In brief - Proposed changes could have significant impact upon the tax profile of individuals with overseas connections
The Board of Taxation recently completed a review of Australia's individual income tax residency rules. The Board's proposal for new residency rules is aimed at improving certainty, reducing compliance costs and removing a potential barrier to Australia's attractiveness as an investment location.
Tax residency rules are a complex area of law and have led to numerous disputes and rulings about the receipt of individual income and the susceptibility of that income to Australian tax. They have also led to high-profile tax evasion cases and investigations relating to the diversion of income via offshore entities and structures.
The Board is of the opinion that there is a strong case for reforming the individual tax residency rules for modernisation as the current rules are uncertain, impose an inappropriately high compliance burden and are perceived to be subjective.
Current individual income tax residency rules are too complex
Four tests currently make up Australia's individual income tax residency rules:
- Residence test: a subjective test that balances various factors, including the intention or purpose of the presence in Australia, family and business/employment ties; the maintenance and location of assets, and social and living arrangements
- Domicile test: a taxpayer is a resident of Australia even if they do not "reside" in Australia under the first test but are nonetheless "domiciled" in Australia
- 183 day test: a taxpayer is assumed to be a resident if they are in Australia for 183 days or more, unless the Commissioner is satisfied that the individual's "usual pace of abode" is outside Australia, and
- Superannuation test: a taxpayer is a resident if they are a member of certain Government Superannuation funds, established under the Superannuation Act 1976.
Given that residency rules are a fundamental part of the income tax system, determining both an individual's tax base and rate, the Board considers it to be inappropriate that these tests should be so complex.
Board of Taxation's proposed reforms to tax residency rules
The Board seeks to consult on the following eight design features:
1. A guiding "adhesive residency" principle
An adhesive residency principle means that it should be harder to cease residency than it is to establish it.
Once sufficient time is spent in Australia, and connections are sufficiently embedded, then it is appropriate that this level of engagement must be scaled back to a large extent before residency ceases.
To provide certainty there should be clear thresholds for confirming residency that will balance the time spent in, and other connections with, Australia but in a way that removes the perceived subjectivity of the current rules.
At the same time, the rules should not make it easier for individuals who have close ties with Australia to be able to game the system and not pay their fair share of tax.
2. There should be a statement of individual residency policy
There should be an objects clause or theme statement in the Income Tax Assessment Act 1997
that encapsulates the principles underpinning the residency rules and the Government's policy intention.
Such a statement along the lines of residency is the extent of the individual's exposure to Australia's economic, social and environmental infrastructure. Exposure to such benefits, through time spent in Australia and certain ties to Australian society, should ultimately lead to tax residency and obligations to pay into the system.
3. Bright-line test for inbound and outbound individuals
The bright-line test will act as a primary test to help those clearly resident and non-resident to identify the basis on which they may claim such status to manage their tax affairs accordingly.
The "inbound individual" test determines whether an individual has automatically established residency. The common standard is 183 days to determine whether an individual spends the majority of their time in Australia. An individual may then be a resident for that part of the first income year in which they were physically present, while the second year would be determined under the "outbound individual" bright-line test, the secondary test or a split year treatment.
The "outbound individual" test will adopt a lower bright-line threshold for those who visit Australia for business or leisure and who do not wish to be caught as a resident.
It also provides for individuals who are working full-time overseas to be non-residents in certain circumstances.
The Board seeks views on whether, similar to the inbound individual test, these thresholds should apply on a 12-month period basis or per income year.
4. Factor test: determining the level of connection to Australia
The factor test acts as a secondary test for individuals who do not satisfy the bright-line tests.
Each factor indicates a level of connection and includes time spent in Australia, immigration status, family, Australian accommodation, and economic ties. The more factors an individual satisfies, the higher level of connection to Australia.
In order to conclude whether an individual is a resident or non-resident, there should be a mechanism designed that reflects the individual's connection to Australia.
The Board proposes two mechanisms:
- individuals require a number of points or "ties" to be regarded as a resident or non-resident, or
- whether a tax payer was a resident in the preceding income year, a set number of X or more factors must be satisfied, whereas if a tax payer is a non-resident in the preceding income year, a higher set number of Y or more factors must be satisfied
There may also be an opportunity to align domestic tax residency with residency under Australia's double tax treaties.
As these concepts are currently not aligned, where an individual is a resident under Australia's domestic law, but not a resident under a relevant double tax treaty, then the individual would be taxed in Australia only on income to which Australia has taxing rights but the individual has access to residence-based concessions.
5. Integrity: resident of nowhere
Under the current system, where an individual becomes a non-resident but has not established tax residency in another jurisdiction, that individual can become a "resident of nowhere".
For high-wealth individuals, this principle may be manipulated to obtain tax advantage and can often occur before a large receipt that would otherwise be taxable is anticipated.
The suggested approach is that where an individual has been an Australian resident and would otherwise satisfy the conditions to become a non-resident, the change in status will only be effective if the individual demonstrates that they have established residency in another country. That is, individuals remain Australian residents unless and until tax residency is established in another jurisdiction.
The board is considering a number of alternatives based on international comparisons. This includes the United Kingdom's temporary non-residents who are charged tax on specified income and gains. A temporary period of non-resident is five years or less.
6. Superannuation test for government employees: options for reform
The Board expects that it will be appropriate to update the superannuation residency test to align with common international practice and reflect the original intention of these rules.
7. Part-year residency
The Board suggests aligning the part-year rules for the tax-free threshold with the residency rules in general, if this can be done with relative simplicity.
Under a secondary test, an individual may cease or establish residency by a method other than time spent in Australia.
8. Transitional rules
It is expected that the rules will operate prospectively from a commencement date.
The Board recognises potential for dispute given the proposed rules are designed differently depending on whether an individual was previously a resident or not.
Board of Taxation's expected impacts of the proposed changes
Revenue impact: intended to have an immaterial or negligible revenue impact.
Economic impact: increased certainty will aid Australia attracting inward investment and may lead to broader economic benefits.
Compliance burden: should drastically reduce, including the need for external advice over time.
Administrative impact: increased certainty should reduce the costs of ongoing monitoring and drastically reduce the need for private rulings or likelihood of costly litigation.
Impact on affected individuals: the majority of individuals will be unaffected by the transition to the Board's proposal - there will be no noticeable impact and no costs.
Disclaimer: The content of this article does not constitute legal or financial advice to be relied upon.