Bills Digest No. 54   1997-98 Taxation Laws Amendment Bill (No. 4) 1997


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WARNING:
This Digest was prepared for debate. It reflects the legislation as introduced and does not canvass subsequent amendments. This Digest does not have any official legal status. Other sources should be consulted to determine the subsequent official status of the Bill.

CONTENTS

Passage History

Taxation Laws Amendment Bill (No. 4) 1997

Date Introduced: 26 June 1997
House: House of Representatives
Portfolio: Treasury
Commencement: Refer to the Main Provisions section for the various commencement dates of the measures.

Purpose

The amendments contained in the Bill relate to:

  • the rules relating to thin capitalisation to reduce the allowable debt to equity ratio and to introduce a number of specific anti-avoidance provisions relating to thin capitalisation;
  • tightening the rules relating to the tax exemption for certain charitable trusts to prevent them making donations overseas that can be used to avoid Australian tax;
  • postponing the increase in the rate of tax for certain insurance income of friendly societies; and
  • introducing provisions relating to the Tax Laws Improvement Program which aims to re-write the current tax law without changing the application of the law.

Background

As there is no central theme to the Bill, the background to the measures will be discussed below.

Main Provisions

Thin Capitalisation

This term refers to the situation where interest is paid to a foreign entity on debt owed to the foreign entity and the foreign entity does not have a sufficient level of equity investment in the body paying the interest. In such a case, the deduction available on the interest payment will be limited. The current rules provide that where the debt to equity ratio is greater that 3:1 (a 6:1 ratio applies to financial institutions reflecting their greater reliance on debt to enable the institution to lend funds and therefore make a profit), the deduction for interest payable on the debt is limited to the interest that would be payable had the required ratio been met. In order for the thin capitalisation rules to apply, the foreign entity to which the interest is paid must have the required stake in the organisation that has paid the interest. This is currently where the foreign entity is considered to be in control of the organisation paying the interest, which sections 159GZE and 159GZJ of the Income Tax Assessment Act 1936 (ITAA) define to be an entity with 15% or more of the votes, or control, of the Australian entity paying the interest. The definition of control is wide, and includes the interest of associates and inter-posed entities such as companies and trusts.

The principle behind the thin capitalisation rules is that if a company wishes to operate in Australia through an entity over which they have substantial control, such investments should be in the form of equity rather than debt. The rules also aim to address problems that may arise where a large debt ratio could be used to generate deductions for interest payments that would substantially reduce the Australian entity's profit and, as a result, the amount of Australian tax payable. The thin capitalisation rules may be seen to be in the same category as measures such as those relating to Controlled Foreign Companies and international Double Taxation Agreements which also address the impact of taxation on international business arrangements.

As noted above, the requisite ratio is currently 3:1 for entities other than financial institutions. It was announced in the 1996-97 Budget, released on 20 August 1996, that the general ratio would be changed to 2:1. The effect of the change will be to require relevant foreign entities that satisfy the current ratio but not the proposed ratio to reduce their lending relevant to equity, increase their equity relative to debt or to accept a lower deduction for the interest payments relating to the relevant foreign debt.

A number of other measures relating to the calculation of the availability of deductions under the thin capitalisation rules were also announced in the 1996-97 Budget, including that:

  • the calculation of the amount of debt would be amended to include debts undertaken by the Australian entity for which the foreign entity has given a legally enforceable guarantee;
  • a deduction would be denied for discretionary trusts in respect of interest paid to a foreign entity that is in a position to control the trust;
  • rules relating to asset re-valuation would be tightened to prevent excessive valuations being used to increase the value of equity investments; and
  • anti-avoidance rules would be tightened.(1)

The Budget Papers estimated that the changes to the thin capitalisation rules would raise an additional $70 million in 1998 99 and $75 million in 1999 2000.(2) It was also announced in the Budget Papers that the measures would have effect from the 1997 98 year of income (ie. 1 July 1997 for those entities using a July-June financial year).

Details of the proposed legislation were released on 17 June 1997, when a Draft Bill on the issue was released for public comment. The proposals received some criticism from major taxation firms. It is reported that an international tax consultant at Price Waterhouse commented:

The release of draft legislation confirms the government's going to make it more difficult for Australia to attract foreign investment, particularly relative to our regional neighbours, which don't have such restrictive rules.

We're going against the international trend. Other countries who've gone down to 2:1 have found it a disincentive to foreign investment, and have reversed their ratio to 3:1.(3)

Section 159GZA of the ITAA contains definitions used in Division 16F, which deals with thin capitalisation. Item 1 of Schedule 1 of the Bill will amend the definition of 'foreign equity product' to change the ratio for bodies other than financial institutions from 3:1 to 2:1.

