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Foreign income tax offsets and discount capital gains – the Burton effect

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Non-residents* no longer have entitlement to the 50% capital gains tax discount (the Discount) on their Australian capital gains, save grandfathering, but the inverse isn’t true: Residents* can apply the Discount to foreign capital gains that meet the requirements of the Discount in their Australian tax.

The CGT discount

Obtaining the Discount principally requires:

  • the entity who made the gain being an individual either directly or as the beneficiary of a trust [50% discount] or a superannuation fund [33⅓% discount] : section 115-100 of the Income Tax Assessment Act [ITAA] 1997). That is the entity is not a company. Companies are ineligible for the Discount;
  • the CGT asset on which the gain is made was held for at least twelve months: section 115-25; and
  • the gain made is not otherwise treated income under the ITAA 1997. So where a gain is both assessable income and a capital gain under the ITAA 1997 the gain is not taxed as a capital gain and so the Discount cannot apply too: section 118-20.

How taxation of foreign income works

Broadly foreign capital gains are included in the Australian assessable income of a resident just as domestic capital gains are. Resident taxpayers are taxed on income from all worldwide sources: sections 6-5 and 6-10. Notable exceptions are foreign income of companies from:

  • their foreign branches with an permanent establishment in those foreign places: section 23AH of the ITAA 1936; and
  • foreign subsidiaries of Australian resident companies or where a company has non-portfolio (at least 10%) holding in a foreign company: section 768-5 of the ITAA 1997.

Foreign income, including of capital gains, of a resident is separately taxed (or exempted) under Australian tax rules even where the foreign income has been, or is to be, taxed under a foreign regime. To address the prospect of double (foreign and domestic) taxation of foreign income a foreign income tax offset (FITO) is available: Division 770 of the ITAA 1997. Australian tax on foreign income can be offset by a FITO for the foreign tax a resident taxpayer has paid, as a non-resident typically but dual tax residence is possible, in the foreign place the foreign income came from.

Double tax and double tax treaties

Australia has double (bilateral) tax treaties with many countries including all large countries and major trading partners which:

  • mutually allow source taxation of income of non-residents of each country (jurisdiction) at tax rates lower than both non-treaty rates and domestic rates on some forms of foreign income – this reduces foreign tax and, consequently the FITO needed to offset that foreign tax; and
  • provide a structure to alter domestic tax law, if need be, to prevent situations where taxpayers will be taxed in both places (double tax) on the same income.

The tax treaties reserve rights to a treaty partner to tax real estate where a taxpayer is resident in the other jurisdiction and taxation of capital gains made on the realisation of real estate, unlike typically interest, dividends and royalties, is not capped at lower rates in the treaties. Broadly this means Australian residents, as non-resident taxpayers, pay foreign capital gains taxes at rates comparable to, or even higher than, the taxes locals pay on capital gains made on foreign real estate.

It follows that foreign capital gains tax can be significant. Can this foreign tax payment be used as a FITO to offset the CGT on an Australian Discount capital gain? The FITO available to offset Discount capital gains on real estate and other investments was considered by the Full Federal Court in Burton v Commissioner of Taxation [2019] FCAFC 141.

Burton v Commissioner of Taxation

In Burton v Commissioner of Taxation it was found that 50% only of US tax paid on a capital gain made on US investments by an Australian resident individual taxpayer was offsettable against the individual’s Australian tax as a FITO.

The reason for this finding is technical but can be understood as follows:

In essence a FITO under section 770-10 of the ITAA 1997 is strictly confined to foreign income that is subject to foreign tax. Under the Discount regime in Division 115 and under section 102-5 of the ITAA 1997 only the net capital gain after applying the Discount, which is 50% in the case of a resident individual, is included in assessable income. It follows that a component of a capital gain taxed as a foreign capital gain is not taxed in Australia where the capital gain is a discount capital gain under Division 115. That is a Discount capital gain to an Australian resident individual taxable on their worldwide income that arises from a capital gain made in the US is made up of:

  • 50% that is taxed in the US which is included in Australia assessable income as net capital gain; and
  • 50% that is taxed in the US but which is not included in assessable income in Australia viz. it is exempt from tax in Australia.

The Full Federal Court confirmed that a FITO is only available in relation to the first of these 50% categories. Logan J. stated at paragraphs 84 and 86:

84. Read in context, the text of s 770-10 is, in my view, fatal to the success of the alternative foundation of Mr Burton’s appeal, grounds 1 to 4 of which challenge the correctness of the conclusion adverse to him reached by the learned primary judge in relation to the allowance of foreign tax offsets under s 770-10 of the 1997 Act. An amount of foreign tax paid only counts towards a tax offset if it was paid “in respect of an amount that is all or part of an amount included in your assessable income for the year”.

….

86. Section 770-10 looks to “an amount that is all or part of an amount included in your assessable income for the year”. The term “assessable income” is defined in s 995-1 of the 1997 Act, which is not the same as “income” as understood for the purposes of the Convention. As defined in the 1997 Act, assessable income includes “ordinary income” (s 6-5) and, materially, what is termed “statutory income” (s 6-10). One form of statutory income included in assessable income is a net capital gain included pursuant to s 102-5(1) of the 1997 Act. As a matter of ordinary language flowing from the text of s 770-10 and, in turn, s 102-5(1), it is only the net capital gain which is, in each instance, included in Mr Burton’s assessable income. Regard to ss 6-5, 6-10 and 102-5 highlights that the phraseology “included in your assessable income” is pervasive in the 1997 Act. There is no contextual warrant for construing “included in” as extending to an amount which is used for computation of an amount that is included in assessable income. The learned primary judge (at [113] – [114]) reached just such a conclusion. That conclusion was correct, for the reasons given by his Honour.

Burton v Commissioner of Taxation [2019] FCAFC 141 at paras. 84 and 86

Repercussions

This outcome is quirky and is entirely due to the laboured statutory drafting of the CGT provisions which is in part consequence of laudable efforts to rewrite and improve the Australian legislation with the advent of the ITAA 1997. If, instead, the taxation of discount capital gains had been governed by a rate set in less intelligible and obscure fine print in the Income Tax Rates Act 1986 as say 50% of the rate otherwise applicable, with that net rate to apply to the whole capital gain; then the whole of the US tax paid on the capital gain could have been offsettable as a FITO. In other words a half of the FITO would not have been lost to Mr. Burton due to the clash of legislative style with treaty terms.

But that is not the case. Accordingly Australian residents with Discount capital gains which are foreign capital gains need to ensure FITO claims in their Australian income tax return reduce the foreign tax claimed by the discount percentage to ensure no FITOs are claimed for the non-assessable/exempt component of the foreign capital gain that technically arises under the Australian CGT legislation.

*In this post resident and non-resident respectively mean resident and non-resident for tax purposes: see “resident of Australia” defined in sub-section 6(1) of the ITAA 1936.

Self-represented perils contesting Australian tax residence

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Royalty-free 3d generated graphic

Impending change to the individual Australian income tax residence rules

A measure in the Federal Budget 2021–22 is to replace the current individual tax residence rules with residency tripwires for an individuals who are tax resident where an individual is any one of:

  • ordinarily resident in Australia (resides test) – based on legal case precedent;
  • has an Australian domicile (domicile test)  – which can activate unless the Commissioner of Taxation (Commissioner) is satisfied the permanent place of abode of the individual is outside of Australia;
  • present in Australia for more than a half of the year of income (183 day test) – which can activate unless the habitual place of abode of the individual is outside of Australia and the Commissioner is satisfied that the individual does not intend to take up residence in Australia ; or
  • a member of certain government superannuation funds;

in a year of income with an “improved and simplified” individual tax residence test based on:

  • a bright-line test derived from the 183 day test under which an individual who is physically present in Australia for more than 183 days are taken to be resident; and
  • the prospect of still being a resident nonetheless “in more complex cases” where the individual is physically present in Australia for less than 183 days such as where an individual is physically present for 45 days or more and has two or more of these other attributes/triggers of Australian tax residence:
    • a right to reside permanently in Australia;
    • Australian accommodation;
    • Australian family; and
    • Australian economic interests.

(45 day triggers) based on recommendations of the Board of Taxation. The reform of the individual tax residence rules is justified in the announcement on the grounds that the current rules are difficult to apply, create uncertainty and result in high compliance costs, including need to seek “third-party” aka professional advice, despite individuals having otherwise simple tax affairs.

Sanderson v. Commissioner of Taxation

The recent case of Sanderson v. Commissioner of Taxation [2021] AATA 4305 is an instance of an individual unsuccessfully running his tax residence appeal under the current rules without professional representation. Mr. Sanderson may or may not have had simple tax affairs but, in any case, the Administrative Appeals Tribunal decision reveals he had an income of $494,668 in the 2016 income year in dispute which suggests professional advice and representation might have been accessible to help him resist the adverse outcomes of his tax appeal.

Self-representation – the statistical ugliness

Self-represented taxpayers can run their own tax appeal and, in the Tribunal at least, rules of evidence and other procedural requirements are relaxed so that a person without legal training can so present their case.

