House of Representatives

Explanatory Memorandum

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

Chapter 3 US interest amendment

Overview

3.1 Schedule 3to this bill will amend the Agreements Act to ensure that interest which is currently not subject to tax in Australia does not become taxable in Australia as a result of changes 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 (referred to as 'the Convention' for the purpose of this chapter).

Summary of the amendment

Purpose of the amendment

3.2 This amendment will insert new subsection 6(4) into the Agreements Act.

3.3 The purpose of the amendment is to ensure that the interest 'source' rules negotiated with the US and contained in Article 11(7) (as amended by Article 7 of the US Protocol) and Article 27(1)(a) of the US Convention do 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 wholly incurred and borne by a permanent establishment or a fixed base of the Australian resident situated outside both Australia and the US. Such interest would not be subject to tax under section 128B of the ITAA 1936, or under any of Australia's other DTAs.

Date of effect

3.4 The amendment will take effect from the date of entry into force of the US Protocol. The Protocol will enter into force upon the exchange of instruments of ratification between the two countries (Article 13(2) of the Protocol) and will have effect for taxes in Australia from 1 July in the calendar year next following that in which the Protocol enters into force.

Background to the legislation

3.5 The Agreements Act was amended by the International Tax Agreements Amendment Act (No.1) 2002 to include a Protocol amending the existing US Convention. Article 7 of the Protocol updated the Interest Article of the Convention.

Explanation of the amendment

3.6 New subsection 6(4) of the Agreements Act ensures that the provisions of the US Protocol do not have the effect of subjecting to Australian tax any interest paid by an Australian resident to a US resident which, apart from the Protocol, would not be subject to Australian tax.

3.7 Prior to the amendments by the Protocol, Article 11(7) of the US Convention contained a deemed source rule for interest for the purposes of the treaty. Former paragraph 7 was designed to ensure that Australia has a taxing right over interest paid by an Australian resident to a US resident by deeming the source of that interest to be in Australia, except 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 in the US or outside both Contracting States. In those cases, the interest is deemed to be sourced in the State in which the permanent establishment (or the fixed base) is situated.

3.8 New Article 11(7) (as amended by Article 7 of the Protocol), however, deems the interest paid by an Australian resident to 'arise' in Australia. Article 27(1)(a) is the provision that deems the interest to have an Australian source for the purposes of the income tax law in Australia both before and after the Protocol amendments. Furthermore, new Article 11(7) will no longer include the words or outside both Contracting States. The effect of new paragraph 7, combined with Article 27(1)(a), is that interest paid by a permanent establishment (or a fixed base) of an Australian resident which is located in a third State will be deemed to be sourced in Australia.

3.9 Subparagraph 128B(2)(b)(i) of the ITAA 1936 excludes from the application of withholding tax in Australia interest paid by an Australian resident where that interest is an outgoing wholly incurred in carrying on business through a permanent establishment of the Australian resident situated in a third State. However, the deemed source rule contained in Article 11(7) (as amended by the Protocol) and Article 27(1)(a) means that a theoretical liability to tax by assessment will arise. It is Australia's established tax treaty policy not to extend its domestic law tax liability in this way. New subsection 6(4) ensures that no new domestic tax liability arises as a result of the changes to the US Convention.

3.10 Similar provisions to new subsection 6(4) have been included for other tax treaties where similar issues arise.