Permanent Establishments and BEPS

Earlier this year I produced some content regarding permanent establishments and how they will be changing under the OECD’s BEPS project.

Permanent establishments are one of the most important and fundamental concepts in international tax and they will be undergoing significant changes in the coming years. Please don’t hesitate to contact me if you have any questions.

Simon

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Taxing Issues for Departing Taxpayers

The following article originally appeared in the November 2016 edition of The Taxpayer (professional journal of Tax & Super Australia https://www.taxandsuperaustralia.com.au/TSA/Products_Services/Publications/The_Taxpayer/TSA/Publications/The_Taxpayer.aspx)

 

Simon Dorevitch explains the potential tax issues that taxpayers encounter when relocating overseas.

It is estimated that approximately 5% of Australian citizens live outside of Australia, with
Europe and Asia the most popular destinations. If your client has made the decision to relocate to another country (whether permanently or for an extended period), they should be aware of two potential tax issues:
1. When a taxpayer becomes a non-resident of Australia, they are deemed to have sold
their non-Australian assets for market value (CGT event I1). However, such taxpayers
may make an election to disregard any capital gain and thereby defer any tax payable.

2. Thanks to recent changes, Australians living abroad must now report their income
and make repayments towards their HELP (university) and TSL (apprenticeship) debts
if their income exceeds a certain threshold. These changes have effectively brought the
repayment obligations of Australians living overseas in line with those living in Australia.

 

A SILENT TAXING POINT: CGT EVENT I1

Generally, the assessable income of taxpayers who are tax residents of Australia includes
income from all sources, whether in or out of Australia. In contrast, the assessable income of foreign residents generally only includes income with an Australian source.
In the context of CGT, this means that foreign residents disregard capital gains or losses that happen in relation to a CGT asset that is not taxable Australian property (TAP)
Broadly, TAP includes:

• taxable Australian real property (TARP) – eg land or buildings situated in Australia
(including a lease of land if the land is situated in Australia). It can also include
mining rights.

• indirect Australian real property Interests – ie a membership interest in another entity,
where the interest is a non-portfolio interest (10% or more) and the entity passes the
principal asset test (market value of TARP assets exceeds market value of non-TARP
assets)

• A CGT asset used in carrying on a business through an Australian permanent establishment, and

• An option or right to acquire one of the above assets.

Where a taxpayer ceases to be an Australian resident those assets that are not TAP are taken outside the remit of the Australian tax system. As you might imagine, the government does not like this, so CGT Events I1 and I2 were included in the legislation to tax these assets before they fell out of Treasury’s grip.

 

WHEN DOES CGT EVENT I1 HAPPEN?
CGT event I1 happens when an individual or company stops being an Australian resident. For an individual taxpayer, this will occur when they no longer satisfy any of the four tests of residency – the resides test, the domicile test, the 183-day test and the superannuation test.

In certain situations, it may be difficult to pinpoint precisely when a taxpayer ceases to
be a resident (or even if they ceased being a resident at all). Where such timing could have a significant impact on the taxpayer’s liability it may be prudent to seek a private ruling from the ATO.

WHAT ARE THE CONSEQUENCES OF CGT EVENT I1 HAPPENING?

The taxpayer is deemed to have disposed of their non-TAP assets, and also their indirect
Australian real property interests, for their market value at the time. Therefore, they make a capital gain if the market value is more than their cost base and a capital loss if the market value is less than the reduced cost base.

There are, however, exceptions:
• A capital gain or loss is disregarded if theasset was acquired before 20 September 1985 (ie before the introduction of CGT).
• If the taxpayer is an individual, they may choose to disregard the capital gain or
loss. This choice is evidenced by how the taxpayer prepares their tax return (ie whether
the gain is included or excluded). Note that the choice is all in or all out – it cannot be
made per CGT asset.

 

The ATO has published a fact sheet that contains a rough “rule of thumb” to assist
emigrating taxpayers. Below is an extract from this fact sheet:

If you go overseas temporarily and do not set up a permanent home in another
country…then you may continue to be treated as an Australian resident for tax
purposes.

If you leave Australia permanently…then you will generally not be considered an Australian resident for tax purposes, from the date of departure.

 

WHAT ARE THE CONSEQUENCES OF MAKING THIS CHOICE?

If a taxpayer makes a choice to disregard the capital gain, the assets are taken to be TAP until the taxpayer disposes of the asset or becomes an Australian resident once more. Effectively, the assets are kept within the Australian tax system.
Note, however, that this may be overridden by a Double Taxation Agreement (DTA).

