Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)
Chapter 2 - Second Protocol (and associated Exchange of Letters) amending the Agreement with Malaysia
2.1 The Second Protocol and associated Exchange of Letters, once in force, will amend the Agreement between Australia and Malaysia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income signed on 20 August 1980, as amended by the First Protocol of 2 August 1999 (referred to as 'the Agreement' for the purpose of this chapter).
2.2 Amendments contained in the Second Protocol and associated Exchange of Letters will operate to exclude persons who benefit from the preferential tax treatment under the Labuan offshore business activity regime, and other substantially similar regimes, from receiving treaty benefits. Such amendments are necessary to ensure that Australian revenue is protected from inappropriate claims for treaty benefits by persons enjoying tax privileges under preferential tax regimes which shelter income from taxation.
2.3 The original Agreement between Australia and Malaysia was signed in 1980. The DTA contains tax sparing provisions. Tax sparing refers to the situation where tax forgone (in the form of tax holidays or tax reduction) by a foreign country on the income of an Australian resident taxpayer is deemed to have been paid (i.e. the tax forgone is credited, as if actually paid, under Australia's foreign tax credit system). The typical circumstances in which this arrangement operates is where tax incentives are offered by developing nations seeking to attract foreign investment. The rationale for tax sparing is that, without special provisions which recognise such incentives, they would be negated to the extent that the tax forgone by the source country would be collected by the resident country.
2.4 Tax sparing arrangements under the original provisions of the Agreement expired on 30 June 1984. The arrangements were later extended for 3 years from 1 July 1984 to 30 June 1987 through an Exchange of Letters and again for another 5 years from 1 July 1987 to 30 June 1992 by an Exchange of Letters made under the First Protocol of 2 August 1999 amending the Agreement.
2.5 Amendments contained in the Second Protocol will operate to provide new tax sparing arrangements (to reflect the changes made to the Malaysian tax incentive legislation) in relation to certain designated development incentives provided by Malaysia for an additional 11 year period, that is, from 1 July 1992 to 30 June 2003, at which time they will permanently expire.
2.6 In addition, the Second Protocol will also update the Agreement to reflect Australia's current tax treaty practice in relation to a number of existing Articles, including those dealing with Associated Enterprises (Article 9), Dividends (Article 10), Royalties (Article 12) and Other Income (Article 21), reflecting the Government's commitment to modernising Australia's tax treaty network.
2.7 The Second Protocol (and associated Exchange of Letters) will:
- exclude from receiving DTA benefits, persons who benefit from the Labuan offshore business activity regime (Malaysia's international offshore financial centre - a low tax regime);
- insert a new paragraph in the Associated Enterprises Article to provide for correlative relief where there is an adjustment of profits;
- replace the Dividends Article with a new article which states that Australia will be limited to a zero rate of dividend withholding tax on franked non-portfolio dividends and 15% on all other dividends. Malaysia will be precluded from imposing dividend withholding taxes;
- update the definition of royalties to take into account modern communication methods, and to include payments for spectrum licences;
- replace the existing Article dealing with third country income of dual residents with an Other Income Article which provides for source country taxation of income not otherwise dealt with in the Agreement;
- ensure that the 'tax sparing' provisions of the Agreement reflect changes in the Malaysian tax incentives legislation;
- extend the operation of the 'tax sparing' provisions of the Agreement for a further period of time, that is, until 30 June 2003, at which time they will permanently expire; and
- insert a provision, in accordance with current Australian tax treaty practice, to deal with disputes which may be brought before the Council for Trade in Services.
