The commonly held view is that where a foreign residents is denied access to the main residence exemption (‘MRE’) they are also denied access to the Special rule for first use to produce income (a provision which deems dwellings as having been acquired for their market value in certain circumstances). However, an alternative view, whereby certain foreign residents are still able to qualify for the Special rule for first use to produce income, does appear to be arguable. This article explores the alternative view in the context of the following example:
- Smith an Australian tax resident purchased a dwelling in Melbourne in July 2006 and established that dwelling as his principal residence shortly thereafter;
- On 1 January 2016, Mr. Smith left Australia permanently and began renting out the Melbourne dwelling (that was previously his principal residence);
- In May 2022, whilst Mr. Smith was a foreign resident, he sold his Melbourne dwelling resulting in a sizeable capital gain.
Overview of the MRE for Foreign Residents
Broadly, foreign residents are denied the MRE for CGT events occurring after 7.30 pm legal time on 9 May 2017. However, transitional provisions provide that if the relevant dwelling was acquired prior to 9 May 2017 and the CGT event happens on or before 30 June 2020 then the foreign resident will not be ineligible for the MRE simply as a consequence of their residency. The MRE may also be available beyond those dates where a particular life event has occurred, however those exceptions are beyond the scope of this article.
Consequently, Mr. Smith is unable to qualify for the MRE to disregard any portion of the capital gain.
However, given that the Melbourne dwelling was initially Mr. Smith’s principal residence and was later used to produce assessable income, a question arises as to whether the Special rule for first use to produce income would operate to deem the cost base of the Melbourne dwelling to be its market value at the first income use time, being 1 January 2016.
Special rule for first use to produce income
Broadly, if the Special rule for first use to produce income (‘the Income Rule’) applies, a taxpayer is taken to have acquired the relevant dwelling for its market value at the time it was first used to produce assessable income.
For the Income Rule to apply, all of the following conditions (paraphrased) must be satisfied:
- The taxpayer would only get a partial exemption under the MRE because the dwelling was used to produce assessable income;
- That income producing use occurred for the first time after 7.30 pm on 20 August 1996; and
- A full MRE would have been available had the CGT event occurred to the dwelling just before the first time it was used to produce assessable income.
At first glance it appears clear cut that the Income Rule is unavailable to foreign residents who are ineligible for the MRE. This is because the foreign resident must first qualify for the full MRE before the partial exemption provisions can operate to deny the MRE from applying to part of the capital gain. In the context of the above example, Mr Smith, was a foreign resident at the time he disposed of his Melbourne dwelling and therefore unable to access the MRE (in full or in part). Consequently, Mr Smith would be ineligible to apply the Income Rule and will not get a market value cost base uplift.
However, further investigation into the history of the Income Rule and its predecessor indicates that the Income Rule could still apply to deem a dwelling that was previously the main residence of a foreign resident to have been acquired for its market value at the time it was first used to produce assessable income, in circumstances similar to the above example.
For completeness we note that paragraph 1.34 of the explanatory memorandum to the bill that resulted in the MRE being amended to preclude foreign residents from qualifying for the MRE clearly states that the Income Rule is not available where the taxpayer is denied access to the MRE (for the same reasons outlined above). Despite this, the bill as enacted did not amend the provisions containing the Income Rule and therefore did not change its operation. It is the author’s view that the explanatory memorandum for that later bill cannot be considered extrinsic materials for the purposes of interpreting the Income Rule, which was enacted approximately 20 years prior under a different bill.
History of the Income Rule
The Income Rule was inserted into the Income Tax Assessment Act 1997 (‘the 1997 Act’) under the third instalment of the rewrite of the Income Tax Assessment Act 1936 (‘the 1936 Act’). The bill that contained the third instalment introduced rewritten CGT provisions (among others) of the 1936 Act into the 1997 Act.
Whilst that bill contained some enhancements to certain former CGT provisions of the 1936 Act, the explanatory memorandum specifically stated that that the majority of the provisions contained in the bill were rewritten without any intention of changing their effect. The Income Rule was not one of the few provisions that were identified as having been rewritten with the intention of changing their effect. Instead the Income Rule was merely identified as being a simple rewrite of the former subsection 160ZZQ(20D) (‘the Former Income Rule’).
The significance of the above is that the 1997 Act specifically states that it contains rewritten provisions of the 1936 Act, and if the 1936 Act expresses an idea in a particular form of words and the 1997 Act appears to have expressed the same idea in a different form of words in order to use a clearer or simpler style then those ideas are not taken to be different just because different forms of words were used. This concept is also reiterated in the Acts Interpretation Act 1901.
The Former Income Rule
In relation to the basic case of an individual who purchased their dwelling, the Former Income Rule applied where the following conditions were met:
- The taxpayer acquired a dwelling on or after 20 September 1985;
- For the first time since the acquisition, the dwelling begins to be used for the purpose of gaining or producing assessable income;
- Assuming that the taxpayer had disposed of the dwelling immediately before the first income time, the disposal would have been covered by the MRE; and
- The taxpayer later disposes of the dwelling.
What becomes apparent from the above is the seemingly differing requirement for the Former Income Rule compared to the Income Rule. Whilst both require that the taxpayer be eligible for a full MRE just prior to the first income time, the Former Income Rule merely requires that the dwelling is later disposed of. In contrast the Income Rule seemingly requires the taxpayer to be eligible for a partial MRE at the time of the disposal. Essentially, the Former Income Rule only has regard to the taxpayer’s eligibility for the MRE at the time the dwelling was first used to produce income and has no regard for their eligibility for the MRE at the time the dwelling was disposed.
As highlighted above, the Income Rule was not intended to have a change of effect from the Former Income Rule. Therefore, on the basis that the Income Rule should be taken to express the same ideas as the Former Income Rule, it could arguably be interpreted as operating in the same manner as the Former Income Rule e.g. to deem a taxpayer as having acquired a dwelling for its market value just before the first income time, provided the taxpayer would have been eligible for a full MRE at that time with no regard to the taxpayer’s current eligibility.
In the case of a foreign resident such as Mr. Smith who is ineligible for the MRE as at the actual time of disposal, if the dwelling was acquired prior to 9 May 2017 and the income producing use first occurred prior to 30 June 2020, then arguably the foreign resident would be able to obtain a market value cost base uplift on their dwelling (because the foreign resident would have been eligible for the MRE just before the first income use time).
Based on this interpretation, the Income Rule would operate to deem Mr. Smith (a foreign resident) as having acquired his Melbourne dwelling for its market value just prior to the first income use time of 1 January 2016. In such a case, Mr. Smith would only be liable to CGT on the increase in the property’s value that has arisen after 1 January 2016.
Whilst there may be an arguable position that the Income Rule can apply to a foreign resident who is otherwise ineligible for the MRE, we expect that the Australian Tax Office (ATO) would likely adopt the contrary position. So, for those foreign residents who apply the alternative view of the Income Rule (as mentioned above), be prepared to face strong resistance from the ATO.
This article provides a general summary of the subject covered and cannot be relied upon in relation to any specific instance. Webb Martin Consulting Pty Ltd and any person connected with its production disclaim any liability in connection with any use. It is not intended to be, nor should it be relied upon as, a substitute for professional advice.