Foreign income tax must have been paid on your income
To count towards a tax offset, the foreign income tax must have been paid on income, profits or gains that are included in your income for Australian income tax purposes.
For example, where a person receives a dividend from a foreign company, the foreign income tax on the underlying company profits (the source of the dividend) is not paid in respect of the shareholder’s dividend income. Similarly, a person receiving a pension from a foreign superannuation fund has not paid the foreign income tax levied on the income of the superannuation fund. In both of these cases, the tax that has been paid relates to the income or gains of the other entity, which is being taxed in its own right.
However, where an entity has been formed under a foreign country’s laws and profits are taxed in the hands of its members then income tax imposed by that country on a distribution to an Australian member may be counted towards their tax offset. This is the case even where the entity is treated as a company for Australian tax purposes and the distribution is characterised as a dividend.
Example 9: Foreign partnership treated as company and foreign income tax deemed to have paid for the dividend distribution
Aust Super Fund is a trustee of a complying superannuation entity and an Australian resident taxpayer with a 2% interest in a US limited partnership.
Under US tax law, the US limited partnership is treated as fiscally transparent, that is, it is not taxed on its profits, but tax is instead borne by the partners on their share of the partnership distribution.
Aust Super Fund’s share of the US limited partnership’s profits is $1 million, on which tax of $350,000 is withheld by the partnership (under US tax law). The tax is imposed in accordance with the Australia–US tax treaty.
Under Australian tax law, Aust Super Fund has not made an election under former subsection 485AA(1) of the ITAA 1936 or paragraph 830-10(2)(b) of the Income Tax Assessment Act 1997 (ITAA 1997) to treat the US limited partnership as a foreign hybrid limited partnership. Accordingly, the US limited partnership is taxed under Australian tax law as a company in accordance with Division 5A of Part III of the ITAA 1936.
The net amount of $650,000 received by Aust Super Fund is characterised as a dividend for Australian tax law purposes and is included in its assessable income. Although Aust Super Fund has not paid the US tax of $350,000 personally (as the US limited partnership has been taxed on the distribution on a withholding basis) it will be treated as having paid it, as the US tax is imposed on the distribution, rather than on the underlying profits, of the US limited partnership out of which the distribution is made.
Aust Super Fund is also required to gross-up its assessable income by the $350,000 of foreign income tax that it is deemed to have paid in relation to the dividend distribution.
End of example
Example 10: Foreign income tax paid on foreign property
A resident taxpayer receives rental income of $5,000 from foreign property, on which $1,000 of income tax is paid in the foreign country. As the resident taxpayer includes the $5,000 of rental income in their Australian assessable income, the requirement for the foreign income tax to be paid on income included in the resident taxpayer's Australian income has been met.
End of example
Foreign income tax paid on part of an amount included in your income
In some situations, only part of an amount on which foreign tax has been paid is included in Australian assessable income. When this occurs, only that proportion of the foreign income tax which equates to the proportion of foreign income included would be available as a tax offset.
In other situations, the foreign income tax paid relates to only part of an amount included in the taxpayer’s income for Australian income tax purposes. This typically applies where a foreign source gain on which foreign income tax has been paid is part of a net amount included in a taxpayer’s assessable income. When this occurs, the foreign income tax counts towards the tax offset only to the extent that it is paid in respect of that part of the amount that is included in the taxpayer’s assessable income.
For example, this may be relevant where a taxpayer has both a capital gain and a capital loss, and only the net amount is included in their assessable income. Under the rules applying to capital gains and capital losses, a taxpayer can choose the order in which capital losses are offset against gains. In particular, a taxpayer can choose to offset capital losses (whether current year or prior-year unapplied net capital losses) firstly against domestic capital gains or foreign gains on which no foreign tax has been paid. Such an ordering of the losses maximises the foreign source capital gain component of a net capital gain on which foreign income tax has been paid.
If only part of a foreign capital gain is assessable in Australia (for example, the gain is subject to the discount capital gains concessions in Division 115 of the ITAA 1997) the foreign tax paid on the gain must be apportioned accordingly.
Example 11: Foreign income tax paid on part of an amount included in assessable income
Company C derives the following capital gains and losses on disposals of assets during the year:
Domestic capital gain on land
Foreign capital gain on asset B
$50,000 (no foreign tax paid)
Foreign capital gain on asset C
$20,000 (on which foreign income tax of $2,000 is paid)
Domestic capital loss on asset A
Net capital gain
As the foreign income tax offset can only apply where foreign income tax has been paid on an amount included in the taxpayer assessable income, company C chooses to offset its domestic capital loss on asset A of $160,000; firstly against the domestic gain on land of $100,000; then $50,000 against the foreign capital gain on asset B on which no foreign income tax has been paid; and the balance of $10,000 against the foreign capital gain on asset C. Therefore, the net capital gain of $10,000 relates to the foreign capital gain on asset C. As this is the amount included in assessable income on which foreign income tax has been paid, the proportionate share of tax paid of $1,000 (that is, (10,000 ÷ 20,000) × 2,000) counts towards company C’s foreign income tax offset.
