House of Representatives

Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

General outline and financial impact

What will the bill do?

This bill will amend the Agreements Act to give the force of law in Australia to the following tax treaties:

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a Convention between the Government of Australia and the Government of United Kingdom of Great Britain and Northern Ireland for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income and on Capital Gains (2003 United Kingdom convention), and the associated Exchange of Notes (2003 United Kingdom notes); and

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an Agreement between the Government of Australia and the Government of the United Mexican States for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income , and the Protocol thereto (Mexican agreement).

The 2003 United Kingdom convention is Australia's third comprehensive tax treaty with the United Kingdom. The existing agreement, which was concluded in 1967 and partially revised by an amending Protocol in 1980, is not well aligned with modern business practices, the respective tax systems and modern tax treaty practice. The new tax treaty will rectify this situation and serves to facilitate trade and investment between Australia and the United Kingdom.

The Mexican agreement will expand trade and investment links between Australia and Mexico by preventing double taxation and reducing tax avoidance and evasion in respect of all forms of income flows between the two countries.

This bill will also clarify within the Agreements Act that references in Australian tax treaties to income from shares, or to income from other rights participating in profits, shall not be taken to include a return on a debt interest.

This bill will also make consequential amendments to:

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the ITAA 1936 to substitute a new paragraph (a) into the definition for 'relevant provision' under subsection 170(14) to ensure that the definition remains current; and

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the Taxation (Interest on Overpayments and Early Payments) Act 1983 to update cross-references to the Agreements Act.

How do tax treaties work?

Tax treaties allocate to the country of source, sometimes at limited rates, a taxing right over certain income, profits or gains derived by residents of the treaty partner country. It is accepted that both countries possess the right to tax the income of their own residents under their own domestic laws and as such, the tax treaty wording will not always explicitly restate this rule.

However, where the country of residence is to be given the sole taxing right over particular categories of income, profits or gains, this sole right is usually represented by the words shall be taxable only in that country . Tax treaties generally also provide that where income, profits or gains may be taxed in both countries, the country of residence (if it taxes) is to allow double tax relief against its own tax for the tax imposed by the country of source. In the case of Australia, effect is given to the relief obligations arising under the tax treaty by application of the general foreign tax credit system provisions of Australia's domestic law, or relevant exemption provisions of the law where applicable.

What is the purpose of Australia's tax treaties?

Australia's tax treaties are primarily concerned with relieving juridical double taxation, which can be described broadly as subjecting the same income of a taxpayer to comparable taxes under the taxation laws of two different countries.

Relief from double taxation is desirable because of the harmful effects that double taxation can have on the expansion of trade and the movement of capital, technology and people between countries. A tax treaty supplements the unilateral double tax relief provisions in the respective treaty partner countries' domestic law and clarifies the taxation position of income flows between the parties.

Australia's tax treaties are designed to:

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avoid double taxation and provide a level of security about the tax rules that will apply to particular international transactions by:

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allocating taxing rights between the countries over different categories of income;

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specifying rules to resolve dual claims in relation to the residential status of a taxpayer and the source of income; and

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providing a taxpayer with an avenue to present a case for determination by the relevant taxation authorities where the taxpayer considers there has been taxation treatment contrary to the terms of a tax treaty; and

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prevent avoidance and evasion of taxes on various forms of income flows between the treaty partners by:

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providing for the allocation of profits between related parties on an arm's length basis;

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generally preserving the application of domestic law rules that are designed to address transfer pricing and other international avoidance practices; and

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providing for exchanges of information between the respective taxation authorities.

Who will be affected by the measures in this bill?

Persons who:

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are residents of Australia or the United Kingdom for the purposes of the 2003 United Kingdom convention and who derive income, profits or gains from the United Kingdom or Australia;

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are residents of Australia or Mexico for the purposes of the Mexican agreement and who derive income, profits or gains from Mexico or Australia; or

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residents of a treaty partner country who derive certain amounts treated as returns on debt-interests under Australia's debt/equity rules.

How is the legislation structured?

The Agreements Act gives the force of law in Australia to Australia's tax treaties which appear as Schedules to that Act. The provisions of the ITAA 1936, the ITAA 1997 and the Fringe Benefits Tax Assessment Act 1986 are incorporated into and read as one with the Agreements Act. The provisions of the Agreements Act (including the terms of the tax treaties) take precedence over provisions of the:

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ITAA 1936 (other than section 160AO which determines maximum foreign tax credits and the general anti-avoidance rules under Part IVA);

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ITAA 1997; and

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Fringe Benefits Tax Assessment Act 1986 (other than section 67 which is an anti-avoidance rule).

In what way does this bill change the Agreements Act?

