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Ruling

Subject: Assessable income

Question 1

Is the taxpayer subject to Australian income tax under the provisions of the Income Tax Assessment Act 1936 or the Income Tax Assessment Act 1997 on any amounts payable to the company in respect of the income received as a result of the scheme outlined in the facts of this ruling?

Answer

No.

This ruling applies for the following periods:

Year ending 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

The scheme commences on:

1 January 2003

Relevant facts and circumstances

The taxpayer is a company that is a tax resident of the Country X for Country X income tax purposes.

At least 50% of the company's ordinary shares are held, directly or indirectly, by Country X citizens.

The taxpayer was formerly the registered holder of a licence.

The taxpayer assigned its 100% interest in the licence to an unrelated company that is an Australian resident for income tax purposes.

In consideration for the assignment the taxpayer received an overriding royalty interest in the licence. The licence was valued at nil at the time of the assignment.

The overriding royalty is calculated with reference to sales derived from the licence.

The Australian company that holds the licence following the assignment is required to include in any subsequent conveyances, transfers or alienations of whatsoever nature that it may execute covering the licence, a description of the obligations it has in relation to the overriding royalty agreement, with a requirement that any transferee from, or successors in the licence is bound by such obligations.

The taxpayer does not have the right to compel or require the Australian company to commence or continue activities utilising the licence.

The term of the assignment do not provide a termination date.

Amount credited to the taxpayer are in Country X dollars.

In Australia, the taxpayer does not have:

(a) a place of management;

(b) a branch;

(c) an office;

(d) a factory;

(e) a workshop;

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

(g) an agricultural, pastoral or forestry property;

(h) a building site or construction, assembly or installation project which exists for more than 9 months; or

(i) an installation, drilling rig or ship that, for an aggregate period of at least 6 months in any 24 month period, is used by an enterprise of one of the Contracting States in the other Contracting State for dredging or for or in connection with the exploration or exploitation of natural resources of the sea-bed and subsoil.

· The taxpayer does not carry on business in Australia through a person who has authority to conclude contracts on behalf of the company and habitually exercises that authority in Australia. In addition, the company has not appointed any agent of independent status.

· The taxpayer does not maintain substantial equipment for rental or other purposes within Australia (excluding equipment let under a hire-purchase agreement) for a period of more than 12 months.

· The taxpayer is not engaged in supervisory activities in Australia for more than 9 months in any 24 month period in connection with a building site or construction, assembly or installation project in Australia.

· The taxpayer does not have goods or merchandise belonging to it that:

(a) were purchased by it in Australia, and not subjected to prior substantial processing outside Australia; or

(b) were produced by it or on its behalf in Australia,

and are, after such purchase or production, subjected to substantial processing in Australia by an enterprise where either enterprise participates directly or indirectly in the management, control or capital of the other enterprise, or where the same persons participate directly or indirectly in the management, control or capital of both enterprises.

Relevant legislative provisions

International Tax Agreements Act 1953 Section 4

International Tax Agreements Act 1953 Schedule 2

International Tax Agreements Act 1953 Article 5 of Schedule 2

International Tax Agreements Act 1953 Paragraph 2 of Article 5 of Schedule 2

International Tax Agreements Act 1953 Paragraph 3 of Article 5 of Schedule 2

International Tax Agreements Act 1953 Paragraph 4 of Article 5 of Schedule 2

International Tax Agreements Act 1953 Paragraph 5 of Article 5 of Schedule 2

International Tax Agreements Act 1953 Article 6 of Schedule 2

International Tax Agreements Act 1953 Article 7 of Schedule 2

International Tax Agreements Act 1953 Article 12 of Schedule 2

International Tax Agreements Act 1953 Paragraph 1 of Article 12 of Schedule 2

International Tax Agreements Act 1953 Paragraph 4 of Article 12 of Schedule 2

International Tax Agreements Act 1953 Article 13 of Schedule 2

International Tax Agreements Act 1953 Paragraph 1 of Article 13 of Schedule 2

International Tax Agreements Act 1953 Paragraph 2 of Article 13 of Schedule 2

International Tax Agreements Act 1953 Article 21 of Schedule 2

International Tax Agreements Act 1953 Schedule 2A

Income Tax Assessment Act 1997 Subsection 6-5(1)

Income Tax Assessment Act 1997 Paragraph 6-5(3)(a)

Income Tax Assessment Act 1997 Section 104-10

Income Tax Assessment Act 1997 Section 116-20

Reasons for decision

Under paragraph 6-5(3)(a) of the Income Tax Assessment Act 1997 (ITAA 1997), the assessable income of a non-resident taxpayer includes ordinary income derived directly or indirectly from all Australian sources during the income year.

