Australia's Future Tax System

Architecture of Australia's tax and transfer system

8.4 The treatment of cross‑border investments

The past two decades have seen substantial increases in the levels of both inbound investment into Australia and outbound investment from Australia, which today represent 146 per cent and 80 per cent of GDP respectively. The compositions of inbound and outbound investment, however, are very different (Chart 8.9). The levels of inbound and outbound equity investment are roughly comparable, but Australians borrow significantly more from overseas than they lend. The tax treatment of the different components of inbound and outbound investment, as categorised in the national accounts, is summarised in Tables 2.13 and 2.14 in Section 2.

Chart 8.9: Stock of inbound and outbound investment Australia

A: Outbound investment

A: Outbound investment

B: Inbound investment

B: Inbound investment

Source: ABS (2008d).

Australian residents are, as a general rule, taxable on their world‑wide income. Non‑residents are only taxable on their Australian source income. Behind these basic principles of 'residence' and 'source' is a set of complex exceptions, multiple rates of tax and rules designed to enforce these taxing rights. Developments that have accompanied the growth in cross‑border investments have, however, placed increased pressure on both residence‑based and source‑based taxation that may reduce the amount subject to tax (Boxes 8.5 and 8.7).

Box 8.5: Residence taxation and its challenges

Residence is concerned with the allegiance a taxpayer has with a jurisdiction. In establishing residence for individuals, countries generally have regard to either a person's physical presence in the country or other facts and circumstances linking them to that country (covering family and other relationships, economic activity and assets). The residence of other entities (companies and trusts) is determined generally with regard to the place of incorporation or management or, in limited cases, the location of shareholders.

Taxing residents on their world-wide (capital) income has become a more significant issue with the increased mobility of capital. Doing so may have global efficiency benefits (see Box 8.6) and better align with community benchmarks regarding equity in assessing ability to pay (see Section 3). However, it can result in complexity (given the need to deal with flows and transactions overseas, foreign legal entities, and interactions with other countries' tax systems), practical enforcement difficulties (both from tax evasion and from avoidance through complex international arrangements) or taxpayers changing their country of residence. Residence taxation can also be problematic for resident companies to the extent they are owned by non-residents.

In practice, countries (including Australia) exclude much foreign source income from taxation or only tax it as it is received, rather than as it accrues. Most tax administrations, (including Australia's), have responded to the enforcement challenges by seeking enhanced international tax cooperation and information exchange — for example, through tax treaties and tax information exchange agreements. Other countries have also sought to meet the challenges by reducing domestic tax rates on capital income, either across the board (in 'dual income tax' systems), for particularly mobile capital income (such as interest), or for more mobile individuals (for example, expatriates).

Taxing the outbound investments of resident companies and residents

The tax treatment of outbound investments by Australian residents, including resident companies, varies depending on the nature of the outbound investment, the resident entity and the underlying investors (for example, shareholders). The different taxation treatments can be mapped against various efficiency benchmarks that guide policy on the taxation of cross‑border (primarily offshore) investments (Box 8.6).

Most foreign income earned by Australian companies is not taxed at the Australian company level. This treatment is preserved on distribution by specific conduit foreign income rules. As a result, non‑resident owners of Australian companies are generally not liable to tax on foreign income. This outcome is consistent with 'capital ownership neutrality' (Box 8.6) and enhances the ability of Australian multinational companies to obtain foreign equity.

For resident owners, it is at the shareholder level that Australian tax is typically collected. The exemption for most foreign income derived by resident companies means the company income tax does not generally operate as a withholding tax on offshore income. Rather, resident shareholders are effectively taxed on foreign income (net of foreign taxes) when they receive the income as a dividend or realise a capital gain by selling their shares. This is because dividend imputation only credits Australian company income tax.

The lack of a credit for foreign tax paid can offset incentives that could otherwise exist to invest offshore in low‑tax jurisdictions and defer taxation at the resident shareholder level (Chart 8.10). This approach is consistent with achieving 'national neutrality'. Dividend imputation also provides an incentive to pay Australian company income tax in preference to foreign tax and, hence, to allocate profits where possible to an Australian company especially where franking credits are valued. As discussed above, neither of these biases may be operative where non‑resident investors are the marginal source of funds for an Australian company.

