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Hong Kong is not a tax haven but it is probably the only international financial centre that is not covered by a Double Tax Agreement (DTA). The relevant DTAs between the People’s Republic of China (PRC) and the UK, the PRC and Australia or the PRC and the US do not apply to Hong Kong. This is because the wording of the relevant DTAs expressly states that the treaties apply only in ‘all territories of the People’s Republic of China in which the laws relating to Chinese tax are in force’, within which Hong Kong, a special administrative region, does not fall. As a consequence, residents of the UK and Australia or citizens of the US who are employed in Hong Kong are required to work out whether they are subject to the domestic tax regimes of their home jurisdictions.

United Kingdom

Taxation in the UK may involve payments to two different levels of government, namely the central government (Her Majesty’s Revenue and Customs (HMRC)) and the local government. Individuals who are employed abroad need to be particularly aware of the taxation obligations imposed by the former.

Residence-based regime
As a residence and source-based tax regime, an individual employed abroad may be subject to income tax in the UK if classified as a resident of the UK for income tax purposes. Notably, there is a difference between residence for income tax purposes and residence for immigration purposes. This article will focus on the income tax regime of the central government as it applies to UK residents working abroad.

A tax resident of the UK who is also an ‘ordinary resident’ for tax purposes is liable to UK tax on the ‘arising basis of taxation’ on all income, UK and foreign. However, special rules may apply to an individual who is a resident of the UK for tax purposes but is not domiciled in the UK or is not ordinarily resident in the UK.

An individual who is a UK resident but who is not domiciled in the UK or not ordinarily resident in the UK can choose to be taxed on either their worldwide income or on the ‘remittance basis’. That individual can also use the remittance basis for foreign capital gains. An individual who is a resident and domiciled in the UK but who is not ordinarily resident in the UK can only use the remittance basis for foreign income. That individual cannot use the remittance basis for foreign capital gains as these will be taxed on the arising basis.

It should be noted that the imposition of UK tax on income from trades and professions that are carried on and controlled outside of the UK and income from overseas investments differs from what has been described above; a discussion of those is beyond the scope of this article.

Marginal income tax rates are applicable to individuals and are quite high (eg 40% or 50% for individuals in the 2010-2011 income year, respectively) in comparison to other OECD countries. Therefore, it is not surprising that individuals who go to work overseas may seek to be classified as non-resident and not-ordinarily resident in the UK.

While ‘residence’, ‘ordinary residence’ and ‘domicile’ are mentioned in ss 829–832 of the Income Tax Act 2007 (UK), they are not comprehensively defined in statute. Instead, their definitions have been principally developed by the HMRC applying the very limited case law in this area. See, for example, Gaines-Cooper v HMRC [2007] STC (SCD) 23; Grace v HMRC [2008] EWHC 2708 (Ch); Shepherd v HMRC [2005] STC (SCD) 644; Inland Revenue v Cadwalader (1904) 12 SLT 449; Levene v IRC [1928] AC 217; IRC v Lysaght [1928] AC 234. This factor alone has led to much uncertainty.

‘Residence’ and ‘ordinary residence’ are to be distinguished. Since ‘residence’ is related to actual presence in the UK during the tax year, which is objectively determined according to whether an individual is present in the UK for 183 days or more in the tax year, or makes visits to the UK that average 91 days or more a year for four consecutive years. If either of these tests are met, then an individual will be classified as a resident of the UK for tax purposes. On the other hand, ‘ordinary residence’ is normally where an individual is resident year after year, with a subjective intention to reside being required. When considering whether an individual leaving the UK has ceased to be ordinarily resident in the UK, for example, relevant factors include pattern of presence both in the UK and overseas, purpose of any return visits to the UK, presence of the individual’s family abroad and lifestyle and habits.

Determining whether an individual is domiciled in the UK is important where there is foreign income during a tax year. Essentially, an individual is domiciled in the country that they regard to be their permanent ‘home’, and unlike residence, domicile cannot be shared–each individual can only be domiciled in one place at any one time.

There are three different kinds of domicile. ‘Domicile of origin’ is a person’s default domicile and is generally the domicile of one’s father at the time of birth. ‘Domicile of dependence’ refers to the domicile of one’s parents for a person under 16. A person who is 16 years of age or older can denounce his or her domicile of origin or domicile of dependence by choosing another domicile, which is known as a ‘domicile of choice’. However, it is often quite difficult to establish a new domicile, as was illustrated in Gaines-Cooper. In that case, a pilot claimed to have abandoned his domicile of origin (England) and acquired a domicile of choice (Seychelles). This case demonstrates that, in order to acquire a new domicile, an individual is required to effectively ‘sever’ all UK ties – a factor that seems to place a heavier burden of proof on the prospective taxpayer.

