House of Representatives

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon Peter Costello MP)

Chapter 1 - Modifications to exemption for foreign earnings

Outline of chapter

1.1 Schedule 1 to this Bill modifies some aspects of the operation of the section 23AG of the Income Tax Assessment Act 1936 (ITAA 1936) foreign employment income exemption. The amendments aim to reduce compliance costs for taxpayers and address some specific issues that have arisen.

1.2 Unless otherwise stated, all legislative references are to the ITAA 1936.

Context of amendments

1.3 Section 23AG exempts foreign employment income of Australian resident individuals engaged in foreign service for a period of 91 continuous days or more (subject to some conditions). Section 23AG was originally introduced as a method of preventing double taxation for individual taxpayers. However, over time as individuals' circumstances and employment conditions have diversified, situations have arisen that were not considered when the legislation was first developed.

1.4 One area of complexity this measure addresses is the 'credits and debits' rule used to allow an individual to be considered to have a continuous period of foreign service despite short absences. This test will be replaced with a simpler and generally more generous rule that allows different foreign service periods to be aggregated, unless the period of absence that separates them exceeds one-sixth of the total number of days of foreign service at any time.

1.5 These amendments also modify section 23AG in two specific situations: where a taxpayer was employed in Iraq during the suspension of the income tax system, and where a taxpayer dies before reaching 91 days of continuous service.

Summary of new law

1.6 These amendments have three components:

•

Individuals will not break a period of foreign service until the time that absences exceed one-sixth of the days in foreign service. This amendment will apply on or after the date of Royal Assent.

•

Foreign earnings of an individual who dies before reaching 91 days of continuous foreign service will be eligible for the exemption if he or she would otherwise have continued to be engaged in foreign service. This amendment will apply in relation to deaths on or after 1 July 2004.

•

Individuals working in Iraq will continue to have access to the section 23AG exemption despite retrospective suspension of the Iraqi income tax system by the Coalition Provisional Authority. This amendment will apply to assessments for the 2002-03 year or later years of income.

Comparison of key features of new law and current law

Detailed explanation of new law

Simplification of section 23AG: the one-sixth rule

1.7 Section 23AG contains rules to allow individuals to take short breaks from foreign service without breaking a continuous period of foreign service. A continuous period of not less than 91 days of foreign service is necessary to claim the exemption.

1.8 Certain types of absences are counted in foreign service under subsection 23AG(6) (eg recreation leave). Other types of absences are not included or not considered to be part of foreign service (eg long service leave). The current rules apply only to absences that are not considered to be part of foreign service.

1.9 The amendments do not change this distinction, but merely substitute a new rule for calculating whether absences that are not included in foreign service break a period of foreign service.

1.10 Under the current rules, absences from work that do not constitute foreign service will not break a foreign service period if the individual's absentee credit balance is greater than nil. Although an individual earns 2.2 hours credit for one day of foreign service the absentee credit balance only counts whole days. An individual can only accumulate a maximum of 31 days credit. For every 24 hour absence the individual incurs a 24 hour debit. Absences from foreign service of less than 24 hours are ignored.

1.11 The 'credits and debits' system will be replaced by a rule that allows periods of foreign service to be added together until a time that absences exceed one-sixth of the days of foreign service.

1.12 The one-sixth rule is generally more generous than the credits and debits system. It allows for more absences and does not have a 31 days credit limit. It will also reduce compliance costs for taxpayers as the calculations will be simpler.

1.13 The amendments allow two or more continuous periods of foreign service to be combined into a total foreign service period until an individual ceases to be engaged in foreign service, or the one-sixth rule is exceeded, whichever occurs first.

