Can I still access the CGT main residence exemption when a DTA makes me a non-resident?

by | Nov 30, 2020

With the transitional period for non-residents to claim the main residence exemption (‘MRE’) having ended on 30 June 2020, practitioners are increasingly going to encounter clients who are denied access to the MRE.

For many non-residents, their eligibility for the MRE will be clear-cut. However, for individuals who are a dual resident (i.e. a tax resident of both Australia and another country) a question arises regarding their eligibility and whether any eligibility is affected by the residency tie-breaker rules contained in Australia’s double tax agreements (‘DTA’).

Similar questions also arise in relation to other CGT concessions that are affected by foreign residency, such as calculating the discount percentage applicable to a capital gain.

As it is possible for individuals to ordinarily be resident (i.e. the “resides” test) in more than one country, dual residency situations may arise more commonly than originally thought i.e. it does not just arise where an individual ordinarily resides in another country and is merely caught by one of Australia’s statutory residency tests in subsection 6(1). For example, an individual who maintains a summer residence in Australia whilst living abroad for the remainder of the year may be a dual resident.

In this article we take a brief look at how dual residency may affect both the application of the MRE and the calculation of the discount percentage along with the interaction between those provisions and Australia’s DTAs. We note that this article does not address circumstances where an individual is a temporary resident under Australia’s domestic tax law.

Domestic law

Before we look at the interaction between Australia’s DTAs and Australia’s domestic tax law (‘the Tax Acts’) we must first ascertain how the MRE and CGT discount will apply to a dual resident under the Tax Acts.

MRE

From 1 July 2020 an individual is no longer eligible to disregard a capital gain or loss if at the time of the CGT event the taxpayer is either:

  • an excluded foreign resident; or
  • a foreign resident who does not satisfy the life events test.

An individual is an excluded foreign resident at a particular time if they are a foreign resident at that time and have been a foreign resident for a continuous period of more than six years.

The life events test is only relevant where the individual has been a foreign resident for six years or less and is centred around terminal illness and death (occurring during the period of foreign residency) or where the CGT event arises as a result of a relationship breakdown.

Practically this means that unless an individual has been a foreign resident for less than six years and passes the life events test, they will not be eligible for the MRE.

Key to both of the above exclusions from the MRE is the definition of a foreign resident, which is defined as “a person who is not a resident of Australia for the purposes of the Income Tax Assessment Act 1936” (i.e. a person who has not satisfied any of the domestic residency tests).

What is apparent from the definition of a foreign resident under the Tax Acts is that it only has regard for a taxpayer’s Australian domestic tax law residence status and not whether the individual may also be a resident of another country under its domestic tax laws.

Therefore, a dual resident would, prima facie, be eligible to apply the MRE to a capital gain arising from the disposal of a direct interest in real property (provided that they have met all other relevant criteria to access the MRE).

CGT discount

Generally, an individual will have their discount percentage in relation to a capital gain reduced based on periods of foreign residence. The various formulas used to calculate the reduced discount percentage all contain either of the variables ‘days that the individual was an Australian resident’ or ‘days that the individual was a foreign resident’.

However, before the provision containing those formulas is enlivened the individual must first satisfy certain conditions. One such condition is that the individual was a foreign resident during any part of the discount testing period (i.e. the period beginning on the day the CGT asset was acquired and ending on the day the CGT event occurs) that occurred after 8 May 2012.

Similar to the MRE, the CGT discount provisions are merely concerned with whether an individual is an Australian tax resident and not whether that individual may also be a resident of another country.

Therefore, an individual who is a dual resident on a particular day during their discount testing period would not, prima facie, have their discount percentage reduced for that period of dual residency. Furthermore, if the dual resident did not have a single day during their discount testing period in which they were not an Australian resident, the provisions relating to the reduction of the discount percentage would not apply at all.

Interaction with Australia’s DTAs

Where a dual resident individual is a resident of a country that is not a party to a DTA with Australia the analysis of whether the MRE is available or the extent to which their discount percentage is reduced need not go further than the Australia’s domestic tax law.

However, where Australia does have a DTA with that country, consideration needs to be given to the relevant DTA, as is the case with any cross-border transactions, to determine whether the position above is modified.

