In Tech Mahindra Limited v Commissioner of Taxation  FCAFC 130, the Australian Federal Court examined the interaction between Article 7 (business profits) and Article 12 (royalties) of the Australia-India Double Tax Treaty (DTA).
The Indian-resident taxpayer carried on business in Australia through a permanent establishment (PE). It performed services for its Australian customers both in Australia and in India. The issue was whether Australia had any taxing rights in respect of the income from the services performed by the taxpayer in Indian (Indian Services).
Articles 12(1) and (2) of the DTA gave taxing rights of royalties earned to both Australia and India. The taxpayer argued that the payments for the Indian Services were royalties which fell under Article 12(4) of the DTA which provided that Articles 12(1) and (2) “shall not apply” if the taxpayer carries on business in Australia through an Australian PE and “the property, right or services in respect of which the royalties are paid or credited are effectively connected with such PE”.
If this was the case, Article 7 would apply such that India would have taxing rights unless the royalties paid in respect of the Indian Services were “attributable to [the Australian] PE”. It was accepted by the parties that the Indian Services were not attributable to the Australian PE.
The taxpayer argued that the expression “effectively connected with” connotes in ordinary language a connection which serves to effect the purposes of the PE. As the Indian Services contributed to the discharge of contractual obligations undertaken by the taxpayer in relation to the business carried on through the Australian PE, they served to effect the purposes of the PE and were accordingly “effectively connected with” the PE.
The Commissioner of Taxation (Commissioner) took the view that the Indian Services would be “effectively connected” to the Australian PE where the profits arising thereunder are “attributable to [the Australian] PE” (which the parties had agreed was not the case). The purpose of Article 12(4) was to give the source state where the royalties had arisen (i.e. Australia) the right to tax the royalties under Article 7 in lieu of Article 12 where the Indian Services were effectively connected with the Australian PE.
The Federal Court held that the evident purpose of Article 12(4) was to relieve the source state (i.e. Australia) from the limitation on taxing rights imposed under Article 12 (which caps the amount of tax that may be charged at a specified percentage of the royalties) by taxing the royalties under Article 7. It is not the intention of Article 12(4) to disentitle Australia from any taxing rights where otherwise Article 7 would not give such taxing rights.
The Federal Court also agreed with the Commissioner’s interpretation of the Articles and agreed that the phrase “effectively connected with” is intended to encapsulate the test of connection under Article 7 which allocates the taxing rights to Australia in respect of the profits of the taxpayer that are attributable to the Australian PE.
In addition, the Federal Court also took the view that “effectively connected with” should be taken to mean having a real or actual connection with the activities carried on through the PE. It is insufficient that the Indian Services “served to effect the purposes of the PE”.
The double tax treaties Singapore has entered into generally contain the equivalent of Article 12(4) relating to royalties. This decision would serve as helpful guidance on how to interpret the requirement of “effectively connected with”.
The New Zealand Taxation Review Authority (TRA) recently confirmed in Smith v Commissioner of Inland Revenue  NZTRA 9 that a taxpayer who has not engaged in taxable activities may not claim input tax incurred.