ap_for04

Foreign Income

Calculation of credit for tax paid to a foreign country

average rate of Australian tax

adjusted net foreign income

Calculation of credit for tax paid to a foreign country

Section 160 AF (1) states that where

the assessable income of a resident taxpayer includes foreign income ..And..

The taxpayer has paid foreign tax, for which he was personally liable on that foreign income

the taxpayer is entitled to a credit of the lesser of ...

(d) the amount of Australian tax ...

Payable in respect of the foreign income

So to work out how much credit is to be allowed, it is necessary to know

the amount of foreign tax paid ... And ...

The amount of Australian tax payable in respect of the foreign income

Note that the taxpayer will get a credit for whichever is less ...

The foreign tax ... Or ...

The Australian tax in respect of the income.

Bear in mind, that if the credit is not used, it is lost - it can not be carried forward for use in future years.

An obvious way to get around this problem of losing foreign tax credits not needed in a particular income year would be to manufacture some foreign income out of thin air to soak up the credit.

Income in the guise of interest payments could be manufactured by the stroke of a pen by a good tax avoidance adviser.

To make this harder to accomplish, section 160 AF (7) requires interest to be treated separately from other income - it is assessed separately and subject to separate foreign tax credit limits. Section 160 AE (3) contains details of the definition of interest and safeguarding measures to stop it being 'transformed' into other forms of income.

The same applies to offshore banking income

Let's get back to the calculation of Australian tax applicable to foreign income - so we can work out whether it is more or less than the foreign tax paid by the resident taxpayer.

Section 160 AF (3) gives details as to how to derive the amount of Australian tax attributable to the foreign income.

This involves applying the average rate of Australian tax of the taxpayer to the adjusted net foreign income...

After you have done that you deduct any rebate which relates exclusively to the foreign income.

Let's not worry about rebates for the moment - let's look at the two key components in the calculation of Australian tax payable on foreign income

average rate of Australian tax

adjusted net foreign income

average rate of Australian tax

Both of these are defined in section 160 AF (8)

	income tax payable on taxable income
Average rate of Australian tax =	------------------------------------------------
	taxable income

Answer this question….

Do you think we would include medicare levy along with tax payable in working out the average rate of tax?

Yes No

refer section 61 R (7)

Section 61 R (7) , which is part of the medicare levy legislation, deems income tax to include medicare levy, unless the contrary intention appears in the legislation. There are some exceptions, dealing particularly with rebates and imputation credits on dividends

adjusted net foreign income

Now for the concept of adjusted net foreign income ... That's the second concept in the definition of Australian tax payable on foreign income

To get the definition of adjusted net foreign income, we need to know the definition of net foreign income - that's also found in section 160 AF (8).

Net foreign income is ...

Assessable income which is foreign income...

Less

(a) deductions relating exclusively to foreign income

(b) any amount of domestic loss the taxpayer has elected to offset against foreign income

(c) so much of any other deductions as the Commissioner considers to be appropriately related to the foreign income

Got that?

Let's simplify it and say that net foreign income is ...

Foreign assessable income

less

foreign income deductions

less domestic losses offset against foreign income

less deductions the Commissioner is prepared to allow against foreign income

The Commissioner will not allow taxpayer's to 'load' deductions against either

Australian or

foreign income

to obtain what he refers to as ...'An unwarranted advantage' - refer ITR 2446 for more details

Adjusted net foreign income

The definition of adjusted net foreign income in section 160 AF (8) is pretty horrendous - it deals with three situations.

The third situation dealt with in the definition will be the most common, so we will start with that one.

Before doing so, it will be necessary to establish the meaning of the term, 'apportionable deductions'. - These are defined in section 6 of the 1936 Assessment Act.

The most commonly encountered apportionable deduction is gifts. You could not say they were related solely to income producing activities. They often represent an attempt by the government to use the income tax law to encourage people to do certain things, such as supporting charities or investing in management investment companies.

So they are apportioned between income producing activities and non income producing activities because no one can think of any better way of splitting them up when such a decision has to be made

So now we are ready to look at part (c) of the definition of adjusted net foreign income ... It says ...

, If the net foreign income

, is less than

, taxable income plus apportionable deductions, then ...

			taxable income
Adjusted net foreign income	= net foreign income *	--------------------------------------------------
			taxable + apportionable deductions

Take the case where there are no apportionable deductions...

Adjusted net foreign income will be the same as net foreign income

Let's look at the other two situations mentioned in the definition

net foreign income greater than

taxable income + apportionable deductions

adjusted net foreign income = taxable income

(b) as in (a) it is activated where net foreign income is greater than taxable income + apportionable deductions ...

Remember the concept of quarantining in section 160 AF (7) - it means that the taxable income includes interest and other income - and each component has to be treated separately in working out the credit, to get the adjusted net foreign interest income we work out the amount of interest in net foreign income - let's use some figures ...

Interest	1,000	1
-------------------- =	--------- =	-
Taxable income	3,000	3

Adjusted net foreign income (interest component) = 1/3 * net foreign income

Obviously net foreign income (other income) = 2/3 * net foreign income

At this stage you are probably wondering what happened to our task of working out how credit is allowed in respect of foreign tax paid on income.

Remember we are going to allow a credit of the lesser of the

Amount of foreign tax ... Or...

The amount of foreign tax payable in respect of the foreign income.

So we will have to work out both amounts ...

The foreign tax paid is easy ...

Figures will be readily available if foreign tax has been paid.

That leaves the calculation of Australian tax payable on the foreign income.

First we need the average rate of tax ...

	Tax payable
average rate of tax =	-------------------
	taxable income

Then you need adjusted net foreign income ...

Let's take the easiest (and perhaps most commonly encountered) case

Net foreign income = gross assessable foreign income

less

deductions relating exclusively to foreign income

(we will assume no domestic losses are to be offset against the income and that no other deductions are to be claimed against the income)

So net foreign income = foreign income less foreign deductions

Let's assume that he did not make gifts or have any other apportionable deductions.

Let's also assume that the taxpayer has Australian income so that his net foreign income is less than his taxable income. In other words...

			taxable income
Adjusted net foreign income	= net foreign income *	--------------------------------------------------
			Taxable income + 0 (apportionable deductions = 0)

Get the tax attributable to the adjusted net foreign income

apply the average rate of tax to the adjusted net foreign income

compare this to the amount of foreign tax actually paid

Whichever is less will be allowed as a credit against tax payable.