In most tax appeals against income tax assessments, brought to either the Tribunal or the Federal Court, the Commissioner succeeds where the appeals progress to full hearing and decision. When the statistics concerning cases where appellants who are professionally represented and appellants who are self-represented are compared the proportion of Commissioner wins becomes even more lop-sided. As someone involved as a representative in, and who follows, these cases I can conclude that tax appeals, where self-represented taxpayers take the Commissioner on and succeed, are rare and reflect that self-represented taxpayers:

  • struggle to comprehend complex tax laws, understand them in context or appreciate how to present contentions about their case in a contested environment; and
  • do not appreciate how facts relevant to their case need to be presented so those facts are accepted or likely accepted as evidence.

Inadequate evidence

As the Budget measures and Board of Taxation suggest, the current individual tax residence rules have amplified challenges for a self-represented appellant to the Tribunal in a tax residence case that made likelihood of success for Mr. Sanderson even more remote. As I have noted in this blog in many places (see the Onus tag) the burden of proof of facts in tax appeals is with the taxpayer but there is more that can go wrong with evidence in tax appeal cases than that. In Sanderson Senior Member Olding of the Tribunal made these findings about the evidence concerning the taxpayer in the case:

29. One is the manner in which Mr Sanderson completed incoming passenger cards when he returned to Australia. He declared that he was a ‘Resident returning to Australia’ and on various cards indicated an intention to stay in Australia for the next 12 months. Mr Sanderson’s response to cross-examination about the passenger cards – ‘I guess I lied on the form’[18] – does not help his credibility, but is probably correct in respect of the latter question since his stays were for less than 12 months.

[18] Transcript of proceedings, P-46, ln 27.

30. Another is a loan application form completed by Mr Sanderson in March 2011. The Benowa property was listed as Mr Sanderson’s residential address with the status box ‘Own home’ selected and the property described as ‘live in’. Again, Mr Sanderson’s response to questioning – ‘Maybe I lied to get the loan I don’t know. I don’t recall.’[19] – was unhelpful. What is clear is that either the statement was not accurate or Mr Sanderson’s evidence that he did not intend to live in the home at the time was not truthful; both statements cannot be correct.

Sanderson v. Commissioner of Taxation [2021] AATA 4305 at paragraphs 29-30

As Senior Member Olding observes, propensity to lie revealed in evidence in a tax appeal depletes credibility of a taxpayer which is generally decisive in a case against the Commissioner whose officers and witnesses are usually thoroughly credible. So the Commissioner’s witnesses will be believed and the taxpayer won’t be believed about contested questions of fact with near inevitable consequences.

Self-serving evidence

Self-represented taxpayers often over-estimate how persuasive their own statements of fact and intent will be in a tax appeal forum. In Sanderson Senior Member Olding reminds us that a taxpayer’s self-serving evidence needs to be approached with caution:

Has Mr Sanderson proved the amounts transferred to his account were repayments of loans?

38. In approaching this issue, I am mindful of two judicial warnings. One is that self-serving evidence of taxpayers should be approach (sic.) with caution. The other is that nevertheless a taxpayer’s evidence should not be regarded as prima facie unacceptable unless corroborated.[24]

[24] Imperial Bottleshops Pty Ltd v Commissioner of Taxation (1991) 22 ATR 148, 155; and generally: Federal Commissioner of Taxation v Cassaniti [2018] FCAFC 212.

Sanderson v. Commissioner of Taxation [2021] AATA 4305 at paragraph 38

The resides test and the weight of facts

So the evidence in Sanderson accepted by the Tribunal diverged from how the taxpayer tried to present it. It transpired that Mr. Sanderson, who had spent 83 days in Australia in the 2016 income year, and was claiming not to be a tax resident of Australia was found by the Tribunal to have:

  • had a home in Benowa on the Gold Coast with his family;
  • business interests in Australia;
  • returned to Australia in the 2016 income year for business purposes where the Sanderson Group maintained a serviced office;
  • held directorships in Australian companies which he had had for some 30 years by 2016;
  • had access, with his wife, to a company car in Australia which he regarded as his own vehicle;
  • been treated by medical professionals in Australia with whom he had longstanding relationships; and
  • maintained Medicare and medical insurance coverage in Australia, although he also had health insurance coverage elsewhere;

in that income year.

From those findings the Tribunal decided that the taxpayer was ordinarily resident in Australia (viz. satisfied the resides test) and, based on that decision, it was unnecessary, according to the Tribunal, for the Tribunal to consider the domicile test. Although the taxpayer was an Australian citizen, thus clearly with Australian domicile, the issue with the domicile test would have been whether the Commissioner should have been satisfied or not that the taxpayer had a permanent place of abode outside of Australia.

What might a professional representative have contributed?

A saving in time and resources may have been achieved if this case had been professionally evaluated at an early juncture. Evidence where the taxpayer eventually admitted to lying could have been considered to understand how detrimental it would be, how it would come across and whether it deprived the taxpayer of realistic prospect of success in the case.

Professional advice could have been taken about the exceptional nature of cases where taxpayers, whose immediate families were living in Australia, had successfully established that they were not tax residents of Australia. A notable instance of an exceptional case is Pike v. Commissioner of Taxation [2019] FCA 2185 which I considered in my December 2019 blog – Tax residence – is it administrable after Pike? https://wp.me/p6T4vg-gW. In Pike the taxpayer was accepted as a credible witness able to establish that he was residing in Thailand while his family lived in Australia at the times in dispute. Mr. Pike’s connections to Australia were comparatively more tenuous to Australia than Mr. Sanderson’s.

In the conduct of Sanderson, the self-represented taxpayer appears not to have raised or agitated the question of residence under the relevant double tax agreement (DTA) which was a key matter in Pike. Despite the long list of factors on which the Tribunal could find that Mr. Sanderson was ordinarily resident in Australia, a taxpayer can still assert that a “tie-breaker” provision in an applicable DTA, where the taxpayer is ordinarily resident in both places (a dual resident), applies to make the taxpayer not ordinarily resident in Australia by virtue of the DTA. Perhaps the taxpayer in Sanderson could have contended that he was a resident of Malaysia who had been lodging income tax returns in Malaysia and that he should have been treated as a resident of Malaysia under the Australia Malaysia DTA?

Or maybe these inferences shouldn’t be drawn from the Tribunal’s decision? We’ll never know, of course, because the taxpayer opted to self-represent.

And what would have happened under the reform had it been the individual tax residence regime?

The taxpayer in Sanderson would not have been a resident under the “bright-line” 183 day test having spent 83 days in Australia in the relevant income year. However, as the taxpayer spent more than 45 days in Australia and these 45 day triggers are enlivened as the taxpayer had:

  • a right to reside permanently in Australia;
  • Australian accommodation; and
  • Australian economic interests,

two of the 45 day triggers are enough to cause the taxpayer to be hypothetically treated as a tax resident of Australia under the reform.

Some other thoughts on the 45 day triggers

This deceptively simple outcome expected in future under the reform is in tension with DTAs and international taxing norms where other countries will generally be looking to tax individuals, present in their country for up to around 320 days (365 – 45) in the country’s fiscal year, as tax resident in their country. Situations were individuals are taxed as resident in both Australia and other countries will abound as the reform, unlike the current rules, is not closely aligned to DTAs and international taxing norms when a 45 day benchmark for residence is used in “complex” cases where the 45 day triggers apply.

45 days is meagre especially in an era where travel plans of expatriate Australian citizens, who return to Australia for a visit planned as short, can be disrupted by border closures. Many such expatriates are eager to avoid, and the reform should be adjusted to prevent, structural impact to their tax affairs on being made Australian tax resident due to a visit which exceeds 45 days for reasons beyond his or her control.

Unpacking taxes on foreign persons – the Australian vacancy fee

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Clip Royalty Free Stock Country Passport Stamps Clipart – Australia @seekpng.com

Laws reflect perspective. When the imposition of laws, especially taxes, turns on whether the taxpayer is a local (resident) or foreign (non-resident) then laws will be designed with elusion in mind so someone cannot elude being treated as:

  • local if the burden and focus of the law (such as a tax) falls on locals; and
  • foreign if the burden and focus of the law falls on foreigners.

Income tax – focus on locals

The Income Tax Assessment Act (C’th) (ITAA) 1936 overall might be considered to be in the former case in Australia. Although Australian non-resident income tax rates can be higher than resident rates, generally a wider range of activity of residents is taxable in Australia, and residents are subject to income tax on their worldwide income. Income tax collection under the ITAA 1936 and 1997 is mainly focussed on collecting income tax from residents. Certainly Australian locals can be income taxed with fewer international constraints.

Thus who is a “resident” or “resident of Australia” in the definition of these terms in sub-section 6(1) of the ITAA 1936  includes, among others: an Australian citizen whose domicile, by virtue of that citizenship, is in Australia unless the Commissioner of Taxation is satisfied the person’s permanent place of abode is outside of Australia. This definition part imposes a satisfaction hurdle without which an Australian citizen, with a domicile in Australia, will be an income tax resident with broad exposure to income tax under the ITAA 1936 and 1997.