The amount of foreign debt held is calculated according to section 159GZF which lists the matters that are to be included in the calculation. Item 2 of Schedule 1 will amend section 159GZF to include amounts when a guarantee or security is given. The amendment provides that where a resident company, other than a financial institution, has a debt to a non-resident (other than a foreign controller of the company or others associated to that entity) and:

  • interest is payable on the loan and would ordinarily be deductible;
  • the interest is not assessable income in the hands of the entity to which it is paid; and
  • the debt is guaranteed by the foreign controller or their associate,

then the amount of the foreign debt is to include the amount so guaranteed or secured. The amendment is an anti-avoidance provision and is designed to address the situation where guarantees and security are used by a foreign controller or an associated entity to artificially reduce the amount of foreign debt where the guarantee or security means that the foreign controller or an associate effectively is responsible for the debt.

Another measure, contained in Item 7 of Schedule 1, can also be viewed as an anti-avoidance measure. The assessment of the degree of foreign equity is determined according to section 159GZG of the ITAA. That section contains different tests for companies, and trusts and partnerships. In relation to the later category the amount of foreign equity is, basically, determined according to the amount of the income of the partnership or trust that the non-resident is entitled to. The new formulas contained in item 7 provide a statutory formula that is based not only on the degree of entitlement to income from the partnership or trust but also on their equity holding as if a partnership balance form had been released, whether the equity holding has income rights or not. As it would be possible for a party to hold 100% of both the rights to income and equity in a partnership, the combined income and equity holdings are halved to determine the applicable degree of foreign equity. In relation to trusts, a similar new formula will be introduced but will be based on the fixed interests of a foreign controller or their associate when determining their entitlement to income and equity.

The proposed formulas are related to the introduction of new provisions relating to asset revaluation (revaluations may be used to alter the debt:equity ratio). Proposed subsection 159GZG(4B) provides that a revaluation of assets will only be taken into account if the partnership or trust has an asset revaluation reserve in its books. In relation to ascertaining the amount of foreign equity, such a reserve is currently required by companies and is reduced where the value of the revaluation exceeds the value that would be obtained if the assets were revalued in an arm's length transaction. This allows the equity in the entity, for purposes of thin capitalisation, to be adjusted so that the equity value of the revalued assets is equivalent to market value.

The calculation of the equity of a foreign controller or their associates for trusts is further complicated by discretionary trusts where the trustee has the ability to direct income to the beneficiaries as they determine. This makes it very difficult to determine who has a right to the income or capital of the trust, and hence the amount of foreign equity. Item 9 of Schedule 1 proposes to introduce new rules where a cap will be placed on the amount of foreign equity in the trust that is deemed to be foreign equity for the thin capitalisation rules (increased foreign equity will allow a higher debt amount and so higher allowable interest deductions). The cap will be determined by reducing the amount of foreign equity in accordance with the formula contained in proposed subsection 159GZG(12), and will depend on various features of the trust and how the trust falls within the definition of discretionary trust contained in proposed subsection 159GZG(13). An example of the operation of the system is where a trust can benefit under the discretionary trust, in which case the foreign equity will be reduced by 100%.

Current sections 159GZO and 159GZP, which deal with schemes involving the use of intermediators to reduce foreign debt, will be repealed by Items 10 and 11 as they will be replaced by the above provisions.

Proposed section 159GZU provides that where a non-resident controller of a trust or partnership owes an amount to the resident entity and this would result in interest being payable to a non-resident associate of the controller, no deduction will be allowed in respect of the interest. This is also an anti-avoidance measure (Item 12).

Item 13 contains transitional provisions. The main effect of the amendments is to allow those who do not balance at the time of commencement of the Bill to treat the period before and after commencement as separate financial years for the purpose of the amendments.

Application: The amendments will apply from the commencement of the 1997 98 financial year (Item 13).

Charitable Trusts

Because of their nature as bodies that distribute funds rather than have full ownership of those funds, charities usually employ a trust structure so that they can distribute funds for reasons contained in the trust deed. As the trust does not have beneficial ownership of the funds, the structure also discourages the possibility ofthe charity closing and taking the funds it controls. To be exempt from tax, the organisation must be a 'charitable institution' (paragraph 23(e) of the ITAA), ie. a trust established for charitable purposes or a fund established by will for charitable purposes (paragraph 23(j)(ii) of the ITAA). To gain this status, the Commissioner must be satisfied that the applicant for the exemption is a charitable institution, which is usually shown by presenting accounts for the previous two years. The exemption is also available for non-resident charitable institutions. The question of whether a body is tax exempt should be distinguished from the deduction available for people who make donations to charities, which are deductible under section 78 of the ITAA.

