House of Representatives

Explanatory Memorandum

(Circulated by the Treasurer, the Rt. Hon. William McMahon).

AGREEMENT WITH JAPAN.

Introductory Note.

In common with the Singapore agreement, the agreement with Japan is broadly along the lines of the agreements negotiated with the United Kingdom, the United States, Canada and New Zealand.

As with those agreements, the country of residence of the recipient of certain classes of income is given the sole right to tax that income. The relief of double taxation on other classes of income is assured by provisions in the agreement which require the country of residence of the recipient to give a credit against its own tax for the tax imposed in the country of origin. The tax of the country of origin on certain income is limited by the terms of the agreement.

In broad terms, the right to impose tax is reserved to the country of residence of the recipient in respect of the following classes of income -

•

business profits not attributable to a permanent establishment in the country of origin (articles 3 and 4);

•

airline and shipping profits derived from operations in international traffic (article 6);

•

remuneration derived by an individual in respect of professional services or like activities where the income is not attributable to a fixed base regularly available to the recipient in the other country (article 10);

•

salaries, wages and similar remuneration derived by an individual in respect of an employment, unless the employment is exercised in the other country and the person deriving the income is in that other country for more than half the taxation year (article 11);

•

pensions (other than Government pensions) and purchased annuities (article 13);

•

remuneration of Government employees (article 14);

•

remuneration of visiting professors and teachers for visits not exceeding two years (article 15);

•

payments for the maintenance or education of visiting students (article 16).

The tax of the country of origin is limited by the agreement in respect of the following classes of income -

•

dividends - limit of 15 per cent (article 7);

•

interest - limit of 10 per cent (article 8);

•

royalties - limit of 10 per cent (article 9).

Interest and royalties which are derived by an Australian resident from sources in Japan and which are, under the agreement, subject to reduced Japanese tax as described above will, together with dividends received by Australian residents from Japanese sources, be subject to Australian tax and a credit will be allowable against the Australian tax in respect of the Japanese tax. Other income derived by an Australian resident from sources in Japan and subject to Japanese tax will be exempt from tax in Australia in accordance with section 23(q) of the Income Tax Assessment Act.

Explanatory notes on each article of the agreement are given in the following paragraphs -

Notes on Articles

Article 1: Taxes the subject of the agreement.

This article specifies the existing taxes to which the agreement applies. These are the Commonwealth income tax (including withholding tax) and the Japanese income tax and corporation tax. For certain purposes which are outlined in the notes on paragraph (2.) of article 6 of the agreement, the agreement also applies to a Japanese local government tax on profits known as the 'enterprise tax'.

The agreement will, of course, apply to any identical or substantially similar taxes which may be imposed by either Government in the future in addition to, or in place of, the Commonwealth income tax or the Japanese income or corporation taxes.

Article 2: Definitions.

Paragraph 1 of this article defines some of the terms used in the agreement. Definitions of other terms are contained in the articles to which the terms relate.

As with Australia's other double taxation agreements, 'Australia' is defined as including Australia's external territories (except Papua and New Guinea). A protocol to the agreement (which is explained later in this memorandum) provides, in effect, for the areas of continental shelf specified in the Second Schedule to the Petroleum (Submerged Lands) Act 1967-1968 to be treated as part of Australia, for the purposes of the agreement, to the same extent as the Australian income tax law so treats them.

The definitions relating to the residential status of taxpayers may be noted. The terms 'resident of Australia' and 'resident in Japan' are the terms used in each country's taxation law to describe taxpayers who are resident in it for taxation purposes. These terms contrast with the terms 'Australian resident' and 'Japanese resident' which mean a person who is resident solely in one or other of the countries. A person who is a 'dual resident', i.e. both a 'resident of Australia' and 'resident in Japan' will not therefore be entitled to the reliefs which are available under the agreement to 'Australian residents' and 'Japanese residents'.

Paragraph 2 of article 2 excludes from the taxes subject to the agreement amounts payable by way of interest or penalty, e.g. for late lodgment of a return or late payment of tax.

