Explanatory Memorandum(Circulated by authority of the Treasurer, the Hon Josh Frydenberg MP)
Chapter 2 - Australia's deemed source rule
Outline of chapter
2.1 This Bill introduces a domestic source of income rule to ensure that Australia can exercise its taxing rights under the Convention and future international tax agreements.
2.2 All legislative references in this Chapter are to the ITAA 1997 unless otherwise stated.
Context of amendments
2.3 It has been Australia's preferred practice to negotiate the inclusion of a source of income ('source') rule in its tax treaties - see for example Article 22 of the New Zealand Convention ( ATS 10), Article 22 of the Canadian Convention ( ATS 14) and Article 22 of the Chilean Convention ( ATS 7).
2.4 These source rules overcome a decision of the High Court in 1965 (Federal Commissioner of Taxation v Mitchum), where the Court held that Australia could not tax certain income even when the treaty allocated the taxing right to Australia, because the income was not 'sourced' in Australia.
2.5 In general terms, Australia's treaty based source rules address this issue by providing that income, profits or gains that are permitted to be taxed by Australia under the relevant treaty are taken to be sourced in Australia for the purposes of Australia's domestic tax rules. The treaty based source rules are given the force of law by section 5 of the Agreements Act, and apply for the purposes of the Assessment Acts. The treaty rules prevail in the event of any inconsistency with a provision of the Assessment Acts, other than the general anti-avoidance rule in Part IVA of the ITAA 1936 (see section 4 of the Agreements Act).
2.6 A specific source rule was not included in the Convention. Where a source rule is not included in the text of a particular tax treaty, Australia's consistent practice has been to instead legislate an equivalent source rule for the treaty in the Agreements Act - see for example section 11S of the Agreements Act, which applies in respect of the Chinese Convention. As with the treaty based source rules, these source rules also apply for the purposes of the Assessment Acts and prevail in the event of any inconsistency with a provision of those Acts, other than Part IVA of the ITAA 1936.
2.7 The treaty specific source rules enable Australia to exercise the taxing rights allocated to it under a treaty. These source rules can have the effect of assigning an Australian source to income that would otherwise not be treated as being sourced in Australia. As foreign residents are generally taxed on their Australian sourced income, the treaty specific source rules can trigger a tax liability for a foreign resident that would not otherwise exist.
2.8 The definition of Australian source is located in subsection 995-1(1). This definition was introduced when the ITAA 1997 was first enacted. The definition refers to amounts of ordinary or statutory income that are derived from sources in Australia for the purposes of the ITAA 1936.
Summary of new law
2.9 This Bill amends the ITAA 1997 to introduce a new deemed source of income rule that ensures Australia can exercise its taxing rights under the Convention and future international tax agreements. The Bill does not affect existing Conventions (all of which already have specified source rules either in the relevant Convention itself or the Agreements Act).
2.10 The new deemed source rule enables Australia to exercise the taxing rights allocated to it under the Convention and any future international agreements. The effect of the deemed source rule is consistent with the specific source rules that apply for each of Australia's existing tax treaties, and ensures there is a consistent approach for all future treaties.
2.11 This approach means that Australia will no longer need to secure agreement to include its specific source rule in the course of negotiating a tax treaty, or legislate a specific rule where such agreement cannot be secured. This is appropriate, as the characterisation of source (and other matters that go to establishing a tax liability) are ultimately a matter for the domestic laws of each Contracting State.
2.12 Consistent with this principle (that source is ultimately a domestic matter), the rule is located in a new Division of the ITAA 1997 (Division 764). Although the location of the provision is different to the other treaty specific source rules (which are in the Agreements Act), the deemed source rule is given the same priority as those treaty rules. This ensures a consistent approach to source in respect of Australia's tax treaties, irrespective of the treaty source rule that applies.
2.13 To facilitate including the deemed source rule in the new Division 764, the amendments also amend the existing definition of 'Australian source'. These changes clarify that the definition of Australian source in the ITAA 1997 includes, but is not limited to, the rules about Australian source in the ITAA 1936.
Comparison of key features of new law and current law
|New law||Current law|
|A general source rule ensures that income that Australia is permitted to tax under an international agreement is deemed to be sourced in Australia. This rule applies to the Convention and any future international agreements.||Treaty specific source rules have previously been either included in the relevant bilateral tax treaty, or implemented unilaterally through the Agreements Act.|
Detailed explanation of new law
Deemed source rule for international agreements
2.14 The amendments introduce a deemed source rule that applies in respect of the Convention and any future international agreements.
