INTERNATIONAL TAX AGREEMENTS AMENDMENT BILL (NO. 1) 2002 Explanatory Memorandum

INTERNATIONAL TAX AGREEMENTS AMENDMENT BILL (NO. 1) 2002

2002

THE PARLIAMENT OF THE COMMONWEALTH OF AUSTRALIA

HOUSE OF REPRESENTATIVES

INTERNATIONAL TAX AGREEMENTS AMENDMENT BILL (No. 1) 2002

EXPLANATORY MEMORANDUM

(Circulated by authority of the

Treasurer, the Hon Peter Costello, MP)

Table of contents

Glossary

The following abbreviations and acronyms are used throughout this explanatory memorandum.

General outline and financial impact

Why are tax treaties necessary?

Australia’s tax treaties are primarily concerned with relieving juridical double taxation, which can be described broadly as subjecting the same income derived by a taxpayer during the same period of time to comparable taxes under the taxation laws of 2 different countries.

Relief from double taxation is desirable because of the harmful effects double taxation can have on the expansion of trade and the movement of capital and people between countries. A tax treaty supplements the unilateral double tax relief provisions in the respective treaty partner countries’ domestic law and clarifies the taxation position of income flows between them.

How do the tax treaties work?

Tax treaties allocate to the country of source, sometimes at limited rates, a taxing right over various income, profits or gains. It is accepted that both countries possess the right to tax the income of their own residents under their own domestic laws and as such, the tax treaty wording will not always explicitly restate this rule.

However, where the country of residence is to be given the sole taxing right over certain types of income, profits or gains, this sole right is usually represented by the words shall be taxable only in that country. Tax treaties generally also provide that where income, profits or gains may be taxed in both countries, the country of residence (if it taxes) is to allow double tax relief against its own tax for the tax imposed by the country of source. In the case of Australia, effect is given to the relief obligations arising under the tax treaty by application of the general foreign tax credit system provisions of Australia’s domestic law, or relevant exemption provisions of the law where applicable.

What is the purpose of Australia’s tax treaties?

Australia’s tax treaties are designed to:

• prevent double taxation and provide a level of security about the tax rules that will apply to particular international transactions by:

− allocating taxing rights between the countries over different categories of income;

− specifying rules to resolve dual claims in relation to the residential status of a taxpayer and the source of income; and

− providing a taxpayer with an avenue to present a case for determination by the relevant taxation authorities where the taxpayer considers there has been taxation treatment contrary to the terms of a tax treaty; and

• prevent avoidance and evasion of taxes on various forms of income flows between the treaty partners by:

− providing for the allocation of profits between related parties on an arm’s length basis;

− generally preserving the application of domestic law rules that are designed to address transfer pricing and other international avoidance practices; and

− providing for exchanges of information between the respective taxation authorities.

How is the legislation structured?

The Agreements Act gives the force of law in Australia to Australia’s tax treaties which appear as Schedules to that Act. The provisions of the ITAA 1936 and the ITAA 1997 are incorporated into and read as one with the Agreements Act. The provisions of the Agreements Act (including the terms of the tax treaties) take precedence over provisions of the ITAA 1936 and the ITAA 1997 apart from provisions dealing with Australia’s general anti-avoidance rules and rules for determining maximum foreign tax credits.

What will this bill do?

This bill will amend the Agreements Act to give the force of law in Australia to the following tax treaties:

• an Agreement between the Government of Australia and the Government of the Russian Federation for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income; and

• a Protocol amending the Convention of 6 August 1982 between the Government of Australia and the Government of the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income.

This bill will also extend existing rules that exclude royalties taxable on a net basis under a tax treaty from the scope of the royalty withholding tax provisions.

Who will be affected by the measures in this bill?

Persons who:

• are residents of Australia or Russia for the purposes of the Russian Agreement and who derive income, profits or gains from Russia or Australia;

• are residents of Australia or the United States for the purposes of the US Convention and who derive income, profits or gains from the United States or Australia; and

• derive royalties taxable on a net basis under a tax treaty that are not currently excluded from the scope of the royalty withholding tax provisions.

In what way does this bill change the Agreements Act?

This bill will make changes to the Agreements Act by:

• inserting into subsection 3(1) definitions of the Russian Agreement and the US Protocol [item 1 of Schedule 1 and item 2 of Schedule 2 to the bill];

• amending the current definition of the ‘United States Convention’ in section 3(1) to provide that the Convention is subject to changes made by the US Protocol [item 1 of Schedule 2 to the bill];

• inserting new sections 11ZK and 6AA which will give the force of law in Australia to the Russian Agreement and US Protocol respectively [item 2 of Schedule 1 and item 3 of Schedule 2 to the bill];

• inserting the text of the Russian Agreement and the US Protocol as Schedules 46 and 2A respectively [item 3 of Schedule 1 and item 6 of Schedule 2 to the bill]; and

• amending section 17A to exclude domestic law royalty payments from the scope of the royalty withholding tax provisions where the payments are not treated as royalties under the Royalties Article of a tax treaty [items 4 and 5 of Schedule 2 to the bill].

When will these changes take place?

The Russian Agreement will enter into force on the last of the dates on which the treaty partners exchange notes through the diplomatic channel advising each other that all domestic requirements necessary to give the Agreement the force of law in the respective countries have been completed.

The US Protocol will enter into force upon the exchange of instruments of ratification. This can only occur after all domestic requirements to give the Protocol the force of law in the respective countries have been completed.

When the treaties enter into force, from what date will they have effect?

The Russian Agreement will have effect:

In Australia:

• for withholding tax on income that is derived by a non-resident, in relation to income derived on or after 1 July in the calendar year next following the year in which the Agreement enters into force; and

• for other Australian taxes, in relation to income, profits or gains of any year of income beginning on or after 1 July in the calendar year next following that in which the Agreement enters into force.

In Russia:

• for taxable years and periods beginning on or after 1 January of the calendar year next following that in which the Agreement enters into force.

The US Protocol will have effect:

In Australia:

• for withholding tax on dividends, interest and royalties derived by a resident of the United States on or after the later of 1 July 2003 and the first day of the second month next following the date on which the Protocol enters into force; and

• for other Australian taxes, in relation to income, profits or gains of any year of income beginning on or after 1 July in the calendar year next following that in which the Protocol enters into force.

In the United States:

• for withholding tax on dividends, interest and royalties derived by a resident of Australia on or after the later of 1 July 2003 and the first day of the second month next following the date on which the Protocol enters into force; and

• for other US taxes, for taxes chargeable for any tax year beginning on or after 1 January in the calendar year next following that in which the Protocol enters into force.

When will the exclusion of certain royalties from the royalty withholding tax provisions and technical corrections have effect?

Amendments to extend existing rules that exclude royalties taxable on a net basis under a tax treaty from the scope of the royalty withholding tax provisions will apply to royalties paid from the day this bill receives Royal Assent.

The financial impact of this bill

The Russian Agreement contained in this bill generally accords with Australia’s other modern comprehensive tax treaties and is not expected to have a significant effect on revenue.

The net yearly cost to revenue of the US Protocol is estimated to be $190 million (some potential offsetting gains to the Australian revenue are unable to be quantified). Over time lower withholding tax rates may be extended to other countries, for example, as a result of most favoured nation clauses in some existing tax treaties. While the withholding tax reductions involve a cost to revenue, the benefits are widely spread in the economy, with the most direct benefits accruing to business. Indirect revenue benefits may arise from increased trade and investment between the countries and reduced tax credit obligations for US taxes.

The changes to the scope of the royalty withholding tax provisions will affect the obligation to withhold tax but not impact on revenue.

Compliance costs

No significant additional compliance costs will result from the entry into force of the respective tax treaties and legislative changes.

Summary of regulation impact statement

The Russian Agreement

Impact: Low.

Main points:

• The Russian Agreement is likely to have an impact on Australian residents with business, investment or employment interests in Russia.

• A limitation of 15% withholding tax applies to dividends unless certain conditions are met which reduce the maximum rate of tax to 5%. These conditions are that the dividends have been fully taxed at the corporate level, the dividend recipient is a company that holds directly at least 10% of the capital of the company paying the dividends, and the resident of the other State has invested a minimum of $A700,000 or the Russian rouble equivalent in the company. In addition, for the 5% limit to apply, where dividends are paid by a company that is resident in Russia, the dividends must also be exempt from Australian tax.

• A source country tax rate limit of 10% will generally apply for both countries in the case of interest and royalties.

• The Russian Agreement will also assist in making clear the taxation arrangements for individual Australians working in Russia, either independently as consultants, or as employees.

• The Russian Agreement will assist the bilateral relationship by adding to the existing network of commercial treaties between the 2 countries.

The US Protocol

Impact: High.

Main points:

• The Protocol will remove withholding tax on certain dividends, enabling major Australian public companies to bring profits made by their subsidiaries back to Australia without further tax being payable. This measure will provide a benefit to the majority of Australian corporate groups with US operations.

• Dividends derived by companies from other direct investment (where the shareholding is 10% or more) will be subject to 5% withholding tax (down from 15%).

• An exemption from withholding tax for interest paid to financial institutions will improve Australia’s standing as a financial centre.

• The reduction in withholding tax on royalties from 10% to 5% will reduce business costs for technology and know-how.

• The Protocol will also protect Australia’s rights to tax capital gains and address widespread business concerns regarding the application of Australia’s CGT to expatriates departing Australia.

Financial impact: Yearly revenue cost of $190 million (some potential offsetting gains to the Australian revenue are unable to be quantified). The withholding tax reductions will trigger most favoured nation obligations for Australia to enter into negotiations and review withholding tax rates in some existing tax treaties (Australia’s tax treaties with the Netherlands, France, Switzerland, Italy, Norway, Finland, Austria and Korea are affected).

Exclusion of certain royalties from the royalty withholding tax provisions

Impact: Low.

Main points:

• The amendments will align the domestic law treatment of equipment royalties paid to US residents with treatment permitted under Australia’s updated tax treaty with the United States.

Financial impact: Nil.

Assessment of benefits: The amendments will result in a continuation of current arrangements for taxing equipment royalties derived by US residents through an Australian permanent establishment or fixed base. Collection difficulties that could arise from the application of the RWT provisions to these royalties would be avoided.

Chapter 1

Agreement with the Russian Federation

Main features of the tax treaty

1.1 The tax treaty between Australia and Russia accords substantially with Australia’s recent comprehensive tax treaties.

1.2 The features of the tax treaty include:

• Dual resident persons (i.e. persons who are residents of both Australia and Russia according to the domestic law of each country) are, in accordance with specified criteria, to be treated for the purposes of the tax treaty as being residents of only one country.

• Income from real property may be taxed in full by the country in which the property is situated. Income from real property for these purposes includes natural resource royalties.

• Business profits are generally to be taxed only in the country of residence of the recipient unless they are derived by a resident of one country through a branch or other prescribed permanent establishment in the other country, in which case the other country may tax the profits.

• Profits from the operations of ships and aircraft are generally to be taxed only in the country of residence of the operator.

• Profits of associated enterprises may be taxed on the basis of dealings at arm’s length.

• Dividends, interest and royalties may generally be taxed in both countries, but there are limits on the tax that the country in which the dividend, interest or royalty is sourced may charge on such income flowing to residents of the other country who are beneficially entitled to that income. These limits are 10% for both interest and royalties. A limitation of 15% applies to dividends unless certain conditions are met which reduce the maximum rate of tax to 5%. These conditions are that the dividends have been fully taxed at the corporate level, the dividend recipient is a company that holds directly at least 10% of the capital of the company paying the dividends, and the resident of the other State has invested a minimum of $A700,000 or the Russian rouble equivalent in the company. For the 5% limit to apply, where dividends are paid by a company that is resident in Russia, the dividends must also be exempt from Australian tax.

• Income or profits from the alienation of real property may be taxed in full by the country in which the property is situated. Subject to that rule and other specific rules in relation to business assets and some shares, capital gains are to be taxed in accordance with the domestic law of each country.

• Income from independent personal services provided by an individual will generally be taxed only in the country of residence of the recipient. However, remuneration derived by a resident of one country in respect of professional services rendered in the other country may be taxed in the other country, if it is derived through a fixed base of the person concerned in the latter country.

• Income from employment, that is, employee’s remuneration, will generally be taxable in the country where the services are performed. However, where the services are performed during certain short visits to one country by a resident of the other country, the income will be exempt in the country visited.

• Directors’ fees and other similar payments may be taxed in the country of residence of the paying company.

• Income derived by entertainers and sportspersons may generally be taxed by the country in which the activities are performed.

• Pensions and annuities may be taxed only in the country of residence of the recipient.

• Income from government service will generally be taxed only in the country that pays the remuneration. However, the remuneration may be taxed in the other country in certain circumstances where the services are rendered in that other country. Similarly, government service pensions will generally be taxed only in the paying country. However, if the pensioner is both a resident and a citizen of the other country and the services for which the pension is paid were rendered in that other country, the pension will be taxable only in that other country.

• Payments to students will be exempt from tax in the country visited insofar as it consists of payments made from abroad for the purposes of their maintenance or education.

• Other income (i.e. income not dealt with by other Articles) may generally be taxed in both countries, with the country of residence of the recipient providing double tax relief.

• Double taxation relief for income, which under the tax treaty may be taxed by both countries, is required to be provided by the country in which the taxpayer is resident under the terms of the tax treaty as follows:

− in Australia, by allowing a credit against Australian tax for Russian tax paid on income derived by a resident of Australia from sources in Russia; and

− in Russia, by allowing a credit against Russian tax for the Australian tax paid on income derived by a resident of Russia from sources in Australia.

• In the case of Australia, effect will be given to the double tax relief obligations arising under the tax treaty by application of the general foreign tax credit provisions of Australia’s domestic law, or the relevant exemption provisions of that law where applicable.

• Limitation of benefits rules apply to ensure that income that is subject to preferential tax regimes are excluded from the benefits of the tax treaty.

• Consultation and exchange of information between the 2 taxation authorities is authorised by the tax treaty.

Agreement between Australia and Russia

Article 1 – Personal scope

Scope

1.3 This Article establishes the scope of the application of the tax treaty by providing for it to apply to persons (defined to include companies and enterprises) who are residents of one or both of the countries. It generally precludes extra-territorial application of the treaty.

1.4 The application of the tax treaty to persons who are dual residents (i.e. residents of both countries) is dealt with in Article 4.

Article 2 – Taxes covered

Taxes covered

1.5 This Article specifies the existing taxes of each country to which the tax treaty applies. These are, in the case of Australia:

• the Australian income tax; and

• the resource rent tax in respect of offshore petroleum projects.

1.6 In the case of Australia, income tax (including that imposed on capital gains) and resource rent tax are covered by the tax treaty. Goods and services tax, fringe benefits tax, wool tax and levies, customs duties, State taxes and duties and estate tax and duties are not covered by the tax treaty. [Article 2, subparagraph 1(a)]

1.7 It is specifically stated that this Article applies only to taxes imposed under the federal law of Australia. This is to ensure that the tax treaty does not bind Australian States and Territories and applies only to federal taxes.

1.8 For Russia, the tax treaty applies to:

• the tax on profits (income) of enterprises and organisations; and

• the tax on the income of individuals.

[Article 2, subparagraph 1(b)]

Identical or substantially similar taxes

1.9 The application of the tax treaty will be automatically extended to any identical or substantially similar taxes which are subsequently imposed by either country in addition to, or in place of, the existing taxes. [Article 2, paragraph 2]

Notification of changes to the law

1.10 Although there is no formal requirement for the 2 countries to notify each other in the event of a significant change in the taxation law of the respective countries, such action is expected to occur from time to time using the mutual agreement procedures of Article 24.

Article 3 – General definitions

Definition of Australia

1.11 As with Australia’s other modern taxation agreements, Australia is defined to include certain external territories and areas of the continental shelf. By reason of this definition, Australia preserves its taxing rights, for example, over mineral exploration and mining activities carried on by non-residents on the seabed and subsoil of the relevant continental shelf areas (under section 6AA of the ITAA 1936, certain sea installations and offshore areas are to be treated as part of Australia). The definition is also relevant to the taxation by Australia and Russia of shipping profits in accordance with Article 8 of the tax treaty. [Article 3, subparagraph 1(b)]

1.12 To accommodate Russian views concerning the claims of sovereignty by various countries to parts of the Antarctic continent (including Australia’s claim to the Australian Antarctic Territory), an additional clause has been added to the tax treaty which provides that this tax treaty in no way furthers or detracts from those claims as provided for in the Antarctic Treaty (signed 1 December 1959 in Washington, DC). [Protocol item 3]

Definition of company

1.13 The definition of company in the tax treaty accords with Australia’s tax treaty practice. It reflects the fact that Australia’s domestic tax law does not specifically use the expression body corporate for tax purposes.

1.14 The Australian tax law treats certain trusts (public unit trusts and public trading trusts) and corporate limited partnerships as companies for income tax purposes. These entities are included as companies for the purposes of the tax treaty. [Article 3, subparagraph 1(f)]

Definition of international traffic

1.15 In this tax treaty, this term is of relevance only for alienation of ships and aircraft (Article 13.3) and wages of crew (Article 15.3). [Article 3, subparagraph 1(h) and Protocol item 2]

Definition of tax

1.16 For the purposes of the tax treaty, the term tax does not include any amount of penalty or interest imposed under the respective domestic law of the 2 countries. This is important in determining a taxpayer’s entitlement to a foreign tax credit under the double tax relief provisions of Article 22 (Methods of elimination of double taxation) of the tax treaty.

1.17 In the case of a resident of Australia, any penalty or interest component of a liability determined under the domestic taxation law of Russia with respect to income that Russia is entitled to tax under the tax treaty, would not be a creditable ‘Russian tax’ for the purposes of Article 22.1 of the tax treaty. This is in keeping with the meaning of foreign tax in the ITAA 1936 (subsection 6AB(2) – Foreign Income and Foreign Tax). Accordingly, such a penalty or interest liability would be excluded from calculations when determining the Australian resident taxpayer’s foreign tax credit entitlement under Article 22.1 (pursuant to Division 18 of Part III of the ITAA 1936 – Credits in Respect of Foreign Tax). [Article 3, subparagraph 1(j)]

Terms not specifically defined

1.18 Where a term is not specifically defined within this tax treaty, that term (unless used in a context that requires otherwise) is to be taken to have the same interpretative meaning as it has under the domestic taxation law of the country applying the tax treaty at the time of its application, with the meaning it has under the taxation law of the country having precedence over the meaning it may have under other domestic laws.

1.19 If a term is not defined in the tax treaty, but has an internationally understood meaning in tax treaties and a meaning under the domestic law, the context would normally require that the international meaning be applied. [Article 3, paragraph 2]

Article 4 – Residence

Residential status

1.20 This Article sets out the basis by which the residential status of a person is to be determined for the purposes of the tax treaty. Residential status is one of the criteria for determining each country’s taxing rights and is a necessary condition for the provision of relief under the tax treaty. The concept of who is a resident according to each country’s taxation law provides the basic test. [Article 4, paragraph 1]

1.21 In the Australian context this means that Norfolk Island residents, who are generally subject to Australian tax on Australian source income only, will not be residents of Australia for the purposes of the tax treaty. Accordingly, Russia will not have to forgo tax in accordance with the tax treaty on income derived by residents of Norfolk Island from sources in Russia (which will not be subject to Australian tax). [Article 4, paragraph 2]

Dual residents

1.22 This Article also includes a set of tie-breaker rules for determining how residency is to be allocated to one or other of the countries for the purposes of the tax treaty if a taxpayer, whether an individual, a company or other entity, qualifies as a dual resident, that is, as a resident under the domestic law of both countries.

