Edited version of private ruling

Authorisation Number: 1011691749040

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Ruling

Subject: Foreign income tax offset

Question

Is an Australian resident company ('the Company') entitled to a foreign income tax offset under section 770-10 of the Income Tax Assessment Act 1997 (ITAA 1997) in the income year ended 31 December 2009 in respect of foreign income tax paid in the income year ended 31 December 2010 on income from their contract work carrying out in a foreign country.

Answers

No, the Company is not entitled to a foreign income tax offset in respect of foreign income tax paid on the income as the requirements set out in subsection 770-10(1) of the ITAA 1997 are not met. It is considered that the foreign income was derived by the Company from the business activities carried on through a permanent establishment of the Company in the foreign country and is to be treated as a non-assessable non-exempt income for the purposes of section 23AH of the Income Tax Assessment Act 1936 (ITAA 1936) and therefore is not required to be included as assessable income in the Australian tax return.

This ruling applies for the following period

Substituted Accounting Period 1 January 2009 to 31 December 2009

The scheme commenced on

The scheme has commenced.

Relevant facts

The Company is an Australian resident company for income tax purposes.

The Company is in the business of metal coating and finishing.

The Company entered into an agreement with a foreign company to carry out a contract work in a foreign country ('the Contract').

The foreign company is not an Australian resident for tax purposes.

The foreign company is a resident of the foreign country and a corporation duly organised and existing under the law of the foreign country.

The foreign company and the Company are not related, each company does not hold shares in the other. The project was a one-off contract.

The Company carried out the contract works during the 2009 calendar year and incurred significant costs which were expensed normally in the 2009 calendar year.

The Company made a series of progress invoices during the 2009 calendar year as measurable segments of the contracted works were completed and accepted by the client. These invoices were not paid until 2010 year.

Payments were delayed because the Company had difficulty receiving a response from the foreign country tax authority to obtain the necessary permits to operate as an Australian company in the foreign country.

The Company was subsequently issued with a Certificate of Registration for various taxes by the foreign country tax authority.

The works involved installation activities occurring in the foreign country

The Contract makes no allowance for regular progress claims and identifies only two milestones as the completions of Plant 1 and Plant 2 which was completed in two separate periods in the 2010 calendar year.

Progress claim invoices for smaller portions were raised to reflect the value of work done to offset expenses in carrying out the work.

There are a total of xx invoices which are for an identical value which represents a fair pro-rata split of the contract value.

The foreign company made two payments to part pay these invoices raised. Income tax was imposed and withheld from these payments under the provision of the foreign country tax authority and paid to the foreign country tax authority.

Details of the payments and tax withheld were provided.

The Company declared all accrued sales and expenses in the year ended 31 December 2009.

The site work carried out in the foreign country was for a period of more than six months.

The Company is an independent contactor of the foreign company in accordance with the terms of the Contact.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 23AH.

Income Tax Assessment Act 1997 Subsection 770-10(1)

Income Tax Assessment Act 1997 Subsection 6-5(2).

Income Tax Assessment Act 1997 Section 11-55.

International Tax Agreements Act 1953

Income Tax Assessment Act 1936 Section 317

Income Tax Assessment Act 1936 Section 386

Income Tax Assessment Act 1936 Section 433

Income Tax Assessment Act 1936 Section 435

Reasons for decision

Subsection 770-10(1) of the ITAA 1997 provides:

You are entitled to a tax offset for an income year for foreign income tax. An amount of foreign income tax counts towards the tax offset for the year if you paid it in respect of an amount that is all or part of an amount included in your assessable income for the year.

Note 1: The offset is for the income year in which your assessable income included an amount in respect of which you paid foreign income tax - even if you paid the foreign income tax in another year.

In the first instance, the Company would be entitled to a foreign income tax offset in its Australian income tax return pursuant to subsection 770-10 of the ITAA 1997. However, if the contract income derived from the foreign country is exempt from Australian tax, no foreign income tax offset will be allowed in the Australian income tax return.

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Section 11-55 of the ITAA 1997 lists those provisions dealing with non-assessable non-exempt income. Included in this list is section 23AH of the ITAA 1936 that deals with foreign branch income of Australian companies.

The objects of this section are:

Subsection 23AH(2) of the ITAA 1936 states:

Subject to this section, foreign income derived by a company, at a time when the company is a resident in carrying on a business, at or through a PE of the company in a listed country or unlisted country is not assessable income, and is not exempt income, of the company

Foreign income is defined under subsection 23AH(15) of the ITAA 1936, which states:

…foreign income includes an amount that:

a) apart from this section, would be included in assessable income under a provision of this Act other than Part 3-1 or 3-3 of the Income Tax Assessment Act 1997 (CGT); and

b) is derived from sources in a listed country or unlisted country

Subsection 23AH(15) provides that the term 'unlisted country' in subsections 23AH(2) and 23AH(15) has the same meaning in Part X of the ITAA 1936. The foreign country is an unlisted country.

The contract income derived from the foreign country would normally be assessable income of the Company under subsection 6-5(2) of the ITAA 1997.

