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Taxing times

Feature Articles

Cite as: Jan/Feb 2010 84(1/2) LIJ, p.46

Changes to s23AG of the Income Tax Assessment Act 1936 (Cth) will have a significant impact on Australian resident individuals who work overseas. 

By Sarah Hinchliffe and Eu-Jin Teo

On 1 July 2009, in response to the 2009/2010 federal Budget, s23AG of the Income Tax Assessment Act 1936 (Cth) (ITAA36) was amended to include a new s23(1AA).1 This amendment has the effect of disallowing certain Australian resident individual taxpayers, who are engaged for more than 90 days of continuous foreign service, from claiming an exemption in respect of their foreign employment income.

At present, Australia’s largest expatriate community is located in the UK followed by the US, New Zealand and Hong Kong.2 With the latest figures available suggesting that nearly 5 per cent of the Australian population lives overseas on a long-term basis,3 this amendment is important to legal advisers of Australian clients who are working or sending employees overseas.

Residence and source

The taxation of income in Australia is principally determined on the basis of whether the taxpayer is an Australian resident or a foreign resident for taxation purposes. Residency for income taxation purposes is different from the immigration meaning of residence.4 For example, an individual may be classified as a tax resident of Australia even though they may not reside or be physically present in Australia. If an individual is a resident of Australia for income taxation purposes, then they are taxed in Australia on their worldwide income.5 If, however, an individual is not a tax resident of Australia, then they are only subject to Australian income tax on income sourced in Australia.

The threshold in determining tax residence is relatively low in Australia and individuals are presumed to be tax residents of Australia under the domicile rule unless they can show that they have a permanent place of abode overseas: s6(1). If their permanent place of abode is overseas, then they are classified as non-residents of Australia for income taxation purposes. Establishing an overseas permanent place of abode broadly requires that an Australian living overseas has no intention of returning to Australia in the foreseeable future.6 Courts have held that income from employment and other forms of personal exertion has its source in the jurisdiction where the services in question are performed.7

Background of s23AG ITAA36

Whether an individual is a resident of Australia is of central importance to the operation of s23AG.

Introduced in 1986, s23AG provided a means of avoiding double taxation by providing an exception to the general rule that Australian resident individuals are taxed on their worldwide income.8 Prior to the amendment of the section in the 2009/2010 Budget, any Australian resident individual taxpayer who derived overseas employment income would be exempt from Australian income tax on that income provided that the taxpayer was engaged in foreign service for a continuous period of more than 90 days. Without this exemption, such income would otherwise be subject to Australian income tax at the individual’s marginal rate, with a credit provided for foreign tax paid. Foreign earnings, however, were not exempt from Australian income tax if they were exempt from tax in a foreign country only because of one or more of the reasons listed in s23AG(2), including (among others) the presence of a tax treaty with Australia or a law giving effect to a treaty agreement.9 This exception did not apply to deny an exemption if the foreign earnings were exempt from tax in the foreign country for a reason other than, or in addition to, those listed in s23AG(2). This is still the case.

Section 23AG therefore had broad application since the exemption could still apply in cases where little or no foreign tax had been paid (if the exceptions listed in s23AG(2) were not applicable), and its operation was not restricted to foreign employment income derived from specific activities. On the one hand, its operation is good for taxpayers in the absence of an applicable Double Tax Agreement (DTA). On the other hand, different outcomes resulted between individuals working in Australia and individuals working overseas who were subject to different, often lower, tax rates.

Section 23AG(1AA) ITAA36 – an effective 21st century change?

The introduction of s23AG(1AA) into the ITAA36 on 1 July 2009 refines the application of the exemption that is provided pursuant to s23AG. Now, foreign income derived on or after 1 July 2009 by an Australian resident individual engaged in continuous foreign service for more than 90 days will only be exempt from income tax in Australia if the income is “directly attributable” to:

  • the delivery of Australian official development assistance by the individual’s employer;10 or
  • the activities of the individual’s employer in operating a public fund declared by the Treasurer to be a developing country relief fund; or
  • a public fund established and maintained by a public benevolent institution solely for providing money for the relief of people in a developing country who are in distress as a result of a disaster, as recognised by the Minister for Foreign Affairs; or
  • the individual is deployed outside Australia by the Australian government (or an authority thereof) as a member of a disciplined force;11 or
  • an activity of a kind specified in the regulations.

