On 27.11.18, the Federal Court held that a taxpayer, was only entitled to a Foreign Income Tax Offset, for 50% of the US tax paid, on the sale of investments, as only half the capital gain had been included in his Australian ‘assessable income’ (after applying the standard 50% CGT discount, for assets held for more than one year).

This is a pretty fundamental issue and appears to be the first case on the point. Look out for an appeal.

An overview:

  • Mr Burton was an Australian resident, at the time he derived gains, in the United States of America (US), on which he paid US taxes under US income tax law.
  • These investments were fractional options to participate in US oil wells. This also meant that the US could tax them, under the US/Australia Double Tax Agreement (as gains related to US real estate).
  • He held these investments trustee of a trust, and after realising the gains, distributed them to himself.
  • The investments were quite valuable. The largest he sold for USD 25m in about 2010 (then about the same in AUD) and the gain was about USD 8m. The proceeds were paid in instalments straddling the US 31 Dec financial year but all falling into the 2010/11 Australian financial year.
  • Under US law, Mr Burton was entitled, in the relevant years, to concessional treatment of capital gains, on assets held for more than a year. This was by way of a reduced rate (the usual rate being 35% and the rate being 15% – less than half).
  • Those gains however were also taxable in Australia, because he was resident. As he’d held these investments, for more than a year, only half of the gain was used to calculate the assessable amount in Australia. Section s102-5(1) of the ITAA97 includes an amount called the ‘net capital gain‘ in ‘assessable income‘ and sets out the method for calculating it (namely: add the capital gains that year; subtract capital losses that year; subtract carry forward capital losses, then, take only half of that amount and then subtract any small business concessions).
  • The Commissioner only allowed Mr Burton, a foreign income tax offset (FITO) for half of the US tax he paid on these capital gains, because (he said) only half of the gain was assessed (under calculation method, in s102-5(1) as I just mentioned).
  • The Commissioner’s position is that, while Australian residents, deriving assessable foreign income, are entitled to relief from double taxation, double taxation occurs where a person pays both foreign tax and Australian tax on the same amount.
  • The Court held that the Commissioner was right, saying that an amount not included in assessable income (namely, 50% of the capital gain) cannot, by definition, be doubly taxed.

To follow the reasoning, however, it is necessary to see what the DTA says about foreign tax credits (as it can override our domestic tax law) and then see what see our domestic Foreign Income Tax Offset  provisions say.

Double Tax Agreement (DTA)

Under the DTA, both Australia and the US are entitled to tax gains on real property, natural resource rights and capital gains: Art 6 and Art 13.

However, the Convention expressly requires Australia to allow, as a credit against Australian tax payable in respect of certain income, the ‘United States tax paid’ in respect of the same income: Art 22(2). It gives some guidance (from which our domestic Offset regime cannot stray, but apart from that, says that the credit can be as delivered as calculated by our domestic regime. (The DTA overrides our domestic tax law by the operation of s4(2) of the International Tax Agreements Act 1953DTA Act.)

The relevant DTA provision (about Australian credits for US tax) is Art 22(2), and it provides:

Subject to paragraph (4), United States tax paid under the law of the United States and in accordance with this Convention, other than United States tax imposed in accordance with paragraph (3) of Article 1 (Personal Scope) solely by reason of citizenship or by reason of an election by an individual under United States domestic law to be taxed as a resident of the United States, 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 of Australia as that law may be in force from time to time.

For these purposes, the Taxpayer’s argument was that the DTA required that:

‘US tax paid … in respect of the income [in this case the whole capital gain] … shall be allowed as a credit against the Australian tax payable in respect of [that same] income.”

Put simply, he says that the US tax on the capital gain should be creditable against the Australian tax on the capital gain (however Australia choses to tax that gain – assessing, half or all – it matters not).

Further, he says, that this is the mandatory part of the DTA, from which the Australian offset/credit regime cannot stray, without being overridden, by the DTA. If our domestic Offset regime were to only allow half of the US tax, as credit, then it would be over-ridden, to that extent (under s4(2) of the DTA Act).

The Court, however, disagreed (but I, respectfully, disagree with the Court)

  1. First, returned to its lengthy analysis, of how our Offset provisions work, which was based on pro-rating the credit based on the 50% amount of the the capital gain made assessable here. But, this misses the thrust of the Taxpayer’s point. This is not the way the DTA works. It works on the amount of the ‘income’ on which the US tax was paid, and makes it creditable against the Australian tax on that same ‘income’. It is for that reason that I say, respectfully, that this argument carries no weight, in justifying the Court finding against the Taxpayer.
  2. Its second argument was really the same point, put around a different way. It said that the DTA did not say that all the US tax was creditable (as, indeed, it doesn’t). But, again, this is just assuming the first point, that you can only use as much of the US tax as springs from the portion of the gain included in the Australian assessable income. There is nothing in the DTA that says that this is the way it works. The US tax, springs from an amount of ‘income’, and it is creditable against the Australian tax on that same ‘income’ (and this function of the DTA overrides our domestic offset provisions, if they are construed otherwise).

