House of Representatives

Explanatory Memorandum

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

Chapter 2 - Treaty source rules

Outline of chapter

2.1 Schedule 2 to this bill includes amendments to the International Tax Agreements Act 1953 (the Agreements Act). The amendments ensure that the source of income derived by widely held unit trusts from funds management activities to which a non-resident beneficiary is presently entitled will generally be determined under the normal rules for determining source for the purposes of the Income Tax Assessment Act 1936 (ITAA 1936) and the Income Tax Assessment Act 1997 (ITAA 1997).

Context of amendments

2.2 Income derived by a resident of a treaty partner country that may be taxed in Australia in accordance with the provisions of Australia's tax treaties, is deemed to have a source in Australia under source of income provisions in those treaties or equivalent provisions of the Agreements Act. For example, Article 21 of the 2003 United Kingdom convention provides:

"Income or gains derived by a resident of the United Kingdom which, under any one or more of Articles 6 to 8 and 10 to 16 and 18, may be taxed in Australia shall for the purposes of the laws of Australia relating to its tax be deemed to arise from sources in Australia."

2.3 Where business profits are attributable to a permanent establishment (generally a branch) operated in Australia by a resident of a treaty partner country, the treaties provide that those profits may be taxed in Australia. In the case of a funds management trust, income from the investment of funds outside Australia may be attributable to activities carried on by the trustee through a permanent establishment in Australia.

2.4 Australia's treaties (and subsection 3(11) of the Agreements Act in respect of treaties pre-dating the subsection) also provide that where business is carried on by a trustee through a permanent establishment in Australia, a non-resident beneficiary who is presently entitled to the income of the trust will be deemed to carry on that business through that permanent establishment. These provisions were introduced to ensure that non-resident beneficiaries of business trusts operating in Australia would be taxed in accordance with the principles of the Business Profits Article in our tax treaties.

2.5 The interaction of the deemed source rules and the permanent establishment rules for beneficiaries of business trusts can have the effect that income derived by non-resident beneficiaries from funds management activities of the trust is deemed to have an Australian source even though the income arises from funds invested offshore. The amendments proposed by this bill will ensure that, where such income has a source outside Australia under the ordinary rules for determining source of income for domestic law purposes, the income will continue to have a foreign source.

Summary of new law

2.6 The amendments provide that the Source of Income Articles in Australia's tax treaties (and similar provisions in the Agreements Act) will not apply to income from funds management activities (as defined) where a non-resident beneficiary is presently entitled to that income through one or more interposed trusts and the beneficiary has a fixed entitlement to the income through those trusts.

Comparison of key features of new law and current law

Detailed explanation of new law

2.7 The amendments insert section 3AA into the Agreements Act. The section will provide that in specified circumstances, the deemed source rules included in Australia's treaties (usually in a Source of Income Article) or the Agreements Act will not apply in relation to managed funds. The alteration of the deemed source rules will apply to funds management activities undertaken through a trust where the trust satisfies the provisions of the section and carries on business in Australia through a permanent establishment in Australia. [Schedule 2, item 1, paragraphs 3AA(2)(a) to (c)]

2.8 The amendments address concerns that the current law discourages the use of Australian expertise in funds management as a result of the interaction between the Business Profits Articles as modified by subsection 3(11) of the Agreements Act, or as provided for in the Business Profits Articles of treaties concluded after the introduction of subsection 3(11), and the deemed source of income provisions in their application to business trusts. The effect of subsection 3(11) and later provisions of Business Profits Articles is to deem a business carried on by a trust through a permanent establishment of the trustee to be a business carried on through a permanent establishment by a non-resident beneficiary who is presently entitled through one or more interposed trusts to the business profits arising from the trustee's operations.

2.9 Section 3AA provides for a limited modification of the deemed source rules that find their expression in Australia's tax treaties.

Background

2.10 Under the current law the Business Profits Articles of Australia's treaties provide for the taxation in Australia of income attributable to a permanent establishment of an enterprise of the treaty partner country in Australia. Attributable income can include income that might normally be considered to be sourced outside Australia. The source rules applicable to Australia's treaties provide that where Australia has a taxing right over that income of a resident of the treaty partner country under the treaty, that income is deemed to have an Australian source.

2.11 Where the trustee of a managed fund has a permanent establishment in Australia under the treaty (and regardless of whether the trustee is an Australian resident or not) and in the course of carrying on a business of funds management through that permanent establishment, it invests funds offshore, the income from such investments will be attributable to that permanent establishment. This income is currently deemed to be sourced in Australia and will be subject to tax in Australia.

