Who benefits from the income and are you sure?

Who benefits from the income and are you sure? Final Edition of taxation for Australian Expats

Who benefits from the income and are you sure?

Advisers from common law countries are generally familiar with the concept of a trust. A trust is a private legal arrangement where one person or group of persons (a trustee or trustees) accepts the legal ownership of assets (for example shares, real property or cash) to look after and use for the benefit of a third person or group of persons (the beneficiary or beneficiaries).

A trust is not a legal entity.  It cannot actually own anything. In fact it is the trustees who are the legal owners of the assets but they must always put the interests of the beneficiaries ahead of their own interests. They have a fiduciary duty, enforceable at law, to act in the interests of the beneficiaries. The trustees must act for the benefit of the beneficiaries. The distinctive feature of a trust, therefore, is a separation of the legal ownership and beneficial ownership of the assets that make up the trust fund.

Thailand does not recognise this distinction. However a review of the 57 double tax agreements (DTAs) that Thailand currently has in place reveals that at least 41 of them make reference to the concept of beneficial ownership and by implication the recognition that the legal ownership and beneficial ownership could be vested in different entities. Commonly in the case of the dividend,

interest and royalty articles, in order to obtain the benefits under a DTA, the entity receiving the income must be the beneficial owner of the income. See for example Article 10 of the DTA between Thailand and Australia at paragraph 1 with respect to dividends:

“Dividends paid by a company which is a resident of one of the Contracting States for the purpose of its tax, being dividends to which a resident of the other Contracting State is beneficially entitled, may be taxed in that other State. “

The second paragraph of the DTA then states:

“Such dividends may be taxed in the Contracting State of which the company paying the dividends is a resident, and according to the law of that State, but if the beneficial owner of the dividends is a company, excluding a partnership, which holds directly at least 25% of the capital of the former company, the tax so charged shall not exceed:

1. 15 per cent of the gross amount of the dividends if the company paying the dividends engages in an industrial undertaking; and
2. 20 per cent of the gross amount of the dividends in other cases.” 
    

Companies in Australia routinely act as trustees of trusts. They may be the legal owner of shares and not the beneficial owner. An Australian company acting as a trustee of a trust in respect of shares is not the beneficial owner of the dividends received and therefore is not entitled to the benefits under the DTA. A Thai company not vested with that knowledge will be at risk of withholding tax at the incorrect rate.

It is important, therefore, to ensure that if you are dealing with an income tax issue that involves one of the DTAs listed in the appendix to this article (those that make reference to beneficial ownership in one way or another), you and your advisory team understand what it means to beneficially own something or to be beneficially entitled to it.

So what is this concept of beneficial ownership?

The terms ‘beneficial owner’, ‘beneficial interest’, ‘beneficial entitlement’ or other variants are not explicitly defined in any of the DTAs listed in the appendix. Limited reference is made to the meaning of ‘beneficial owner’ in the OECD commentary however Thai tax advisers will often be frank in stating that Thailand is not a member of the OECD and the Revenue Department does not necessarily follow OECD commentary.

The concept, as mentioned previously, has its origin in common law for the purposes of trust law and equity, traceable back to the time of the crusades under the King of England. The critical element is the distinction between the legal ownership of assets held by the trustee and the beneficial ownership held by the beneficiaries who can enforce their right (to due administration of the trust fund in equity, that is, in all fairness, for their benefit) against the trustees.

One can note that the agreements which do not have reference to beneficial ownership are generally older agreements. The term was introduced to the OECD Model in 1977 as an anti-avoidance measure. The specific aim was to prevent a resident of a State benefitting from a tax treaty to which it would not otherwise be entitled to by inserting an intermediary in a third State. Consider the following example.

Company A is resident in country A. Company B is a resident of country B and holds all the shares in company A and is entitled to all the dividends.  Country A and country B do not have a DTA but the benefit of a DTA with country B is desired. Perhaps to obtain reduced withholding rates on the dividend payments. Company C is incorporated in country C. Country C has DTAs with both country A and country B that reduce the overall rate of taxes paid on dividends from company A to company B via company C. Under a trust agreement, company C becomes the legal owner of the shares. Company B remains the beneficial owner. Dividends are now paid from company A to company C and then on to company B with the benefits of reduced tax rates under the DTAs. However, this is not possible when the DTA between country A and country C requires company C to be beneficially entitled to the dividends. As paragraph 12 of the OECD commentary states:

The requirement of beneficial ownership was introduced in paragraph 2 of Article 10 to clarify the meaning of the words ”paid…to a resident” as they are used in paragraph 1 of the Article. It makes plain that the State of source is not obliged to give up taxing rights over dividend income merely because that income was immediately received by a resident of a State with which the State of source had concluded a convention.

The series of events described above is known as treaty shopping.

