House of Representatives

Explanatory Memorandum

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

Chapter 4 - Regulation impact statements

The 2003 United Kingdom Convention

Specification of policy objectives

4.1 Two key objectives of the existing Australia-United Kingdom tax treaty are to:

•

promote closer economic cooperation between Australia and the United Kingdom by eliminating possible barriers to trade and investment caused by the overlapping taxing jurisdictions of the two countries; and

•

create a framework through which the tax administrations of Australia and the United Kingdom can prevent international fiscal evasion.

4.2 The negotiation of a new tax treaty (to replace the 1967 tax treaty and Protocol of 1980) is intended to advance these objectives by:

•

providing an enhanced element of legal and fiscal certainty within which cross-border trade and investment can be carried on, over and above that currently afforded under the existing 1967 tax treaty and Protocol;

•

improving the level of cooperation between the tax administrations of the two countries;

•

modernising the tax treaty to reflect changes to tax treaty policies and practices of both countries since the existing tax treaty's conclusion;

•

ensuring broad consistency in the taxation treatment of Australia's major trading partners, particularly in light of the recently signed Protocol to the Australia-United States of America tax treaty;

•

facilitating and promoting future commercial relations between Australia and the United Kingdom; and

•

giving effect to the Government's announcement of 11 November 1999 that priority be given to renegotiating Australia's aging tax treaties with major trading partners.

Background

4.3 The stated policy objective of tax treaties is to avoid double taxation and prevent fiscal evasion with respect to taxes on income, but their wider function is to facilitate investment, trade, movement of technology, and movement of personnel between countries. They are widely used to develop and strengthen bilateral relationships between countries, especially in commercial areas. Tax treaties also provide certainty and protection regarding the level of taxation on investments abroad which may, for instance, be valued by business when deciding on the location of a regional headquarters.

4.4 A renegotiated tax treaty is important for the future commercial relations between Australia and the United Kingdom, particularly because the United Kingdom is the second largest foreign investor in Australia ^[F1] and the second largest destination for Australian investment abroad. ^[F2] The United Kingdom is also a particularly important gateway for European Union investment in Australia and will be an increasingly important window for Australian investment in the European Union.

How tax treaties operate

4.5 Australian tax treaties are usually based on the OECD Model with some influences from the UN Model. In addition, negotiating countries propose variations to these models to reflect their particular economic interests and legal circumstances.

4.6 Tax treaties reduce or eliminate double taxation caused by the overlapping taxing jurisdictions because treaty partners agree (in certain situations) to limit taxing rights over various types of income. The respective countries also agree on methods of reducing double taxation where both countries have a right to tax.

4.7 Australia seeks an appropriate balance between source and residence country taxing rights. Generally the allocation of taxing rights under Australian tax treaties is similar to international practice as set out in the OECD Model, but there are a number of instances where Australian practice leans more towards source country taxing rights.

4.8 In addition, tax treaties provide an agreed basis for determining whether the income returned or expenses claimed on related party dealings by members of a multinational group operating in both countries can be regarded as acceptable. Tax treaties are therefore an important tool in dealing with international profit shifting.

4.9 To prevent fiscal evasion, tax treaties include exchange of information provisions. The two tax administrations can also use the mutual agreement procedures available for treaties to develop a common interpretation and resolve differences of application of the tax treaty. There is also provision for residents of either country to instigate a mutual agreement procedure.

The United Kingdom tax treaty

4.10 The existing Australia-United Kingdom tax treaty was signed on 7 December 1967 and has effect from 1 July 1967 (for Australian tax purposes) replacing an earlier tax treaty signed in 1946. The 1967 tax treaty was amended in 1980 mainly to update the Dividends Article to reflect changes made to the treatment of dividends under United Kingdom domestic tax law. While the 1967 tax treaty and 1980 Protocol have served the interests of both countries well over the intervening years, it is now considered that these arrangements (based in many respects on the tax treaty practice of the time, rather than modern models) are outdated. This applies both in regard to the tax treaty practices of Australia and of the United Kingdom, and that of the international community more generally.

4.11 Renegotiation of the Australia-United Kingdom tax treaty commenced in February 2001, a second round of negotiations were held in March 2002 and a third round in November 2002.

Australia's investment and trade relationship with the United Kingdom ^[F3]

4.12 Trade and investment ties between Australia and the United Kingdom are very significant. In 2000-2001, the United Kingdom was Australia's third largest trading partner, and sixth largest merchandise trading partner. In 2002, total two-way trade totalled A$18.7 billion with Australian merchandise exports of A$5.6 billion. Major Australian exports included non-monetary gold (A$1,285 million), alcoholic beverages (A$920 million), coal (A$363 million), aircraft and parts (A$192 million), and lead (A$177 million). In 2002 Australian exports of services totalled A$3.6 billion.

