The Commonwealth of Symmetrica Income Tax Act - A commentary on this hypothetical tax law, September 29, 2000

COMMONWEALTH OF SYMMETRICA

INCOME TAX ACT 20**

COMMENTARY

BACKGROUND

1. The main purpose of this Commentary is to explain briefly the presentation and form of

the Commonwealth of Symmetrica Sample Income Tax Law (the “Sample”). The

Background to this Commentary is as much about explaining what the Sample is not as

it is about explaining what it is. The Sample is an example of a relatively

comprehensive income tax law and one particular drafting style. It is not an example of

an ideal income tax, if it were possible to draft one in any case.

2. For example, there are many areas of income tax theory where experts do not agree.

The taxation of income on a realisations basis is one as is whether the exemption or

credit method should be used to provide foreign tax relief and the treatment of savings.

Even in areas where experts do agree that a particular approach is correct in theory,

many will further agree that the theoretically correct approach is not a practical one from

an implementation perspective. The identification of where an in-kind benefit

constitutes income (and is therefore included in calculating taxable income) or an

expense constitutes human consumption (and is therefore not deductible) are two

examples where a practical approach must be taken. Another is the level of control

required to justify allocation of income of entities to their owners.

3. An income tax must be adapted to the circumstances in which it is to be applied.

Different countries have different social values, different social structures, different

levels of resources, and different government funding arrangements, including level of

reliance on other forms of taxation. An ideal income tax for one country is unlikely to

be ideal for another country. An income tax should be adapted to local conditions and

can only be ideal in this sense.

4. The Sample is not adapted to any particular country’s circumstances. One of its primary

objectives is that it can readily be adapted for use by particular countries. The particular

countries towards which it is targeted are developing countries with an Anglo-Saxon

based legal system. However, it may also be of interest to other countries including

developed countries engaged in tax simplification projects. The Anglo-Saxon influence

is apparent on the face of the Sample and, particularly, the terminology used.

Nevertheless, the Sample departs in many respects from the traditional United Kingdom

approach to income tax. For example, the Sample does not adopt the traditional United

Kingdom distinction between income and capital.

5. The Sample purports to be relatively complete and comprehensive. These two aspects

require further explanation. It is complete in the sense that its provisions cover most all

topics that should be treated in an income tax. Further, these provisions are fully cross-

referenced and heavily integrated. It has been decided not to adopt a modular approach

under which alternate provisions are provided demonstrating different approaches to a

particular policy issue. Different approaches to particular policy issues invariably

involve adjustment of more than one provision, which makes the modular approach very

difficult, if not impossible, to present in a complete form. The Sample adopts only one

policy approach to particular issues. This does not suggest that the approaches adopted

are ideal or the best. Another of the purposes of this Commentary is to identify the

policy options adopted and point out some different approaches.

6. The Sample also purports to be comprehensive. The tax base is broad and the

exemptions limited. However, except in isolated cases, a realisations rather than accrual

tax base is adopted. The Sample addresses many difficult tax base issues. Many of

these issues are not even appropriately addressed by many developed countries, at least

in legislative form. Examples of these types of issues are:

• tax base erosion by non-resident controlled entities by repatriation of profits through

payments subject to low-final withholding taxes (usually only directly addressed in

the context of interest by thin capitalisation rules);

• the treatment of long-term contracts (which involve the potential for tax deferral);

• the treatment of annuities, instalment sales, and finance leases (consistently with

interest paid on a loan);

• a comprehensive set of source rules covering income, losses, gains, and amounts

included or deducted in calculating income (usually dealt with in part if at all);

• the coverage of liabilities under transactional basis (capital gains) treatment (which

are often ignored in legislation); and

• value shifting between interests and liabilities held in entities (an issue either ignored

or only dealt with in isolated cases).

7. It is not suggested that all countries need these rules or that they should adopt them as in

the Sample. Rather, the purpose of the Sample is to demonstrate the issues that a

country should consider when drafting or redrafting an income tax. In this way, the

Sample serves as a useful checklist of things to be considered and provides but one

example of how to address particular issues. Keen attention has been paid to structural

issues. Too many countries’ income tax laws are littered with provisions that appear

under headings to which they do not relate and only cover part of the generic issue

because that was the part that was initially causing a problem. They find later on that

variations of the problem continue to arise because they did not address the issue from a

structural perspective in the first place.

8. Some further general explanation is required with respect to the approach to drafting.

Some will find the approach too complex and others will find that it is not sufficiently

specific in particular places. In particular, those favouring a principles approach to

drafting, such as that adopted by Continental Europe, may find the use of definitions

overwhelming. However, such an approach typically assumes a particular legal system

underpinning the income tax law and relies on that legal system to fill the gaps that the

income tax law does not cover. Many countries, particularly developing countries, do

not have a sufficiently sophisticated legal system such that it may be assumed that a

particular issue will be appropriately covered by some other law, e.g. accounting law.

The approach of the Sample is to assume the lack of a sophisticated legal system. It

seeks to cover virtually all matters pertaining to the income tax law. That is, the Sample

seeks to be self-standing.

9. Nevertheless, the Sample does not seek the level of sophistication adopted in many

developed countries' income tax laws. Often this sophistication is superficial and only

hides a poorly structured or drafted income tax, using a number of provisions to deal

with issues that are dealt with by substantially fewer provisions in the Sample. In any

case, as mentioned above at paragraph 4, the Sample is primarily targeted at developing

countries where the sophistication often sought by developed countries is not justified.

10. Not only does the Sample seek to be comprehensive but it also seeks to be uniform. If it

is possible to deal with a number of issues using only one concept, then the Sample does

so. Again, this approach is lacking in many income tax laws. It is perhaps this goal of

uniformity rather than that of comprehensiveness that has caused a lengthy general

definitions section. The general definitions section is in many ways the map to the

Sample. It is this section that ensures that singular concepts are used consistently

throughout the Sample.

11. In most cases, the general definitions section does not define a term but directs the

reader to the section where a particular term or phrase is defined. Where the meaning of

a particular word or phrase is central to a particular Division or Subdivision, the term is

often defined in a central concepts section at the beginning of the Division or

Subdivision. This approach is felt superior to one in which all definitions are collected

in one definitions section. Placing related definitions within close proximity of one

another provides a greater insight into the approach adopted by the Sample. If these

related definitions were scattered throughout a very large definitions section, this

advantage would be lost.

12. A further tool is provided in order to assist with navigation through the Sample and

identification of defined terms and phrases. All terms and phrases appearing in the

Sample that are intended to be used in the sense defined in the general definitions

section are underlined. This is intended to alert the reader that a particular term or

phrase is used in the defined sense. Finally, in the usual way, if a defined term is only

used in one section, the term is defined at the end of that section and not in the general

definitions section.

13. The section numbering used in the Sample is also worthy of short comment. It accepts

the inevitability that income tax laws will be amended. In order to make provision for

amendment, section numbers are reserved at various points throughout the Sample. The

general approach is to begin each Part, Division, or Subdivision with a section number

based on a multiple of five. This results in reserve section numbers at the end of each

Part, Division, or Subdivision.

PART I: IMPOSITION OF INCOME TAX

14. The Sample begins with the charging provision, section 1. The charging provision is the

central provision of the Sample from which the rest of the Sample branches. It is the

only section that imposes income tax. The Sample distinguishes the imposition of

income tax and other "tax" imposed by the Sample. "Tax" is defined in section 205 and

includes not only amounts charged under section 1 but amounts charged under other

provisions such as interest and penalties.

15. Income tax is imposed under section 1 for each "tax year". Amounts used in calculating

income tax must, therefore, be allocated to specific tax years. This allocation process is

primarily detailed by Subdivision B of Division II of Part II. The charging provision

specifies that income tax payable is to be paid in accordance with the procedure in Part

16. Income tax is charged under four heads in section 1(1). The amount of income tax

payable by a person for a tax year is the total of the amount payable under these heads

for the year. The calculation process is different for each of these heads and is set out in

the rest of the charging provision. The tax rates applicable follow in Division II.

Income tax is imposed on a "person". "Person" is another central concept that is defined

in section 105 to mean an individual or an entity (partnership, trust, company, or foreign

branch). Income tax treatment varies dramatically under the four heads depending on

whether the person deriving the income is an individual, an entity, or a non-resident

person. The following discussion considers taxation under these income tax heads by

reference to these different types of persons.

Individuals

17. The first head of charge to income tax is the traditional profits base. The concept of

"taxable income" is used to represent profits. Taxable income is calculated in

accordance with Division I of Part II, see the discussion below at paragraphs 33 to 96.

Income tax payable under this head is primarily calculated under section 1(3) by

applying the tax rates set out in section 5 to the relevant individual's taxable income.

The resulting amount is reduced by "offsets" to arrive at tax payable. This term is

defined in section 345 by reference to personal, medical costs, and foreign tax offsets.

The policy underlying these offsets is discussed in the Commentary relevant to the

sections under which these offsets are calculated, see the discussion below at paragraphs

218 to 222 and 311 to 316. Often an amount that reduces tax otherwise payable in this

manner is referred to as a "tax credit". The Sample only uses the term "tax credit" for

what are effectively pre-payments of income tax made during the year on account of the

end of year tax liability under the first head of charge to income tax. For example, tax

credits are available for non-final withholding tax and tax paid by instalment. Excess

tax credits are refundable under the Sample, see section 301 and the discussion below at

paragraph 365. By contrast, there is no provision for the refund of excess offsets but

often they may be carried forward under the relevant calculation provision.

18. Section 1(4) is an exception to the calculation under section 1(3). This provision

effectively turns wage withholding tax into a final withholding tax in certain

circumstances. This has the administrative advantage of reducing, potentially

dramatically, the number of returns of income that have to be filed with the tax

administration. As soon as an employee has more than one source of income or claims

deductions for payments made by the employee it becomes difficult for the employer to

accurately determine the tax payable by the employee. This is one reason why

employees are essentially denied deductions in calculating taxable income, see the

discussion below at paragraph 69. Similarly, the final nature of the wage withholding

tax is withdrawn where an employee claims tax rate averaging or, for payments not

made through an employer, a medical costs offset or reduction in taxable income for

retirement savings contributions. These are matters that are difficult for employers to

substantiate, see section 236 and the discussion below at paragraph 337.

19. Section 5(1) deals with rates of tax generally applicable to resident individuals. The

currency for Symmetrica is the SY the value of which is assumed to be somewhere in

the vicinity of the Euro, the US Dollar, and 100 Yen. The thresholds and rates provided

for in section 5(1) are only an example of a typical rate schedule and must be adjusted to

local considerations. One point worthy of note is the absence of any exemption

threshold. Rather than an exemption threshold, the Sample adopts a personal offset that

directly reduces tax payable under this head of income tax, see the discussion below at

paragraphs 218 and 219.

20. Section 5(2) and (3) provide an example of a general provision for averaging fluctuating

incomes. Loss relief, such as the carry forward under section 33, does not fully address

problems with income fluctuating from year to year within bands of taxation. Where

two persons have the same amount of income over a five year period, the one whose

income fluctuates the most year by year over that period may find they pay more tax

than the person with the more stable stream of income. Two industries particularly

prone to this problem are the agriculture industry and that of artists and entertainers.

However, the issue is not specific to these or any other industries, e.g. it arises with

respect to gains recognised on a transactional basis (such as capital gains) and some

lump sum retirement payments. This is a general issue under an income tax calculated

on a periodic basis.

21. Most countries deal with only part of the income fluctuation problem, e.g. by applying

special rates or an averaging mechanism to capital gains. The problem with a piecemeal

approach is that it raises characterisation issues, e.g. where persons seek to structure

their arrangements so as to take advantage of any relief on offer. Rather than take such

an approach, or make no provision at all, the Sample seeks a structural approach to the

issue. Section 5(2) and (3) provide a limited averaging of income over a 5-year period

subject to certain exclusions from averaging for non-residents and full-time students.

Many countries may feel that this approach is too complicated. Again this is an area

where the approach taken should be adjusted to local considerations.

22. As mentioned below at paragraphs 40 and 41, the Sample adopts the individual as the

tax subject. This can cause particular problems with income splitting between parents

and children. Under section 5(4) the investment income of a resident minor is taxed at

the highest individual rate. The relevant income is defined in section 117 and discussed

below at paragraph 223. Another approach would be to tax children under the standard

rate schedule and place greater reliance on an anti-income splitting rule such as that

provided in section 63, discussed below at paragraph 134. Another approach is to adopt

the family as the tax subject. Each of these alternate approaches has problems, in terms

of perceived equity and administrability.

23. Finally, the treatment of individuals who are resident for only part of a tax year requires

comment. Some countries do not recognise parts of tax years with respect to residence

and a person is either resident for the whole year or non-resident. This is the approach

adopted under the Sample with respect to entities. However, residence for part of a tax

year is recognised under the Sample for individuals, see section 109(3) and (4) discussed

below at paragraph 211. Where this occurs it is appropriate to reduce the tax rate

thresholds that apply to such part-time residents to ensure that they do not benefit from

thresholds designed for a full year. This reduction is achieved under section 5(7). The

same issue arises in the context of personal offsets and is dealt with in section 115,

discussed below at paragraph 219.

Entities

24. Entities are divided into partnerships, trusts, companies, and foreign branches. A

different tax regime is provided under the Sample for each of these types of entities.

While the treatment of each type of entity is dealt with in detail in the discussion of Part

III, see below at paragraphs 201 to 297, an overview is necessary at this stage.

Partnerships and foreign branches are taxed on a look through basis. Their income or

loss is calculated on a separate entity basis but the income or loss for a tax year is

generally allocated to the partners or branch owner for the year and tax is paid at this

level. The exception is domestic branches of non-residents, which are taxed directly as a

proxy for the non-resident owner.

25. The treatment of foreign branches as an entity separate from their owners is somewhat

unconventional and has a number of important consequences. In particular, it results in

recognition of dealings between a foreign branch and, e.g. its head office. These

dealings will be subject to the arm's length principle as are dealings between other

associated parties. It also means that a foreign branch may be resident in a country

different from that in which its owner is resident. This is particularly important for

domestic branches of non-residents. As a resident, such a branch will be required to

withhold tax from certain payments made by it, including payments made to the branch's

owner (subject to double tax treaty requirements). Further, such branches will be

taxable on their world-wide income but entitled to foreign tax relief in the usual manner

(including under double tax treaty where this is consistent with the treaty). This

treatment will also be relevant where the source of a payment is determined by reference

to the residence of the payer.

26. The reason for this treatment of foreign branches is to assimilate them, to the extent

possible, with the treatment of subsidiaries. It is also viewed as an appropriate method

of securing the tax base (e.g. by applying all anti-abuse rules directly to foreign

branches). This treatment also means that only one set of provisions is required for

calculating the income of entities situated in one country that are controlled by a resident

of another country. That is, no special provisions are incorporated in the Sample for

allocating income between a foreign branch and its owner.

27. Trusts are taxed on a semi-look through basis. Their income or loss is calculated on a

separate entity basis. However, losses are not allocated to beneficiaries. Income may be

allocated to beneficiaries but only in limited circumstances and, in the case of resident

trusts, not in any tax year after the year in which the income is derived. Income that is

not allocated to a beneficiary is taxed at the trust rate mentioned in section 6(1), which is

equal to the highest rate for individuals. This restricts the use of trusts as a tax shelter

device. Income tax imposed on a trust under the first head of section 1(1) is calculated

in the same manner as for individuals, see the discussion above at paragraph 17.

However, personal and medical costs offsets may only be claimed by individuals.

Income that is allocated to a beneficiary is taxed at the beneficiary's tax rate.

28. By contrast, companies are taxed on a separate entity basis. Losses and income of

companies are not generally allocated to shareholders. Income tax under the first head

of section 1(1) is imposed on companies at a rate that is 5 percentage points below the

highest rate for individuals. The calculation of tax payable is the same as that for trusts.

Dividends distributed by resident companies are subject to a 10 percent final

withholding tax under the third head of charge to income tax in section 1(1). The effect

is that there may be some benefit in the form of tax deferral for income retained in a

company, taxation at 30 percent instead of a potential 35 percent. However, where

profits are distributed the overall tax levied with respect to corporate profits is slightly

higher than the highest rate for individuals, 37 percent instead of 35 percent. This

system represents only a compromise and one form of the many corporate tax systems

that may be implemented. It has the advantages of relative simplicity and a small

incentive towards saving through companies. The final withholding tax is also likely to

be creditable for non-resident shareholders under foreign tax credit systems of foreign

countries.

29. The downside of the system is the potential taxation of individuals at rates exceeding

their personal marginal rates with respect to income derived through companies, i.e. for

individuals otherwise subject to the lower individual marginal rates. This may be true

where individuals do not control the distributing company, although in this case there is

a question as to who bears the burden of the corporate tax. However, where the

company is closely held, the individual controllers will typically be able to engage in

self-help integration by removing what might otherwise be profits in a form that is

deductible to the company, such as interest or remuneration. It is unlikely that these

sorts of payments would be viewed as excessive where they do not exceed the threshold

applicable to the highest individual tax rate.

Non-residents

30. The Sample suggests the taxation of non-resident individuals under the first head of

section 1(1) at a flat rate of 20 percent of their taxable income. The type of income in

question is likely to be predominantly income from employment. This is because

domestic businesses of non-residents will normally create a domestic branch and such

branches are treated as separate persons for the purposes of the Sample, see section 105

and the discussion above at paragraphs 24 to 26 and below at paragraph 212. Further,

many domestic source payments to non-residents (other than for employment) are

subject to final withholding tax under the third head of section 1(1). Like income from

employment exercised domestically, these types of payments typically represent

domestic wealth created (value added). As mentioned below at paragraphs 141 and 142,

domestic wealth created is the primary tax base of the Sample. In order to suppress the

incentive for non-residents to characterise payments as of a particular type in order to

reduce domestic tax otherwise payable, the Sample seeks to impose a consistent level of

tax on payments to non-residents for domestic wealth created. Deductions are

essentially denied in calculating income from employment. Therefore, there is a level of

equivalence between the taxation of domestic employment income of non-residents at a

flat rate under the first head of section 1(1) and the subjection of other domestic source

payments to non-residents to final withholding tax at the same rate under the third head.

31. The tax rate selected for non-resident individuals under the Sample is at the low end of

the rate schedule applicable to resident individuals. There are a number of reasons for

this selection. Non-residents are not granted personal offsets, medical costs offset, or

foreign tax offsets and are typically denied many social benefits available only to

residents. Further, progression is usually felt inappropriate for non-resident individuals

as it is difficult to collect sufficient information to tax them according to their ability to

pay, if that were considered appropriate in any case. Further, non-residents may be

subject to taxation in their own country of residence. In many cases the thresholds to

higher tax rates in the country of residence may be higher than in the country of source.

In this case, higher taxation in the source country than in the residence country may have

the disadvantage of discouraging highly skilled labour from working in the source

country.

32. The second head under which income tax is imposed by section 1(1) is on the repatriated

income of domestic branches of non-residents, i.e. a branch profits tax. This tax is

imposed in order to provide a treatment similar to the treatment of dividends distributed

by resident subsidiaries to non-resident parents. It is possible to produce a similar

treatment by treating such branches as resident companies. The present treatment is

viewed as more transparent and consistent with common international practice. Branch

profits taxes are, however, inconsistent with Article 10(5) of the OECD Model Tax

Convention on Income and on Capital (the "OECD Model") and are often suppressed in

double tax treaties.

PART II: INCOME TAX BASE

33. This Part contains rules for calculating taxable income, the tax base that is used in the

calculation of income tax payable under the first head of section 1(1). Division I of this

Part contains mechanical rules for the calculation of taxable income. Essentially it

involves identifying amounts that are included, excluded, or deducted in that calculation.

By contrast, Divisions II and III elaborate on amounts identified under Division I.

Division II deals with timing the recognition of amounts, quantifying and characterising

amounts and allocating them to particular persons. While these issues must be dealt

with under any income tax, often they are not well identified or grouped by income

taxes in practice.

34. Some amounts included or deducted in calculating income are recognised on a deferred

basis. In the case of costs incurred for depreciable assets, the recognition is deferred

over the useful life of the asset. In other cases, the recognition may be deferred until an

asset or liability is “realised”. This type of deferral sets up what is referred to herein as

the “transactional basis income tax”. This phrase is used in contradistinction to the usual

“payments basis income tax” set out in Division I. The distinction is further discussed

below at paragraphs 106 to 108 and 157 and 158. The transactional basis income tax is

essentially set out in Division III together with the deferred recognition rules for

depreciable assets. The latter may have been incorporated within the timing rules in

Division II. However, the rules for depreciable assets are heavily integrated with the

transactional basis income tax and are incorporated in Division III for convenience.

Otherwise, Division III covers the traditional ground of what is referred to in Anglo-

Saxon terms as the “capital gains tax”. That phrase is not used in the Sample or this

Commentary as there is an effort to minimise the distinction between capital and

revenue payments.

Division I: Calculating the Income Tax Base

Subdivision A: Taxable Income

35. This short Subdivision contains the general formula for calculating the base to which

income tax rates are applied in calculating income tax charged under the first head of

section 1(1). Section 10 makes it clear that a "slice by slice" (sometimes referred to as a

"schedular") approach to the calculation of income is adopted by the Sample. Under this

approach a person calculates their income from each employment, business, or

investment for a particular tax year. Deductions, if available, are taken separately in

each of these calculations of income. This income, after any deductions, is filtered

through the jurisdictional rules in section 15 to arrive at the person's assessable income

from each employment, business, or investment for a tax year. These filtered incomes,

i.e. the person's assessable income from each employment, business, or investment, are

aggregated for a year under section 10. The aggregate is reduced by certain

contributions to approved retirement funds under section 191, discussed below at

paragraph 310, to arrive at the person's taxable income for the year.

36. There are other ways to calculate taxable income. In particular, a global approach is

often used. Under this approach income is not calculated separately for particular

activities such as separate employments, businesses, or investments. Rather, inclusions

in income from all activities are totalled and amounts deductible are totalled with taxable

income equalling any excess of the former over the latter. The primary difference in the

approaches is what deductions may be taken against or reduce. Under the global

approach, losses from one activity (excess deductions) automatically reduce income

(excess inclusions) from other activities. While this may be appropriate in theory and

may increase simplicity, it does have some disadvantages.

37. The primary disadvantage of the global approach is a lack of flexibility in targeting

potential for abuse. Almost invariably, countries that adopt a global approach end up

"schedularising" the calculation of taxable income by quarantining certain deductions,

e.g. those incurred on passive investment (sometimes referred to as "negative gearing").

The difficult theoretical issues that justify quarantining include the blurred distinction

between whether a cost is incurred in producing income or whether it represents

consumption by a person and is, therefore, not deductible. A simple example is costs

incurred in conducting a hobby farm. Another is the difficult issue of determining the

timing of deduction for costs incurred in securing lasting assets or benefits. Here there is

the potential to "front load" deductions where the real return with respect to which they

are incurred will not be derived until an asset is realised in the future.

38. By contrast, countries that adopt the slice by slice approach almost invariably permit

losses incurred on one particular slice of activity to offset income on other slices.

Therefore, the differing effects of adopting a slice by slice or global approach are often

an issue of form and not substance. One disadvantage of the slice by slice approach is

that it is necessary to allocate deductions to particular activities. To the extent that a

global approach is schedularised, such an approach faces the same issue. The slice by

slice approach will vary depending on the types of activity identified for which income

must be calculated separately. It is also possible to aggregate the calculation of income

from similar activities, e.g. calculate income from all businesses conducted.

39. The slice by slice approach is adopted in the Sample because it is viewed as more

transparent and providing greater flexibility for quarantining, particularly deductions. It

is also viewed as more intuitive in that persons are more likely to consider whether they

have derived income or incurred losses on particular activities before considering

whether they have an overall income or loss. This is also likely to be the manner in

which accounting records are kept.

40. Taxable income is determined separately for each person. There is no grouping of

income between associated persons under the Sample. For example, in the case of

natural persons, the individual is adopted as the tax subject. Many countries adopt a

broader economic unit as the tax subject, such as a couple or family. A main argument

in favour of the broader approach is that it does not discriminate between, e.g. dual

income couples and single income couples. However, countries implementing this

broader approach often have problems with their tax systems either encouraging or

discouraging marriage or other union within an economic unit.

41. By contrast, using the individual as the tax subject discriminates in favour of each

member of an economic unit contributing to the unit's income and sharing in its

domestic tasks. Where men are the dominant income earners, this may encourage

women to enter the workforce and is often viewed as consistent with economic

independence of women. Using the individual as the tax subject causes problems with

income splitting between members of the same family unit. However, this is also

typically true of countries adopting some broader economic unit as the tax subject as

there is no obvious line as to when a person is within or outside an economic group. On

top of these considerations, many countries may have to factor in the effect of social

security or child payments from the government. The tax unit also has important

implications for tax administration; generally, the individual unit is simpler. In the

result, the Sample opts for using the individual as the tax subject. This approach is

another matter that must be adjusted to local considerations and social values.

42. As in the case of individuals, there is no grouping of entities under the Sample in

determining the tax subject, e.g. no consolidation is allowed. This approach appears

consistent with the slice by slice approach (consolidation appears more consistent with a

global approach). Under the slice by slice approach it is possible to provide for the

transfer of tax attributes between entities and their associates so as to provide a similar

treatment to that available under, e.g. consolidation. This is the approach taken under

the Sample. There are three manners in which tax attributes may be transferred between

entities and their associates under the Sample. The first is the transfer of losses under

section 33, the second is the transfer of assets and liabilities on a non-recognition basis

under section 94, and the third is the transfer of excess foreign income tax for purposes

of calculating foreign tax offsets under section 200. These transfers recognise that many

entities and their associates form but one economic unit and are consistent with a general

approach of basing recognition on the substance of activities rather than their form.

Each of these provisions and this rationale is discussed further below at paragraphs 93 to

95, 189 to 193, and 316.

Subdivision B: Assessable Income

43. As mentioned above at paragraph 35, section 15 is the primary jurisdictional filter in the

Sample. In the usual manner, world-wide income of residents is assessable whereas

only domestic source income of non-residents is assessable. The source of income is a

characteristic of income and is determined under section 68, discussed below at

paragraphs 140 to 146. Residence is a characteristic of a person, is dealt with in Part III,

and is particularly discussed below at paragraphs 210 to 212.

General Formula for Calculating Income

44. Sections 16, 17, and 18 provide for the calculation of income of a person from an

employment, business, or investment for a tax year, respectively. Each section begins

with a provision stating that such income is remuneration (employment) or gains and

profits (business and investment) from the activity in question. The reference to gains

and profits is intended to confirm that the term "income" where used in the Sample is a

net concept, i.e. after deductions. This is supported by the definition of "income" in

section 345, which is generally in terms of income from employment, business, or

investment, and these types of income are defined by reference to sections 16, 17, and

18. While the Sample adopts the general concepts of remuneration and gains and profits

to represent income, it then proceeds to be rather specific as to the amounts that must be

included and those that may be deducted in calculating income. Specific inclusions are

generally provided for by sections 16(2), 17(2), and 18(2) and specific deductions are

generally provided for by Subdivision D.

45. The slice by slice approach adopted in the Sample means that income is calculated

separately for each activity of a person that constitutes an employment, business, or

investment. It is, therefore, necessary to determine the character of a person's activities

in order to determine whether they are of these types. The definitions of "employment",

"business", and "investment" in section 345 provide the relevant characterisation.

46. "Employment" is the dominant definition and whether an employment exists is primarily

determined according to general law (paragraph (a) of the definition). Employment is

typically an earning activity consisting predominantly of the provision of labour by an

individual. The definition of "employment" is extended, in particular, to include most

"managers" of entities, e.g. directors of a company and trustees of a trust, see the

definition of the latter term in section 106. The primary reason for this extension is to

ensure that these managers are subject to wage withholding. An alternative approach is

to treat the activities of these managers as a business and subject payments to them by

their entity to withholding as service fees. Under this approach, tax withheld would be

adjusted under the tax instalment system. "Employer" and "employee" are defined in

terms of "employment" and all of these terms make it clear that only an individual may

be the subject of employment.

47. "Business" is defined broadly in section 345 to include trades, professions, vocations,

and arrangements with a business character. In this way, the term is used throughout the

Sample as a shorthand reference to these types of activities. If a business activity may

also be characterised as employment, primacy is given to the characterisation as

employment. However, unlike employment, business is an earning activity typically

consisting not only of the provision of labour but of the combined provision of labour

and capital.

48. It is possible that a particular person conducts more than one business and, therefore,

must calculate income separately for each business. There are no rules in the Sample for

determining whether a particular person's business activities constitute one or more than

one business. This will depend on the facts of each case and local jurisprudence. This

matter is not further elaborated in the Sample. As losses from one business of a person

may be set against income from another business of the person, the issue will most often

not be critical and may be dealt with in practice notes issued by the tax administration.

However, the issue will become more acute if a particular country quarantines some or

all business losses.

49. "Investment" is also defined broadly in section 345 in terms of holding "depreciable

assets" or "investment assets". These types of assets are, in turn, broadly defined in

section 76. Essentially, these definitions cover any assets unless they are held primarily

for personal use and are not used in the production of gains and profits. The definition

of "investment" excludes employment or business. In this way, "investment" is used as

the residual manner in which income may be derived and "income from an investment"

is the residual category of income. In contrast to employment and business, investment

is typically an earning activity consisting predominantly of the provision of capital.

50. As with the definition of "business", the issue arises as to whether certain activities of a

person constitute one or more investments. There are two tests adopted for this purpose

in the definition of "investment". The first is whether the assets held are of a similar

nature. So, for example, a block of shares may constitute a single investment. The

second test is whether the assets are used in an integrated fashion, on similar terms, and

subject to similar conditions, including as to location. So, for example, a house that is

held passively and rented out with associated furniture, will constitute a single

investment. Any liabilities incurred with respect to the asset or assets held are also part

of the investment.

51. Each of the definitions of "employment", "business", and "investment" is extended to

include past, present, or prospective employment, business, or investment, respectively.