Chart 8.10: Nominal EMTRs for an Australian parent company investing
in a foreign or domestic subsidiary(a)

Chart 8.10: Nominal EMTRs for an Australian parent company investing in a foreign or domestic subsidiary(a)

  1. For outbound investments, EMTRs are calculated for an individual resident shareholder on a 46.5 per cent personal tax rate, investing in an Australian company which invests in a subsidiary located either in Australia or a foreign destination. The subsidiary invests in an asset that provides a 6 per cent nominal rate of return (with inflation 2.5 per cent) and retains all profits. Profits are distributed after seven years.

Source: Australian Treasury estimates.

The decision to exempt foreign income requires rules around the deductibility of related interest expenses. Australia's approach is to allow deductions for interest expenses in respect of most foreign income (thereby avoiding practical difficulties of applying a 'tracing approach'). The outbound 'thin capitalisation' rules, which are broadly based on the level of debt an entity can use to fund assets used in its Australian operations, are then the primary means by which Australia seeks to limit excessive allocation of debt to Australian operations.

Another significant aspect of cross‑border investment is the growing importance of collective investment vehicles. World‑wide, these entities hold assets worth more than $29.7 trillion as at December 2007 (Investment Company Institute 2008). In Australia, the most significant form of collective investment vehicle is managed funds (largely trusts, including superannuation funds), which have assets under management in excess of $1.3 trillion at December 2007 (ABS 2008e) of which around 20 per cent is invested overseas.

Income from such offshore portfolio investment (and non‑portfolio investment when not undertaken by a company) is generally subject to tax either when earned (including under the anti‑tax‑deferral rules) or on repatriation, with a credit provided for certain foreign taxes paid (such as dividend withholding taxes). This is broadly consistent with a 'capital export neutrality' benchmark (Box 8.6) as it limits the impact of source country taxation. However, as is the case with direct offshore investment undertaken by Australian companies, generally no credit is given for foreign taxes paid by foreign entities.

Box 8.6: Efficiency benchmarks for the taxation of cross‑border investments

A number of efficiency benchmarks have been identified for the taxation of cross-border investments. The benchmarks focus on achieving a non-distorting (neutral) outcome for particular aspects of cross-border investments and savings, with a view to improving the efficiency of the national or global economy.

Capital export neutrality aims for neutrality in international investment decisions so that the allocation of investments between countries is unaffected by tax considerations. It could be achieved by countries taxing their residents on all their income from offshore investments as it accrues, with a full credit for foreign tax paid. Capital export neutrality has previously been an objective for some countries moving to more comprehensively tax outbound investment income.

Capital ownership neutrality aims for neutrality in the allocation of capital to companies so that the most efficient and productive companies attract capital. It can be achieved by countries not taxing the offshore investments of resident companies, with company income tax focussed on taxing domestic source income. Achieving capital ownership neutrality would be consistent with capital import neutrality, which aims for neutrality in international savings decisions.

National neutrality aims for neutrality in residents' investment decisions on the gross return to their country of residence, with pre-tax returns on domestic investments matching post‑foreign tax returns on offshore investments. National neutrality maximises national, but not global, welfare. In effect, it is a variant of a capital export neutrality benchmark but with a bias to domestic investment achieved by treating foreign tax as an expense of doing business.

The relative merits of the benchmarks are a matter of debate among economists. From a world‑wide efficiency viewpoint, ideally the capital export neutrality, capital ownership neutrality and capital import neutrality benchmarks would all be met. In practice, given the complexity of commerce, the interrelationships between countries' tax systems and sophisticated tax planning arrangements, achieving even one benchmark is challenging.

Taxing the inbound investment of non‑residents

Equity investments in Australia by non‑residents are primarily subject to Australian tax through company income tax. For debt, nil or low withholding tax rates apply to interest income. Other forms of inbound investment may be taxed either on assessment or by means of a withholding tax. Withholding tax rates are set out in domestic law, but are usually reduced on a reciprocal basis under tax treaties.

Tax treaties play an important role in allocating taxing rights between countries, thus giving investors greater certainty as to how their investment will be taxed. The generally adopted approach in Australia's tax treaties is to apply the OECD model tax treaty, which generally restricts source country taxation in favour of residence taxation. Recent treaties have seen Australia's position move closer to the OECD model in some respects. However, Australia's taxing rights over 'real property' are typically broader than under the OECD model, particularly in relation to our natural resources.