Australia currently has 45 DTAs in force, which have significant similarities to each other, but still contain their own nuances. For this reason, the analysis below focuses solely on the Australia-US DTA (‘US DTA’) with all references being to it.

In respect of a dual resident the logical starting point for determining the potential impact that the DTA may have is article 4, which contains the residency definitions and the tie-breaker rule.

Upon ascertaining that an individual is in fact a resident of both countries under the definitions contained in the DTA (residency under Australian DTAs usually refers to the domestic law residency rules of each contracting state) the tie-breaker rule must be applied to ascertain which country it resolves in favour of. The individual will be deemed to be a resident of only that country “for all purposes of this convention”.

Any inconsistencies between the convention and the Tax Acts are resolved in favour of the convention, which raises the issue as to what exactly the term “for all purposes of the convention” means. The explanatory memorandum (‘EM’) for the 1983 US convention provides no further insight, however the EM’s for more recently ratified conventions (i.e. Israel and Germany) are more explicit in its meaning, specifically stating that person remains a resident for the purposes of Australian domestic tax law regardless of the tie-breaker provisions.

Support for this position may be found in the Canadian case Black v Queen (2014 TCC 12), which specifically addressed the issue in respect of the Canada-UK convention, which found that a residency tie-breaker provision contained in a DTA will not operate to modify the domestic tax law residency alone. We note that various countries’ domestic tax laws do include provisions to deem an individual to be a non-resident if a DTA tie-breaker resolves in favour of another country. The Tax Acts do not contain such a provision, however in the Board of Taxation’s ‘Review of The Income Tax Residency Rules for Individuals’ one of the questions posed was whether any new residency rules should include a provision to align domestic and DTA residency for dual residents.

Regardless of whether a reasonably arguable position that is favourable to the taxpayer can be formed it is always prudent to ascertain the Commissioner’s position on an issue and whether that position is contained in binding rulings.

The Commissioner’s position on the issue is quite clearly stated in TR 98/17:

“66. Where the tie-breaker tests in an agreement provide that a dual resident be treated solely as a resident of the treaty partner country for the purposes of the agreement, most foreign source income of that individual is not subject to tax in Australia and the extent to which Australia can tax the individual’s Australian source income may also be affected. The terms of the relevant double tax agreement should be referred to when determining tax liability. However, Australian resident status is not lost for purposes of the general operation of the domestic law, so that the individual continues to be eligible, for example, for the tax-free threshold in respect of his or her income which remains assessable to Australian tax.” [emphasis added]

And again, stated in TR 2001/13 as follows:

“13. Accordingly, the DTAs contain ‘tie-breaker’ rules to ensure that a dual resident ‘person’ (whether an individual, company or other entity) is treated as a resident of only one of the countries for the purposes of applying the DTA. These tie-breaker rules do not directly affect whether the person is a resident of a country at domestic law – the ‘person’ remains a domestic law resident of each country. Therefore, a dual resident who is treated as solely a resident of another country for the purposes of an Australian DTA remains a resident of Australia for the purposes of the Assessment Act.” [emphasis added]

This position has also been repeated in other non-binding rulings such as ATO IDs 2004/177 and 2006/12 and was restated by the Commissioner as recently as 13 November 2020 in the decision impact statement in relation to Pike’s case ([2020] FCAFC 158).

On the basis that a taxpayer may rely on the Commissioner’s position that a DTA will not alter the domestic tax residency of a dual resident, the next step is to ascertain whether a specific article will, nonetheless, allow Australia to tax the capital gain as if the dual resident were not entitled to the MRE and also to reduce the discount percentage applicable to a gain.

Sub-article 13(1) of the US DTA is, in part, concerned with the disposal of real property situated in Australia. It provides that:

“Income or gains derived by a resident of one of the Contracting States from the alienation or disposition of real property situated in the other Contracting State may be taxed in the other State.” [emphasis added]

Once again, an interpretational issue arises as to the meaning of the term “…may be taxed in the other state” and once again, the EM for the ratification of the US DTA provides little insight.

However, the commentary for the UN and OECD model conventions both explicitly state that “The Article can in no way be construed as giving a State the right to tax capital gains if such right is not provided for in its domestic law.”

