Equity taxes: Putting it all together

Now that we’ve covered source taxation, US taxation, and Australian taxation, we can finally talk about all the exciting edge cases you hit when trying to file equity-related taxes after moving internationally. Some of these problems are from lack of clarity in one or the other of the domestic tax systems, but most come about from the quirks of how domestic tax systems interact with international tax law.

These edge cases are necessarily quite tied to the countries in question – the US and Australia in this case – but I hope that they’re illustrative enough to show you where you might need to be careful with other countries. More so for this post than for the others, we start to reach the edge of what’s clearly defined in the law, and move into “this behavior is undefined, but a reasonable way to think about it might be…”. This leaves a lot of scope for interpretation, and as ever, I’m not a tax professional. If something seems off, send me an email, I’d love to hear about it!

🏠 Tax residency

One of the first problems you run into when filing taxes internationally is figuring out where exactly you actually are a tax resident. This question, oddly enough, is nearly completely decoupled from the question of whether you’re a resident for immigration purposes, so it’s not enough to look at what your passport says. Reasoning from first principles, you might think that you could only be a tax resident of one country in any given year, and that you’d be a tax resident of whichever country you spent the majority of the year in. While this is often true, there are some sharp edges you need to watch out for.

🇺🇸 Tax residency: the US

In the eyes of the IRS, and so the US federal system, if you’re a US citizen or permanent resident, you’re out of luck: you’re required to file US tax returns and pay US tax regardless of the country in which you currently live. However, if you’re not, things get more complex. The year that you move to the US tends to be the simplest, and assuming you haven’t spent time in the US previously, the following applies:

  • If you spend less than 31 days of your first year in the US, you are not a tax resident
  • If you spend more than 183 days of your first year in the US, you are a tax resident
  • If you spend between 31 and 183 days of your first year in the US, you can choose to be a tax resident, or a “dual status alien”, i.e. to file a resident return that only counts income earned after a certain date. The IRS calls choosing between these options the First Year Choice

Once you reside in the US for a full tax year, with the exception of certain visa classes (e.g. the J-1, typically used for student internships), you’ll become a US tax resident until you leave, by virtue of the Substantial Presence Test. This test states that you must be a US tax resident if you both spend more than 31 days in the US in a given year, and if the sum of days you spent in the US in the current year, the previous year (divided by three), and the year before that (divided by six) is greater than 183 days.

However, this test can catch you out in the year that you leave the US. Assuming that you have spent the vast majority of your time in the US in previous years, spending 31 days in the US the year after you move is enough to qualify you as a resident under the Substantial Presence Test (since 31 + 365/3 + 365/6 > 183). This can be a problem if you’re returning to the US for business meetings on a somewhat regular cadence.

In that case, you might need to rely on the Closer Connection Exception to the Substantial Presence Test. This exception is pretty subjective, but at a high level relies on you proving that you have transitioned your tax residency to another country, and that you have a more material connection to that country than to the United States.

🇦🇺 Tax residency: Australia

Australia, like the US, is quite clingy with taxation rights over its citizens, and has a number of tests that compel someone to be a resident for tax purposes:

  • Resides test: if you reside in Australia, in the same vague way that the US defines a closer connection (where you physically are, your intention, your family, etc), you are a tax resident.
  • Domicile test: if your permanent home is in Australia, you are a tax resident. In practice, if you are born in Australia, this test will compel you to be a tax resident unless you choose to permanently migrate to another country.
  • 183 day test: if you are present in Australia for more than 183 days in a given year, you are a tax resident unless you have a usual place of abode outside of Australia.

Meeting any of these will cause you to become an Australian tax resident.

👯‍♀️ Tax residency: Doubly resident

You’ll note that it’s possible to satisfy both countries’ residency conditions in a single year. For example, if you retain a permanent home in Australia, but spend more than 183 days in the United States, both countries might consider you to be a tax resident. I’d recommend avoiding this situation, but if it does come up, the US/AU Income Tax Treaty provides tie-breaking clauses for this case, which largely boil down to “where do you usually sleep”, and “which country is your employer domiciled in”.

