Distributions (profit/capital returns)
Repatriating funds to shareholders
An Australian company may distribute funds to its shareholders in the form of dividend distributions or capital returns.
Shareholder profile will dictate that certain types of repatriation will be preferred from a tax perspective.
The tax law contains a number of integrity rules which seek to regulate the extent to which a company can tailor distributions to meet the tax preferences of its shareholders.
Dividend distributions
Under Australia's imputation system, where an Australian company pays corporate tax, this will give rise to tax credits – referred to as "franking credits". These franking credits can be attached to dividends that are paid to shareholders ("franked dividends"). Dividends that are paid from untaxed profits are referred to as "unfranked dividends".
To the extent that a dividend that is paid to a non-resident shareholder is franked, that dividend will not be subject to Australian dividend withholding tax.
Dividends received by an Australian company from an offshore subsidiary and then on-paid to a non-resident shareholder should generally be free of Australian dividend withholding tax under the Conduit Foreign Income rules.
Otherwise, to the extent that a dividend that is paid to a non-resident shareholder is unfranked or does not represent Conduit Foreign Income, such dividends will generally be subject to Australian dividend withholding tax.
The rate of dividend withholding tax that will apply to an unfranked dividend will depend on whether the non-resident shareholder is a tax resident of a country with which Australia has concluded a double tax treaty. If the non-resident shareholder is a resident of a treaty country, the rate of dividend withholding tax will typically be reduced from the Australian domestic rate of 30% to a treaty rate of 15% or lower (and in some cases even to nil).
To the extent that a dividend that is paid to an Australian resident shareholder is franked, that shareholder will generally be entitled to claim the franking credits attached to that dividend as an offset against the Australian assessable income earned by the shareholder in receiving that dividend.
An Australian company that pays franked distributions to its shareholders will need to ensure that it does not breach certain rules in relation to the payment of franked distributions (eg. the benchmark franking rule, which requires that all distributions paid in the same franking period need to be franked to the same extent), and any anti-avoidance rules (eg. the anti-streaming rules), which preclude an Australian company from streaming franked distributions to those shareholders who could obtain a greater tax benefit from the distribution.
Capital distributions
An Australian company may repatriate funds to its shareholders by way of a capital distribution or return of capital.
For a non-resident shareholder who holds shares in an Australian company on capital account, a return of capital should not be assessable to the non-resident shareholder unless:
- the shares in the Australian company are indirect Australian real property interests (very broadly, more than 50% of the market value of the assets of that company are derived from its Australian land assets or other "taxable Australian property" (eg. mining rights over Australian land)); and
- the return of capital exceeds the shareholder's tax cost base of the shares held in the Australian company.
For a shareholder that is an Australian resident, a capital distribution may give rise to an Australian capital gain (where the distribution exceeds the cost base) that will need to be included in the shareholder's Australian assessable income.
In either case, any available Australian capital losses may reduce the amount of any taxable capital gain.
However, where an Australian company repatriates funds to its shareholders by way of a return of capital, the Australian company will need to consider the application of anti-avoidance provisions, in particular, section 45B of the Income Tax Assessment Act 1936.
Very broadly, section 45B will apply if the Commissioner of Taxation considers that:
- the capital distribution is a disguised dividend which represents a distribution of profits;
- a relevant taxpayer obtains a tax benefit as a result of receiving the disguised dividend in the form of a return of capital as distinct from a dividend distribution; and
- the purpose of allowing the relevant taxpayer to obtain such a tax benefit was more than an incidental purpose.
The Commissioner has stated there is no “profits first” rule. However, in general, the Commissioner considers distributions out of operating profits should be in the form of dividends. In contrast, a capital return should reflect the liberation of a company’s capital base – such as would result from the disposal of part of the business. There is a wide discretion given to the Commissioner to determine what is an acceptable capital return. For this reason, companies undertaking significant capital return transactions will approach the Australian Taxation Office (ATO) for sign off on the dividend / capital return split, in the form of a private binding ruling. Where it is not possible to precisely identify a distribution with a particular event, such as a business sale, the Commissioner may accept a “slice approach”, where the return is classified according to the proportion of the company’s retained earnings to its net assets.
The ATO will also examine transactions very closely where capital is returned, but effectively replaced by related party debt. Transactions which are seen as artificially inflating tax deductible borrowings may be challenged under the general anti-avoidance rules.
Transfer pricing
Australia's transfer pricing rules look to ensure that arm's length terms are substituted for tax purposes when parties are not dealing at arm's length. The rules typically look to transactions between affiliates – although affiliation is not in itself a technical requirement of the rules. The rules may be applied to transactions between separate entities, or to profit attributions where a company conducts international business through a branch operation.
The transfer pricing law has been substantially updated over recent years to bring it into line with OECD international standards. The rules essentially require a comparison between what was actually transacted with what an independent party operating at arm's length would have done in similar circumstances.
There is a very powerful reconstruction provision. In theory this could be used by the Australian Tax Office (ATO) to re-characterise the actual transaction which has been entered into and replace it with one that it considers would have been entered into by parties acting at arm's length. This means that in effect there is a focus on the arm's length nature of underlying transactions – not simply a focus on arm's length pricing. So, for example, where a foreign parent loans funds to an Australian subsidiary the ATO might argue that a foreign party dealing at arm's length would not have lent as much as was actually lent – and as a consequence the ATO would seek to disallow a portion of the interest which relates to the excessive loan amount.
