Foreign Income and Foreign Losses: income derived from trading shares on the United States stock exchange

Is a deduction for prior year foreign losses allowable under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) against an Australian resident taxpayer's income derived from trading shares listed on the United States (US) stock exchange?

Yes. A deduction for prior year foreign losses is allowable under section 8-1 of the ITAA 1997 against an Australian resident taxpayer's income derived from trading shares listed on the US stock exchange as the income is foreign assessable income which is of the same class as the foreign losses.

The taxpayer is a resident of Australia. The taxpayer undertakes a business of trading shares listed in the US stock market. These activities are conducted via the internet from the taxpayer's home utilising the services of stock brokers in the foreign jurisdiction.

Orders for the purchase or sale of shares are transmitted via the internet. On the acceptance of these orders, the contracts for the purchase or sale of the shares are subsequently issued from the US. The taxpayer maintains funds in securities accounts in the US for this purpose.

The taxpayer had losses from share-trading activities carried forward from previous years. During the 2002-03 income year, the taxpayer derived a net income from the share-trading activities.

Section 8-1 of the ITAA 1997 allows a deduction for all losses or outgoings to the extent to which they are incurred in gaining or producing assessable income, except where the outgoings are of a capital, private or domestic nature, relate to the earning of exempt income or a provision of the Income Tax Assessment Act 1936 (ITAA 1936) or ITAA 1997 prevents the deduction.

Subsection 8-5(2) of the ITAA 1997 provides that some provision of the ITAA 1936 or the ITAA 1997 prevent or limit the deduction of an otherwise deductible amount.

The provisions which prevent or limit an otherwise deductible amount are listed in section 12-5 of the ITAA 1997. Included in this list is section 79D of the ITAA 1936 which deals with limitations on deductions relating to foreign income.

Under section 79D of the ITAA 1936 where a taxpayer incurs foreign income deductions in relation to a class of assessable income, and the amount of these deductions exceeds the amount of foreign assessable income of that class, then the deduction is limited to the amount of income received. The term 'foreign income deduction' is prescribed by subsection 79D(2) of the ITAA 1936 to have the same meaning as in section 160 AFD of the ITAA 1936.

Section 160AFD(9) of the ITAA 1936 defines 'foreign income deduction' in relation to a class of assessable foreign income to mean, subject to certain exclusions, any allowable deduction to the extent that it relates to assessable foreign income of the same class. Section 160AFD(2) prescribes that losses carried forward can be applied to income of the same class in any future year of income.

The phrase 'any deduction ... allowed or allowable' in section 160AFD(9) of the ITAA 1936 refers to any deduction allowable under the ITAA 1936 or the ITAA 1997 - both general (section 8-1 of the ITAA 1997) and specific deductions (section 8-5 of the ITAA 1997).

To be allowable the foreign income deduction must relate to assessable foreign income of the same class. The term 'assessable foreign income' is defined in section 160AFD(9) of the ITAA 1936 to include foreign income which is included in the assessable income of the taxpayer.

Subsection 6AB(1) of the ITAA 1936 provides that a reference to 'foreign income' is a reference to income derived from sources in a foreign country or foreign countries.

Under subsection 160AFD(8) of the ITAA 1936, each of the following kinds of assessable foreign income constitutes a single class: • interest income • modified passive income • offshore banking income, and • all other assessable foreign income.

The question under consideration is whether prior year foreign losses accumulated from share trading activities can be applied against income derived from the trading of shares listed on the US stock exchange in accordance with section 160AFD of the ITAA 1936.

In determining whether, for the purposes of section 6AB of the ITAA 1936, income, and hence losses which have been incurred in the same manner, have been derived from a source in a foreign country, no legislative rules are provided in section 6AB itself.

Apart from certain rules prescribed for statutory income (for example, royalties, interest and dividends), there are no statutory guidelines in the Income Tax Legislation for determining the source of income or losses. The Double Tax Agreement between the US and Australia (the US Convention) does not provide guidance in relation to the source of the income in question.

In the absence of statutory source rules, reliance is placed on the general common law source rules as they relate to income.

In Nathan v. Federal Commissioner of Taxation (1918) 25 CLR 183 at 189-190, Justice Isaacs said that the term 'source' meant not a legal concept, but something which a practical man would regard as the real source of income. In FC of T v. Efstathakis 79 ATC 4256 at 4256; (1979) 9 ATR 867 at 870, Justice Bowan stated that 'the answer is not to be found in the cases, but in the weighing of the relative importance of the various factors which the cases have shown to be relevant.'

In Cliffs International Inc v. FC of T 85 ATC 4374; (1985) 16 ATR 601, Justice Kennedy stated that '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.'

In Australian Machinery and Investments Company Ltd v. Deputy Commissioner of Taxation (1946) 180 CLR 9; (1946) 8 ATD 81; (1946) 3 AITR 359, 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 the above cases the courts have taken the view that where the immediate cause of the derivation of income is the contract under which the right to the relevant income arises, the source of that income is the contract itself. As such losses incurred relating to the derivation of such income will have the same source as the income derived.

In the present case, the contracts for the purchase and sale of the shares are made in the US. The income arising from the sale of the shares is attributed to the jurisdiction in which the contracts are concluded. Losses incurred in the derivation of such income will also have their source in the jurisdiction where the contracts are concluded. The income is foreign income as defined in section 6AB of the ITAA 1936.

Prior year foreign losses carried forward relate to income from the same class as defined in subsection 160AFD(8) of the ITAA 1936. Accordingly, the taxpayer can apply the losses incurred in prior years against income derived from buying and selling shares pursuant to section 160AFD of the ITAA 1936 and section 8-1 of the ITAA 1997.