. Notwithstanding the difference between a ‘motive’ and ‘purpose’ for these purposes we have referred to such test as a purpose test. We further note that any purpose test would have limited relevance where tainted sales and tainted services are concerned, since the transactions generating such income are seldom entered into for the purpose of minimising Australian tax or, to the extent that they are, the anti transfer pricing provisions are sufficient to deal with the matter. Australia’s international tax regime is primarily based on capital import neutrality (CIN) and we agree with the Board of Taxation that on balance, a CIN paradigm should be maintained. In this context, we submit that the proper justification for attribution measures is to prevent the deliberate minimisation of Australian tax in circumstances where there is an integrity risk. The Board of Taxation has also stated that there are more elementary policy objectives. We submit that a purpose test is conducive to four of these objectives:

that Australian businesses with active offshore exposure are not made uncompetitive that Australia remains an attractive place to do business and to locate regional headquarters appropriate account is taken of market and business factors the economic efficiency applies to minimise distortions in commercial choices.

Recommendation 4.17 We believe that the CFC policy dictates that a purpose test should be included. We reiterate that we would be concerned if the potential inclusion of a purpose test was seen as a justification for less precision in the development of other exemptions from and modifications to the CFC measures.

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a) Australia remains an attractive place to do business and to locate regional

headquarters

Aside from its impact on Australian investment, one of the aims of the Review of International Taxation Arrangements (RITA) reforms was to make Australia an attractive place for a foreign company to locate its regional headquarters. A secondary aim was to allow Australian companies the opportunity to raise foreign capital to invest offshore without an impact of Australian taxes on the foreign investor. The dividend exemption, the participation exemption and the conduit foreign income measures addressed both of these concerns. The CGT non-resident exemption addressed the latter. However, as far as attracting businesses to locate in Australia is concerned, the CFC measures continue to act as an impediment to establishing Australia as a regional holding company location. Complexity is only partially responsible for this. In addition, it is difficult to explain to potential investors why they have a risk of attribution of tainted services and tainted sales income, or the reason why certain categories of income and gains are ‘passive’. To this end, while reforms may make the CFC measures more consistent and therefore less complex, international experience shows that anti-tax-deferral rules are still, in general, not simple. We suggest that it is axiomatic that a foreign resident would not establish a regional holding company in Australia to avoid Australian tax. Therefore, these investors would find great comfort in a purpose test. b) Australian businesses with active offshore exposure are not made uncompetitive

and appropriate account is taken of market and business factors and that economic efficiency applies to minimise distortions in commercial choices

Consistent with the comment above, we submit that any new anti-tax-deferral rules will still have a level of complexity. One lesson from the current experience with the CFC measures is that, in a globalised economy, Australian businesses must be responsive to be competitive. Despite the best intentions, we submit that priority demands on governmental resources will mean that changes to the CFC measures will significantly lag changes to the global economy. As a purpose test operates on a ‘real time’ basis, it assists in ensuring that the CFC measures do not impinge on the ability of Australian companies to operate in a global economy as that economy changes. c) The rules are simple to understand and operate with due consideration of

complexity, and compliance and administrative costs and do not create an unacceptable level of risk to revenue

In our view, a purpose test, of itself, does not create a risk to revenue. Rather, any risk to revenue arises only if, in a self assessment environment, insufficient resources are allocated to reviewing claims for exemption under the purpose test. It would appear that the primary issue raised in the Discussion Paper related to the administrative issues of certainty and administration in a self assessment environment. Often the comparison of the experience with a purpose test is based on the experience with Part IVA.

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If the CFC measures were more appropriately targeted, the purpose test with only residual operation might not occupy significant resources (of either the taxpayer or the ATO), provided that the factors were suitably drawn. We submit that a purpose test under the CFC measures would not be as administratively complex as the purpose tests under (say) Part IVA. In particular, Part IVA operates at large and must be considered in all cases where (amongst other things) there is a claim for a deduction or reduction of assessable income. This makes it potentially applicable to a large number of cases. Since the CFC measures apply to a relatively small number of taxpayers and within that only limited categories of income, it is reasonable to assume that there are only a small number of cases where the purpose test would be relevant. Therefore, the administrative resources that would need to be allocated to reviewing the taxpayer’s purpose would be limited.

As far as the impact on the taxpayer in a self assessment environment is concerned, some risk is always borne by the taxpayer for any claim made without a private or public binding ruling on the matter. We do not consider that a purpose test as a parallel or ‘sweep up’ provision will create difficulties, in contrast to the circumstances where the purpose test was the primary test for whether or not the CFC measures applied. It is also reasonable to assume that the purpose test would not need to be reviewed each year. Provided the activities of a particular CFC did not change from year to year, there would be no need for the ATO to revisit the purpose test. With regards to the integrity issue, provided the administration is manageable (and we submit that it would be) in contrast to anti avoidance provisions such as Part IVA where the relevant transaction must be identified by the ATO, a purpose test under the CFC measures would need to be asserted by the taxpayer. Such assertion can simply be provided to the ATO as part of the taxpayer’s income tax return. Factors that might be considered in the purpose test Such factors might include the following: (1) Whether the effective rate of tax was a given percentage (say 75%) of the Australian

tax rate. This effective tax rate should not be based on a laborious calculation of the foreign tax paid compared to the Australian tax that would be payable under a branch equivalent calculation using the current extensive compliance rules governing branch equivalent calculations. It should be based on the effective tax rate calculated by reference to the accounts of the CFC.

