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Ruling

Subject: Satellite customer income

Question

Is the customer income received by A Controlled Foreign Company (CFC), in respect of owning and operating a satellite, a 'royalty' pursuant to subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No.

This ruling applies for the following periods:

year ending 30 June 2014

year ending 30 June 2015

year ending 30 June 2016

year ending 30 June 2017

year ending 30 June 2018

The scheme commences on:

1 July 2013

Relevant facts and circumstances

The Taxpayer is a company incorporated in Australia and is a resident of Australia for tax purposes.

The Taxpayer is an attributable taxpayer in relation to CFC as defined in Part X of the ITAA 1936. The Taxpayer has an attribution percentage of 100% in relation to CFC.

CFC is not an Australian resident entity for Australian income tax purposes. CFC is a resident of Country X for Country X income tax purposes.

CFC will have its effective management and control and also its management and control in Country X at all times.

CFC will not carry on business through permanent establishments anywhere outside of Country X (including Australia).

CFC will contract directly with unrelated third-party customers, which will include both non-resident entities and Australian entities.

CFC will directly receive transmission services revenue from customers and will incur all relevant interest and other operating expenses. It is expected that CFC will provide a significant volume of satellite transmission services to unrelated customers.

CFC will fail the active income test under section 432 of the ITAA 1936.

CFC will typically contract with customers to provide communication transmission services (the transmission services) in accordance with the terms set out in their customer contracts (customer contracts).

The standard customer contract provides each party with a variety of rights and obligations, including the following:

· CFC will provide the customer with a specified amount of bandwidth capacity on the satellite.

· While the customer will be allocated capacity from a specified 'beam' or 'transponder' (depending on their required transmission locations), CFC retains the right to supply the contracted amount of bandwidth capacity from another transponder that meets the relevant technical specification requirements or allows them to access the relevant radiofrequency. That is, they retain the right to assign or reassign customers to different transponders in order to provide or restore their service.

· CFC maintains the right to supply customers with bandwidth capacity on other satellites without the customer's consent. Additionally, CFC reserves the right to subcontract out and assign its service provision obligations to external third parties.

· CFC is required to provide customers with an 'Outage Credit' should CFC fail to provide the transmission services under the contracts. If CFC fails to provide the services (i.e. the service suffers a confirmed failure which CFC does not rectify within 60 days) stipulated by the contract, the customer maintains the right to terminate the contract.

· The services agreement provides that nothing in the services agreement grants the Customer any proprietary rights or title to any intellectual property rights subsisting in any of the agreements.

· The services agreement also provides that the Customer shall not assert any right, interest or lien in any Terrestrial Facilities, property or assets of CFC, including any of its Network Facilities and related equipment that CFC may own.

Broadly, bandwidth is a reference to the capacity of the radiofrequency bands or waves upon which satellite communication signals (i.e. data/sounds/visual images) are transmitted and relayed to their required locations (i.e. it carries the signals from earth to the satellite and then from the satellite down to earth to be picked up by customers on the ground). Satellite transponders can only access a limited amount of bandwidth.

A reference to a particular amount of bandwidth in the customer contracts is a reference to a specific amount of the throughput of the particular radiofrequency CFC will have access to in providing a customer with their specific service requirements. The terrestrial geographic area over which the signal needs to be received will determine which of the transponders CFC will use to provide the transmission service (i.e. each transponder has a different geographical coverage area).

In order for transmission services to be provided by CFC, it is expected that the following operations will be carried out by CFC pursuant to the customer contracts:

· The customer's communication signals will be received for transmission on the ground by a telecommunications port (teleport) or a portable or fixed dish or antenna used by either CFC or the customer. These signals will be received from the customer's localised, earth-based telecommunications network via a digital transmitter. A teleport is essentially an earth-based station which functions as a transmitting bridge between an orbiting satellite and localised telecommunications networks.

· The teleport will then transmit or beam the customer's communication signals into space on the relevant bandwidth frequency where they will be received by a satellite antenna. This signal is then passed from the antenna to a receiver which will route it to a transponder located on the satellite. A satellite transponder is, broadly, the series of interconnected units which form the communications channel between the receiving and transmitting antennae.

