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Ruling

Subject: Section 23AA - income tax exemption

Question 1:

Does section 23AA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the income to be derived by the Company from a permanent establishment in Australia during the income years ending 30 June 2012 to 30 June 2014 inclusive where the income is from a project connected with an approved project in Australia?

Answer:

Yes.

Question 2:

Does subsection 12-1(1) in Schedule 1 to the Taxation Administration Act 1953 (TAA) apply so that the Company has no obligation to withhold an amount from payments to Country X expatriate employees of the Company who are working at the approved project in Australia?

Answer:

Yes.

Question 3:

Are the payments to Country X expatriate employees of the Company salary or wages in terms of subsection 136(1) of the Fringe Benefits Tax Assessment Act 1986 (FBTAA)?

Answer:

No.

This ruling applies for the following periods:

The income year ended 30 June 2012

The income year ended 30 June 2013

The income year ended 30 June 2014

The scheme commences on:

The scheme has commenced.

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 incorporated in Country X. The Company is classified as an "S Corporation" for Country X's statutory purposes. The shareholders in the Company are natural persons who are residents of Country X.

The Company will be a subcontractor to a Country X entity, in relation to an approved project in Australia (the project). The Country X entity to which the Company is subcontracting is the head contractor, which is said to have a contract with the US Government in respect of the project.

The subcontract is for construction services and all work will be undertaken on the site of the approved project. The Company will not engage in any other contracts in Australia outside of this contract.

The project work by the Company will continue for a lengthy period of time. The Company's employees in Country X will be sent to Australia to work on the project, the majority of whom will be in Australia for a specified period on a fly-in, fly-out basis, while a number of managers may remain on the project site for the full term of the project. The staff on the project will be Country X citizens who are employees of the Company. Each employee will be provided with accommodation while they are in Australia.

Assumptions

The following assumptions have been made.

The Country X entity has a contract with the Government of the Country X in connection with an approved project in Australia.

No election in terms of section 911 of Title 26, Subtitle A, Chapter 1 of the Internal Revenue Code of 1986 (IRC 1986) of the United States of America will be made, by any Country X expatriate employee of the Company who is a citizen or resident of Country X, in relation to the salary, wages, commission, bonuses or allowances derived by the employee from work performed in connection with an approved project in Australia to exclude that "foreign earned income" as defined in the IRC 1986 from the gross income of such employee.

Relevant legislative provisions

Fringe Benefits Tax Assessment Act 1986

Subsection 136(1)

Income Tax Assessment Act 1936

Section 23AA

Income Tax Assessment Act 1997

Section 11-15

Subsection 960-100(1)

Subsection 995-1(1)

Taxation Administration Act 1953

Section 12-1, Schedule 1

Section 12-35, Schedule 1

Internal Revenue Code 1986

Section 862

Section 911(a)

Section 1363(a)

Section 1366(a)

Section 1366(b)

Reasons for decision

Question 1:

Summary

The Company carries on business in Australia through a permanent establishment. The Company will derive income from a subcontract in connection with an approved project as defined in subsection 23AA(1) of the ITAA 1936. Section 23AA of the ITAA 1936 applies to the income derived by the Company from the subcontract in Australia so that the Company is deemed to be a non-resident and the income is deemed to have been derived from a source out of Australia. Consequently no income is attributable to the permanent establishment in Australia.

Detailed reasoning

Permanent establishment

The business profits article of the tax treaty between Australia and Country X (Country X Agreement) is relevant to this question. That article provides that the business profits of an enterprise of Country X shall be taxable only in Country X unless the enterprise carries on business in Australia through a permanent establishment in Australia. If the enterprise carries on business in Australia through a permanent establishment the business profits of the enterprise which are attributable to that permanent establishment may be taxed in Australia.

The permanent establishment article of the Country X Agreement which defines a permanent establishment to be a fixed place of business through which the business of an enterprise is wholly or partly carried on includes a building site or construction, assembly or installation project which exists for more than a specified period.

The construction project for which the Company has subcontracted will take more than the specified period to complete and therefore that project constitutes a permanent establishment of the Company in Australia.

Thus the business profits attributable to that permanent establishment may be taxed in Australia. However, it is necessary to consider the application of section 23AA of the Income Tax Assessment Act 1936 (ITAA 1936) to those profits.

Section 23AA of the ITAA 1936

Section 23AA of the ITAA 1936 applies to income and profits from "prescribed contracts" made in connection with certain projects of the US Government in Australia. Subject to specific conditions being met, section 23AA will deem such income to be derived from a source outside Australia and deem the recipient of such income not to be a resident of Australia. Thus where section 23AA applies in this way the income is not subject to tax in Australia.