2.12 The deemed permanent establishment rules for non-resident beneficiaries mean that this result also applies to the beneficiaries.

Impact on funds management activities

2.13 Section 3AA will operate to ensure that the source of such offshore income from funds management activities will be determined in accordance with Australia's normal domestic law source rules rather than the treaty deemed source rules. As funds management involves highly mobile forms of income that can be managed anywhere in the world, the deemed source rules have the effect of subjecting to Australian tax, profits that would not be subject to tax in Australia if a non-resident investor made those investments directly. [Schedule 2, item 1, subsection 3AA(2)]

2.14 The following conditions need to be met before the deemed source rules in the treaty cease to apply to funds management income:

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the beneficiary must be a beneficiary in a widely held unit trust, or, indirectly, a beneficiary through one or more interposed trusts. The term 'widely held unit trust' is defined by reference to the trust loss measures in Schedule 2F of the ITAA 1936 (section 272-105). The amendments are confined to widely held unit trusts in recognition of the fact that the unit holders in such trusts are generally not carrying on business through these trusts [Schedule 2, item 1, subsection 3AA(1)] ;

•

the beneficiary must be a treaty resident of the other country. In dual residency cases the beneficiary will be a treaty resident of the country to which the tie-breaker rules in the treaty allocate sole residence [Schedule 2, item 1, paragraph 3AA(1)(a)] ;

•

the beneficiary needs to be presently entitled to the income of the widely held unit trust either directly or indirectly through interposed trusts [Schedule 2, item 1, paragraph 3AA(1)(b)] :

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where the beneficiary is presently entitled to funds management income through interposed trust estates those trusts do not have to be widely held but the beneficiary has to have a fixed entitlement to the income through each interposed trust estate [Schedule 2, item 1, paragraph 3AA(1)(b)] ;

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the term 'fixed entitlement' has the same meaning as it has for purposes of the ITAA 1997 and the tests necessary to determine fixed entitlement contained in Schedule 2F of the ITAA 1936 will apply. The requirement for fixed entitlements in the funds management trust or interposed trusts will operate to minimise the opportunities for streaming foreign sourced income away from resident beneficiaries to non-resident beneficiaries [Schedule 2, item 1, paragraph 3AA(1)(b)] ;

•

the trustee of the widely held unit trust must carry on business;

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the business must be carried on in Australia through a permanent establishment as defined in the relevant agreement [Schedule 2, item 1, subsection 3AA(4)] ;

•

the business carried on must be one of funds management with funds management activities being defined [Schedule 2, item 1, subsection 3AA(4)].

2.15 Funds management activities are any activities carried on by the trustee of:

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a widely held unit trust that is a managed investment scheme under the Corporations Act 2001; or

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a closely held trust that is a managed investment scheme and that is closely held by either:

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a managed investment scheme that is a widely held unit trust;

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a complying superannuation entity;

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a life insurance company; or

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any combination of these.

[Schedule 2, item 1, subsection 3AA(4)]

2.16 'Closely held' will be interpreted by reference to Schedule 2F to the ITAA 1936 (section 272-105). 'Complying superannuation entity' and 'life insurance company' will take their meaning from the ITAA 1936.

Example 2.1

In the above example David, a non-resident beneficiary of Trust A, is presently entitled to 50% of the income from that trust. Trust A carries on a manufacturing business through a permanent establishment in Australia and exports its manufactures to Malaysia. Trust A also has discretionary beneficiaries who are entitled to be considered by the trustee in the distribution of the 50% of income to which David is not entitled.

Trust A holds 10% of the units in Widely Held Trust 1. This is a fixed entitlement to 10% of the income and capital of Widely Held Trust 1. Widely Held Trust 1 is a managed investment scheme which carries on business in Australia through a permanent establishment in Australia. It derives offshore income from placing funds in overseas markets and managing those funds.

In calculating the trustee's tax liability on behalf of David under subsection 98(4) of the ITAA 1936, section 3AA will mean that the deemed source rules in the treaty between Australia and country X, of which David is a resident, will not apply with respect to the offshore income of Widely Held Trust 1. Where the offshore income has a source outside Australia under the normal rules applicable to domestic law, the income will not be included in assessable income.