Foreign acquisitions and takeovers – focus on foreigners

In contrast the burdens imposed by the Foreign Acquisitions and Takeovers Act (C’th) 1975 (FATA) in Australia are on foreigners and is so, along with the state and territory foreign person surcharges mentioned below, an example of the latter case in Australia. The FATA is concerned with the acquisition, monitoring and control of Australian real estate and other Australian-based investment interests by foreigners. The FATA obliges notification to the Foreign Investment Review Board (FIRB) of proposed acquisitions of specified types which can be approved or rejected by the Australian Treasurer on the recommendation of the FIRB.

Vacancy fee

A vacancy tax on foreigners commenced under the FATA as a measure to improve housing affordability for Australian locals in 2017. The vacancy fee is contained in Part 6A of the FATA under which a foreign person who owns a residential dwelling in Australia is charged an annual vacancy fee where the dwelling is not residentially occupied or rented out for more than 183 days in yearly periods which measure from the date of acquisition of ownership by the foreigner. The vacancy fee under Part 6A is imposed as a tax by section 5 of the Foreign Acquisitions and Takeovers Fees Imposition Act (C’th) 2015.

Vacancy fee rates

Vacancy fee rates are tethered to the FIRB fees (also imposed as taxes under the same section 5) applicable to a foreign person making an application to acquire the residential land. which is ad valorem based on the value of the real estate on acquisition. Here is an extract from a table with the ad valorem fees:

Acquiring an interest in residential land where the
price of the acquisition is…		Fee payable
less than $75,000$2,000
between $75,000 – $1,000,000$6,350
between $1,000,001 – $2,000,000$12,700
between $2,000,001 – $3,000,000$25,400
from FIRB Guidance 10 Fees on Foreign Investment Applications (18 Dec 2020)

Under section 4 of the FATA:

“foreign person” means:
(a) an individual not ordinarily resident in Australia; or
(b) a corporation in which an individual not ordinarily resident in Australia, a foreign corporation or a foreign government holds a substantial interest; or
(c) a corporation in which 2 or more persons, each of whom is an individual not ordinarily resident in Australia, a foreign corporation or a foreign government, hold an aggregate substantial interest; or
(d) the trustee of a trust in which an individual not ordinarily resident in Australia, a foreign corporation or a foreign government holds a substantial interest; or
(e) the trustee of a trust in which 2 or more persons, each of whom is an individual not ordinarily resident in Australia, a foreign corporation or a foreign government, hold an aggregate substantial interest; or
(f) a foreign government; or
(g) any other person, or any other person that meets the conditions, prescribed by the regulations.

section 4 of the FATA

It follows that any person, including an Australian citizen, can be a foreign person caught by these provisions however, under a convoluted exemption arrangement, Australian citizens who are not ordinarily resident in Australia are relieved from the vacancy fee.

Relief for non-resident Australian citizens

I understand that the relief works in this way:

Section 28 of the Foreign Acquisitions and Takeovers Regulation 2015 [Select Legislative Instrument No. 217, 2015] (FATR 2015) prescribes every section of the FATA, aside from the definition of foreign person in section 4 itself and other provisions to which that definition relates to, as excluded provisions. (Bold emphasis added by me.)

Section 28 also carries a note which provides:

The effect of this Division is that acquisitions of interests of a kind mentioned in this Division are not significant actions, notifiable actions or notifiable national security actions, but are taken into account for the purposes of the definition of foreign person in section 4 of the Act.

Note to section 28 of the FTAR 2015

and

paragraph 35(1)(a) of FATR 2015 provides:

Acquisitions of any land by persons with a close connection to Australia

(1)  The excluded provisions do not apply in relation to an acquisition of an interest in Australian land by any of the following persons:

(a)  an Australian citizen not ordinarily resident in Australia;

…

paragraph 35(1)(a) of FATR 2015

There does not appear to be any further “close connection”, as referred to in the heading to section 35, required to trigger the exemption beyond being an Australian citizen in the case of paragraph 35(1)(a). That is: a non-resident Australian citizen has, by virtue of being a citizen, a close connection to Australia.

Application of the non-resident Australian citizen exemption to the vacancy fee?

The vacancy fee, though, is a tax imposed on a foreign person when a dwelling, already acquired by the foreign person, is not residentially occupied or rented out for more than 183 days in yearly period as stated above. Could it be that a foreign person, including a non-resident Australian citizen, will still be caught by the vacancy fee because the vacancy fee is concerned with omission to occupy or rent out property for more than 183 days over a yearly period and not with acquisition of the property so paragraph 35(1)(a) relief can’t be attracted?

The answer appears to be in section 115B of the FATA which scopes when vacancy fee liability under Part 6A arises. Section 115B provides:

Scope of this Division–persons and land
(1) This Division applies in relation to a person if:
(a) the person is a foreign person; and
(b) the person acquires an interest in residential land on which one or more dwellings are, or are to be, situated; and
(c) either:
(i) the acquisition is a notifiable action; or
(ii) the acquisition would be a notifiable action were it not for section 49 (actions that are not notifiable actions–exemption certificates).
Note: Regulations made for the purposes of section 37 may provide for circumstances in which this Division does not apply in relation to a person or a dwelling….

sub-section 115B(1) of the FATA

It follows that the provisions of “this Division”, which is Division 2 of Part 6A of the FATA and which contains the provision imposing vacancy fee liability, are excluded provisions and so vacancy fee liability on an omission to occupy or rent residential land, where the interest in that residential land was acquired by a non-resident Australian citizen under paragraph 35(1)(a) of FATR 2015, is not attracted by a non-resident Australian citizen purchaser of the residential land. That is so even though a non-resident Australian citizen is a foreign person caught by paragraph 115B(1)(a).

This is a very complicated way to exempt non-resident Australian citizens from treatment as foreigners. Couldn’t section 4 of the FATA just carve out non-resident Australian citizens from being foreign persons to broadly the same effect?

Adding to the confusion is FIRB Guidance Note 31 Who is a foreign person (1 July 2017) which refers to paragraph 15 of the decision in Wright v. Pearce (2007) 157 CLR 485 as guidance on the position with Australian citizens. This reference is actually in error and should be Wight v. Pearce (2007) 157 FLR 485 (not a decision of the High Court of Australia). In any case I can’t see where that reference has anything to say about resident and non-resident Australian citizens having a close connection to Australia, which, unlike being ordinarily resident in Australia which is the matter under consideration at paragraph 15 of the case, is the apparent touchstone of liability when paragraph 35(1)(a) of FATR 2015 is taken into account.

Comparison of the federal vacancy fee with state foreign person surcharge land tax and surcharge purchaser duty

The vacancy fee can apply over and above the foreign person surcharge land tax and surcharge purchaser duty imposed by Australian states introduced at around the same time also to achieve housing affordability for Australian locals.

The foreign person surcharges in New South Wales also adopt the “foreign person” formulation in section 4 of the FATA to pinpoint foreigners liable to the surcharges but with modifications including under paragraph 104J(2)(a) of the Duties Act (NSW) 1997:

(a) an Australian citizen is taken to be ordinarily resident in Australia, whether or not the person is ordinarily resident in Australia under that definition,

paragraph 104J(2)(a) of the Duties Act (NSW) 1997

which carves out non-resident Australian citizens from “foreign persons” and thus the complexity of excluded provisions from the FATR 2015, a Commonwealth statutory instrument, do not need to be contended with to find exemption for non-resident Australian citizens from the surcharges.

In making a comparison between the the federal vacancy fee on the one hand with state foreign person surcharge land tax on the other hand it should also be observed that the state foreign person land tax surcharges are generally imposed on foreigners per se, that is: whether the residential land is vacant for a period is immaterial. So omission by a foreign person to occupy or rent out property for more than 183 days generally means liability for both the federal vacancy fee and a state land tax surcharge will be attracted.

Temporary residents

When an individual owner of residential real estate is not an Australian citizen then whether the individual is ordinarily resident in Australia does become a touchstone for tax and surcharge liability as a “foreign person”. Sub-section 5(1) of the FATA provides:

(1)  An individual who is not an Australian citizen is ordinarily resident in Australia at a particular time if and only if:

(a) the individual has actually been in Australia during 200 or more days in the period of 12 months immediately preceding that time; and

(b)  at that time:

  (i)  the individual is in Australia and the individual’s continued presence in Australia is not subject to any limitation as to time imposed by law; or

  (ii)  the individual is not in Australia but, immediately before the individual’s most recent departure from Australia, the individual’s continued presence in Australia was not subject to any limitation as to time imposed by law.

Sub-section 5(1) of the FATA

A temporary resident for tax is someone who is not an Australian citizen or permanent resident who can stay in Australia under an immigration visa which, as a matter of course, will be a visa with a limitation as to the time the holder can stay in Australia.

