Chapter 2: Background
Australia's international tax system
Background
2.1 Australia's tax policy is an important contributor to the country's ability to sustain and improve its competitiveness in a changing global environment. Australia's international taxation system must remain attuned to global investment trends to support investment by Australians abroad and to attract foreign investment to Australia.
2.2 To enhance the competitiveness of Australia's international tax settings, Australia has made a number of recent changes to its international tax system, including in more recent times through the Review of International Taxation Arrangements (RITA). In a climate of global tax competition Australia cannot afford to rest on its laurels. This review of the attribution rules provides an opportunity for another instalment of reforms that recognises that ongoing changes are necessary if Australia is to keep pace with changes in the global business environment.
The current tax environment
2.3 Australia's attribution rules form an integral part of Australia's international taxation system. They are important integrity rules needed to protect Australia's residence-based taxation system. The rules are designed to prevent resident taxpayers benefiting unduly from deferring the payment of tax by accumulating income or assets in foreign companies or trusts.
2.4 Australia's CFC rules apply to shareholdings in foreign companies that are controlled by Australian residents. To prevent tax deferral, the rules tax resident shareholders on their pro rata share of a CFC's tainted income as it is earned unless the income is comparably taxed offshore or the CFC satisfies an active income test. Examples of tainted income include interest, royalties, dividends, amounts arising from certain related-party transactions, and capital gains made on tainted assets.
2.5 In a similar vein, Australia's FIF rules broadly apply to Australian residents with non-controlling shareholdings in foreign companies, or with interests in foreign trusts or beneficial interests in foreign life insurance policies. These rules apply to approximate a resident taxpayer's share of the undistributed profits of a FIF and to assess the taxpayer on those profits.
2.6 For trusts not subject to the FIF rules, the transferor trust rules are designed to ensure no undue tax deferral benefit arises as a result of income accumulating in, generally, foreign discretionary trusts.
2.7 The deemed present entitlement rules generally apply to interests in closely held foreign trusts and other interests in foreign trusts that are exempt from the FIF rules. These rules prevent tax deferral by deeming beneficiaries to be presently entitled to a share of profits accumulated in a foreign trust based on their rights to receive distributions from the trust in the future.
2.8 However, the integrity risk that these rules are designed to address, particularly the CFC and FIF rules, must be balanced against other policy objectives such as equity, efficiency, simplicity and low compliance costs. These objectives are fundamental to ensuring Australian businesses remain competitive within an increasingly globalised world economy. The overwhelming message that the Board heard during the review process is that the current rules, and in particular the FIF rules, are not appropriately balanced as they impose compliance costs that far exceed the potential integrity risk they are designed to counter.
Economic context
2.9 Ensuring the competitiveness of Australia's international tax system is especially important given the changes in the global economic landscape in recent years. As Chart 1 illustrates, Australian investment abroad has increased markedly since the attribution rules were introduced with the consequence that Australian businesses with offshore operations and investments abroad have had increased exposure to the attribution rules.
Chart 1: Increasing investment abroad
Australian investment in equity interests abroad, 1990-2007
Source: Balance of Payments and International Investment Position; ABS publication 5302.0; March 2008.
2.10 In just over two decades, the stock of Australian foreign direct investment (FDI) abroad has increased more than fifteen fold, reaching $318 billion at the end of 2007. The principal destinations for Australian FDI are the United States, the United Kingdom and New Zealand. Just under 90 per cent of Australian outward FDI is to OECD countries. The principal destinations for investment in Asia are Singapore and Hong Kong. The stock of Australian investment in major markets such as China, Indonesia and India is small but is growing.2
2.11 While FDI into Australia is coming more from outside of OECD countries, Australia's outward FDI is becoming more concentrated in OECD countries.3 Many OECD member countries have tax treaties with Australia and tax systems that, broadly speaking, are comparable to that of Australia's (thereby mitigating the extent to which attribution rules are needed).
2.12 According to the Department of Foreign Affairs and Trade, the increase in outward investment reflects the globalisation of Australian business, many of which are expanding their presence offshore to spread market and production risks, to achieve economies of scale, to be closer to shareholders and customers and to secure access to deeper capital markets.4
2.13 The increase in outward FDI has been driven largely by growth in the finance and insurance sector, reflecting the benefits of being physically located in an export market.5 The number one driver for offshore expansion is reportedly to increase revenues/expand market share, with taking control of the supply chain and decreasing costs coming equal second. The dominant barriers to international expansion are a lack of local business and market knowledge and access to finance.6
2.14 McKinseys have noted that the greater complexity of products and services, higher energy prices, and increasing financial volatility as the key factors influencing supply chain strategies. In their experience:
'... when possible, companies seek to maximize economies of scale in the supply chain, and many companies treat it as a shared utility of the broader organisation—not only to take advantage of synergies, but also to strengthen their operational expertise.'7
2.15 Reflecting the increase in outward FDI, it is estimated that sales made by the offshore entities of Australian-owned companies have now caught up with the value of Australian-owned goods and services exports.8
Chart 2: Goods and services offshore revenue
2.16 The Export Finance and Insurance Corporation has observed:
'In the past, when overseas trade and investment barriers were higher and the digital revolution hadn't yet started, Australian companies of necessity had to look mainly to the national marketplace. Any overseas sales were made chiefly by exporting from Australian shores. But in today's highly integrated world economy, companies increasingly target a world marketplace and are prepared to locate the different stages of their production and supply chains wherever the business benefit is greatest — and regardless of whether it is onshore or offshore. No longer is it the case that the Australian economy pays for its import needs mainly with exports; it is now just as likely to pay its way with earnings from offshore affiliates.'9
2.17 These trends raise a number of issues regarding the attribution rules and the general framework of trade policies and programs that Australia should maintain in the future. The attribution rules need to ensure that they do not unnecessarily impede Australian businesses from being competitive in their expansion into international markets.
