The Tax and Superannuation Laws Amendment (2014 Measures No 4) Bill 2014 was passed by the Senate on 25 September 2014 without amendment and received Royal Assent on 16 October 2014.

The Act includes, amongst other things, amendments to the foreign dividend exemption that was contained in section 23AJ of the Income Tax Assessment Act 1936 (ITAA 1936).

As mentioned in our PwC TaxTalk articles on 9 May 2014 and 1 June 2014, the Government announced its proposal to align the treatment of dividends from foreign companies with the debt-equity rules elsewhere in the tax law.

There are specific provisions which determine the classification of an instrument as debt or equity for tax purposes, with the classification affecting many aspects of their treatment such as deductibility and franking of returns.

However, under section 23AJ of the ITAA 1936 the tax exemption, for dividends from foreign associates has historically not been affected by this classification, remaining instead based on the legal form of the investment.

This is particularly relevant for certain hybrid instruments (such as types of redeemable preference shares) that may be treated as debt for tax purposes, yet the return received is currently exempt in Australia as it is a dividend at law.

The key change now enacted is that the exemption for foreign dividends no longer applies to distributions made from 17 October 2014 where the instrument on which the distribution is made is otherwise treated as debt for tax purposes.

Broadly, new Subdivision 768-A of the Income Tax Assessment Act 1997 (ITAA 1997) has been introduced to provide that the exemption for foreign dividends will be restricted to returns (including non-share dividends) on equity interests as defined in Division 974 on the ITAA 1997, rather than basing the exemption on voting rights as previously provided for by section 23AJ.

In addition, for instruments that still are able to access the exemption the previous threshold test of holding more than 10% of the voting power in the foreign associate is replaced with a 10% “participation interest” threshold, which is the higher of the percentage of share capital held and the percentage of votes able to be cast in relation to dividends, changes to the constitution or changes to share capital.

The amendments apply to distributions and non-share dividends made from 17 October 2014, being the day after the Bill received Royal Assent.

Most companies do not show any deferred tax in respect of such investments, for one or both of the following reasons:

  1. There is no tax payable on the return. This means no Australian tax due to the exemption for foreign dividends, and no (material) foreign withholding tax on payment of the dividends.
  2. As an investment in a subsidiary, any deferred tax liability is eligible for the recognition exception in AASB 112, on the grounds that the company can control the timing of the reversal of the temporary difference, and it is not likely that it will reverse in the foreseeable future.

The change to the law will effectively remove the first point for certain instruments where the return will now become subject to Australian income tax.

In addition, where an instrument is tax debt, and therefore returns are assessable, any foreign exchange gains and losses on FX denominated investments may also become taxable or deductible (in whole or in part).

The question which needs to be resolved is the extent to which unrealised FX positions as at the date of Royal Assent will be assessable or deductible in the future. There are also consequential implications, such as in relation to related hedges or borrowings in connection with making the foreign investment. These considerations are not the focus of this article. Suffice to say these are complex questions!

Beyond the tax considerations, these issues give rise to tax accounting considerations, as FX can give rise to significant temporary differences.

Given that these changes are expected to generate “new” temporary differences for deferred tax purposes, companies will now need to consider whether the recognition exception can apply to such instruments (which may be classified as debt for accounting purposes).

Practically, for these kinds of instruments, it may be difficult to show that the deferred tax liability will not reverse in the foreseeable future, as many of the terms of issue that result in the shares being debt for tax purposes (length of term, compulsory redemption, cumulative dividends, etc.) will mean that the reversal of the temporary difference is foreseeable or even inevitable.

As such, many companies will not be able to access this recognition exception, and will need to raise deferred tax liabilities in respect of these investments.

It is clear that there are many uncertainties in terms of the tax issues to consider as well as the associated tax accounting issues.

Importantly, whilst the measures have legal effect in respect of distributions received after16 October 2014, the passing of the amendments by both Houses of Parliament on 25 September 2014 means they were “substantively enacted” for financial reporting purposes on that date. This means that financial report preparers will need to account for the impact of these tax law changes from 25 September 2014. Companies should consider the likely impact of these changes and how they will need to be reflected in financial reports. Depending on the timing of the company’s year end, the change in tax law may at a minimum need to be disclosed as a subsequent event requiring note disclosure.

Either way, companies will need to do the work required to be in a position to reflect any adjustment in their financial reports.

Accordingly, we strongly recommend that companies take stock of their outbound instruments (if this has not already been done) to identify those potentially impacted, and if required, formulate a plan to understand and quantify the impact of the tax law changes before period end.

For completeness, we note that while this article is focused on outbound instruments with returns currently not taxable, where those returns may become assessable, the issues are also relevant to those instruments with currently assessable returns which will become non-taxable under the new law.

This article originally appeared in PwC TaxTalk Monthly for June 2014 and has been updated for the enactment of Tax and Superannuation Laws Amendment (2014 Measures No 4) Bill 2014.