A temporary resident is taxable for income tax only:

  • on income derived in Australia; and
  • on foreign income but only foreign income earned from employment or services performed overseas while a temporary resident.

A temporary resident is not income taxable on capital gains made on assets which are not Taxable Australian Property e.g. real estate.

See the ATO website here: https://is.gd/DbJJmk

A temporary resident is a foreign person under the FATA no matter how long the individual is present in Australia until and unless the temporary resident becomes a permanent resident or an Australian citizen due to paragraph 5(1)(b) of the FATA as set out above.

Temporary residents can acquire residential real estate, including established residential premises with conditions, under the FATA and FIRB regime however the vacancy fee and the state and territory foreign person surcharges can apply to their interests in Australian residential land.

Permanent residents

As permanent resident visa holders are not subject to any limitation as to time they can be in Australia imposed by law the requirements in paragraph 5(1)(a) of the FATA are of ongoing concern to them until and unless they become Australian citizens. That is: a permanent resident who has not actually been in Australian for 200 days in the applicable preceding twelve months is taken not to be ordinarily resident in Australia despite their visa.

If such a permanent resident owns Australian real estate but has not been in Australia for the required 200 days in an applicable twelve months then he or she is a foreign person for that year. Then the vacancy fee and the state and territory foreign person surcharges can apply to a permanent resident’s interests in Australian residential land.

Offshoring of non-resident capital gains – the India experience of Vodafone and Cairn Energy

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Two Indian tax cases that have now largely run their course illustrate difficulties faced by countries determined to tax major economic activity in their own territory by non-residents.

India stands out as a rare jurisdiction determined to tax major foreign investors that greatly gain from economic activity there.

The cases show how difficult it can be to prevent profit shifting to tax havens, such as the Cayman Islands which features in each of the cases considered in this blog. The Cayman Islands is a haven of financial secrecy with no direct resident taxation of companies that can attain Cayman resident status.

The Indian cases have comparable facts and have followed a similar course:

Vodafone

In 2007 Vodafone Group PLC (British) sought to re-organise its nationwide telecommunications business in India. So Vodafone International Holdings BV (VIHBV) acquired the share capital of a Cayman Islands holding company from Hutchison Telecommunication International Ltd giving Vodafone Group PLC 67% control of Hutch Essar, an Indian joint venture company that owned the business’s Indian telecommunications licences.

A “crore” is 107. The Indian Income Tax Department sought to tax VIHBV on a capital gain of around Rs 12,000 crore with penalties on the transfer of telecommunications licences, the capital assets of the Indian business, re-organised between non-residents.

Cairn

In 2006-7 Cairn Energy PLC (British) re-organised the largest privately owned oil and gas business in India by transferring its shares in Cairn India Holdings, a Cayman Islands company to Cairn India, an Indian company.

In 2011 Cairn India merged with Vedanta Resources, another Indian mining conglomerate. The Indian Income Tax Department sought to tax a capital gain of around Rs 24,500 crore on these transfers of the capital assets of the Cairn India business.

Source taxation

The capital gains reflected growth and the increase in value in Indian-based business assets. India sought to subject these Indian-based gains to taxation based on their source in India.

Vodafone contested their assessment and was successful before the Supreme Court of India. The Supreme Court found that the Indian Tax Department couldn’t tax VIHBV, a non-resident, on gains it realised in the Vodafone re-organisation as there was no relevant capital asset of VIHBV of, or facilitation of a look-through to a capital asset in, the Indian Income-tax Act 1961 in its pre-amendment version.

Following that loss in the Supreme Court the Indian government amended the Income-tax Act 1961 with the Finance Act 2012 to retrospectively target indirect gains made by non-residents on realisation of Indian capital assets. Section 9(1)(i) of the Income-tax Act 1961, with retrospective effect from 1961, treats income in the nature of capital gains from the direct or indirect transfers of Indian capital assets between non-residents as Indian-sourced income.

The retrospectivity was justified as a “clarification” of how the Indian tax law is to apply but the impact of the amendment suggest this government descriptor was euphemistic.

Comparison with Australian tax on indirect gains on non-residents’ assets

There is no comparable between Section 9(1)(i) of the Income-tax Act 1961 of India and the Australian and most other taxation systems where source taxation of gains on moveable assets made by non-residents is generally not pursued unless the non-resident has a direct interest in an asset used in a local business permanent establishment.

Australia has conformed with OECD model treaty conventions, and so most Australian treaties are based on, or are comparable to the OECD model convention which provides:

4. Gains derived by a resident of a Contracting State from the alienation of shares deriving more than 50 per cent of their value directly or indirectly from immovable property situated in the other Contracting State may be taxed in that other State.

Article 13(4) of the OECD model convention

This substantially confines when Australia and these other places will tax non-residents on their disposals of shares in companies. That is the source country only taxes gains on shares of a non-resident who is resident of the other treaty state where shares reflect immovable interests such as in real estate, mines, forests, fisheries etc.

The rationale of the confinement, as I understand it, is to avoid double and multiple taxation arising when countries tax dealings by non-residents outside of, or with no connection to, their own country especially understanding the country where a person is resident is expected to tax the person on their worldwide income. But the confinement in Article 13(4) and the like excludes the right to tax indirect gains enjoyed by non-residents on movable property that does have a true connection with the country such as the movable business property in India of Vodafone and Cairn owned by Cayman Islands companies.

So these treaties don’t concede rights to countries to tax a non-resident to gains on shares reflecting growth in capital assets used in a local business realised indirectly through a sale of company shares of the non-resident. Instead that right to tax is ceded to the treaty partner where the owner of the shares is tax resident in that other country.

Comparison with taxes on business profits under OECD-like treaties

This is in contrast to business profits with a source in, say, Australia where Australia has first right to tax non-residents under OECD model-like articles when a non-resident, though tax resident in the other treaty country, has a permanent establishment in Australia.

In other words Australia, like many other countries but unlike India, generally does not pursue source income taxation of gains on Australian assets of non-residents made outside of a business permanent establishment. Capital gains on Australian assets realised by non-residents, and not just treaty partner residents, that are not Taxable Australian Property (I capitalise this defined term in the Income Tax Assessment Act (ITAA) 1997) are not subjected to the Australian CGT regime under Division 855 of the ITAA 1997 though capital gains of non-residents made on Taxable Australian Property which extends to:

  1. immovable real estate, mines, etc. and interests in them – see section 855-25 of the ITAA 1997: that is, indirect interests in these too are Taxable Australian Property, and options to acquire them; and
  2. assets that are business assets used in permanent establishment though:
    • inclusion of permanent establishment business assets in Taxable Australian Property can be subject to treaty constraints; and
    • indirect interests in business assets used in permanent establishment are not included in Taxable Australian Property;

(see the table in section 855-15 of the ITAA 1997;)

are subject to Australian CGT.

The limits on non-residents relying on treaty protection to resist Australian tax on indirect capital gains are also evident in Australia in Resource Capital Fund IV LP v Commissioner of Taxation [2019] FCAFC 51 which again featured the Cayman Islands. The Full Federal Court found that a Cayman Islands limited partnership with U.S. resident limited partners could not invoke Article 13 in the Australia USA Double Tax Treaty to prevent Australia taxing capital gains on sales of shares in a limited partnership (treated as a company under Australian tax law) which held interests in immovable mining assets in Australia.

Australian opportunities for non-residents and tax havens

Where Australian shares or other business assets aren’t or don’t reflect interests in immovable property or direct interests in permanent establishment assets (other than Taxable Australian Assets in Australia’s case) then Australia and other OECD member states generally don’t look to tax non-residents on gains on them say by imposing withholding taxes to assure collection from non-residents.

It follows that these countries give non-residents based in low-tax jurisdictions, or non-residents who structure their holdings through tax havens, much opportunity to invest in movable Australian assets including brands, digital assets, designs, licences, other intellectual property and goodwill on a virtual CGT free basis.

It is known that the rather extreme minimal or zero tax outcomes these non-residents can access by offshoring their interests are a principal driver of “private equity” opportunities where restructure into, or using, either genuine or contrived non-resident ownership is a common feature.

Desirable destinations for foreign investment

Australia and other OECD nations supposedly encourage and compete for foreign investment by their light touch of capital gains on moveable property connected to local business which non-residents can realise their interests in offshore. Patent boxes, conduit foreign income exemptions, CGT participation exemptions come to mind as light touches on non-residents onshore.

Clearly, and rather dramatically, the Indian government is not so willing to give up the huge tax revenue at stake although there is awareness in India about the impact of their policy of pursuing non-residents for taxes on India-generated capital gains on India as a desirable destination for foreign investment.

The retrospectivity stumbling block

India also tried to introduce General Anti Abuse Rules (GAAR) in 2012 to retrospectively attack the Vodafone and Cairn arrangements however India was not able to implement their GAAR until 2018-19.

