House of Representatives

Explanatory Memorandum

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

General outline and financial impact

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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a Protocol amending the Convention of 21 May 1980 between the Government of Australia and the Government of Canada for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Canadian Convention); and

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a Second Protocol amending the Agreement of 20 August 1980 between the Government of Australia and the Government of Malaysia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income (Malaysian Agreement).

The Canadian Protocol will facilitate trade and investment between Australia and Canada by reducing withholding taxes in some circumstances and reducing the possibility of double taxation of capital gains by extending coverage of the Canadian Convention to taxes on such gains.

The Second Malaysian Protocol will protect Australia's tax revenue by denying treaty benefits to those who benefit from the preferential tax treatment under the Labuan offshore business activity regime and other substantially similar regimes. It will also operate to extend tax sparing arrangements in relation to certain designated development incentives provided by Malaysia until 30 June 2003, at which time they will permanently expire. Furthermore, the Second Malaysian Protocol will update the Malaysian Agreement to reflect modern business and tax treaty practices.

This bill will also amend the Agreements Act to ensure that interest does not become taxable in Australia solely as a result of changes made to 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 (US Convention) by the International Tax Agreements Amendment Act (No. 1) 2002 .

Finally, this bill will make a number of minor technical amendments 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 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 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 derived by a taxpayer during the same period of time to comparable taxes under the taxation laws of two 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 countrie's domestic law and clarifies the taxation position of income flows between them.

Australia's 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 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?

The measures in this bill will affect the following categories of persons:

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persons who are residents of Australia or Canada for the purposes of the amended Canadian Convention and who derive income, profits or gains from Canada or Australia;

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persons who are residents of Australia or Malaysia for the purposes of the amended Malaysian Agreement and who derive income, profits or gains from Malaysia or Australia; and

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persons who are residents of the United States and derive interest paid by a permanent establishment or fixed base of an Australian resident in a third State.

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 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 Australia's general anti-avoidance rules and rules for determining maximum foreign tax credits.

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) the definition of the Canadian and Second Malaysian Protocols;

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amending the current definition of the Canadian Convention in subsection 3(1) to provide that the Convention is subject to changes made by the Canadian Protocol;

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substituting a new definition of the Malaysian Agreement in subsection 3(1) to provide that the Agreement is subject to changes made by the first and second Malaysian Protocols;

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inserting new sections 6AB and 11FB, which will give the force of law in Australia to the provisions of the Canadian and Second Malaysian Protocols according to their tenor;

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adding the text of the Protocols as Schedules 3A and 16B;

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inserting new subsection 6(4), which will ensure that the recently enacted amending US Protocol will not have the unintended effect of subjecting to Australian tax, interest paid by an Australian resident to a US resident where the indebtedness on which the interest is paid is incurred and borne by a permanent establishment or a fixed base of the Australian resident situated outside both Australia and the US; and

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making a number of minor technical amendments to existing tax treaties.

When will the Protocols enter into force?

The Canadian Protocol will enter into force on the latest date on which diplomatic notes are exchanged between the two governments formally advising of the completion of all the requirements necessary to give the Protocol effect in the domestic law of Australia and Canada respectively.

The Second Malaysian Protocol will enter into force on the latest date on which diplomatic notes are exchanged between the two governments formally advising of the completion of all the requirements necessary to give the Protocol effect in the domestic law of Australia and Malaysia respectively.

The US interest amendment will take effect from the date of entry into force of the US Protocol. The US Protocol will enter into force on the latest date on which diplomatic notes are exchanged between the two governments formally advising of the completion of all the requirements necessary to give the Protocol effect in the domestic law of Australia and the United States respectively. While this may mean that the amendment may take effect retrospectively, the amendment is technical only and no one will be disadvantaged.

The other amendments effected by this bill will commence on the day on which the Act receives Royal Assent. While some of the amendments will apply retrospectively, the amendments are technical only and no one will be disadvantaged.

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

The Canadian Protocol will have effect:

In Australia:

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for withholding tax imposed on income derived by a resident of Canada on or after 1 January, in the calendar year next following that in which the Protocol enters into force; and

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for other Australian taxes covered by the Protocol, generally in respect of 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 Canada:

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for tax withheld at the source on amounts paid or credited to a resident of Australia on or after 1 January in the calendar year next following that in which the Protocol enters into force; and

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for other Canadian tax, for taxation years beginning on or after 1 January in the calendar year next following that in which the Protocol enters into force.

