Foreign income derived by a resident taxpayer from conducting an active business abroad, as well as dividends from non-portfolio holdings, are generally exempt from tax in Australia. Most other types of foreign income derived by the taxpayer are included in its assessable Australian income, with credit being granted for tax paid on such income. The foreign tax relief system in place prior to 1 July 2008 was replaced by the Foreign Income Tax Offset (FITO) system, which has made significant changes to the application of the Australian foreign tax credit mechanism. Unless otherwise indicated, the description below covers only the FITO system.
The foreign income tax must have been imposed on income, profits, or gains and covers taxes specifically included in double taxation agreements, but excludes "inheritance taxes, annual wealth taxes, net worth taxes, or taxes based on receipts, turnover or production". The inclusion of tax paid on capital gains is subject to special rules that have the effect of including only the net capital gain and excluding any foreign capital gains tax paid where the taxpayer had a net capital loss.
The taxpayer (whether resident or non-resident) claiming the credit need not have been personally liable for the foreign tax paid. Payments made on the taxpayer’s behalf, such as by CFCs or FIFs, as well as taxes withheld at source by the payer, equally qualify to be claimed by the taxpayer under the credit mechanism. In such cases, the taxpayer must gross-up its assessable income to reflect the amount of foreign tax paid.
There is no country or income segmentation of foreign income under the FITO mechanism. The foreign income in respect of which foreign tax has been paid is aggregated for purposes of the claim under the FITO system. However, no foreign tax offset is available for foreign taxes paid in respect of certain amounts, including:
- Exempt branch profits;
- Exempt direct dividends received by a resident company;
- Underlying foreign taxes;
- Tax paid in the foreign country based on the taxpayer’s residence in that country and in respect of an amount from a source outside that country;
- A credit absorption tax (i.e. a tax imposed in the foreign country purposely to absorb the credit claimable in Australia on the income); or
- A unitary tax (i.e. a tax imposed in the foreign country on a company that takes into account income, losses, outgoings, or assets of the company (or an associated company) from outside that country).
The amount of foreign tax that may be offset against Australian tax is the lower of the total foreign income tax paid and the Australian tax that is attributable to the income, calculated according to prescribed rules and subject to a "foreign income tax offset cap" of AUD 1,000 where the offset is lower than that amount.
The FITO system does not permit a taxpayer to transfer or carry forward any excess foreign taxes. Any such excess will therefore be lost.
The double tax relief mechanism provided for under most of Australia’s treaties is by way of an ordinary credit.
On 26 August 2020, the Australian Taxation Office (ATO) has published a Taxation Determination (TD 2020/7) on the inclusion of capital gains while calculating the FITO limit. The TD clarifies that the foreign capital gains on which no foreign tax has been paid by the taxpayers cannot be considered as ‘disregarded income’ in computing the FITO limit and therefore over-claiming the FITO. The TD is applicable to both before and after its date of issue except if it conflicts with the terms of a settlement of a dispute agreed to before the date of issue of this TD.