How the ATO will become aware of a foreign resident disposing of non-TAP assets is unclear, though it is noted that data-sharing between tax authorities has increased in recent years.
WHEN SHOULD THE CHOICE TO DISREGARD CGT EVENT I1 BE MADE?

In some cases the taxpayer will simply not have the cash to fund the CGT liability (since, being a deemed disposal, they have not actually received any capital proceeds). In those situations the choice to disregard any capital gain is clear.

In other cases, knowing whether it is in a taxpayer’s interests to make the choice requires a consideration of numerous factors and, ideally, a well-functioning crystal ball! The time between the CGT event and the lodging of the return is an important consideration (see table).

Keep in mind also that non-residents are subject to non-resident rates of tax and no longer have access to the CGT discount. This makes it more likely that the taxpayer will face higher taxation on the future capital gain if a choice is made to disregard the deemed gain.

It may be more favourable to make the choice where

 

It may be less favourable to make the choice where

 

The taxpayer’s taxable income is higher than it is expected to be in the year of disposal (since CGT is applied at marginal tax rates)

 

The taxpayer’s taxable income is lower than it is expected to be in the year of disposal (since CGT is applied at marginal tax rates)

 

The asset is expected to fall in value (and therefore the capital gain in the future will be lower)

 

The asset is expected to rise in value (and therefore the capital gain in the future will be greater)

 

Being able to defer payment to a later date is important

 

The taxpayer intends to return to Australia (and the market value is expected to rise whilst they are away)
The subsequent disposal will not be taxable in Australia (e.g. because of a DTA)  

Keep in mind also that non-residents are subject to non-resident rates of tax and no longer have access to the CGT discount. This makes it more likely that the taxpayer will face higher taxation on the future capital gain if a choice is made to disregard the deemed gain.

What if the taxpayer becomes a resident again?

On becoming a resident, a taxpayer is deemed to have acquired their non-TAP assets for market value. Therefore, a former resident, having not made the choice to disregard a capital gain from CGT event I1, who returns to Australia (and becomes a resident once more) receives an uplift in the cost base of their non-TAP assets. For CGT discount purposes, the date of regaining residency (and not the original date of actual acquisition) is used to determine whether the asset has been held for 12 months.

Example

In June 2016 James decides he has had enough of Australia and emigrates to France, vowing never to return. He is considered to have terminated his Australian residency at this time. Upon departure James owns the following assets:

·         A home in Toorak

·         An investment property in the United States

·         50% of the shares in Gemba Pty Ltd, a company whose major asset is a farm in NSW

When James’ Australian residency ends, CGT Event I1 happens. He is deemed to have disposed of his investment property and shares for their market value, triggering a capital gain.

James decides not to make the choice to disregard the gain. However, having been out of work since August 2015, James taxable income in the 2016 financial year is very low and therefore low marginal tax rates apply to the capital gain.

Five years later, with his favourite Australian sporting team competing for their fourth-straight premiership, James decides he misses Australia too much and returns permanently. He is deemed to have reacquired his investment property for its market value when he becomes an Australian resident once more. Any increases in value that occurred whilst he was in France will not be subject to Australian tax.

 

 

HELP Debts

In November 2015, the government passed legislation closing a loophole which enabled university graduates living overseas to avoid making student loan repayments. From 1 July 2017, the HELP (Higher Education Loan Program) and TSL (Trade Support Loan) repayment obligations for overseas residents will be brought in line with those who remain in Australia.

From 1 January 2016

Taxpayers with an existing HELP or TSL debt who leave Australia and intend to be overseas for more than six months in any 12-month period will need to need to notify the ATO within seven days of leaving Australia. Those who already live overseas will need to update their details no later than 1 July 2017.

It does not matter whether the taxpayer is overseas for work, study or travel.

Taxpayers should notify the ATO by updating their contact details, including international residential and email addresses, using the ATO’s online services via the myGov website. This means that, if they haven’t already, such taxpayers will need to register for a myGov account. The ATO should also be informed if there are any further changes to a taxpayer’s contact details whilst they reside overseas.

From 1 July 2017

Taxpayers who are living overseas and are not Australian residents for tax purposes will need to self-assess the world-wide income they have received in the 2016-17 financial year and submit details to the ATO via myGov. Foreign income will be translated to Australian dollars using the average exchange rate for the financial year.

They should do this, even if their income is below the threshold (or if they have not worked at all). Income details should be submitted by 31 October each year.

