previous
next



  ― 253 ―

21. Chapter 17 International Aspects of Income Taxation

17.1. Australia asserts jurisdiction to tax income on the bases of residence of the tax-payer in Australia and origin of the income in Australia. Origin is determined by general principles and statutory provisions defining ‘source’ of income in Australia. It is also determined by statutory provisions which, for purposes of imposing a withholding tax on dividends and interest, give an Australian origin to payments by Australian residents and, in the case of interest, by non-residents carrying on business in Australia.

17.2. When it first imposed an income tax, Australia exercised jurisdiction to tax income only if the income had a source in Australia. In 1930, concerned at the decline in revenue resulting from the depression, Australia began to exercise a limited jurisdiction to tax the foreign-source income of Australian residents. The jurisdiction did not extend to foreign-source dividend income. Nor did it extend to other foreign-source income if that income was subject to income tax in another country.

17.3. In 1941 foreign-source dividends of Australian residents were made subject to Australian income tax, whether or not they were subject to income tax in another country. An allowance for foreign tax paid on the dividends, where they were derived by an individual, was at first given by way of a deduction of the amount of that tax in determining the amount of the dividends subject to Australian tax. This deduction was replaced in 1947 by a credit of the amount of the foreign tax, the credit being available against Australian tax on the dividends. This credit continues to be available under the present law.

17.4. Where the dividends were derived by an Australian resident company, the foreign-source dividends, though technically subject to Australian tax, remained in substance exempt because of a rebate of tax allowed to the company of the amount of the Australian tax on the dividends. They are still exempt in this way.

17.5. The exercise of jurisdiction based on residence has been extended in relation to foreign-source royalties and interest which, under the provisions of double taxation agreements to which Australia is a party, cannot be taxed in the foreign country at a rate exceeding 10 per cent of the gross amount of the royalties or interest (or 15 per cent in the case of royalties having a source in New Zealand). Since 1967 such royalties and interest are subject to Australian tax, even though taxed in the foreign country, credit being given for the foreign tax against Australian tax on the royalties or interest.

17.6. In 1959 Australia extended its jurisdiction based on origin of income in Australia so that dividends from whatever source became subject to Australian tax, in the form of a withholding tax, when paid to non-residents by Australian resident companies. In 1968 a further extension of jurisdiction resulted from the application of the withholding tax to interest paid to non-residents, where it was paid by Australian residents or by non-residents carrying on business in Australia. This withholding tax continues to apply to these dividends and interest.

17.7. The exercise by Australia of jurisdiction based on origin and, to a lesser extent, on residence is limited by a number of double taxation agreements to which Australia is a party. Typically, an agreement denies jurisdiction to one country to tax profits having their origin in that country, if they are ‘industrial or commercial profits’


  ― 254 ―
derived by a resident of the other country, unless they result from business operations amounting to a ‘permanent establishment’ in the country of origin. Where such a permanent establishment is involved and the country of origin is therefore not denied jurisdiction to tax, the country of residence is required to give credit for tax imposed by the country of origin. The country of origin may be denied jurisdiction to tax other specified kinds of income. Where jurisdiction is not denied and the country of origin taxes the income, the country of residence is required to give credit.

17.8. A double taxation agreement in seeking to regulate the exercise of jurisdiction by two countries inevitably becomes involved in problems of definition. The agreements to which Australia is a party use the language of ‘residence’ and ‘source’, but do not always define these terms for purposes of the agreement. Where the terms are not defined, their meaning is left to the law of the country applying the agreement. In the result both countries may be the country of residence or the country of source, and the operation of the agreement substantially defeated.

17.9. It is proposed in Section I of this chapter to consider the exercise by Australia of jurisdiction to tax on the basis of residence. Attention will be given to the definition of residence and to the limitation on the exercise of jurisdiction which is involved in the continuing exemption of some foreign-source income that has been taxed in the country of source. Attention will also be directed to what is, in substance, the exemption of dividends from a foreign source received by an Australian resident company, more especially to the implicatons of the exemption in regard to operations by ‘tax-haven’ companies abroad. A ‘tax-haven company’ is one incorporated in a country with no income tax or low rates of income tax, in which Australian residents, or trusts created or controlled by them, have substantial interests.

17.10. It is proposed in Section II to consider the exercise by Australia of jurisdiction on the basis of origin of income in Australia. The meaning of source in different contexts is examined. Attention is directed to the scope for a non-resident to ensure that the amount of income arising in circumstances that would give it an Australian source is minimised. Attention is also directed to the scope for a non-resident to ensure that profits which would otherwise have been derived by an Australian resident with whom he is in some way associated are diverted to himself and do not have an Australian source. In this connection, attention is again directed to the operations of tax-haven companies abroad.

17.11. In Section III some general observations are made in relation to double taxation agreements. It is thought that a brief comment on the drafting of such agreements, concerned with structure and technique, may be appropriate.

I. The Taxation of Foreign-Source Income of Australian Residents

Concept of Resident of Australia

17.12. The Income Tax Assessment Act defines resident of Australia, in relation to an individual, so as to adopt the meaning of the word in ordinary usage and to extend that meaning in ways which depend on the domicile of the person concerned or his presence in Australia for more than half the year of income. The definition, even without the extensions, is likely to include persons who are held also to be resident in another country under that country's concept of residence. In the Committee's view, the resulting competition of jurisdiction to tax must be accepted and adjusted where


  ― 255 ―
possible by appropriately drafted provisions of double taxation agreements. The matter of appropriate provisions is explored in paragraph 17.98.

17.13. A resident of Australia in relation to a company is defined by exclusively statutory tests, though one of these—central management and control in Australia—uses the language of judicial decisions that adopts the notion of residence of a company under United Kingdom law. Incorporation in Australia is sufficient to give a company a residence in Australia. So too is central management and control in Australia wherever the company is incorporated. A third test, again sufficient, is carrying on business in Australia and having voting power controlled by shareholders who are residents of Australia.

17.14. Although the definition of resident in relation to a company is wide and may include companies that are resident in another country under that country's law, the Committee does not consider that a narrower definition would be appropriate. In a number of respects, however, the definition might be clarified. The second test requires that a company both has its central management and control in Australia and be carrying on business in this country. As the test has been interpreted, the reference to carrying on business in Australia is unnecessary: central management and control, it is said, involves the carrying on of business. In any event, in the Committee's view it should be enough to give a company a residence in Australia that its central management and control is here.

17.15. The meaning of central management and control calls for clarification. It would bring some tax-haven companies within the jurisdiction of Australian tax if these words were held to be wide enough to include the exercise of control and direction of the company's affairs otherwise than in the formal proceedings of the board-room. It might be thought to be enough to give a residence in Australia that the board of directors habitually responds to intructions formulated in Australia, even though the board meets elsewhere. This wide meaning would, however, increase the likelihood of a company being resident both in Australia and in a foreign country to a degree that might be regarded as unacceptable: many wholly-owned subsidiaries of Australian resident companies, though incorporated in foreign countries and resident there, could become Australian resident companies. On the other hand, the objective of bringing tax-haven companies within the jurisdiction of Australian tax should not be lightly abandoned. Some compromise might be possible which would involve identifying tax-haven countries, either in the Act or, preferably, in regulations, and would provide that a company incorporated in such a country would be deemed to have an Australian residence if effective control and direction of the company's affairs are exercised in Australia, regardless of where the board of directors meets or other formal corporate proceedings take place.

17.16. In Chapter 15 the Committee has proposed that the law should define a concept of an ‘Australian trust’, parallel with the concept of an Australian resident company. The purpose of this concept would be to provide a basis of jurisdiction to tax the accumulating income of the trust. The concept, as there explained, would in part depend on the management and control of the trust being in Australia. Where the trust is administered in a tax-haven country, the same wide meaning of management and control should apply as proposed in relation to companies incorporated in tax-haven countries.




  ― 256 ―

Foreign-source Income Not Subject to Australian Tax

17.17. The effect of two provisions of the Australian law, noted briefly at the beginning of this chapter, is to exclude from Australian tax a very considerable part of foreign-source income of Australian residents. One of these provisions is section 23(q) which, subject to a number of exceptions, exempts from Australian tax foreign-source income that is subject to tax in the country of source. The other is section 46 which, by allowing a rebate at the Australian rate of tax, in effect exempts foreign-source dividends received by a company, whether or not the profits from which the dividends were paid, or the dividends themselves, have been subject to foreign tax.

