In a decision of the Full Federal Court last week, the Court unanimously held that the typical sourcing rule in Australia’s treaties means what it says and is not restricted by any principle that treaties are exclusively relieving or, as it is sometimes put, tax treaties can only act as a shield, not a sword.
The relevant rule in article 23(1) of Australia’s 1991 tax treaty with India states:
"Income, profits or gains derived by a resident of one of the Contracting States which, under any one or more of Articles 6 to 8, Articles 10 to 20 and Article 22 may be taxed in the other Contracting State, shall for the purposes of the law of that other State relating to its tax be deemed to be income from sources in that other State."
Article 12(3) of that treaty has a very broad definition of royalties that extends beyond the definition used for withholding tax purposes in Australian law. The case concerned services by an Indian company that were rendered in India for Australian customers. The services came within the treaty definition but were not caught by the narrower definition for domestic law royalty withholding tax (and so were not subject to Australian withholding tax). It was agreed that the payments were ordinary income within section 6-5 of the Income Tax Assessment Act 1997 and (implicitly at least) that the payments would not be sourced in Australia under domestic law apart from the treaty but the treaty allowed Australia to tax them under Article 12(5) as they were paid by Australian residents. The question was whether the rule quoted above, having been implemented into Australian law by the International Tax Agreements Act meant that the services were sourced in Australia for the purposes of section 6-5(3)(a) of the 1997 Act and hence assessable income of the Indian resident taxpayer.
The short answer of the Court is that the treaty sourcing rule clearly says it has effect for domestic tax law purposes – more or less end of story. In an earlier case at first instance the judge had held the same and the issue was not further contested on appeal in that case. Accordingly this time around the issue came immediately before the Full Federal Court.
The taxpayer argued that the quoted provision was merely enabling so that Australia could implement the necessary source rules in the Income Tax Assessment Act 1997. The Court held that the language of the provision was clear that it affected domestic tax law and the process of enactment via the Agreements Act which incorporated the Assessments Acts and then provided that treaty provisions implemented into domestic law by that Act applied notwithstanding anything inconsistent in the Assessment Acts, produced that result. Another provision of the Agreements Act which turned off the treaty sourcing rule in limited cases was noted as further evidence of this intended result (and the Court could have found several other contextual arguments in that Act to similar effect).
The taxpayer also argued that this was inconsistent with the treatment of tax treaties in India where levy of tax by a separate domestic law is necessary and further produced double taxation. The Court dismissed these arguments as not producing a different interpretation of the treaty on the two sides but as a result of the (different) way Australian domestic law operated in implementing the treaty. The treaty itself had a separate provision in relation to sourcing income for the purposes of double tax relief which mirrored Australia’s source taxing rights on the relief side in India. The Court regarded the Explanatory Memorandum as supporting the ATO and not the taxpayer’s view but in any event the treaty text was clear.
In response to the shield not sword argument, the ATO conceded that the treaty did not confer a standalone taxing power nor itself independently impose tax – the allocation of taxing rights under treaties is permissive and do not oblige states to tax but if states choose to tax they can and the sourcing rule operates according to its terms as part of Australian domestic tax law.
The final argument revolved around the fact that the royalties article limits source tax by reference to a gross amount of the royalty whereas tax by assessment is on a net basis and this would involve "a substantial reconstruction" of the Australian statutory scheme for taxing various kinds of income. The Court disagreed – again the treaty text was quite clear: Australia can tax up to the treaty limit but otherwise is not limited in how it does it.
The vibe of the judgment is that the taxpayer’s arguments needed little thought to dismiss them. Probably the real gripe of the taxpayer is that someone from a treaty country ends up paying more tax in Australia than one from a non-treaty country like Hong Kong. It is not clear why Australia has chosen the route of taxing more in treaty cases, nor why it has used the route of a provision in the treaty to change domestic law source rules rather than in the Agreements Act. But it has long been clear that this was the intention and the Court’s decision has confirmed that outcome.
There are many other technical and practical questions around the operation of Australia’s treaty sourcing rule which has a significant degree of variation across treaties, and an apparently conflicting rule in Australia’s treaty with the US. Now that the threshold issue of the general operation of the provision is settled, these other issues need consideration.
On the practical side issues include:
- residents do not have to withhold for payments which do not constitute royalties for domestic law, even if they are royalties under a treaty;
- in such cases the resident is not at risk of losing its deduction for not withholding, though it needs to be certain which side of the line it is on;
- but the non-resident has to file a return in Australia for assessment on a net basis; and
- the non-resident has to claim a foreign tax credit in its own country (which may or may not be honoured by that country).
The ATO is aware of the complexities due to taxpayer’s questions following the earlier court decision but apparently is yet to make up its mind how to proceed.