The ATO have indicated that, at this stage, their first priority is to educate taxpayers and encourage self-compliance. However, they have also confirmed that individuals who do not comply with their obligations will potentially be subject to the same range of penalties that apply under broader taxation law.

Taxpayers who remain Australian residents despite being overseas will continue to file tax returns and will therefore not need to report income via myGov.

If the taxpayer’s income for repayment purposes exceeds the minimum repayment threshold, they will be required to make compulsory repayments towards their debt. Non-resident taxpayers will make repayments via myGov.

The repayment income threshold for the 2016-17 financial year is;

Repayment income Repayment rate
Below $54,869 Nil
$54,869 – $61,119 4.0%
$61,120 – $67,368 4.5%
$67,369 – $70,909 5.0%
$70,910 – $76,222 5.5%
$76,223 – $82,550 6.0%
$82,551 – $86,894 6.5%
$86,895 – $95,626 7.0%
$95,627 – $101,899 7.5%
$101,900 and above 8.0%

These rates are identical to those that apply to taxpayers who remain in Australia. As with resident taxpayers, non-resident taxpayers may also make voluntary repayments.

 

 

 

 

 

 

 

 

Australia’s Diverted Profits Tax now Law

The following article originally appeared on the FTI Tax website in April 2017.

http://fti.tax/wp/wp-content/uploads/2017/04/AA_2017_DPT_20170434_v_final.pdf

 

