A new tax residency framework: Certainty and unintended consequences

Australian tax residency rules have been in place for more than 80 years, but that’s not necessarily a good thing. It’s 2023, and we’re living in the Digital Age with the future of artificial intelligence on the horizon.

They way people live, work and travel has changed a lot since the dawn of the Atomic Age. It’s clear that these residency rules are no longer fit for purpose, but identifying the problem is the easy part.

How we actually transition to a modern set of rules that can addresses the short comings of the current regime is a bit more complicated, and a raft of recent tax law cases has highlighted why providing this kind of advice is so challenging for advisers.

Practitioners require certainty and, if they are uncertain, their only real option is to seek advice from the ATO, so a lack of clarity in the current regime results in a significant increase in the number of requests for private binding rulings that deal with residency issues.

The consequences of these outcomes can have significant implications for a client's tax position, hence the reason why advisers want to make sure their ducks are carefully lined up in a row before they provide advice.

While practitioners can base their advice on reasonably arguable positions, there is a high level of difficulty with the application of the current rules creating uncertainty.

The current residency rules require the holistic evaluation of an individual’s facts and circumstances, which also requires the significant investment of time and resources at a substantial cost to clients.

The current law is based on outdated subjective concepts such as the resides test and the domicile test. Furthermore, the current regime requires the practitioner to prove their client’s intent, which is problematic at the best of times.

The impetus for change is long overdue, especially given the lack of certainty, and the compliance burden practitioners face when applying the current rules. Simply put, the current regime imposes risk for advisers under the tax self-assessment system.

Bright-line tests increase certainty

The Government's starting point for a new individual tax residency framework is based on recommendations made by the 2019 Board of Taxation (BOT) report Reforming Individual Tax Residency Rules – A Model for Modernisation.

This framework places more reliance on objective tests to improve certainty and reduce the compliance burden, and uses a two-step approach.

The primary test is the 183-day ‘bright-line test’, which specifies that any individual physically present in Australia for 183 days or more in any income year will be an Australian tax resident.

If an individual spends less than 183 days in Australia across two income years, a secondary test, based on 45 days of physical presence and other factors, can be used to establish that the individual has a sufficient connection to Australia and that they should be treated as a resident for tax purposes.

There is insufficient detail provided on how the other factors are defined, so we expect some interesting interpretational issues going forward, which can potentially create its own complexity and undo some of the simplicity around the two-step approach.

The proposed framework will provide more certainty and lower compliance costs for the majority of taxpayers.

Unintended consequences of a new tax residency framework

Once an individual has spent sufficient time in Australia and made enough connections to become a tax resident, the proposed framework assumes it is appropriate for the individual to remain a tax resident until those connections are scaled back to such an extent that they no longer benefit from their connection to Australia enough to justify being taxed as a resident.

As a result, this new overriding principle will make it harder to cease being a tax resident than it is to become a tax resident, which is an outcome that not everyone will be pleased about.

There are many scenarios where someone can spend more than 45 days working in Australia for an overseas entity in an income year on a regular basis that could trigger tax residency for them here.

It would be unfortunate and very problematic for individuals who want to visit Australia for an extended period of time to be discouraged from doing so. As such, it’s important to understand how this framework can create unintended consequences based on how other factors are used to determine residency.

The proposed framework addresses some of the known integrity issues such as where an outbound individual is no longer a resident, but not legally qualifying for residency under another country’s tax law — i.e., a ‘resident of nowhere’.

Introducing bright-line tests could also potentially lead taxpayers to manipulate their behaviours to achieve a certain outcome that is inconsistent with the policy intent that the legislation aims to achieve.

More certainty can come at a cost, so we need to weigh the benefits of improved certainty against the unintended outcomes that they might cause as we move to a more simplified regime for determining tax residency.

Consultation and next steps

Despite the BOT recommendation that the new rules should align domestic tax residency with outcomes under double tax agreements, the Government is not planning to adopt this recommendation at this stage, stating that it would likely make it more complicated for many taxpayers with otherwise simple tax affairs.

As a result, the interaction of our domestic rules with double tax agreements is out of scope for this consultation process.

We have the benefit of looking at the way other jurisdictions around the world have developed rules for dealing with this issue because it’s not unique to Australia.

Let the consultation process begin, and let’s be grateful that there is a long response period to hammer out all the details.

Depending on the outcome of the consultation process the Government may not even proceed with the proposed framework if it does not achieve the intended outcome of simplicity, consistency and certainty.

IPA members are invited to provide feedback: tony.greco@publicaccountants.org.au