Edited version of your written advice

Authorisation Number: 1051321725192

Date of advice: 1 February 2018

Ruling

Subject: Permanent establishment and royalty withholding tax under a double tax agreement

Question 1

Is the income received by Foreign Co from the arrangement with Australia Co sourced from Australia?

Answer 1

Yes

Question 2

Does Foreign Co have a Permanent Establishment in Australia in relation to the activities carried out under the Goods and Services Contract with Australia Co pursuant to Article 5(1) of the relevant Double Tax Agreement?

Answer 2

Yes

Question 3

Are the amounts payable by Australia Co to Foreign Co royalties under section 6 of the 1936 Act or Article 12 of the DTA?

Answer 3

No

Question 4

Are the amounts payable by Australia Co to Foreign Co subject to royalty withholding tax under section 128B of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer 4

No

This ruling applies for the following period:

The relevant income year

The scheme commences on:

The relevant start date

Relevant facts and circumstances

Foreign CO

Foreign Co is incorporated in and is a tax resident of a foreign country.

Foreign Co has sales and service offices in various countries including Subcontractor Co.

Subcontractor Co

Subcontractor Co is incorporated in Australia and is a resident for tax purposes.

Service maintenance contract with Australia Co

Foreign Co entered into a maintenance contract (a head contract) with Australia Co to provide it with maintenance services.

Under the contract, Australia Co sends periodic invoices to Foreign Co to provide it with maintenance services.

The maintenance contract contains provisions allowing Foreign Co to subcontract its obligations to Australia Co while remaining liable for those obligations and ultimately retaining the risks associated with the contract.

Contract between Foreign Co and Subcontractor Co

Foreign Co entered into a service contract (subcontract) with Subcontractor Co for three years to fulfil the Australia Co maintenance contract.

Foreign Co’s service department orders service works which are to be performed by Foreign Co Austraila for 3 or 4 month contracts and Foreign Co’s purchase department prepares the purchase order in its home country.

Relevant legislative provisions

Relevant Double Tax Agreement Article 5(1)

Relevant Double Tax Agreement Article 7

Relevant Double Tax Agreement Article 12

Income Tax Assessment Act 1936 Subsection 6(1)

Income Tax Assessment Act 1936 Subsection 128B(2B)

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

Income Tax Assessment Act 1997 Subsection 6-5(3)

Income Tax Assessment Act 1997 Section 995-1

International Tax Agreements Act 1953 Subsection 4(1)

International Tax Agreements Act 1953 Subsection 4(2)

Reasons for decision

Question 1

Summary

The work under the maintenance contract is physically performed in Australia. As such, the payments received by Foreign Co from Australia Co have an Australian source.

Detailed reasoning

Subsection 6-5(1) of the ITAA 1997 states –

6-5(1) Your assessable income includes income according to ordinary concepts, which is called ordinary income.

Subsection 6-5(3) of the ITAA 1997 goes on to state –

6-5(3) If you are a foreign resident, your assessable income includes:

(a) the ordinary income you derived directly or indirectly from all Australian sources during the income year; and

(b) other ordinary income that a provision includes in your assessable income for the year on some basis other than having an Australian source.

Section 995-1 of the ITAA 1997 defines ‘Australian source’ as –

Australian source: ordinary income or statutory income has an Australian source, if, and only if, it is derived from a source in Australia for the purposes of the Income Tax Assessment Act 1936.

The source of trading or business profits is generally determined by reference to the place where the trader (or its employees or agents) trades or renders services. The source of income is determined according to the general principal set out in Nathan v. Federal Commissioner of Taxation (1918) 25 CLR 183, where the High Court held the determination of source of income is a ‘practical hard matter of fact’. In Thorpe Nominees Pty Ltd v. Commissioner of Taxation 88 ATC 4886; (1988) 19 ATR 1834, the Full Federal Court held that the question of source must be decided in accordance with the practical realities of the situation without giving undue weight to matters of form.

In this case, the fees from Australia Co are for the performance of work under the maintenance contract. The work is physically completed under the subcontract agreement by Subcontractor Co in Australia at the workshop of Australia Co as required.

Therefore, the payments received by Foreign Co from Australia Co have an Australian source.

Question 2

Summary

Foreign Co will have a Permanent Establishment in Australia under Article 5(1) of the relevant Double Tax Agreement for the obligations contained in the maintenance contract. Foreign Co, through a subcontract arrangement with Subcontractor Co, is carrying on its business through the fixed site or sites made available to them in the maintenance contract with Australia Co.

Detailed reasoning

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

When determining whether Australia has a taxing right in respect of income derived in Australia by a foreign resident company, we must also consider the International Tax Agreements Act 1953 (Agreements Act).

Subsection 4(1) of the Agreements Act incorporates the Income Tax Assessment Act 1936 (ITAA 1936) and ITAA 1997 so that those Acts are read as one with the Agreements Act. Subsection 4(2) of the Agreements Act effectively overrides the ITAA 1936 and ITAA 1997 where there are inconsistent provisions (except for some limited situations).

