Bills Digest No. 131  1998-99 Taxation Laws Amendment Bill (No. 4) 1998


Numerical Index | Alphabetical Index

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
Purpose
Background
Main Provisions
Concluding Comments
Endnotes
Contact Officer and Copyright Details

Passage History

Taxation Laws Amendment Bill (No. 4) 1998

Date Introduced: 3 December 1998

House: House of Representatives

Portfolio: Treasury

Commencement: Upon Royal Assent, however, the measures contained in the Bill have different application dates, which will be considered in the Main Provisions section of this Digest.

Purpose

The amendments contained in the Bill are:

  • Measures to implement the 'Australia - A Regional Financial Centre' part of the Investing for Growth statement made by the Government on 8 December 1997 (Schedule 1)
  • Measures relating to commercial debt forgiveness (Schedule 2)
  • Measures relating to the depreciation of plant previously owned by an exempt entity (Schedule 3)
  • Measures relating to franking credits and the intercorporate dividend rebate (Schedules 4, 5 & 7)
  • Measures to allow deductible donations for gifts of $2 or more made to the Menzies Research Centre Public Fund (Schedule 6).

Background

As the Bill contains no central theme the background to the various measures is included in the discussion of the main provisions.

Main Provisions

Australia as a regional financial centre

The measures in Schedule 1 were announced by the Prime Minister on 8 December 1997 in the Investing for Growth statement (Statement). The Statement contains the following comment:

We recognise, however, the intensive international competition for financial services activity. In advance of major reform, we have decided to introduce specific tax measures at a cost of $22 million(1) in revenue foregone in a full year.

The measures are described in the Explanatory Memorandum to the Bill as promoting Australia's potential to be a world financial centre through the provision of new tax concessions to supplement existing tax concessions provided to the international banking and finance industry. The Explanatory Memorandum states that the measures ensure Australia's participation in the expanding global trade in financial services.

There are four types of income tax concessions provided in the measures. They are:

  • expansion of the existing section 128F withholding tax exemption
  • expansion of the existing concessions provided for offshore banking units
  • the provision of an exemption to foreign banks from the thin capitalisation rules for funds raised under the section 128F withholding tax exemption, and
  • provision of certain exemptions from the foreign investment fund regime of the income tax law.

The measures contained in Schedule 1 were first introduced into Parliament on 2 July 1998 in Taxation Laws Amendment Bill (No. 5) 1998. This Bill lapsed when Parliament was prorogued for the 1998 General Election. The Minister's second reading speech to the Bill states that the measures in the first Bill were amended following dialogue with industry bodies. The amendments to the Bill were announced by the Treasurer by Press Release No. 80 on 13 August 1998.

Section 128F interest withholding tax exemption

Australia imposes interest withholding tax of 10 per cent on interest payments from Australia to non-resident lenders. In order to ensure payment of the tax the collection obligation is imposed on the Australian borrower. While the tax is imposed on the lender, lenders are generally able to pass any interest withholding tax burden on to borrowers because lenders are generally able to lend to borrowers in countries that do not impose interest withholding tax on corporate fund raising. The net result is that a borrower is required to pay not only the interest on the borrowing, but also any domestic interest withholding tax.

To remove the burden of interest withholding tax from borrowings by Australian companies an exemption was provided for certain debentures issued overseas.(2) The main requirements of the existing section 128F are that: the company issued the debentures outside Australia; the interest in respect of the debentures was paid outside Australia; the resident company issued the debentures outside Australia for the purpose of raising finance outside Australia; and, the public offer requirement is satisfied.

The banking and finance industry has suggested that interest withholding tax should be withdrawn from government bonds. The industry has stated that, in light of the measures contained in Schedule 1, it is an anomaly to retain withholding tax on Commonwealth Government bonds which are traded widely among overseas investors.(3)

Item 27 of Schedule 1 will:

  • repeal the existing requirement that eligible debentures be issued outside Australia for the purpose of raising finance outside Australia, and
  • repeal the existing requirement that interest in respect of eligible debentures be paid in Australia.

Following the amendments Australian companies will be able to issue debentures both overseas and in Australia. They will be able to pay interest to overseas lenders either overseas or in Australia. This relaxation will provide Australian companies with more flexibility in raising finance. The Explanatory Memorandum to the Bill states that this measure is designed to encourage the development of the domestic corporate debt market.(4) The Explanatory Memorandum also states that by easing access to the exemption for financial institutions, the government anticipates that the measures will increase competition by lenders in the home-lending market and the consumer loan market.

Central borrowing authorities - uncertainty prevails?