17.18. The exclusion from Australian tax by these provisions avoids the need to give relief from the double taxation that would result were the income subject to Australian tax. In this respect they may be regarded as a method of giving relief from double taxation and can be compared with other provisions of the Act that give relief by allowing credit for foreign tax on foreign-source income subject to Australian tax. The discussion that follows is cast in the frame of such a comparison.

Credit for Foreign Tax on Foreign-source Income Subject to Australian Tax

17.19. Section 23 (q) of the Act has no application to a foreign-source dividend received by an Australian resident: such a dividend is subject to Australian tax. But section 45 allows a credit to an Australian resident who receives a foreign-source dividend in respect of income tax imposed on that dividend by the country in which the company paying the dividend is resident, if the Australian resident was personally liable for that tax. The credit is the lesser of the foreign tax or the Australian tax on the dividend, calculated by applying the average rate. By its terms section 45 is applicable both to an individual and to a company. In fact, however, it is relevant only to a dividend received by a resident individual: as indicated in 17.17, no Australian tax against which credit might be given is imposed on a foreign-source dividend received by an Australian resident company.

17.20. Section 23 (q) has no application to income derived by an Australian resident from sources in Papua New Guinea. Such income is subject to Australian tax. However, Division 18 of Part III of the Act allows the Australian resident a credit for Papua New Guinea tax against his Australian tax. The credit is the lesser of the Papua New Guinea tax and the Australian tax. For the reason explained in the last paragraph, the credit has no relevance to a dividend with a Papua New Guinea source received by an Australian resident company.

17.21. Section 23 (q) has no application to royalties or interest received by an Australian resident when the source of the royalties or interest is in a foreign country with which Australia has a double taxation agreement and when, in addition, that agreement has the effect of limiting the rate of tax the foreign country may impose on the gross amount of the royalties or interest. The foreign countries involved are United Kingdom, Singapore, Japan and New Zealand. The rate as limited by these agreements, if the agreement applies to the particular royalties or interest, 10 per cent in all cases except royalties having a New Zealand source, in which case the rate is 15 per cent. By section 12 of the Income Tax (International Agreements) Act, a credit against Australian tax is given, the amount of the credit being limited to the amount of Australian tax on the royalties or interest.




  ― 257 ―

Exemption and Credit as Methods of Giving Relief against Double Taxation

17.22. A comparison between exemption and credit as methods of affording double taxation relief may assist a decision on whether Australia should extend further its exercise of jurisdiction to tax foreign-source income. The comparison is made in terms of the criteria of equity, efficiency and simplicity.

17.23. Equity. Sections 23 (q) and 46 discriminate between a resident individual who derives all his income from Australian sources and a resident individual who has some foreign-source income that is exempt, or has an interest in a resident company deriving foreign-source income that is exempt, under one of those sections. These provisions thus defeat the equity objective which is one of the justifications for taxing on the basis of residence.

17.24. In the case of exemption under section 23 (q), the equity objective is defeated principally because it involves a taxpayer's income being split and the graduated Australian rates being applied to the Australian-source income and not to the whole of the taxpayer's income. Admittedly, this aspect could be overcome by provisions which, while continuing to exempt foreign-source income, would require it to be aggregated with Australian-source income to determine a rate on the latter. However, the inequity that arises from exemption when the foreign tax is less than the Australian tax would remain.

17.25. Sections 23 (q) and 46 create inequities between shareholders in a company deriving all its income from Australian sources, and shareholders in a company some or all of whose income is exempt under one of those sections.

17.26. An aspect of the inequities arising from section 46 is that the section significantly increases the advantages of using tax-haven companies as the means through which foreign-source income is derived. Section 46 allows tax-haven company profits to be repatriated without generating any liability to Australian company tax. This would not be possible under a credit system, though profits accumulated in the tax-haven company enjoy an immunity from Australian tax under a credit system as well as under the exemption system. This immunity could only be taken away by a system imposing Australian tax on the profits of the tax-haven company when they are derived by that company, either by taxing the company or the shareholders in the company. The matter is further considered in paragraphs 17.46–17.55.

17.27. A credit system of the kind now applying to dividend income derived by individuals (section 45), to income with a Papua New Guinea source (Division 18) and to some royalties and interest (section 12 of the Income Tax (International Agreements) Act) offers the prospect of ensuring a substantial degree of equity and, in this respect, contrasts with the exemption system. One limitation on its success is apparent when the foreign tax for which credit would otherwise be available exceeds the Australian tax on the income in question. In this situation the credit system avoids the inequity of the exemption system arising from non-aggregation with Australian-source income to determine the rate of tax on the latter; but it does not overcome the inequity involved in the foreign-source income having borne a greater tax than would be imposed on an equivalent amount of Australian-source income. The credit system could be made to overcome this inequity if the excess tax were allowed to generate a credit and, if necessary, a refund. No country in fact has a credit system of this kind. To adopt it would be to give to foreign countries an unacceptable degree of control over Australian taxation revenue.




  ― 258 ―

17.28. Other limitations on the success of the credit system in ensuring equity are inherent in the difficulties of relating foreign tax to the income in respect of which credit is to be given. These difficulties are referred to later in paragraphs 17.36–17.40.

17.29. Efficiency. The Committee has taken the view that economic efficiency is generally best served by a neutral tax system. A neutral tax system, in the present context, is one that does not affect the choice between operations directed to deriving Australian-source income and operations directed to deriving foreign-source income. And the ‘tax system’ must be understood to refer to all the taxes, Australian and overseas, that bear on the operations.

17.30. Equity and efficiency run closely parallel in their implications: a more equitable way of taxing foreign-source income is likely to be more efficient. But the emphasis in considering equity is on income taxation viewed in isolation from other taxes, whereas an appraisal in terms of efficiency must be made of the tax system as a whole. It is thus not enough in judging efficiency to look only at the impact of income tax in Australia and in the foreign country. Even though the same amount of income tax is paid on income from Australian sources as on income from foreign sources, efficiency will be compromised if the profitability of operating abroad, rather than at home, is affected by other international tax differences—not least those in the area of customs duties.

17.31. It is clearly not within the competence of the Australian tax system to ensure complete efficiency in regard to the effect of Australian and foreign taxes on the activities of Australian residents. This is a matter requiring the widest international co-operation.

17.32. Where efficiency requires a deliberate non-neutrality, as sometimes it may, equity and efficiency will not run parallel, and the exemption system may be preferred as furthering the ends of non-neutrality more effectively. If, for example, Australia wishes to encourage its residents to operate abroad, it can do so by applying an exemption system to foreign-source income rather than a credit system. An exemption system allows the Australian resident to operate, at least so far as income tax is concerned, in equal competition with residents of other countries.

17.33. The exemption system may also be thought to offer an attraction to foreign companies, in countries operating a credit system, to establish subsidiaries in Australia as bases for operating in other countries with low rates of income tax. The Australian Government may desire to encourage this.

17.34. A number of developing countries give special income tax incentives to attract investments. Under an exemption system the value of such incentives to an Australian investor is fully preserved. Australia, in the language that has become current in this context, ‘spares’ the Australian investor the amount of tax the developing country has forgone. This, too, may reflect an aspect of Australian Government policy.

17.35. But in the Committee's view, as indicated in paragraph 3.25, encouragement for a field of activity should be given through the tax system only if other means of encouragement are likely to prove less effective. And where it is thought appropriate to act through the tax system, this should be done by explicit provision. Section 44A is a provision of this kind: even though a credit system otherwise operates, tax sparing in regard to Papua New Guinea is achieved by this section through the exemption of dividends paid from profits with a Papua New Guinea source when those profits are exempt in that country under its Industrial Development (Incentives to Pioneer


  ― 259 ―
Industries) Ordinance. Encouragement to a field of activity by across-the-board exemptions such as are given by sections 23 (q) and 46 is clearly unwarranted.

17.36. Simplicity. An exemption system is unquestionably simpler to administer than a credit system, though some of the simplicity of section 23 (q) would be lost if it were amended to require aggregation of the foreign-source income with Australian income to determine the rate of tax on the latter.