This extension is intended to ensure that amounts derived and costs incurred with

respect to a particular activity either before the activity is started or after it ceases are

treated appropriately. For example, where start-up costs are incurred before a business

commences, they may be deductible during the tax year in which they are incurred,

unless they give rise to a lasting asset in which case Division III will deal with them.

This may cause a loss in early years of a business that may be set against income from

other businesses or be carried forward under section 33. Another example is where an

employee receives remuneration either before or after employment. The remuneration

will be included in calculating income from the employment even for tax years before

the employment activity commences or after it ceases.

Specific Inclusions in Calculating Income

52. Sections 16(2), 17(2), and 18(2) each provide for specific amounts to be included in

calculating income from an employment, business, or investment, respectively. That is,

these are amounts that must be included in the calculation of remuneration or gains and

profits under section 16(1), 17(1), or 18(1), as the case requires. The relevant lists of

inclusions are quite comprehensive but are not intended to be exhaustive. That is, even

amounts that are not mentioned must be included if they are required to be included by

the ordinary meaning of "remuneration" or "gains and profits".

53. The inclusions in calculating income from an employment for a tax year are couched in

terms of payments made to the employee during the year. "Payment" is a central

concept of the Sample and is broadly defined in section 41, discussed below at

paragraphs 103 and 104. In essence, the definition will cover any financial gain

including through in-kind payments. The payments must be made by the employer to

the employee. The “making” of a payment is determined by reference to sections 45

and 60, discussed below at paragraphs 111 and 131, respectively. In the case of

payments of the type referred to in section 16(2)(a) to (f), no particular nexus is required

with the employment. If a payment may be characterised as of one of those particular

types then the fact that the payment is made by the employer to the employee is

sufficient to require the amount to be included in calculating the employee's income

from the employment.

54. By contrast, section 16(2)(g) is of a residual character requiring a more specific nexus,

i.e. any other payment made "in respect of" the employment must be included in

calculating the employee's income from the employment. This phrase, "in respect of", is

a typical nexus test used throughout the Sample. It is not defined and so will take its

ordinary meaning. Any further elaboration of this term is only likely to result in further

generalities. The tax administration may issue practice notes setting out its view as to

when payments, not covered by the prior paragraphs of section 16(2), will meet the

nexus in section 16(2)(g).

55. Specific inclusions in calculating income from a business or investment for a tax year

are couched in different terms to that used for income from employment. Here the

phrase used is "amounts derived". The reason for the difference in terminology is

primarily one of timing. Employees are required to account for tax purposes on a cash

basis and so payments made to an employee as employee are recognised for tax

purposes at the time of payment, see section 46. By contrast, income from business or

investment may be accounted for on a cash or accrual basis depending on the type of

person involved and the activities of that person. In this case, a payment may be

recognised for tax purposes at a time that is different from when the payment is made.

"Amount derived" is defined in section 41 in terms of a payment received by a person or

which a person is entitled to receive. Which timing is appropriate will depend on the

method of tax accounting used by the person.

56. Section 17(2) and 18(2) have some common inclusions in the calculation of income.

They include gains on the realisation of assets and liabilities of a business or investment

as well as recapture of excess depreciation on the realisation of depreciable assets.

These gains and recapture are calculated under Division III and, as mentioned above at

paragraph 34, are essentially net amounts that form the core of the transactional basis

income tax.

57. Another common inclusion worthy of specific mention is gifts received in respect of a

business or investment. This inclusion in many ways reflects the residual inclusion in

calculating income from employment mentioned above at paragraph 54. However, as a

payment received in conducting a business or investment may be received as a

contribution of capital (generally made out of pre-taxed funds), it is necessary to limit

this residual category to "gifts". "Gift" is defined broadly in section 345 as essentially

excess consideration received. Gifts from associates are not included in section 17(2) or

18(2) as it will often be difficult to determine if such gifts are made in respect of a

business or investment or as a result of the relationship giving rise to the association.

Gifts made to entities by associates are generally treated as a contribution to the capital

of the entity, see section 165 and the discussion below at paragraph 269. This approach

is also consistent with the approach to “income” under the Sample, which does not

include mere transfers of wealth, see further below at paragraphs 106 to 108.

58. There are some amounts that are exclusively included in calculating income from a

business or investment under sections 17(2) and 18(2). "Service fees" are included in

calculating income from a business under section 17(2) as are "incomings" for "trading

stock". The first of these terms is defined in section 345 in terms of a payment

attributable to the rendering of services by a business. As an investment activity will not

involve the provision of labour, this head of inclusion is not reflected in section 18(2).

Similarly, "trading stock" is defined in section 76 in terms of assets sold in the ordinary

course of conducting a business. "Incomings" is a central concept in the transactional

basis income tax and will include all amounts received in respect of assets such as

trading stock, see section 81 and the discussion below at paragraphs 165 and 166. This

means that sale proceeds from trading stock are directly included in calculating income.

This is in contrast to amounts derived from the realisation of other assets of a business

where only the net gain on the realisation is so included. In order to balance this

situation, a person may deduct an allowance for trading stock under section 28, which

essentially represents the cost of trading stock sold. The result on the realisation of

trading stock is essentially consistent with that on the realisation of other business assets

under the transactional basis income tax.

59. Another important inclusion in calculating income from a business is provided by

section 17(2)(g). An amount of the type referred to in section 18(2), i.e. included in the

calculation of income from an investment, that is effectively connected with a business

is included in calculating income from the business and not income from an investment.

The phrase "effectively connected" is not defined and again is an issue of nexus. This

phrase is often used in double tax treaties and is intended to have the same meaning as in

such treaties. The primary operation of section 17(2)(g) is with respect to amounts

referred to in section 18(2)(a). This head of inclusion in calculating income from an

investment is not otherwise reflected in section 17(2) in calculating income from a

business.

60. Section 18(2)(a) makes reference to the classic forms of return on capital being

"dividend", "interest", "natural resource payment", "rent", and "royalty". Gains from

“investment insurance” and “an unapproved retirement interest" as well as "retirement

payments" are also referred to and are further discussed below, see paragraphs 305, 309,

and 310. Each of these terms is defined in or via section 345. "Dividend" is defined

broadly and is essentially any return of a shareholder from an interest in a company.

"Interest" is defined in terms of a payment for the use of money. This definition

includes certain payments under debt obligations and other financial instruments as well

as amounts payable under an annuity, instalment sale, or finance lease that are

characterised as interest by section 67.

61. "Natural resource payment" is defined as payment for a right to take natural resources.

Natural resource payments are treated in the same manner as rents and royalties under

the Sample. The definitions of "rent" and "royalties" exclude natural resource payments.

"Rent" is defined in terms of a payment under a lease of a tangible asset and "royalty" in

terms of a payment under a lease of an intangible asset with a list of specific inclusions.

"Lease" is also defined in section 345 in terms of a temporary right in respect of an asset

of another person, other than money. Accordingly, the broad approach under the

Sample is that payments for the use of money are interest, payments for the use of

tangible assets are rents, and payments for the use of intangible assets are royalties. The

reason for the separate identification of natural resource payments is that in most cases

these payments are not for the use of an asset but, rather, the removal of assets forming

part of the land. Further, these payments often give rise to greater source country rights

to taxation under double tax treaties.

Specific Exclusions in Calculating Income

62. Sections 16(3), 17(3), and 18(3) provide for the exclusion of certain amounts in

calculating income from an employment, business, or investment, respectively.

Commonly excluded by these provisions are "exempt amounts" and "final withholding

payments". Both of these phrases are defined in or via section 345. Exempt amounts

are excluded because they either represent taxed funds or are exempt on other policy

grounds. Final withholding payments are excluded because withholding of tax from

these payments represents a final income tax liability under the third head of charge in

section 1(1).

63. Certain other amounts excluded in calculating income by section 16(3), 17(3), or 18(3)

are not reflected by exclusions in the other sections. The exclusive exclusions under

section 16(3) are relatively self-explanatory. The exclusive exclusion under section

17(3) is intended to give primacy to inclusion in calculating income from an

employment and that in section 18(3) to give primacy to inclusion in calculating income

from an employment or business.

Subdivision C: Exempt Amounts

64. Section 20 is the primary exemption provision in the Sample. Exemptions are kept to a

minimum and there are no particular industry concessions. Conventional wisdom

suggests that these types of concessions often cause more harm than good. Most of the

exemptions in section 20 are self-explanatory but a couple require some further

elaboration.

65. Section 20(1)(f) and (g) are related and can be dealt with together. The Sample

incorporates a relatively comprehensive income tax. While some academically

supported comprehensive definitions of income suggest that gifts should be included, in

practice countries predominantly do not tax gifts as income, except in limited

circumstances. Gifts are often taxed in practice under a gift, wealth, or inheritance tax.

The reasoning is that the income tax is targeted at wealth creation (value added) and not

the simple holding or transfer of assets, see further paragraphs 106 to 108. Consistent

with this theme, it is possible to include gifts in calculating income of the donee if a tax

deduction is granted to the donor. This approach seems to add unnecessary complexity

to an income tax and open up opportunities for income splitting.

66. Accordingly, the Sample exempts gifts (including on death) unless they are derived in

the course of an earning activity, see section 20(1)(f). Gifts from non-associated persons

are included in calculating income where derived in the course of an earning activity

because it is difficult to distinguish such gifts from the return from the activity in

question. Further, while gifts are generally not included in calculating income of the

donee, where the gift is of an asset, the donor will realise the asset. Typically, the donor

will be treated as deriving an amount from the realisation equal to the market value of

the asset, see section 94. This means that the donor may be treated as deriving a gain

from realisation or, in limited circumstances, a loss. Such a gain or loss may be included

or deducted in calculating the donor's income, i.e. as a result of the transactional basis

income tax, where the relevant asset is held as part of a business or investment.

67. Also exempted are amounts derived in respect of assets and liabilities held for personal

purposes that are not used in the production of gains and profits. Such amounts would

not be included in calculating income under Subdivision B in any case and so section

20(1)(g) is mainly by way of confirmation. This exemption is necessary for

administrative purposes, e.g. people are unlikely to retain records of the assets in

question.

68. Section 20(1)(h) exempts amounts derived by exempt organisations. The exemption

does not extend to amounts derived in conducting a business that is unrelated to the

organisation's exempt status. This limitation is needed in order to ensure that exempt

organisations do not compete in markets where they have a tax advantage over other

market participants. This would distort competition in the market. "Exempt

organisation" is defined in section 20(2). The types of organisations exempted must be

adjusted to local social values and the inclusions in the Sample are only by way of

example. The Sample grants the exempt status only where the organisation has obtained

a private ruling confirming its status and meets the requirements against providing

collateral benefits outlined in section 20(2)(c).

Subdivision D: Deductions

69. This Subdivision contains rules regarding the deductibility of amounts in calculating a

person's income. It begins with a general deduction provision and the rest of the

Subdivision proceeds to deal with some particular issues that might not be appropriately

dealt with by the general provision. As a general rule, no deductions are available in

calculating income from employment. This is because section 25(1) prohibits

deductions unless expressly allowed and none of the primary deduction provisions allow

deductions in calculating income from employment. This approach is adopted for two

reasons. Firstly, payments for work performed in the course of employment usually

represent pure payments for the provision of labour and this is a form of wealth created

(value added). By contrast, many payments in the course of conducting a business or

investment represent payments for the transfer of wealth and not wealth created through

the provision of capital. Therefore, deductions are primarily available in calculating

income from a business or investment to ensure that transfers of wealth are not taxed.

This reasoning does not apply in the case of income from employment. Secondly, as

mentioned above at paragraph 18, a lack of deductions in calculating income from

employment means that in many cases the wage withholding tax may serve as a final

tax.

General Deduction Provision

70. Section 25 is divided into two main parts, the first is a provision denying deductions and

the second is a provision allowing deductions. Section 25(1) overrides all other

provisions of the Sample in providing that certain amounts are not deductible. The

broad residual category is that no deduction is allowed unless expressly provided for by

the Sample. The effect of this is to override any deduction that might otherwise be

available by reason of the general formula of income from an employment, business, or

investment being based on remuneration or gains and profits, as the case requires.

"Consumption costs" and "excluded costs" are not deductible in any case, even if the

costs would otherwise be treated as deductible by another provision. These terms are

defined in section 25(4).

71. As the name suggests, "consumption costs" are essentially costs that are considered to

represent consumption by an individual and, therefore, that should not reduce income.

The classic examples of these costs are set out in paragraph (a) of the definition, i.e.

costs with respect to shelter, food, leisure, commuting, clothing, and education. A clear

distinction between costs that represent personal consumption and those that are

incurred in deriving income is difficult, if not impossible, to make or apportion. Again

the Sample takes the approach of outlining some general principles that must be adapted

to particular circumstances and may appropriately be the subject of practice notes issued

by the tax administration.

72. Paragraph (a) of the definition of "consumption costs" deals with costs incurred by

individuals in respect of themselves whereas paragraph (b) deals with costs incurred by

another person in respect of an individual. In the case of paragraph (b) the provision of

shelter, food, leisure, commuting, clothing, or education by a person to an individual

will constitute a payment by the person to the individual, see the definition of "payment"

in section 41(1). The issue becomes whether the person may claim a deduction for costs

incurred in making the payment to the individual. No deduction will be allowed for

such costs unless one of the conditions of paragraph (b)(i), (ii), or (iii) of the definition

are met.

73. The first of these conditions is that the payment is included in calculating the

individual's income. Whether or not the payment is included in calculating the

individual's income will depend on whether the payment is sufficiently connected with

an earning activity of the individual for the purposes of sections 16, 17, and 18. For

example, assume that an employer provides an employee with a payment in the form of

a fringe benefit. If the fringe benefit is not included in calculating the employee's

income, e.g. the provision of in-house meals and refreshments referred to in section

16(3)(b), generally no deduction will be allowed to the employer for costs incurred in

making the payment, e.g. the costs of the food and any help in serving the meals. In

other words, the costs incurred by the employer in making the provision to the employee

represent consumption by the employee. If the payment is included in calculating the

employee's income then whether or not a deduction is available for costs incurred by the

employer in making the payment depends on whether the costs are deductible under

another provision such as section 25(2).

74. The second condition that excludes costs incurred in making a payment to an individual

from the definition of "consumption costs" is where the individual provides market

value consideration for the payment. So, for example, costs incurred in providing a

meal at a restaurant will be deductible by the restaurant owner if individuals to whom

meals are provided pay for them. Costs incurred in providing free meals to relatives

would not be deductible. This rule should not deny a deduction for costs incurred in

providing samples or prizes to individuals. In this case, by providing their services in

sampling or entering a competition, individuals may be considered to have provided

market value consideration through the provision of their services. Such costs may also

not be consumption costs by reason of paragraph (b)(iii) of the definition of

"consumption costs", which is relatively self-explanatory.

75. Deduction of "excluded costs" is also prohibited. This term includes costs incurred in

paying certain bribes, fines, and penalties. The policy here is to ensure that the effective

cost of bribes, fines, and penalties to the payer is not reduced by reason of deductibility.

"Excluded costs" also include those incurred in deriving exempt amounts and those

incurred by non-residents in deriving final withholding payments. In the latter case, this

is consistent with these payments being subject to a final withholding tax on the gross

amount of the payment. Costs incurred by residents in deriving final withholding

payments are not "excluded costs" and so deductions may be available for such costs.

The only types of final withholding payments that may be made to residents are

dividends, gains from investment insurance, and gains from unapproved retirement

interests paid by resident entities. In all these cases the final withholding tax represents

a second layer of tax on top of any tax levied on the distributing entity's income, see the

discussion above at paragraphs 28 and 29. If a deduction were denied for costs paid in

deriving this income, the inclusion of the costs in calculating the income of the recipient

of the costs and the taxation of this income might produce a third layer of tax with

respect to the same wealth created. This would be inconsistent with the theme of the

Sample.

76. Section 25(2) is the general provision allowing deductions in calculating income from a

business or investment for costs incurred in the production of the income. "Costs

incurred" is defined in section 41 in terms of making a payment or being obliged to

make a payment. In a similar fashion to the deriving of an amount, when a person

incurs a cost will depend on the method of tax accounting being used by the person, see

section 46. The words "to the extent" in section 25(2) provide for apportionment of

costs that are only partly incurred in the production of income. This phrase, or a similar

phrase, is used throughout the Sample where apportionment is available. Section 25(3)

proceeds to deny a deduction for certain costs. However, section 25(2) and (3) are

subject to the other express deduction provisions in the Sample. Further, section 25(2) is

expressly subject to section 25(3). Therefore, a deduction that may be allowed by

section 25(2) may be denied by another provision, including section 25(3). A deduction

that may be denied by section 25(3) may be allowed by another provision, but not

including section 25(2).

77. Under section 25(3) a deduction is denied for costs of a capital nature. This reflects an

Anglo-Saxon approach to income taxation. However, the definition of "costs of a

capital nature" in section 25(4) does not bear out the traditional capital/revenue

distinction. In particular, costs incurred in acquiring an asset are of a capital nature

where the useful life of the asset exceeds 12 months. The resultant non-deductibility of

such costs is ameliorated in two ways. With respect to costs incurred by a business or

investment in purchasing a wasting asset, the costs are effectively deductible over the

useful life of the asset by reason of the allowance for depreciation under section 31.

Secondly, if the asset is non-wasting, the costs are effectively deductible when the asset

is realised under the transactional basis income tax, i.e. in calculating any gain or loss

from the realisation of the asset under Division III.

78. Under section 25(3)(d) a deduction is denied for costs incurred on the realisation of a

liability. Again however, these costs will be effectively deductible in calculating any

gain or loss on the realisation, assuming the liability is owed by a business or

investment. Under section 25(3)(e) foreign income tax is not deductible. This is

because foreign tax offsets are provided under section 200. Under section 200(5), a

person may relinquish a foreign tax offset in favour of a deduction. In this case, a

deduction is not denied by section 25(3) because that section is expressly subject to Part

IV, which contains section 200(5).

Specific Deduction Provisions

79. Sections 26 to 33 in a sense override section 25(2) and (3) by either granting a deduction

that would be denied by the general deduction provision or denying a deduction

otherwise deductible under that provision. Section 26 is different from sections 27 to 33

in that it plugs into section 25(2). Its intention is to treat interest paid on funds borrowed

as incurred in the production of income where the funds are used in that production or

used to acquire an asset used in that production. Section 26 looks to the use to which the

borrowed funds are put and not the purpose for which the funds were borrowed. This

means that where the use of the funds changes so may the deductibility of interest

incurred with respect to the funds.

80. Section 27 requires some explanation. It is intended to address the tax base erosion

problem towards which thin capitalisation and similar provisions are directed. This

erosion results from controllers of an entity being able to remove funds from the entity

in a deductible form that is subject to less taxation than if the funds were removed from

the entity in the form of a distribution of profits. While this is a general tax design issue

and relates to the inherent fungibility of different types of payments, it is typically of

greatest concern with respect to non-resident controllers of resident entities. The typical

provisions adopted in this area, such as thin capitalisation rules, are either very

complicated, very arbitrary, or both. There appears no justification for repeating this

style of provision in a Sample income tax.

81. The tax base in issue is typically the source tax base and raises a classic issue for source

countries, particularly developing countries. The issue is the amount of tax that may be

levied on the basis of source without deterring foreign investment. There are at least

two source tax bases that may not result in such deterrence. The first is tax for which

foreign tax relief is available in the capital exporting country. As capital exporting

countries adopt many different methods of foreign tax relief this tax base is problematic,

particularly the complexity it involves for developing countries. The most likely tax that

will be granted foreign tax relief by capital exporting countries is a relatively low rate

direct tax. The Sample seeks to access this tax base by imposing a consistent 20 percent

final withholding tax on potentially deductible payments by resident entities to non-

residents that essentially represent domestic wealth created. This tax may not always hit

the mark in securing foreign tax relief in a capital exporting country, e.g. where the

foreign investor is tax exempt in that country. It may also be sacrificed to some extent

in negotiating double tax treaties. Again, the level of this withholding tax must be

adjusted to local considerations.

82. In principle, the second relatively secure tax base available to source countries is

economic rents derived by non-residents from the source country. The taxation of

economic rents may not deter foreign investment as the source country is only taxing the

amount above what can generally be secured elsewhere. Indeed, there seems strong

justification for taxing abnormal returns derived by non-residents, which at some level

represent exploitation of the source country's markets and resources. The primary

benefits from these markets and resources should go to the local society.

83. Section 27 is a relatively simple rule directed towards securing this second tax base. As

with other provisions of the Sample, it is just one example of an approach to address a

particular problem and must be adjusted to local considerations. It places a cap on the

total amount of deductions that a person can claim for certain payments that are subject

to final withholding tax, referred to as "investment final withholding payments". This

phrase is defined in section 222 to cover payments of interest, natural resource

payments, rents, and royalties to non-residents. It may also include payments of wages

or service fees to a non-resident that is associated with the payer. A deduction may be

claimed for these types of payments cumulatively during the year until the relevant

threshold is reached, at which stage a deduction is denied for any further payments of

these types.

84. The threshold is calculated by reference to the formula in section 27(1). In order to

identify economic rents it is necessary to deduct a standard rate of return. The standard

rate identified in the Sample is the statutory interest rate, i.e. the general rate applied

throughout the Sample to calculate things like interest on outstanding tax. It is viewed

as in the low range and particular countries may use a higher rate. The rate is applied to

the "gross domestic value" of the business or investment at the start of the year or an

average value over the year may be used on notice by the tax administration, e.g. in

cases of suspected abuse. This value is defined in section 27(2) by reference to the book

value of assets, determined gross of liabilities and according to generally accepted

accounting principles.

85. As in the case of other thin capitalisation type rules, the rule in section 27 raises issues as

to whether it is permitted by international norms. One issue is whether it is contrary to

Article 24(4) of the OECD Model. This provision requires "interest, royalties and other

disbursements" by a resident of one country to a resident of the treaty partner to be

deductible "under the same conditions" as if paid to a resident of the one country. It is

arguable that, in the context of section 27, a payment to a resident that is not subject to

final withholding tax and one to a non-resident that is subject to final withholding tax are

not paid "under the same conditions". In order to enable non-residents to put themselves

under the same conditions as residents, section 222(3) enables non-residents to elect that

a payment that would otherwise be a final withholding payment is not a final

withholding payment. In this case, the non-resident would be taxed by assessment.

Therefore, it appears section 27 does not breach Article 24(4). In any case, Article 24(4)

is subject to Article 17(1), which may secure the operation of Section 27 in the context

of payments to foreign associated persons, the predominant situation in which it is likely

to apply. Further, Article 24(4) is often suppressed in double tax treaties.

86. Another issue is whether income tax levied as a result of the denial of a deduction under

section 27 is available for foreign tax relief in capital exporting countries. While this

issue must be investigated on a country-by-country basis, it does seem that the denial of

this deduction, just like that under more conventional thin capitalisation rules, would not

change the nature of the tax. In any case, even if a particular capital exporting country

denied foreign tax relief for this tax, it may be that the foreign investor could engage in

self-help. The threshold is only likely to be breached with respect to payments made to

a foreign associate of the resident entity. In this case, it would appear appropriate for the

resident entity to change the nature of the relevant payments to distributions of profits to

the foreign associate. As a distribution of profits, the payments will not be deductible

and will be subject to a final withholding tax or branch profits tax. In essence, the

excessive payments will be subject to the same tax treatment by the source country

irrespective of whether they take the form of a non-deductible payment under section 27

or a distribution of profits. Where characterised as a distribution of profits, the tax

underlying the distribution (representing a denial of a deduction for the payment) should

be granted foreign tax relief by capital exporting countries.

87. Section 28, dealing with trading stock, is more straightforward. The terminology used in

this section is heavily integrated with Division III dealing with assets and liabilities.

Essentially, section 28 grants a deductible allowance for the cost of trading stock

disposed of during a tax year but otherwise denies a deduction for the cost of trading

stock. The combined effect of this section and section 17(2)(b), which includes amounts

derived in respect of trading stock directly in calculating income, is consistent with that

under the transactional basis income tax with respect to other assets under Division III.

The issue of identifying the cost of trading stock at the end of a tax year and, thereby, the

cost of trading stock disposed of during the year is determined under section 80 and

discussed further below, see paragraphs 163 and 164.

88. The approach to repair and improvement costs in section 29 requires some explanation.

Many income taxes grant an immediate deduction for costs incurred in repairing

depreciable assets but require depreciation of costs incurred in improving depreciable

assets. However, the distinction between a repair and an improvement is notoriously

difficult to determine. Section 29 ignores this distinction by granting a limited

deduction for costs incurred in the repair or improvement of depreciable assets. The

deduction available with respect to all assets in a particular pool of depreciable assets is

limited to 5 percent of the written down value of the pool at the end of the tax year in

question. Any cost that is not deductible is added to the depreciation basis of the pool

and will be depreciated. Pools of depreciable assets are discussed below at paragraphs

175 to 183.

89. Section 30 provides a deduction for certain research and development costs. In the

absence of section 30, these costs might not be deductible under section 25(2), e.g.

because they are of a capital nature or not incurred in producing income. This provision

does not grant an immediate deduction for costs that are incurred in the acquisition or

improvement of an asset. Such costs are dealt with under the general provisions

applicable to costs of that type. Section 30 only grants a deduction for research and

development costs that are not directly connected with an asset.

90. Depreciation allowances are deductible under Section 31 and are discussed below in the

context of Subdivision B of Division III at paragraphs 175 to 183.

91. Section 32 deals with the deductibility of losses on the realisation of business and

investment assets and liabilities. It is the counterpart of sections 17(2)(c) and 18(2)(b),

which include gains on such a realisation in calculating income from a business or

investment. Under section 32(1), losses on the realisation of business assets and

liabilities are essentially fully deductible. This treatment is more in keeping with a

Continental European approach to income tax than an Anglo-Saxon approach under

which capital losses are generally quarantined and only permitted to be deducted against

capital gains. Losses on the realisation of investment assets and liabilities are treated in

the same manner.

92. Section 33(1) is the primary provision that controls the use of losses from one earning

activity to reduce income from another earning activity. The general approach is that

any loss from a business for a tax year may reduce any other income from a different

business or investment for the same year but not income from an employment. Any

excess business loss may be carried forward to reduce income from any business or

investment of a future tax year, i.e. unlimited carry-forward. Section 33(2) essentially

provides for the quarantining of certain losses. Losses from an investment are treated in

the same manner as losses from a business except that they may only reduce income

from an investment. Further, foreign losses sourced in a particular country may only

reduce foreign income sourced in the same country. The source of income or a loss is

determined in accordance with section 68, discussed below at paragraphs 140 to 146.

These two quarantining rules are cumulative. The reason for this approach to

quarantining was discussed above at paragraphs 35 to 39 and its content should be

adjusted to local considerations.

93. Section 33(1)(c) specifically allows a person to use, by way of transfer, an unrelieved

loss of an associate where the requirements in section 33(3) are met. A transferred loss

does not become a loss of the transferee and once transferred is no longer an “unrelieved

loss” of the associate transferor, see the definition of that phrase in section 33(8). The

requirements in section 33(3) need further explanation. Firstly, one of the parties to the

transfer must be an entity and neither a partnership. The transfer of losses to or from an

entity enables the transfer of tax attributes. The reasons for permitting this were

discussed above at paragraph 42. Secondly, the transferor and the transferee must be

residents from the time the loss is incurred until it is transferred. This requirement seeks

to protect the tax administration against bogus claims where the administration may

have difficulty in substantiating a transfer claim. Where substantiation is not an issue,

e.g. where there is good exchange of information under a double tax treaty, this

requirement may be relaxed.

94. Section 33(3) also requires common underlying ownership of at least 50 percent

between the transferor and the transferee of a loss. The justification for transfer where

there is 100 percent common underlying ownership is strong, i.e. the difference of

identity between the transferor and the transferee is only a matter of form and not

economic substance. Where the required level of common underlying ownership is less,

there is potential for tax arbitrage. This level is also discussed below in the context of

the non-recognition treatment of transfers of assets and liabilities under section 94, see

paragraph 192. Section 94 may permit the transfer of unrealised losses on assets and

liabilities between associates. It is, therefore, important that the requirements for

transfer of realised losses under section 33(1)(c) are similar to those for the transfer of

unrealised losses under section 94. The level of common underlying ownership required

by section 33(3)(b)(ii) is relatively low. This level and the general availability of

transfer of tax attributes under rules such as those in sections 33(1)(c) and 94 should be

adjusted to local considerations. However, where one or both of these rules are adopted,

broad value shifting rules such as those in sections 173 and 174 are of added importance.

These are the primary rules that seek to prevent tax arbitrage through the use of sections

33(1)(c) and 94.

95. Under section 33(3)(c), a loss may only be transferred to the extent that it can be used

immediately by the transferee. Therefore, a loss cannot be transferred such that it is

available for carry-forward by the transferee under section 33. If this were otherwise,

the common underlying ownership rule would have to be extended to the time at which

the transferee uses the loss. Finally, section 33(3)(d) requires a written transfer. Further,

for reasons of administrative certainty, the transfer must occur by the time for filing the

relevant return of income.

96. Section 33(4) and (5) specifically pertain to losses incurred under long-term contracts

and are further discussed below at paragraph 125. Section 33(6) is a specific anti-

avoidance rule. Generally, non-residents are not required to withhold tax from

payments with a domestic source under Subdivision A of Division II of Part V.

However, under section 213 non-residents may elect to bring themselves within the

withholding obligations for a tax year. Where those withholding obligations are

complied with then, as mentioned above at paragraph 85, the non-resident may further

elect that what would otherwise be final withholding payments derived by the non-

resident during the year are not final withholding payments. This election would entitle

the non-resident to claim deductions and be taxed by assessment instead of final

withholding tax. Section 33(6) is designed to prevent non-residents abusing these

elections by, e.g. incurring domestic source deductions in election years and not making

elections in years in which domestic source amounts are derived.