An Australian company will need to self-assess each year whether its dealings give rise to a transfer pricing benefit. It is important that the Australian company maintains contemporaneous documentation which allows it to substantiate the transfer pricing position to reduce its potential exposure to higher penalties. There are simplified transfer pricing measures which reduce the compliance burden for "small" taxpayers and/or low risk transfer pricing arrangements (eg. low value adding intra-group services, low-level inbound or outbound loans). Large multinational companies (broadly those with global revenues of over A$1 billion) additionally need to meet country-by-country reporting requirements.
It is possible to enter into an "advance pricing arrangement" or APA with the ATO to manage transfer pricing tax risk. The APA is an arrangement between the taxpayer and the ATO which seeks to settle appropriate methodology, comparables and assumptions to give greater certainty to taxpayers in their related party pricing decisions. The APA will usually have a term of between three and five years.
The ATO has a powerful reconstruction power in transfer pricing questions.
Australia holding jurisdiction issues (participation exemption, CFI, CFC rules)
Australian conduit taxation regime
Over a period of time, Australia has developed its tax regime with the intention of maximising its attractiveness as a conduit holding jurisdiction. The overall objective is to reduce the potential income tax leakages associated with Australian entities being interposed between foreign ultimate owners and non-Australian investments. The comments below are directed at exploring some of the key features of the Australian conduit tax regime.
Relief for the sale of shares in foreign companies with assets used in an “active business”, and dividends
The Participation Exemption
In broad terms the Participation Exemption disregards capital gains or capital losses to the extent an Australian company or a controlled foreign company sells shares in a foreign company (Foreign Share Sale) which holds assets which are used in an “active business”. The exemption is only available for specified taxing events.
For a Foreign Share Sale to be eligible for the Participation Exemption, the relevant taxpayer is required to satisfy two conditions:
- a company must have held a direct voting percentage in a foreign company of at least 10%; and
- a company must have held the requisite interest for a continuous period of at least 12 months in the two years before the CGT event.
The gain or loss in respect of a Foreign Share Sale which is eligible for the Participation Exemption is reduced by the "active foreign business asset percentage". Broadly speaking, this is the percentage of business assets of the foreign company the subject of the Foreign Share Sale that are active and ready for use or already being used in the business, expressed as a total percentage of the foreign business' assets ie. "active assets". Passive assets such as cash or properties used to derive rent are not "active assets".
If the “active business asset percentage” is less than 10%, then it will be rounded down to 0 (ie. there is no reduction in the capital gain or loss). If the percentage is more than 90% it will be rounded up to 100% (ie. the reduction in the capital gain or loss is 100%).
It is important to note that if a Foreign Share Sale satisfies the Participation Exemption, the relevant taxpayer must make a choice to use one of two methods (market value or book value method) to calculate the reduction percentage available under the rules. A taxpayer who does not make any calculation will automatically be denied all capital losses or assessed on all capital gains.
Generally speaking, the Participation Exemption can be especially useful in transactions where multinational companies are seeking to restructure through selling shares held in foreign companies which holds assets which are used in an “active business” and would ultimately make a capital gain.
Non-Portfolio Dividend Exemption
Non-portfolio dividends received from a foreign resident company by an Australian resident company may be exempt from tax in certain circumstances. Such dividends are generally exempt if the company receiving the dividend has a 10% or greater participation interest (generally, equity that gives rise to control or voting rights) in the foreign company at the time the distribution is made.
Conduit Foreign Income (CFI)
Broadly, the CFI rules are aimed at encouraging foreign groups to establish holding companies in Australia and to improve Australia's attractiveness for multinational companies.
Certain income which is ultimately received by a foreign resident through one or more Australian companies and some trusts are classified as CFI. This includes non-portfolio dividends and capital gains exempted under the participation exemption.
In summary, if a distribution is made to:
- a foreign tax resident, then the portion declared to be CFI is exempt from withholding tax; or
- another Australian company or certain trusts, then that entity may pass the CFI directly or indirectly through interposed Australian corporate tax entities, to a foreign resident without withholding or further tax.
The CFI rules also apply to capital gains and losses. However, there are timing adjustments to ensure any CFI arising from a capital gain or loss is recognised in the income year in which the capital gain event occurred.
There are also anti-avoidance streaming rules which prevent distributions from being streamed in a way that takes advantage of the CFI rules.
Controlled Foreign Company (CFC)
The CFC rules are an accruals taxation measure that targets certain types of income (Attributable Income) (Attributable Income includes certain types of passive, services and sales income), which is derived in countries that are not seen as having sufficiently comparable tax systems to Australia (ie. "listed countries"). These rules have broad design features which are seen in other accruals tax regimes around the world (for example, under the Subpart F regime in the US). The main effect of the CFC rules is to tax Attributable Income on a current basis in Australia, even where not distributed to Australia.
The CFC rules are complex. However, in broad terms, an Australian tax resident which "controls" a foreign company may be subject to the CFC rules.
While there are de facto control tests which do not have regard to minimum ownership interests in determining whether a company is a CFC, in most wholly owned group structures, it should be assumed that the CFC rules will need to be considered.
The rules distinguish between “listed countries” and “unlisted countries”. Listed countries, as noted above, are countries which have a comparable tax system to Australia (Canada, France, Germany, Japan, New Zealand, United Kingdom and United States of America). The CFC rules generally treat listed country CFCs more favourably, with the result that very little, if any, of their income is typically treated as Attributable Income – the most commonly encountered exception to this rule relates to exempt capital gains in New Zealand.