4.13 Australia's merchandise imports from the United Kingdom amounted to A$5.8 billion in 2002. Principal imports included medications (A$962 million), passenger motor vehicles (A$363 million), aircraft and parts (A$183 million), and telecommunications equipment (A$181 million).

4.14 As at June 2002, the United Kingdom was the second largest foreign investor in Australia (A$224 billion) and the second largest destination for Australian investment abroad (A$71 billion). Around a third of all regional headquarters' operations in Australia are European, and of these almost half are British.

4.15 There are over 1,000 Australian companies active in the United Kingdom with a large number using Britain as a base for trade and investment into the European Union.

Identification of implementation option(s)

4.16 The implementation options for achieving the policy objectives are:

•

no further action - rely on the existing tax treaty measures; or

•

conclude a new tax treaty.

Option 1: No further action - rely on the existing tax treaty measures

4.17 While the existing tax treaty has provided a good measure of protection against double taxation and prevention of fiscal evasion since its inception, it is clear that the existing tax treaty has become outdated and does not adequately reflect the current tax treaty policies and practices of either Australia or the United Kingdom, nor modern international norms.

4.18 In particular, relying on the existing tax treaty would not involve any adaptation of the tax treaty to modern developments, such as recent changes to the United Kingdom dividend taxation regime and modern ways of doing business, and legal and fiscal certainty would thus reduce over time. Furthermore, this option would not address the taxation of capital gains, and therefore the current uncertainty over taxing rights in this area would continue.

Option 2: Conclude a new tax treaty

4.19 The internationally accepted approach to meeting the policy objectives specified above is to conclude a new bilateral tax treaty or to amend an existing treaty to reflect current policies. ^[F4] The dated language of the existing tax treaty and the developments in both countries' domestic law, commercial practices, and treaty policies and practices support a revision of the full text.

4.20 As mentioned earlier, a new tax treaty would be largely based on the current OECD Model and the UN Model, with some mutually agreed variations reflecting the economic, legal and cultural interests of the two countries.

4.21 Both countries have particular policy objectives to achieve in updating the tax treaty and the end result ultimately represents compromises necessary to achieve a mutually acceptable agreement. The key changes in the new tax treaty are:

•

a reduction in the maximum royalty withholding tax rates from 10% to 5 %;

•

nil interest withholding tax where interest is paid to a financial institution or body performing governmental functions;

•

nil dividend withholding tax for dividends on certain non-portfolio holdings of 80% or more and 5% dividend withholding tax for non-portfolio holdings between 10% and 80%; and

•

inclusion of a comprehensive Alienation of property Article preserving source country taxing rights over most capital gains.

4.22 The specific application of a revised tax treaty to dual listed companies and expatriates has been clarified, and a number of other technical matters (such as the treatment of pensions and the definitions of 'permanent establishment' and 'royalties') have also been addressed in accordance with Australia's established tax treaty practice.

Assessment of impacts (costs and benefits) of each option

Difficulties in quantifying the impacts of tax treaties

4.23 Only a partial analysis of costs and benefits can be provided because all the impacts of tax treaties cannot be quantified. While the direct cost to Australian revenue of withholding tax changes can be quantified relatively easily, other cost impacts such as compliance costs are inherently difficult to quantify. There are also efficiency and growth gains and losses to Australia that provide estimation problems. Analysis has been conducted to establish plausible impacts on Australian economic activity and consequent tax revenue flowing from implementation of the tax treaty. The tax revenue estimates are subject to more uncertainty than the estimates of costs but are best estimates given the technology of estimation, the availability of estimates of behavioural responses, and data.

4.24 Benefits that flow to business are generally equally difficult to quantify. Some impacts can be determined with greater authority, for instance, the direct revenue impact of reducing rates of withholding tax. The evidence from international consideration (e.g. OECD) and from consultation with business strongly indicates, however, that while the quantum of benefits is very difficult to assess, a modern tax treaty provides a clear positive benefit to trade and investment relationships.

Impact group identification

4.25 A revised tax treaty with the United Kingdom is likely to have an impact on:

•

Australian residents doing business with the United Kingdom, including principally:

-

Australian residents investing directly in the United Kingdom (either by way of a subsidiary or a branch);

-

Australian banks lending to United Kingdom borrowers;

-

Australian residents supplying technology and know-how to United Kingdom residents;

-

Australian residents supplying consultancy services to the United Kingdom; and

-

Australian residents exporting to the United Kingdom;

•

Australian employees working in the United Kingdom;

•

Australian residents receiving pensions from the United Kingdom;

•

the Australian Government; and

•

the ATO.

Assessment of benefits

Option 1: No further action - rely on existing unilateral measures

4.26 By adopting this option there would be no need for further action and resources could be devoted to other tax treaty issues. However, this option is not current Government policy.