Division II: Rules Governing Amounts Used in Calculating the Income Tax Base

97. As mentioned at paragraph 33, this Division deals with issues of timing the recognition

of amounts used in calculating the income tax base, quantifying and characterising these

amounts, and allocating them to particular persons. It begins with a subdivision devoted

to some concepts that are important for the entire Sample but that are particularly central

to the rules contained in the following subdivisions.

Subdivision A: Central Concepts

98. The first central concept dealt with in this Subdivision is the period by reference to

which income tax is calculated. This period is referred to as the "tax year". The

simplest approach to identifying this period is to require all persons to use the same tax

year. However, this approach is inflexible and some persons have legitimate reasons for

requesting the use of a non-standard tax year. The typical reason of most substance

involves an entity that is part of an international group where the tax accounting of the

group may be performed more accurately and efficiently if it is performed according to a

common period. Nevertheless, permitting persons to adopt a non-standard tax year adds

to the complexity of an income tax and has the potential to open opportunities for tax

reduction or deferral. Again, whether this type of permission should be available must

be determined according to local considerations.

99. Section 40 provides a relatively simple example of permitting certain persons to adopt a

non-standard tax year. The general rule is that all persons must use the calendar year as

their tax year. The tax administration is empowered to approve an application to

substitute this tax year in particular cases. This power is broad and may be subject to

conditions. Further, the permission may be revoked by the tax administration and there

are no express prerequisite conditions as to when the power of revocation may be used.

The reason for limiting the use of non-standard tax years in this manner is, as mentioned

above in the last paragraph, the potential for tax reduction or deferral. Tax reduction

may be an issue where tax rates change, particularly if the change takes effect from the

start of a tax year, e.g. tax years beginning after the change. One manner to address the

problem of tax rate changes and non-standard tax years is to ensure that the change takes

effect from a particular date. Where this date falls within the middle of a tax year of a

particular person, the person could be required to calculate their income separately for

the part of the year falling before the change and the part after the change. Alternately,

income for the entire year may be apportioned according to the part of the year falling

before and after the change. Neither option is ideal as the first increases compliance

costs and the second may prove somewhat arbitrary.

100. Tax deferral through the use of non-standard tax years may be direct or indirect.

Deferral will be direct if the tax payment procedure is fixed by reference to the standard

tax year. For example, the tax instalment system and return and assessment procedures

will not apply appropriately to persons using a non-standard tax year if they are timed

for the standard tax year. For this reason it is essential that, if non-standard tax years are

permitted, the tax payment procedure is timed differently for each person depending on

their particular tax year. This means that different persons will have different dates for

making instalment payments, filing returns, and making final tax payments. This is the

approach taken in the Sample. However, this approach does raise tax administration

issues. On the one hand, this approach may create difficulties for the tax administration

in auditing compliance. On the other hand, it also has the potential to enable the tax

administration to spread its workload over the standard tax year. Again, this is an issue

for local consideration. However, if the view is taken that the tax payment procedure

must run according to a uniform timetable, it is better if non-standard tax years are not

permitted.

101. Tax deferral may be indirect where an entity is taxed on a pass through basis and the

entity and its owners have different tax years. This is the treatment of partnerships,

resident's foreign branches, and potentially trusts under the Sample. All entities are

required to calculate their income separately from their owners. If the entity's income

(or loss) is only allocated at the end of the entity's tax year, the usual approach, and its

owners have a tax year ending after that of the entity, there is the potential for tax

deferral. This potential deferral may be largely addressed by requiring the entity to pay

instalments of tax during its tax year. This is the approach adopted under the Sample

with trusts.

102. By contrast, in the case of partnerships and resident's foreign branches, the Sample

requires the partners or the owner to pay tax rather than the entity. The potential for

deferral is addressed in the case of resident's foreign branches by requiring the branch to

have the same tax year as its owner. This option is not possible in the case of

partnerships because the partners themselves may have different tax years. It would be

possible to require partnerships to pay instalments of tax in the same manner as trusts.

However, given the potentially small size of partnerships and that the income of

individual partners may be taxed at the lower end of the individual tax rate scale, this

option is not ideal. It would also be possible to only require certain partnerships to pay

instalments, e.g. partnerships other than those where the partnership and all partners

have the same tax year. This would create greater complexity. The Sample does not

directly address this issue of potential tax deferral in the case of partnerships other than

through general powers given to the tax administration including the power to revoke

the use of a non-standard tax year.

103. Section 41 includes definitions of three terms that in many ways form the backbone

of the Sample. These terms have been discussed in part above at paragraphs 53, 55, and

76. The key building blocks to the income tax base are payments, whether they are

made, obliged to be made, received, or entitled to be received. "Payment" is defined in

section 41(1) and is intended to reflect all manners in which a financial benefit or

satisfaction may be directly conferred on a person and should cover all forms of fringe

benefits. It is, therefore, broader than the conventional meaning of the term "payment"

and, perhaps, closer to conferring wealth on another person.

104. The definition of "payment" has a number of heads the first of which requires a

direct reduction of the payer's assets or increase of the payer's liabilities by way of

transfer. The second head of payment involves the creation of assets in the payee, e.g.

the granting of a lease or option. It also covers the decrease of liabilities of the payee,

e.g. the forgiveness of a debt or release of a guarantee, lease, or option. The third head

of payment involves the provision of services and the fourth the use or availability for

use of an asset owned by another. This means, e.g. that the provision by an employer of

a driver, gardener, or the use of a car to an employee will constitute a payment to the

employee. As these forms of payment may be continuous over a period of time, section

41(2) contains rules to divide these payments so that the payer and payee may

appropriately account for them with respect to particular tax years.

105. As mentioned above at paragraphs 55 and 76, the phrases "amount derived" and

"cost incurred" are variations of the concept of payment that focus on tax accounting

under the Sample. That is, the timing of when an amount is derived or a cost is incurred

depends on whether the person in question accounts on a cash or accrual basis. In

particular, a person may derive an amount on an accrual basis where the person is

entitled to the amount or incur a cost where the person is obliged to make a payment

provided the other requirements of section 48(2) and (3) are met. This is why the

definitions of “amount derived” and “cost incurred” incorporate references to

entitlement to a payment and an obligation to make a payment, respectively.

106. The definition of "cost incurred" requires some further comment. It is limited to

"payments" under the first head of that term, i.e. those involving a transfer causing a

direct reduction of the payer's assets or increase of the payer's liabilities. As mentioned

above at paragraph 65, in principle an income tax is targeted at creation of wealth or

value added and not transfers of assets. Arguably, wealth is constituted by anything that

a person is willing to pay for, i.e. has the potential to provide human satisfactions. An

asset is like a store of future human satisfactions. On this view, the primary forms of

wealth creation (the creation of human satisfactions or value added) are through human

labour and the use of assets. Transfer of an asset is not a creation of wealth. Wealth of a

person may also be created through an increase in the value of the person’s assets but

equally it may be lost through a decrease in value of those assets. Any net increase in

the value of all assets of a country (capital gains) will typically form a small part of an

income tax base by comparison to creations of wealth through human labour and the use

of assets. Most increases in the value of assets that are recognised under an income tax

only represent a relative change in prices that are offset by decreases in the value of

other assets.

107. The distinction between earning activities and leisure (or consumption) means that

wealth creation is typically only recognised under an income tax where it occurs in the

course of an earning activity. Further, the realisations criterion means that creations of

wealth (value added) are only recognised where they are paid for by a person other than

the person creating the wealth or holding the asset creating the wealth. Assume a market

scenario in which all payments to and by a person are balanced by a return payment by

or to the person of an equal value. In this case, the value of a payment to a person for

wealth created will equal the value of the wealth. Further, all wealth obtained (payments

received) by a person less divestitures of assets by the person should approximate wealth

created by the person. Therefore, a simple definition of the "payments" income tax base,

which is typically the primary income tax base, of a person for a particular time period

involves-

(i) all wealth obtained (payments derived) by the person during the period in

conducting an earning activity, less

(ii) all assets divested of the person during the period in conducting an earning activity.

108. The first limb of the definition conforms to the basic approach under the Sample of

including in calculating income all payments derived in the course of an earning activity.

In order to approximate just wealth created by the person assets divested of the person

are deducted under the second limb. It is towards this end that costs incurred in

conducting a business or investment are deductible. It also means that the definition of

"costs incurred" is limited to "payments" under the first head of that term, i.e. those

involving transfer causing a direct reduction of the payer's assets or increase of the

payer's liabilities. Head three and four payments made by the person represent the

creation of wealth, i.e. the primary base towards which the income tax is targeted, and a

deduction is not appropriate. Head two payments made by a person do not represent a

divestiture by the person and so do not meet the realisations criterion, even if they result

in a reduction in value of the person’s net assets. Of course, these basic rules in the

Sample are supplemented by many complex rules to account for liabilities, capital gains,

timing issues, and the market value and arm's length principles.

109. Section 41(5) contains what is commonly referred to as the claim of right doctrine.

It is essentially an elaboration of when a person is considered entitled to or obliged to

make a payment. As mentioned above at paragraph 105, this is important for

determining when an amount is derived or a cost is incurred where the person in

question is accounting on an accrual basis. A person is treated as entitled to receive or

obliged to make a payment if the person claims to be legally so entitled or obliged, even

if the person is under a misconception.

110. Section 42 causes the rules in Division II to apply to amounts recognised on a

transactional basis under Division III. As mentioned previously at paragraph 34, under

an Anglo-Saxon approach “capital” payments are not directly recognised under the

income tax but, rather, are used in calculating gains and losses on the realisation of

assets and liabilities, i.e. they are recognised under the transactional basis income tax. In

essence the issue is one of event giving rise to recognition, i.e. a payment or the

completion of a transaction (realisation of an asset or liability). Therefore, it seems

appropriate that the same timing, quantification, allocation, and characterisation rules

apply to all amounts used in calculating income irrespective of whether their recognition

is directly on a payments basis or indirectly on a transactional basis.

Subdivision B: Timing of Amounts

111. This Subdivision contains the central timing provisions in the Sample. It begins in

section 45 by outlining the time at which the central concept of a payment is made and

received. This timing is determined by reference to the activity giving rise to the

payment. Importantly, the timing of a payment is not affected by tax accounting rules,

i.e. whether a person is accounting on a cash or accrual basis. By contrast, section 46

deals with when an amount is derived or a cost is incurred and, as mentioned above at

paragraph 105, this is affected by the method of tax accounting used. The Sample is

particular throughout in the use of these concepts of payments made and received,

amounts derived, and costs incurred. For example, inclusions and deductions in

calculating income from a business or investment use the concepts amounts derived and

costs incurred and so tax accounting is important. By contrast, the obligations to

withhold tax from certain payments under Division II of Part V use the concept of

payment made and so the tax accounting method of the payer is irrelevant.

112. Section 46 recognises the cash and accrual methods of tax accounting. It specifies

use of these methods along conventional lines, e.g. the cash method is to be used by

employees and the accrual method by companies. Otherwise and subject to adjustment

by the tax administration, a person may choose their method of tax accounting. A

person should use the method that best reflects the person’s gains and profits. Which

method is most appropriate for a particular person will depend on the person’s

circumstances and this is another area in which it may be appropriate for the tax

administration to issue practice notes.

113. Sections 47 and 48 outline the content of the cash and accrual methods. The timing

of amounts derived and costs incurred under the cash method is primarily aligned with

the timing of the underlying payment. By contrast, under the accrual method the timing

of amounts derived and costs incurred is typically an issue of entitlement to the

underlying payment or an obligation to make the underlying payment. However, the

entitlement or obligation is not of itself sufficient for recognition that an amount is

derived or a cost incurred under the accrual method. The amount of the underlying

payment must be able to be determined with reasonable accuracy and there must be

what is sometimes referred to as economic performance for the underlying payment.

This means that where the underlying payment is to be made or received in return for

another payment, the underlying payment is only incurred or derived to the extent the

other payment has been made. This is an example where the tax accounting method of

the person making or receiving the other payment is irrelevant, there must be actual

payment. For example, assume that a person sells trading stock to another person in

return for cash. On the signing of the contract the purchaser will be entitled to the

trading stock and obliged to make the cash payment and the vendor will have the

opposite entitlement and obligation. However, the vendor will not derive the cash and

the purchaser will not incur the cost of the cash payment under the accrual method until

either the trading stock is transferred or the cash payment is made.

114. In the case where a particular payment is made between two persons accounting for

tax on different bases, the intended recipient may derive the payment at a different time

than the payer incurs the payment. Where the deriving is recognised for tax purposes

after the incurring, there is the potential for tax deferral. Section 48(4) is directed

towards tax arbitrage in this area of timing. Tax arbitrage of this type is only possible

where different persons are able to use different methods of tax accounting.

115. Under section 48(2) and (3) an amount derived or cost incurred may only be

recognised before the actual underlying payment is made where the amount of the

payment can be determined with reasonable accuracy. If this requirement is met, the

amount derived or cost incurred will be quantified by the rules under Subdivision C.

Despite this cautious approach, it is possible that the actual underlying payment, when

made, will be quantified by those rules in a different amount. A classic example of this

problem is where an amount of foreign currency is considered derived or incurred before

payment and by the time the actual payment is made the exchange rate of the foreign

currency with the domestic currency has changed. In this case, the rules in Subdivision

C will ascribe a different quantity to the payment at the time it is derived or incurred

compared with the quantity at the time the payment is made. If the inaccurate earlier

amount is recognised for tax purposes, it is appropriate to make an adjustment at the

time of payment to ensure that the person’s income is accurately calculated. Section

48(5) requires these adjustments.

116. Section 48(6) to (8) detail the adjustments required under section 48(5). These

adjustments vary depending on the type of payment in question, the manner in which it

is recognised for tax purposes, and whether the activities that gave rise to the early

recognition on an accrual basis continue at the time the adjustment is required. The

adjustments in section 48(6) to (8) are rather complex and in particular cases it may be

appropriate to move them to the regulations or use a more general formula.

117. Section 49 deals with an issue that is in some ways similar to that dealt with in

section 48(5). Section 48(5) provides for adjustments for quantification inaccuracies

that directly result from use of the accrual method of tax accounting. By contrast,

section 49 provides for adjustments for inaccuracies that result from recognition of

amounts that, in hindsight, should not have been recognised or that have been reversed.

In particular, it covers payments that have been refunded or recovered. It does not

directly cover compensation payments, which are dealt with in section 66 and typically

do not involve an intention to reverse or refund a previous payment but, rather, to

mitigate the economic effects of a loss.

118. Section 49 also covers a number of inaccuracies that occur under accrual basis

accounting but that are not directly caused by it. These involve recognitions that require

reversal rather than adjustment in the quantity recognised, the latter being covered by

section 48(5). As a result of the claim of right doctrine contained in section 41(5), a

person may recognise an amount as derived or incurred because the person claims to be

legally entitled to receive the amount or obliged to pay the amount. Section 49 provides

adjustments where the person subsequently, but prior to receipt or payment, disclaims

the entitlement or obligation. In many cases, a person may not want to disclaim an

entitlement to receive a payment even though it is unlikely that the payment will ever be

received, e.g. where the payment right has gone bad. The right to a payment is included

in the definition of “debt claim” in section 76. Accordingly, disclaiming the right to a

payment will amount to a forgiveness of debt. Instead of requiring a person to forgive a

debt in order to make an adjustment, section 49 permits a person to make an adjustment

where the person writes off a debt as bad.

119. Section 49(2) places restrictions on a person’s right to disclaim entitlement to an

amount or write off a debt as bad. This is because the adjustments on disclaimer or

writing off will often provide a reduction in income of the person in question. The

manner in which financial institutions write off bad debts is often governed by

prudential regulation. Section 49(2)(a) adopts this procedure in order to provide

consistency. However, countries should consider whether their local prudential

regulations are too liberal in this regard and expose the tax base to erosion. Other cases

are covered by section 49(2)(b), which substantially limits the circumstances in which a

person may make a disclaimer or write off.

120. Section 49(3) details the adjustments required under section 49(1). These

adjustments are similar to those required under section 48(5) but are somewhat simpler

because in this case there is a full opposite adjustment rather than a partial adjustment up

or down. If the rules in section 48(6) to (8) are relegated to regulations or otherwise

thought unnecessary, the rules in section 49(3) should be dealt with in a similar manner.

Section 49 and the accounting rules in sections 47 and 48 may be applied a number of

times with respect to a particular payment. For example, an expected payment (debt)

may be included in calculating income on an accrual basis and subsequently deducted

under section 49 if the debt is written off as bad. If the written off debt is subsequently

recovered, section 48 will apply a second time to require the amount to be included

again in calculating income.

121. Section 50 is targeted at a broader timing issue, the requirement that income be

calculated for fixed periods. A contract that spans more than one time period may be

structured such that deductible amounts disproportionately fall within early periods and

amounts to be included in calculating income disproportionately fall within later periods.

While in particular circumstances this situation may be viewed as appropriate, it also

gives rise to the potential that persons will collude in structuring contracts so as to

maximise tax deferral. This issue is similar to but not the same as the issue dealt with in

section 48(4). That provision is targeted at potential tax deferral through the use of

accrual basis accounting when compared with cash basis accounting. Section 50

addresses tax deferral under long-term contracts that may be available irrespective of the

method of tax accounting used. Section 48(4) may apply in many cases where section

50 does not, e.g. to short-term contracts and payments under long term-contracts that do

not breach the 80 percent rule in section 50 discussed in the next paragraph. Section 50

may apply in many cases where section 48(4) does not, e.g. to persons accounting on a

cash basis and those accounting on an accrual basis where that accounting, of itself, does

not present tax deferral over that available under the cash basis.

122. Where section 50 applies, the percentage of contract completed method is used to

determine when amounts are derived or costs incurred under the contract. The section

only applies to “long-term contracts” as defined in section 50(2). The definition has two

requirements. Firstly, the contract must have a duration of at least six months and span

more than one tax year. The six month period may be adjusted to suit local

considerations. Secondly, the contract must be either a construction or similar contract

or a "contract with a deferred return”. Contracts that constitute an interest in an entity,

or that are treated in a similar manner by the Sample, are excluded. “Contract with a

deferred return” is defined in negative terms in section 50(8). Essentially, it is a contract

under which the return is consistently 80 percent or less of that suggested by the

completed-contract method. If a party to a contract can show at least once every six

months that this test is not breached, the contract is not a contract with a deferred return

and section 50 does not apply to it. The section also applies to potential deferral under

contracts where an overall loss rather than a profit is expected.

123. “Percentage of contract completed” is defined in complex terms in section 50(8).

The method used to determine this percentage varies depending on the type of contract

in question. For example, deferred interest to be paid at the end of the term of a

debenture will be treated as derived by the holder proportionately over the term of the

debenture. Under a construction contract, amounts are treated as derived or incurred

proportionately to the percentage of total costs incurred. These and the other tests

provided to determine percentage completed should be adjusted to local considerations.

Further, these rules may be moved to the regulations.

124. A long-term contract will also constitute an asset or liability of the parties to the

contract and consideration must be given to the effect of section 50 where the contract is

transferred prior to its completion, i.e. under the transactional basis income tax. If

section 50 accelerates profits to be derived under the contract, the transferor may pay tax

with respect to profits that will be received by the transferee. The transferee will pay for

these potential profits in acquiring the contract with the result that the transferor may be

taxed a second time, i.e. with respect to any gain on the realisation of the contract. Any

double taxation may be temporary and removed once the contract expires and the

transferee effectively claims a deduction for the price paid for the contract. However, it

is a relatively simple matter to ensure that the double taxation does not arise in the first

place and this is achieved by the adjustments in section 50(6) and (7). These are similar

to adjustments made elsewhere in the Sample such as to the basis of a partner’s interest

in a partnership with respect to allocations of profits and distributions of the partnership,

see below at paragraphs 230 and 231.

125. Finally, as mentioned above at paragraph 96, where a loss is incurred or carried

forward at the end of a long-term contract, section 33(4) may permit the loss to be

carried back and set against any income from the contract of prior years (that has not

been reduced by other losses). This carry-back is provided to ensure that any

accelerated recognition of income as a result of section 50 does not work against the

person in question. That would happen if the operation of section 50 caused a loss in the

final years of the contract that, absent section 33(4), would only be available for carry

forward when overall the contract did not produce such a loss or produced a loss of a

lesser amount.

Subdivision C: Quantification of Amounts

126. This Subdivision contains the primary rules in the Sample for quantifying amounts

used in calculating income. The central provision is section 55, which incorporates rules

for quantifying a payment and through those rules quantifying an amount derived or cost

incurred. The general approach is to quantify payments by reference to market value.

This general approach may be inappropriate in a number of circumstances, e.g. where it

is difficult to determine the extent of a payment, there is no ready market value for the

payment, or the costs in determining a market value do not warrant its use. This may be

the case with the provision of a motor vehicle partly for private purposes. In these types

of circumstances more objective or arbitrary rules may be viewed as appropriate.

Another circumstance in which a market value rule may be inappropriate is with respect

to “unwanted” payments. A person may receive a payment that the person would not

acquire in the market place. This can be the case with many types of fringe benefits

provided to employees. In this type of case a more subjective valuation rule than the

market value rule may be considered appropriate.

127. Like many other areas of an income tax, valuation rules should be adjusted to local

considerations. The Sample adopts the basic market value rule but also applies

examples of some different types of rules to some typically difficult areas of valuation.

For example, section 55(1)(b) makes provision for more arbitrary rules in the case of the

provision of a motor vehicle for private purposes. The Sample does not outline any

rules in this regard but leaves them to be dealt with in the regulations, a common

practice. The content of these rules often varies from country to country. In the context

of employee fringe benefits, some countries use a percentage of wages, some use a flat

amount per car, and in others the amount of private use is the main factor. Section

55(1)(c) provides an example of quantifying a payment according to the costs incurred

by the payer in making the payment. This rule is more arbitrary than the market value

rule but may be appropriate in cases where the payer is unlikely to add any substantial

value to the payment over the costs incurred in making it.

128. In the case of loans at low interest rates, it may be difficult to determine what is the

appropriate market interest rate in order to determine the amount of payment made in

this form. As mentioned above at paragraph 84, the Sample identifies a statutory

interest rate that is likely to be on the conservative side. Section 55(1)(d) uses the

statutory rate to quantify the amount of a payment in the form of a low interest loan.

Many unwanted types of payments will take the form of the provision of services or the

use of an asset. With respect to residual payments of this kind, the Sample adopts a

more subjective approach in section 55(1)(e), valuing such payments by reference to a

“reasonable person in the position of the payee”. Often this will not be the market value

of the payment. A common example is fringe benefits provided to government

employees in developing countries. These can exceed the actual cash remuneration of

such employees and are of questionable value to many of these employees. In these

cases, a reasonable government employee may place a substantial discount on the

market value of a particular fringe benefit.

129. Section 56 is somewhat of a supplement to section 55. It may be argued that a

payment that cannot be transferred to another person or readily converted into cash has

no, or a very low, market value. Section 56 overrides this argument and ensures that

fringe benefits cannot easily be excluded from income of the recipient by placing

restrictions on transfer or conversion.

130. Section 57 requires all amounts used in calculating a person’s income to be

quantified in local currency. Where an amount is not quantified in local currency, it

must be converted at the time the amount is recognised for tax purposes. This approach

ensures that foreign currency gains and losses are included in calculating income. This

general rule can become onerous where a person is required to make numerous

calculations during a tax year, such as where a person holds a foreign currency bank

account and has many debits and credits during the year. In principle, each time an

amount is paid from or into the account there should be a conversion. Many countries

consider this approach too onerous and adopt some ameliorating rules. The Sample only

adopts limited relief in this regard. The tax administration may permit a person to use an

average exchange rate for conversions under section 57(3). Further, some relief may be

provided in the form of the order in which foreign currency is considered realised under

section 80(3), e.g. through the first-in-first-out or average-cost methods.

Subdivision D: Allocation of Income and Amounts

131. This Subdivision is concerned with the allocation of amounts to particular persons,

i.e. who is considered to derive or incur an amount. Again, the Subdivision begins in

section 60(1) with the central rule that a payment is made by the “payer” and made to or

received by the “payee”. “Payer” and “payee” are essentially identified by reference to

the definition of "payment” in section 41. Section 60(2) contains a rule targeted at

diverting the receipt of a payment. It gives the tax administration power to treat a person

diverting a payment as the payee or payer of the payment. For example, this power may

be used to collapse back-to-back arrangements. Under section 60(2), the tax

administration may also treat a payment as two separate payments, first to the intended

beneficiary of the payment and a separate payment by the beneficiary to the actual

payee. Section 60(2) may be used by the tax administration to prevent abuse or to relax

unintended effects of the Sample. For example, it may be used in cases of direct and

indirect value shifting involving independent parties, see discussion below at paragraphs

285 to 287. It might also be used to treat a person as making a payment to ensure that

the person receives the benefit of the payment. For example, retirement contributions

made by an employer directly to a retirement fund on behalf of an employee may be

treated as made by the employee to ensure that the employee can claim a reduction of

taxable income under section 191. A similar example is contributions by third parties to

the purchase price of an asset, which as a result of section 60(2) may be included in the

outgoings of the purchaser.

132. Section 61 provides for allocation of amounts included or deducted in calculating

income between persons holding an investment jointly. It only applies to investments

because two persons conducting business jointly will constitute a partnership, see the

definition of “partnership” in section 105. In this case, the inclusions and deductions

will be used to calculate partnership income and that income is allocated to the partners

under Subdivision B of Division II of Part III.

133. Transfer pricing also involves the allocation of amounts, but this time between

associated persons. Transfer pricing is dealt with under the Sample by section 62, which

applies to “arrangements” between associated persons. “Arrangement” is defined in

broad terms in section 345. In the case of such arrangements, the tax administration is

given power to allocate amounts to be included or deducted in calculating income

between the associated persons on an arm’s length basis. The provision does not go

further in suggesting how the arm’s length principle may be met in specific cases. This

is notoriously complex and may be appropriately dealt with in regulations or practice

notes.

134. Section 63 deals with an issue that is caused by progressive taxation. It is targeted at

arrangements that are commonly referred to as “income splitting”. Because different

persons are taxed at different rates, a person being taxed at a high rate may seek to have

some of their income allocated to a person taxed at a low rate. In many cases it will be

possible to tax the high rate person on any “kick-back” received from the low rate

person for the allocation of income. However, the “kick-back” may not always be

readily identifiable, especially in dealings between associated persons, or may take an

unrealised form, such as an increase in value of an asset held by the high rate person.

Where persons attempt to reduce income tax in this manner and the requisite intention is

present, the tax administration may adjust amounts to be included or deducted in

calculating income so as to negate the reduction. Unlike the transfer pricing provision in

section 62, this section is not limited to arrangements between associates and may apply

even where the arm’s length principle is respected.

Subdivision E: Characterisation of Amounts

135. The timing and quantity of an amount as well as its allocation to a particular person

may be considered characteristics of the amount. However, in the context of income

tax, a reference to, e.g. a payment being of a particular character is usually a reference to

it being of a particular form or type. It is not possible to list all the forms or types that a

payment may take. Some of the more important used in the Sample are annuities,

capital contributions, consumption costs, capital costs, distribution of profits, natural

resource payments, retirement contributions, retirement payments, repayments of

capital, royalties, service fees, and wages. Another manner in which an amount may be

characterised is according to its geographical source, i.e. whether the amount has a

domestic or foreign source. This Subdivision deals with characterisation in the sense of

the type or form and source of amounts used in calculating income.

136. Section 65 provides a general rule for characterising the type of a payment. The rule

is to generally respect the legal nature of the arrangement giving rise to the payment. It

is possible to adopt a substance or economic equivalence approach but this sort of

approach is typically difficult to implement and creates uncertainty and inconsistency

with characterisation under other areas of the law. A formal approach, such as the one

adopted in the Sample, is often viewed as open to abuse. This is not the case where

payments of differing characters are provided the same treatment under an income tax.

It is towards this end that, to take but one example, most forms of domestic returns on

capital to non-residents are subject to the same rate of final withholding tax. Where this

is not possible, e.g. with respect to the distinction between repayments of capital and

returns on capital, it is necessary to supplement the formal approach. This is necessary

to ensure consistency and that the income tax base is not open to substantial erosion

through the re-characterisation of payments.

137. Section 66 is the first supplementary rule of this type. It concerns compensation and

recovery payments. This provision is subject to section 49, which deals with the reverse

of certain amounts included or deducted in calculating income. Section 49 and its

relationship with section 66 were discussed above at paragraph 117. As mentioned,

unlike section 49, section 66 covers payments from third parties that compensate for or

represent the recovery of certain losses incurred by a person. It also covers payments for

the loss of expected income and the loss in value of an asset. Section 66 does not re-

characterise compensation payments according to the amount compensated for. Rather,

it treats compensation payments in the manner they would have been treated if they

were so re-characterised. For example, compensation for a deductible cost or lost

income will be included in calculating income. This treatment is provided for in section

66(2), which is similar to the inclusive limbs of section 49(3), i.e. section 49(3)(b), (d),

and (f). If the rules in section 48(6) to (8) and 49(3) are relegated to regulations or

otherwise thought unnecessary, the rules in section 66(2) should be dealt with in a

similar manner.

138. In contrast to section 66, section 67 actually re-characterises payments under

annuities, instalment sales, and finance leases as interest and a repayment of capital paid

on a blended loan. This is to ensure similar treatment between these substitutable forms

of financing. Without this re-characterisation rule, payments under annuities may be

considered to have purely an income character, i.e. involve no repayment of capital. By

contrast, payments under instalment sales may be viewed as having purely a capital

character. Payments under finance leases would be treated as the payment of rent or

royalties with no part being treated as a capital payment despite substantial equivalence

between a finance lease and an instalment sale. “Annuity”, “blended loan”, “finance

lease”, and “instalment sale” are all defined in section 67(5). Countries with currencies

particularly susceptible to devaluation may also consider re-characterising foreign

currency losses on the repayment of a foreign currency loan as interest. These losses

represent an interest equivalent to borrowing in local currency. Without re-

characterisation, there may be a disincentive to borrowing in local currency. This will

particularly be the case if foreign currency losses are deductible. In this case,

withholding tax on interest paid to a non-resident lender will be less if the borrowing is

in a strong foreign currency than if it is in local currency.

