5. Taxation

Australia’s income tax legislation is one of the longest and most complex in the world.

It is contained in two statutes, the Income Tax Assessment Act, 1936 (1936 Act) and the Income Tax Assessment Act 1997 (1997 Act). The 1997 Act is a re-write – in modern language and using modern taxation law concepts – of a steadily increasing portion of the 1936 Act. The un-rewritten part of the 1936 Act operates in tandem with the 1997 Act.

During World War II, the income taxing powers of the Australian states were taken over by the Commonwealth and have not been revived, with the result that Australia has only one income tax, and that is a tax imposed at federal level.

The un-rewritten parts of the 1936 Act have been extensively amended over the last 20 years under successive Australian governments.

In 1985, Australia introduced a capital gains tax (CGT). The Australian CGT regime taxes worldwide capital gains of Australian residents and capital gains of non-residents who dispose of an asset comprising direct or indirect interests in Australian real estate. The CGT regime re-characterises net capital gains (capital gains less capital losses) of a taxpayer as income of the taxpayer and imposes income tax on it, although individuals (including individuals sharing in the gain through trusts) are taxed on only 50% of the gain where the asset has been held for more than one year.

In 1991, a controlled foreign corporation (CFC) system and a transferor non-resident trust regime were introduced, followed by a foreign investment fund (FIF) system in 1992. These regimes, which have a direct impact on the Australian tax treatment of certain trusts, are discussed below.

Australia’s CFC regime is substantially based on the US tax model.

b. Tax system

i. General concepts of tax liability

The Australian tax system taxes income when it is ‘derived’, irrespective of whether it has been physically received by the recipient or paid by direction on the recipient’s behalf to a third party. The Australian tax system taxes the worldwide income and capital gains of all Australia’s residents, regardless of the source of the income, subject to a foreign tax credit system and tax treaty relief where a double tax treaty (DTT) is in force between Australia and the source country.

The Australian tax system also taxes the Australian source income of all non-residents, including the capital gains derived by non-residents on direct and indirect interests in Australian real property assets (including rights associated with land, such as mining rights).

Beneficiaries of trusts are taxed on the share of trust ‘net income’ to which they have a present entitlement in the particular year of income as a matter of trust law, irrespective of whether they actually receive a physical distribution of the trust income. Where no beneficiary is entitled to any part of the net income of the trust, the trust itself is liable for tax on the trust net income where the trust income is sourced in Australia or where the trust is a resident Australian trust estate.

In 1985, when the CGT regime was introduced, assets acquired before 20 September 1985 were treated as being pre-CGT assets, exempt from CGT until sold, gifted or otherwise transferred to another owner, at which time they become CGT-assets subject to the CGT regime.

The CGT regime treats the excess of the disposal consideration for a CGT asset or, where the transaction occurs on a non-arm’s length basis, the asset’s market value at disposal date, less its cost base as capital gain, which, after being netted off against the taxpayer’s capital losses, becomes a net capital gain included wholly (for a company) or as to 50 per cent (for an individual) as taxable income of the taxpayer.

ii. Rates and tax incentives

Beneficiaries of trusts who are individuals are taxed at the individual rate of tax, which is a graduated rate. The rates as from 1 July 2008 for residents are:

Income | Tax rate

AUD0–6,000 | 0%

AUD6,001–AUD34,000 | 15%

AUD34,001–AUD80,000 | 30%

AUD80,001–AUD180,000 | 40%

AUD180,001+ | 45%

The rate for non-resident individuals for the first AUD34,000 is 29 per cent.

In addition, a Medicare levy of 1.5 per cent applies above an individual threshold of AUD17,605. Income earners with a taxable income above AUD100,000 (or couples with a combined taxable income above AUD150,000) without private health insurance will be subject to a Medicare surcharge of 1 per cent on top of the mandatory 1.5 per cent Medicare levy, bringing the top marginal tax rate to 47.5 per cent.

The Australian tax system is integrated with a number of tax benefits for families, particularly those with dependent children. The interaction can be quite complex but at lower income levels results in significant amelioration of the rates set out above.

Resident Australian taxpayers are entitled to a credit for the lesser of, on the one hand, the foreign tax paid by the taxpayer on foreign source income less any tax relief available in the source country and, on the other hand, Australian tax payable on that income.

