Following the last post on tax havens and small business, I recevied a few questions from readers that were along the lines of:
I have a shareholding in a privately held foreign company. Does it affect my Australian tax? What do I need to declare on my tax return?
These readers included:
- An Australian who inherited shares in a foreign company from their deceased spouse (who used to complete his own tax return on e-tax…).
An Australian who owned shares in a foreign company that had been set up when they were living overseas.
A foreign expat who owned shares in a foreign company and had recently arrived in Australia for a long-term contract.
Responding to these three readers was an eye-opening experience for me.
Well, they were not at all concerned about how they could use their foreign company as a tax shelter.
Quite the opposite in fact.
They just wanted to make sure that their foreign company was being disclosed correctly in their tax return.
So, let me share with you what I ended up sharing with them: 5 steps to assess if, when and how, shares in a foreign company can affect your end of year taxes.
The 5 step process
- Determine Australian tax residency.
- Identify owners and controllers.
- Identify country of residence.
- Consider operating activities.
- Calculate amount to include in tax return.
Before diving into the detail, it's important to set the scene:
This post was written for Australian resident taxpayers (individuals, companies and trusts) who are shareholders in privately held foreign companies.
References to a ‘foreign’ company are references to a company that is not incorporated in Australia.
For simplicity’s sake, assume the foreign company has only one class of shares on issue and these shares carry with them all voting rights, dividend rights and rights to distributions of capital.
1. Determine Australian tax residencyThe first step in the process is determining whether a foreign company is actually a non-resident of Australia for tax purposes.
This is because regardless of where the foreign company is incorporated, it would be taxed in exactly the same way as a company incorporated in Australia if it is considered a tax resident of Australia. This means the company would need to obtain an Australian tax file number and lodge an Australian tax return declaring its worldwide income.
If the foreign company is not considered an Australian tax resident, it would generally not have any Australian income tax obligations, unless it carries on business in Australia through a branch office (also known as a ‘permanent establishment’).
You should exercise a high degree of caution when using the process in Figure 1 to come to a final conclusion on a company’s residency status. While it may seem deceptively simple to follow, the concepts introduced are actually quite complex.
Whether a company carries on business in Australia and whether a company’s central management and control is located in Australia are often contentious questions that have been considered in many a case heard before the courts. Detailed analysis is often required before reaching a yes or no conclusion.
For example, it is standard practice for foreign companies to appoint directors who are resident in the foreign country in which the company is incorporated. Care should be taken where these directors are simply nominees who ‘rubber stamp’ decisions made by the company’s Australian owners, as it may be that the Australian owners are the true controllers of the company and central management and control of the company may in fact be located in Australia.
Assuming that the foreign company is in fact a non-resident of Australia, the next step is to examine who the company’s owners and controllers are.
2. Identify owners and controllersThe Australian owners of a foreign company can be taxed in Australia in one of two ways - on a repatriation basis or accruals basis.
Which of these methods applies depends upon who owners and controls the foreign company.
Repatriation vs accruals
Generally speaking, income from a foreign company is only subject to tax in Australia where the company pays a dividend to its Australian resident shareholders. This known as tax on a ‘repatriation’ basis. However, Australian residents with shares in certain foreign companies, known as ‘controlled foreign companies’ (or ‘CFCs’), can be taxed in Australia on the company’s profits in the year that they are earned – even if the company does not pay a dividend. This is known as tax on an ‘accruals’ basis.
Is the company a CFC?
A CFC is a foreign resident (i.e. non Australian resident) company that is controlled by Australian tax residents.
Typically, foreign companies that are set up by small businesses and independent investors are wholly owned by Australian residents. Where this is the case, the relevant foreign company would be a CFC.
Where the foreign company has a more complex ownership / control structure, up to three tests may need to be applied to establish whether sufficient ‘control’ exists and the company is a CFC. More detail on these tests can be found here.
3. Identify what country the company is resident in.The overarching purpose of taxing certain CFCs on an ‘accruals’ basis is to prevent tax deferral by Australian residents who set up companies in foreign countries, with the aim of accumulating profits in these companies at low effective tax rates.
It follows that there is generally no tax advantage to be gained by Australian residents by setting up foreign companies in countries with comparable effective tax rates to Australia.
Countries with comparable effective tax rates to Australia are known as ‘listed’ countries. At the time of writing, these are:
- New Zealand
As a general rule, if the CFC is resident in one of these listed countries (according to the domestic tax rules in that country), accruals taxation would not apply (there are some specific exceptions to this for certain types of income).
If the CFC is resident in a country that is not listed (i.e. an unlisted country), a wider range of income may be subject to tax in Australia on an ‘accruals’ basis. Where this is the case, an analysis of the company’s operating activities is required.
4. What are the company’s operating activities?A company’s operating activities can generally be placed into one of the following categories:
Active trading Active trading companies earn income from operating an active business, often with staff, offices, equipment and customers located around the world.