Option 2: Conclude a new tax treaty

4.27 The immediate benefits to be derived from a new tax treaty with the United Kingdom are expected to be significant. Given the long-term nature of such arrangements, a revised tax treaty is expected to promote greater certainty than the existing tax treaty and will have the following benefits.

Economic benefits

4.28 Business has for many years raised concerns about the lack of competitiveness of Australia's tax treaty network and has particularly sought a reduction in withholding tax rates. Submissions received have also expressed the need for certainty over the taxation of capital gains, as well as raising a range of other desired features in a revised tax treaty with the United Kingdom.

4.29 These issues were addressed in the recently signed Protocol amending the Australia-United States of America tax treaty. Ensuring consistent treatment, where possible, in Australia's revised tax treaties maintains the integrity of Australia's treaty network and discourages treaty shopping. While a reduction in maximum withholding tax rates will involve a cost to revenue, the benefits to the revenue and the wider economy are much more widely spread, with the most direct benefits accruing to business. Indirect revenue benefits may arise from increased trade and investment between the countries.

4.30 The economic benefits of the expected major changes from the existing tax treaty are summarised in paragraphs 4.31 to 4.46.

Dividends

4.31 Under the existing tax treaty, a 15% rate of United Kingdom dividend withholding tax notionally applies to dividends paid to Australian companies. However, the United Kingdom unilaterally (via its domestic law) exempts such payments. The achievement of a nil or 5% United Kingdom dividend withholding tax in a revised tax treaty on non-portfolio dividends would provide certainty for business that this situation will continue, even if, for example, the domestic law changes so that there is no longer a general exemption.

4.32 The achievement of a reduced rate of Australian dividend withholding tax on non-portfolio dividends is widely supported by Australian business, and would make Australia's taxation treatment of subsidiaries and branches more consistent (as branches are not subject to dividend withholding tax) as well as making direct investment in Australia more attractive. Business views the current 15% Australian dividend withholding tax rate on non-portfolio dividends as making Australia a less attractive investment location compared to other countries, which reduces Australia's ability to attract foreign capital.

Interest

4.33 A nil Australian interest withholding tax rate on interest derived by United Kingdom financial institutions will be consistent with the exemption currently provided for interest derived from widely distributed arm's length debenture issues and recognises that a 10% interest withholding tax rate on gross interest derived by financial institutions may be excessive given their cost of funds. The cost to Australian business of raising capital from United Kingdom financial institutions is expected to reduce, making this source of capital more affordable for marginal investment projects.

Royalties

4.34 Australian residents required to meet the cost of Australian royalty withholding tax on royalty payments made to United Kingdom residents would benefit from a reduced royalty withholding tax rate. Consultation with business representatives have indicated that such gross-up obligations are commonly imposed on the payer of the royalty, so that they may bear the cost of the higher rate, in comparison with payers from other countries.

4.35 Australian residents who derive royalty income from the United Kingdom may also benefit from a reduced United Kingdom royalty withholding tax rate. Additional tax payable in Australia due to a reduced credit for United Kingdom royalty withholding tax would generally result in imputation credits that can be passed on to shareholders.

Alienation of property

4.36 The inclusion of an Alienation of property Article, which preserves Australia's source country taxing rights, would ensure Australian taxing rights over capital gains are retained. It would also facilitate investment between the countries by making the taxation treatment of capital gains more certain and reducing the risk of double taxation. Further, the Article would address widespread business concerns about the potential for double taxation arising from the application of Australia's CGT to expatriates departing Australia. These concerns have negatively affected the ability of Australian located companies to attract and retain skilled expatriate staff. They also have the potential to affect headquarters location decisions to Australia's detriment. The Article would also improve arrangements for taxing gains accrued on assets held by departing residents by reducing compliance difficulties and ensuring appropriate relief is provided from double taxation.

Revenue benefits

4.37 Analysis has been undertaken to establish the plausible impacts on Australian economic activity of the Australia-United Kingdom tax treaty. This analysis indicates that the proposed reduction in interest withholding tax is likely to result in reduced interest rates for Australian business, increased domestic investments, and an increase in GDP. This increase in economic activity is likely to result in increased tax revenue in the order of A$70 million from each year's reduction in interest withholding tax.

4.38 A further second round effect is the revenue gain to the Federal Budget that flows from Australian companies no longer claiming Australian tax relief for the former higher levels of United Kingdom withholding tax on interest and royalties. Estimates of these gains are less precise than the estimates of revenue costs of withholding tax changes and are estimated at A$5 million - A$10 million annually.

