27 September 2021

Undeclared Foreign Income – the stick approach (TA 2021/2)

This article was written by Jerome Tse and Amanda Kazacos.

Over the course of almost a decade, the ATO has been consistently focused on ensuring foreign income of Australian residents is taxed correctly in Australia. This can be seen from as early as the launch of Project DO IT in 2014 to the introduction of the Common Reporting Standard (CRS) for the automatic exchange of financial account information through to the ATO’s “Tax Avoidance Taskforce” launched in 2019 (and in operation until the 2022-23 income year).

On 17 September 2021, the ATO released Taxpayer Alert TA 2021/2 identifying the ATO’s concerns with certain arrangements where Australian resident taxpayers derive income or capital gains (foreign assessable income) offshore, but fail to declare the foreign assessable income in their Australian income tax returns due to the characterisation of the funds as a “gift” or “loan” from a related overseas entity (Taxpayer Alert). The Taxpayer Alert is the latest initiative by the ATO in its focus on ensuring Australian residents are assessed for tax on all of their worldwide income.

The importance of the Taxpayer Alert is that while the ATO’s focus on taxing foreign assessable income has remained unchanged, the motivational approach the ATO employs to ensure that foreign assessable income is taxed in Australia has changed. Namely, the ATO has moved from a “carrot” approach, being an incentives-based voluntary disclosure regime in Project DO IT, to a “stick” approach, a warning in the form of the Taxpayer Alert that arrangements of this nature could result in both taxpayers and their advisers facing “substantial penalties and [the] risk of potential sanctions under criminal law”. The transition to the “stick” approach also aligns with the ATO’s increased ability to source data to identify arrangements of this nature.

This combination of factors should cause taxpayers to pause and either ensure that they have enough documentation to substantiate the receipt of funds as a genuine gift or loan, or voluntarily disclose the arrangement to the ATO to minimise substantial penalties, interest and sanctions.  The ATO’s increased data collection and matching capabilities means that it is only a matter of time until the transaction is reviewed.

Key takeaways from Taxpayer Alert TA 2021/2

The ATO has indicated that it will target arrangements that have some or all of the following common features:

  • An Australian resident taxpayer deriving foreign assessable income that is not declared in their Australian income tax return (whether by deriving the foreign assessable income, attribution of the foreign assessable income or otherwise).
  • The foreign assessable income is repatriated by a related overseas entity to the taxpayer (or associate of the taxpayer) in Australia (whether in a single instalment or multiple instalments).
  • The true character of the foreign assessable income is concealed under the guise of a gift or loan.
  • In the case of a purported loan used by the Australian resident taxpayer in gaining or producing assessable income, the taxpayer claims a deduction for interest on the purported loan and while withholding tax is remitted, often no amount of interest or principal is ever repaid (interest is capitalised).
  • Where the transaction is identified or audited, the Australian resident taxpayer concedes that they were disguised transfers to avoid laws in other countries (without evidence of this).

The ATO is not focused on arrangements where an Australian resident taxpayer has not derived any foreign assessable income but has received a genuine gift or genuine loan from a related overseas entity. A genuine gift or loan would be one where appropriate documentation supports the characterisation of the receipt as a gift or loan (as appropriate), the parties’ behaviour is consistent with that characterisation and the monies provided are sourced from funds genuinely independent of the taxpayer. 

The taxpayer’s burden and the need for evidence

Where a taxpayer has received a gift or loan from a foreign related entity, the onus will be on the taxpayer to substantiate the position that this gift or loan (as appropriate) is a genuine gift or genuine loan and not an arrangement that will fall within the Taxpayer Alert. The ATO has provided guidance on examples of the types of appropriate documentation to evidence a genuine gift or genuine loan. 

Evidence to Support a Genuine Gift

Evidence to Support a Genuine Loan

Contemporaneous declarations the donor has made in their country of residence about the nature of the amounts transferred.

Properly documented loan agreement that details the terms of the loan (including parties, term of loan, interest rate payable, principal amount and other conditions).

An executed contemporaneous deed of gift prepared by the donor (or other similar documentation).

Correspondence / documentation relating to the loan arrangement, including pre-contractual negotiations as to the terms and any variations made post agreement.

Formal identification of the donor (such as a copy of their photo identification from their passport or identity card).

Documents to support security provided or guarantees given in support of the loan.

A copy of the donor's bank statements showing the gift and the donor's capacity to make the gift from their own resources.

Facility arrangements governing the draw down and transmission of funds as well as authorisation to access or draw down loan amounts.

A certified copy of the donor's will or distribution statement for the estate (to the extent it relates to the distribution of the gift).

Financial records such as bank statements evidencing the terms of the loan (e.g. showing the advance of funds and subsequent repayments, including interest payments).

Financial records reflecting the donor's transfer to the taxpayer.

Financial and accounting records that show how the taxpayer used the amounts (e.g. journal entries, bank statements, receipts).

 

Any declarations the lender has made in their country of residence about the provision of the loan.

 

Foreign bank account statements reflecting the transactions relating to the loan and the lender's ability to make the loan.

