House of Representatives

Explanatory Memorandum

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

General outline and financial impact

Why are tax treaties necessary?

Australias tax treaties are primarily concerned with relieving juridical double taxation, which can be described broadly as subjecting the same income derived by a taxpayer during the same period of time to comparable taxes under the taxation laws of 2 different countries.

Relief from double taxation is desirable because of the harmful effects double taxation can have on the expansion of trade and the movement of capital 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 them.

How do the tax treaties work?

Tax treaties allocate to the country of source, sometimes at limited rates, a taxing right over various income, profits or gains. 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 certain types 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 Australias domestic law, or relevant exemption provisions of the law where applicable.

What is the purpose of Australias tax treaties?

Australias tax treaties are designed to:

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prevent 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 arms 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.

How is the legislation structured?

The Agreements Act gives the force of law in Australia to Australias tax treaties which appear as Schedules to that Act. The provisions of the ITAA 1936 and the ITAA 1997 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 ITAA 1936 and the ITAA 1997 apart from provisions dealing with Australias general anti-avoidance rules and rules for determining maximum foreign tax credits.

What will this 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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an Agreement between the Government of Australia and the Government of the Russian Federation for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income; and

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a Protocol amending the Convention of 6 August 1982 between the Government of Australia and the Government of the United States of America for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income.

This bill will also extend existing rules that exclude royalties taxable on a net basis under a tax treaty from the scope of the royalty withholding tax provisions.

Who will be affected by the measures in this bill?

Persons who:

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are residents of Australia or Russia for the purposes of the Russian Agreement and who derive income, profits or gains from Russia or Australia;

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are residents of Australia or the United States for the purposes of the US Convention and who derive income, profits or gains from the United States or Australia; and

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derive royalties taxable on a net basis under a tax treaty that are not currently excluded from the scope of the royalty withholding tax provisions.

In what way does this bill change the Agreements Act?

This bill will make changes to the Agreements Act by:

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inserting into subsection 3(1) definitions of the Russian Agreement and the US Protocol [item 1 of Schedule 1 and item 2 of Schedule 2 to the bill] ;

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amending the current definition of the United States Convention in section 3(1) to provide that the Convention is subject to changes made by the US Protocol [item 1 of Schedule 2 to the bill] ;

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inserting new sections 11ZK and 6AA which will give the force of law in Australia to the Russian Agreement and US Protocol respectively [item 2 of Schedule 1 and item 3 of Schedule 2 to the bill] ;

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inserting the text of the Russian Agreement and the US Protocol as Schedules 46 and 2A respectively [item 3 of Schedule 1 and item 6 of Schedule 2 to the bill] ; and

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amending section 17A to exclude domestic law royalty payments from the scope of the royalty withholding tax provisions where the payments are not treated as royalties under the Royalties Article of a tax treaty [items 4 and 5 of Schedule 2 to the bill] .

When will these changes take place?

The Russian 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 US Protocol will enter into force upon the exchange of instruments of ratification. This can only occur after all domestic requirements to give the Protocol the force of law in the respective countries have been completed.

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

The Russian Agreement will have effect:

In Australia:

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for withholding tax on income that is derived by a non-resident, in relation to income derived on or after 1 July in the calendar year next following the year in which the Agreement enters into force; and

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for other Australian taxes, in relation to income, profits or gains of any year of income beginning on or after 1 July in the calendar year next following that in which the Agreement enters into force.

In Russia:

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for taxable years and periods beginning on or after 1 January of the calendar year next following that in which the Agreement enters into force.

The US Protocol will have effect:

In Australia:

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for withholding tax on dividends, interest and royalties derived by a resident of the United States on or after the later of 1 July 2003 and the first day of the second month next following the date on which the Protocol enters into force; and

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for other Australian taxes, in relation to income, profits or gains of any year of income beginning on or after 1 July in the calendar year next following that in which the Protocol enters into force.