2.8 The Second Protocol will insert a new paragraph in the Associated Enterprises Article of the Agreement to provide for correlative relief where there is an adjustment of profits by the revenue authority of one of the two countries. The Article deals with parent and subsidiary companies and companies under common control, and provides that the profits of such associated enterprises may be taxed on the basis of dealings at arm's length. Where a reallocation of profits is made so that the profits of an enterprise of one country are adjusted upwards, a form of double taxation would arise if the profits so reallocated continued to be subject to tax in the hands of an associated enterprise in the other country. To avoid this result, the other country is required to make an appropriate compensatory adjustment to the amount of tax charged on the profits involved to relieve any such double taxation. The new paragraph replaces the former relief mechanism in the Methods of Elimination of Double Taxation Article of the Agreement that requires Australia to give a credit to the resident company for the extra tax chargeable on the amount of adjusted profits of the associated foreign company.
2.9 The Second Protocol will substitute a new Dividends Article into the Agreement to bring it into line with Australia's current tax treaty practice.
2.10 The Article allows each Contracting State to tax residents who are beneficially entitled to receive a dividend from the other State. Dividends may also be taxed in the country where the company paying the dividends is resident, but the rate of tax that can be imposed is limited (in some cases to nil). [New paragraphs 1&2]
2.11 Under this Article as it existed prior to this Second Protocol, Australia limited its rate of withholding tax on dividends paid by Australian resident companies, to beneficially entitled Malaysian residents, to 15% of the gross amount of the dividends.
2.12 The Second Protocol will provide that Australia will not tax franked dividends flowing to a Malaysian company which holds directly at least 10% of the voting power in the company paying the dividends. In practice, the tax treatment of franked dividends derived by Malaysian residents remains unchanged, as Australian sourced franked dividends are generally exempt from dividend withholding tax in Australia under current domestic law. Australia will continue to tax at 15%, those dividends that do not meet the nil rate criteria. [New paragraph 2 (a) (i) and (ii)]
2.13 Article 10 of the existing Agreement does not allow Malaysia to impose dividend withholding tax. However it provides that, in the event of Malaysia subsequently introducing such a tax, the rate of dividend withholding tax would not exceed 15%. The new Article 10 will continue to preclude Malaysia from imposing dividend withholding tax, but provides, in accordance with Australia's treaty practice, that in the event of a significant change of the relevant law in either country, Australia and Malaysia would consult with a view to agreeing an appropriate amendment to the source country taxing rights provided under paragraph 2. [New paragraphs 2 and 3]
2.14 New paragraph 4 deals with the definition of the term 'dividends', and new paragraph 5 deals with dividends derived by a permanent establishment. The new paragraph 7 provides that dividends paid by a company which is a resident of Malaysia will include dividends paid by a company which is a resident of Singapore that has declared itself to be a resident of Malaysia for the purpose of those dividends. The new paragraph 7 also states that dividends paid by a company that is resident of Malaysia, which for the purpose of those dividends has declared itself to be a resident of Singapore, shall not be covered by this article. These new paragraphs reflect recent treaty language and are not different in substance to the paragraphs replaced.
2.15 The extra-territorial application by either country of taxing rights over dividend income will be precluded by providing, broadly, that a country (the first country) will not tax dividends paid by a company which is a resident of the other country, unless:
- the person beneficially entitled to the dividends is a resident of the first country; or
- the shareholding in respect of which the dividends are paid is effectively connected with a permanent establishment in that first country.
2.16 An example of the effect of this paragraph is that Australia may not tax dividends paid out of profits derived from Australian sources, if they are paid by a Malaysian company to a Malaysian resident shareholder, unless the shareholding is effectively connected with a permanent establishment situated in Australia.
