A foreign resident of Australia for tax purposes is generally only subject to Australian tax on Australian sourced income.
However, when it comes to capital gains tax, a foreign (tax) resident will not recognise a capital gain or loss on a CGT event which occurs to a CGT asset. That is, unless the asset is Taxable Australian Property (TAP).
The exclusion of capital gains over non TAP assets can provide significant advantages for a foreign resident who generate wealth through non depreciating capital assets which are not TAP.
It is worth noting immediately that the CGT exemption for non TAP assets does not extend to capital distributions to a foreign resident from a resident discretionary trust.
What is taxable australian property?
Taxable Australian Property (TAP) includes any real property a foreign resident owns and any indirect interest in Australian real property. By indirect interest, we refer to situations where a person has a membership interest in an entity and that membership interest satisfies certain tests as outlined below.
To be comprehensive, in addition to taxable Australian real property and indirect Australian real property interests, the following CGT assets are also TAP:
- The business assets of a Permanent Establishment in Australia.
- Option or rights to acquire any of the above.
- CGT assets that are deemed to be TAP where a taxpayer, on ceasing to be an Australian resident, makes a tax deferral election under section 104-165 of the Income Tax Assessment Act 1997.
The five categories of TAP are clarified below.
1. Taxable australian real property
Taxable Australian real property refers to any real property situated in Australia. It also includes leases over Australian land and certain other rights relating to mining, quarrying or prospecting.
2. Indirect real property interest
As mentioned above, TAP includes indirect interests in Australian real property that can be traced through interposed entities.
For example, if Marcela holds shares in a company and that company owns land in Australia, the membership interest of Marcela (her shares) may be classified as an indirect Australian Real Property interest making the shares TAP. In this way, if Marcela is a foreign resident for tax purposes, CGT will not be disregarded if a CGT event happens to the shares. The same principle applies to membership interests where there is chain of interposed entities between the foreign person and the entity which holds the real property. For example, if Marcela held shares in a company and that company was a unit holder in a unit trust that holds land. It is possible for the shares in the company to be TAP despite the company itself not being the owner of the land.
For there to be an indirect Australian real property interest, both of the below tests must be passed.
- The non portfolio interest test
- The principal asset test
The non portfolio interest test
The holding entity (e.g. a shareholder of a company) holds a direct interest in the test entity (the entity that owns the real property) and that direct interest, plus the direct interests of associates in that test entity exceeds 10%.
The threshold is tested at the time of the CGT event, or for any 12 month period within the 24 months leading up to the CGT event.
In respect of a company, a direct interest refers to the rights of a shareholder to:
- Paid up share capital, or
- Voting or rights to participate in decision making, or
- Profits of the company
In respect of a trust, a direct interest refers to the rights of a beneficiary to:
- Income which the beneficiary is entitled to, or
- Capital which the beneficiary is entitled to.
Principal asset test
For there to be an indirect interest in Australian real property, the principal asset test must also be satisfied. This test determines if the test entity’s underlying value is primarily attributed to ownership of Australian real property. That is, it tests to see if the test entity is a land rich entity.
The interest of a holding entity in the test entity will pass the principal asset test where more than 50% of the value of the test entity’s total assets relates to Australian real property.
A few things to note here:
- The value of the test entity’s assets is determined on the assumption that all assets were sold simultaneously to the same Buyer.
- Assets includes anything which has economic value and which the Buyer would for. For example, goodwill.
- If the assets of multiple entities are considered under this test, the market value of assets that are not taxable Australian real property assets which are exchanged between these entities should be disregarded to prevent dilution of the value of TAP compared with total asset values.
- Any arrangements or schemes designed to bypass this test (or the non portfolio interest test) may be scrutinised by the ATO. Remember that the ATO has anti avoidance powers that enable the cancellation of tax benefits achieved under a scheme and the imposition of penalties.
- There are complex rules in section 855-30 of the ITAA 1997 which deal with the treatment of assets of the test entity that are membership interests held in another entity (e.g. shares of the test entity in another entity). These membership interests can constitute taxable Australian real property and this may affect outcomes under the 50% test.