 

Financial plans, cashflow forecasts, net assets position or budgets showing an intention or capacity to repay the loan.

We acknowledge that the ATO’s guidance requires taxpayers to obtain and retain extensive documentation.  In our experience, it can be difficult to obtain the documents mentioned above from entities in foreign jurisdictions for a number of reasons. 

First, it is common for gifts or loans (even of substantial sums) between family members and/or related entities to lack documentation simply due to the relationships between the parties.  Whilst the greater the sum involved, the more likely the ATO will objectively consider documentation to be necessary, this is not always the case in practice.  In these situations, we have suggested to taxpayers to consider other evidentiary sources by which a loan or gift can be substantiated.  This might include taking witness statements overseas or providing sufficient comfort to the ATO of the source of those funds through financial records or by a review of less formal contemporaneous communications (emails, faxes and social media apps such as WhatsApp and WeChat).  It may become the case that the various sources of information, individually or when viewed holistically, can provide sufficient evidentiary comfort to the ATO.

Secondly, such difficulties could be owing to an unfamiliarity by the foreign entity, or sometimes even the Australian taxpayer, with the necessity for the requested documentation to be provided to the ATO.   Here, a patient explanation of the Australian tax system, including the reverse onus of proof, is required.  Just as we in Australia sometimes misunderstand foreign laws when travelling, the same can apply when foreigners or those newer to Australia are being asked to apply our laws.  Ultimately, an unwilling or resistant taxpayer (or foreign party) will only harm themselves, and our job as advisers is to address the root of such unwillingness or resistance so that we can achieve the best outcome possible. 

Thirdly, there may be a reluctance to hand over information because it will be provided to a government authority (ie the ATO).  Amongst other reasons, this reluctance can stem from a mistrust of government generally, having regard to the lived experiences of the foreigner, or because, as the ATO states, the transaction is intended to “avoid laws in other countries”.  These are the most difficult discussions, as even genuine loans or gifts that lack corroborating evidence will result in the taxpayer failing to satisfy the evidentiary burden.  In these situations, it is critically important to find an alternative means to identify the true source of the donor’s or lender’s funds.

Overall, while it is trite to say, it is in a taxpayer’s best interests to ensure that where they have a loan or gift arrangement of a substantial sum from an overseas party, appropriate contemporaneous documentation is prepared, obtained and retained.

ATO intelligence and data gathering

The ATO’s movement from a “carrot” to a “stick” approach aligns with the ATO’s increased capabilities to first obtain data from domestic Government agencies and overseas regulators and secondly, to process significant terabytes of data at astonishing speeds.  In doing so, the ATO’s data capabilities to identify potential arrangements of the nature described in the Taxpayer Alert should not be underestimated.  By way of example, the ATO and the Australian Transaction Reports and Analysis Centre (AUSTRAC) have an agreement to share and compare financial information.  Specific data matching programs are also commonplace and the list of the ATO’s current specific data matching protocols can be found on its website.   In addition, specifically with respect to foreign information, Australia has entered into 36 Taxation Information Exchange Agreements (including with Lichtenstein, Bermuda, The Cayman Islands and The Bahamas) and additionally under the CRS, the ATO has shared data on financial account information of foreign tax residents with over 65 foreign tax jurisdictions.  It should be assumed that the ATO will exercise at least some of these powers in the course of auditing arrangements the subject of the Taxpayer Alert.  The increased information at the ATO’s fingertips, combined with its focus on taxing foreign assessable income of Australian residents, means that the ATO is likely to identify and investigate arrangements that are the subject of the Taxpayer Alert.

What should affected taxpayers consider?

Taxpayers that are potentially able to obtain sufficient evidence to prove their loan or gift is genuine should seek professional advice and begin to do so immediately.

Taxpayers that cannot obtain evidence to discharge their burden of proof or have, to date, failed to declare foreign assessable income in their tax returns should very seriously consider obtaining professional advice and voluntarily disclosing arrangements of this nature to the ATO.  As the ATO has outlined in the Taxpayer Alert, arrangements of this nature will result in both taxpayers and their advisers facing substantial penalties. Voluntary disclosures can significantly reduce the imposition of penalties of up to 90% of the tax liability.  Additionally, where the ATO alleges fraud or evasion in its review of the arrangement, the time limit for the ATO to review the potential arrangement is unlimited.  Again, a voluntary disclosure, on the basis that it is more and more likely that the ATO will become aware of the transaction, should be considered. 

Finally, the tax issues around undeclared foreign assessable income received by an Australian resident can be incredibly complicated. They involve not just a consideration of whether income is assessable under ordinary principles in Australia.  In our experience, the issues can also include (and are not limited to) whether there should have been an application of Division 7A, the transfer pricing regime, the controlled foreign company regime, the transferor trust regime or Part IVA. The ambit of potential tax issues that could arise, along with penalties and interest that often exceed the primary tax in dispute, mean that it is in a taxpayer’s best interests to obtain advice quickly, and to get greater peace of mind in order to move forward with their business and personal lives.


[1] This article was published by Thomson Reuters in the Weekly Tax Bulletin on 24 September 2021.

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