1.14 When applying the one-sixth rule the numerator is the days absent from foreign service that do not constitute foreign service, and the denominator is the total number of days of foreign service. The days included in a total period of foreign service, at a particular time, are the foreign service days from the beginning of the first of the foreign service periods up until that time. The days included in a total period of absence at a particular time are the days of absence from the beginning of the first foreign service period up until that time. [Schedule 1, item 3, subsections 23AG(6A) and (6B)]

1.15 If the total days of absence exceed one-sixth of foreign service days at any time, an individual ceases to be engaged in a period of foreign service for the purposes of subsection 23AG(1). The individual will begin a new period of foreign service when he or she next engages in foreign service and must determine anew whether that foreign service lasts for at least 91 continuous days. [Schedule 1, item 3, subsections 23AG(6A) and (6B)]

1.16 The definitions of 'total period of foreign service' and 'total period of absence' are only relevant for determining whether multiple periods of foreign service may be combined into a continuous period of foreign service. An absence is not considered to be part of a continuous period of foreign service (subject to subsection 23AG(6)).

1.17 The aim of the amendment is to allow taxpayers a similar total period of absence to that allowed by section 23AF, (ie a foreign employment income exemption for individuals working on approved projects). Section 23AF also contains a one-sixth rule.

1.18 However, the rule in section 23AG differs to that in section 23AF, reflecting differences in the basic structure of the two sections. For example, the one-sixth rule in section 23AF applies only to absences in Australia, while the rule in section 23AG does not have this limitation. Also, the one-sixth rule in section 23AF is not applied on an on-going basis, but to an overall period. The one-sixth rule to be inserted into section 23AG will be applied on an on-going basis, in the same way as the current 'credits and debits'. Individuals will effectively calculate daily whether they remain engaged in a continuous period of foreign service or not.

Example 1.1

Jason, an Australian resident, engages in foreign service for 65 days. He takes five days off due to illness which is in accordance with the terms and conditions of that service. This is considered to be foreign service under paragraph 23AG(6)(b). He then takes a further 10 days off that is not considered to be part of foreign service, and re-commences for a further 40 days. In determining whether these two periods of foreign service constitute one continuous period of foreign service for the 91 continuous days test, he must determine whether the total period of absence exceeds one-sixth of his days of foreign service.

Total period of absence: 10 days

Days of foreign service in first period: 70 days (65 + 5)

10/70 = 1/7 As this is less than one-sixth, the next period of foreign service may be added.

Days of foreign service in second continuous period: 40

Added to foreign service days in the first period: 40 + 70 = 110

10/110 = 1/11

As absences do not exceed one-sixth of the total number of days of foreign service at any time, Jason's two periods of foreign service will be taken to constitute one continuous period of foreign service under subsections 23AG(6A) and (6B). Since he has been engaged in foreign service for 110 days (65 + 5 + 40) he would be entitled to the exemption under section 23AG for earnings from those days.

Example 1.2

Assume the same facts as in Example 1.1, except that instead of 10 days, Jason has 20 days of absence that is not considered to be part of foreign service.

Total period of absence: 20 days

Days of foreign service in first period: 70 days (65 + 5)

20/70 = 2/7 As this is more than one-sixth, the next period of foreign service (ie the further 40 days) may not be added to the first period of 70 days. Jason's total foreign service period was therefore limited to 70 days once his absence exceeded one-sixth of his 70 days in foreign service (ie at day 12 of his total period of absence).

As the first foreign service period was only 70 days, Jason's foreign earnings will not be eligible for the section 23AG exemption. When Jason recommences work for 40 days he will start a completely new period of foreign service and needs 91 days of service before any of his earnings for the period are exempt.

Death during a period of foreign service

1.19 The amendments address the situation where an individual does not meet the 91 continuous days of engagement in foreign service test because of his or her death. In this situation the individual will be taken to have met the 91 day test if he or she would otherwise have continued in foreign service for a continuous period of not less than 91 days. [Schedule 1, item 1, subsection 23AG(1A)]

Iraq amendment

1.20 The exemption in section 23AG does not apply where any of the conditions in subsection 3AG(2) exist, for example, where foreign earnings are exempt from tax in the foreign country because the law of that country does not provide for the imposition of income tax on employment income, or similar income (paragraph 23AG(2)(c)).