Currently, securities issued by an authority of the Commonwealth Government, State governments and authorities of State governments are eligible for the section 128F exemption [subsection 128F(7)]. Under subsection 128F(7) an authority of the Commonwealth, a state or an authority of a state is treated as a resident company for the purposes of section 128F. This legal fiction satisfies the requirement in subsection 128F(1) that the exemption applies to interest paid by a company. Proposed subsection 128F(5A) prescribes that the new exemption will not apply to a company under subsection 128F(7) or a central borrowing authority of a state or territory that issues debentures in Australia (Item 29). Examples of central borrowing authorities are listed in proposed subsection 128F(5A). The following bodies are included in that list:

  • the Tasmanian Public Finance Corporation;
  • the Queensland Treasury Corporation;
  • the South Australian Government Financing Authority;
  • the Western Australian Treasury Corporation;
  • the New South Wales Treasury Corporation;
  • the Treasury Corporation of Victoria; and
  • the Northern Territory Treasury Corporation.

[The digest refers to the entities described in subsection 128F(7) and proposed subsection 128F(5A) as borrowing agencies.]

The drafting of Item 29 is obscure. In addition, the proposed provisions and the comments in the Explanatory Memorandum are contradictory. Item 29 was introduced in its current form on 2 July 1998 in Taxation Laws Amendment Bill (No. 5) 1998 and then re-introduced without alteration on 3 December 1998 in Taxation Laws Amendment Bill (No. 4) 1998.

The use of the words 'issued in Australia' in proposed subsection 128F(5A), without a reference to the recipient of the debentures, may lead to a construction that a borrowing agency cannot issue any debentures that qualify for the withholding tax exemption. This construction is supported by the heading in the Bill: No exemption for central borrowing authorities.

An alternative interpretation of the provision suggests that the borrowing agencies may not issue debentures in Australia that are eligible for the exemption but that they can issue debentures overseas that are eligible for exemption. This construction depends on the reader being aware that a company can issue debentures overseas and that such issues are unaffected by the proposed amendment. Most readers would require assistance from a source external to the Bill indicating that there is a difference between a company issuing debentures overseas or issuing debentures in Australia. The Explanatory Memorandum, however, does not make this point. Under this construction the proposed amendments may result in a significant easing of the section 128F requirements for borrowing agencies because of the repeal of the following existing requirements in section 128F:

  • that the debentures be issued overseas for the purpose of raising finance overseas (paragraph 128F(1)(c));
  • that interest in respect of the debentures be paid overseas (paragraph 128F(1)(d)); and
  • that the debentures not be issued to residents of Australia (subsection 128F(5)).

It would appear from the Explanatory Memorandum that this latter construction of the provisions was unintended. Under the proposed amendments the borrowing agencies are only subject to the requirement that the debentures be issued overseas. However, proposed subsection 128F(5A), as stated above, does not refer to a recipient. Consequently, under this provision borrowing agencies will be able to: issue debentures overseas for the purpose of raising finance in Australia; pay interest in respect of the debentures in Australia; and issue debentures overseas to residents of Australia. It is puzzling as to why borrowing agencies would be prohibited from issuing debentures in Australia but could issue the debentures overseas to residents of Australia and pay interest in Australia.

According to the Explanatory Memorandum, proposed subsection 128F(5A) may not be an accurate reflection of the Government's intention. The Explanatory Memorandum contains the following comment on Item 29:

The wider exemption will not be available to Commonwealth Government securities or securities issued by State or Territory central borrowing authorities (sovereign issues). However, the existing section 128F exemption applying to offshore issues of debentures will continue to be available to these entities.(5)

The Explanatory Memorandum is silent as to the reason for the amendments proposed in Item 29 in relation to borrowing agencies.

In conclusion, it would appear from the Explanatory Memorandum that, the intention of the Government may have been to restrict borrowing agencies to a version of section 128F that requires: debentures to be issued overseas by borrowing agencies for the purpose of raising finance overseas; borrowing agencies to pay interest overseas in respect of section 128F debentures; and, borrowing agencies to issue debentures overseas to non-residents. This result was not achieved and it appears that the requirements for borrowing agencies may have been significantly eased. Moreover, there is no statement as to why borrowing agencies should be subject to special restrictions.

Section 126 interest paid by a company on bearer debentures

Section 126 is an anti-avoidance provision. It imposes income tax at the top marginal rate of tax, currently 47 per cent, on a company issuing bearer debentures, if the company is unable to give the Commissioner of Taxation the name and address of the holder of the debentures. This counters the avoidance opportunities, that would otherwise be available to Australian taxpayers, of holding bearer debentures and not declaring the interest income in respect of the debentures. A person holding a bearer debenture is able to require payment of interest without disclosing the person's identity to the payer of the interest. Bearer debentures are generally issued overseas because they are readily traded.

The term 'permanent establishment' is defined in section 6 of the Income Tax Assessment Act 1936 by virtue of subsection 995-1(1) of the Income Tax Assessment Act 1997 to generally mean a place in Australia at which a person carries on business. In relation to non-resident companies, a permanent establishment is generally a branch of the company located in Australia through which the company carries on its business.