Possible avoidance problems with charitable institutions have arisen over a number of years. The matter was addressed by the House of Representatives Standing Committee on Finance and Public Administration in it's 1991 report Follow the Yellow Brick Road. Some of the potential avenues of avoidance noted in that report have since been closed. For example, the making of a tax deductible donation to an exempt overseas charity which then returns the money, less a commission.(4) (This has been prevented by tightening the rules contained in section 78 regarding the availability of deductions for charitable donations.) However, the use of charitable institutions still offers the potential for avoidance. Affairs may be arranged so that a deductible donation is made to an Australian institution, which in turn makes a donation to an overseas charity. The overseas charity then remits the funds, less a commission, to the original donor, usually by placing the funds in an off-shore bank account. Such schemes depend on the various charities being willing to participate, which is not the case with most reputable charities. The schemes are therefore generally confined to charitable trusts and charitable bodies established by will.

It was announced in the 1996 97 Budget that the tax exempt status would be lost unless any distribution was to a charity in Australia (including overseas aid funds operating under section 78) or was used directly by the trust in Australia for the purposes contained in its trust deed. The measure is designed not to effect genuine charities or charitable trusts and it was stated in the 1996 97 Budget:

[The government] will undertake consultations before introducing the legislation into the Parliament to ensure that bona fide charities are not detrimentally effected.(5)

The Draft legislation was released on 20 February 1997 and the Treasurer issued an invitation for interested parties to comment on the Draft. In the Press Release announcing the release of the Draft legislation, the Treasurer noted that there was one difference between the announced changes and those contained in the Draft legislation. This was that in the original announcement charitable trusts established by will prior to that announcement would be excluded from the new rules. The Press Release indicates that 'in order to prevent these testamentary trusts from being used as conduits in further tax avoidance arrangements' amounts received by such trusts on or after the date of the Press Release would be subject to the new rules. Therefore, the proposed rules will not apply to distributions made from assets held by such trusts before the 20 February 1997 announcement but will apply to distributions from assets obtained after this time. There has been minimal public comment on the Draft legislation.

The Explanatory Memorandum to the Bill estimates that the measures relating to charitable trusts and related bodies will raise an additional $25 million in 1996 97 and $30 million per year from 1997 98.

Paragraph 23(e) of the ITAA provides an exemption from tax for religious, scientific, charitable or public educational institutions. Item 2 of Schedule 5 will amend this paragraph to provide that the exemption will only be available to such bodies which fall into one of the following categories:

  • they have a physical presence in Australia and principally incur their expenditure in Australia;
  • is an institution to which a tax deductible donation may be made;
  • is a prescribed institution located outside Australia and is exempt from tax in its country of residence;
  • is a prescribed charitable or religious institution which has a physical presence in Australia and which principally incurs its expenditure outside Australia.

A similar amendment will be made in relation to public and non-profit hospitals, although they will be required to fall into one of the first three categories listed above to remain tax exempt (Item 2 of Schedule 5). Similarly, Item 4 will amend provisions relating to non-profit cultural, sporting and friendly societies in the same manner as for public and non-profit hospitals. (The later measure may raise concerns for non-profit cultural associations who may wish to support an entity that would fall within the last category listed above.)

Paragraph 23(j)(ii), which exempts bodies established by will or trust for public charitable purposes, will be amended by Item 5 of Schedule 5 to remove the exemption for such bodies established on or after the time of the Budget announcement (7.30 pm on 20 August 1996). However, the exemption will be preserved after this time if the conditions contained in proposed paragraph 23(j)(iii) are complied with. These are that the trust deed or will prohibits the distribution of funds overseas and the body satisfies one of the following conditions:

  • since 20 August 1996, it has principally expedited its money in Australia and which has pursued its purposes solely in Australia;
  • it is a fund to which a donation is deductible under section 78;
  • it distributes its funds solely to a charitable fund, foundation or institution that, to the best ofthe trustee's knowledge, is located in Australia, principally spends its fund in Australia and pursues its purposes solely in Australia;
  • it distributes solely to a charitable fund, foundation or institution that, to the best ofthe trustee's knowledge, is such a body that a donation made to it would be deductible under section 78.

Paragraph 23(j)(iii) currently provides that a fund established to enable research to be carried on at, or in conjunction with, a public university or hospital, is also exempt. This will be amended to provide that to remain exempt the body must be located in Australia, and was established to conduct such research in Australia or is a fund to which donations are deductible under section 78.

The exempting of trusts established by will in relation to amounts received after the Budget announcement will be achieved by proposed section 23AAAB, which provides that the property held before the announcement will be treated as being held in a separate trust from property held after this time. The new rules will apply only to that part of the trust recognised as holding property after 20 February 1997.