The retrospective elements of Section 9(1)(i) of the Income-tax Act 1961 and the proposed GAAR are controversial and the retrospective application of Section 9(1)(i) by the Indian Tax Department, especially with the imposition of penalty, now appears to be its stumbling block in its pursuit of Vodafone and Cairn.

Both Vodafone and Cairn have lately been able to rely on international treaties (not tax treaties) to resist Indian taxation under the retrospective law on the basis that imposition of the retrospective law was unfair and inequitable.

Treaty arbitration

India and the Netherlands entered into a Bilateral Investment Treaty in 1995. In the Vodafone case VIHBV obtained an order against the Indian government for violation of the treaty at the Permanent Court of Arbitration (The Hague, Singapore seat) as the tax, interest and penalties assessed to VIHBV under retrospective legislation violated the fair and equitable treatment of Dutch investment required under the treaty. Simply stated VIHBV was held to account against a tax law that was not in place at the time it undertook Vodafone India re-organisation and when VIHBV would have returned its income in India.

In December 2020, three months after the Vodafone arbitration, Cairn obtained a similar arbitrated order under a similar Bilateral Investment Treaty between the UK and India.

The Indian government can still pursue rights under these treaties to appeal to the High Court in Singapore however they will be aware that this court will be reluctant to disturb Permanent Court of Arbitration findings. Nevertheless it is surprising that both arbitrations treated the Vodafone investment as Dutch and the Cairn investment as British respectively even though the investments in India in both cases were by Cayman Islands entities presumably outside of the coverage of these bilateral investment treaties.

Conclusion

It seems clear enough that countries with the will and fortitude to do so, like India, can impose tax laws which bring gains on offshore holdings of non-residents which indirectly reflect or look through to gains on onshore capital assets used in local businesses to local tax. However these countries will be pitted against powerful interests willing to structure through tax havens and keen to resist taxes relying on any weakness in the imposition of their tax collecting law.

In that context legislation that takes effect retrospectively, even where effective under local law, is a serious flaw in the international treaty domain. Further, like in the Vodafone and Cairn cases, these countries may find tax pursuit of non-residents stymied by:

  1. treaty commitments;
  2. international norms largely set and dominated by the OECD nations; and
  3. reputational risk that the country does not welcome foreign investment;

with tax havens like the Cayman Islands and others ever ready to facilitate offshore realisation of gains effectively tax free for their clients.

Australian non-fixed trust liable for CGT on non-TAP gains given to a foreign resident: Peter Greensill Family Co Pty Ltd

BigBen

A mirror of the general principle of source and residence taxation broadly setting the parameters of international taxation, and reflected in Australia’s income tax law, is that income of a foreign resident not from sources in the state is not taxable in the state (in this post called the Mirror Principle). In Australia:

  • interests in real property in Australia and related interests; and
  • interests in assets used in business in permanent establishments in Australia:

are designated “Taxable Australian Property” (TAP) (see Division 855 of the Income Tax Assessment Act (ITAA) 1997). TAP is used in Australian income tax law to apply the Mirror Principle.

Foreign resident capital gains from non-TAP disregarded

Property which is not TAP, that is, property not taken to be connected to Australia for income tax purposes in the hands of foreign residents includes shares and securities as opposed to property interests in or related to Australian land or of permanent establishments carrying on enterprises in Australia which are TAP.

Capital gains made by foreign residents from non-TAP assets are disregarded for tax purposes: section 855-10.

Trouble pinpointing trusts as foreign or not

Trusts are elusive and create enormous difficulties in the international tax system see Trusts – Weapons of Mass Injustice. Trusts can detach beneficiaries who benefit from property who may be in one state from:

  • the trustee of the trust, in whose name the property is held, who may be in another state; and
  • the activities of trust which may be in yet another state.

Apt taxation of those activities in line with Mirror Principle thus poses a significant challenge to governments. States are justified imposing laws to counter offshoring with trusts to ensure the integrity of their tax systems.

Some states don’t recognise trusts.

In Australia trusts are mainstream. Some types of trusts are considered tax benign and conducive to legitimate business, investment and prudential activity. Fixed trusts are often treated transparently for Australian income tax purposes so that a fixed trust interest holder is:

  • taxed similarly to a regular taxpayer or investor; and
  • no worse off, tax wise, than a taxpayer or investor who owns the property outright rather than by way of a trust beneficial interest.

So, consistent with the Mirror Principle that a foreign resident owner of non-TAP who makes a gain on the non-TAP shouldn’t be taxable on the gain, a foreign resident beneficiary (FRB) of a fixed trust can disregard a capital gain made in relation to their interest in a fixed trust: section 855-40.

Peter Greensill Family Co Pty Ltd (trustee) v Commissioner of Taxation

In the Federal Court case Peter Greensill Family Co Pty Ltd (trustee) v Commissioner of Taxation [2020] FCA 559 this week the issue arose whether an Australian resident family discretionary trust – a non-fixed trust, was entitled to rely on section 855-10 and the Mirror Principle to disregard capital gains distributed to a FRB, a beneficiary based in London, of the trust from realisation by the trust of shares in a private company, GCPL, which were non-TAP of the trust.

Detachment of capital gains from the workings of trust CGT tax rules

The capital gains of a trustee are distant from the capital gains of a beneficiary under the ITAA 1936 and the ITAA 1997. Transparent treatment or look through to the capital gains of the trustee as capital gains of the beneficiary/ies became even more remote following changes to Sub-division 115-C of the ITAA 1997 including the introduction of Division 6E of Part III of the ITAA 1936.

These changes brought in distinct treatment of capital gains and franked distributions of a trust from other trust income following the High Court decision in Commissioner of Taxation v Bamford [2010] HCA 10 and the clarification of taxation of trust income in that case.

Legislation unsupportive of transparent treatment

In Greensill Thawley J. analysed the provisions in Sub-division 115-C and Division 6E to deconstruct the applicant’s case to disregard capital gains using Division 855. 

Section 855-40 specifically allows a FRB of a fixed trust to disregard non-TAP capital gains. The absence of an equivalent exemption for FRBs of non-fixed trusts is telling unless section 855-40 is otiose or represents an abundance of caution. Thawley J. did not follow that line. As the applicant in Greensill could not disregard the capital gains using section 855-40 in the case of non-fixed trust, or section 855-10, the capital gains were taxable in Australia.

Unless there is an appeal to the Full Federal Court the Commissioner can finalise his draft taxation determination TD 2019/D6 Income tax: does Subdivision 855-A (or subsection 768-915(1)) of the Income Tax Assessment Act 1997 disregard a capital gain that a foreign resident (or temporary resident) beneficiary of a resident non-fixed trust makes because of subsection 115-215(3)? as the Federal Court has accepted the view in it.

When 183 days is not enough to make you an Australian tax resident

The recent AAT case of Schiele v. Commissioner of Taxation [2020] AATA 286 (24 February 2020) illustrates when 183 days presence in Australia in an income year is not enough to make someone a resident for tax purposes.

Background

Mr Schiele:

  • is a German citizen;
  • lived with his parents prior to coming to Australia;
  • obtained a working holiday visa for the year ended 30 June 2016;
  • arrived in Australia on 30 October 2015 and departed Australia on 18 July 2016;
  • left his personal belongings and furniture with his parents in Germany while in Australia;
  • did not leave Australia between 30 October 2015 and 18 July 2016;
  • stayed on a farm between 1 December 2015 and 5 June 2016 where he did farm work between 22 March 2016 and 4 June 2016, and travelled to visit friends and to see the country in his remaining time while in Australia;
  • did not become a member of any community groups, churches, clubs or organisations while in Australia; and
  • returned to live with his parents in Germany after departing Australia.

Before the AAT the taxpayer contended he was an Australian tax resident for the 2016 income year. The taxpayer was looking for the tax free threshold that applies to an Australian tax resident’s taxable income.

A visitor

From the above facts the AAT found that the taxpayer was a visitor to Australia.

What makes an individual an Australian tax resident?

The relevant passages of the taxation legislation in the case are from the definition “resident” or “resident of Australia”:

  (a)  a person, other than a company, who resides in Australia and includes a person:

    (i)  whose domicile is in Australia, unless the Commissioner is satisfied that the person’s permanent place of abode is outside Australia; or

    (ii)  who has actually been in Australia, continuously or intermittently, during more than one-half of the year of income, unless the Commissioner is satisfied that the person’s usual place of abode is outside Australia and that the person does not intend to take up residence in Australia;

from sub-section 6(1) of the Income Tax Assessment Act 1936

If the taxpayer could satisfy any of the phrase in paragraph (a), or either of sub-paragraphs (i) or (ii), then the taxpayer would be a tax resident. It is to be noted that both sub-paragraphs (i) and (ii) have prominent conditions (after the word “unless”).

paragraph (a) resides – resident according to ordinary concepts

The term resides in Australia in paragraph (a) is the legal parameter of residence (in Australia) according to ordinary concepts. Residence according to ordinary concepts has been developed in the common law in tax court cases each typically involving a controversy about where a person resides. The AAT approved of a summary of case authority on residence according to ordinary concepts submitted by the Commissioner. To keep this extract brief I extract the Australian High Court cases so summarised in paragraph 24 of the AAT decision:

…. Determination of a person’s residence is a “question of degree and …fact”; ….