Item 23 proposes a consequential amendment to section 126 because of the proposed amendment to section 128F enabling section 128F exempt debentures to be issued in Australia and interest in respect of the debentures to be paid in Australia (see comments on Item 27 above). Item 23 proposes that section 126 will not apply in relation to section 128F debentures to the extent that the provision applies to non-residents not engaged in carrying on a business in Australia at or through a permanent establishment (generally a branch).

The proposed amendment appears to create significant compliance problems for companies issuing bearer debentures under section 128F. A company issuing bearer debentures which are eligible for the section 128F exemption will usually not know the identity of the bearer. This is a normal feature of section 128F debenture issues. Consequently, the company will be unable to determine if the bearer of a debenture is carrying on a business in Australia through a permanent establishment. If, under amended paragraph 126(1)(c) a company which has issued debentures eligible for exemption under section 128F is unable to assert that the person holding debentures does not carry on a business in Australia through a permanent establishment, that company will be liable to pay tax in respect of the interest paid at the top marginal rate.

Offshore banking units

The term offshore banking refers to an Australian entity entering financial transactions with overseas customers. The transactions include borrowing funds, lending funds and the provision of financial services. Provided these transactions are isolated from the domestic banking system, tax concessions are available for the income derived from the transactions. Income derived by an offshore banking unit (OBU) from certain listed activities is taxed at a rate of 10 per cent instead of the ordinary corporate tax rate of 36 per cent. Interest paid by an OBU is exempt from non-resident interest withholding tax.

The term OBU is defined in section 128AE. Certain types of companies, prescribed in subsection 128AE(2) are eligible to be declared by the Treasurer to be an OBU. Under the existing provision only banks and corporations that carry on foreign exchange dealings are eligible to be OBUs.

Eligible entities

The proposed amendments will expand the range of entities eligible for the OBU concession. Item 24 expands the category of eligible entities to include registered life insurance companies (proposed paragraph 128AE(2)(d)); and certain companies that provide funds management services (proposed paragraph 128AE(2)(e); and any company that the Treasurer determines in writing to be an OBU (proposed paragraph 128AE(2)(f)). As any company may be declared by the Treasurer to be an OBU under proposed subsection 128AE(2), it is unnecessary to prescribe specific types of eligible companies in the 1936 Act.

Expanded range of OBU activities

The range of activities an OBU can undertake have been expanded (Items 6-21).

Overseas charities

Overseas charities whose funds are managed by an OBU are presently taxed on investments in Australian assets. To encourage investment in Australia by overseas charities through an OBU, proposed section 121ELA exempts the income and proposed section 121ELB exempts the capital gains of such charities from taxation (Item 22).

Reduction of OBU withholding penalty tax

An entity which is an OBU engaging in proscribed activities may be liable to pay a penalty. The penalty rate of tax is currently set at 300 per cent under the Income Tax (Offshore Banking Units) (Withholding Tax Recoupment) Act 1988. Item 38 reduces the penalty rate to 75 per cent. The Explanatory Memorandum(6) to the Bill states that the Government is of the view that the existing penalty is excessive. The new penalty is described as being more in line with other penalties for breaches of the OBU rules.

Thin capitalisation

The thin capitalisation rules of the income tax law(7) are an anti-avoidance measure to limit the amount of deductible debt that may be claimed by a foreign owned Australian enterprise. The thin capitalisation rules are limited to overseas debt from related parties. Due to the preferential tax treatment provided to debt investments, foreign investors have the incentive to make investments in their own enterprises in the form of debt and equity. The thin capitalisation rules set a fixed 'debt to equity' ratio of 6:1 for financial institutions and 2:1 for all other taxpayers. For every $2 lent to the Australian enterprise (foreign debt) by a foreign investor, the foreign investor must have equity of $1 in the enterprise (foreign equity). Foreign equity is reduced if the Australian enterprise lends amounts to the foreign investor. If the foreign debt to foreign equity ratio is exceeded, the interest in respect of the excess debt cannot be claimed as a deduction.

Foreign banks operating in Australia through a branch are not able to access the section 128F interest withholding tax exemption because they are not Australian companies. Such a branch may arrange for a subsidiary company to be incorporated in Australia for the purpose of borrowing funds overseas that are eligible for the section 128F exemption; and then on-lending those funds to the branch. Such loans are treated, under the existing thin capitalisation rules, as a loan-back of equity by a bank subsidiary to the foreign bank. This would result in the subsidiary being ineligible for a deduction on loans from the foreign bank to the subsidiary.

The amendments contained in Item 34 disregard, for the purposes of the thin capitalisation rules, any on-lending of section 128F funds by an Australian subsidiary of a foreign bank to the Australian branch of the bank. This allows the Australian subsidiary of a foreign bank to lend section 128F funds to its Australian branch (the foreign bank itself) without suffering any consequences under the thin capitalisation rules.

Application

Items 39 and 46 sets the application date for Schedule 1 as after 2 July 1998. The first Bill was introduced in the House of Representatives on 2 July 1998.