(2) Whether the CFC is generating significant foreign losses and the passive income is

unconnected with the ordinary business generating the passive income. This might also include a case where the CFC had foreign losses prior to the injection of funds generating the passive income.

(3) In the case of liquid assets, whether there are commercial reasons why the funds

generating the passive income have been retained by the CFC (e.g. exchange controls preventing repatriation of funds).

(4) Whether the foreign company is listed on a foreign stock exchange, widely held and

actively traded (this would only be relevant where a specific exemption was not granted for reasons other than the potential inclusion of a purpose test).

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(5) Whether the passive income was generated from funds injected in a start up phase (this would only be relevant where a specific exemption was not granted for reasons other than the potential inclusion of a purpose test).

Q4.18 For managed funds, how could the rules better target offshore income

accumulation? The managed funds industry is one of Australia’s most successful industries developed in the last decades, and Australian retirement savings and wealth are now generally invested through the managed funds industry, particularly with respect to offshore investment. In considering the redesign of the anti-tax-deferral rules, it is useful for Australia to adopt international best practices or international norms, rather than developing esoteric mechanisms which apply only in Australia. The UK provides some useful precedents for the application of anti-tax-deferral rules to the offshore funds management industry. The UK approach, as noted in the Discussion Paper, limits the rules to scenarios where foreign funds accumulate income and wealth in foreign jurisdictions, especially where those jurisdictions are low taxed jurisdictions and the nature of the income is overwhelmingly passive. In our view, widely held managed funds are less likely to be structured for purposes of deliberate tax deferral than is the case in privately held managed funds. However, we recognise that a wide ranging exemption from the FIF rules for widely held managed funds might invite the establishment of widely held closed-end or accumulating foreign managed funds. Recommendation 4.18 We support the provision of an exemption for widely held managed funds making distributions to investors at least on an annual basis. The definition of a widely held managed fund should cover not only the “retail” funds in which the widely held investors hold their interests, but should also encompass collector funds and wholesale funds which act to pass the retail-level funds to foreign sector managers for investment. Q4.19 Could any changes for managed funds apply more broadly to cover, for

example, companies? If so, why and how? and Q4.20 Should a public company exemption be included in the attribution

regimes? If so, why? The Institute recognises the attraction of an exemption from the CFC or other anti-tax-deferral rules for widely held public companies. Such an exemption would be particularly relevant if Australian companies are not granted the ability to pass on franking credits to their Australian shareholders in respect of dividends paid from foreign source income.

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• • •

•

• •

It is clear that widely held Australian publicly listed companies can demonstrate higher intrinsic integrity in their tax dealings, from a combination of them being audited, their public filing of financial statements and their array of independent directors, as well as their governance by the Australian Securities Exchange and Australian Securities & Investments Commission in a manner different to private companies. Those enhanced integrity factors, allied to:

the desire of investors for franked dividends the stronger scrutiny by the ATO of widely held large entities the continued application of transfer pricing and Part IVA rules to such companies given their stronger documentation practices compared to privately owned entities their likelihood of making fewer decisions driven by tax issues than by business expansion

suggest that a public company exemption is a useful addition to the measures to reduce unnecessary, unproductive, CFC and FIF compliance tasks. We recognise however such a public company exemption would mean that entities which are not widely held public companies would be denied the benefit of this desirable compliance improvement. This would mean that such entities would when compared to their public company counterparts:

have higher tax compliance costs and potentially have higher Australian tax imposts in relation to their foreign income, causing them to be less competitive.

Accordingly, this public company exemption might be seen as non-neutral and inconsistent with the level playing field for Australian businesses.

Recommendation 4.20 If the Board of Taxation recommends (and the government agrees to provide) a much stronger array of properly structured bright line and purpose-based exemptions which are geared towards exempting income arising from legitimate business activities conducted offshore, these will be significant improvements for widely held listed public companies, and also to private companies and other entities which are properly carrying on business activities overseas rather than seeking to inappropriately defer Australian income. If an outright public company exemption was considered too politically challenging, we recommend, at minimum, improved de minimis exemptions for widely held public companies. Q4.21 Could a more generic approach to defining an accumulation vehicle be

used to address neutrality concerns? If so, how? Where an Australian investor invests in a foreign public company, the general hypothesis is that:

• the foreign public company is conducting legitimate business activities

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•

•

the foreign public company is not operating merely as a cashbox or mechanism for the accumulation of passive income and there is transparency in and regulation of the foreign public company’s activities.