2.17 However, the exemption does not apply where the dividend paying company is a resident of both Australia and Malaysia. This provision ensures that Australia retains the right to tax dividends paid to a person resident outside of both countries by a company which is a resident of Australia under its domestic law, notwithstanding that the company is deemed to be a resident of Malaysia for the purposes of the tax treaty under the dual resident tie-breaker test for companies contained in Article 4 of the Agreement. [New paragraph 6]
2.18 The Second Protocol will amend the definition of royalties to take into account modern communications methods as reflected in Australian domestic law. A provision has also been included in the Second Protocol that deems radiofrequency spectrum licence payments to be royalties for the purposes of the Agreement. This is in accordance with Treasurer's Press Release No. 26 of 11 March 1998 concerning revised taxation treatment to be afforded to spectrum licences. [New paragraph 6(d) and (e)]
2.19 The Royalties Article has also been amended to delete:
- the current exemption from Malaysian tax of approved industrial royalties; and
- the current exclusion from Malaysian tax of royalties that, as film rentals, are subject to cinematograph film-hire duty in Malaysia.
2.20 The existing Article dealing with third country income of dual residents will be replaced with a more comprehensive Other Income Article which provides rules for the taxation of income not otherwise dealt with in the Agreement.
2.21 The new Article allocates taxing rights between the two countries on items of income not dealt with in the preceding Articles of the Agreement. The scope of the Article is not confined to such items of income arising in one of the countries - it extends also to income from sources in a third country.
2.22 Broadly, such income derived by a resident of one country is to be taxed only in the country of residence unless it is derived from sources in the other country, in which case the income may also be taxed in that other country. Where this occurs, the country of residence of the recipient of the income would be obliged by Article 23 ( Methods of Elimination of Double Taxation ) to provide double taxation relief. [New paragraphs 1 and 3]
2.23 With the exception of income from land as defined in paragraph 2 of Article 6, this Article does not cover income derived by a resident of one of the contracting states where that income is effectively connected with a permanent establishment situated in the other contracting state. In such a case, Article 7 ( Business Income or Profits ) shall apply. [New paragraph 2]
2.24 The Second Protocol will make a number of amendments to Article 23 of the Agreement.
2.25 The relief mechanism in paragraph 4 of the existing Article which requires Australia to give a credit to the resident company for the extra tax chargeable on the amount of adjusted profits of the associated foreign company will be deleted and replaced by a new paragraph in the Associated Enterprises Article.
2.26 New paragraph 4 defines the term 'Malaysian tax forgone' for the purposes of the tax sparing credit and ensures that the provision reflects changes in the Malaysian tax incentives legislation.
2.27 Under the new paragraph 5, tax forgone on income derived from certain sectors is excluded from the tax sparing provisions. A general anti-avoidance provision is also included.
2.28 New subparagraph 5(a) excludes income from banking, insurance, consulting, accounting, auditing or similar services from the scope of tax sparing. These exclusions reflect the fact that, under Malaysian tax incentive laws, most of the finance sector is not eligible for tax incentives.
2.29 New subparagraph 5(b) excludes income from shipping and aircraft operations from tax sparing - except where operations are carried on within Malaysia. Tax sparing concessions relating to income from highly mobile assets such as ships and aircraft is susceptible to exploitation and so has been specifically excluded.
2.30 New subparagraph 5(c) is designed to prevent abuse of tax sparing, under schemes where Malaysia-based intermediaries are used as conduits for flows of income, profits or gains, or where property is located in Malaysia. If the scheme is entered into to avoid Australian tax through the exploitation of the Australian foreign tax credit provisions (which includes tax sparing under the Agreement) or to confer a benefit on a resident of a third country, then under this subparagraph, Malaysian tax forgone is not deemed to be paid and thus tax sparing is not available.
2.31 The reference in this provision to a scheme having the purpose of using Malaysia as a location of property would not apply to genuine loans nor to the provision of assets effectively connected with the carrying on of a business.
2.32 New paragraph 6 provides that for the purposes of the tax sparing credit, Malaysian tax forgone as defined in new paragraph 4 and which is not of a type referred to in new paragraph 5 is to be treated as Malaysian tax paid.
2.33 The operation of the tax sparing provisions in the Agreement expired on 30 June 1992. The Second Protocol will extend the operation of tax sparing in the Agreement until 30 June 2003, at which time they will expire permanently. [New paragraph 7]
2.34 The Second Protocol will insert a new provision for the purposes of the General Agreement on Trade in Services, in accordance with current Australian treaty practice, to deal with disputes which may be brought before the Council for Trade in Services.