Compliance and administration cost reduction benefits

4.39 Compliance costs would be significantly reduced by clarifying Australia's right to tax United Kingdom companies on capital gains derived from the disposal of an Australian subsidiary. Interpretative issues relating to the extent Australia can tax these gains under the existing tax treaty have resulted in considerable uncertainty and costly legal arguments. Administrative costs in explaining the ATO view and responding to legal arguments would also be significantly reduced. Clarifying other areas of uncertainty, such as tax treaty tests of 'residency' and the relationship of the tax treaty with current United Kingdom domestic dividend taxation, should also decrease compliance costs and uncertainty.

Other benefits

4.40 Where Australians invest directly in the United Kingdom, the United Kingdom would not generally be able to tax an Australian resident unless that Australian resident carries on business through a permanent establishment in the United Kingdom. A revised tax treaty would, to some extent, further refine the basis for allocation of profits to that permanent establishment and further clarify what level of activity would constitute such an establishment. A revised tax treaty may also establish a specific rule for taxation of income from real property and the alienation of property, both of which are currently lacking in the existing tax treaty.

4.41 Likewise, for Australians investing through a United Kingdom subsidiary, a revised tax treaty will modernise the internationally accepted framework for dealing with parent-subsidiary transactions and other transactions between associated enterprises. In this regard, a revised tax treaty clearly offers superior protection to the domestic rules of the two countries because it will provide for mutual agreement to be reached between the two taxing authorities as to the methodology to be applied for taxing the profits of the respective enterprises.

4.42 To some extent, the revised rules embodied in a new tax treaty will further reduce the risks for Australians investing in the United Kingdom (and vice versa) because a new tax treaty would record agreement between the two Governments on an enhanced framework for taxation of cross-border investments. In the case of mining investments that cannot easily be relocated, this reduction in risk may be quite important.

4.43 Commodity exporters would be assisted in some respects because of the way a revised tax treaty would restrict the circumstances in which Australians trading with the United Kingdom are to be taxed by requiring the existence of a permanent establishment in the United Kingdom before United Kingdom taxation will take place.

4.44 A revised tax treaty will also assist in making clear the taxation arrangements for individual Australians working in the United Kingdom, either independently as consultants or as employees. Income from professional services and other similar activities are now likely to be taxed under the permanent establishment rules rather than the former international standard provided in the existing tax treaty. This required that the services are attributable to a fixed base of the person concerned in that country.

4.45 Employees' remuneration would generally be taxable in the country where the services are performed. However, where the services are performed during certain short visits to one country by a resident of the other country, the income would generally be exempt in the country visited.

4.46 A revised tax treaty will also assist the bilateral relationship by updating an important treaty in the existing network of commercial treaties between the two countries. A revised tax treaty would also promote greater cooperation between taxation authorities to prevent fiscal evasion and tax avoidance. Updating the tax treaty to take account of changes to the OECD Model would also help to maintain Australia's status as an active OECD member, which in turn would maintain Australia's position in the international tax community.

Assessment of costs

Option 1: No further action - rely on the existing tax treaty measures

4.47 As this option represents a continuance of the current position, the revenue, administration and compliance costs that apply to the existing tax treaty would not change.

4.48 Nevertheless, even though both countries have bilaterally agreed to measures to prevent double taxation of cross-border investments, this option does not resolve all areas of difference. For example, the existing tax treaty does not have an Article dealing specifically with the alienation of property (i.e. the taxation of capital gains), although such an Article is now standard practice in Australia's recent tax treaties with other countries and features in both the OECD Model and the UN Model. This lack of a specific Article comprehensively dealing with capital gains has given rise to major interpretation issues and the ATO was required to issue a public ruling to provide guidance to taxpayers on how capital gains derived by British residents should be taxed in Australia. Even though officials from the ATO and the Inland Revenue consider that the existing tax treaty does not limit Australia's right to tax capital gains, in the event of an adverse court decision, the potential revenue cost could be high. Compliance costs to taxpayers would also be higher because of this uncertain legal position.

4.49 Furthermore, this option does not allow either country to take advantage of more modern treaty practices adopted by the international community in tax treaties generally since 1967 (such as the lowering of certain maximum withholding tax rates). Nor does it reflect subsequent unilateral changes to the internal laws of both countries designed to regulate current business and investment practices. Since the tax treaty generally overrides other tax laws, its operation in the light of changed domestic laws since it was negotiated (such as changes to United Kingdom dividend taxation) is often far more complex than in more modern tax treaties. This option also prevents Australia from better reflecting its current position as both a significant capital exporter and a significant capital importer, a position quite different to that pertaining in 1967.

4.50 Australian investors view the existing United Kingdom treaty as an impediment to business expansion, making countries with more modern tax treaties with Australia relatively more attractive as investment destinations. It is also seen as disadvantaging our investors in the United Kingdom compared with investors from other countries with more modern tax treaties with the United Kingdom (such as United States of America enterprises).