Application: As noted above, the amendments described above relate to a Budget announcement and generally will commence at the time of the introduction of the Budget (ie. 7.30 pm on 20 August 1996). The amendments relating to proposed section 23AAAB will apply for the 1996 97 year of income (Item 11).

Quasi-ownership of Fixtures

Schedule 6 of the Bill contains provisions that will replace the current legislation relating to when a person will be taken to be the owner of certain fixtures. The proposed amendments are part of the Tax Laws Improvement Project which commenced in 1994. Although the project was expected to be completed in 3 years, considerable work remains before the project will be completed. The project is designed to replace the current legislation to provide a more comprehensible version of the current law. Central to the project is the proposition that the re-write of the law is not to alter the current application of the laws or alter policy. As such, the amendments contained in Schedule 6 do not introduce policy changes and will not be further addressed in this Digest.

Friendly Societies

Friendly societies are mutual bodies registered under State or Territory laws to provide certain benefits and services to their members. As mutual bodies, friendly societies are not subject to tax on receipts from members but are subject to tax on various categories of income, such as investment income.

Prior to 1993, friendly societies paid tax at the rate of 30% on income derived from accident and income insurance and other insurance policies not covered by other categories listed in the ITAA. In comparison, such policies issued by life assurance companies were taxed at the 39% rate. In 1993, the rate of tax for friendly societies was legislated to increased to 33% in 1995 96; 36% in 1996 97; and to 39% in 1997 98 and later years (Taxation (Deficit Reduction) (No. 2) Act 1993). However, it was announced in the 1995 96 Budget that there would be a review of the life insurance business of friendly societies and life insurance companies. The then government determined that while the review was in progress the rate of tax on friendly societies should remain at 33% until the end of 1996 97, and increase to 39% for 1997-98 and later years. This was introduced by the Taxation Laws Amendment (Budget Measures) Act 1995.

It was announced in the 1997 98 Budget that pending the completion of the review the rate of tax would remain at 33% until 1998 99 and will increase to 39% from 1999 2000. In regard to this announcement, it would appear that while the increase in the rate of tax has been postponed pending the result of the review, a decision has already been made that the rate will increase in 1999 2000 regardless of the result of the review. However, while the Budget papers base proposed revenue on the increased rate of tax, it is also noted that the increase will apply 'unless other relevant amendments to the taxation treatment of friendly societies are made prior to that time.'(6)

The measure is estimated to cost $6 million in 1997-98; $29 million in 1998 99; $4 million in 1999 2000; and to raise an additional $2 million in 2000-01.(7)

The measures described above will be introduced by Schedule 8 of the Bill which will amend the Taxation (Deficit Reduction) (No. 2) Act 1993. As this Act amended the Income Tax Rates Act 1986, the effect of the amendments will be to alter the rate of tax payable by friendly societies in the manner described above. Such a measure could also have been introduced through direct amendments to the later Act.

Luxury Cars

The ITAA contains provisions that cap the maximum value of a car that can be used in the calculation of any claimed deduction. The ITAA also contains provisions, relating to the valuation of leases and dealing with various leasing schemes, aimed to prevent the avoidance of the deduction limits. Schedule 9 of the Bill proposes to insert new provisions into the Income Tax Assessment Act 1997 that reflect the current treatment of luxury vehicle leases. The Table contained in the Schedule refers to the ITAA to ensure consistent treatment. The Income Tax Assessment Act 1997 is part of the Tax Laws Improvement Program which, as noted above, is not intended to change the operation of the tax law but to be a rewrite of the ITAA. As there is no policy change, the amendments will not be further discussed.

Application: For the 1997 98 and later years of income (Item 30).

Endnotes

  1. 1996-97, Budget Paper, no. 1, pp. 4 15 & 4 16.
  2. Ibid., p. 4 5.
  3. The Australian Financial Review, 18 June 1997.
  4. Parliamentary Paper, no. 61, 1991, pp. 51 & 52.
  5. 1996-97 Budget Paper, no. 1, p. 4 14.
  6. 1997-98 Budget Paper, no. 2, p. 188.
  7. Ibid., p. 187.

Contact Officer and Copyright Details

Chris Field
3 October 1997
Bills Digest Service
Information and Research Services

This Digest does not have any official legal status. Other sources should be consulted to determine whether the Bill has been enacted and, if so, whether the subsequent Act reflects further amendments.

IRS staff are available to discuss the paper's contents with Senators and Members and their staff but not with members of the public.

ISSN 1328-8091
© Commonwealth of Australia 1997

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Published by the Department of the Parliamentary Library, 1997.

This page was prepared by the Parliamentary Library, Commonwealth of Australia
Last updated: 7 October 1997

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