1.23 The tie-breaker rules for individuals apply certain tests, in a descending hierarchy, for determining the residential status (for the purposes of the tax treaty) of an individual who is a resident of both countries under their respective domestic laws.

1.24 These rules, in order of application, are:

• If the individual has a permanent home in only one of the countries, the person is deemed to be a resident solely of that country for the purposes of the tax treaty.

• If the individual has a permanent home available in both countries or in neither, then the person’s residential status takes into account the person’s personal or economic relations (including habitual abode) with Australia and Russia, and the person is deemed to be a resident only of the country for the purposes of the tax treaty with which the person has the closer personal and economic relations. An individual’s citizenship shall be a factor in determining the degree of the person’s personal and economic relations with that country.

[Article 4, paragraph 3]

1.25 Dual residents remain, however, in relation to each country, a resident for the purposes of their domestic law, and subject to its tax as such, insofar as the tax treaty allows.

1.26 Where a non-individual (such as a body corporate) is a resident of both countries for their domestic tax purposes, the entity will be deemed to be a resident of the country in which its place of effective management is situated. [Article 4, paragraph 4]

Article 5 – Permanent establishment

Role and definition

1.27 Application of various provisions of the tax treaty (principally Article 7 relating to business profits) is dependent upon whether a person who is a resident of one country carries on business through a permanent establishment in the other, and if so, whether income derived by the person in the other country is attributable to, or effectively connected with, that permanent establishment. The definition of the term permanent establishment which this Article embodies, corresponds generally with definitions of the term in Australia’s more recent tax treaties.

Meaning of permanent establishment

1.28 The primary meaning of the term permanent establishment is expressed as being a fixed place of business through which the business of an enterprise is wholly or partly carried on. A permanent establishment must comply with the following requirements:

• there must be a place of business;

• the place of business must be fixed (both in terms of physical location and in terms of time); and

• the business of the enterprise must be carried on through this fixed place.

[Article 5, paragraph 1]

1.29 Other paragraphs of this Article elaborate on the meaning of the term by giving examples (by no means intended to be exhaustive) of what may constitute a permanent establishment – for example:

• an office;

• a workshop; or

• a mine.

As paragraph 2 of Article 5 is subordinate to paragraph 1 of Article 5, the examples listed will only constitute a permanent establishment if the primary definition in paragraph 1 is satisfied. [Article 5, paragraph 2]

Agricultural, farming or forestry activities

1.30 Most of Australia’s comprehensive tax treaties include as a permanent establishment an agricultural, pastoral or forestry property. This reflects Australia’s policy of retaining taxing rights over exploitation of Australian land for the purposes of primary production. This approach ensures that the arm’s length profits test provided for in Article 7 (Business profits) apply to the determination of profits derived from these activities. This position is also reflected in this tax treaty. [Article 5, subparagraph 2(g)]

Building sites or construction, installation or assembly projects

1.31 Also consistent with Australia’s tax treaty practice, subparagraph 2(h) of the tax treaty includes building sites or construction, installation or assembly projects, which exist for more than 12 months as examples of a permanent establishment. Building sites, construction, installation and assembly projects lasting less than 12 months, which nevertheless meet the requirements for a fixed place of business, will be permanent establishments.

Supervisory activities

1.32 Supervisory activities carried on for more than 12 months in connection with a building site or a construction, installation or assembly project are deemed to constitute a permanent establishment. Australia has a reservation to Article 5 of the OECD Model reflecting this position. The rationale for inclusion of this provision is the prevalence of the use in Australia of imported expertise in relation to supervision of such projects.

1.33 The term “a building site or construction, installation or assembly project” covers constructional activities such as excavating or dredging. The term “building site” can only mean such work as is directly connected with the erection of buildings and similar projects (earthwork, masonry, painting, roofing, glazing and plumbing). Planning and supervision are certainly part of the building site if carried out by the construction contractor. However, planning and supervision of work does not represent a building site permanent establishment if carried out by another enterprise. [Article 5, subparagraph 2(h)]

Preparatory and auxiliary activities

1.34 Certain activities are deemed not to give rise to a permanent establishment (e.g. the use of facilities solely for storage or display).

1.35 Generally these activities are of a preparatory or auxiliary character and are unlikely to give rise to substantial profits. The necessary economic link between the activities of the enterprise and the country in which the activities are carried on does not exist in these circumstances.

1.36 Unlike the OECD Model, which provides that the listed activities are deemed not to constitute a permanent establishment, the tax treaty incorporates the Australian tax treaty approach of stating that an enterprise will not be deemed to have a permanent establishment merely by reason of such activities. This is to prevent the situation where enterprises structure their business so that most of their activities fall within the exceptions when – viewed as a whole – the activities ought to be regarded as a permanent establishment.

1.37 Another feature consistent with Australia’s tax treaty practice is that subparagraph 4(f) of Article 5 of the OECD Model – dealing with combinations of the activities in subparagraphs 4(a) to (e) – is not included. Australia does not consider that an enterprise undertaking multiple functions of the kind indicated in subparagraphs 4(a) to (e) could reasonably be regarded as only engaged in preparatory or auxiliary activities. [Article 5, paragraph 3]

Delivery of goods

1.38 Consistent with Russian views, the delivery of goods or merchandise is to be treated as a business activity conducted through a permanent establishment. Accordingly, the provision of a delivery service is not an activity that may be excluded from constituting a permanent establishment under the terms of paragraph 3 of Article 5.

Deemed permanent establishments

Cost-toll operations

1.39 The inclusion of subparagraph 4(a) is consistent with another of Australia’s reservations to the OECD Model. It deals with so-called cost-toll situations, under which a mineral plant, for example, refines minerals at cost, so that the plant operations produce no Australian profits. Title to the refined product remains with the mining consortium and profits on sale are realised mainly outside of Australia.

1.40 Subparagraph 4(a) deems such a plant to be a permanent establishment because the manufacturing or processing activity (which gives the processed minerals their real value) is conducted in Australia, and therefore Australia should have taxing rights over the business profits arising from the sale of the processed minerals to the extent that they are attributable to the processing activity carried on in Australia. This subparagraph prevents an enterprise which carries on very substantial manufacturing or processing activities in a country through an intermediary from claiming that it does not have a permanent establishment in that country.

1.41 The inclusion of this subparagraph is insisted upon by Australia in its tax treaties and is consistent with Australia’s policy of retaining taxing rights over profits from exploitation of its mineral resources. [Article 5, subparagraph 4(a)]

Heavy industrial equipment

1.42 Under subparagraph 4(b) an enterprise is deemed to have a permanent establishment in a country if heavy industrial equipment is being used in that country by, for or under contract with the enterprise.

1.43 This provision aligns with Australia’s reservation to the OECD Model concerning the use of substantial equipment and is designed to further protect Australia’s right to tax income from natural resources. Australia’s experience is that the permanent establishment provision in the OECD Model may be inadequate to deal with high value activities involved in the development of natural resources, particularly in offshore regions.

1.44 Some examples of heavy industrial equipment would include:

• large industrial earthmoving equipment or construction equipment used in road building, dam building or powerhouse construction, etc;

• manufacturing or processing equipment used in a factory;

• oil and drilling rigs, platforms and other structures used in the petroleum/mining industry; and

• grain harvesters and other large agricultural machinery.

1.45 For the purposes of the tax treaty the enterprise is deemed to carry on business through the heavy industrial equipment permanent establishment. [Article 5, subparagraph 4(b)]

Dependent agents

1.46 Paragraph 5 reflects Australia’s tax treaty practice in relation to a person who acts on behalf of an enterprise of another country of deeming that person to constitute a permanent establishment if that person either has and habitually exercises an authority to conclude contracts on behalf of the enterprise or maintains a stock of goods or merchandise to make deliveries in that State. With regard to the authority to conclude contracts, this will not apply if the agent’s activities are limited to the purchase of goods or merchandise for the enterprise. [Article 5, paragraph 5]

Independent agents

1.47 Business carried on through an independent agent does not, of itself, constitute a permanent establishment, provided that the independent agent is acting in the ordinary course of that agent’s business as such an agent. [Article 5, paragraph 6]

Subsidiary companies

1.48 Generally, a subsidiary company will not be a permanent establishment of its parent company. A subsidiary, being a separate legal entity, would not usually be carrying on the business of the parent company but rather its own business activities. However, a subsidiary company gives rise to a permanent establishment if the subsidiary permits the parent company to operate from its premises such that the tests in paragraph 1 of Article 5 are met, or acts as an agent such that a dependent agent permanent establishment is constituted. [Article 5, paragraph 7]

Other Articles

1.49 The principles set down in this Article are also to be applied in determining whether a permanent establishment exists in a third country or whether a third country has a permanent establishment in Australia (or in Russia) when applying the source rule contained in:

• paragraph 5 of Article 11 (Interest); and

• paragraph 5 of Article 12 (Royalties).

[Protocol item 4]

Article 6 – Income from real property

Where income from real property is taxable

1.50 This Article provides that the income of a resident of one country from real property situated in the other country may be taxed by that other country. Thus, income from real property in Australia will be subject to Australian tax laws. [Article 6, paragraph 1]

Definition

1.51 Income from real property is effectively defined as extending, in the case of Australia, to:

• the direct use, letting or use in any other form of real property and any other interest in or over land (including exploration and mining rights); and

• royalties and other payments relating to the exploration for or exploitation of mines or quarries or other natural resources or rights in relation thereto.

1.52 In the case of Russia, real property is generally defined as immovable property and includes:

• property accessory to immovable property;

• usufruct of immovable property (generally, a right to use property without degrading it and to retain any profits derived from it);

• rights to which the provisions of the general law respecting landed property apply including direct use, letting or use in any other form of such property; and

• rights to variable or fixed payments either as consideration for or in respect of the exploitation of, or the right to explore for or exploit, mineral deposits, oil or gas wells, quarries or other places of extraction or exploitation of natural resources.

[Article 6, paragraphs 2 and 4]

Ships and aircraft

1.53 Ships and aircraft shall not be regarded as real property. [Article 6, subparagraph 2(c)]

Deemed situs

1.54 Under Australian law the situation of an interest in land, such as a lease, is not necessarily where the underlying property is situated – there may not necessarily be a situs. Paragraph 3 puts the situation of the interest or right beyond doubt. [Article 6, paragraph 3]

Real property of an enterprise and of persons performing independent personal services

1.55 The operation of this Article extends to income derived from the use or exploitation of real property of an enterprise and income derived from real property that is used for the performance of independent personal services.

1.56 Accordingly, application of this Article (when read with Articles 7 and 14) to such income ensures that the country in which the real property is situated may impose tax on the income derived from that property by:

• an enterprise of the other country; or

• an independent professional person resident in that other country,

irrespective of whether or not that income is attributable to a permanent establishment of such an enterprise, or fixed base of such a person, situated in the firstmentioned country. [Article 6, paragraph 5]

Article 7 – Business profits

1.57 This Article is concerned with the taxation of business profits derived by an enterprise that is a resident of one country from sources in the other country.

1.58 The taxing of these profits depends on whether they are attributable to the carrying on of a business through a permanent establishment in the other country. If a resident of one country carries on business through a permanent establishment (as defined in Article 5) in the other country, the country in which the permanent establishment is situated may tax the profits of the enterprise that are attributable to that permanent establishment.

1.59 If an enterprise which is a resident of one country carries on business in the other country other than through a permanent establishment in that other country, the general principle of this Article is that the enterprise will not be liable to tax in the other country on its business profits (except where paragraph 5 of this Article applies – see the explanation in paragraphs 1.62 and 1.63). [Article 7, paragraph 1]

Determination of business profits

1.60 Profits of a permanent establishment are to be determined for the purposes of this Article on the basis of arm’s length dealing. The provisions in the tax treaty correspond to international practice and the comparable provisions in Australia’s other tax treaties. [Article 7, paragraphs 2 and 3]

1.61 No profits are to be attributed to a permanent establishment merely because it purchases goods or merchandise for the enterprise. Accordingly, profits of a permanent establishment will not be increased by adding to them any profits attributable to the purchasing activities undertaken for the head office. It follows, of course, that any expenses incurred by the permanent establishment in respect of those purchasing activities will not be deductible in determining the taxable profits of the permanent establishment. [Article 7, paragraph 4]

Profits dealt with under other Articles

1.62 Where income or gains are otherwise specifically dealt with under other Articles of the tax treaty the effect of those particular Articles is not overridden by this Article.

1.63 This provision lays down the general rule of interpretation that categories of income or gains which are the subject of other Articles of the tax treaty (e.g. shipping, dividends, interest, royalties and alienation of property) are to be treated in accordance with the terms of those Articles (except where otherwise provided  – e.g. by Article 10.5 where the income is effectively connected to a permanent establishment). [Article 7, paragraph 5]

Inadequate information

1.64 This provision allows for the application of the domestic law of the country in which the profits are sourced (e.g. Australia’s Division 13 of the ITAA 1936) where, due to inadequate information, the correct amount of profits attributable on the arm’s length principle basis to a permanent establishment cannot be determined or can only be ascertained with extreme difficulty. For the purposes of this provision competent authority for Russia also includes the Ministry of Taxes and Duties as this Ministry assists the Russian Ministry of Finance in transfer pricing cases. [Protocol item 5(a)]

Insurance with non-residents

1.65 Each country has the right to continue to apply any provisions in its domestic law relating to the taxation of income from insurance. However, if the relevant law in force in either country at the date of signature of the tax treaty is varied (otherwise than in minor respects so as not to affect its general character), the countries must consult with each other with a view to agreeing to any amendment of this paragraph that may be appropriate. An effect of this paragraph is to preserve, in the case of Australia, the application of Division 15 of Part III of the ITAA 1936 (Insurance with non-residents). [Protocol item 5(b)]

Trust beneficiaries

1.66 The principles of this Article will apply to business profits derived by a resident of one of the countries (directly or through one or more interposed trust estates) as a beneficiary of a trust estate. [Protocol item 5(c)]

Example 1.1

In accordance with this Article, Australia has the right to tax a share of business profits, originally derived by a trustee of a trust estate (other than a trust estate that is treated as a company for tax purposes) from the carrying on of a business through a permanent establishment in Australia, to which a resident of Russia is beneficially entitled under the trust estate. Protocol item 5(c) ensures that such business profits will be subject to tax in Australia where, in accordance with the principles set out in Article 5, the trustee of the relevant trust estate has a permanent establishment in Australia in relation to that business.

Article 8 – Profits from the operation of ships and aircraft

1.67 The main effect of this Article is that the right to tax profits from the operation of ships or aircraft in international traffic, including profits derived from participation in a pool service or other profit sharing arrangement, is generally reserved to the country in which the operator is a resident for tax purposes. [Article 8, paragraphs 1 and 3]

Non-transport operations

1.68 However, this Article reflects Australian treaty policy to reserve to the source country the right to tax profits from internal traffic, profits from other coastal and continental shelf activities, including non-transport shipping and aircraft activities, within its own waters.

1.69 Thus, the term transport is not used in the title of this Article, as the Article applies to survey ships, oil drilling ships, etc, where transport is not necessarily involved. [Article 8, paragraph 2]

Internal traffic

1.70 By reason of the definition of Contracting State contained in Article 3 and the terms of Protocol item 6, any shipments by sea or air from a place in Australia (including the continental shelf areas and external territories) for discharge at another place in or for return to that place in Australia, is to be treated as constituting internal traffic. [Protocol item 6]

Example 1.2

Profits that are derived from the transport of goods between Perth and Sydney, that were uploaded in Perth onto a ship operated by a Russian enterprise making that stopover as part of an international voyage from Vladivostok to Sydney, would be profits from internal traffic. As such, 5% of the amount paid in respect of the internal traffic carriage would be deemed to be taxable income of the operator for Australian tax purposes pursuant to Division 12 of Part III of the ITAA 1936.

Article 9 – Adjustments to profits of associated enterprises

Reallocation of profits

1.71 This Article deals with associated enterprises (parent and subsidiary companies and companies under common control). It authorises the reallocation of profits between related enterprises in Australia and Russia on an arm’s length basis where the commercial or financial arrangements between the enterprises differ from those that might be expected to operate between independent enterprises dealing wholly at arm’s length with one another.

1.72 This Article would not generally authorise the rewriting of accounts of associated enterprises where it can be satisfactorily demonstrated that the transactions between such enterprises have taken place on normal, open market commercial terms. [Article 9, paragraph 1]

1.73 Each country retains the right to apply its domestic law relating to the determination of the tax liability of a person (e.g. Australia’s Division 13 of the ITAA 1936) to its own enterprises, provided that such provisions are applied, so far as it is practicable to do so, consistently with the principles of the Article. [Article 9, paragraph 2]

1.74 Australia’s domestic law provisions relating to international profit shifting arrangements were revised in 1981 in order to deal more comprehensively with arrangements under which profits are shifted out of Australia, whether by transfer pricing or other means. The broad scheme of the revised provisions is to impose arm’s length standards in relation to international dealings, but where the Commissioner cannot ascertain the arm’s length consideration, it is deemed to be such an amount as the Commissioner determines. Paragraph 2 is designed to preserve the application of those domestic law provisions.

Correlative adjustments

1.75 Where a reallocation of profits is made (either under this Article or, by virtue of paragraph 2, under domestic law) so that the profits of an enterprise of one country are adjusted upwards, a form of double taxation would arise if the profits so reallocated continued to be subject to tax in the hands of an associated enterprise in the other country. To avoid this result, the other country is required to make an appropriate compensatory adjustment to the amount of tax charged on the profits involved to relieve any such double taxation.

1.76 It would generally be necessary for the affected enterprise to apply to the competent authority of the country not initiating the reallocation of profits for an appropriate compensatory adjustment to reflect the reallocation of profits made by the other treaty partner country. If necessary, the competent authorities of Australia and Russia will consult with each other to determine the appropriate adjustment. [Article 9, paragraph 3]

1.77 To allay Russian concerns about their need to automatically grant double taxation relief by correlative adjustment for all transfer pricing adjustments made by Australia, it was necessary to include a provision in the Protocol mirroring the OECD Model Commentary’s amplification of this point. This clause clarifies that Russia need only make correlative adjustments when the original adjustments made by Australia are appropriate but that this consideration depends on applying objective international standards. [Protocol item 7(a)]

1.78 Australia also agreed to Russia’s request to include the Ministry of Taxes and Duties as a competent authority for certain administrative purposes concerning such adjustments. [Protocol item 7(b)]

Article 10 – Dividends

1.79 This Article broadly allows both countries to tax dividends flowing between them but in general limits the rate of tax that the country of source may impose on dividends payable by companies that are residents of that country under its domestic law to residents in the other country who are beneficially entitled to the dividends. [Article 10, paragraph 1]

Rate of tax

1.80 Under subparagraph 2(a) of Article 10, both Australia and Russia are required to reduce their respective rates of dividend withholding tax to 5% in certain cases. In the case of Australia, this is to occur where those dividends are franked (i.e. are paid out of profits which have borne the normal rate of company tax), are flowing to a Russian company which directly holds at least 10% of the capital of the Australian company and the investment in that Australian company is at least $A700,000. However, at present, Australia’s domestic law does not subject fully franked dividends to withholding tax and as such, Russian shareholders will continue to receive these dividends free of any withholding tax whilst this remains a feature of the Australian domestic law.

