CURRENT AS AT 23 December 2020
When we refer one of our Australian clients to an international colleague, the first step in the engagement is often to choose the foreign structure that gives our client the optimal outcome. Several factors must be considered, but the global tax outcome is always one of the most important.
Understanding the global tax outcome requires an analysis of both the tax that will be payable in the foreign country, as well as the final tax to the Australian investors, so below is a brief and basic summary of how Australian tax rules apply in various scenarios.
Generally, where an Australian company operates a business overseas, either as an incorporated subsidiary or as a branch of the Australian company, the income derived by the company from that business is exempt from tax in Australia.
Unfortunately, however, when the profit is distributed to Australian shareholders of the Australian company, the rate of tax that applies may be higher than expected.
To take a very simple example, assume an Australian resident individual owns 100% of an Australian resident private company (AusCo). AusCo owns 100% of a foreign resident company (ForCo). ForCo makes a profit of $100 and pays foreign corporate tax of $25, leaving distributable cash of $75. ForCo pays a dividend to AusCo of $75, from which it deducts withholding tax of $5.
The dividend received is exempt from tax in the Australian company, and AusCo is therefore not entitled to a foreign tax credit for the withholding tax, so is left with after tax profit of $70.
As there is no tax paid on the $70 dividend, no franking credits were generated, and the profit is eventually paid to the Australian shareholder as, what is called an unfranked dividend. The dividend is then taxed at the shareholder’s marginal rate of tax. Assuming the highest marginal rate of tax of 47% applies, tax of $32.90 will be incurred.
Total tax on the profit is therefore $62.90, being the $25 of foreign tax, plus the $5 of withholding tax, plus the $32.90 of Australian income tax. This is an effective rate of 62.9%.
Importantly, only the foreign tax is payable in the year the profit is earned. Withholding tax is incurred when ForCo pays a dividend, and the Australian tax is only incurred when AusCo pays an unfranked dividend to its shareholders, which could be several years later.
The global tax rate can sometimes be reduced where a tax transparent entity (such as a US LLC) is used in the foreign country, but only where the investment in the foreign entity is held by Australian individuals or a trust rather than corporate ownership. The trade-off is that all tax is payable in the year the profit is earned.
The table below presents a simplified comparison between an Australian investment in a foreign corporate through an Australian corporate, and an Australian investment in a foreign tax transparent entity with Australian individual shareholders.
|Foreign Company||Foreign Tax Transparent Entity|
|Foreign Tax Paid (by either company or shareholder)||$25.00||$25.00|
|Net Repatriated to Australia||$70.00||$70.00|
|Credit for Foreign and Withholding Tax||$0.00||$30.00|
|Total Tax Paid||$62.90||$47.00|
|Global Tax Rate||62.9%||47%|
The decision on which structure is best may come down to how long the business plans to reinvest its profits in business growth. In the above example, using a foreign company reduces the immediate tax liability by $17 per $100 of profit, an amount that can be reinvested until dividends are paid.
So when we are discussing a new structure for an Australian owned business in your country, the above will give you some background of some of the discussions we will have with you to ensure we obtain the optimal after tax result for our clients. The tax paid in your country, as well as the tax paid in Australia when it is repatriated, will help provide guidance as to what structure will best suit the client.
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