The interaction between Australia’s domestic law and tax treaties on the taxation of “natural resource payments”, or override royalties, paid to non-residents has come to a head with the ATO’s draft Tax Ruling TR 2016/D3.
The ATO has the power to impose a non-final withholding tax in respect of “natural resource income” paid to a foreign resident, as a collection mechanism prior to assessment of the recipient. Unlike other forms of withholding (such as interest and dividend withholding taxes), the payer must notify the ATO prior to making the first payment so that the rate of withholding can be set.
“Natural resource income” means payments calculated by reference (wholly or partly) to the value or quantity of minerals or petroleum produced or recovered in Australia. They are known as override royalties, but often such payments do not come within the definition of “royalty” (in cases where they do, royalty withholding tax may apply instead). Typically the payer, not the recipient, will hold an interest in the mining or petroleum tenement.
Section 6CA of the Income Tax Assessment Act 1936 deems natural resource income to have been derived from an Australian source. TR 2016/D3 deals with the interpretation of s.6CA and the income from real property articles in Australia’s double tax agreements (DTAs) to override royalty arrangements.
The origin of s.6CA was the Weeks Petroleum Royalty paid by Esso and BHP to a US geologist for advice to look in the Bass Strait for oil (click here for background). Consistent with this origin, the Press Release announcing the measure in 1986 referred to income “directly related to the development and exploitation of Australia's natural resources. … Being directly related to the exploitation of Australian resources, it is reasonable that the income should be subject to full Australian tax” (our emphasis). The relevant Explanatory Memorandum used the same language.
The ATO does not refer to this origin and claims its interpretation of s.6CA takes a substance over form approach. It extends its operation to “a right to receive income [that] may be granted as consideration for the provision of finance, or in satisfaction of some other liability”.
The ATO considers that:
- first, a direct causal connection between the amount of income and the level of production is not required. The payment could instead be calculated by reference to sales or shipping volume, provided this is based on (i.e. a proxy for) the level of production; and
- secondly a relevant natural resource may exist and be “produced or recovered” either by mere extraction, physical separation following extraction, or by chemical processes applied after separation – although in each case all “material” processes must occur in Australia.
Income from real property under Australia’s DTAs
Natural resource income under s.6CA will be income from Australian real property under the majority of Australia’s DTAs, which thereby confer a taxing right on Australia. There is typically an express limb in the “income from real property” article with a definition the ATO concludes is analogous to natural resource income under s.6CA. The ATO states in this regard that “The task is to characterise the nature of the right and its link to exploitation. It is not to analyse the relationship between the parties, nor the reasons for, nor the transactions which gave rise to, the right to receive the payments.”
For these DTAs, there is no requirement for the foreign resident to have a permanent establishment in Australia. In contrast, under the USA DTA, the income from real property article is limited to where the non-resident recipient (not the Australian payer) holds an interest in a tenement. This narrows the application of s.6CA and the corresponding obligation to withhold under the Taxation Administration Act, unless the non-resident has a permanent establishment in Australia.
For the majority of Australia’s DTAs, an alternative view – which requires the non-resident to have a role in the Australian production activities in order for the real property article to apply – is rejected by the ATO. Having concluded that the treaty is simply rephrasing s.6CA, this is putting the cart before the horse. The question is what s.6CA means. The draft ruling ignores the origin and history of s.6CA and so is doubtful on that score. What the ruling needs to do is explore in more detail what connection to exploitation amounts to being “directly related” rather than dismissing such a connection out of hand.
The deadline for comments on the draft ruling is 10 February.