I. The Taxation of Foreign-Source Income of Australian Residents

Concept of Resident of Australia

17.12. The Income Tax Assessment Act defines resident of Australia, in relation to an individual, so as to adopt the meaning of the word in ordinary usage and to extend that meaning in ways which depend on the domicile of the person concerned or his presence in Australia for more than half the year of income. The definition, even without the extensions, is likely to include persons who are held also to be resident in another country under that country's concept of residence. In the Committee's view, the resulting competition of jurisdiction to tax must be accepted and adjusted where

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possible by appropriately drafted provisions of double taxation agreements. The matter of appropriate provisions is explored in paragraph 17.98.

17.13. A resident of Australia in relation to a company is defined by exclusively statutory tests, though one of these—central management and control in Australia—uses the language of judicial decisions that adopts the notion of residence of a company under United Kingdom law. Incorporation in Australia is sufficient to give a company a residence in Australia. So too is central management and control in Australia wherever the company is incorporated. A third test, again sufficient, is carrying on business in Australia and having voting power controlled by shareholders who are residents of Australia.

17.14. Although the definition of resident in relation to a company is wide and may include companies that are resident in another country under that country's law, the Committee does not consider that a narrower definition would be appropriate. In a number of respects, however, the definition might be clarified. The second test requires that a company both has its central management and control in Australia and be carrying on business in this country. As the test has been interpreted, the reference to carrying on business in Australia is unnecessary: central management and control, it is said, involves the carrying on of business. In any event, in the Committee's view it should be enough to give a company a residence in Australia that its central management and control is here.

17.15. The meaning of central management and control calls for clarification. It would bring some tax-haven companies within the jurisdiction of Australian tax if these words were held to be wide enough to include the exercise of control and direction of the company's affairs otherwise than in the formal proceedings of the board-room. It might be thought to be enough to give a residence in Australia that the board of directors habitually responds to intructions formulated in Australia, even though the board meets elsewhere. This wide meaning would, however, increase the likelihood of a company being resident both in Australia and in a foreign country to a degree that might be regarded as unacceptable: many wholly-owned subsidiaries of Australian resident companies, though incorporated in foreign countries and resident there, could become Australian resident companies. On the other hand, the objective of bringing tax-haven companies within the jurisdiction of Australian tax should not be lightly abandoned. Some compromise might be possible which would involve identifying tax-haven countries, either in the Act or, preferably, in regulations, and would provide that a company incorporated in such a country would be deemed to have an Australian residence if effective control and direction of the company's affairs are exercised in Australia, regardless of where the board of directors meets or other formal corporate proceedings take place.

17.16. In Chapter 15 the Committee has proposed that the law should define a concept of an ‘Australian trust’, parallel with the concept of an Australian resident company. The purpose of this concept would be to provide a basis of jurisdiction to tax the accumulating income of the trust. The concept, as there explained, would in part depend on the management and control of the trust being in Australia. Where the trust is administered in a tax-haven country, the same wide meaning of management and control should apply as proposed in relation to companies incorporated in tax-haven countries.

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Foreign-source Income Not Subject to Australian Tax

17.17. The effect of two provisions of the Australian law, noted briefly at the beginning of this chapter, is to exclude from Australian tax a very considerable part of foreign-source income of Australian residents. One of these provisions is section 23(q) which, subject to a number of exceptions, exempts from Australian tax foreign-source income that is subject to tax in the country of source. The other is section 46 which, by allowing a rebate at the Australian rate of tax, in effect exempts foreign-source dividends received by a company, whether or not the profits from which the dividends were paid, or the dividends themselves, have been subject to foreign tax.

17.18. The exclusion from Australian tax by these provisions avoids the need to give relief from the double taxation that would result were the income subject to Australian tax. In this respect they may be regarded as a method of giving relief from double taxation and can be compared with other provisions of the Act that give relief by allowing credit for foreign tax on foreign-source income subject to Australian tax. The discussion that follows is cast in the frame of such a comparison.