The company tax rate (including that of Australian resident corporate beneficiaries of trusts that are presently entitled to trust net income in the year of income) in Australia as from 1 July 2001 (i.e. year ended 30 June 2002 and subsequent income years) is 30 per cent.

iii. Tax evasion and avoidance

Part IVA of the 1936 Act contains the general anti-avoidance rule (GAAR) for the Australian income tax regime. In addition, there are specific anti-avoidance measures.

Application of the GAAR rule by the Australian Revenue (Australian Taxation Office, or ATO) involves objective determination that a party, not necessarily the taxpayer, entered into a ‘scheme’, broadly defined, for the dominant purpose of enabling a taxpayer to obtain a ‘tax benefit’ – defined to include not only the non-inclusion of an amount of income in the taxpayer’s assessable income for tax purposes, but also the securing of a deduction for an outgoing or expense and certain other tax reductions, which would not have otherwise occurred under a hypothetical alterative transaction which the party or parties concerned could reasonably be expected to have entered into but for their entry into the subject scheme.

iv. Taxable periods and filing requirements

The Australian tax system assesses tax based on a 12-month income year, which, in the absence of an election being made to change the tax year (which in any event must be a 12-month period starting at the end of the previous 12-month period), commences on 1 July and ends on the following 30 June.

Tax returns must be filed by 31 October following the end of the tax year unless a taxpayer’s tax return is being filed by a registered tax agent, in which case the tax return is due for filing with the ATO in accordance with the tax agent’s filing programme.

Tax returns can be filed electronically by the due date for filing, subject to a hard copy signed by the taxpayer being filed with the ATO in due course after the due date for filing.

c. International

i. Residents with foreign investments/transactions

Australian resident taxpayers are taxed on worldwide income and capital gains regardless of source. They are entitled to a credit for the lesser of, on the one hand, the foreign tax paid by the taxpayer on foreign source income less any tax relief available in the source country and, on the other hand, Australian tax payable on that income. The Australian foreign tax credit (FTC) regime includes a credit for withholding taxes paid in source countries.

ii. Expatriates

Expatriate Australian taxpayers’ taxation treatment in Australia depends on residency status. If they lose their Australian residence, then they are taxed only in the country of their residence and cease to be taxed as Australian residents on worldwide income and capital gains.

Foreign national expatriates living in Australia are also taxed based on their residency status. If the foreign nationals acquire Australian residence, then they are taxed in Australia on their worldwide income and capital gains.

Australia has a 183-day rule for foreign national expatriates, which deems them to be non-residents, and hence taxable only on their Australian source income, if they are physically present in Australia for less than 183 days of a particular year of income.

Temporary residents holding a special temporary resident’s visa can obtain non-resident treatment for a maximum period of four years.

iii. Non-residents

Non-residents are taxable only on Australian source income, of which passive income such as dividends, interest and royalties is taxed by a withholding tax system. The basic rates are 30 per cent for dividends and royalties, and 10 per cent for interest. Where there is a DTT in force, withholding tax is imposed at treaty rates, and the non-residents must look to their country of residence to claim FTC for Australian tax paid on their Australian source income.

As a credit is allowed to shareholders for tax paid by a company at the company tax rate, corporate dividends will be free of withholding tax unless the company does not apply credits (‘franking credits’) to the dividend in question.

Non-residents are liable to capital gains tax only in respect of taxable Australian real property, including permanent establishments in Australia, and non-portfolio (basically, 10 per cent or more of the total) equity interests in companies and trusts where such assets comprise 50 per cent or more of the total assets of the company or trust concerned.

iv. Tax treaties

Australia is a party to DTTs with most major trading partners and OECD member states. The standard Australian DTT is based on the OECD Model Double Tax Convention on Income and on Capital.

Australian DTTs all include the model OECD business profits article, which limits Australian source-country taxing rights to the income of an enterprise carried on in Australia through a permanent establishment in Australia.

Australian DTTs generally limit the Australian tax on interest and royalty income sourced in Australia to 10 per cent of the income derived, and the limitation on the Australian tax payable on dividend income derived by non-residents from Australian resident companies, if otherwise taxable, ranges from 5 per cent to 25 per cent of the dividend payable to the non-resident shareholders, depending on the terms of the individual DTT.

d. Taxation of trusts

i. Types of trusts and tax liability

In Australia, beneficiaries are taxed on unaccumulated income, rather than on the trust itself. The test of whether there are beneficiaries who are ‘presently entitled’, as a matter of trust law, to all the income of the trust at the end of the income year is the test applied to determine who is liable to pay tax on the net income.