The OECD Commentary on Articles 10, 11 and 12 contain some general guidance on interpretation of beneficial ownership. Paragraph 12 of the Commentary on Article 10, in respect of dividends, states that the term is not to be used in a “narrow technical sense”.  It must be considered in light of the object and purpose of the convention which includes avoiding double taxation but also fiscal evasion and avoidance. For those without a technical training in trust law, this may be seen as comforting.

Some further guidance on when beneficial ownership will not exist is provided. Paragraph of 12.1 of the Commentary states:

Where an item of income is received by a resident of a Contracting State acting in the capacity of agent or nominee it would be inconsistent with the object and purpose of the Convention for the State of source to grant relief or exemption merely on account of the status of the immediate recipient of the income as resident of the other Contracting State.

Drawing on a report from the Committee on Fiscal Affairs entitled “Double Taxation Conventions and the Use of Conduit Companies” it states:

“…a conduit company cannot normally be regarded as the beneficial owner if, though the formal owner, it has, as a practical matter, very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties.”

Paragraphs 9 and 10 of the OECD Commentary on Article 11, with respect to interest, provides similar guidance. So too do paragraphs 4 and 4.1 of Article 12, with respect to royalties.

The commentaries would seem to make it clear that treaty benefits should not be available to agent, nominee or conduit companies. This list is not exhaustive and practitioners familiar with trust law will be aware that the spectrum of beneficial ownership is very wide. Limited, some might propose, only by the imagination and creativity of the drafter of the relevant instrument.

Some suggest that considering the term has been taken by the OECD from a common law notion, the meaning under those common law systems should be the prevailing meaning for DTA purposes. Others suggest that this would be illogical and unfair for civil law countries in which the

notion is not well understood. Perhaps, in time, a standard definition can be developed. Possibly purely for the purpose of DTA interpretation. One example given is the notion that the beneficial owner is “the person to whom the income is attributable for tax purposes” in line with some of the reasoning on partnerships.

So what is “beneficial ownership”? A truthful response is that in the international taxation context nobody really knows for sure. There is no doubt as to its designated function as an anti-treaty abuse measure attempting to prevent the use of intermediaries to secure a more favourable tax treatment under existing DTAs. The only certainty is that there is no international definition and local authorities will in all likelihood interpret it differently. Notwithstanding these conclusions, clients and their advisers would be well served in ensuring that they have knowledge of the existence of the term in the relevant DTAs and have a commensurate understanding of the term so as not to head down a non-beneficial path.

This Month We Complete the Triangle of Residency Issues for Australian Expatriates

This month we complete a triangle of residency issues for Australian expatriates. We focus this month on expat Australians who are not residents of Australia for tax purposes - usually by virtue of establishing a permanent place of abode outside of Australia. We answer the questions: when do non-residents still have tax obligations in Australia and how do they go about satisfying them?

Much of the income derived by non-residents is not assessable in Australia and does not need to be declared on a tax return. It is often a relief to be out of the Australian tax system which is regarded as one of the more complex and potent tax systems in the world. However we should always bear in mind the need to be correct in a conclusion about your residency. The ATO could take a different view and assess a person (as a resident) on amounts at some later stage. Refer to our first article on the residency trap for that discussion.

So let’s look at the common types of income that expat non-residents usually derive and how they should be dealt with from an Australian tax return perspective.

Salary and wages

For most of us working overseas, for overseas employers, our salary is not taxable in Australia. There is no obligation to declare it on an Australian annual tax return.

Interest and dividends

These are generally quite easily dealt with. If you have funds deposited with an Australian bank or invested in an Australian company, then they will withhold tax from your interest or dividend payments. The rate at which they withhold is based on where you are and whether there is a Double Tax Agreement (DTA). DTAs usually reduce the withholding tax rate from the standard rate that would apply if there was no DTA. Expats in Hong Kong, once again, take note. Australia does not have a DTA with Hong Kong.

This issue is quite simply handled by advising the bank, or the share registry of the company, of your overseas address and non-resident status. This will trigger their systems into withholding tax from the payments. Once tax has been withheld it is a final tax and no further action is required.

Shares that you held when you became a non-resident represent an interesting challenge from a capital gains tax (CGT) point of view. That is discussed in more detail later.

Rental income

This is the type of income that will cause most Australian expats to have to file yearly tax returns in Australia. Rent from a property in Australia is Australian sourced income and non-resident property owners are liable to pay tax on it. There is no withholding at source. Non-resident property owners are required to lodge an annual tax return showing (amongst other things of an administrative nature) the gross rent received from the property and the expenses incurred in gaining the rent. Common deductible expenses incurred in gaining rental income are property management fees, body corporate fees, council rates, insurance, interest on loans taken to purchase or repair and renovate the property, repairs, water rates. Land tax is also deductible and all property owners should register for land tax to ensure that they can get a land tax clearance certificate when they wish to sell. The most commonly overlooked tax deduction with respect to rental properties is depreciation. This can be extremely valuable. To obtain the deductions a report by a specifically qualified quantity surveyor must be obtained however it is very often, very much, worth the cost and effort of obtaining such a report. The net rent is then taxed at the following rates:
 

The common situations where expat non-residents will own rental property in Australia are:

1. They had a rental property as an investment when they left;
2. The bought rental property as an investment whilst they were overseas;
3. They rented out their ‘family home’ upon leaving.
    

