Edited version of private ruling

Authorisation Number: 1011749000829

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Ruling

Subject: Permanent establishment and carry on business

Question 1

Does Entity A carry on business through the deemed permanent establishment (PE) in Australia in accordance with the business profits article of the tax treaty between Australia and Country X contained in the International Tax Agreements Act 1953 (the Country X Convention)?

Advice/Answers

No.

Question 2

If Entity A does carry on business through the deemed PE in Australia, does the relevant PE article of the Country X Convention apply such that it is deemed not to have a PE?

Advice/Answers

Not applicable as Entity A is considered not to carry on business in Australia.

This ruling applies for the following period

Year ended 30 June 2010

Year ending 30 June 2011

Year ending 30 June 2012

Year ending 30 June 2013

Year ending 30 June 2014

Year ending 30 June 2015

Year ending 30 June 2016

The scheme commenced on

1 July 2009

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.

Entity A has a deemed PE in Australia pursuant to the Country X Convention.

Entity A has a representative office in Australia that carries on a small number of limited functions such as gathering information related to oil, gas and metal mining in the particular region. This office performs no administrative functions in relation to Entity A's participation in mineral exploitation projects in Australia.

Entity A is currently involved in Australian joint ventures (JV).

Each of those joint venture agreements (JVA) has similar clauses as to the management committee, operator, production, etc. because they originated from a standard form agreement. However, some terms are not the same between each JVA.

Entity A's participation in the Operating Committee of each JVs is not materially different. That is, Entity A's participation is by way of simple oversight to ensure the smooth operation of the JV; that is, to discuss the status of the Project and 'house-keeping matters' (such as invoicing procedures), to approve budgets, and to monitor expenditure under the relevant Project.

The Entity A Law 200X (the Entity A Law) states:

The purposes of Entity A are to supply the necessary funds for exploring for petroleum and combustible natural gas (hereinafter referred to as "Petroleum, etc.") as well as metallic minerals….thereby contributing to a stable and low-price supply of Petroleum, etc and metallic mineral products….

The Entity A Law goes on to provide that Entity A shall conduct operations to achieve the purposes mentioned in the Article, ,by acquiring the right to explore for petroleum, etc, and metallic minerals overseas and other similar rights (limited to the acquisition of such right for the purpose of assigning the right to a party other than Entity A).

While there is no obligation imposed on nominees to use the minerals acquired under the JVA in Country X, Entity A anticipates that its nominee will bring those metallic mineral products into Country X to sustain and promote Country X's industrial activities.

Entity A does not intend to make a profit from its Australian JV activities (or indeed from any of its activities worldwide). If Entity A withdraws from an Australian JV, it will incur a loss in respect of the JV, as it will have incurred expenditure for no return.

Alternatively, if Entity A determines that a JV has potential, it will offer its rights under the JV to its nominees by way of public tender. Entity A computes the actual expenditure that has been incurred, which is set out as a 'predetermined price'.

In the public tender, if the tendered prices by the Country X mining companies (that is, Entity A's nominees) are below the predetermined price, Entity A will ask them to re-tender their bids until the tendered prices are equal to or above the predetermined price.

There are two types of JVs in terms of Entity A's JV budget. One type of JV program is commissioned by the relevant Country X government department on the annual budget basis. The other type of JV program is granted by the department.

In case of the commissioned program, Entity A must pay the tendered price to the Country X government as soon as possible. However, in the case of the granted program, Entity A does not have to pay immediately but must instead pay the remaining amount between the tendered prices and the Entity A JV expenditures at the end of each 'intermediate target period'.

That is, in the commissioned JV, Entity A must pay the whole of the tendered price to the Country X government immediately after it is received from the nominee without any setoff.

On the other hand, in the granted JV, Entity A can set off the received tender price against actual expenditure during the intermediate target period, and must return any surplus to the Country X government at the end of the intermediate target period. The average term of each intermediate target period is typically four or five years.

Relevant legislative provisions

International Tax Agreements Act 1953

Reasons for decision

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Entity A has a deemed PE under the Country X Convention.