Option 2: Conclude a new tax treaty

Revenue costs

4.51 The direct cost to revenue from the renegotiated agreement is estimated to be approximately A$100 million per annum. This cost is attributed to the main changes appearing in a revised tax treaty, being:

•

a reduction in dividend withholding tax to nil or 5% on non-portfolio dividends derived by United Kingdom companies down from 15% for unfranked dividends (franked dividends are already exempt from dividend withholding tax under Australia's domestic law);

•

an interest withholding tax exemption for interest paid to United Kingdom financial institutions (down from 10%); and

•

a reduction in the general royalty withholding tax rate to 5% (down from 10%).

Knock-on revenue costs

4.52 A recognised consequence of the recently signed Protocol amending the Australia-United States of America tax treaty was that over time the lower withholding tax rates contained therein are likely to be extended to other countries because of most favoured nation clauses in some existing treaties. This will come at a cost to the revenue in relation to countries exporting capital and technology to Australia but will lower the cost of capital to Australian businesses seeking funding in those countries and reduce the cost of accessing new technologies. The amount by which costs to Australian businesses will be reduced depends on the extent to which those businesses currently bear the costs of the relevant withholding taxes.

4.53 The United Kingdom will be the first country seeking the lower withholding tax rates, notwithstanding that the existing United Kingdom tax treaty does not contain a most favoured nation clause. Requests for similar reductions in withholding from other countries which also do not currently have a most favoured nation with Australia are expected, but of course some concessions of benefit to Australian business can be sought in return.

Taxpayer costs

4.54 No material costs to taxpayers have been identified as likely to arise from the renegotiation of this tax treaty. The closer alignment with more recent treaty practice would generally be expected to reduce compliance costs, and any tax exemptions (such as on certain interest payments) would be likely to reduce such costs.

Administration costs

4.55 There would be a small unquantifiable cost in administering the changes made by the revised tax treaty, including minor implementation costs to the ATO in educating the taxpaying public and ATO staff concerning the new arrangements.

4.56 The cost of negotiation and enactment of a new tax treaty with the United Kingdom will be small. Most of these costs will be borne by the ATO, the Treasury, and the Department of Foreign Affairs and Trade. There will also be an unquantified but small cost in terms of parliamentary time and drafting resources in enacting the proposed new tax treaty.

4.57 There are also 'maintenance' costs to the ATO and the Treasury associated with tax treaties in terms of dealing with enquiries, mutual agreement procedures (including advance pricing arrangements) and OECD representation. However, these costs also apply to the existing tax treaty. Bringing the United Kingdom tax treaty into basic conformity with modern treaty practice will, over time, reduce these costs, as the existing tax treaty has many unusual and difficult aspects due to many of its features deriving from traditional United Kingdom tax treaty practise rather than modern OECD or UN Models.

Other costs

4.58 Government policy in relation to taxation of United Kingdom residents would be to some extent constrained by changes to treaty obligations, but as the more significant changes would not be unique in our tax treaty practice, that is not likely to be a major constraint. Ultimately, the tax treaty could be terminated if it became out of step with Government policy, though such termination is very rare in international tax treaty practice.

4.59 The impact of new tax treaties on tax policy flexibility is generally quite marginal because Australia already has a substantial tax treaty network.

Consultation

4.60 Information on the revision of the existing tax treaty has been provided to the States and Territories by the Commonwealth through the Commonwealth/State Standing Committee on Treaties' Schedule of Treaty Action following the Government's 11 November 1999 announcement concerning its Stage 2 response to A Tax System Redesigned .

4.61 Since the Government's acceptance of the Review of Business Taxation recommendation to update aging treaties, the business community has been aware that Australia would be renegotiating with its major trading partners, including the United Kingdom. Submissions from the business community were formally requested through the tax treaty Advisory Panel. In addition, specific companies from various industry sectors have been approached to provide practical perspectives on the operations of the existing tax treaty and any desirable features of a revised tax treaty.

4.62 Treasurer's Press Release No. 3 of 25 January 2002 announced the dates of the talks and invited submissions from stakeholders and the wider community. As negotiations proceeded, further targeted and confidential consultation was undertaken with business and industry groups, professional bodies, and the main affected companies.

4.63 In general, business and industry groups supported the recently concluded Protocol amending the Australia-United States of America tax treaty and encouraged the Government to pursue a similar result in the revised tax treaty with the United Kingdom. While some of those consulted recommended going further than the changes negotiated with the United States of America, most recognised the need for both a consistent treaty policy and a degree of moderation in the extent to which Australia can afford to concede taxing rights.

4.64 The new tax treaty will also be considered by Commonwealth Joint Standing Committee on Treaties, which provides for public consultation in its hearings.

Conclusion and recommended option

4.65 While the existing tax treaty has provided a good measure of protection against double taxation and prevention of fiscal evasion since coming into force, it is clear that it has become outdated and no longer adequately reflects current tax treaty policies and practices of either Australia or the United Kingdom, nor modern international norms.