Paragraph 3 is related to a provision of the Japanese taxation law, which has no counterpart in the Australian taxation law, whereby a person who is resident in Japan may in some circumstances (broadly, if he is a 'non-permanent' resident) be taxed there on foreign-source income only if that income is remitted to Japan. Paragraph 3 provides that Australia is not to allow exemption from, or reduction of, its tax on income that, because it is not remitted to or received in Japan by a Japanese resident who derives it, is not subject to Japanese tax.

Paragraph 4 of article 2 is a conventional provision which specifies that terms in the agreement that are not defined in it are to have the meanings which they have under the respective taxation laws of Japan and Australia.

Article 3: Permanent establishment.

The definition of the term 'permanent establishment' which this article embodies corresponds with definitions of the term in Australia's other double taxation agreements, including the agreements with the United Kingdom and Singapore.

The necessity for a detailed definition of the term arises because application of various provisions of the agreement is dependent upon whether or not income of a taxpayer resident in one country is attributable to, or connected with, a trade or business carried on through a 'permanent establishment' in the other country. For example, Australia is entitled by article 4 to tax the business profits of a Japanese resident company that are attributable to the company's permanent establishment in Australia.

Paragraph 1 of the article sets out the basic meaning of the term 'permanent establishment' as being a fixed place of trade or business in which the trade or business of the enterprise is wholly or partly carried on. Other paragraphs of the article, particularly paragraph (2.), provides examples of what constitutes a permanent establishment and defines the circumstances in which a resident of one country shall, or shall not, be deemed to have a permanent establishment in the other country.

Article 4: Industrial or commercial profits.

This article is concerned with the taxation of industrial or commercial (business) profits derived by a resident of one country from sources in the other country.

As is the case under Australia's other agreements, the general position is that these profits will be subject to tax only in the country of residence of the recipient, unless the recipient carries on trade or business through a permanent establishment (as defined in article 3) in the other country, in which case the country in which the permanent establishment is situated may tax the profits which are attributable to the permanent establishment.

A Japanese resident who is taxed in Australia on profits attributable to a permanent establishment in Australia will be entitled to a credit for Australian tax under article 17 against any Japanese tax on that income. In the case of an Australian resident, profits (other than any dividend component of them) attributable to a permanent establishment in Japan and subject to tax in that country will qualify for exemption from Australian tax under section 23(q) of the Income Tax Assessment Act.

The article specifies an arm's length basis for ascertaining the amount of profits attributable to a permanent establishment and the deductions to be allowed when determining those profits. In other words, despite any special arrangements which might be made between the branch in Australia of a Japanese company on the one hand and its overseas head office or affiliates on the other, Australia will be entitled to tax as the profits of the branch in Australia the profits which the branch might have been expected to derive if it were independent of its head office and affiliates.

Paragraph 5 of the article defines the term 'industrial or commercial profits' as meaning profits derived from the conduct of a trade or business. Dividends, interest, rents or royalties that are effectively connected with a trade or business carried on through a permanent establishment are to be treated as 'industrial or commercial profits'. However, such income not so connected is specifically excluded from the term, as is income from operation os ships or aircraft and remuneration for personal (including professional) services. Other articles govern the taxation of the excluded classes of income.

Article 5: Associated companies.

This article, which is supplementary to the provisions for taxing 'industrial or commercial profits' set out in article 4, enable the allocation of profits between inter-connected companies in Australia and Japan on an arm's length basis where the commercial or financial arrangements between the companies differ from those that might be expected to operate between independent enterprises dealing at arm's length with one another.

In these cases profits may be re-allocated for taxing purposes to ensure that a company resident in one country that has participation from the other country in its ownership or control pays tax on the basis of the profits which it might have been expected to derive if its dealings with its overseas parent or associate company were at arm's length.

The article deems profits that are allocated to an enterprise in accordance with the article to be income derived from sources in the country in which the enterprise is resident and declares that they are to be taxed accordingly.

Article 6: Shipping and aircraft profits.