Article 7 of the relevant Double Tax Agreement (the Agreement) governs the taxation of business profits derived from Australia by a resident of the other country. Under Article 7 of the Agreement, the business profits of an enterprise of the other country shall be only taxable in that other country unless the enterprise carries on business in Australia through a permanent establishment situated in Australia. If so, the profit of the enterprise that is attributable to that permanent establishment in Australia may be taxed in Australia.

The term ‘permanent establishment’ is defined in Article 5(1) of the Agreement to mean

… a fixed place of business through which the business of the enterprise is wholly or partly carried on.

Article 5(2) of the Agreement contains a list of examples that each may be regarded as constituting a permanent establishment, such as

(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 relating to the exploration for or exploitation of natural resources; and

(g) an agricultural, pastoral or forestry property.

In Thiel v. Federal Commissioner of Taxation (1990) 171 CLR 338; 90 ATC 4714; (1990) 21 ATR 531 (Thiel), the High Court accepted that the OECD Commentaries may be referred to when interpreting tax treaties in accordance with Article 32 of the Vienna Convention (See paragraph 90 of Taxation Ruling TR 2001/13 Income tax: Interpreting Australia’s Double Tax Agreements).

Paragraph 44 of the OECD Commentaries on Article 5: Concerning the definition of permanent establishment (Commentary on Article 5) affirms that:

A permanent establishment begins to exist as soon as the enterprise commences to carry on its business through a fixed place of business. This is the case once the enterprise prepares, at the place of business, the activity for which the place of business is to serve permanently. The period of time during which the fixed place of business itself is being set up by the enterprise should not be counted, provided that this activity differs substantially from the activity for which the place of business is to serve permanently

On this basis, the definition of a ‘permanent establishment’ contains three conditions (as outlined in paragraph 6 of the OECD Commentaries):

● the existence of a ‘place of business’,

● the place of business must be fixed, and

● the business of the enterprise is, wholly or partly, carried on through this fixed place of business.

Existence of a ‘place of business’

On 21 November 2017, the OECD Council approved the contents of the 2017 Update to the OECD Model Tax Convention (OECD Commentary).

The OECD Commentary on Article 5 relevantly states at paragraph 10 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… It is immaterial whether the premises, facilities or installations are owned or rented by or are otherwise at the disposal of the enterprise…

Paragraph 20 of the OECD Commentary on Article 5 goes on to state –

The words “through which” must be given a wide meaning so as to apply to any situation where business activities are carried on at a particular location that is at the disposal of the enterprise for that purpose. Thus, for instance, an enterprise engaged in paving a road will be considered to be carrying on its business “through” the location where this activity takes place.

Foreign Co entered into a maintenance contract with Australia Co (maintenance contract) to provide it with maintenance services for a period of at least 3 years. Foreign Co entered into a subcontract with Subcontractor Co (subcontract) for Subcontractor Co to fulfil the maintenance contract with Australia Co.

Under the maintenance contract, Australia Co sends periodic invoices to Foreign Co to provide maintenance services. Foreign Co then orders service works which are to be performed by Subcontractor Co.

Under the maintenance contract, work is undertaken at Australia Co’s workshop.

Therefore, this aspect is satisfied as there is a place of business, being the relevant workshop.

The place of business must be fixed

Paragraph 21 of the OECD Commentary on Article 5 defines ‘fixed’ as -

According to the definition, the place of business has to be a “fixed” one. Thus in the normal way there has to be a link between the place of business and a specific geographical point. It is immaterial how long an enterprise of a Contracting State operates in the other Contracting State if it does not do so at a distinct place, but this does not mean that the equipment constituting the place of business has to be actually fixed to the soil on which it stands. It is enough that the equipment remains on a particular site…

Paragraph 28 of the OECD Commentary on Article 5 relevantly states that –

Since the place of business must be fixed, it also follows that a permanent establishment can be deemed to exist only if the place of business has a certain degree of permanency, i.e. if it is not of a purely temporary nature. A place of business may, however, constitute a permanent establishment even though it exists, in practice, only for a very short period of time because the nature of the business is such that it will only be carried on for that short period of time…

As discussed above, Foreign Co entered into the maintenance contract with Australia Co for a period of at least 3 years.

Paragraph 17 of the OECD Commentary on Article 5 outlines the following example –

A fourth example is that of a painter who, for two years, spends three days a week in the large office building of its main client. In that case, the presence of the painter in that office building where he is performing the most important functions of his business (i.e. painting) constitute a permanent establishment of the painter.

The maintenance contract gives Foreign Co non-exclusive access to the Australia Co’s workshop sufficient to enable them to carry out their obligations under the maintenance contract. Therefore, the place of business is fixed.

