Edited version of private advice

Authorisation Number: 1052018067168

Date of advice: 10 August 2022

Ruling

Subject: CGT - foreign income tax offset

Question

Will you be entitled to a Foreign Income Tax Offset (FITO) under Division 770 of the Income Tax Assessment Act 1997 (ITAA 1997) in relation to the foreign tax paid to Country A on your capital gain?

Answer

No

This ruling applies for the following period

Year ending 30 June 20XX

The scheme commences on

1 July 20XX

Relevant facts and circumstances

In April 20XX you were a resident of Country A and were employed by Company X.

You were granted Options under an Employee Share Scheme (ESS).

You were granted these Options according to Company X's Country A Share Option Plan as an employee of the company.

The terms of the Options are as follows:

Table deleted.

The options underlying the share (the Options) will become vested and exercisable with respect to XX% Options per annum every anniversary following the Vesting Commencement Date for a period of X consecutive years

A X into X share split occurred resulting in the exercise price changing from $X per share to $X per share.

Three tranches of the Options vested while you were an employee of Company X.

Your employment with Company X ended while you were residing in Country A.

The taxing point of all of the Options for ESS purposes occurred while you were a resident of Country A.

On XX January 20XX you became an Australian resident for tax purposes.

You have not worked as an employee for Company X since returning to Australia.

Company X was an unlisted company until September 20XX when it became a public company.

On XX January 20XX, you exercised the Options and acquired a number of Company X shares.

On XX November 20XX you sold some of the Shares and the net sale proceeds were $X.

You paid $X in tax to Country A's tax authorities.

On XX December 20XX you received a net amount of $X.

Assumption

For the purposes of this ruling it is assumed that there was no change in the market value of the options between when you became an Australian resident and when you exercised the Options.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 6-5 (2)

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 1110-25

Income Tax Assessment Act 1997 Subsection 770-10(1)

Income Tax Assessment Act 1997 Section 770-15

Income Tax Assessment Act 1997 Part 3-1

Income Tax Assessment Act 1997 Part 3-3

Income Tax Assessment Act 1997 Division 83A

Income Tax Assessment Act 1997 Subdivision 130-D

International Tax Agreements Act 1953.

Convention between the Government of Australia and the Government of the State of Israel for the Elimination of Double Taxation with respect to Taxes on Income and the Prevention of Tax Evasion and Avoidance.

Reasons for decision

Employee Share Scheme

An employee share scheme (ESS) is a scheme under which ESS interests in a company are provided to its employees (including current, past or prospective employees and their associates) in relation to their employment.

If the ESS provisions apply then they are first in priority. Other taxing provisions wait until the ESS component is complete.

The ESS provisions are contained in Division 83A of the ITAA 1997.

They recognise the dual nature of grants of shares (and rights to acquire shares) as both remuneration and investments. To this end, the ESS provisions provide a mechanism for recognising an appropriate value for remuneration purposes and an adjustment to the purchase price for investment purposes to reflect the amount treated as remuneration.

Whether an amount is included in a taxpayer's assessable income under the ESS rules will depend on the taxpayer's residency status and the source of the income.

An Australian resident taxpayer is subject to income tax on their worldwide income. A foreign resident taxpayer is only subject to Australian income tax on their Australian sourced income.

Whether the discount on the ESS interest acquired under an ESS relates to employment in Australia or outside Australia is a question of fact that needs to be determined on a case-by-case basis.

Paragraph 12.7 of the OCED Commentary about interpreting Tax Treaties states that generally options are considered to be earned between the grant date and the date they vest (and become exercisable). Options should not be considered to relate to any services rendered after they vest.

Application to your circumstances

You were granted a number Options under an ESS while working in Country A.

Three tranches of Options vested while you were working in Country A. These Options are considered to relate only to your employment in Country A and therefore have a Country A source.

The deferred taxing point for all of your vested ESS Options occurred while you were a resident of Country A. You lost your unvested Options when your employment ended.

The ESS discount is not assessable in Australia as the Options have a Country A source and you were a resident of Country A for taxation purposes at the time the deferred taxing point occurred.

Capital Gains Tax

After the ESS treatment of your options has been finalised, the capital gains tax provisions take over in respect of the CGT asset you owned at that time.

CGT event C2 happens when you exercise an option but any capital gain or loss you make due to exercising the option is disregarded (subsection 134 -1(4) of the ITAA 1997).

When you dispose of a CGT asset (for example, a share) CGT event A1 will happen (subsection 104-10(1) of the ITAA 1997).