By this article, the right to tax profits from the operation of ships or aircraft in international traffic is restricted to the country of residence of the recipient.

The right of the country of origin to tax shipping or airline profits derived by a resident of the other country is, however, preserved in respect of profits from the carriage of cargoes, mails or passengers from one place in the first-mentioned country for discharge at another place in that country. For this purpose, places in Australia's external territories included in the definition of Australia in article 2 will, of course, be treated as places in 'Australia'. Also, by virtue of paragraphs (4) and (5) of the Protocol to the Agreement, places in Papua or New Guinea and on Australia's continental shelf will be so treated to the appropriate extent.

Paragraph (2) extends the operation of the exemption for profits from operation in international traffic to the enterprise tax which is levied by Japanese local authorities and which is akin to an income tax. An Australian airline or shipowner will therefore not be obliged to pay this tax on profits which it derives from carrying passengers and cargoes between Japan and overseas.

Article 7: Dividends.

Paragraphs (1) and (2) of this article limit to 15 per cent of the gross amount of dividends the tax (other than tax on the profits out of which the dividends are paid) that the country of source may impose on dividends payable to shareholders resident in the other country.

The effect of the article will be to reduce the withholding tax on dividends payable by a company that is a resident of Australia to a shareholder resident in Japan to the rate at which tax is withheld from dividends payable residents of the other countries with which comprehensive double taxation agreements have been concluded by Australia. The article will effect a reduction from 20 per cent in the rate of Japanese tax on dividends derived from Japanese companies by residents of Australia.

The gross amount of dividends derived from a Japanese company by an Australian resident shareholder will be subject to tax in Australia under the normal assessment provisions of the Income Tax Assessment Act and a credit for the reduced Japanese tax will be allowable against the Australian tax on those dividends.

Paragraph (3) declares that the 15 per cent limitation will not apply to dividends derived by a resident of one country who has a permanent establishment in the country from which the dividends are derived if the holding giving rise to the dividends is effectively connected with a trade or business carried on through that establishment. Dividends of that nature are included in the definition of 'industrial or commercial profits' as defined in article 4 and fall to be taxed in accordance with that article.

Paragraphs (4) and (5) of the article are conventional provisions which, in broad terms, ensure that a country (be it Australia or Japan) will not tax a dividend paid by a company resident in the other country if the person deriving the dividend is not a resident of the first- mentioned country.

Article 8: Interest.

By paragraphs (1) and (2) of this article the tax which the country of source may impose on interest payable to a resident of the other country is generally limited to 10 per cent of the gross amount of the interest.

This is the rate at which the withholding tax provisions of the Australian law otherwise require tax to be withheld from interest payable to persons resident in Japan and Japan will, under the agreement, give credit against its tax for the 10 per cent Australian tax. In converse circumstances an Australian resident deriving interest from sources in Japan will be taxed in Australia on the interest and a credit will be allowed against the Australian tax for the reduced Japanese tax on that income (the normal rate of Japanese tax being 20 per cent.)

Interest derived by a resident of one country which is effectively connected with a trade or business carried on through a permanent establishment of that person in the other country will form part of the `industrial or commercial profits' of that establishment and be subject to the provisions of article 4. Accordingly, paragraph (3) of article 8 provides that the 10 per cent limitation specified in the article is not to apply to such interest.

Paragraph (4) will restrict the application of the 10 per cent limitation to the amount of interest which might have been expected to have been agreed upon by persons at arm's length in cases where, because of a special relationship between the persons associated with the loan transaction, the amount of interest paid is excessive.

Article 9: Royalties.

Paragraphs (1) and (2) of this article limit to 10 per cent of the gross amount of royalties the tax which the country of source may charge on royalties derived by a resident of the other country. In the absence of the article, the Australian tax on royalties derived by a Japanese resident is imposed at general rates of tax on the amount of royalties as reduced by allowable deductions, while the Japanese tax on royalties received by an Australian resident amounts to 20 per cent of the gross amount of them.