In order to examine how this provision operates it is necessary to begin with subsection 23AA(1) of the ITAA 1936 as it contains definitions of relevant terms used in the legislation. The relevant terms are "approved project", "foreign contractor", "prescribed contract" and "prescribed purposes".

In accordance with subsection 23AA(1) the project for which the Company has subcontracted with the head contractor is an "approved project". The subcontract is a "prescribed contract" because it is made for purposes connected with the performance of a contract to which the Government of the country X is a party where that contract is related to an approved project. The Company is a "foreign contractor" being a company incorporated overseas which is a party to a prescribed contract. Further with respect to the definition of "prescribed purposes", the purposes of the Company as a foreign contractor come within that definition because its purposes relate to the performance of a prescribed contract.

There are two other subsections within section 23AA to be considered namely subsections 23AA(3) and 23AA(5).

Company deemed non-resident

Subsection 23AA(3) of the ITAA 1936 deals with a person who is deemed to be a non-resident. Note that in terms of subsection 995-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) the term "person" includes a company.

Paragraph 23AA(3)(a) of the ITAA 1936, as far as it is relevant, provides:

Where a person:

· has been in Australia, or has carried on business in Australia solely for prescribed purposes during a period when he was a foreign contractor or foreign employee:

· …

· …

· that person shall, for the purposes of this Act other than Subdivision A of Division 17, be deemed not to have been a resident of Australia during that period, and the presence of that person in Australia during that period shall be disregarded in determining, for the purposes of those provisions, whether the person was a resident of Australia at any other time.

(Note: Subdivision A of Division 17 in Part lll of the ITAA 1936, which deals with rebates, does not apply in this case.)

The Company satisfies the terms of subsection 23AA(3) as it is a foreign contractor which will carry on business in Australia solely for prescribed purposes and thus will be deemed not to be a resident of Australia during the time it carries on that business in Australia.

Foreign contractor: Income deemed to have an ex Australian source

Turning to subsection 23AA(5) of the ITAA 1936 which reads as follows:

Where:

· a foreign contractor or foreign employee has derived income wholly and exclusively from, or from employment in connection with, the performance in Australia of a prescribed contract;

· the income is not exempt from income tax imposed by Chapter One of Subtitle A of the Internal Revenue Code of 1986 of the United States of America; and

· the foreign contractor or foreign employee was, at the time the income was derived , in Australia or carrying on business in Australia, solely for prescribed purposes;

· the income shall for the purposes of this Act, be deemed to have been derived from sources out of Australia.

Paragraphs 23AA(5)(a), (b) and (c) thus set out the conditions that need to be met in order for the income of the Company to be treated as having an ex-Australian source. Each paragraph is discussed below.

First, the Company will derive income wholly and exclusively from the performance in Australia of a prescribed contract and thereby satisfies the condition in paragraph 23AA(5)(a) of the ITAA 1936.

Secondly, with respect to paragraph 23AA(5)(b) of the ITAA 1936 it is necessary to examine the facts of this case in detail in order to determine whether the condition contained in that paragraph is met. This is because paragraph 23AA(5)(b) requires that the income received by the Company cannot be exempt from tax imposed by Chapter One of Subtitle A of the Internal Revenue Code of 1986 (IRC 1986) of the United States of America.

The Explanatory Memorandum to Income Tax and Social Services Contributions Assessment Bill (No.2) 1963 which introduced section 23AA into the ITAA 1936 states:

· An important condition of the exemption is that the income, which will have its origin in moneys provided by the United States Government, is not exempt from United States income tax.

Section 23AA of the ITAA 1936 gives the force of law to the terms of the agreement between the Government of the Commonwealth of Australia and the Government of the United States of America relating to the approved project.

It is clear from both the explanatory memorandum and the treaty that the term 'not exempt' in paragraph 23AA(5)(b) of the ITAA 1936 is intended to apply to income derived under the specified contract which, whether by reason of specific exemption or the nature of the entity, would not be taxed in country X. That is, the provision requires that the income actually be taxed in the country X.

It is also clear from the provision itself that the income which must be taxed (or which must be 'not exempt') is the income from the relevant contract.