Federal Commissioner of Taxation v Miller [1946] HCA 23; (1946) 73 CLR 93, 103

… “a person does not necessarily cease to be a resident there because he or she is physically absent. The test is whether the person has retained a continuity of association with the place … together with an intention to return to that place and an attitude that the place remains “home””; ….


Koitaki Para Rubber Estates Limited v The Federal Commissioner of Taxation [1941] HCA 13; (1941) 64 C.L.R. 241 at p.249

The AAT found that the taxpayer did not reside in Australia and was not a resident according to ordinary concepts as a matter of fact and degree. The AAT found no persuasive evidence that the taxpayer intended to dwell permanently or for a considerable time in Australia. His presence in Australia for 7 months did not make him a resident on its own.

sub-paragraph (i) – the domicile test

Domicile is another technical legal test governed by the Domicile Act (C’th) 1992. Shortly stated a domicile is most often in the country where a person is born, or based on the nationality the person is born with which is taken to be where he or she intends to live indefinitely (domicile of origin) . Domicile of origin is intractable but can be changed: where the person can demonstrate his or her intention to make his or her home in another place indefinitely. Without a quest for a permanent right to live in a country no change to that country as a domicile of choice is evident. Clearly in the taxpayer’s case, the taxpayer has a domicile which remains his domicile of origin in Germany.

The condition to domicile in Australia concerning the permanent place of abode of the taxpayer is not enlivened because the taxpayer does not have a domicile in Australia.

sub-paragraph (ii) – the 183 day (half year) test

The 183 day test was the test on which the taxpayer sought to qualify as an Australian resident. The taxpayer was present in Australia for over 183 days and sought to correct immigration records that suggested to the contrary through the course of the case.

However the taxpayer’s difficulty in the case was not with his presence in Australia for more than 183 days, which the AAT accepted, but with the condition to the 183 day test of residence. The Commissioner and the AAT were satisfied that the taxpayer’s usual place of abode was in Germany so the condition to sub-paragraph (ii) was both enlivened and satisfied. The taxpayer was not an Australian tax resident because his usual place of abode was not in Australia despite his presence in Australia of more than 183 days.

Tax residence – is it administrable after Pike?

passportsIn the recent case of Pike v Commissioner of Taxation [2019] FCA 2185 Federal Court judge Logan J. noted:

This is the third in a succession of taxation appeals in the original jurisdiction entailing a tax residence issue, the others being Stockton v Commissioner of Taxation [2019] FCA 1679 (Stockton) and Addy v Commissioner of Taxation [2019] FCA 1768 (Addy), which have fallen for determination by me since the Full Court’s judgment in Harding v Commissioner of Taxation (2019) 365 ALR 286 (Harding).

The Commissioner’s losses

In each of the cases, the Federal Court overturned decisions of the Commissioner of Taxation that each of the protagonists were residents of Australia for tax purposes, and found that they were non-residents. Addy and Stockton were “working holiday” cases. In Pike too Logan J. overturned an objection decision of the Commissioner that Mr. Pike had Australian tax residence for the 2009 to 2014 income years but the Pike case raises wider questions about the income tax residence rules and indeed, Pike differs from the Full Federal Court decision (special leave to appeal to the High Court refused) in Harding too as it concerned a taxpayer whose spouse and children lived in Australia during the income years in dispute and was especially borderline. How that perhaps perplexing outcome could come about is the concern of this post.

Dissatisfaction with the tax residence rules already

In 2016 the Board of Taxation initiated a review into income tax residence rules which considered:

  • whether the existing Australian individual income tax residence rules that are largely unchanged since enactment in 1930:
    • are sufficiently robust to meet the requirements of the modern workforce;
    • address the policy criteria of simplicity, efficiency, equity (fairness) and integrity;
  • integrity concerns;
  • the increase in litigation relating to the tax residence rules since 2009; and
  • any changes that could be adopted to improve the tax residence rules.

The Board reported a core finding that the current individual tax residence rules are no longer appropriate and require modernisation and simplification. Nevertheless the Board also noted that change runs inherent integrity risks such as high net worth individuals in particular could become citizens of nowhere.

Pike – applying the existing tests

The curious and complex aspects of the existing Australian individual income tax residence rules where comprehensively considered and applied by Logan J. in Pike. Mr. Pike, even in the submission of the Commissioner, was a dual resident of Australia and Thailand during the relevant years. This meant that Logan. J needed to look to the “tie-breaker” provisions in the Australia Thailand Double Tax Agreement (the DTA) to determine which of Australia or Thailand could treat Mr. Pike as a tax resident of their jurisdiction during those years.

The domicile test

In the tax residence tests in the definition of “resident” or “resident of Australia” in sub-section 6(1) of the Income Tax Assessment Act (ITAA) 1936 there is an interplay between ordinary residence with the test in paragraph (a)(i) where the domicile of the taxpayer is relevant. Under that definition in the ITAA a “resident” or “resident of Australia”means:

(a)  a person, other than a company, who resides in Australia and includes a person:

(i)  whose domicile is in Australia, unless the Commissioner is satisfied that the person’s permanent place of abode is outside Australia; …

And so Logan J. needed to consider the evidence in Pike to understand whether Mr. Pike had a domicile in Australia during the relevant years.

Principal facts relating to the domicile test in Pike

In the context of Mr. Pike’s domicile the principal facts in Pike were:

  1. Mr. Pike was a native of Zimbabwe.
  2. Mr. Pike and his de facto, Ms. Thornicroft, with whom Mr. Pike had children, left Zimbabwe. Ms. Thornicroft obtained a position with Ernst & Young in Brisbane however Mr. Pike’s skills and career were in the tobacco industry and he had to relocate elsewhere. In the event he relocated alone to Thailand, and after 2014, to Tanzania and to the United Arab Emirates to use his skills and pursue his career in the tobacco industry.
  3. Ms. Thornicroft and their children became Australian citizens in 2010. Mr Pike applied to become an Australian citizen in 2013 and, initially, he was rejected presumably with the Department of Immigration taking into account the paucity of time Mr Pike was physically in Australia and his Thailand connections:
Income year Days spent in Australia Percentage of time spent in Australia
2008 76 20%
2009 155 42%
2010 97 27%
2011 109 30%
2012 102 28%
2013 86 23%
2014 123 33%
(2015) 32 8%
(2016) 44 12%
(2017) 77 21%
  1. Despite those Mr. Pike did eventually become an Australian citizen in 2014.

These principal facts are but a snapshot and simplification of the factual matrix in Pike all of which beared on, in varying degrees, the questions of residence and domicile at issue in the case. Resolution of these questions based on these facts plainly justified the full remittance of penalties by the Commissioner which the Commissioner conceded to Mr. Pike at the objection stage.

Domicile of origin of Mr. Pike

Logan J. observed that Mr. Pike had sought to become and became an Australian citizen though somewhat as a matter of convenience to overcome the complications for an international businessman travelling on a Zimbabwean passport. Logan J. found that Mr. Pike clearly had a domicile of origin in Zimbabwe and applied legal reasoning and learning to understand when Mr. Pike may have acquired Australian domicile as a domicile of choice. Even though the evidence was far from conclusive Logan J. stated that there were sufficient signals from Mr. Pike’s activity to conclude that Mr. Pike did not have a domicile of choice in Australia before 2014.

Thus Logan J. found that Mr. Pike was not a “resident of Australia” due to the operation of the domicile test in paragraph (a)(i) of the definition in sub-section 6(1) even should the Commissioner have reason not be satisfied that Mr. Pike had a permanent place of abode in Thailand.

Dual resident

Logan J. explained with reference to applicable authority including Dixon J. in Gregory v D.F.C.T. (W.A.) [1937] HCA 57; 57 CLR 774 at p.777-778 that an individual can be ordinarily resident in two places. In Pike further principal facts relating to Mr. Pike’s ordinary residence included:

  1. Ms. Thornicroft and their children opted not to move to Thailand so that the children’s schooling could be in Australia and could continue undisrupted.
  2. Despite their living apart the Federal Court was impressed by Mr. Pike’s commitment to his de facto, children and his wider family including his full economic support of Ms. Thornicroft and the children after Ms. Thornicroft ceased earning an income from her employment in 2011 after sustaining an injury.
  3. Although Mr. Pike and Ms. Thornicroft had purchased a vacant block in Brisbane in the hope of building a home, the block was sold undeveloped for a loss in 2014. Ms. Thornicroft, the children, and Mr. Pike when in Australia, thus always occupied rental accommodation in Australia.
  4. Mr. Pike too rented a succession of apartments and cottages in Chaing Mai, Thailand which accommodated the family when Ms. Thornicroft and their children visited Mr. Pike in Thailand; and
  5. Mr. Pike was keen on sports, both as a participant as a spectator and was a member of a number of sports clubs in Thailand. Logan. J. accepted evidence of Mr. Pike and Ms. Thornicroft that Mr. Pike had his own “life abroad” for the long periods he was present in Thailand for his work commitments.