On 4 April 2017, the Diverted Profits Tax Bills received Royal Assent and became Australian Acts No. 21 and 27 of 2017. The new law applies to income years commencing 1 July 2017 (whether or not a relevant transaction entered into before that date) and targets ‘significant global entities’ that have a global income of more than A$1 billion and an Australian income of more than A$25 million and provides for 40% tax on diverted profits; 30% franking; payment of tax to object; 12 months to supply documents in defence; and with limited rights of appeal.
Background
The Diverted Profits Tax (DPT), first announced in the 2016-17 Federal Budget, is the latest in a raft of measures (including the Multinational Anti-Avoidance Law (MAAL)) designed to combat multinational tax avoidance.
The Australian Treasury indicates there are approximately 1,600 taxpayers with income sufficiently large to potentially fall within the scope of the new law, though it is expected that the DPT will apply in only very limited circumstances. Treasury estimates that the tax will raise A$100 miilion in each of the 2018-19 and 2019-20 financial years.
When will DPT apply
The DPT will apply to an entity if, broadly:
• It is reasonable to conclude that a scheme (or any part of a scheme) was carried out for a principal purpose of, or for more than one principal purpose that includes, enabling a taxpayer (the relevant taxpayer) to obtain a tax benefit. This ‘principal purpose’ threshold is lower than the ‘sole or dominant purpose’ threshold that applies for Part IVA anti-avoidance purposes (Australia’s GAAR). Taxpayers may however provide evidence to support the non-tax financial benefits of the scheme;
• The relevant taxpayer is a ‘significant global entity’ (i.e. it has annual global income of A$1 billion or more being either a global parent entity or member of a group of entities consolidated for accounting purposes) for theincome year in which it would obtain the tax benefit;
• A foreign entity that is an associate of the relevant taxpayer entered into, carried out or is otherwise connected to the scheme or part of it. Therefore, the DPT will not apply to a scheme with which only Australian entities are connected; and
• The relevant taxpayer obtains a tax benefit (as defined for Part IVA purposes) in connection with the scheme.
When will DPT not apply
The DPT will only apply if it is reasonable to conclude that none of the following tests are satisfied:
The $25 million turnover test
The DPT does not apply where it is reasonable to conclude that the Australian turnover of the relevant taxpayer and other entities that are members of the same global group does not exceed A$25 million. This test has been broadened to take into account the Australian assessable income of foreign entities (not just Australian entities) that are part of the same global group.
The sufficient foreign tax test
The DPT does not apply where it is reasonable to conclude that, in relation to the scheme, the increase in foreign tax liability is equal to or exceeds 80% of the corresponding reduction in the Australian tax liability. To work out the amount of the increased foreign tax liability, it is necessary to consider any specific tax relief provided by a foreign country to relation to the scheme. Where the tax benefit is an allowable deduction and the taxpayer must withhold an amount in respect of withholding tax, the Australian tax liability is reduced by the amount withheld.
We note that many countries currently have a corporate tax rate that is equal to or less than 24% (i.e. 80% of Australia’s 30% rate). These include the United Kingdom, Russia, Croatia, Sweden, Hungary, the Czech Republic, Singapore and Hong Kong. The United States will be added to this list if President Trump’s tax policies are enacted.
The sufficient economic substance test
The DPT does not apply where it is reasonable to conclude that the profits derived, received or made as a result of the scheme reasonably reflects the economic substance of the entity’s activities in connection with the scheme, having regard to the functions, assets used and risks assumed by the entity. For the purposes of applying this test, consideration should be given to the OECD transfer pricing guidelines.
A carve-out has also been created for managed investment trusts, foreign collective vehicles with a wide membership, foreign entities owned by a foreign government, complying superannuation entities and foreign person funds.
Interaction with the thin capitalisation and CFC provisions
The DPT’s interaction with the thin capitalisation and controlled foreign company (CFC) provisions have been clarified. In particular;
•If a taxpayer is subject to the thin capitalisation provisions and the DPT tax benefit includes a debt deduction, when calculating the DPT tax benefit, the rate is to be applied to the debt interest actually issued (rather than to the debt interest that would have existed if the scheme had not been carried out).
• In relation to the CFC provisions, where an amount of attributable income is included in the assessable income of the relevant taxpayer or their associate, it should be excluded from the taxpayer’s DPT tax benefit.
If DPT applies
If the DPT applies to a taxpayer, the Commissioner may make a DPT assessment and issue it to the relevant taxpayer. The ATO will establish a DPT panel (similar to the existing General Anti-Avoidance Rule (GAAR) panel) and will generally seek
endorsement from this panel before issuing an assessment.
Tax is payable on the amount of diverted profits at a penalty rate of 40% . Furthermore, the DPT due and payable will not be reduced by the amount of foreign tax paid on the diverted profits. The DPT assessment will also include an interest charge.
The DPT will only give rise to franking credits at 30% and not the 40% penalty rate.
The assessment and review process
If the Commissioner considers that a taxpayer is in scope of the DPT, he may make a DPT assessment at any time within 7 years of first serving a notice of assessment on the taxpayer for an income year. In practice, the Commissioner would only do this after communication with the relevant taxpayer had failed to reach an agreement about the correct amount of tax that should be paid.
The relevant taxpayer must then pay the amount set out in the DPT assessment no later than 21 days after the Commissioner gives the notice of assessment.If the Commissioner gives an entity a notice of a DPT assessment, a period of review will generally apply. This
review period gives the taxpayer the opportunity to provide additional documents and information relating to the DPT assessment to the Commissioner.
This review period will typically end 12 months after the DPT assessment is given but can be shortened (for example if the taxpayer considers that it has provided the Commissioner with all relevant information and documents) or extended (for example where the entity provides information close to the end of the 12 month period and the Commissioner needs additional time to properly examine the material).
As a result of receiving additional information, the Commissioner may conclude that the DPT assessment is excessive or that the liability should be increased. He may then make an amended DPT assessment. Where an amended DPT assessment is made, interest will be payable (by the Commissioner on the refund where the liability is reduced or by the taxpayer on the additional amount payable where the liability is increased).
Objections to DPT assessments
The relevant taxpayer may object to the DPT assessment by appealing to the Federal Court within 60 days of the end of the period of review. Previously under the draft legislation this period was 30 days. However, any information or documents that were not provided to the Commissioner during the period of review, or that the Commissioner did not already have prior to the period of review, will not be admissible without either
the Commissioner’s consent or the leave of the court.
What should businesses be considering with regards to potential DPT exposure?
Businesses should first review existing and proposed arrangements, having regard to the the following DPT threshold questions:
1. Is the Australian company (or permanent establishment) a significant global entity (being a member of a group with annual global income of AU$1 billion or more)?
2. Is it reasonable to conclude that annual Australian income is less than AU$25 million (though this includes any DPT benefit)?
3. Is it reasonable to conclude that sufficient foreign tax (effectively over a 24% rate) has not been paid/imposed in all jurisdictions directly or indirectly relevant to the
supply chain into Australia?
4. Is it is reasonable to conclude that the sufficient economic substance test is not satisfied? The taxpayer must prove the arrangement reasonably reflects the economic substance of the entity’s activities. In most cases, this will require a ‘two-sided analysis’, applying an Australian transfer pricing examination to the functions, assets and risks of the activities carried out in Australia and those activities carried out in one or more other overseas jurisdictions; and/or
5. Was obtaining a tax benefit a principal purpose (or one of the principal purposes) behind the taxpayer carrying out the scheme? This is a lower threshold than the existing
Part IVA/GAAR, which requires a ‘dominant purpose’ of obtaining a tax benefit.
We expect that ATO transfer pricing reviews and compulsory Country By Country Reporting may signal to the ATO the existence of potential DPT arrangements. Therefore it is incumbent upon affected taxpayers to review and understand their positions and have in place robust documentation.
Further, the DPT may also encourage multinational taxpayers to engage in a dialog with the ATO in relation to their cross-border activities such that they may consider Advance Pricing Agreements (APAs) to provide greater certainty with respect to their international arrangements and transfer pricing.
The ATO has significant power to raise DPT assessments and taxpayers should be prepared.