Pursuant to the business profits article of the Country X Convention, the practical effect of having a PE is that Entity A may be subject to tax in Australia. The business profit article of the Country X Convention states that the profits of an enterprise of a Contracting State shall be taxable only in that Contracting State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as previously mentioned, the profits of the enterprise may be taxed in that other Contracting State but only so much of them as is attributable to that permanent establishment (emphasis added).

While the permanent article of the Country X Convention deems activities to be performed through a PE if the requirements of the article are satisfied it lacks an express deeming to 'carry on business in Australian through that PE'.

While the permanent article of the tax treaty between Australia and the United States of America contained in Schedule 2 to the International Tax Agreements Act 1953 (the US Convention) contains different requirements to be satisfied to the permanent article of the Country X Convention, they are worded similarly in respect of the lack of an express deeming to 'carry on business in Australia through that PE'.

In respect of the lack of an express deeming to 'carry on business in Australia through that PE' in the US Convention, Taxation Ruling TR 2007/10 Income tax: the treatment of shipping and aircraft leasing profits of United States and United Kingdom enterprises under the deemed substantial equipment permanent establishment provision of the respective Taxation Conventions, states at paragraph 35:

A US lessor enterprise that is deemed to have a permanent establishment in Australia under Article 5(4)(b), must also satisfy the condition in Article 7(1) that it is carrying on business in Australia through that deemed permanent establishment. Whether this is the case is a question of fact and degree having regard to the circumstances of each particular case.

Entity A has contended that it does not carry on business. Similar to the position outlined in paragraph 35 of TR 2007/10 in respect of the US Convention, the business profits article of the Country X Convention will only be satisfied where Entity A is carrying on business in Australia through the deemed PE.

Therefore, consideration needs to be given to whether Entity A satisfies the phrase 'carries on business in the other Contracting State through a permanent establishment' in the business profits article of the Country X Convention.

Consistent with the approach taken in Unisys Corporation Inc v. Federal Commissioner of Taxation 2002 ATC 5146; (2002) 51 ATR 386 (see paragraph 32 of the judgment at ATC 5151; ATR 391) it is necessary to separately consider if Entity A is carrying on business and if so, whether it carries on that business in Australia through the PE in Australia.

This approach to interpretation is also supported by paragraph 168 of TR 2007/10 which states:

Even though a US lessor that maintains a ship or aircraft in Australia may have a deemed permanent establishment in Australia, and constitute an enterprise carrying on business, it is still necessary to establish that it is carrying on business in Australia through that permanent establishment. This requires an examination of the business activities of the enterprise that relate to the deemed permanent establishment to determine whether they have been undertaken in Australia through that permanent establishment.

Carrying on business

The definition article of the Country X Convention defines business to include 'the performance of professional services and of other activities of an independent character' but does not define the term 'carries on business'. Therefore, pursuant to that article unless the context requires otherwise, the term will have the meaning that it has under Australia's domestic tax law.

Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production (TR 97/11) summarises indicators that have been found to be relevant by Australian courts in determining whether a taxpayer's activities constitute the carrying on of a business.

Although TR 97/11 states the Australian Taxation Office view on whether a taxpayer is carrying on a primary production business, the general indicia set down by the courts in relation to carrying on a business apply to all taxpayers undertaking this consideration.

Whether a taxpayer carries on business turns on its own particular facts. The determination of the question is generally the result of a process of weighing all the relevant indicators. Paragraph 18 of TR 97/11 states:

The following table provides a summary of the main indicators of carrying on a business. The last three items shown are factors which support the main indicators.

Entity A contends as a non-profit enterprise established by the Country X government, it does not carry on business. In support of this position, Entity A points to its 2009 Annual Report which provides that revenues represent the amount paid by government to cover the cost of specific activities requested by the government and states that revenues from all these grants are calculated and paid to correspond to the corporation's operating expenses, general and administrative expenses and expenses for entrusted activities, Entity A, in principle, derives no profit from these business activities.

