Edited version of private ruling

Authorisation Number: 1011516434671

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Ruling

Subject: Permanent establishment

Question 1

Is the income derived by the Company from the sale of the product under Option 1 in the arrangement described in the application assessable income in Australia in terms of section 6-5 of the Income Tax Assessment Act 1997?

Answer

Yes.

Question 2

Is the income derived by the Company from the sale of the product under Option 2 in the arrangement described in the application assessable income in Australia in terms of section 6-5 of the Income Tax Assessment Act 1997?

Answer

No.

This ruling applies for the following period:

2009 - 2010 income year

The scheme commenced on

8 March 2010

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling

The Company is a registered Country X company.

The Company exports to various countries including Australia. The exports comprise materials ('Goods'). The Goods can be cut into smaller sizes for customers. The Goods will be cut and sold to customers at different prices.

The Company proposes to export to Australia and sell the Goods to Australian customers.

With respect to the cutting of the Goods the Company is considering two options as follows:

export the Goods to Australia to be stored with the Warehouse Company and have the Warehouse Company cut the Goods as requested by the Company's customers ('Option 1'); or

cut the Goods and export the cut Goods to Australia and have the cut Goods stored with the Warehouse Company ('Option 2').

Product

The products to be imported into Australia will fall into two categories.

The Contractor

The Company has entered into a contract with the Contractor to seek orders for the Goods. The Contractor may perform services for third parties which are similar or identical to the services that are provided to the Company.

A copy of an extract from the contract with the Contractor has been provided.

The extract states that the Contractor does not have authority to bind the Company or enter into contracts on behalf of the Company. Further the Contractor must not hold itself out to third parties as having authority to bind the Company, enter into contracts on behalf of the Company or conclude the Company's sales.

The Contractor will be paid an hourly rate plus additional annual payments based on Gross Profit and Net Profit, as defined.

The Contractor will send purchase orders to the Company which will consider them and, if accepted, will send the customer a purchase order confirmation. The Company will send invoices directly to the customer. All sales and contracts will be concluded by the Company.

The Contractor is responsible for obtaining premises and equipment appropriate to perform the contracted services. The Company will not be responsible for the payment of rent for any such premises.

The Contractor is a sole trader, who trades as a private contractor offering consulting services.

The Contractor currently only has one principal, that is, the Company.

The Contractor is not related in any way to the Company.

The Contractor's role in obtaining a sales order is to communicate price information and discuss products and service options with customers. The price is determined by the Company and ultimate decisions on pricing and acceptance of the order are made by the Company.

With respect to the technical back-up which the Contractor is required to provide to customers under the contract this back-up includes advice on product types for specific applications and factors to consider when running these products. Where more specific information is needed, the Contractor refers it to the Company and its technical team. The Contractor's technical knowledge comes predominantly from experience in the industry. The Company has not provided the Contractor with any formal training.

Warehouse Company

When imported into Australia the Company intends the Goods be stored with an Australian company ('Warehouse Company') which is able to warehouse and, if required, cut the Goods. The Warehouse Company will not own the Goods.

With respect to the Warehouse Company under Option 1 you state the product on the Large Reel will not be cut by hand, it will be cut by machine.

Under Option 1 a warehouse company with the capability to cut the product would be used and the following would apply:

(a) the warehouse company would own the cutting machine; and

(b) the machine would weigh up to 4,000 kg and would occupy up to 15 square metres.

Under Option 2 the product will be cut before being exported to Australia. Accordingly, the warehouse company in Australia with which the product will be stored will not need to have the capability to cut the product.

When the product is cut it will not be modified in any way by the Company. Further, you state specifically that the customer's name or logo will not be printed on or affixed to the product by the Company.

In relation to the role of the Warehouse Company:

(a) The Company is looking for a company that is purely a provider of the cutting service only on a toll basis.

(b) The Company has not yet selected a particular supplier.

(c) None of the potential cutting companies is related in any way to the Company.

(d) The potential cutting companies are predominantly entities providing a cutting service, which will also store the cut and uncut products of the Company.