Ordinary income

Subsection 6-5(1) of the ITAA 1997 provides a taxpayers assessable income includes income according to ordinary concepts, which is called ordinary income. In Ivanac v DFC of T 95 ATC 4683 (Ivanac) the taxpayer and their partner were bona fide prospectors and the registered proprietors of several gold-mining leases (the mining tenements). In April 1985 they entered into an Option Agreement with A Co under which A Co was granted an option to purchase the mining tenements for $150,000. The Option Agreement provided further that A Co would pay the prospectors a 'royalty' of $1 per tonne of ore from the tenements mined, crushed and treated. At the same time the prospectors and B Co made a Deed of Acknowledgement that A Co had granted option rights to B Co. In June 1986 A Co and B Co exercised their respective options. In June 1987 B Co sold the tenements to C Co. In 1989 C Co and A Co made a Deed of Surrender under which A Co purported to surrender and convey to C Co its right to, and interest in, the royalty with the intent that the liability of C Co to pay the royalty ceased. On the same day the prospectors and C Co made a Royalty Deed under which C Co purported to undertake a liability to pay the prospectors a royalty of $1 per tonne in consideration of the prospectors 'surrendering' to C Co all their interest in the royalty payable to them by A Co, and releasing A Co, B Co and C Co from any liability in respect of the prospectors' entitlement to it. In its terms the Royalty Deed did not assign to C Co the prospectors' entitlement to the royalty payable to them by A Co. The taxpayer subsequently received royalty payments from C Co.

It was held by the court that the royalty payment was not derived from the sale of the mining leases to A Co. Rather, they represented ordinary income when derived by the taxpayer.

The amounts received by the taxpayer are similar to those received by the taxpayer in Ivanac. The contract for disposal of the licence by the taxpayer to the Australian company separates the overriding royalty payments from the purchase price of the title paid by the Australian company. The amount received by the taxpayer is determined by sales from the licence by the holder of the licence, as is the amount received by the taxpayer in Ivanac. Therefore, it is considered that the amounts received by the taxpayer are ordinary income in accordance with the decision handed down in Ivanac.

Australian source

The income received by the taxpayer is ordinary income derived from an Australian source. Therefore, the income is assessable income of the taxpayer under paragraph 6-5(3)(a) of the ITAA 1997 in the income year in which it is derived.

Application of the Australia/ Country X double taxation agreement

In determining liability to Australian tax on income received by a non resident, it is necessary to consider not only Australian income tax laws but any applicable double tax agreement (DTA) contained in the International Tax Agreements Act 1953 (ITA 1953).

Section 4 of the ITA 1953 incorporates that Act with the ITAA 1997, so that these Acts are read as one.

Schedule 2 to the ITA 1953 contains the DTA between Australia and the Country X (the Country X DTA). Schedule 2A of the ITA 1953 contains the Protocol amending the Country X DTA (the Country X Protocol). The Country X DTA and Country X Protocol operate to avoid double taxation of income received by Australian and Country X residents.

Based on the facts of this private ruling, it is considered that potentially relevant articles of the Country X DTA are Article 6 (income from real property), Article 7 (business profits), Article 12 (royalties) and Article 13 (alienation from real property).

Article 6 of the Country X DTA

Article 6 of the Country X DTA considers which country has taxing rights over income from real property. Income from real property may be taxed by the Contracting State in which the real property is situated.

It is considered that the income receive by the taxpayer is not income from real property for the purposes of Article 6 of the Country X DTA.