2.35 Paragraph 3 of Article XXII of the World Trade Organisation General Agreement on Trade in Services provides that a disputed measure that falls within the scope of an 'international agreement relating to the avoidance of double taxation' may not be resolved under the dispute resolution mechanisms provided by Articles XXII and XXIII of the General Agreement on Trade in Services.
2.36 If there is a dispute as to whether a measure actually falls within the scope of a tax agreement, however, either country may take the matter to the World Trade Organisation's Council on Trade in Services for referral to binding arbitration.
2.37 New paragraph 5 of the Agreement will require the consent of both Australia and Malaysia before a dispute as to whether a measure falls within the scope of the DTA may be brought before the Council on Trade in Services. This is seen as the most effective way of dealing with such disputes, and avoids difficult questions as to when a disputed issue falls within the dispute resolution mechanism of the Agreement or of the General Agreement on Trade in Services.
2.38 This provision is based, in all essential respects, on an OECD Model Commentary recommendation, and is common in recent international treaty practice.
2.39 The Second Protocol will insert two new paragraphs in Article 27 that will operate to deny the benefits of the Agreement in certain circumstances identified in an Exchange of Letters between Australia and Malaysia.
2.40 When the Second Protocol was signed on 28 July 2002, an associated Exchange of Letters were also signed on the same day. The Second Protocol and the Exchange of Letters will exclude from receiving DTA benefits, persons who benefit from the preferential tax treatment under the Labuan offshore business activity regime (specifically, activity under the Labuan Offshore Business Activity Tax Act 1990 , as amended) and other substantially similar regimes. [New paragraphs 2 and 3 and Exchange of Letters]
2.41 This Article provides for the entry into force of the Second Protocol. The Second Protocol will enter into force when the notifications between the two countries that the procedures necessary to give it the force of law in the respective countries have been completed.
2.42 Once it enters into force, the Second Protocol will form an integral part of the Agreement. In Australia, enactment of the legislation giving the force of law in Australia to the Second Protocol along with tabling the Second Protocol are prerequisites to the exchange of diplomatic notes.
2.43 Legislation is not required for the Exchange of Letters. In accordance with section 4A of the Agreements Act, the Exchange of Letters, once they enter into force (at the same time as entry into force of the Second Protocol) will be published in the Gazette.
2.44 Under subparagraph (a)(i) of this Article, the Second Protocol will, on entry into force, have effect for the purposes of the tax sparing provisions of Article 5 of the Second Protocol, in respect of tax on income of any year of income beginning on or after 1 July 1992 in Australia and in respect of Malaysian tax for any year of assessment beginning on or after 1 January 1993.
2.45 Australian taxpayers who have received the benefit of the relevant Malaysian tax sparing concessions during the years referred to in the above paragraph, may request a foreign tax credit determination or amended determination from the Commissioner of Taxation once the Second Protocol enters into force, to claim the relevant Malaysian tax forgone as a foreign tax credit.
2.46 Subparagraphs (a)(i) and (b)(i) of this Article will also operate so that the Second Protocol will have effect, on its entry into force, for the purposes of underlying tax credit relief in respect of tax on income of the 1992-1993 and subsequent years of income in the case of Australia and in respect of tax for any year of assessment beginning on or after 1 January 1993 in the case of Malaysia.
2.47 In the case of Australia, the domestic underlying tax credit provision would be applicable in any event.
2.48 In respect of other income, the Second Protocol will have effect in Australia in relation to income of any year of income beginning on or after 1 July in the calendar year next following that in which the Second Protocol enters into force. It will have effect in respect of Malaysian tax for any year of assessment beginning on or after 1 January in the calendar year next following the calendar year in which the Second Protocol enters into force.