Foreign tax credit and refundable tax offsets

Does subsection 160AO(2) of the Income Tax Assessment Act 1936 (ITAA 1936) operate to reduce the foreign tax credit calculated under section 160AF of the ITAA 1936 to nil where an individual taxpayer is in receipt of foreign income and is entitled to refundable tax offsets and where the amount of refundable tax offsets exceeds the basic income tax liability?

No. Subsection 160AO(2) of the ITAA 1936 does not operate to reduce the foreign tax credit calculated under section 160AF of the ITAA 1936 to nil where an individual taxpayer is in receipt of foreign income and is entitled to refundable tax offsets and where the amount of refundable tax offsets exceeds the basic income tax liability.

The individual taxpayer is a resident of Australia for income tax purposes.

The taxpayer is in receipt of foreign sourced income on which foreign tax was paid.

The taxpayer also receives salary and wages income and fully franked dividends from resident Australian companies.

The franked dividends are subject to the refundable tax offset rules under section 67-25 of the Income Tax Assessment Act 1997 (ITAA 1997).

The taxpayer's assessable income is summarised below: $ Salary & Wage income 6,000 Australian dividend income 2,100 Franking credits 900 Foreign income (gross) 500 (foreign tax paid $50) Foreign tax credit 31 (which is equal to the Australian tax payable as worked out under section 160AF of the ITAA 1936) Taxable income 9,500 Tax on taxable income 595 (based on the tax rate of 17%)

$

Salary & Wage income | 6,000

Australian dividend income | 2,100

Franking credits | 900

Foreign income (gross) | 500 | (foreign tax paid $50)

Foreign tax credit | 31 | (which is equal to the Australian tax payable as worked out under section 160AF of the ITAA 1936)

Taxable income | 9,500

Tax on taxable income | 595 | (based on the tax rate of 17%)

Section 13-1 of the ITAA 1997 lists the provisions which allow a taxpayer a tax offset. Included in this list is section 160AF of the ITAA 1936 which deals with credit for overseas tax paid on foreign income.

Subsection 160AF(1) of the ITAA 1936 provides that a foreign tax credit may arise where a resident taxpayer's assessable income includes foreign income and the taxpayer has paid foreign tax in respect of that income for which the taxpayer was personally liable. Section 160AF of the ITAA 1936 limits the amount of the foreign tax credit to the lesser of the foreign tax paid and the Australian tax payable on the assessable foreign income.

Subsection 160AO(2) of the ITAA 1936 provides that 'notwithstanding anything contained in this Act or in the Income Tax (International Agreements) Act 1953-1960 , (this Act is now called the International Tax Agreements Act 1953) where a credit is or credits are allowable to a person in respect of tax paid or payable in respect of income derived by that person in a year of income, that credit or the sum of those credits, as the case may be, shall not exceed the amount of Australian tax that: (a) before the allowance of that credit or those credits (as the case may be); and (b) before the application of any tax offset under section 205-70 of the Income Tax Assessment Act 1997

is payable by the person in respect of the person's taxable income of that year of income.'

Section 160AO of the ITAA 1936 (introduced by the Income Tax and Social Services Contribution Assessment Bill 1960) predates both the imputation system and the concept of refundable tax offsets and was introduced in circumstances where several provisions of the Act granted a foreign tax credit. The intent behind section 160AO of the ITAA 1936 is to prevent taxpayers receiving a refund of foreign tax. This is achieved by capping the maximum foreign tax credit at the amount of Australian tax payable.

Division 4, Part 1-3, of the ITAA 1997 provides the rules about how to work out the income tax payable on a taxpayer's taxable income. Specifically, subsection 4-10(3A) of the ITAA 1997 sets out how tax offsets are to be applied. It provides that (ignoring refundable tax offsets) where the sum of the tax offsets (of which the foreign tax credit is one) is more than the basic income tax liability then the taxpayer is not entitled to a refund.

The basic income tax liability is defined in subsection 4-10(3) of the ITAA 1997 to be the result of applying the tax rate to taxable income. Subsection 4-10(3A) of the ITAA 1997 therefore operates to ensure that the total non-refundable tax offsets do not exceed the basic income tax liability effectively ensuring that there is no refund of, amongst other things, foreign tax credits. It is therefore effectively doing the same thing as subsection 160AO(2) of the ITAA 1936 was intended to do.

Subsection 4-10(3A) of the ITAA 1997 also provides that where the taxpayer is entitled to tax offsets that are subject to the refundable tax offset rules and the total of those offsets exceeds the taxpayer's basic income tax liability, the taxpayer is entitled to a refund of the excess under subsection 67-30 of the ITAA 1997 after allowing certain other tax offsets.

Section 67-30 of the ITAA 1997 contains an ordering rule which directs taxpayers to apply the refundable tax offsets last (that is, after the non-refundable tax offsets) to ensure that the maximum amount of refund is granted.

Subsection 160AO(2) of the ITAA 1936 ignores the availability of refundable tax offsets and appears to operate on the premise that any refund that results would be a refund of foreign tax. The overall effect of subsection 160AO(2) of the ITAA 1936 is inconsistent with the intent of section 67-30 of the ITAA 1997 as it would effectively apply the refundable tax offsets first and could result in the refundable tax offset being reduced by the foreign tax credit amount calculated in section 160AF of the ITAA 1936.

Given that subsection 4-10(3A) of the ITAA 1997 is the later provision and that subsection 160AO(2) of the ITAA 1936, if given its full operation, is inconsistent with section 67-30 of the ITAA 1997 in that it frustrates the clear intention to maximise the amount of refundable tax offsets by ensuring they are applied against the basic income tax liability last, subsection 160AO(2) of the ITAA 1936 is impliedly repealed to the extent that it requires refundable tax offsets to be taken into account in determining the maximum allowable foreign tax credit (see Goodwin v. Phillips (1908) 7 CLR 1; Gaudron J in Saraswati v. R (1991) 100 ALR 193 at 204).

Accordingly, based on the scenario given above, the taxpayer is entitled to a foreign tax credit of $31 and the refundable amount under Division 67 of the ITAA 1997 will be $336 that is, $900 - ($595 - $31) = $336. (The effect of other tax offsets such as the low income rebate is not considered in this calculation).