Article 7 of the Country X DTA

Article 7 of the Country X DTA provides the extent to which business profits of an enterprise can be taxed in a Contracting State. Essentially, the business profits of an enterprise of one of the Contracting States shall be taxable only in that 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 aforesaid, the business profits of the enterprise may be taxed in the other State but only so much of them that are attributable to that permanent establishment.

Paragraph 2 of Article 5 of the Country X DTA provides the meaning of the term 'permanent establishment' for the purposes of the Country X DTA. It is stated that the term means a fixed place of business through which the business of an enterprise is wholly or partly carried on. The term includes:

(a) a place of management;

(b) a branch;

(c) an office;

(d) a factory;

(e) a workshop;

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

(g) an agricultural, pastoral or forestry property;

(h) a building site or construction, assembly or installation project which exists for more than 9 months; and

(i) an installation, drilling rig or ship that, for an aggregate period of at least 6 months in any 24 month period, is used by an enterprise of one of the Contracting States in the other Contracting State for dredging or for or in connection with the exploration or exploitation of natural resources of the sea-bed and subsoil.

Paragraph 4 of Article 5 of the Country X DTA goes on to provide that an enterprise of one of the Contracting States shall be deemed to have a permanent establishment in the other Contracting State if:

(a) it carries on business in that other State through a person, other than an agent of independent status to whom paragraph 5 of Article 5 applies, who has authority to conclude contracts on behalf of that enterprise and habitually exercises that authority in that other State, unless the activities of such person are limited to those mentioned in paragraph 3 of Article 5 which, if exercised through a fixed place of business, would not make that fixed place of business a permanent establishment under the provisions of that paragraph;

(b) it maintains substantial equipment for rental or other purposes within that other State (excluding equipment let under a hire-purchase agreement) for a period of more than 12 months;

(c) it engages in supervisory activities in that other State for more than 9 months in any 24 month period in connection with a building site or construction, assembly or installation project in that other State; or

(d) it has goods or merchandise belonging to it that:

(i) were purchased by it in that other State, and not subjected to prior substantial processing outside that other State; or

(ii) were produced by it or on its behalf in that other State,

and are, after such purchase or production, subjected to substantial processing in that other State by an enterprise where either enterprise participates directly or indirectly in the management, control or capital of the other enterprise, or where the same persons participate directly or indirectly in the management, control or capital of both enterprises.

The taxpayer does not meet any of the criteria set out by Article 5 of the Country X DTA that would result in the taxpayer having a 'permanent establishment' in Australia.

Given that the taxpayer does not have a permanent establishment in Australia, regardless of whether the income received by the taxpayer that is the subject of this ruling constitute business profits, that income does not meet the requirements of Article 7 of the Country X DTA as the taxpayer does not have a permanent establishment in Australia.

Article 12 of the Country X DTA

Paragraph 1 of Article 12 of the Country X DTA provides that Royalties from sources in one of the Contracting States, being royalties to which a resident of the other Contracting State is beneficially entitled, may be taxed in that other State.

Paragraph 4 of Article 12 of the Country X DTA outlines the 'royalties' to which Article 12 of the Country X DTA applies. Royalties are defined to include:

(a) payments or credits of any kind to the extent to which they are consideration for the use of or the right to use any:

(i) copyright, patent, design or model, plan, secret formula or process, trademark or other like property or right;

(ii) motion picture films; or

(iii) films or audio or video tapes or disks, or any other means of image or sound reproduction or transmission for use in connection with television, radio or other broadcasting;

(b) payments or credits of any kind to the extent to which they are consideration for:

(i) the supply of scientific, technical, industrial or commercial knowledge or information owned by any person;

(ii) the supply of any assistance of an ancillary and subsidiary nature furnished as a means of enabling the application or enjoyment of knowledge or information referred to in sub-paragraph (b)(i) or of any other property or right to which Article 12 of the Country X DTA applies; or

(iii) a total or partial forbearance in respect of the use or supply of any property or right described in this paragraph; or

(c) income derived from the sale, exchange or other disposition of any property or right described in this paragraph to the extent to which the amounts realized on such sale, exchange or other disposition are contingent on the productivity, use or further disposition of such property or right.

