International taxation is a complex topic. So let’s start with some building blocks.
International Taxation 101
The world has become much smaller. Fifty years ago you would have had to be a large operation to consider expanding overseas. But now it is much easier, it’s perfectly feasible even when you are relatively small with a turnover of maybe $0.5m or $1m.
But when your clients expand overseas, their tax affairs become very complex. So for this purpose let’s drill deep into international tax over the next few weeks
In this episode Clint Harding of Arnold Bloch Leibler in Sydney will walk you through seven concepts in international tax – the foreign hybrid rules, the hybrid mismatch rules, thin cap and transfer pricing, CFCs, portfolio v non-portfolio dividends, and of course withholding tax.
To listen while you drive, walk or work, just access the episode through a free podcast app on your mobile phone.
International Taxation
Let’s look at 7 basic concepts highly relevant to international taxation:
1 – Foreign Hybrid Rules
2 – Foreign Mismatch Rules
3 – Thin Cap
4 – Transfer Pricing
5 – CFCs
6 – Portfolio v Non-portfolio dividends
7 – Withholding Tax
If you understand these, you got the basics.
1 – Foreign Hybrid Rules
The foreign hybrid rules live in Div 830 ITAA97 and are about foreign look-through entities – the US calls these ‘flow-through entitites’.
If the source country treats a company as a flow-through, so as a partnership or sole trader, then we do the same in Australia thanks to the foreign hybrid rules. Without these rules we would have to treat the foreign company as what it is – a company.
Take a US-American LLC as an example. Without these rules the LLS would be treated as a company in Australia. With the foreign hybrid rules you treat the LLC as a sole trader or partnership in Australia if it qualifies as a flow-through in the US.
The foreign hybrid rules only apply if the relevant entity is not an Australian tax resident.
2 – Foreign Mismatch Rules
The hybrid mismatch rules are just to stop funny games using mismatches between local tax laws and double tax agreements.
3 – Thin Cap
The thin cap rules are to stop you from gearing Australian entities with high amounts of debt and to then use interest payments to transfer profit to overseas entities, most likely in tax havens.
So the thin cap rules are all about your debt-to-equity ratio but only kick in if you want to deduct more than $2m of interest. But even if the thin cap rules don’t kick in, you still have the transfer pricing rules to contend with.
4 – Transfer Pricing
The transfer pricing rules – just like the thin cap rules – are all about profit shifting. They are to make sure that profits generated in Australia are not shifted overseas through inflated management fees, royalties in IP or stock prices or – see above – interest payments through a low debt to equity ratio.
5 – CFCs
The Controlled Foreign Company (CFC) rules are to stop you from parking passive income overseas.
So let’s say you set up a company in the BVI, move $10m into that company and get $0.5m return each year. Without the CFC rules you could just park those profits in the BVI.
But with the CFC rules – if you have control – those profits are attributed to you, so the foreign company is basically treated like a look-through entity.
But before you look at the CFC rules, first check residency and how passive the income is. Because if the company is an Australia resident anyway or if 90% of the income is active, then you don’t need to worry about the CFC rules. So the CFC rules are only about passive income without Australian residency.
6a – Portfolio Dividends
When you hold less than 10% in an overseas company, you receive portfolio dividends. Think of your ‘investment portfolio’.
The dividends are subject to withholding tax but you receive a foreign income tax offset (FITO) in Australia. You recognise the gross-up amount as assessable income.
A company also receives a FITO but since the overseas tax doesn’t hit the franking account, the FITO is lost upon distribution to shareholders. This is called withholding tax leakage. Please see episode 284 Investing in Overseas Shares for more on this.
When you hold portfolio shares in individual names or through a trust, then you don’t have withholding tax leakage.
6b – Non-Portfolio Dividends
When you hold 10% or more in an overseas company, then you receive non-portfolio dividends. These dividends might also be subject to withholding tax (WHT), but often at a lower rate.
Thanks to the Australia – US DTA for example the WHT drops from 15% to 5% when you hold at least 20% and drops to 0% when you hold at least 80%.
Non-portfolio dividends are NANE in Australia due to s768A ITAA97, meaning they don’t hit your assessable income. But for that you also don’t receive a FITO.
But whether they are NANE or not and whether you get a FITO or not only matters while you retain the profits within the Australian company. When you distribute those profits, the profits are taxed as unfranked dividends at the shareholder’s marginal tax rate, so the benefit of any NANE or FITO is lost anyway.
7 – Withholding Tax
Withholding tax is a mechanism to cover your tax obligation in the source country.
Withholding tax rates are a confusing conglomerate of DTAs and amendment protocols. When you receive a dividend (or royalty fees or interest), the WHT is what it is unless you think there is a mistake.
But when you pay a dividend (or royalty or interest), then you need to check the relevant DTAs, any amending protocols and the fine print in those to make sure you withhold the correct amount.
TOFA
And then we also spoke about TOFA. But TOFA is not really an international tax concept but about financial gains and losses – be it domestic or overseas.
TOFA has a minimum threshold of $100,000,000 so most of us won’t have to worry about TOFA. You can opt into TOFA but that only works in your favour in very limited circumstances.
Summary
So the foreign hybrid rules are about foreign look-through entities. If the source country treats a company as a look-through, then we do the same thanks to the foreign hybrid rules.
The hybrid mismatch rules are just to stop funny games using mismatches between local tax laws and double tax agreements.
The thin cap rules are to stop you from highly gearing Australian entities with debt and to then use interest payments exceeding $2m a year to transfer profit to overseas entities, most likely in tax havens.
But even if the thin cap rules don’t kick in because you are under $2m interest a year, you still have the transfer pricing rules to contend with.
And of course the transfer pricing rules also apply, when you try to transfer profit through management fees, royalties in ip or inflated stock prices for example.
The CFC rules are to stop you from parking passive income overseas by attributing that passive income from controlled companies back to you.
And TOFA has a minimum threshold of $100,000,000 so most of us won’t have to worry about how to treat gains and losses from financial arrangements under TOFA and TOFA is not about international tax as such anyway but about financial arrangements.
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