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ATO To Crack Down On Foreign Tax Credit Abuses

by Mary Swire,, Hong Kong

16 May 2007

The Australian Tax Office (ATO) has announced that it is investigating arrangements that seek to reduce tax on Australian income through the use of foreign tax credits.

Tax Commissioner Michael D’Ascenzo revealed that the arrangements are mainly marketed to financial institutions. The arrangements involve the purchase of bonds by Australian financial institutions from offshore banks to generate large foreign tax credits.

“We are concerned that financial institutions who participate in these arrangements may be claiming foreign tax credits they are not entitled to under double taxation agreements. The anti-avoidance provisions may apply to such arrangements and we are investigating further," D’Ascenzo said.

The 'Taxpayer Alert,' issued by the ATO on Monday, describes an arrangement where an Australian resident taxpayer seeks to enhance its return on a bond investment, through access to foreign tax credits for withholding tax claimed to be payable under the arrangement. The desired net effect of the arrangement is that neither the bond issuer group, nor the Australian resident taxpayer, bears the economic cost of the tax withheld.

Under this arrangement, an Australian resident taxpayer establishes a wholly owned limited liability company (LLC) in an offshore jurisdiction. The LLC is treated on a flow-through basis for the purposes of tax in the foreign jurisdiction and is treated as a foreign hybrid for Australian tax purposes. The LLC acquires bonds (or similar instruments) issued in another jurisdiction, for example, in the United Kingdom (UK) by a UK financial institution, which offer an enhanced return over those of a similar grade of issuer. The payment of interest on the bonds is claimed by the issuer to attract UK withholding tax at the rate applicable.

A securities lending arrangement is then put in place within the issuer's group that is claimed by that group to create a credit known as a 'reverse charge' tax credit. That credit is equal to the amount of the UK withholding tax liable to be paid under UK tax law. A foreign tax credit is claimed by the taxpayer for the amount of UK withholding tax paid. The foreign tax credit exceeds the Australian income tax payable on the net interest income from the arrangement. This excess is claimed to be available for use to reduce Australian tax payable on other foreign sourced income of the taxpayer. The effect of this arrangement is that the taxpayer is provided with an enhanced return funded not by the issuer, but through the availability of the foreign tax credits.

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