Changes in 2008
In April 2008, certain changes were implemented under the Finance Act 2008, including day counting for the purpose of determining residence and changes to the remittance basis.

Prior to 6 April 2008, days of entry and exit were not counted towards the tests for establishing residence in ss 829–832 of the Income Tax Act 2007 (UK). For example, business people arriving in the UK on a Monday morning and leaving on a Wednesday evening were only taken to have been in the UK for one day. If this was carried out for 52 weeks of a year, they only accumulated 52 days out of an allowable 90. Now, presence in the UK at ‘midnight’ (excluding days in transit) will count as one day of residence. The ‘midnight test’ has made it easier for non-domiciles of the UK, previously also classified as non-residents of the UK, to now be classified as residents.

Accordingly, individuals who are classified as residents but notdomiciled or not-ordinarily residents in the UK need to be aware of changes to the ‘remittance basis’ introduced in April 2008.

Prior to 6 April 2008, all resident non-domiciles were free to claim the ‘remittance basis’ of tax without charge, which meant that their non-UK income and capital gains were only taxed when and if such income or gains were remitted to the UK. What this meant in practice was that instead of being taxed on the actual income/gain arising in the year, they were taxed on the amount of that income/gain actually brought into the UK in the tax year. The relatively narrow definition of ‘remittance’ allowed certain offshore income (and gains) to be remitted tax free–generally in non-cash form. ‘Alienation’ by way of gifts of cash or assets derived directly or indirectly from foreign income or gains by a resident non-domicile to family members was also not caught.

From 6 April 2008, however, the benefits previously derived were, for the most part, swept away. For example, it is no longer possible to gift non-UK income or capital gains to a connected person outside of the UK and for that person to subsequently remit this without a tax charge on the individual receiving the original income or gains. Nor is it possible to remit income tax free in a tax year when the source of that income had ceased before the start of the year–a measure that puts an end to the so-called ‘carousel’ planning of offshore bank accounts. An individual who chooses the remittance basis, provided certain criteria are first met, will now be subject to a £30,000 (HK$367,000) levy. In addition, he or she will not be entitled to a personal allowance or annual capital gains exemption for that year. Keep in mind, however, that the £30,000 levy will only apply to individuals who have been resident in the UK in seven out of the nine tax years preceding the tax years in question.

Australia

The Australian system of taxation is derived from the UK and is also residence-based. Residents of Australia (for tax purposes) are subject to income tax in Australia on their ordinary income and statutory income from all sources: Income Tax Assessment Act 1997 (Cth) ss 6-5(2) and 6-10(4). Non-residents of Australia are only subject to income tax in Australia on their ordinary income and statutory income from Australian sources: Income Tax Assessment Act 1997 (Cth) ss 6-5(3)(a) and 6-10(5)(a). Ordinary income is essentially income according to common law concepts and statutory income is income expressly listed in legislation.

Section 6(1)(a) of the Income Tax Assessment Act 1936 (Cth) lists a number of alternative tests to determine residency. Under the 183 day test, an individual will be a resident of Australia for income tax purposes if he or she is physically present in Australia (either concurrently or intermittently) for more than half of the year of income, unless the Federal Commissioner of Taxation is satisfied that the individual’s usual place of abode is outside Australia and that the individual does not intend to take up residence in Australia.

Under the domicile and permanent place of abode test, an individual who is domiciled in Australia will be an income tax resident of Australia unless the commissioner is satisfied that that individual’s permanent place of abode is outside of Australia. The courts have held that ‘permanent’ in this regard requires a presence that is more than temporary or transitory, although not necessarily everlasting. For example, taxpayers who had left Australia for an indefinite period (even though they intended to return) or who had left for a fixed period of substantial duration were regarded as having a permanent place of abode outside Australia. See, for example, FCT v Applegate (1979) 38 FLR 1; FCT v Jenkins (1982) 59 FLR 467.

Changes in 2009
Australian residents for tax purposes who are working abroad may be entitled to an exemption from income tax for income from foreign services if s 23AG of the Income Tax Assessment Act 1936 (Cth) applies. Prior to 1 July 2009, any Australian resident for tax purposes who derived overseas employment income would be exempt from Australian
income tax on that income provided that the taxpayer was engaged in foreign service for a continuous period of 91 days or more. From 1 July 2009, however, this exemption only applies to certain limited categories of foreign services income where foreign services were performed for a consecutive period of 91 days or more. One category is the delivery of Australian official development assistance by the individual’s employer.

