Explaining the Saving Clause I

When it comes to fixing the tax treaty, the “Saving Clause” is a key piece of the puzzle. From the discussion that followed the Strategy Roadmap, it is clear that many find the saving clause very confusing. So, in a series of three posts, I’m going to attempt to explain how the saving clause works and why it is important. In this first post we’ll look at how international tax works under the Residence Based Taxation model used by three quarters of the taxing jurisdictions in the world and covering almost 90% of world population, without the saving clause. The second post will look at how the saving clause, coupled with Citizenship Based Taxation changes the result. In a nutshell, we’ll see that the saving clause allows the US to tax US citizens living in Australia on their Australian source income. The final post will explore ways to fix the problem.

Part 1: What does the world look like without a saving clause?

In an ideal world, each country has sovereignty over its own territory. This means that each country should be able to tax the economic activity within its borders without interference. In semi-technical tax jargon, this can be stated as:

The Australian Source income of Australian Residents should be taxable only by Australia.

Let’s break that down. Australian Source income is any income earned inside Australia:

• salaries and wages where the work is done in Australia,
• rental income from property in Australia,
• investment income from shares of Australian companies and managed funds organised in Australia,
• superannuation,
• Australian government benefits.

Australian Resident means anyone whose home is normally in Australia or who is living in Australia for more than half of the year. See this page for the precise ATO rules.

If you’re an Australian resident for tax purposes, then Australia has the right to tax you according to Australian tax law on all of your worldwide income. The principle above relates only to the Australian source income of Australian residents. What happens when you have income from a country you don’t live in? Each country has the sovereign right to tax economic activity within its borders.

If there is no treaty, then the law of the source country (the country where the income is earned) determines whether that country will tax income earned by non-residents.

If a tax treaty exists, its purpose is to specify what each country can tax when residents of one country have income or assets from the other country. The treaty works in conjunction with the tax law for non-resident taxpayers in each country. For example, if you’re not an Australian resident for tax purposes, then Australia will tax you only on Australian Source income under the tax rules for foreign-resident (non-resident) taxpayers. Where there is a treaty, it can override Australian tax law to determine how a particular foreign person is taxed on their Australian income.

For the vast majority of Australian residents, the income they earn from working in Australia or from assets they own in Australia is taxable only by Australia. They may also be British subjects or citizens of China or Chile, but while they are Australian tax-residents, they are subject to Australian tax, and almost no other country claims the right to tax that Australian source income. This is logical and just. A dual Australian-Chilean citizen will only be interested in the tax treaty if they have assets and/or income from a country they are NOT resident in.

This is pretty abstract, so let’s work with a hypothetical example. Say Maria is a dual Australian-Chilean citizen[1] who has lived and worked in Perth for decades. She inherits a small rental property in Santiago, Chile from her parents. Who gets to tax the rental income? As an Australian resident, Maria is subject to Australian tax on her worldwide income – this includes the rental property in Chile. However, the tax treaty with Chile says that income from real property may be taxed by the country where the property is located – Chile. So, Maria will pay tax to Chile on the rental income. When Maria computes her Australian tax, she will include the Chilean rental income, but she will be able to deduct the Chilean tax paid from her Australian tax on that income (a foreign tax credit). In computing her Chilean tax, all Maria will report to Chile is the rental income from Santiago – any income she earns in Australia is not taxable in Chile. In fact, before she inherited the property in Santiago, Maria would have had no reason to file Chilean taxes at all.

Australia does have a tax treaty with Chile, and that treaty does not have a saving clause. The saving clause, if it existed, would be in the part of the treaty that determines who the treaty applies to. In the Australia/Chile treaty, this is Article 1 which reads:

Article 1

PERSONS COVERED

This Convention shall apply to persons who are residents of one or both of the Contracting States.

Pretty simple, right? If you are a resident of either Chile or Australia, you can use this treaty. If you’re an Australian resident with assets or income from Chile, then you can read through the treaty to see whether your type of income is covered. For example, if you run a business in Australia and have sales in Chile, then the treaty will tell you that your income from sales in Chile are only taxable in Chile if you have a “Permanent Establishment” in Chile. Roughly translated – if you open a  shop in Chile, the income of that shop is taxable in Chile. If you sell into Chile through eBay with no operations in Chile, then your income is not taxable in Chile[2].

In sum, if you’re an Australian resident who is NOT a US citizen and you have income from another country, that country may tax you, but only on income from within their borders. Your Australian source income will only be taxed by Australia.

In the next post, we’ll look at how a saving clause coupled with citizenship based taxation would change Maria’s tax liability.

[1] Actually, citizenship is irrelevant for Maria because Chile taxes based on residence rather than citizenship – the important facts are that she is an Australian resident for tax purposes, and she owns property in Chile.

[2] Remember that this post is just general information. If you have a real transaction worth real money, then consult with a real tax professional!