In the last few months we have been speaking to many clients about the merits of participating in Project DO IT and encouraging those who wish to participate to make an early start (not wait until December - see our previous alert Project DO IT: ‘Undisclosed Offshore Assets & Income: ATO announces Project DO IT: disclose offshore income today’
The cut-off date for a Project DO IT disclosure to be made is 19 December 2014; a little over 50 business days away.
Late last week the ATO updated it's Project DO IT fact sheet. Most importantly, the ATO has updated its position on:
- income and capital losses; and
- distributions of pre-disclosure period funds.
Taxpayers who are considering making a Project DO IT disclosure, or who have already made one returning income or capital losses, should be alert to these changes. Particularly with income and capital losses, the ATO has significantly revised its previous position and offer to taxpayers.
Income losses and capital losses
In many of the cases we have seen so far, taxpayers have incurred a net income loss or net capital loss during the disclosure period. In the main, this has happened because the (often exorbitant) account keeping and managements costs applying to overseas accounts and investments have exceeded the return generated.
Under the original terms of Project DO IT, income and capital losses could be applied against already disclosed Australian taxable income in previous years from any source. This resulted in many taxpayers being entitled to receive a tax refund. In the case of capital losses, these were carried forward and applied against other or future capital gains.
Under the revised terms for Project DO IT, taxpayers will not be entitled to claim a tax deduction for a net overall tax or capital loss against income from all sources so as to give rise to a tax refund. The ATO rationalises this on the ground that the terms offered to taxpayers under Project DO IT are already generous and concessionary.
So what happens to income and capital losses now?
- Deductions arising in a year during the disclosure period can be claimed but only against income that has been previously undisclosed;
- Income losses that arose in earlier years within the disclosure period can only be claimed against previously undisclosed income;
- Capital losses that arose in earlier years within the disclosure period can be claimed but only against previously undisclosed capital gains;
- Losses that arose before the disclosure period cannot be carried forward into the disclosure period (there was no change on this position).
From the end of the disclosure period to 12 months after signing a settlement deed, losses incurred in the disclosure period can’t be deducted or carried forward. However, capital losses arising during the disclosure period can be used to reduce capital gains arising from the repatriation of offshore assets (see below). After the disclosure period, any income losses or capital losses incurred can be claimed normally.
Bringing it back: Distributions of pre-disclosure period funds
An important objective of Project DO IT for the ATO is that previously undisclosed offshore assets and income are brought back into the Australian tax system. In some cases, that will involve the assets or investment continuing to be held as they currently are, but the taxpayer ensuring they are making proper disclosure about them in their income tax returns from now on. In other cases, however, the best thing for a taxpayer to do will be to wind-up the structure and repatriate the funds to Australia.
A wind-up in this sense could involve a formal legal wind-up of a structure (for example, liquidating an overseas company or vesting an overseas trust) or simply closing an overseas account and returning the funds to Australia.
The ATO has clarified its administrative approach to dealing with the wind-up of overseas structures and repatriation of funds back to Australia.
In a significant concession to taxpayers, the ATO has agreed that in determining the tax effect of a wind-up of an offshore structure, ‘funds that are held by the offshore entity prior to the disclosure period’ will be presumed to have a non-taxable source: for example, paid-up share capital, trust corpus, loans or ‘some other source of funds that are not assessable on distribution’.
To benefit from this, a taxpayer must, in their disclosure, differentiate ‘pre-disclosure funds’ from other (post-disclosure) funds so that the ATO can determine assessable and non-assessable amounts on distribution, enter into a settlement agreement with the ATO and ensure that the funds are distributed from the off-shore entity within 12 months.
However, this concessional treatment will not apply to funds held by or in the off-shore structure that have their source in earnings (or capital gains) that were derived by the off-shore entity during or after the relevant disclosure period. Instead, these funds will be taxed under Australian tax law on distribution to Australian taxpayers on the wind-up of the structure. The basis on which these kinds of amounts could be taxed may be, for example, a capital gain and/or a ‘deemed dividend’ under section 47 or 47A of the 1936 Act on a liquidator’s distribution or as a return of trust capital taxable under section 99B of the 1936 Act.