Royalties derived by a person resident in Japan from sources in Australia will continue to be subject to tax in Australia under the normal assessment provisions of the Income Tax Assessment Act but the article will operate to limit the Australian tax on the royalties to 10 per cent. As in the case of interest, royalties derived by a resident of Australia from sources in Japan which are subject to reduced Japanese tax in accordance with the article will be subject to tax in Australia. Each country will allow its residents a credit for the tax of the other.

The definition of the term 'royalties' in paragraph (3) of the article is on all fours with the corresponding definition in the new United Kingdom agreement. As such, it has the same meaning which the term has for the general purposes of the Income Tax Assessment Act.

As in the case of dividends and interest, the limitation of tax in the country of origin is specified in paragraph (4) as not applying to royalties effectively connected with a permanent establishment of the recipient in that country.

Paragraph (5) provides that the 10 per cent limitation will apply to royalties flowing between persons not dealing at arm's length only to the extent that the royalties paid do not exceed the amount that might be expected to be paid in the absence of the special relationship between the parties.

Article 10: Income from professional services or similar independent activities.

At present, an individual resident in Australia or Japan may be taxed in the other country on the remuneration derived from the performance in the other country of professional services or other similar independent activities. This article provides that such remuneration will continue to be subject to tax in the country in which the services are performed if the recipient has a fixed base regularly available to him in that country for the purposes of performing his activities and the remuneration is attributable to that base. If the tests mentioned are not met the remuneration will be taxed only in the country of residence.

Remuneration derived as an employee and income derived by public entertainers and athletes are the subject of other articles of the agreement and will not be covered by this article.

Article 11: Income from an employment.

The basis for the taxing of remuneration derived by visiting employees is set out in this article. The article does not apply to remuneration of employees who are public entertainers, Government officials, professors or teachers as these classes of persons are the subject of other articles of the agreement.

Paragraph (1) states two general principles. One is that a resident of one country may not be taxed in the other country on salaries, wages etc. from an employment unless the remuneration for an employment exercised in the other country is deemed to have a source in that other country and, subject to paragraph (2), may be taxed by it.

Paragraph (2) qualifies the second general principle by providing an exemption from tax in the country in which an employment is exercised where a visiting employee is present in that country for one-half or less of the taxation year of that country. This exemption applies where the services of the visiting employee are performed for or on behalf of an employer who is not a resident of the country visited and the remuneration is not deductible in determining the profits of a permanent establishment or fixed base which the employer has in that country.

Paragraphs (3) and (4) of the article provide respectively that income from an employment exercised on ships or aircraft in international traffic may be taxed in the country of residence of the operator and that the remuneration of a director of a company will be subject to the provisions of the article as if it were remuneration of an employee.

Article 12: Public entertainers.

This article ensures that income derived by public entertainers and athletes from their personal activities as such will continue to be taxed in the country in which these activities are exercised.

The article further deems an enterprise of one country which is controlled, directly or indirectly, by a public entertainer or athlete to have a 'permanent establishment' in the other country if the enterprise provides in that country the services of the public entertainer or athlete. This is designed to ensure that the enterprise will be subject to tax in that other country on the p profits derived by the enterprise from the provision of those services in that other country.

Article 13: Pensions and annuities.

By this article, pensions (other than Government pensions) and purchased annuities derived by a resident of one country from sources within the other country may be subject to tax only in the country of residence of the recipient.

Although the country of source will be entitled to tax a Government pension, i.e. a pension paid to a former official in respect of services to the Commonwealth or to the Government of Japan, such a pension derived by a resident of Australia from sources in Japan will remain subject to tax in one country only as the pension, if taxed in Japan, will qualify for exemption from tax in Australia under section 23(q) of the Income Tax Assessment Act. In converse circumstances, Japan will give credit for the Australian tax on a pension paid to a former Commonwealth official who is resident in Japan.

Article 14: Governmental remuneration.

This article provides for a reciprocal exemption from tax by the respective countries in respect of remuneration of government employees (including local government employees). The article is subject to the proviso, however, that the exemption conferred by the article will not apply where the services are rendered in connection with a trade or business carried on by a governing body. It will not apply either where, in broad terms, the employee is a citizen of, or normally resides in, the country where he performs his governmental duties for the other country.