Additionally, various cases, such as Lamesa Holdings ([1997] FCA 785,) GE Capital ([2007] FCA 558), and Chevron ([2015] FCA 1092), have addressed whether certain provisions of a DTA are a “grant of stand-alone taxing power”. Each of these cases concluded that an enabling provision, such as the above, cannot give Australia a taxing power without working in conjunction with an operative provision of the Tax Acts.

The application of those cases to the current circumstances is not altered by the relatively recent Satyam Computer Services case ([2018] FCAFC 172), which resulted in a greater tax liability than would have arisen had the relevant DTA not existed. The key distinction being that in Satyam Computer Services the DTA merely deemed certain income to have an Australian source and still required operative provisions of the Tax Acts to create a tax liability.

As highlighted above, it is prudent to ascertain the Commissioner’s position. His view on this issue is contained in TR 2001/13 as follows:

“24. A common mistake in the practical consideration of a DTA is to see the phrase ‘may be taxed’ as indicating that the country referred to (usually the source country) is the only one entitled to tax that category of income, but that it need not do so (because of the word ‘may’) while viewing the phrase ‘shall be taxable only’ as requiring the country mentioned (usually the residence country) to tax that income. In fact, a country is never required by a DTA to exercise a taxing right under that DTA if it does not wish to. What the phrase ‘may be taxed’ normally means is that the country mentioned (the source country) has a non-exclusive entitlement to tax the income. Under normal international tax principles, the other (residence) country may also continue to tax its residents (where its domestic law so provides) on the income, wherever sourced, unless the DTA explicitly prevents it from doing so.” [emphasis added]

“40. As well as not dictating that the allocated taxing rights must be exercised by a country, DTAs also do not, except in certain respects to ensure their effectiveness, dictate how they are to be exercised. Whether and how those rights are exercised is usually left to the respective ordinary domestic laws (that is, the domestic laws other than the DTA as domestically implemented). It is therefore possible, and unexceptional, to have a situation where there is a right under a treaty to impose a form of taxation, but where the legislature has not decided to impose (or has positively decided not to impose) such a tax liability under domestic law. A future legislature may pass legislation exercising the right, and that would be consistent with the treaty. When new legislation is being proposed, the consistency of such legislation with Australia’s treaty obligations will sometimes be an issue for these reasons.” [emphasis added]

This position is reasonably clear that a DTA alone will not grant Australia expanded taxing powers.

Although the DTA provides Australia with the right to tax a dual resident individual, on the disposal of real property, who is deemed to be a resident (for the purposes of the DTA) of the other country that is a party to the DTA, the DTA does not prescribe how Australia should do so. Based on the above it appears that the taxation of a dual resident’s capital gain would still be determined in accordance with Australia’s domestic taxation laws (noting that a taxpayer could rely on the Commissioner’s positions in the above public rulings). Based on the position that a dual resident individual would still be considered a resident of Australia for the purposes of the Tax Acts, the resident should still be eligible for the MRE and not have their CGT discount percentage reduced for periods of dual residency.

Multilateral Instrument

Where a dual resident individual is a resident of a country that is a party to a DTA with Australia, consideration also needs to be given to the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting, also known as the Multilateral Instrument (‘MLI’).The MLI is a multilateral treaty that enables jurisdictions to swiftly modify the operation of their tax treaties to implement various measures. Australia and many of its treaty partners are signatories to the MLI, however the United States is a notable exception.

The MLI contains various articles which may modify a DTA, with the two relevant articles in this case being Articles 4 and 9. However, as Article 4 of the MLI, which relates to residency, is not applicable to dual resident individuals, any modification to a covered tax agreement would not alter the above analysis. Article 9, which is in respect of shares or interest deriving their value principally from immovable property, is similarly not applicable to a dual resident individual who has a direct ownership interest in real property situated in Australia.

Accordingly, the MLI does not appear to affect the arguments raised above.

Summary

The removal of the MRE for foreign residents was controversial, especially for taxpayers who are Australian citizens. However, an individual’s eligibility for the MRE (and certain other residency based concessions) may need to be reconsidered where the individual is a dual resident and their non-residency status arises merely under a tie-breaker provision in the relevant DTA.

The author notes that the above does not constitute advice and the specific facts of each taxpayer’s circumstances needs to be considered together with the relevant DTA, which may vary to the US DTA articles discussed above.

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