TAX NEWS - DECEMber 2009

Australia tax: Update on proposed changes to laws relating to sovereign immunity

On 30 November 2009, the Australian government issued a press release and Consultation Paper on proposed changes to the tax laws relating to sovereign immunity. This is further to the government's announcement in August 2009 that it would codify current administrative practice.

While sovereign immunity is recognized in Australia, it is somewhat undefined with no legislation and minimal binding guidance from the tax authorities. The proposed changes are intended to provide greater certainty to foreign governments about the tax treatment of their investments in Australia, enhance Australia's attractiveness as a destination for foreign government investment and assist in promoting Australia as a financial services hub.


Current administrative practice

Certain income derived by foreign governments and many sovereign wealth funds has traditionally been exempt from Australian income taxation under the doctrine of sovereign immunity. Broadly, income derived by a foreign government from the performance of governmental functions is exempt from Australian income tax. The Australian Taxation Office (ATO) has provided a guideline on the current practice in Interpretative Decision ATO ID 2002/45.

The ATO states in this Interpretative Decision that the following requirements must be met to establish that sovereign immunity applies to exempt dividend and interest income from tax:

- The person making the investment (and therefore deriving the income) is a foreign government or an agency of a foreign government, undertaking governmental functions;
- The funds being invested are and will remain government funds; and
- The income is derived from non-commercial activities. This has typically limited the exemption to equity investments of less than 10% of issued capital.


Consultation process

While the August 2009 announcement proposed that the new law would codify existing practice, the release of the Consultation Paper indicates that the government may be prepared to move away from current practice. The Consultation Paper seeks to obtain comments on the broad legislative design principles of the proposed changes, including:

- The appropriate definition of "foreign government";
- How non-commercial (passive) income should be defined to ensure that it can be easily distinguished from commercial (active) income, thereby securing a level playing field for competing Australian businesses;
- What effect the derivation of active income should have on the tax treatment of an entity's passive income (i.e. tainting);
- The range of taxes that should be captured under the sovereign immunity legislation; and
- Integrity rules, such as the need for a governmental functions test.

The Consultation Paper frequently refers to U.S. tax law in this area, and seeks comments on whether Australia should adopt a model similar to or different from the U.S. model.


Conclusion

The consultation process provides a forum for foreign governments, Sovereign Wealth Funds and others to actively participate in and influence the policy development in this area. Submissions close on 5 February 2010. Draft legislation is expected to be introduced in the first half of 2010.