TAX NEWS - 2010

Foreign Income Tax & Fairness: Australia and the United States

Fairness, alongside certainty and simplicity, is a posited ideal of a tax system. But fairness to whom? Both residents and foreigners must pay tax. Normatively speaking, it is accepted that residents face more substantial tax burdens. But how is residence determined? By fact or degree or perhaps by citizenship? Further, how do fairness principles apply to different types of taxpayers, e.g. corporations? Both Australia and the United States have developed different legislative answers to some of these questions. They will be considered below.

Fairness, it is said, is best evidenced by the 'ability to pay' concept which says people should contribute to their society according to their means (Shay). According to the various philosophical rationales for this (Smith, Kant, Rawls), it is accepted that residents carry a burden to pay tax in connection with their status as members of the community. Liability is determined by material ability or "well-being", judged by reference to income as equitably ascertained (Shay, 306).

For example, this means that foreign income (in addition to domestic income) must be assessed in calculating a resident's ability to pay (Shay et al, 310-12). Fleming posits the scenario of 'A' and 'B' (both US residents) each earning $8,000 of domestic income. A has no foreign income. However, assume that B has $10million in foreign income. Ergo A and B are not comparable taxpayers. Clearly B has a greater ability to pay and must be taxed on that ability – if A and B are to be treated fairly relative to each other. Another demonstrative implication of the fairness principle applies to corporate taxpayers. Arguably corporate status changes considerations of the 'ability to pay' and lofty obligations implied by societal membership.

But regardless of those wider arguments, a simple answer can be rendered in equity – corporations must pay according to the ability to pay in the same terms a natural person might – because, if they did not, individuals would simply use corporate structures to manipulate their tax obligations (e.g. deferral measures). Given this those better able to arrange their tax affairs would pay less tax than those less able to arrange their tax affairs.

Another contested aspect of fairness relates to when a individual or company should be treated as being a resident of a jurisdiction. Residence is important because different tax obligations accrue to residents versus non-residents. Critically, residence-based taxation allows a country to tax the foreign income of an individual or corporation.

Various statutory tests determine whether an individual is an Australian resident (ITAA s 6(1)). Specific thresholds aside, a person is an Australian resident of they are a resident by ordinary concepts, their place of domicile is in Australia (not elsewhere) or they meet the 183 day test (TR98/17). A person will cease being an Australian resident if they (a) establish a domicile elsewhere, (b) cease to be a resident by ordinary concepts or (c) leave Australia for more 2 years (TD2650). Arguably Australia attempts to give weight to the fairness rationale by excluding those from residence taxation who do not maintain a substantial connection with Australian society.

Further, if a resident takes foreign employment for 91 days or more, that income will be excluded from residence taxation and only investment income will be taxable (s23AG ITAA36). It might be questioned, however, whether a fixed test of days is really fair. Arbitrariness acknowledged, a fixed standard is certain. In addition, alternative tests allow the ATO to look to the substance of a personal arrangement (see TR98/17 examples).

For foreigners, the US adopts a "substantial presence" test for applying residence taxation. A sufficient presence is established if a person is physically present in the US for a total 183 days over a specified period (current year, plus last two years) (§ 7701(b)(3)). Exemptions apply for students and medically sick persons (§ 7701(b)(3)(D),(5)(C)). Citizens, however, are taxed regardless of a "substantial presence". A US citizen will pay tax on foreign income, regardless of whether (s)he treats the US as home or permanently resides outside the US. A US citizen could remain abroad for 30 years and never return, yet still be subject to taxation as a resident (note however a US$90,000 foreign-income threshold).

A fairness objection is persuasively put: citizens who have no substantial connection to the taxing society should not be taxed as members of that society. It might be argued that citizenship residence is imposed (a) because of past connection to the society (i.e. liability for past benefits) or (b) on an assumption of the continuing availability of benefits associated with citizenship. Either way, it is argued the deemed association is voluntary. An estranged citizen can simply renounce.

With respect to corporate residents, Australian and US regulation is similar. Residence is determined by place of incorporation, management or where voting shareholder power is located. Inevitably corporate residence is more easily manipulated than personal residence. Typically a resident corporation will incorporate a foreign resident subsidiary elsewhere. This can achieve significant tax deferral benefits in low tax jurisdictions (Fleming, Time Value). Arguably fairness relative to personal taxation is sacrificed here unless tax reform is achieved.

One avenue is to tax shareholders directly (ignoring the separate corporate entity) as residents of their respective countries. In this way deferral benefits would be removed and individuals relative to corporations would be taxed similarly. In summary, fairness requires that resident taxpayers should be treated alike. Different hooks upon which residence taxation is imposed across jurisdictions raise comparative fairness questions.

On balance, inflexible rules (re US citizenship test) seem less fair. Fairness also requires corporate and individual taxpayers be taxed on a comparable basis. It is evident that present regimes leave fairness still wanting in some aspects.