Nevertheless, individuals who now derive non-exempt foreign employment income as a result of the amendment to s 23AG are able to claim a non-refundable tax offset for foreign income tax paid on that income, arguably relieving double taxation for those individuals.

United States

Like Australia, the US was a former British colony. But, unlike Australia, it does not adopt the residence basis of taxation. Generally, citizens and permanent residents of the US are subject to US tax on worldwide income regardless of source. Non-resident aliens are subject to US tax only on income that originates in the US or is deemed to have a US source. While a detailed discussion of taxation implications regarding estate, gifts and social security, amongst others, is beyond the scope of this article, they are of paramount consideration in relation to the taxation obligations of an American individual.

United States citizens
Citizenship for taxation purposes overlaps with citizenship for immigration purposes and is determined objectively: 8 USCA § 1401(a). It is possible for a person to be a citizen of more than one country at any given time.

An individual can lose their citizenship through the commission of certain voluntary acts, (such as renouncing their US citizenship or expatriating) provided that there is an intention to surrender US nationality. The case of Afroyim v Rusk, 387 US 253 (1967) recognised that a US citizen cannot be deprived of American citizenship involuntarily – there must be intention. Originally, the US Constitution did not address the issue, but now intention appears to be implied in the wording of 26 USCA § 877A(g).

Permanent residents
An individual is classified as a permanent resident if one of a number of tests is satisfied. For example, the ‘Green Card test’ would be met by someone lawfully admitted to the US for permanent residence for US immigration purposes at any time during the calendar year.

It is therefore apparent that the US adopts an immigration approach when casting its income tax net, whereas in the UK and Australia the tests to determine tax residency do not depend on immigration status.

There are three possible scenarios that an American who is working abroad may fall into, namely a US citizen and/or permanent resident of the US who is working abroad: (i) on assignment by a US employer; (ii) who has relinquished this position and is therefore classified as an expatriate; or (iii) employed by an employer overseas. We will look at the second and the third scenarios.

Incentive to expatriate
The US Congress has repeatedly signalled its desire to make taxation of covered expatriates a tax-neutral regime. This desire likely grows from the long-held belief in the US that people should be free to immigrate to and emigrate from the US – recognised as early as 1804 in Murray v The Schooner Charming Betsy, 6 US 64, 93 (1804). This may, however, seem somewhat at odds with the increasingly burdensome obligations that an individual who expatriates may be subject to.

In 2008, the Heroes Earnings Assistance and Relief Tax Act of 2008 (the ‘HEART Act of 2008’) introduced § 877A into the Internal Revenue Code whereby ‘covered expatriates’ are exposed to an ‘exit tax’: 26 USCA § 877A(g). This arguably created more transparency by closing a ‘loophole’ that previously allowed wealthy citizens to delay gains realised for the first 10 years following expatriation. The ‘exit tax’ system arguably removes tax driven incentives to expatriate because, from 17 June 2008, all ‘covered expatriates’ are subject to an ‘exit tax’ upon expatriation regardless of asset source and income from them.

There are some issues concerning the ‘exit tax’. First, enforceability, in particular that the Internal Revenue Service (IRS) has little jurisdictional power to recover money where an expatriate is in a taxhaven where there is no DTA. Also, the IRS lacks sufficient resources to expose every taxpayer’s worldwide assets. Second, there is the potential for double taxation because while the HEART Act of 2008 adjusts the expatriate’s basis in the asset for US tax purposes, thus avoiding double taxation by the US in the event the taxpayer returns to US taxing jurisdiction, no such adjustment is guaranteed for foreign tax purposes. While these potential double taxation issues are not technically of concern to the US government, they are a concern from a policy standpoint in examining the implementation of the HEART Act of 2008.

Employed overseas
Given the unique citizenship-based tax regime applicable in the US, and the potential for overlapping taxation imposed by a foreign country based on residence and/or source in that country, it is even more important for US citizens and/or permanent residents of the US who are employed abroad to utilise the availability of any foreign exclusions and/or credits. In fact, even where there is an applicable DTA, the operation of a ‘savings clause’ will generally not permit a US citizen or permanent resident to avoid US tax.