How the internet has challenged international tax concepts

Hi,

I thought I’d post an essay that I wrote a few months back for my Masters course on Australian International Taxation. I was pretty pleased to get an HD because my writing was a bit rushed and at times I felt like I had bitten off more than I could chew for a 4,000 word paper.

I haven’t included my footnotes here (because this is just a blog) but would be happy to share them. Please properly give me credit if using this article, ESPECIALLY, ESPECIALLY if it is for a university assignment.

So here it is;

 

TOPIC

 

Critically evaluate the following statement;

 

“As technological change weakens the link between economic activity and a particular location, traditional tax concepts such as residency and source become difficult to apply, if not unworkable. A new approach is needed.”

 

ABSTRACT

 

This paper evaluates the effect of technological developments, particularly the internet and associated communications technologies, on the core tax concepts of residency and source. It considers how these concepts can be applied in an environment where physical presence is less important. It starts by discussing the impact on residency (both individual and corporate) and permanent establishments before moving on to discuss source (focusing on digitised goods and services). Finally, it evaluates two alternate approaches but concludes that neither is an improvement on the current system. The paper argues that, fundamentally, the current rules remain workable, especially if a common-sense, substance-over-form approach is taken.

 

 


ESSAY BEGINS

 

The concepts of residence and source are fundamental building blocks of Australia’s international tax system. Together they determine how tax is applied and which country has jurisdiction to tax. The core rules of these concepts were developed decades ago, long before the internet, video-conferencing and associated modern communications technologies were developed (or even imagined). Fundamentally based on a connection to physical, territorial locations, the rules of residency and source were intended for a very different world. Attempts to apply these rules to an electronic commerce environment pose significant difficulties. So much so that some have alleged a significantly new approach is needed. This paper seeks to identify the issues caused by the internet and associated technologies, evaluate their impact and potential solutions. It is argued that, while substantial challenges exists, the existing rules are fundamentally capable of responded to these challenges if authorities adopt a ‘substance-over-form’ approach.

 

Part one – the impact of technological change on residency and permanent establishments

 

This section of the paper will consider how new technologies have impacted the application of the residency and permanent establishment rules. In particular, it is interested in whether they have made those rules more difficult to apply or open to manipulation. It concludes that while technology creates substantial opportunities for taxpayers and difficulties for revenue authorities, the existing rules are largely workable, if authorities don’t lose sight of real, substantive ties to a territory instead of focusing on formal rules.

 

Individual residency

 

An individual will be resident of Australia under domestic tax law if they reside in Australia, are domiciled in Australia (and don’t have a permanent place of abode elsewhere), are present for more than half of the income year or pass the superannuation test. In the case of dual-residency, most Double Tax Agreement contain a tie-breaker provision that considers permanent home, personal and economic relations, habitual abode, nationality and finally mutual agreement. Some commentators have suggested that these rules can be manipulated by high-skilled, high-wealth taxpayers utilising communications technology. One suggested scenario involves an individual who sets up camp in a tax haven while continuing to operate in Australia via the internet. A more extreme version has the individual living on a yacht sailing the high seas.

 

Writing in 1996, Zak Muscovitch envisioned that residency would become “meaningless” in the internet age. In fact, traditional concepts of residency have remained largely intact because most people privilege lifestyle and social factors when deciding where to live. To satisfy himself that a permanent place of abode exists outside of Australia, the Commissioner will compare an individual’s presence overseas with their association with Australia. This presents a significant hurdle for most people.  No matter how easy it becomes to conduct business on-line, physical presence will remain crucial to people in the social context. Thus the residency tests for individuals work well because they rely on real, substantive ties.

 

Corporate residency

 

While a corporation cannot form social and emotional connections, it can also form real, substantive ties with a territory. The current residency rules don’t adequately reflect this and are therefore more susceptible to manipulation.