17.37. The complexities of a credit system are at their greatest when credit is being given for tax on profits derived in a foreign country by an Australian resident who himself carries out business operations there. For one thing, the Australian tax accounting period may differ from that applying in the foreign country. For another, the tax base of the foreign country's tax may not be the same as Australia's. The difference in the base may result from the fact that the foreign country includes capital gains in its base. Until Australia adopts a capital gains tax the foreign tax will need to be dissected if credit is to be confined to tax on income. The difference in the base may be because the foreign country adopts a different method of valuing closing stock or different rates of depreciation. Because of the differences in the base there may be a spread of profits over a period of years in the foreign country different from the spread in Australia. The experience of countries with a credit system, more particularly the United Kingdom and United States, will suggest rules by which the differences in accounting periods can be handled. The problem of excess tax for which credit is sought, which may arise because of the way profits are spread over a period of years, can be dealt with by a carry-forward and carry-back of excess credits on the model of the United States provisions. Australia has had some experience in operating a tax credit system in relation to income derived from sources in Papua New Guinea; but because of the substantial similarity between the tax systems of Papua New Guinea and Australia, the complexities referred to in this paragraph have yet to be faced.

17.38. The complexities of a credit system may be less when credit is to be given against Australian tax on a dividend received from a foreign source. Australia already has long experience of such credits where dividends are derived by an individual. If jurisdiction is extended so that the credit system applies to dividends derived by a company, there will be a new problem in the allowing of credit for the underlying tax paid by the foreign company on the profits from which the dividends have been paid. Where the foreign company's profits themselves include dividends received from subsidiary companies, the problem will be compounded if the credit for underlying tax is extended to include tax on the profits of those companies. Again it will be necessary to turn to the experience of other countries: the tax credit system Australia already employs in relation to income from sources in Papua New Guinea does not offer any relevant experience, since section 46 applies.

17.39. Credit for underlying tax could at best be available only to a limited degree. It would be administratively impossible to extend such credit, on a general basis, to dividends derived by an individual. Where a company derives a dividend from a foreign source, credit for underlying tax would need to be confined to cases involving a substantial shareholding in the foreign company paying the dividend. Double taxation agreements commonly impose an obligation to give credit for underlying tax where there is a 10 per cent holding.

17.40. To the extent that administrative feasibility imposes limitations on the availability of credit for underlying tax, the equity and efficiency of the credit system will be compromised and the advantages of moving to such a system will be less.




  ― 260 ―

17.41. It may be appropriate here to draw attention to the revenue implications of a change to a credit system. The change is unlikely to involve any loss of tax revenue to Australia, assuming that the credit available is limited to the amount of Australian tax. It is implicit in a credit system that where a profit from foreign operations would be included in the net income of the Australian resident, a loss made in the same operations is deductible. Only in this respect could a credit system result in the Australian tax paid being less than under an exemption system. Indeed, a credit system might involve a significant increase in revenue, particularly if Australian investment abroad continues to grow as rapidly as it has done over the past decade.

Committee's Proposals

17.42. In the Committee's view, the comparison in the previous paragraphs establishes a case for extending the exercise of jurisdiction to tax on the basis of residence so that all foreign-source income is subject to Australian tax and credit, so far as administratively feasible, is given for foreign tax on that income. Equity and efficiency considerations point strongly to this conclusion and outweigh the loss in simplicity likely to result.

17.43. The Committee would, however, wish to leave open the possibility of making specific exceptions to the general regime to retain some of the simplicity of the exemption system. Where an Australian resident company receives dividends from a foreign resident company in which it has a substantial shareholding and that company is resident in a country which imposes a rate of company tax comparable with the Australian rate, it may not be inappropriate to continue the exemption given by section 46. In these circumstances the credit system and the present exemption system will bring about much the same result. But it would be necessary to confine section 46 treatment to dividends from profits having a source in the foreign country: a wider exemption would open up the prospect of defeat of the purpose of the general regime where the foreign country applies an exemption system to income from sources outside that country.

17.44. It might also be thought appropriate to continue exempting profits derived by an Australian resident company from sources in a foreign country if the foreign country imposes a rate of company tax comparable to the Australian rate. It would be necessary to confine the exemption to profits bearing the foreign company tax. Where royalties and interest with a source in the foreign country bear tax at a lesser rate, for example by way of a withholding tax, the exemption should be denied. The denial of the exemption would follow the precedent set by section 12 of the Income Tax (International Agreements) Act in relation to royalties and interest which, because of a provision in an international agreement, are taxed in the country of source at a low rate.

17.45. With regard to salary and wages, equity considerations would clearly favour the application of a credit system to foreign-source income. There may, however, be reason to exempt such income where it relates to a substantial period of service abroad.

17.46. The adoption of a credit system will take away some of the tax advantages to be gained from establishing tax-haven companies in foreign countries. When income which may have borne no foreign tax is repatriated as dividends to an Australian resident company, it will be no longer be freed from Australian company tax by section 46, but will be taxed in full. However, the advantages of indefinite deferral of tax on income accumulated by the tax-haven company will remain.




  ― 261 ―

17.47. Similar advantages can at present be obtained by the use of what might be called a ‘tax-haven’ trust: that is, a trust created or controlled by Australian residents but which has foreign trustees and is administered in a tax-haven country. If a trust has foreign-source income that is accumulating, no Australian tax is payable even though the persons who it may be expected will ultimately receive the income are Australian residents.

17.48. The tax advantages to be obtained from establishing tax-haven companies could be removed by provisions of the kind adopted by the United States in Subpart F of its 1954 Code. The accumulating income of a tax-haven company would be taxed currently to its Australian resident shareholders by reference to some apportionment to them of that income. The tax advantages of tax-haven trusts could be removed by similar provisions, though in this case it would be necessary to seek to tax the trust estate on a proportion of its income in some way related to the extent of the contingent interests held by Australian residents. It would not be appropriate to attempt to tax those Australian beneficiaries without vested interests.

17.49. The complexities and problems of administration which such provisions would involve should not be underestimated. In the case of a company there is a question of defining the persons whose interests would make them subject to current taxation on the company's profits. Rules of constructive ownership would be necessary.

17.50. It would be necessary to define the income to which the provisions apply. It may not be thought appropriate to include income from active business operations in the tax-haven country itself. And it may not be thought appropriate to include income that has its origin in third countries. To include such income would be to put Australian companies using tax-haven subsidiaries for their foreign operations at a competitive disadvantage. On the other hand, it would be of the first importance to ensure that any income that has an Australian origin is included, where present Australian law does not tax that income on the basis of such origin. Income from operations involving ‘invoicing-on’ of goods that move from or to Australia but are at no time physically present in the tax-haven country is the most likely illustration.

17.51. United States experience has not been encouraging. Its provisions are extremely complex and pose great difficulties in enforcing compliance. Canada has adopted similar provisions but there has been some delay in bringing them into operation.

17.52. Apart from the complexities and administrative difficulties involved, the observations made in paragraph 17.50 in relation to the income to which the provisions would be applied may suggest some doubt about their policy. Deferral of tax on foreign-origin income of a foreign subsidiary of an Australian resident company or of foreign-origin income of a foreign resident trust will in the normal case, under the Committee's proposals, be allowed until the income is remitted to Australia as dividends or distributed to Australian resident beneficiaries. It may fairly be asked whether it should make any difference that the foreign-origin income has, because of the tax-haven residence of the company or trust, been subject to foreign tax only at low rates. If it is thought that the policy should be simply to ensure that Australian-origin income be adequately taxed, it is possible to achieve this by other means.

17.53. At present Australian-origin income may be inadequately taxed for a number of reasons. A tax-haven company or trust will commonly enter into transactions with Australian residents which give rise to income with an Australian origin that is not subject to Australian tax because it does not come within the scope of the jurisdiction


  ― 262 ―
Australia exercises in taxing Australian-origin income. The meaning of source in relation to Australia's jurisdiction to tax on the basis of origin needs to be clarified and extended in certain respects. When the scope of the jurisdiction Australia exercises does extend, the amount of income brought to tax may be thought too little because of expenses claimed by the tax-haven company or trust; the amount of tax may be thought too little because a withholding tax is the only tax applicable. Broader reconstruction provisions might be made available which will enable the Commissioner to deny the deductibility of expenses in appropriate cases. Special rates of withholding tax might be applied to income going to a tax-haven company or trust.

17.54. Australian-origin income may be inadequately taxed because it has been diverted by an Australian resident to a tax-haven company or trust in whose hands it is exempt because it does not have an Australian source or is subject only to Australian interest withholding tax. Broader reconstruction provisions would enable the Commissioner to prevent this diversion of income and tax the Australian resident.