(e) No contract has been entered into with a cutting service provider.

Relevant legislative provisions

Income Tax Assessment Act 1997- Section 6-5 and

International Tax Agreements Act 1953 - Section 4 of the

Reasons for decision

Question 1

Detailed reasoning

This question relates to Option 1 as described in the application and in the further correspondence. Under that arrangement the Company purchases material which will be imported into Australia. The Goods will be stored with the provider of a cutting service that is able to cut the material. The material will be cut by the cutting service provider as directed by the Company. The Company will sell the cut material to customers in Australia.

Income derived from the business activity constituted by the sale of goods to customers in Australia is ordinary income which will only be taxable in Australia if the activity is carried on in Australia through a permanent establishment.

If a permanent establishment exists the business profits will be deemed to have an Australian source in the hands of the non-resident by operation of the source of income article of the Country X double tax agreement in the schedule to the International Tax Agreements Act 1953 (Agreements Act).

Section 4 of the Agreements Act incorporates that Act with the Income Tax Assessment Act 1997 (ITAA 1997) so that both Acts are read as one.

A relevant provision of the ITAA 1997 is subsections 6-5(3).

Detailed reasoning

The Company is a resident of Country X and consequently the Country X double tax agreement applies.

The business profits article of the Country X double tax agreement provides that the profits shall only be taxable in Australia if the Company carries on business in Australia through a permanent establishment as defined in terms of the business profits article.

Therefore it is necessary to examine the provisions of the permanent establishment article in detail.

Permanent establishment article

The permanent establishment article of the Country X double tax agreement contains a general definition of a 'permanent establishment' to mean a fixed place of business of an enterprise through which the business of an enterprise is wholly or partly carried on.

The material which is shipped to Australia is not in a state that can be used by a customer when it arrives in Australia. The material is required to be cut to specific dimensions in order to meet the customers' needs. Specialist machinery is needed to cut the material.

The term 'processes' as used in the permanent establishment is not defined in the legislation and thus it is necessary to look elsewhere for a definition of this term.

The Macquarie Dictionary, Fifth Edition gives several definitions of the noun 'process' including the following:

1. a systematic series of actions directed to some end: the process of making butter.

2. a continuous action, operation, or series of changes taking place in a definite manner: the process of decay.

The verb 'process' is defined as follows:

11, to treat or prepare by some particular process, as in manufacturing.

Given these definitions it is clear that the progression of the material from the state it is in when it arrives in Australia to the state that it is in when supplied to a customer involves a process. The cutting of the material into the dimensions required by the customer is one part of that process.

The entity in Australia which performs the cutting service is processing the material on behalf of the Company.

Therefore the Company shall be deemed to have a permanent establishment in Australia and to carry on business through that permanent establishment under the permanent establishment article of the Country X double tax agreement.

Turning to consideration of the role of the Contractor as an agent of the Company in terms of the permanent establishment article of the Country X double tax agreement.

In order for the permanent establishment article to apply to deem an enterprise to have a permanent establishment it is necessary that the agent, other than an independent agent, in acting on behalf of the enterprise habitually exercises an authority to conclude contracts on behalf of the enterprise.

The Contractor is an agent of the Company and amongst other things it is necessary to determine whether the Contractor is a dependent agent or an independent agent.

It is a characteristic of an independent business that the operator of the business bears the risks and reaps the rewards from carrying on that business. However, an examination of the terms of the contract reveals that is not the case for the Contractor. In the statement regarding the payment of an additional sum upon achieving certain profit targets it is stated that the measure of this performance is to have regard to the invoiced sales and the 'costs invoiced by the Contractor (hourly rate, plus expenses)'.

The recovery by the Contractor of expenses from the Company is the direct opposite of the way in which an independent business would be expected to operate in these circumstances and therefore the claim that the Contractor is an independent agent cannot be accepted. Where expenses are recovered from the Company this would indicate that they are expenses incurred by the Contractor on behalf of the Company and not expenses incurred by the Contractor in the course of conducting a distinctly separate business.

