Edited version of private advice

Authorisation Number: 1052130890556

Date of advice: 21 June 2023

Ruling

Subject: Employee share schemes - CGT - options

Question 1

Does Article 15 of the Convention between the Government of Australia and the Government of the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income as amended by the United States Protocol (No 1) (the Convention) permit the United States of America (US) to tax your director's fees and Options received as remuneration with respect to your role as a member of the board of directors of the US based Company (the Company), to the extent that relevant services were performed in the United States?

Answer

Yes

Question 2

Are you entitled to a foreign income tax offset under subsection 770-10(1) of the Income Tax Assessment Act 1997 (ITAA 1997) with respect to the US Federal income taxes paid on your director's fees and Options to the extent that tax has been correctly imposed by the US under the US Federal income tax law and the Convention?

Answer

Yes

Question 3

Are you entitled to a foreign income tax offset under subsection 770-10(1) of the ITAA 1997 in respect of the State income tax paid on your director's fees and Options with respect to your role as a member of the board of directors of the Company, to the extent that the tax is correctly imposed under State law?

Answer

Yes

Question 4

Are you entitled to claim US and State income tax as a foreign income tax offset irrespective of whether gains from the Options (and or resulting shares) are taxed in Australia under Division 83A of the Income Tax Assessment Act 1997 (ITAA 1997) or under the CGT provisions?

Answer

Yes

If you exercise the Options and immediately sell the Company shares, the ESS deferred taxing point for your Options will occur at the time you sell the shares acquired on exercise of the Options, as this will be within 30 days of exercise of the Options. Your assessable income for the income year in which the ESS deferred taxing point occurs will include the market value of the shares at the ESS deferred taxing point, reduced by the cost base of the shares, under section 83A-110(1) of the ITAA 1997.

Note: If you do not sell the shares within 30 days of exercise of the Options and the ESS deferred taxing point occurs when you exercise the Options, the capital gains tax provisions will apply to any gains made on the sale of the shares after the ESS deferred taxing point. To the extent that the whole of the capital gain on the sale of shares acquired on exercise of the Options is not taxable in Australia if the shares are held for more than 12 months and the gain is a discount capital gain, only a proportionate share of the foreign income tax would count towards the foreign income tax offset.

Question 5

Is a capital gain you make from sale of the Company shares acquired on exercise of the Options, that is transacted on a US stock exchange, US sourced for the purposes of subsection 770-10(3) of the ITAA 1997?

Answer

Yes

Question 6

Is the portion of the remuneration that may be taxed in the US under Article 15 of the Convention determined based on the number of board and committee meetings you attended in the US in your role as director between grant and vest (that is, the number of such meetings attended in person in US, as a proportion of the total number of such meetings attended, in person and/or remotely, between grant and vest)?

Answer

Yes

This private ruling applies for the following periods

The years ended 30 June 20XX to 30 June 20YY

This Ruling applies to Options granted after 30 June 2015

The scheme commenced on:

1 July 2015

Relevant facts and circumstances:

1.    You are an Australian citizen and also a US citizen.

2.    You resided in the US for many years prior to returning to reside permanently in Australia.

3.    You became a tax resident of Australia under subsection 6(1) of the Income Tax Assessment Act 1936 from a specific date.

4.    You are an Australian tax resident under Article 4 of the Convention.

5.    You have been a member of the board of directors (the Board) of the Company for a number of years. Since your appointment to the Board you have been a member of various Board committees.

6.    You attend most Board meetings in person in the US (travel restrictions permitting), while attending others remotely from Australia. You attend and use the Company's offices when you are in the US.

7.    Your remuneration included cash and options to acquire Company shares (Options), granted under the Company's Incentive plans.

8.    This Ruling applies to the Options awarded to you after 30 June 2015 and after returning to reside in Australia.

9.    The Options you were awarded vested over a period of time (some vested proportionately each month after grant, while others vested 25% after 12 months with the remainder vesting proportionately each month thereafter) and have an expiry date of up to seven (7) years after grant.

10.  Vesting of the Options was subject to your continued service to the Company and in the capacity for which the grant was made.

11.  All awards covered by this Ruling have vested but have not been exercised.

12.  The key terms of the Options granted to you were included in an Award Agreement made under the Incentive plans.

13.  Immediately after you acquired all of the above Options, you did not hold a beneficial interest in more than 10% of the shares of the Company nor were you in a position to cast or control the casting of more than 10% of the votes (taking into account and including the stock that you could acquire by exercising any Options you held and the holdings of your associates).

14.  Since being awarded the Options, the Company conducted a stock split. The terms of your Options were adjusted to reflect the stock split.

Taxation of the Options in the United States

Federal taxes

15.  As a US citizen, you are taxed on your worldwide income subject to the Convention.

Tax on Options

16.  You are subject to Federal Income tax (and US social security tax) on the Options when they are exercised.

17.  Any subsequent gain on sale of the stock acquired on exercise of the Options is taxed as a capital gain for Federal income tax purposes.

18.  The Options are non-statutory stock options (NSOs). NSOs are taxable under section 83 of the Internal Revenue Code.

19.  Your NSOs are taxable in the year that they are exercised because they do not have a readily determined fair market value at grant. At exercise, you are taxed on the difference between the fair market value of the stock received pursuant to the Option exercise and the amount paid for the stock (in your case, the exercise price).

20.  You hold the stock acquired as a result of the exercise of the Option as a capital asset. Your holding period for the stock begins when you acquire the stock on exercise.