Any non-resident discretionary beneficiaries of Trust A, resident in country X, who become presently entitled to the income of the trust will be assessed on the offshore income of Widely Held Trust 1 that is attributable to its permanent establishment in Australia, as such beneficiaries do not have a fixed entitlement to the income of Trust A.

The amendments will not affect the source of income from activities other than fund management activities. Accordingly, David and any non-resident discretionary beneficiaries resident in country X becoming entitled to the income of the trust will be taxed on the Malaysian income attributable to Trust A's manufacturing permanent establishment in Australia. The income is attributable to the permanent establishment of Trust A as Trust A's salespeople market and conclude contracts for its manufactures during quarterly trips to Malaysia of two weeks duration. This income is taxed under subsection 98(4).

The liability to tax arises because those beneficiaries are, under subsection 3(11) (country X is a pre-subsection 3(11) treaty), deemed to have a permanent establishment in Australia (the permanent establishment of Trust A) and to carry on business through that permanent establishment (the business of Trust A). The Malaysian income is attributable to the permanent establishment and the Source of Income Article in country X's treaty with Australia provides that income that can be taxed in Australia under the treaty is deemed to have a source in Australia for both treaty and domestic law purposes..

Example 2.2

Trust A has a fixed entitlement to the income of Widely Held Trust 2 (a unit trust and managed investment scheme). Widely Held Trust 2 has a fixed entitlement to 20% of the income of Closely Held Trust (a managed investment scheme). Widely Held Trust 2, in the course of carrying on its business of funds management through a permanent establishment in Australia, receives offshore income from funds management activities of Closely Held Trust.

David has a fixed entitlement to the income of Widely Held Trust 2 from funds management activities. Accordingly, section 3AA applies in respect of that income and any offshore income from sources outside Australia will not be included in the assessable income of the trustee attributable to David.

Profit shifting adjustments

2.17 The deemed source rules will continue to apply even in circumstances where the conditions of subsection 3AA (1) (see paragraph 2.14) are satisfied if the profits of the trust carrying on the funds management activities are adjusted under provisions of the applicable treaty that ensure that the profits of a permanent establishment are determined as if the permanent establishment were an independent entity dealing independently with other parts of the entity and with associated enterprises (arm's length dealing). Such adjustment can be made by the taxpayer themselves (where arm's length prices are used instead of the contracted prices), a debit amendment initiated by the taxpayer or by the Commissioner of Taxation (Commissioner). The deemed source rules will operate to the extent of the adjustment. This will ensure, that even though the profit being attributed to the permanent establishment in Australia may be considered to have its notional source in the treaty partner country, it will be deemed to have a source in Australia and to be taxable in the hands of a non-resident beneficiary here. [Schedule 2, item 1, subsection 3AA(3)]

Example 2.3

A united States (US) funds management trust (US Trust) has a permanent establishment in Australia through which it carries on fund management activities. The permanent establishment borrows $10 million from sources in Australia. The interest rate for this loan is 9.25% (p.a.).

The funds are made available to the head office of the trust in the US which lends the $10 million to Associate Fund. The interest rate on this loan is 9.3% p.a. and the loan is entered into in New York.

Associate Fund lends this $10 million to an unassociated US company at an arm's length rate of 9.4% (p.a.).

US Trust has calculated its taxable profit in Australia on the basis that if its permanent establishment was a distinct and separate enterprise it would have lent the funds at an arm's length interest rate of 9.28% (p.a.). This gives a taxable profit of $3,000 (0.03% of $10 million (per year)).

However, the Commissioner considers that the arm's length interest rate for a loan to an independent party in the circumstances is 9.31% (p.a.). This results in a profit of $6,000 (0.06% of $10 million (per year)). An argument could be raised that part of the Australian permanent establishment's adjusted profit of $6,000 is sourced in the US (the loan funds having been contracted for in the US and the funds made available from accounts in the US). However, as the $6,000 profit is attributable to the permanent establishment in Australia the deemed source rules in our treaties would ensure that the arm's length profit would for assessment purposes be sourced in Australia.

Where a beneficiary is a resident of a treaty partner country and is presently entitled to the income of the trust (in this case all the income of the trust), the adjustment to the trust's income will have an Australian source and be included in the beneficiary's Australian assessable income.

Application and transitional provisions

2.18 The amendments will apply from the beginning of a taxpayer's year of income in which this bill receives Royal Assent and for later years of income. In most instances this will be the year of income commencing on 1 July 2004. However, some taxpayers with substituted accounting periods may not have the amendments apply until their 2005-2006 year of income.