139. The definition of “finance lease" requires some further comment. Finance leases are

treated as sales under the Sample, see section 77(3) and (4). Therefore, the definition of

“finance lease” is intended to provide a list of tests where a lease may be considered

essentially equivalent to a sale and, therefore, justify the treatment as a sale. As this

equivalence is a grey area and one that is often utilised by tax planners, the definition is

necessarily somewhat arbitrary and therefore could be adjusted to local considerations.

140. Section 68 is the central sourcing provision. It provides rules for determining not

only the source of income but also losses, amounts included or deducted in calculating

income, and payments. The source of income and losses are determined separately for

each earning activity of a person by reference to the source of amounts included and

deducted in calculating income from the activity. So, for example, income from a

business with a domestic source is determined as the excess of amounts included in

calculating the income with a domestic source over amounts deducted in that calculation

with a domestic source. By contrast, many countries adopt a matching approach under

which the source of income is primarily determined as amounts included in calculating

income with a domestic source less deductible amounts that are attributable to the

inclusions, irrespective of the source of the deductible amounts. This approach is

rejected as it exposes the tax base to potential erosion. This requires some further

explanation.

141. As mentioned above at paragraphs 106 to 108, the income tax is primarily targeted

at wealth creation or value added. In the context of domestic persons, the income tax

seeks to track payments from person to person in order to identify any person by whom

or in whose hands value is added and tax that person with respect to the addition. This is

achieved though the netting of an intricate set of inclusions and deductions. For

example, through a deduction for interest paid on a loan used in conducting a business,

part of the apparent value added by a business will be allocated to the lender. Part of

this value added allocated to the lender may be further allocated to other persons where

the lender claims deductions. The overall system is to tax in full the net value added

within a particular economy. However, if a deduction is granted against domestic value

added for payments that are made outside the domestic jurisdiction, the whole of the

domestic value added may not be taxed. So to allow amounts with a foreign source to

be deducted in calculating domestic source income exposes the source income tax base

to substantial erosion. Many developing countries experience this sort of tax base

erosion by domestic activities claiming deductions for amounts paid outside the country

that are not subject to withholding tax by the developing country.

142. The approach under section 68 seeks to remedy this situation by only allowing a

deduction in calculating domestic source income for amounts that have a domestic

source. In particular, payments that have a domestic source (for which a deduction is

claimed) will typically be included in calculating the domestic source income of the

payee or may otherwise be taxable, at least by way of final withholding tax. The

resulting security of the tax base should ensure that the source tax base includes most all

value added domestically. It should also assist in minimising "double dipping" whereby

a person claims a deduction for a cost against the source tax bases of more than one

country. In any case, if the allowance of deductions is viewed in terms of a negative

inclusion in calculating income, it appears anomalous that positive inclusions with a

foreign source are not included in calculating domestic source income whereas negative

inclusions with a foreign source may be so included. The approach in the Sample

removes this anomaly.

143. Gains, losses, and allowances accounted for in calculating income are generally

considered to have a domestic source where a "domestic asset" or "domestic liability" is

involved. These terms are defined in sections 76 and 78, respectively, by reference to

assets or liabilities held by resident persons. A branch that is situated in a country that is

not the country of residence of its owner is treated as a separate person under the

Sample, see section 105, and if situated domestically will be a resident person, see the

discussion below at paragraph 212. Therefore, domestic assets and liabilities are

essentially those held by domestic branches as well as assets and liabilities held by

residents other than through a foreign branch. The exception to this general rule is with

respect to land and buildings, which are considered domestic or foreign depending on

their location. If the holding of land or buildings were considered, of itself, a permanent

establishment, this particular exception would not be required.

144. Other amounts included or deducted in calculating income should involve an

underlying payment and the source of the amount included or deducted is determined

according to the source of the underlying payment. The source of payments is

determined in accordance with section 68(5). The source of a payment that is a return

on capital typically follows the residence of the payer. In this context, the inclusion of

foreign branches within the definition of "person" in section 105 is again important. For

example, in form the source of rent and royalties follows the location of the asset giving

rise to the rent or royalties. However, an asset attributable to a branch will typically be

located at the same place as the branch. As a foreign branch is a separate person under

the Sample, the location of such a branch will typically determine the source of rent and

royalties paid by it. Again, land and buildings are treated consistently with a branch and

the source of rent from land or buildings follows the location of the land or buildings.

By contrast, the source of a payment for services, including remuneration of an

employee, typically follows the place of performance of the services.

145. Special source rules are provided for amounts used in calculating the income of a

person engaged in international transportation of individuals or tangible assets.

Payments for transportation commencing domestically are generally considered to have

a domestic source. Repair and improvement costs and depreciation are allowed as

deductions with a domestic source with respect to tangible assets used in such

transportation to the extent to which the assets are used for transportation commencing

domestically. The source of other amounts used in calculating income from such

transportation is determined according to the general rules in section 68. These and the

other source rules in section 68 may be adjusted by double tax treaties.

146. Section 68(6) essentially provides that any amount that is not treated as having a

domestic source has a foreign source. However, in some cases this is not sufficient and

it is important to determine the particular foreign country in which an amount is sourced.

In particular, this determination is necessary in applying the country-by-country rule for

quarantining the deduction of foreign losses in section 33(2), discussed above at

paragraph 92, and foreign tax offset limitations on a country by country basis under

section 200(3), discussed below at paragraphs 315 and 316. Under section 68(7), the

particular foreign country in which an amount is sourced is determined by applying the

rules in section 68 to the country in question. In some cases, in order to determine the

source of an amount it will be necessary to determine the residence of a person in a

particular foreign country. This residence is determined in accordance with section

108(4), discussed below at paragraph 210.

147. Finally, the characterisation or re-characterisation of amounts is a fertile area for tax

planning. Section 69 provides the tax administration with some broad powers to re-

characterise income, losses, and amounts used in calculating income including

payments. This re-characterisation power extends to both the source and type of the

amount in question. For this purpose, the type of an amount takes an extended meaning

under section 69(2). The power in section 69 is available with respect to arrangements

between associates to which section 62 applies and income splitting to which section 63

applies. It also applies to "tax avoidance arrangements" and arrangements that do not

have substantial economic effect. "Tax avoidance arrangement" is determined under

section 69 by reference to a main purpose to avoid or reduce tax.

Division III: Assets and Liabilities

148. This Division contains some general rules that apply to amounts the recognition of

which is deferred under the income tax, i.e. that are not immediately included or

deducted in calculating income when derived or incurred. In Anglo-Saxon terminology,

these are often referred to as "capital amounts". Subdivision A contains rules that apply

to such amounts that are dealt with on a transactional basis. This is the classic province

of a capital gains tax. However, the relevance of the Subdivision is broader. It includes

some important general definitions and covers issues such as the cost of trading stock

and ordering rules for disposal of fungible assets. In essence, the transactional basis is a

cautious approach (used instead of the payments basis under Division I) that seeks to

ensure that transfers of assets are not taxed under an income tax. Subdivision B contains

rules that apply to costs incurred with respect to depreciable assets. These costs are

recognised according to the wasting nature of depreciable assets with residual

transactional basis recognition. Subdivision C contains a number of special rules that

detail and amend some of the general rules in Subdivisions A and B including anti-abuse

rules and rules to relieve hardship in particular cases.

Subdivision A: Central Concepts

149. This Subdivision begins with the general formula for the calculation of gains and

losses from assets and liabilities. Such gains may be included in calculating income

under section 17(2)(c) or 18(2)(b). Such losses may be deducted in calculating income

under section 32. The formula in section 75 uses a number of concepts that are central

to the Sample and particularly to Division III. Gain or loss is calculated with respect to

an "asset" or "liability". These terms are defined in sections 76 and 78, respectively.

Gain or loss from an asset or liability is determined by comparing "incomings" for the

asset or liability with "outgoings" for the asset or liability. These terms are defined in

sections 81 and 80, respectively. The rules in Subdivision A provide for recognition of

certain amounts on a transactional basis. This is achieved through the concept of

"realisation", i.e. the realisation of an asset or liability determines the time at which

amounts derived or incurred with respect to the asset or liability will be recognised on a

transactional basis. "Realisation" is defined in section 82.

150. Section 76 contains definitions of the major types of assets recognised under the

Sample and section 78 contains the complementary definitions of the major types of

liabilities. Many of these definitions have been previously discussed. The definitions of

"business asset", "depreciable asset", "investment asset", and "trading stock" are related

and require further short comment. The dominant definition in this group is "trading

stock", referred to in some countries as "inventory". "Trading stock" takes its usual

meaning but specifically includes work in progress on assets that will become trading

stock and inventory to be incorporated into trading stock. Unlike trading stock, which

may only be held by a person in conducting a business, "depreciable assets" may be held

by a person in conducting a business or investment. These are wasting assets that are

the primary subject of Subdivision B. "Business asset" is essentially the residual

category of assets held in conducting a business. "Investment asset" is also residual in

this sense but, as discussed above at paragraph 49, is central to the identification of an

activity as an investment.

151. The general definitions of "asset" and "liability" also require further comment. In

order to provide a broad base under an income tax, "asset" is often defined in terms of

legal rights. Income taxes often do not deal with liabilities in a comprehensive manner.

In order to do so, "liability" may be defined in terms of legal obligations. In this context,

it is necessary to determine whether rights and obligations are to be recognised on an

individual basis, e.g. on a right-by-right or obligation-by-obligation basis, or under some

other grouping approach. In practice, some form of grouping approach is invariably

adopted, either expressly or implicitly. This appears necessary as the individual

approach to rights and obligations is likely to be administratively unworkable. Under a

grouping approach, it is necessary to group rights and obligations so as to properly

identify assets and liabilities for income tax purposes.

152. The conventional meanings of "asset" and "liability" are often sufficient for

identification purposes. However, there will be cases producing some uncertainty. For

example, while at the extremes the difference between an asset and a liability is obvious,

there will be cases where it is not clear whether a particular group of rights and

obligations is an asset or a liability. Appropriate identification is important as different

consequences may result depending on whether an asset or liability is involved. In

particular, where amounts derived from an asset exceed costs incurred for the asset,

there is a transactional reconciliation, i.e. a realisation giving rise to a capital gain. This

is not the case with a liability as amounts derived in respect of incurring a liability are

often expected to exceed costs incurred for the liability at some stage while the liability

is outstanding.

153. The definitions of "asset" and "liability" do not adopt specific grouping rules for

identifying assets and liabilities. Rather, a general principles approach is adopted. The

definitions make it clear that a particular asset may incorporate not only rights but also

obligations and a liability may incorporate not only obligations but also rights. For

example, the rights and obligations of a lessee under a lease are not separated into a

group of rights and another group of liabilities. Rather, rights and obligations are

grouped along traditional property lines. That is, rights and obligations typically

associated with a particular form of property are grouped for the purposes of identifying

assets and liabilities under the Sample. Not all rights may be viewed as falling within

traditional notions of "property", e.g. there is often a question as to whether certain rights

to information or know-how are property. Accordingly, the residual grouping rule

groups rights and obligations that are integrated or amalgamated. If a right or obligation

cannot be grouped under the residual rule, it is dealt with in isolation.

154. After grouping rights and obligations, an assessment must be made as to whether a

particular group is an asset or liability. This is essentially an issue of whether the group

has a positive market value or a negative market value. If the group has a positive or nil

market value at the time the rights and obligations are acquired, the group is considered

an asset. If the group has a negative market value at this time it is considered a liability.

In practice, it is possible that during the holding of an asset it will turn into a liability or a

liability will turn into an asset. However, under the Sample a group of rights and

obligations is only identified as an asset or liability once, i.e. at the time of acquisition.

This approach provides certainty and does not appear open to any substantial abuse.

155. Both the definition of "asset" and that of "liability" have a short inclusions head.

These are essentially self-explanatory. "Part" of an asset or liability is included in order

to ensure that the calculation of gain or loss provisions work appropriately where only

part of an asset is realised. The definitions also have an exclusions head. The exclusion

of entitlements and obligations referred to in section 48(2)(a)(i) and (3)(a)(i) is to avoid

the need for reconciliation that might otherwise be required as a result of recognising

amounts under the income tax on an accrual basis before they are paid. Insurance and

compensation rights are also excluded from the definition of "asset" where they are

associated with a primary asset or liability. Payments under these rights will be taken

into account in the calculation of any gain or loss with respect to the primary asset or

liability.

156. Sections 77 and 79 provide essential rules that allocate assets and liabilities to

particular persons. Gains and losses on the realisation of an asset or liability may only

be included in calculating a person's income where the asset or liability realised is the

person's asset or liability, see sections 17(2)(c), 18(2)(b), and 32. This allocation is to

the person who "owns" an asset or "incurs" a liability and is generally made at the time

that ownership begins or the liability is incurred. Section 77(2) provides a special rule

applicable to arrangements under which a third party provides a business with trading

stock available for sale in the ordinary course of the business where ownership in the

stock does not pass by the time the stock is first available for sale. Showroom leases to

car sale retailers are an example. Section 77(2) and (4) treat such arrangements as a sale

and transfer of ownership at the time the stock is first available for sale. This is

essentially a substance over form rule and ensures that the provisions applicable to

trading stock operate consistently. Similarly, section 77(3) and (4) treat the lease of an

asset under a finance lease as a sale and transfer of the asset. Finance leases were

discussed above at paragraph 139.

157. Sections 80 and 81 identify amounts that are subject to treatment under the

transactional basis income tax. This identification is most important in securing a

comprehensive tax base. In order to explain this importance, it is necessary to return to

the conceptual base of the income tax. As discussed above at paragraphs 65 and 106 to

108, an income tax is primarily targeted at wealth creation or value added. This

typically has two aspects, the largest of which is likely to be through the provision of

labour and capital with the smaller aspect being any net increase in the value of an

economy's existing assets. The primary calculation provisions in Division I, i.e. the

payments basis income tax, are intended to reflect the larger aspect. The transactional

basis rules in Division III have two primary purposes. Perhaps the dominant purpose is

to cover any holes in Division I. In this sense, the transactional basis rules are a large

anti-avoidance rule for the dominant tax base, i.e. the payments basis income tax. The

second primary purpose of the transactional basis rules is to cover the smaller aspect of

wealth creation, i.e. any net increase in the value of an economy's existing assets.

Where there is a net decrease in the value of an economy's assets, the transactional basis

rules may give rise to an overall loss of tax revenue. Another purpose of the

transactional basis income tax is to make appropriate adjustments between persons for

relative changes in the value of assets and liabilities.

158. The transactional basis rules, therefore, are very broad and, absent reconciliation

rules, cover any amount recognised under Division I. Under the transactional basis,

amounts to be recognised are allocated to particular assets or liabilities. So, for example,

if wages were not included in calculating income on the payments basis, they would be

recognised under the transactional basis by allocation to the employee's employment

contract. Costs incurred that are allocated to an asset are conventionally referred to as

the asset's "cost base". However, as mentioned at paragraph 151, income tax laws often

do not comprehensively deal with liabilities and, indeed, liabilities are sometimes treated

as falling within the definition of "asset". In these types of circumstances, countries

often struggle with the concept of a "negative" cost base. The "cost base" of an asset

typically represents costs incurred with respect to an asset less any amounts derived with

respect to the asset, disregarding any costs or amounts recognised on a payments basis.

"Cost base" is therefore, typically a net concept.

159. In order to avoid the problems associated with the potential for negative cost bases,

the Sample focuses on amounts that are to be recognised only on a transactional basis.

Costs of this type incurred with respect to assets and liabilities are referred to as

"outgoings", a term defined in section 80. Amounts of this type derived with respect to

assets and liabilities are referred to as "incomings", a term defined in section 81. These

amounts may be netted at any particular time, including on realisation of an asset or

liability, in order to calculate "net outgoings" or "net incomings" for a particular asset or

liability. These terms are defined in section 345. "Net outgoings" for an asset are

essentially equivalent to a conventional reference to the asset's "cost base". "Net

incomings" for a liability is, therefore, equivalent to the "negative cost base" of a

liability. This terminology may be adjusted to suit local considerations.

160. Further specific comment is required with respect to sections 80 and 81. Under

section 80, the outgoings for an asset or liability fall under three main heads, ignoring

the incidental costs head. The first only applies to assets and includes costs in acquiring

an asset. These include, where relevant, costs of constructing an asset. Section

80(1)(a)(ii) may also include amounts by way of reconciliation. It may be that the

acquisition of the asset is a payment by a third party for wealth created by the acquiring

person. An example is where an employer pays an employee with an asset rather than

cash. The payment, being the transfer of the asset, will be included in calculating the

employee's income and be taxed to the employee. It is inappropriate to tax the wealth

created a second time on a transactional basis when the asset is realised by the

employee. It is possible to address this reconciliation by including as an outgoing any

"payment" made by the person in acquiring the asset. However, this would mean that

any wealth creation that escaped Division I would not be covered by the transactional

basis in Division III.

161. The second head of outgoings applies to both assets and liabilities, covering any

costs incurred in owning the asset or owing the liability in question. Again there are

specific inclusions, the most notable being costs of repair and improvement. There is a

similar reconciliation rule to that provided under the first head. The third head also

applies to both assets and liabilities and covers costs of realisation.

162. The resuming words in section 80(1) provide for some specific exclusions from the

outgoings for an asset or liability. Outgoings under the transactional basis income tax

are analogous to deductions under the payments basis income tax. It is, therefore,

necessary to exclude "consumption costs" and "excluded costs" for similar reasons to

those discussed above at paragraphs 71 to 75 in the context of section 25. The specific

exclusions also provide a reconciliation rule. Amounts that may be deducted under the

payments basis income tax are excluded from the outgoings for an asset or liability to

prevent "double dipping", i.e. double relief for the same cost.

163. Section 80(2) is a special rule that overrides section 80(1) in determining the

outgoings for trading stock. This provision is directly related to the deductible

allowance granted for the cost of trading stock under section 28. Again the approach is

to adopt generally accepted accounting principles in the form of the "prime-cost" and

"absorption-cost" methods of costing trading stock. These and related terms are defined

in section 80(4) in conventional terms.

164. Section 80(3) is also a special rule that applies generally accepted accounting

principles, this time in allocating outgoings to assets that are difficult to identify. For

example, the quantity and nature of particular units of trading stock held by a business

may make it difficult to identify which units are sold in a particular transaction and,

therefore, which outgoings should be taken into account with respect to the sale

transaction. The issue may be addressed either through flexible rules for identifying the

trading stock considered sold or through flexible rules in allocating outgoings to the

trading stock actually sold. Section 80(3) adopts the latter approach. Where trading

stock is fungible and not readily identifiable, the owner may elect to use the "first-in-

first-out" or the "average-cost" method for determining the outgoings for trading stock.

These terms are defined in section 80(4) in conventional terms. This identification

problem is not limited to trading stock. Therefore, the application of section 80(3) may

be extended to other types of assets by the regulations. The types of assets that may be

considered for this treatment include securities held in entities.

165. The structure of section 81 in identifying incomings for assets and liabilities reflects

the structure of section 80(1). Just as the first head of section 80(1) only applies to

assets, the first head of section 81 only applies to liabilities. The second and third heads

also follow similar lines to those in section 80(1). However, the reconciliation rules in

section 80(1)(a)(ii) and (b)(iii) are not reflected in the first and section heads of section

81. This is because of the nature of amounts that may be included as incomings for an

asset or liability. Outgoings for an asset or liability may only include "costs incurred".

As discussed above at paragraphs 106 to 108, this term is defined by reference to only

the first head of the definition of "payment" in section 41. By contrast, incomings for an

asset or liability include "amounts derived" in respect of the asset or liability. This term

is defined by reference to all heads of "payment" and so the reconciliation rule is not

required.

166. The third head of incomings includes not just amounts derived but amounts "to be"

derived in respect of a realisation of an asset or liability. The effect is to accelerate the

recognition of such amounts under the transactional basis income tax, perhaps to an

even greater extent than under the payments basis income tax. This aspect is again one

of protecting the tax base and is intended to ensure that, e.g. sales with delayed

payments of the purchase price do not give rise to a formal loss (with no economic

substance) at the time of sale. In the case of sales, this provision will only apply to

short-term delays (less than one year from the realisation). Delays of a greater length

will result in characterisation of the sale as an instalment sale. Payments under

instalment sales are subject re-characterisation as interest and a repayment of capital on

a loan under section 67, discussed above at paragraph 138. In conjunction with section

67, instalment sales are also subject to a special market value rule under section 91,

discussed below at paragraph 186. The reconciliation rules in the resuming words of

section 81 exclude amounts "to be" included in calculating a person's income. The net

result is that the third head of incomings in section 81 only accelerates the recognition of

amounts that will not be directly included in calculating income. Amounts that will be

so included are recognised on the payments basis.

167. The realisation of an asset or liability determines the time at which amounts derived

or costs incurred with respect to the asset or liability will be recognised on the

transactional basis. "Realisation" is defined under a number of heads in section 82(1)

for assets and 82(2) for liabilities. There are a number of common heads of realisation

in section 82(1) and (2) and these heads fall into two broad categories. The first two

heads cover situations in which the person owning the asset or owing the liability parts

with that ownership or the obligations constituting the liability. The remaining heads

under both section 82(1) and (2) cover situations in which the person owning the asset or

owing the liability does not formally part with the ownership or obligations.

Nevertheless, the situations outlined under these heads are felt to justify recognition of

amounts derived and costs incurred on a transactional basis.

168. The first head of "realisation" covers situations in which the person parts with

ownership of an asset or the obligations of a liability. Importantly, a person need not

part with the asset or liability in favour of another person. This head also covers the

destruction of an asset or liability and any other manner in which an asset or liability

may cease to exist. The related second head covers the situation where the person in

question ceases to exist, e.g. where an individual dies. This head also applies to entities,

e.g. where an entity is dissolved. The Sample adopts the approach that all gains or

losses with respect to an asset or liability should in principle be allocated to the person

holding the asset or owing the liability at the time the gain or loss accrues. This means

that the death of an individual is viewed as the final time of reconciliation for gains or

losses accruing during the life of the deceased.

169. This approach does not turn the income tax into an inheritance tax. An inheritance

tax is a tax on the transfer of assets and, as mentioned above at paragraphs 65 and 106,

the income tax is primarily targeted at creations of wealth. With respect to assets and

liabilities passing on an individual's death, the Sample only reaches gains or losses that

accrue to the deceased, the recognition of which were delayed during the deceased's life.

Many countries provide some relief from the recognition of gains at death. However,

this approach almost invariably causes distortions. It will either encourage or discourage

the transfer of assets before death or at the time of death. The approach in the Sample is

to treat either form of transfer in the same manner. Nevertheless, the approach in section

82 may not be acceptable to particular countries and the approach should be adjusted to

account for local considerations.

170. The third head of realisation for assets occurs where the incomings for an asset

exceed the outgoings for the asset. The reason for this head is again related to the

income tax being primarily targeted at creations of wealth. The transactional approach

is a cautious approach that measures wealth creation with respect to a transaction, e.g. in

the case of acquisition of an asset, only when the transaction is completed, typically

when ownership of the asset is parted with. To recognise incomings for an asset prior to

the end of the transaction may result in the effective taxation of money or assets that

were transferred by a person in acquiring the asset, i.e. money or assets reflected in

outgoings for the asset. Again, the income tax is not a tax on the transfer of assets.

However, where the incomings for an asset exceed the outgoings for the asset it is clear

that the excess does not represent the transfer of money or assets in acquiring the asset in

question, i.e. it most likely represents wealth created in the person owning the asset. It

is, therefore, appropriate to tax the excess on a payments basis and this is the effect of

the third head.

171. The fourth head of realisation for assets deals with bad debts. Section 49 also deals

with bad debts and some explanation of the interaction between the two provisions is

required. Essentially, section 49 deals with debt claims that were recognised on a

payments basis as an inclusion in income of the holder of the debt claim. By contrast,

section 82(1)(d) deals with debt claims that are only to be recognised to the holder of the

claim on a transactional basis. The classic type of debt claim to which this provision

applies is a loan. The purpose of the provision is to permit a person to recognise, in

particular, losses on debt claims where the debt claim has become a bad debt. The tests

for determining whether or not a debt claim is a bad debt claim are essentially the same

as discussed in the context of section 49 at paragraphs 118 and 119.

172. As mentioned at paragraph 107, the income tax does not typically cover wealth

created through the holding of all types of assets and liabilities, it only covers assets used

in an earning activity. The treatment of amounts recognised under the transactional

basis income tax may vary depending on the type of earning activity in which an asset or

liability is used, e.g. the varying treatment of losses under section 33. Therefore, tax

arbitrage is possible, e.g. by removing an asset with an unrealised gain from an earning

activity and using it in a non-earning activity such as leisure or consumption. In order to

protect the tax base, the fifth head of realisation for assets deals with changes in use of

certain types of assets. Where an asset of a particular type within the tax net is used in

such a manner that it ceases to be an asset of that type, it is treated as realised.

173. The last three heads of realisation are the same for assets and liabilities. Foreign

currency assets and liabilities, defined in sections 76 and 78, are treated as realised at the

end of each year. In the absence of this provision, a person is more likely to realise

foreign currency losses and seek to prevent the realisation of foreign currency gains.

While this is a generic problem with transactional basis income tax, it is particularly

acute in the context of foreign currency assets and liabilities, where realisation is a

relatively simple matter. An alternative approach is to quarantine foreign currency

losses so that they may only be set off against foreign currency gains. Again, this is an

issue that should be adjusted to local considerations including any exchange restrictions.

There is also a realisation of all the assets and liabilities held by an entity where there is

a change in control of the entity in the terms of section 171(1), discussed below at

paragraph 281. The final head of realisation occurs where a person becomes a non-

resident. This head treats as realised an asset or liability that will fall outside the tax net

after the change in residence. The tax administration is granted power to override this

realisation.

174. The definition of "realisation" does not cover a quasi-parting of ownership of an

asset through borrowing with respect to the asset. It is often viewed as abusive that a

person may borrow money on the security of an unrealised gain on an asset and thereby

obtain the use of the gain without having to recognise the gain for tax purposes. There

are difficulties in seeking to address this issue. One problem is allocating funds

borrowed to unrealised gains and another is the requirement for market valuations. One

possible approach is to adopt a presumptive rule. For example, funds borrowed by a

person, unless specifically secured by an asset outside the tax net, may be considered

incomings for assets of the person used in earning activities up to the market value of

those assets. The person would be permitted to allocate the incomings among the assets

at their selection. Such a rule may go a long way to addressing any perceived abuse of

the transactional basis income tax. However, this does not reflect common international

practice and is not adopted in the Sample.

Subdivision B: Depreciable Assets, Allowances, and Inclusions

175. The primary treatment of outgoings for depreciable assets under the Sample is to

recognise the wasting character of such assets and provide a deductible allowance under

section 31 for each tax year at the end of which a depreciable asset is held. This

recognition of outgoings is provided without the requirement of a realisation. Where a

depreciable asset is realised, the transactional basis income tax is applied in a residual

manner by way of reconciliation with the allowance system.

176. Subdivision B pools, for each earning activity, the treatment of assets that waste at

broadly similar rates. The exception is with respect to buildings and similar assets that

typically have a slow wasting rate as well as intangible assets. The pooling approach is

viewed as having compliance cost benefits over depreciation on an asset by asset basis

with a minimal loss of accuracy, if any. Each depreciable asset is categorised as being

of a particular Class by section 85(1). The inclusions in Classes 1 to 6 are intended to

represent assets that will waste at similar rates. This classification is only an example,

and this is another issue that should be adjusted to local considerations. Section 85(2)

provides for the pooling of assets of a particular business or investment. Class 1 to 5

assets are generally pooled with all assets of the business or investment of the same

class. Class 6 and 7 depreciable assets are pooled individually.

177. There are special pools required by section 85(2)(c) for assets used to transport

individuals and goods. This is in order to facilitate apportionment in determining the

source of a depreciation allowance under section 68(4)(b)(i), discussed above at

paragraph 145. There are also special rules for costs incurred in respect of natural

resource prospecting, exploration, and development. Often these costs will not be

incurred with respect to a particular asset such as a mining right. This might happen

where the prospecting or exploration is unsuccessful. These costs might be deductible

immediately. However, the costs incurred in uncovering a viable natural resource

deposit are typically low compared with the value of the deposit or right to the deposit.

In many ways, the costs incurred on unsuccessful prospecting and exploration are

incurred with respect to the finding of the odd viable deposit and may be allocated to it.

The Sample does not adopt this allocation process directly but does provide for the

depreciation of these types of costs as though they were incurred in acquiring an asset,

see section 85(3).

178. Standard depreciation allowances are calculated under section 86. The general

formula in section 86(2) involves the application of the relevant depreciation rate to the

depreciation basis of each pool of depreciable assets at the end of a tax year. The rates

are provided in section 86(6) and are mere guides that should be adjusted to suit local

considerations. Only in the case of intangible depreciable assets is the rate directly

determined according to the useful life of the asset. The depreciation basis of pools at

the end of a tax year are determined under section 86(3) and (4) for Class 1 to 5 and

Class 6 and 7 pools, respectively. Under each provision, outgoings for a depreciable

asset in a pool are added to the depreciation basis of the pool. Class 1 to 5 pools are also

reduced by two types of amounts. The first type of reduction is for depreciation granted.

This means that depreciation allowed for Class 1 to 5 pools is calculated on a

diminishing value basis. Further, the depreciation basis of a Class 1 to 5 pool is

decreased by incomings for assets in the pool during the year. The main type of

incoming for treatment in this manner is amounts derived in respect of the realisation of

assets in the pool.

179. By contrast, the depreciation basis of Class 6 and 7 pools (buildings and intangibles)

are not written down, meaning that the application of the depreciation rate produces

straight line depreciation. Section 86(8) contains the necessary rule for limiting the

amount of depreciation allowances under this method to the depreciation basis of the

relevant pool. Whether and where the diminishing value or straight line depreciation

methods are used is another issue that should be adjusted to local considerations.