21.  You may make a capital gain when you sell the stock for more than your adjusted basis. The amount of the capital gain will be the selling price reduced by your basis in the stock (the amount paid for the exercise of the option and any amount included in income upon the option's exercise).

22.  The gain will be a long term capital gain if you held the stock for more than one year and a lower tax rate may apply to the gain than the tax rate that applies to your ordinary income.

23.  You would be taxable on the Options in the United States upon exercise to the extent the income is US sourced regardless of whether you are a tax resident of the US. Directors' fees earned by a non-resident in the US are considered to be effectively connected income with a trade or business in the United States. Income received during the tax year that is effectively connected with a trade or business in the United States is, after allowable deductions, taxed at the graduated rates that apply to U.S. citizens and resident aliens.

24.  The US considers that the days worked in the US is the appropriate basis for determining US source under the Convention.

25.  The US law and regulations provide that compensation should be sourced based on where the services are performed. You have filed your returns in the US based on where you attended board meetings. You consider this a reasonable approximation of the US/rest-of-the-world workdays apportionment. Your returns in the US have been prepared and accepted on this basis.

State taxes on Options

26.  You are not a resident of the State.

27.  You are subject to income tax on the Options in the State.

28.  An NSO that did not have a readily ascertainable fair market value at the time it was granted to a director is subject to income tax at the time the option is exercised. Income tax is assessed at the time of exercise on the difference between the fair market value of the stock received pursuant to the exercise of the Option and the amount paid for the stock.

29.  Non-residents of the State are subject to tax only on income sourced in the State. Income paid to an independent director, who is a non-resident of the State, for services performed for a company is sourced to the State where that is where the highest ranking corporate officers carry out the board of director's directions.

30.  The Company was based in the State and that is where the highest ranking corporate officer's carried out the Board's directions.

Assumptions

31.  You will continue to be an Australian tax resident under Article 4 of the Australia/United States Double Tax Agreement for the rest of the applicable ruling period.

32.  You will exercise the Options and immediately sell the Company shares.

Reasons for decision

Question 1

Summary

You will be an Australian resident under Article 4 of the Convention at the time when an amount of income in respect of the Options is included in your assessable income under Division 83A of the ITAA 1997. Therefore, Australia is the country of residence for the purposes of Article 15 of the Convention and may tax the income, regardless of whether it is sourced from Australia or the US.

The US will be entitled to tax the income to the extent that the services you provide as a director of the board of the Company are performed in the US.

Australia has an obligation to provide a tax credit for tax paid in the US in accordance with Article 22 of the Convention.

Detailed reasoning

Division 83A of the ITAA 1997

1.    The combined effect of section 83A-20 and paragraph 83A-105(1)(a) is that Division 83A (and, in particular, either Subdivision 83A-B or 83A-C) will apply to an ESS interest if you acquire the interest under an employee share scheme and at a discount.

2.    Division 83A of the ITAA 1997 will apply to the Options you acquired because you acquired the Options at a discount (you did not pay anything for the Options and the Options had a value greater than nil[1]).

3.    Subdivision 83A-C of the ITAA 1997 applies to your Options because all of the applicable conditions in subsection 83A-105(1) are met.

• The condition in paragraph 83A-105(1)(a) of the ITAA 1997 is met because the Options are acquired under an employee share scheme (as defined in subsection 83A-10((1)) and at a discount.
• The conditions in paragraphs 83A-105(1)(aa) and (ab) are met.
• The conditions in paragraph 83A-105(1)(b) of the ITAA 1997 are met because:

-       You are employed (within the expanded definition of employment in section 83A-325) by the Company [83A-45(1)];

-       the ESS interests available under the ESS relate to ordinary shares (common stock of the Company) [83A-45(2)];

-       the Company's predominant business is not the acquisition, sale or holding of shares, securities or other investments [83A-45(3)]; and

-       immediately after acquisition of the Options you do not hold a beneficial interest in more than 10% of the shares in the Company nor will your be in a position to cast, or control the casting of, more than 10% of the votes [83A-45(6)] taking into account and including any shares and any voting rights that you would have by exercising any rights you have over shares (subsection 83A-45(7)) and the holdings of your associates (83A-305(2)).

• the condition in paragraph 83A-105(1)(d) is met because subsection 83A-105(3) applies to the Options. We agree that when you acquired the Options there was a real risk that you would forfeit or lose them before the date that they vested.

4.    Section 83A-110 provides that your assessable income for the income year in which the ESS deferred taxing point occurs includes the market value of the ESS interest at the ESS deferred taxing point reduced by the cost base of the interest.

5.    The ESS deferred taxing point for a right is determined under section 83A-120.

6.    Relevantly, the deferred taxing point for the Options is when the ESS interest is exercised and there is no real risk of forfeiting the share and the scheme no longer genuinely restricts disposal of the share (subsection 83A-120(7)).

7.    However, the ESS deferred taxing point for the interest is the time the taxpayer disposes of the interest (other than by exercising the right) or the beneficial interest in the share if that time occurs within 30 days after the time worked out above: subsection 83A-120(3).

8.    Section 83A-125 deals with the tax treatment of ESS interests held after the ESS deferred taxing point. It states: "For the purposes of this Act (other than this Division), the ESS interest (and the share or right of which it forms part) is taken to have been acquired immediately after the ESS deferred taxing point for the interest for its market value, unless the ESS deferred taxing point occurs at the time the interest is disposed of."