· The satellite transponder will then take the signals as received by the antenna from the teleport via the receiver and amplify them (ensuring that there is no distortion between the signals received by the receiving antenna and those sent back down via the transponder and transmitting antenna) ready for transmission back to earth.

· The signals will then be redirected by the transponder to the satellite's transmitting antenna and relayed ("transmitted") back down to earth over the satellite's "footprint". A satellite's footprint is a reference to the operational area of the satellite - i.e. the area of the earth over which the satellite can receive and relay signals.

· Here, the signals can then be received by another teleport and picked up by the digital receivers of CFC's customers (or end consumers), or be picked up directly by customer's portable or fixed dishes or antennas (without the need of a teleport).

· The digital receiver then decodes the signal allowing the customer to receive it in its original form (i.e. data/sounds/visual images).

Following this (or reversing the process), signals will be able to be transmitted from the digital receiver of the customer back up to the satellite via an available teleport or portable dish or antenna, then retransmitted back down to earth and relayed over the satellite's footprint to be picked up by another customer (the recipient) under the same process as set out above (i.e. signal transmission is generally a two-way process). This can broadly be summarised as the use of the satellite's radiofrequency spectrum. The spectrum is the medium on which the customers can transfer their own data content.

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 6(1),

Income Tax Assessment Act 1936 Section 317,

Income Tax Assessment Act 1936 Section 320,

Income Tax Assessment Act 1936 Section 382,

Income Tax Assessment Act 1936 Subparagraph 385(2)(a)(i),

Income Tax Assessment Act 1936 Subsection 386(1),

Income Tax Assessment Act 1936 Section 456 and

Income Tax Assessment Act 1936 Paragraph 446(1)(g).

Reasons for decision

All legislative references are to the ITAA 1936 unless otherwise indicated.

Section 456 broadly provides that where a CFC has attributable income in respect of an attributable taxpayer, the taxpayer's attribution percentage of the attributable income is included in the assessable income of the taxpayer.

The Taxpayer is the attributable taxpayer in respect of CFC with an attribution percentage of 100%. Therefore, it is necessary to consider whether the customer income received by CFC is attributable income that is included in the Taxpayer's assessable income.

The attributable income of a CFC includes its notional assessable income (section 382). Where a CFC is a resident of an unlisted country and fails the active income test, its notional assessable income includes its 'adjusted tainted income' (paragraph 384(2)(a)).

CFC is a resident of Country X, which is an unlisted country (section 320; and Regulation 152C and Part 1 of Schedule 10 to the Income Tax Regulations). As CFC fails the active income test, its notional assessable income must include amounts that are adjusted tainted income.

Adjusted tainted income is defined in subsection 386(1) to include, inter alia, passive income. Passive income includes 'tainted royalty income' (paragraph 446(1)(g)). In turn, 'tainted royalty income' is defined in section 317 as 'royalties' derived by the company, except particular royalties listed within the definition in section 317.

A 'royalty' or 'royalties' is defined in subsection 6(1). Therefore, for present purposes, it is necessary to consider whether the customer income received by CFC, in respect of owning and operating the satellite, is a 'royalty' pursuant to subsection 6(1).

Definition of a 'royalty' in subsection 6(1)

Subsection 6(1) lists certain types of payments that are to be treated as royalties for the purposes of the ITAA 1936. The list is inclusive and the Commissioner's view, as expressed in Taxation Ruling IT 2660 Income tax: definition of royalties, is that payments that are 'royalties' within the ordinary meaning of that term come within its scope. The Commissioners approach to the definition of royalties in subsection 6(1) at paragraph 8 in IT 2660 is to:

(i) consider the ordinary meaning of the term "royalty";

(ii) look at how the definition in subsection 6(1) extends the ordinary meaning; and

(iii) focus on the differences between royalty payments and payments for services.

The ordinary meaning of a royalty

The ordinary meaning of a royalty has been considered by the courts on many occasions: see McCauley v Federal Commissioner of Taxation (1944) 69 CLR 235; and Stanton v FC of T (1955) 92 CLR 630; 11 ATD 1. There are several characteristics of a royalty as defined within the common law. The Commissioner's view as expressed in ATO Interpretative Decision ATO ID 2006/307 Whether payments for use of broadcasting and apparatus licences fall within the domestic law definition of a royalty is that, essentially, 'a royalty under the common law meaning of the term covers payments for the use of intellectual property or natural resources from the land, provided the quantum of the payment corresponds with the quantum of the use of the relevant intellectual property or property resource'.