You will make a capital gain from the disposal if the capital proceeds (the amount you receive or are entitled to receive from the event) from the disposal are more than the asset's cost base (subsection 104-10(4) of the ITAA 1997).

The first element of the cost base of a CGT asset that was an ESS interest is not based on the date that the deferred taxing point happened if they become an Australian resident at a later time.

Section 855-45 of the ITAA 1997 states that if you become an Australian resident, there are rules relevant to each CGT asset at you owned just before you became an Australian resident, except an asset:

(a)  that is taxable Australian property; or

(b)  that you acquired before 20 September 1985.

The first element of the cost base and reduced cost base of the asset (at the time you become an Australian resident) is its market value at that time.

The table in section 134-1(1) sets out how the cost base of shares acquired through the exercising of options is calculated.

The result is that the cost base of the options are folded into the cost base of the shares that are acquired as a result of exercising the option, together with any amount you paid to exercise the Options.

Application to your circumstances

You became an Australian resident for tax purposes on XX January 20XX.

At that time you owned a number of Options.

The first element of the cost base of your Options is their market value as at that date. You will need to seek assistance from Company X to work this out.

On XX January 20XX, you exercised the Options and acquired some Company X shares.

The first element of the cost base of your Company X shares is the cost base of the Options (unknown) together with any amount you paid to exercise the Options.

You sold some of these shares on XX November 20XX with the net sale proceeds being $X.

The amount of capital gain made on the disposal of the Company X shares is taxable in Australia.

CGT Discount

Subdivision 115-A of the ITAA 1997contains the rules for what is considered a discount capital gain.

Where you held the asset as an Australian resident individual for more than 12 months since the date of acquisition, the capital gain discount percentage you can apply to your capital gain is 50%.

Application to your circumstances

You acquired the Company X shares on XX January 20XX and held them until their disposal over 12 months later.

Therefore, you can apply a 50% discount to the capital gain you made on disposal.

Double Tax Agreements

Different countries can have differing income tax treatments for options that are granted as part of your remuneration. This can be important if you change your country of residence while owning such options or the shares acquired by exercising them.

Amounts may be taxed in Australia and may also be taxed in another country. This can potentially give rise to double taxation. To overcome this, Australia has a system of credits and exemptions and has signed tax treaties with more than 40 countries, including all our major trade and investment partners.

The foreign country Double Tax Agreements (DTAs) are contained under the International Tax Agreements Act 1953.

The Convention between the Government of Australia and the Government of the State of Israel for the Elimination of Double Taxation with respect to Taxes on Income and the Prevention of Tax Evasion and Avoidance (the Convention) acknowledges the dual nature of ESS as both remuneration for employment and investment. It does this by changing the operative Article at the time the options are exercised.

OECD commentaries provide tax authorities, taxpayers and judges with key insights on how DTAs should be applied.

Paragraph 4.6 of the Explanatory Memorandum for the New International Tax Arrangements (Foreign-owned Branches and Other Measures) Bill 2005 states:

4.6 The OECD commentary on the articles of the model tax convention is relevant in interpreting Australia's tax treaties. The revised commentary treats the benefit accruing up to the exercise of a right as an employment benefit to which Article 15 (Income from Employment) of the model tax convention applies. The commentary recognises that the facts and circumstances of the particular case will determine the period of employment to which the right relates. The number of days worked in a treaty country during this employment period then determines the extent of that country's source taxing rights.

Article 15 of the commentary on the model tax convention concerns the taxation of income from employment, and is particularly relevant. The treatment of employee stock options is discussed from paragraph 12.

The treatment of employee stock-options

The different country rules for taxing employee stock-options create particular problems which are discussed below. While many of these problems arise with respect to other forms of employee remuneration, particularly those that are based on the value of shares of the employer or a related company, they are particularly acute in the case of stock-options. This is largely due to the fact that stock-options are often taxed at a time (e.g. when the option is exercised or the shares sold) that is different from the time when the employment services that are remunerated through these options are rendered.

12.1 As noted in paragraph 2.2, the Article allows the State of source to tax the part of the stock-option benefit that constitutes remuneration derived from employment exercised in that State even if the tax is levied at a later time when the employee is no longer employed in that State.

