On 12 November 2015, Australia and Germany signed a Double Taxation Agreement (2015 DTA), which replaced the 1972 Double Tax Agreement (1972 DTA) between the two countries. Parliament has released the International Tax Agreements Amendment Bill 2016 (Amendment Bill) which will give force in Australia to the 2015 DTA by amending the International Tax Agreements Act 1953.
The 2015 DTA will enter into force once Australia and Germany have both completed and exchanged their legislative instruments of ratification.
How does a DTA affect taxation?
DTAs operate so as to avoid the double taxing of profits by allocating taxing rights or requiring credits to be provided for tax paid in another country. For example, if a foreign resident company produces business profits in Australia through a ‘permanent establishment’ (PE), Australia has the right to impose income tax on those profits (and vice versa). DTAs generally outline the circumstances in which a foreign resident will be considered to be operating through a PE in Australia.
Ordinarily, if a resident Australian company pays dividends, interest, or royalties to a foreign entity, it is liable to pay withholding tax – which is the income tax payable – on the overseas payments (and vice versa).1 The rates of withholding tax are 30% on dividends and royalties, and 10% on interest.2 These rates are reduced by DTAs between Australia and a range of countries, including Germany.
Key objective of the 2015 DTA
The key objective of the changes in the 2015 DTA is to remove tax impediments and create a more favourable investment environment between Australia and Germany. A reduction in withholding taxes in particular circumstances will reduce the cost of investment and trade between the two countries, fostering further growth in business relations. A stronger economic connection with Germany will not only provide Australia with significant strategic access to the European market, but will also decrease its reliance on the Chinese economy.
The changes have also attempted to address some of the shortcomings in the older style DTAs that have been identified in the OECD’s study into Base Erosion and Profit Shifting.
Significant changes in the 2015 DTA
The following provides a summary of some of the key changes introduced by the 2015 DTA.
The 2015 DTA strengthens the definition of PE in Article 5 by:
- extending the length of time that a building site, construction or installation project must operate before a PE is taken to arise, from 6 months to 9 months;
- removing ‘assembly projects’ from the definition, regardless of the duration of operation;
- adding exploration or exploitation of natural resources to the definition (where it occurs for at least 90 days in a year);
- adding the operation of substantial equipment to the definition (so long as it occurs for an aggregate 183 days in a year);
- restricting the exclusions from the definition of a PE for activities that involve storage, display, delivery, maintenance of stock, purchasing stock, collecting information or advertising to situations where those activities are merely preparatory or auxiliary; and
- extending the concept of a PE arising from the actions of an agent (including employees) to include situations where the agent plays the principal role in the process which leads to the conclusion of a contract and the principal completes the contract without ‘material modification’.
The 2015 DTA also introduces a number of integrity measures intended to prevent the artificial avoidance of PE status, including:
- introducing the concept of ‘connected’ activities to prevent enterprises splitting contracts in order to fall below the relevant time thresholds; and
- introducing the concept of ‘closely related enterprises’ to prevent enterprises fragmenting their business in order to artificially categorise different entities as merely carrying on preparatory or auxiliary activities.
The dividend withholding tax rate under the 1972 DTA is 15%. This is generally payable on the receipt of unfranked dividend paid by an Australian resident company to a German resident shareholder (franked dividends paid by an Australian resident company are not subject to withholding tax).
Under the 2015 DTA, this withholding tax rate is reduced for particular intercorporate dividends, including:
- where the shareholder corporation holds more than 10% of the voting power in the paying company (and this has been the case for more than 6 months), the withholding tax rate is reduced to 5%; and
- where the shareholder corporation holds more than 80% of the voting power in the paying company (and this has been the case for more than 12 months), the withholding tax rate is reduced to nil.
The minimum holding periods are designed to prevent shareholders increasing their holding immediately before the payment of dividends solely for the purpose of securing the exemption.
Under the 1972 DTA, the source country may withhold up to 10% of the value of interest payments made between Australia and Germany.
The 2015 DTA provides exemptions to this interest payment withholding tax where the interest is derived by:
- a political or government body;
- a bank performing central banking functions; or
- a financial institution that is unrelated to the payer (but not where the interest is paid under back-to-back loans or other similar arrangements).
The denial of the exemption in back-to-back loan arrangements is designed to prevent financial institutions effectively shifting the benefit to a person or entity in the contracting state of the payer, who would otherwise not be entitled to the exemption.
Under the 1972 DTA, the source country may impose a 10% withholding tax rate on royalty payments made between Australia and Germany. The 2015 DTA reduces this tax rate to 5%.
The 2015 DTA also extends the definition of ‘royalties’ to include payments made in relation to the right to use radio frequencies spectrum licences.
Australia and Germany have strong relationships in the technology and innovation industries. In particular, Germany is a net exporter of intellectual property and is widely acknowledged for its technological innovation. The reduction of the withholding tax payable on royalty payments will provide a benefit to the German technology and innovation sector and assist those Australian businesses that import or purchase intellectual property rights from German enterprises.
The amendments to the definition of PE will provide the Australian tax authorities with greater scope to impose tax on local mining and other activities. These changes are based on Australia’s view that the current OECD Model is inadequate to deal with high value mobile activities, in particular those involving the use of ‘substantial equipment’.
Practically speaking, a German enterprise which operates a mobile drilling rig at a mining site in Australia for more than 183 days in a year will be deemed to have a PE in Australia under the new rules. In contrast, if the German enterprise merely leases the drilling rig to another entity for its own purposes, this will not be considered a PE, so long as that entity is not considered a ‘closely related enterprise’ or engaging in ‘connected activities’ and therefore captured by the new integrity provisions.
The changes will not only impact the mining industry. The explanatory memorandum to the Amendment Bill provides that the term ‘substantial equipment’ will capture the use of industrial earthmoving equipment in road or dam building, manufacturing equipment used in factories, and oil and drilling rigs used in the petroleum and gas industries, thereby having a multi-industry effect.
Separately, the exemption from interest withholding tax provided by the 2015 DTA recognises that the 10% tax rate can be excessive given the cost of funds for particular types of entities. This will reduce the cost of investment between Australia and Germany and promote further growth in business relations between the two countries.
Implementation of the OECD/G20 BEPS recommendations
Many of the amendments discussed above implement the recommendations made by the OECD/G20 Final Report on Base Erosion and Profit Shifting (BEPS Report).
Most significantly, these include a number of integrity measures introduced by the 2015 DTA. For example, the provisions designed to prevent contract splitting and business fragmentation, in the context of PEs, adopts the recommendations of Action Item 7 of the BEPS Report, aimed at preventing the artificial avoidance of PE status. Further, the minimum holding periods required under the dividend exemption amendments adopts the recommendations of Action Item 6 of the BEPS Report, designed to target the prevention of treaty abuse.
This demonstrates both countries’ continued commitment to tacking international tax avoidance practices.