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Are allowances received by an Australian resident taxpayer to cover various expenses related to their employment in a foreign country, assessable income under subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997)?

The part of the allowances received by the Australian resident taxpayer in respect of expenses that are attributable to the period that the taxpayer is engaged in foreign service is not assessable under subsection 6-5(2) of the ITAA 1997. It is exempt under subsection 23AG(1) of the Income Tax Assessment Act 1936 (ITAA 1936) as it is foreign earnings derived from foreign service.

The part of the allowances received by the taxpayer in respect of expenses that are attributable to a period prior to the commencement or after the completion of the foreign service, is not exempt from tax under subsection 23AG(1) of the ITAA 1936 as it is not derived from foreign service.

The taxpayer is an Australian resident for taxation purposes.

The taxpayer is employed in a foreign country for a continuous period of not less than 91 days.

The taxpayer's employment contract provides that their foreign employment begins on their first working day in the foreign country and finishes on their last working day in the foreign country.

As part of the overall remuneration package, the taxpayer receives salary and two allowances.

The first allowance is a one-off payment paid on moving to the foreign country, to cover expenses of obtaining a passport, transport to airports in Australia for departure to the foreign country, transport from airports in the foreign country on arrival in that country, excess baggage on departure from Australia and purchase of household items for use in the foreign country.

The second allowance is a one-off payment paid on moving back to Australia, to cover expenses of transport to airports in the foreign country for departure to Australia, transport from airports in Australia to the taxpayer's home following arrival back in Australia, excess baggage costs on departure from the foreign country and relocation expenses once back in Australia.

The taxpayer's employment income is exempt from income tax in the foreign country for a reason other than those listed in subsection 23AG(2) of the ITAA 1936 and therefore subsection 23AG(2) does not apply to the taxpayer's situation.

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Allowances are ordinary income for the purposes of subsection 6-5(2) of the ITAA 1997.

Subsection 6-15(2) of the ITAA 1997 provides that if an amount is exempt income it is not included in assessable income. Section 11-15 of the ITAA 1997 lists those provisions dealing with income which may be exempt. Included in this list is section 23AG of the ITAA 1936 which deals with overseas employment income.

Subsection 23AG(1) of the ITAA 1936 provides that, where a resident taxpayer is engaged in foreign service for a continuous period of not less than 91 days, any foreign earnings derived from that foreign service will be exempt from tax in Australia. 'Foreign service' includes service in a foreign country as an employee and 'foreign earnings' include income consisting of salary, wages, bonuses or allowances (subsection 23AG(7) of the ITAA 1936).

To qualify for the exemption it is a requirement that the 'foreign earnings' be derived by a resident of Australia who was 'engaged in foreign service' and whose earnings were 'derived from that foreign service': Chaudhri v. Federal Commissioner of Taxation [2001] FCA 554; 2001 ATC 4214; (2001) 47 ATR 126.

That does not mean that the foreign earnings need to be received at the time of engaging in a period of foreign service. The important test is that the foreign earnings need to be attributable to that period of service in a foreign country rather than to a period before or after the period of foreign service.

The question of when a taxpayer begins or ceases to be engaged in foreign service is a question of fact to be determined according to the circumstances of each particular case. However, as subsection 23AG(7) of the ITAA 1936 defines the term 'foreign service' to mean service in a foreign country, a taxpayer's foreign service period generally cannot begin or end at a time when the taxpayer is not actually present in the foreign country where the service will be performed.

However, the mere presence of the taxpayer in the foreign country does not mean that the taxpayer is engaged in foreign service - the beginning and end of the taxpayer's foreign service period will depend on the terms of the taxpayer's employment.

In this instance the taxpayer's foreign employment begins on their first working day in the foreign country and finishes on their last working day in the foreign country.

The part of the allowances received by the taxpayer that relates to the purchase of household items for use in the foreign country will be exempt from tax under subsection 23AG(1) of the ITAA 1936. This amount is paid to cover expenditure while the taxpayer is in the foreign country and engaged in a period of foreign service, and is therefore derived from that foreign service.

The part of the allowances that relates to obtaining a passport and relocation costs following the taxpayer's return to Australia is not exempt. These amounts are paid to cover expenditure incurred by the taxpayer in Australia prior to engaging in, and after completion of, foreign service and do not qualify for exemption under subsection 23AG(1) of the ITAA 1936.

Further, the part of the allowances that relates to transfer costs (such as transport to and from airports and excess baggage costs) also relates to expenses incurred prior to the commencement of, or after the completion of, the taxpayer's foreign service period, and is therefore not exempt. Note: as the allowances are received as lump sum amounts, the taxpayer is required to apportion the allowance to assessable and exempt income based on a fair and reasonable assessment of the allowance.