While the prospect of profit is a very important indicator, the absence of a prospect of profit cannot alone be relied upon to conclude that Entity A does not carry on business. Rather consideration needs to be given to Entity A's exploration activities against each of the indicators of carrying on a business.

Significant commercial purpose

The fact that Entity A is controlled and funded by the Country X government in discharging government functions does not mean that it cannot undertake commercial activities.

In Reid v. Republic of Nauru [1993] 1 VR 251 (Reid Case) the court considered whether the Republic was entitled to claim that as a sovereign state it enjoyed immunity from the jurisdiction of the Supreme Court in respect of proceedings commenced by a pilot employed by an airline that was directly owned and funded by government.

The airline was governed and administered at all relevant times by the Department of Island Development and Industry, and the costs involved in its operations were met out of the funds appropriated from the Treasury Fund.

Vincent J. at 254 of the judgment stated in relation to sovereign immunity:

….there would seem to be general acceptance of the proposition that a state is not entitled to claim immunity with respect to trading or commercial activities in which it may have engaged…..[t]he reasons underlying, or the benefits or protection that it is anticipated may be received from, such involvement are not regarded as influencing the character of the activity if it is otherwise properly classified as being of a trading or commercial nature.

At 257 it was concluded that the Republic was not entitled to immunity, stating:

It would seem to be quite obvious that there are a number of reasons and national aspirations, including the making of a symbolic statement of independence, which explain why the Government of the Republic has chosen to commit, as the evidence indicates it has, such a large part of its annual budget to an enterprise that has not, to the present time, returned a profit and appears unlikely to do so in the foreseeable future. Such decisions involve the assertion and exercise of governmental authority. However, they are, nevertheless, decisions to pursue state objectives through engagement in an essentially commercial enterprise.

In this case Entity A has entered into contracts to enter into a JV whereby it will contribute to exploration expenditure and thereby earn equitable interests in the JV property. Entity A enters into such an agreement with the aim to secure a stable and low-price supply of mineral products to Country X.

Similar to the judgment in the Reid Case it is considered that while the entry into JVA by Entity A is motivated to pursue a state objective, funding exploration activities to earn an equitable interest in the JV property is essentially a commercial undertaking.

Intention of Entity A

As stated previously, the intention of Entity A is to secure minerals for Country X. If commercially mineable quantities of minerals are detected by the exploration activities the equitable interests in the JV property will be transferred to one of their nominees.

These equitable interests are transferred at cost by public tender to reduce exploration risks for the Country X's mining industry. Therefore, there is no intention to make a profit from these activities.

It is possible to incur expenses before a particular business is commenced, for example where experimental or pilot activities are undertaken which do not amount to a business and do not result in any assessable income.

In Esso Australia Resources Ltd (formerly Esso Exploration and Production Australia Incorporated) v. Federal Commissioner of Taxation 98 ATC 4768; (1998) 39 ATR 394 (Esso Case) one of the issues considered by the Full Federal Court was whether Esso was conducting a mining business.

The facts of the case were that Esso had explored for and produced oil and gas offshore as part of its longstanding business in Australia of producing and selling oil and gas. In 1973 Esso was directed to extend the scope of their business operations beyond oil and gas production into other resources including coal, oil shale and minerals.

The evidence presented established that large sums of money were spent on genuine exploration activities.

In concluding that Esso was not carrying on an exploration business, Lee, Heerey and Merkell JJ. distinguished this case from the decision of the majority in Federal Commissioner of Taxation v. Ampol Exploration Limited 86 ATC 4859; (1986) 13 FCR 545 (Ampol case). At ATC 4783; ATR 410 Lee, Heerey and Merkell JJ. stated:

In our view the reliance placed on Ampol by the appellant is misconceived. It was critical to the majority's findings in favour of the taxpayer in Ampol that the taxpayer was engaged for reward in the exploration business. In other words, it was an exploration company which incurred the relevant expenditure with a view to turning to account for profit or reward the benefits it obtained from its exploration activities. That may be contrasted with the position in the present case. His Honour found that the appellant was not an exploration company and that it did not incur the relevant expenditure with a view to turning to account for profit or reward the benefits it obtained from its exploration activities. Rather, his Honour found (at ATC 4381; ALR 469) that the activities were:

``... of a preliminary nature, aimed at ascertaining whether it was commercially worthwhile to enter into mining joint ventures.''