Article 15: Visiting professors and teachers.

This article applies in respect of teachers or professors resident in one country who visit the other country for the purpose of teaching or research at an educational institution for a period of not more than two years. In these circumstances, the remuneration of the teacher or professor for his teaching or research work is to be exempt from the tax of the country visited.

Article 16: Visiting students.

This article applies in respect of students resident in one of the countries who are present in the other country solely for the purposes of their education. In these circumstances, a student will be exempt from the tax of the country visited in respect of payments made to him from abroad for the purposes of his maintenance or education.

Article 17: Relief from double taxation.

Double taxation cannot arise, of course, in respect of income flowing between the two countries where the terms of the agreement provide for the income to be taxed only in the country of residence of the recipient.

It is necessary, however, to prescribe a method for relieving double taxation in respect of other classes of income which remain subject to tax in both the country of source of the income and the country of residence of the recipient. Australia's other double taxation agreements provide a credit basis for the relief of double taxation in these cases and the same basis has been adopted in this agreement.

Paragraphs (1) and (2) of the article provide for the relief of double taxation by the credit method by requiring each country to give a credit against its own tax, on income derived by its residents from sources in the other country of source.

There will not, of course, be any scope for Australia to give credit for Japanese tax in respect of income that is exempt from Australian tax under section 23(q) of the Income Tax Assessment Act. However, as explained earlier in this memorandum, it is proposed that the section 23(q) exemption will not apply to interest or royalties in respect of which, under articles 8 and 9 of the agreement, Japanese tax is limited to 10 per cent. Instead, paragraph (1) of this article will operate to provide that a credit for the reduced Japanese tax will be allowed against Australian tax imposed on that income.

Paragraph (2) of the article requires Japan, in addition to giving credit for the Australian withholding tax on dividends, to allow a credit for the Australian company tax on the profits out of which the dividends are paid if the recipient is a Japanese resident company owning not less than 10 per cent of the voting shares or of the total shares of the dividend-paying Australian company. Although there is no corresponding obligation on Australia in converse circumstances, the rebate of tax in respect of inter-company dividends under section 46 of the Income Tax Assessment Act ensures that an Australian company is effectively freed from Australian tax in respect of dividends from Japan.

Paragraph (3) of article 17 specifies the source of various items of income for the purposes of the agreement. It obviates any difficulties which might arise should each country, by the application of the source rules applicable under its domestic law, claim to be the source of the income. (Source rules in relation to other classes of income are included in other articles of the agreement.) In broad terms, paragraph (3) of article 17 provides that -

•

dividends have a source where the paying company is resident;

•

interest and royalties have a source in the country in which is situated the business against the profits of which the interest or royalties are charged;

•

remuneration in respect of an employment exercised aboard an international ship or aircraft has a source in the country of residence of the operator of the ship or aircraft;

•

profits derived by a resident of one country from carriage by ships or aircraft between places in the other country have a source in that other country.

Paragraph (5) of article 17 relates to article 5 of the agreement which allows reconstruction, for income tax purposes, of accounts of associated companies. It ensures that double taxation relief is available in those cases.

Article 18: Exchange of information.

This article authorises the normal exchange of information between the taxing authorities of each country where this is necessary for carrying out the provisions of the agreement, or for the prevention of fraud, etc.. The reservations which it contains correspond with those included in comparable provisions in Australia's other double taxation agreements.

Article 19: Consultation between taxing authorities.

This article provides for consultation between the respective taxing authorities with a view to reaching a satisfactory accord where a person is able to demonstrate that he has been, or is likely to be, subjected to double taxation contrary to the provisions of the agreement.

Article 20: Implementation of agreement.

This article authorises consultation between the respective taxing authorities for the purpose of giving effect to the agreement and assuring its consistent interpretation and application.

Article 21: Extension to territories.

