Still call Australia home?

Hilton Partners

The government’s acceptance of a new bright line test should put to rest much confusion over individual tax residency rules that have not kept pace with Australians who lead global lives.

The Federal Government’s 2021‑22 Budget announcement that it intends to implement a revised set of individual tax residency rules as recommended by the Board of Taxation represents an important development in a process that began with a self‑initiated review by the board in May 2016.

After two separate reports, one in August 2017 and the other in March 2019, and following an extensive consultation process, there is expected to be yet further consultation on some of the detail, and we will probably see draft legislation released ahead of a bill. Only then will the new rules take effect.

Making much needed changes to Australia’s tax system can sometimes be an excruciatingly slow process, although we note that of the five years it has taken to get to this point, two years were taken up with the board’s consultation, design and report writing work, while three years were spent waiting for the government to respond to its recommendations. Still, we shouldn’t grumble – they have been busy with other matters of late.

Importance of tax residency

A person’s tax residency is one of the fundamental elements that governs the way they engage with Australia’s income tax system.

It determines:

  • what income is taxed in Australia and at what rates
  • capital gains tax outcomes, both on commencing and ceasing to be a resident
  • the Medicare levy, and
  • whether Australian-sourced dividend and interest income is taxed on an assessment or a withholding basis.

Note, tax residency also affects an employer’s withholding obligations and is a critical factor in the tax equalisation work that is done on behalf of inbound and outbound expats.

Board of Tax’s recommendations

It has been a couple of years since we covered the board’s 2019 report, Reforming individual tax residency rules – a model for modernisation, in this publication, so a brief recap is in order. The board put forward a two-step framework that relies primarily on a 183-day bright line test. For the vast majority of individuals, this test will neatly dispose of the residency question and in terms of certainty, this represents a significant improvement over the current rules, which include a 183-day test that can be trumped by the ‘resides’ test or the ‘domicile’ test. A legion of legal challenges has been fought out over the subjective elements (such as intention) that make up those tests. Hopefully, these kinds of disputes will soon be a thing of the past.

Things get a bit trickier for the more challenging cases of individuals starting or ceasing residency. It is helpful to look at these cases separately, as the board has done.

A person’s tax residency is one of the fundamental elements that governs the way they engage with Australia’s income tax system.

Commencing tax residency

This test applies to individuals who were not tax residents in the previous income year. If they spend less than 45 days in Australia in the year of income, they are not an Australian tax resident. But where they spend between 45 and 182 days in Australia, they will be a tax resident if they also satisfy two of the four factors in the Factor Test. These factors are:

  • Having the lawful right to reside permanently in Australia for immigration purposes.
  • Having the ability to access Australian accommodation, not necessarily as a proprietary right, but not including couch surfing or staying with parents.
  • Having an Australian family, meaning that their spouse and children aged under 18 are generally located in Australia.
  • Having Australian economic connections, meaning employment in Australia, active participation in an Australian business or a direct or indirect interest in certain Australian assets.

Under these rules, an inbound individual with a job and a place to stay would generally be regarded as being an Australian resident if they are in Australia between 45 and 182 days in a year of income.

While the board has done its best to come up with factors that are as objective as possible, there is sometimes an unavoidable trade-off between having tests that are clear versus more nuanced tests that are better able to deal with more complex cases. It will be of great interest to see how the Factor Test is drafted in the law because there is some risk that we will end up with prescriptive tests that more or less replicate some of the current common law tests, but without having the flexibility of the common law to deal with unusual cases.

Temporary residents

What about Australia’s temporary tax residency relief rules, under which inbound international students, visiting professors, authors, entertainers and the like are exempt from paying Australian tax on some of their foreign income, even if they are Australian residents? The board (at 4.54) indicates these rules should be further analysed during implementation but recommends that any relief should be capped at four years. They have wisely decided to remain above the fray in relation to the backpacker’s tax, which is currently before the High Court (at 4.62).

Ceasing tax residency

This is where things get even more tricky, and the board has come up with different sets of rules for short-term and long-term departing residents. The rationale for this is that tax residency should be more ‘adhesive’ for longer term Australian residents. This seemingly innocuous assertion is supported by the comment that this principle is also observed by other countries. However, it does not really answer the question of whether tax residency ought to be relatively disposable or stick to you like an unwelcome piece of chewie on the bottom of your shoe!