The business of the enterprise is carried on through this fixed place of business

Foreign Co entered into a subcontract with Subcontractor Co to fulfil the maintenance contract.

Paragraph 40 of the OECD Commentary on Article 5 relevantly states –

40. An enterprise may also carry on its business through subcontractors, acting alone or together with employees of the enterprise. In that case, a permanent establishment will only exist for the enterprise if the other conditions of Article 5 are met (this, however, does not address the separate question of how much profit is attributable to such a permanent establishment). In the context of paragraph 1, the existence of a permanent establishment in these circumstances will require that these subcontractors perform the work of the enterprise at a fixed place of business that is at the disposal of the enterprise. Whether a fixed place of business where subcontractors perform work of an enterprise is at the disposal of that enterprise will be determined on the basis of the guidance in paragraph 12; in the absence of employees of the enterprise, however, it will be necessary to show that such a place is at the disposal of the enterprise on the basis of other factors showing that the enterprise clearly has the effective power to use that site, e.g. because the enterprise owns or has legal possession of that site and controls access to and use of the site. Paragraph 54 illustrates such a situation in the case of a construction site; this could also happen in other situations. An example would be where the enterprise that owns a small hotel and rents out the hotel’s rooms through the Internet has subcontracted the on-site operation of the hotel to a company that is remunerated on a cost-plus basis.

Paragraph 40 of the OECD Model Commentaries on Article 5 recognises that an enterprise may carry on its business through subcontractors, either acting alone or together with employees of the enterprise. It is irrelevant whether the enterprise itself performs activities in Australia or subcontracts the work to others, either wholly or in part. That is, an enterprise cannot subcontract out of a permanent establishment in Australia where the other conditions of Article 5 are met.

In this case, Foreign Co continues to be liable for their obligations under the maintenance contract as well as being liable for the acts and omissions of Subcontractor Co and any of its personnel as if those acts or omissions were Foreign Co’s. That is, the work of Subcontractor Co is the work of Foreign Co under the maintenance contract.

Accordingly, Foreign Co is considered to have carried on the service obligations contained in the maintenance contract under Article 5(1) of the Agreement. This is because Foreign Co, as contractor, is considered to have carried on the activities through Subcontractor Co as subcontractor.

Conclusion

Foreign Co will have a Permanent Establishment in Australia under Article 5(1) of the Agreement for the obligations contained in the maintenance contract. This is because Foreign Co, through a subcontract arrangement with Subcontractor Co, is carrying on its business of maintenance through the fixed site or sites made available to them in the maintenance contract.

Question 3

Summary

The payments made by Australia Co to Foreign Co for services performed under the maintenance contract are not Royalties under Article 12 of the Agreement or subsection 6(1) of the ITAA 1936.

The maintenance contract is a contract for the supply of goods and the provision of services under the maintenance contract.

As such, the payments for the provision of services from Foreign Co to Australia Co via the maintenance contract will be subject to Article 7 of the Agreement.

Detailed reasoning

Subsection 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936) relevantly states:

royalty or royalties includes any amount paid or credited, however described or computed, and whether the payment or credit is periodical or not, to the extent to which it is paid or credited, as the case may be, as consideration for:

(a) the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trade mark or other like property or right;

(b) the use of, or the right to use, any industrial, commercial or scientific equipment;

(c) the supply of scientific, technical, industrial or commercial knowledge or information;

(d) the supply of any assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application or enjoyment of, any such property or right as is mentioned in paragraph (a), any such equipment as is mentioned in paragraph (b) or any such knowledge or information as is mentioned in paragraph (c);

(da) …

(db) …

(dc) …

(e)…

(f) a total or partial forbearance in respect of:

(i) the use of, or the granting of the right to use, any such property or right as is mentioned in paragraph (a) or any such equipment as is mentioned in paragraph (b);

(ii) the supply of any such knowledge or information as is mentioned in paragraph (c) or of any such assistance as is mentioned in paragraph (d);

(iia)…

(iib)…

(iic)…

(iii)…

Article 12 of the Agreement broadly reflects the definition contained in subsection 6(1) of the ITAA 1936

In this case, the maintenance contract is a contract for the supply of goods and the provision of services. Therefore, the payments made by Australia Co to Foreign Co for services performed under the maintenance contract are not Royalties under Article 12 of the Agreement or subsection 6(1) of the ITAA 1936.

As such, the payments for the provision of services from Foreign Co to Australia Co via the maintenance contract will be subject to Article 7 of the Agreement as detailed in question 2 above.

Question 4

Summary

Subsection 128B(2B) of the ITAA 1936 will not apply as the payments made by Australia Co to Foreign Co under the maintenance contract are not Royalties.

Detailed reasoning

Broadly, subsection 128B(2B) of the ITAA 1936 extends the withholding tax provisions to royalties paid to a non-resident.

As discussed at question 3 above, the payments made by Australia Co to Foreign Co are not royalties. As such, subsection 128B(2B) will not apply.