💳 Tax credits

Once you figure out which country you’re resident or non-resident of for tax purposes, you still need to figure out which parts of your income will be taxed in each country. At a high level, a tax treaty between two countries typically tries to ensure that an individual with tax obligations in both countries pays tax in at least one country, and where possible, that they aren’t double taxed on income. Double taxation is usually avoided by ensuring that countries don’t have overlapping taxation rights on the same income, or where they do, that they provide a tax credit if tax has already been paid on that income. In Australia, these credits are referred to as Foreign Income Tax Offsets (FITO for short).

🕰 Time inconsistencies

Of course, there’s a problem with this tax credit theory which pops up pretty immediately: the misalignment of tax years. In the US, the tax year runs with the calendar year, and returns are generally due in April of the following year. In Australia, the tax year runs July to June, and returns are typically due in October. While people from countries with tax years aligned to the calendar are often surprised by this, the problem is far from unusual, and many countries have fiscal years that start on different dates.

This is problematic, because in Australia and many other countries, you can only claim a credit for income that would be taxed in Australia, and for tax that has already been paid. That’s an issue if you sell an asset in say, March. Without an extension, you’ll need to file your Australian taxes in October of the same year, but wouldn’t file your US taxes for that transaction until January of the following year at the earliest, and April typically. This means that in order to claim a credit, you either need to delay filing your Australian returns and attempt to file your US returns earlier in the filing window, or you need to file your Australian returns without the credit, pay both sets of taxes, then amend your past Australian return to include the US taxes you’ve now paid, and request a refund from the ATO.

You could, of course, try to claim a foreign tax credit in the US instead in this situation. Unfortunately though, the tax treaties between two countries typically only applies to their federal taxes, and not their state taxes. In many cases, this means that you by design will end up paying the higher of the two countries’ federal tax rates, and then additionally any state taxes.

However, the ATO is quite kind in this respect, and states that they consider Californian income taxes to be a part of the US tax system, and that you can therefore claim them as a foreign tax credit. The same is not true in reverse – California will not give you a tax credit for your Australian taxes – so you really want to find a way to file your US taxes first.

In practice, the easiest way to do this is to pay an accountant to file your Australian returns on your behalf, as they’re able to apply for filing extensions until at least March the following year. If you’re dealing with international tax, it’s also likely worth paying someone to make sure that it’s being done correctly.

💵 Foreign tax credits and currencies

Assuming you do file your returns in the “correct” order, you’re then likely to run into problems with identifying what tax was paid when. Your Australian return for a given financial year will potentially need credits from two different US tax years, but you can’t just sum up the tax paid in each, since some of the transactions might count for the previous or next Australian tax year.

Further, you pay US taxes in US dollars, but Australian taxes in Australian dollars. Which exchange rate do you use for tax calculations? The rate on the first or last day of the financial year? The rate on the day you paid your taxes?

📗 An example

The ATO handles this by opting to do all tax return working in percentages and Australian dollars. This is best demonstrated by example, so let’s say that you exercised an NSO that was granted after July 1 2015 and vested in the US, while you were an Australian resident. The spread between the FMV and the strike price of the options you exercised was US$10,000, and because of the dates involved, 100% of that spread is taxable at income tax rates in both Australia (residency taxation) and the US (source taxation).

From the ATO’s perspective, the first thing to work out is the amount of income your US$10,000 equates to in Australian dollars, a process called translation. The ATO is surprisingly flexible in the rates that they allow, and allows you to choose between either the actual exchange rate you receive from your bank when the transaction settles to AUD (if that happens immediately), or their view of the “spot rate” for that currency. We’ll say that 1 USD purchased 1.300 AUD on the date of your transaction, per the ATO’s rates, and so you realized income of AU$13,000.

While that tells us the amount of income you need to put down on your Australia tax return, it doesn’t indicate the amount of FITO credit that you can claim. That is calculated by taking the overall percentage tax paid on your US tax return, and then applying that to the Australian income realized on the sale.