Individual beneficiary taxpayers are taxable on their share of the net income of the trust at the tax rates listed above under the heading ‘5. b. ii. Rates and tax incentives’. Resident beneficiaries may also be taxed on foreign trust income accumulated abroad for them, and pay additional tax in respect of any period of deferral of recognition of such income.

Trustees are only liable to pay tax on the net income of the trust where there are no ‘presently entitled’ beneficiaries at the end of the taxation year. In this situation, trustees are taxable at the highest marginal rate of tax (plus Medicare levy), which is 47.5 per cent, without any graduation of tax rates or the benefit of the tax-free threshold, where the trust is an inter vivos trust. Where the trust is a testamentary trust, the trust is taxable on its net income with benefit of the tax-free threshold and graduated tax rates. The trustee has withholding obligations in respect of income to which non-resident beneficiaries are presently entitled.

ii. Duration and termination

The Australian tax system places no relevance on duration and termination of trusts. It makes no attempt to penalise by imposing higher rates of tax than would otherwise apply where trusts are of a long duration.

However, where a trust instrument requires, or a trustee decides under a power of appointment or discretion to implement, an accumulation of the net income of the trust in the hands of the trustee (regardless of whether it is capitalised and becomes an accretion to the trust corpus), the trustee will be taxed on the net income of the trust, because in that situation there are no presently entitled beneficiaries in respect of the trust net income. This will result in the trust being taxed on all of its accumulating net income at the highest marginal tax rate, but applied as a flat tax rate, of 47.5 per cent of the net income of the trust.

iii. Transfers to a trust

In 1991, a transferor trust regime was introduced into the Australian tax system. This regime essentially attributes to Australian resident taxpayers income and capital gains of non-resident trust estates where the resident taxpayers have transferred either property or services to the trustee of a non-resident trust or where they control the non-resident trust, irrespective of whether the income or capital gains of the non-resident trust are ever distributed to the resident taxpayer, who need not even be a beneficiary of the trust in order to have attribution in Australia of the trust income. 

Furthermore, in the early 1990s, the foreign investment fund (FIF) regime was introduced. Under the FIF regime, taxpayers with an associate-inclusive control interest in an FIF (i.e. a foreign company or foreign trust) and an interest in the income of the FIF (FIF income) are deemed to have their share of the accrued FIF income (i.e. the foreign source income of the FIF deemed to have accrued to the taxpayer under the FIF regime rules on an annual basis), irrespective of whether this trust income is ever distributed to the taxpayer in Australia.

iv. Taxation of income earned in the trust

This topic is discussed above. The Australian tax system looks through trusts and taxes the beneficiaries, unless there are no beneficiaries having a present entitlement to the trust income.

v. Distributions to beneficiaries

This topic is discussed above.

vi. Non-resident trusts and foreign investment entities

This topic is discussed above.

e. Taxation of estates

i. Estate and gift taxes

There is no federal Australian estate duty or death duty nor any federal Australian gift tax or gift duty. Some states and territories have estate and death duties, but these estate and death duties no longer apply to deceased estates where, in most cases, the deceased person has died within the last 20 to 23 years. Estate and death duties no longer play a part in the estate planning methodologies of trust and estate practitioners and tax advisers in Australia.

ii. Taxation on death

On death, a taxpayer’s legal personal representative must file two tax returns under the Australian tax system. One tax return is for the income and capital gains derived by the deceased taxpayer up to the date of death. The second tax return is to recognise income of the estate from the date of death until the end of the income year in which the death occurred, which is usually 30 June following the date of death.

The Australian CGT regime gives the legal personal representative and beneficiaries of the estate of a deceased taxpayer an election to defer capital gains tax liability of the deceased, under what is termed ‘the death roll-over’, on the CGT assets transmitted or gifted to them under the will or intestacy laws, until the eventual sale of the CGT assets.

Where the deceased died with pre-CGT assets, the taxpayer’s death is treated as the conversion of the assets into post-CGT assets which are deemed to have been acquired by the legal personal representative or beneficiaries to whom they have been gifted at a cost base equal to their market value at the date of death, in order to enable calculation of the capital gain on the eventual sale of those CGT assets in the hands of the legal personal representative or beneficiaries to whom they have been gifted.

© 2012 Society of Trust & Estate Practitioners