In our view, the practical issue for most taxpayers will be that in many (if not most cases), the ‘funds’ that are held in or by an offshore structure will not necessarily be cash or a cash-equivalent, which might be easily identified as having its source in earnings or a capital gain derived by the entity before the relevant disclosure period. Rather, the ‘funds’ held in or by the offshore structure will be represented by an asset or investment, which in many cases will have an unrealised capital gain attached.
In such a case, the Commissioner has confirmed that there is no ‘re-setting’ of the cost base of that asset (for example, at its market value at the start of the relevant disclosure period) and there will be no concessional treatment of the unrealised capital gain attached to the asset (for example, assessing the capital gain generated only in the four year amendment period). As such, if the unrealised capital gain on the asset is realised as a part of winding-up the offshore structure, that capital gain will crystallise and may be taxable.
Mike, now an Australian resident, established the Fine Fruit Trust (Trust) in the Isle of Man while he was working and residing in Silicon Valley in the early 1990s.
In 1991, the Trust acquired 10,000 Apple Corporation shares, at a price of $7 each. Due to the exponential growth in the Apple share price, those shares are now worth $7,000,000.
Mike wishes to make a Project DO IT disclosure in respect of the Trust. His relevant amendment period is the 2013, 2012, 2011 and 2010 years.
Here are some scenarios, which show the difference in the taxing point:
- Scenario 1: The Trust sold the Apple shares in 2008, for $4,000,000 and holds that amount in cash. The Trust would have a capital gain of approximately $3,930,000 in 2008. As this capital gain arose before the disclosure period, the funds can be repatriated in 2014 with no tax.
- Scenario 2: The Trust sold the Apple shares in 2011, for $5,000,000 which it holds in cash. The Trust would have a capital gain of approximately $4,930,000 in 2011. This amount will be taxed, as the capital gains tax event was during the disclosure period.
- Scenario 3: The Trust has not sold the Apple shares. In the disclosure period, the Apple shares represent an unrealised capital gain (of $6,930,000). If under an agreed Project DO IT settlement the Trust is to be wound-up in favour of Mike, the unrealised capital gain will be realised a taxable to Mike (who needs to make sure he has the cash to pay the tax).
- Scenario 4: As per Scenario 1, the Trust sold the Apple shares in 2008 for $4,000,000 but rather than holding that amount in cash, it was reinvested in 2008 into Google shares, which the Trust still owns. In this scenario, it appears that the capital gain realised on the Apple shares is not taxed (but will be deemed to be an amount with a non-taxable source) but the unrealised capital gain in the Google shares will be, as per Scenario 3.
Basically, if your client is considering winding up a structure, be aware that the taxing point will be on the realisation of the asset. There might be a taxing point not only on the sale of the asset, but also on the winding up of the entity itself.
What is the ATO’s approach to settlements?
To give a degree of comfort to taxpayers making a disclosure under Project DO IT, the ATO proposes entering into a deed of settlement, to outline how the ATO will treat a repatriation of funds.
We have received guidance from the ATO that their main concern is ensuring that future profits are taxed. So if a client wants certainty about the treatment of a repatriation of capital or funds, they have the option of outlining this in a settlement deed with the ATO, so that when their next tax return is prepared (ie 2015 year) they can rely on this settlement deed to confirm the terms of their repatriation and taxation treatment.
This will be very important for clients, especially those that wish to confirm that the 'capital' at the start of the 4 year period will be treated as such (as capital!), and tax free, in the future.
What to do next?
If you think your clients won’t be able to get the information together by 19 December, you have the option to put in an expression of interest - adding 90 days to their timeline. In any event, it can take quite a bit of time to get information about overseas investments (especially if you are waiting on overseas financial institutions) and then collate and analyse it so you can provide the information required in the Project DO IT disclosure form.
We can discuss options with you around disclosing the right type of information, whether it may be appropriate to lodge an Expression of Interest, and reporting the right type of income and assets that are taxable to you.