17.55. The Committee is not persuaded that it is an appropriate policy to seek to tax foreign-origin income of tax-haven companies and trusts and is very conscious of the complexities and administrative and compliance costs of attempting to do so. It prefers to ensure that the general provisions of the Australian law as to source of income in Australia are effective; that there are adequate provisions in regard to the reconstruction of Australian-origin income of non-residents; and that there are also adequate provisions to prevent the diversion of income by Australian residents to non-residents. There may, in addition, be room for special provisions whereby some income of a tax-haven company or trust that has an origin in Australia is made subject to a special rate of tax, and whereby procedures are established to ensure collection of Australian tax payable by tax-haven companies and trusts. These matters are taken up in Section II.

II. Australian-Origin Income of Non-Residents

17.56. Since income tax was first imposed, Australia has asserted a jurisdiction to tax the income of non-residents on the basis of its origin in Australia. Initially the scope of the jurisdiction based on origin was wholly determined by ‘source’ in Australia, within the meaning of that word in our law. More recently, Australia has exercised jurisdiction to tax some dividends and interest on the basis of an origin in this country that may differ from their source.

17.57. In the earlier history, dividends were taxed to non-residents only if they had a source in Australia. Where it was a matter of taxing a shareholder in the company, Australian-source dividends referred at that time, as now, to dividends paid from profits of the company with a source in Australia. The meaning of source in relation to dividends paid by one company (company A) which form part of the profits of another company (company B) which in turn has paid a dividend has been debated over the years. On one view the source of the dividends forming part of the profits of company B is simply the place of residence of company B. But there are alternative views which would consider other factors to be relevant, such as the place of the share register of company A or the residence of company A. Tracing the dividends back to the operating profits derived by company A, or by some earlier company, and treating those dividends as having the same source as those operating profits would now appear to be rejected.




  ― 263 ―

17.58. A non-resident shareholder, whether an individual or a company, who was subject to tax on Australian-source dividends was entitled, in the earlier years of the Australian income tax, to a rebate of tax in recognition of the tax that had been paid by the company on the profits from which the dividends came. The rebate, in the case of an individual shareholder, was at the lesser of the company rate of tax or the shareholder's rate. In the case of a company the rebate was at the company rate, with the result that the dividends bore no tax. At this time, then, a non-resident company enjoyed the same exemption from tax on dividends as did a resident company.

17.59. Where a non-resident company received Australian-source dividends and thereafter paid dividends to its non-resident shareholders out of these Australian-source dividends, the shareholders were in theory subject to Australian tax on the dividends. The difficulty of enforcing this liability led to a change in the law in 1939. The rebate of tax that until then had been available to the non-resident company was withdrawn, and the company became liable to pay tax on the dividends at the company rate.

17.60. In 1940 the rebate of tax was withdrawn from all individuals, resident and non-resident.

17.61. In 1959 some dividends paid to non-residents became subject to withholding tax. The tax applied to dividends paid to a non-resident by a company resident in Australia, except where the non-resident receiving the dividend was engaged in business through a ‘permanent establishment’ in Australia. The person subject to the tax might elect to be taxed by assessment. In 1967 the election was abolished and the tax became a final one. The tax continues to apply. The rate is 30 per cent, except where a double taxation agreement to which Australia is a party provides for a lesser rate. A dividend may be subject to withholding tax even though paid from profits that do not have an Australian source. In this respect withholding tax involves an extension of Australia's exercise of jurisdiction to tax non-residents beyond the taxing of income with an Australian source.

17.62. In 1968 withholding tax was extended, subject to some qualifications, to interest paid by residents to non-residents and in certain circumstances to payments by non-residents to non-residents. In the latter case the origin of the interest in Australia relied on to justify the exercise of jurisdiction was that the interest is an outgoing incurred by the non-resident in carrying on a business in Australia through a permanent establishment. The tax continues to apply, at the rate of 10 per cent. Like withholding tax on dividends, it is a final tax. Interest may be subject to withholding tax even though it would not be regarded as having a source in Australia as the word is understood in Australian law.

Justification for Taxing Income of Non-residents on the Basis of Origin in Australia

17.63. There are obvious reasons why a country will wish to exercise jurisdiction on the basis of origin. More especially where it is a debtor country—an importer rather than an exporter of capital—income will be generated by economic activity within the country which, if not taxed on the basis of origin, would be excluded from the total base of income tax. The tax on the remaining base will need to be so much the greater, or other means of taxation used. Whatever the immediate incidence of any other tax, it will for the most part be borne by Australian residents, more particularly in their capacity as consumers. Indeed, income tax on non-residents may have to be retained at existing levels even if the movement away from income tax towards commodity taxation, favoured by the Committee, occurs in the taxing of residents.




  ― 264 ―

17.64. Revenue considerations aside, the justification for imposing income tax on non-residents on the basis of origin in Australia rests on the ‘benefit’ principle referred to earlier in paragraph 3.7. The non-resident's income has been generated by economic activity conducted under the protection of the country of origin and relying on facilities provided, at least in part, at public expense. This is equally true whether the income has been produced by the activity of the non-resident himself, as by manufacturing operations in Australia conducted by him through a branch, or by a resident who pays what would otherwise have been his profit to the non-resident, by way of interest or royalties.

17.65. The benefit principle is an aspect of equity. More refined notions of equity, deriving from the principle of ‘ability to pay’, have no obvious relevance in the present context. Australia taxes a non-resident on a base representing only part of his total income, and does not attempt to concern itself with the remainder of his income. Ensuring that the non-resident's tax liability reflects his ability to pay must rest with his country of residence.

17.66. The equity reflected in the application of the benefit principle will to some extent run parallel with the objective of efficiency in the sense of neutrality. It will be apparent, though, from observations made in paragraphs 17.29–17.31 that no provisions of the Australian tax system standing alone can ensure neutrality. Whether a non-resident chooses to invest in his own country, in another foreign country or in Australia will depend, in terms of tax, on the whole range of taxes in each of those countries.

17.67. If it is thought that efficiency requires a deliberate non-neutrality—the encouragement or perhaps the discouragement of foreign investment—the Committee would take the view, in line with its observations in paragraphs 17.32–17.35, that this should be done as far as possible outside the tax system. If the tax system is used, explicit provisions directed to the specific non-neutrality are to be preferred to any general provision. Sections 128F and 128G of the Act, which exempt certain interest from withholding tax, are illustrations of such specific provisions.

17.68. Because it need not concern itself with ability to pay aspects of equity, income tax on Australian-origin income of non-residents can, to this extent, be a simple tax. Tax is imposed, for the most part, at the flat rates associated with company tax and withholding tax. In the case of withholding tax there is also an element of simplicity in the collection of the tax by withholding rather than by assessment.

Taxation on the Basis of Source in Australia

17.69. Except where the income is dividends or interest and withholding tax applies, origin of income in Australia is tested by judicially established principles, and by a few statutory provisions, which are concerned with the interpretation of the word ‘source’ in section 25. That section subjects income of non-residents to Australian tax where the income has a source in Australia. The judicially established principles, for the most part, yield no determinate rules. Indeed, it has often been asserted by the Courts that source refers to ‘something which a practical man would regard as a real source of income and that the ascertainment of the actual source of a given income is a practical hard matter of fact’. The matters that the Courts have tended to think important, as indicating a source in Australia, rather emphasise formal aspects of a transaction than the place of the economic activity generating the income. In this there is some conflict with the assertion of the importance of the view the ‘practical man’ would take. The matters thought important by the Courts in determining the


  ― 265 ―
source of income received in respect of the use of industrial or commercial information are the place of the contract to supply the information and the place where the information is handed over, not the place where the knowledge is used. The matters thought important in determining the source of interest are the place of the contract of loan and the place where the loan moneys were provided, not the place where the moneys are used.

17.70. In the Committee's view, determinate rules are desirable in this area of the law. The rules, where possible, should seek to identify income as having a source in Australia where it can be seen to be the product of economic activity in this country. Proposals in regard to the appropriate rules are made in Appendix A to this chapter.

Tax on Australian-origin Income by Withholding

17.71. The provisions applying withholding tax to certain dividends and interest have been explained in paragraphs 17.61–17.62; and for the reasons expressed in paragraph 17.68, the Committee would approve of the use of withholding tax where such a tax can be conveniently administered. Some comment is appropriate here on the problems of setting the spheres of operation of withholding tax and tax by assessment on Australian-source income. Where withholding tax applies, the person receiving the dividends or interest is not subject to tax by assessment. This is expressly provided in section 128D. But tax by assessment on the basis of source in Australia is not excluded when that person makes a payment of dividends or interest to another. It would make for certainty, in the Committee's view, if the occasions when tax by assessment applies were expressly defined in the Act. Thus tax by assessment—as proposed in paragraph 17.A23 of Appendix A—on interest paid by a permanent establishment abroad of an Australian resident might be expressed to apply only when the interest is received by a tax-haven company or a tax-haven trust. Where dividends or interest have borne Australian tax by withholding when paid to a non-resident company, subsequent distributions of dividends by the company from those dividends or interest will, under the present law, be subject to tax by assessment to the extent that the dividends or interest are from an Australian source. Tax by assessment in these circumstances might be confined to dividends received by a tax-haven company or a tax-haven trust. Tax by assessment is already excluded by a number of double taxation agreements where a non-resident company pays dividends that might have been subject to tax on the basis of Australian source.