Depreciation of plant previously owned by an exempt entity

Divisions 50 and 51 of the Income Tax Assessment Act 1997 provides an exemption from income tax for a range of prescribed non-profit organisations such as charities. A non-profit organisation may become a business enterprise and be subject to income tax. This may occur if an organisation is floated on the stock exchange and is then to become a business enterprise. If a non-profit organisation changes its status to that of a taxable entity certain tax consequences arise. One issue is the valuation of an entity's assets for depreciation purposes.

When an entity changes its character from a tax-exempt entity to a taxable entity, it must value its plant for income tax depreciation purposes at its notional written down value (NWDV). Under the existing law, a tax exempt entity's plant is treated as being used, from the time of acquisition, for the production of assessable income. In effect, items of plant are treated as depreciating while held by tax exempt entities. This process for valuing plant acquired from tax-exempt entities by taxable entities could be avoided by the purchaser acquiring the assets of the entity rather than acquiring the entity. In this situation the purchaser is able to value the assets for depreciation purposes at their purchase price which would often be higher than the NWDV. The net result is that the purchaser is entitled to a larger depreciation deduction by acquiring the assets of the seller rather than the entity itself.

This avoidance problem does not arise in relation to the acquisition of plant from sellers who are subject to income tax. If a seller sells an asset for a value that exceeds the depreciation value of the asset for income tax purposes, the seller will be subject to income tax on the difference between the depreciation value and the sale value of the asset. This process captures the tax benefit the seller has obtained by depreciating the value of plant to a level below its market value. A tax-exempt entity cannot obtain the benefit of a depreciation deduction and therefore it is indifferent to a sale process that values assets at their market value rather than the asset's value in the entity's balance sheet. This indifference provides potential for tax planning by buyers to maximise the opening value of assets acquired from tax-exempt entities.

The Treasurer announced in Press Release No. 84 of 4 July 1997 that the depreciation values were being manipulated by the sale of assets to a purchaser. The Treasurer stated that legislation would be introduced to allow the purchasers of exempt entities, or the purchasers of assets owned by exempt entities, only to claim depreciation based on the higher of the NWDV and the undeducted pre-existing audited book value recorded in the exempt entity's audited annual accounts. The Treasurer released technical details, in respect of this measure, in Press Release No. 2 of 14 January 1998 and Press Release No. 45 of 30 November 1998. The measures contained in Schedule 3 were initially introduced in Taxation Laws Amendment Bill (No. 4)(8) which lapsed when Parliament was prorogued for the 1998 General Election.(9)

The Schedule 3 measures are designed to provide a consistent method of valuing assets acquired from tax-exempt entities regardless of whether the purchaser has acquired the entity itself or the plant of the entity. Proposed Division 58 sets out rules that apply in calculating depreciation deductions and balancing adjustments in relation to plant previously owned by an exempt entity. Proposed Division 58 applies regardless of whether a purchaser acquires the entity or the plant of the entity in connection with the acquisition of the seller's business.

Proposed section 58-20 provides a transitional entity (a previously tax-exempt entity) with a choice of two methods of valuing its plant; the NWDV or the undeducted pre-existing audited book value. Proposed section 58-15 defines a 'transitional entity' as an entity that was tax-exempt and then becomes an entity which is subject to income tax. Proposed section 58-155 provides a parallel valuation mechanism for purchasers of assets from tax-exempt entities.

The term 'notional written down value' is defined in proposed section 58-80. The term 'pre-existing audited book value' of plant is defined in proposed section 58-10.

Application

The amendments generally apply from 4 August 1997. Some of the amendments commence for the 1998-99 income year and later income years.

Franking credits, franking debits and the intercorporate dividend rebate

The intercorporate dividend rebate is a tax credit mechanism to prevent the double taxation of dividends flowing through a chain of companies. If a company pays a dividend to a corporate shareholder, it will be able to obtain a credit for any income tax incurred in respect of the dividend. This mechanism allows a dividend to pass through several levels of corporate shareholders without any taxation being levied on the dividend. The dividend will generally be subject to tax in the hands of a shareholder that is not a company.

Australian has an imputation system for the taxation of companies. Under the imputation system a company paying a dividend to shareholders is able to pass on a tax credit for the company tax it has paid. Dividends which carry a tax credit are called 'franked dividends'. Such dividends may be fully franked if the company's income was taxed at the corporate rate of tax, which is currently 36 per cent. Some companies are able to use tax concessions to reduce their company tax. The consequence is that such companies will be unable to fully frank their dividends. For example, if a company claims a deduction for research and development, its taxable income and in turn the income tax liability of the company will be reduced. This results in the company having fewer franking credits to distribute to shareholders. Such companies may partly frank their dividends. Some companies may not have a franking credit to pass on and may pay unfranked dividends.

A taxpayer receiving a franked dividend may use the franking credit against the tax payable on the dividend itself. If there is an excess credit, the taxpayer may use the credit against other income derived during the same income year. The imputation rules do not allow excess credits in one income year either to be refunded or to be carried forward to a future income year.