4.66 The existing tax treaty is also seen by business as impeding the expansion of trade and investment, especially the absence of provisions for the taxation of capital gains, and its rates of withholding taxes applying to remittances of dividends, interest and royalties.

4.67 A new tax treaty with reductions in the maximum rates of withholding taxes similar to that recently agreed with the United States of America will provide significant benefits to Australian business. It will be another step forward in providing Australian business with an internationally competitive tax treaty network and business tax system. It will also directly facilitate trade and investment between the countries, provide a boost to GDP and hence tax revenues, further reduce fiscal evasion and improve the integrity of the tax system (especially protecting our tax base by clarifying our right to tax United Kingdom residents in respect of capital gains), improve Australia-United Kingdom relations, and maintain Australia's position in the international tax community.

4.68 There is a direct cost to revenue from the new tax treaty, largely sourced in reduced withholding tax collections. The compliance costs associated with this measure are considered to be small.

4.69 On balance, the benefits of a revised tax treaty outweigh the cost to revenue. Option 2 is therefore recommended as the preferred option.

The Mexican Agreement

Specification of policy objectives

4.70 The three key objectives of the Australia-Mexico tax treaty are to:

•

avoid double taxation of incomes arising from overlapping tax jurisdictions;

•

prevent international fiscal evasion; and

•

facilitate trade and investment between Mexico and Australia.

Background

How tax treaties operate

4.71 The proposed tax treaty is based on the OECD Model with some influences from the UN Model. In addition, both countries have included variations reflecting their economic interests and legal circumstances.

4.72 The tax treaty would reduce or eliminate double taxation caused by the overlapping taxing jurisdictions, because under the tax treaty, Australia and Mexico agree (in specified situations) to limit taxing rights over various types of income. The countries also agree on methods of reducing double taxation where both countries have a right to tax. For example, the tax treaty contains the standard tax treaty provision that neither country would tax business profits derived by residents of the other country unless the business activities in the taxing country are substantial enough to constitute a permanent establishment and the income is attributable to a permanent establishment (Article 7).

4.73 In negotiating the sharing of taxing rights, Australia seeks an appropriate balance between source and residence country taxing rights. Generally the allocation of taxing rights under the tax treaty is similar to international practice as set out in the OECD Model, but (consistent with Australian practice) there are a number of instances where it is biased more towards source country taxing rights; the definition of 'permanent establishment' is wider in some respects than the OECD Model, and the Business Profits, Ships and Aircraft, Royalties, Alienation of Property and Other Income Articles also give greater recognition to source country taxing rights.

4.74 In addition, the tax treaty provides an agreed basis for determining whether the income returned or expenses claimed on related party dealings by members of a multinational group operating in both countries can be regarded as acceptable (Articles 7 and 9). This is an example of how a tax treaty is used to address international profit shifting.

4.75 To prevent fiscal evasion the tax treaty includes an exchange of information facility. The two tax administrations can also use the mutual agreement procedures to develop a common interpretation and resolve differences of application of the tax treaty. There is also provision for residents of either country to instigate a mutual agreement procedure.

Australia's investment and trade relationship with Mexico ^[F5]

4.76 For Australia the major impact of a tax treaty will be on Australian enterprises trading with and investing in Mexico. While Australia's trade and investment relationship with Mexico is the largest Australia has with any Latin American country, it does not figure among Australia's top ten relationships. However, the size of the Mexican economy (ninth largest in the world) and its growth prospects emphasise the potential importance of the relationship.

4.77 Total Australia-Mexico trade exceeded A$1 billion in 2002 with Australian exports over the last five years growing at an annual rate of more than 27%. Australian merchandise exports were A$439 million and merchandise imports A$514 million with services imports and exports of A$28 million and A$15 million respectively. Major Australian exports to Mexico were coal and agricultural products while major imports included telecommunications equipment, computers and computer parts, and motor vehicle parts.

4.78 The stock of Australian direct investment in Mexico is fairly modest at just over A$300 million. Australian interests have invested in over 60 Mexican enterprises in the manufacturing, mining, fisheries, and service sectors. There is little or no direct investment by Mexico in Australia, and portfolio investment is low.

Identification of implementation option(s)

4.79 The implementation options for achieving the objectives are:

•

no further action - rely on existing unilateral measures; or

•

conclude the tax treaty.

Option 1: No further action - rely on existing unilateral measures

4.80 If nothing was done - that is, the tax treaty was not concluded - it could be argued that many of the above policy objectives will nevertheless be achieved. Many of the policy objectives have already been met to a significant extent through the internal tax laws of both the Mexican and Australian Governments. For example unilateral enactment of foreign tax credit measures by Australia already provides substantial relief from juridical double taxation.

