INSIGHT

Changes to tax rules for offshore investment

By Martin Fry
Banking International Business Obligations Oil & Gas Resources Tax

In brief

A Bill is currently before Federal Parliament that will more closely (but not completely) align the foreign non-portfolio dividend NANE treatment with debt/equity concepts. Partner Martin Fry and Senior Associate Jennifer Richards report on the changes.

How does it affect you?

  • From the date on which the legislation receives Royal Assent:
    • Section 23AJ of the 1936 Act1 will be replaced with subdivision 768-A in the 1997 Act2;
    • non-assessable, non-exempt (NANE) treatment will no longer be available for dividends on redeemable preference shares that are debt interests;
    • dividends on portfolio interests (less than 10 per cent) derived by a controlled foreign company (CFC) will no longer be notional exempt income; as a result it will no longer be possible to escape Australian tax on portfolio interests by pooling them in a CFC that repatriates the income to Australia as NANE non-portfolio dividends; and
    • a broader range of non-portfolio (10 per cent or greater) distributions on equity interests may qualify for NANE treatment including distributions:
      • on non-share equity interests;
      • received by public trading trusts, corporate unit trusts and corporate limited partnerships; and
      • received through interposed trusts and partnerships (other than corporate tax entities).
  • The 10 per cent participation test is expanded beyond voting interests, and the new test borrows from the participation interest test in sections 960-185 and 960-190 and ultimately from the direct control interest test in s350 (excluding rights on winding up). As s350 is not aligned with debt/equity concepts, the new rules do not achieve complete alignment with debt/equity concepts.

Section 23AJ – The position to date

History

Section 23AJ currently provides that 'non-portfolio dividends' paid to an Australia resident company (not in a trustee capacity) by a non-resident company are NANE income. When first introduced in 1991, the section only applied to dividends paid by companies resident in 'listed countries' (countries with comparable tax regimes). Where dividends were paid from such countries, the foreign tax credit system was seen as giving a broadly equivalent outcome to an exemption. As a result, the exemption was introduced merely to reduce the compliance burden.3

On 13 May 2003, the then Federal Treasurer Peter Costello announced a variety of reforms designed to 'maintain Australia's status as an attractive place for business and investment'.4 Among these measures was an amendment to s23AJ to remove the 'listed country' limitation. The amendment was enacted in 2004, and the Explanatory Memorandum explained that the measure was 'principally aimed at removing the Australian company tax burden from active business income earned by a foreign subsidiary company resident in any foreign country'.5 From a policy perspective, the amendment was designed to ensure that Australian businesses would not be discouraged from pursuing offshore expansion6 by ensuring they could 'compete on an equal footing with other businesses located in that foreign country'.7 The press release also explained that the measure would reduce compliance costs and complexity.

The press release indicated that CFC and FIF (foreign investment fund) rules were to be relied upon to ensure appropriate taxation outcomes were achieved in relation to 'passive and other mobile income derived from low tax jurisdictions'.8

What is a non-portfolio dividend?

Section 23AJ only applies to 'non-portfolio dividends', with the intention of excluding portfolio interests (interests of less than 10 per cent).

Under the current definition of non-portfolio dividend, a return will be a non-portfolio dividend if:

  • the return is in the form of a dividend;
  • the company has a 'non-portfolio' interest, being a voting interest9 of at least 10 per cent; and
  • the return is not an eligible finance share dividend10 or a widely distributed finance share dividend11. While this excludes a limited range of debt type interests held by non-associates, it does not exclude any debt type interests held by associates such as redeemable preference shares issued to a parent company.
Interaction between s23AJ and s25-90

Section 25-90 was introduced in 2001 in conjunction with the 'thin capitalisation' rules as a compliance saving measure. The section allows deductions for interest (and other costs in relation to debt interests issued by an entity) incurred in deriving foreign source income that is NANE under s23AJ. (The section is necessary for a deduction to be allowable because under s8-1, a loss or outgoing cannot be deducted to the extent it is incurred in relation to gaining NANE income.)

The combined result of s25-90 and s23AJ is that:

  • financing costs are deductible where the finance raised is used to acquire a non-portfolio interest in non-resident companies in the expectation of receiving foreign sourced income in the form of dividends; and
  • receipt of such dividends will be NANE.