As stated, the Commissioner too had accepted that Mr. Pike was an ordinary resident of both Australia and Thailand. Thus the Federal Court needed to apply the “tie-breaker” tests in the DTA.

The paramount DTA

Logan J. explained how the DTA is paramount over the ITAA  in cases where the DTA applies. Thus an individual who is, or could be a resident of, Australia under the ITAA definition in sub-section 6(1) could nevertheless come to be treated as a resident of Thailand and not a resident of Australia under the DTA. That is the outcome under sections 5 and 4 of the International Tax Agreements Act 1953 if, under the DTA, the “tie-breaker” provisions of the DTA apply to treat a dual resident as a resident of Thailand.

The DTA tie-breakers

However like with the domicile test considered above, the tie breaker tests in the DTA were not so readily capable of application to resolve Mr. Pike’s circumstances.

Tie-breaker 1 – didn’t work

The first tie-breaker under Article 4.3(a) of the DTA is:

the person shall be deemed to be a resident solely of the Contracting State in which a permanent home is available to the person;

Based on relevant authorities and OECD commentary Logan J. found that a rented home, albeit a family home occupied as such for the foreseeable future, is not a permanent home in this context. Similarly Mr. Pike’s various accommodations in Thailand also did not amount to any permanent home. So this tie-break was of no assistance to the Federal Court to resolve the question of Mr. Pike’s tax residence.

Tie-breaker 2 – didn’t work

The second tie-breaker is in Article 4.3(b) of the DTA:

if a permanent home is available to the person in both Contracting States, or in neither of them, the person shall be deemed to be a resident solely of the Contracting State in which the person has a habitual abode;

which also turns on the availability of a permanent home to Mr. Pike was indeterminate as Mr. Pike had habitual abodes available to him in both Australia and Thailand.

Tie-breaker 3 – applied

The third tie-breaker in Article 4.3(c) of the DTA is:

if the person has a habitual abode in both Contracting States, or in neither of them, the person shall be deemed to be a resident solely of the Contracting State with which the person’s personal and economic relations are closer.

was applied by Logan J. Logan J. analysed Mr. Pike personal relations to Australia which included the presence of his de facto wife and children in Australia and the availability of a not so permanent home which he occupied in Australia when he was living with his family. Those were clearly of greater significance, as personal relations, than his sporting and social activity in Thailand to him in his personal space. Against that Logan J. considered Mr. Pike’s economic relations to Thailand which gave rise to all of his income which, from 2011, was the income which sustained both Mr. Pike and his family in Australia.

Although Mr. Pike spent considerably more days each year between 2009 and 2014 in Thailand due to work than in Australia Logan J. stated:

I do not accept Mr Pike’s submission that habitual abode ought to be determined just by length of residence such that Mr Pike’s greater length of residence in Thailand in each year meant that, between the 2009 and 2014 income years, only in Thailand could be said to have a habitual abode.

Although it was something of an oranges versus apples comparison Logan J. broadly found that Mr. Pike’s relations (in the main, economic) to Thailand were closer than Mr. Pikes relations (in the main, personal) to Australia.

Hence Logan J. found that, under the DTA tie breaker in Article 4.3(c), Mr. Pike was a resident of Thailand and a non-resident of Australia between the 2009 and 2014 income years.

How then to change the tax residence rules?

At the outset of this post I raised the Board of Taxation’s recommendation that the tax residence rules should be modernised and simplified. In the context of Pike and how that case ultimately turned it is not so easy to formulate how the tax residence rules could be changed to avoid the perhaps arbitrary application of overly simple and ineffective DTA tie-breakers based on OECD settled model provisions which change may put Australia out of alignment with international norms.

Or is Pike too unusual to worry about?

That said the facts in Pike seem exceptional to the wisdom that tax residence will generally be at the habitual place of abode a taxpayer has with his or her spouse and children. In Pike the following factors, which were somewhat unusual, appear to have given rise to a different outcome:

  • Mr. Pike had a foreign history and never seemed to really settle with his family in Australia before 2014;
  • Mr. Pike and Ms. Thornicroft never purchased a home in Australia and the family lived in a succession of rented homes; and
  • Mr. Pike and Ms. Thornicroft were unusually credible and convincing witnesses who were able to establish to the Federal Court that they really had reasons for and had a believable distance though stable family relationship.

Commissioner hamstrung by equivocal tax residence rules

Still unusual residential arrangements abound and, for many taxpayers, this means wide surveys of their facts and background of their tax residence will need to be undertaken and presented to the Commissioner. The Commissioner does not have the benefit of laws fit for purpose to assist the Commissioner to administer the law and clearly resolve the question of tax residence even when fully appraised of assiduously supplied facts. This ultimately can lead to administration challenges for the Commissioner and to expensive disputes with taxpayers over tax residency which will be as impenetrable as Pike was to resolve.

Sluggish anti-money laundering reform in Australia

Australia has resiliently protected its revenue base. Under Australian law and administration it is risky for Australian tax residents to have involvements in tax havens. Australia is a firm committer to a comprehensive series of double tax agreements and is rarely thought of as a tax haven.

Financial Secrecy Index ranking

In its Financial Secrecy Index (2015), the Tax Justice Network noted that “Australia accounts for less than 1 per cent of the global market for offshore financial services, making it a tiny player compared with other secrecy jurisdictions…. Australia has taken significant steps to address tax evasion and tax avoidance, especially as it relates to revenue loss from Australia. However, its record of helping other countries combat tax evasion and money laundering is somewhat mixed.” Australia was given a 44 rating in this study, which is better than Switzerland (1), USA (3), Great Britain (15) and the Netherlands (41). Still, this middling rating does reflect sluggish progress by Australia with anti-money laundering measures.

Extent of scrutiny of money flows

In 2006, the Anti-Money Laundering and Counter-Terrorism Financing Act and Rules were introduced empowering AUSTRAC to track money flows through providers of banking, remittance and gambling services. In 2007 the Australian Government announced measures to extend the regime to non-financial businesses and professions including the legal, accounting and real estate professions. Now it is 2017 and the extended measures are yet to be implemented. Various lobbies and sectional interests have successfully pressed successive governments to delay and reconsider the extended measures.

Is that scrutiny enough?

Although the 2006 measures appear to be functioning successfully there is growing concern that a vast amount of illicit foreign money, particularly from China, has eluded AUSTRAC scrutiny and has found its way into the very buoyant Australian real estate market.

According to the Financial Action Task Force and the Asia/Pacific Group Mutual Evaluation Report of April 2015 Australia has strong legal, law enforcement and operational measures for combating money laundering and terrorism financing, but the report says important improvements are needed in a number of key areas and an underlying concern remains that Australian authorities are overly focussed on predicate crime rather than on money laundering risks.

Australia could achieve an improved Financial Secrecy ranking by commencement of the extended money laundering measures.

Why setting up offshore companies for Australians is a tricky business

Suppliers of offshore companies often supply companies to international clients with the promise that the company will give rise to no or little income tax. What they might really mean is the tax that applies in the offshore place of incorporation or the offshore place of operation of the company. The promise may not be informative about income tax implications in the place of tax residence of the client of taking on the offshore company.

It is useful for Australians looking to acquire an offshore company, and for offshore company suppliers who may supply an offshore company to them, to know about how offshore companies may be treated for Australian income tax purposes. And the involvement of the offshore company supplier in the company may be significant to what that treatment may be.

When offshore companies are controlled foreign corporations

Australia has had a controlled foreign corporations (“CFCs”) regime since 1990 which applies to treat an offshore company controlled by Australian tax residents (“AUTRs”) as a CFC. Like with other CFC regimes, the CFC itself is not, by virtue of being a CFC, treated as a tax resident of Australia generally subject to Australian income tax on its worldwide income; nonetheless the regime functions by attributing offshore income of the CFC to its AUTR controllers. So, although tax may be low on the company in the country of operation of the company, the AUTR faces Australian income tax on the income of the CFC even where the income of the CFC remains unrepatriated from the CFC.

The CFC regime has an active income exemption which applies to exclude income earned by a CFC carrying on an active business in an offshore place from attribution to AUTRs. Where the active income exemption can apply to the CFC an offshore company supplier may be better placed to make good on their promise of low income tax to an Australian client.

Another way of making good on the promise, but a way which is not, in any way, legal under Australian laws, including under the associate-inclusive control tests in the CFC rules, is to hide the Australian control of the offshore company from Australian authorities and from others whom it may concern. Offshore company suppliers have been known to do this by providing local-based company directors and nominee shareholders who follow the directions of the client through opaque protocols, which can be in various forms, to give the client the necessary control and assurance that the client’s directions concerning the offshore company will be followed.

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Offshore company is an Australian tax resident after all?

