First Impressions – Test driving the proposed residency rules

The pending overhaul of Australia’s individual tax residency rules, announced in the Commonwealth Government’s 2021-2022 budget[1] based on the Board of Taxation’s 2019 report, ‘Reforming Individual Tax Residency Rules – A model for modernisation: a report to the Treasurer’[2] (‘Report’) mark significant change for individuals who live or work offshore and heralds wholesale reform to legislation introduced in 1930.

A need for Change?

Following wide consultation, the Report recommended replacement of Australia’s individual residency rules, concluding that existing rules are complex, unsuited to modern work practices and modern mobility, entail high compliance costs and result in significant numbers of disputes.[3]

Applying new rules to past disputes

Commissioner of Taxation v Pike [2020] FCAFC 158[4] is the most recent substantive decision by the Full Federal Court belonging to a class of tax residency disputes where an individual lives and works overseas but maintains a family in Australia and is an useful example of the uncertainty that can arise when applying current rules – see our article. 

While the exact content and form of the changes isn’t known yet, we understand that the changes will be based largely on the recommendations in the Report. For illustration purposes, we apply the Board of Taxation’s proposed framework.

The Taxpayer

In 2005 Mr Pike, ‘the Taxpayer’, his de-facto partner and their children moved to Australia from Africa. His Partner and their children settled in Australia at that time and gained Australian Citizenship in 2010. The Taxpayer obtained permanent residency in February 2009 and secured Citizenship in 2014.

Due to the Taxpayer’s occupational specialisation, he was unable to obtain suitable employment in Australia and instead, had to look overseas. In 2006 he found employment matching his particular specialisation in Thailand, where he lived and worked until 2014. In 2015, he was promoted to a role in Tanzania and again in 2016 to a role in the UAE.

The Taxpayer visited his family in Australia a minimum of 4 times a year, and although never stayed for more than one half an income year, was present in Australia for significant periods of time in each of the years subject to dispute.[5]

When returning to Australia, the Taxpayer would stay with his family in one of a succession of family dwellings maintained jointly by he and his partner. These were funded substantially through the Taxpayer’s earnings, particularly after 2010 when his partner ceased professional employment due to injury.

The Taxpayer maintained close connections[6] with his family in Australia and Zimbabwe while living overseas, financially supporting both and later settling his mother in his family’s home.[7] 

In 2017 the Commissioner assessed the Taxpayer on his worldwide income years for the 2009 – 2016 income years[8] on the basis that he considered the Taxpayer a tax resident of Australia.[9]

The Federal and Full Court[10] both held that the Taxpayer was a resident under domestic law for the entirety of the period in dispute[11], but was deemed by application of the residency tie breaker provisions in the Australia-Thailand Double Taxation Agreement,[12] (‘Thai DTA’), to be a resident of Thailand for the income years 2009-2014.

A key part of the factual matrix, particularly in respect of his classification as a resident under ordinary concepts, was the relevance of the Taxpayer’s intention, evidenced in his citizenship application, and in evidence at trial, that he considered Australia as home. 

The Commissioner’s appeal from Justice Logan’s application of the residency tie breaker provisions in respect of the 2009-2014 income years and the Full Court’s detailed assessment of where his closer social and economic relations lay suggest the outcome of the DTA tie breaker provisions was ‘finely balanced.’[13]

Applying the Board of Taxation’s proposed rules to the Taxpayer – 2009-2016

We apply the rules as proposed in the Report, but caution that this report is not draft legislation and may differ materially from what parliament passes.

Primary test: 183 days

In no income year was the Taxpayer in Australian for 183 or more days. He was therefore not a resident in any of the income years under the primary test.[14]

Commencing Residency

The Commencing Residency test applies where the Taxpayer was in Australia for less than 183 days, but more than 45 days in an income year.[15] If an individual is present for 45 days or more in an income year, it is then necessary to determine which factors, described below, are present in that income year. If two or more factors are present, then an individual is a resident for that income year.

Factors

The Board’s four recommended factors are:

(a) The right to reside permanently in Australia (including citizenship and permanent residency);

(b) Australian accommodation;

(c) Australian family;

(d) Australian economic connections.[16]

Considering the factors

(a) The right to reside permanently in Australia

This factor is satisfied if an individual held permanent residency or Australian citizenship during an income year.[17]

The Taxpayer gained permanent residency in February 2009 and Australian citizenship in 2014, therefore he will satisfy this factor from the income year 2009 onwards.

(b)  Australian Accommodation

This factor is satisfied in an income year if the Taxpayer had access to Australian accommodation at any point during that period.[18]

From the arrival of the Taxpayer and his family to Australia in 2005, he and his partner maintained residential accommodation to which the Taxpayer had access to and stayed at when he returned to Australia.

The Taxpayer therefore satisfies this factor for all of the income years subject to dispute.

