Taxation Law

MONASH

BUSINESS

SCHOOL

KEY CONCEPTS: DERIVATION,

RESIDENCE AND SOURCE.

LECTURE 3

BTF5965 TAXATION LAW | SEMESTER 1, 2019

MONASH

BUSINESS

SCHOOL

Reading list

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 General jurisdictional rules in s 6-5 ITAA97:

KEY CONCEPTS:

| PoTL paragraphs [4.10] – [4.20]

Australian residents

Assessed on income derived from all sources

Medicare levy (ML) and Medicare levy surcharge (MLS)

applies

Foreign residents

Assessed on income derived from Australian sources only

ML and MLS do not apply;

limited access to tax offsets; tax rate scale has no tax-free

threshold

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 Apple Inc – link

– A US Senate investigation in 2013 found that two of Apple’s Irish subsidiaries were structured so that, for tax purposes, they weren’t “residents” of either Ireland or the U.S., allowing them to pay almost nothing to either country

– EC penalties – following EC intervention Ireland has now collected more than €14bn in back-taxes and interest from Apple but both Ireland and Apple have lodged appeals against the EC ruling – link

 Meanwhile, in Australia,

– Apple pays about $85 mil tax on $8 billion revenue (ca 1% tax) - link

A case of international tax avoidance

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 Australian residents taxed on income from all sources – Restructure to use foreign resident entities & foreign source income

– Locate entities in tax havens

 Australian tax applies to taxable income (= AI – Dedns) – Restructure to increase deductions, including:

– Transactions with affiliated foreign entities (‘transfer pricing’)

 eg. CIR(NZ) v Europa Oil – POTL [2.165]

– Borrow funds at high interest from related entities (‘thin capitalisation’)

– Pay affiliates for use of intellectual property (at high rates)

 Global supply chains open up many ‘loopholes’ eg, Apple Iphone

– OECD/G20 Base Erosion and Profit Sharing Project (‘BEPS’) – POTL [22.517]

HOW DOES TAX INTERNATIONAL TAX AVOIDANCE OCCUR?

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 Accounting for income tax purposes is different to financial

accounting.

 Taxpayers are required to pay income tax on taxable income in each

“income year”: s 4-10 ITAA97. Taxable income includes:

 Assessable income - only counted when it is ‘derived’.

 Less Deductions - only allowed when they have been ‘incurred’.

 Consequently, the key issues are:

KEY CONCEPTS:

1. DERIVATION OF INCOME

| PoTL paragraph [16.10]

Tax accounting

Derivation of income

When is a gain “derived”? (this lecture)

Timing of deductions

When is a loss or outgoing deductible?

(Topic 8)

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 assessable income includes both ordinary income and statutory

income that is “derived” within the relevant tax period: s 6-5 ITAA97

 “derived” is not defined in statute, however in Brent v FCT (HCA,

1971), Gibbs J comments that it should be determined by:

MEANING OF “DERIVE”

| PoTL paragraphs [16.20] - [16.30]

1

• Application of ordinary business and commercial principles

2

• Method of accounting that reflects the taxpayer’s true income

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 For income tax purposes, the “accruals” or “cash” basis can be

adopted

 Which method?

 Sole practitioners - Carden’s case (1938), Firstenberg (1976)

Professional fees of sole practitioners closely connected with services –

cash method provides the most ‘substantially correct reflex of true

income’.

 Large partnerships - Henderson v FCT (1970) fees attributable to

extensive business organisation, not individual partners. Accruals or

earnings method is more appropriate. (POTL p 554)

CASH VS ACCRUALS METHODS

| PoTL paragraph [16.40]

Derivation of income Recognition of when income is received:

Accruals basis Cash basis

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Question

 In the following timeline, a business provides services for a fee of

$10,000 - in which income tax year would the $10,000 be “derived”

under the:

– Accruals method?

– Cash method?

 What if the business switches from cash to accruals at 30 June

2019?