Recommendation 4.21 We see significant merit in establishing an exemption from Australia’s anti-tax-deferral rules in relation to such foreign public companies, subject to appropriate integrity measures. These, as noted in the Discussion Paper, would involve:

• •

Listing of the foreign public company on an appropriate stock exchange If there was concern about the appropriate spread of shareholding, potentially adding conditions involving an appropriate spread of shareholding.

Q4.22 Could a foreign public company exemption consistent with that in the

FIF regime be applied across the attribution regimes? We strongly support an exemption in relation to the CFC rules for investments in foreign listed public companies, consistent with the CFC approach discussed above.

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Chapter 5: Method of Attribution Q5.1 How could the current attribution methods be improved to resolve the

distortions that currently exist (both across the regimes and within the regimes)?

The policy behind the accruals taxation of Australian residents is to prevent such taxpayers obtaining significant tax advantages – deferral of Australian taxation – by holding foreign source income offshore in a foreign company or trust.6

The income and capital gains which have been historically targeted as attributable have been income and gains from passive investments which are considered as being able to be readily moved from one tax jurisdiction to another and certain forms of business income which can be readily diverted to low-tax jurisdictions.7 Having applied exemptions – particularly relating to the investment in foreign companies predominately carrying on an active business – the methods of calculating attributable income should seek to target only the passive and base company income from non-commercial activities derived in the foreign entity (regardless of the level of investment) unless compliance and complexity would be created. These factors justify the choice of more “broad brush” approaches, such as the use of accounting profits, measurement of the increase in the value of the investment, or a deemed rate of return. Recommendation 5.1.1 All taxpayers should be permitted to elect to use any attribution method (see further below) regardless of the level of their investment (ie portfolio or non-portfolio), and regardless of the nature of the entity in which the investment is made. Recommendation 5.1.2 The calculation of attributable income under the branch equivalent method or under an accounting profit approach should restrict potentially attributable income to the passive and base company income which has been targeted for attribution consistently with the policy objective. The targeting of passive and base company income derived by foreign entities in listed country jurisdictions to that which has been specifically designated should continue. Q5.2 How could the current branch-equivalent calculation approach be improved? Would the adoption of the FIF calculation method adequately address concerns in relation to complexity and compliance costs? The focus here should not be on replacing the branch-equivalent calculation with a FIF-type calculation method, but rather making it easier (ie reduce complexity and compliance costs)

6 “Taxation of Foreign Source Income – A Consultative Document”, 25 May 1988, page 18 7 “Taxation of Foreign Source Income – An Information Paper”, 12 April 1989, page 44

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for the taxpayer when calculating the amount to be attributed. If taxpayers wish to adopt a branch equivalent approach they should be able to do so. For those who do not want to incur high compliance costs in undertaking a branch equivalent calculation, other methods, including the FIF-type calculation method should be available. Recommendation 5.2.1 The branch equivalent calculation could be improved by:

i. Restricting the sections of the Australian tax law which apply (see below)

ii. Making the distinction between passive and base company income versus active income divide more appropriate and much clearer

iii. Allowing intra-group transactions to be ignored for attribution purposes except where such transactions have an Australian leg

Recommendation 5.2.2 The FIF-type calculation method may address complexity and compliance costs and a similar method should continue to be made available to taxpayers. However, we would not recommend replacing the branch-equivalent calculation with a FIF-type calculation method if it is envisaged that in the latter case attributable income will consist of the entire accounting profit. In those cases where it is possible for the taxpayer to identify passive and base company income, the branch equivalent regime should be available. Q5.3 Which provisions of the Australian tax laws should be excluded from

branch-equivalent calculations and why? Requiring taxpayers to perform an analysis of complex provisions to foreign transactions to perform branch-equivalent calculations greatly increases compliance costs, and in some cases, is not appropriate. Recommendation 5.3 We recommend excluding the following from the branch equivalent calculation (we note that some of these provisions are currently excluded from the calculation of a CFC’s attributable income and some are also identified in the Discussion Paper as possible exclusions):

•

•

Section 51AD/Division 16D – these provisions are designed to ensure that taxable entities do not transfer tax benefits in respect of property which is made available under certain arrangements to users who are tax exempt or do not use the property for the purpose of deriving assessable income and is not relevant in the context of arrangements conducted wholly offshore.

Provisions which are highly complex and require detailed analysis: for example, the value shifting provisions in Division 723, 725 and 727 of the ITAA 1997, thin capitalisation provisions in Division 820 of the ITAA 1997,

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•

•

provisions governing the taxation of financial arrangements, the foreign exchange conversion rules contained in the ITAA 1997, the provisions in Division 16E and the tax consolidation rules

Specific non-deductibility provisions (eg non-deductible entertainment)

Transfer pricing provisions in Division 13, except where transactions have an Australian leg. By applying Division 13 in a CFC context taxpayers are subjected to two sets of compliance obligations, the transfer pricing rules and the CFC rules.

Q5.4 How could the market value method be improved?

The market value method requires valuations to be performed on what should be essentially exempt interests (ie. they are interests in listed companies, investment in which is unlikely to be motivated by tax deferral strategies).