1.81 In the case of Russia, the 5% rate is to be applied to dividends flowing to an Australian company which directly holds at least 10% of the capital of the Russian company, where those dividends are paid out of profits that are assessable to tax in Russia and the minimum investment level has been reached, and the dividends are exempt from Australian tax in Australia.

1.82 It was agreed that the 5% rate limit should be restricted to cases where the dividends flowing from Russia to Australia are exempt from tax in the hands of the Australian shareholder. Russia wishes to ensure that the full benefit of any reduction in dividend withholding tax would flow to the investor. Should Russia be listed as a comparable tax country (in either the broad or limited exemption list) under Australia’s controlled foreign corporation regime, in the future inter-company non-portfolio dividends would then become exempt in Australia.

1.83 In all other cases, the tax treaty provides that Australia and Russia will generally limit its tax to 15% of the dividend. In the case of Australia, this will mean that the normal withholding tax rate imposed on unfranked dividends will be reduced from 30% to 15%. [Article 10, paragraph 2(b)]

1.84 There is also provision for flexibility if there is a change to either country’s general approach to dividend withholding tax, such as a change to domestic law arrangements for franked dividends flowing overseas. In such a case, the 2 countries are obliged to consult to make appropriate amendments to this paragraph. [Protocol item 8]

Exception to limitation

1.85 The limitation on the tax of the country in which the dividend is sourced does not apply to dividends derived by a resident of the other country who has a permanent establishment or fixed base in the country from which the dividends are derived, if the holding giving rise to the dividends is effectively connected with that permanent establishment or fixed base.

1.86 Where the dividends are so effectively connected, they are to be treated as business profits or income from independent personal services and therefore subject to the full rate of tax applicable in the country in which the dividend is sourced (in accordance with the provisions of Article 7 or Article 14, as the case may be). In practice, however, under changes made to Australia’s domestic law with the introduction from 1 July 1987 of a full imputation system of company taxation, such dividends, to the extent that they are franked dividends, remain exempt from Australian tax, while unfranked dividends will be subject to withholding tax at the rate of 15% instead of being taxed by assessment. [Article 10, paragraph 5]

Extra-territorial application precluded

1.87 The extra-territorial application by either country of taxing rights over dividend income is precluded by providing, broadly, that one country (the first country) will not tax dividends paid by a company resident solely in the other country, unless:

• the person deriving the dividends is a resident of the first country; or

• the shareholding giving rise to the dividends is effectively connected with a permanent establishment or fixed base in the first country.

1.88 An example of the effect of this paragraph is that Australia may not tax dividends paid by a Russian company to a resident of Russia out of profits derived from Australian sources, otherwise than through a permanent establishment or a fixed base.

1.89 However, the exemption does not apply where the dividend paying company is a resident of both Australia and Russia. This proviso ensures that Australia retains the right to tax dividends paid to a person resident outside of both countries by a company which is a resident of Australia under its domestic law, notwithstanding that the company is deemed to be a resident of Russia for the purposes of the tax treaty under the dual resident tie-breaker test for companies contained in Article 4. [Article 10, paragraph 6]

Article 11 – Interest

Rate of tax

1.90 This Article provides for interest income to be taxed by both countries but requires the country of source to generally limit its tax to 10% of the gross amount of the interest where a resident of the other country is beneficially entitled to the interest. [Article 11, paragraphs 1 and 2]

1.91 The limitation of the source country tax rate to 10% accords with the general rate of interest withholding tax applicable under Australia’s domestic law.

Definition of interest

1.92 The term interest is defined for the purposes of this Article in a way that, in relation to Australia, encompasses items of income such as discounts on securities and payments under certain hire purchase agreements which are treated for Australian tax purposes as interest or amounts in the nature of interest. [Article 11, paragraph 3]

Interest effectively treated as business profits

1.93 Interest derived by a resident of one country which is effectively connected to a permanent establishment or fixed base of that person in the other country, will form part of the business profits of that permanent establishment or fixed base and be subject to the provisions of Article 7 (Business profits) or Article 14 (Income from independent personal services). Accordingly, the 10% tax rate limitation does not apply to such interest in the country in which the interest is sourced. [Article 11, paragraph 4]

Deemed source rules

1.94 Interest source rules are set out in this Article. Those rules operate to allow Australia to tax interest to which a resident of Russia is beneficially entitled where the interest is paid by a resident of Australia. Australia may also tax interest paid by a resident of Russia to which another Russian resident is beneficially entitled if it is an expense incurred by the payer of the interest in carrying on a business in Australia through a permanent establishment.

1.95 However, consistent with Australia’s interest withholding tax provisions, an Australian source is not deemed in respect of interest that is an expense incurred by an Australian resident in carrying on a business through a permanent establishment outside Australia. [Article 11, paragraph 5]

Related persons

1.96 This Article includes a general safeguard against payments of excessive interest where a special relationship exists between the persons associated with a loan transaction – by restricting the 10% source country tax rate limitation to an amount of interest which might have been expected to have been agreed upon if the parties to the loan agreement were dealing with one another at arm’s length. Any excess part of the interest remains taxable according to the domestic law of each country but subject to the other Articles of the tax treaty. [Article 11, paragraph 6]

Article 12 – Royalties

Rate of tax

1.97 This Article in general allows both countries to tax royalty flows but limits the tax of the country of source to 10% of the gross amount of royalties paid or credited to residents of the other country beneficially entitled to the royalties. [Article 12, paragraphs 1 and 2]

1.98 The 10% rate limitation is not to apply to natural resource royalties, which, in accordance with Article 6, are to remain taxable in the country of source without limitation of the tax that may be imposed.

1.99 In the absence of a tax treaty, Australia taxes royalties paid to non-residents at 30% of the gross royalty.

Definition of royalties

1.100 The definition of royalties in the tax treaty largely reflects the definition in Australia’s domestic income tax law. The definition encompasses payments for the use of, or the right to use industrial, commercial or scientific equipment. It also includes payments for the supply of scientific, technical, industrial or commercial know-how but not payments for services rendered, except as provided for in subparagraph 3(d). Payments made for the right to copy or adapt computer software in a manner which would, without the permission of the copyright owner, constitute an infringement of copyright, also constitute royalty payments. [Article 12, paragraph 3]

Payments for the supply of know-how versus payments for services rendered

1.101 It is considered that a German Supreme Court decision (Bundesfinanzhof (No. IR 44/67) of 16 December 1970) provides a definitive test to distinguish between a know-how contract and a contract for services. A know-how contract, it was held, involved the supply by a person of their know-how to the paying entity (e.g. teaching a personal expertise), whereas in a contract for services, although it may involve the use of know-how, that know-how is applied by the person in the performance of their services.

1.102 Payments for design, engineering or construction of plant or building, feasibility studies, component design and engineering services may generally be regarded as being in respect of a contract for services, unless there is some provision in the contract for imparting techniques and skills to the buyer.

1.103 In cases where both know-how and services are supplied under the same contract, if the contract does not separately provide for payments in respect of know-how and services, an apportionment of the 2 elements of the contract may be possible.

1.104 Payments for services rendered are to be treated under Article 7 (Business profits) or Article 14 (Income from independent personal services).

Spectrum licences

1.105 A provision has been included in this tax treaty that deems radiofrequency spectrum licence payments to be royalties for the purposes of the tax treaty. This is the first occasion that such a provision has been included in an Australian tax treaty and is in accordance with Treasurer’s Press Release No. 26 of 11 March 1998 concerning revised taxation treatment to be afforded to spectrum licences. [Article 12, subparagraph 3(h)]

Forbearance

1.106 Consistent with Australian tax treaty practice, subparagraph 3(i) expressly treats as a royalty, amounts paid or credited in respect of forbearance to grant to third persons, rights to use property covered by the Royalties Article. This is designed to prevent arrangements along the lines of those contained in Aktiebolaget Volvo v. Federal Commissioner of Taxation (1978) 8 ATR 747; 78 ATC 4316, where instead of amounts being payable for the exclusive right to use the property they were made for the undertaking that the right to use the property will not be granted to anyone else, not being subject to tax as a royalty payment under the terms of Article 12. [Article 12, subparagraph 3(i)]

Other royalties effectively treated as business profits

1.107 As in the case of interest income, it is specified that the 10% tax rate limitation is not to apply to royalties effectively connected with a permanent establishment or fixed base in the country in which the income is sourced – such income being subject to full taxation under either Article 7 or Article 14 as the case may be. [Article 12, paragraph 4]

Deemed source rule

1.108 The royalties source rule provided for in the tax treaty effectively corresponds in the case of Australia with the deemed source rule contained in section 6C (Source of royalty income derived by a non-resident) of the ITAA 1936 for royalties paid to non-residents of Australia. It broadly mirrors the source rule for interest income contained in paragraph 5 of Article 11 (Interest). [Article 12, paragraph 5]

Related persons

1.109 If royalties flow between the payer and the person beneficially entitled to the royalties as the result of a special relationship between them, the 10% source country tax rate limitation will apply only to the extent that the royalties are not excessive. Any excess part of the royalty remains taxable according to the domestic law of each country but subject to the other Articles of this tax treaty.

1.110 A special relationship is generally taken to exist where royalties are paid to an individual by an associate or legal person who is directly or indirectly controlled by an individual or associated legal person or to a subordinate, or a group having a common interest with them. It covers those relationships that exist by way of blood or marriage and in general any community of interest. [Article 12, paragraph 6]

Article 13 – Income from alienation of property

Taxing rights

1.111 This Article allocates between the respective countries taxing rights in relation to income or profits arising from the alienation of real property and other items of property.

1.112 With regard to alienation of real property it has been Australia’s treaty practice since the introduction of CGT to use the phrase “income, profits or gains” in this Article. However, Russian domestic law draws no distinction between income and capital. As a result, a compromise solution was agreed so that references in the tax treaty to “income” and “profits”, in the case of Australia, are to include capital gains.

1.113 The reference to “income or profits” in this Article is designed to put beyond doubt that a gain from the alienation of property which in Australia is income or a profit under ordinary concepts, will be subject to tax in accordance with this Article, rather than the Business Profits Article (Article 7), together with relevant capital gains. [Protocol item 1(b)]

Real property

1.114 Income or profits from the alienation of real property may be taxed by the country in which the property is situated. The term ‘real property’ is to be defined for the purposes of this Article as it is under Article 6. Where the property is situated is determined in accordance with paragraph 3 of Article 6. [Article 13, paragraph 1]

Permanent establishment

1.115 Paragraph 2 deals with income or profits arising from the alienation of property (other than real property covered by paragraph 1) forming part of the business assets of a permanent establishment of an enterprise or pertaining to a fixed base used for performing independent personal services. It also applies where the permanent establishment itself (alone or with the whole enterprise) or the fixed base is alienated. Such income or profits may be taxed in the country in which the permanent establishment or fixed base is situated. This corresponds to the rules for taxation of business profits and income from independent personal services contained in Articles 7 and 14 respectively. [Article 13, paragraph 2]

Disposal of ships or aircraft

1.116 Income or profits from the disposal of ships or aircraft operated in international traffic, or of associated property (other than real property covered by paragraph 1) are taxable only in the country in which the operator of the ships or aircraft is resident. This rule corresponds to the operation of Article 8 in relation to profits from the international operation of ships or aircraft in international traffic. [Article 13, paragraph 3]

1.117 For the purposes of this Article, the term ‘international traffic’ shall not include any transportation which commences at a place in a country and returns to that place, after travelling through international waters but not visiting another country (e.g. so called ‘voyages to nowhere’ by cruise ships). [Protocol item 2]

Shares and other interests in land-rich entities

1.118 Paragraph 4 applies to situations involving the alienation of shares or other interests in companies, and other entities, whose assets consist principally of real property (as defined in Article 6) which is situated in the other country (again, in the terms of Article 6). Such income or profits may be taxed by the country in which the real property is situated. This paragraph complements paragraph 1 of this Article and is designed to cover arrangements involving the effective alienation of incorporated real property, or like arrangements.

1.119 This is to be the case whether the real property is held directly or indirectly through a chain of interposed entities. While not limited to chains of companies, or even chains of entities only some of which are companies, the example of chains of companies is used to make clear that the corporate veil should be lifted in examining direct or indirect ownership.

1.120 This provision responds to the tax planning opportunities exposed by the decision of the Full Federal Court in the Commissioner of Taxation v. Lamesa Holdings BV (1997) 77 FCR 597. It is designed to protect Australian taxing rights over income or profits on the alienation or effective alienation of Australian real property (as defined) despite the presence of interposed bodies corporate or other entities. [Article 13, paragraph 4]

Capital gains

1.121 This Article contains a sweep-up provision in relation to capital gains which enables each country to tax, according to its domestic law, any gains of a capital nature derived by its own residents or by a resident of the other country from the alienation of any property not specified in the preceding paragraphs of the Article. It thus preserves the application of Australia’s domestic law relating to the taxation of capital gains in relation to the alienation of such property. [Article 13, paragraph 5]

1.122 Generally, Australian tax treaties have referred to “gains of a capital nature” in this paragraph, rather than “capital gains” as agreed in this tax treaty. It was agreed with the negotiators for the Russian Federation that in this context Article 13.5 relates only to gains of a capital nature.

Business profits

1.123 As indicated earlier, income, profits or gains from the alienation of property that fall within the scope of this Article are not affected by the business profits provisions of Article 7. In the event that the operation of this Article should result in an item of income or gain being subjected to tax in both countries, the country of which the person deriving the income or gain is a resident (as determined in accordance with Article 4) would be obliged by Protocol item 1(a) and Article 22 (Methods of elimination of double taxation) to provide double tax relief for the tax imposed by the other country.

Article 14 – Income from independent personal services

Taxing rights

1.124 Under this Article, income derived by an individual in respect of professional services or other activities of an independent character will be subject to tax in the country in which the services or activities are performed only if the recipient has a fixed base regularly available in that other country for the purposes of performing their activities.

1.125 If this condition is met, the country in which the services or activities are performed will be able to tax so much of the income as is attributable to the activities exercised from that fixed base. [Article 14, paragraph 1]

1.126 If the above test is not met, the income will be taxed only in the country of residence of the recipient.

1.127 Remuneration derived as an employee and income derived by public entertainers are the subject of other Articles of the tax treaty and are not covered by this Article.

Article 15 – Income from employment

Basis of taxation

1.128 This Article generally provides the basis upon which the remuneration of visiting employees is to be taxed. The provisions of this Article do not apply, however, in respect of income that is dealt with separately in:

• Article 16 (Directors’ fees);

• Article 18 (Pensions and annuities); and

• Article 19 (Income from government service),

of the tax treaty.

1.129 Generally, salaries, wages and similar remuneration derived by a resident of one country from an employment exercised in the other country will be liable to tax in that other country. However, subject to specified conditions, there is a conventional provision for exemption from tax in the country being visited where visits of only a short-term nature are involved. [Article 15, paragraph 1]

Short-term visit exemption

1.130 The conditions for this exemption are that:

• the visit or visits does not exceed, in the aggregate, 183 days in any 12 month period commencing or ending in the year of income of the visited country;

• the remuneration is paid by, or on behalf of, an employer who is not a resident of the country being visited; and

• the remuneration is not borne by a permanent establishment or a fixed base which the employer has in the country being visited.

1.131 Where all of these conditions are met, the remuneration so derived will be liable to tax only in the country of residence of the recipient. [Article 15, paragraph 2]

1.132 Where a short-term visit exemption is not applicable, remuneration derived by a resident of Australia from employment in Russia may be taxed in Russia. However, the Article does not allocate sole taxing rights to Russia in that situation.

1.133 Accordingly, Australia would also be entitled to tax that remuneration in accordance with the general rule of the ITAA 1997 that a resident of Australia remains subject to tax on worldwide income. In common, however, with other situations where the tax treaty allows both countries to tax a category of income, Australia would be required in this situation (pursuant to Article 22), as the country in which the income recipient is resident for tax purposes, to relieve the double taxation that would otherwise occur.

1.134 Although that Article provides for the double tax relief to be provided by Australia to be in the form of the grant of a credit against the Australian tax for the Russian tax paid, the exemption with progression method of providing double tax relief in relation to employment income derived in the situation described would normally be applicable in practice pursuant to the foreign service income provisions of section 23AG of the ITAA 1936. This method takes into account the foreign earnings when calculating the Australian tax on other assessable income the person has derived.

Employment on a ship or aircraft

1.135 Income from an employment exercised aboard a ship or aircraft operated in international traffic may be taxed in the country in which the enterprise is situated. [Article 15, paragraph 3]

1.136 For the purposes of this Article, the term ‘international traffic’ shall not include any transportation which commences at a place in a country and returns to that place, after travelling through international waters but not visiting another country (e.g. so called ‘voyages to nowhere’ by cruise ships). [Protocol item 2]

Article 16 – Directors’ fees

1.137 Under this Article, remuneration derived by a resident of one country in the capacity of a director of a company which is a resident of the other country may be taxed in the latter country.

Article 17 – Income of entertainers and sportspersons

Personal activities

1.138 By this Article, income derived by visiting entertainers (which has a reasonably wide meaning in international tax treaty usage) and sportspersons from their personal activities as such may generally be taxed in the country in which the activities are exercised, irrespective of the duration of the visit. The words, “income derived by entertainers ... from their personal activities as such ...” extend the application of this Article to income generated from promotional and associated kinds of activities engaged in by the entertainer or sportsperson while present in the visited country. [Article 17, paragraph 1]

Safeguard

1.139 There is a safeguard provision included in this Article which is designed to ensure that income in respect of personal activities exercised by an entertainer or sportsperson, whether received:

• by the entertainer or sportsperson; or

• by another person, for example, a separate enterprise which formally provides the entertainer’s or sportsperson’s services,

is taxed in the country in which the entertainer or sportsperson performs, whether or not that other person has a permanent establishment or fixed base in that country. [Article 17, paragraph 2]

Article 18 – Pensions and annuities

1.140 Pensions (excluding government service pensions dealt with under Article 19.2) and annuities (the term annuity as used in this Article is defined in paragraph 2) are taxable only by the country in which the recipient is resident. This Article extends to pension and annuity payments made to dependants, for example, a widow, widower or children of the person in respect of whom the pension or annuity entitlement accrued where, upon that person’s death, such entitlement has passed to that person’s dependants. [Article 18, paragraphs 1 and 2]

Article 19 – Income from government service

Salary and wage income

1.141 Salary and wage type income, other than pensions or annuities, paid to an individual for services rendered in the discharge of governmental functions to a government (including a political subdivision or local authority) of one of the countries, is to be taxed only in that country. However, such remuneration will be taxable only in the other country if:

• the services are rendered in that other country; and

• the recipient is a resident of that other country for the purposes of that country’s tax, who is either:

− a citizen of that country; or

− did not become a resident of that other country solely for the purpose of rendering the services.

