Foreign income tax offset: entitlement where foreign capital gain is only partly assessable in Australia

Where a resident of Australia pays foreign income tax on the whole of a foreign capital gain which is only partly assessable in Australia, does only a proportionate share of the foreign income tax count towards the foreign income tax offset under subsection 770-10(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Yes. Where a resident of Australia pays foreign income tax on the whole of a foreign capital gain which is only partly assessable in Australia, only a proportionate share of the foreign income tax counts towards the foreign income tax offset under subsection 770-10(1) of the ITAA 1997.

The taxpayer is an individual and a resident of Australia.

The taxpayer realised a capital gain in a foreign country and paid foreign tax on the whole of this gain in the foreign country.

Only 50% of the gain is assessable in Australia because the taxpayer is entitled to the capital gains tax (CGT) discount under Division 115 of the ITAA 1997.

Subsection 770-10(1) of the ITAA 1997 provides the basic entitlement rule for the foreign income tax offset and states: You are entitled to a tax offset for an income year for foreign income tax. An amount of foreign income tax counts towards the tax offset for the year if you paid it in respect of an amount that is all or part of an amount included in your assessable income for the year.

Subsection 770-10(1) of the ITAA 1997 uses the phrase 'in respect of' to link the foreign income tax with an amount included in the taxpayer's assessable income. The phrase 'in respect of' was considered in the case Workers' Compensation Board of Queensland v. Technical Products Pty Ltd 165 CLR 642; 81 ALR 260. In a joint judgement Deane, Dawson and Toohey JJ said the following about this phrase: The phrase gathers meaning from the context in which it appears and it is that context which will determine the matters to which it extends.

Subsection 770-5(1) of the ITAA 1997 provides relevant context by explaining the object of Division 770 as follows: The object of this Division is to relieve double taxation where: (a) you have paid foreign tax on amounts included in your assessable income; and (b) you would, apart from this Division, pay Australian tax on the same amounts.

The references in the objects provision to relieving 'double taxation' and 'amounts included in your assessable income' demonstrate that, where a taxpayer pays foreign tax on the whole of a capital gain but only a portion of that gain is assessable in Australia, the purpose of Division 770 is to only provide a foreign income tax offset for the portion of the gain that is included in assessable income and thus subject to taxation in both Australia and the foreign country (that is, double taxation). This can be described as an 'apportionment approach' to the allowance of a foreign income tax offset.

Such an approach is also consistent with the approach explained in Note 2 to subsection 770-10(1) of the ITAA 1997 which states: If the foreign income tax has been paid on an amount that is part non-assessable non-exempt income and part assessable income for you for the income year, only a proportionate share of the foreign income tax (the share that corresponds to the part that is assessable income) will count towards the tax offset (excluding the operation of subsection (2)).

While Note 2 is non-operative material, it is relevant context as it is provided to help understand provisions (see sections 2-35 and 2-45 of the ITAA 1997). Accordingly, Note 2 is further contextual support for the view that the words used in subsection 770-10(1) of the ITAA 1997 were intended to require apportionment of the foreign income tax paid when only part of an amount that is subject to foreign income tax is included in Australian assessable income.

The foreign income tax offset provisions in the ITAA 1997 were introduced by the Tax Laws Amendment (2007 Measures No. 4) Bill 2007. Paragraph 1.18 of the Explanatory Memorandum accompanying the Bill summarises the new law, in part, as follows: Taxpayers will be entitled to a non-refundable tax offset for foreign income tax paid on an amount included in assessable income (a 'double-taxed amount'). This offset effectively reduces the potential Australian tax that would be payable on double-taxed amounts.

This statement also confirms that a foreign income tax offset will only be allowed on an amount that is included in assessable income in Australia and subject to double taxation. The Explanatory Memorandum also makes many other references to a foreign income tax offset being limited to amounts included in assessable income and subject to double taxation.

However, there is one statement in the Explanatory Memorandum which is inconsistent with these references. Example 1.20 at paragraph 1.150 of the Explanatory Memorandum states: The taxpayer is entitled to an offset for the lesser of the foreign tax paid ($39,000) and the Australian tax payable in respect of the foreign net capital gain that is included in assessable income (even though only part of the capital gain on foreign asset D is included in the taxpayer's net capital gain).

In this example, the amount of Australian tax ($37,500) on the $125,000 net capital gain is less than the foreign tax paid ($39,000) on the foreign capital gain of $130,000. The above statement in Example 1.20 implies that if the foreign tax on the whole of the foreign capital gain had been less than the Australian tax on the net capital gain, the whole of the foreign tax would have been allowed as a foreign income tax offset even though only part of the gain was included in assessable income in Australia and subject to double taxation. That is, it implies that in such circumstances there would not have been an apportionment of the foreign tax paid in calculating the allowable foreign income tax offset. Accordingly, this statement in Example 1.20 is inconsistent with the rest of the Explanatory Memorandum.

In Federal Commissioner of Taxation v. Myer Stores Ltd 98 ATC 4384; (1998) 38 ATR 447, Hill J suggested that a paragraph of an Explanatory Memorandum may have been incorrect, and stated: While no doubt it is appropriate, perhaps generally essential, to have regard to the explanatory memorandum either where there is ambiguity or to confirm the ordinary meaning of the words or indeed to determine the mischief for which a particular statutory provision has been enacted, the explanatory memorandum cannot control the meaning of words used by the legislature.

Similarly, in Deputy Federal Commissioner of Taxation v. PM Developments Pty Ltd [2008] FCA 1886; 2008 ATC 20-078; (2008) 70 ATR 741, Logan J stated that an assertion in an Explanatory Memorandum 'is not a substitute for the language employed by the Parliament in the Bill as enacted'. Then, in relation to the Explanatory Memorandum that he was considering, Logan J concluded that a particular paragraph was not completely correct.

The Commissioner's view is that the statement above from Example 1.20 in the Explanatory Memorandum is not consistent with the words and purpose of the legislation and accordingly should be disregarded as relevant context to the extent that it implies that an apportionment approach would not apply to the allowance of a foreign income tax offset in such circumstances.

The rest of the Explanatory Memorandum, in particular, paragraph 1.18 and other similar passages are still considered to be relevant contextual guidance because they are consistent with the words and purpose of the legislation and they consistently confirm that the meaning of the phrase 'in respect of an amount that is all or part of an amount included in your assessable income for the year' in subsection 770-10(1) of the ITAA 1997 requires an apportionment approach.

Consequently, where a resident of Australia pays foreign income tax on the whole of a foreign capital gain but only 50% of the gain is included in the assessable income of the taxpayer in Australia because the taxpayer is entitled to the CGT discount, only 50% of the foreign income tax counts towards the foreign income tax offset under subsection 770-10(1) of the ITAA 1997. Note : an apportionment approach would also apply in other similar circumstances, for example, where only part of a foreign capital gain is assessable in Australia because the gain is subject to the small business active asset concessions in Division 152 of the ITAA 1997 or because a foreign capital gain is reduced by a capital loss under Division 102 of the ITAA 1997. Again, the amount of foreign income tax paid that counts towards the foreign income tax offset for the year under subsection 770-10(1) of the ITAA 1997 will be the proportion of the foreign tax that corresponds with the proportion of the foreign gain that is included in assessable income in Australia and thus subject to double taxation.