The market value method also taxes unrealised gains, and even in the case of a corporate with a greater than 10% voting interest, provides an effective deduction, rather than a credit, for foreign tax paid.

Recommendation 5.4

See recommendation for Q5.7 below.

Q5.5 How should the deemed rate of return be changed to better

approximate returns on foreign investment? To what level and why? Although the deemed rate of return is intended as a proxy for the return that the taxpayer should have received and on which they should have paid tax (ie. consistent with the policy objective to prevent deferral of Australian tax), it is set at a penal rate (an increase of four percentage points over a base rate), rather than a rate which approximates the return on the investment. The annual deemed rate of return for 2006-07 is a very high 10.198%. Recommendation 5.5 We recommend setting the deemed rate of return by reference to the average yield of 90-day Bank Accepted Bills published by the Reserve Bank of Australia (RBA). This is a rate set objectively, is easily accessible and does not penalise the taxpayer for the investment made offshore. It is consistent with the rate of interest paid on overpayments and early payments of tax, and therefore should approximate a reasonable return. This method could be made more attractive by providing an exemption in respect of dividends and capital gains derived from such investments. Such an exemption is

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consistent for example with the New Zealand approach. In this case, it is acknowledged that a rate in excess of a debt rate might be required. However, it should still be set at a lower rate than the current rate, which is overly penal.

Q5.6 Could the deemed rate of return method be applied consistently across

all the attribution rules? As mentioned above, the attribution methods should seek to approximate the passive income and base company income which has been identified as attributable unless compliance and complexity necessitates a more broad approach. Consistent with this, if a taxpayer does not have the information necessary to calculate attributable income under either a branch equivalent regime or a FIF-type calculation method, a deemed rate of return method should be available.

Recommendation 5.6 We would suggest that the deemed rate of return could be applied consistently across all attribution regimes, provided it is improved along the lines described above. All methods of calculating attributable income should be available to all taxpayers with interests in foreign companies and trusts.

Q5.7 What other attribution methods are viable alternatives? Would these

methods strike an appropriate balance between compliance, complexity, integrity and neutrality?

Currently, if the market value method is not available because the interest is not quoted or there is no publicly available buy-back price, the taxpayer who has a small interest in the foreign company or trust is forced to use the (penal) deemed rate of return. This may not accurately reflect the return on the investment and offends the principle of neutrality.

Recommendation 5.7 The Board of Taxation should explore whether a further option such as the NZ fair dividend rate method is appropriate in the Australian context. That method requires only one valuation to be performed – at the beginning of the year of income – and a flat 5% tax imposed on the value of pooled interests in foreign entities held at the beginning of the year. This method has been provided in NZ for individual and managed fund portfolio investors in addition to the other methods. Another method used in NZ requires the taxpayer to apply a cumulative return of 5% to the cost of each investment. The availability of an accounting profit approach in a CFC context would greatly reduce complexity and compliance costs for some taxpayers. It would also address the concerns raised in Q5.3 where Australian tax principles are inappropriately

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applied under the branch equivalent calculations. Q5.8 Should taxpayers be permitted to choose which attribution method to

apply or should some restrictions apply? It is clear that choice is desirable, as the Discussion Paper notes at 5.35, because it allows taxpayers to choose the attribution method that best suits their needs. We agree with the comments in the Discussion Paper too, that choice allows taxpayers to be treated consistently, and does not create distortions which currently arise depending upon whether or not the taxpayer invests in a company or a trust, and the extent of their interest. The Discussion Paper raises the concern that taxpayers will “trial” methods, and therefore the concept of having multiple methods of calculating attributable income available may increase compliance for investors. We would suggest that the existence of a choice of methods of calculating attributable income will implicitly reduce complexity and compliance because the taxpayer can adopt the method that suits their circumstances. Certain safeguards may need to be put in place to ensure that no undue advantage arises from switching of attribution methods between different years of income.

Recommendation 5.8 All taxpayers should be allowed to choose which attribution method to apply as this implicitly reduces complexity and compliance by allowing taxpayers to apply methods which best suit their circumstances. Q5.9 How should the percentage of income attributed be determined where

the taxpayer has no fixed, legal interest in the foreign entity? This question raises a preliminary issue as to the most appropriate basis for determining the percentage of income to be attributed to any taxpayer (not just a taxpayer that has no fixed, legal interest in the foreign entity).

The policy benchmark for the attribution rules is “capital export neutrality” (CEN), except where this would be inconsistent with the CIN benchmark of a foreign jurisdiction in which a foreign entity carries on business. It follows that these rules should subject the taxpayer’s share of the foreign entity’s income to the same overall tax burden as would have been imposed on an equivalent Australian investment.

On that basis, it would be unreasonable to impose tax on a taxpayer in respect of a share of the foreign entity’s income in which they have no economic interest. Conversely, it would seem reasonable to impose tax on a taxpayer in respect of a share of the foreign entity’s income in which they have an economic interest. We therefore contend that a taxpayer’s attribution percentage, in relation to attributable income, should be determined by reference to their economic interest in the income.