People renting out their family home fall into a unique category due to the exemption from CGT on selling one’s main residence that can extend for a significant period of time even after having moved out. That topic is discussed a bit more below but is worthy of a separate article itself.

If you have a rental property in Australia, you need to lodge a tax return with the ATO every year.

Capital gains

Australia has a very robust system for taxing the capital gains. In order to not impede foreign investment, Australia only seeks to tax foreign residents on capital gains on a limited basis – only on taxable Australian real property (TARP). Significantly for the current discussion, one type of asset that, self evidently, is a TARP asset is real property situated in Australia. The view is that the very substantial location advantage of owning property in Australia is enough to attract foreign investment without the need to provide concessional tax treatment as well. Also, investors in property in Australia require the use of the infrastructure and legal system which taxes provide for. Investors in share companies, for example, generally do not. Albeit that the companies themselves do.

Property and CGT

Expats with rental property in Australia will need to include any capital gains they make from selling the property in a tax return for the year of sale. The amount of the gain is calculated by taking the cost base of the asset from the consideration received. At its simplest: ‘what you got’ less ‘what you paid’.

‘What you paid’ sounds simple. However it can be made up of many components and there are several circumstances where this can get complicated. If the property in question was your family home until you came overseas, ‘what you paid’ will generally be the market value when you started to rent it out. Not ‘what you paid’ at all.

Market value is also a very important concept with respect to changes made on 8 May 2012. As non-resident property investors in Australia, you will be aware (or should have been informed) that the 50% general CGT discount was removed for non-residents from that date. The mechanics of this are far beyond the scope of this article. However, in general terms, it is only the increase in value after that date to which the discount will not be able to be applied. Only 50% of the increase in value before that date will be taxable. 100% of the increase after that date will be taxable.  Prudent investors, therefore, will obtain market valuations showing the value at that date to ensure the maximum benefit possible is obtained. The ATO has kindly provided a calculator on its website to help accurately apply the changes and apportion the discount properly.

Two of the most generous concessions in Australian tax law are the exemption from CGT for a person’s main residence and the extension of that exemption for up to six year after the residence was first rented. These concessions will generally remain available to expats who have rented their family home and have become non-residents. With the removal of the CGT 50% discount as discussed above, these concessions have actually become more valuable. There are many intricacies lurking in this area of the tax law. One of the most commonly misunderstood is how the ‘six year rule’ operates if the property is sold after more than six years. What about after ten years, for example? The simplest answer is that it is pro-rated. But not much is simple in this area so it is best dealt with here by saying “get advice”.

Shares and CGT

Shares in companies can also be TARP and subject to CGT if they were owned at the time a person becomes a non-resident. The best way to move forward on this is by going backwards.

CGT is payable in a tax year when there is a CGT event. The most common form of CGT event is the disposal of an asset. A CGT event also occurs when a person becomes a non-resident. This CGT event only applies to assets that would not otherwise be TARP. So, generally, not to property but most certainly to shares. The amount of the capital gain is calculated as the market value of the asset at the time the person becomes a non-resident less ‘what was paid for it’. You may remember comments we made in an earlier article stating that it is beneficial if you can become a non-resident when your share portfolio is down. That’s because the market value is lower and therefore the capital gain is lower.

It can be difficult for a person to pay the capital gains tax on an asset that they haven’t sold. Unfair even. Where would they get the money from? The person can make an election to mitigate this problem. They can elect to disregard any capital gain they make from the ‘becoming a non-resident’ event. That election is not a formal election. It is made, or evidenced, or implied, by not including any capital gain in the tax return. The catch becomes that when you later sell the shares, as a non-resident, the capital gain will be taxable despite the general position that shares sold by non-residents are not subject to capital gains tax in Australia. The question for the person boils down to: “Should I pay tax when I become a non-resident, and have any increase in value after that time not exposed to CGT, or defer the taxing point till when I actually sell them and expose any future value increase to CGT?” - without the benefit of the CGT 50% benefit I might add. In the absence of a crystal ball or a good fortune teller, it is very hard to decide. But you can make some assumptions and run some numbers and make an educated guess. “Get advice” is probably the best advice here also.

Conclusion

The circumstances in which an expat non-resident person will have tax, and tax return filing, obligations in Australia are limited. However in some circumstances they can provide difficult challenges and good advice is most certainly necessary. If any of the issues described above are a cause for concern, or you do need to file a tax return in Australia, please feel free to drop us a line or call in for coffee and we can have a chat.  RSM Thailand is in the unique position of employing two (2) expatriate Australian Chartered accountants who are qualified to advise Thai (Australian) expatriates on their Australian taxation liabilities. Accordingly, RSM Thailand can now offer Australian tax consulting services as well as the lodgment of Australian tax returns.