9.    Under section 83A-125 of the ITAA 1997, relevantly the share is taken to have been acquired "immediately after" the ESS deferred taxing point for the ESS interest for its market value, for the purposes of the ITAA 1997 (other than Division 83A).

Foreign employment and Division 83A

10.  The actual liability to tax in Australia on employee share scheme discounts is determined by Division 83A of the ITAA 1997 in concert with Division 6 of the ITAA 1997.

11.  Both subsections 83A-25(2) and 83A-110(2) of the ITAA 1997 merely define the component of an employee share scheme discount that relates to foreign employment as having a foreign source.

12.  Subsection 6-5(2) of the ITAA 1997 provides that the taxpayer's assessable income includes ordinary income derived directly or indirectly from all sources whether in or out of Australia during the income year. Subsection 6-10(4) of the ITAA 1997 provides that the assessable income of an Australian resident taxpayer includes statutory income from all sources, whether in or out of Australia.

13.  Under ordinary income rules and common law, the Options would be 'derived' at the time of grant (Abbott v. Philbin (1961) AC 352 and Donaldson v. Commissioner of Taxation (Cth) [1974] 1 NSWLR 627). Division 83A can change what would otherwise be considered to be income under ordinary concepts and does not rely on the common law or ordinary income concepts of derivation. As Division 83A is a statutory income regime, derivation is not relevant.

14.  As statutory income, the actual amount to be included in assessable income is determined by either subsection 6-10(4) of the ITAA 1997 for Australian residents or subsection 6-10(5) of the ITAA 1997 for foreign residents.

15.  Paragraphs 1.347 to 1.357 of the Explanatory Memorandum for the Tax Laws Amendment (2009 Budget Measures No. 2) Bill 2009 confirm this intention and states:

1.347 Consistent with the treatment of most other types of income, whether an amount is included in a taxpayer's assessable income under the new employee share scheme rules will depend on the taxpayer's residency status and the source of the income.

1.348 Under the core rules of the Australian income tax system, 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.

1.349 Under the existing law, this outcome is achieved by excluding discounts from interests acquired under employee share schemes from tax under the employee share scheme tax rules, to the extent that they relate to foreign service of a taxpayer.

1.350 This mechanism operates in a manner inconsistent with core rules. The new rules use the core rules to achieve the desired outcome. The new rules instead include source rules and rely on the core rules to exclude foreign sourced income of foreign residents from Australian income tax. That is, the employee share scheme rules attribute a source to discounts received on securities acquired under employee share schemes.

1.351 To the extent that a discount on an ESS interest relates to employment outside Australia, the discount is taken to be from a foreign source. In the case of an ESS interest that is subject to a deferred taxing point, it is the amount included in your assessable income that is attributed a source (that is, both the discount and subsequent gains are attributed with a source). The attribution is done in manner consistent with the rule applying to discounts. [Schedule 1, item 1, subsections 83A-25(2) and 83A-110(2)]

1.352 The apportionment between foreign sourced and Australian sourced income is to be done in a manner consistent with Organisation for Economic Development and Cooperation (OECD) practice, as explained in the explanatory memorandum to the New International Tax Arrangements (Foreign-owned Branches and Other Measures) Bill 2005.

1.353 Source is attributed to amounts 'included' in assessable income either upfront or under the deferral method at the ESS deferred taxing point. The inclusion in assessable income is merely notional as all amounts included in assessable income must pass through the core rules before being taken into account in the calculation of taxable income. At this time foreign sourced income of foreign residents will be removed from the calculation of taxable income.

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

1.355 Australian resident taxpayers are subject to Australian income tax on all discounts they receive under employee share schemes regardless of whether they received it in relation to employment in Australia or outside Australia. However, this may be affected by Australia's double tax treaties and the temporary residents rules. [emphasis added]

1.356 Foreign resident taxpayers are only subject to Australian income tax on discounts they receive under employee share schemes to the extent that the discount relates to the employment in Australia. The core rules are contained in sections 6-5 and 6-10 of the ITAA 1997.

1.357 The outcome effectively mirrors the tax treatment of employment income. It has been necessary to modify the treatment of employee share scheme discounts received in respect of employment outside Australia in order to bring the employee share scheme rules into closer alignment with the ordinary treatment of salary and wage income and to prevent taxpayers avoiding the recent changes to section 23AG of the ITAA 1936 (exemption for foreign employment income).

16.  In determining liability to tax in Australia, it is necessary to consider any applicable tax treaty contained in the International Tax Agreements Act 1953 (the Agreements Act). Section 4 of the Agreements Act incorporates the ITAA 1936 and the ITAA 1997 into the Agreements Act so that all those Acts are read as one. The Agreements Act effectively prevails over the ITAA 1936 and the ITAA 1997 where there are inconsistent provisions (except for limited situations not relevant for present purposes).

17.  A tax treaty does not give a contracting state power to tax, or oblige it to tax an amount over which it is allocated the right to tax by the treaty[2].

The Convention

18.  Article 1 of the Convention between the Government of Australia and the Government of the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income as amended by the United States Protocol (No 1) (the Convention) provides that the Convention will apply to persons who are residents of either Australia or the United States.

19.  The situation of persons, other than companies, who are dual residents (i.e. residents of both countries), is dealt with in Article 4.

20.  Since a specified date, you have been an Australian tax resident under Article 4 of the Convention. This ruling is on the assumption that you will be an Australian tax resident for the duration of applicable the ruling period.