This question impliedly assumes that, if the taxpayer has no fixed, legal interest in the foreign entity, it will not be possible to determine directly the taxpayer’s economic interest in a foreign entity’s attributable income. However:

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•

•

(i) The interest need not be “fixed” but merely ascertainable in relation to an attribution accounting period.

(ii) The interest need not be “legal”. In fact, it would be more appropriate to focus on “economic” or, failing that, “beneficial” interests.

(iii) The interest need not be an interest “in the foreign entity” but merely in the particular income.

We nonetheless acknowledge that in the case of a foreign “entity”8 that is a discretionary trust (or similar vehicle), the taxpayer would have neither a fixed legal interest in the entity, nor an ascertainable economic interest in its attributable income. We therefore still need to determine how the attribution percentage should be determined in this situation.

The current law assumes that, in this situation, it is not possible to determine the attribution percentage by reference to the taxpayers who are likely to benefit from the attributable income in the future. The law therefore determines the attribution percentage by reference to the taxpayers who, in the past, contributed the capital that has produced the attributable income. Reference to the past is, of course, much more certain than speculation about the future.

However, reference to past contributions rather than future benefits is only justified if the fiscal benefits of additional certainty outweigh the unfairness of attributing income to a taxpayer who does not ultimately benefit from it. It is by no means clear that this is the case.

In any event, this uncertainty does not arise in relation to attributable income from which someone else (not necessarily an Australian resident) has actually benefited.

To the extent attribution is considered to be appropriate in respect of income derived by a foreign entity, but the interests in the foreign entity cannot be adequately measured (as in the case of a discretionary trust or non-common law entities where fixed legal interests cannot be adequately determined), one approach might be to have a number of options available to attribute income for Australian tax purposes. The two options include:

An ‘attribution percentage’ rule; or

A deemed interest charge on accumulated distributions made in a foreign trust.

The “attribution percentage” rule could apply where it is possible to obtain sufficient information to work out this percentage (for example, by reference to assets contributed by the taxpayer into the entity – refer below for further commentary). The deemed interest charge could apply by way of an annual election as an alternative if insufficient information is available to work out the attribution percentage under the first method.

Recommendation 5.9.1 The Board of Taxation should consider allowing taxpayers alternative options to

8 This response uses the word “entity” in the same way as does section 960-100 of the ITAA 1997 – to describe any

entity, relationship or capacity that is treated for any tax purpose as though it were a legal entity.

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adopt approaches in calculating the attribution amount where the taxpayer has no fixed, legal interest in the foreign entity. The option applied by a taxpayer would depend on whether sufficient information is available for taxpayers. Recommendation 5.9.2 Conceptually, where there is no fixed, legal interest in the foreign entity, it will generally be difficult to work out precisely the percentage of income to be attributed in the absence of any deeming rule. In any event, the attribution percentage should be reduced to the extent that others have an ascertainable economic interest in the attributable income (eg. because the foreign entity has already distributed income in respect of the attribution accounting period). Recommendation 5.9.3 There also should be an unlimited power to amend an assessment in respect of attributed income if others ultimately benefit from the attributable income (eg. because, in a future income year, the foreign entity distributes the accrued income to someone else). Q5.10 Is it practicable to calculate attributable income on the proportional

value of the property or services transferred (rather than attributing all income of the foreign entity)?

This proposal would be considerably fairer than the current law. However, it should be modified to reflect some of the considerations discussed above in relation to Q5.9.

The attribution percentage should also take into account the following additional elements:

(i) Some transferred property or services may not produce attributable income at all (eg. an asset that the foreign entity uses to carry on an active business). Why should the transferor of such an asset be taxed on attributable income that the foreign entity produced from completely different assets?

(ii) Some transferred property or services may produce attributable income at different rates, in different amounts and/or in different attribution accounting periods. Why should the transferor of a low-return asset be taxed on attributable income that the foreign entity produced from other, higher-return, assets?

(iii) A “blended” rate of the kind implied by the question could be appropriate in situations where the foreign entity has used the transferred property or services to produce income, which it has then reinvested.

One solution might therefore be to move away from a percentage-based attribution approach, to an amount-based approach. That is, if a foreign entity has an amount of attributable income in respect of which no entity has an ascertainable economic interest, then the income will be attributed to the transferor(s) of the property or services that

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produced it. If no such transferor can be identified in relation to the income then, as a last resort, consideration could be given to attributing the income proportionally to all the transferors of property or services to the entity, in proportion to the value of what they previously transferred.

Option A: A proportionate approach A threshold test for attribution in the case of, for example, a foreign trust could be determining whether the transferor or other persons are ‘substantial owners of the trust property’. The transferor’s taxable income would include the income of the foreign trust that is attributable to the portion the transferor is treated as the owner of. A calculation based on a measurable base of a portion of the foreign trust’s assets may be considered appropriate. For example, if the transferor contributed 50 percent of the trust assets, then it would be reasonable to only attribute 50 percent of the income. The test may be, for example, based on the market value of the assets at the end of the income year. The same principle would apply for non-common law entities where fixed legal interests cannot be easily measured, e.g. legal entities such as “stichting” (refer to ATOID 2007/42).