Investment Investment companies earn income from holding and trading in non-controlling, portfolio-type investments such as loans, equities, commodities, currencies (including bitcoins), derivatives and bonds.
Holding Holding companies own long-term investments in other entities. They typically have little to no activity of their own aside from owning such investments.
Whether income earned by a CFC is taxed to its Australian owners, will depend on which of these categories the company’s activities fall into.
Generally, the income of a CFC conducting an active trading business would not be taxed to the company’s Australian owners upfront on an accruals basis.
There are however situations where active trading companies can fall foul of this. In particular:
where the CFC transacts either directly or indirectly with Australia (more specifically, with associates that are Australian residents, or non-residents carrying on business in Australia); or
where the CFC earns passive income such as interest, rent, dividends or investment trading income (including companies whose entire business involves trading in investments such as securities, commodities or currencies).
These types of income are considered ‘tainted’ income of the CFC.
Recognising that companies who carry on active businesses often earn small amounts of tainted income (e.g. from interest bearing bank accounts) there is a test, known as the ‘active income test’, designed to carve out this income from accruals taxation.
Under the active income test, where a CFC’s total tainted income is less than 5% of the company’s entire turnover, the test is passed and accruals taxation would not apply.
If however the CFC’s turnover comprising tainted income is more than 5%, the active income test would be failed and accruals taxation may apply.
Note that where the active income test is failed, only the company’s tainted income would be subject to accruals taxation. The remainder of the company’s income would only be taxable to the company’s Australian shareholders where it is paid out to them by way of dividend (i.e. on a repatriation basis).
The income earned by a CFC operating purely as an investment vehicle is generally passive in nature and therefore considered ‘tainted’ income. This means the company’s Australian shareholders would be subject to accruals taxation on most, if not all, of the company’s income.
Where a CFC acts as a holding company for another company (which I will refer to as the “subject company”), it would not derive any income unless the subject company pays the holding company a dividend.
Where the subject company is also a CFC (due to ultimate ownership or control by Australian residents), its operations would also need to be examined, in order to determine whether any of its income would be assessable to the holding company’s Australian shareholders on an accruals basis.
5. Quantify Australian tax liability
By this step, the following facts should have been established in respect of the foreign company:
- The company is a non-resident of Australia.
- The company is owned or controlled by Australian residents (and is therefore a CFC).
- The company is not resident in a listed country.
- The company’s ‘tainted’ income comprises more than 5% of the company’s total turnover.
These facts indicate that some or all of the company’s income may be taxable to its Australian owners on an ‘accruals’ basis. This taxable amount is known as the company’s ‘attributable income’.
A CFC’s attributable income is essentially the company’s taxable income calculated as if it were an Australian resident company, with some adjustments, including:
Only the company’s tainted income (i.e. its passive income and income from transactions with Australia) is taken into account.
A deduction is allowed for foreign income tax (or Australian withholding tax) paid by the company on amounts included in attributable income.
Trading stock must be valued at cost.
Losses are not attributed to the company’s Australian owners in the year of the loss. Rather, they can be carried forward and claimed as a deduction against future attributable income.
As demonstrated Figure 3, only the company's tainted income (i.e. passive income) and expenses related to that income, are taken into account in calculating the company's CFC attributable income.
Once the CFC’s attributable income for the year has been calculated, it is attributed to each of the company’s Australian owners based on their ‘attribution percentage’.
Where the CFC has only Australian resident shareholders and a single class of shares on offer, each shareholder's attribution percentage would be their ownership percentage in the CFC.
Calculation of the CFC attribution percentage can become infinitely more complex than this where there are multiple Australian resident and non-resident owners, changes in ownership mid-year, indirect shareholdings, and multiple classes of shares or hybrid instruments such as preference shares on issue.
In Figure 4, Ben and Simon own their shares in the foreign company (Panda Co) directly. This means they would each need to include $707 as assessable income in their Australian tax return and would be subject to tax on that amount at marginal rates.
Tim owns his shares through an Australian company (Koala Co), which means that Koala Co would be the attributable taxpayer, not Tim himself. This means $707 would need to be included in the Koala Co's Australian tax return and would be taxed at corporate tax rates (currently 30% assuming the company is not a small business entity).
If you got lost somewhere along the way, let me leave you with this short summary:
If you have shares in a foreign company that operates an active business, you probably don't need to declare anything in your tax return until the company pays you a dividend. But, if the foreign company is used to invest and earn passive income, it's likely you are going to be taxed as if you earned that income yourself. This means declaring the income in your tax return.
And remember - this is a comprehensible guide. Not a comprehensive guide. So don’t forget to get professional advice.
It is important to remember that everyone's situation is different. The information contained in this post is general in nature and should not be relied upon as specific professional advice. Please contact us to obtain specific advice in relation to your particular situation.
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