A offshore company under covert directions of AUTRs not only faces the risk that its income will be attributed as attributable income taxable in Australia under the CFC regime but also faces possible treatment as an Australian tax resident, itself. In that eventuality Australian tax authorities won’t need to rely on the CFC regime to tax the income of the offshore company in Australia.

When a company will be treated as an Australian tax resident

Under the Australian Income Tax Assessment Act 1936 a company is resident in Australia if:

it is incorporated in Australia or, if not incorporated in Australia, if it carries on business in Australia and has either its central management and control in Australia or its voting power controlled by shareholders who are residents of Australia

(definition of “resident” or “resident of Australia” in sub-section 6(1))

This is similar to the formulation of tax residence of companies that applies in most OECD countries.

The highest court in Australia, including on tax matters, is the High Court of Australia. In the 1973 case of Esquire Nominees Ltd. v. Federal Commissioner of Taxation, Gibbs J., who lead the High Court in this case, observed that:

  • “the real business [of a company] is carried on where the central management and control actually abides”; and
  • “the question where a company is resident is one of fact and degree”.

In Esquire Nominees, the High Court was able to find that a Norfolk Island company was not centrally managed and controlled from Australia despite evidence that Australian-based accountants:

  • formulated a tax avoidance scheme involving the company acting as the trustee of a number of trusts; and
  • communicated every aspect of the scheme of the trusts to the directors of the corporate trustee in Norfolk Island including how the scheme was to be carried out.

Gibbs J. was satisfied that the directors of the corporate trustee in Norfolk Island  had sufficient independent power in their role, beyond the control of the Australian-based accountants, to support a finding that the central management and control of the company was on Norfolk Island. This was despite what appeared to be the whole reliance of the directors on the communications from the Australian-based accountants. The board of directors of the company did not to have to comply with directions from the Australian-based accountants.  Gibbs J. found that the (board of) directors were making the decisions of the company, albeit in line with the strong influence of the Australian-based accountants, and that they met to do so on Norfolk Island.

Bywater Investments Limited v Commissioner of Taxation, Hua Wang Bank Berhad v Commissioner of Taxation

A November 2016 decision of the High Court has shown that:

  • relevant matters to be taken into account in ascertaining the central management and control of a company include, but are not limited to:
    • the location of the company’s registered office;
    • the residency of the company’s directors;
    • the residency of the company’s shareholders;
    • where the company’s meetings, including its directors’ meetings, are held; and
    • where the books of the company are kept;
  • the place where the board of directors meets, in particular, is not sufficient, by itself, to show where the central management and control of a company, and thus the Australian tax resident status of a company is; and
  • despite the outcome in Esquire Nominees,  Australian courts will not always accept, just because a company has a properly appointed and functioning offshore-based board of directors, that the independence or autonomy of those directors can be inferred.

In Bywater Investments Limited v Commissioner of Taxation Hua Wang Bank Berhad v. Commissioner of Taxation [2016] HCA 45 a Sydney accountant (“G”) had complete legal and actual control of Swiss-based and Samoan-based companies despite the considerable lengths taken by G:

  • to conceal the fact of G’s control of the companies; and
  • to project apparent control of these companies by boards of directors in Switzerland and Samoa arranged by Swiss-based and Samoan-based offshore company and corporate services providers.

Companies involved were incorporated in the Cayman Islands and in the Bahamas. Only through the course of the Australian investigation and litigation did it become clear that various legal means, including:

  • in the case of Hua Wang Bank Berhad, the device of an unredeemed secured bearer debenture which operated to suspend the rights of the offshore shareholders of the company to vote or demand a poll; and
  • in the case of “JA Investments”, another significant company in the structure, appointment of G as “Appointor” with the power to appoint additional members of this company who in turn could remove directors;

had been devised to give G control of the companies.

The abrogation exception

The High Court in Bywater Investments Hua Wang Bank Berhad found that, although the central management and control of a company will ordinarily be where meetings of its board are conducted; a long line of authorities, including Esquire Nominees and the UK House of Lords decision in Unit Construction Co Ltd v Bullock [1960] AC 351, identify a significant exception where a board of directors abrogates its decision-making power in favour of an outsider, and the board operates as a puppet or cypher, effectively doing no more than noting and implementing decisions made by the outsider as if they were, in truth, decisions of the board.

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In Bywater Investments Hua Wang Bank Berhad it was found that G was such an outsider in control of companies that made the decisions of each company. These decisions were implemented as decisions of the boards of the Samoan-based and Swiss-based companies and the central management and control of these companies, was with G, the outsider, who was thus carrying on the business of each company in Australia.

Place of effective management of offshore companies

In the case of the Swiss-based companies, where a consideration of the place of effective management was also relevant under the applicable double tax treaty between Switzerland and Australia , the finding viz. that that place of effective management was Australia, was no different. The consequence was that the Swiss-based companies were not entitled to protection from Australian taxation under the double tax treaty.

Demonstrating board autonomy of an offshore company

The company in Esquire Nominees was able to show that it was in the ordinary case, albeit by an indistinct or possibly by a fine margin, in contrast to the boards of directors of the companies in Bywater Investments Hua Wang Bank Berhad which failed to show that they were not puppets or cyphers of its AUTR controller.

The evidence in Bywater Investments Limited Hua Wang Bank Berhad was in stark contrast to the evidence in Esquire Nominees from which the court accepted the contention that the board of the Norfolk Island company had maintained a sufficient autonomy over decision-making by the company. In Bywater Investments Hua Wang Bank Berhad the evidence of the companies unravelled as it was found that:

  • the documents and evidence produced by directors of the companies where untruthful and falsely contrived to corroborate testimony that the offshore directors operated autonomously;
  • the offshore directors were a “fake”;
  • the offshore ownership structure of the companies was a “ruse”; and
  • the means used by G to conceal that he was the true owner of one of the companies suggested dishonesty. Every decision of consequence for that company was made by G.

It follows that AUTR clients of offshore company suppliers may be challenged to sustain that an offshore company has central management and control in an offshore jurisdiction where the offshore directors are nominees, arranged by offshore company service providers potentially identifiable as “puppets and cyphers” and not directors with real understanding of the affairs of the offshore company who are genuinely involved in the decision-making of the offshore company.

Conclusion

Following Bywater Investments Hua Wang Bank Berhad Australian clients of offshore company suppliers may have reason for concern that an offshore company they procure from an offshore company provider may be an Australian tax resident.  Those concerns arise in the absence of real business activity by the company in the offshore place or real autonomy, in relation to the affairs of the company, given to the offshore directors in the offshore place which is evident from a holistic evaluation of the constituent legal documents of the company on which control of the company comes to rely.

Although the appearance of offshore decision-making by the company may initially show that the central management and control of the company is outside of Australia, that conclusion may not withstand a persistent scrutiny should the company be investigated, or more, and forced to produce its constituent legal documents to defend its offshore tax resident status. The outcome may be that the company is dealt with as an Australian tax resident without reliance on the CFC provisions to attribute and tax income of the offshore company to its AUTR controllers.

Are there limits to interest deductions in Australia in participative loan arrangements involving entities in the same economic group?

Question on taxlinked.net members forum about Participative Loan Taxation

Since 1st January 2015 in Spain, interests are (interest is) not tax deductible when the participative loan is agreed to between entities of the same economic group. Is there similar treatment in your countries?

Response to post

Generally not in Australia.

In Australia interest is deductible if incurred on debt finance obtained to earn assessable income or to carry on a business even if debt finance arrangements include entities not dealing with each other at arms length.

These deductibility tests are serious purposive tests so non-arms length transactions attract particular scrutiny and, like in most jurisdictions, the burden of making out either purpose is on the taxpayer. As well as the general construct of sham there are a numerous specific instances where the Australian law denies interest deductions including:

  • sometimes where deductions are prepaid;
  • where there is not a sufficient relation between the loan and income received after a “commonsense” or “practical” weighing of the circumstances; and
  • where deductions are artificial or contrived or have those elements– if specific anti-avoidance rules do not apply.

Australia has a longstanding general anti-avoidance provision that can apply even if the interest deduction was otherwise available under the law. In international outbound financing the deduction can be lost because foreign income can be treated as other than assessable income. International debt/hybrid mismatch rules are being developed in Australia following some taxpayer success resisting anti-avoidance rules and the international experience.

Deductions are also lost if a “loan” is technically found to have characteristics of equity in substance.

Australian courts look at the role of associated entities to understand their purpose and look at transactions holistically. In other words they will focus on the economic units, rather than on juristic entities which seems to happening in Spain from what you say. Hence an interest deduction to an entity can be reduced, for instance, if the debt finance is on-lent to a related entity to earn income palpably less than the deduction.

Australia also has thin capitalisation rules which apply to limit otherwise allowable large cross border interest deductions.

Chevron Australia is involved in the first major transfer pricing case under the new BEPS regime where the Commissioner of Taxation is fighting to contend that interest paid and deducted exceeded the arms length amount based on BEPS arms length principles. The Commissioner won the first stage of the case in 2015.