The scope of the CFC rules and the manner of calculating the attributable income of a CFC is proposed to be extensively revised.  These proposed changes are expected to favour taxpayers.  For example, multinational corporate groups will no longer need to apply the CFC rules to related party sales and services income.  Some large scale property investors will also benefit because the new CFC rules will not extend to rental income derived in the course of actively conducting a business.

On Friday 16 July 2010 the Assistant Treasurer, Senator Nick Sherry, released for public comment a consultation paper setting out the preliminary design of a new regime for the taxation of controlled foreign companies (CFCs).  The consultation paper is the third in a series released by Treasury in response to the recommendations made in September 2008 by the Board of Taxation.

This latest consultation paper proposes to retain an operative provision which is familiar to those who have previously dealt with the CFC rules.  That is, in the absence of any exception, the assessable income of an attributable taxpayer will continue to include their share of the attributable income of a CFC.

However, the scope of the CFC rules and the manner of calculating the attributable income of a CFC is proposed to be extensively revised.

Definition of a CFC

The paper proposes a new definition for CFCs.  The two objective tests of control in sections 340(a) and (b) and the subjective test of control at section 340(c) will be removed.  Under the revised definition, a foreign company will be a controlled foreign company if there is at least one attributable taxpayer for the company.  An entity is an attributable taxpayer in relation to a foreign company if it is an Australian resident entity and:

• it controls the foreign company; or
• is an associate of another entity that controls the foreign company,

and has a total participation/ownership interest in the foreign company of greater than zero.

It is proposed that control will be determined in accordance with the principles in AASB 127, which defines control as the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities.  The standard contains a rebuttable presumption of control if an entity controls 50% or more of the voting rights in another company.

If two or more entities jointly control a CFC, each of them is treated as controlling the CFC.  Joint control is determined in accordance with AASB 131 (Interests in Joint Ventures).  That standard defines joint control as the “contractually agreed sharing of control over an economic activity which exists when the strategic and financial and operating decisions relating to the activity require the unanimous consent of the parties sharing control.  Given the nature of the definition of joint control, it is noted that these rules are targeted at incorporated joint ventures.

Exemptions from the CFC rules
 
A revised “de minimis passive income exemption” will replace the old de minimis exemption at section 385(4) and will simultaneously replace the role of the active income test.  This proposed exemption allows attributable taxpayers to disregard the attributable income of a CFC if less than 5% of the income of the relevant CFC has a passive character.

Lightly taxed entities will also be able to disregard the attributable income of a CFC.  Such entities include complying superannuation funds and certain life insurance companies.

Attributable income

The range of attributable income will be reduced.  Tainted sales income and tainted services income will no longer be included in attributable income under the proposed new CFC regime.  Passive income will be the sole focus of the new CFC rules, and the range of income that falls under that heading will also be reduced.

Prima facie passive income will continue to be targeted by the CFC rules.  However, the proposed new rules will provide exclusion for income that is inherently passive in nature, but which passes the “active business income test”.  Prima facie passive income will pass the active business income test if it “arises in the ordinary course of the active conduct of a trade or business”.

The consultation paper also sets out rules that would introduce grouping relief to the CFC provisions.  In working out the passive income of a CFC, any prima facie passive income that is referable to a financial benefit provided by another entity that is a member of the same CFC group will be ignored.   Conversely, no Australian tax deduction will be made available to the provider of the relevant financial benefit.  It is proposed that the definition of a group company will draw from the definition of control under AASB 127.

Previous announcements

The proposed reforms to the CFC rules form part of a broader review of Australia's accruals taxation regime for foreign income.  As part of this review, the Government has repealed the foreign investment fund (FIF) and deemed present entitlement rules with effect from 1 July 2010.  The government proposes to replace these rules with a more accommodating anti-avoidance rule to ensure that Australian residents cannot defer or avoid a tax liability for income generated by low risk investment vehicles referred to as “foreign accumulation funds”.  A rewrite of the transferor trust rules is also expected in the near future.

If you have any further queries, please contact your Moore Stephens relationship partner.

Author: Nick Zanikos, Senior Manager, Moore Stephens Melbourne