2.18 Clearly, since the attribution rules were introduced, globalisation has significantly affected the business environment faced by Australian businesses and seen them increasingly competing in the world economy. As integration and liberalisation of world markets, including capital markets, increases and the number of companies grow, investment and capital flows may become more sensitive to taxation arrangements.
2.19 Globalisation has altered the business environment in such a way that it is desirable for governments to ensure that impediments do not stand in the way of residents who wish to expand their activities offshore. As firms reach the limits of possible growth in Australia, they are faced with the need to consider expanding offshore. This is not only true for Australian multinational firms but equally relevant for Australian managed funds.
2.20 The business model under which these expanded global operations are conducted has evolved from the time the attribution rules were first developed. Ongoing changes to Australia's taxation system (including the development of the transfer pricing rules, dividend imputation system and self-assessment system), as well as changes to Australia's regulatory environment, mean that the operation of the attribution rules needs to be critically examined.
2.21 Improving international competitiveness is critical to Australia's capacity to succeed in international markets and to attract foreign investment. International competitiveness is determined by a range of factors, including the cost of inputs, productivity levels and the capacity of firms to penetrate markets and to gain access to global supply chains and networks. Productivity is, in the long term, the key to building a more internationally competitive Australian economy.
The way forward
2.22 To complement the review's terms of reference, the Board developed further criteria to assess the merits for change to Australia's attribution rules with a view to improving the productivity of Australian businesses with offshore operations and increasing their international competitiveness. These criteria included:
- Australian businesses with active offshore exposure are not made uncompetitive.
- Australia remains an attractive place to do business and to locate regional headquarters.
- Appropriate account is taken of market and business factors.
- The rules are simple to understand and operate with proper account taken of complexity, compliance and administrative costs.
- As far as possible, economic efficiency applies to minimise distortions in commercial choices.
- The revenue does not bear an unacceptable level of risk.
2.23 The Board issued a series of consultation papers to assist in the analysis of these criteria. The Board's May 2007 discussion paper posed the question of whether harmonising some or all of the existing attribution regimes would help reform and modernise the rules, as well as address a number of issues that exist across the regimes.
2.24 After undertaking consultations and examining submissions, the Board considered that the focus of the reforms should not be on harmonisation itself but rather on the range of policy factors that are relevant in decisions to engage in undue deferral of taxation. The Board reasoned in its position paper that these factors are more important considerations when evaluating possible reforms to the attribution regimes. Accordingly, the Board identified a number of policy factors across three different levels – the resident investor level; the resident entity level, where the foreign investment is made indirectly; and the foreign entity level — to help set out its considered views on the high-level principles that should apply in any future design of the attribution rules.
2.25 The release of a number of issues papers following on from the position paper and subsequent consultations has allowed the Board to formulate its final recommendations in respect of reforms to the attribution rules. These recommendations are set out in Chapter 3.
2 In contrast, the stock of FDI in Australia has grown six fold, reaching $357 billion at the end of 2007. The largest foreign direct investors in Australia are the United States, the United Kingdom and Japan.
3 Largely due to increases in investment in the United States, the EU (excluding the United Kingdom) and New Zealand. 'Review of Export Policies and Programs Issues Paper', Department of Foreign Affairs and Trade, 2008.
4 Department of Foreign Affairs and Trade, 'Review of Export Policies and Programs', Key Issues Paper, 2008.
5 Outward FDI in this sector has doubled in value from $48 billion in 2001 to $102 billion in 2006. Mining-related outward FDI has also increased threefold, from $9 billion in 2001 to $26 billion in 2006. Property and business services related outward FDI increased from $1 billion in 2001 to $7 billion in 2006. Source: 'International Investment Position'; ABS publication 5352.0; 2006.
6 Export Finance and Insurance Corporation, 'Global Readiness Index Report', April 2008, p 6.
7 McKinsey Quarterly, September 2008, 'Managing global supply chains'.
8 Exports by Australian owned entities in 2007 were $102 billion, compared with $110 billion for the offshore earnings of Global 100 companies. Export Finance and Insurance Corporation, 'Global Readiness Index Report', April 2008, p 5.
9 Export Finance and Insurance Corporation, 'Global Readiness Index Report', April 2008, p 5.
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