21.  Therefore, as the Convention applies to you, any relevant domestic tax law provisions (such as Division 83A) will operate as necessarily modified by the Convention.

Article 15 - Dependent Personal Service Income

22.  Article 15 deals with income derived from 'dependent personal services'. Article 15(1) relevantly provides:

Subject to the provisions of Articles 18 (Pensions, Annuities, Alimony and Child Support) and 19 (Governmental Remuneration), salaries, wages and other similar remuneration derived by an individual who is a resident of one of the Contracting States in respect of an employment or in respect of services performed as a director of a company shall be taxable only in that State unless the employment is exercised or the services performed in the other Contracting State. If the employment is so exercised or the services so performed, such remuneration as is derived from that exercise or performance may be taxed in that other State.

23.  Article 15 permits both the country of source and the country of residence to tax salaries, wages and other similar remuneration derived by an individual who is a resident of one of the Contracting States in respect of an employment or in respect of services performed as a director of a company in the country of source.

24.  The country of residence retains its right to tax the individual's income, but the country of source (being the place where the employment is exercised or the services are performed) is also permitted to tax the income and, to the extent to which it does so, the country of residence must provide relief for tax paid in the country of source in accordance with the Convention.

25.  It is considered that the income falls within Article 15 because it is a benefit or gain in kind that arises from, and is for, the services you provided as a director of the Company. The term 'salaries, wages and other similar remuneration' is generally understood to include benefits in kind received in respect of employment or services rendered.

26.  Article 15(1) engages at the point when the item of income, here being the remuneration that is subject to tax under Division 83A, is included as income of the individual.

27.  At all relevant times, you are an Australian tax resident under Article 4 of the Convention. Therefore, Australia is the state of residence for the purposes of the Convention and is entitled to tax the remuneration (i.e. the Options) under Article 15 of the Convention.

28.  The US is also entitled to tax the remuneration under Article 15 to the extent that the services performed in respect to which the remuneration is derived, are exercised or performed in the US.

29.  Article 22 of the Convention provides:

(2) Subject to paragraph (4), United States tax paid under the law of the United States and in accordance with this Convention, other than United States tax imposed in accordance with paragraph (3) of Article 1 (Personal Scope) solely by reason of citizenship or by reason of an election by an individual under United States domestic law to be taxed as a resident of the United States, in respect of income derived from sources in the United States by a person who, under Australian law relating to Australian tax, is a resident of Australia shall be allowed as a credit against Australian tax payable in respect of the income. The credit shall not exceed the amount of Australian tax payable on the income or any class thereof or on income from sources outside Australia. Subject to these general principles, the credit shall be in accordance with the provisions and subject to the limitations of the law of Australia as that law may be in force from time to time.

...

(4) For the purposes of computing United States tax, where a United States citizen is a resident of Australia, the United States shall allow as a credit against United States tax the income tax paid to Australia after the credit referred to in paragraph (2). The credit so allowed against United States tax shall not reduce that portion of the United States tax that is creditable against Australian tax in accordance with paragraph (2).

30.  Further, relevantly Article 27(1) of the Convention provides that:

(b) Income derived by a resident of Australia which, under this Convention, may be taxed in the United States, other than income taxed by the United States in accordance with paragraph (3) of Article 1 (Personal Scope) solely by reason of citizenship or by reason of an election by an individual under United States domestic law to be taxed as a resident of the United States, shall for the purposes of paragraph (2) of Article 22 (Relief from Double Taxation) and of the income tax law of Australia be deemed to be income from sources in the United States.

31.  This means that, ordinarily, the amounts attributable to your Australian and US employment are determined in accordance with Article 15 (rather than Division 83A which is modified by the outcome determined under Article 15). Further, by the operation of Article 27 of the Convention, the amounts so determined by Article 15 will be taken to have an Australian and US source respectively.

32.  Article 22(2) of the Convention obliges Australia to provide a credit. The domestic law provisions in Division 770 have been enacted in satisfaction of that obligation.

Question 2

Summary

You will be entitled to a foreign income tax offset with respect to the US Federal income taxes paid on your director's fees and Options under subsection 770-10(1) to the extent the tax has been correctly imposed by the US under the US Federal income tax law and the Convention. The amount of foreign income tax that counts towards the tax offset is the amount you paid in respect of an amount that is all or part of an amount included in your assessable income.

Detailed reasoning

33.  Subsection 770-10(1) of the ITAA 1997 provides that you are entitled to a tax offset for an income year for foreign income tax. An amount of foreign income tax counts towards the tax offset for the year if you paid it in respect of an amount that is all, or part of an amount included in your assessable income for the year.

34.  The tax offset is for the income year in which your assessable income included an amount in respect of which you paid foreign income tax - even if you paid the foreign income tax in another income year.

35.  Subsection 770-15(1) defines 'foreign income tax' to mean, for present purposes, tax that is imposed by a law other than an Australian law and is a tax on income or tax on profits or gains, whether of an income or capital nature.

36.  The note to subsection 770-15(1) states:

Foreign income tax includes only that which has been correctly imposed in accordance with the relevant foreign law or, where the foreign jurisdiction has a tax treaty with Australia (having the force of law under the International Tax Agreements Act 1953 ), has been correctly imposed in accordance with that tax treaty.

37.  You are required to pay US Federal income taxes in accordance with the Internal Revenue Code, a law other than an Australian law. Furthermore, the tax imposed by the Code is a tax on your income, profits or gains. Accordingly, tax paid by you in the US under the Code is 'foreign income tax' as defined.