DERIVATION OF INCOME:

CASH VS ACCRUALS METHODS

| PoTL paragraph [16.40]

Invoice issued $10,000

30 June 2019

Payment received

30 June 2020

Services provided

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 Moneys received in advance of goods or services being supplied,

may not yet be “derived”

– See, Arthur Murray (NSW) Pty Ltd v FCT (1965) where prepaid

dance lessons were not “derived” until provided (POTL p 555)

– In the above illustration, when would income be derived using

the Arthur Murray principle?

 Consistent treatment applies to “lay-by” sales where derivation

occurs when title to the goods passes to the customer.

DERIVATION OF INCOME:

PREPAYMENTS AND “LAY-BY” SALES

| PoTL paragraphs [16.90] – [16.95]

Prepayment by customer

30 June 20X1

Services rendered

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 For taxpayers that:

– Account on an accruals basis; and

– Are owed money at the end of the income year that has not been

paid due to bona fide dispute

 The disputed amount is not “derived” in the year when the goods or

services were sold/provided: BHP Billiton Petroleum v FCT (2002)

– customers disputed passing on of PRRT by gas supplier (POTL p 557)

DERIVATION OF INCOME:

DELAYS BECAUSE OF A DISPUTE

| PoTL paragraph [16.110]

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 ‘Taxable income’ to be declared in a tax return will vary

from net profit shown in a business profit and loss

account. There will be temporary (timing) differences and

permanent differences. See ATO Tax Reconciliation

Worksheet

Practical impact

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KEY CONCEPTS:

2. RESIDENT OF AUSTRALIA

| PoTL paragraphs [4.10], [4.40]

Is the taxpayer a resident of Australia? – See s 6(1) ITAA36

Individual

Four ITAA tests of residence:

1. Ordinary concepts; 2. Domicile; 3. 183-day test; or 4. Superannuation test.

Subject to any relevant DTA rules

Company

Three ITAA tests of residence:

1. Place of incorporation; 2. Central management

and control; or 3. Controlling shareholders

Subject to any relevant DTA rules

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 Known as the “residence according to ordinary concepts” test

 The term “resides” is not defined in statute and its ordinary meaning

is ascertained from a dictionary, for example:

– “to dwell permanently or for a considerable time” (Macquarie

Dictionary)

 Ultimately, the determination of tax residency rests on a question of

fact and degree: Miller v FCT (1946)

INDIVIDUALS:

(1) Ordinary concept of residence

| PoTL paragraphs [4.60] – [4.70]

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 Intention or purpose of presence: Miesagaes v Commissioners of

Inland Revenue (1957)

 If the person is a visitor, the frequency, regularity and duration of

visits: IRC v Lysaght (1928) AC 234

 Maintenance of a place of abode in Australia for the taxpayer’s use

 Person’s family, business and social ties: Levene v IRC (1928)

 Location of assets

 Sufficient time to demonstrate continuity, routine or habit: TR 98/17

INDIVIDUALS:

Ordinary Concept – Key Factors

| PoTL paragraphs [4.60] – [4.70]

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 Under the domicile test, an individual is a resident of Australia if his

or her domicile is in Australia, unless the Commissioner is satisfied

that the person has a permanent place of abode outside Australia

(a) ‘domicile is in Australia’

 ‘Domicile’ is a common law concept now modified by the Domicile

Act 1982:

– Domicile of origin at birth

– Domicile of choice: country where the taxpayer intends to make

their home indefinitely

INDIVIDUALS:

(2) The domicile test

| PoTL paragraph [4.100]

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(b) Permanent place of abode outside Australia

 The domicile test does not apply when the individual has a

“permanent place of abode outside Australia”

– “Permanent” does not mean forever and is objectively assessed

each year: FCT v Applegate (POTL p 97)

 Commissioner considers various factors to determine if a permanent

place of abode is outside Australia. These factors include:

– Intended and actual length of stay in the overseas country

– Permanent / temporary intentions to stay in the overseas country

– Place of established home & durability of Australian associations

INDIVIDUALS:

