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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.