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.

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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.

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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

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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

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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.

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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.

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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

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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.

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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.