  (c) Australian Family

This factor is satisfied[19] if the Taxpayer had a spouse[20] or children under the age of 18[21] living in Australia on an ongoing basis at any time during the income year.[22]

As the Taxpayer’s family, including his two sons, who were both under the age of 18, and his spouse, lived in Australia from 2005 and presumably to the present, the Taxpayer satisfies this factor for all of the income years subject to dispute. 

(d) Australian Economic Connections

The proposed economic connections factor has three parts:

1. 1. Employment located in Australia;
   2. Active Participation in the carrying on of a business in Australia; and
   3. Interests in Australian assets.[23]

At no time was the Taxpayer engaged in employment in Australia, or actively participate in the carrying on of a business in Australia.

The Taxpayer did however hold interests in certain specified Australia assets.[24] Relevant assets include taxable Australian real property[25] or a bank account held with an Australian bank containing significant cash deposits.[26]

The Taxpayer established a bank account in Australia shortly after arriving in 2005 and soon thereafter opened a joint bank account with his partner. These bank accounts where utilised to receive transfers from overseas earnings and fund the lives of his partner and children in Australia[27] and would seem to satisfy the description of a bank account with other than a nominal balance in the Report.   

The presence of these bank accounts from 2005, indicates this factor is satisfied in respect of all of the income years in questions.

Additionally, the joint purchase of a vacant block of land, being taxable Australian real property in September 2010 until its sale in November 2013, would also satisfy the economic connections test for the income years in which it was held – being the 2011, 2012, 2013 and 2014 income years. 

Ceasing Residency – Long Term Resident

Designed to provide an increased ‘level of adhesion’[28] for individuals that have developed an enduring connection to Australia, the Report recommends a ceasing residence test to apply to individuals who have been residents of Australia for the past three income years or ‘long term residents’.

The alternate ceasing resident test for individuals who have been resident in Australia for less than the preceding three income years, ‘short term residents’, will be discussed below. 

The proposed Ceasing Residency test for Long Term Residents provides:

An individual, resident in Australia for the three income years preceding the current year, ceases residency in Australia for the current income year if they spend:

(a)  less than 45 days in Australia in the current income year; and

(b)  less than 45 days in Australia in each of the two preceding income years.[29]

As the Taxpayer was present in Australia for less than 45 days for only two consecutive years, being 2015 and 2016 income years, he did not cease to become a resident for any of the income years subject of dispute.

By contrast, if the Taxpayer had been present in Australia for less than 45 days in the 2017 income year, he would have ceased to be a resident in that year but would have remained a resident for the 2015 and 2016 years under this test.

Treaty & Domestic alignment – ‘Alignment rule’

The Report also recommends alignment between residency treaty tie breaker and domestic outcomes[30](‘Alignment rule’).

Significantly, this provides that where an individual fails to satisfy the ceasing residency test or is otherwise a resident under domestic law, but is deemed to a resident of the other country under residency tie breaker articles of a bilateral tax treaty; the individual will be a non resident of Australia by reason of the operation of the tax treaty and also a non-resident under domestic law, by operation of the alignment rule.

In the present case, both the Federal Court[31] and Full Court[32] held the Taxpayer to be a resident of the other state under the residency tie breaker provisions of the applicable treaty for the 2009 – 2014 income years, but a resident of Australia under domestic law for all of the income years in dispute.[33]

The alignment rule has the effect of changing the Taxpayer’s domestic residency classification to reflect the treaty outcomes for the 2009 to 2014 income years.[34]

In the Taxpayer’s case, this change of necessitates re-examination of the ceasing residency test, but as a short term, rather than long term resident.

Ceasing Residency – Short term resident

The ceasing resident test for short term residents, individuals who have been resident for less than three consecutive income years, provides:

(a)  An individual, who has been a resident for less than three consecutive income years immediately preceding the current income year, ceases to be a resident if they spend less than 45 days in the current income year and satisfy less than two factors.

(b)  The individual ceases to be a resident on the day that they depart Australia.[35]

By operation of the alignment rule, the Taxpayer is not a resident in the domestic sense for the 2009-2014 income years. As the Taxpayer spent less than 45 days in Australia in the 2015 and 2016 income years and was not a resident for the three previous consecutive income years it is necessary to consider the short term resident ceasing residency test for either or both of these years.

In both the 2015 and 2016 income years, the Taxpayer spent less than 45 days in Australia, satisfying the first part of the test. In both years, however, the Taxpayer had four factors present, more than the allowable two factors, and hence failed to cease to be a resident for either years.

The Overseas Employment Rule – ‘OER’

In a nod the complexity faced by expatriate Australians, the Report proposes an overseas employment rule, (‘employment rule’, ‘OER’), reflecting in the Board’s view and IT2650 ‘rule of thumb’ of two years of two years intended absence from Australia at the time of departure as criteria for ceasing Australian residency.

