For anyone that has had to plough through the complex provisions in Part X of the Income Tax Assessment Act 1936, the reform of the Controlled Foreign Companies ("CFC") rules is likely to be good news. The new Foreign Accumulation Fund ("FAF") rule seeks to address only the most abusive cases of deferral that are not caught by the CFC measures following the repeal of the foreign investment fund regime. However, there are a few concerns over certain aspects of the new rules.
Control
A threshold issue for any CFC regime is the meaning of control of a foreign entity. Under the existing rules, there are three control tests. Satisfaction of any of the three will potentially result in passive income derived by the controlled entity being subject to attribution. The three control tests are:
1. Strict Control Test
If five or fewer Australian entities have an associate-inclusive control interest of 50% or more, then that entity is a CFC.
2. Objective De Facto Control Test
Where a single Australian entity has an associate-inclusive control interest of not less than 40% and no other group of entities control the foreign entity, then that entity is a CFC.
3. Subjective De Facto Control Test
Five or fewer Australian entities together with associates control the foreign entity.
The new legislation moves away from a quantitative control interest test towards a qualitative control test as it generally relies on accounting standards. This is a positive development for reporting entities because they already use these concepts in their financial accounts. As a result, it should lead to potential compliance cost savings.
The main argument against adopting these proposals is that the relevant accounting standards (AASB 127 and AASB 131) can require a degree of discretion in determining whether an Australian entity or group of Australian entities control a foreign entity. This may lead to uncertainty in some circumstances. Under a quantitative control test there is a greater level of certainty in determining whether an entity is controlled by another because it is often merely a case of determining the amount of equity the Australian entity has in the overseas entity.
The final issue is that because the accounting standards are determined by the US based IFRS board, it is unlikely to consider the Australian tax implications of changes it makes to the definition of control. This raises issues in relation to Australian territorial sovereignty and the claimed revenue neutrality of the proposed reforms.
Passive Income – New Active Income Carve Out
Under the new rules, income of an active character is not included in an entity's passive income if:
- the income is attributable to a permanent establishment of the entity
- it arises from the entity competing in a market
- it arises substantively from the ongoing use of labour by the entity.
At this point in time, there is no guidance on what "competing in a market" and "substantially from the ongoing use of labour" mean, so it is difficult to advise with any certainty until final legislation is released.
One of the major changes provided for in the new rules is the removal of tainted sales income and tainted services income, which previously went into the tainted turnover ratio. Under the current rules, where the tainted income ratio exceeded 5% (ie, gross "tainted turnover" is greater than 5% of gross turnover) then income is generally subject to attribution.
The new rules are still based on a 5% passive/active mix – providing an early exit out of the CFC rules if less than 5% of a CFC's income, as determined by reference to its financial accounts, has a passive character. "Prima facie passive income" includes dividends, rent, royalties and so on, which are all similar to the old rules. The main difference is that they are determined by reference to the financial accounts.
What's Next?
The Government claims there will be no leakage as a result of these changes. However, given that such threshold issues as the definition of control and passive income will be determined by reference to accounting rather than tax concepts and by a foreign board, the possibility of leakage is not remote. Consequently, it is likely there will be further changes once this legislation finally comes into effect.
For further information generally please contact your local Crowe Horwath Head of Tax advisor: Sydney - Steve DiLeo +612 9619 1637 steve.dileo@crowehorwath.com.au; Melbourne – Norman Elliott +613 9258 6866 norman.elliott@crowehorwath.com.au; Perth - Peter Fallon +618 9488 1102 peter.fallon@crowehorwath.com.au; Brisbane – Tony Marks +617 3233 3593 tony.marks@crowehorwath.com.au
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.