The term 'permanent establishment' in relation to an unlisted country is defined in subsection 23AH(15) of the ITAA 1936 which relevantly states:

(a) if there is a double tax agreement in relation to that country- has the same meaning as in the double tax agreement…

Therefore, in the present case, it is necessary to consider the meaning of the term 'permanent establishment' contained in the tax treaty between Australia and the foreign country ('the Double Tax Agreement').

Article Y of the Double Tax Agreement defines the term 'permanent establishment'. Article Y of the Double Tax Agreement provides that:

for the purposes of this Agreement, the term "permanent establishment" means a fixed place of business through which the business of an enterprise is wholly or partly carried on.

(a) a place of management;

(b) a branch;

(c) an office;

(d) a factory;

(e) a workshop;

(f) a mine, oil or gas well, quarry or other place of extraction of natural resources;

(g) an agricultural, pastoral or forestry property;

(h) a building site or construction, installation or assembly project, or supervisory activities in connection therewith where such site, project or activity continues for more than six months;

(i) premises used as a sales outlet;

(j) a warehouse, in relation to a person providing storage facilities for others;

(k) a place in one of the Contracting States through which an enterprise of the other Contracting State furnishes services, including consultancy services, for a period or periods aggregating more than six months in any taxable year or year of income, as the case may be, in relation to a particular project, or to any project connected therewith.

In the present case, the Company carried out installation activities at a site in a foreign country for a period of more than six months.

In Thiel v. Federal Commissioner of Taxation (1990) 171 CLR 338; 90 ATC 4717; (1990) 21 ATR 531, the High Court accepted that the Model and the Commentaries on the Articles of the OECD Model (the OECD Commentary) may be relevant to the interpretation of tax treaties based on the OECD Model. The High Court approved recourse to the OECD Model and the OECD Commentary under Article 32 of the Vienna Convention (see paragraph 102 of Taxation Ruling TR 2001/13).

Paragraph 16 to 20 of the OECD Commentary on Article 5 of the OECD Model discusses situations where a building site or construction or installation project constitutes a permanent establishment where that building site or construction or installation project lasts more than 12 months.

In paragraph 17 of the OECD Commentary, it is explained that the term installation project is not restricted to an installation related to a construction project; it also includes the installation of new equipment, such as a complex machine, in an existing building or outdoors.

In these circumstances, it is considered that the Company has a permanent establishment (PE) in the foreign country for the purpose of Article Y of the Double Tax Agreement, being an installation project which continues for more than six months.

Hence, the Company derives the foreign income 'in carrying on a business at or through a PE of the Company' in an unlisted country for the purposes of subsection 23AH(2) of the ITAA 1936.

However, subsection 23AH(7) of the ITAA 1936 provides that subsection 23AH(2) will not apply to foreign income derived by the company if:

(a) the PE is in an unlisted country;

(b) the PE does not pass the active income test; and

(c) the foreign income is adjusted tainted income.

All three conditions must apply before subsection 27AH(7) operates to exclude the application of subsection 23AH(2) to the foreign income.

Subsection 23AH(12) of the ITAA 1936 provides that a PE of an entity passes the active income test for a year of income if the entity would have passed the active income test in section 432 of the ITAA 1936 if certain assumptions listed in subsection 23AH(14) were made and if the subsections and paragraphs listed in subparagraph 23AH(12)(b) had not been enacted.

To pass the active income test, the tainted income ratio of a branch for a statutory accounting period must be less than 0.05.

The 'tainted income ratio' is defined in section 433 of the ITAA 1936 to mean the company's 'gross tainted turnover' divided by the company's 'gross turnover' of the statutory accounting period.

Section 435 of the ITAA 1936 defines 'gross tainted turnover' to include 'passive income', 'tainted sales income' and 'tainted services income'.

Pursuant to section 317 and section 386 of the ITAA 1936, adjusted tainted income comprises of amounts that would be passive income, tainted sales income or tainted services income if certain modifications were made.

In the present case, the Company has a PE in the foreign country, which is an unlisted country.

The income derived by the Company's PE in the foreign country is neither tainted income nor adjusted tainted income as it was an active business income of the Company derived wholly for the site works carried out in the foreign country from a non resident company which is unrelated to the Company. As a result, the exception in subsection 23AH(7) of the ITAA 1936 does not apply to prevent the application of subsection 23AH(2) of the ITAA 1936 to treat the branch income of the Company as non-assessable non-exempt income.

Conclusion

Accordingly, the foreign income derived by the Company from a branch in the foreign country is not assessable income and not exempt income under subsection 23AH(2) of the ITAA 1936.

Therefore, the foreign income in question will be excluded from the assessable income in the Company's income tax return for the year ended 31 December 2009.

Accordingly, as a result of the exclusion of the foreign income from the Company's assessable income, the Company is not entitled to a foreign income tax offset in respect of the foreign income tax paid on the income as the requirements set out in subsection 770-10(1) of the ITAA 1997 are not met.

Further issues for you to consider

Amendment of tax return

As a consequence of the above advice, the Company may need to request an amendment to its income tax return for the year ended 31 December 2009 to exclude the relevant foreign income and associated expenses.