Proposed amendments to s23AJ

History

In September 2008, the Board of Taxation recommended that s23AJ be amended to prevent its application to dividends on all debt-like interests and to extend its operation to a broader range of equity-like interests by expanding the range of factors to be taken into account to establish an interest of 10 per cent or more.12 In addition, the Board of Taxation recommended the repeal of s404 (which provided that dividends from one company resident in a listed country or a designated s404 country to another such company were 'notional exempt income'13). It considered that this section permitted dividends on portfolio interests to be 'pooled' in an interposed offshore entity (without attracting Australian tax) and then to be repatriated to Australia as NANE dividends under s23AJ. As a result, 'portfolio' interests were indirectly obtaining the benefit of s23AJ, contrary to policy intent.

These recommendations were accepted in the 2009-10 Budget,14 but legislation to implement the changes did not follow.

As part of the 2013-14 Budget, the Government again announced that it would proceed with the 2009-10 recommendations and, in addition, stated that it would extend s23AJ to non-portfolio dividends received through trusts and partnerships. 15 These changes were to take effect from 1 July 2014. At the same time, the Government announced that it would repeal s25-90 because the section was being used to shift profits out of Australia and presented an unacceptable integrity risk. 16 On 6 November 2013, the newly elected Coalition Government announced that it would not proceed with the repeal of s25-90 but would instead introduce a targeted anti-avoidance measure.

The Tax and Superannuation Laws Amendment (2014 Measures No. 4) Bill 2014

On 8 May 2014, the Government released an exposure draft containing draft amendments to implement the changes to s23AJ explained above. Following consultation (and consequent amendments), the Tax and Superannuation Laws Amendment (2014 Measures No. 4) Bill 2014 was introduced into the House of Representatives and received its second reading on 17 July 2014.

The Bill proposes to replace s23AJ with new subdivision 768-A.

The basic requirements

Under the draft subdivision, the basic requirements that need to be satisfied for income to be NANE are as follows:

  • the income is a 'foreign equity distribution' (a distribution17 or a non-share dividend18 made by a company that is a foreign resident in respect of an 'equity interest' (determined in accordance with the Division 974 debt/equity classification));
  • the recipient is an Australian resident and a 'corporate tax entity' (namely a company, a corporate limited partnership, a corporate unit trust, or a public trading trust);
  • the recipient either:
    • receives the distribution in the capacity of trustee of a corporate unit trust, or a public trading trust; or
    • does not receive the distribution in the capacity of trustee; and
  • the recipient passes a 10 per cent 'participation test' at the time the distribution is made (see below).
Dividends through trusts or partnerships

There are also specific rules to provide NANE treatment to foreign equity distributions received by a corporate tax entity (the ultimate beneficiary) via a partnership or trust, or a chain of partnerships or trusts (excluding corporate tax entities such as a corporate limited partnership, a corporate unit trust, or a public trading trust). Where these rules apply, for the purposes of applying the foreign source income requirement in s25-90, the income received by the ultimate corporate beneficiary is deemed to have the same source as the original foreign equity distribution. (It will still be necessary to ascertain the source of the original distribution according to general legal principles.)

The participation test

In order to satisfy the participation test, it is necessary for the sum of the recipient's direct participation interest and indirect participation interest (excluding rights on winding up) to be at least 10 per cent.

To ascertain the direct participation interest, it is necessary to ascertain the percentage that the entity holds, or is entitled to acquire, of each of the following:

  • total paid up share capital of the company;
  • total rights of a shareholder to vote, or participate in any decision-making, concerning any of the following:
    • making distributions of capital or profits to shareholders;
    • the constituent document of the company;
    • any variation of the share capital of the company;
  • the total rights to distributions of capital or profits of the company to its shareholders otherwise than on winding up.

In addition, when ascertaining the direct participation interest:

  • where the percentages differ, the highest of the above percentages applies; and
  • eligible finance shares in a company are to be ignored.

The indirect participation interest will only be relevant where foreign equity distributions are received through a partnership or trust as the general test is modified to disregard interests held via interposed corporate tax entities. The general test is also modified to ignore rights on winding up.

The participation tests rely upon the pre-existing rules in s960-190 of the 1997 Act and ultimately upon the rules in s350 of the 1936 Act. As s350 does not rely upon Division 974 debt and equity concepts, the amendments will not achieve complete alignment with Division 974. In particular:

  • While 'eligible finance shares' are excluded from the direct participation interest calculations, other debt interests in the legal form of a share are not excluded. This could have the potential to affect outcomes, particularly in borderline cases.
  • Each of the three participation tests focus on the types of rights that would be held by a shareholder (ie interest in share capital, rights of a shareholder to vote and rights to distributions of the company to its shareholders). This may have the result that non-share dividends will only be NANE under s25AJ where the holder also holds other equity interests in the form of shares that are sufficient to satisfy the participation test.