38.  Where the foreign jurisdiction has a tax treaty with Australia, the foreign income tax includes only the tax that has been correctly imposed in accordance with that tax treaty.

39.  As the US taxes the income from the ESS interests to the extent that the income relates to services that you performed as a director of the Company in the US, the income is taxed in accordance with the Convention (Article 15).

40.  Therefore, the conditions in subsection 770-15(1) have been satisfied.

41.  Subsection 770-10(3) provides that foreign income tax does not count toward the tax offset for the year if that tax is paid to a foreign country because the taxpayer is a resident of that country for tax purposes and in respect of amounts sourced outside that country.

42.  The tax on the income from the ESS interests would be payable by you in the US regardless of whether you are a resident of the US for tax purposes or not. It is payable in respects of amounts sourced in the US (where the services are provided as a director of the Company). Therefore, the tax will not be paid because you were a resident of the US in respect of amounts sourced outside the US. Subsection 770-10(3) does not apply to deny you a foreign income tax offset.

Foreign income tax offset limit

43.  Subsection 770-75(2) provides that the amount of the foreign income tax that counts towards the foreign income tax offset is subject to the foreign income tax offset limit.

44.  Where the taxpayer is claiming a foreign income tax offset of more than $1,000, he or she must calculate their foreign income tax offset limit. If the amount of the foreign income tax offset exceeds the limit, then the tax offset must be reduced by the amount of the excess to the amount of the limit. Any foreign income tax paid in excess of the limit is not available to be carried forward to a later income year and cannot be refunded to the taxpayer.

Question 3

Summary

You are entitled to a foreign income tax offsetunder subsection 770-10(1)in respect of the State income tax paid on your director's fees and Options with respect to your role as a member of the Board to the extent that the tax is correctly imposed under State law.

Detailed reasoning

45.  In order to be entitled to a tax offset for foreign income tax under subsection 770-10(1), a taxpayer must have paid an amount of foreign tax in relation to an amount included in their assessable income.

46.  Subsection 770-15(1) defines 'foreign income tax' to mean, for present purposes, tax that is imposed by a law other than an Australian law and is a tax on income or tax on profits or gains, whether of an income or capital nature.

47.  The note to subsection 770-15(1) states:

Foreign income tax includes only that which has been correctly imposed in accordance with the relevant foreign law or, where the foreign jurisdiction has a tax treaty with Australia (having the force of law under the International Tax Agreements Act 1953), has been correctly imposed in accordance with that tax treaty.

48.  Taxation Ruling IT 2507 Income tax: foreign tax credit system - foreign taxes eligible for credit against Australian income tax, contains a non-exhaustive list of foreign taxes which were recognised as creditable taxes under the former foreign tax credit system (replaced by the foreign income tax offset provisions). It is noted that it did cover personal income taxes in the State.

49.  The Guide to foreign income tax offset rules 2022, ATO document QC 67996, confirms that the foreign income tax may be imposed at a national, state, provincial, local, municipal or supra-national level (an example of a supra-national tax is that imposed by the European Union on pensions paid to its former employees.)

50.  The State personal income tax is a tax that is imposed by a law other than an Australian law and is a tax on income or profits or gains, whether of an income or capital nature. Accordingly, personal income tax paid by you in the State on your Options is 'foreign income tax' as defined.

51.  Subsection 770-10(3) provides that foreign income tax does not count toward the tax offset for the year if that tax is paid to a foreign country because the taxpayer is a resident of that country for tax purposes and in respect of amounts sourced outside that country.

52.  The State tax in question is being imposed on you because it is considered to have a State source. The services performed as a director of a board of a Company is considered to have a State source if the highest ranking corporate officers carried out the Board's directions in the State.

53.  Therefore, it is not covered by subsection 770-10(3) and this subsection does not deny you a foreign income tax offset for the State income tax paid.

Question 4 & Question 5

Summary

You are entitled to claim US Federal income tax and State income tax as a foreign income tax offset in accordance with the provisions in Division 770 of the ITAA 1997, irrespective of whether any gains from the Options (and/or resulting shares) are taxed in Australia under Division 83A or under the CGT provisions.

A capital gain you make from the sale of the Company shares acquired on exercise of the Options, being transacted on a US stock exchange, is US sourced for the purposes of subsection 770-10(3) of the ITAA 1997.

However, to the extent that the whole of the capital gain on the sale of shares acquired on exercise of the Options is not taxable in Australia because the gain is a discount capital gain (the gain from the relevant ESS deferred taxing point for the Options to the sale of the shares) only a proportionate share of the foreign income tax would count towards the foreign income tax offset.

Once the Options have been exercised Article 15 of the Convention will not apply to the gain. The relevant Article of the Convention is Article 13 of the Convention.

Detailed reasoning

The Convention

54.  Taxation Ruling TR 2001/13 provides the Commissioner's views on interpreting tax treaties.

55.  At paragraph 104 of TR 2001/13, the ruling states that the 'OECD Model Tax Convention on Income and on Capital' (OECD Model) and Commentary (OECD Commentary), along with the various observations and reservations of the member countries as a matter of practice will often need to be considered in the application of tax treaties, at least where the wording is ambiguous. Paragraph 108 of the ruling notes that changes to the OECD Commentary are usually not expressed as forming a new meaning but as reflecting a common view as to what the meaning is and always has been. Unless it is apparent that the substance of the OECD Model has changed since a tax treaty was negotiated or the treaty does not conform to the OECD Model or it is clear that an interpretation has been substantially altered, the ATO considers it appropriate to at least consider the most recently adopted OECD Commentaries.

