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
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.
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.
As there is no central theme to the Bill, the background to the
measures will be discussed below.
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).
- 1996-97, Budget Paper, no. 1, pp. 4 15 & 4
16.
- Ibid., p. 4 5.
- The Australian Financial Review, 18 June 1997.
- Parliamentary Paper, no. 61, 1991, pp. 51 &
52.
- 1996-97 Budget Paper, no. 1, p. 4 14.
- 1997-98 Budget Paper, no. 2, p. 188.
- Ibid., p. 187.
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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Last updated: 7 October 1997
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