Credit for Foreign Tax on Foreign-source Income Subject to Australian Tax

17.19. Section 23 (q) of the Act has no application to a foreign-source dividend received by an Australian resident: such a dividend is subject to Australian tax. But section 45 allows a credit to an Australian resident who receives a foreign-source dividend in respect of income tax imposed on that dividend by the country in which the company paying the dividend is resident, if the Australian resident was personally liable for that tax. The credit is the lesser of the foreign tax or the Australian tax on the dividend, calculated by applying the average rate. By its terms section 45 is applicable both to an individual and to a company. In fact, however, it is relevant only to a dividend received by a resident individual: as indicated in 17.17, no Australian tax against which credit might be given is imposed on a foreign-source dividend received by an Australian resident company.

17.20. Section 23 (q) has no application to income derived by an Australian resident from sources in Papua New Guinea. Such income is subject to Australian tax. However, Division 18 of Part III of the Act allows the Australian resident a credit for Papua New Guinea tax against his Australian tax. The credit is the lesser of the Papua New Guinea tax and the Australian tax. For the reason explained in the last paragraph, the credit has no relevance to a dividend with a Papua New Guinea source received by an Australian resident company.

17.21. Section 23 (q) has no application to royalties or interest received by an Australian resident when the source of the royalties or interest is in a foreign country with which Australia has a double taxation agreement and when, in addition, that agreement has the effect of limiting the rate of tax the foreign country may impose on the gross amount of the royalties or interest. The foreign countries involved are United Kingdom, Singapore, Japan and New Zealand. The rate as limited by these agreements, if the agreement applies to the particular royalties or interest, 10 per cent in all cases except royalties having a New Zealand source, in which case the rate is 15 per cent. By section 12 of the Income Tax (International Agreements) Act, a credit against Australian tax is given, the amount of the credit being limited to the amount of Australian tax on the royalties or interest.

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Exemption and Credit as Methods of Giving Relief against Double Taxation

17.22. A comparison between exemption and credit as methods of affording double taxation relief may assist a decision on whether Australia should extend further its exercise of jurisdiction to tax foreign-source income. The comparison is made in terms of the criteria of equity, efficiency and simplicity.

17.23. Equity. Sections 23 (q) and 46 discriminate between a resident individual who derives all his income from Australian sources and a resident individual who has some foreign-source income that is exempt, or has an interest in a resident company deriving foreign-source income that is exempt, under one of those sections. These provisions thus defeat the equity objective which is one of the justifications for taxing on the basis of residence.

17.24. In the case of exemption under section 23 (q), the equity objective is defeated principally because it involves a taxpayer's income being split and the graduated Australian rates being applied to the Australian-source income and not to the whole of the taxpayer's income. Admittedly, this aspect could be overcome by provisions which, while continuing to exempt foreign-source income, would require it to be aggregated with Australian-source income to determine a rate on the latter. However, the inequity that arises from exemption when the foreign tax is less than the Australian tax would remain.

17.25. Sections 23 (q) and 46 create inequities between shareholders in a company deriving all its income from Australian sources, and shareholders in a company some or all of whose income is exempt under one of those sections.

17.26. An aspect of the inequities arising from section 46 is that the section significantly increases the advantages of using tax-haven companies as the means through which foreign-source income is derived. Section 46 allows tax-haven company profits to be repatriated without generating any liability to Australian company tax. This would not be possible under a credit system, though profits accumulated in the tax-haven company enjoy an immunity from Australian tax under a credit system as well as under the exemption system. This immunity could only be taken away by a system imposing Australian tax on the profits of the tax-haven company when they are derived by that company, either by taxing the company or the shareholders in the company. The matter is further considered in paragraphs 17.46–17.55.

17.27. A credit system of the kind now applying to dividend income derived by individuals (section 45), to income with a Papua New Guinea source (Division 18) and to some royalties and interest (section 12 of the Income Tax (International Agreements) Act) offers the prospect of ensuring a substantial degree of equity and, in this respect, contrasts with the exemption system. One limitation on its success is apparent when the foreign tax for which credit would otherwise be available exceeds the Australian tax on the income in question. In this situation the credit system avoids the inequity of the exemption system arising from non-aggregation with Australian-source income to determine the rate of tax on the latter; but it does not overcome the inequity involved in the foreign-source income having borne a greater tax than would be imposed on an equivalent amount of Australian-source income. The credit system could be made to overcome this inequity if the excess tax were allowed to generate a credit and, if necessary, a refund. No country in fact has a credit system of this kind. To adopt it would be to give to foreign countries an unacceptable degree of control over Australian taxation revenue.