This is not the sole feature of the relationship between the Contractor and the Company which suggests the absence of the requisite independence of the agent. Other reasons for this view are set out below in this report.

Further in considering the status of the Contractor as an agent of the Company reference has been made to the OECD Commentary on the permanent establishment article of the July 2008 OECD Model Tax Convention on Income and on Capital.

In that commentary under the heading 'Paragraph 6' there is a discussion of the indicators and attributes of an agent of independent status. The commentary states:

37. A person will come within the scope of paragraph 6, i.e. he will not constitute a permanent establishment of the enterprise on whose behalf he acts only if:

he is independent of the enterprise both legally and economically, and

he acts in the ordinary course of his business when acting on behalf of the enterprise.

38. Whether a person is independent of the enterprise represented depends on the extent of the obligations which this person has vis-à-vis the enterprise. Where the person's commercial activities for the enterprise are subject to detailed instructions or to comprehensive control by it, such person cannot be regarded as independent of the enterprise. Another important criterion will be whether the entrepreneurial risk has to be borne by the person or by the enterprise the person represents.

Later it is stated:

38.6 Another factor to be considered in determining independent status is the number of principals represented by the agent. Independent status is less likely if the activities of the agent are performed wholly or almost wholly on behalf of only one enterprise over the lifetime of the business or a long period of time. However, this fact is not by itself determinative. All the facts and circumstances must be taken into account to determine whether the agent's activities constitute an autonomous business conducted by him in which he bears risk and receives rewards through the use of his entrepreneurial skills and knowledge. Where an agent acts for a number of principals in the ordinary course of his business and none of these is predominant in terms of the business carried on by the agent legal dependence may exist if the principals act in concert to control the acts of the agent in the course of his business on their behalf.

Having regard to the recovery of expenses from the Company it is concluded that the entrepreneurial risk is not borne by the Contractor but by the Company which the Contractor represents. Further having failed this important criterion it is concluded that the Contractor is not economically independent of the Company.

Consideration has also been given to the terms of the contract between the Company and the Contractor. Our examination of that contract leads to the conclusion that the Contractor is not carrying on an independent business in the Contractor's own right. The contractual requirements that the Contractor 'Define, agree and deliver a plan to target customers' is not compatible with an independent operator of a business who in the words of the OECD Commentary 'bears risk and receives rewards through the use of his entrepreneurial skills and knowledge.'

Whilst the development of a plan could be part of the activities that an independent contractor would carry out for their own purposes, the contractual obligation to do so and to present that plan to the principal in order to reach agreement upon it is at odds with the concept of an independent contractor. The principal is dictating the way in which the Contractor is to carry on the Contractor's business. These contractual conditions do not permit the requisite unfettered exercise of skill and knowledge in the conduct of the business by the Contractor.

Further the Company is the sole principal for which the Contractor acts. The OECD Commentary suggests that independent status is less likely when this occurs but requires that all the circumstances must be taken into account to determine whether the agent's activities constitute an autonomous business conducted by the agent.

When the recovery of expenses from the Company, the dictating by the Company of the way in which the Contractor perform its activities, and the role of the Company as the sole principal are considered collectively they lead to the conclusion that the Contractor is not an independent agent, the Contractor is a dependent agent.

In order for the Company to be deemed to have a permanent establishment in Australia in terms of the permanent establishment a of the Country X double tax agreement it is necessary that the Contractor not only act on behalf of the company but that the Contractor habitually exercises an authority to conclude contracts on behalf of the Company.

However, the description of the way in which the contracts are made with customers states that the Contractor's function is to communicate price information and discuss products and service options with customers. Purchase orders will be sent to the Company for consideration and acceptance. The price is determined by the Company and ultimate decisions on pricing and acceptance of the order are made by the Company. All sales and contracts will be concluded by the Company which will send the customer a purchase order confirmation.

The contract between the Company and the Contractor states that the Contractor does not have authority to bind the Company or to enter into contracts on behalf of the Company.

Accordingly, because the necessary condition that the agent habitually exercise an authority to conclude contracts on behalf of the Company is not met, and in view of the way in which contracts are made with the customers the permanent establishment article of the Country X double tax agreement does not apply to deem the Company to have a permanent establishment in Australia.