The proposed employment rule provides:

An individual will cease residency on the day after departure from Australia if they:

(a)  are an Australian tax resident for the three consecutive income years prior;

(b)  undertake employment overseas that is mandated to be for a period of more than two years at the time employment commences;

(c)  have accommodation available continuously in the place of employment for the duration of their employment; and

(d)  return to Australia for less than 45 days in each income year that they continue their overseas employment after the year in which they depart.[36]

The first criteria of the employment rule requires an individual to be a resident for the three consecutive income years prior. 

A consequence of the alignment rule in the Taxpayer’s case arises that because he is not a resident of Australia for domestic purposes for the 2009-2014 income years, he fails the first criteria of the of the employment rule for 2015 and 2016 income years.

This is a curious outcome for the Taxpayer, as the 2015, 2016 and 2017 income years coincide with a loss of treaty protection and a substantial reduction in physical presence in Australia when compared with prior income years. The Taxpayer would otherwise appear to meet this criteria for the EOR for the 2015 and 2016 income years in the absence of the alignment rule, and hence not been a resident in those income years.

Summary

Interestingly, the outcome for the Taxpayer under both the current and proposed rules is identical for each of the income years, ultimately determined by the presence and application of a double taxation agreement.

Although not examined in detail in this article, the application of the residency tie breaker articles in double taxation agreements, including the Thai DTA in the case of the Taxpayer, requires appropriate consideration.  

Timing of these changes

The latest public guidance is that the changes to individual residency discussed here (if enacted) will be introduced sometime prior to the commencement of the 2022 tax year, commencing from 1 July of 2022, or 1 July following royal assent.

[1] The Commonwealth of Australia, 2021-2022 Commonwealth Budget Papers (Budget Paper 2, Part 1: Receipt Measures, Modernising the individual tax residency rules, 11 May 2021) 21-22, ‘2021-2022 Commonwealth Budget’.

[2] Board of Taxation, Reforming Individual Tax Residency Rules – A model for modernisation: a report to the Treasurer (Final Report, March 2019), ‘Residency Reform Report 2019’.

[3] Residency Reform Report 2019 (n 2) 6–8, [3.8].

[4] Commissioner of Taxation v Pike [2020] FCAFC 158 (‘Pike Appeal’).

[5] Pike v Commissioner of Taxation [2019] FCA 2185 [41]-[42] (‘Pike’).

[6] Pike Appeal (n 4) [35a].

[7] Pike (n 5) [15]-[17].

[8] Pike (n 5) [45]-[46].

[9] s6(1) Income Tax Assessment Act 1936 (Cth) (‘ITAA 1936’).

[10] Pike (n 5) [67]. Pike Appeal (n 4) [17].

[11] ITAA1936 (n 9) s6(1).

[12] Agreement between Australia and the Kingdom of Thailand for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, signed 31 August 1989, [1989] ATS 36 (entered into force 27 December 1989), Article 4 (‘Thai DTA’).

[13] Pike (n 5) [101]-[104]; Pike Appeal (n 4) [41].

[14] Residency Reform Report 2019 (n 2) [3.4].

[15] Residency Reform Report 2019 (n 2) [4.9].

[16] Residency Reform Report 2019 (n 2) [7.15].

[17] Residency Reform Report 2019 (n 2) [7.20]

[18] Residency Reform Report 2019 (n 2) [7.24].

[19] Residency Reform Report 2019 (n 2) [7.32].

[20] s995-1 of the Income Tax Assessment Act 1997 (Cth), (‘ITAA 1997’).

[21] Residency Reform Report 2019 (n 2) [7.36 (a) – (b)].

[22] Residency Reform Report 2019 (n 2) [7.35].

[23] Residency Reform Report 2019 (n 2) [7.41].

[24] Residency Reform Report 2019 (n 2) [7.49].

[25] Residency Reform Report 2019 (n 2) [7.50 (a)].

[26] Residency Reform Report 2019 (n 2) [7.50 (b)].

[27] Pike (n 5) [21].

[28] Residency Reform Report 2019 (n 2) [5.20].

[29] Residency Reform Report 2019 (n 2) [5.24].

[30] Residency Reform Report 2019 (n 2) [5.46], [5.50].

[31] Pike (n 5) [104].

[32] Pike Appeal (n 4) [39]-[41].

[33] Pike (n 5) [67]. Pike Appeal (n 4) [17].

[34] The Report notes that the change in domestic residency status would have the effect of removing access to the tax free threshold and the capital gains discount, see Residency Reform Report 2019 (n 2) [4.35]- [4.42].

[35] Residency Reform Report 2019 (n 2) [5.36].

[36]  Residency Reform Report 2019 (n 2) [5.65].