However, only the diminishing value method is consistent with pooling the treatment of

multiple assets.

180. Section 86(5) contains a rule that may delay the inclusion of part of outgoings for a

depreciable asset in the depreciation basis of the pool in which the asset is placed.

Without a delay rule, there is an incentive for a person to incur costs with respect to

depreciable assets just before the end of a tax year. Such a person would otherwise be

granted the same depreciation allowance for the year as a person who incurs similar

costs at the start of the year. The most accurate rule is to apportion the inclusion on a

daily basis. For the sake of simplicity, the Sample adopts a more arbitrary approach

based on quarters of a year. Only a portion of outgoings for depreciable assets is

included in the depreciation basis of the relevant pool in the tax year they are incurred,

depending on the quarter in which they are incurred. The balance is added to the

depreciation basis of the pool during the following tax year.

181. Section 86(7) contains a special rule permitting the writing off of small residual

balances in the depreciation basis of a pool of depreciable assets. The relevant threshold

must be adjusted to local considerations. Section 86(9) contains another special rule

limiting the depreciation of luxury road vehicles. This is an arbitrary rule seeking to

prevent a person from claiming depreciation with respect to road vehicles to the extent

that they may be considered attributable to consumption or leisure activities. Road

vehicles are a particular problem in this area justifying their special treatment under the

Sample. Again however, this is only an example of a generic issue and such an arbitrary

rule may be applied to other types of depreciable assets. This rule and the threshold it

incorporates should be adjusted for local considerations.

182. Section 87 contains the residual transactional basis treatment of depreciable assets of

a business or investment. This residual treatment will either result in the inclusion of an

amount in calculating income from the business or investment under section 17(2)(d) or

18(2)(c) or a further depreciation allowance that is deductible in the calculation under

section 31. Section 87(1) contains a special rule applicable to depreciable assets in Class

1 to 5 pools. The assets in such pools are essentially treated on a single asset basis. In

this context, section 87(1) contains a rule that reflects the application of section 82(1)(c)

to other types of assets. In essence, where incomings for a person's assets in a Class 1 to

5 pool derived during a tax year exceed the depreciation basis of the pool, the excess is

included in calculating the person's income.

183. By contrast, section 87(2) applies where a pool of depreciable assets is emptied by

the end of a tax year, i.e. where all the assets in the pool are realised. In this case, no

depreciation is allowed under section 86 in respect of the pool for the year. Rather, the

transactional basis income tax is used to make appropriate adjustments by essentially

comparing the written down value of the pool with incomings for the assets that were

disposed of during the year. Any excess of incomings is included in calculating the

income of the relevant business or investment for the year. Any excess of written down

value is granted as an allowance that is deductible in calculating that income. "Written

down value" for this purpose is defined in section 87(4). In the case of Class 1 to 5

pools it is essentially the depreciation basis of the pool. In the case of Class 6 or 7 pools,

it is essentially the depreciation basis of the pool less depreciation allowed in respect of

the pool.

Subdivision C: Special Rules

184. This Subdivision contains a number of special rules that apply to the transactional

basis income tax. Many of these rules are complex, some are essentially policy issues,

and so are optional, and others may or may not be appropriately dealt with by

accounting rules. In all cases these rules must be adjusted to suit local considerations.

The approach in the Sample is to provide an example of a relatively comprehensive set

of rules that do not rely on accounting rules.

185. The first special rule deals with situations in which a person is considered to realise

an asset or liability but has not formally parted with the asset or liability. These

situations were discussed above at paragraphs 167 and 171 to 173. The general

approach in section 90(1) and (4) is to treat realisation as at market value and to

effectively reset the net outgoings or net incomings for the asset or liability to that value.

In the case of the realisation of an asset by way of change of use of the asset, section

90(2) essentially permits non-recognition provided the asset stays within the tax net.

Section 90(3) is a variation of this rule to cater for this type of realisation of depreciable

assets, which are subject to the pooling provisions discussed above at paragraphs 176 to

177.

186. The second special rule applies a market value rule to assets realised by way of

instalment sale or finance lease. This integrates with the re-characterisation rule in

section 67, discussed above at paragraphs 138 and 139. Section 67 treats payments to be

made under instalment sales and finance leases in excess of the market value outgoings

allocated to the asset by section 91 as interest, to be included directly in calculating

income.

187. Section 92 applies a limited non-recognition rule to the transfer of assets and

liabilities between spouses. It only applies where the transfer is part of a divorce or

separation agreement. This situation is analogous to involuntary realisations covered by

section 96 but in this case the transferor need not acquire a replacement asset and an

election by the transferee is required (since the transferee may be accepting an

underlying tax liability). Some countries allow non-recognition of transfers between

spouses on a broader basis. However, where, as under the Sample, the individual is the

tax subject, a broader rule may give rise to income-splitting opportunities. A market

value rule is otherwise applied in the case of transfers between spouses, see section 94.

188. Section 93 contains a market value rule for transfers resulting on the death of an

individual. Typically, this transfer will be, in the first instance, to the deceased's estate,

which will be administered by an executor or administrator. The estate will be a trust

and, therefore, treated as a separate person under the Sample, see section 105. As a

result of section 93, the deceased may realise gains or losses from the realisation of

assets and liabilities that must be included in calculating the deceased's income, see the

discussion above at paragraphs 168 and 169. The executor or administrator will be

required to pay any outstanding tax of the deceased by reason of section 281. The estate

will have market value outgoings with respect to assets transferred from the deceased

and market value incomings for transferred liabilities. Any further transfer to a

beneficiary of the deceased will also be treated as made at market value, see section 94.

The result is likely to be no gain or loss to the estate and market value outgoings for

assets or market value incomings for liabilities for the beneficiary. Some gain or loss to

the estate may occur in isolated circumstances, e.g. where there is substantial delay

between the date of death and the date of transfer to the beneficiary.

189. Special rules also apply to transfers between associates or for no consideration.

These are of the typical form in section 94(1) and (4), which apply market value to the

transfer except where this would result in the recognition of a loss. This exception seeks

to deter "wash sales" between associates whereby persons seek to realise assets and

liabilities with underlying losses by transferring them to associates while preventing

realisation of any assets or liabilities with underlying gains. By contrast, section 94(2),

(3), and (5) contain special rules that may allow a person transferring an asset or liability

to an associate to not recognise a gain. Section 94(2) applies generally to assets within

the tax net with section 94(3) catering specifically for depreciable assets, which are

subject to the pooling provisions discussed above at paragraphs 176 to 177. Section

94(5) applies to liabilities within the tax net. Non-recognition under each of these rules

is subject to the requirements in section 94(7).

190. The first requirement in section 94(7) is that either the transferor or the transferee is

an entity. The second is that the asset or liability remains in the tax net in the hands of

the transferee. For this reason, both the transferor and the transferee must be residents.

Because foreign branches are treated by the Sample as persons, this means that the

transfer may be between a domestic subsidiary and a domestic branch of a non-resident

person. The third requirement is that there is 50 percent continuity of underlying

ownership or underlying obligation in the asset or liability, respectively. Because the

operation of section 94(2), (3), and (5) are likely to result in the transfer of a tax liability,

the last requirement is that both the transferor and the transferee elect for the non-

recognition.

191. The first and third requirements in section 94(7) are worthy of further consideration.

The main justification for non-recognition treatment in transfers between associates is

where there is in substance no realisation, only a change in the form of holding the asset

or owing the liability. This is clear where there is 100 percent continuity of "underlying

ownership" or "underlying obligation" in the asset or liability, respectively. These terms

are defined in section 345. The underlying ownership of an asset owned by an entity or

underlying obligation of a liability owed by an entity is determined by reference to the

holding of interests in the entity. That holding is determined by looking through entities

that hold interests in other entities until an individual or an entity in which no person has

an interest is identified. "Interest" in an entity is defined in section 106 and discussed

below at paragraph 205. Underlying ownership and underlying obligation are only

relevant in the context of assets or liabilities where they are owned or owed by entities.

This means that non-recognition treatment is available under section 94(2), (3), or (5)

only where either the transferor, the transferee, or both are entities, i.e. non-recognition

is not available for transfers between associated individuals.

192. The justification for non-recognition of gains under section 94(2), (3), and (5) is not

as clear where continuity of underlying ownership or underlying obligation is less than

100 percent. In this case, in the absence of sophisticated rules, non-recognition will give

rise to the transfer of tax attributes between persons, something that is generally resisted

under an income tax for tax arbitrage reasons. However, to deny non-recognition will

result in a "lock-in" effect whereby persons will resist restructuring the manner in which

their assets are held or their liabilities are owed for fear of realising a taxable gain, even

where restructuring may be the commercially efficient alternative. There appears no

easy way to deal with this issue and the Sample adopts somewhat of a compromise. It

allows non-recognition where there is continuity of underlying ownership or underlying

obligation of at least 50 percent. This is consistent with the approach adopted with

respect to the transfer of losses under section 33(1)(c), discussed above at paragraphs 93

and 94, and the transfer of foreign income tax under section 200(3)(b), discussed below

at paragraph 316. These discussions are also relevant to the requirement that the

transferor and transferee both be residents. The potential for tax arbitrage is left to the

value shifting rules in sections 173 and 174. Further, the transfer pricing rule in section

62 may be applied if one of the main purposes of the transfer is the reduction of tax, i.e.

to secure non-recognition the transfer must be for other main purposes, see section

94(6).

193. The non-recognition rules in section 94(2), (3), and (5) are important and have

potentially broad application. They can apply to contributions to an entity in which the

contributor holds a 50 percent interest, e.g. on the incorporation of a business. They can

apply on the reconstruction of an entity including mergers and demergers as well as the

addition and departure of partners of a partnership. They can also apply to transfers on

the winding up of an entity. Whether more sophisticated rules are desired for particular

cases and whether the threshold of 50 percent underlying ownership or underlying

obligation is too low or even too high are issues that must be adjusted to suit local

considerations.

194. Section 94 only applies to transfers between associates. It is also possible to effect

the economic equivalence of a transfer between associates by the creation of a liability

in one person that constitutes an asset of an associate, e.g. by granting an option to

purchase an asset. Section 95 is targeted at this situation and provides a market value

rule that applies to both the creation of the asset and liability and their simultaneous

realisation.

195. Section 96 provides non-recognition treatment for involuntary realisations by way of

parting with ownership of assets or obligations of liabilities. Non-recognition is

available where a replacement asset or liability is acquired or incurred within one year of

the realisation. The rule is complicated somewhat by covering situations in which the

replacement asset or liability is of a greater or lesser value than the asset or liability

realised. These situations may result in part recognition of any gain. Non-recognition

only applies where the person makes an election. The section does not define

"involuntary", which will take its ordinary meaning. The application of the term to

particular circumstances may be an appropriate subject for practice notes. However,

"involuntary" would not cover, e.g. the exchange of securities in a merger. This is a

situation in which relief is often provided in order to prevent lock-in. This lock-in is

similar to that which may occur through the taxation of transfers between associates and

which is addressed by section 94, see discussion above at paragraph 192. Section 96(7)

provides that the regulations may treat an exchange of securities as an involuntary

realisation.

196. Section 97 and 98 deal with two particularly difficult issues. The separate existence

of an asset or liability (the "merging asset or liability") may be extinguished where it is

combined with another asset or liability (the "combined asset or liability"). As the

holder of the merging asset or liability will no longer own or owe the asset or liability,

the holder will realise the asset or liability. It is possible for an asset to be combined

with an asset or a liability and for a liability to be combined with an asset or a liability.

Section 97(2) provides a non-exhaustive list of some circumstances in which section 97

applies. Where it applies, section 97 provides a non-recognition of any gain or loss from

the realisation of the merging asset or liability with an appropriate adjustment to the

outgoings and incomings for the combined asset or liability. This rule is complicated by

the possibility, e.g. via section 97(1)(b), that the addition of net incomings for a merging

liability may turn the net outgoings for a combined asset pre-combination into net

incomings for the asset post-combination. In this case, the non-recognition rule only

partly applies and a part gain may be recognised for the realisation of the merging

liability. This is consistent with the approach to realisation in section 82(1)(c), i.e.

where the incomings for an asset exceed the outgoings for the asset, and is appropriate

for the reasons discussed above at paragraph 170. Section 97(1)(a) covers the opposite

variation on this theme and may result in partial recognition of a loss on realisation of a

merging asset.

197. Section 98 deals with the related issue of separation of assets and liabilities. The

issue is whether the creation of rights or obligations with respect to an asset or liability is

a part realisation of the asset or liability or the creation of a new asset or liability. The

classic example is where a person creates a lease over an asset owned by the person in

favour of another person but would also extend to cover other arrangements such as a

usufruct or option. Section 98 takes the approach that where the rights are permanent

there is a part realisation of the asset or liability. Where they are temporary there is no

part realisation but, rather, the creation of a new asset or liability. So the granting of a

lease or option with respect to an asset or liability is not typically treated as a part

realisation. This is the preferred approach because it avoids problems with, e.g. persons

claiming partial losses where assets are leased (due to apportionment of any net

outgoings to the part realised) or the need to recognise a part re-acquisition when

temporary rights expire. "Permanent" is not defined and so will take its ordinary

meaning. Section 98 is subject to section 77(4), discussed above at paragraph 156, a

provision that treats finance leases as sales. So even though rights and obligations under

finance leases may only be temporary, they are treated as a realisation. On expiry of a

finance lease, there may be a re-acquisition by the lessor of the asset, see section 77(5).

198. While section 99 is the longest non-interpretative section in the Sample, it deals with

a relatively simple issue. Its purpose is stated in section 99(1) as to provide an

apportionment of outgoings and incomings over more than one asset or liability in the

situations described in section 99(2) to (4). Section 99(2) covers the situation in which,

e.g. a person makes one payment in acquiring a number of assets with or without a

number of associated liabilities such as in the acquisition of a business. Section 99

apportions the price paid as outgoings and incomings for individual assets and liabilities

by comparing the market value of assets acquired and the market cost of liabilities

incurred. This is the general approach adopted with respect to all the situations covered

by section 99.

199. Section 99(3) covers the opposite situation to section 99(2), i.e. where a person

transfers more than one asset or liability at the same time or under the same

arrangement. For example, it covers the vendor in the sale of business example

provided in the last paragraph. The third situation, covered by section 99(4), is where a

person realises only part of an asset or liability and retains the remainder. Section 98,

discussed above at paragraph 197, is relevant in determining if there is a part realisation.

The purpose of section 99 in this situation is to apportion any net outgoings or net

incomings for the asset or liability in question between the part of the asset or liability

realised and the part retained.

200. The general apportionment formula is contained in section 99(5) and (6). This

formula, and the related definitions and formulas in section 99(8), are complex for a

number of reasons. Firstly, there is the potential that the netting of the market value of

the assets and liabilities subject to apportionment does not equal the payment for the

assets and liabilities under section 99(2) or (3), or may not equal the net incomings or

net outgoings for the asset or liability under section 99(4). This is why section 99(5) and

(6) deal with excess value and inadequate value, respectively. Complexity also results

from catering for positives and negatives, i.e. the positive market value of assets as well

as the negative market value of liabilities. Again, the approach under section 99 is to

provide an example of a comprehensive rule. This rule may be too complex for local

conditions. It may be moved to the regulations or a more general rule adopted and the

difficult issues covered by section 99 dealt with in practice notes.

PART III: RULES GOVERNING TYPES OF PERSONS

201. This Part moves to provide special rules that apply to particular types of persons or

by reason of the involvement of a particular type of person in an arrangement. It is

divided into three divisions. The first is again a general concepts division and contains

some central definitions that are of particular relevance to particular types of persons and

in considering the treatment provided by the rest of the Part. Division II is divided into a

number of subdivisions that each provides special rules devoted to a particular type of

person. By contrast, the rules in Division III apply generally to entities.

Division I: Central Concepts

202. This Division contains a number of definitions that are not only central to this Part

but to the Sample as a whole. They are the definitions that make distinctions between

different types of persons. Section 105 begins with the primary distinctions. Section

105(1) initially distinguishes between natural persons and artificial persons, i.e.

individuals and entities. Non-exhaustive subcategories of individuals are "minors" and

"incapacitated individuals". Exhaustive subcategories of "entities" are "partnerships",

"trusts", "companies", and "foreign branches". Subcategories of "trusts" and

"companies" are "controlled foreign trusts" and "controlled foreign companies". All of

these terms are defined in section 105(2).

203. The reason for these distinctions is that different types of persons receive different

tax treatment under the Sample. An overview of this treatment was provided above at

paragraphs 17 to 32. The Sample only provides some typical examples of how different

types of persons may be distinguished and the type of tax treatment that may be applied

to them. In all cases these distinctions and the treatment must be adjusted to local

circumstances. However, in distinguishing between different types of entities, it is

important to have one category of entity as a residual type to ensure that all types of

entities are covered by the income tax. This is particularly important with respect to

foreign entities, which may not be easy to classify according to local distinctions.

204. The residual type of entity under the Sample is "company", which at its broadest

covers unincorporated associations and bodies of persons. By contrast, "partnership" is

defined in terms of persons carrying on business jointly and "trust" in terms of a trustee

holding assets. Partnerships and trusts are generally excluded from the definition of

"company". However, to the extent possible, tax treatment should follow the substance

of an activity and not the form in which it is conducted. It is towards this end that some

trusts and partnerships are treated as companies. Under the Sample, "limited

partnerships" and "unit trusts", as defined in section 105(2), are treated as companies.

205. Section 106 moves to particular types of persons involved in entities. These are of

two basic types divided along the traditional distinction between ownership and

management, i.e. "beneficiaries" and "managers". These terms are defined in section

106 including by way of sub-categorisation. "Beneficiary" is defined in terms of a

person with an "interest" in an entity. This term is further defined by reference to a right

to participate in income or capital of an entity. The form of the right is not relevant.

Subcategories of "beneficiary" include "partners", beneficiaries of partnerships, and

"shareholders", beneficiaries of companies. There is no separate term for the beneficiary

of a trust.

206. "Manager" in relation to an entity is defined in section 106 in terms of participation

in senior management decisions of the entity. Therefore, directors of a company will be

considered managers of the company. The definition also includes some types of

persons irrespective of such participation. These include partners, trustees, and owners

of foreign branches. "Trustee" is defined in section 106 in broad terms to include any

person with a fiduciary position that involves holding assets for the benefit of other

persons or an object permitted by law. The inclusive part of the definition of "trustee"

provides examples of arrangements that are considered trusts such as deceased estates,

estates of incapacitated persons and insolvents, receiverships, and mortgagees in

possession. As mentioned above at paragraph 204, the concept of "trustee" is central to

the definition of "trust".

207. Section 107 deals with the important category of associated persons. Special rules

apply to associated persons throughout the Sample, typically to apply arm's length

treatment. By reason of their relationship, associated persons are often able to engage in

tax reduction arrangements that independent persons would not. The definition of

"associated persons" is very broad. Section 107(1) provides a general definition in terms

of it being reasonable to expect that one person will act in accordance with the wishes of

another. This is an objective test and it is not necessary that one person actually act in

this manner, although that would be relevant under the test. Section 107(2) provides for

specific inclusions in the concept of "associated persons", which broaden the general

definition. Individuals and relatives are presumed to be associated as are partners. This

presumption can be rebutted by satisfying the tax administration that in the particular

case the general test in section 107(1) would not be met. "Relatives" is defined in

section 107(3) by reference to three generations of individuals from a common

descendant, including by way of marriage or adoption.

208. The other inclusive heads of "associated persons" in section 107(2)(c) and (d) are not

subject to rebuttal and the persons referred to are associated irrespective of whether the

test in section 107(1) is met. The main head in this regard is section 107(2)(d), which

has particularly broad application in determining who an entity is associated with. An

entity is associated with each member of a group of associated persons that, e.g. together

hold 50 percent of the entity in question. An entity can be a member of the group of

associated persons and section 107(2)(d) may be triggered by the inclusion of an entity

in the group under a previous application of that provision.

209. For example, entity A is owned 40 percent by Y and 60 percent by Z. Therefore,

entity A and Z are associated. Entity B is owned 40 percent by entity A, 40 percent by

X, and 20 percent by Z. Entity A and Z are a group of persons holding more than 50

percent of entity B. Therefore, by reason of multiple applications of section

107(2)(d)(i), entity A, entity B, and Z are all associated. Further, by reason of section

107(2)(d)(ii), all other associates of entity A or entity B (e.g. their subsidiaries) or of Z

(e.g. subject to rebuttal Z's relatives or partners) all fall within the group of association

and are considered associates of each other.

210. Persons are also distinguished on the basis of residence. Sections 109 and 110

provide tests for determining whether different types of persons are resident. Under

section 108, if a person is not resident then the person is considered a non-resident. In

some cases it is necessary to determine in which foreign country a non-resident person is

considered resident. As mentioned above at paragraph 146, this might be the case in

applying the country-by-country limitations to the use of foreign source losses and the

calculation of foreign tax offsets. Section 108(4) adapts the tests in sections 109 and

110 for this purpose.

211. Section 109 determines when an individual is considered resident. The three tests in

section 109(1) follow standard lines and require little discussion other than to emphasise

again that they should be adjusted to suit local considerations. If one of these tests is

met for a tax year, the individual will generally be considered resident for the whole

year. Exceptions to this rule are found in section 109(3) and (4). If an individual who

becomes a resident for the current tax year was not a resident in the previous tax year,

the individual is only considered resident from the date the individual is first present

domestically during the current year. If an individual is not a resident in the current tax

year, the individual is only a resident for the previous tax year up to the date the

individual is last present domestically during the previous year. Being resident during

part only of a tax year has certain consequences regarding tax rates and the calculation

of assessable income, discussed above at paragraph 23 with respect to section 5 and also

see section 15. Section 109(6) also contains a definition of "temporarily resident" for

individuals. This is relevant to section 115(4), which effectively applies exemption with

progression to the foreign source income of a temporarily resident individual.

212. Section 110 determines when different types of entities are considered resident. The

tests for partnerships and companies follow standard lines, the latter incorporating both

the place of establishment and centre of management and control tests. The tests for

trusts also incorporate the place of establishment as well as residence of a trustee. Given

the ease with which these tests for trusts can be avoided, a third test is added. If a

resident person, with or without other persons, directs or may direct senior managerial

decisions of a trust, the trust is considered resident. For example, a person who has

power to remove or appoint trustees may be considered to be in such a position. Finally,

a domestic branch of a non-resident person is considered a resident person. The

treatment of foreign branches as persons and the inclusion of domestic branches of non-

residents as resident persons ensure that domestic subsidiaries and domestic branches of

non-residents are treated in a similar fashion, see further the discussion above at

paragraphs 24 to 26. To further this similar treatment, domestic branches are also

subject to a branch profits tax, see discussion above at paragraphs 30 to 32 and the

discussion below at paragraphs 248 and 249.

Division II: Rules Applicable to Particular Types of Persons

213. This Division is divided into six subdivisions each dealing with special rules that

apply to particular types of persons identified in section 105. Subdivision A is devoted

to individuals. The remaining subdivisions are devoted to different types of entity.

Subdivisions B to E are devoted to the main types of entity, i.e. partnerships, trusts,

companies, and foreign branches. These four subdivisions follow a similar format.

Each begins with a section setting out the general principles applicable under the Sample

to income derived and distributed by the entity in question. These general principles

were discussed above at paragraphs 24 to 29. Each of these four types of entity is

treated separately from their beneficiaries and managers in calculating income. In order

to ensure this treatment, each of the initial sections of these subdivisions contains a

number of common provisions that require some further comment.

214. The first of these common provisions, sections 120(3), 130(4), 140(3), and 145(4),

seek to emphasis this separation by stating that amounts derived and costs incurred by an

entity are treated as only derived or only incurred by the entity and no other person.

This is intended to avoid the argument that, while an entity that has no separate legal

existence at general law can be given such an existence for tax purposes, it will have no

income. For example, it may be argued that the income of a partnership is only the

income of the partners. The same argument may arise in the context of assets owned

and liabilities owed by entities and a similar approach is adopted to overcome this

argument in sections 120(4), 130(5), 140(4), and 145(5). Similar problems arise with

respect to foreign income tax paid with respect to the income of an entity. Other

countries may tax the entity, the managers, or the beneficiaries with respect to such

income. All foreign income tax paid with respect to an entity's income is treated as paid

by the entity, see sections 120(5), 130(6), 140(5), and 145(6).

215. The final common provision in these introductory sections deals with the recognition

of arrangements between entities and their managers and beneficiaries, see sections

120(6), 130(7), 140(6), and 145(7). As a general rule, these arrangements are

recognised. So, for example, a partner may be an "employee" of a partnership if the

partner falls within the definition of that term in section 345. Further, sales between a

head office and a foreign branch and loans by a shareholder to a company will be

recognised. However, all such arrangements will be subject to adjustment under the

transfer pricing, income splitting, or general anti-avoidance rules in sections 62, 63, and

69. Many countries do not adopt this approach and will often ignore arrangements

between an entity and its managers and beneficiaries. While this is again an issue that

must be adjusted to local considerations, care should be taken to ensure consistent

treatment of entities that can be used to derive income in a similar manner.

216. Because entities are treated as separate persons and their income is treated as their

own, distributions or other allocation of entities' income potentially give rise to a second

source of income, i.e. a source of income derived by the beneficiaries of the entity. As

mentioned above at paragraphs 24 to 29, economic double taxation is generally avoided

in the cases of partnerships, trusts, and resident's foreign branches but there is the

potential for partial double taxation in the case of companies and domestic branches of

non-residents. Nevertheless, in all cases there is a need to define this secondary tax

base, i.e. the tax base of the beneficiaries with respect to their interest in an entity. This

is typically the second issue addressed by Subdivisions B to E. These subdivisions then

proceed to the taxation treatment of the beneficiaries when this secondary tax base is

allocated to them. Finally, these subdivisions, other than Subdivision D dealing with

companies, make certain adjustments to beneficiaries' interests in entities to ensure

appropriate treatment under the transactional basis income tax.

217. Subdivision F deals with controlled foreign trusts and companies. It is only partly

structured like the other subdivisions dealing with entities. This is because Subdivision

F is essentially based on but varies the treatment that would otherwise result under

Subdivisions C and D, which generally deal with trusts and companies, respectively. In

essence, Subdivision F adjusts the rules in Subdivisions C and D so that they more

closely resemble the rules in Subdivisions B and E, which generally deal with

partnerships and foreign branches, respectively.

Subdivision A: Individuals

218. This Subdivision is relatively short, containing three sections that are particularly

applicable to individuals. Section 115 allows resident individuals to claim certain

personal offsets. These offsets directly reduce income tax payable by an individual

under the first head of charge in section 1(1). Any excess offset is not refundable and is

lost if it cannot be used in the tax year in which it is claimed. This approach is used

rather than providing an exemption threshold in the tax rates applicable to resident

individuals in section 5(1) and was discussed above at paragraph 19. Its purpose is the

same as an exemption threshold, i.e. to remove taxation from a basic living amount.

Ideally, this amount should be sufficient to meet the bare necessities of life.

219. Section 115 provides a basic personal offset to all resident individuals. It also

provides certain additional personal offsets to resident individuals for their resident

"dependants". "Dependant" is defined in section 345 and is also relevant to some of the

terms used with respect to retirement savings under Division II of Part IV, discussed

below at paragraphs 306 to 310. The additional personal offset for temporarily resident

individuals with respect to their foreign source income under section 115(4) was

discussed above at paragraph 211. Finally, under section 115(5) apportionment rules

apply to individuals who are only resident for part of the tax year in question. These are

consistent with those in sections 5(7), and 15(2), the former was discussed above at

paragraph 23.

220. Section 116 provides individuals with an offset for medical costs incurred by the

individual. A deduction would typically be denied for medical costs under section

25(1)(a) because they are personal in nature. However, as with the personal offset, the

medical costs offset recognises that basic medical costs are a necessity of life. This is a

highly political area where the approach to the issue will invariably depend on local

considerations. For governments that provide comprehensive health services to their

residents, this provision may be unnecessary. Again, section 116 provides just one

possible approach to the issue. In particular, the approach offered assumes the lack of a

comprehensive government run health service.

221. Section 116(1) permits an individual to claim an offset for "approved medical costs".

This phrase is defined in section 116(5) by reference to the regulations. Which medical

costs are considered to justify a reduction in income taxation is likely to be highly

subjective to particular countries. "Medical costs" is defined in section 345 in

conventional terms but includes the payment of premiums for medical insurance. An

individual may claim the offset with respect to medical costs paid by the individual or a

dependant of the individual. The extension to dependants is consistent with the

additional personal offset available with respect to dependants under section 115. Under

section 116(2), the medical costs offset is calculated by applying a rate to the medical

costs. This rate should represent the extent to which the government wishes to subsidise

health care under the income tax system and is likely to vary substantially from country

to country. Where the government provides some sort of government funded health

care, the level of this rate will determine the extent to which the government wishes to

encourage the use of private health care.

222. The amount of the medical costs offset that an individual may claim for any tax year

is capped under section 116(3). It is limited to a "reasonable medical insurance

premium" the level of which must be set locally. The idea is that the government

identifies a basic level of medical insurance and uses the premiums for that as the base

to calculate the limit. This limit may work harshly against individuals who opt to not

have health insurance, i.e. who opt to self-insure. This is because medical costs for an

individual tend to vary greatly from year to year. Where an individual incurs medical

costs for which an offset is not available for a tax year, e.g. where they exceed the

reasonable medical insurance premium selected, the excess may be carried forward and

used in calculating the medical costs offset of the next tax year. This method of

averaging is consistent with the approach applying to losses under section 33, discussed

above at paragraph 92.

223. Section 117 identifies "taxable investment income" of a minor and, therefore, the

income of a minor that is subject to tax at the highest marginal rate under section 5(4).