The rights held by the taxpayer fall outside the exhaustive definition of royalties provided by paragraph 4 of Article 12 of the Country X DTA. As such, it is accepted that the income received is not caught by Article 12 of the Country X DTA.

Article 13 of the Country X DTA

Paragraph 1 of Article 13 of the Country X DTA provides that income or gains derived by a resident of one of the Contracting States from the alienation or disposition of real property situated in the other Contracting State may be taxed in that other State. Paragraph 2 states that for the purposes of this Article, the term 'real property', in the case of Australia, shall have the meaning which it has under the laws in force from time to time in Australia and, without limiting the foregoing, includes real property referred to in Article 6 of the Country X DTA.

Income or gains derived by the taxpayer from disposal of the licence would be taxable in Australia as a result of Article 13 of the Country X DTA.

The disposal of the licence represents a capital gains tax (CGT) event A1 happening under section 104-10 of the ITAA 1997. A capital gain is made as a result of a CGT event A1 happening where the capital proceeds from the CGT event are greater than the cost base of the CGT asset. Section 116-20 of the ITAA 1997 provides that for the capital proceeds from a CGT event are the total of the money you have received, or are entitled to receive, in respect of the event happening, and the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event).

Draft Taxation Ruling TR 2007/D10 considers the capital tax consequences of earnout arrangements. A standard earnout arrangement is described for the purposes of TR 2007/D10 to be any transaction in which an income-earning asset is sold for consideration that includes the creation of an 'earnout right' in the seller of the asset. An earnout right is defined as a right to an amount calculated by reference to the earnings generated by the asset for a defined period following the sale. Whilst it is recognised that the overriding royalty interest that the taxpayer received as consideration for the disposal of the licence to the Australian company does not have a defined period of existence, it is considered that the overriding royalty interest the taxpayer holds is akin to an earnout right as described in TR 2007/D10. As such, it is considered that TR 2007/D10 is applicable to the overriding royalty amounts received by the taxpayer.

Paragraphs 12 to 14 of TR 2007/D10 state that an earnout right is not a right to receive money for the purposes of calculating the capital proceeds from a CGT event A1. Rather, an earnout right is property received by the seller in respect of disposing of the original asset. As such, the capital proceeds from the CGT event A1 include the market value of the earnout right at the time of the CGT event A1, not any subsequent payments made in satisfaction of the earnout right following the CGT event A1 happening.

The overriding royalty interest received by the taxpayer following the disposal of the licence represent payments in satisfaction of the earnout rights acquired by the taxpayer at the time the taxpayer disposed of the exploration permit. In accordance with TR 2007/D10 these amounts are not taken in to account when determining the capital proceeds from the disposal by the taxpayer of the licence. Therefore, the overriding royalty amounts received by the taxpayer are not considered income or gains derived from the alienation or disposal of real property. Article 13 of the Country X DTA does not apply to the amounts to make them taxable in Australia. Rather, the market value of those rights at the time of the disposal of the exploration licence by the taxpayer may represent capital proceeds from the CGT event A1 happening, and be covered by Article 13 of the Country X DTA.

As determined above, none of the Articles of the Country X DTA make the overriding royalty amounts taxable in Australia.

Article 21 of the Country X DTA states that income of a resident of one of the Contracting States, wherever that income arises that is not made taxable in the other Contracting State by any of the Articles of the Country X DTA preceding Article 21 is taxable only in the state of which the entity is a resident.

Given that the taxpayer is a Country X resident for taxation purposes and none of relevant Articles of the Country X DTA enable Australia to tax the income received by the taxpayer that is the subject of this ruling, the taxpayer will not be subject to Australian income tax on that income.

Conclusion

The income received by the taxpayer is ordinary income with an Australian source. Therefore, the income is assessable under paragraph 6-5(3)(a) of the ITAA 1997 subject to the application of the Country X DTA. None of the Articles of the Country X DTA make the income received by the taxpayer taxable in Australia. Therefore, in accordance Article 21 of the Country X DTA, Australia may not tax the income received by the taxpayer under the overriding royalty agreement.