Foreign Tax Credit: Distribution from New Zealand unit trust

Is an Australian taxpayer assessed under section 97 of the Income Tax Assessment Tax 1936 (ITAA 1936) on foreign income distributed by a resident discretionary trust entitled to a foreign tax credit under subsection 160AF(1) of the ITAA 1936 where that income originated from a New Zealand (NZ) unit trust?

Yes. An Australian taxpayer assessed under section 97 of the ITAA 1936 on foreign income distributed by a resident discretionary trust is entitled to a foreign tax credit under subsection 160AF(1) of the ITAA 1936 where that income originated from a NZ unit trust.

The taxpayer is an Australian resident for income tax purposes.

The taxpayer is a potential beneficiary under an Australian discretionary trust.

The Australian discretionary trust holds units in a NZ unit trust.

The NZ unit trust derives income from carrying on a business in NZ and pays NZ tax on that income.

The NZ unit trust distributes some income to the Australian discretionary trust. No NZ withholding tax is paid on the income.

The Australian discretionary trust exercises its discretion and distributes the income to the taxpayer.

Section 97 of the ITAA 1936 provides that an Australian resident beneficiary who is presently entitled to a share of the income of a trust estate is assessed on their share of the trust estate's net income. Where a discretionary trustee exercises its discretion and distributes an amount in favour of a beneficiary, section 101 of the ITAA 1936 deems the discretionary beneficiary to be presently entitled in relation to that amount. As a result, the taxpayer who received income from an Australian discretionary trust is assessable on that income under section 97 of the ITAA 1936.

Subsection 160AF(1) of the ITAA 1936 provides a credit to a taxpayer who is assessed on foreign income from which foreign tax has been paid. The amount of the credit is the lesser of the Australian tax payable or foreign tax paid on the income.

Paragraph 160AF(1)(a) of the ITAA 1936 requires the taxpayer's assessable income to include an amount of foreign income. Subsection 6AB(1) of the ITAA 1936 defines 'foreign income' to mean income derived from sources in a foreign country. Subsection 6B(2A) of the ITAA 1936 provides that income derived by a beneficiary has the same source as that in the trustee's hands if the beneficiary's income can be attributed to income from a particular source. In the present case, the beneficiary received distributions from the Australian discretionary trust who in turn received income from a NZ unit trust carrying on a business in New Zealand. The beneficiary's income can be attributed to a New Zealand source and so is foreign income by virtue of subsection 6B(2A). Accordingly paragraph 160AF(1)(a) is satisfied.

Paragraphs 160AF(1)(b) and 160AF(1)(c) of the ITAA 1936 requires that the taxpayer paid foreign tax on the foreign income and be personally liable for that foreign tax. In the present case, the NZ tax was paid by the NZ unit trust before being distributed ultimately to the taxpayer. Subsection 6AB(4) of the ITAA 1936 deems a beneficiary in receipt of foreign income from which foreign tax has been paid at an earlier point in time to be personally liable for and have paid that foreign tax. Accordingly the taxpayer is deemed to be personally liable for and have paid the New Zealand tax paid by the NZ unit trust.

Having satisfied paragraphs 160AF(1)(a) to 160AF(1)(c) of the ITAA 1936, the taxpayer is entitled to foreign tax credits calculated in accordance with paragraphs 160AF(1)(d) and 160AF(1)(e) of the ITAA 1936.

Subsection 160AF(7) of the ITAA 1936 requires that a foreign tax credit be calculated separately for each class of income specified under that subsection. A trust distribution retains its character as it passes through the trustee's hands ( FC of T v. TadCaster 82 ATC 4316; (1982) 13 ATR 245). In the present case, the NZ unit trust derived business income and distributed it to the Australian discretionary trust. The income retains its character as business income and remains as business income as it is distributed to the ultimate beneficiary by the Australian discretionary trust.

As the income retains its character as business income in the beneficiary's hands it falls into the 'other income' category for the purposes of subsection 160AF(7) of the ITAA 1936.

It is also necessary to consider the tax treaty between Australia and New Zealand (the NZ Agreement) contained in Schedule 4 of the International Tax Agreements Act 1953 (Agreements Act). Subsection 6B(1A) of the Agreements Act gives the NZ Agreement the force of law in Australia. Subsection 4(1) of the Agreements Act provides that the ITAA 1936 and the Income Tax Assessment Act 1997 must be read as one with the Agreements Act.

As discussed above, the income received by the resident beneficiary retains its character as business income as it flows through the trusts. Therefore, Article 7 of the NZ Agreement would apply to give Australia the secondary right to tax the business income due to the beneficiary being a resident of Australia.

Article 24(2) of the NZ Agreement provides that credit shall be allowed against Australian income tax payable on income for taxes paid under the law of NZ and which are levied in accordance with the NZ Agreement.

In interpreting the wording of the double tax agreement, the Commissioner in Taxation Ruling TR 2001/13 accepts that it is appropriate to have regard to the OECD Commentary on the Model Tax Convention on Income and on Capital (Condensed Version 2005) (the OECD Commentary).

According to the OECD Commentary, tax is considered to be levied in accordance with the treaty even if the two contracting states apply different articles of the treaty because of the differences in their respective domestic law. The OECD Commentary states on Model Articles 23A and 23B that: 32.2 The interpretation of the phrase "in accordance with the provisions of this Convention, may be taxed"...is particularly important when dealing with cases where the State of residence and the State of source classify the same item of income or capital differently for purposes of the provisions of the Convention. 32.3 ... Where, due to differences in the domestic law between the State of Source and the State of Residence, the former applies, with respect to a particular item of income or capital, provisions of the Convention that are different from those that the State of residence would have applied to the same item of income or capital, the income is still being taxed in accordance with the provisions of the Convention, as interpreted and applied by the State of Source. In such a case, therefore, the two Articles require that relief from double taxation be granted by the State of residence notwithstanding the conflict of qualification resulting from these differences in domestic law.

Consequently, Australia is obliged to give relief for NZ tax paid under Article 24(2) of the NZ Agreement. The Australian taxpayer assessed under section 97 of the ITAA 1936 on foreign income received from the resident discretionary trust is entitled to a foreign tax credit under subsection 160AF(1) of the ITAA 1936 for the NZ tax paid by the NZ unit trust on the income.