The reasons for this treatment were discussed above at paragraph 22. There is a carve

out under section 117(2) to prevent this treatment in the context of an incapacitated

minor.

Subdivision B: Partnerships

224. Section 120(1) states the general principle that partnerships are not taxpaying

subjects for the purposes of the first head of charge under section 1(1). They are,

however, required to calculate their taxable income and, if served with a notice by the

tax administration, required to file a return of income, see section 236. Any income or

loss of a partnership is allocated to the partners, see section 120(2). Similar to resident's

foreign branches but in contrast to companies, this allocation occurs irrespective of

distribution. The tax base that is used for this allocation, i.e. the secondary tax base, is

defined in section 121 and is similar but not the same as the tax base used to calculate a

partnership's taxable income, i.e. the primary tax base. The rest of section 120 was

discussed above at paragraphs 214 to 216.

225. The secondary tax base of partnerships is defined in section 121 in terms of

"partnership income" or "partnership loss". As "partnership" is defined in section 105 in

terms of a business, section 121 assumes that all income and losses of a partnership will

be from a business, i.e. any other joint income or loss of persons will be allocated under

section 61. Partnership income is assessable income of the partnership from a business

calculated as though the partnership were a resident partnership. This is in order to

ensure that partnership income includes world-wide income but does not include final

withholding payments and exempt amounts. In particular, final withholding payments

are taxed to partnerships under the third head of charge in section 1(1). Partnership

income is calculated without reference to section 33. Because partnership losses are

allocated to the partners, it is inappropriate to take them into account in calculating

partnership income.

226. Partnership income or partnership loss is allocated to partners under section 122(1)

according to each "partner's share". This term is defined in section 122(6)(a) in terms of

the partner's percentage interest in income of the partnership under the partnership

arrangement. Section 122(6)(b) provides an alternative test where the primary test is

inappropriate. Section 122(1) makes separate reference to the tax year of the partnership

and the tax year of a partner. Issues arising where a partnership and a partner have

different tax years were discussed above at paragraph 102. Importantly, the allocation to

a partner only provides an inclusion or deduction in calculating the partner's income, i.e.

it is not directly included or deducted in calculating the partner's assessable or taxable

income. For example, this means that any allocated income may be further reduced by

deductions claimed at the partner level such as with respect to interest on money

borrowed to acquire an interest in a partnership.

227. Section 122(2) provides that amounts allocated to a partner retain their character in

the hands of the partner, i.e. the character under the secondary tax base is determined

according to the primary tax base. This allocation of individual amounts included or

deducted in calculating the primary tax base, i.e. the partnership's income, is made

proportionately to each partner's share. The proportionate approach goes some way to

preventing abuse through the streaming of particular types of income, such as foreign

income, to persons who can most efficiently use that income from a tax perspective, e.g.

through use of foreign tax offsets claimed under section 200. Section 122(2) also

provides a timing rule that the partner is treated as deriving or incurring amounts

allocated at the end of the relevant tax year of the partnership. This is to ensure that the

allocation under section 122 and the consequent adjustments to the incomings and

outgoings for the partner's interest in the partnership under section 123 occur at the same

time. Further, for administrative simplicity reasons it is felt more appropriate that the

allocation and adjustment only be made once per year.

228. Section 122(3) proceeds to allocate tax considered paid by the partnership with

respect to its income. This allocation is at the same time and on a similar basis as the

allocation of partnership income and losses, i.e. proportionately according to each

partner's share. Section 122(4) treats a partner as having paid partnership tax allocated

to the partner and this in turn triggers an entitlement to, e.g. a foreign tax offset for

partnership foreign income tax or a tax credit for domestic income tax withheld from

payments to the partnership. In particular, a tax credit may be available under section

223 for tax paid by the partnership "as though tax were withheld from a payment to the

partner." As discussed below at paragraphs 313 and 331, sections 200 and 223 ensure

that any such offset or tax credit is included in calculating the partner's income, i.e. they

ensure gross-up.

229. Section 122(5) provides a special rule applying to non-resident partners in resident

partnerships. It first treats such a partner as having a domestic branch and then, e.g.

allocates domestic source partnership income under section 122(1) to the branch and not

the partner. The branch will be directly liable to pay tax with respect to this income,

including by way of instalment. The branch's income will be further allocated to the

non-resident partner under section 148. It may also be subject to branch profits tax

under the second head of section 1(1).

230. Section 123(1) includes in the outgoings for a partner's interest in a partnership

amounts allocated and included in calculating the income of the partner under section

122. This is in order to remove the potential for double taxation. This may occur where

partnership income is taxed to a partner but is retained by the partnership causing an

increase in the value of the partner's interest in the partnership that is then sold giving

rise to a taxable gain. For reasons mentioned above at paragraph 124 in the context of

long-term contracts, this double taxation will only be temporary but the adjustment is

incorporated because it is relatively simple in the case of partnerships. Note that

adjustments to outgoings are also made under section 123 for amounts that are not

allocated to partners under section 122, i.e. exempt amounts and final withholding

payments. This ensures that, in the former case, preferences granted under the payments

basis income tax are not washed out by the transactional basis income tax and, in the

latter case, that double taxation is avoided by reason of doubling up of these two income

taxes.

231. Section 123(2) makes adjustments to the incomings for a partner's interest in a

partnership that reflect those in section 123(1). "Distributions" by partnerships to

partners are treated as incomings for a partner, offsetting the outgoings granted under

section 123(1) for allocated partnership income. "Distribution" by an entity is defined in

section 165, discussed below at paragraphs 265 to 271. Further, a partner's share of non-

deductible costs incurred by a partnership is included as incomings for the partner, e.g.

consumption costs and excluded costs that are not deductible under section 25(1),

discussed above at paragraphs 70 to 75. In this case, the inclusion is to ensure that a

deduction is not effectively available for these costs under the transactional basis income

tax (their non-deductibility will have increased partnership income allocated to partners

and, therefore, the outgoings for the partners under section 123(1)). This rule does not

apply where the deduction is only deferred and will otherwise be recognised for the

partnership under the transactional basis income tax, i.e. it does not apply to outgoings

for partnership assets and liabilities.

Subdivision C: Trusts

232. Trusts are treated differently from partnerships under the Sample. The general

treatment of trusts is outlined in section 130. They are directly liable for tax under the

first head of charge under section 1(1) with respect to their taxable income. Further, the

income of a trust may be allocated and taxed to the beneficiaries of the trust in certain

circumstances, see discussion of section 133 below at paragraphs 235 to 238. This

allocation is a hybrid between the treatment of partnerships and resident's foreign

branches and that of companies. It may occur without distribution but may be triggered

by distribution. For the purposes of this allocation, it is necessary to define the

secondary tax base for trusts and this is done through the concept of "attributable

income" in section 131. In order to avoid double taxation of trust income, beneficiaries

are also allocated any tax paid by a trust with respect to income allocated to the

beneficiaries, see discussion of section 133 below at paragraph 239. The remainder of

section 130 is either self-explanatory or was discussed above at paragraphs 214 to 216.

233. "Attributable income" of a trust is defined in section 131 in similar terms as

"partnership income" in section 121. The discussion of "partnership income" at

paragraph 225 is also relevant to the concept of "attributable income". The major

difference between these two concepts is that losses of a trust may not be allocated to

beneficiaries of the trust. This treatment is similar to the treatment of shareholders in

companies. Losses may, however, be used at the trust level in accordance with section

33.

234. Section 132 contains a special rule only applicable to trusts. In limited

circumstances, it enables a trust to be treated in a similar manner as a partnership, i.e. not

subject to income tax with respect to what would otherwise be its taxable income. This

is achieved by granting a trust a deduction with respect to certain entitlements of a

resident beneficiary. The entitlement must be a "vested right" to income or an amount

included in calculating the income of the trust and exist during the tax year in which the

trust derives the income or amount. "Vested right" is not defined and so will take its

ordinary meaning. It generally means a right that is not subject to contingency. Where

section 132 applies, the beneficiary rather than the trust will be liable to pay tax with

respect to the income or amount by reason of allocation under section 133(2), discussed

in the next paragraph. This payment of tax includes by way of instalment under section

230. In order that the payment of instalments may not be deferred, section 132 only

applies where the trust and the beneficiary have the same tax year. The main benefit of

section 132 is that tax is levied at the beneficiary's marginal rate instead of at the trust

rate. The latter is equal to the highest marginal rate and its application may result in a

claim by a beneficiary (to whom attributable income of a trust is allocated) for a refund

of excess tax credits under section 301.

235. Section 133 deals with the taxation of beneficiaries of trusts and contains a number

of provisions that are analogous to those in section 122, discussed above at paragraphs

226 to 228. However, unlike section 122, section 133 has two provisions that may

allocate attributable income of a trust to a beneficiary. The dominant allocation

provision is section 133(2). It provides for the allocation of parts of the attributable

income of a trust to the trust's beneficiaries in certain conditions. As with partners, the

inclusion is in calculating the beneficiary's income and not directly in assessable or

taxable income. There are three heads in section 133(2) under which allocation may

occur. The first is where section 132 applies, i.e. where the trust is entitled to a

deduction with respect to a vested right of a beneficiary.

236. The second head of allocation under section 133(2) is less stringent. It applies where

a beneficiary is "entitled" to part of or an amount included in calculating the attributable

income of a trust. "Entitled" is not defined. It will take its technical meaning under the

law of trusts or otherwise its general meaning. The third head of allocation under

section 133(2) applies where the attributable income or amount is actually distributed to

a beneficiary. "Distribution" of an entity is defined in section 165 and is discussed

below at paragraphs 265 to 271. With respect to both these heads of section 133(2), the

entitlement must exist or the distribution must be made either during the trust's tax year

to which the attributable income relates or within 30 days of its end. An entitlement or

distribution occurring after this time does not result in allocation under section 133(2).

Unless the trust in question is a non-resident trust and allocation occurs under section

133(3), this means that any tax levied at the trust level is a final tax.

237. Allocation under section 133(3) is not subject to the time limitation in section

133(2). However, section 133(3) only applies to a trust's attributable income of a year

during which the trust was a non-resident trust. The reason for the difference in

treatment is that non-resident trusts are not taxed on their world-wide income and when

their income accrues to the benefit of a resident beneficiary, the country of residence

will not be sure that an appropriate level of taxation has been suffered by the income.

Shareholders of non-resident companies are treated in a similar manner with respect to

dividends received from such companies. The heads of allocation under section 133(3)

correspond to the second and third heads under section 133(2).

238. Section 133(4) applies a pass through of characterisation on allocation under section

133(2) similar to that in section 122(2)(a) discussed above at paragraph 227. By

contrast, allocation of attributable income of a non-resident trust under section 133(3),

i.e. after the year in which the attributable income is derived by the trust, does not result

in the pass through of characterisation treatment. Rather, the income or amounts

allocated are treated as derived by the beneficiary from an investment. Section 133(5)

deals with the timing of allocation. This timing is different from that applying in the

context of partnerships under section 122(2)(b), discussed above at paragraph 227. This

is because the adjustments to incomings and outgoings with respect to an interest in a

partnership to alleviate the potential for temporary double taxation as a result of

allocation, discussed above at paragraph 230, are not made in the context of trusts. In

the case of trusts, as in the case of companies, this adjustment is problematic because it

is more likely that income allocated to one beneficiary may actually be distributed to

another.

239. Sections 133(6) and (7) are similar to sections 122(3) and (4) and so the discussion

above at paragraph 228 in the context of partnerships is relevant. In the case of trusts,

however, there is greater scope for the type of tax that may be allocated to beneficiaries.

Unlike partnerships, trusts are taxpaying entities and so income tax levied directly on

trusts by way of withholding, instalment, or assessment as well as foreign income tax

may be allocated to beneficiaries.

240. Sections 134 and 135 are designed to maximise the benefit that trusts of

incapacitated individuals, estates of deceased individuals, and beneficiaries of both may

derive from section 132. The intention is that, more often than not, the income of these

trusts will be allocated and taxed to the beneficiaries and not the trust. In the case of

trusts of incapacitated individuals, the trustee will still be liable for tax payable by the

incapacitated individual by reason of section 281. However, that tax will be payable at

the individual's rate and not that applicable to the trust.

241. As mentioned above at paragraph 238, the adjustments made to the interests of

partners in partnerships by section 123 are not made in the context of trusts. However,

like section 123, section 136 seeks to prevent the wash out under the transactional basis

income tax of exemptions granted under the payments basis income tax. Further, it

seeks to prevent the double taxation that may occur were both of these income taxes to

apply to final withholding payments and the attributable income of trusts. This wash out

or double taxation may occur if the distribution of exempt amounts, final withholding

payments, or attributable income of trusts were considered incomings for a beneficiary's

interest in a trust. By contrast, this wash out and double taxation may occur in the

context of companies, discussed below at paragraphs 244 to 246.

Subdivision D: Companies

242. Like trusts, companies are taxpaying subjects, see section 140(1). However, unlike

partnerships, trusts, and resident's foreign branches, the income of a company will

generally only be allocated to shareholders where a company distributes a dividend.

Further, dividends of resident companies are taxed by means of a final withholding tax,

discussed above at paragraphs 28 and 29. By contrast, dividends of non-resident

companies are fully taxable in the hands of residents for the reasons discussed above at

paragraph 237 in the context of trusts. In neither case, however, is tax paid by the

company with respect to income that is used to distribute dividends allocated to

shareholders. An exception applies in the context of controlled foreign companies,

discussed below at paragraphs 260 to 262. The remaining provisions in section 140

were discussed above at paragraphs 214 to 216.

243. The secondary tax base for corporate income is "dividends". This term is defined in

section 141 in terms of a "distribution" by a company that is not a "repayment of

capital". Both of these terms are defined in section 165 and discussed below at

paragraphs 265 to 271. Unlike the secondary tax base for partnerships, trusts, and

resident's foreign branches, the definition of dividend will include distributions from

amounts that are either exempt or final withholding payments in the hands of the

distributing company.

244. Section 142 deals with the taxation of shareholders. As mentioned at paragraph 242,

shareholders are generally taxed with respect to dividends either by final withholding tax

(resident companies) or by assessment (non-resident companies). Subdivision D, unlike

Subdivisions B, C, and E, does not provide for specific adjustments to the incomings for

shares in companies. This is for two reasons. Firstly, as discussed at paragraph 238, in

the case of trusts and companies there is no effort to seek to remove the temporary

double taxation that is addressed in the context of long-term contracts, partnerships, and

resident's foreign branches. Secondly, double taxation of corporate income under the

payments basis income tax is intended. As mentioned at paragraph 241, this also means

the wash out of exemptions granted to a company and the double taxation of final

withholding payments received by a company, i.e. on distribution. At worst, this wash

out or double taxation is limited to final withholding tax applied to dividends.

245. However, where the shareholder is also a company, the distribution of corporate

income, exempt amounts, and final withholding payments to the corporate shareholder

will give rise to yet another level of final withholding tax when the corporate

shareholder redistributes these amounts. Where there is a chain of corporate

shareholdings there is the potential for the final withholding tax on dividends to cascade

down the chain. To ameliorate this unintended effect, section 142(2) provides that

certain dividends distributed between resident companies are exempt from tax, i.e.

exempt from final withholding tax. Essentially, the recipient company must hold 25

percent or more of the distributing company.

246. Section 142(3) limits the exemption in section 142(2). It is not available where the

shareholder is an "exempt organisation". This term is defined in section 20 and was

discussed above at paragraph 68. In this case, a dividend will be exempt only if it falls

within the organisation's exemption in section 20. Section 142(2) also does not apply to

dividends distributed on redeemable shares. This is because these types of shares are

highly fungible with debt. Companies in a loss position may essentially borrow funds

through the issue of redeemable shares. The deduction usually associated with interest

payments on debt is of little use to a company with existing losses. By contrast, if the

exemption in section 142(2) applied to redeemable shares the effective lender may be

exempt on the effective interest received in the form of dividends, when the lender

would be taxable if interest were received. This would, in essence, provide a loss

company with a mechanism for passing the benefit of its losses to a lender.

Subdivision E: Foreigner's Symmetrican Branches and Other Foreign Branches

247. Whether foreign branches, i.e. branches situated outside their owner's country of

residence, are treated under the Sample as taxpaying subjects depends on where they are

located. Section 145(1)(a) says that foreign branches that are situated domestically are

taxed with respect to their income but the owner is not, i.e. the owner is exempt with

respect to such income. These branches are also subject to branch profits tax in order to

provide a similar treatment to subsidiaries owned by non-residents, see section 145(2)

and the discussion above at paragraph 32. By contrast, section 145(1)(b) says that other

foreign branches, i.e. those situated in foreign countries, are not taxpaying subjects,

rather the owner is taxed with respect to any taxable income of the branch. In this case,

the income or loss of the foreign branch is allocated to the owner, see section 145(3).

By contrast, only the income of a domestic branch of a non-resident is allocated to the

non-resident and not exceeding the branch's repatriated income. In either case, the

allocation is made in much the same manner as under Subdivision B applying to

partnerships. The remaining provisions of section 145 were discussed above at

paragraphs 214 to 216.

248. The second head of income tax in section 1(1) is the branch profits tax, discussed

above at paragraphs 32 and 212. Section 146 calculates the tax base for this head of

income tax in terms of "repatriated income". Unlike branch profits taxes implemented

by some countries that subject all profits of a branch to the tax, the approach in the

Sample is to tax only those profits that have left the country. "Repatriated income" of a

foreign branch for a tax year is defined in section 146 by reference to "distributions"

made during the year that are not "repayments of capital". Both of these terms are

defined in section 165 and discussed below at paragraphs 265 to 271.

249. The definition of "repatriated income" is similar to the definition of "dividends" in

the context of companies and the discussion above at paragraph 243 of section 141 is

relevant. One difference is that in the case of foreign branches the secondary tax base

for branch income differs depending on the location of the foreign branch. That is, in

the case of domestic branches of non-residents the secondary tax base is repatriated

income and in the case of branches situated in a foreign country it is the income or loss

of the branch calculated under section 147. As mentioned above at paragraph 32, this

treatment of domestic foreign branches is similar to resident subsidiaries of non-

residents. One difference is that in the case of subsidiaries income tax on the secondary

tax base, i.e. dividends, is collected by way of final withholding tax under Division II of

Part V. By contrast, income tax on the secondary tax base of domestic branches is

collected from the branch through the instalment system under Division III of Part V.

250. Section 147 calculates the foreign branch income or loss of a foreign branch in a

similar manner as partnership income or loss is calculated under section 121. The

discussion above at paragraph 225 of section 121 is also relevant to section 147. One

difference is that, as mentioned above at paragraph 247, losses of a domestic branch of a

non-resident are not allocated to the non-resident. Therefore, in calculating the foreign

branch income of such a branch losses may be deducted under section 33.

251. The application of section 148 to foreign branches and their owners substantially

reflects the application of section 122 to partnerships and their partners. The discussion

above at paragraphs 226 to 228 of section 122 is also relevant to section 148. Section

148 is simpler than section 122 in that there is no issue of allocating the income or loss

between partners. The income or loss of a foreign branch is all allocated to its owner.

As mentioned above at paragraph 247, a difference from the partnership provisions is

that in the case of a domestic branch of a non-resident, foreign branch income is

allocated to the non-resident only to the extent of repatriated income of the branch.

Further, losses of the branch are not allocated. Section 148(4) ensures that branch

profits tax paid under the second head of income tax in section 1(1) by such a branch is

allocated to the non-resident owner together with other income tax paid by the branch.

The reason for allocating income and tax to such an owner when the owner has no direct

tax liability with respect to the branch income is that this tax may be further allocated to

other persons. For example, where the non-resident owner is a controlled foreign trust

or company the further allocation may be to a beneficiary or associated shareholder.

252. Section 149 makes adjustments to the outgoings and incomings for an owner's

interest in a foreign branch. They are the same adjustments that are made in the context

of interests in partnerships under section 123. Therefore, the discussion above at

paragraphs 230 and 231 of section 123 is also relevant to section 149.

Subdivision F: Controlled Foreign Trusts and Companies

253. This Subdivision differs from Subdivisions B to E in that it amends the treatment

relating to certain trusts and companies under Subdivisions C and D. The approach is to

treat these trusts and companies as distributing their unallocated income at the end of

each tax year. This causes a treatment similar to, but not the same as, that applying to

the income of partnerships and resident's foreign branches. The reason for the

Subdivision is to prevent deferral of taxation by residents with respect to their foreign

source income by holding funds in non-resident trusts and companies. These rules are

typically complex and whether they should be adopted or not will depend on local

considerations. These rules may also be adopted in a simplified but less precise form.

For example, Subdivisions C and D may be entirely overridden, all income of the trust

or company may be allocated to beneficiaries and shareholders at the end of a tax year,

and all distributions made during the year exempted.

254. The Subdivision applies to "controlled foreign trusts" and "controlled foreign

companies", phrases that are defined in section 105. These are non-resident trusts and

companies in which an "associated" resident person holds an interest. "Associated

persons" is defined in section 107 and was discussed above at paragraphs 207 to 209.

This interest can be held directly or indirectly through other non-resident entities. For

example, Company A and Trust B are non-residents and Z is a resident. Company A

holds 51 percent of Trust B and Z holds 51 percent of Company A. By reason of section

107(2)(d)(i), Company A and Z are associates. Further, Z holds a direct interest in

Company A and so Company A is a controlled foreign company. Further, by reason of

section 107(2)(d)(i), Company A and Trust B are associates and, by reason of section

107(2)(d)(ii), because Company A is also associated with Z, Trust B and Z are also

associates. As Z holds an indirect interest in Trust B, i.e. through Company A, Trust B

is a controlled foreign trust.

255. The definition in section 105 is further extended where this association with the non-

resident company or trust would be met if not more than five residents were associated.

For example, V, W, X, Y, and Z are non-associated residents that each hold 12 percent

of Company C, a non-resident company. If V, W, X, Y, and Z were associated, they

would each be associated with Company C by reason of their aggregated holding in the

company exceeding 50 percent, see section 107(2)(d)(i). Therefore, as they hold an

interest in Company C, Company C is a controlled foreign company.

256. Section 156(1) defines "unallocated income" of a controlled foreign trust or

company. In the case of a trust, this is the trust's "attributable income" under section 131

for a tax year less the amount of that income that is allocated under section 133(2) for

the year. The discussion above at paragraphs 233, 235, and 236 is relevant in this

respect. The "unallocated income" of a controlled foreign company is also its

"attributable income" but this time less dividends distributed during the year.

"Attributable income" of a controlled foreign company is defined in section 156(2). It is

similar to the definition of that term in the case of trusts in section 131 and the

discussion above at paragraph 233 is relevant.

257. Section 157(1) provides for the distribution of unallocated income of a controlled

foreign trust or company. The provision only applies to a trust or company that is a

controlled foreign trust or company at the end of the tax year in question. Any attempt

by a resident person to divest themselves of an interest in a non-resident trust or

company just before the end of the year in order to avoid the allocation under this

provision may be thwarted by section 69, the general anti-avoidance rule. This may

particularly be the case if the interest is re-acquired shortly after the end of the year.

Unallocated income is generally treated by section 157(1) as distributed in accordance

with beneficiaries rights to the income. In some cases this allocation may be difficult,

e.g. in the case of a discretionary trust or a company with different classes of shares. In

this case, the tax administration is given power to provide an allocation.

258. The amount treated as distributed to the beneficiaries will be included in calculating

the income of the beneficiaries. In the case of resident beneficiaries, this will be

assessable income, e.g. under section 18 including by way of section 133(2)(c) or (3)(b),

and, therefore, may be taxed under the first head of income tax in section 1(1).

Importantly, where the beneficiary is a partnership, trust, or foreign branch, the

distribution will be included in calculating the entity's partnership income, attributable

income, or foreign branch income, respectively. Similarly, if the beneficiary is also a

controlled foreign trust or company, the distribution will be included in calculating the

unallocated income of the trust or company. Returning to the example above at

paragraph 254, assume that Company A and Trust B do not have any distributions or

allocations for the tax year in question. In this case, section 157(1) will allocate 51

percent of the unallocated income of Trust B to Company A, which will be included in

calculating the unallocated income of Company A. 51 percent of the unallocated

income of Company A will be allocated to Z. The effect is to allocate 26% of the

unallocated income of Trust B to Z.

259. Income that is treated as distributed ("allocated") in one year may actually be

distributed in a future year. If both the allocation and the distribution are taxed, there is

double taxation. Section 157(2) seeks to relieve this double taxation by granting a

beneficiary a deduction for amounts allocated under section 157(1). The deduction is

only permitted in a tax year after the tax year of allocation and only to the extent of

allocations under the general provisions applicable to trusts and companies for the future

year, e.g. allocation under section 133(3) and distributions of dividends. The exception

is that in the case of a controlled foreign trust, the deduction can be used in the year of

allocation under section 157(1) to the extent of allocations made under section 133(3)

for that year. This allocation is similar to dividends distributed by companies out of

prior years' attributable income. However, under section 156(1), these distributions

reduce a company's unallocated income but allocations under section 133(3) do not

reduce the unallocated income of a trust.

260. Section 157(3) applies to controlled foreign companies in a similar manner as

sections 122(2), 133(4), and 148(2) apply to partnerships, trusts, and foreign branches,

respectively. The above discussion of those provisions at paragraphs 227, 238, and 251

is relevant to section 157(3). Section 157(3) only applies to controlled foreign

companies whereas section 133(4)(a) will apply to amounts treated as distributed by

controlled foreign trusts by section 157(1). Unlike, Subdivisions B, C, and E,

Subdivision D does not provide for the pass through of characterisation on the

distribution of dividends by companies. That is, dividends typically have the character

of dividends and do not take their character from the income of the company from which

they may be considered distributed. Section 157(3) provides an exception to this rule.

The main reason for this is to facilitate underlying foreign tax relief, relief that is often

automatically available in the case of partnerships, trusts, and foreign branches, see

further the discussion below at paragraphs 311 to 316.

261. Section 157(3) applies to all dividends distributed by a controlled foreign company

and not just those treated as distributed by section 157(1). However, in order to receive

the pass through of characterisation treatment, the recipient of the dividend must be an

associate of the company. This provision does not contain the additional requirement

that the recipient also be a company, as is often found in underlying foreign tax relief

systems in practice. In the context of what is close to full dividend relief for shareholder

and corporate income taxes under the Sample, see the discussion above at paragraphs 28

and 29, this restriction does not seem appropriate. Further, there does not seem to be

any situation in which this approach can be abused to reduce taxation. If countries wish

to restrict underlying foreign tax relief only to resident companies, it is a relatively

simple matter to add this requirement to section 157(3).

262. Sections 157(4) and (5) correspond to sections 122(3) and (4), 133(6) and (7), and

148(3) and (5) applying in the cases of partnerships, trusts, and foreign branches,

respectively. The above discussion of those provisions at paragraphs 228, 239, and 251

is relevant to section 157(4) and (5). Section 157(4) and (5) also only apply to

controlled foreign companies. Section 133(6) and (7) will apply in the context of

controlled foreign trusts. Section 157(4) and (5) allocate tax paid or treated as paid by a

controlled foreign company to distributions to which section 157(3) applies. The effect

is that shareholders associated with a controlled foreign company will be proportionately

allocated tax of the company with distributions of the company. As such tax is treated

as paid by an associated shareholder, the shareholder will be entitled to foreign tax

offsets under section 200 with respect to the tax. Section 157(3), (4), and (5) may have

an extended operation by reason of section 175(3). The effect is that domestic income

tax paid by a resident company is allocated to non-resident associated shareholders with

dividends received from the company. If such a shareholder is also an entity, the

domestic tax may be further allocated (as foreign income tax) and, if allocated to a

resident beneficiary, the beneficiary may claim foreign tax offsets for the underlying

domestic tax.

263. Finally, section 158 supplements the treatment of outgoings and incomings for

interests in trusts and companies discussed above at paragraphs 241 and 244. It is

targeted at removing the potential temporary double taxation towards which section 123

and 149 are targeted in the context of partnerships and foreign branches, respectively.

To that extent, the above discussion of those provisions at paragraphs 230, 231, and 252

is relevant.

Division III: General Provisions Applicable to Entities

264. This Division contains a number of provisions that apply commonly to partnerships,

trusts, companies, and foreign branches. The Division is predominantly directed

towards issues arising as a result of the potential overlap of the payments basis income

tax and the transactional basis income tax. This is a complex area because entities

effectively create two levels of transactional basis income tax, a direct one at the entity

level and an indirect one with respect to interests in entities held at the beneficiary level.

265. Section 165(1) begins by defining the central concept of "distribution" by an entity.

This definition is particularly important with respect to the taxation of entities and their

beneficiaries. Distributions are often included in calculating income of beneficiaries

under the payments basis income tax, e.g. by section 18(2)(a) and 133(2) and (3) with

respect to companies and trusts, respectively. They are also taken into account under the

transactional basis income tax, e.g. by sections 123 and 149 with respect to partnerships

and foreign branches, respectively.

266. "Distribution" is defined in terms of a "payment" by an entity to a beneficiary.

"Payment" is defined in section 41, see above discussion at paragraphs 103 and 104.

"Distribution" potentially includes any payment by an entity to a beneficiary irrespective

of the capacity in which the beneficiary receives the payment, e.g. whether received as

beneficiary, employee, purchaser, or debt holder. Given the broad definition of

"payment", the definition of "distribution" is very broad but is subject to exclusions. A

payment by an entity to a beneficiary is not a distribution to the extent that the

beneficiary makes a return payment of an equal amount. For example, to the extent that

a beneficiary pays market value for goods sold by the entity, the transfer of the goods by

the entity is not a distribution. Further, to the extent that the payment is, otherwise than

as a distribution, included in calculating the income of a beneficiary it is not a

distribution by the entity. The same is true where the payment is a final withholding

payment of the beneficiary.