[Article 19, paragraph 1]

Government service pensions

1.142 Pensions paid by, or out of funds created by, one of the countries (or a political subdivision or local authority of that country) for services rendered in the discharge of governmental functions to that country will be taxable only in that country. It has been agreed with the Russian negotiators that governmental functions will only include those core activities of government (e.g. police, defences, foreign affairs, judiciary). [Article 19, subparagraph 2(a)]

1.143 However if the recipient is a resident and a citizen of the other country, the pension will be taxable in that other country provided the services in respect of which that pension is paid were rendered in that country. Thus, an Australian government service pension paid to a Russian resident who is also a Russian citizen will only be taxable in Russia, if the services which gave rise to that pension were rendered in Russia. [Article 19, paragraph 2]

Trade or business income

1.144 Remuneration for services rendered in connection with a trade or business carried on by any governmental authority referred to in paragraphs 1 and 2 of the Article is excluded from the scope of this Article. Such remuneration will remain subject to the provisions of Article 15 (Income from employment), Article 16 (Directors’ fees) or Article 18 (Pensions and annuities). [Article 19, paragraph 3]

Article 20 – Payments to students

Exemption from tax

1.145 This Article applies to students temporarily present in one of the countries solely for the purpose of their education if the students are, or immediately before the visit were, resident in the other country. In these circumstances, payments from abroad received by the students solely for their maintenance or education will be exempt from tax in the country visited, even though they may qualify as a resident of the country visited during the period of their visit, and therefore might be taxable but for this Article.

1.146 The exemption from tax provided by the visited country is treated as extending to maintenance payments received by the student that are made for maintenance of dependent family members who have accompanied the student to the visited country.

Employment income

1.147 Where, however, a student from Russia who is visiting Australia solely for educational purposes undertakes:

• some part-time work with a local employer; or

• during a semester break undertakes work with a local employer,

the income earned by that student as a consequence of that employment may, as provided for in Article 15, be subject to tax in Australia. In this situation the payments received from abroad for the student’s maintenance or education will not however be taken into account in determining the tax payable on the employment income that is subject to tax in Australia. No Australian tax would be payable on the employment income, however, if the student qualifies as a resident of Australia during the visit and the taxable income of the student does not exceed the tax-free threshold applicable to residents.

Article 21 – Other income

Allocation of taxing rights

1.148 This Article provides rules for the allocation between the 2 countries of taxing rights to items of income not dealt with in the preceding Articles of the tax treaty. The scope of the Article is not confined to such items of income arising in one of the countries – it extends also to income from sources in a third country.

1.149 Broadly, such income derived by a resident of one country is to be taxed only in the country of residence unless it is derived from sources in the other country, in which case the income may also be taxed in the other country. Where this occurs, the country of residence of the recipient of the income would be obliged by Article 22 (Methods of elimination of double taxation) to provide double taxation relief. [Article 21, paragraphs 1 and 3]

1.150 This Article does not apply to income (other than income from real property as defined in Article 6.2) where the right or property in respect of which the income is paid is effectively connected with a permanent establishment or fixed base which a resident of one country has in the other country. In such a case, Article 7 (Business profits) or Article 14 (Income from independent personal services), as the case may be, will apply. [Article 21, paragraph 2]

Article 22 – Methods of elimination of double taxation

1.151 Double taxation does not arise in respect of income flowing between the 2 countries where the terms of the tax treaty provide either:

• for the income to be taxed only in one country; or

• where the domestic taxation law of one of the countries exempts the income from its tax.

Tax credit

1.152 It is necessary, however, to prescribe a method for relieving double taxation for other classes of income which, under the terms of the tax treaty, remain subject to tax in both countries. In accordance with international practice, Australia’s tax treaties provide for double tax relief to be provided by the country of residence of the taxpayer by way of a credit basis of relief against its tax for the tax of the country of source of the income. This Article also reflects that approach.

Source of income – double taxation relief

1.153 A special rule has been included in the Protocol which is designed to ensure that where an item of income, profits or gains is taxable in both countries, double taxation relief will be given by the income recipient’s country of residence (pursuant to this Article) for tax levied in the other country as prescribed under the tax treaty. In this way, income derived by a resident of Australia, which is taxable in Russia under the tax treaty, will be treated as being foreign income for the purposes of the ITAA 1936, including the foreign tax credit provisions of that Act. [Protocol item 1(a)]

Australian method of relief

1.154 Australia’s general foreign tax credit system, together with the terms of this Article and of the tax treaty generally, will form the basis of Australia’s arrangements for relieving a resident of Australia from double taxation on income arising from sources in Russia. The source of income rules specified by Protocol item 1(a) for the purposes of the tax treaty will also apply for those purposes.

1.155 Accordingly, effect is to be given to the tax credit relief obligation imposed on Australia by paragraph 1 of this Article by application of the general foreign tax credit provisions (Division 18 of Part III) of the ITAA 1936. This will include the allowance of underlying tax credit relief in respect of dividends paid by Russian resident companies that are related to Australian resident companies, including for unlimited tiers of related companies, in accordance with the relevant provisions of the ITAA 1936.

1.156 Notwithstanding the credit basis of relief provided for by paragraph 2 of this Article, the exemption with progression method of relief will be applicable, as appropriate, in relation to salary and wages and like remuneration derived by a resident of Australia during a continuous period of foreign service (as defined in subsection 23AG(7) of the ITAA 1936) in Russia. Other foreign source income exemptions in Australia’s domestic law will also continue to be applicable in respect of relevant Russian source income. [Article 22, paragraph 1]

Russian relief

1.157 Russia is required to allow its residents a credit for Australian tax paid where they have derived income which is taxed in Australia and which is also taxed in Russia. [Article 22, paragraph 2]

Article 23 – Limitation of benefits

1.158 This Article provides that any income or profits which benefits from a preferential tax regime established under the law of either Australia or Russia which could potentially deny access to information by the other treaty partner is not to be accorded treaty benefits. Such treaty benefits are to be denied in relation to income or profits derived from certain specified activities. These activities generally do not require a substantial presence in the other treaty partner country, are preferentially taxed in that country and the information concerning that income or profits is granted greater than usual confidentiality by that country.

1.159 Preferentially taxed for these purposes means income or profits which are exempt from tax, or subject to a lower than normal rate of tax or are receiving other benefits in relation to that income or those profits (other than by reason of the application of other Articles of the tax treaty). [Article 23, paragraph 2]

Article 24 – Mutual agreement procedure

Consultation

1.160 One of the purposes of this Article is to provide for consultation between the competent authorities of the 2 countries with a view to reaching a satisfactory solution where a person is able to demonstrate actual or potential imposition of taxation contrary to the provisions of the tax treaty.

1.161 A person wishing to use this procedure must present a case to the competent authority of the country of which the person is a resident within 3 years of the first notification of the action which the taxpayer considers gives rise to taxation not in accordance with the tax treaty. [Article 24, paragraph 1]

1.162 If, on consideration by the competent authorities, a solution is reached, it may be implemented irrespective of any time limits imposed by the domestic tax law of the relevant country. [Article 24, paragraph 2]

Resolution of difficulties

1.163 This Article also authorises consultation between the competent authorities of the 2 countries for the purpose of resolving any difficulties regarding the interpretation or application of the tax treaty and to give effect to it. [Article 24, paragraphs 3 and 4]

Article 25 – Exchange of information

Limitations on exchange

1.164 This Article authorises and limits the exchange of information by the 2 competent authorities to information necessary for the carrying out of the tax treaty or for the administration of domestic laws concerning the taxes to which the tax treaty applies. [Article 25, paragraph 1]

1.165 The limitation placed on the kind of information authorised to be exchanged means that information access requests relating to taxes not within the coverage provided by Article 2 (Taxes covered), for example, goods and services tax, are not within the scope of the Article.

Purpose

1.166 The purposes for which the exchanged information may be used and the persons to whom it may be disclosed are restricted consistently with Australia’s other tax treaties. Any information received by a country shall be treated as secret in the same manner as information obtained under the domestic law of that country. [Article 25, paragraph 1]

1.167 An exchange of information that would disclose any trade, business, industrial, commercial or professional secret or trade process or which would be contrary to public policy is not permitted by this Article. [Article 25, paragraph 2]

Article 26 – Members of diplomatic missions and consular posts

1.168 The purpose of this Article is to ensure that the provisions of the tax treaty do not result in members of diplomatic missions and consular posts receiving less favourable treatment than that to which they are entitled in accordance with international conventions. Such persons are entitled, for example, to certain fiscal privileges under the Diplomatic (Privileges and Immunities) Act 1967 and the Consular (Privileges and Immunities) Act 1972 which reflect Australia’s international diplomatic and consular obligations.

Article 27 – Entry into force

Date of entry into force

1.169 This Article provides for the entry into force of the tax treaty. This will be on the last date on which notes are exchanged notifying that the last of the domestic processes to give the tax treaty the force of law in the respective countries has been completed. In Australia, enactment of the legislation giving the force of law in Australia to the tax treaty along with tabling the treaty in Parliament are prerequisites to the exchange of diplomatic notes.

Date of application for Australian withholding taxes

1.170 Once it enters into force, the tax treaty will apply in Australia in respect of withholding tax on income that is derived by a non-resident in relation to income derived on or after 1 July in the calendar year next following that in which the tax treaty enters into force.

Date of application for other Australian taxes

1.171 In Australia the tax treaty will first apply to other Australian taxes on income, profits or gains of the Australian year of income beginning on or after 1 July in the calendar year next following that in which the tax treaty enters into force.

Substituted accounting periods

1.172 Where a taxpayer has adopted an accounting period ending on a date other than 30 June, the accounting period that has been substituted for the year of income beginning on 1 July of the calendar year next following that in which the tax treaty enters into force will be the relevant year of income for the purposes of the application of other Australian tax.

Date of application in Russia

1.173 In Russia, the tax treaty will first apply to taxable years and periods beginning on or after 1 January in the calendar year following that in which the tax treaty enters into force.

Article 28 – Termination

1.174 The tax treaty is to continue in effect indefinitely. However, either country may give written notice of termination of the tax treaty through the diplomatic channel on or before 30 June in any calendar year beginning after the expiration of 5 years from the date of its entry into force.

Cessation in Australia

1.175 In the event of either country terminating the tax treaty, the tax treaty would cease to be effective in Australia for the purposes of withholding tax on income derived by a non-resident in relation to income derived on or after 1 July in the calendar year next following that in which the notice of termination is given.

1.176 For other Australian tax, it would cease to be effective in relation to income, profits or gains of any year of income beginning on or after 1 July in the calendar year next following that in which the notice of termination is given.

Cessation in Russia

1.177 The tax treaty would correspondingly cease to be effective in Russia for taxable years and periods beginning on or after 1 January in the calendar year next following that in which the notice of termination is given.

Protocol item 1(a) – Deemed source

1.178 Item 1(a) of the Protocol, which has application to the tax treaty as a whole, effectively deems income, profits or gains derived by a resident of one country which, under the tax treaty, may be taxed in the other country to have a source in the latter country for the purposes of the tax treaty and the domestic income tax law of the respective countries. It therefore avoids any difficulties arising under domestic law source rules in respect of, for example, the exercise by Australia of the taxing rights to Australia by the tax treaty over income derived by residents of Russia. [Protocol item 1(a)]

Chapter 2

Protocol amending the Convention with the United States of America

What is the US Protocol?

2.1 The US Protocol, once in force, will amend the Convention of 6 August 1982 between Australia and the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income.

Why is the Protocol necessary?

2.2 The Protocol is required to amend the existing tax treaty to reflect modern business practice and changes to both countries’ law and tax treaty policy since the Convention was negotiated. The Protocol will facilitate trade and investment between Australia and the United States by reducing or eliminating withholding taxes in some circumstances and by extending coverage of the Convention to taxes on capital gains.

Main features of the Protocol

2.3 The Protocol will:

• update the list of taxes covered by the Convention;

• ensure profits derived through a permanent establishment of a fiscally transparent entity (e.g. a trust) can be taxed in the country where the permanent establishment is located;

• extend the circumstances where exclusive residence country taxation will apply to profits from the bare boat lease of ships and aircraft used in international traffic and from the use and maintenance of containers used in international traffic;

• provide that certain intercorporate dividends will be either exempt or subject to a maximum 5% rate of source country tax;

• remove the limit on US tax on dividends derived from certain substantial holdings in US Real Estate Investment Trusts;

• provide an exemption for interest paid to government bodies and financial institutions;

• reduce the general rate of source country tax on royalties to 5% of the gross amount. Payments for the use of industrial, commercial or scientific equipment will also cease to be treated as royalties for the purposes of the Convention;

• provide distributive rules for capital gains and improve arrangements for taxing gains accrued on assets held by departing residents; and

• insert a new Limitation on Benefits Article to prevent residents of third countries from using interposed companies or other entities resident in one of the treaty countries to inappropriately access treaty benefits (i.e. treaty shopping).

Detailed explanation of changes made by the Protocol

Article 1 of the Protocol

Amends Article 1 of the Convention – Personal Scope

2.4 The Protocol will amend the Personal Scope Article of the Convention to extend the savings clause for former US citizens to also cover former long-term US residents. The current savings clause allows the United States to tax persons as US citizens for up to 10 years if they give up their citizenship to avoid US tax. Following the amendment, former long-term US residents who relinquish their residence status (e.g. green card holders who surrender their cards) to avoid tax may be subject to US tax for up to 10 years following the residence change.

Article 2 of the Protocol

Amends Article 2 of the Convention – Taxes Covered

2.5 Article 2 of the Protocol updates the list of taxes covered by the Convention by replacing paragraph (1) of Article 2 of the Convention. In the case of the United States, the Protocol will remove current references to the accumulated earnings tax and the personal holding company tax as US Federal income taxes not covered by the Convention. In the case of Australia, the Protocol deletes the undistributed profits tax and includes specific references to Australia’s tax on capital gains and petroleum resource rent tax. [New paragraph (1)]

2.6 The coverage of the US accumulated earnings tax and personal holding company tax by the Convention will have little effect because foreign corporations are normally exempt, or fall outside the parameters of the taxes. Where the taxes apply, the tax payable is likely to be insignificant.

2.7 The Convention currently does not apply to taxes on capital gains. The reference to Australia’s tax on capital gains is intended to clarify that capital gains are to be covered by the Convention following the Protocol.

2.8 Consistent with Australia’s recent treaty practice, a specific reference is also included to the petroleum resource rent tax. Although this tax is considered by Australia to be encompassed by the term “Australian income tax”, a specific reference is included to put beyond doubt that it is a tax covered by the Convention.

Article 3 of the Protocol

Amends Article 4 of the Convention – Residence

2.9 The United States taxes US citizens and resident aliens on their worldwide income. The Protocol will amend the Residence Article of the Convention to ensure that US citizens, wherever resident, will generally be treated as US residents for the purposes of the Convention. A US citizen will not be treated as a resident of the United States, however, if the person is treated as a resident of a third country under an Australian tax treaty with that country. This exclusion will prevent US citizens from cherry picking treaty benefits in Australia under more than one tax treaty. [Subparagraph (1)(b)(ii)]

Article 4 of the Protocol

Amends Article 7 of the Convention – Business Profits

2.10 The Protocol will amend the Business Profits Article of the Convention to clarify that the source country can tax business profits derived by a resident of the other country through one or more fiscally transparent entities where the profits are effectively connected with a permanent establishment of the transparent entity in the source country. The amendments thus ensure that Australia can tax US beneficiaries on their share of business profits derived by a trust operating through a permanent establishment in Australia. [Paragraph (9)]

2.11 The clarification of Australia’s source country right to tax trust beneficiaries on their share of business profits effectively connected with an Australian permanent establishment is consistent with Australia’s recent treaty practice and subsection 3(11) of the Agreements Act. The clarification has been expressed in bilateral terms to similarly protect US source country taxing rights. The term “fiscally transparent entity” has been used to cover any entity, not just trusts, that may be taxed on a “look-through” basis (e.g. US limited liability companies treated as partnerships for US tax purposes).

Article 5 of the Protocol

Amends Article 8 of the Convention – Shipping and Air Transport

2.12 The Protocol will amend the Shipping and Air Transport Article of the Convention to extend exclusive residence country taxation to certain profits from the bare boat lease of ships or aircraft and from the use and maintenance of containers. This will help to simplify compliance for international shipping and air transport operators.

Removal of the requirement that ships or aircraft leased on a bare boat basis be used in international traffic by the lessee

2.13 Currently profits from the lease of ships or aircraft on a bare boat basis (generally, without crew) or of containers are taxable only in the lessor’s country of residence where:

• the lease is incidental to the lessor’s international transport operations; and

• the ships, aircraft or containers are used in international traffic by the lessee.

[Article 8(1)(b) of the Convention]

2.14 The Protocol will remove the requirement that the ships or aircraft be used in international traffic by the lessee. Profits derived from a bare boat lease of a ship or aircraft, whether used domestically or in international traffic by the lessee, would thus be taxable only in the lessor’s country of residence where the lease is incidental to the lessor’s international transport operations. [Subparagraph (1)(b)]

2.15 The Protocol will also extend exclusive residence country taxation under the Shipping and Air Transport Article to profits from the use, maintenance or rental of containers used in international traffic. [Paragraph (2)]

2.16 Profits from the lease of ships, aircraft or containers that are not covered by the Shipping and Air Transport Article will come within the scope of the Business Profits Article. This follows from changes to the Royalties Article which remove payments for use of equipment from the definition of ‘royalties’ (paragraph (b) of Article 8 of the Protocol). Profits that would come within the Business Profits Article include:

• profits from the lease on a full basis of ships or aircraft where the equipment is not operated in international traffic by the lessee or where the lessor only operates ships or aircraft between places in the source country and does not regularly lease ships or aircraft on a full basis;

• bare boat leases not incidental to the lessor’s international transport operations; and

• profits from the lease of containers not used in international traffic by the lessee.

2.17 Source country taxation is only permitted under the Business Profits Article to the extent the profits are effectively connected with a permanent establishment in that country.

No change to rules dealing with participation in a pool service or for internal traffic

2.18 New paragraphs dealing with participation in a pool service and internal traffic reflect recent treaty language and are not different in substance to the paragraphs replaced. [Paragraphs (3) and (4)]

Article 6 of the Protocol

Substitutes new Article 10 of the Convention – Dividends

2.19 The Protocol will substitute a new Dividends Article into the Convention that introduces a number of exceptions to the general 15% limit on source country taxation of dividends. The new Article will:

• provide that certain cross border intercorporate dividends will be either exempt or subject to a maximum 5% rate of source country tax;

• remove the limit of US tax on dividends derived from certain substantial holdings in US REITs;

• generally prevent Australia from taxing dividends paid by US companies out of profits derived from sources in Australia; and

• permit dividend equivalent taxation of profits attributable to a permanent establishment or real property situated in the source country.

Certain cross border intercorporate dividends to be exempt or subject to reduced rates of source country tax

2.20 No tax will be chargeable in the source country on dividends where a beneficially entitled company resident in the other country holds 80% or more of the voting power of the company paying the dividends and satisfies certain requirements in the Limitation on Benefits Article [paragraph (3)]. A limit of 5% will apply for other company shareholdings that constitute a voting interest of 10% or greater [subparagraph (2)(a)]. These limits will apply in Australia to both franked and unfranked dividends.

