Tax treaties are formal agreements between countries that help the individual tax authorities communicate, prevent double taxation and fiscal evasion, and assist each other by enforcing their different tax laws. Australia has tax treaties with over 40 countries, including the U.S. While it can seem quite complicated, we’re here to break down some of the basics for you to help you get a better understanding of how the U.S.-Australia Tax Treaty might affect you as an American living in Australia.
U.S. Taxation of Australian Income
The United States remains one of the only countries that enforces its taxation on worldwide income. So, if you are a U.S. citizen or green card holder and your worldwide income exceeds the IRS’s minimum thresholds, you will be required to not only file a U.S. tax return but also pay taxes to the IRS, no matter where in the world you’re residing or where you’re earning that income.
Additionally, if your income is sourced within Australia, you will also need to lodge an Australian tax return and pay tax to the ATO. So, after all this, you might be thinking, well, what will be left over?
This is where the tax treaty comes in handy and why it was designed in the first place. It contains provisions that help Americans living in Australia avoid this exact double taxation situation. The two main solutions are the Foreign Earned Income Exclusion and the Foreign Tax Credit.
Foreign Earned Income Exclusion vs Foreign Tax Credit
There is quite a difference between the income exclusion scheme and tax credits, and one might be more beneficial for your situation than the other. Foreign tax credits work by lowering your income tax directly, which will reduce the tax you might owe. Certain Foreign Tax Credits are refundable, and they can even increase your tax refund if you’re eligible for one.
On the other hand, the Foreign Earned Income Exclusion (FEIE) lowers your taxable income. This option reduces the figure that the IRS will use to calculate your tax, which can lessen or eliminate your tax bill altogether. It allows you to exclude a certain amount of your foreign-earned income from your tax return. For the 2023 financial year, the threshold allows you to exclude up to $120,000 in foreign income through FEIE. So, if you’re a U.S. expat who earned under $120,000 during the financial year in foreign income, you could end up with a $0 tax bill from the IRS.
For Americans living in Australia, claiming Foreign Tax Credits are often the better choice. Because the tax rate is higher in Australia than in the U.S., claiming the FTC will typically eliminate any U.S. tax you might owe. The Foreign Tax Credit route also offers more flexibility than FEIE, and doesn’t have any lock-in requirements or limit your U.S. travel. You’re also able to carry unused tax credits forward and apply them to your next 10 years of tax returns. Even so, it’s always important to consider your unique financial situation and your eligibility for these provisions before choosing one or the other.
I want to know more about US taxes abroad
As you probably know, the U.S. and Australia have quite different definitions of residency, and because of this, an individual may qualify as a resident in both countries. To avoid issues and complications that may arise from this, the U.S.-Australia Tax Treaty includes a tie-breaker test to determine which country holds the tax priority.
This test includes questions such as:
– Where the person maintains their home
– Or, if they maintain a home in both or neither country, where they maintain a ‘habitual abode’
– And where the person undertakes closer personal and economic relations.
If these questions end in yet another tie, the tax authorities from each country will settle it between themselves until they reach a mutual agreement.
Because both Australia and America have their own unique social security systems, a Totalization Agreement was designed to prevent taxpayers from contributing to both. The Totalization Agreement covers the Australian Super Guarantee contributions, as superannuation is a major, if not the primary, source of retirement income for many Australians.
This Super Guarantee is paid to an individual’s designated super fund by Australian employers on behalf of the employee as a pre-tax contribution—similar to how a 401(k) works. But unlike a 401(k), this income is then taxed within the superannuation and continues to grow until it is eventually distributed upon retirement. This matter of super fund growth is where the rules start to get a little complicated and vague from a U.S. tax perspective.
U.S. Taxation on Australian Superannuation
Usually, ‘private pensions’ and any distributions from them would be considered taxable by the IRS because the income from those distributions was generated with pre-tax dollars. This would be categorized as taxable income under the worldwide income tax rule. And as there is no direct reference in the U.S./Australia Tax Treaty regarding superannuation growth and the income that is a result of this growth, it remains a grey area.
While for Australians, making extra contributions to a super fund is a great low-tax, low-risk investment, issues can arise with voluntary contributions from a U.S. tax perspective. Any contributions that exceed the Super Guarantee will essentially make your super fund a ‘Foreign Grantor Trust’ in the eyes of the IRS, and will be treated as such on your U.S. tax return. This would make any contribution taxable at your personal tax rate, and cancel out any advantages that the Australian super system may provide.
What do I need to know?
While some of the areas within the U.S.-Australia Tax Treaty are not clearly defined or addressed, none of that affects your requirement to report your worldwide income on your U.S. tax return. Because of the tax treaty, both the ATO and the IRS have the ability and requirement to share their tax information with each other, so trying to hide or avoid your tax obligations in either location will only end up leaving you with hefty fines or penalties for non-compliance.
It’s always best to stay on the safe side and report all of your local and international income, and when it comes to saving on your tax bill and utilizing the U.S./Australia tax treaty to your benefit, there are qualified tax professionals out there who can help.