267. Section 165(2) sub-categorises distributions by entities. These sub-categories often

result in differing tax consequences. Under section 165(3), a distribution can only be a

distribution of profits or a repayment of capital if it effectively reduces the distributing

entity's resources. This means that these types of distributions will typically involve

payments under the first limb of the definition of "payment" in section 41 but may

involve a payment under the second limb of that definition. Section 165(4) then

contains a profits-first rule. To the extent that the market value of an entity's assets

exceeds the market value of its liabilities and capital contributions, a distribution of this

type is a distribution of profits. To the extent there is no such excess, a distribution of

this type is a repayment of capital. This general profits-first rule is used to minimise the

potential for tax arbitrage, e.g. by entities streaming repayments of capital to taxable

persons and distributions of profits to exempt persons. Often commercial law adopts a

profits-first rule, although usually only for companies. Whether this tax law profits-first

rule is necessary should be assessed according to local considerations such as these.

268. Section 165(5) contains an exception to the profits-first rule in certain cases of

termination of interests in entities including buy-backs. The exception only applies

where distributions made in these circumstances are not referable to a share of profits of

the entity. Further, the entity must terminate sufficient of the beneficiary's interest in the

entity that after the termination the beneficiary is no longer an "associate" of the entity.

"Associate" is defined in section 107 and discussed above at paragraphs 207 to 209.

This means that it is not necessarily sufficient for the beneficiary to part with all their

interests in the entity. The beneficiary must also sever all substantial connections with

the entity including, e.g. any indirect holdings and holdings of relatives. Where these

conditions are met, the profits-first rule is replaced with a rule considering the

distribution as proportionately a distribution of profits and a repayment of capital. For

example, this provision will apply when entities are liquidated.

269. In order to balance the broad definition of distribution of profits, section 165(6)

contains a broad definition of "capital contribution". Under section 165(4), capital

contributions effectively reduce the amount of distributions considered distributions of

profits and increases those considered a repayment of capital. Reflecting section 165(1),

a "capital contribution" is potentially any payment under the first or second limb of the

definition of "payment" in section 41, discussed above at paragraphs 103 and 104, made

by a beneficiary or potential beneficiary to an entity. The exceptions are to the extent

that the entity makes a return payment to the beneficiary or the payment is an exempt

amount, final withholding payment, or included in calculating the entity's income.

Despite the broad definition, some informal value transfers to an entity will not be a

capital contribution. An example is a gift to an entity that is made "in respect of" a

business or investment of the entity, which must be included in calculating the entity's

income under section 17(2)(f) or 18(2)(e). These provisions do not apply in the case of

gifts by associates of an entity, the most likely type of beneficiary to make a gift to an

entity. Such gifts by such a beneficiary will be treated as a capital contribution. Further,

if the "in respect of" nexus is not met, a gift to an entity by a beneficiary will be a capital

contribution in any case. Capitalisations of profits are also not a capital contribution and

the distribution of capitalised profits by an entity will be a distribution of profits.

270. Section 166 is a short provision setting out the treatment of an entity with respect to

capital contributions to and distributions by the entity. The approach under the Sample

is, from the perspective of an entity, to ignore interests in the entity. It would be

possible to set up a consistent treatment, particularly under the transactional basis

income tax, by treating interests in entities as liabilities of the entity. This treatment

would, perhaps, be closer to economic reality. However, it is not an approach used in

practice and is not used in the Sample. Accordingly, the definition of "liability" in

section 78 specifically excludes an entity's rights and obligations with respect to an

interest of a beneficiary in the entity.

271. Any distribution of an entity that is not a distribution of profits or a repayment of

capital is a "distribution of a collateral benefit", see section 165(7). These distributions

will typically consist of payments under the third and fourth limbs of the definition of

"payment" in section 41, discussed above at paragraphs 103 and 104. The effect of

distributions of this type is to cause an entity to not derive income but, rather, provide a

benefit directly to the beneficiary, i.e. the distribution to the beneficiary represents

notional income of the entity. For example, a company may have a property available

for rent but permits a shareholder to stay in it for free. There are two approaches to the

taxation of this type of benefit. One is the same as is used in the context of employee

fringe benefits. The notional income of the company may be ignored and the benefit

fully included in calculating the income of the beneficiary.

272. This approach appears inconsistent with taxing corporate income twice under the

Sample, i.e. once to the company and a second time by way of final withholding tax on

distribution. The alternate approach is to include the notional income in calculating the

income of the entity and otherwise treat the distribution of a collateral benefit in the

same manner as any other distribution of profits. This is the approach taken in the

Sample under section 167(1). This issue could also be addressed through an

equalisation tax by requiring entities to match distributions with taxed profits and to the

extent they cannot impose a make-up tax. However, an equalisation tax will have other

effects. It may also tax distributions of unrealised gains and wash out other preferences

such as direct exemptions and foreign tax relief. This treatment is inconsistent with the

treatment of income derived directly by individuals and has been avoided in the Sample

on that basis. A more principled approach to the quasi-realisation of unrealised gains,

e.g. through borrowing, was discussed above at paragraph 174.

273. Nevertheless, section 167(1) does create some inconsistency with the treatment of

individuals. Individuals are not taxed with respect to notional income, e.g. notional rent

is not allocated under the Sample to individuals who live in their own homes. In the

context of an individual, this is consistent with the basic approach under the Sample of

not taxing wealth created unless it is paid for by a third party, see discussion above at

paragraph 107. In the context of an entity, it may be argued that the entity is being paid

for wealth created that is represented by distributions of collateral benefits, i.e. the

beneficiaries pay in the form of allowing to entity to use their capital. Even if the entity

is looked through, often it will be a group of persons managing and owning the entity

that will be receiving the payment in the form of the use of capital. In these

circumstances, the taxation of the notional income to the entity may be justified.

274. While this justification for taxation appears convincing in the case of widely held

entities, it is less so in the case of closely held entities, particular those acting in a

passive manner. In this case, as the beneficiary may have conducted the passive activity

directly, to tax the entity's notional income but not to tax if the beneficiary conducts the

activity is to prefer form over substance. To this end, section 167(2) adopts a limited

exception to section 167(1). The exception only applies to entities that are closely held

by individuals and where the collateral benefit is provided outside the course of a

business of the entity. Similar to the case of an individual in the same situation,

deductions are denied for amounts to the extent that they relate to the provision of the

collateral benefit. For example, this exception may apply where a deceased individual

places the family home in trust and the surviving spouse is permitted to live in the home

rent free. By reason of section 167(2), the notional rent will not be taxable to the trust

but the trust cannot claim deductions with respect to the home, e.g. rates and utilities.

275. Section 168 essentially applies the market value rules in sections 94(1) and (4) and

95 to dealings between entities and their beneficiaries. In this context, the above

discussion of those sections at paragraphs 189 and 194 is relevant. The main difference

between section 94(1) and (4) and section 168(1) and (2) is that under the latter

provisions the transferor may incur a loss on the transfer. Where the entity and the

beneficiary are associates, section 94(1) and (4) will override section 168(1) and (2) to

deny any such loss. Section 168 only applies with respect to the transactional basis

income tax. A transfer of an asset or liability between an entity and a beneficiary may

give rise to a gain or loss from the realisation but may also result in a distribution by the

entity or a capital contribution to the entity, e.g. where excessive or inadequate

consideration is provided for the transfer.

276. Section 168(4) expressly excludes section 168 from applying to dealings in interests

in entities between the entity and a beneficiary. The issuing of interests in entities is

governed by section 169. It also applies to the transfer by an entity of an interest in

itself, e.g. treasury stock. The general approach in section 169(1) is consistent with

section 168 in applying a market value rule to the new beneficiary. The only

circumstances in which a person is likely to acquire an interest in an entity from the

entity for other than market value is where the person either already holds an interest in

the entity or where the person is an associate of the entity. Where market value is not

paid, there is an effective value shift either to or from the existing interests in the entity,

except in some circumstances outlined in section 169(2). Such a value shift may be

abusive where it is to or from a person associated with the entity. Value shifts of this

type are dealt with in sections 173 and 174 and are discussed below at paragraphs 289 to

295. The market value rule in section 169(1) is consistent with these rules.

277. Section 169(2) and (3) apply an exception to the market value rule in section 169(1).

They apply where the beneficiary already holds an interest in the entity, the new interest

is issued or transferred in respect of the existing interest, and there is a value shift

between the two interests. They do not apply where there is an effective value shift

between interests of different beneficiaries of the entity. In particular, section 169(2)

applies to a proportionate bonus issue to all beneficiaries in an entity. It also applies

where the difference between the amount paid by a beneficiary for the new interest and

the market value of the interest is balanced by an opposite change in value of the

beneficiary’s existing interest. Where section 169(2) applies, section 169(3) substitutes

the market value rule with a rule that spreads the net outgoings for the old and new

interests over both interests according to their market value.

278. The cancellation of an interest in an entity or the transfer of such an interest to the

entity, e.g. in the case of a buy back, typically gives rise to both payments basis and

transactional basis income tax consequences. Any payment by the entity to the

beneficiary for the cancellation or transfer will be a distribution by the entity. Any part

of this distribution that is not a repayment of capital may be subject to payments basis

income tax treatment, depending on the type of entity involved. Any part that is a

repayment of capital is subject to transactional basis income tax treatment. The extent to

which such a distribution is a repayment of capital is determined under section 165,

discussed above at paragraphs 265 to 269. The quantity of such a distribution is

typically determined in accordance with section 55. Section 170(1) provides an

exception to this approach where the entity and the beneficiary whose interest is

cancelled or transferred are associates. In this case the beneficiary is treated as receiving

a market value distribution for parting with the interest in the entity. This is consistent

with the approach in sections 94 and 95. Section 95 would not apply in this case

because section 78 specifically excludes an entity's obligations with respect to an interest

in the entity from the definition of "liability".

279. Where an entity purchases an interest in itself on a recognised stock exchange,

section 170(2) provides an exception to the combination payments basis and

transactional basis income tax treatment discussed in the last paragraph. The reason for

this exception is that beneficiaries selling on the stock exchange will typically be subject

to transactional basis income tax treatment only with respect to amounts derived for the

sale. Further, due to the anonymity of sales in the ordinary course of business on a stock

exchange, a beneficiary will not know that it is the entity that is buying the interest.

Section 170(2) seeks to ensure that a beneficiary has the same tax consequences in these

circumstances irrespective of who is the buyer. This rule may not be necessary for

countries that do not permit entities to buy interests in themselves.

280. Section 170(2) effectively provides the selling beneficiary with transactional basis

income tax treatment only. The entity is then treated as the holder of the interest in itself

and cancelling that interest for a payment equal to the one made to the beneficiary for

the interest. This deemed payment would be divided into a profits portion and a

repayment of capital portion calculated in accordance with section 165(5). The profits

portion may be subject to, e.g. dividend withholding tax. The capital portion will be

treated as received in respect of the cancellation of the interest. This may result in a loss

for the entity from the realisation of the interest. The overall effect of section 170(2) is

similar to that which would have applied to the beneficiary if both the payments basis

and transactional basis income taxes were applied as usual. The difference is that the

entity may realise a loss that is offset by the beneficiary realising a smaller loss or

realising a gain from the sale.

281. Sections 33(1)(c), 94, and 200(3)(b) permit, in limited circumstances, the direct

transfer of tax attributes to and from entities, see discussion above at paragraphs 93 to 95

and 189 to 193 and below at paragraph 316. As mentioned at paragraph 42, this is

essentially an issue of looking through the form in which a business or investment is

held and looking to economic substance. Section 171 is of an opposite nature in seeking

to prevent an indirect transfer of tax attributes of an entity to persons who do not own or

are not commonly owned with the entity. A provision of this nature is recommended in

order to prevent tax arbitrage irrespective of whether the corresponding provisions are

implemented to permit the direct transfer of entity tax attributes. Section 171(1)

prevents the carry forward of tax attributes under the transactional basis income tax. It

treats an entity as realising all its assets and liabilities where there is a change of 50

percent or more in the underlying ownership of the entity within a three year period.

This level of underlying ownership is consistent with that required for the direct transfer

of tax attributes to associates. Section 90, discussed above at paragraph 185, will apply

a market value rule to the realisation. The result is that the entity will realise any

previously unrealised gains and losses just before the change. This, combined with

section 171(2), prevents the purchaser of an entity indirectly obtaining access to these

tax attributes.

282. Section 171(2) denies the carry forward of certain tax attributes of an entity under

the payments basis income tax where a change in ownership of the entity occurs. The

provision also applies to the carry back of tax attributes, where that is possible. The tax

attributes described in section 171(2) are self-explanatory. Section 171(1) and (2) may

apply in tandem, e.g. where section 171(1) causes the realisation of a loss that is not

available to be carried forward by reason of section 171(2)(a). Section 171(3) applies

the rules in section 171(2) to parts of tax years.

283. Section 172 is also of an anti-abuse nature. It is primarily targeted at the indirect

removal of profits from an entity in a manner that avoids taxation that would occur if the

profits were distributed, e.g. the final withholding tax on dividends. This might occur,

e.g. where a foreign parent sells shares in a domestic subsidiary (with retained profits) to

another resident company (the "acquirer"). The acquirer may try to remove the profits

exempt from tax by reason of section 142(2), discussed above at paragraphs 245 and

246. Further, the foreign parent will not be subject to tax on a transactional basis with

respect to any gain on the shares realised. The shares will not be “domestic assets” as

defined in section 76, so the gain will not have a domestic source by reason of section

68(3)(a), and, therefore, the gain will not be included in the parent’s assessable income

under section 15(1)(b). Such a scheme would only result in deferral of the dividend tax

since the dividend tax would be levied whenever the subsidiary’s profits were ultimately

redistributed to a shareholder not entitled to the benefit of section 142(2). However, as

the distribution is likely to cause the value of the shares in the subsidiary to drop, there is

also the potential for the acquirer to throw up a loss by disposing of the shares post

distribution.

284. Section 172 addresses this situation by treating the payment by the acquirer to the

foreign parent for the shares in the subsidiary as a distribution of dividends by the

subsidiary to the parent. Such a payment would, therefore, give rise to a final

withholding tax liability. This treatment will also reduce the outgoings of the acquirer

for the shares in the subsidiary, removing the potential for any loss where those shares

are further realised by the acquirer.

285. Sections 173 and 174 provide rules that seek to restrict arbitrage that might

otherwise occur due to the dual application of the transactional basis income tax and its

interaction with the payments basis income tax where entities are involved. In

particular, it is targeted at the shifting of value between assets and liabilities held in an

entity by persons who are associates of the entity. Value shifting may occur in other

cases, e.g. the cancelling of one direct interest in an asset that causes another direct

interest in the asset held by an associated person to increase in value. This form of value

shifting does not involve an entity and is not specifically dealt with by the Sample.

Rather, it is viewed as an issue of identifying a transfer and, therefore, a payment. The

cancellation will effect a transfer of the person's interest in the asset to the associate.

Section 94(1) will typically provide market value treatment for such a transfer. Where

the transferred interest merges into the associate's existing interest, it will be a cost

incurred in improving the existing interest and so included in the outgoings for the

existing interest.

286. By contrast, value shifting between independent parties is viewed as an issue of

allocation of payment under the Sample. For example, a person downgrades a right

against a third party in return for an associate of the third party granting rights to an

associate of the person. The granting of rights by the third party's associate is a payment

under section 41(1)(b). Under section 60(2) the tax administration may treat the

payment as made to the person in respect of the downgrade of that person's right. It

would, therefore, be treated as an incoming with respect to the downgraded right. The

same approach applies where the rights or liabilities are held in an entity that is not an

associate of the person holding the rights. For example, the same approach would apply

where an interest of a beneficiary in an entity is cancelled by the entity but a subsidiary

of the entity issues an interest to an associate of the beneficiary.

287. Importantly, this treatment of value shifting cannot be avoided through the use of

back-to-back arrangements with independent parties. For example, assume with respect

to the last example that the subsidiary does not issue an interest to an associate of the

beneficiary. Rather, a bank that is independent from the entity and its subsidiary makes

an agreement with the associate of the beneficiary that in the event that the beneficiary's

interest in the entity is cancelled, the bank will make a payment to the associate. The

subsidiary of the entity makes a separate agreement with the bank to indemnify the bank

with respect to any payment under this agreement. Under section 60(2)(c), the tax

administration may look through the agreement with the bank and the indemnification of

the bank and treat the payment by the bank as received by the beneficiary in respect of

the cancellation of the interest in the entity. The broad anti-abuse powers in sections 62,

63, and 69 may also apply in these types of circumstances.

288. One remaining area of difficulty with respect to value shifting is the use of entities to

shift value between associates. This may occur directly, i.e. where the shift in value is

between various interests in a particular entity. In this case, there is no relative change

in the value of the entity, only the assets and liabilities held in it. Value shifting between

interests in entities of persons who are associates of the entities may also be indirect, i.e.

where value is shifted out of a particular entity and into an associate of the entity or vice

versa. There are two types of indirect value shift. Firstly, an indirect value shift may be

a consequence of a direct value shift such as where an entity holds the interest that value

is moved to or from. Alternately, an indirect value shift may, in certain circumstances,

result from an entity directly making a payment to or receiving a payment from an

associate for inadequate consideration, i.e. a gift. The discussion proceeds to consider

these types of direct and indirect value shifting in the context of sections 173 and 174.

289. The direct value shifting provisions in section 173 apply where an "event" occurs

with respect to an asset or liability held in an entity that causes an increase or decrease in

value of another asset or liability in the entity. "Event" is defined broadly in section

173(8) and essentially involves an acquisition, realisation, or part acquisition or

realisation ("variation") of an asset or liability. Section 173 only applies where both

assets or liabilities are held by persons who are "associates" of the entity in question, see

definition of "associate" in section 107 discussed above at paragraphs 207 to 209. This

ensures that the arrangements in question are not made at arm's length. Because of this,

invariably the event will give rise to market value consequences for the party holding the

asset or liability with respect to which the event occurs, e.g. under section 94 or 95 or,

where the asset is an interest in an entity, section 169 or 170. So, for example, the

issuing of a share in a company will be treated as acquired for market value or the

cancelling of a share in a company will be treated as realised for market value. This

treatment is appropriate and so section 173 does not apply to the asset or liability with

respect to which the event occurs.

290. Section 173 only applies to the asset or liability held in the entity the value of which

is increased or reduced by reason of the event. The problem is that no event has

occurred with respect to this asset or liability that directly permits adjustment to its

incomings or outgoings such as to ensure that the Sample applies appropriately. It may

be that in many cases the general provisions of the Sample may be applied to indirectly

provide an appropriate adjustment to this asset or liability, e.g. through the use of

sections 60(2), 62, 63, and 69. However, there may be certain circumstances in which

such an adjustment is problematic. For example, in the case of a cancellation of an

interest in an entity, there is no transfer of the interest to the entity and, further, such an

interest is not a "liability" of the entity, see the definition of that term in section 78. In

this case there may be no payment made by the person whose interest is cancelled that

can be allocated under section 60(2) to the holding of say an increased value interest in

the entity. Further, the use of sections 60(2), 62, 63, and 69 require the exercise of

power by the tax administration. Section 173 applies automatically. This is appropriate

as section 173 encompasses some of the most likely scenarios in which value shifting

will occur.

291. The adjustments required to the asset or liability into or from which value is moved

are provided by section 173(2) to (7). Effectively, those provisions adjust the incomings

or outgoings for the asset or liability in question. Where there is a decrease in value of

an asset, the person is treated as realising part of the asset and deriving in respect of the

realisation an amount equal to the reduction in value. Any net outgoings for the asset

are apportioned to the part of the asset retained and the part treated as realised and so

this process may result in recognition of a gain. Any loss that may result is not

recognised. This is consistent with the approach in section 94. Where there is a

decrease in the market value of a liability, the person's incomings for the liability are

increased by a similar amount. This process may also result in the recognition of a gain

but not a loss. Where there is an increase in the market value of an asset or liability, the

increase is treated as outgoings for the asset or liability.

292. Section 174 deals with indirect value shifting. It applies where an entity holds the

asset or liability the incomings or outgoings for which are adjusted under section 173. It

also applies to entities making gifts to or receiving gifts from associates. In either case,

there is a movement of value between the entity and the associate. The difference

between these two cases of indirect value shifting is that in the first case there is no

actual payment to or from the entity but there is in the second case. Value is also shifted

between an entity and an associate where losses are transferred under section 33(1)(c) or

foreign income tax is transferred under section 200(3)(b). In order to ensure consistent

treatment, "gift" is defined in section 345 to include such transfers for inadequate

consideration.

293. In the second case of indirect value shifting (see above at paragraph 288), if the gift

is by an entity to a beneficiary, it will typically be a distribution by the donor entity. If

the gift is to an associate of a beneficiary, it may still be a distribution if the tax

administration makes use of section 60(2). Section 174(1) alleviates the need for use of

section 60(2) and covers decreases in value under section 173. It treats such movements

in value from an entity as a distribution to associates of the entity in proportion to their

interests in the entity. The reverse situation is where an entity receives a value shift, e.g.

is the donee of a gift. As mentioned in the discussion of section 165 above at paragraph

269, the receipt of a gift will not be included in calculating the income of the donee

under section 17(2)(f) or 18(2)(e) where the donor and the donee are associates. Rather,

where the donee is an entity and the donor an associated beneficiary the gift is treated as

a contribution to the capital of the entity. Section 174(3) reflects section 174(1) by

treating value shifted into an entity by associates, whether under section 173 or as a

result of a gift, as a contribution to capital made by associates of the entity in proportion

to their interests in the entity. Effectively, this results in an upward adjustment to the

outgoings for these interests.

294. Section 174(1) and (3) deal with value shifts to and from an entity by associates of

the entity, irrespective of whether they are also beneficiaries of the entity. However,

those provisions adjust the treatment of the beneficiaries of the entity who are also

associates of the entity. Where the associated beneficiary in an entity (the "primary

entity") is itself an entity (the "secondary entity"), the value shift to or from the primary

entity should have a similar proportionate effect on the value of interests in the

secondary entity. Adjustments similar but proportionate to those made by section

174(1) and (3) are, therefore, appropriate. These adjustments are made by section

174(2) and (4). The provisions are recurrent and so further apply where an associated

beneficiary in the secondary entity is itself an entity, and so on.

295. The rules in sections 173 and 174 are complex, difficult to apply, and represent but

one approach to value shifting. Many countries may not wish to adopt them but, rather,

rely totally on general anti-abuse rules. However, if entities are permitted to transfer tax

attributes such as under sections 33(1)(c), 94, and 200(3)(b), value-shifting rules are of

added importance. Another manner in which the issue may be addressed, if arbitrarily,

is by only permitting losses under the transactional basis income tax to offset gains

under that income tax. This does not prevent potential abuse through value shifting, it

only focuses it in the transactional basis income tax where most, but not all, value

shifting problems occur. This in turn will cause friction between the payments basis and

the transactional basis income taxes. This might occur where a person has transactional

basis losses. The person may attempt to turn payments basis gains into transactional

basis gains in order to use the losses. Whatever approach is taken to value shifting, a tax

administration should be aware of the issue and how to appropriately deal with it under

the income tax law.

296. Section 175 provides special rules designed to provide the tax administration with

relief where domestic source income and losses are allocated to or through non-residents

under the entity provisions. As mentioned above at paragraphs 227, 238, 251, and 260,

amounts allocated under sections 122 (partnerships), 133 (trusts), 148 (foreign

branches), and 157 (controlled foreign companies) may retain their character in the

hands of a beneficiary. Where this allocation is of, e.g. domestic source income to a

non-resident, the non-resident may be required to include the amount allocated in

calculating their assessable income and, therefore, required to file a return of income.

This may be administratively inconvenient, particularly where such income is allocated

through a number of non-resident entities. Further, where the non-resident beneficiary's

tax rate is lower than the tax rate imposed on the entity from which the income is

allocated, the non-resident may seek a refund of excess tax paid. This is also true of

resident beneficiaries that are allocated domestic source income through non-resident

entities. This scenario may also expose the tax administration to bogus claims for

refunds.

297. In order to address this situation, section 175(1) overrides the sourcing rules in

section 68 to treat certain domestic source income and losses that are derived or incurred

through entities as having a foreign source. Section 175(1) applies in two cases. Firstly,

it applies where the domestic source income or loss is derived or incurred by a non-

resident person through a resident entity. The second case is where domestic source

income is derived through a non-resident entity. The treatment of domestic source

income as foreign source income means that it will not be included in calculating

assessable income of non-resident beneficiaries. This rule does not apply to the

allocation of income of partnerships, which is partly covered by section 122(5),

discussed above at paragraph 229, and where the administrative inconvenience appears

minimal. Section 175(2) overrides the definition of "foreign income tax" in section 345

to provide that domestic income tax paid with respect to income re-sourced under

section 175(1) is treated as foreign income tax. This rule means that such domestic

income tax may not be claimed as a tax credit and, therefore, may not be the subject of a

refund claim. However, where a resident beneficiary is involved, foreign tax offsets

may be claimed with respect to such tax under section 200, see the discussion below at

paragraphs 312 to 314. Section 175(3) was discussed above at paragraph 262.

PART IV: SPECIAL INDUSTRIES AND OFFSETS

298. In contrast to Part III (which provides special rules that apply to particular types of

persons), Part IV provides special rules that are particular to certain types of activity,

without particular reference to the type of person conducting the activity. Division I

covers insurance, Division II covers retirement savings, and Division III provides

special offsets for persons deriving foreign source income.

Division I: Insurance Business

299. This Division contains special rules applicable to the insurance industry. It begins

with section 180, which contains definitions of some central concepts for the Division.

In particular, it distinguishes between "general insurance" and "investment insurance".

"Investment insurance" is insurance that contains an investment aspect, i.e. where a

return on the premium paid is expected. This type of insurance is broader than but

includes the classic province of life insurance. "General insurance" is defined to cover

other types of insurance. The following sections in Division I proceed to consider the

treatment of premiums paid for insurance, the calculation of income from an insurance

business, and the treatment of proceeds from insurance. The first and third of these

involve the treatment of persons interacting with insurance businesses whereas the

second involves the tax treatment of such businesses. The second will be considered

before the first and third.

300. Section 182 provides for calculating income from a general insurance business.

Premiums received in respect of insurance conducted by the business are included in

calculating income from the business. This is offset by a deduction for proceeds paid in

respect of such insurance. Otherwise, income from a general insurance business is

calculated in the usual manner under Part II. One particular issue with respect to

insurance business is the fluctuating profitability of the business. Insurance business is,

arguably, subject to greater fluctuations in income and losses than many other forms of

business. This issue is generally addressed through the provision for loss carry forward.

However, in the case of insurance, this is often viewed as insufficient. One approach

often adopted is to permit insurance businesses to accrue a tax-free reserve, e.g. through

a deduction for a claims reserve. This approach is often aligned with the requirements

of prudential supervision of the insurance industry.

301. A disadvantage of this approach is that it enables the insurance industry to create a

pool of tax-free funds that may be invested to derive a return. No other industry is

permitted to save in this manner unless the receipts in question consist of contributions

of capital to business. Typically such contributions are made out of taxed funds and

often this is not the case with respect to premiums paid for general insurance. In

particular, the tax-free reserve approach discriminates against persons providing self-

insurance because they are not permitted to create tax-free reserves. Therefore, section

182(3) addresses the volatility of insurance business in a different manner. Instead of

permitting the creation of tax free reserves, general insurance businesses may not only

carry forward losses but may carry them back for up to five years. The effect is similar

to the reserve approach without permitting the investment of tax-free funds. Which

approach is taken, if any, to the volatility of insurance business should be determined

according to local considerations. The same applies to the length of the carry back

period if the carry back approach is adopted.

302. By contrast, the general approach under the Sample is to treat investment insurance

in a similar manner as an investment in shares of a company. This is clear from the

manner in which income from an investment insurance business is calculated under

section 183. As in the case of capital contributions to companies, premiums received in

the course of conducting an investment insurance business are not included in

calculating income from the business. Similarly, proceeds paid on insurance by such a

business are not deductible. Given this treatment, there is no apparent need to make

adjustments for any volatility of investment insurance business such as those made with

respect to general insurance.

303. Sections 181 and 184 deal with the treatment of an insured with respect to the

payment of insurance premiums and the receipt of proceeds from insurance,

respectively. Section 181 states that the deductibility of premiums paid for insurance is

generally determined under the general deduction provision in section 25, discussed

above at paragraphs 70 to 78. A deduction would not be available for premiums paid by

an individual for investment insurance of the individual because such premiums would

be of a capital nature. Similarly, the general rule under section 184(1) is that the

treatment of proceeds received from insurance is determined under section 66, discussed

above at paragraph 137, i.e. the treatment depends on the type of event insured against.

This is the treatment under the payments basis income tax.

304. The treatment under the transactional basis income tax is split. If the insurance

covers a loss with respect to an asset or liability, the insurance is not viewed as an asset

separate from the asset or liability, see the definition of "asset" in section 76 and the

discussion above at paragraph 155. Rather, premiums paid may be treated as an

outgoing for the asset or liability and the proceeds of insurance as an incoming. This

will typically be the case with general insurance and is consistent with the approach

taken to proceeds from insurance under the payments basis income tax. Where

insurance does not cover loss with respect to an asset or liability, the insurance is an

asset of itself and the premiums and proceeds may be outgoings and incomings with

respect to that asset. This will often be the case with respect to investment insurance.

305. Section 184(2) also requires specific mention. It requires the calculation of any gain

from investment insurance, i.e. the difference between premiums paid and proceeds

received. This amount is treated in the same manner as a dividend. Therefore, where

such gains are received from a resident person, they are subject to a final withholding

tax at the same rate as dividends. Where received from a non-resident person, the gain

is fully taxable but a foreign tax offset may be available under section 200 for any

foreign income tax paid with respect to the gain. The gain is treated in this way because

the domestic country may not be sure if the funds from which the proceeds are paid have

been appropriately taxed.

