Complex secondary tests put obstacles in the way of an objective definition.
Why the long road to tax residency will be plagued by detours
Treasury recently released a consultation paper, Modernising individual tax residency, prompted by a Board of Taxation (BoT) review of the definition of a tax resident back in 2016. That concluded that the rules were no longer appropriate and needed to be simplified.
In the 2021 federal budget, the former Coalition government announced that it would replace the existing definition with revisions modelled on the BoT proposals, and the Treasury consultation paper now seeks views on those proposals with a closing date of 22 September.
Residency is fundamental
It almost goes without saying that the definition of who is a tax resident is fundamental to the taxing rights that Australia has in respect of that individual. Accordingly, any proposal to change the definition – and particularly one as radical as that proposed – is something the government needs to think about very carefully.
The taxing rights that Australia declares it has over individuals deriving income both in Australia and overseas, which is heavily dependent on the definition of ‘resident’, is something that can have a significant impact on the ability to attract and retain a global workforce. The government must ensure that changes to the fundamental concept of residency don’t scare off people who we desperately need to come and work here.
The consultation paper says (paragraph 6), “The outcomes of consultation will help to inform the government’s decision on whether to proceed with this measure.” So we cannot yet say whether the proposed changes are definitely going to happen.
The definition needs an upgrade
The BoT was correct in initiating a review into the definition of ‘resident’. The issue of determining whether an individual is a tax resident of Australia can be a very difficult decision. It requires a strong knowledge of case law, ATO practice, the obscure concept of a ‘domicile’, and an ability to speculate about what the Commissioner of Taxation considers to be the permanent or usual place of abode of an individual – even when the Commissioner is not aware of the facts!
I have recently run training sessions for accountants in public practice on the Commissioner’s latest ruling (TR 2023/1) on the current definition of residency, released in June 2023. As part of that training I asked participants to give their opinions concerning some of the examples provided in that ruling. On a number of occasions many (sometimes most) of the accountants gave incorrect opinions about the residency status of individuals in the ATO examples. So, if people who make their living from advising clients on their tax status can’t get the answers right, what hope is there for the average person?
The ‘bright line’ test
To fix the uncertainty, it is proposed to have a ‘bright line’ test. If a person is actually in Australia for 183 days or more in a financial year, they will be deemed to be a tax resident of Australia. That’s it! It’s clear and simple.
The problem with bright line tests is that there will always be winners and losers. The bright line will fall favourably for some and unfavourably for others. However, that is the nature of such tests. There is inevitably a trade-off between certainty and simplicity and avoiding harsh or seemingly capricious outcomes.
Those who lose can be most evident during the transition phase from the old law to the new law. People may have one residency status under the old law and then by stroke of parliamentary pen now have a different status with, possibly, a much poorer tax outcome.
One way that the government could deal with this is to have an anti-detriment provision in the new law. The idea would be that if a person could show to the satisfaction of the Commissioner that they were worse off due to the changes, the law could operate so as to put them in the same place as if the old law were still operative. This anti-detriment provision could operate for a fixed period – say, three years.
However, the real issues of complexity and nuances of the new law will be experienced in what are referred to as the secondary tests. The primary test is the 183 day bright line test.
But what if a person is in Australia for 90 days in an income year? Can they still be a resident of Australia? The answer is yes, but to determine this there is a proposed set of complex secondary tests. Space does not allow me to discuss these in detail.
The current proposals employ a secondary set of tests that hinge on whether an individual has been in Australia for 45 days or more (but less than 183 days). There is also a need to know whether a person has been a resident for at least three consecutive years of income before the current year of income. There are also four factors proposed that will be used to indicate whether a person has a sufficient connection with Australia. In addition, there is an ‘overseas employment rule’.
These new concepts will cause complexity, debate, requests for rulings and, ultimately, judicial consideration. Much of the views sought by the Treasury consultation paper concern these secondary tests.
Admirably, the BoT strove to design a system that was completely based on objective tests. The aim is that anyone could answer these objective tests and determine with certainty their residency position. If that aim can be achieved, it will be one of the most significant achievements in the taxation system.
Nevertheless, I note that the Law Council of Australia and the Tax Institute have already expressed reservations about the approach of the BoT in prior submissions to the Treasury in 2021. Broadly, the concerns of those organisations were that the BoT proposals would mean a significant alteration to the concept of who is a resident and would cause more people to become tax residents of Australia. A cynical person may say that is an intended outcome. However, the Treasury disavows any motivation to collect more revenue from the proposed changes.
I think the government should be commended for taking on the significant challenge of updating our tax residency rules for the modern era. Such a fundamental change will, without doubt, attract its fair share of problems and winners and losers. Nevertheless, this is a wholly commendable and worthwhile endeavour.
There is currently no date for the commencement of the new residency rules if they are ever legislated. Due to the release of the consultation paper in July 2023, it may be that Treasury will try to have the new law operational from 1 July 2024 – but there is a long way to travel before then.
John Jeffreys is a director of John Jeffreys Tax Pty Ltd.