 

A company is resident if it is incorporated in Australia or it carries on business in Australia and has either its ‘central management and control’ in Australia or its voting power controlled by resident shareholders. It is broadly accepted (although not by the ATO) that the ‘carries on business’ element of the test is redundant if the central management and control of a company is situated in Australia (as this is where the “real business is carried on”). Furthermore, the Commissioner will generally accept that central management and control is in Australia if the majority of the board meetings are held in Australia.

 

With modern technology (e.g. the development of video conferencing facilities and the increasing affordability of air travel) it is relatively easy to move the location of board meetings and therefore to manipulate the residence of a company. The central management and control test does not adequately reflect the realities and complexities of the modern business environment. This has led to increasing uncertainty and opportunities for shrewd tax planning. To date there has been scant guidance from the ATO and few cases to suggest that, as the ATO has suggested, the courts are open to modifying the test to the electronic communications environment. Where directors are dispersed throughout the world and ‘meet’ via videoconferencing facilities or where they are constantly on the move and arrange to meet in different places throughout the year the residency of the company becomes difficult to determine at best and purely a matter of convenience at worst.

 

In the case of dual-residency, most of Australia’s Double Tax Agreements allocate residency to the ‘place of effective management’.  Though similar to the concept of central management of control, this concept appears to focus more on where decisions are made and less on where meetings are held. It is arguably also more interested in the day-to-day management of the company than the major policy decisions. For these reasons, while it is conceivable to envisage a situation where the managing director of a company is constantly on the move and making decisions across numerous countries (and perhaps even while flying over the ocean), ‘place of effective management’ is certainly more difficult to manipulate than ‘central management and control’.

 

However, a better approach would be one that draws on the strengths of the individual residency tests discussed above. As Lord Loreburn wrote; “in applying the conception of residence to a company, we ought, I think to proceed as nearly as we can upon the analogy of an individual”. Mathew Collett has argued that, like an individual, one may consider than a multi-national corporation resides where it has the closest economic, political, financial, cultural and legal links. Similarly Uta Kohl has advocated a broad-based control test that looks for a substantive rather than formal nexus. This real, substantive approach to corporate residency would be a significant improvement to the current rules, and certainly better than the (admittedly simple and certain) sole incorporation test that business groups appear to advocate. However, as more businesses become decentralised and less tied to physical assets (itself a development made possible by modern technology), even this approach may become difficult to apply in some circumstances. Whether or not this means that the whole concept of residency should be jettisoned is something that will be considered in part three of this paper.

 

Permanent establishments

 

Where an entities’ presence in Australia is insufficient to create residency, the concept of a permanent establishment is important in establishing Australia’s right to tax that entity, especially in regards to its business profits. Article 7(1) of the OECD model, upon which Australia’s tax treaties are based, provides that a resident of a contracting state shall be taxable only in that state unless it carries on an enterprise in the other state through a permanent establishment. If such a permanent establishment exists, the profits that are attributable to it may be taxed in the other state. Article 5 defines a permanent establishment as “a fixed place of business through which the business of an enterprise is wholly or partly carried on”. Writing about the similar s6(1) definition of permanent establishment, the Commissioner considers that there must be an element of permanence, both geographic and temporal. The model treaty deems certain specific locations to be permanent establishments, a physical presence of some permanence being common to all, and others not to be. Included among the latter category are facilities used solely for storage, display or delivery of goods or merchandise and solely for activities of a preparatory or auxiliary character.

 

An important question in international taxation is how and whether, the concept of permanent establishment can be applied to electronic commerce.  Can a computer server constitute a permanent establishment and if so, how can profit be attributed to it? The majority (but not unanimous) view is that the mere presence of a server in a particular jurisdiction is usually not sufficient to create a permanent establishment. An analogy has been drawn between a server and a warehouse or mail-order activities, both of which have traditionally not been held to be permanent establishments. The correct treatment may depend on the functions performed on the server. For example, a server that is used merely for advertising will not be held to be a permanent establishment, consistent with the exclusion of preparatory and auxiliary activities. However, where the server is also used for taking orders and accepting payment, it may, according to some, be a permanent establishment. Where it is also used for digitised delivery of goods there is an even stronger case. However, multiple servers, each performing particular functions in different locations, cannot be cumulated into a single permanent establishment.

 

A server should rarely, if ever, be treated as a permanent establishment since its location is largely arbitrary and has little or no connection to where the real economic activity takes place. However, even if justified on theoretical grounds, there are many practical obstacles to servers as permanent establishments. A server is highly mobile and therefore, if it can constitute a permanent establishment, the likely taxpayer response will simply be to relocate them to a tax haven. There are also problems of how profit would be attributed to it. Article 7(2) provides for attribution based on what it might be expected to make, “if it were a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions”. This deceptively simple article belies the tremendous complexity which could arise in regards to the allocation of income between competing jurisdictions. These issues demonstrate the difficulties of applying traditional tax concepts in an electronic commerce environment.