Under section 1363(a) of the IRC 1986 an S Corporation is not 'subject to the taxes imposed' by Chapter One of Subtitle A of the IRC 1986. Instead, under section 1366(a) and (b) of the IRC 1986, the shareholders include their pro-rata share of the S Corporation's income and the character of the income is determined as if it was 'realized directly from the source from which realized by the corporation' (see specifically section 1366(b)). Thus, under section 1366(a)(1) of the IRC 1986, the pro rata share of income that is 'passed through' to a particular shareholder is taxed under Chapter One of Subtitle A of the IRC 1986 as if it was realised directly by the shareholder.

Therefore, in the case where an individual is the shareholder, the income derived by the S Corporation from the prescribed contract is taxed to the shareholder pursuant to Chapter One Subtitle A of the IRC 1986.

So, while the S Corporation itself is not subject to taxation, the income originally derived by the S Corporation is subject to taxation in the hands of the shareholders, and thus is "not exempt" from tax imposed by Chapter One of Subtitle A of the IRC 1986 within the meaning of paragraph 23AA(5)(b) of the ITAA 1936.

Accordingly, as the income is not exempt from tax imposed by Chapter One of Subtitle A of the IRC 1986 within the meaning of paragraph 23AA(5)(b) of the ITAA 1936 the condition set down in that paragraph is met,

Thirdly, the Company is at the time the income is derived, in Australia, or carrying on business in Australia, solely for prescribed purposes and therefore the Company satisfies the condition in paragraph 23AA(5)(c) of the ITAA 1936.

Thus as the requirements of paragraphs 23AA(5)(a), (b) and (c) of the ITAA 1936 are satisfied, the income derived by the Company from the subcontract is deemed to have been derived from a source outside Australia.

Conclusion

Subsection 23AA(3) of the ITAA 1936 deems the Company not to be a resident of Australia during the period it carries on business in Australia and subsection 23AA(5) deems the income from the business the Company carries on in Australia to be derived from a source outside Australia.

This means that no income will be attributable to the permanent establishment of the Company in Australia so no tax will be payable in Australia by the Company on the income from the subcontract in connection with the approved project.

Question 2:

Summary

The Company will pay salary or wages and an allowance to its Country X expatriate employees who work in Australia on an approved project as defined in subsection 23AA(1) of the ITAA 1936. That income is exempt income in the hands of the Country X expatriate employees in accordance with section 23AA of the ITAA 1936 and section 11-15 of the Income Tax Assessment Act 1997 (ITAA 1997). Therefore as the income of the recipient employee is exempt income section 12-1 in Schedule 1 to the TAA applies so that the requirement that the Company withhold an amount of tax from the payment in terms of section 12-35 in Schedule 1 to the TAA does not apply.

Detailed reasoning

Section 12-35 in Schedule 1 to the TAA prescribes that an "entity" must withhold an amount of tax from salary, wages, commission, bonuses or allowances it pays to an individual as an employee.

An "entity" is defined in subsection 960-100(1) of the ITAA 1997 to mean, amongst other things, a body corporate and therefore the Company is an entity subject to section 12-35.

The payments made by the Company to its Country X expatriate employees who come to Australia to work on the project are salary or wages and an allowance and as such an obligation to withhold an amount of tax exists.

However, subsection 12-1(1) in Schedule 1 to the TAA provides that an entity need not withhold an amount under section 12-35 from a payment if the whole of the payment is exempt income of the entity receiving the payment.

An "entity" is defined in subsection 960-100(1) of the ITAA 1997 to mean, amongst other things, an individual.

In this case each Country X expatriate employee who is receiving a payment of salary or wages and an allowance comes within that meaning of entity.

It is therefore necessary to determine whether the salary or wages and allowance is exempt income in the hands of the Country X expatriate employees and this requires consideration of section 23AA of the ITAA 1936.

In terms of the definition in subsection 23AA(1) of the ITAA 1936, each Country X expatriate employee of the Company is a "foreign employee" because each is an employee of a foreign contractor and is not an Australian citizen or ordinarily resident in Australia.

There are two other subsections within section 23AA to be considered namely subsections 23AA(3) and 23AA(5).

Foreign employee deemed non-resident

Subsection 23AA(3) of the ITAA 1936 deals with a person who is deemed to be a non-resident. The condition to be met in order for a foreign employee to be deemed a non-resident is that the foreign employee is in Australia solely for prescribed purposes during the period when the person is a foreign employee. This condition will be met by the Country X expatriate employees and hence each will be deemed to be a non-resident.

Foreign employee: Income deemed to have an ex Australian source

Further, the income derived by each foreign employee will be deemed to have an ex-Australian source where the terms of paragraphs 23AA(5)(a), (b) and (c) of the ITAA 1936 are met.