The new rules apply to foreign earnings derived on or after 1 July 2009 from foreign service performed on or after 1 July 2009. Foreign earnings derived on or before 30 June 2009 remain eligible for exemption under the old rules and foreign service performed on or after 1 July 2009 is included in the calculation of the period of continuous foreign service, even where the foreign earnings derived on or after 1 July 2009 are no longer exempt. The more limited foreign income that is now exempt remains subject to the existing exceptions in s23AG(2) ITAA36.

Individuals who now derive non-exempt foreign employment income as a result of the amendment to s23AG are able to claim a non-refundable tax offset for foreign income tax paid on that income, arguably relieving double taxation for those individuals. This is already provided for in the foreign income tax offset (FITO) rules which apply to income years beginning on or after 1 July 2008 and which are contained in Division 770 ITAA97. The FITO rules replaced the former foreign tax credit system and were designed to provide taxpayers with a simplified way of claiming relief for foreign income taxes paid on amounts included in their assessable income in Australia.

It may seem that limiting the scope of the tax exemption provided by s23AG will assist to maintain the integrity of the Australian tax system by ensuring that most Australian resident individuals face the same effective overall income tax burden in relation to their worldwide income. However, this may not always be the case.

Case study

The effect of the amendments can be illustrated by reference to the example of a solicitor who:

  • is a resident of Australia for income tax purposes;
  • is at the highest marginal tax rate in Australia of 46.5 per cent;12 and
  • works for an international legal practice with commercial clients.

If the solicitor is not employed by and working at an Australian office of the firm, then the Australian income tax consequences with respect to the employment income of the solicitor would be dependent on the jurisdiction in which the particular office at which the solicitor is employed (and working at) is located.

UK

If the solicitor is employed by (and working at) the London office of the firm, they could potentially be subject to tax in the UK on their employment income at the highest marginal income tax rate in the UK of 40 per cent. Australia is a party to a DTA with the UK13 and under that agreement, the UK would have exclusive rights to tax in relation to the employment income of the solicitor in the UK.14 The solicitor is subject to a lower rate of income tax in the UK on their UK employment income than the rate that they would have been subject to in Australia if they had earned the same income in Australia.

Sweden

If the same solicitor is employed by (and working at) the Stockholm office of the firm, they could potentially be subject to tax in Sweden on their employment income at the highest marginal income tax rate in Sweden of around 57 per cent. Australia is a party to a DTA with Sweden15 and under that agreement, Sweden would have exclusive rights to tax in relation to the employment income of the solicitor in Sweden.16 The solicitor is subject to a higher rate of income tax in Sweden on their Swedish employment income than the rate that they would have been subject to in Australia if the solicitor had earned the same income in Australia.

Hong Kong

Finally, if the solicitor in question is employed by (and working at) the Hong Kong office of the firm, they could potentially be subject to tax in Hong Kong on their employment income at the highest marginal income tax rate in Hong Kong of 17 per cent. Hong Kong is a Special Administrative Region of the People’s Republic of China,17 and the DTA between Australia and China does not appear to extend to cover Hong Kong.18 As a result, the solicitor would be liable to income tax in Australia on the income from their employment in Hong Kong only at the rate of 29.5 per cent (this being the difference between the highest marginal tax rate that they would face in Australia of 46.5 per cent and the Australian income tax credit of 17 per cent for the Hong Kong tax on the employment income from Hong Kong that has already been paid). Prior to the amendment to s23AG, the solicitor would not have been liable for Australian income tax in respect of their employment income from Hong Kong.

Conclusion

The objective behind amending s23AG is to minimise the potential for “horizontal” and “vertical” inequity concerning Australian resident individuals working overseas and Australian resident individuals working in Australia. While this appears consistent with the general principle that individuals who are Australian residents for income tax purposes should pay tax on their worldwide income, it remains unclear as to why the whole section was not repealed. Such a move seems at odds at a time when the government is apparently pursuing a simplification agenda with respect to many aspects of the income tax law, including the taxation arrangements that apply to foreign income.