 

Part two – the impact of technological change on source

 

Having discussed the impact of new technologies on the residency rules, this section will now apply a similar evaluation to the source rules. Traditional source rules were developed for a physical world and therefore rely on physical presence or economic connection to a physical location. However, as the physical location of an activity becomes less important to certain types of transactions, it becomes more difficult to determine where an activity is carried out and hence the source of income. Furthermore, the hybrid nature of digital products blurs income categories and makes income characterisation significantly more difficult to determine. This is of fundamental importance because the characterisation of income affects how source is determined and how the income is taxed. For example, the rules applying to royalties (such as copyright and know-how) are significantly different to the rules applying to business income (such as the sale of intangible goods and the provision of professional services).

 

 

Digitised products

 

When digitised products are viewed or downloaded it can be difficult to determine how to characterise the income.  New types of products and methods of delivery are challenging traditional tax distinctions. Take for a book for example – previously it could only be bought in physical form. Today, it is possible to download on electronic version to a computer or mobile device, to subscribe to an online database that includes the book and even to receive online updates of the book. Similar possibilities (and thus issues) also arise with software, images, movies, music, newspapers and other documents. As Jinyan Li has said, digital transactions “defy the pigeon-hole approach of characterisation because of the hybrid nature of digital products, the modes of delivery and the fact that digital products may be simply, accurately and cheaply reproduced”. The application of traditional tax principles to digital products could potentially lead to impractical and unreasonable results, with minor differences in the nature or mode of delivery of a product leading to significantly different tax results.

 

An important issue in e-commerce is whether the payment for the supply of the book (or similar product) is consideration for the supply of goods or for the copyright to reproduce a digitised product. A royalty includes an amount paid for “the use of, or the right to use any copyright… or other like property or right”. From a strictly technical perspective, many transactions in digitised products meet this definition because they involve creating an electronic copy. Therefore some have argued that payments for such transactions should be (whether fully or partially) classified as royalties. However, it seems that this is a minority position within the OECD. A majority take the more common-sense approach that that consideration is to acquire digital products for the acquirer’s own use and enjoyment does not give rise to a royalty payment.  To the extent that it constitutes the use of copyright under the relevant law, this is merely an incidental part of the process. This approach, which focuses on the true economic substance of the transaction, is far better than one that focuses on strict legal form. The mere fact that a digital product is delivered electronically should not change its classification. To treat it differently for tax purposes would offend the principle of neutrality. While the ATO has provided very little guidance on its approach, Tax Ruling TR93/12 (which addresses computer software and royalties) suggests that they are willing to take a pragmatic approach. The ruling recognises that while amounts attributable to the right to load a program onto the user’s computer would strictly be a royalty, that the amount, if quantifiable, is likely to be minimal.

 

Services and know-how

 

Another area of difficulty arises in the provision of services. Historically, the person performing and receiving the service would be in the same jurisdiction. Today, modern communications technology enables services to be provided entirely on-line, across jurisdictions and without a fixed base in the other country. Typically it is consulting services, such as advice provided by a lawyer, accountant, doctor, engineer or other professional that is most commonly provided online. In the case of dependent personal services, the source of the income is generally the place where the services are performed. The technology used to conduct the transaction may be new but it should not pose a significant problem for the determination of source. However, where creative talents or specialised skills are exercised, or where the services are furnished an independent contractor, other factors become important. These factors include the place of contracting and the place of payment. This potentially opens the door to difficulties and manipulation where services are contracted, provided and paid over the internet. It should be remembered, however, that where Double-Tax Agreements are in place the issue is of less importance. This is because the independent personal services article will generally require a resident of one of the contracting states to have a fixed base regularly available to them in the other contracting state before they can be taxed n that other state.

 

Like the provision of services, the supply of know-how is now frequently made on-line and across borders. However, it can be frequently be difficult to distinguish between the two. Examples of the type of payments where this issue arises include payments made for preparing or developing designs, models, plans or drawing, or for performing engineering, research, testing, experimental or other similar services. The correct characterisation is important as the tax treatment varies considerably between the two. Payment for the transfer of know-how is often included as part of the royalty article in bilateral tax treaties and is also included in the definition of royalties for domestic tax purposes. Payments for services will generally be covered by the business profits article. The Tax Office has stated its view on the distinction between royalties and payments for services rendered in IT 2660. It explains that the main distinctive feature of know-how is that it is an asset and, as such, is something which is already in existence. By contrast a contract involving the performance of services results in the creation, development or bringing into existence of a product. The OECD Commentary makes very similar distinctions. Where standard advice based on inputted data is supplied, some have argued that the tax treatment is unclear. In such cases it would be helpful to remember that the necessary knowledge base must have been created by human input.