17.72. Rates of withholding tax appear modest. The rate on dividends is 30 per cent, unless a lower rate applies under a double taxation agreement. The rate on interest is 10 per cent. Some double taxation agreements preclude a higher rate being imposed on interest in the circumstances specified in the agreements. However, withholding tax is imposed on the gross amount of dividends or interest and may result in higher tax than would be payable if tax by assessment applied and the tax were imposed after deduction of interest paid or other costs of deriving the dividends or interest.

17.73. The rate of withholding tax on interest affords opportunities for tax planning through a tax-haven company or a tax-haven trust lending to a related company in Australia whose profits, which bear company tax, are made less by the amount of the interest paid. There is some discouragement to such planning in provisions excluding withholding tax and applying tax by assessment where income received by a trust would attract tax under section 99A (explained in Chapter 15). However, these provisions are only in part effective since they cannot apply to interest that does not have an Australian source. There is some correction possible in the reconstruction of the profits of the Australian resident paying the interest. This is considered in paragraphs


  ― 266 ―
17.84–17.90. In addition the Committee would recommend that a special rate of withholding tax be applied to interest paid to a tax-haven company or trust. An appropriate rate might be the prevailing company tax rate. The tax would be collected from any payment of interest to a company or trust in the tax-haven country. It would be necessary for any such company or trust that is not, within the meanings in paragraphs 17.9 and 17.47, a tax-haven company or trust to obtain prior permission to have the normal rate of withholding tax applied or to seek repayment of the excess withholding tax collected.

17.74. The rate of withholding tax on interest encourages loan capital in preference to share capital as a means of providing finance for an Australian resident subsidiary company. The scope for reconstruction of the profits of the subsidiary when an undue emphasis has been given to loan capital is the subject of observations in Chapter 16.

17.75. The 30 per cent rate of withholding tax on dividends might appear attractive if the dividends paid to a tax-haven company or a tax-haven trust were to satisfy the obligation of an Australian resident private company to make a sufficient distribution so as to avoid undistributed profits tax. The present law, through provisions preventing the distribution being treated as a sufficient distribution, adequately discourages the use of a tax-haven company in this way.

17.76. There is much to be said for extending the withholding tax provisions to cover the gross amount of payments in respect of the use of commercial and industrial property and know-how with an Australian source on the tests proposed in paragraphs 17.A15, 17.A17–17.A18 of Appendix A. There are very real difficulties in determining the deductions allowable in calculating the net income arising from these payments. If a withholding tax on royalties is introduced, it would be appropriate to provide for a special rate on payments to tax-haven companies and trusts in accordance with the provisions in paragraph 17.73.

Tests of Foreign Origin of Income

17.77. The present exemption and credit provisions explained in Section I of this chapter, whereby relief is given against double taxation of income that has its origin outside Australia, impose Australian law tests of foreign origin. Any new credit provisions may be expected to do the same. In the Committee's view, the tests of foreign origin ought to mirror the tests of Australian origin. It is hardly appropriate that Australia should, for example, apply the tests in section 6C in determining that royalties have a source in Australia but adopt the principle in the United Aircraft Case note so as to hold that royalties paid by a resident in another country have a source in Australia. To do so would mean allowing no exemption or credit in respect of the tax paid in the foreign country.

Reconstruction of Australian-source Income of Non-residents

17.78. A non-resident subject to tax by assessment may be able to control the amount of his income liable to Australian tax by incurring inflated costs that will limit his net income from Australian sources. His costs may involve payments to an associated person, who is a non-resident, for goods or services, for money borrowed or for the supply of information. As at present interpreted, the general deduction section (section 51) requires the Commissioner to allow deduction of the actual costs.




  ― 267 ―

17.79. A non-resident with a branch in Australia, where he manufactures or assembles goods, may sell those goods to an associated person in a foreign country at a price calculated to ensure that no profit arises from the branch operations. Section 42, referred to later in paragraph 17.A5 of Appendix A, enables the Commissioner to apportion the profit between the manufacturing operations in Australia and the selling of the goods. But he can apportion only the actual profit. Section 36, which deems a disposition of trading stock made otherwise than in the ordinary course of business to be a disposition at market value, may be helpful: there is some authority that a sale to an associated person may in some circumstances be regarded as a sale outside the ordinary course of business. However, the assistance it can give to the Commissioner is much less than required.

17.80. The Commissioner should, in the Committee's view, have adequate general power to reconstruct the Australian-source income of a non-resident so as to bring to tax an amount of income that would have been derived had the non-resident's costs been incurred in arm's length transactions and had his receipts been such as might have been expected in arm's length transactions.

17.81. Section 136 of the Act is intended to give the Commissioner such power. It provides:

‘Where any business carried on in Australia—

  • (a) is controlled principally by non-residents;
  • (b) is carried on by a company a majority of the shares in which is held by or on behalf of non-residents; or
  • (c) is carried on by a company which holds or on behalf of which other persons hold a majority of the shares in a non-resident company,

and it appears to the Commissioner that the business produces either no taxable income or less than the amount of taxable income which might be expected to arise from that business, the person carrying on the business in Australia shall, notwithstanding any other provisions of this Act, be liable to pay income tax on a taxable income of such amount of the total receipts (whether cash or credit) of the business as the Commissioner determines.’

In the Committee's view, however, the section does not give the Commissioner adequate power.

17.82. The operation of section 136 in the situations of the kind described in paragraph 17.78, involving inflated costs incurred by the non-resident, is limited by the condition that there must be a business carried on in Australia. The section does not enable the Commissioner to increase the amount of net royalties derived by a tax-haven company. The tax-haven company may have paid, to an associated tax-haven company, an amount in royalties for the information in turn supplied to an Australian resident such as to ensure that the net royalties from an Australian source are zero.

17.83. The operation of the section in situations of the kind described in paragraph 17.79, involving deflated receipts by the non-resident, is probably limited by the condition that the Commissioner must tax an ‘amount of the total receipts … of the business’, which would appear to deny him power to substitute for the actual receipts those receipts that would have been derived in an arm's length transaction.




  ― 268 ―

Reconstruction of Income of Australian Residents from Transactions with Non-residents

17.84. Income may be diverted by an Australian resident to a non-resident in whose hands it either escapes Australian tax altogether, because it does not have an Australian source, or is subject to tax at a rate less than it would have borne in the hands of the Australian resident.

17.85. Thus an Australian resident company may buy goods at an inflated price from an associated non-resident company or pay an inflated commission to that company in a transaction which will ensure that the non-resident company's profit does not have an Australian source. Furthermore, the profits of the resident company, subject to company tax, may be the less because of an interest payment to the non-resident subject only to withholding tax at 10 per cent. The non-resident company may be a tax-haven company.

17.86. The diversion of income may take the form of a sale of goods by a resident company to an associated non-resident company at a price which ensures that the resident company makes no profit. The non-resident company may be a tax-haven company that simply ‘invoices-on’ to a foreign buyer. The resident company may pay a commission to an associated non-resident company for making a sale abroad. Again the non-resident company may be a tax-haven company.

17.87. Sections 51, 42 and 36 are no more helpful in enabling reconstruction in these situations than they are in enabling reconstruction of the incomes of non-residents in the situations considered in paragraphs 17.78–17.83. And here, too, section 136, which can apply to income derived by a resident, is inadequate. The resident company will be carrying on business in Australia, but in the deflated receipts situation described in paragraph 17.86 the Commissioner's power to substitute notional receipts in a non-arm's length transaction is doubtful. Both in this situation and in the inflated cost one described in paragraph 17.85, the Commissioner may have no power to reconstruct because the resident company does not come within any of the clauses of section 136 identifying the persons to whom the section may apply. Clause (b) can be avoided if a majority of the shares is vested in residents, even though those shares carry only a small fraction of rights to dividends or distribution of capital and have no voting rights. Since a company holding shares in another company does not hold those shares on behalf of its shareholders, clauses (b) and (c) can be avoided by interposing a second company incorporated in Australia to hold the shares in the resident company and, in the case of clause (b), in the non-resident company. The control contemplated by clause (a), in the case of a company, probably refers to director control. It may be inferred from judicial authorities on the meaning of central management and control in the definition of residence in relation to a company that it will be enough to prevent the operation of clause (a) if a majority of the directors are Australian residents. In any event, where tax-haven operations are involved, the persons who have the real interests in and control of the resident company are likely to be Australian resident individuals: thus, unless the tax-haven company is its subsidiary, section 136 will not be applicable.