The inability of a shareholder to obtain a refund of tax or to carry forward a tax credit to a future income year was an intended feature of the imputation system.(10) This aspect of the imputation system creates the incentive for tax planners to create arrangements that ensure that franking credits are only paid to shareholders who can use the tax credit. The income tax law contains strict rules to counter such practices. There are rules to prevent the streaming of franked dividends to certain types of taxpayers and unfranked dividends to tax-exempt entities or taxpayers unable to fully use the franking credit.

The Government announced in its Tax Reform: not a new tax, a new tax system that it would tax trusts like companies to achieve tax neutrality.(11) The features of the proposed system are:

  • A simplified imputation system involving full franking of all profits paid to individuals or other entities outside consolidated groups. The full franking would involve the taxing of all distributed profits at entity level - with all distributed profits then having attached imputation credits for the tax already paid.
  • Refunds of excess of imputation credits for resident individual taxpayers and complying superannuation funds. (sic) Special arrangements would apply to registered charitable organisations.(see below)

. . .

The introduction of entity taxation arrangements would mean that trust distributions to charitable funds and organisations are made from post-tax income. In order not to penalise charities, provisions would be included in the law to establish a registration process for such organisations. Only those organisations listed on the register would be tax exempt or able to qualify for gift deductibility. Registered organisation would also be allowed to claim refunds of excess imputation credits for tax paid at the trust level on donations to them by way of trust distributions. (12)

The proposal to allow for the refund of franking credits involves a significant change to the imputation system. This would change the current premise of the imputation system that some franking credits will be unused. This change will result in taxpayers not having an incentive to enter avoidance schemes because they will be able to obtain a refund for any excess franking credits in respect of a year of income.

One method of avoidance is for a shareholder who cannot fully use the imputation credit to sell the share shortly before an announced franked dividend is paid. The sale price of the shares reflects the value of the dividends and the attached franking credits. The buyer acquires the shares in order to obtain the franking credit and then resells the shares soon after the dividend is paid. Through the technique of holding shares for short periods of time, in respect of which a franked dividend payment is imminent, some taxpayers are able to obtain significant tax benefits.

The Treasurer announced in the 1997-98 Budget that measures would be introduced to counter schemes designed to increase the value of the franking credits to certain shareholders. The measures are:

  • providing a specific anti-avoidance scheme for dividend streaming;
  • ensuring that when a dividend payment is in effect an interest payment, franking credits will not be provided;
  • inserting a new definition of 'class of shares' to ensure that shares with similar rights will have to treated in the same way for franking purposes; and
  • measures to prevent trading in franking credits. (13)

This Bill addresses the last three of the four items. The first item was dealt with in Taxation Laws Amendment Act (No 3) 1998. The measures contained in Schedule 4 were first introduced into Parliament on 2 July 1998 in Taxation Laws Amendment Bill (No. 5) 1998. This Bill lapsed when Parliament was prorogued for the 1998 General Election.

The purpose of the amendments is to counter arrangements designed to provide franking credits or an intercorporate dividend rebate to persons who do not own shares or are the owners of shares for a brief period of time to receive the imputation credit. This anti-avoidance measure creates certain tests that a shareholder must satisfy in order to be treated as the owner of a share for the purposes of the imputation system and the intercorporate dividend rebate system. As these persons do not want the risk associated with holding the shares for a significant period of time, the measures focus on the short-term nature of the holding of shares in which a dividend has been announced.

Item 8 of Schedule 3 inserts proposed Division 1A of Part IIIAA of the Income Tax Assessment Act 1936. Proposed Division 1A contains the requirements for a taxpayer to qualify for a franking credit, a franking rebate or the intercorporate dividend rebate. To qualify for a franking credit a shareholder must satisfy the holding period rule and a related payments rule.

Proposed section 160APHO contains the holding period test and a related payments test for determining if a person is entitled to a franking benefit. The related payment test requires that the taxpayer holding shares in respect of which a dividend has been paid is not under an obligation to make a related payment to another person (proposed subsection 160APHO(1)). The measure prevents a person from acquiring shares on the basis that future dividends will be paid to another person. The avoidance arrangement may be described as a conduit arrangement whereby the shareholder receives dividends, takes the benefit of any franking credit and then makes a payment to another person who may have the risk of loss or chance of gain in relation to the shares.

The holding period test is that the shareholder must have held the shares for set periods of time (proposed subsection 160APHO(2)). In the case of non-preference shares the shareholder must hold the shares for a continuous period of 45 days (proposed paragraph 160APHO(2)(a)(i)). For preference shares the holding period is 90 days (proposed paragraph 160APHO(2)(a)(ii)). Under this provision the shares must be held for the set time during the 'qualification period'. This term is defined in proposed section 160APHD. In general the qualifying period ends 45 days after a share became 'ex dividend'. This term is defined in proposed section 160APHE to mean the last day on which a person acquiring shares is entitled to receive a dividend in respect of the share. The sale price of a share, in respect of which a dividend has been announced, will usually reflect the value of the dividend because the announced dividend is present property and not a mere expectation.