2.21 The exemption provides broadly reciprocal treatment for the dividend withholding tax exemption provided by Australia for franked dividends paid to non-residents. The United States does not provide a comparable exemption for dividends paid from profits taxed previously at the corporate level.

Requirements that must be satisfied to qualify for the dividend exemption

2.22 Anti-treaty shopping rules will apply to prevent residents of third countries from using interposed companies resident in one of the treaty countries to inappropriately access the dividend exemption. To qualify for the dividend exemption, a company beneficially entitled to the dividends must, in addition to the general requirement that it holds 80% or more of the voting power of the company paying the dividends, be a ‘qualified person’ based on one of the following tests from the Limitation on Benefits Article:

• the principal class of shares in the company receiving the dividends must be listed on a recognised US or Australian stock exchange [new Article 16, subparagraph (2)(c)(i)];

• at least 50% of the vote and value of the shares in the receiving company must be owned directly or indirectly by 5 or fewer companies that satisfy the stock exchange listing requirements [new Article 16, subparagraph (2)(c)(ii)]; or

• the competent authority in the source country must determine in accordance with the domestic law that the establishment, acquisition or maintenance of the receiving company and the conduct of its operations did not have as one of its principal purposes the obtaining of benefits under the Convention [new Article 16, paragraph (5)].

2.23 Refer to the discussion on the Limitation on Benefits Article (Article 10 of the Protocol) for a further explanation of these requirements.

No exemption or reduced rate for dividends paid by US Regulated Investment Companies or Real Estate Investment Trusts

2.24 Consistent with recent US treaty practice, the dividend exemption and 5% rate limitation will not apply for dividends paid by a RIC or REIT [subparagraph (4)(a)]. These are types of US collective investment vehicles that are taxed differently to other companies in the United States. Generally profits derived through companies are taxed in the United States at the company level and again on distribution to shareholders. In contrast, profits derived through a RIC or REIT are typically deductible to the extent they are allocated to shareholders, subject to the RIC or REIT satisfying a minimum distribution requirement. This deduction has the effect that the profits are generally only taxed at the shareholder level.

2.25 The US tax payable on dividends derived from a RIC or REIT will generally be capped at the standard treaty rate of 15%. [Subparagraphs (4)(b) and (c)]

No rate limit for dividends derived from certain substantial holdings in REITs

2.26 Also consistent with recent US tax treaty practice, no rate limit will apply for dividends derived from certain substantial holdings in REITs. These dividends may therefore be taxed at the US domestic law rate which is currently 30% for companies.

2.27 The higher rate reflects that REITs primarily derive income from US real property and are intended to facilitate collective investment. US treaty practice is to tax income derived through a REIT at full rates where a holding is sufficient to be comparable to holding real property directly.

2.28 The current treaty rate limit of 15% on REIT dividends will continue to be available if:

• the person beneficially entitled to the dividends is an individual holding an interest of not more than 10% in the REIT;

• the dividends are paid with respect to a class of stock that is publicly traded and the person beneficially entitled to the dividends holds an interest of not more than 5% of any class of the REIT’s stock; or

• the person beneficially entitled to the dividends holds an interest of not more than 10% in the REIT and the gross value of no single interest in real property held by the REIT exceeds 10% of the gross value of the REIT’s total interest in real property.

2.29 A class of stock will be taken to be publicly traded (relevant to the second test) if all the shares in the class or classes of shares that represent more than 50% of the voting power and value of the company are regularly traded on a recognised stock exchange located in either country. Refer to the discussion on new subparagraph (2)(c) of the Limitation on Benefits Article for a further explanation of the publicly traded requirement.

Treaty rate limit to generally apply for REIT dividends derived by a listed Australian property trust

2.30 The 15% dividend rate limit will generally continue to apply for REIT dividends derived by a LAPT regardless of its holding in the REIT. Dividends paid by a REIT may, for instance, qualify for the 15% dividend rate where the REIT is wholly-owned by a LAPT. These arrangements reflect that LAPTs are used for collective investment in Australia and that investments held through these trusts are generally widely-held. [Subparagraph (4)(d)]

2.31 Look-through rules will apply where the responsible entity for a LAPT knows, or has reason to believe, that a unitholder has a beneficial interest in the LAPT of 5% or more. In this case, the REIT holding limits will be tested at the unitholder level and the treaty rate limit of 15% will only apply to the unitholder’s share of a REIT dividend where the unitholder satisfies one of the REIT holding limit tests discussed above. This may mean that the portion of a REIT dividend allocated to a unitholder for the purposes of applying the tests may be subject to full rates of US tax whereas the balance of the dividend derived by the LAPT is subject to the standard treaty rate limit of 15%.

2.32 A unitholder will be taken under the look-through rules to hold an interest in a REIT equal to the person’s proportionate interest in the LAPT multiplied by the LAPT’s direct interest in the REIT. A unitholder with a 10% interest in a LAPT that has a 60% interest in a REIT would, for instance, be taken to have a 6% (10% × 60%) interest in the REIT. In applying the tests, the person is taken to be beneficially entitled to the REIT dividends and the dividends are taken to be paid with respect to a class of stock that is publicly traded. This allows the holding limit tests to be satisfied for an indirect interest in a REIT dividend.

2.33 Changes made by the Protocol to the Dividends Article will not apply to REIT dividends derived by a LAPT where the shares on which the dividends are paid were:

• owned by the LAPT on 26 March 2001 (i.e. the time of the first round of negotiations on the Protocol);

• acquired by the LAPT pursuant to a binding contract entered into on or before 26 March 2001; or

• acquired by the LAPT pursuant to a reinvestment of dividends (ordinary or capital) with respect to such shares.

2.34 Rules in the current Dividends Article that limit US tax payable to 15% on the gross amount of these dividends will thus continue to apply. [Paragraph (3) of Article 13 of the Protocol]

2.35 A LAPT is defined as an Australian unit trust registered as a ‘Managed Investment Scheme’ under the Australian Corporations Act. The principal class of units must also be listed on a recognised stock exchange in Australia and be regularly traded on one or more recognised stock exchanges [subparagraph (4)(d)]. Refer to the discussion on paragraph (6) in the new Limitation on Benefits Article for an explanation of recognised stock exchanges (i.e. Article 10 of the Protocol).

Dividends paid by a company resident in one of the countries will generally be taxable exclusively in that country

2.36 Dividends paid by a company resident in one of the countries will be taxable exclusively in that country, unless:

• the person deriving the dividends is a resident of the other country; or

• the shareholding in respect of which the dividends are paid is effectively connected with a permanent establishment or fixed base in that other country.

[Paragraph (7)]

2.37 This rule will not apply to dividends paid by companies that are residents of both Australia and the United States because they are not treated as residents of either country for the purposes of applying the Convention (Article 3(1)(g) of the Convention). Australia will thus continue to be able to tax dividends paid by dual resident companies.

2.38 The rule will, however, prevent Australia from taxing dividends paid by a US company out of profits derived from sources in Australia (i.e. dividends taxable under paragraph 44(1)(b) of the ITAA 1936) unless the dividends are derived by an Australian resident or the shareholding is effectively connected with an Australian permanent establishment. Australia can currently tax dividends paid by a US company from these Australian source profits if the profits are attributable to an Australian permanent establishment and the gross income attributable to the permanent establishment constitutes at least 50% of the company’s gross income from all sources (subparagraph (5)(c) of the Convention). The new Dividends Article does not, however, contain an equivalent provision. This is consistent with Australia’s other tax treaties and the changes will thus place US companies operating in Australia on an equal footing with companies from other tax treaty countries.

Dividend equivalent taxation of profits attributable to a permanent establishment or real property situated in the source country

2.39 The source country will generally be able to impose additional tax on notional dividends attributable to a permanent establishment or real property situated in that country [paragraph (8)]. This treatment reflects current US treaty practice and replaces rules for dividend equivalent taxation in existing paragraph (6) of the Convention. The rules will equate the taxation treatment of profits from activities conducted through a permanent establishment and income from real property investments with profits from similar activities conducted through a subsidiary resident in the source country. In this regard, profits derived through a subsidiary can be taxed at both the corporate level and again on distribution as dividends. Australia does not seek to impose dividend equivalent taxation.

2.40 No dividend equivalent taxation will apply to such profits where a company is a ‘qualified person’ based on one of certain tests specified in the Limitation on Benefits Article [paragraph (8)]. These tests are the same as those discussed above for determining whether a company can qualify for the dividend exemption (refer to the discussion on paragraph (3)). A 5% limit will apply to source country tax that can be charged on the dividend equivalent amount for companies that do not satisfy one of these tests [paragraph (9)].

2.41 The following notes reflect agreements reached during the negotiation of the Protocol with regard to the operation of the rules:

“In relation to Article 10 (Dividends), both delegations agreed that, where a Contracting State may impose additional tax in accordance with paragraph (8) of that Article on the dividend equivalent (or analogous) amount of profits, income or gains of a company which is a resident of the other Contracting State, no further additional tax may be imposed by the first-mentioned State on such amount under any other provision of the Convention.

It was further agreed that an amount analogous to the dividend equivalent amount of a company resident in one Contracting State is the amount equal to the after-tax earning attributable to the company’s business profits attributable to a permanent establishment in the other Contracting State and income or gains that may be taxed in that other Contracting State on a net basis under Article 6 (Income from Real Property) or under paragraphs (1) or (3) of Article 13 (Alienation of Property), reduced by any increase in the company’s net investment in assets in that other Contracting State, or increased by any reduction in the company’s net investment in assets in that other Contracting State.”

Substantially similar provisions

2.42 Paragraphs (1), (5) and (6) dealing with dividends paid by resident companies, dividends derived by a permanent establishment and the definition of the term ‘dividends’ respectively reflect recent treaty language and are not different in substance to the paragraphs replaced.

Article 7 of the Protocol

Substitutes new Article 11 of the Convention – Interest

2.43 The Protocol will substitute a new Interest Article into the Convention that will generally maintain a 10% limit on source country taxation of interest flows. This rate accords with the general rate of interest withholding tax applicable under Australia’s domestic law. The new Article will:

• provide an exemption for interest paid to government bodies and financial institutions;

• modify the definition of interest to include premiums attached to bonds, debentures and government securities and to exclude penalty charges and amounts covered by the Dividends Article;

• allow interest calculated with reference to profits to be taxed at the standard dividend rate limit of 15%;

• remove the interest rate limit for amounts derived from a residual interest held in a US REMIC; and

• deem notional interest to arise where deductions for interest claimed in determining profits attributable to a permanent establishment or connected with real property situated in the source country exceeds the interest paid by the permanent establishment or on the debt secured by the real property.

Exemption for interest paid to government bodies and financial institutions

2.44 The Protocol will provide an exemption from source country tax for interest paid to:

• a government body of the other country (i.e. a political or administrative subdivision or a local authority thereof, or any other body exercising governmental functions in Australia or the United States, or a bank performing central banking functions); and

• a financial institution resident in the other country (subject to certain safeguards relating to back-to-back loans).

[Paragraphs (3) and (4)]

Exemption for interest paid to government bodies

2.45 The exemption for interest paid to government bodies will apply to interest derived in the course of exercising governmental functions but will not extend to interest derived by a government body from the conduct of a trade or business. Similar exemptions apply in a number of Australia’s tax treaties.

Exemption for interest paid to financial institutions

2.46 The exemption for interest paid to financial institutions reflects that the current 10% rate on gross interest can be excessive given their cost of funds. The exemption will also align the treatment of interest paid to US financial institutions with the domestic law exemption for interest paid on widely distributed arm’s length corporate debenture issues (section 128F of the ITAA 1936). The term financial institution means a bank or other enterprise substantially raising debt finance in the financial markets or by taking deposits at interest and using those funds in carrying on a business of providing finance.

2.47 The exemption will not be available for interest paid as part of an arrangement involving back-to-back loans or other arrangement that is economically equivalent and intended to have a similar effect to back-to-back loans. The denial of the exemption for these back-to-back arrangements is directed at preventing related party and other debt from being structured through financial institutions to gain access to a withholding tax exemption. The exemption will only be denied for interest paid on the component of a loan that is considered to be back-to-back.

2.48 A back-to-back arrangement would include, for instance, a transaction or series of transactions structured in such a way that:

• a US financial institution receives or is credited with an item of interest arising in Australia; and

• the financial institution pays or credits, directly or indirectly, all or substantially all of that interest (at any time or in any form, including commensurate benefits) to another person who, if it received the interest directly from Australia, would not be entitled to similar benefits with respect to that interest.

2.49 However, a back-to-back arrangement would generally not include a loan guarantee provided by a related party to a US financial institution.

2.50 Australia currently reserves the right to apply its general anti-avoidance rules where there is a conflict with the provisions of a tax treaty (subsection 4(2) of the Agreements Act). New subparagraph (4)(b) will clarify that the above safeguards do not restrict the general application of any anti-avoidance rule.

Changes to the definition of interest

2.51 The new definition of interest largely accords with Australia’s treaty practice. The definition encompasses items of income such as discounts on securities and payments made under certain hire purchase agreements which, in the case of Australia, are treated as interest or amounts in the nature of interest. [Paragraph (5)]

2.52 Consistent with US treaty practice, the new interest definition includes premiums attached to bonds, debentures and government securities. An amount paid by an issuer of a loan security on redemption in excess of the amount paid by the subscriber would, for instance, be treated as interest paid to the subscriber. Source country tax would thus be limited to 10% of the gross amount of the premium paid on redemption. Australia’s domestic law does not provide for a reduction in the interest liable to withholding tax where a security is issued at a premium (e.g. where the amount paid by a subscriber exceeds that repaid on redemption).

2.53 The new interest definition will also exclude income dealt with by the Dividends Article. This will clarify that the Dividends Article takes precedence over the Interest Article in cases where both Articles can apply. The exclusion from the definition of penalty charges for late payment will have little effect in Australia because Australia’s domestic law generally does not permit the imposition of these types of penalties.

Standard dividend rate limit to apply for interest calculated with reference to profits

2.54 The new Interest Article will permit the source country to tax interest paid to a resident of the other country at a higher rate of 15% if the interest is calculated with reference to profits of the issuer or of one of its associated enterprises. This will equate the rate of source country tax on such interest with the rate that generally applies to dividends. [Subparagraph (9)(a)]

2.55 An enterprise will be associated with the issuer if:

• it participates directly or indirectly in the management, control or capital of the issuer; or

• the same persons participate directly or indirectly in the management, control or capital of the enterprise and the issuer.

[Paragraph (1) of the Associated Enterprises Article of the Convention]

No interest rate limit for amounts derived on residual interests in US Real Estate Mortgage Investment Conduits

2.56 A REMIC is a US tax vehicle that holds a fixed pool of real estate loans and issues debt securities with serial maturities and differing rates of return backed by those loans. Through a REMIC, a financial institution can repackage and sell long-term mortgages to the investing public. A REMIC generally does not pay US income tax. Its tax liability is paid by holders of its residual interests, which include in income their share of the REMIC’s income or loss each year.

2.57 Consistent with recent US treaty practice, the new Interest Article will permit the United States to charge US tax at full rates on the purchasers of residual interests in REMICs. This will ensure that foreign purchasers do not have a competitive advantage over US purchasers. It will also counter tax avoidance opportunities that could arise in the United States from differences in the timing of taxable and economic income on residual interests.

2.58 Full US tax will be limited to the amount of interest paid on a residual interest that exceeds the normal rate of return on publicly-traded debt instruments with a similar risk profile. The share of REMIC income attributable to a normal rate of return is generally treated as portfolio interest and is exempt from withholding tax under US domestic law. [Subparagraph (9)(b)]

Notional interest in respect of excess interest expenses

2.59 Consistent with US treaty practice, the new Interest Article will allow the source country to tax an amount of notional interest where deductions for interest claimed in determining profits attributable to a permanent establishment or connected with real property in that country exceed the interest paid by the permanent establishment or on the debt secured by the real property. The notional interest will equal the amount of the excess of interest deductions over interest paid and be deemed to be interest arising in the source country to which a resident of the other country is beneficially entitled. [Paragraph (10)]

2.60 The notional interest would, for instance, be calculated as the difference between interest expenses of an Australian company allocated and claimed as a deduction in determining the taxable profits of its US permanent establishment over the amount of interest paid by the permanent establishment. Currently the US can charge withholding tax on the component of interest borne by the permanent establishment on indebtedness connected with that permanent establishment, and this will continue to be the case under new paragraph (7). Paragraph (10) will allow the US to charge withholding tax on an interest expense claimed by the Australian company in determining the profits of the US permanent establishment in cases where the interest expense is not actually paid by the permanent establishment. To achieve this result, the interest expense in excess of that actually paid by the permanent establishment will be deemed to be interest arising in the United States to which a resident of Australia is beneficially entitled.

2.61 Australia does not have similar rules for taxing notional interest under its domestic law.

Substantially similar provisions

2.62 Paragraphs (1), (2) and (6) to (8) dealing with general limits on source country tax, interest derived by a permanent establishment, rules for determining when interest arises in a country and adjustments for non-arm’s length amounts reflect recent treaty language and are not different in substance to the paragraphs replaced.

Article 8 of the Protocol

Amends Article 12 of the Convention – Royalties

2.63 The Protocol will amend the Royalties Article of the Convention. Broadly, both countries will continue to be able to tax royalty flows with a limit generally applying to the tax that the source country can charge. The changes will:

• reduce the general rate of source country tax on royalties to 5% of the gross amount;

• exclude payments for the use of industrial, commercial or scientific equipment from the scope of the Royalties Article; and

• extend the royalties definition to cover additional types of broadcasting media.

Reduction in the general rate of source country tax on royalties

2.64 The Protocol will reduce the limit on source country taxation of royalties from 10% to 5%. [Paragraph (a) of Article 8 of the Protocol]

Exclusion of payments for the use of industrial, commercial or scientific equipment

2.65 The definition of royalties currently includes payments for the use of industrial, commercial or scientific equipment other than equipment let under a hire purchase agreement. The Protocol will amend the definition to exclude these payments [subparagraph 4(a)]. Consequential amendments to ensure these payments are excluded from the scope of the domestic law royalty withholding tax provisions are discussed in Chapter 3.

2.66 The effect of the change to the royalties definition is that the Royalties Article will cease to apply to payments previously treated as equipment royalties, and the Business Profits Article will apply to these payments. The source country will therefore only be able to tax the payments to the extent they are connected with a business carried on through a permanent establishment in that country.

2.67 The exclusion of payments for the use of equipment from the Royalties Article reflects that source country taxation on a gross basis may be excessive given low profit margins.

Inclusion of additional broadcasting media

2.68 The Protocol will extend the royalties definition in respect of broadcasting media to reflect modern technologies. The definition will include payments for the use of video or audio disks, or any other means of image or sound reproduction or transmission for use in connection with television, radio or other broadcasting (e.g. satellite and internet broadcasting). The changes will clarify that the source country can tax these payments as royalties. [Subparagraph (4)(a)(iii)]

2.69 The following notes were agreed during the negotiation of the Protocol with regard to the definition:

“In relation to Article 12 (Royalties), both delegations agreed that the definition of “royalties” in subparagraph (4)(a)(iii), in referring to a payment for a transmission in connection with broadcasting, does not include payments made for the reception of images or sounds for personal use by the payer.”