Source of income article

As previously concluded the Company has a permanent establishment in Australia within the terms of the permanent establishment article of the Country X double tax agreement. Consequently Australia has a right to tax the business profits of the Company which is carrying on business in Australia because that business is carried on through a permanent establishment in Australia. This is in terms of the business profits article of the Country X double tax agreement.

The source of income article of the Country X double tax agreement provides that where income may be taxed in Australia under the business profits article that income shall for the purposes of the laws of Australia relating to its tax be deemed to arise from sources in Australia.

Under the arrangement described as Option 1 in the application the Company is carrying on business in Australia when it sells material to customers in Australia. The permanent establishment article of the Country X double tax agreement deems the Company to have a permanent establishment in Australia and to carry on business through that permanent establishment. The business profits of the permanent establishment are taxable in Australia in terms of the business profits article of the Country X double tax agreement. The income that is taxable under the business profits article is deemed to have a source in Australia by the source of income article of the Country X double tax agreement. Australian source income of the Company is assessable income in terms of section 6-5(3) of the ITAA 1997.

Question 2

Detailed reasoning

This question relates to Option 2 as described in the application and in the further correspondence. Under that arrangement the Company purchases material. The material will be cut and the cut material imported into Australia. The cut material will be stored in a warehouse in Australia. The Company will sell the cut material to customers in Australia.

Income derived from the business activity constituted by the sale of goods to customers in Australia is ordinary income which will only be taxable in Australia if the activity is carried on in Australia through a permanent establishment.

If a permanent establishment exists the business profits will be deemed to have an Australian source in the hands of the non-resident by operation of the source of income article of the Country X double tax agreement in the schedule to the International Tax Agreements Act 1953 (Agreements Act).

Section 4 of the Agreements Act incorporates that Act with the Income Tax Assessment Act 1997 (ITAA 1997) so that both Acts are read as one.

A relevant provision of the ITAA 1997 is subsections 6-5(3).

Detailed reasoning

The Company is a resident of Country X and consequently the Country X double tax agreement applies.

The business profits article of the Country X double tax agreement provides that the profits shall only be taxable in Australia if the Company carries on business in Australia through a permanent establishment as defined in terms of the permanent establishment article.

Therefore it is necessary to examine the provisions of the permanent establishment article in detail.

Permanent establishment article

The permanent establishment article of the Country X double tax agreement contains a general definition of a 'permanent establishment' to mean a fixed place of business of an enterprise through which the business of an enterprise is wholly or partly carried on.

An enterprise shall not be deemed to have a permanent establishment merely by reason of the conditions specified in the article. Those conditions include the use of facilities solely for the purpose of storage, display or delivery of goods or merchandise belonging to the enterprise and the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage display or delivery.

Both of those conditions are met and those articles apply to the Company. That is to say it is not deemed to have a permanent establishment by virtue of those actions.

Turning to consideration of the role of the Contractor as an agent of the Company in terms of the permanent establishment article of the Country X double tax agreement.

The reasoning set out above with respect to the permanent establishment article applies equally here. It will not be repeated except for stating the conclusion reached in respect of the agent namely that the Contractor is a dependent agent. However although the Contractor is a dependent agent the Contractor does not habitually excise an authority to conclude contracts on behalf of the Company because the Contractor does not have that authority.

Accordingly, because the necessary condition that the agent habitually exercises an authority to conclude contracts on behalf of the Company is not met, and in view of the way in which contracts are made with the customers the permanent establishment article of the Country X double tax agreement does not apply to deem the Company to have a permanent establishment in Australia.

Conclusion

Under the arrangement described as Option 2 in the application the Company is carrying on business in Australia when it sells material to customers in Australia. However, the Company does not have a permanent establishment in Australia in terms of the permanent establishment article of the Country X double tax agreement. Accordingly, the business profits from the sales in Australia are not taxable in Australia.

The income is not assessable income in terms of section 6-5 of the ITAA 1997.