Domicile Test - cont

| PoTL paragraphs [4.110] – [4.120]

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 Under the 183-day test, an individual is a tax resident of Australia

when his or her physical presence in Australia, continuously or

intermittently, is for more than one-half of the income year

 Exceptions:

– If the Commissioner is satisfied that the individual’s usual place

of abode is outside Australia; and

– The individual does not intend to take up residence in Australia

 Working holiday visa holder who was in Australia for more than 183

days was not a resident as their “usual place of abode was outside

Australia”: Re Koustrup v FCT (2015) AATA 126

– Special rules now apply to working holiday makers (see #23)

INDIVIDUALS:

(3) 183-day Test

| PoTL paragraph [4.130]

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 Applies in relation to Commonwealth superannuation funds

 Under the superannuation test, the member of a Commonwealth

superannuation fund (ie Commonwealth public servants) and the

member’s family are deemed to be tax residents of Australia

(5) Effect of Double Tax Agreements

In the event of ‘dual residence’ DTAs generally provide a tie-breaker

test to ensure taxpayer is treated as a resident in only one country,

based on location of a ‘permanent home’, ‘centre of vital interests’

‘habitual abode’ or by mutual agreement - see Article 4 in the OECD

Model Tax Convention on Income and Capital 2017 – link (Contents at p 25)

INDIVIDUALS:

(4) The Superannuation Test

| PoTL paragraph [4.140]

Other relevant DTA rules

• Special rules for services income of individuals, in particular:

• Specific rules exist, eg, for teachers, entertainers, sportspeople.

• Annuities / pensions: taxed in taxpayer’s country of residence

• Dividends, interest, royalties have rate limits (15%, 10%, 10%-5%)

Art 15 - Dependent services

• Income from employment.

• Taxed in the country where performed, unless:

• (i) Taxpayer is in that country for < 183 days; and

• (ii) Paid by a person not a resident of the country where services are performed.

Independent services

• Generally subject to tax in the taxpayer’s country of residence, unless taxpayer has a fixed base, in the country where the services are performed.

• Or treated as ‘profits of an enterprise’ under Art 7

PoTL 2019 paragraph [22.490]

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 A person may be resident for a whole or part year, depending on the

residency test used:

 Tax free threshold in the individual progressive income tax rates is

pro-rated for the residency period

PART YEAR RESIDENCE

| PoTL paragraph [4.145]

Test Residency period

Resides (ordinary

concepts)

Commences from the date when the

person first resides in Australia

Domicile Resident for the days when in Australia

183-day test Taken to be a resident for the whole year

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 Get relief from Australian tax on most foreign income and capital

gains if taxpayer a resident of Australia but holding a temporary

migration visa – under Subdivision 768-R ITAA97.

 taxed at resident individual rates for Australian source income but

not entitled to 50% discount on capital gains or main residence

exemption.

 Eligibility:

(1) must hold a temporary visa granted under the Migration Act 1958

(2) must not be an Australian resident within the meaning of the Social Security

Act 1991, and

(3) must not have a spouse who is an Australian resident within the meaning of

the Social Security Act 1991

TEMPORARY RESIDENTS

| PoTL paragraph [4.150]

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 Also known as the “backpacker tax”

 A taxpayer is defined as a working holiday marker if they are in

Australia under the following visa categories:

– 417 (working holiday)

– 562 (work and holiday)

 Special income tax rates apply:

WORKING HOLIDAY VISAS

| PoTL paragraph [4.155]

Threshold Rate

$0 - $37,000 15%

$37,000 + Ordinary rates

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 Statutory definition in s 6(1) Income Tax Assessment Act 1936

 Only one out of three tests needs to be satisfied for a company to be

considered a tax resident of Australia:

RESIDENCE TESTS FOR COMPANIES

| PoTL paragraph [4.170]

1 • Incorporated in Australia

2 • Central management and control test

3 • Controlling shareholders test

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 A company that is incorporated in Australia under the Corporations

Act 2001 (Cth) is automatically a tax resident of Australia, regardless

of any other factors.