56.  In this case, the OECD Commentary on Article 15 of the OECD Model is most relevant (as opposed to Article 16 Director's Fees) as it closely resembles the relevant Article 15 in the Convention, which also covers remuneration for services performed as a director of a company.

57.  The OECD Commentary on Article 15 explains that the general rule is that income from employment is taxable in the State where the employment is actually exercised. Employment is exercised in the place where the employee is physically present when performing the activities for which the employment income is paid (Paragraph 1).

58.  The OECD Commentary specifically addresses the treatment of employee stock options. It notes that the problem of double taxation can be particularly acute for stock-options because they are often taxed at a time that is different from when the services are exercised e.g. when option is exercised or sold (Paragraph 2.1).

59.  It states that Article 15 allows the State of source to tax the part of the 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 (paragraph 12.1). The article does not impose any restriction as to when the tax may be levied by the State of source (paragraph 12.3).

60.  The OECD Commentary explains (paragraph 12.2) that it is however necessary to distinguish between an employment benefit and the capital gain that may be derived from the alienation of shares the subject of the Options. Article 15, and not Article 13, applies to any employment benefit derived from a stock option until it is exercised, sold or otherwise alienated, and therefore, it doesn't matter how the benefit is characterised for domestic law purposes (e.g. as income or capital).

61.  The Article will be interpreted to allow the State of source to tax the benefits accruing up to the time the option is exercised, sold or otherwise alienated but it is left to the State to decide how to tax such benefits (paragraph 12.4). The commentary notes the distinction between the employment benefit and any subsequent capital gain from alienation of the shares acquired on exercise of the option. Once the option has been exercised or alienated the employment benefit has been realised and any subsequent gain on the shares is derived in the capacity as shareholder and will be covered by Article 13 (unless the shares will not irrevocably vest until an employment service period has been satisfied where it will be appropriate to apply Article 15 to the gain until the employment period is satisfied): see paragraph 12.2.

62.  It is considered that the Convention should be interpreted consistently with the OECD Commentary on employee stock-options.

63.  Therefore, for the period between grant and exercise it is considered that Article 15 of the Convention will apply with respect to US Federal taxes. The US is entitled to tax the benefit to the extent that the services are provided in the US.

64.  Article 13 of the Convention relevantly provides:

... each Contracting State may tax capital gains in accordance with the provisions of its domestic law.

65.  Therefore, following exercise of the Option, the Convention permits both Contracting States to tax any capital gains in accordance with the provisions of the domestic law.

66.  Under Article 22(2) of the Convention:

Subject to paragraph (4), United States tax paid under the law of the United States and in accordance with this Convention, other than United States tax imposed in accordance with paragraph (3) of Article 1 (Personal Scope) solely by reason of citizenship or by reason of an election by an individual under United States domestic law to be taxed as a resident of the United States, in respect of income derived from sources in the United States by a person who, under Australian law relating to Australian tax, is a resident of Australia shall be allowed as a credit against Australian tax payable in respect of the income. The credit shall not exceed the amount of Australian tax payable on the income or any class thereof or on income from sources outside Australia. Subject to these general principles, the credit shall be in accordance with the provisions and subject to the limitations of the law of Australia as that law may be in force from time to time.

67.  Further, relevantly Article 27(1) of the Convention provides that:

(b) Income derived by a resident of Australia which, under this Convention, may be taxed in the United States, other than income taxed by the United States in accordance with paragraph (3) of Article 1 (Personal Scope) solely by reason of citizenship or by reason of an election by an individual under United States domestic law to be taxed as a resident of the United States, shall for the purposes of paragraph (2) of Article 22 (Relief from Double Taxation) and of the income tax law of Australia be deemed to be income from sources in the United States.

68.  As capital gains are able to be taxed by the US in accordance with Article 13 (and not by reason of Article 1(3)), Australia will be required under the Convention to grant tax relief to the extent that the taxes are correctly imposed in accordance with the US Federal tax law and the Convention in respect of gains derived from sources in the US and such that the credit shall not exceed the amount of Australian income tax payable on the income from sources outside Australia.

Capital Gains Tax treatment in Australia

69.  As all of the Options covered by this Ruling were granted to you after you became an Australian resident, section 855-45 is not relevant to these Options.

70.  Subsection 130-80(1) of the ITAA 1997 operates to disregard any capital gain or capital loss to the extent it results from a CGT event (other than where the capital gain or loss results from CGT events E4, G1 or K8) if the CGT event happens in relation to an ESS interest you acquire under an employee share scheme and, if subdivision 83A-C applies to the interest:

• the time of the acquisition is the time when the CGT event happens; or
• the CGT event happens on or before the ESS deferred taxing point for the interest.

71.  As subdivision 83A-C applies to the Options, the effect of subsection 130-80(1) is to disregard the capital gain or capital loss from CGT events that happen from the time of acquisition up until the ESS deferred taxing point.

72.  Once the ESS deferred taxing point happens to an ESS interest, section 83A-125 operates to reset the cost base of the right or the share (as relevant), at its market value unless the deferred taxing point occurs at the time the right is disposed of, or if the right is exercised, the time the share is disposed of (if that time occurs within 30 days after the time that would otherwise be the ESS deferred taxing point)

73.  After the ESS treatment of your Options under Division 83A has been finalised, the capital gains tax provisions take over in respect of the CGT asset you owned at that time.