The Second Malaysian Protocol will have effect:

In Australia:

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in relation to the tax sparing provisions for any year of income beginning on or after 1 July 1992. The other provisions of the Second Protocol and the associated Exchange of Letters will have effect in Australia for any year of income beginning on or after 1 July in the calendar year next following that in which it enters into force.

In Malaysia:

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in relation to the tax sparing provisions, for any year of assessment beginning on or after 1 January 1993. In all other cases, the Second Protocol and the associated Exchange of Letters will have effect in Malaysia for any year of assessment beginning on or after 1 January in the calendar year next following that in which it enters into force.

The financial impact of this bill

The amending Canadian Protocol generally accords with Australia's other modern comprehensive tax treaties and is not expected to have a significant effect on revenue. The main cost to revenue will result from removing the existing exemption for remuneration not exceeding specified monetary limits derived during short-term visits.

Although the cost of this measure cannot be precisely defined, it is expected to be approximately $1 million per annum over the forward estimate period as follows:

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

Minimal cost to revenue from concluding the Amending Second Malaysian Protocol is expected from providing tax sparing credits for Malaysian tax incentives. The proposed tax sparing is limited to concessions relating to active income (which will generally be derived by Australian residents in the form of exempt dividends), and, for the most part, related to activities that have already been undertaken. As such the cost is likely to be in the order of $1 million to $2 million for 2002-2003.

The Second Malaysian Protocol provides that persons carrying on any offshore business activity under the Labuan offshore business activity regime (a preferential tax regime in Malaysia) or any substantially similar regime shall not be entitled to benefits accorded under the DTA. This exclusion from DTA benefits will ensure that the revenue is protected by preventing abuse of the DTA provisions.

The US interest amendment is expected to have no revenue impact. It is Australia's established policy not to extend its domestic law tax liability to cover interest which would be taxable under the revised Interest Article.

Compliance costs

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

Summary of regulation impact statement

The Amending Canadian Protocol

Impact: Low.

Main points:

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Withholding tax on certain non-portfolio dividends (those which are also fully franked, in the case of dividends flowing from Australia to Canada) will be limited to a maximum rate of 5% reduced from the current Double Tax Convention rate of 15%. While each country will be allowed to impose a branch profits tax, the rate limit will be reduced from 15% to 5%. Only Canada currently imposes such a tax.

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The interest withholding tax rate limitation will be reduced from the current treaty rate of 15% to Australia's usual treaty and domestic rate of 10%.

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The definition of royalty will be expanded in conformity with current Australian tax treaty practice to take into account modern communication methods.

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The Alienation of Property Article will be revised in line with current Australian tax treaty practice, including ensuring that the coverage extends to real property owned through corporate or other entities. A new provision will also help to avoid double taxation when a resident of one of the Contracting States departs to become a resident of the other.

The Amending Second Malaysian Protocol

Impact: Low.

Main points:

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The 'tax sparing' provisions of the existing DTA will be amended to reflect changes in the Malaysian tax incentives legislation; and tax sparing relief has been extended for a further period of time (i.e. until 30 June 2003).

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Persons who benefit from the Labuan offshore business activity regime (Malaysia's international offshore financial centre - a low tax regime) will be excluded from receiving DTA benefits.

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The Second Protocol will also update the existing DTA in a number of respects to bring it into line with Australia's recent tax treaty policies and practices.

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For Australia, nil dividend withholding tax is to apply to Malaysian residents in receipt of franked dividends where they hold at least 10% of the voting power of the Australian company. For all other dividends the existing 15% rate limit will apply. Malaysia is precluded by the treaty from imposing dividend withholding tax. This accords with Malaysia's current domestic law. The Second Protocol provides that in the event of a significant change of the relevant law in either country, Australia and Malaysia would consult with a view to agreeing an appropriate amendment.

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The definition of 'royalties' is amended to take into account modern communications methods, and to include payments for spectrum licences.

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A new paragraph is included in the Associated Enterprises Article to provide for correlative relief where there is an adjustment of profits.

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The existing provision dealing with third country income of dual residents is replaced with a more comprehensive Other Income Article based on the Australian Model which provides for source country taxation of income not otherwise dealt with in the DTA.