Option 2: Conclude the double tax agreement

4.81 The internationally accepted approach to meeting the above policy objectives is to conclude a bilateral tax treaty. ^[F6] The tax treaty regulates the way the two countries would reduce double taxation, by agreeing to restrict their taxing rights in accordance with its terms. The tax treaty also records important bilateral undertakings in relation to exchange of information.

4.82 For business and investors generally the tax treaty has the advantage of providing some degree of legal and fiscal certainty - unlike domestic laws which can be amended unilaterally.

4.83 As mentioned earlier, the tax treaty would be largely based on the OECD Model and the UN Model, with some mutually agreed variations reflecting the economic, legal, and cultural interest of the two countries.

Assessment of impacts (costs and benefits) of each option

Impact group identification

4.84 A tax treaty with Mexico is likely to have an impact on:

•

Australian residents doing business with Mexico, including principally:

-

Australian residents investing directly in Mexico (either by way of a subsidiary or a branch);

-

Australian banks lending to Mexican borrowers;

-

Australian residents supplying technology and know-how to Mexican residents;

-

Australian residents exporting to Mexico; and

-

Australian residents supplying consultancy services to Mexican residents,

•

Australian employees working in Mexico;

•

certain departing Australian residents who subsequently become Mexican residents;

•

people receiving pensions from the other country (although the number of cross-border pension payments is understood to be minimal);

•

the Australian Government; and

•

the ATO.

Assessment of costs

Option 1: No further action - rely on existing unilateral measures

4.85 As this option represents a continuance of the current position, it would be expected that the administration and compliance costs of this option would be minimal. Revenue costs would also be expected to be very small.

4.86 On the other hand, even though both countries have unilaterally introduced measures to prevent double taxation of cross-border investments, this option would not resolve all areas of difference; for example, even if both countries had very similar mechanisms for allowing credit for foreign tax paid, differences could arise over fundamental matters such as the source of income and residence of taxpayers. Furthermore this option does not protect against future unilateral changes to the internal laws and does not limit source country taxing of, for example, dividends, interest, and royalties.

4.87 In addition, investors are concerned that unilateral tax laws do not provide the longer term certainty desirable for making substantial long term investments offshore. This is because the Governments of either country can vary key tax conditions unilaterally. Similarly, so far as the tax administrations are concerned, unilateral rules do not provide a dependable long term framework for information exchange.

Option 2: Conclude a new tax treaty

4.88 The negotiation and enactment of this tax treaty would cost approximately A$0.15 million. Most of these costs would be borne by the ATO, although other agencies, such as Treasury, the Department of Foreign Affairs and Trade and the Australian Government Solicitor would bear some of these costs. There would also be an unquantified cost in terms of Parliamentary time and drafting resources in enacting the proposed tax treaty.

4.89 There is a 'maintenance' cost to the ATO associated with tax treaties in terms of dealing with enquiries, mutual agreement procedures and advance pricing agreements, and OECD representation. In some cases arrangements have emerged to exploit aspects of tax treaties which have required significant administrative attention. Of course it is unknown whether such arrangements would emerge in relation to this particular tax treaty. There is therefore a small unquantified cost in administering a tax treaty. There would also be minor implementation costs to the ATO relating to changes in withholding tax rates.

4.90 The tax treaty is not expected to result in increased compliance costs for taxpayers.

4.91 There would be some reduction in Australian Government revenue from taxation of Mexican investments and other business activities in Australia (because, for example, the tax treaty restricts source country taxation of certain items of income). Treasury estimates this revenue loss at A$2 million. On the other hand, limitation of Mexican taxation rights in circumstances where Australia may have given credit for Mexican taxation is likely to lead to increased Australian tax revenue that more than offsets the revenue loss. Given the modest investment and trade relationship between our two countries, any revenue cost is not expected to be significant.

4.92 It should also be recognised that the limitations agreed to by the two countries, places limits on their policy flexibility in relation to cross-border taxation. However because Australia already has a substantial treaty network, the cost of the proposed tax treaty in terms of a reduced policy flexibility would only be marginal.

Assessment of benefits

Option 1: No further action - rely on existing unilateral measures

4.93 This option represents the status quo. By adopting this option there would be no need for further action and resources could be devoted to other issues. In the domestic context the two Governments would be free to act without being restricted by treaty obligations.

Option 2: Conclude a new tax treaty

4.94 A tax treaty with Mexico would have the following broad effects:

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Where Australians invest directly in Mexico, Mexico would not generally be able to tax an Australian resident unless the resident carries on business through a permanent establishment in Mexico. In addition to reducing Mexican income taxes payable by Australians, the tax treaty would have a similar effect on their liability to Mexican assets taxes. The tax treaty would, to some extent, establish a basis for allocation of profits to that permanent establishment. The tax treaty would also establish specific rules for taxation of shipping profits and income from real property.