Option B: An ‘all or nothing approach’ If an ‘all or nothing’ approach is adopted i.e. once an attributable taxpayer is identified, all income of the trust is attributed rather an attribution percentage approach discussed above, consideration may need to be given to a mechanism that provides a credit for tax paid on the attributable income in circumstances where it can be shown the attributable income has been actually distributed to other beneficiaries/members of the foreign trust or entity. An approach that produces an outcome that the right amount of tax paid for the transferor’s portion of the income would seem reasonable. Another aspect to consider is if a distribution is made by the foreign entity within a specified timeframe (eg. 1-4 years), there should be no attribution for tax purposes. Recommendation 5.10 If a foreign entity has an amount of attributable income in respect of which no entity has an ascertainable economic interest, then the income will be attributed to the transferor(s) of the property or services that produced it. If no such transferor can be identified in relation to the income then, as a last resort, consideration could be given to attributing the income proportionally to all the transferors of property or services to the entity, in proportion to the value of what they previously transferred. In situations where a proportionate approach is thought to be appropriate, Option A would seem to provide the most equitable result but would still require consideration of valuation rules to determine the portion of the amount of assets contributed to the foreign entity. If Option B is adopted, a credit mechanism is needed where it can be shown that attributable income has been actually distributed to other beneficiaries or members of the foreign entity.

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Q5.11 Should attributable income be apportioned to reflect part-year ownership of the foreign entity, and how would apportionment apply?

The CEN benchmark suggests that a taxpayer should only be taxed on income that is earned from their investment in the foreign entity (not income that the foreign entity earned before they made their investment). This can only be achieved by apportioning attributable income in a part-year ownership situation.

There is another aspect to this question – attributable income should also be apportioned if a taxpayer’s attribution percentage changes during an attribution accounting period.

There seem to be two main methods of apportionment:

(i) The “rule the books” method, in which the taxpayer would divide its attribution accounting period in relation to the foreign entity into two or more sub-periods, each starting and/or ending on a date on which the taxpayer’s attribution percentage changed (including from or to zero). The taxpayer could then be taxed on a different attribution percentage of the attributable income in relation to each such sub-period.

(ii) The “daily accruals” method, in which the taxpayer would calculate a single amount of attributable income for the entire attribution accounting period, and then calculate a weighted average attribution percentage based on the number of days for which it held a given attribution percentage during that period.

The “rule the books” method would be quite impractical in situations where the taxpayer cannot compel the production of a separate calculation of attributable income for each sub-period, or where the attribution percentage changes frequently during the attribution accounting period. The “daily accruals” method should therefore be the default approach, but taxpayers should be given an option to use the “rule the books” method if they wish.

The Discussion Paper makes the observation that “[a]pportionment should arguably only apply if the resident has no claims to income earned before the interest in the foreign entity was acquired”. This seems to reflect a view that, if a taxpayer buys a foreign company, and then procures that the company will pay a dividend from its pre-acquisition profits, it is reasonable to tax that dividend in the hands of the taxpayer. Whilst this is currently (often) the outcome of such a transaction under Australian tax law, it is inconsistent with both commercial reality and the applicable accounting treatment, which would regard the dividend as a partial repayment of the original capital investment. We see no reason why the accruals rules should deliberately perpetuate this anomaly.

Moreover, the inclusion of a part-year apportionment rule would also be consistent with other tax integrity rules (e.g. thin capitalisation, losses and tax consolidation).

The foregoing discussion assumes that the “branch-equivalent calculations” method is used to determine the amount of a foreign entity’s attributable income. However, the same need for a part-year apportionment rule would arise in relation to some of the other methods (eg. the “calculation” and “deemed rate of return” methods).

The Australian investor should also receive a foreign tax credit to the extent that foreign tax is paid on the attributed income for the part-year period. It may be necessary to address issues in relation to the quantification of the foreign tax credit entitlement (eg. how should it

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be apportioned) and will the information be available in time before the resident taxpayer needs to lodge a tax return.

Listed country exemption should continue to be provided, ie. where an interest in an attributable foreign entity is acquired in a listed country, then an exemption is provided under the attribution rules.

Recommendation 5.11

The Board of Taxation should consider including a part year attribution rule.

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Chapter 6: Design Principles of a harmonised attribution regime Q6.1 To what extent would harmonising the regimes benefit taxpayers?

