Tax payable by foreign residents on capital gains may increase under proposed changes

In brief - ATO issues preliminary views on capital gains made by foreign beneficiaries of non-fixed trusts and relevance of source concept for capital gains, while government introduces legislation to remove entitlement to main residence exemption for foreign residents

Recently, there have been proposed changes which when finalised potentially increase the amount of tax payable in Australia by foreign residents on capital gains.

Capital gains made by foreign beneficiaries of non-fixed trusts

The ATO has issued its preliminary view in TD 2019/D6 on capital gains made by foreign beneficiaries of Australian non-fixed trusts (including discretionary trusts).

Generally, a foreign resident is only taxed in Australia on capital gains made on taxable Australian property. Taxable Australian property includes:

• interests in Australian real property, including a mining, quarrying or prospecting right
• an interest of at least 10% of an entity where more than 50% of the market value of the entity's assets is represented by Australian real property
• assets used in carrying on a business through a permanent establishment in Australia

There is a specific provision in section 855-40 of the Income Tax Assessment Act 1997 (Cth) that applies to beneficiaries of fixed trusts. The purpose of that provision is to apply the treatment set out above to capital gains made indirectly by foreign beneficiaries of fixed trusts. Critically, this provision does not apply to beneficiaries of trusts that are not fixed trusts.

Based on this, and the way the capital gains tax provisions have developed over time, the ATO considers that tax is payable in Australia where (subject to the application of a double tax agreement):

• a capital gain is made by the trustee of an Australian non-fixed trust
• the capital gain is taken to be made by a foreign beneficiary (for example where the foreign beneficiary is specifically entitled to the capital gain)

It doesn't matter that the capital gain relates to an asset that is not taxable Australian property.

Tax is payable by the trustee of the trust and the foreign beneficiary is also liable for tax but receives a refundable tax offset for the tax paid by the trustee.

The position is even more penal for temporary residents as tax is payable irrespective of whether the trust is fixed or non-fixed. This is because there is no equivalent to section 855-40 for temporary residents. A temporary resident is a holder of an Australian temporary visa that is not an Australian resident for social security purposes and does not have a spouse that is an Australian resident for social security purposes.

When TD 2019/D6 is finalised, it will have retrospective application.

Source concept is not relevant for capital gains made by a foreign beneficiary

The ATO has issued its preliminary view in TD 2019/D7 that the source concept is not relevant to determine whether a foreign beneficiary of an Australian trust is taxed on a capital gain.

The source concept is a longstanding principle that a foreign resident is only taxed on income or gains sourced in Australia.

The ATO's view is based on the interim measures to restore streaming of capital gains introduced in 2011, which the ATO considers do not have regard to source. Prior to the introduction of these measures, the common approach was that the source concept was relevant to determine the tax payable on capital gains made by a foreign beneficiary.

The outcome is perplexing as tax is payable on a capital gain arising from a CGT event that has no connection with Australia, other than it involves the trustee of an Australian trust. This is subject to the application of a double tax agreement. The only exception is where the asset is not taxable Australian property and the capital gain is made by the trustee of a fixed trust. 

An example is a capital gain made by a trustee of an Australian discretionary trust on the sale of land in the United Kingdom that is attributed to a foreign beneficiary.

When TD 2019/D7 is finalised, it will apply from the current income year and will generally not have retrospective application. The ATO will not change the treatment adopted by taxpayers in earlier years for capital gains on assets that are not taxable Australian property in accordance with the source concept. This is subject to the qualification that the treatment is not artificial or contrived or does not have  a dominant purpose of tax avoidance.

Removal of entitlement to the main residence exemption for foreign residents

Legislation has been introduced by the Federal government in Treasury Laws Amendment (Reducing Pressure on Housing Affordability Measures) Bill 2019 (Cth) to remove the entitlement to the main residence exemption for foreign residents, with effect from 9 May 2017.

This measure was announced in the 2018 Federal Budget and was previously introduced in the Treasury Laws Amendment (Reducing Pressure on Housing Affordability Measures No. 1) Bill 2018 (Cth). The earlier Bill lapsed when the Federal election was called in May 2019.

A concession under the new Bill is that a foreign resident can continue to access the main residence exemption if they have not been a foreign resident for a continuous period of more than six years and any of the following conditions (called life events) is satisfied:

• during all or part of the period of the person's foreign residency, the person, their spouse or their minor child, had a terminal medical condition
• during the period of the person's foreign residency, their spouse or their minor child dies
• the CGT event occurs because of a relationship breakdown, maintenance agreement or financial arrangement involving the person or their spouse (or former spouse).

Transitional arrangements will allow foreign residents to access the main residence exemption provided the CGT event occurs (this is when the contract is signed) no later than 30 June 2020 and an ownership interest in the residence has been held continuously since before 9 May 2017.

Removal of the main residence exemption is likely to affect expatriates who are thinking of selling their Australian residence after they have stopped being an Australian resident. 

If the residence has been held continuously since before 9 May 2017, a contract to sell the residence must be entered into by 30 June 2020 to access the main residence exemption. If the contract of sale is entered into after 30 June 2020, the main residence exemption will only apply if the owner has not been a foreign resident for a continuous period of more than six years and a life event occurs.

If the residence has not been held continuously since before 9 May 2017, the main residence exemption will only apply if the owner has not been a foreign resident for a continuous period of more than six years and a life event occurs.

As the legislation applies retrospectively from 9 May 2017, foreign residents who have sold their main residence and have not returned a capital gain because the legislation had not been passed at the time of sale, will need to amend the relevant income tax return. 

The ATO has announced that it will not apply penalties and will remit interest accrued up to the date the legislation becomes law to the base interest rate (the 90-day Bank Accepted Bill rate published by the Reserve Bank). The ATO will also remit interest which accrues after this date to the base interest rate if foreign residents actively seek to amend their income tax returns within a reasonable time after the Bill becomes law.