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17.28. Other limitations on the success of the credit system in ensuring equity are inherent in the difficulties of relating foreign tax to the income in respect of which credit is to be given. These difficulties are referred to later in paragraphs 17.36–17.40.

17.29. Efficiency. The Committee has taken the view that economic efficiency is generally best served by a neutral tax system. A neutral tax system, in the present context, is one that does not affect the choice between operations directed to deriving Australian-source income and operations directed to deriving foreign-source income. And the ‘tax system’ must be understood to refer to all the taxes, Australian and overseas, that bear on the operations.

17.30. Equity and efficiency run closely parallel in their implications: a more equitable way of taxing foreign-source income is likely to be more efficient. But the emphasis in considering equity is on income taxation viewed in isolation from other taxes, whereas an appraisal in terms of efficiency must be made of the tax system as a whole. It is thus not enough in judging efficiency to look only at the impact of income tax in Australia and in the foreign country. Even though the same amount of income tax is paid on income from Australian sources as on income from foreign sources, efficiency will be compromised if the profitability of operating abroad, rather than at home, is affected by other international tax differences—not least those in the area of customs duties.

17.31. It is clearly not within the competence of the Australian tax system to ensure complete efficiency in regard to the effect of Australian and foreign taxes on the activities of Australian residents. This is a matter requiring the widest international co-operation.

17.32. Where efficiency requires a deliberate non-neutrality, as sometimes it may, equity and efficiency will not run parallel, and the exemption system may be preferred as furthering the ends of non-neutrality more effectively. If, for example, Australia wishes to encourage its residents to operate abroad, it can do so by applying an exemption system to foreign-source income rather than a credit system. An exemption system allows the Australian resident to operate, at least so far as income tax is concerned, in equal competition with residents of other countries.

17.33. The exemption system may also be thought to offer an attraction to foreign companies, in countries operating a credit system, to establish subsidiaries in Australia as bases for operating in other countries with low rates of income tax. The Australian Government may desire to encourage this.

17.34. A number of developing countries give special income tax incentives to attract investments. Under an exemption system the value of such incentives to an Australian investor is fully preserved. Australia, in the language that has become current in this context, ‘spares’ the Australian investor the amount of tax the developing country has forgone. This, too, may reflect an aspect of Australian Government policy.

17.35. But in the Committee's view, as indicated in paragraph 3.25, encouragement for a field of activity should be given through the tax system only if other means of encouragement are likely to prove less effective. And where it is thought appropriate to act through the tax system, this should be done by explicit provision. Section 44A is a provision of this kind: even though a credit system otherwise operates, tax sparing in regard to Papua New Guinea is achieved by this section through the exemption of dividends paid from profits with a Papua New Guinea source when those profits are exempt in that country under its Industrial Development (Incentives to Pioneer

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Industries) Ordinance. Encouragement to a field of activity by across-the-board exemptions such as are given by sections 23 (q) and 46 is clearly unwarranted.

17.36. Simplicity. An exemption system is unquestionably simpler to administer than a credit system, though some of the simplicity of section 23 (q) would be lost if it were amended to require aggregation of the foreign-source income with Australian income to determine the rate of tax on the latter.

17.37. The complexities of a credit system are at their greatest when credit is being given for tax on profits derived in a foreign country by an Australian resident who himself carries out business operations there. For one thing, the Australian tax accounting period may differ from that applying in the foreign country. For another, the tax base of the foreign country's tax may not be the same as Australia's. The difference in the base may result from the fact that the foreign country includes capital gains in its base. Until Australia adopts a capital gains tax the foreign tax will need to be dissected if credit is to be confined to tax on income. The difference in the base may be because the foreign country adopts a different method of valuing closing stock or different rates of depreciation. Because of the differences in the base there may be a spread of profits over a period of years in the foreign country different from the spread in Australia. The experience of countries with a credit system, more particularly the United Kingdom and United States, will suggest rules by which the differences in accounting periods can be handled. The problem of excess tax for which credit is sought, which may arise because of the way profits are spread over a period of years, can be dealt with by a carry-forward and carry-back of excess credits on the model of the United States provisions. Australia has had some experience in operating a tax credit system in relation to income derived from sources in Papua New Guinea; but because of the substantial similarity between the tax systems of Papua New Guinea and Australia, the complexities referred to in this paragraph have yet to be faced.