17.88. In the Committee's view section 136 should be replaced by a new section empowering the Commissioner to reconstruct the profits of non-residents derived from sources in Australia and the profits of residents dealing with associated non-residents. The models of reconstruction provisions in double taxation agreements, such as articles 5 and 7 of the United Kingdom agreement, may be helpful.

17.89. The effectiveness of a redrafted section 136 will depend on the Commissioner coming to know facts which persons liable to pay tax may have sought, sometimes with the co-operation of governments in other countries, to keep from him. And it will


  ― 269 ―
depend on there being assets in Australia that may be taken in payment of tax. These limitations on effectiveness are inevitable, but they do not justify denying power to do what can be done.

17.90. Special measures may be necessary to assist the enforcement of provisions intended to ensure adequate taxation of Australian-origin income when tax-haven operations are involved. The existing provisions of the Act, in particular sections 254–257, may not be adequate. The Committee has noted the recent amendments to the Banking Act and the Taxation Administration Act relating to the tax screening of proposed transactions with persons in tax-haven countries, and the notice issued by the Treasurer specifying the acts or things to which section 39B of the Banking Act applies. Experience with these new provisions will doubtless indicate whether further measures will be needed to ensure adequate taxation of Australian-origin income.

Taxation of Branch Operations in Australia

17.91. Where a foreign company has a branch operation in Australia it will, subject to the provisions of any double taxation agreement, be subject to Australian company tax on its Australian-source profits. When it makes a distribution to its shareholders from those profits, the shareholders will, again subject to any double taxation agreement, be subject to Australian tax on the dividends they receive. But this is generally only a theoretical liability which the Commissioner will not be able to enforce. When the foreign company has a subsidiary company carrying on the operations in Australia, there will be company tax on the subsidiary company's profits and withholding tax at 30 per cent (or 15 per cent if a double taxation agreement applies) on profits distributed to the company by way of dividends. The result is a discrimination in favour of the branch operation.

17.92. In some countries a special tax is imposed on profits of branch operations to remove the discrimination. The Committee would favour the introduction of a branch earnings tax in the form of an additional tax on a proportion of a non-resident company's Australian taxable income after the deduction of company tax. Tax on half the after-tax income is proposed. The rate of tax should be the normal dividend withholding tax rate of 30 per cent; but where a company establishes that it is a resident of a country that has a double tax agreement with Australia under which the withholding tax rate is reduced to 15 per cent, the rate should be 15 per cent.

17.93. Dividends paid by a non-resident company to non-resident shareholders after the commencement of the proposed provision should be made exempt from Australian tax. In addition, the requirement that a non-resident private company make a sufficient distribution to avoid the imposition of Division 7 tax should be dispensed with. However, neither of these two proposed measures ought to have application if the company is a tax-haven company.

17.94. The branch earnings tax should not be applied to income of the branch which takes the form of dividends. These dividends under the present law will have been taxed in the hands of the branch by assessment at corporate rates as the section 46 rebate does not operate; withholding tax does not apply. The treatment of dividends received by a non-resident company which has a branch operation in Australia involves a discrimination against a branch operation. If the non-resident company operates through a subsidiary the dividends received by the subsidiary will be relieved from tax by the operation of the inter-corporate rebate (section 46) and when distributed as dividends paid to the non-resident company they will attract only withholding tax.




  ― 270 ―

17.95. Submissions have been made to the Committee that the discrimination against branch operations in relation to dividend income should be removed by extending the inter-corporate rebate to dividends received by a non-resident company which has a branch operation in Australia. In the Committee's view this treatment would be too generous since, for reasons already explained, there is unlikely to be any further Australian tax when the non-resident company distributes to its shareholders. There is, however, in the Committee's view a case for applying withholding tax to dividends received by a non-resident company which has a branch operation in Australia. The dividends would then not be subject to tax by assessment and would in effect bear the same Australian tax as would apply to dividends received by an Australian subsidiary which are the subject of a distribution to the non-resident parent company. The rate of withholding tax should be the same as would apply to distributions by an Australian subsidiary of the non-resident company.

III. Double Taxation Agreements

17.96. Australia has entered into double taxation agreements with a number of countries. The first of these was with the United Kingdom in 1946. Agreements with the United States, Canada and New Zealand were signed in 1953, 1957 and 1960 respectively. The original agreement with the United Kingdom was negotiated in 1968. The new agreement with that country owes much to the model OECD convention issued in 1963. This is true also of the agreements with Japan and Singapore signed in 1969, and of the one renegotiated with New Zealand in 1966. An agreement with West Germany was signed in 1972 but has yet to come into force. Australia has also entered into limited agreements with France and Italy in relation to airline profits.

17.97. Double taxation agreements reflect the revenue interests of the parties, their economic and social policies and, of course, their respective bargaining strength. They also reflect the concern of the parties to prevent injustice and discouragement of trade, investment and other contact between their residents which tend to result when the same income is subject to unrelieved double taxation.

17.98. The Committee does not propose to examine the compromises reached in particular treaties. It is concerned, however, to make some general observations on the structures and techniques of agreements that will be most effective in preventing double taxation. This of course is not to imply that the failure of an agreement to adopt these structures and techniques is a matter of inadequate expertise. Thus the failure to define the source of some kind of income may simply reflect the inability of the parties to agree to a compromise of revenue interests. The failure to define cloaks the problem of double taxation, it does not resolve it.

17.99. Those agreements subsequent to the OECD model convention of 1963 are distinctly sounder in structure and technique than earlier ones. The observations which follow, for the most part, express objectives that are already reflected in the OECD draft.

17.100. A double taxation agreement should resolve the conflicts of claims to tax that arise when a taxpayer is, by the law of each of the participating countries, resident in that country. The method of resolving the conflict involves adopting a notion of residence which will ensure that a person who is a dual resident has, for purposes of the agreement, only one residence. The country of residence, in the agreement sense, should be given the sole jurisdiction to tax the person's income from


  ― 271 ―
sources outside both countries. The other country should be denied jurisdiction to tax the person's income from sources in the country of residence.

17.101. These limitations on jurisdiction should also apply where there is no dual residence. The person may be resident by the law of only one country, which is thus the country of residence for purposes of the agreement. The jurisdiction of the other country should be limited so that it may not tax income having a source in a third country or in the country of residence. The United States claims to tax certain income of a foreign resident, even though it does not have a source in the United States, if that income is effectively connected with a trade or business which the foreign resident carries on in the United States. There is no express provision of the present double taxation agreement with the United States to prevent the United States from exercising this jurisdiction. Curiously, the United Kingdom agreement denies such jurisdiction to the country that is not the country of residence for purposes of the agreement in a dual residence situation, but not otherwise.

17.102. A double taxation agreement should define the meaning of source in relation to different kinds of income in ways which will ensure that the same income cannot be held to have a source in both countries. The definitions should apply to determine the meaning of source when jurisdiction to tax depends on source, and also in relation to the obligation of the country of residence to give credit for tax imposed in the country of source. The tendency in earlier agreements was to leave definitions of source to the operation of a provision in the agreement that ‘any term not otherwise defined shall, unless the context otherwise requires, have the meaning which it has under the law of the country applying the agreement’. There are wide divergencies of meaning of source in relation to different kinds of income in the laws of different countries. Dual source situations and unresolved double taxation problems must result if the matter is simply left to the law of the country applying the agreement. Moreover, the prospect is raised that the country applying the agreement may, in effect, rewrite the agreement unilaterally by changing a definition of source in its own law. There may be some justification for saying that the enactment by Australia of section 6C, defining the source of royalties, was a unilateral rewriting of the double taxation agreement with the United States.

17.103. The United Kingdom agreement, in relation to the obligation of the country of residence to give credit for tax imposed in the country of source requires, in some instances, that the country of residence accept the meaning of source given by the law of the country of source. This is some advance on an agreement leaving the matter to the country applying the agreement, but it is nonetheless unsatisfactory. The agreement should include its own definitions and not definitions imported by reference.