Article 9 of the Protocol

Amends Article 13 of the Convention – Alienation of Property

2.70 Consistent with the extension of the Convention to cover tax on capital gains (new subparagraph (1)(b)(i) of Article 2), the Protocol amends the Alienation of Property Article to delete paragraph (3) (which deals with certain income or gains from the alienation of ships, aircraft and containers) and to insert a number of new provisions designed to deal comprehensively with gains from the alienation of property.

2.71 The Protocol will amend the Alienation of Property Article to:

• include distributive rules for alienation of business property connected with a permanent establishment or fixed base;

• update the distributive rules for dealing with alienation of ships, aircraft and containers used in international traffic;

• improve arrangements for taxing gains accrued on assets held by departing residents by reducing compliance difficulties and ensuring appropriate relief is provided from double taxation; and

• provide for capital gains not covered by specific distributive rules to be taxed in accordance with the domestic laws of each country.

Capital gains to be covered

2.72 References to “income or gains” in the Alienation of Property Article will cover capital gains as well as revenue gains following the changes made by the Protocol. Changes to the Taxes Covered Article specifically include Australia’s tax on capital gains as a tax covered by the Convention. The amended Alienation of Property Article will therefore allocate between Australia and the United States taxing rights in relation to income or capital gains arising from the alienation of real property and other items of property.

Source country taxation permitted on amounts derived from direct and indirect alienation of land rich entities

2.73 It has been Australia’s treaty practice following the decision of the Full Federal Court in the Commissioner of Taxation v Lamesa Holdings BV to include a provision that expressly allows Australia to tax amounts from the direct or indirect alienation of entities that principally hold Australian real property. An equivalent provision has not been included in the amended Alienation of Property Article because existing subparagraph (2)(b) of Article 13 in the Convention is sufficient to cover these disposals. The following notes were agreed by the delegations to clarify that disposals of entities that indirectly hold an interest in a land rich entity can be taxed in the country where the property is situated.

“For purposes of subparagraphs (2)(b)(ii) and (iii) of Article 13 (Alienation of Property), both delegations agreed that assets which consist wholly or principally of real property situated in Australia include assets consisting wholly or principally of such real property which is held directly or indirectly, including through one or more interposed entities (e.g. through a chain of companies).”

Source country taxation of amounts derived from alienation of business property

2.74 New paragraph (3) deals with income or gains arising from the alienation of property (other than real property covered by paragraph (1)) forming part of the business assets of a permanent establishment of an enterprise or pertaining to a fixed base used for performing independent personal services. It also applies where the permanent establishment itself (alone or with the whole enterprise) or the fixed base is alienated. Such income or profits may be taxed in the country in which the permanent establishment or fixed base is situated. This corresponds to the rules for taxation of business profits and income from independent personal services contained in Articles 7 and 14 respectively.

2.75 Paragraph (3) does not deal with the taxation of amounts arising from the alienation of other business property (i.e. property not connected with a permanent establishment or fixed base in that country). Capital gains from the alienation of this property will be taxed in accordance with new paragraph (7). Revenue gains will generally be covered by the Business Profits Article.

Update of distributive rules dealing with alienation of ships, aircraft and containers used in international traffic

2.76 The Protocol will provide for exclusive residence country taxation of income and capital gains from the alienation of ships, aircraft or containers operated or used in international traffic. A current exception that allows source country taxation to recoup depreciation will be removed consistent with recent tax treaty practice in both countries. The exception for income described in subparagraph (4)(c) of the Royalties Article will also be deleted because payments for the use of equipment will no longer be covered by that Article. [Paragraph (4)]

Taxation of gains accrued on assets held by departing residents

2.77 Changes made by the Protocol will help prevent double taxation that may arise when an individual changes residence. Unrealised gains on assets that do not have the necessary connection with Australia are generally taxable under Australia’s domestic law when a person ceases to be a resident of Australia (section 104-160 of the ITAA 1997). Double taxation can potentially arise in the new country of residence if the country taxes the gain on the subsequent disposal of the asset and does not provide a credit for the Australian tax.

Option to align the taxation of residence change gains

2.78 New paragraph (5) allows an individual to elect in the new country of residence to be treated as having alienated property at the residence change time. The election will be available where property is taken as a result of a residence change to have been alienated under the laws of the former country of residence and the individual is taxable in that country on the residence change gain (or loss) that arises. Where the election applies, the property will be taken to have been alienated and reacquired in the new country of residence at the time the individual ceased to be a resident of the country of former residence (according to the taxation laws of that country). The alignment of the taxing point in both jurisdictions will help ensure appropriate relief is provided in the country that the individual is leaving for foreign tax that may have accrued in the other country. [Paragraph (5)]

Example 2.1

An individual departing Australia may, for instance, hold a less than 10% shareholding in an Australian public company. This shareholding will not have the ‘necessary connection with Australia’ and thus the individual may be taken to have alienated the shares at the residence change time. Double taxation could arise if the United States taxes the pre-residence change component of the gain on a subsequent alienation of the shares.

If the election in paragraph (5) is exercised, the individual would be taken in the United States to have alienated the shareholding immediately before ceasing to be a resident of Australia under Australian tax law. The provisions of the Convention would then operate to ensure appropriate relief is provided from double taxation. Relief may not be required because the United States is unlikely to tax a non-US resident on the disposal of a foreign (Australian) asset unless the individual is a US citizen. The United States would be able to tax the post-residence change gain on the subsequent disposal of the shareholding.

2.79 A residence change disposal will generally not give rise to a gain in the other country unless the asset has some connection with that country (e.g. the asset is real property situated in that country). Paragraph (5) will crystallise a gain immediately before an individual changes residence and the country in which the individual is resident at that point in time would generally be required to provide a credit for tax, if any, that arises in the new country of residence. Australia would therefore provide a credit for US tax that may be paid on the deemed disposal of a US asset when an individual ceases to be a resident of Australia. The United States would, however, be required to provide a credit for the Australian tax if the residence change gain is taxable in the United States solely by reason of citizenship (Articles 22(1) and (2) of the Convention).

Exemption from former residence country taxation

2.80 The taxation of unrealised gains can give rise to cash flow problems because proceeds from the gains are not available to pay the tax. Australia’s domestic law provides relief by allowing departing individuals to defer tax on unrealised gains if they elect to treat assets to which the gains relate as having the necessary connection with Australia (subsections 104-165(2) and (3) of the ITAA 1997). The effect of the election is that a gain on the subsequent disposal of the property will be taxable in Australia even though the individual is not an Australian resident.

2.81 The Protocol will provide an exemption from former residence country taxation for gains deferred by an individual on ceasing to be a resident of that country if the individual is a resident of the other country when the gains are crystallised [paragraph (6)]. An individual departing Australia who defers tax by electing for an asset to have the necessary connection with Australia will, for instance, be exempt in Australia on a gain arising from a subsequent disposal of the asset if the individual is a resident of the United States at the time of the disposal. This will reduce compliance difficulties for departing residents, ensure post-residence change gains on foreign assets are not taxable in Australia (the US can still tax post-residence change gains derived by departing citizens on a citizenship basis (Article 1(3) of the Convention)) and that appropriate relief is provided from double taxation.

2.82 Paragraph (6) will not affect the taxation of gains derived from the disposal of assets that, prior to a residence change, already have the necessary connection with Australia. A requirement of paragraph (6) is that an individual must elect to defer tax on a residence change gain. This requirement will not be satisfied for assets that have the necessary connection with Australia because there is no deemed disposal of these assets when an individual ceases to be an Australian resident. Australia may therefore continue to tax gains realised on the disposal of these assets.

2.83 Similarly, paragraph (6) will not affect the inclusion in assessable income of a discount on a qualifying share or right that has been deferred under an employee share acquisition scheme. Again, this is because there is no taxation deferred as a result of a residence change. Paragraph (6) could operate, however, to exempt gains accrued on shares after allocation where an individual ceases to be a resident of Australia and elects to defer the residence change gain.

Capital gains not covered by specific distributive rules to be taxed in accordance with the domestic laws of each country

2.84 The Protocol inserts a sweep-up provision in relation to capital gains which enables each country to tax such gains in accordance with its domestic law, except where different treatment is provided in the preceding paragraphs of the Article [paragraph (7)]. Thus, except where Australia’s right to tax capital gains is limited by the other paragraphs (e.g. new paragraphs (4) and (6)) or otherwise affected by those paragraphs (e.g. new paragraph (5)), the provision preserves the application of Australia’s domestic law relating to the taxation of capital gains. Australia will thus continue to be able to tax, for instance, capital gains derived by US residents on the disposal of Australian entities.

2.85 The taxation of revenue gains (including revenue gains assessable under the CGT rules) will not be covered by new paragraph (7). In this regard, the term capital gains is intended to have the same meaning in Australia as gains of a capital nature. Revenue gains not covered by the distributive rules of the Alienation of Property Article may be covered by other Articles of the Convention (e.g. the Business Profits or Other Income Articles).

Article 10 of the Protocol

Substitutes new Article 16 of the Convention – Limitation on Benefits

2.86 The Protocol will insert a new Limitation on Benefits Article into the Convention.

2.87 The Limitation on Benefits Article is intended to prevent residents of third countries from using interposed companies or other entities resident in one of the treaty countries to inappropriately access treaty benefits (i.e. treaty shopping). The new Article sets out a series of objective tests to determine the extent to which a person resident in one of the countries can claim benefits under the treaty. These tests generally avoid reference to a person’s purpose or intent (a relevant factor when applying the current Article).

2.88 Treaty benefits will generally only be available for qualified persons specified in the Limitation on Benefits Article [paragraph (1)]. Certain items of income derived by other persons may also qualify for treaty benefits if the income is derived from an active trade or business conducted in the United States or Australia [paragraph (3)]. Persons other than qualified persons may also be granted treaty benefits if the relevant competent authority is satisfied that the establishment, acquisition or maintenance of such person and the conduct of its operations did not have as one of its principal purposes the obtaining of treaty benefits [paragraph (5)].

Qualified persons

2.89 Qualified persons entitled to claim treaty benefits are specified in new paragraph (2). Only residents of the United States or Australia for the purposes of the Convention can be qualified persons.

Individuals and government bodies

2.90 Individuals need only be residents of the United States or Australia to be treated as qualified persons. Government bodies (including Federal, State and local governments and other political subdivisions) of the United States or Australia will also be treated as qualified persons. [Subparagraphs (2)(a) and (b)]

Publicly traded companies

2.91 A company resident in the United States or Australia will be treated as a ‘qualified person’ if the company’s principal class of shares is listed on a recognised US or Australian stock exchange and is regularly traded on one or more recognised stock exchanges. [Subparagraph (2)(c)(i)]

2.92 The principal class of shares of a company is the class that accounts for more than half of the voting power and value of the company. If no single class accounts for more than half of the company’s voting power and value, the listing and trading requirements must be satisfied for each class of a group that taken together account for more than half of the voting power and value of the company. A class of shares would be taken in Australia to account for more than half of the voting power in a company if they convey more than half the number of votes that can be cast on a poll at, or arising out of, a general meeting of a company as regards all questions that can be submitted to such a poll.

2.93 Recognised US and Australian stock exchanges on which the company’s principal class of shares must be listed are specified in new paragraph (6). Recognised US stock exchanges are the NASDAQ System and any stock exchange registered with the US Securities and Exchange Commission as a national securities exchange under the US Securities Exchange Act 1934 [subparagraph (6)(a)]. Recognised Australian stock exchanges are the Australian Stock Exchange and any other Australian stock exchange recognised as such under Australia law [subparagraph (6)(b)].

2.94 Trading of the company’s principal class of shares can occur on any stock exchange agreed upon by the competent authorities [subparagraph (6)(c)]. These stock exchanges may be located in third countries. The term “regularly traded” is not defined in the Convention and will therefore have, for Australian purposes, the meaning that it has under domestic law.

2.95 Companies resident in the United States or Australia held directly or indirectly by companies that satisfy the above listing and trading requirements may also be treated as qualified persons. To qualify, at least 50% of the aggregate vote and value of shares in the company must be owned directly or indirectly by 5 or fewer companies that satisfy the listing and trading tests. Each intermediate company through which an interest is being traced must be a qualified person. [Subparagraph (2)(c)(ii)]

Other publicly traded entities

2.96 An entity other than a company (e.g. a public unit trust) resident in the United States or Australia will be treated as a ‘qualified person’ if the entity’s principal class of units is listed or admitted to dealings on a recognised US or Australian stock exchange and is regularly traded on one or more recognised stock exchanges [subparagraph (2)(d)(i)]. These entities may also be treated as qualified persons where they are held directly or indirectly by entities that satisfy the listing and trading requirements. To qualify, at least 50% of the beneficial interests in the entity must be owned directly or indirectly by 5 or fewer entities that satisfy the listing and trading tests [subparagraph (2)(d)(ii)].

Benevolent organisations

2.97 Benevolent organisations established and maintained in the United States or Australia are also specified as qualified persons. These include entities set up and maintained in the United States or Australia exclusively for religious, charitable, educational, scientific or other similar purposes even if the entities are exempt from tax in their home country. [Subparagraph (2)(e)]

Pension funds

2.98 A trust or other fund resident in the United States or Australia that is established and maintained in that country to provide pensions or similar benefits to employees or self-employed persons will be treated as a ‘qualified person’ (even if exempt) if the majority of the fund’s beneficiaries, members or participants are individuals resident in either Australia or the United States. [Subparagraph (2)(f)]

Entities principally owned by qualified persons

2.99 Entities resident in the United States or Australia that are principally owned directly or indirectly by specified qualified persons for at least half the tax year may be treated as qualified persons if the entities satisfy a base erosion test. [Subparagraph (2)(g)]

2.100 Qualified persons who must principally own the entity either directly or indirectly are:

• individuals resident in the United States or Australia (i.e. qualified persons covered by new subparagraph (2)(a));

• government bodies of the United States or Australia (i.e. qualified persons covered by new subparagraph (2)(b)); and

• entities resident in the United States or Australia that satisfy public listing and trading requirements (i.e. qualified persons covered by new subparagraphs (2)(c)(i) and (d)(i)).

2.101 These persons must own at least 50% of the aggregate vote and value of the shares or other beneficial interests in the entity. Each intermediate entity through which an interest is being traced must also be a ‘qualified person’. [Subparagraph (2)(g)(i)]

2.102 The base erosion test will be satisfied if less than 50% of an entity’s gross income for a taxable year is paid or accrued, directly or indirectly, to residents of third countries in the form of payments that are deductible in the entity’s country of residence. Deductions for arm’s length payments made in the ordinary course of business for services or tangible property will not be treated as base-eroding and count towards the 50% of gross income limit. Nor will deductions for payments made on financial obligations to a bank resident in a third country if the payments are attributable to a permanent establishment of the bank in either the United States or Australia. [Subparagraph (2)(g)(ii)]

2.103 The term “gross income” is not defined for the purposes of the base erosion test. In this context it is intended that, consistent with US treaty practice, “gross income” in Australia will be taken to be gross receipts less cost of goods sold.

Headquarters company

2.104 A recognised headquarters company resident in the United States or Australia will be treated as a ‘qualified person’ even though it is owned by persons resident in third countries. [Subparagraph (2)(h)]

2.105 To qualify as a “recognised headquarters company”:

• a headquarters company must provide in its country of residence a substantial portion of the overall supervision and administration of a group of companies. The headquarters role can include group financing functions but these cannot be its principal headquarters functions. The company must also exercise independent discretionary authority in conducting its headquarters functions;

• the group of companies that the headquarters company supervises must consist of companies resident in, and engaged in an active business in, at least 5 countries. The business activities conducted in each of these 5 countries must also generate at least 10% of the gross income of the group. Holdings in countries can be grouped together for the purposes of applying these requirements but the requirements must be satisfied for at least 5 countries or groups of countries;

• the business activities of the group conducted in any one country other than the headquarters company’s country of residence must not generate 50% or more of the gross income of the group;

• the headquarters company must not generate more than 25% of its gross income from the other treaty country. Income derived by the company group from the other treaty country must also be derived in connection with, or be incidental to, the active business of the group; and

• the headquarters company must be subject to the taxation laws generally applicable in the country where it is resident.

2.106 A headquarters company may still be recognised if any of the above gross income tests are not fulfilled provided that the required percentages are met when averaging the gross income of the previous 4 years.

Access to treaty benefits for persons other than qualified persons

Persons carrying on an active trade or business

2.107 Persons resident in the United States or Australia who are not qualified persons will nevertheless generally be entitled to treaty benefits for income derived from the other State which is connected with, or incidental to, an active trade or business conducted in the person’s country of residence. The trade or business activity must, however, be substantial relative to the trade or business activity conducted in the other treaty country that gave rise to the income. Activities conducted by related persons are generally to be taken together for the purposes of determining the extent to which an active trade or business is being conducted. [Paragraph (3)]

2.108 The term “trade or business” is not defined and will thus have in Australia the meaning it has under Australian tax law. The new paragraph excludes, however, a business of making or managing investments for a person’s own account, unless these activities are banking, insurance or securities activities carried on by a bank, insurance company or a registered, licensed or authorised securities dealer. A company that functions solely as a holding company for a company group is managing investments for its own account and thus would not be treated as being engaged in an active trade or business [subparagraph (3)(a)]. Whether a trade or business activity in a person’s country of residence is substantial relative to a trade or business activity conducted in the other treaty country is to be determined based on the facts and circumstances [subparagraph (3)(b)].

2.109 The activity grouping rules for related persons will deem a person to be engaged in an active trade or business where the trade or business is carried on by a connected person or by a partnership in which the person is a partner. The activities of these persons will therefore be taken together in determining whether an active trade or business is being conducted in a person’s country of residence and whether the activities are substantial relative to a trade or business activity being conducted in the other treaty country. [Subparagraph (3)(c)]

2.110 A person will be taken to be connected to another if, based on the relevant facts and circumstances, one has control of the other or both are under the control of the same person or persons. This general rule is not limited by the specific connected person tests provided in the subparagraph.

2.111 The specific connected person tests provide that a person will be connected with a trust if the person holds at least half of the beneficial interests in the trust. Similarly, a person will be connected with a company if the person holds at least half of the aggregate vote and value of the company’s shares or of the beneficial equity interest in the company. Each person in a group of entities that share 50% common ownership held directly or indirectly by a head entity are also to be treated as connected.

Competent authority discretion to grant treaty benefits

2.112 Persons resident in the United States or Australia who are not qualified persons may be granted benefits of the Convention if the competent authority of the other treaty country determines that the establishment, acquisition or maintenance of the person and the conduct of its operations did not have as one of its principal purposes the gaining of benefits under the Convention. This discretion recognises that there may be cases where significant participation by third country residents in an enterprise resident in one of the treaty countries may be warranted by sound business practice or long-standing business structures and does not necessarily indicate a treaty shopping motive. [Paragraph (5)]

2.113 Paragraph (7) will clarify that the Limitation on Benefits Article will not restrict the application of Australia’s domestic anti-avoidance rules such as the general anti-avoidance rule.

