In brief - Full Federal Court confirms that foreign tax credits are only available to the extent income is returned as assessable income
This means that foreign tax credits are not available in relation to the discount component of capital gains. The decision in Burton v Commissioner of Taxation  FCAFC 141 confirms the ATO's view in its guide to foreign income tax offset rules.
Burton unsuccessful in Federal Court proceedings against Commissioner
Burton was an Australian resident who derived capital gains from oil and gas investments in the United States. He derived the gains as a beneficiary of an Australian discretionary trust.
Burton paid tax in the United States. Some of the gains were taxed at a concessional rate of 15% and the other gains were taxed at the full rate of 35%.
Burton was entitled to the 50% discount on the capital gains in Australia. He returned the discounted capital gains as assessable income in his income tax return and claimed a credit for the full amount of tax paid in the United States. The credit was claimed on the basis that it was either:
a foreign tax credit under Article 22(2) of the Australia and United States double tax convention (Convention), or
a foreign income tax offset under Division 770 of the Income Tax Assessment Act 1997 (Cth) (ITAA)
The Commissioner issued amended assessments which only allowed a tax offset of 50% of the tax paid in the United States, because only 50% of the capital gains were included in Burton's assessable income.
Burton's objection was rejected and he was unsuccessful before a single judge of the Federal Court. He appealed to the Full Federal Court.
Wording of Article 22(2) of the double tax convention and section 770.10 of the Income Tax Assessment Act
Article 22(2) of the Convention relevantly provides:
"…United States tax paid under the law of the United States and in accordance with this Convention…in respect of income derived from sources in the United States by a person who, under Australian law relating to Australian tax, is a resident of Australia shall be allowed as a credit against Australian tax payable in respect of the income. The credit shall not exceed the amount of Australian tax payable on the income or any class thereof or on income from sources outside Australia. Subject to these general principles, the credit shall be in accordance with the provisions and subject to the limitations of the law in Australia as that law may be in force from time to time." (Emphasis added)
Section 770.10(1) of the ITAA provides:
"You are entitled to a tax offset for an income year for foreign income tax. An amount of foreign income tax counts towards the tax offset for the year if you paid it in respect of an amount that is all or part of an amount included in your assessable income for the year.
Note 2: If the foreign income tax has been paid on an amount that is part non-assessable non-exempt income and part assessable income for you for the income year, only a proportionate share of the foreign income tax (the share that corresponds to the part that is assessable income) will count towards the tax offset (excluding the operation of subsection (2))." (Emphasis added)
Court considers double tax Convention
A majority of the Federal Court found that Article 22(2) did not create any entitlement to a foreign tax credit.
The purpose of Article 22(2) was to provide relief against double taxation. The wording of Article 22(2) requires identification of the income that is subject to double taxation. The same income must be taxed twice. It is not enough to identify a transaction or subject matter that is subject to double taxation. Burton's position provided him relief on income that was not taxed in Australia, and this was more relief than the Convention intended.
The Convention and the International Tax Agreements Act 1953 (Cth), which gave the Convention the force of law in Australia, did not contain any mechanism for the Commissioner to grant a credit or to determine the amount of the credit, other than placing a limit on the amount of the credit. This was left to Division 770, as Article 22(2) provides that the amount of the relief is in accordance with the provisions and subject to the limitations of Australian law. Further, the general tax offset provisions of the ITAA did not deal with these matters.
Court considers Division 770 of the Income Tax Assessment Act
The Federal Court unanimously found that the amount of the credit allowed under Division 770 is proportionate to the amount of income included in assessable income. This was based on the ordinary meaning of the words in section 770-10 and the object and purpose of Division 770. Further, note 2 to section 770-10 and the explanatory memorandum expressly contemplated a proportionate approach.
The Federal Court indicated that the same reasoning would apply to a capital gain that has been reduced by capital losses. Other examples include:
a capital gain that has been reduced by the application of the small business concessions
foreign income included in the assessable income of a trust or a partnership, where there is no net income of the entity because the amount of deductions or losses exceeds its assessable income.
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