If a shareholder is able to materially affect the risk of loss or opportunity for gain in respect of the shares, such periods of time are not counted for the holding period rule (proposed subsection 160APHO(3)). This measure counters arrangements under which a person is nominally the shareholder but the risk of loss and opportunity for gain are held by another person, who cannot obtain the benefit of the franking credit. To counter arrangements designed to avoid the holding period test, proposed section 160APHH treats a shareholder as having acquired or disposed of shares at a time other than the time of actual acquisition or disposal of shares.

Some shareholders who do not satisfy the holding period and related payments test may nevertheless qualify for franking credits if they hold shares in a managed and discrete fund. Such taxpayers may elect under proposed section 160APHR to have their franking credit or rebate determined under a set formula.

Application

The amendments made in Schedule 4 generally apply in respect of shares acquired by taxpayers on or after 1 July 1997 (Item 25).

Franking of dividends by exempting companies and former exempting companies

Background on the imputation system is contained above in the section of the Digest titled 'Franking credits, franking debits and the intercorporate dividend rebate'. Certain shareholders, such as non-residents and tax exempt entities, are unable to fully use franking credits. Tax-exempt bodies are unable to use franking credits because the credits cannot be refunded. Non-resident shareholders are unable to fully use the franking credit because the non-resident dividend withholding tax is less than the franking credit. Non-resident dividend withholding tax is 30 per cent but is reduced in most of Australia's double tax treaties to 15 per cent. Fully franked dividends carry a tax credit of 36 per cent. Non-resident taxpayers and tax exempt entities have an incentive to enter arrangements to seek to fully use the franking credits attached to their dividends.

A shortcoming of the existing legislation was the expectation that non-resident taxpayers and tax exempt entities receiving franked dividends would not attempt to fully use their franking credits. This gave such shareholders the incentive to turn these franking credits, through schemes, into a pecuniary benefit. These avoidance practices have created the need for specific anti-avoidance measures to prevent non-resident and tax-exempt shareholders from receiving dividends with a franking credit in the first place. The measures contained in Schedule 5 were first introduced into Parliament on 2 April 1998 in Taxation Laws Amendment Bill (No. 4) 1998. This Bill lapsed when Parliament was prorogued for the 1998 General Election.

Schedule 5 will enact anti-avoidance measures to prevent trading in franking credits by restricting a significant source of franking credits likely to be sold to resident taxpayers. The measures are targeted at companies owned by non-resident shareholders and tax-exempt entities. This measure will limit the imputation system to: companies which are not wholly owned by non-residents; or companies which are not tax-exempt entities.

The proposal treats persons who cannot themselves receive a franking credit or franking rebate as 'prescribed persons'. Prescribed persons are non-residents and tax-exempt entities (proposed section 160APHBF). Companies in which 95 per cent of the shares are owned by prescribed persons are treated as 'exempting companies' (proposed sections 160APHBA and 160APHBB). Exempting companies will be required to create franking credits and franking debits and will be subject to the operation of the imputation system. However, dividends paid by such entities will only be exempt from non-resident dividend withholding tax. The dividends will not give rise to a franking rebate or a franking credit.

Transitional rules apply to former exempting companies whose status changes. If the shareholding of a former exempting company changes, it may be able to pay franking credits to its Australian shareholders (proposed section 160APHBE). Such companies will be required to maintain two separate franking accounts. The franking credits and debits created by a company while it was an exempting company are eliminated on its conversion to a non-exempting company (proposed sections 160AQCNG and 160AQCNH).

Franked dividends paid by an exempting company are generally only exempt from dividend withholding tax [proposed paragraph 128B(3)(ga)]. This is the same tax exemption which applies under the current law to franked dividends [paragraph 128B(3)(ga)]. An exempting company may pay a franked dividend which entitles the shareholder to a franking credit in certain situations. If the shareholder is a life assurance company, it will be entitled to a franking credit in respect of any franked dividends it receives (proposed subsection 160AQTA(4)). A similar exception is provided for franked dividends paid under an employee share scheme (proposed subsection 160AQTA(5)).

Distributions to beneficiaries and partners that are equivalent to interest

Background on the imputation system is contained above in the section of the Digest titled 'Franking credits, franking debits and the intercorporate dividend rebate'. One of the features of the imputation system is the anti-streaming rules to ensure that franking credits are distributed to shareholders in proportion to their shareholdings. A company is proscribed from streaming franked dividends to certain shareholders and streaming unfranked dividends to other shareholders. Under the existing provisions, franking credits must be distributed on a pro rata basis to shares within the same class of shares. For example, all shareholders holding A Class shares are entitled to receive the same franking credit per share. By providing unfranked dividends to taxpayers who cannot use the franking credit, a company may increase the franking credits available for other shareholders.