First, in addressing paragraph 23AA(5)(a) it is noted that in answer to Question 1 above it was found that the subcontract which the Company has is a prescribed contract. This is where that subcontract is with an entity that in turn has a prescribed contract with the US Government. Accordingly, the Country X expatriate employees working in Australia, will derive income from employment in connection with the performance of a prescribed contract. As this will be their sole Australian income they will meet the condition in paragraph 23AA(5)(a) of the ITAA 1936.

Secondly, in order to determine whether paragraph 23AA(5)(b) is met it is necessary to examine Chapter One of Subtitle A of the Internal Revenue Code of 1986 (IRC 1986) of the United States of America.

Under section 862 of the IRC 1986 which deals with gross income from sources without the United States it is stated that "compensation for labor or personal services performed without the United States" forms part of the gross income of each Country X expatriate employee.

As section 862 is in Title 26, Subtitle A of Chapter 1 in Subchapter N of Part 1 of the IRC 1986 the income is not exempt from tax imposed under Chapter 1 of Subtitle A of the IRC 1986 and consequently the condition in subparagraph 23AA(5)(b) is prima facie met.

Note that meeting the condition to be "not exempt" from tax in the US as required by paragraph 23AA(5)(b) is subject to the assumption made that no Country X expatriate employee will make an election in terms of section 911 of the IRC 1986 to exclude the foreign earned income from their taxable income.

Thirdly, the Company's Country X expatriate employees, who are foreign employees, will be in Australia only for the purpose of working for the Company in carrying out the prescribed contract which means the terms of paragraph 23AA(5)(c) of the ITAA 1936 are satisfied.

Both subsection 23AA(3) and 23AA(5) of the ITAA 1936 apply to the Country X expatriate employees in this case. Subsection 23AA(3) deems each Country X expatriate employee not to be a resident of Australia during the period the employee will be in Australia solely for prescribed purposes when each employee is a foreign employee; and subsection 23AA(5) deems the income of each foreign employee to be derived from a source outside Australia.

Section 11-15 of the ITAA 1997 deals with ordinary or statutory income which is exempt only if it is derived by certain entities. Section 11-15 lists as exempt income the income from country X projects where section 23AA of the ITAA 1936 applies. Thus section 11-15 applies to exempt the salary or wages and the allowance which are ordinary income in the hands of the Country X expatriate employees working in Australia.

As the income of the Country X expatriate employees from performing work in connection with an approved contract is exempt income subsection 12-1(1) in Schedule 1 to the TAA applies. Because subsection 12-1 applies it negates the operation of section 12-35 in Schedule 1 to the TAA.

Conclusion

The Company is not required to withhold an amount in terms of section 12-35 in Schedule 1 to the TAA from the salary or wages and allowance paid by the Company to its Country X expatriate employees in Australia.

Question 3:

Summary

Subsection 136(1) of the Fringe Benefits Tax Assessment Act 1986 (FBTAA) contains a definition of salary or wages. That definition is conditional upon the application of a provision in Schedule 1 to the TAA which requires the withholding of an amount where the payment is assessable income. In this case the salary or wages are exempt income in the hands of the Country X expatriate employees of the Company in terms of section 23AA of the ITAA 1936 and section 11-15 of the ITAA 1997. Thus as the salary or wages are not assessable income they do not come within the definition of salary or wages in subsection 136(1) of the FBTAA.

Detailed reasoning

Subsection 136(1) of the FBTAA contains a definition of salary or wages.

As far as it is relevant to this case, salary or wages means:

· a payment from which an amount must be withheld (even if the amount is not withheld) under a provision in Schedule 1 to the Taxation Administration Act 1953 listed in the table, to the extent that the payment is assessable income;

The table referred to in paragraph 136(1)(a) lists at Item 1 the withholding payments covered by section 12-35 in Schedule 1 to the TAA for payments to employees. However, that listing is noted as being subject to the exception in section 12-1 in Schedule 1 to the TAA.

It has been found in answer to Question 3 above that as a consequence of the application of section 23AA of the ITAA 1936 and section 11-15 of the ITAA 1997 that the income derived by the Country X expatriate employees is exempt income. It was also found that as the income comprising salary or wages and an allowance was exempt income section 12-1 in Schedule 1 to the TAA applied so that the obligation upon a payer to make a withholding from such payments in terms of section 12-35 in Schedule 1 to the TAA does not apply.

Consequently the payment of salary or wages and an allowance to the Country X expatriate employees of the Company does not come within the definition of salary or wages in subsection 136(1) of the FBTAA.