Edited version of private ruling

Authorisation Number: 1011785471824

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Ruling

Subject: Permanent Establishment and foreign branch profit

Question 1

Does the company have a permanent establishment (PE) in foreign country X?

Answer

Yes.

Question 2

Is the income derived by the company through a PE in foreign country X , 'non-assessable non-exempt income' under section 23AH of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes.

This ruling applies for the following period

Income year ending 30 June 2011

Income year ending 30 June 2012

Income year ending 30 June 2013

Relevant facts

A Pty Ltd (the company) provides electronic commerce service (the service). The company is incorporated in Australia.

The service was built overseas by unrelated parties. The company has two Australian shareholders and it is registered to purchase and take control of the service from the original owner.

The company is a highly sophisticated collection of custom-built machines and custom written software components. The service provided by the company is fully automatic and operated entirely from servers.

The original business consisted of a number of physical servers. You added a few more servers and they all currently run on the company's single powerful physical machine. Most of the servers are active 24 hours a day, seven days a week, all are currently hosted under one physical host.

You stated that, the size of the equipment is not sufficiently large to be considered to be substantial in an absolute sense. However, all of the equipment is required to operate the service provided by the business and 100% of the equipment is dedicated to your business.

The company leased space in foreign country X where the servers owned by the Company are installed. The space leased is a data centre on a one year renewable lease. The company's machine for the relevant period for this ruling application has been at this one fixed location and this arrangement is expected to be on-going.

The equipment carries out the core business activity of the enterprise and it is this equipment alone which generates inserts and monitors the service provided by the company to its customers that produces the income of the company.

All servers automatically communicate with one another via a dedicated private gigabit LAN and with customers and through the internet. Every server has specific role they play which collectively provides the complete service and each is 100% dedicated to the business.

The hardware that hosts all the company's virtual machines costs approximately $X Australian dollars and represents the largest single investment made by the company.

Ongoing advertising of the business is done through worldwide Google X campaigns linked to and managed by the server automatically. Customers principally find the company through search engines, others find the company through word of mouth, the company's international X campaigns, historical press releases and associated internet commentary.

Customers purchase service subscriptions using 3^rd party system (via particular merchant providers) which are integrated with the company systems for automatic service fulfilment.

Your customers pay online to receive automatic access, with the entire payment process (payment reminders, fulfilment, etc) completely automated by the company server (in conjunction with the particular payment processors).

The company pays overseas contractors to oversee the server hardware operation and maintenance, and foreign contractors for software technical maintenance and enhancements and an Australian contractor to answer occasional customer support questions.

You stated that the vast majority of your customers never communicate with you or your contractors. The company has a few hundred thousands users and only a tiny percentage of them are from Australia.

There is no difference of cost between customers of different geographies (that is - the proportion of your Australian costs and profits is 1%).

The profit from your overseas branch is distributed to shareholders and invested in capital projects.

The accounts of the company are prepared in accordance with Australian commercially accepted accounting principles.

You can produce the accounts of the company to substantiate your claim that it will meet the active income test, if required.

You confirm that the tainted income ratio of the company is currently stable at 0.01% and you do not anticipate that it will grow to exceed 5%.

Relevant legislative provisions

International Tax Agreements Act 1953 Schedule 20

International Tax Agreements Act 1953 Schedule 20 Article 5(1)

International Tax Agreements Act 1953 Schedule 20 Article 5(4)(b)

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

Income Tax Assessment Act 1997 Subsection 6-15(3)

Income Tax Assessment Act 1997 Section 11-55

Income Tax Assessment Act 1936 section 23AH

Income Tax Assessment Act 1936 Subsection 23AH (2)

Income Tax Assessment Act 1936 Subsection 23AH (15)

Income Tax Assessment Act 1936 Subsection 23AH (7)

Income Tax Assessment Act 1936 section 6 (1)

Income Tax Assessment Act 1936 Subsection 23AH (12)

Income Tax Assessment Act 1936 Subsection 23AH (13)

Income Tax Assessment Act 1936 Subsection 23AH (14)

Income Tax Assessment Act 1936 section 433

Reasons for decision

Question 1

Does the company have a PE in foreign country X?

Schedule 20 to the International Tax Agreements Act 1953 contains the tax treaty between Australia and foreign country X (the country X Agreement).

The term 'permanent establishment' is defined in Article 5(1) of the country X Agreement as a fixed place of business through which the business of the enterprise is wholly or partly carried on. Article 15(2) of the country X Agreement provides that the term PE shall include a place of management, a branch, an office, a factory or a workshop.