74.  The ESS deferred taxing point for your Options will occur at the time you exercise the Options or, if you sell the shares acquired on exercise of the Options within 30 days of exercise, the time that you sell the shares.

75.  If you do not dispose of the shares acquired on exercise of the Options within 30 days of exercise, CGT event A1 will happen (subsection 104-10(1) of the ITAA 1997) when you dispose of the shares.

76.  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).

77.  Subdivision 115-A of the ITAA 1997 contains the rules for what is considered a discount capital gain. Where you hold 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%.

78.  Where you exercise the Options and hold the shares for more than 12 months before sale, the capital gain will qualify as a discount capital gain.

FITO provisions

79.  Subsection 770-10(1) of the ITAA 1997 provides that you are entitled to a tax offset for an income year for foreign income tax. An amount of foreign income tax counts towards the tax offset for the year if you paid it in respect of an amount that is all, or part of an amount included in your assessable income for the year.

80.  The tax offset is for the income year in which your assessable income included an amount in respect of which you paid foreign income tax - even if you paid the foreign income tax in another income year.

81.  Subsection 770-15(1) defines 'foreign income tax' to mean, for present purposes, tax that is imposed by a law other than an Australian law and is a tax on income or tax on profits or gains, whether of an income or capital nature.

82.  The note to subsection 770-15(1) states:

Foreign income tax includes only that which has been correctly imposed in accordance with the relevant foreign law or, where the foreign jurisdiction has a tax treaty with Australia (having the force of law under the International Tax Agreements Act 1953), has been correctly imposed in accordance with that tax treaty.

83.  Subsection 770-10(3) provides that foreign income tax does not count toward the tax offset for the year if that tax is paid to a foreign country because the taxpayer is a resident of that country for tax purposes and in respect of amounts sourced outside that country.

84.  The tax imposed by the US on the capital gains made on the shares is paid to the US because the taxpayer is a resident of that country. However, to the extent that it is not paid in respect of amounts sourced outside that country it will be eligible for a foreign income tax offset.

85.  ATO Interpretative Decision ATO ID 2010/54 Income Tax Capital Gains Tax: foreign source capital gains made by a resident trust for CGT purposesrelevantly states:

Facts

The trustee owns shares in foreign companies that are listed on stock exchanges located in foreign jurisdictions. The shares are all traded on foreign stock exchanges. The trustee engages the services of an overseas broker for all trades. Different overseas brokers are used for different trades on particular stock exchanges. No retainer was paid to any overseas broker.

The trustee decides which investments to buy and sell. Overseas brokers act only under the orders of the trustee. No overseas broker has a power of attorney to conclude contracts without the approval of the trustee. The issue in this case is whether capital gains from the disposal of the shares by the trustee are sourced in Australia. The capital gains tax provisions do not contain any provision that expressly determines the source of a capital gain, or net capital gain, for the purposes of Division 6 of Part III of the ITAA 1936. The 'taxable Australian property' tests in section 855-15 of the ITAA 1997 are not relevant for this purpose.

Reasons for decision

In the absence of a statutory source rule for capital gains for the purposes of Division 6 of Part III of the ITAA 1936, reliance is appropriately placed on the common law source rules as they relate to income, notwithstanding that net capital gains are a form of statutory income.

In Nathan v. Federal Commissioner of Taxation (1918) 25 CLR 183 at 189-190, Isaacs J said:

The Legislature in using the word "source" meant, not a legal concept, but something which a practical man would regard as a real source of income. Legal concepts must, or course, enter into the question when we have to consider to whom a given source belongs. But, the ascertainment of the actual source of a given income is a practical, hard matter of fact. The Act on examination so treats it.

In Federal Commissioner of Taxation v. Efstathakis (1979) 38 FLR 276 at 280; 79 ATC 4256 at 4259; 9 ATR 867 at 870 Bowen CJ stated 'the answer is not to be found in the cases, but in the weighting of the relative importance of the various factors which the cases have shown to be relevant.' Also, Kennedy J in Cliffs International Inc v. Commissioner of Taxation (Cth) (1985) 80 FLR 12; 85 ATC 4374; (1985) 16 ATR 601 stated 'there is no simple universal rule which can be applied to identify the source of any particular income. In some cases, particular features may be determinative. In others, they may not.'

The leading Australian authority on the source of profits from the sale of shares is Australian Machinery and Investments Company Ltd v. Deputy Commissioner of Taxation (WA) (1946) 180 CLR 9; 3 AITR 359; (1946) 8 ATD 81, where it was held that where shares are situated outside Australia and sold outside Australia the profit on sale is derived wholly from a source outside Australia. Starke J said that the relevant source rule is where a business habitually enters into and carries out those contracts with a view to profit.

In Lovell & Christmas Ltd v. Commissioner of Taxes (Vict.) [1908] AC 46 at 52-53, Sir Arthur Wilson said:

In the present case their Lordships are of opinion that the business which yields the profit is the business of selling goods on commission in London. The commission is the consideration for effecting such sales. The moneys received by the appellants out of which they deduct their commission, and from which, therefore, their profits come, are paid to them under the contract of sale effected in London. The earlier arrangements entered into in New Zealand appear to their Lordships to be transactions the object and effect of which is to bring goods from New Zealand within the net of the business which is to yield a profit. To make those transactions a ground for taxing, in New Zealand, the profits actually realized in London would, in their Lordships opinion, be to extend the area of taxation further than the authorities warrant. [Emphasis added]

Although these cases relate to profits that are ordinary income, we consider that similar principles apply in determining the source of a capital gain included in the calculation of a net capital gain. Thus, where shares are sold using an offshore broker, the buying and selling is undertaken and thus sourced, where the contract is concluded. We consider that the decisions by the trustee to sell the shares are incidental to the activities that actually realise the profits.