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Likewise for Australians investing through a Mexican subsidiary, the tax treaty would set out an internationally accepted framework for dealing with parent-subsidiary transactions and other transactions between associated enterprises. In this regard the tax treaty clearly offers superior protection compared to the domestic rules of the two countries, because it would provide for mutual agreement to be reached between the two taxing authorities.

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To some extent, the rules embodied in the tax treaty would reduce the risks for Australians investing in Mexico (and vice versa) because the tax treaty records agreement between the two Governments on a framework for taxation of cross-border investments. Especially in the case of mining investments which cannot easily be relocated, this reduction in risk may be quite important. ^[F7]

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Furthermore, it is only in the context of a tax treaty ^[F8] that Mexico would agree to limit domestic withholding taxes on royalties and certain interest. (Australia reduces royalty and certain dividend withholding taxes under its tax treaties.)

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The tax treaty would reduce Mexican taxation on royalties and certain interest thereby making Australian suppliers of capital and technology more competitive. This is particularly significant in the banking sector. Reduction in source country taxation is also likely to result in timing advantages for such investors, because the source country taxation is generally withheld when the income is derived, whereas residents are generally taxed by assessment on income derived during a financial year after the end of that financial year. The Australian revenue might also benefit to the extent that greater after-tax profits are remitted to Australia and subject to Australian tax. Of course there are similar advantages in relation to Mexican investment in Australia. Again the tax treaty would assist Australian investors by increasing the certainty of the taxation rules applying to cross-border investment.

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Commodity exporters would be assisted in some respects because of the way the tax treaty would restrict the circumstances in which Australians trading with Mexico are to be taxed by requiring the existence of a permanent establishment in Mexico before Mexican taxation could take place. However, in practice this benefit is not great because Mexico's domestic taxing rules adopt a similar approach.

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The tax treaty would also assist in making clear the taxation arrangements for individual Australians working in Mexico, either independently as consultants , or as employees. Income from professional services and other similar activities provided by an individual would generally be taxed only in the country in which the recipient is resident for tax purposes. However, remuneration derived by a resident of one country in respect of professional services rendered in the other country might be taxed in the latter country, where derived through a fixed base of the person concerned in that country, or if the person is present for more than 183 days in that country.

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Employee's remuneration would generally be taxable in the country where the services are performed. However, where the services are performed during certain short visits to one country by a resident of the other country, the income would generally be exempt in the country visited.

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The tax treaty would relieve double taxation of capital gains on certain assets held by departing Australian residents , where such residents elect to defer taxation on unrealised gains under Australia's domestic tax law and subsequently become Mexican residents and dispose of the assets. In these cases, the gains are taxable only in Mexico.

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There are important impacts on the Governments which are party to the tax treaty. As mentioned the revenue impact for the Australian Government is not expected to be significant. The tax treaty would assist the bilateral relationship by adding to the existing network of commercial treaties between the two countries. It also completes our tax treaty network with North American Free Trade Area countries. As mentioned the tax treaty would promote greater cooperation between taxation authorities to prevent fiscal evasion and tax avoidance.

Consultation

4.95 Information on the tax treaty has been provided to the States and Territories through the Commonwealth-State Standing Committee on Treaties' Schedule of Treaty Action.

4.96 Before negotiations in July 1997, informal consultations took place with banking interests in respect of the tax treaty.

4.97 The ATO established an advisory panel of private sector representatives and tax practitioners to review draft treaties before enactment. The draft tax treaty was submitted to this panel in February 2002.

4.98 The tax treaty would be subject to scrutiny by the Joint Standing Committee on Treaties which would probably provide for public consultation in its hearing. This body is charged with the task of examining and reporting to the Parliament on matters arising from treaties or international instruments.

4.99 The Treasury and the ATO monitor tax treaties, as part of the whole taxation system, on an ongoing basis. In addition Treasury has consultative arrangements to obtain feedback from professional and small business associations and through other taxpayer consultation forums.

Conclusion and recommended option

4.100 Present unilateral arrangements for elimination of double taxation go much of the way to satisfying the policy objectives of this measure. However, while these arrangements provide some measure of protection against double taxation, it is clear the tax treaty would further reduce the possibility of double taxation - especially in relation to associated enterprises. By establishing an internationally accepted framework for the taxation of cross-border transactions it would also reduce investor risk. In addition, a tax treaty would also reduce certain source country withholding taxes on dividend, interest and royalties. The tax treaty is unlikely to result in increased compliance costs for business.

4.101 There would be benefits to both Australia and Mexico in terms of improved bilateral relationships and information exchange. On the other hand the tax treaty would reduce the governments' policy flexibility.

4.102 On balance the benefits of the proposed tax treaty outweigh the costs. The tax treaty should be enacted.