The purpose of this article is to provide for extension of the agreement, either as it stands or with modifications, to any territory for whose international relations Australia is responsible. Any extension would be on conditions which might be agreed to between Australia and Japan.

Under this article the two Governments could agree to extend the agreement to the Territory of Papua and New Guinea. In the absence of any such extension the agreement between Australia and Japan does not apply in relation to income tax levied by the Territory.

Article 22: Commencement.

This article provides for the coming into operation of the agreement.

The article provides for ratification of the agreement by the Government of each country and for the agreement to enter into force on the thirtieth day after the exchange of instruments of ratification. Ratification of the agreement is a stage that follows consideration of the agreement by the Commonwealth Parliament and the Japanese Diet. As mentioned earlier in this memorandum, it is proposed that there will be a notification inserted in the Commonwealth Gazette of the day on which the agreement enters into force in Australia. This will be the thirtieth day after the exchange of instruments of ratification and the Gazette notice will provide an authoritative statement of the date of its entry into force in Australia.

Assuming ratification takes place before the end of November 1969, the agreement will in general have effect for purposes of Australian tax as from 1 July 1969, and for purposes of Japanese tax as regards income or profits derived on or after 1 January 1969.

Article 23: Termination.

This article declares that the agreement shall continue in effect indefinitely. Either country may, however, give to the other country written notice of termination on or before 30 June in any calendar year beginning after the expiration of three years from the date of entry into force of the agreement. In that event the agreement would cease to be effective in accordance with the terms of the article.

Protocol to the Japanese agreement

The protocol contains a number of provisions which are normally contained in the body of double taxation agreements to which Australia is a party but which have, at Japan's request, been dealt with in a separate document in the arrangements with it. This does not give the provisions any limited legal effect as the protocol itself provides that its provisions are to form an integral part of the double taxation agreement.

Paragraph 1 of the protocol operates to preserve the application of the special provisions of the Australian income tax law relating to film businesses controlled abroad and insurance with non-residents of Australia. The paragraph deems an amount included in a person's taxable income under those provisions to be income derived from sources in Australia for the purposes of the tax credit relief provisions in article 17 of the agreement.

Paragraph 2 of the protocol relates to the methods which may be used, for the purposes of article 4 of the agreement, in determining the 'industrial or commercial profits' which are attributable to a permanent establishment. It provides for the continued application of methods customarily used by each country for this purpose, including in the case of Australia the procedure spelt out in section 38 of the Income Tax Assessment Act which applies where goods manufactured out of Australia are imported into Australia and sold in Australia by the manufacturer.

Paragraph 3 of the protocol covers the situation where there is insufficient information available to enable the arm's length basis of determining profits to be properly applied for purposes of articles 4 and 5 of the agreement.

In effect, the paragraph will authorise the Commissioner of Taxation in Australia, in an appropriate case, to apply the provisions of section 136 of the Income Tax Assessment Act. That section provides, under certain conditions, for assessment on the basis of such portion of the total receipts of a business as the Commissioner determines. The paragraph requires, however, that the Commissioner is to apply those provisions, so far as is practicable, in accordance with the arm's length principle set out in articles 4 and 5 of the agreement.

Paragraph 4 of the protocol provides in effect that, for the purposes of articles 6 and 17 of the agreement, the carriage by ship or aircraft of passengers, cargo or mails from a place in Australia (as defined in article 2) for discharge in Papua or New Guinea is to be treated as carriage between places in Australia. This will give Australia prior taxing rights in respect of profits from this carriage.

Paragraph 5 of the protocol will, subject to the general provisions of the agreement, have the same practical effect as regards Japanese residents as does section 6AA of the Income Tax Assessment Act. It ensures that Australia continues to have the right to tax, in accordance with the agreement, income derived by a Japanese resident from, or in connection with, the exploration for or exploitation of petroleum in the areas of the continental shelf specified in the Second Schedule to the Petroleum (Submerged Lands) Act as if those areas were part of Australia.

Paragraph 6 of the protocol is the source of paragraph (d) of clause 3 of the Bill, which has been explained on page 2 of this memorandum.