17.38. The complexities of a credit system may be less when credit is to be given against Australian tax on a dividend received from a foreign source. Australia already has long experience of such credits where dividends are derived by an individual. If jurisdiction is extended so that the credit system applies to dividends derived by a company, there will be a new problem in the allowing of credit for the underlying tax paid by the foreign company on the profits from which the dividends have been paid. Where the foreign company's profits themselves include dividends received from subsidiary companies, the problem will be compounded if the credit for underlying tax is extended to include tax on the profits of those companies. Again it will be necessary to turn to the experience of other countries: the tax credit system Australia already employs in relation to income from sources in Papua New Guinea does not offer any relevant experience, since section 46 applies.

17.39. Credit for underlying tax could at best be available only to a limited degree. It would be administratively impossible to extend such credit, on a general basis, to dividends derived by an individual. Where a company derives a dividend from a foreign source, credit for underlying tax would need to be confined to cases involving a substantial shareholding in the foreign company paying the dividend. Double taxation agreements commonly impose an obligation to give credit for underlying tax where there is a 10 per cent holding.

17.40. To the extent that administrative feasibility imposes limitations on the availability of credit for underlying tax, the equity and efficiency of the credit system will be compromised and the advantages of moving to such a system will be less.

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17.41. It may be appropriate here to draw attention to the revenue implications of a change to a credit system. The change is unlikely to involve any loss of tax revenue to Australia, assuming that the credit available is limited to the amount of Australian tax. It is implicit in a credit system that where a profit from foreign operations would be included in the net income of the Australian resident, a loss made in the same operations is deductible. Only in this respect could a credit system result in the Australian tax paid being less than under an exemption system. Indeed, a credit system might involve a significant increase in revenue, particularly if Australian investment abroad continues to grow as rapidly as it has done over the past decade.

Committee's Proposals

17.42. In the Committee's view, the comparison in the previous paragraphs establishes a case for extending the exercise of jurisdiction to tax on the basis of residence so that all foreign-source income is subject to Australian tax and credit, so far as administratively feasible, is given for foreign tax on that income. Equity and efficiency considerations point strongly to this conclusion and outweigh the loss in simplicity likely to result.

17.43. The Committee would, however, wish to leave open the possibility of making specific exceptions to the general regime to retain some of the simplicity of the exemption system. Where an Australian resident company receives dividends from a foreign resident company in which it has a substantial shareholding and that company is resident in a country which imposes a rate of company tax comparable with the Australian rate, it may not be inappropriate to continue the exemption given by section 46. In these circumstances the credit system and the present exemption system will bring about much the same result. But it would be necessary to confine section 46 treatment to dividends from profits having a source in the foreign country: a wider exemption would open up the prospect of defeat of the purpose of the general regime where the foreign country applies an exemption system to income from sources outside that country.

17.44. It might also be thought appropriate to continue exempting profits derived by an Australian resident company from sources in a foreign country if the foreign country imposes a rate of company tax comparable to the Australian rate. It would be necessary to confine the exemption to profits bearing the foreign company tax. Where royalties and interest with a source in the foreign country bear tax at a lesser rate, for example by way of a withholding tax, the exemption should be denied. The denial of the exemption would follow the precedent set by section 12 of the Income Tax (International Agreements) Act in relation to royalties and interest which, because of a provision in an international agreement, are taxed in the country of source at a low rate.

17.45. With regard to salary and wages, equity considerations would clearly favour the application of a credit system to foreign-source income. There may, however, be reason to exempt such income where it relates to a substantial period of service abroad.

17.46. The adoption of a credit system will take away some of the tax advantages to be gained from establishing tax-haven companies in foreign countries. When income which may have borne no foreign tax is repatriated as dividends to an Australian resident company, it will be no longer be freed from Australian company tax by section 46, but will be taxed in full. However, the advantages of indefinite deferral of tax on income accumulated by the tax-haven company will remain.