In accordance with the Esso Case the lack of an intention to turn the exploration expenditure into a profit or reward by Entity A could indicate that the activities conducted by Entity A are preparatory which do not amount to a business.

Prospect of profit

Entity A has stated that it does not enter into JVs with an intention to make a profit; rather it undertakes exploration activities to reduce exploration risk for the Country X's mining industry.

While we accept that Entity A's intention is not to make a profit, the amount submitted by tender can exceed the exploration costs incurred (the predetermined price).

In the case of the commissioned program, Entity A must pay the tendered price to the Country X government as soon as possible. However, in the case of the granted program, Entity A does not have to pay immediately but must instead pay the remaining amount between the tendered prices and the Entity A JV expenditures at the end of each "intermediate target period".

Repetition and regularity

It is often a feature of business that similar sorts of activities are repeated on a regular basis. Entity A's activities in respect of the JV were:

· Review monthly technical reports submitted by the Operator;

· Participate in technical meetings, which are convened as required (no formal decisions are made at these meetings, rather the Operator and Entity A engage in a frank exchange of opinions to review exploration results and to design an exploration program that is satisfactory to both parties);

· Review accounting information;

· Participate in the Operating Committee (meetings are held once each year, or more frequently as required), which is the decision making body for the joint venture.

Accordingly, there is a repetition and regularity in Entity A's activities.

Activity of same kind and carried on in a manner characteristic of industry

In respect of the JV, it is noted that Entity A's representatives who attend the operating committee and technical meetings have extensive qualifications, experience and expertise in mineral explorations and its representatives involved in other exploration activities have similar knowledge and experience.

Entity A's exploration activities are carried on in a similar manner to which they would normally be expected in the industry, except that on detecting commercially mineable quantities of a mineral other industry participants would seek to maximise their profit on their interest.

Organisation in a businesslike manner and the use of system

In respect of the JV, the minutes of the Operating Committee and the monthly technical reports show that the JV is organised in a businesslike manner. Entity A contributes to this via their representatives at the operating committee and technical meetings as well as by reviewing the books and accounting records relating to the exploration expenditure.

Entity A has confirmed that other exploration JV are organised in a similar manner. It is concluded that the exploration activities are organised in a businesslike manner.

Size and scale of the activity

The size and scale of the activity is consistent with that of other exploration activities conducted in the industry.

Hobby or recreation

Clearly the activities undertaken by Entity A do not relate to the pursuit of a hobby or recreation activity.

Weighing up all of the indicators

In respect of the exploration activities, Entity A's activities can be summarised as entered into JVA to fund exploration expenditure and thus earning equitable interest in JV property which, if mineable quantities of minerals are located, can be offered for tender to Country X's mining companies. In this sense, the Country X government bears the risk of exploration activities.

As has been stated previously whether a taxpayer carries on business turns on its own particular facts, the determination of which is the result of a process of weighing all the relevant indicators.

In weighing all of the relevant indicators, Entity A conducts exploration activities in a thorough systemic manner that is consistent with industry practice.

While Entity A's activities can be seen to benefit the Country X government, the absence of an intention to turn the relevant expenditure into a profit or reward indicate that the activities conducted are, on balance, considered to be preliminary in nature and more aimed at ascertaining whether it is commercially worthwhile to enter into a mining JV.

Notwithstanding that it has previously been concluded that Entity A has a deemed PE under the Country X Convention, Entity A is not carrying on a business in relation to its exploration activities and as such the business profits article of the Country X Convention is not satisfied.

Therefore, Australia does not have a taxing right over any profits from Entity X's exploration activities under the business profits article of the Country X Convention.