Box 8.7: Source taxation and its challenges

Source is the primary basis upon which countries tax the residents of other countries on income that has a nexus with their jurisdiction. The source of income can be unclear or indeterminate, and countries determine what income is sourced in their jurisdiction differently: some legislate comprehensive source rules while others (including Australia) generally rely on judicial interpretation. Tax treaties may also set out source rules that modify the operation of domestic law. Typically, capital gains are not assessed to non‑residents on the basis of source of the gain, but on a narrower connection of the asset with the country. In Australia's case, that connection is satisfied where the asset is land, or a non‑portfolio interest in a land‑rich entity.

As with residence‑based taxation, enforcement of source‑based taxation has faced a number of challenges that have become more acute as: cross-border capital flows have increased; cross-border trade between members of the same corporate group has become more important; intangibles have increased as a share of total assets; e-commerce has developed; financial instruments (and exploitation of debt/equity dividing lines) have become sophisticated; and as tax planning techniques have evolved. More recently, there has been an increased use of hybrid entities and securities that can duplicate tax benefits across jurisdictions, which can give rise to characterisation difficulties and avoid taxation in both residence and source countries.

Countries counter practices that seek to minimise source taxation primarily through 'thin capitalisation' rules to limit the excessive allocation of debt to source country operations, and 'transfer pricing' rules to prevent profit‑shifting to low tax countries through sales between related parties.

Australian tax is, however, only part of the story. Effective rates of tax on an investment in Australia (or alternative investment location) also depend on the tax system of the foreign country from which the investment originates. This includes whether it provides a credit for Australian tax paid or, alternatively, exempts the income from tax. Additionally, effective tax rates are also affected by the country or countries through which the investment is channelled, and the operation of any relevant tax treaties.

The relationship between capital investment flows and taxation is complex. A number of studies have established a link between taxation, foreign direct investment (Box 8.8) and related decisions. However, the extent to which these findings can be applied to Australia may also depend on Australia's geographic position and the presence of location‑specific rents in respect of its mineral resources.

Box 8.8: Taxation and foreign direct investment (FDI)

Optimal tax literature suggests that, in the absence of location‑specific rents, a small open economy should not impose source‑based capital taxes when capital is perfectly mobile between countries. Doing so would reduce investment and, with lower levels of investment, labour productivity, wages and returns to other immobile factors (such as land) would fall.

In practice, capital is not perfectly mobile, location‑specific rents are present (for example, in respect of natural resources and the existing capital stock) and foreign countries may credit domestic tax paid. However, as capital has become more mobile, countries have begun to compete more to attract capital investment. This is particularly so for FDI given its potential spillover benefits — for example, increased productivity in the domestic economy from replicating the efficient processes of multinationals.

While the motivation for competing to attract investment should be increasing real net national disposable income (see Box 3.2), empirical studies have focused on the responsiveness of various measures of foreign investment to taxes. The OECD commissioned a survey that found a direct relationship between levels of tax and FDI, although there is a wide variation in the estimates. Due to methodological and data limitations, the estimates set out in Table 8.1 should be used with caution.

Table 8.1: Summary of empirical studies on the sensitivity of FDI to tax

  Semi‑elasticity   Ordinary elasticity
  Mean Median   Mean Median
Time series -2.61 -2.75   -1.23 -1.28
Cross section -7.16 -4.24   -0.85 -0.78
Panel -2.73 -2.41   -0.78 -0.66
Discrete choice -3.43 -2.80   -0.30 -0.19
All -3.72 -2.91   -0.75 -0.57

Source: OECD 2007e.

On average, the literature review found that a one percentage point increase in the rate of tax would result in a decrease in FDI of 3.72 per cent. In addition, the responsiveness of FDI to tax has increased over time, with investments in physical capital more responsive than other investments (such as acquisitions). The originating country's taxation regime (specifically, whether it has a credit or exemption regime) does not appear to affect the FDI response, possibly because tax planning by multinationals negates its effect.

As noted in Section 5, non-tax factors are also important drivers of FDI. These non-tax factors include macroeconomic stability, a supportive legal and regulatory framework, skilled labour and labour market flexibility, and well‑developed infrastructure. The new economic geography literature that considers location‑dependent benefits (such as from business concentration economies and economies of scale) suggests these may alter the changes in capital flows that might otherwise occur following changes in taxation.