Taxation Ruling TR 2001/13 at paragraphs 101 to 105 provides the Commissioner's view that the OECD Model Tax Convention and Commentaries (OECD commentary) are relevant to interpreting Australia's tax treaties. Paragraph 2 of the OECD Commentary on Article 5 of the OECD Model Tax Convention explains that the general definition of a permanent establishment contains the following conditions:

· the existence of a 'place of business', that is, a facility such as premises or in certain instances, machinery or equipment;

· this place of business must be 'fixed', that is, must be established at a distinct place with a certain degree of permanence;

· the carrying on of the business of the enterprise through this fixed place of business. This means usually that persons who, in one way or another, are dependant on the enterprise (personnel) conduct the business of the enterprise in the State in which the fixed place is situated.

The OECD Commentary considers that the term 'place of business' covers any premises, facilities or installations used for carrying on the business of the enterprise whether or not they are used exclusively for that purpose. The mere fact that an enterprise has a certain amount of space at its disposal which is used for business activities is sufficient to constitute a place of business.

Taxation Determination TD 2005/2 provides guidance on the application of the PE article on whether the sale of trading stock through an internet website hosted by an internet service provider can constitute a PE. TD 2005/2 discussed the distinction between computer equipment and the data and software used by, or stored on, that equipment. TD 2005/2 considers that the server on which a website is stored is a piece of equipment with a physical location and it may constitute a 'fixed place of business' of an enterprise which has that server at its disposal.

The OECD Commentary on the PE article at paragraph 42.4 provides that the computer equipment at a given location may only constitute a PE if it meets the requirement of being fixed. In order to constitute a fixed place of business, a server will need to be located at a certain place for a sufficient period of time so as to become fixed within the meaning of Article 5(1) of the country X Agreement.

In this case, the servers and the machine have been in one fixed location for the relevant period of this ruling and this arrangement is expected to continue.

Another issue raised by the OECD Commentary at paragraph 42.5 for this Article, is whether the business of an enterprise may be said to be wholly or partly carried on at the location where the enterprise has equipment such as a server at its disposal. The Question needs to be examined, having regard to whether it can be said that because of such equipments, the enterprise has facilities at its disposal where the business functions of the enterprise are performed.

Paragraph 10 of the OECD Commentary on this article, provide that a PE may exist if the business of the enterprise is carried on mainly through automatic equipment, the activities of the personnel being restricted to setting up, operating, controlling and maintaining such equipment. Similarly, paragraph 42.6 of the OECD commentary on this article provides that where an enterprise operates computer equipment at a particular location, a PE may exist even though no personnel of that enterprise is required at that location for the operation of the equipment. The presence of personnel is not necessary to consider that an enterprise wholly or partly carries on its business at a location when no personnel are in fact required to carry on business activities at that location.

However, no PE may be considered to exist where the electronic commerce operations carried on through computer equipment at a given location in a country are restricted to the preparatory or auxiliary activities covered by the relevant preparatory paragraph of Article 5.

But where the functions performed by the equipment are an essential and significant part of the business activity of the enterprise as a whole or where other core functions of the enterprise are carried on through the computer equipment constituted a fixed place of business of the enterprise there will be a PE (see paragraph 42.8 of the Commentary on this Article).

What constitutes core functions for a particular enterprise clearly depends on the nature of the business carried on by the enterprise.

In this case, the main core business of the company is the provision of copyright protection and usage reporting for emails and documents service (the service). The service provided by the company is fully automatic and operates entirely from these servers. The core business service of the company is essentially performed by a highly sophisticated collection of custom-built machines and customer written software components. You stated that all of the machinery is required to operate the business and 100% of the machine is dedicated to your business. It is the equipment alone which generates, inserts and monitors the copyright protection service which produces 100% of the income of the company.

The server also performs other auxiliary processes of the business such as payment reminders and the advertising for the business are linked and managed by the server automatically.

Since the functions performed by the equipment are 100% of the core business services provided by the company and its servers are expected to be in a fixed location where space is leased by the company, a PE is considered to exist under paragraph 5(1) of the country X Agreement as a fixed place business through which the business of the company is carried on.

Since we consider that the company has a PE under Article 5(1) of the country X Agreement, it is not necessary to consider Article 5(4)(b) of the country X Agreement.

Question 2

Assessability of the income

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (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. However, subsection 6-15(3) provides that if the income is non-assessable and non-exempt income, it is not assessable income.

Included in the list of non-assessable and non-exempt income is section 11-55 of the ITAA 1997 is the branch profit of Australian companies under section 23AH of the Income Tax Assessment Act 1936 (ITAA 1936).

Subsection 23AH(2) of the ITAA 1936 provides that foreign income derived by a resident company in carrying on a business at or through a permanent establishment in a listed or unlisted country is not assessable income and is not exempt income.

To qualify for the exemption, the company must be a resident and the company must, at a time when it is a resident, derive "foreign income" in carrying on a business at or through a Permanent Establishment (PE) of the company in a listed or unlisted country.