With respect to the Court, it approached the issues the wrong way round, dealing with our domestic offset provisions first, even though they can be over-ridden by the mandatory part of the DTA. And its analysis of the offset provisions was very long (61 paragraphs) and it’s analysis of this mandatory DTA point very short (2 paras). It then let its analysis of subordinate (offset) provisions, colour its interpretation of the mandatory provisions.

The Taxpayer contended (correctly, I would have thought) that one has to be ‘practical’ or ‘pragmatic’ in achieving the object of giving credits in one jurisdiction, for tax paid, on income, in another jurisdiction – such are the multitude of different approaches, that could be taken, to taxing that income, and taxing income generally, in the two jurisdictions (and there was a UK case: Anson v HMRC [2015] 4 All ER 288, that said this – para 67 of this Court’s judgement).

There was a certain ‘common sense’ to the Taxpayer’s approach, that US tax, paid on a capital gain, ought be creditable against Australian tax, on that same capital gain. And, the Court’s more limited conclusion, does damage to that common sense.

Australian ‘Foreign Income Tax Offset’ (FITO) provisions

Our FITO provisions are in Division 770 of the ITAA97.

The relevant provision, to construe, is in s770-10(1), which provides as follows.

770-10(1)   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. [emphasis added]

The Taxpayer’s argument here was that the whole of the ‘capital gain’ was ‘included‘ in the calculation of the assessable amount (viz: ‘net capital gain’ per s102-5(1)). And the 50% discount only appeared as an element in the calculation. Further, the 50% element of the calculation might never have effect, to reduce a ‘capital gain’. Capital gains are only reduced by this 50% amount, only so far as there is anything left, after offsetting current and past year carry forward capital losses.

There is something to be said for this argument, combined with the ‘pragmatic’ approach required to make such offsets work (in justifying the ‘common sense’ view that the US tax on the capital gain should be creditable against the Australian tax on that same gain – discounted or otherwise).

However, it was always going to be hard for the Taxpayer to win this argument, given that our domestic FITO provisions include a requirement, not in the DTA, namely that the foreign tax must have been paid on an amount that that is ‘included in your assessable income’. That might seem like a logical interpolation (it must have been included in your ‘assessable income’ to be taxable) but the 50% reduction of otherwise taxable capital gains, is a good case in point.

The closest case on point was one about a s25-45 deduction for money stolen, that had been included in the taxpayer’s assessable income: Commissioner of Taxation v Lean [2009] FCA 490. In this case, it was the proceeds of a capital gain that were stolen, and the Court accepted, that the proceeds had been included in ‘assessable income’ at least to the extent of the s102-5(1) calculation of ‘net taxable income’. This, however, could still lead to the amount being reduced by 50%.

There was a lot of talk about the ‘purpose’ of Div 770 being to avoid double taxation, but the Court, in the end, couldn’t get past the Commissioner’s proposition that an amount that has never made it into ‘assessable income’ can’t be double taxed (and therefore, only a 50% offset should be allowed).

My own view (for what it’s worth) is that the Taxpayer’s DTA argument was the stronger point – namely that our domestic offset provisions must bend to the mandatory DTA requirement, that:

‘US tax paid … in respect of the income [in this case the whole capital gain] … shall be allowed as a credit against the Australian tax payable in respect of [that same] income.” 

This does not rest on any amount having to be included, in Australian ‘assessable income’, and recasts the double tax point in a way that sits favourably with the Taxpayer’s ‘pragmatic’ and ‘common sense’ approach.

(Burton v CofT [2018] FCA 1857, McKerracher J, 27 November 2018.)

FJM 9.12.18

[LTN 230, 28/11/18; Tax Month – November 2018]


CPD questions (answers available)

  1. Was the taxpayer’s position that the whole of the US tax he paid, on some capital gains, should be available as a ‘foreign income tax offset’ under Div 770?
  2. Was the Commissioner’s position that only 50% of the US tax should be available as an Offset?
  3. Why?
  4. Is our offset regime based on the amount on which the US tax is paid, being included in the taxpayer’s ‘assessable income’?
  5. Is that what the DTA requires?
  6. What does the DTA require?
  7. Does this DTA requirement prevail over the Australian Offset provisions, if they were inconsistent?
  8. Under what provision?
  9. Who won the case (what was the result)?


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