This bill will make changes to the Agreements Act by:

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repealing the following definitions in subsection 3(1):

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United Kingdom tax [Schedule 1, item 6];

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the United Kingdom [Schedule 1, item 3];

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the United Kingdom agreement [Schedule 1, item 4];

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the United Kingdom protocol [Schedule 1, item 5]; and

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the previous United Kingdom agreement [Schedule 1, item 2];

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inserting the following new definitions into subsection 3(1):

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the 1946 United Kingdom agreement [Schedule 1, item 7];

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the 1967 United Kingdom agreement [Schedule 1, item 8];

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the 1980 Protocol to the 1967 United Kingdom agreement [Schedule 1, item 9];

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the 2003 United Kingdom convention [Schedule 1, item 10];

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the 2003 United Kingdom notes [Schedule 1, item 11]; and

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the Mexican agreement [Schedule 2, item 1];

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repealing paragraph (b) under the defined term 'agreement' in subsection 3(1) and substituting paragraphs (b), (ba) and (bb) in its place [Schedule 1, item 1];

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repealing Schedules 1 and 1A and inserting the text of:

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the 2003 United Kingdom convention (including the text of the 2003 United Kingdom notes) as Schedule 1 [Schedule 1, item 14]; and

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the Mexican agreement (and Protocol) as Schedule 47 [Schedule 2, item 3];

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repealing sections 5 and 5A and substituting new sections 5 and 5A that [Schedule 1, item 12];

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provide for the entry into force of the provisions of the 2003 United Kingdom convention according to their tenor; and

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preserve the operation of the 1946 United Kingdom agreement, the 1967 United Kingdom agreement, and the 1980 Protocol to the 1967 United Kingdom agreement so far as the provisions that affect Australian tax continue to have the force of law in relation to tax in respect of income in relation to which the treaties remain effective;

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inserting a new section 11ZL to provide for the entry into force of the provisions of the Mexican agreement and protocol according to their tenor [Schedule 2, item 2];

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repealing section 17B [Schedule 1, item 13]; and

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inserting a new subsection (2A) after subsection 3(2) clarifying that any reference in Australian tax treaties to income from shares, or to income from other rights participating in profits, does not include a reference to a return on debt interest [Schedule 3, item 3].

This bill will also make consequential amendments to:

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subsection 170(14) of the ITAA 1936 to:

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substitute a replacement paragraph (a) that does not reference any specific tax treaty into the definition of 'relevant provision' (the existing paragraph (a) of the definition references paragraph 3 of Article 5 and paragraph 1 of Article 7 of the 1967 United Kingdom agreement) [Schedule 3, item 1]; and

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repeal the definition of the United Kingdom agreement [Schedule 3, item 2]; and

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update references to the Agreements Act that occur within subsection 3(1) of the Taxation ( Interest on Overpayments and Early Payments ) Act 1983 [Schedule 3, items 4 and 5].

When will these changes take place?

The 2003 United Kingdom convention will enter into force on the last of the dates on which the treaty partners exchange notes through the diplomatic channel advising each other that all domestic requirements necessary to give the tax treaty the force of law in the respective countries have been completed.

The Mexican agreement will enter into force on the last of the dates on which the treaty partners exchange notes through the diplomatic channel advising each other that all domestic requirements necessary to give the Agreement the force of law in the respective countries have been completed.

The other amendments effected by this bill will commence on the day on which this bill receives Royal Assent.

When the treaties enter into force, from what date will they have effect?

The 2003 United Kingdom convention will have effect:

In Australia:

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for withholding taxes on income derived:

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on or after 1 July next following the date on which the tax treaty enters into force;

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in respect of fringe benefits provided:

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on or after 1 April next following the date on which the tax treaty enters into force; and

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for other Australian taxes on income or gains:

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the Australian year of income beginning on or after 1 July next following the date on which the tax treaty enters into force.

In the United Kingdom:

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for taxes withheld at source for amounts paid or credited:

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on or after 1 July next following the date on which the tax treaty enters into force;

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in relation to capital gains tax and income tax (excluding taxes withheld at source for which the date of effect is 1 July next following the date on which the tax treaty enters into force):

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for any United Kingdom year of assessment commencing on or after 6 April next following the date on which the tax treaty enters into force; and

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in relation to the corporation tax:

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for any financial year commencing on or after 1 April next following the date on which the tax treaty enters into force.

The Mexican agreement will have effect

In Australia:

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for withholding taxes for amounts paid or credited:

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on or after the first day of the second month next following the date on which the agreement enters into force if the tax treaty enters into force prior to 1 July of that year; or

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on 1 January of the year following the year in which the tax treaty enters into force in other cases; and

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for other Australian taxes, in relation to income, profits or gains:

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any year of income beginning on or after 1 July in the calendar year next following that in which the tax treaty enters into force.