Treaty benefits not available for disproportionate income streamed to persons other than qualified persons

2.114 Treaty benefits may be denied for income derived by a company resident in a treaty country if the company has outstanding a class of shares that enables a disproportionate share of income derived from the other treaty country to be streamed to holders of that class of shares. Benefits will be denied if persons other than qualified persons hold at least half of the voting power and value of the class of shares. In this case, treaty benefits will not be available for the disproportionate share of income derived from the other treaty country that is streamed to the holders of the class of shares. Treaty benefits will similarly be denied for income derived by a company where more than half of the aggregate vote and value of the company is owned by another company that has outstanding a class of shares that allows a disproportionate share of income derived from the other treaty country to be streamed to persons other than qualified persons. [Paragraph (4)]

2.115 A company will not have outstanding a class of shares in Australia if the shares are unissued or have been cancelled. Similarly, unissued and cancelled shares will not be taken into account when determining whether persons other than qualified persons hold at least half of the voting power and value of a class of shares.

Article 11 of the Protocol

Substitutes new Article 21 of the Convention – Other income (previously Income Not Expressly Mentioned)

2.116 The Protocol will insert a new residual Article to deal with items of income not specifically dealt with by other Articles of the Convention. The new Article reflects recent treaty language and has the same effect as the Article replaced. The source country will thus retain the right to tax income not dealt with by other Articles of the Convention.

Article 12 of the Protocol

Amends Article 22 of the Convention – Relief from Double Taxation

2.117 The Protocol will amend the Relief from Double Taxation Article to specify Australian income taxes considered to be income taxes for the purposes of providing credit relief in the United States. The specified taxes include the Australian income tax, including tax on capital gains, but the petroleum resource rent tax is not specifically covered for these purposes. This leaves it open as to whether the United States will view the petroleum resource rent tax as an income tax. Double taxation will be relieved in respect of such tax where a credit is available under US domestic law.

Article 13 of the Protocol

Entry into force

2.118 Article 13 provides for the entry into force of the Protocol.

2.119 The Protocol will enter into force once both countries have exchanged instruments of ratification [paragraph (1)]. This can only occur after all domestic requirements to give the Protocol the force of law in the respective countries have been completed.

2.120 For withholding tax purposes, the Protocol will generally have effect in Australia from 1 July 2003 if it enters into force during the 2002 calendar year. In this regard, the Protocol cannot apply to withholding taxes on dividends, interest or royalties paid or credited before 1 July 2003 [subparagraph (2)(a)(i)(B)]. For other Australian taxes, the Protocol will apply to income, profits or gains derived by a person in a year of income beginning in the calendar year next following that in which the Protocol enters into force [subparagraph (2)(a)(ii)]. The Protocol would thus apply to these taxes starting from the year of income commencing 1 July 2003 (or substituted period commencing in the 2003 calendar year) if the Protocol enters into force during the 2002 calendar year.

2.121 Different commencement arrangements will apply for withholding taxes if the Protocol does not apply to these taxes from 1 July 2003. Under these arrangements the Protocol would apply to withholding taxes on dividends, interest or royalties paid or credited on or after the first day of the second month next following the date on which the Protocol enters into force. For example, the Protocol would thus apply to dividends paid or credited on or after 1 October 2003 if instruments of ratification are exchanged on 25 August 2003. [Subparagraph (2)(a)(i)(A)]

2.122 The same commencement arrangements will apply for withholding taxes in the United States [subparagraph (2)(b)(i)]. Commencement arrangements in the United States for other taxes will be similar to those in Australia except that the Protocol will apply for taxable periods beginning on or after 1 January in the calendar year next following that in which the Protocol enters into force. The Protocol would thus apply to these taxes starting from the taxable period commencing 1 January 2003 (or substituted period commencing in the 2003 calendar year) if the Protocol enters into force during the 2002 calendar year. The difference in the commencement arrangements reflects that a standard taxable period in the United States commences on 1 January rather than 1 July as in Australia [subparagraph (2)(b)(ii)].

2.123 The provisions of the new Dividends Article will not affect certain dividends paid by a US real estate investment trust [paragraph (3)]. Provisions in the existing Dividends Article will apply. Refer to the discussion on the Dividends Article for an explanation of these arrangements.

Chapter 3

Exclusion of certain royalties from the royalty withholding tax provisions

What will the amendments do?

3.1 The amendments will exclude domestic law royalty payments from the scope of the RWT provisions in cases where the payments are not treated as royalties under the Royalties Article definition in a tax treaty. This will be achieved by extending existing rules that apply where a tax treaty excludes royalties derived through a permanent establishment from the Royalties Article. [New subsection 17A(5) to the Agreements Act]

Commencement

3.2 The amendments will apply to royalties paid from the day this bill receives Royal Assent. [Item 5 of Schedule 2 and clause 2 to the bill]

Reason for the amendments

3.3 Australia’s tax treaties generally allow Australia to charge 10% tax on the gross amount of royalties paid to a person resident in a treaty partner country. Different treatment applies, however, where the person derives royalties through a permanent establishment (e.g. branch) or fixed base in Australia. Such royalties are included in the calculation of profits attributable to the permanent establishment or fixed base and may be taxed in Australia at full rates. Outgoings must, however, be allowed in determining the profits and thus the profits are only taxable on a net basis. Rules currently apply to exclude these royalties from taxation on a gross basis under the RWT provisions (subsection 17A(4) of the Agreements Act).

3.4 The US Protocol will exclude equipment royalties paid to US residents from the treaty definition of royalties and thus result in the payments being either exempt or, where derived through a permanent establishment, taxable on a net basis. The current exclusion from the RWT provisions will not apply because the payments, while royalties for domestic law purposes, are not treated as royalties for treaty purposes.

3.5 The amendments will address collection difficulties that could arise if amounts taxable on a net basis were subject to the RWT provisions. Such difficulties can arise because the correct amount of tax to be withheld on net amounts generally cannot be determined when the withholding obligation arises. Payers are also likely to withhold too much tax because they are personally liable for any shortfall. Overpayment of withholding tax can lead to compliance and administrative costs in processing claims for tax refunds.

3.6 Example 3.1 illustrates collection difficulties that could arise as a result of the US Protocol and how they would be addressed by the amendments.

Example 3.1

Payments derived by a US resident through an Australian permanent establishment from the lease of industrial equipment may currently be taxed on a net basis under the Business Profits Article of the US tax treaty. These payments, while treated as royalties for the purposes of the treaty, would not be covered by the Royalties Article because the payments are connected with a permanent establishment (Article 12(3)). Collection difficulties do not currently arise because the royalties are excluded from the RWT provisions (subsection 17A(4) of the Agreements Act). The exclusion also has the effect that the royalties become taxable on a net basis under general assessment provisions.

The payments will continue to be taxable on a net basis under the Business Profits Article following the US Protocol. Changes to the royalty definition will, however, mean that the payments will cease to be royalties for the purposes of the US tax treaty. Section 17A(4) would not apply in this case and the payments would not be excluded from the scope of the RWT provisions. The lessee would therefore be obliged to withhold tax on the payments but would have difficulty determining the amount to withhold at the time the obligation arises. The proposed amendments will continue current arrangements and exclude the payments from the RWT provisions.

Amendments to have general application

3.7 The exclusion from the RWT provisions is expressed in general terms to deal with other cases where domestic law royalties may not be treated as royalties for the purposes of a tax treaty. Legislation expressed in general terms would, in addition, deal with royalty payments excluded from the royalty definition in future tax treaties.

Chapter 4

Regulation impact statement

THE RUSSIAN AGREEMENT

Specification of policy objective

4.1 Two key objectives of an Australia-Russia DTA are to:

• promote closer economic cooperation between Australia and Russia by eliminating possible barriers to trade and investment caused by the overlapping taxing jurisdictions of the 2 countries. A DTA would provide a reasonable element of legal and fiscal certainty within which cross-border trade and investment can be carried on; and

• create a framework through which the tax administrations of Australia and Russia can prevent international fiscal evasion.

Background

How DTAs operate

4.2 Australian tax treaties are usually based on the OECD Model with some influences from the UN Model. In addition, both countries propose variations to these Models to reflect their particular economic interests and legal circumstances.

4.3 DTAs reduce or eliminate double taxation caused by overlapping taxing jurisdictions because treaty partners agree (in certain situations) to limit taxing rights over various types of income. The respective countries also agree on methods of reducing double taxation where both countries have a right to tax. For example, DTAs contain a standard tax treaty provision that neither country will tax business profits derived by residents of the other country unless the business activities in the taxing country are substantial enough to constitute a permanent establishment and the income is attributable to that permanent establishment (usually Article 7).

4.4 In negotiating the sharing of taxing rights, Australia seeks an appropriate balance between source and residence country taxing rights. Generally, the allocation of taxing rights under Australia’s DTAs is similar to the international practice as set out in the OECD Model, but there are a number of instances where it leans more towards source country taxing rights: the definition of permanent establishment is wider in some respects than the OECD Model, and the Business Profits, Profits from the Operation of Ships and Aircraft, Royalties, Income from Alienation of Property and Other Income Articles also give greater recognition to source country taxing rights.

4.5 In addition, DTAs provide an agreed basis for determining whether the income returned or expenses claimed on related party dealings by members of a multinational group operating in both countries can be regarded as acceptable (usually Articles 7 and 9). This also provides an example of how a DTA is used to address international profit shifting.

4.6 To prevent fiscal evasion DTAs normally include an exchange of information facility. The 2 tax administrations can also use the mutual agreement procedures to develop a common interpretation and resolve differences of application of the DTA. There is also provision for residents to instigate a mutual agreement procedure.

Australia’s investment and trade relationship with Russia^[1]

4.7 Concluding a DTA would also assist in improving the bilateral framework for investment and trade with Russia and hence would provide a further incentive to Australian investors.

4.8 In 2000, Australian exports to Russia were approximately $A267 million (mostly alumina, meat and dairy) and imports were $A27 million. As at April 2001, Russia was Australia’s 47^th largest trading partner, was ranked 39^th amongst our export destinations and was our 64^th largest source of imports.

4.9 Australian investment in the Russian Federation is estimated at $A25 million and Russian investment in Australia is estimated at $A36 million. Given the size of the Russian economy and its import dependency, there is considerable potential for future growth in these areas.

Identification of implementation options

4.10 The implementation options for achieving the policy objectives are:

• no further action – rely on existing unilateral measures; or

• conclude the DTA.

Option 1: No further action – rely on existing unilateral measures

4.11 If nothing was done – that is, the DTA was not concluded – it could be argued that many of the above policy objectives have already been met to a significant extent through the internal laws of both Australia and Russia. For example, unilateral enactment of foreign source income measures by Australia already provides substantial relief from juridical double taxation. While Australian and Russian tax administrators can contact each other at an official level, Australian law strictly limits the sharing of taxpayer specific information between the ATO and foreign tax administrations, such as the Russian tax administration.

Option 2: Conclude a DTA

4.12 The internationally accepted approach to meeting the above policy objectives is to conclude a bilateral DTA^[2]. A DTA regulates the way the 2 countries will reduce double taxation, by agreeing to restrict their taxing rights in accordance with its terms and to provide double taxation relief. A DTA would also record important bilateral undertakings in relation to exchange of information.

4.13 For business and investors generally a DTA has the advantage of providing some degree of legal and fiscal certainty – unlike domestic laws which can be amended unilaterally.

4.14 As mentioned in paragraph 2.2, the DTA would be largely based on the OECD Model and the UN Model, with some mutually agreed variations reflecting the economic, legal and cultural interests of the 2 countries.

Assessment of impacts (costs and benefits) of each option

Impact group identification

4.15 A DTA with Russia is likely to have an impact on:

• Australian residents doing business with Russia, including principally:

− Australian residents investing directly in Russia (either by way of a subsidiary or a branch);

− Australian banks lending to Russian borrowers;

− Australian residents supplying technology and know-how to Russian residents;

− Australian residents supplying consultancy services to Russia; and

− Australian residents exporting to Russia;

• Australian employees working in Russia;

• people receiving pensions from the other country (although the number of cross-border pension payments is understood to be minimal);

• the Australian Government; and

• the ATO.

Assessment of costs

Option 1: No further action – rely on existing unilateral measures

4.16 As this option represents a continuance of the current position, it would be expected that the administration and compliance costs of this option would be minimal. Revenue costs would also be expected to be very small.

4.17 On the other hand, even though both countries have unilaterally introduced measures to relieve double taxation of cross-border investments, this option will not resolve all areas of difference. For example, even if both countries had very similar mechanisms for allowing credit for foreign tax paid, differences could arise over fundamental matters such as the source of income and residence of taxpayers. Furthermore this option does not protect against subsequent unilateral changes to the internal laws of either country, nor does it place a maximum limit on source country taxing of, for example, dividends, interest and royalties.

4.18 In addition, investors are concerned that unilateral tax laws do not provide the certainty desirable for making substantial long term investments offshore. This is because the Governments of either country can vary key tax conditions unilaterally. Similarly, so far as the tax administrations are concerned, unilateral rules do not provide a broad or dependable long term framework for information exchange.

Option 2: Conclude a DTA

4.19 The negotiation and enactment of a DTA will cost approximately $A150,000. Most of these costs will be borne by the ATO, although other agencies, such as the Treasury, the Department of Foreign Affairs and Trade and the Australian Government Solicitor will bear some of these costs. There will also be an unquantified cost in terms of Parliamentary time and drafting resources in enacting the proposed DTA.

4.20 There is a maintenance cost to the ATO associated with DTAs in terms of dealing with enquiries, mutual agreement procedures (including advance pricing agreements) and OECD representation. In some cases arrangements have emerged to exploit aspects of DTAs which have required significant administrative attention. Of course it is unknown whether such arrangements will emerge in relation to this particular DTA. Accordingly, there is a small unquantified cost in administering a DTA. There will also be minor implementation costs to the ATO relating to changes in withholding tax rates.

4.21 The DTA is not expected to result in increased compliance costs for taxpayers.

4.22 There might be some reduction in Australian Government revenue from taxation of Russian investments and other business activities in Australia (e.g. the DTA restricts source country taxation of certain types of income). On the other hand, limitation of Russian taxation rights in circumstances where Australia may have otherwise been required to give credit for Russian taxation may lead to increased Australian tax revenue. Given the modest investment and trade relationship between our 2 countries, the revenue cost is not expected to be significant.

4.23 It should also be recognised that the limitations agreed to by the 2 countries, will place limits on their policy flexibility in relation to cross-border taxation. However, as Australia already has a substantial tax treaty network, the cost of the proposed DTA in terms of reduced policy flexibility will only be marginal.

Assessment of benefits

Option 1: No further action – rely on existing unilateral measures

4.24 This option represents the status quo. By adopting this option there would be no need for further action and resources could be devoted to other issues. In the domestic context the 2 Governments would be free to act without being restricted by treaty obligations.

Option 2: Conclude a DTA

The effects of a DTA with Russia

4.25 Where Australians conduct business activities in Russia, Russia would not generally be able to tax an Australian resident unless that Australian resident carries on business through a permanent establishment in Russia. A DTA would establish a basis for allocation of profits to that permanent establishment. A DTA also establishes specific rules for taxation of shipping profits and income from real property.

4.26 Likewise for Australians investing through a Russian subsidiary, a DTA will set out an internationally accepted framework for dealing with parent-subsidiary transactions and other transactions between associated enterprises. In this regard, a DTA clearly offers superior protection to the domestic rules of the 2 countries because it would provide for mutual agreement to be reached between the 2 taxing authorities as to the methodology to be applied for taxing the profits of the respective enterprises.

4.27 To some extent, the rules embodied in a DTA would reduce the risks for Australians investing in Russia (and vice versa) because a DTA records agreement between the 2 Governments on a framework for taxation of cross-border investments. In the case of mining investments which cannot easily be relocated, this reduction in risk may be quite important.

4.28 Furthermore, it is only in the context of a DTA that Russia will agree to limit domestic withholding taxes on dividends, interest and royalties. This is the internationally accepted practice, which Australia also follows by reducing royalty and certain dividend withholding taxes under its DTAs. This is to ensure that only residents of treaty partner countries are entitled to the benefit of reduced source country taxation of such income.

4.29 A DTA would reduce Russian taxation on interest, dividends and royalties, thereby making Australian suppliers of capital and technology more competitive. Reduction in source country taxation would also be likely to result in timing advantages for such investors, because source country taxation is generally imposed at the time the income is derived, whereas residents are generally taxed by assessment on income derived during a financial year after the end of that financial year. The Australian revenue might also benefit to the extent that greater after-tax profits are remitted to Australia and subject to Australian tax. Of course there are similar advantages in relation to Russian investment in Australia. Again, a DTA would assist Australian investors by increasing the certainty of the taxation rules applying to cross-border investment.

4.30 Commodity exporters would be assisted in some respects because of the way a DTA would restrict the circumstances in which Australians trading with Russia are to be taxed by requiring the existence of a permanent establishment in Russia before Russian tax will be imposed.

4.31 A DTA would also assist in making clear the taxation arrangements for individual Australians working in Russia, either independently as consultants or as employees. Income from professional services and other similar activities provided by an individual will generally be taxed only in the country in which the recipient is resident for tax purposes. However, remuneration derived by a resident of one country in respect of professional services rendered in the other country may be taxed in the latter country, where the services are attributable to a fixed base of the person concerned in that country.

4.32 Employees’ remuneration would generally be taxable in the country where the services are performed. However, where the services are performed during certain short visits to one country by a resident of the other country, the income would generally be exempt in the country visited.

4.33 There are important impacts on the countries which are party to a DTA. As mentioned, the revenue impact for the Australian Government is not expected to be significant. A DTA would assist the bilateral relationship by adding to the existing network of commercial treaties between the 2 countries, and would also promote greater cooperation between taxation authorities to prevent fiscal evasion and tax avoidance.

Consultation

4.34 Information on the DTA has been provided to the States and Territories through the Commonwealth-State Standing Committee on Treaties’ Schedule of Treaty Action.

4.35 The DTA was reviewed and approved by the ATO’s Tax Treaties Advisory Panel of industry representatives and tax practitioners on 5 May 2000.

4.36 On 10 October 2000, the DTA was considered by the Parliamentary Joint Standing Committee on Treaties which provides for public consultation in its hearings. The Committee supported the proposed DTA with the Russian Federation.

4.37 The Treasury and the ATO monitor DTAs, as part of the whole taxation system, on an ongoing basis. In addition, the ATO has consultative arrangements to obtain feedback from professional and small business associations and through other taxpayer consultation fora.

Conclusion and recommended option

4.38 Present unilateral arrangements for elimination of double taxation go much of the way to satisfying the policy objectives of this measure. However, while these arrangements provide some measure of protection against double taxation, it is clear a DTA will further reduce the possibility of double taxation, especially in relation to associated enterprises. By establishing an internationally accepted framework for taxation of cross-border transactions, it will also reduce investor risk. In addition, a DTA will also reduce source country withholding taxes on dividends, interest and royalties. A DTA is unlikely to result in increased compliance costs for business.

4.39 There will be benefits to both Australia and Russia in terms of improved bilateral relationships and information exchange. On the other hand, the DTA will reduce the Government’s policy flexibility.

4.40 On balance, the benefits of the proposed DTA outweigh the costs. Option 2 is therefore recommended as the preferred option.