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17.47. Similar advantages can at present be obtained by the use of what might be called a ‘tax-haven’ trust: that is, a trust created or controlled by Australian residents but which has foreign trustees and is administered in a tax-haven country. If a trust has foreign-source income that is accumulating, no Australian tax is payable even though the persons who it may be expected will ultimately receive the income are Australian residents.

17.48. The tax advantages to be obtained from establishing tax-haven companies could be removed by provisions of the kind adopted by the United States in Subpart F of its 1954 Code. The accumulating income of a tax-haven company would be taxed currently to its Australian resident shareholders by reference to some apportionment to them of that income. The tax advantages of tax-haven trusts could be removed by similar provisions, though in this case it would be necessary to seek to tax the trust estate on a proportion of its income in some way related to the extent of the contingent interests held by Australian residents. It would not be appropriate to attempt to tax those Australian beneficiaries without vested interests.

17.49. The complexities and problems of administration which such provisions would involve should not be underestimated. In the case of a company there is a question of defining the persons whose interests would make them subject to current taxation on the company's profits. Rules of constructive ownership would be necessary.

17.50. It would be necessary to define the income to which the provisions apply. It may not be thought appropriate to include income from active business operations in the tax-haven country itself. And it may not be thought appropriate to include income that has its origin in third countries. To include such income would be to put Australian companies using tax-haven subsidiaries for their foreign operations at a competitive disadvantage. On the other hand, it would be of the first importance to ensure that any income that has an Australian origin is included, where present Australian law does not tax that income on the basis of such origin. Income from operations involving ‘invoicing-on’ of goods that move from or to Australia but are at no time physically present in the tax-haven country is the most likely illustration.

17.51. United States experience has not been encouraging. Its provisions are extremely complex and pose great difficulties in enforcing compliance. Canada has adopted similar provisions but there has been some delay in bringing them into operation.

17.52. Apart from the complexities and administrative difficulties involved, the observations made in paragraph 17.50 in relation to the income to which the provisions would be applied may suggest some doubt about their policy. Deferral of tax on foreign-origin income of a foreign subsidiary of an Australian resident company or of foreign-origin income of a foreign resident trust will in the normal case, under the Committee's proposals, be allowed until the income is remitted to Australia as dividends or distributed to Australian resident beneficiaries. It may fairly be asked whether it should make any difference that the foreign-origin income has, because of the tax-haven residence of the company or trust, been subject to foreign tax only at low rates. If it is thought that the policy should be simply to ensure that Australian-origin income be adequately taxed, it is possible to achieve this by other means.

17.53. At present Australian-origin income may be inadequately taxed for a number of reasons. A tax-haven company or trust will commonly enter into transactions with Australian residents which give rise to income with an Australian origin that is not subject to Australian tax because it does not come within the scope of the jurisdiction

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Australia exercises in taxing Australian-origin income. The meaning of source in relation to Australia's jurisdiction to tax on the basis of origin needs to be clarified and extended in certain respects. When the scope of the jurisdiction Australia exercises does extend, the amount of income brought to tax may be thought too little because of expenses claimed by the tax-haven company or trust; the amount of tax may be thought too little because a withholding tax is the only tax applicable. Broader reconstruction provisions might be made available which will enable the Commissioner to deny the deductibility of expenses in appropriate cases. Special rates of withholding tax might be applied to income going to a tax-haven company or trust.

17.54. Australian-origin income may be inadequately taxed because it has been diverted by an Australian resident to a tax-haven company or trust in whose hands it is exempt because it does not have an Australian source or is subject only to Australian interest withholding tax. Broader reconstruction provisions would enable the Commissioner to prevent this diversion of income and tax the Australian resident.

17.55. The Committee is not persuaded that it is an appropriate policy to seek to tax foreign-origin income of tax-haven companies and trusts and is very conscious of the complexities and administrative and compliance costs of attempting to do so. It prefers to ensure that the general provisions of the Australian law as to source of income in Australia are effective; that there are adequate provisions in regard to the reconstruction of Australian-origin income of non-residents; and that there are also adequate provisions to prevent the diversion of income by Australian residents to non-residents. There may, in addition, be room for special provisions whereby some income of a tax-haven company or trust that has an origin in Australia is made subject to a special rate of tax, and whereby procedures are established to ensure collection of Australian tax payable by tax-haven companies and trusts. These matters are taken up in Section II.