Another avoidance activity is for an investor to recharacterise a loan as an equity investment in order to obtain the benefit of the intercorporate dividend rebate. Section 46D of the Income Tax Assessment Act 1936 is designed to counter such investment arrangements. Under section 46D dividends that are really interest in respect of a loan are not eligible for the intercorporate dividend rebate. Such dividends are called debt dividends. The avoidance scheme is designed to make the interest payment tax-free in the hands of the recipient.

Section 45Z of the Income Tax Assessment Act 1936 extends the intercorporate dividend rebate to dividends derived by certain persons through a trust or partnership structure. The Explanatory Memorandum to the Bill states that some trusts have used a technique to treat certain payments as a dividend when in fact the payment is equivalent to interest.(14)

The measures contained in Schedule 7 were first introduced into Parliament on 2 July 1998 in Taxation Laws Amendment Bill (No. 5) 1998. This Bill lapsed when Parliament was prorogued for the 1998 General Election.

The Explanatory Memorandum states that trust and partnership structures may be used to enable the streaming of franking credits to certain persons.(15) According to the Explanatory Memorandum such structures can effectively allow certain persons to receive interest-like returns that are fully franked. Persons who lend funds directly to a company and receive interest from the company are denied both franking credits and the intercorporate dividend rebate under the income tax law.

Item 2 of Schedule 7 inserts proposed section 45ZA to counter certain avoidance arrangements by denying certain taxpayers the intercorporate dividend rebate. The elements for the application of this measure are:

  • an amount, called the distributed amount, is distributed to a corporate taxpayer in respect of an interest in a trust or partnership
  • an amount, called the attributable amount, that is part of the distributed amount, was attributable to the payment of a dividend
  • the attributable amount was paid to the taxpayer in respect of an interest in a trust or partnership that was acquired after the commencing time (7.30 pm 13 May 1997)
  • the attributable amount was paid to the taxpayer in respect of an interest in a trust or partnership or is attributable to a financing arrangement, and
  • the payment to the taxpayer of either the attributable amount or the distributed amount may reasonably be regarded as equivalent to the payment of interest on a loan.

If the above tests are satisfied proposed subsection 45ZA(3) directs that such a taxpayer is not entitled to the intercorporate dividend rebate under sections 46 or 46A.

Proposed subsections 160APQ(4), 160APQ (5) and 160APQ (6) prevent shareholders from obtaining a franking credit if a trust or partnership distribution was paid under a finance arrangement which could reasonably be regarded as the payment of interest on a loan.

A critical element of both of the above measures is the requirement that the payments 'may reasonably be regarded as the equivalent of interest on a loan'. This phrase is not defined and it is a matter which will have to be decided on a case by case basis. It is almost impossible to specify the criteria against which one may determine if a payment is the equivalent of interest. This requirement provides the opportunity for the overall arrangement to be examined to determine if a payment has the form of a dividend which in substance is a payment of interest. This aspect of the measure, some may argue, will create uncertainty for some shareholders.

Deductible gifts - Menzies Research Centre Public Fund

The Menzies Research Centre Public Fund (the Centre) was established in 1995 with the stated aim of providing research into economic, social, cultural and political policies to enhance individual liberty, free speech, competitive enterprise and democracy. In practice, the Centre could be classified as a Liberal Party 'think-tank'. It is broadly equivalent to the Evatt Foundation which was established in 1979 and performs similar functions for the Labor Party.

The funding of organisations bearing the name of politicians has a relatively long history, however, it must be noted that generally such bodies engage in a range of functions as well as party research. The Menzies Foundation was established in 1978 and, it is reported, that it subsequently received approximately $4.4 million prior to the Liberal Party losing government in 1983. In relation to the Evatt Foundation, an initial Government grant of $250,000 was made in the 1984-85 Budget and this continued for eight years, comprising a total of $2 million. Further indexed grants were made in later budgets, the reported total contribution being approximately $3 million. In addition, the Murphy Foundation which was established in 1987 was reported to receive total grants of approximately $1.2 million prior to the election of the current government. The current government ceased making grants to the Murphy Foundation. It has been reported in the press that the sum of grants to such foundations is: Menzies: $4.62 million; Evatt: $3.24 million; and Murphy: $1.17 million.(16)

On 9 October 1996 the Minister for Administrative Services announced that annual grants would be made to the Menzies Research Centre and the Evatt Foundation and that both organisations would receive $100,000 per year. The Press Release announcing the grants did not specify if the grants were to be indexed or for how long they would continue.(17)

In relation to tax deductions for donations to such foundations, which are dealt with by this Bill, the Treasurer announced on 10 October 1996 that donations to the Menzies Research Centre of $2 or more would be deductible. Currently, donations of $2 or more are deductible if made to the Menzies Foundation or the Evatt Foundation as philanthropic trusts, while such donations to the Murphy Foundation are deductible as an education body. The measures contained in Schedule 6 were first introduced into Parliament on 2 April 1998 in Taxation Laws Amendment Bill (No. 4) 1998. This Bill lapsed when Parliament was prorogued for the 1998 General Election.