2.15 This rule provides that 'income, profits or gains' have an Australian source if:
- for the purposes of an international tax agreement, the income profits or gains are those of a person who is a resident of a foreign country or foreign territory; and
- the effect of the agreement is that the income, profits or gains may be taxed in Australia.
- [Schedule 2, item 1, subsection 764-5(1)]
2.16 This deemed source rule applies for the purposes of 'this Act'. The reference to 'this Act' includes provisions of the ITAA 1997, ITAA 1936 and certain provisions of the Taxation Administration Act 1953 (see the definition of 'this Act' in subsection 995-1(1)). [Schedule 2, item 1, subsection 764-5(1)]
2.17 The rule only applies to international tax agreements that were made on or after 28 March 2019, which is the day the Convention was signed. [Schedule 2, item 1, subsection 764-5(2)]
2.18 This ensures that the source rule will apply to the Convention and any new agreements entered into, but does not apply to any existing agreements. In the event that it is not appropriate for the deemed source rule to apply to a future agreement, the effect of the deemed source rule can be limited at the time that the legislation implementing the agreement is enacted.
2.19 The effect of this rule in determining when an amount is sourced in Australia is consistent with the existing source rules contained in Australia's tax treaties, and the treaty specific rules in the Agreements Act. To ensure this consistency, the deemed source rule is formulated in a way that closely aligns with those existing rules. However, the rule has been necessarily adapted to ensure that it can be applied to international agreements generally (in contrast to the specific rules that apply to a single treaty).
2.20 In broad terms, the deemed source rule treats income, profit, or gains as being sourced in Australia where Australia is allocated a right to tax the amount under an international tax agreement. The deeming rule only applies to income, profits or gains of a person who is treated as a resident of a foreign country or foreign territory for the purposes of the agreement.
2.21 The phrase 'income, profits or gains' draws directly from the concepts that are used in Australia's tax treaties (which are based on the OECD Model).
2.22 The reference to an 'international tax agreement' means an agreement that is given the force of law by the Agreements Act (as per section 5 of that Act). This term 'international tax agreement' extends to agreements that are not double tax treaties, the deemed source rule is also capable of applying to such agreements. However, for this to occur, the agreement must also allocate Australia taxing rights in respect of the income of a foreign resident.
2.23 The residency requirement ensures that the deemed source rule does not apply to persons who are an Australian resident for the purposes of the relevant agreement. This is appropriate because although Australian residents are generally taxed on their worldwide income, some provisions (including tax exemptions) are based on a resident having foreign sourced income. For example, section 23AG of the ITAA 1936 provides a tax exemption to Australian residents for certain foreign income derived from foreign services.
2.24 The reference to a person being a resident of a 'foreign country' is applicable to any international tax agreement that Australia has with another country. The term 'foreign country' takes on its meaning from section 2B of the Acts Interpretation Act 1901. The reference to a person being a resident of a 'foreign territory' is applicable to any international tax agreement that Australia has with a territory, rather than a country. Under Australia's existing agreement of this kind, a person's residence is defined in respect of such territories. The term 'foreign' is used to distinguish a territory that is a counter-party to an agreement from Australia's external territories.
2.25 The deemed source rule does not require the person who is actually taxed in Australia on the income, profits or gains to be the person who is a resident of a foreign country or foreign territory under an agreement (although in most cases they will be one and the same). For example, where an entity is treated as fiscally transparent by a treaty partner country but not by Australia, the deemed source rule could still apply to the income, profits or gains of the entity. For this to occur the agreement must permit Australia to tax the income, profits or gains in the hands of a resident of the treaty partner country (for example, in the hands of a partner of the corporate limited partnership).
2.26 In contrast to the existing treaty specific source rules, which refer to particular Articles in the relevant treaty, the deemed source rule refers to the treaty in its entirety. Despite this difference in approach, the actual scope of the deemed source rule is the same. This is because the Articles that are not specified in the specific treaty rules do not allocate taxing rights. As a result, the more general reference in the new deemed source rule does not have any operation in respect of these types of provisions. For example, Articles 1 to 5 in most of Australia's existing tax treaties cover the scope of the treaty and its various definitions. These rules do not allocate taxing rights between Australia and the other country. Because of this, there is no basis for triggering the deemed source rule in respect of these Articles. Adopting a more general reference to the treaty is preferable for a general rule of this kind because the Articles contained in individual international tax agreement, and their numbering, differs from agreement to agreement.