As part of its post-implementation review of the debt and equity rules, the Board of Taxation is currently considering the appropriateness of the 'non-interaction' between the control interest test in s350 and the debt/equity rules in Division 974, including in light of s23AJ.19 It therefore seems likely that any complete alignment between Division 974 and the successor of s23AJ will have to wait for the outcome of this review.

Substitution of s404

The Exposure Draft indicated that s404 was to be repealed in order to ensure that dividends on portfolio interest receive the same tax treatment, whether derived directly or indirectly through a foreign resident company. Submissions20 on the Exposure Draft pointed out that this repeal may have the unintended consequence that non-portfolio dividends derived by an interposed foreign resident company could also become taxable in Australia under the CFC rules.21

As a result, s404 is now to be replaced with a new provision that ensures non-portfolio foreign equity distributions received by a CFC will not be part of the CFC's attributable income.

Commencement date

The new legislation is to apply to distributions and non-share dividends made after the day on which the legislation receives Royal Assent.

This represents a departure from the previous announcement that the changes were to commence from 1 July 2014.

Footnotes

  1. Income Tax Assessment Act 1936 (Cth).
  2. Income Tax Assessment Act 1997.
  3. Explanatory Memorandum, Taxation Laws Amendment (Foreign Income) Bill 1990 (Cth).
  4. Press Release No 32, 13 May 2004, Peter Costello, Treasurer.

  5. Explanatory Memorandum, New International Tax Arrangements (Participation Exemption and Other Measures) Bill 2004, [2.15].
  6. Board of Taxation, Review of the debt and equity tax rules, Discussion Paper, March 2014, page 124.
  7. Explanatory Memorandum, Tax and Superannuation Laws Amendment (2014 Measures No. 4) Bill 2014, [2.4].
  8. Press Release No 32, 13 May 2004, Peter Costello, Treasurer.

  9. The company must beneficially own shares carrying the right cast at least 10 per cent of the votes that can be cast on a poll at a general meeting as regards all questions that can be submitted to such poll and there must be no arrangement in force by virtue of which any person is in a position, or may become in a position, to affect that right.
  10. Broadly meaning dividends on shares issued to a non-associate which is an Australian Financial Institution (AFI), or a subsidiary of an AFI in the ordinary course of that entity's business and where the dividend on the shares may reasonably be regarded as equivalent to interest on a loan, having regard to various specified matters.
  11. Broadly meaning dividends on shares issued by a listed entity, or a 90 per cent owned subsidiary of a listed entity to a non-associate where the payment of dividends may be regarded as equivalent to interest on a loan, and where (having regard to various specified matters) the shares were issued for public subscription/wide distribution.
  12. Review of the Foreign Source Income Anti-Tax-Deferral Regimes, A Report to the Assistant Treasurer and Minister for Competition Policy and Consumer Affairs, September 2008, page 36-37.
  13. The result of this provision was that such dividends would not be subject to attribution (and consequent taxation in Australia) under the CFC rules.
  14. Budget, Budget Measures, Budget Paper No.2, 2009-10, Part 1, Revenue Measures, page 23.
  15. Addressing profit shifting through the artificial loading of debt in Australia, Proposals Paper, 14 May 2013, [33]-[34].
  16. Ibid., [35]-[38].
  17. A dividend or something that is taken to be a dividend under the Act (see s960-20, item 1).
  18. A distribution on a non-share equity interest, except to the extent the distribution is debited to the company's non-share capital account or share capital account.
  19. Board of Taxation, Review of the debt and equity tax rules, Discussion Paper, March 2014, page 124-125 and see in particular question 8.6.
  20. Law Council of Australia (Business Law Section) Submission, 6 June 2014, [27]-[30]; Institute of Chartered Accountants Australia Submission 10 June 2014, page 7.
  21. This result arises because s389A requires any provision to be disregarded for the purposes of calculating attributable income to the extent it depends upon Division 974 (debt/equity) concepts. As a result of the definition of 'foreign equity distribution' in proposed s768-10, the proposed s768-5 only applies where something has been classified as an 'equity interest' under Division 974. If this section were disregarded under s389A, non-portfolio dividends received by a CFC would be part of the CFC's attributable income.