Deductibility of a Tax Equalisation Scheme repayment for salary and wages earned in the US

Is an amount repaid by an Australian resident to their employer as part of a tax equalisation scheme that relates to overpaid salary and wages earned in the United States (US), deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No. An amount repaid by an Australian resident to their employer as part of a tax equalisation scheme that relates to overpaid salary and wages earned in the US, is not deductible under section 8-1 of the ITAA 1997.

The taxpayer is an Australian citizen.

The taxpayer was posted by their employer to the US for a period of several years.

For the period that the taxpayer worked in the US, the taxpayer was a US resident for income tax purposes. The taxpayer became a non-resident of Australia for income tax purposes during this period.

The taxpayer subsequently returned to Australia and became an Australian resident for income tax purposes at that time.

The taxpayer had a tax equalisation scheme in place with their employer. Under the scheme, the taxpayer's salary and wages are adjusted by a tax equalisation amount to ensure that they do not pay any more or less tax on their assessable income when working overseas than would have been payable had the taxpayer remained in Australia.

The taxpayer's employer overestimated the tax equalisation amount payable to the taxpayer and consequently the taxpayer received an overpayment of salary and wages.

The taxpayer was required to repay the amount of overpaid salary and wages to their employer.

The taxpayer repaid the amount after they returned to Australia.

Subsection 8-1(1) of the ITAA 1997 allows a deduction for any loss or outgoing to the extent that: (a) it is incurred in gaining or producing your assessable income; or (b) it is necessarily incurred in carrying on a business of the purpose of gaining or producing your assessable income.

However, a deduction is not allowable under subsection 8-1(2) to the extent that the loss or outgoing: (a) is capital, or of a capital nature; or (b) is of a private or domestic nature; or (c) is incurred in gaining or producing your exempt income; or (d) a provision of the Act prevents it.

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.

Subsection 6-5(3) of the ITAA 1997 provides that the assessable income of a non-resident includes ordinary income derived directly or indirectly from Australian sources during the income year, as well as other ordinary income that is included on some basis other than having an Australian source.

Subsection 6-15(2) of the ITAA 1997 provides that if an amount is exempt income, it is not assessable income.

Section 11-15 of the ITAA 1997 lists some provisions about exempt income. Included in this list is paragraph 23(r) of the Income Tax Assessment Act 1936 (ITAA 1936) which deals with foreign source income of non-residents.

Paragraph 23(r) of the ITAA 1936 provides that income derived by a non-resident from sources wholly out of Australia (except income that a provision of this Act includes in a taxpayer's assessable income on some basis other than having an Australian source) is exempt from income tax.

In determining liability to foreign sourced income received by a non-resident taxpayer it is necessary to consider not only the income tax laws but also any applicable double tax agreement contained in the International Tax Agreements Act 1953 (the Agreements Act).

Section 4 of the Agreements Act incorporates that Act with the ITAA 1997 so that those Acts are read as one.

Schedule 2 to the Agreements Act contains the double tax agreement between Australia and US (the US Convention). Schedule 2A to the Agreements Act contains the protocol amending the US Convention (the US Protocol). The US Convention and the US Protocol operate to avoid the double taxation received by Australian and US residents.

Article 15(1) of the US Convention states that salaries, wages and other similar remuneration derived by an individual who is a resident of the US, in respect of an employment, shall be taxable only in the US if the employment is performed in the US.

Therefore, Article 15 of the US Convention does not give Australia a taxing right over the salary and wages earned by the taxpayer.

The taxpayer was required to repay a portion of their employment income to their employer under a tax equalisation scheme. The obligation to make the repayment arose due to an overpayment of salary by the taxpayer's employer during the taxpayer's posting in the US. The overpayment of salary occurred because the taxpayer's employer incorrectly estimated the taxpayer's hypothetical Australian tax liability had they been an Australian resident in the year the income was earned.

The income was exempt from tax in Australia because of paragraph 23(r) of the ITAA 1936. In any event, as the overpaid salary had a US source, it was taxable only in the US under the US Convention.

Although the taxpayer was a resident of Australia when they repaid the amount, the repayment relates to overpaid salary and wages earned by the taxpayer from working in the US which were wholly earned while the taxpayer was a non-resident and therefore were exempt income.

Therefore, the repayment made by the taxpayer under the tax equalisation scheme was not an outgoing incurred in gaining or producing the assessable income earned by the taxpayer. Accordingly, no deduction is allowable under section 8-1 of the ITAA 1997 for the repayment because of paragraph 8-1(2)(c) of the ITAA 1997. Note: Taxation Ruling IT 2623 set out an administrative approach to deal with repayments of overpaid income amounts in recognition of the need to avoid unfair treatment of a taxpayer where overpaid salary is required to be repaid subsequent to the income year in which the salary or benefits were received and assessed to tax. The general approach in these circumstances has been to use the amendment provisions in the law, subject to the statutory time limits in those provisions, to exclude the overpayment from the assessable income of the year in which the overpayment was made. The administrative approach set out in IT 2623 does not apply to the taxpayer as no amount of the overpaid salary and wages was previously included in the taxpayer's assessable income in the year it was originally received.