12.2 While the Article applies to the employment benefit derived from a stock-option granted to an employee regardless of when that benefit is taxed, there is a need to distinguish that employment benefit from the capital gain that may be derived from the alienation of shares acquired upon the exercise of the option. This Article, and not Article 13, will apply to any benefit derived from the option itself until it has been exercised, sold or otherwise alienated (e.g. upon cancellation or acquisition by the employer or issuer). Once the option is exercised or alienated, however, the employment benefit has been realised and any subsequent gain on the acquired shares (i.e. the value of the shares that accrues after exercise) will be derived by the employee in his capacity of investor-shareholder and will be covered by Article 13. Indeed, it is at the time of exercise that the option, which is what the employee obtained from his employment, disappears and the recipient obtains the status of shareholder (and usually invests money in order to do so). Where, however, the option that has been exercised entitles the employee to acquire shares that will not irrevocably vest until the end of a period of required employment, it will be appropriate to apply this Article to the increase in value, if any, until the end of the required period of employment that is subsequent to the exercise of the option.

12.3 The fact that the Article does not apply to a benefit derived after the exercise or alienation of the option does not imply in any way that taxation of the employment income under domestic law must occur at the time of that exercise or alienation. As already noted, the Article does not impose any restriction as to when the relevant income may be taxed by the State of source. Thus, the State of source could tax the relevant income at the time the option is granted, at the time the option is exercised (or alienated), at the time the share is sold or at any other time. The State of source, however, may only tax the benefits attributable to the option itself and not what is attributable to the subsequent holding of shares acquired upon the exercise of that option (except in the circumstances described in the last sentence of the preceding paragraph).

12.4 Since paragraph 1 must be interpreted to apply to any benefit derived from the option until it has been exercised, sold or otherwise alienated, it does not matter how such benefit, or any part thereof, is characterised for domestic tax purposes. As a result, whilst the Article will be interpreted to allow the State of source to tax the benefits accruing up to the time when the option has been exercised, sold or otherwise alienated, it will be left to that State to decide how to tax such benefits, e.g. as either employment income or capital gain. If the State of source decides, for example, to impose a capital gains tax on the option when the employee ceases to be a resident of that country, that tax will be allowed under the Article. The same will be true in the State of residence. For example, while that State will have sole taxation right on the increase of value of the share obtained after exercise since this will be considered to fall under Article 13 of the Convention, it may well decide to tax such increase as employment income rather than as a capital gain under its domestic law.

Article 14 of the Convention states that salaries, wages and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State.

Up to the point where the options are exercised, Article 14 applies.

Article 13(5) of the Convention states gains from the alienation of any property other than that referred to in paragraphs 1, 2, 3 and 4 shall be taxable only in the Contracting State of which the alienator (taxpayer) is a resident, unless the taxpayer is not the beneficial owner of the gains.

Once the options are exercised, Article 13(5) then applies.

Application to your circumstance

You were a resident of Australia at the time the Company X shares were sold. Article 13(5) of the Convention only gives the taxpayer's country of residence the right to tax gains of a capital nature.

This applies to the whole of the gain made after you exercised the Options.

Australia is only taxing the capital gain you made after you exercised the Options (as there was no increase in value during the few days between you becoming an Australian resident and exercising them).

Therefore, the capital gain you made on the disposal of the Company X shares is taxable solely in Australia and Australia's taxing right is not limited by the Convention.

Foreign Income Tax Offset

Subsection 770-10(1) of the ITAA 1997 provides that a person is entitled to a FITO for foreign tax paid in respect of an amount that is included in the person's assessable income in a year of income.

The tax offset has the effect of reducing the Australian tax that would otherwise be payable on the double-taxed amount. A FITO is a non-refundable tax offset.

To determine the amount of FITO in any particular year, a person must first calculate the total foreign income tax paid on amounts included in their assessable income for the year.

Section 770-15 of the ITAA 1997 defines foreign income tax to include a tax on income that is imposed by a law other than an Australian law. A note to section 770-15 of the ITAA 1997 states that foreign income tax includes only that which has been correctly imposed under the foreign law.

Application to your circumstances

In your case you are an Australian resident for tax purposes who has paid tax in Country A on the capital gain you made on the disposal of the Company X shares.

The Convention assigns the sole taxing right on the capital gain to Australia.

Tax was withheld by your employer on the sale of the Company X shares and remitted to Country A's tax authority, presumably on the basis that you had been a resident of Country A for the whole of the period between the date the Options were granted and the date the Company X shares were sold.

However, the Convention has only given a taxing right to Country A for the period between the grant of the Options up until the date they were exercised. That means Country A does not have the right to tax any growth that has occurred after the Options were exercised.

As Australia is only taxing the growth that has occurred after the Options were exercised (under the CGT provisions) there should not be any amount that is subject to tax in both Country A and Australia.

The tax that you paid to Country A on the capital gain made on the disposal of the Company X shares was not correctly imposed according to the Convention. Therefore, you will not be entitled to a FITO.

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