Short-term residents

Where an individual has only been an Australian tax resident for less than three consecutive income years, they will stop being a resident if they are physically present in Australia for less than 45 days and they satisfy less than two of the Factor Tests (ie, one or none). For short-term residents departing Australia it should be reasonably straightforward to navigate these tests.

Long-term residents

A long-term resident is anyone who is not a short-term resident, meaning an individual who has been an Australian tax resident for the last three consecutive years of income. These individuals will need to spend less than 45 days in Australia, not only in the year of income being examined, but also in each of the previous two income years.

This would mean that an individual who leaves Australia for good and takes up residency elsewhere will be treated as an Australian tax resident for up to another three years after having permanently left Australia. Any adverse consequences of that seemingly odd outcome can probably be avoided where the individual takes up residency in a treaty country, because the tie break rules would give primacy to the state where the individual has their permanent home. But that will not be the case for non-treaty destinations. Having starkly different outcomes for individuals with identical personal circumstances depending on the state of Australia’s tax treaty network is somewhat of a weakness in the board’s proposed framework.

Overseas employment rule

The proposed overseas employment rule will overcome some of the anomalies identified above by (sort of) enacting the two-year rule of thumb in IT 2650, which treats an individual as a non-resident where an overseas assignment involves an intended physical absence from Australia of two years or more. But by framing their recommendation in an overly prescriptive way, the board may be creating further anomalies.

Recommendation 9 (at p 69) proposes to treat Australian expats as non-residents where, among other things – such as having accommodation available at the work location and not returning to Australia for more than 44 days in any one income year – the overseas employment being contracted is mandated for two years or more from the start of the assignment. This represents a significant departure from IT 2650 and requires more flexibility to cover rolling 12-month contracts that are understood to be commonplace in the Middle East, even for what are expected (and turn out to be) long-term assignments. Otherwise Australian expats heading for that part of the world in search of tax-free earnings could be in for a rude shock.

Counting the days – some flexibility needed

The board contemplates some limited flexibility on day counting for the purpose of the 183-day test and includes examples (at 3.27) involving volcanic eruptions, hospitalisation after a traffic accident and a family illness. However, it was not prepared to extend any flexibility to the 45‑day test for commencing and ceasing residence for reasons that are not particularly convincing (suggesting that such a rule might reduce certainty). If anything, the 45-day test is more sensitive to unexpected events.

One additional factor that absolutely must be included is the time spent in health mandated quarantine (and the board can be forgiven for this omission, given the timing of its report). Adding two weeks’ quarantine to inbound visits would blow away the 45-day threshold from just a few business trips and family visits. Quarantine time should not be included in the day count for either the 183 or the 45-day tests.

Double tax treaties – same old uncertainty?

Australia has a lot of double tax treaties – 46 at last count and covering most of the world in terms of population and economic activity. All of these treaties have residency tiebreaker rules, which in many cases can be resolved by looking at where an individual has a permanent home. But where that individual has a permanent home in both states (which is not unusual these days), or in neither state, the questions become rather vague: Where is the individual’s usual place of abode? Where do they have the closest personal and economic connection? This takes us back to the subjective common law tests the board has identified as being so problematical in the first place. Since treaties override the domestic law, the increased certainty and reduced compliance costs expected from the proposed rules may not eventuate in many cases. See example below.

Double tax treaties will continue to create their own uncertainty and complexity, not every time, but often enough.

Overseas employment rule

Take Bev and Bob, self-funded retirees from Adelaide who, after holidaying in Bali many times over the years have bought a small villa in Seminyak while retaining their home in Australia. They divide their time roughly equally between the two locations and never spend less than three months per year in either Australia or Indonesia. They sometimes visit other countries as well. The proposed strong adhesion rules around ceasing residency would make them tax residents of Australia indefinitely, and they would likely be regarded as tax residents of Indonesia under Indonesian domestic laws as well.

Looking at the tiebreaker provisions of Article 4(3) of the Australia/Indonesia treaty, they have a permanent home in each of the two states and their habitual place of abode is difficult to pin down because of their itinerant lifestyle. This then takes us to the question of which is the state with which their economic and personal relations are the strongest. Good luck in sorting that one out without resorting to senior council at ten paces.