US PROTOCOL AMENDING THE AUSTRALIA-USA DOUBLE TAXATION CONVENTION

Specification of policy objective

4.41 The key objective in updating Australia’s tax treaty with the United States is to make a significant advance in providing a competitive tax treaty network for companies located in Australia by reducing the rate of DWT on US subsidiaries and branches of Australian companies. An important secondary goal is to prevent double taxation of capital gains derived by US residents on the disposal of interests in Australian entities while retaining Australian taxing rights.

Background

4.42 The stated purpose of tax treaties is to avoid double taxation and prevent fiscal evasion with respect to taxes on income, but their wider function is to facilitate investment, trade, movement of technology and movement of personnel between countries. They are widely used to develop and strengthen bilateral relationships between countries, especially in commercial areas. Tax treaties also provide certainty and protection regarding the level of taxation on investments abroad which may, for instance, be valued by business when deciding on the location of a regional headquarters. The impact of new tax treaties and the amendment of existing tax treaties on tax policy flexibility is marginal because Australia already has a substantial tax treaty network.

Review of Business Taxation: A Tax System Redesigned

4.43 The Government agreed in its Stage 2 response to the Review of Business Taxation: A Tax System Redesigned recommendations that priority be given to renegotiating Australia’s aging tax treaties with major trading partners (in particular, with the United States, the United Kingdom and Japan) and that Australian investment offshore would significantly benefit from a lowering of DWT on non-portfolio dividends (i.e. dividends paid on 10% or greater shareholdings) under these older tax treaties.

How tax treaties operate

4.44 Australian tax treaties are usually based on the OECD Model with some influences from the UN Model. In addition, countries propose variations to these Models to reflect their particular economic interests and legal circumstances.

4.45 Tax treaties reduce or eliminate double taxation caused by the overlapping taxing jurisdictions because treaty partners agree (in certain situations) to limit taxing rights over various types of income. The respective countries also agree on methods of reducing double taxation where both countries have a right to tax.

4.46 Australia seeks an appropriate balance between source and residence country taxing rights. Generally the allocation of taxing rights under Australia’s tax treaties is similar to international practice as set out in the OECD Model, but there are a number of instances where it leans more towards source country taxing rights.

4.47 In addition, tax treaties provide an agreed basis for determining whether the income returned or expenses claimed on related party dealings by members of a multinational group operating in both countries can be regarded as acceptable. Tax treaties are therefore an important tool in dealing with international profit shifting.

4.48 To prevent fiscal evasion, tax treaties normally include an exchange of information facility. The 2 tax administrations can also use the mutual agreement procedures to develop a common interpretation and resolve differences of application of the tax treaty. There is also provision for residents of either country to instigate a mutual agreement procedure.

Background to the US tax treaty

4.49 The current tax treaty with the United States was signed on 6 August 1982 and had effect from 1 December 1983 (for Australian income tax purposes) replacing an earlier tax treaty signed in 1953. The current tax treaty, although signed in 1982, largely reflects the positions agreed by both countries in the early 1970’s.

4.50 Talks to update the US tax treaty were held in March and June 2001 following scoping talks in November 2000.

Australia’s investment and trade relationship with the United States^[3]

4.51 As at 1999-2000, the United States was Australia’s second largest merchandise trading partner after Japan and our second largest export destination, with 2-way trade totalling $A33 billion or 16% of total trade.

4.52 Exports to the United States in 1999-2000 totalled $A9.68 billion. The United States remains Australia’s largest market for services ($A4.6 billion in 1999-2000). The major services exports were transportation and travel.

4.53 Australia’s imports from the United States amounted to $A23.34 billion in 1999-2000.

4.54 As at 1999-2000, the United States was the largest foreign investor in Australia ($A215 billion). US investment in Australia is diversifying, with many US firms establishing regional headquarters and other operations here. The United States is the largest investment destination for Australian investment abroad, with investment of $A156.7 billion as at 1999-2000, of which $A90 billion is direct equity investment (with earnings in 1999-2000 of $A3 billion) that would benefit from reduced US DWT. The level of Australian investment in the United States has increased rapidly in recent years. Australia’s direct equity investment in the United States, for instance, exceeded US direct equity investment in Australia during 1999-2000 by $A27.7 billion (US direct equity investment in Australia was $A62.3 billion).

Identification of implementation option(s)

4.55 The policy objectives can realistically only be achieved by updating the US tax treaty.

Option 1: Update the tax treaty

4.56 The proposed Protocol would update the tax treaty to:

• reduce the rate of DWT on US subsidiaries and branches of Australian companies; and

• prevent the double taxation of capital gains derived by US residents on the disposal of Australian entities while retaining Australian source country taxing rights.

Option 2: Do not update the tax treaty

4.57 Unless the tax treaty is updated, the rate of DWT on US subsidiaries and branches of Australian companies will continue to be higher than for competitors from many other countries that have negotiated lower rates of DWT with the US. There is also a risk that double taxation could arise on capital gains. The tax treaty generally does not cover taxes on capital gains and thus provisions in the treaty that provide relief from double taxation in respect of such gains may not be available.

Assessment of impacts (costs and benefits) of each option

4.58 Broadly, both sides had particular policy objectives to achieve in updating the tax treaty and some major departures from Australia’s long standing treaty practice were required to reach a mutually acceptable agreement. These departures include reductions in withholding tax on royalties and for certain dividend and interest income. While the withholding tax reductions involve a cost to revenue, the benefits are much more widely spread in the economy, with the most direct benefits accruing to business. Indirect revenue benefits may arise from increased trade and investment between the countries and reduced tax credit obligations for US taxes.

Difficulties in quantifying the impacts of tax treaties

4.59 Only a partial analysis of costs and benefits can be provided because the impacts of tax treaties cannot be quantified in a number of important areas. Estimates of the expected growth in trade and investment, for instance, tend to be speculative because of a lack of information and difficulties associated with determining the range and impacts of behavioural responses with any certainty. Benefits that flow to business are generally equally difficult to quantify. Some impacts can be determined with greater authority, for instance, the direct revenue impact of reducing rates of withholding tax.

Impact group identification

4.60 The Protocol is likely to impact on Australian residents who derive income or capital gains from the United States and on US residents who derive such amounts from Australia. The main groups affected by a reduction in the rate of US DWT and from comprehensively covering the taxation of capital gains are likely to be the approximately 70 publicly listed Australian companies with investments in the United States and 200 publicly listed US companies with investments in Australia. Australian persons that have or are seeking debt finance from US financial institutions or know how from US persons may benefit from the interest withholding tax exemption for interest paid to US financial institutions or the reduced royalty withholding tax rate. Persons may also be indirectly affected by the facilitation of investment flows between the countries (e.g. persons may benefit from a growth in economic activity that improves employment opportunities). Some tax entities (e.g. certain discretionary trusts which do not have a substantial connection with either Australia or the United States) may cease to be eligible for treaty benefits where they do not satisfy the requirements of the new Limitation on Benefits Article. The Article is intended to prevent residents of third countries from inappropriately accessing treaty benefits.

4.61 The ATO will need to administer the changes to the tax treaty.

Assessment of costs

Option 1: Update the tax treaty

Revenue costs

4.62 The net yearly cost to revenue of the Protocol is estimated to be $A190 million. This cost is largely attributable to:

• a reduction in DWT to nil or 5% on non-portfolio dividends derived by US companies (down from 15% for unfranked dividends, franked dividends are already exempt from DWT under Australia’s domestic law);

• an IWT exemption for interest paid to US financial institutions (down from 10%); and

• a reduction in the general RWT rate to 5% (down from 10%).

4.63 Some potential offsetting gains to the Australian revenue have been unable to be quantified as discussed later in the section on “(offsetting) revenue benefits”.

Knock-on revenue costs

4.64 Over time the lower withholding tax rates may be extended to other countries, for instance, as a result of most favoured nation clauses in Australia’s tax treaties with the Netherlands, France, Switzerland, Italy, Norway, Finland, Austria and Korea. As noted above this will come at a cost to the revenue in relation to countries exporting capital and technology to Australia but will lower the cost of capital to Australian businesses seeking funding in those countries and reduce the cost of accessing new technologies. The amount by which costs to Australian businesses will be reduced depends on the extent to which those businesses currently bear the costs of the relevant withholding taxes.

Business costs

4.65 No DWT rate limit will apply in the US for dividends paid on certain substantial holdings in US REITs. These dividends may therefore be taxed at the US domestic law rate which is currently 30% for companies (up from 15%). The negative impact of this increase is significantly reduced because non-portfolio REIT dividends derived by certain publicly listed Australian unit trusts (the main group potentially impacted) will generally continue to qualify for the 15% DWT rate. Others affected will have until at least 1 July 2003 to reduce their holding in a REIT.

Administration costs

4.66 There would be a small unquantifiable cost in administering the changes made by the Protocol, including minor implementation costs to the ATO in educating the taxpaying public and ATO staff concerning the new arrangements. Some additional administrative costs may arise for the ATO in considering applications for treaty benefits from persons who do not qualify based on the general tests in the Limitation on Benefits Article. The need to make an application would also increase compliance costs for the applicant.

Option 2: No further action – rely on the existing tax treaty

4.67 This option represents a continuance of the current position. Continuing higher rates of US DWT, uncertainty on the taxation of capital gains and the potential for double taxation could have an ongoing negative but unquantifiable impact on investment between the countries. Uncertainty regarding the taxation of capital gains is currently giving rise to major interpretive issues resulting in compliance and administrative costs (and the possibility of litigation).

Assessment of benefits

Option 1: Update the tax treaty

Economic benefits

4.68 Major Australian companies have for many years raised concerns about the lack of competitiveness of Australia’s tax treaty with the United States, and in particular the high level of US DWT permitted under the current tax treaty. They have welcomed the reduction in withholding tax rates made by the Protocol, particularly on non-portfolio dividends.

Dividends

4.69 The 15% rate of US DWT currently applying to non-portfolio dividends paid to Australian companies is a significant impediment to the expansion of the activities of Australian companies in the United States, with these companies facing an effective US tax rate of around 50% on repatriated earnings. Given companies from other countries generally face a significantly lower US DWT rate (5%), the 15% rate of US DWT is a significant penalty on multinationals operating out of Australia and adversely affects their cost of capital.

4.70 The importance of this issue has recently been brought to public attention by James Hardie’s restructuring that involved moving its parent company from Australia to the Netherlands. While the move was not aimed solely at reducing rates of US DWT, the high level of US DWT was said to have been a contributing factor.

4.71 The achievement of a nil or 5%US DWT rate for non-portfolio dividends paid to Australian companies will also significantly improve the ability of Australian multinationals to manage their capital base by freeing capital flows from tax. In some cases this could see a return of capital to Australia.

4.72 A nil Australian DWT rate would make the treatment of subsidiaries and branches of US businesses in Australia more consistent in that branches in Australia are not subject to DWT on distributions of profits. Economic efficiency may be improved by this reduction to the extent in which taxation considerations are a factor in deciding whether to structure operations through a branch or a subsidiary.

Interest

4.73 A nil Australian IWT rate on interest derived by US financial institutions would be consistent with the exemption currently provided for interest derived from widely distributed arm’s length debenture issues and recognises that a 10% IWT rate on gross interest derived by financial institutions may be excessive given their cost of funds. The cost to Australian business of raising capital from US financial institutions may also be reduced making this source of capital more affordable and increasing competition in capital markets.

Royalties

4.74 Australian residents required to meet the cost of Australian RWT on royalty payments made to US residents will benefit from the reduced RWT rate. Consultations with business representatives have indicated that such gross-up obligations are commonly imposed.

4.75 Australian residents who derive royalty income from the United States may also benefit from the reduced US RWT rate. Additional tax payable in Australia due to a reduced credit for US RWT will generally result in imputation credits that can be passed on to shareholders.

Alienation of property

4.76 Changes to the Alienation of Property Article will ensure Australian taxing rights are retained and facilitate investment between the countries by making the taxation treatment of capital gains more certain and reducing the risk of double taxation. The Protocol also addresses widespread business concerns about the potential for double taxation arising from the application of Australia’s CGT to expatriates departing Australia. These concerns have negatively affected the ability of Australian located companies to attract and retain skilled expatriate staff, and has the potential to affect headquarters location decisions to Australia’s detriment. The Protocol will improve arrangements for taxing gains accrued on assets held by departing residents by reducing compliance difficulties and ensuring appropriate relief is provided from double taxation.

Compliance and administration cost reduction benefits

4.77 Compliance costs would be significantly reduced by clarifying Australia’s right to tax US companies on capital gains derived from the disposal of an Australian subsidiary. Interpretative issues relating to the extent Australia can tax these gains under the existing treaty have resulted in considerable uncertainty and costly legal arguments. Administrative costs in explaining the ATO view and responding to legal arguments would also be significantly reduced.

(Offsetting) revenue benefits

4.78 A lower US DWT rate on non-portfolio dividends would not directly result in additional tax revenue for Australia because Australian companies are exempt on dividends they derive from their US subsidiaries. Some (unquantifiable) additional revenue may however be collected when unfranked profits referable to US dividends are distributed to shareholders, and if Australian multinationals reduce the capitalisation of their US subsidiaries. A reduced US DWT rate would also result in a comparable reduction in the imputation credit available for foreign DWT (once implemented). There may also be an (unquantifiable) increase in CGT collections if improved post-tax profits boost the market value of shares in Australian companies that have US operations.

Option 2: No further action – rely on the existing tax treaty

4.79 The existing tax treaty would continue to provide relief from double taxation and limitation of source country taxation in relation to most income, but high US DWT and uncertainty over capital gains would remain. Failure to deal with these issues would be a serious retrograde step in achieving an internationally competitive business tax system.

Consultation

4.80 Information on the revision of the existing tax treaty has been provided to the States and Territories through the Commonwealth-State Standing Committee on Treaties’ Schedule of Treaty Action.

4.81 The ATO’s Tax Treaties Advisory Panel of industry representatives and tax practitioners was consulted on the changes along with the American Chamber of Commerce in Australia. Industry representatives of parties that may be negatively affected by the changes to the taxation of REIT dividends indicated that they were satisfied with the REIT provision in the Protocol. The Protocol will also be considered by the Parliamentary Joint Standing Committee on Treaties which provides for public consultation in its hearings.

4.82 The Treasury and the ATO monitor tax treaties, as part of the whole taxation system, on an ongoing basis. In addition, the ATO has consultative arrangements to obtain feedback from professional and small business associations and through other taxpayer consultation fora.

Conclusion and recommended option

4.83 The reduction under the Protocol in rates of DWT in particular, as well as RWT and IWT, will provide significant benefits to Australian business, and mark a major step forward in providing Australian located companies with an internationally competitive treaty network and business tax system. It will also directly help facilitate trade and investment between the countries.

4.84 These benefits come at a direct cost to revenue. The revenue costs are considered to be outweighed by the overall benefits of updating the tax treaty. In addition, clarifying Australia’s right to tax US residents in respect of capital gains is an important tax base protection measure.

4.85 The Protocol is unlikely to significantly increase compliance costs for business and the clarification of the taxation of capital gains will reduce compliance and administrative costs (as well as the potential for double taxation).

4.86 The benefits of a Protocol outweigh the costs. Option 1 is therefore recommended as the preferred option.

EXCLUSION OF CERTAIN ROYALTIES FROM THE ROYALTY WITHHOLDING TAX PROVISIONS

Specification of policy objective

4.87 To align the domestic law treatment of equipment royalties paid to US residents with treatment permitted under Australia’s tax treaty with the United States following changes to that treaty made by a Protocol signed in Canberra on 27 September 2001. The changes made by the Protocol will exclude equipment royalties from the scope of the royalties definition in the US treaty.

4.88 A secondary objective is to deal with other cases where domestic law royalties are not treated as royalties under a tax treaty and to provide for this outcome in future tax treaties.

Background

4.89 Equipment royalties paid to US residents are currently taxable on a gross basis under the withholding tax provisions unless derived through an Australian permanent establishment or fixed base. The changes made by the Protocol to the royalties definition in the US tax treaty will result in these royalties being either exempt or taxable on a net basis.

4.90 Collection difficulties could arise unless royalties taxable on a net basis are excluded from the scope of the RWT provisions. Such difficulties can arise because tax to be withheld on a net amount generally cannot be determined when the obligation to withhold arises. Persons are thus likely to withhold too much tax because they are personally liable for any shortfall. Overpayment of withholding tax can lead to compliance and administrative costs in processing claims for tax refunds.

4.91 These collection difficulties can arise whenever domestic law royalties are not also treated as royalties for the purposes of a tax treaty.

Identification of implementation option(s)

4.92 The policy objectives can only be achieved by amending the law.

Option 1: Amend the law

4.93 The law could be amended to exclude domestic law royalties from the RWT provisions where the royalties fall outside the royalty definition of a tax treaty. This would ensure there is no obligation to withhold tax on these royalties and allow them to be taxed on a net basis under the general income tax assessment provisions unless made exempt by a tax treaty.

Option 2: Do not amend the law

4.94 Royalties are currently excluded from the RWT provisions when derived by treaty residents through an Australian permanent establishment or fixed base. An indirect result of changes to be made by the US Protocol is that the current domestic law exclusion will cease to apply to equipment royalties derived by US residents. Collection difficulties could arise unless the law is amended to continue the exclusion for these royalties.

Assessment of impacts (costs and benefits) of each option

Impact group identification

4.95 The amendments will affect residents of treaty partner countries who derive domestic law royalties that are not treated as royalties for the purposes of an applicable tax treaty. They will also affect persons who would otherwise be obliged to withhold tax on the royalties and the ATO which would be required to process refunds for overpaid RWT.

Assessment of costs

Option 1: Amend the law

4.96 The amendments will align the domestic law treatment of royalties with treatment permitted under tax treaties and thus will not give rise to revenue or other costs.

Option 2: Do not amend the law

4.97 Persons obliged to withhold RWT would face compliance difficulties in determining the amount to withhold and persons liable for the RWT may incur costs when seeking refunds of overpaid tax. The ATO would also incur administrative costs in processing tax refunds. These compliance and administrative costs are unquantifiable.

Assessment of benefits

Option 1: Amend the law

4.98 The amendments will result in a continuation of current arrangements for taxing equipment royalties derived by US residents through an Australian permanent establishment or fixed base. Collection difficulties that could arise from the application of the RWT provisions to these royalties taxable on a net basis would thus be avoided. As discussed above, such difficulties can result in the overpayment of withholding tax and lead to compliance and administrative costs in processing claims for tax refunds.

4.99 The amendments will deal with other cases where domestic law royalties are not treated as royalties under a tax treaty. These cases are uncommon in practice. The amendments will also provide for future changes to the royalties’ definition in tax treaties without the need for further amendments.

Option 2: Do not amend the law

4.100 No benefits.

Consultation

4.101 The issue was identified by an affected taxpayer. There has not been wider consultation.

Recommended option

4.102 The benefits of Option 1 outweigh the costs and the amendments are therefore recommended.

^[1] Source: Department of Foreign Affairs and Trade

^[2] There are very few multilateral tax treaties, which reflect the widely differing economic interests and unique tax law structures of most countries.

^[3] Source: Department of Foreign Affairs and Trade and Australian Bureau of Statistics