Conduit foreign income: impairment of shares in a foreign company that paid a non-portfolio dividend

Is an impairment loss included in the income statement of an Australian company an 'expense reasonably related' to a dividend received from the company's wholly owned foreign company for the purposes of subsection 802-30(5) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. An impairment loss included in the income statement of an Australian company is an 'expense reasonably related' to the dividend received from the wholly owned foreign company for the purposes of subsection 802-30(5) of the ITAA 1997.

The taxpayer (Aus Co) is an Australian resident company for Australian income tax purposes.

Aus Co acquired 100% of the shares in a foreign resident company (For Co). These shares are accounted for at cost in Aus Co's income statement as allowed by Australian Accounting Standard AASB 127 'Consolidated and Separate Financial Statements', subject to impairment under Australian Accounting Standard AASB 136 'Impairment of Assets' (AASB 136).

Immediately after the acquisition, For Co paid a dividend to Aus Co. This dividend was paid following the sale of assets held by For Co prior to the date of acquisition. This dividend payment substantially reduced the value of the shares in For Co and led to an impairment of these shares in accordance with AASB 136.

The dividend income and the impairment loss were recognised in Aus Co's income statement for the relevant period.

For Australian income tax purposes the dividend paid by For Co is non-assessable non-exempt pursuant to section 23AJ of the Income Tax Assessment Act 1936 (ITAA 1936) (the section 23AJ dividend). Aus Co cannot deduct the impairment loss from its assessable income.

The amount of an entity's CFI at a particular point in time is calculated in accordance with sections 802-30 to 802-55 of the ITAA 1997.

The amount of foreign source income that will be included in an entity's CFI is calculated in accordance with subsections 802-30(1) through to 802-30(7) of the ITAA 1997.

Subsection 802-30(1) of the ITAA 1997 includes in the calculation of an entity's CFI the amount of ordinary income and statutory income derived by the entity that has been, is or will be included in an income statement or similar statement of the entity or of another entity and that would not be included in the entity's assessable income if the entity were a foreign resident at the relevant time.

Subsection 802-30(2) of the ITAA 1997 reduces the subsection 802-30(1) amount by any part of that amount that is, or will be included in the entity's assessable income.

The section 23AJ dividend received by Aus Co is included in its income statement and will be included in the calculation of Aus Co's CFI under subsection 802-30(1) of the ITAA 1997. As the section 23AJ dividend will not be included in Aus Co's assessable income, the amount of the dividend will not be reduced by operation of subsection 802-30(2) of the ITAA 1997. Subsections 802-30(3) and (4) do not apply.

Subsection 802-30(5) of the ITAA 1997 requires that the amount remaining after the application of subsections 802-30(1) - (4) of the ITAA 1997 be reduced by 'any of the entity's expenses that are reasonably related to that amount, except expenses the entity has deducted or can deduct under this Act'.

It is therefore necessary to determine whether Aus Co has any 'expenses' which are 'reasonably related' to the dividend it has received from For Co.

The term 'expenses' is not defined in the legislation. Therefore, the term is interpreted to have its ordinary meaning in the context of the legislative provision in which it appears (see for example Project Blue Sky v. ABA [1998] HCA 28, at paragraph 69, and Stevens v. Kabushiki Kaisha Sony Computer Entertainment [2005] HCA 58 at paragraph 124).

The specified rationale for subsection 802-30(5) of the ITAA 1997 is to ensure that the amount included in an entity's CFI represents an amount actually available for distribution. In explaining this, paragraph 5.49 of the Explanatory Memorandum to the Tax Laws Amendment (Loss Recoupment Rules and Other Measures) Bill 2005 (the EM) states that the expenses to be included are those expenses that would 'normally' be taken into account in preparing the entity's income statement. That paragraph further provides: Expenses should reduce the amount of conduit foreign income because the profit available for distribution that is sourced from foreign income is reduced. Correctly reducing the amount of conduit foreign income prevents other types of income being distributed as an unfranked distribution declared to be conduit foreign income.

In identifying the amount to be included in the calculation of an entity's CFI, subsection 802-30(1) of the ITAA 1997 relies on a combination of tax and accounting concepts, but ultimately requires that the amount will be included in an income statement or similar statement of the entity. Thus, the EM, in reference to this latter condition in subsection 802-30(1) provides at paragraph 5.24: This condition is based on accounting concepts and is used as a mechanism to restrict conduit foreign income to amounts of distributable profits. It is appropriate to use accounting concepts because these determine the actual amounts a company may distribute.

Thus, the intent of the CFI calculation is to arrive at the amount of net foreign income that is available for distribution, availability being determined by the accounting profit.

Therefore, although there is no explicit reference to an income statement in connection with the term 'expenses' in subsection 802-30(5) of the ITAA 1997, consideration of the context of the subsection makes it appropriate to refer to the expenses recorded on the income statement or similar statement of an entity.

An impairment loss is an expense recognised on an income statement. AASB 136 provides that if the 'recoverable amount' of an asset is less than its 'carrying amount', the carrying amount of that asset shall be reduced to its recoverable amount. This reduction is referred to as an 'impairment loss' (see paragraph 59 of AASB 136). That reduction appears on the income statement as an expense and operates to reduce the accounting profit.

Therefore the impairment loss recorded against the carrying amount of the shares in For Co will be an expense for the purposes of subsection 802-30(5) of the ITAA 1997.

Since the impairment loss is an expense under subsection 802-30(5) of the ITAA 1997 that cannot be deducted under any provision of the Act, the next step is to determine whether the impairment loss is 'reasonably related' to the section 23AJ dividend received by Aus Co.

The term 'reasonably related' was considered by the High Court in Airservices Australia v. Canadian Airlines International Ltd (1999) 202 CLR 133. McHugh J said, at paragraph 245: The concept of "reasonableness" is a category of indeterminate reference. Its application in a given factual situation cannot depend upon a logical formulation... The requirement that the charges be reasonably related to the expenses as described above at least requires that there be some rational relationship between the charges and the expenses. But once this rather low threshold is met, the degree of closeness of the relationship which is required in order for the statutory requirement to be satisfied cannot be described in the abstract. It depends on the application, to the circumstances of a particular case, of the fact-value complex that the word "reasonably" invokes. Important in that assessment are the purposes or objects of [the Act].

Whether the impairment loss (the expense) is reasonably related to CFI will therefore depend on the circumstances in which it was required to be recognised.

In the present case the dividend paid by For Co is paid out of profits realised upon the sale of assets it held prior to its acquisition by Aus Co. The payment of the dividend resulted in a reduction of the carrying amount of the shares in For Co to its recoverable value such that, in accordance with AASB 136, Aus Co was required to recognise an impairment loss in its income statement. There is therefore a rational relationship between the impairment loss (the expense) and the section 23AJ dividend. Moreover, as the expense would not have been recognised but for the payment of the dividend, impacting on Aus Co's reported profit, that relationship is reasonable both in terms of the degree of connection between the expense and the dividend and in the context of a provision directed at ascertaining net foreign income available for distribution.

Therefore, given the particular factual circumstances of the case being considered, the impairment loss, being a relevant expense, is considered to be reasonably related to the section 23AJ dividend received from For Co, and will be included in the calculation of Aus Co's CFI under subsection 802-30(5) of the ITAA 1997. This means the amount of foreign source income included in Aus Co's CFI pursuant to subsection 802-30(6) will reflect a reduction by the amount of the impairment loss.