In the United States:

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for withholding tax on dividends, interest and royalties derived by a resident of Australia on or after the later of 1 July 2003 and the first day of the second month next following the date on which the Protocol enters into force; and

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for other US taxes, for taxes chargeable for any tax year beginning on or after 1 January in the calendar year next following that in which the Protocol enters into force.

When will the exclusion of certain royalties from the royalty withholding tax provisions and technical corrections have effect?

Amendments to extend existing rules that exclude royalties taxable on a net basis under a tax treaty from the scope of the royalty withholding tax provisions will apply to royalties paid from the day this bill receives Royal Assent.

The financial impact of this bill

The Russian Agreement contained in this bill generally accords with Australias other modern comprehensive tax treaties and is not expected to have a significant effect on revenue.

The net yearly cost to revenue of the US Protocol is estimated to be $190 million (some potential offsetting gains to the Australian revenue are unable to be quantified). Over time lower withholding tax rates may be extended to other countries, for example, as a result of most favoured nation clauses in some existing tax treaties. While the withholding tax reductions involve a cost to revenue, the benefits are widely spread in the economy, with the most direct benefits accruing to business. Indirect revenue benefits may arise from increased trade and investment between the countries and reduced tax credit obligations for US taxes.

The changes to the scope of the royalty withholding tax provisions will affect the obligation to withhold tax but not impact on revenue.

Compliance costs

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

Summary of regulation impact statement

The Russian Agreement

Impact: Low.

Main points:

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The Russian Agreement is likely to have an impact on Australian residents with business, investment or employment interests in Russia.

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A limitation of 15% withholding tax applies to dividends unless certain conditions are met which reduce the maximum rate of tax to 5%. These conditions are that the dividends have been fully taxed at the corporate level, the dividend recipient is a company that holds directly at least 10% of the capital of the company paying the dividends, and the resident of the other State has invested a minimum of $A700,000 or the Russian rouble equivalent in the company. In addition, for the 5% limit to apply, where dividends are paid by a company that is resident in Russia, the dividends must also be exempt from Australian tax.

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A source country tax rate limit of 10% will generally apply for both countries in the case of interest and royalties.

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The Russian Agreement will also assist in making clear the taxation arrangements for individual Australians working in Russia, either independently as consultants, or as employees.

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The Russian Agreement will assist the bilateral relationship by adding to the existing network of commercial treaties between the 2 countries.

The US Protocol

Impact: High.

Main points:

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The Protocol will remove withholding tax on certain dividends, enabling major Australian public companies to bring profits made by their subsidiaries back to Australia without further tax being payable. This measure will provide a benefit to the majority of Australian corporate groups with US operations.

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Dividends derived by companies from other direct investment (where the shareholding is 10% or more) will be subject to 5% withholding tax (down from 15%).

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An exemption from withholding tax for interest paid to financial institutions will improve Australias standing as a financial centre.

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The reduction in withholding tax on royalties from 10% to 5% will reduce business costs for technology and know-how.

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The Protocol will also protect Australias rights to tax capital gains and address widespread business concerns regarding the application of Australias CGT to expatriates departing Australia.

Financial impact: Yearly revenue cost of $190 million (some potential offsetting gains to the Australian revenue are unable to be quantified). The withholding tax reductions will trigger most favoured nation obligations for Australia to enter into negotiations and review withholding tax rates in some existing tax treaties (Australias tax treaties with the Netherlands, France, Switzerland, Italy, Norway, Finland, Austria and Korea are affected).

Exclusion of certain royalties from the royalty withholding tax provisions

Impact: Low.

Main points:

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The amendments will align the domestic law treatment of equipment royalties paid to US residents with treatment permitted under Australias updated tax treaty with the United States.

Financial impact: Nil.

Assessment of benefits: The amendments will result in a continuation of current arrangements for taxing equipment royalties derived by US residents through an Australian permanent establishment or fixed base. Collection difficulties that could arise from the application of the RWT provisions to these royalties would be avoided.