So, let’s say that you also performed other transactions in the US that meant that overall, your US Federal and Californian income for the year of the transaction was US$200,000. On this, you paid US$40,000 in income tax federally, US$10,000 in FICA tax federally, and US$15,000 in Californian tax. Overall, this means that you paid US$65,000 in tax.

For your Australian return, you would calculate that in that US tax year, you paid 65,000 / 200,000 = 32.5% tax. Since your transaction was considered to be AU$13,000 of income, you can claim up to AU$13,000 * 0.325 = AU$4,225 in FITO credit on your Australian return. However, you can only claim FITO credits up to the amount of tax that you would pay in Australia. This means that if your overall tax rate in Australia is only 30%, you can only claim a AU$3,900 FITO credit.

You apply this same logic to each piece of income that you earn and might be eligible for FITO credit.

😤 Disagreements about the state of assets

This FITO credit strategy makes a lot of sense for the simple case given above, and side-steps a lot of questions about when and how currency translation should be calculated. However, it starts to make a lot less sense when the ATO and the IRS/FTB disagree on the current state of an asset.

This is particularly likely with pre-2015 options, or with NSOs that are valid substantially beyond your employment at a company. In those cases, the two countries have different definitions of what type of events cause an option to be taxed. If you are granted an option before July 1 2015, and it is considered not to have transfer restrictions on it, it is considered to be taxed at vest by the ATO. However, the IRS does not consider this to be a taxing point, so if you are a US resident at the time, you aren’t obliged to pay Australian taxes, and so nothing is due. A similar logic applies if you leave your company with unexercised NSOs, but while living in the US: you hit an Australian taxation point while not an Australian resident, so no tax is due.

Since you’ve already hit an Australian taxation point, if you subsequently become an Australian tax resident, the ATO will consider those options to be CGT assets, and will reset their cost basis on the day that your residency status changes.

This means that your options are considered a CGT asset in Australia, with a cost basis based on the FMV of date of your residency status change, but still an as-yet-untaxed option in the US, with a cost basis of the strike price.

When you later go to do your FITO tax calculations, the amount of income earned on the asset in each country will be different, which leads to unexpected behavior.

For example, if the strike price of your option in this situation is US$1, the FMV on the day you move is US$5, and you later exercise and sell the option for US$10:

  • The US believes that you have a spread of US$9, and taxes you at income tax rates. You pay 37% tax on this amount, i.e. US$3.33.
  • Meanwhile, California believes that you have a spread of US$9, but that it should be apportioned. If you spent half of the time from grant to exercise in California, you would have a CA-taxable spread of US$4.50. You pay 8% on this amount, i.e. US$0.36.
  • Australia believes that you have a spread of US$5 (because the cost basis of the options is higher) which at the spot exchange rates equates to AU$6.50. You pay 47% tax on this amount, i.e. AU$3.055.
  • In the US federally, Australia calculates that you paid 37% tax. For this, you get a FITO credit on your AU$6.50 of income of AU$2.405 on your Australian return.
  • In California, Australia calculates that you paid 8% tax. However, your income in California equates to just AU$5.85 at spot exchange rates, which is less than the income on your Australian return. Since the ATO only grants credits for tax “actually paid”, even though Australia would expect California to tax 100% of the income, you can only claim a credit on AU$5.85 * 8% = AU$0.468.
  • This gives you a total FITO credit of AU$2.873, meaning that overall you pay US$3.33 to the IRS, US$0.36 to the FTB, and AU$0.182 to the ATO. This is an effective tax rate of 42.55% – lower than the Australian tax rate, because Australia believes that the cost basis of the option is higher; and lower than the overall US tax rate, because California apportions income differently, and does not believe that they have the right to tax all of the spread.

📈 Capital gains

As might be obvious, capital gains is where this all starts to get a bit wonky, and in fact the situation is actually more strange than just the disagreement mentioned above. Typically, capital gains taxes are only payable in your country of residence – they’re charged on assets that are capital in nature (i.e. investments), so aren’t subject to source taxation the way that compensatory income is.