 However country which taxes profits is often determined by Double

Tax Agreements.

COMPANIES:

(1) PLACE OF INCORPORATION TEST

| PoTL paragraph [4.180]

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 A company is a resident of Australia if it:

 Following Bywater Investments Limited & Ors v. Commissioner of

Taxation (2017 HCA 45)

– Location of a company’s central management and control is a

question of fact and degree

– No general presumption that the location is where the directors

meet or where the board meetings take place

 PWC Tax Talk

COMPANIES:

(2) CENTRAL MANAGEMENT AND CONTROL TEST

| PoTL paragraph [4.190]

Carries on business in

Australia

Central management &

control in Australia

Resident of Australia

(s 6(1) ITAA36)

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 The Commissioner has determined in Ruling TR 2018/5 the

relevant factual matters for consideration are as follows:

COMPANIES:

Central Management and Control Test - cont

| PoTL paragraph [4.200]

1

• Does the company carry on business in Australia?

• If a business has its central management and control in Australia, it will be carrying on a business in Australia

2

• What does central management and control mean?

• Determine location of where high-level decisions that set the company’s policies, direction of its operations and type of transactions it will enter.

3

• Who exercises central management and control?

• Determine in reality who controls and directs the company (not the legal power or authority to control)

4

• Where is central management control exercised?

• Determine in reality where decisions are made (not where merely recorded or formalised)

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 Two limb test:

1. Voting power is controlled by shareholders who are residents of

Australia (that is, more than 50% of the voting power at general

meetings); and

2. The company is carrying on business in Australia (same as the

first limb of the central management and control test).

Anti-avoidance rules – controlled foreign entities

– Where a group of 5 or fewer Australian residents indirectly control at

least 50% of a foreign company income may be ‘attributed’ to Australian

controllers (Part X of ITAA36).

– Similar rules apply to Foreign Trusts and (formerly) to Foreign

Investment Funds. See POTL [22.160]

COMPANIES:

(3) CONTROLLING SHAREHOLDERS TEST

| PoTL paragraph [4.210]

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OVERVIEW

 If an taxpayer is a foreign resident, the taxpayer is taxed only taxed

on ordinary and statutory income sourced in Australia, unless

deemed assessable income on some other basis

 Question of source has been described as “something which a

practical man would regard as a real source of income” and a

“practical, hard matter of fact”: Nathan v FCT (1918)

 Practically, it requires classification of income into different classes

to determine source

3. SOURCE OF INCOME

| PoTL paragraph [4.230]

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SOURCE OF INCOME:

RULES GENERALLY DEPEND ON TYPE OF INCOME

| PoTL paragraphs [4.240] – [4.290]

Category Source principle

Sale of goods Generally, the place where the trading activities take place.

Sale of property other

than trading stock

For real property, the place where the property is located.

Services Generally, the place where the performance of services occurs:

FCT v French (1957); FCT v Efstathakis (1979). Is there an

exception?

Interest Emphasis on the place where the contract for the loan was

made and where the money was advanced: Spotless Services

v FCT (1993).

Dividends The place where the company derived its profits: Esquire

Nominees Ltd v FCT (1973).

Royalties The place where the location of the industrial or intellectual

property from which the royalty flows.

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Business profits (OECD Model Art 5 and 7) – link (Contents at p 25)

Profits of an enterprise of a Contracting State may be taxed only in that State unless:

– The enterprise carries on business in the other Contracting State through a permanent establishment (PE) situated therein; and

– the profits are attributable to the PE.

– A PE is defined in Article 5 - broadly means a fixed place of business: see Thiel v FCT (1990).

ITAA36 s 23AH – exempt foreign branch income

– business income (‘active income’) earned through a permanent establishment in a listed country may be exempt (avoids double taxation).

Other rules on business profits

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Topic 4 – What is included in Assessable Income?

 Ordinary concept of income

 Income from property

 Income from personal services

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