Schedule 6 provides an income tax deduction for donations of $2 or more to the Menzies Research Centre Public Fund for donations made after 2 April 1998. This was the date on which the measure was to commence when first included in a Bill introduced in to the previous Parliament. The Centre will be classified as a research recipient.(18)

Under the proposed goods and services tax (GST), donations to non-profit organisations will not be subject to GST.

Endnotes

1. The Minister for Financial Services and Regulation, the Hon Joe Hockey MP, stated in his second reading speech that the entire package of measures in Schedule 1 was estimated to cost $22 million. However, the Explanatory Memorandum to the Bill is not clear on the actual revenue cost of the measures in Schedule 1. In the section of the Explanatory Memorandum titled 'General outline and financial impact' (p 3) the package of measures contained in Schedule 1 is estimated to cost $22 million. The section states that:

The package is estimated to cost $22 million in a full year. There may also be an indirect cost to the revenue as a result of the proposed FIF [foreign investment fund] exemption because of the increased investment in US FIFs. The cost to the revenue is unquantifiable because the amount of capital transferred to US funds will be dependent on prevailing economic conditions and on the investment strategies of Australian funds managers.

While the quote states that the foreign investment fund measures are unquantifiable, the section titled 'Summary of Regulation Impact Statement - Part 2 of Schedule 1, Foreign Investment Funds' (p 5) states that:

The cost to the revenue of providing the [foreign investment fund] exemption is expected to be $2 million in the 1998-99 income year and $3 million annually for the subsequent income years.

The Explanatory Memorandum is contradictory, however, on the revenue cost of the foreign investment fund measures.

In the section of the Explanatory Memorandum titled 'Summary of Regulation Impact Statement - Part 1 of Schedule 1, Interest Withholding Tax Exemption, Offshore Banking Units and Thin Capitalisation' (p 4) the following revenue estimate is made:

The proposed legislation is estimated to negatively affect revenue to the amount of $22 million in a full year.

According to this part of the Explanatory Memorandum the amendments proposed in Schedule 1, other than the foreign investment fund measures, will have a revenue cost of $22 million. According to pp 4-5 of the Explanatory Memorandum, the total cost of the measures will be $24 million in the 1998-99 income year and $25 million in the following income years. These amounts each exceed the revenue cost quoted by the Minister in his second reading speech in respect of the Bill.

2. The Hon BM Snedden, Treasurer, second reading speech, Income Tax Assessment
Bill (No. 2) 1971, extracted in Taxation Laws of Australia (Butterworths), volume 5,
p 791.

3. The Australian Financial Review, Monday 8 March 1999, p 39.

4. Explanatory Memorandum to the Bill, para 1.29.

5. Explanatory Memorandum to the Bill, para 1.30.

6. Explanatory Memorandum to the Bill, para 1.96.

7. Income Tax Assessment Act 1936, Division 16F.

8. There are two Bills with the title Taxation Laws Amendment Act (No. 4) 1998. The
first Taxation Laws Amendment Bill (No. 4) 1998 was introduced in the House of
Representatives on 2 April 1998. It was passed by the House on 3 June 1998 and
was introduced in to the Senate on 22 June 1998.

9. This measure was first considered in Bills Digest No. 193 1997-98.

10. At para 4.6, Explanatory Memorandum to the Bill, it is stated that it was intended
that some shareholders would be unable to use a franking credit attached to a
dividend.

11. AGPS, Canberra, 1998, p 113.

12. Ibid, pp 114-115.

13. Budget Press Release dated 13 May 1997.

14. Explanatory Memorandum to the Bill, para 7.36.

15. Explanatory Memorandum to the Bill, para 7.5.

16. The Sydney Morning Herald, 4 April 1998.

17. Minister for Administrative Services, Press Release, 9 October 1996.

18. The information for Schedule 6 of this Digest was based on material in Bills Digest
No. 193 1997-98 for Taxation Laws Amendment Bill (No 4) 1998, Schedule 5.

Contact Officer and Copyright Details

Bob Bennett
11 March 1999
Bills Digest Service
Information and Research Services

This paper has been prepared for general distribution to Senators and Members of the Australian Parliament. While great care is taken to ensure that the paper is accurate and balanced, the paper is written using information publicly available at the time of production. The views expressed are those of the author and should not be attributed to the Information and Research Services (IRS). Advice on legislation or legal policy issues contained in this paper is provided for use in parliamentary debate and for related parliamentary purposes. This paper is not professional legal opinion. Readers are reminded that the paper is not an official parliamentary or Australian government document.

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and their staff but not with members of the public.

ISSN 1328-8091
© Commonwealth of Australia 1999

Except to the extent of the uses permitted under the Copyright Act 1968, no part of this publication may be reproduced or transmitted in any form or by any means, including information storage and retrieval systems, without the prior written consent of the Parliamentary Library, other than by Members of the Australian Parliament in the course of their official duties.

Published by the Department of the Parliamentary Library, 1999.

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