Would these benefits outweigh the associated transitional costs? Harmonising the regimes would, prima facie, appear to offer some benefits to taxpayers. Theoretically, standardising the anti-tax-deferral regimes so that there are the same/similar entry conditions, same/similar exemptions and similar/same attribution approaches and outcomes is desirable as it means that taxpayers with similar investments are treated similarly or the same irrespective of “form”. In other words, with appropriate targeting of passive income and harmonization of the regimes, the attribution outcomes should aim to be the same irrespective of structure of the investment (i.e. investment neutrality principle). Furthermore, removal of the need to consider which regime or regimes could potentially apply to an interest by having a regime(s) that, using the example of CFCs, did not have to rely on a control test and did not incorporate the concept of associate, is attractive. Having the same choice of methods would also be beneficial. In developing the harmonised regimes, important factors to bear in mind are:

• The need for policy objectives to be met. In this respect, we submit that it might be an opportune time for the Government to clearly state the precise current policy objectives of the anti-tax-deferral regimes (e.g. extent of CIN vs. CEN). The Board will no doubt appreciate that Australia’s international tax arrangements have evolved significantly as a result of its RITA Report to the Government in 2003. This follows an appreciation of the fact that Australia is increasingly a part of the global economy and being competitive is paramount to successful participation. At the time of the Treasurer’s budget announcement in 2003, various aspects of the CFC, FIF, transferor trust and deemed present entitlement rules were identified for change – rather than a total review of the anti-tax-deferral regimes, which was deferred until now.

• The need for positive aspects of the various regimes to be retained. As

identified in relevant sections of our responses on Chapters 3, 4 and 5 (and so not repeated here), the current regimes do incorporate aspects that should be retained in any harmonised regime(s).

• Whether problems with the existing regimes can be addressed within any

proposed, revised framework. As identified in relevant sections of our responses on Chapters 3, 4 and 5, the current regimes present difficulties that should be addressed in any harmonised regime(s).

Transitional costs will not doubt arise depending on the approach taken (see question 6.8 for transitional issues). However, it is likely that these will be outweighed by the benefits. Recommendation 6.1 Harmonising the regimes would, prima facie, appear to offer some benefits to taxpayers. However, we recommend that important factors such as the need to meet policy objectives, the need for positive aspects of the various regimes to be retained and whether problems with the existing regimes can be addressed should be borne

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in mind for any proposed, revised framework. It is likely that transitional costs will be outweighed by the benefits. Q6.2 Of the three harmonisation options, which one is preferred and why?

Are there different approaches to harmonisation that should be considered?

Of the harmonisation ‘blueprints” proposed, we are of the view that Option C: Merging some regimes (or aspects of regimes) seems the most suitable at this time (assuming that our concerns raised elsewhere can be adequately addressed within this framework – which of course is to be the subject of further consultation). Merging the CFC and FIF rules offers the possibility of bringing about positive changes such as:

• Having one regime applying to CFCs and FIFs so as to avoid issues such as the difficulties of moving back and forth from the FIF to CFC rules.

• Standardising the definition of an interest. • Dispensing with problematic aspects of the regimes, such as the control test and the

definition of associate in the CFC rules at present. • Providing the same exemptions from the regime at the entry level – the nature of

these exemptions going forward has already been discussed in this submission. • Choice of methods to use in calculating attributable income - we also submit that

other possible options/variations to methods raised in this submission should be given as a choice.

The possibility of collapsing the CFC and FIF regimes into one regime makes us favour Option C over Option A which proposes maintaining separate regimes but with more consistent outcome. We agree with paragraph 6.24 of the Discussion Paper that the transferor trust regime is predominantly aimed at high net wealth individuals and closely held trusts, making it difficult for it to be merged with the CFC/FIF rules. This would present issues in trying to have a single anti-tax-deferral regime (Option B). We do not propose any other approaches than those raised in the Discussion Paper for harmonisation of the regimes. Recommendation 6.2 Option C: Merging some regimes (or aspects of regimes) seems the most suitable at this time. Merging the CFC and FIF rules offers the possibility of bringing about positive changes.

We see difficulties in trying to merge the transferor trust regime with the CFC and FIF rules.

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•

•

Q6.3 Under the second option, how could the FIF-style active business exemption apply to eliminate the need to replicate the CFC-style active income exemption?

We do not support the second option, “Option B: Single regime”. However under “Option C: Merging some regimes” the prospect of this approach should be explored. When merging the FIF and CFC regimes, having the same active income/business exemption would result in less complexity. In this respect, we note our comments in response to Q4.3, i.e. “The current CFC exemption of 5% of the relevant income is quite uncommercial and a focus purely on income is inappropriate. We recommend that the exemption should be structured with income and assets legs. As a suggestion for further consultation:

The income exemption could be lifted to the lesser of say 25% of the income of the foreign entity or $250,000.

To deal with disparities of income, which often cause significant problems, the active income test could be supplemented by an active assets test. This would provide that, if more than 50% of the gross assets of the relevant entity were used in the conduct of a business either by that entity or by related entities, then the relevant entity would not have any income subject to attribution”.

However, the precise form of the exemption should be the subject of further consultation. Recommendation 6.3 We do not support the second option. However under our preferred option, “Option C: Merging some regimes” the prospect of having the same active income/business exemption should be explored. Q6.4 If the FIF-style active business exemption was extended to what are

currently CFC interests, would that produce an unmanageable revenue risk for government? If not, why?