86.  ATO Interpretative Decision ATO ID 2010/55 Income Tax Capital gains tax: Australian source capital gains made by a resident trust for CGT purposes, relevantly states:

Facts

...

During the year the trustee made capital gains from the disposal of some shares in a company listed on the Australian Stock Exchange.

...

Reasons for Decision

...

The issue in this case is whether the capital gains from the disposal of the shares are from sources in Australia. There is no statutory source rule for capital gains or net capital gains, for the purposes of Division 6 of Part III of the ITAA 1936. The 'taxable Australian property' tests in section 855-15 of the ITAA 1997 are not relevant for this purpose.

In the absence of such a statutory source rule reliance is appropriately placed on common law source rules as they relate to income.

The leading authority on the source of profits from the sale of shares is Australian Machinery and Investments Company Ltd v. Deputy Federal Commissioner of Taxation (WA) (1946) 180 CLR 9; 3 AITR 359; (1946) 8 ATD 81, where it was held that where shares are situated outside Australia and sold outside Australia the profit on sale is derived wholly from a source outside Australia. Starke J held that the relevant source rule is where a business habitually enters into and carries out those contracts with a view to profit.

Because the shares held by the trust were in an Australian company and the disposal of the shares occurred in Australia, the capital gains made by the trustee are considered to have a source in Australia.

87.  Therefore, it is considered that any capital gains derived by you from the sale of shares acquired on exercise of the Options on a US stock exchange via a US broker will have a source in the US for the purposes of subsection 770-10(3).

88.  As confirmed in Burton v Commissioner of Taxation [2019] FCAFC 141, where a resident of Australia pays foreign income tax on the whole of a foreign capital gain which is only partly assessable in Australia, only a proportionate share of the foreign income tax counts towards the foreign income tax offset under subsection 770-10(1).

89.  Therefore, if you did not sell the shares within 30 days of exercise of the Options, to the extent that the whole of the capital gain on the sale of shares acquired on exercise of the Options (the gain from the relevant ESS deferred taxing point to the sale of the shares) is not taxable in Australia (if the shares are held for more than 12 months and the gain is a discount capital gain), only a proportionate share of the foreign income tax would count towards the tax offset.

State income tax

90.  In respect of the State income taxes on the Options at exercise, it would be appropriate to use the same treatment. Therefore, for the period between grant and exercise to the extent that the State taxes the income correctly you will be entitled to a foreign income tax offset whether the amount is taxed in Australia only under Division 83A or partly under Division 83A and partly under the CGT provisions. However, we note in this case, the Options will be taxed at exercise, or within 30 days if the shares are sold, and so will be taxed under Division 83A.

91.  To the extent that the whole of the capital gain (the gain from the relevant ESS deferred taxing point to the sale of the shares) is not taxable in Australia (e.g. if the shares are held for more than 12 months and the gain is a discount capital gain), only a proportionate share of the foreign income tax would count towards the tax offset.

Question 6

Summary

The portion of the remuneration that may be taxed in the US under Article 15 of the Convention is determined based on the number of board and committee meetings attended by you in the US in your role as director between grant and vest (that is, the number of such meetings attended in person in the US, as a proportion of the total number of such meetings attended, in person and/or remotely, between grant and vest).

Detailed Reasoning

92.  The OECD Commentary explains that the determination of whether and to what extent a stock option benefit is derived from employment in a particular State must be done in each case based on all the relevant facts and circumstances and considering the contractual conditions associated with the option e.g. the conditions under which the option may be exercised or disposed of (paragraph 12.6).

93.  Where the benefit of an option is derived from employment rendered in more than one State the employment benefit attributable to the stock option should be considered to be derived from a particular country in proportion of the number of days during which the employment has been exercised in that country to the total number of days during which the employment services from which the stock option is derived have been exercised (para 12.14).

94.  It is possible for member countries to depart from the above case by case principles by specific bilateral agreement (paragraph 12.15).

95.  As stated earlier, it is considered that Article 15 of the US Convention should be interpreted consistently with the OECD Commentary on employee stock-options.

96.  On the basis that you were awarded your Options in your capacity as a non-executive director of the Company for your role as director and committee member, it follows that the labour and skill that you apply for the benefit of the Company would primarily be so applied during your attendance at the board of director meetings and committee meetings.

97.  Therefore we accept that an appropriate portion of the remuneration that may be taxed in the US under Article 15 of the Convention is determined based on the number of board and committee meetings attended by you in the US in your role as director and chair between grant and vest (that is, the number of such meetings attended in person in US, as a proportion of the total number of such meetings attended, in person and/or remotely, between grant and vest).

[1] The market value of the options and the value of the Options under the Income Tax Assessment Regulations 1997 and Income Tax Assessment (1997 Act) Regulations 2021 (as relevant)

[2] Undershaft (No 1) v Commissioner of Taxation (Cth) [2009] FCA 41; Federal Commissioner of Taxation v Lamesa Holdings BV (1977) 77 FCR 597.