In ATO ID 2006/307, it was concluded that an amount of payment for the exclusive use of a broadcasting licence was not a royalty because the payment was not calculated in respect of any quantity or value taken from the exercise of the right. Furthermore, the bands of radiofrequency spectrum, was a natural phenomenon that is not created, like an item of intellectual property.

Similarly, under the services agreement and the service order to be incorporated into each customer contract, CFC will provide each customer with a specified amount of bandwidth capacity on the satellite. The service fee (which is the customer income received by CFC) is not calculated in respect of any quantity or value taken from the exercise of the use of the bandwidth capacity.

Furthermore, the bandwidth that will be provided by CFC is a measure of throughput of frequencies which make up the radiofrequency spectrum. Bandwidth capacity on the satellite is natural phenomenon that is not created, like an item of intellectual property. Nor is it the removal of natural resources.

Accordingly, consistent with the conclusions made in ATO ID 2006/307, the customer income to be received by CFC in respect of owning and operating the satellite is not a royalty as defined under the common law.

Extended meaning of royalty within subsection 6(1)

As discussed above, subsection 6(1) extends the ordinary meaning of a royalty by listing certain types of payments that are to be treated as royalties for the purposes of the ITAA 1936. The following discussion will address those payments listed under the subsection 6(1) definition that the Commissioner considers relevant to the facts of the private ruling.

Paragraphs (b) and (d): 'the use of, or right to use, any industrial, commercial or scientific equipment' and the supply of ancillary assistance as a means of enabling enjoyment of that equipment

Paragraph (b) of the definition of royalty under subsection 6(1) includes payments for 'the use of, or right to use, any industrial, commercial or scientific equipment'. The Commissioner's view at paragraph 18 in IT 2660 is that 'industrial, commercial or scientific equipment' has a wide meaning and includes such things as machinery and apparatus. Accordingly, it is clear that the satellite and the transponders that will be owned and operated by CFC are 'industrial, commercial or scientific' equipment for the purpose of paragraph (b) of the definition of royalties in subsection 6(1).

Taxation Ruling TR 2003/2 Income tax: the royalty withholding tax implications of ship chartering arrangements at paragraphs 111 to 114 explains, the tax treaty meaning of the expression 'use of, or the right to use' should also be adopted when interpreting the domestic tax definition of 'royalty' in subsection 6(1) because the definition traces back to Australia's tax treaty with the United Kingdom.

Paragraph 83 of TR 2003/2 provides that it is appropriate to consider the Organisation of Economic Cooperation and Development commentary of the 1977 Model Double Tax Convention on Income and on Capital (1977 OECD Model Commentary) to ascertain the relevant meaning. The OECD Model removed reference to industrial, commercial or scientific equipment in Article 12 (the royalty article) in 1992, but it continues to be used in many of Australia's tax treaties in accordance with the 1977 version of the OECD Model.

The meaning of 'the use of, or right to use' as ascertained from the 1977 OECD Model Commentary is outlined in TR 2003/2, concluding that it refers to a lease or akin to a lease of equipment, as opposed to the provision of services. Referring to the OECD Committee of Fiscal Affairs Report on Treaty Characterisation Issues Arising from E-Commerce, TR 2003/2 outlines the following factors that distinguish a lease of equipment or property from service contracts:

(a) the customer is in physical possession of the property;

(b) the customer controls the property; and

(c) the provider does not use the property concurrently to provide significant services to entities unrelated to the service recipient.

On facts of this private ruling, CFC will at all times be the owner and operator of the satellite. CFC will retain possession of the satellite, with customers only retaining the entitlement to receive satellite transmission services from CFC in the form of the bandwidth capacity. Customers are provided with access to the satellite's radiofrequency spectrum which is not equipment, but the medium on which they can transfer their content. The customers do not use the equipment (being the satellite) but access its output.

Furthermore, this access to the radiofrequency spectrum is completely controlled by CFC. Without CFC's operational management services and operation of the satellite, customers would be unable to access the satellite's spectrum.