2.27 Consistent with the way that the existing treaty related source rules apply, this rule takes priority over any other rule that determines source in the ITAA 1997 or ITAA 1936, other than the general anti-avoidance rule in Part IVA of the ITAA 1936. [Schedule 2, item 1, subsection 764-5(3)]
2.28 In practice, the only source rules in the Assessment Acts that could be inconsistent with the deemed source rule are those that treat an amount as not being from an Australian source.
2.29 The existing treaty related source rules are given priority over the provisions of the Assessment Acts (other than Part IVA of the ITAA 1936) and any Act imposing tax because of subsection 4(2) of the Agreements Act. The rules are also given priority over any provisions of the Fringe Benefits Tax Assessment Act 1986 because of subsection 4AA(2) of the Agreements Act.
2.30 In contrast to the priority rules in the Agreements Act (which apply to that Act generally), the priority rules for the deemed source rule do not refer to the imposition acts or the Fringe Benefits Tax Assessment Act 1986. This does not result in a difference in scope because those Acts do not have any provisions that refer to an amount being Australian sourced (while an imposition Act may ultimately impose tax on an amount of income that is Australian sourced, the assessment of such tax is determined under the Assessment Acts).
2.31 The deemed source rule is, however, subject to the specific rule in subsection 3AA(2) of the Agreements Act. That provision disregards the specific treaty based source rules for the purposes of working out the source of certain income from funds management activities. Consistent with this approach, the deemed source rule only applies for the purposes of working out the source of income that is covered by that provision when the other treaty related rules also apply. [Schedule 2, item 4, paragraph 3AA(2)(d) of the Agreements Act]
Division 764 - Source rules & Australian source generally
2.32 The amendments create a new Division (Division 764) to facilitate the introduction of the new deemed source rule for international agreements. [Schedule 2, item 1, Division 764]
2.33 It is expected that, over time, any new provisions that have general application in respect of source would be included in this Division (including any existing provisions that are re-written as part of some other process).
2.34 As part of these amendments, some modifications are made to the existing definition of 'Australian source' in the ITAA 1997. These changes clarify that the definition of Australian source in the ITAA 1997 includes, but is not limited to, the rules about Australian source in the ITAA 1936. [Schedule 2, item 2, subsection 995-1(1) (definition of Australian source]
2.35 These changes are not intended to alter the meaning or scope of the existing definition of Australian source. Reframing the definition as an inclusive definition makes it clear that the ordinary meaning of 'Australian source' is directly relevant to the ITAA 1997, rather than relevant through the concepts in the ITAA 1936.
2.36 This approach is not intended to change the relevance of existing concepts and common law principles for determining source. This is consistent with the scope of the original definition. Although that definition referred to amounts being derived from an Australian source for the purposes of the ITAA 1936, the meaning of that concept in the context of the ITAA 1936 has always been determined having regard to established principles and jurisprudence about source.
2.37 Similarly, the changes do not disturb or disrupt any provision that includes an amount of income in assessable income on a basis other than source (such as paragraph 6-10(5)(b)).
2.38 In working out whether a particular amount is Australian sourced or not, regard must be had to any specific provision in the ITAA 1936 or ITAA 1997 that relate to source. Examples of specific statutory provisions that deem an amount to be sourced in Australia are subsections 6B(2A), 6C(1A), 6CA(2), 6CA(3) and 26E(1) of the ITAA 1936. The new deemed source rule for international agreements (explained above) is another example of a provision that has this effect.
2.39 Conversely, any provisions that provide that a particular amount is not sourced in Australia must also be taken into account. Examples of specific statutory provisions that have this effect are subsections 83A-25(2), 83A-110(2) and 276-820(7), items 8 and 9 in the table in subsection 230-310(4).
Technical correction to the Agreements Act
2.40 The amendments also correct an incorrect cross-reference in section 3AA to the specific source rule that applies in respect of the earlier agreement with Germany. [Schedule 2, item 3, paragraph 3AA(2)(c) of the Agreements Act]
2.41 A specific source rule was included in the Agreements Act in respect of the previous agreement with Germany. This rule was re-written to preserve its operation when the German Convention was renegotiated in 2015 and given force of law in 2016. However, the reference to this rule in section 3AA was not updated to reflect its new location. The amendments correct this cross-reference to ensure that it refers to the updated source rule.
2.42 While amendments described in this Chapter generally apply from the time that they commence, the deemed source rule applies in respect of any international tax agreements that are made on or after 28 March 2019. While this includes the Convention, as noted above, the Convention will only take effect after it enters into force.