US citizens abroad may claim a limited exclusion for foreign earned income (FEI) and, with respect to foreign-source nonexcluded income, claim a foreign tax credit (FTC) against US tax for foreign taxes paid or accrued. In relation to the foreign earned income exclusion (FEIE), an individual can exclude a maximum of US$91,500 (HK$711,000) of FEI. It is possible for an individual to take advantage of both the FTC and FEIE, but the FTC is reduced by the FEIE. Further, an individual can claim the FEIE, but if they choose to exclude their FEI or housing cost amounts, then they cannot deduct, exclude, or claim a credit for any item that can be allocated to or charged against the excluded amounts.

Alternatively, it is possible to claim an FTC or deduct foreign income. Taken as a deduction, foreign income tax reduces taxable income. Taken as a credit, foreign income tax reduces tax liability. Essentially, if an individual is working in a high-tax country, then it would be best to elect the FTC. In addition, there may be benefits associated with carry-backs and carry-overs: ie that if the foreign taxes paid or incurred during the year exceed the limit on an individual’s credit for the current year, then the unused foreign taxes can be carried back as credits to two prior tax years and any remaining unused foreign taxes carried forward to five later tax years.

Comparing taxation regimes

There exist a number of advantages and disadvantages in relation to the variation in tax regimes that face individuals from the UK, Australia and the US who are employed in Hong Kong. While the validity of taxing worldwide income (particularly on the rationale of the ‘ability-to-pay’ theory that an individual’s economic resources, both current income and accumulated wealth, are under his or her control) is not disputed, the rationales for taxing citizens and residents who are employed abroad may shed some light on which regime is preferable.

The validity of citizenship-based taxation can be justified on a number of basis. First, it serves the goal of neutrality by minimising the role of taxes in a citizen’s residency decision – a factor reinforced by the imposition of the ‘exit tax’ in 2008. It can be argued that eliminating citizenship-based taxation might lead to resident citizens believing that citizens abroad are getting away with something, consequently leading them to lose confidence in the tax system and the social norm of tax compliance.

Second, according to the ability-to-pay principle, a concept that in fact originated in 1380s England, citizens abroad are treated as members of US society and are thus subject to a liability to pay tax because their failure to renounce citizenship reflects a selfidentification with the population of the US or an acceptance that citizenship is worth the price. The benefits afforded to citizens residing abroad, such as ‘personal protection’, ‘property protection’, ‘right to vote’, ’right to enter’, and ‘past benefits’, provide the US with sufficient justification to exercise some type of taxing jurisdiction over those citizens. In fact, this rationale could be said to be justified on the converse basis of the principle of ‘no taxation without representation’– a principle that influenced the War of Independence.

Not all US citizens who are overseas for long periods, however, utilise such benefits. Certainly, citizenship-based taxation could be justified if a citizen has a strong enough connection with the US, for example if they live year-after-year in the US and seldom depart for short-term business. In fact, fundamental fairness suggests that such citizens should be equitably allocated a tax burden.

On another note, there appears to be a clash between neutrality and equity in the existence and administration of citizenship-based taxation. The IRS’ drive for compliance (demonstrated by, amongst other measures, the IRS’ international enforcement measures concerning offshore bank accounts) coupled with its extensive information gathering powers gives it quite a heavy hand when compared to a US citizen who is employed overseas often with a lack of satisfactory taxation resources.

Comparatively, the validity of a residence-based system can be put down to being effectively an ‘accident of history’. In lieu of an applicable DTA, there is a heightened importance to have certainty in determining residency for tax purposes. Presently, this is lacking, the impact of which is particularly apparent in the UK. While the concept of residence is referred to in statute in both the UK and Australia, it is not comprehensively defined and the principles that do exist are complicated and relatively vague. A solution to this problem could lie in the development of a statutory test, which may be possible in the future, particularly in the UK.

In finding a basis to compare citizenship-based taxation with residence-based taxation, a concept already mentioned becomes relevant as a starting point, namely that of ‘no taxation without representation’. Essentially, the US appears to have adopted a principle from 1340s England that no taxation should be imposed without the consent of the commonalty, and that if one has representation, one should also be subject to taxation. Interestingly enough, taxation only on the basis of residency is not consistent with this concept. In a residence-based tax regime, there is a distinction between residency for tax purposes and citizenship for immigration purposes, so that there exists taxation without
representation and, on the flip-side, representation without taxation.

In summary, there does not appear to be any ‘right’ or ‘wrong’ view in relation to which regime is preferable. Rather, it depends on whether one adopts the perspective of the taxpayer, the tax collector or a wider social view.

Sarah Hinchliffe
Barrister and Solicitor
(Supreme Court of Victoria, High Court of Australia)
Associate of the Taxation Institute of Australia
Teaching Fellow, The University of Melbourne
sarahah@unimelb.edu.au