In Mexico:

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for withholding taxes for amounts paid or credited:

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on or after the first day of the second month next following the date on which the tax treaty enters into force if the agreement enters into force prior to 1 July of that year; or

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on 1 January of the year following the year in which the tax treaty enters into force in other cases; and

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for other Mexican taxes:

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on or after 1 July in the calendar year next following that in which this tax treaty enters into force.

The financial impact of this bill

The 2003 United Kingdom convention

The direct cost to revenue from the proposed tax treaty is estimated to be approximately A$100 million per annum. The estimated distribution of this first round cost in future years is shown in the table below:

Treasury has estimated that the cost to revenue will be partially offset by a number of second round gains from implementation of the new treaty. There is an expected increase in revenue of around A$70 million per annum as a result of the boost to economic activity sourced in the proposed treaty's downward pressure on interest rates. Other offsets include a reduction in Australian tax credits claimed for United Kingdom withholding taxes (perhaps A$5 million - A$10 million per annum), an increase in GDP as a result of the more efficient allocation of resources flowing from a reduction in pricing distortions, and a small increase in Australia's growth rate as a result of the more open and competitive environment encouraged by the new treaty. Overall, it is anticipated that the new treaty will produce a positive economic outcome for Australia.

The Mexican agreement

The Mexican agreement contained in this bill generally accords with Australia's other modern comprehensive tax treaties and is not expected to have a significant effect on revenue. Although the cost of this measure cannot be precisely defined, it is expected to be approximately A$2 million per annum over the forward estimate period. That is:

The benefits are widely spread in the economy. Indirect revenue benefits may arise from increased trade and investment between Australia and Mexico and reduced tax credit obligations to Mexico.

Compliance costs

No significant compliance costs will result from the entry into force of the respective tax treaties and legislative changes.

Summary of regulation impact statements

The 2003 United Kingdom convention

Impact: High.

Main points:

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The United Kingdom tax treaty is expected to have an impact on Australian residents doing business with the United Kingdom and includes Australian investors, banks, suppliers of technology, consultants, exporters, Australian employees working in the United Kingdom, and Australian residents receiving pensions from the United Kingdom. The treaty will also impact on the Australian Government and the ATO.

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While source country tax on interest will continue to be limited to 10%, there will be no withholding tax charged on interest derived by a financial institution resident in the other country, or on interest derived by a government body of the other country. No tax is payable on dividends in the source country where the dividend recipient is a company that holds directly at least 80% of the voting power of the company paying the dividend, subject to certain conditions. A 5% rate limit applies to other dividends where the dividend recipient is a company that holds directly at least 10% of the voting power of the company paying the dividend. A 15% limitation applies to other dividends. These limits apply to both franked and unfranked dividends. The general limit for royalties will be reduced from 10% to 5%.

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Article 13 ( Alienation of property ) preserves Australia's source country taxing rights over capital gains. The Article also addresses widespread business concerns about the potential for double taxation arising from the application of Australia's capital gains tax to expatriates departing Australia.

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The revised tax treaty will assist the bilateral relationship by updating an important treaty in the network of commercial treaties between the countries and provides for greater cooperation between tax authorities to prevent fiscal evasion and tax avoidance.

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The direct annual cost to revenue of the proposed treaty is estimated to be around A$100 million, which is likely to be offset by estimated second round revenue gains from increased investment, GDP, and growth. No material costs to taxpayers have been identified as likely to arise from the proposed treaty but there is likely to be a small, unquantifiable administration cost. It is expected that overall, the new treaty will produce a positive economic outcome for Australia.

The Mexican agreement

Impact: Low.

Main points:

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The Mexican agreement is likely to have an impact on Australian residents with business, investment or employment interests in Mexico.

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Dividends, interest and royalties may generally be taxed in both countries, but there are limits on the tax that the country in which the dividend, interest or royalty is sourced may charge on such income flowing to residents of the other country who are beneficially entitled to that income. These limits are 10% for royalties and 10% or 15% for interest depending on the nature of the interest. No tax is payable on dividends which have been fully taxed at the corporate level and where the dividend recipient is a company that holds directly at least 10% of the voting power of the company paying the dividend. A 15% limitation applies to other dividends.

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Article 13 ( Alienation of property ) covers real property owned through corporate or other entities. A provision will also help to avoid double taxation when a resident of one of the countries departs to become a resident of the other.

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The Mexican agreement will also assist in making clear the taxation arrangements for pensions and annuities and for individual Australians working in Mexico, either independently as consultants, or as employees.

The Mexican agreement will also assist the bilateral relationship by adding to the existing network of commercial treaties between the two countries.