The question should be in terms of whether using the FIF-style active business exemption would still allow capture of those tax deferrals that should, according to policy, be captured. We have concerns with any proposal that would seek to adopt a FIF like approach that would attribute all income if the test were failed (paragraph 6.19). This goes totally against the policy of only attributing tainted income/passive income. Recommendation 6.4 We recommend that the question should be in terms of whether using the FIF-style active business exemption would still allow capture of those tax deferrals that should, according to policy, be captured. We do not support using this test if all income was to be attributed if the test was failed.

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Q6.5 Should the transferor trust rules be harmonised with the other

attribution rules? If not, why? Is justification on the basis that they target different taxpayers sufficient? What integrity issues could arise if the transferor trust rules were harmonised with the other rules?

These rules are different from the other anti-tax-deferral rules because often it is not possible to establish an interest held by an Australian beneficiary in profits accumulating in a foreign trust. We therefore do not believe that the transferor trust rules should be harmonized with the other anti-tax-deferral rules (as suggested in the Discussion Paper in Option C). Recommendation 6.5

We do not recommend that the transferor trust rules be harmonised with the other attribution rules given aspects such as difficulties in establishing that an interest is held. Q6.6 What improvements to tax administration would assist taxpayers meet

their obligations under the attribution rules? and Q6.7 What improvements could be made to the administration of the

attribution rules that would reduce compliance costs and complexity, while balancing integrity objectives?

and Q6.10 What material, information or other support might be needed to ensure

a smooth transition to a new regime? Optimisation of the design of the new anti-tax-deferral rules in the legislation will be by far the most important aspect in improving the related administration requirements and taxpayers’ obligations. We have already set out in this submission our views on how the existing regimes could be improved from a legislative design point of view and where relevant, our opinions have been influenced by the desirability of minimising complexity and compliance costs, which in turn impacts on tax administration matters. We are looking forward to continuing our involvement in the current review and as it develops, we will continue to be very mindful of tax administration matters in further consultations on the development of legislation. However, there are a number of tax administration issues that we believe should be borne in mind at this early stage:

• The National Tax Liaison Group – Foreign Source Income Subcommittee, or a working group thereof, with representatives from Treasury, the ATO, the Institute and other professional bodies and tax practitioners should be convened in advance to promptly address interpretative issues that will undoubtedly arise (e.g. the need for rulings) and identify any legislative “glitches” that require fixing.

• Judging by the introduction of certain legislation relating to business tax reform such as tax consolidation, the ATO needs to be properly resourced and ready to

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administer the resulting legislation. This includes having the appropriate support materials available from “day 1”. In the case of the new anti-tax-deferral regime(s), thought may need to be given to the production of fairly comprehensive material – such as a “Foreign source income anti-tax deferral reference manual”.

• There needs to be access to ATO personnel with the necessary expertise able to resolve issues raised by tax practitioners and taxpayers.

• Due to teething problems, the administration needs to be responsive to taxpayers when they may at first grapple with new rules.

Recommendation 6.6, 6.7 and 6.10

Optimisation of the design of the new anti-tax-deferral rules in the legislation will be by far the most important aspect in improving the related administration requirements and taxpayers’ obligations.

Some tax administration issues that should be considered include ensuring the ATO is properly resourced and ready to administer the resulting legislation from the start. The ATO will also need to be responsive to issues raised by tax practitioners and taxpayers to ensure a smooth transition to a new regime. Q6.8 What transitional issues are likely to arise and how should they be

addressed? Transitional issues will arise to the extent that current exemptions or the basis of calculating attributable income are either removed or made more restrictive. However, to the extent that the current exemptions are enhanced or improved, and greater flexibility is provided in the ways in which attributable income is calculated, we suggest that transitional issues faced by taxpayers will be kept to a minimum. We recognize that consideration will need to be given in the new design to such issues as:

• The consequences when a taxpayer elects to move from using one attribution method to another under new system – branch equivalent to say using market value, the circumstances in which this may be done, and what if any adjustments will need to be made.

• The treatment of previously attributed amounts and if/when remitted or realised. • Ideally, transitional rules could be minimised by a clean cut off of the old law and the

application of the new rules with, perhaps, an amnesty to apply the new rules retrospectively (say in the previous three years) to assist SME taxpayers who may have had difficulties in complying in the past. Further consideration would need to be given to tracking taxpayers’ overseas interests in the context of risk assessment by the ATO.

In this regard, further consultation with business groups and professional bodies should be undertaken once the design features are finalized. Recommendation 6.8

We suggest that transitional issues faced by taxpayer will be kept to a minimum and enhancement or improvement of the current exemptions and greater flexibility will in return be provided in the ways in which attributable income is calculated.

We recommend that further consultation with business groups and professional

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bodies should be undertaken once the design features are finalized. Q6.9 How should the previously announced transferor trust amnesty be dealt

with under harmonised arrangements? Recommendation 6.9

As mentioned above, we do not believe that the transferor trust rules should be harmonised with the CFC and FIF rules.