17.104. A double taxation agreement fixes the limits of each country's jurisdiction to tax in relation to different kinds of income. Here too it is of great importance that the agreement should contain its own definitions of terms. The United States agreement uses the term ‘royalties’ without its own definition of the term. The question has been raised whether Australia effectively extended the jurisdiction to tax given it by the agreement when, in 1968, it inserted a very wide definition of ‘royalties’ in the Act.




  ― 273 ―

Chapter 17: Appendix A: Rules for Determining Source of Income of Non-Residents

17.A1. Income from sale of goods imported into Australia. Where goods are manufactured abroad by a non-resident and imported into Australia or bought abroad and imported, the test of source of any profit arising on their sale is whether something was done in Australia by the non-resident personally, or by his agent or representative, which was instrumental in bringing about the sale. The relevant sections of the Act (sections 38–41) appear under a heading ‘Business Carried on Partly in and Partly out of Australia’. Unless the heading is taken to control the interpretation of the sections, the profit from a casual sale may be held to have a source in Australia. In the Committee's view Australian law should be brought closer to the law of the United States and the United Kingdom so as to require that there be a place of operations in Australia through which the action to bring about the sale has been taken. The place of operations might be constituted by an agent or representative of the non-resident. The notion of action instrumental in bringing about a sale should nevertheless be preserved. To require that contracts be concluded at the place of operations in Australia is to give undue weight to a factor depending on legal forms.

17.A2. Where the goods have been manufactured abroad by the non-resident, it is only the selling profit that is subject to Australian tax. The calculation of the selling profit, under section 38, involves subtracting from the proceeds of sale of the goods ‘the amount for which … goods of the same nature and quality could be purchased by a wholesale buyer in the country of manufacture, and the expenses incurred in transporting them to and selling them in Australia’. Under this provision there is the prospect of a reconstruction of the Australian-source profit where the manufacturer's costs have been inflated, by prices he has paid to related persons, so as to prevent any profit arising. However, the calculation of the selling profit under section 39, where goods have been bought by the non-resident and then imported into Australia, does not allow of any reconstruction. The Commissioner has only such powers of reconstruction as may be given him by section 136. The need to increase his powers under that section was considered in paragraphs 17.80–17.89.

17.A3. Income from purchase and sale of goods that are at all times in Australia. The Committee's view is that a place of operations in Australia should be necessary to give an Australian source to a profit from the sale of goods imported into Australia. A casual act of purchase and sale should, however, be sufficient to give a profit an Australian source if the goods are at all times in Australia and acts done in Australia by the non-resident personally, or by his agent or representative, were instrumental in bringing about both the purchase and the sale.

17.A4. Income from purchase of goods in Australia and their sale abroad. An act done in Australia by the non-resident personally, or by his agent or representative, which is instrumental in bringing about the purchase of goods might be thought to justify giving a source to at least part of a profit resulting from the sale of those goods in an export transaction. There is some support for this view in judicial decisions. However, the Committee would prefer that the emphasis be placed on the place of selling. If an act done in Australia by the non-resident, or by his agent or representative, is instrumental in bringing about the sale, the profit should be treated as having an Australian source. It should not otherwise be treated in this fashion.




  ― 274 ―

17.A5. Income from manufacturing operations in Australia. Where manufacturing operations are carried on in Australia by a non-resident using materials or components he has imported into Australia, the determination of the amount of profit from the sale of the goods having a source in Australia will be made by the Commissioner under section 42. The Committee considers that section 42 is an appropriate provision. It is noted, however, that the Commissioner under the section must accept the profit: his function is only to determine how much of the profit has an Australian source. Here, too, any power of reconstruction must be found in section 136.

17.A6. Income from sales of Australian real property. There is no definitive decision on the source of a profit from the sale of Australian real property. Such a profit should, in the Committee's view, be treated as having a source in Australia even though the purchase and sale of the property took place abroad. While the increase in value reflected in the profit may have been generated by selling activity in the foreign country, it is more likely to have been the result of factors at work in the Australian economy. The suggestion is sometimes made, based on a judicial decisionnote concerning shares in companies, that a profit has a foreign source when it results from the sale abroad of an option over land in Australia. In the Committee's view, the sale of an option should not be distinguished from the sale of the land to which it relates. Option should be given a wide meaning for this purpose. It should not be necessary to attract the operation of the source rule that the option has conferred an interest in the land in Australia.

17.A7. Income from sale of shares. The judicial decision referred to in paragraph 17.A6 may be taken to reject any general principle that the source of a profit made on the sale of shares is the place where the shares are situated. The Committee is not disposed to disagree. A share is situated in the place where the register of the share is kept. To make this the source of the profit would be to allow form to govern the matter. It might be suggested by analogy with real property that the source of the profit on the sale of shares should be taken to be the country where the company derives its profits. While a related test referred to in paragraph 17.57 applies in determining the source of a dividend paid by a company, the Committee does not see this as the appropriate test in the present context. The test is unworkable, requiring information about company affairs that would not be available when an assessment is to be made. A profit on the realisation of shares acquired by a non-resident abroad and sold in the Australian market should, in the Committee's view, be regarded as having a source in Australia if the non-resident has a place of operations in Australia and action through that place of operations was instrumental in bringing about the sale. Where, however, the shares have been both purchased and sold in the Australian market in the sense that acts by the non-resident personally, or by his agent or representative, in Australia were instrumental in bringing about both the purchase and the sale, the resulting profit should be regarded as having a source in Australia. In this case whether or not the non-resident has a place of operations in Australia will be irrelevant.

17.A8. Under these principles many stock exchange transactions would generate profits which would have an Australian source. Where a number of sales are made on an Australian exchange the stock broker or agent instructing the sale of the shares may constitute a place of operations sufficient to give an Australian source. Where the taxpayer buys and sells on an Australian exchange there will be an Australian source. The Committee understands that the law is not at present administered so as to bring all profits of non-residents to tax where they arise from transactions on Australian stock exchanges. There is, of course, great difficulty in establishing that a non-resident has engaged in transactions which, either because he is a trader or by the operation of section 26 (a) and 26AAA, give rise to profits which are income. This is especially so when the non-resident has given instructions through a broker or agent in the foreign country, who has in turn instructed an Australian broker. In many cases a non-resident operates through a nominee company and his identity is not known to the broker or agent acting in Australia. In addition, he may buy through one broker and use another for the sale of the securities. If a liability to tax can be established the Commissioner will very likely have to rely on the agency provisions (referred to in paragraph 17.90) to collect the tax, at some inconvenience and risk of loss to the Australian broker, or other agent, who is constituted the agent for the non-resident under those provisions.




  ― 275 ―

17.A9. The difficulties for the Revenue in ascertaining and enforcing the liability of the non-resident to tax and the related difficulties for the stock broker or other agent could only be overcome by a general provision exempting from tax all profits by non-residents arising from stock-exchange transactions in Australia. The Committee would not support such an exemption as a way of dealing with these difficulties, though it could understand an exemption in these terms, or even wider terms, as a way of attracting to Australia financial operations by non-residents. The Committee would regard recommending an exemption for the latter purpose as outside its functions.

17.A10. Income from services performed as an employee. Judicial decisions suggest a somewhat elusive distinction between the wages or salary of an artisan in relation to which the place of performance tends to be an important factor in determining source, and the wages or salary of an employee whose services may be called professional, especially one holding an ‘office’, in relation to which the place of performance tends to be less important. In the Committee's view, place of performance should be the sole test of source of wages or salary. It may be appropriate, though, on grounds of administrative simplicity, to exempt the wages or salary of a non-resident if the services were performed for a non-resident and did not exceed a certain number of days—say sixty—in any year of income. In some double taxation agreements to which Australia is a party, an exemption of this kind is given in respect of a longer period of service. It may be appropriate to restrict the exemption so that it does not apply to services performed for a non-resident in connection with a place of operations the non-resident has in Australia. In another respect, however, it may be appropriate to extend the exemption so that it applies to services performed for a resident in connection with a place of operations the resident has outside Australia.

17.A11. Whether the exemption should be restricted so that it will not apply to the income derived in Australia by public entertainers and professional sportsmen, who may earn substantial rewards for very short periods of service, will need to be considered.

17.A12. Income from services performed otherwise than as an employee. Judicial decisions suggest that factors other than place of performance will determine the source of income from independent performance of services, such as the conducting of a geological survey or the giving of professional advice. The place of performance of service should, in the Commission's view, be adopted as the test of source, whether the services are performed as an employee or independently. It may be appropriate to allow an exemption parallel to that suggested in relation to wage and salary income.