Division II: Retirement Savings

306. This Division follows the general approach in Division I. Retirement savings is

singled our for special treatment because of its importance, particularly with an

increasing proportion of the population consisting of retirees and the diminishing ability

or commitment of governments to appropriately provide for retirees. This is a highly

political area and one that is particularly sensitive to local considerations. In the usual

manner, the Sample simply provides one example of a possible approach. In many

cases this approach will not be appropriate, particularly where there is heavy

government involvement in the provision of benefits to retirees. The approach under

this Division is standard in providing an incentive to save for retirement. This incentive

takes the form of a limited exclusion from income for contributions to an approved

retirement fund and exemption for income derived by such a fund but taxation of all

funds removed from the fund. Therefore, the incentive is one of deferral only.

307. Section 190 distinguishes between "approved retirement funds" and "unapproved

retirement funds". These phrases are defined in section 190(2) as is "retirement fund",

which is defined in terms of entities exclusively engaged in accepting and investing

retirement contributions in order to provide retirement payments to individuals. All

retirement funds are unapproved unless they are approved by the tax administration in

accordance with requirements to be prescribed by the regulations. The Sample does not

provide an example of these requirements, which are likely to be highly subjective to

local considerations. These requirements may include some restrictions requiring

protection of funds invested with an approved fund and that retirement benefits are

withheld until beneficiaries reach some uniform retirement age.

308. Section 192 provides for the tax treatment of retirement funds. Unapproved

retirement funds are essentially treated in the same manner as companies and investment

insurance businesses. This means that contributions to an unapproved retirement fund

are not taxed to the fund and retirement payments are not deductible. Income of an

unapproved retirement fund, calculated under Part II but subject to these rules, is fully

taxed to the fund. By contrast, an approved retirement fund is exempt from tax. Section

192(4) removes the benefits of approved retirement fund status where such a fund ceases

to be approved. The removal is in the form of income tax calculated under that

provision and charged under the fourth head of section 1(1).

309. Sections 191 and 193 deal with contributions to retirement funds and retirement

payments, respectively. Under sections 191(1) and 193(1) the general deductibility of

these types of payments is determined under section 25. The exception is with respect to

retirement payments made by a retirement fund, which are not deductible as mentioned

in the last paragraph. Section 193(2) dealing with gains from an unapproved retirement

interest is in similar terms to section 184(2) and the above discussion of the latter

provision at paragraph 305 is relevant.

310. The treatment of retirement contributions to and retirement payments by an

approved retirement fund require further comment. Under section 191(2) an individual

may claim a reduction in taxable income for retirement contributions made by the

individual to such a fund. The total reduction claimed for a tax year is limited by section

191(3) to a specific amount to be prescribed by the regulations. An absolute amount

limitation is viewed as more appropriate than a percentage of income limitation as high

tax rate individuals disproportionately benefit from the latter approach. The level of this

limitation must be adjusted to local considerations. Notably, an individual may claim

the reduction in respect of retirement contributions made on behalf of a spouse. The

limit provided in section 191(3) should be aggregated for spouses in order to facilitate

this provision. The intention is that couples are encouraged to save for the retirement of

both spouses irrespective of who in the couple derives income. The effective exemption

of funds used to contribute to an approved retirement fund and the exemption of the

fund is balanced by section 193(3), which provides for the taxation of retirement

payments received from an approved retirement fund. Where a pay-out from an

approved retirement fund takes the form of a lump sum, some bunching relief may be

provided by section 5(2), discussed above at paragraphs 20 and 21.

Division III: Foreign Tax Offsets

311. Section 200 provides a resident person deriving foreign source income with foreign

tax offsets for foreign income tax paid by the person with respect to the income. Section

200(5) provides a person with the alternative of simply claiming a deduction for foreign

income tax paid. Like personal offsets under section 115 and the medical costs offset

under section 116, discussed above at paragraphs 218 to 222, foreign tax offsets directly

reduce income tax payable by a person under the first head of section 1(1), see above at

paragraph 17. The granting of foreign tax offsets is consistent with the principle of

source country entitlement. This principle is typically recognised by countries either

exempting foreign source income of residents or providing a foreign tax credit for

foreign income tax paid with respect to such income. Which approach is adopted will

depend on a number of factors including the contentious issue as to which approach is

more efficient and local considerations. In particular, the foreign tax credit method is

generally viewed as more complex and so the level of sophistication of the tax

administration may be an issue in selection. In the usual manner, the Sample provides

but one example of a relatively simple foreign tax credit system. The reasons why the

Sample uses the word "offset" instead of "credit" were discussed above at paragraph 17.

312. Section 200(1) entitles "resident persons" to claim foreign tax offsets for "foreign

income tax" paid with respect to their "taxable foreign income". "Resident person" is

defined in sections 108 to 110 and was discussed above at paragraphs 210 to 212.

Importantly, it includes a domestic branch of a non-resident. This means that such

branches may claim foreign tax offsets in the same manner as domestic subsidiaries of

foreign parents and is consistent with their similar treatment under the Sample. "Foreign

income tax" is defined in section 345 and "taxable foreign income" in section 200(7).

"Taxable foreign income" is defined by reference to "foreign source income", which is

essentially defined in section 68. However, "foreign source income" may have an

extended meaning by reason of section 175, discussed above at paragraphs 296 and 297.

Similarly, "foreign income tax" may have an extended meaning by reason of section

175.

313. As a result of these definitions, resident beneficiaries will often be able to claim

foreign tax offsets with respect to income tax paid by an entity, or treated as paid by an

entity. For example, this will be the case with resident's foreign branches by reason of

the allocation of foreign income tax paid by such branches to their owners under section

148(4), discussed above at paragraph 251. This is because the beneficiary is treated as

having paid the tax, thereby triggering the right to a foreign tax offset under section 200.

This is also true in the case of a trust, provided the resident beneficiary is allocated the

foreign income in the year in which it is derived under section 133(2) rather than section

133(3), see section 133(4) and (7) and the discussion above at paragraphs 238 and 239.

These provisions can work in tandem to provide a foreign tax offset. For example,

foreign income tax paid by a foreign branch of a resident trust will be treated as paid by

the trust under section 148(4) and may further be treated as paid by a beneficiary under

section 133(7). Section 200(6) ensures that the amount of any offset is included in

calculating the person's taxable foreign income, i.e. it ensures gross-up. This provision

is required, e.g. where a beneficiary of a trust is entitled to attributable income of the

trust net of tax.

314. The effect of the treatment discussed in the last paragraph is to provide underlying

foreign tax relief. Foreign income tax is not typically allocated from companies to their

shareholders under the Sample. The exception is in the case of controlled foreign

companies. The income of a controlled foreign company may be allocated to certain

resident shareholders of the company under section 157(1). Further, foreign income tax

paid by the company with respect to its income may be treated as paid by shareholders

who are associates of the company under section 157(5), see discussion above at

paragraph 262. The effect is again to provide underlying foreign tax relief but only with

respect to shareholders who are associates of the company and only where the company

in question is a controlled foreign company. All non-resident companies that have an

associated resident shareholder fall within this category. As discussed above at

paragraph 262, this treatment may be extended to distributions of resident companies in

limited circumstances as a result of section 175(3).

315. Section 200(2) provides for the manner in which foreign tax offsets are calculated.

This is done on a country-by-country basis. As discussed above at paragraph 146, this

makes it necessary to specifically identify the foreign country in which income is

sourced. The foreign tax offset for income sourced in a particular country is limited to

the average rate of domestic income tax payable by the person for the tax year in

question. This rate is calculated under section 200(7). The country-by-country

limitation is designed to minimise any incentive to invest in low-tax countries in order to

use up excess foreign income tax paid to high-tax countries. As with many other issues,

this limitation should be adjusted to local considerations.

316. Section 200(3) provides some relief from the restrictive manner in which foreign

income tax may be used as a result of section 200(2). Firstly, it permits excess foreign

income tax (i.e. excess resulting from the limitation in section 200(2)) to be carried

forward for use in future tax years in a similar manner to excess losses under section 33,

i.e. subject to a country-by-country limitation. Further, a person may transfer excess

foreign income tax to an associate of the person subject to the country-by-country

limitation and the requirements of section 200(4). These requirements are essentially

the same as those required for the transfer of losses under section 33(3) and the

discussion above at paragraphs 93 to 95 is relevant. As mentioned above at paragraph

42, this is the last of the three manners in which tax attributes may be transferred

between an entity and an associate under the Sample. The overall treatment of excess

foreign income tax is consistent with the treatment of excess losses subject to one

exception. The restriction on the set off of investment losses against business income,

discussed above at paragraph 92, is not reflected in the treatment of excess foreign

income tax. The reasons for this restriction, discussed at paragraphs 35 to 39, do not

appear as pertinent in the case of excess foreign income tax.

PART V: TAX PAYMENT PROCEDURE

317. This Part and Part VI are what are conventionally considered the tax administration

provisions. These provisions may be structured along a number of logical lines and the

one adopted by the Sample is just one example. Part V contains what is referred to as

the "Tax Payment Procedure". It is an effort to bring together most all administrative

provisions involving the payment of tax. "Tax" in this sense must be understood in the

broad context defined in section 205, which includes not just income tax but also

interest, penalties, and certain other payments in the context of recovering tax. By

contrast, Part VI is concerned with administration of the Sample by the tax

administration authority.

318. Part V is structured under six divisions. The Part follows the common approach in

the Sample of beginning with a central concepts division, in this case entitled "General

Obligations". Division I sets out general obligations regarding the payment of tax,

including the method and timing of payment. The following divisions largely follow the

process of paying tax. Division II begins with the earliest point at which income tax

may be payable during a tax year, i.e. by withholding from payments. Division III

continues with the next point of payment, which is by instalment. Division IV deals

with the traditional income tax payment procedure, i.e. on assessment. Division V

continues by considering the consequences of non-compliance with the income tax

payment procedure. In particular, it deals with interest and penalties, offences, and

various methods of recovery of tax. Importantly, many of the provisions in this Division

give rise to a tax, though not income tax, liability. Finally, Division VI deals with

remission and refund of tax.

Division I: General Obligations

319. Section 205 is the central provision in the Sample regarding payment of tax. It

begins by defining "tax". As mentioned above at paragraph 317, this includes not only

income tax but other amounts considered tax under the Sample such as interest,

penalties, and certain other amounts. This approach is important because it ensures that

the interest, penalty, and recovery provisions all apply to these amounts. Section 205(2)

proceeds to identify the methods by which tax is payable, including by withholding, by

instalment, on assessment, and on notification. Section 205(3) requires tax to be paid in

the form and at the place prescribed by the tax administration.

320. Section 206 deals with timing the payment of tax. The Sample makes a distinction

between tax that is due and tax that is due and payable. Tax is generally due when all

the events needed to give rise to a liability to pay the tax have occurred. When tax is

due it is a debt owed to the government. Tax may be payable some time after it is due.

The amount of time given for payment should be adjusted to local conventions. When

tax is payable, the tax administration may use the recovery procedure in Division V to

recover the tax. The distinction between tax due and tax due and payable is used in

some of the recovery provisions where, e.g. the tax administration may secure its

position with respect to tax that is due but not yet payable. Of course, this position may

be secured through the granting of a more general power to the tax administration. This

approach is avoided because in certain situations it may be open to abuse by the tax

administration. Whether a distinction between tax due and tax due and payable is

adopted is yet another issue that must be decided after accounting for local

considerations. Another useful consequence of clearly identifying all payments

considered tax is that one provision can be used permitting the tax administration to

extend the time for payment. This permission is provided by section 206(4).

321. A general obligation imposed on persons that is a consequence of the requirement to

pay tax is the requirement to maintain documentation. Documentation is required in

order that the tax base may be calculated and in order that information provided to the

tax administration may be audited. The documents that a person must maintain under

section 207 are consistent with these purposes. The length of time for which documents

must be maintained and the language in which they must be kept are issues for local

consideration. Often the length of time coincides with that provided by a general statute

of limitations.

Division II: Income Tax Payable by Withholding

322. This Division requires withholding of tax from certain payments that have a

domestic source. The "source" of a payment is determined in accordance with section

68, discussed above at paragraphs 140 to 146. The obligation to withhold is generally

only imposed on resident payers. However, under section 213 a non-resident person

may elect to withhold under this Division. A non-resident person may make this

election in order to make the further election under section 222(3) that certain payments

received by the person are not final withholding payments. This further election will

mean that non-resident persons can claim deductions in order to reduce their tax liability

with respect to what would otherwise be final withholding payments. This was

discussed above at paragraph 85. The distinction between "resident" and "non-resident"

persons was discussed above at paragraphs 210 to 212. The treatment of domestic

branches of non-residents as resident persons is again important in this regard as such

branches will be required to withhold under this Division.

323. The obligation to withhold does not apply to all types of payments. It applies

comprehensively to payments for services. Payments by an employer to be included in

calculating the income of an employee are subject to withholding under section 210.

Importantly, all forms of payments of this type are covered, including in-kind payments.

The Sample takes the approach that if an employer, or any other person liable to

withhold tax under the Division, makes an in-kind payment, it is up to the payer to

arrange with the payee how the tax is to be paid and to make that payment. The rate of

tax to be withheld under section 210 is to be prescribed by the regulations. These rates

are often outlined in tables and, in the context of resident employees, are adjusted for

marginal tax rates and personal offsets. These rates typically permit an individual's main

employer to apply the standard tax rate schedule and offsets to the individual's income

from the employment.

324. Other employers and payers for services will not easily be able to identify an

appropriate rate for withholding. Therefore, an arbitrary rate must be used in these

cases. In the case of secondary employers, this is often equal to the highest marginal

rate. The reason for this is that employees are not subject to the instalment system and

there is a potential for tax deferral if tax is not withheld at a relatively high rate. By

contrast, other payees for services, e.g. independent contractors, are subject to the

instalment system. They will be able to credit any tax withheld during a quarter against

their quarterly tax instalment. In this case the potential for deferral is substantially less

and a lower rate may be viewed as appropriate. This is the approach adopted in the

Sample where the rate applied to payments of service fees to residents is the same as the

final withholding rate for non-resident payees, see section 212(1). As mentioned above

at paragraphs 30 and 31, this is also the rate for non-resident employees with respect to

their taxable income and so is the rate at which resident employers are required to

withhold tax from payments to such employees.

325. Withholding is also required from investment returns as outlined in section 211. In

the case of these types of payments, it is expected that a substantial amount of the

payment will often remain subject to taxation on assessment even after deductions are

claimed, although this will not always be the case. Further, where such payments have a

domestic source and are paid to non-residents they are likely to represent wealth created

or value added domestically and, on that basis, justify source based taxation, see the

discussion above at paragraphs 141 and 142. For these reasons, investment returns are

subject to withholding tax under the Sample. The rate selected is uniform and the

reasons for this were discussed above at paragraphs 30 and 81. Persons for whom the

tax withheld is not a final withholding tax, will credit tax withheld during a quarter

against their quarterly tax instalment.

326. Other payments are not subject to withholding tax. In this case, the percentage of

the payment that represents value added, if any, will be unclear. Many countries do

impose a general withholding tax at a low rate on all contract payments. However,

inevitably there is a dispute as to the rate of this withholding tax and how it applies in

the context of non-resident payees. The approach taken in the Sample is to give the tax

administration power to require withholding from contract payments to non-residents in

specific cases, see section 212(2). For example, this power may be used with respect to

insurance premiums paid by residents to non-resident insurers. Otherwise, the Sample

relies on the tax instalment system with respect to contract payments. Particularly in a

domestic context, it is felt that tax administration resources are better allocated to robust

enforcement of a tax instalment system, that can be seen to be fair, rather than an

arbitrary withholding tax that is difficult to enforce and justify. Further, greater reliance

on the tax instalment system, which must be enforced in any case, simplifies

withholding requirements for payers.

327. Another manner in which the withholding system is simplified is by providing

uniform rates of withholding. The more rates applied to different types of payments and

payees the more difficult it is for the payer who must make the distinctions in order to

correctly withhold. The obvious example is where a payer must determine the residence

of a payee in order to determine the appropriate rate of withholding. Another method of

simplifying the withholding tax system is to exclude from its ambit persons acting in a

private capacity. Therefore, individuals making payments outside the conduct of a

business are not required to withhold tax. This is another area in which resources may

be better allocated to enforcing the instalment system than to enforcing the withholding

system on persons who may have difficulty understanding and complying with that

system.

328. Section 220 moves to the administration side of withholding. Again, it is

emphasised that the Sample provides but one approach to withholding. The withholding

procedure is another issue that should be adjusted to local considerations, particularly

with respect to issues such as the timing of reporting requirements. Section 220 requires

a withholding agent, i.e. a person under an obligation to withhold under Division II, to

file monthly statements with the tax administration specifying details of withholding by

the agent. Importantly, tax withheld is required to be paid with the filing of the

statement. If a withholding agent fails to withhold tax, they are required to pay to the

tax administration the amount that they should have withheld. The withholding agent is

entitled to recover any such payment from the withholdee, i.e. the person receiving the

payment subject to withholding. The only circumstance in which the withholdee is

liable for payment of an amount that should have been withheld is where the

withholding agent both fails to withhold and does not make the payment to the tax

administration as required.

329. A withholding agent is required to give the withholdee a certificate regarding

amounts withheld from payments to the withholdee, see section 221. The withholdee is

required to attach any such certificates received to the withholdee's return of income for

the relevant tax year, see section 235(2)(c)(i). In the case of employees, these

certificates are to be provided yearly, and in other cases monthly.

330. Section 222 is an important provision that identifies final withholding payments.

The gross amount of these payments constitutes the tax base for income tax charged

under the third head of section 1(1). As mentioned above at paragraphs 28 and 29, all

dividends distributed by resident companies are final withholding payments. Further as

mentioned above at paragraphs 305 and 309, gains from investment insurance and

unapproved retirement interests are treated similarly. Further, all payments to non-

residents that are subject to withholding are prima facie final withholding payments.

Again, as domestic branches of non-residents are treated as resident persons, many

payments to such a branch that are subject to withholding will not be final withholding

payments. Further as mentioned above at paragraph 322, non-residents that make an

election under section 213 to act as a withholding agent and do so may further elect that

payments subject to withholding, other than dividends and similar payments, are not

final withholding payments. Section 222 also defines "investment final withholding

payments". This definition is particularly relevant to the limitation on deduction of

certain final withholding payments under section 27, discussed above at paragraphs 80

to 86.

331. In contrast to section 222, section 223 deals with withholding tax that is not a final

tax. Section 222 provides a tax credit to the withholdee for tax withheld. This tax will

reduce any liability to pay tax by instalments as well as be taken into account in

determining the withholdee's overall income tax liability for a tax year on assessment,

see discussion below at paragraphs 332 and 333. Section 223 proceeds to ensure that

any tax withheld is included in calculating the withholdee's income, i.e. gross-up.

Finally, as mentioned above at paragraphs 228 and 239, the allocation rules under the

partnership and trust regimes may treat tax paid by a partnership or trust "as though the

tax were withheld from a payment" to a partner or beneficiary, i.e. under sections 122(4)

and 133(7). In this case the partner or beneficiary will be entitled to a tax credit under

section 223.

Division III: Income Tax Payable by Instalment

332. This Division provides for the payment of income tax by a person by quarterly

instalments during a tax year based on an estimate of the person's taxable income for the

year. It co-ordinates with the payment of income tax by withholding under Division II,

see above at paragraphs 324 to 327 for the interaction with the withholding tax system.

Payment of tax by instalments is fundamentally different from payment of tax by

withholding. Withholding requires a person's tax to be paid by a third party, whereas

under an instalment system the person pays their own tax. A similarity between these

two systems is that the tax paid under them is generally adjusted at the end of the tax

period, i.e. they are preliminary and typically do not involve a final payment of tax.

333. The obligation to pay income tax by instalments under section 230 does not apply to

an individual who only has employment income for a tax year. Section 230(2) sets out

the timing of instalment payments. This timing is based on three monthly intervals.

Importantly and for the reasons mentioned above at paragraph 100, this timing varies

from person to person depending on their tax year. Section 230(3) provides a basic

formula for calculating the amount of an instalment. It is a progressive formula that

adjusts instalments during the year, e.g. for changes in circumstances, in an attempt to

ensure that the amount of tax paid by instalment by the end of a tax year is reasonably

sufficient to meet the person's full tax liability for the year. Therefore, the amount of a

particular instalment is adjusted for tax paid by prior instalment, tax withheld from

payments that are not final withholding payments, and, in the case of individuals, any

potential claim for a medical costs offset under section 116. Section 230(4) provides

that instalments of an amount below a small threshold may be disregarded. This

threshold must be adjusted to suit local considerations. As with withholding tax that is

not final, income tax paid by instalment is credited against the instalment payer's final

tax liability.

334. Section 231 provides for the estimation of tax payable by a person that is used in

section 230 in calculating the person's liability to pay tax by instalments. The Sample

requires a person to estimate by the time of the first instalment for a tax year the amount

of tax to be payable by the person for the whole year. Many countries permit persons to

use their tax liability for the previous tax year for this purpose. This approach often

proves substantially inaccurate. The Sample primarily requires an actual estimate, with

the potential to change an estimate during the year with consequent adjustments to the

calculation of future instalments under the formula in section 230(3). The potential for

tax deferral through low estimates is addressed through an interest charge under section

251. The tax administration is provided with a power to exempt a person or class of

persons from providing an estimate, e.g. small taxpayers. In this case the tax

administration will make the estimate for the person, which may be based on taxable

income of the previous tax year. The tax administration is also given power to override

an actual estimate of a person.

Division IV: Income Tax Payable on Assessment

335. As mentioned above at paragraph 332, income tax payable by withholding and

instalment is only a preliminary tax liability (other than where withholding is final).

This Division provides for an overall assessment of a person's income tax liability under

the first head of section 1(1) for a tax year with an appropriate accounting for any tax

paid by withholding or instalment. In the usual manner, it provides for the filing of a

return of income with the tax administration and an assessment of that return. However,

in most cases this is a deemed assessment that is only relevant for purposes of triggering

the availability of administrative review. That is, the Sample generally adopts self-

assessment, with appropriate safeguards.

336. Section 235 provides for the filing of returns of income. This is a relatively

straightforward provision. The time for filing, i.e. 3 months after the end of a tax year, is

only an example. As discussed above at paragraph 100, this time runs from the end of

the person's own tax year and not from the end of any standard tax year. This means

that the tax administration will not receive all returns of income at the same time. There

is no formal requirement that a return of income be prepared with any professional

assistance. However, where there is such assistance, the professional must sign the

return and if in disagreement with the return must provide a statement of reasons, to be

attached to the return. Professionals who assist in preparing a return that is inaccurate

may be liable for penalties and guilty of an offence, e.g. see sections 254 and 265.

Section 235(5) gives the tax administration power to require a person to file an early

return in particular circumstances. This provision must be read in light of sections 281

and 321. In particular, under section 321 the tax administration may require any person

to create a document. This would enable the tax administration to require a person to

prepare a return of income on behalf of another person, e.g. require an executor to

prepare a return on behalf of a deceased individual.

337. Section 235 potentially requires all persons to file a return of income for a tax year,

e.g. it does not include any jurisdictional limitations. Section 236 sets out the

circumstances in which a return of income is not required. A person with no tax payable

for a tax year under the first two heads of income tax in section 1(1) is not required to

file a return of income. This will exclude from the obligation to file most non-residents

as well as persons who only derive exempt income or income subject to final

withholding tax and those whose tax payable is reduced to nil, e.g. through claiming

personal offsets, medical costs offset, or foreign tax offsets. Section 236 also excludes

an individual who only has income from one employment. As mentioned above at

paragraph 18, the effect of section 1(4) is to turn wage withholding tax into a final

withholding tax, although it is not formally treated as such by the Sample. Section

236(b) reflects this by not requiring individuals subject to this treatment to file a return

of income.

338. Section 237 is a standard provision enabling the tax administration to extend the

time for filing a return of income. The length of extension is an issue for local

consideration. An example of 60 days is provided by section 237.

339. Section 240 provides for self-assessment. The filing of a return of income and even

the non-filing of a return of income are treated as an assessment on the due date for the

filing of the return. This deeming provision is offset by the power of the tax

administration to raise assessments under sections 241 and 242. Where the tax

administration makes use of these powers to raise an assessment, the person in question

must be served with a notice of assessment under section 243.

340. Section 241 concerns jeopardy assessments, i.e. assessments raised in circumstances

where there is concern for securing that payment of tax will be made. This provision

works in tandem with section 235(5) under which the tax administration may require a

person to file an early return of income. Importantly, under section 206(3)(c) the time at

which tax must be paid by reason of section 241 is basically at the discretion of the tax

administration. This is provided the relevant notice of assessment or notice requiring a

return of income is served on the person in question. In principle but subject to general

restrictions on abuse of administrative powers, it is possible for the tax administration to

make a jeopardy assessment and require immediate payment of the tax assessed. If

immediate payment is not forthcoming the tax administration could immediately

proceed to collect the amount of tax assessed under Division V. A jeopardy assessment

may be final, in that it replaces the assessment that would otherwise take place at the end

of a tax year, or preliminary, in which case it will be adjusted when an end of year return

of income is filed.

341. Section 242 provides the tax administration with a broad power to amend

assessments. This is a necessary balance to self-assessment but is common even in

cases where full tax administration assessment is used. This power extends to self-

assessments, jeopardy assessments, as well as assessments amended under a previous

use of section 242. The tax administration may amend an assessment in a manner

"consistent with the intention" of the Sample and using its "best judgement". These are

the only substantive restrictions on exercise of the power. There is also a time limit

restriction, which is primarily an encouragement for the tax administration to perform its

duties in a timely fashion. Section 242(2) adopts a general time limit of three years but

this should be adjusted to local considerations. Section 242(3) provides an exception in

the case of fraud, in which case there is no time limit. Often this exception is not

adopted on grounds of administrative certainty and in order to focus administrative

resources on current tax liabilities. There is the usual exclusion of amendment with

respect to issues that have been decided by a court.

Division V: Non-Compliance

342. This relatively lengthy Division deals with the consequences of non-compliance

with the tax payment procedure and the Sample in general. It is structured under five

subdivisions. The first two deal with the imposition of sanctions designed to discourage

non-compliance. These subdivisions are separated in order to emphasis the distinction

between the civil consequences of non-compliance and the criminal consequences.

Because non-compliance may give rise to both types of consequence, Subdivisions A

and B follow the same format. Subdivision A provides the civil consequences. In

principle, it is not concerned with punishment of a non-compliant person but, rather,

seeks to remove any financial incentive for non-compliance. In cases that lack intent,

this often means a penalty in the nature of interest. However, where there is intent, it is

clear that the chance of not being discovered is an added financial benefit. This justifies

a substantially increased penalty in cases of intentional non-compliance.

343. The interest and penalties imposed by Subdivision A are imposed by the tax

administration. This is appropriate and in some ways is similar to penalties imposed

under other civil relationships, e.g. penalties under a contract. By contrast, Subdivision

B deals with the criminal consequences of non-compliance. It deals with punishing

persons who do not comply with the tax law. This punishment should be meted out in a

similar fashion to non-compliance with other laws and is clearly not an appropriate

matter to be dealt with by the tax administration. It is more appropriately administered

by a government agency such as the Public Prosecutor or the Ministry of Law and

Justice, with the penalty being imposed by a court having jurisdiction over criminal

cases.

344. Subdivisions C and D provide the tax administration with broad powers for the

collection of tax, and this includes both income tax as well as interest and penalties but

not fines for offences under Subdivision B. Subdivisions C and D provide for recovery

from the person liable for tax as well as, in certain circumstances, third parties,

respectively. Subdivision E deals with a number of provisions that have common

application with respect to the other Subdivisions.

Subdivision A: Interest and Penalties

345. The approach in this Subdivision is to adopt a minimal number of provisions under

which interest and penalties may be imposed. It begins by focusing on the main

obligations of a person liable to income tax and proceeds to cover aggravated non-

compliance where intent is an element. As mentioned at paragraph 342, the intention of

the interest and penalty provisions is to remove any financial incentive for non-

compliance. In the case of the non-payment of tax, this goal is achieved by imposing

interest at a market rate. In other cases of non-compliance, an issue is the manner in

which the penalty is calculated. In order to remove the financial incentive for non-

compliance, it seems that the amount of a penalty should vary depending on the amount

of tax potentially at risk. In the case of a failure to file a statement or maintain records,

the total amount of inclusions in calculating income multiplied by the highest marginal

tax rate is used. In cases smacking with intention to reduce tax, it seems appropriate to

calculate penalties by reference to the amount of tax that might have been reduced. In

some cases it may be difficult to calculate this amount. Often a more arbitrary approach

is adopted. However, any such approach should attempt to raise the level of penalties by

reference to the amount of tax at risk.

346. Section 250 covers the failure of persons to maintain proper documentation under

section 207 or to file a statement with respect to withholding, an estimate of tax payable

for instalment purposes, or a return of income. A failure with respect to any of these

matters may result in delay in the payment of tax. The penalty is calculated as the

statutory interest rate applied to the tax at risk. As mentioned above at paragraph 84,

this is the general interest rate applied throughout the Sample.

347. Section 251 provides for the imposition of interest where a person files an inaccurate

estimate of tax payable for instalment purposes. The need to prevent tax deferral

through underestimation of tax payable by instalments was discussed above at paragraph

334. An instalment payer is given a ten percent margin for error before interest is

imposed. The interest is imposed at the statutory rate and only until such time as a

return of income is to be filed. After the time for filing a return of income, section 252

takes over. It is the general provision that imposes interest for a failure to pay tax.

Again the rate is the statutory rate. Section 252 applies to all "tax" as broadly defined in

section 205, see the discussion above at paragraph 319. Further, interest is imposed

where tax is not paid by the time it is "due and payable". This time is determined under

section 206, discussed above at paragraph 320.

348. Section 253 imposes heavier penalties where a person without reasonable excuse,

knowingly, or recklessly makes a misleading statement to the tax administration. This

provision also applies to omissions of a similar nature. Section 254 applies to persons

who knowingly or recklessly aid or abet another person to commit an offense. As

mentioned above at paragraph 336, this section may have particular relevance to tax

professionals providing other persons with assistance in preparing returns of income and