Under the customer contracts, CFC is also not contractually obliged to provide the services using the satellite or its transponders, but is entitled at its absolute discretion and without the customer's approval to provide the services using any other satellite or transponders.

Additionally, CFC, again at their discretion and without the customer's approval, may subcontract or assign their service provision obligations to external third parties.

In light of this, the Commissioner accepts that paragraph (b) within the subsection 6(1) definition of royalty does not apply to the customer income to be received by CFC from the ownership and operation of the satellite in providing satellite transmission services. Whilst the customer contracts provide for a 'Transponder Capacity Lease', the services agreement provides that nothing in the services agreement or the service order grants the Customer any proprietary rights or title to any intellectual property rights subsisting in any of the agreements.

Furthermore, services agreement also provides that the Customer shall not assert any right, interest or lien in any Terrestrial Facilities, property or assets of CFC including any of its Network Facilities and related equipment that CFC may own.

Accordingly, paragraph (b) of the definition of a royalty under subsection 6(1) does not apply to the customer income to be received by CFC in relation to the ownership and operation of the satellite.

Paragraph (d) applies to an amount for 'the supply of any assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application or enjoyment of' any such equipment to which paragraph (b) applies. As such, paragraph (d) of the definition of royalty under subsection 6(1) will also not apply.

The technical support provided by CFC is in relation to the specific bandwidth capacity that has been provided to the customer under the terms of the contract. As concluded above, paragraph (b) of the section 6(1) definition of royalties does not apply to the fees that will be received for the provision of bandwidth. Therefore, paragraph (d) cannot apply to the associated technical support services that CFC will provide.

Paragraphs (da) and (db): the reception of, or the right to receive, visual images and/or sounds transmitted to the public by satellite and television and radio broadcasting through by satellite

Paragraphs (da) and (db) of the definition of royalty under subsection 6(1) includes income in respect of:

'(da) the reception of, or the right to receive, visual images or sounds, or both, transmitted to the public by:

(i) satellite; …

(db) the use in connection with television broadcasting or radio broadcasting, or the right to use in connection with television broadcasting or radio broadcasting, visual images or sounds, or both, transmitted by:

(i) satellite; …'

Paragraphs (da) and (db) were inserted into the definition of a royalty in subsection 6(1) in 1992 with the introduction of final withholding tax for royalties paid, inter alia, to non-residents. At the time, only 'film and video royalties' were taxed on a withholding basis. According to Explanatory Memorandum (EM) to the Tax Laws Amendment Bill (No. 5) 1992, the introduction of paragraphs (da) and (db) into the subsection 6(1) definition was to:

' … make it clear that it includes television transmission and radio broadcast, and other transmission to the general public - whether edited or delayed - by means of satellite and cable. That technology has replaced, to a significant extent, film and video tapes. The payments are normally made to a person who has exclusive rights in relation to the matter which is the subject of the transmission or broadcast'.

This indicates that it was not intended that payments made by providers of the communication transmission services were to be captured by paragraphs (da) and (db). Instead the payments made by those providing the broadcasting service (i.e. pay television providers who use the content in connection with their television broadcasting services) to those who own the copyright in the content being transmitted, regardless of the means by which the content is transmitted to the public, are the object of this provision. In this respect, CFC will merely be the transmitter (i.e. carrier) of its customers' content and will have no beneficial ownership of the content.

This is consistent with the conclusions in ATO ID 2006/307 that payments received for the exclusive use of a broadcasting licence were also not royalties under the definition in paragraph (db) of the subsection 6(1) definition, paragraph (db) relates to payment for the 'use' of sounds or images transmitted, '[t]he payment must therefore be for the use of sound content, such as a song or radio program, used in radio broadcasting in order to be a royalty under this aspect of the definition'.

Similarly, paragraph (da) relates to the payment for the 'reception' of visual images and/or sounds that are transmitted by satellite or cable. As indicated in the EM quoted above, paragraph (da) of the subsection 6(1) definition applies where the payment relates to the exclusive rights over the images or sounds that are transmitted, and not over the transmission itself.

Accordingly, the payments that will be made to CFC are not royalties as defined in paragraphs (da) or (db) of the definition of royalty in subsection 6(1) as the payments relate to only to receiving bandwidth capacity and associated support services.

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