3. Permanent establishment in australia
Assets that a foreign resident has at any time used in carrying on a business through a permanent establishment can also be TAP. The meaning of permanent establishment is usually be set out in the relevant tax treaty (if any) between Australia and the country to which the foreign investor is a resident. If there is no tax treaty between the respective countries, the definition in section 6(1) of the ITAA 1936 may be used.
If the asset was only temporarily used in a permanent establishment, any capital gain on the asset is proportionally reduced for the period the asset was held but not used in the permanent established. Take as an example, Thomas, who is a tax resident of France. He carries on a business through a permanent establishment in Australia. He acquires a CGT asset on 1 July 2021 for $100,000 and immediately puts it to use in the business. On 1 July 2022, he ceases to the use the asset in the business. On 1 July 2023, he sells the asset for $300,000. In this instance, the capital gain is $200,000. However, for half of the period of ownership (365 days out of 730 days), the asset was not used in carrying on a business through a permanent establishment. Therefore, the gain is reduced in proportion to the time it was not used in the business as follows:
365 / 730 x $200,000 = $100,000.
Only $100,000 of the $200,000 capital gain is subject to Australian capital gains tax.
4. An option or right to acquire any of the above categories of TAP
5. An election made by an individual under section 104-165 of the ITAA 1997
Where an individual or entity becomes a non resident, the CGT assets of that individual or entity are subject to a taxing point for CGT purposes. Specifically, CGT event I1 happens to all the CGT assets of an Australian tax resident when that individual or entity becomes a non-resident. Section 104-165 of the ITAA 1997 enables an individual to make an election to defer any capital gain which flows from CGT event I1 being triggered. If the election is made, all the CGT assets of the taxpayer become TAP and capital gains tax is deferred until the first of either:
- The CGT asset being disposed; or
- The taxpayer again becoming an Australian tax resident.
Foreign residents who receive capital distributions from resident trusts
The tax law provides a CGT exemption where a foreign resident makes a capital gain in relation to an interest held in a fixed trust. This exemption is intended to align the treatment of capital gains which are made by foreign persons through direct investment (not subject to capital gains tax if not TAP) with capital gains distributed by fixed trusts.
The CGT exemption is applicable where:
- The interest holder is a foreign resident at the time the gain is made; and
- The gain is attributable to a CGT event occurring to a CGT asset of a trust; and
- That trust is a fixed trust; and
- The asset subject to the CGT event is not TAP for the trust at the time the CGT event occurs; or
- The asset which is subject to the CGT event is TAP but either (i) at least 90% of the value of the assets of the fixed trust are not TAP, or (ii) at least 90% of the value of the assets held by another fixed trust (in which the first fixed trust has an interest) are not TAP.
Importantly, the CGT exemption is not available in respect of capital entitlements of a foreign beneficiary which flow from a non fixed resident trust (e.g. a discretionary trust), even where the capital gain relates to an asset within the trust which is not inherently TAP.
Remember that these rules only relate to a resident trust that is distributing to a foreign person. By way of refresher, a resident trust for CGT purposes is a trust that has the following attributes:
For a non unit trust:
- the trustee is a tax resident of Australia; or
- the central management and control of the trust is based in Australia.
For a unit trust:
- the property of the trust is situated in Australia; or
- the trustee carries on a business in Australia; and
- either the central management control of the trust is based in Australia; or
- Australian residents hold greater than 50% of the beneficial interests in the income or capital of the trust.
If a non resident trust makes a capital gain, any capital gain happening to an asset of the trust that is not TAP which is distributed to beneficiaries is disregarded. However, note that section 99B of the ITAA 1936 may apply to include an amount (reflective of the gain) in the beneficiarys assessable income if the beneficiary is an Australian tax resident.
A non final withholding tax applies on the sale of TAP which flows to non-residents. This is designed to increase the prospects of recovering CGT from foreign residents who may otherwise be incentivised to avoid tax due to being located overseas.
This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.