At present, Australia has one of the highest income tax rates for individuals among the countries in the Organisation for Economic Co-operation and Development.19 The limited operation of s23AG is likely to further inhibit the international competitiveness of Australia’s taxation system, detract from the movement of human capital and create added complexity for Australian employers who deploy Australian resident individuals overseas. For instance, where the exemption under s23AG no longer applies to an employee, Australian employers may be required to review their payroll operations to ensure that they are correctly complying with pay as you go, withholding tax, fringe benefits tax, compulsory superannuation and workers’ compensation obligations.

The amendment may also prove to be problematic for employees who have already accepted assignments on the basis of the previous application of s23AG, as these individuals would have only received six weeks notice of the proposed changed treatment which applies from 1 July 2009. Individuals in this category may not be able to renegotiate their contracts as the contracts will not necessarily be conditional on a particular Australian tax status.

SARAH HINCHLIFFE is a teaching fellow at The University of Melbourne and an associate of the Taxation Institute of Australia. EU-JIN TEO is an adjunct lecturer at Monash University, a senior lecturer at The University of Melbourne and a fellow of the Taxation Institute of Australia.

1. Section numbers in the text refer to the Income Tax Assessment Act 1936 (Cth) unless otherwise specified.

2. Hugo, Graeme, Rudd, Dianne and Harris, Kevin, Australia’s Diaspora: Its size, nature and policy implications (Final Report, Committee for Economics Development of Australia, July 2003), pp21-2.

3. See Jogarajan, Sunita, “Bring them home – the case for tax concessions for returning Australians”, Revenue Law Journal, vol 16 issue 1, article 2, 2006.

4. Compare Migration Act 1958 (Cth) ss44 and 204(2) with Income Tax Assessment Act 1997 (Cth) (ITAA97) s995-1 and ITAA36 s6(1)(a).

5. ITAA97 ss6-5, 6-10.

6. Federal Commissioner of Taxation v Applegate (1979) 9 ATR 899, 911 (Fisher J); compare Federal Commissioner of Taxation v Jenkins (1982) 12 ATR 745, 749 with Taxation Case Q68 (1983) 83 ATC 343.

7. See e.g., Federal Commissioner of Taxation v French (1957) 98 CLR 398; Federal Commissioner of Taxation v Efstathakis (1979) 38 FLR 276.

8. See Commonwealth, Second Reading Speech: Taxation Laws Amendment (Foreign Tax Credits) Bill 1986, House of Representatives, 22 May 1986, 3799 (Paul Keating); Commonwealth, Second Reading Speech, House of Representatives, 4 June 1986, 3373 (Senator Walsh). See also Tax Laws Amendment (2005 Measures No. 5) Act 2005 (Cth).

9. See International Tax Agreements Act 1953 (Cth) s4(2).

10. “Australian official development assistance” is intended to refer to the Australian government’s overseas aid program.

11. A “member of a disciplined force” is intended to include defence and police force personnel. It is unclear whether this would extend to state government personnel.

12. This is inclusive of a Medicare levy of 1.5 per cent.

13. Convention between the Government of Australia and the Government of the United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect To Taxes on Income and on Capital Gains, opened for signature 21 August 2003, [2003] ATS 22 (entered into force 17 December 2003) (Australia–United Kingdom Double Tax Agreement).

14. Australia–United Kingdom Double Tax Agreement art 22.

15. Agreement between the Government of Australia and the Government of Sweden for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect To Taxes on Income, opened for signature 14 January 1981, [1981] ATS 18 (entered into force 4 September 1981) (Australia–Sweden Double Tax Agreement).

16. Australia–Sweden Double Tax Agreement art 24.

17. The Basic Law of the Hong Kong Special Administrative Region of the People’s Republic of China, opened for signature 4 April 1990, 29 ILM 1522, art 11 (entered into force 1 July 1997).

18. See Agreement between the Government of Australia and the Government of the People’s Republic of China for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, opened for signature 17 November 1988, [1990] ATS 45 (entered into force 28 December 1990).

19. See Business Council of Australia, Taxation Action Plan for Future Prosperity (2005) 51.

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