On 17 September 2021, the ATO released Taxpayer Alert 2021/2 (the Alert) concerning disguising undeclared foreign income as gifts or loans from a related overseas entity. In essence, the ATO is concerned with unexplained wealth – any such disconnect between the amount of income recognised by an Australian taxpayer in their Australian income tax returns.
As outlined in the Alert, the ATO is currently undertaking reviews and audits and actively engaging with taxpayers who have arrangements to not declare foreign income or gains, with the Alert warning of the ‘substantial penalties and risk of potential sanctions under criminal law’ that may result, for both taxpayers and their advisers.
For the purpose of the Alert, a related overseas entity may include a friend, family member or related company of trust, of the relevant taxpayer.
Omitted foreign income may include:
- overseas business or employment income;
- dividends from foreign companies; and/or
- a capital gain on the disposal of a foreign asset (such as shares in a foreign company)
To ensure compliance, there are several essential factors that ought to be considered by taxpayers and advisers alike, so that foreign income is accurately provided for in the taxpayer’s return.
1. Is the taxpayer an Australian tax resident?
Despite appearing seemingly simple, the answer to this initial question will make a significant difference to subsequent tax treatment and liabilities of the relevant taxpayer, as the income on which tax is paid is dependent on residency for tax purposes. As an oversimplification, the current residency provisions are principle-based and generally require a detailed analysis of current case law, which can understandably lead to incorrect application of the applicable tests.
Notably, the Government has announced that the individual tax residency provisions will be ‘modernised’ in the 2021-22 Federal Budget. While we are yet to see any draft legislation, the rules will be based on recommendations made by the Board of Taxation, with many of us hoping to see some sort of transitional arrangement to ensure that taxpayers have time to understand and plan for the upcoming changes.
From the outset, an Australian tax resident is, generally, taxed on their worldwide income and capital gains, irrespective of source. For this reason, the tax issues surrounding undeclared foreign assessable income received by an Australian resident can be incredibly complicated. In contrast, a non-resident is typically only taxed on their Australian-sourced income. There are, however, a number of factors that should be considered to ensure non-resident compliance.
2. Consider the foreign income stream
The Alert explicitly provides that the ATO is concerned with situations where the relevant taxpayer is aware of their residency requirement, as well as the tax implications that flow from such, but make attempts to avoid or evade their foreign assessable income by concealing the character of the funds upon their repatriation to Australia by disguising the funds as a gift, or a loan, from a related overseas entity.
While serving as a stark warning, the ATO does reiterate that they are not focused on arrangements where an Australian resident taxpayer has not derived any foreign assessable income but has received a genuine gift or loan from a related overseas entity, which would be an arrangement where appropriate documentation supports the characterisation of the receipt as a gift or loan.
For a gift to be genuine, a contemporaneous Deed of Gift, along with evidence of the donor’s capacity to make the gift, would be typically required. The level of additional documentation would, however, be dependent on both the size of the gift and the relationship between the parties. In any event, the production of supporting material in the form of, for example, the donor’s bank statements and/or financial records, may be required.
With respect to loans, the ATO expects a ‘properly documented’ loan agreement, of which principal and interest is periodically repaid over time. Additional evidence to support a genuine loan may include documentation in support of security provided, or guarantees given in support of the loan, correspondence relating to the particular arrangement (including pre-contractual negotiations) and financial records evincing the loan terms. As it can be understandably difficult to obtain documents of this kind from entities in foreign jurisdictions, it may be the case that various sources of information, either individually or holistically, will provide sufficient evidentiary comfort to the ATO.
While it is important that the arrangement is appropriately documented, this will only be the start. The ATO will review the facts and circumstances to the arrangement, which may result in the Commissioner forming an alternative view as to genuineness. To detect sinister arrangements, the ATO has advised that it will be exercising its exchange of information powers to gather information in the course of auditing arrangements the subject of the Alert.
3. Further considerations
Australian tax residents (excluding tax temporary residents) are liable for tax on worldwide capital gains (subject to double tax relief). In contrast, non-residents are only subject to capital gains tax (CGT) on gains that they make on assets that are ‘taxable Australian property’. Therefore, a non-resident taxpayer needs to understand any Australian tax liability, as well as the liability in any foreign country in which the taxpayer is a tax resident. This is particularly important as it may significantly impact wealth creation plans.
Some further considerations for non-residents are:
- consideration of applicable double tax agreements in place between Australia and the relevant country;
- income that is subject to Australian withholding tax; and
- certain Australian sourced income (such as rental income from an Australian rental property), which may be subject to tax at the non-individual resident tax rates.
These issues may include, for example, where there should have an application of Division 7A and/or the transfer pricing regime. Depending on the particular circumstances, it may also be necessary to consider Australia’s Controlled Foreign Company scheme, where while Australia does not typically tax the trading profits of an overseas company, the CFC rules can apply to certain passive or related party income of a foreign company.
4. Making a voluntary discloosure
If it is considered that foreign income may have been omitted from a prior income tax return, a voluntary disclosure may be made to the ATO. Making a voluntary disclosure can result in the reduction of penalties and interest otherwise applicable on the failing to disclose the taxable income. The outcome will, typically, be more favourable if disclosure is made prior to the commencement of an ATO audit into the taxpayer’s affairs. The ATO will, however, consider each voluntary disclosure on a case-by-case basis, and the treatment will depend on the particular circumstances. Voluntary disclosures must therefore be handled with care and sensitivity.
In any event, it is important to ensure that appropriate tax advice, planning, documentation and post-implementation processes are understood by the taxpayer so that potential tax issues that may arise can be avoided from the outset.