For Australia and the US (and California), this applies to exercised options. Once you’ve exercised an option, any subsequent gain is capital, and you’ll only need to pay tax on that gain in the country (and in the US, the state) you’re currently a tax resident of.

This is a bit weird! It means that if you exercise an ISO while not a US resident, you’ll pay AMT, but you’ll never actually pay “normal” tax on that option, since all other taxes due on ISOs are capital gains taxes. If the “other country” is Australia, which itself has capital gains taxes, this doesn’t make much of a difference, but if you were to move to a country with no capital gains taxes (e.g. Switzerland), this acts as a substantial loophole.

While both those examples have resulted in you paying less tax, not all of the oddities are favourable. Remember how the FITO credit in Australia is calculated on the basis of your Australian income? Long term capital gains tax discounts in Australia are applied by reducing the income you count on your tax return, which effectively halves the amount of FITO credit you can claim.

For example, let’s say that you pay US tax of US$2 on US$10 of income. In Australia, that income is AU$13, but is a long-term capital gain, so only AU$6.50 goes on your return. You pay a rate of 47% on that income, or AU$3.055. Your tax rate in the US was 20%, but since your income was halved on your Australian return, you’re only given a FITO credit of AU$1.30. In the end, you pay AU$1.755 and US$2 of tax, or 33.5% tax. This is higher than the tax rate that the US charged (20%), or that Australia charged (23.5%), and represents double taxation on half of your income.

While not the intent of Australia’s FITO credit system, this is the implementation, and speaks to how the same edge cases that create loopholes also create traps. It’s important to be aware of these when dealing with international tax.

😘 Couple problems

One final issue you might run into between countries is the question of who really owns the equity you’re talking about. California is a “community roperty” state, which means that if you and your partner are married, all assets earned while married are considered to be owned by the two of you jointly. When you file your tax return at the end of the year, you file a joint return with any income that either of you earned on it, and your tax bracket is determined jointly.

Australia meanwhile is a separate property state, with each individual required to file their own tax return, and assessed separately.

If you are married when you are granted and vest equity in the US, and then return to Australia, whose return should the income go on on your Australian return? In fact, in the US it’s not possible to file with the status “Married Filing Jointly” while a non-US resident, so whose return should the income go on on your US federal and Californian returns?

For ESS assets in Australia, the answer is quite clear. Regardless of where the equity was originally granted, an ESS asset can only have been issued to an employee of a company and their “associates”. In the case where an asset is owned by an associate, income from that asset must still be declared on the employee’s tax return.

For CGT assets in Australia, the answer is more murky, and will depend on the interpretation of the original grant under Australian law. Since in most cases this grant will reference only your name and not your partner’s, and since individual taxation would be the default in Australia, in all likelihood all income would appear on your individual return. (Definitely check with a professional if this case applies to you though!)

In the US federally and in California, as far as I can tell, there is no published answer. Having spent several hours on the phone to the IRS trying to get an answer to this question, I was told to “ask my accountant”. For our personal situation, this has meant declaring income only on the individual who was originally granted the equity’s return, but if this applies to you, definitely also talk to a professional.

🎁 Wrapping up

That’s hopefully more than you’ve ever wanted to know about international taxation of equity: the overall design, the interactions with individual domestic tax situations, and the very strange cases you start to hit when you put all the pieces together.

I haven’t given a lot of examples in this last post, because they have a tendency to get very complicated. In fact, as part of the research I’ve done into this over the years, it’s become so hard to reason about what will happen in different circumstances that I’ve written several thousand lines of Python to make sure that I understand all the different edge cases.

If you take anything away from this, I hope that it’s an understanding of just how time-consuming all of this can be, and how much of it is mired in good intentions trying to patch together fundamentally inconsistent systems. If you’re curious to know more about how tax treaties are designed to take these situations into account, I recommend a read through “The treatment of employee stock-options” on page 263 of the OECD commentary on the model tax convention, which goes into detail on the various ways in which problems can arise from deferred taxation of equity.

Thanks to Vivian Ho for encouraging me to finish off this series, and to Wing Ho for suggesting extra areas to include! 😊