1.21 The Iraq Coalition Provisional Authority retrospectively suspended the Iraqi personal income tax system from 1 January 2003 to 30 April 2004. This suspension meant the section 23AG exemption no longer applied to Australian residents deriving foreign earnings in Iraq during that period. This was contrary to the expectations of these Australian residents at the time they decided to take up employment in Iraq.

1.22 An amendment reinstates the exemption by providing that subsection 23AG(2) does not apply to foreign earnings derived from foreign service in Iraq during the period in which the Iraqi personal income tax system was suspended. This is referred to in the amendments as the period 'after 31 December 2002 but before 1 May 2004'. [Schedule 1, item 2, subsection 23AG(2A)]

Application and transitional provisions

1.23 The use of the one-sixth rule to determine whether absences from foreign service break the period of foreign service will apply generally to foreign service performed on or after the date of Royal Assent. [Schedule 1, subitem 5(3)]

1.24 A transitional rule will apply to individuals who are engaged in a continuous period of foreign service the day before Royal Assent; that is individuals who are engaged in foreign service, have a credit balance under current subsection 23AG(6A), or would have had a credit balance if absentee credits were able to be counted in hours. These individuals will be able to add foreign service days from their continuous foreign service period before Royal Assent, to the new total foreign service period.

1.25 As the amendments only apply to foreign service performed on or after Royal Assent, the existing rules apply to determine the days of continuous foreign service before Royal Assent. The absentee credit balance will cease to have any relevance. The one-sixth rule will be applied to the total foreign service period plus the days of foreign service accumulated before Royal Assent. [Schedule 1, subitem 5(4)]

Example 1.3

Amy, an Australian resident, is engaged in foreign service for 50 days before Royal Assent. She therefore has four days and 15 hours credit in her absentee credit balance. After Royal Assent she works for a further 20 days, and is then absent for 10 days that is not considered to be part of foreign service. She then works a further 30 days in foreign service. Amy would apply the one-sixth rule as follows:

Days in foreign service: 70 days (50 days before Royal Assent, 20 days after Royal Assent)

Days of absence: 10 days

10/70 = 1/7

As this is less than one-sixth, Amy can add her next period of foreign service.

Days in foreign service after next foreign service period: 100 days (70 days in first continuous period + 30 days in second continuous period).

As 100 continuous days is more than 91 continuous days, Amy is eligible for the section 23AG exemption for her foreign earnings. The four days in her absentee credit balance cease to have relevance, but are effectively replaced by an absentee allowance of one-sixth of 50 days.

If, however, Amy had not been on foreign service for the four days immediately before Royal Assent, she would have had an absentee credit balance of 15 hours (under the modified definition of that term) immediately before the day of Royal Assent. She would then still have been able to add the 50 days of foreign service to her foreign service performed from that day on.

1.26 The amendment allowing the exemption for foreign earnings to apply to individuals who die before 91 continuous days of foreign service applies to deaths that occur on or after 1 July 2004. The amendment is retrospective to clarify the tax treatment in a small number of recent cases where Australian residents have died during a period of foreign service. [Schedule 1, subitem 5(1)]

1.27 The amendment to remove the application of subsection 23AG(2) to foreign earnings derived from foreign service in Iraq during the period in which the Iraqi personal income tax system was suspended, will apply to assessments for the 2002-03 and later years of income. The amendment potentially covers a longer period than the period of relevant foreign service because in some cases taxpayers may receive the relevant foreign earnings at a later stage (eg a later payment made in a lump sum). [Schedule 1, subitem 5(2)]

Consequential amendments

1.28 The amendments repeal the definition of 'whole day' in subsection 23AG(6J). This term will become redundant with the repeal of the 'credits and debits' rules. [Schedule 1, item 4 ]