End of example
Where foreign income tax is paid on a foreign source gain, but the taxpayer is in an overall capital loss situation for the income year because of other capital losses, none of the foreign income tax paid counts towards a tax offset because the gain is not included in the taxpayer’s assessable income.
Example 12: No foreign income tax offset - foreign income not included in assessable income
On the sale of an asset, an Australian-resident taxpayer makes a foreign source capital gain of $10,000, on which foreign income tax of $2,000 has been paid.
The taxpayer also realises a capital loss of $10,000 on the disposal of an Australian asset.
The loss of $10,000 is offset against the foreign gain of $10,000, which results in no net capital gain being included in the taxpayer's assessable income. As their assessable income does not include an amount on which foreign income tax has been paid, the taxpayer is not eligible for a foreign income tax offset for the foreign income tax paid on the foreign source capital gain.
End of example
The same principle applies where foreign income tax has been paid on an amount that forms part of a partnership or trust’s assessable income, but because there is an overall partnership or trust loss for the year (rather than there being net income) the relevant foreign income is not included in the partner or beneficiary’s assessable income.
Deferred non-commercial business losses
Foreign income tax paid on foreign source business income counts towards a foreign income tax offset, regardless of whether there is a net business loss from the activity, because all foreign business income forms part of the taxpayer's assessable income. In this respect, the treatment of business losses differs from the treatment of a net capital gain where only the net amount is included in assessable income.
However, when calculating the offset limit similar principles apply for deferred business losses as apply for capital losses.
If a taxpayer has both Australian and foreign source income and prior-year deferred losses, from the same or similar business activity, they can choose whether the losses are taken to be a deduction against the business income from the Australian source or the foreign source. For example, they can choose to offset deferred losses firstly against Australian business income, until the Australian business income is reduced to nil, and then against the foreign business income.
Offsetting the losses in this way maximises the foreign source component of the net business income, which will maximise any claim for the foreign income tax offset.
Exempt or non-assessable non-exempt income
Foreign income tax paid on amounts that are exempt or non-assessable non-exempt (NANE) income in Australia does not count towards a foreign income tax offset, except where the taxpayer derives NANE income under section 23AI or 23AK of the ITAA 1936.
Example 13: No foreign income tax offset - NANE income
Austco, an Australian-resident company, wholly owns Foreignco, which pays a dividend of $10 million to Austco, out of which foreign income tax of $2 million is paid. This dividend is not paid out of previously attributed income. As the dividend is NANE income of Austco under section 768-5 of the ITAA 1997, the foreign income tax paid of $2 million does not count towards Austco’s tax offset.
End of example
Foreign income must be grossed up
Where you have paid foreign income tax on an amount that forms part of your assessable income, you must include the gross amount (including any tax paid by you) in your assessable income on your tax return.
Example 14: Grossing up foreign income
An Australian-resident taxpayer invests directly in a foreign company which pays a dividend of $100, from which it deducts $15 withholding tax.
The taxpayer must gross-up the net distribution of $85, adding the foreign income tax withheld of $15, to show $100 in their tax return as assessable income. This is the amount on which the taxpayer is assessed for income tax purposes.
End of example
A special grossing-up rule applies to attributable taxpayers that are deemed to have paid foreign income tax that is actually paid by their controlled foreign company (CFC). In respect of the attributed income of a CFC, a notional deduction is allowed for any foreign income tax, income tax or withholding tax it pays. The attributable taxpayer includes in their assessable income this net amount multiplied by their attribution percentage. As a result, the attributable taxpayer is effectively entitled to a deduction for foreign income tax, income tax or withholding tax paid on an amount included in the CFC's attributed income.
Where the attributable taxpayer is deemed to have paid the foreign income tax that is actually paid by the CFC and counts that towards their tax offset, they have to gross-up their attributed income by the amount of foreign income tax (including withholding tax) they are deemed to have paid.
There are special rules for claiming an offset for foreign income tax paid on attributed income.
Example 15: Grossing up foreign income - attributed income
A Co is an Australian-resident company with a 100% interest in Y Co, a controlled foreign company (CFC). Y Co works out its notional assessable income as $1.2 million and claims a notional allowable deduction of $200,000 for foreign tax paid by it, resulting in attributed income of $1 million. A Co includes the amount of $1 million in its assessable income under section 456 of the ITAA 1936, as its attribution percentage is 100%. A Co is also required to treat the foreign income tax paid by Y Co as having been paid by it under the special tax-paid deeming rules that apply to attributable taxpayers. As a result, A Co is required to gross-up its attributed income of $1 million by the $200,000 of foreign income tax that it is deemed to have paid.
End of example