  ― 276 ―
Here too it will be necessary to consider whether there should be some kinds of services in relation to which the exemption will not apply. It should be made clear that the test extends to services performed by a company through its employee or other agent.

17.A13. Income in the form of rentals in respect of real property. Rentals in respect of real property in Australia should be regarded as having a source in Australia. They are probably so regarded by the present law.

17.A14. Income in the form of rentals of chattels. The present law does not give any clear directive as to the source of rentals of chattels, for example payments for the hire of computer equipment. One factor that might be thought important is the location of the chattel at the time of rental payment. But to adopt this as the test means that the source of the rentals would alter with any change in the location of the chattel. Clearly the test would be unworkable where the item is a ship or an aircraft. In the Committee's view, the appropriate tests of source are those adopted by section 6C of the Act, which already applies where the chattel is an item of ‘industrial, commercial or scientific equipment’. Section 6C defines the source of ‘royalties’ for purposes of the Act and the definition of royalties in that section includes payments for the use of these items. The tests depend on the connection of the rentals with economic activity carried on in Australia. There is a source in Australia where the payment is made by an Australian resident to a non-resident, except to the extent that the payment was an outgoing incurred in carrying on business in a country outside Australia through a permanent establishment of the Australian resident in that country. And there is a source in Australia where the payment is made by a non-resident, to the extent that it is an outgoing incurred by that non-resident through a permanent establishment he has in Australia.

17.A15. In one respect the tests may be defective in their presumed object of ensuring that gains resulting from economic activity in Australia are treated as having an Australian source. A permanent establishment abroad of an Australian resident may pay rentals for chattels to a non-resident and receive matching rentals in respect of the same chattels from another Australian resident who uses the chattels in Australia. The rentals paid by the permanent establishment will not have an Australian source under section 6C. However, they will be deductible by the Australian resident, in computing his profits, against the rentals received from the other Australian resident. The latter will be entitled to a deduction for the rentals he pays. A similar defect in the provisions imposing withholding tax on interest paid to a non-resident has been overcome by an amendment to those provisions to which reference is made in paragraph 17.A23. An amendment may be thought appropriate to section 6C, which would give an Australian source to a payment by a resident representing an expense of a permanent establishment abroad, if payment for the use of the same property has been received from another Australian resident.

17.A16. Where the person making the payment is a resident, and the exception relating to a permanent establishment abroad does not apply, the tests assume that the resources from which the payment is made will be generated by economic activity of the resident in Australia. The assumption may not always be correct, but in the Committee's view it is justified for the sake of a workable rule. It would be possible to adopt a test making the extent of the Australian source of the rentals depend on the amount of Australian-source income compared with foreign-source income derived by the resident undertaking the payment. But the Committee would not favour introducing a complexity of this kind.




  ― 277 ―

17.A17. Income in the form of payments for the use of commercial or industrial property. Payments for the use of commercial or industrial property in Australia should be regarded as having a source in Australia. There is support for such a view in judicial decisions and in the effect of section 6C of the Act, though that section does not in its terms make the source depend on the location of the property. Reference is made to section 6C in paragraph 17.A12 above. The definition of royalties in section 6, for purposes of that section, includes payments made ‘as consideration for the use of, or the right to use, any copyright, patent, design, … trade mark, or other like property or right’.

17.A18. Income arising from payments for commercial or industrial property. A profit from the sale of Australian commercial or industrial property should be treated as having a source in Australia. The treatment of such a profit ought to parallel the treatment of a profit on the sale of real property in Australia. In each case the existence of the property depends on rights given by Australian law.

17.A19. Income arising from payments for scientific, technical, industrial or commercial knowledge or information. The source of income arising from payments for know-how—scientific, technical, industrial or commercial knowledge or information—is the subject of judicial decision in the United Aircraft Case note and of statutory provision in section 6C of the Act already referred to in paragraphs 17.A12–17.A13. The United Aircraft Case is authority that income will have a foreign source if the contract under which the information is supplied and the actual supply of the information take place abroad. The inference is that the income will have a source in Australia if both the contract and the supply take place in Australia. The case is unhelpful where only one of these elements takes place in Australia. Section 6C is not concerned with either element. Source, it was seen in paragraphs 17.A12–17.A13, depends on the payment being a ‘royalty’ as defined and on its having been made by an Australian resident or, in some circumstances, by a non-resident. The definition of ‘royalties’ in section 6 includes ‘payments … for the supply of scientific, technical, industrial or commercial knowledge[or] information’. In the Committee's view, both the United Aircraft Case principle and section 6C are unsatisfactory. The principle over-emphasises form; the section imposes tests in terms of connection with the Australian economy that may be too wide.

17.A20. The approach taken by section 6C is to be preferred but its operation in the present context should be restricted. Where the total amount of the payments for the know-how is in any way dependent on the extent of use of the know-how or the productivity of the business using it, section 6C should apply. But the section should not apply to payments that are not dependent on use or productivity. A payment for a machine should not be treated differently from a payment for plans and specifications for building the machine. The test of source in Australia should, in this case, be whether the sale of the know-how was made through a place of operations in Australia that was instrumental in bringing about the sale.

17.A21. While the operation of section 6C should be restricted in this way, it ought to be extended in the manner already considered in paragraph 17.A13. The purpose of section 6C, as at present drafted, may be defeated by an arrangement involving the supply of know-how to a permanent establishment of an Australian resident who then supplies the know-how to another Australian resident.




  ― 278 ―

17.A22. Income in the form of dividends. Dividends and interest, as has already been explained, are taxed by withholding on a basis of their origin in Australia that may differ from their source. Where withholding tax applies, section 128D excludes tax by assessment so that source in Australia has no immediate consequences. There are occasions, however, in relation both to dividends and to interest when source in Australia continues to have consequences. Some of these occasions were explained in paragraphs 17.71–17.75.

17.A23. The source of a dividend for the purpose of taxing a non-resident receiving the dividend is determined by section 44. The test is the source of the profits from which the dividend has been paid. But the source of a dividend, where it is part of the profits from which a dividend is paid to a non-resident is not determined by the Act. If regard is to be paid to the principle that origin in Australia should depend upon economic activity in Australia, the source ought perhaps to be determined by tracing back to active business profits in Australia. However, such an assertion of jurisdiction could not generally be enforced. For this reason the Committee favours the place of residence of the company (A), from which another company (B) receives a dividend out of which it pays a dividend to a non-resident (C), as being the source of the dividend profits received by B for the purpose of determining the source, under the statutory test, of the dividend received by C.

17.A24. Income in the form of interest. The source of interest has been considered in a number of judicial decisions and there are statutory provisions in section 25(2) giving an Australian source to interest in some circumstances and perhaps denying it in others. The judicial decisions tend to emphasise elements of form—where the contract of loan was made or the loan moneys were provided. The provisions of section 25(2) give a source in Australia to interest upon money secured by mortgage of any property in Australia. There is an exception to the operation of the provision when interest is paid outside Australia to a non-resident on debentures issued outside Australia by a company. It is not clear whether the exception, by preventing a deemed source arising under section 25(2), requires that the interest be treated as not having a source in Australia.

17.A25. In the Committee's view, the tests of origin for purposes of withholding tax should in general be adopted as the tests of source for purposes of tax by assessment. Those tests express the basic notion that source depends on whether the income has been produced by economic activity in Australia. The tests are payment by a resident, except where it is an expense incurred by the resident in relation to a permanent establishment he has abroad, or payment by a non-resident where it is an expense incurred by him in relation to a permanent establishment he has in Australia. A recent amendment has sought to give more effective expression to the basic notion by imposing withholding tax on a payment of interest by a resident to the permanent establishment abroad of another resident. The intention is to ensure that where the permanent establishment has borrowed in order to lend to an Australian resident, withholding tax is paid at some stage. It would have been impossible, however, to apply a provision making the liability to withholding tax on the interest paid by the resident's permanent establishment depend on the tracing of the moneys borrowed into loans made by the permanent establishment to Australian residents. But where tax is imposed by assessment, a provision making the determination of an Australian source for the interest paid by the permanent establishment depend on a tracing may be feasible. The tracing might be done by applying to the interest paid that fraction of the total interest received by the permanent establishment which was received from


  ― 279 ―
Australian residents. It would be necessary, however, to confine the liability to tax by assessment in ways proposed in paragraph 17.71.

previous
next