The definition of resident in section 6 (1) of the ITAA 1936 provides that if a company is incorporated in Australia it is a resident of Australia. As your company is incorporated in Australia it is an Australian resident company.

The income of an Australian company from international dealings through the company's PE in a treaty country is considered to be foreign source income.

Australia has a tax treaty with foreign country X. The company is considered to have a PE in foreign country X where 100% of its core business functions are carry on through the custom built servers located in foreign country X. The income derive from the electronic commerce services provided by the equipment are considered to be attributable to the PE and therefore foreign source.

The definition of foreign income in subsection 23AH(15) of the ITAA 1936 states that foreign income includes an amount that:

· Apart from section 23AH, would be assessable income under a provision of the ITAA 1936 or ITAA`1997, and

· Is derived from sources in a listed or unlisted country.

In this case, the foreign income of the company apart from section 23AH of the ITAA 1936, would be included in the assessable income of the company under subsection 6-5(2) as ordinary income of the company, and the income is derived from a PE in foreign country X which is an unlisted country.

Therefore, the income of the company attributable to the PE in foreign country X will be non-assessable, non-exempt income under section 23AH of the ITAA 1936 if all the requirements of subsection 23AH(2) of the ITAA 1936 are satisfies and are not excluded from the operation of subsection 23AH(2) by subsection 23AH(7) of the ITAA 1936.

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

· The PE is in an unlisted country;

· The PE does not pass the active income test (see subsection 23 AH(12); and

· The foreign income is adjusted tainted income (see subsection 23AH(13).

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

In this case, the company PE is in an unlisted country.

Active income test

The active income test is defined in subsection 23AH(12) of the ITAA 1936. It requires the PE to pass the active income test in section 432 of the ITAA 1936. Additionally, subsection 23AH(12) requires that certain assumptions in subsection 23AH(14)of the ITAA 1936 are made.

Conditions that must be met to satisfy the active income test are:

· It keeps proper records; that is, the accounts of the company are properly prepared in accordance with Australian commercially accepted accounting principles.

· It can substantiate a claim that it has met the active income test, and

· Its tainted income ratio is less than 5%.

Where there are commercially accepted accounting principles in the country of residence of the company, it is acceptable if the accounts of the company comply with those principles.

You confirmed that the annual accounts of the company are prepared in accordance with Australian commercially accepted accounting principles. You can produce the accounts of the company to substantiate a claim that the company will pass the active income test.

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. This ratio is required to be less than 0.05.

Section 435 of the ITAA 1936 defines gross tainted turnover to include passive income, tainted sales income and tainted service income. Passive income includes dividends, tainted interest income, tainted rental income, tainted royalty income and income derived from carrying on a business of trading in tainted assets (section 446 of the ITAA 1936).

Tainted sales income relates to income from the sale of goods (section 447 of the ITAA 1936). Tainted services income includes income from the provision of services to an entity which is a Part X Australian resident or if not such a resident, the income is derived in connection with the entity's business in Australia (section 448 of the ITAA 1936).

You confirmed that the company's tainted income ratio is currently at 1% and you do not anticipate the company's tainted income ratio will exceed 5% for the income year ending 30 June 2011 to 2013.

Accordingly, the company's PE in Ireland satisfies the active income test under section 432 of the ITAA 1936 and therefore section 23AH(14) of the ITAA 1936.

Adjusted tainted income

In considering adjusted tainted income under subsection 23AH(13) of the ITAA 1936, this is defined in section 317 of the ITAA 1936 as having the meaning given in section 386 of the ITAA 1936. The same assumptions for active income test in subsection 23AH(14) of the ITAA 1936 as outlined above also apply.

Section 386 of the ITAA 1936 defines adjusted tainted income as being passive income, tainted sales income and tainted services income with certain modifications. These modifications essentially include gross amounts instead of net gains from the disposal of tainted assets and tainted commodity investments, and from currency exchange fluctuations.

Adjusted tainted income is based on the definition of tainted income used for the active income test. Since you confirm that company's tainted income ratio is 0.01 and you do not anticipate it to exceed 5% for the relevant income, and the company's income is from the business of providing services through the equipment in the PE, the income of the PE is not adjusted tainted income under subsection 23AH(13) of the ITAA 1936.

In summary, the company is an Australian resident company. It derives foreign income from a business carry on through a PE in an unlisted country. The income passes the active income test and the income is not adjusted tainted income.

Accordingly, the income attributable to the company's PE in Ireland is 'non-assessable non-exempt income' under subsection 23AH (2) of the ITAA 1936, as the requirements of the application in subsection 23AH(2) of the ITAA 1936 are satisfied and the exceptions for unlisted countries in subsection 23AH (7) of the ITAA 1936 do not apply.