 

Tom Magney has advocated, albeit not with the communications revolution in mind, a ‘factor approach’ to determining source. This would give emphasis to the actions taken by the taxpayer, and in particular the decision making, in determining the source of income. Other, more formal factors such as the place of making the contract would be of less significance. This section has demonstrated how traditional tax concepts such as source can be difficult to apply in an electronic commerce environment. However, if Magney’s approach is followed and the focus remains on the activities being conducted and the value being added, the existing rules are flexible enough to remain workable. Unfortunately, as Magney’s 1997 paper illustrates, too often judges pay lip-service to such an approach, whilst simultaneously ignoring it. Time will tell how the challenge of electronic commerce will be addressed.

 

Part three – possible new approaches

 

Parts one and two of this paper have demonstrated that technological changes have made traditional tax concepts such as residency and source significantly more difficult to apply.  Some have even suggested that a completely new approach to international taxation is needed. Part three now evaluates the case for two of the more radical approaches that have been put forward; exclusive residence- and exclusive source-based taxation. Any proposal to alter the tax system is typically evaluated on the grounds of equity, efficiency and simplicity and therefore it is these factors that will form the basis of the succeeding discussion.

 

In the international tax context an important aspect of equity involves determining how tax revenues should be divided between countries. For some, equity (or fairness) means taxes collected should reflect the benefits received from those taxes.  The ‘benefits theory’ applies this thinking to the international context, viewing taxes as consideration for benefits provided by the state. Under this approach, the country that makes the greater contribution to the income-earning activities should receive a greater share of the tax revenue flowing from these activities. As we shall see below, determining which state makes the greater contribution, especially in an electronic commerce environment, can be problematic.

 

Efficiency is concerned with maximising economic growth. Conventional wisdom holds that growth is maximised when taxes (and also, it can be argued, government benefits) don’t influence the attractiveness of alternate goods, investments or activities. That is, efficiency is maximised when government policies are neutral. In the international context Peggy Musgrave is credited with identifying two aspects of neutrality; capital-export and capital-import neutrality. Both these objectives can only be achieved if taxes are the same in all countries. Since this is a practical impossibility, the two criteria are often in conflict. Whether one supports residence- or source-taxation depends in large part on their preference for capital-import or expert neutrality.

 

Exclusive residence-based taxation

 

The United States Treasury Department has been a prominent advocate for residence-based taxation, arguing that “as traditional source principles lose their significance, residence-based taxation can step in and take their place”. 

 

Residence taxation has been justified under the benefits principle since residents enjoy the benefits of the social, economic, physical and legal infrastructure of the state in which they reside. This infrastructure contributes to their ability to earn income and therefore it is considered just for residents to contribute to the tax revenue that finances it. However, a traditional, bricks-and-mortar store avails itself of government infrastructure to a significantly greater degree than online businesses and it has therefore been argued that this justification of residence taxation is weaker in an e-commerce environment. Georg Von Schanz argues that residence not a valid criterion for establishing tax liability because it would “lead to taxing people who get no benefit or who at best get only a partial benefit from a State’s activities”.

 

Residence taxation has also been supported on the grounds that it is consistent with capital-export neutrality. Export neutrality means that income earned by a resident of a given country is taxed at the same rate, regardless of where it was sourced. This is achieved via a combination of residence taxation and fully-refundable foreign tax credits. The case for capital-export neutrality rests on the proposition that, in order to secure efficiency in capital allocation, the choice of investment location should not be affected by tax considerations. Capital-export neutrality achieves this while capital-import neutrality leaves capital allocation decisions open to tax differentials between countries of residence and source. Capital is thus attracted to low-tax countries and the international allocation of capital is distorted. For this reason, Charles McLure, and indeed most economists, shows a preference for capital-export neutrality (and thus residence taxation).

 

Moving to an exclusively residence-based system would represent a fundamental shift in taxing rights and is therefore unlikely to receive broad international support. Taxation of internet transactions on the basis of residency would tend to favour net exporters of internet products and services (which are typically developed countries) and disadvantage net importing countries (which are typically developing countries). The United States is the world’s largest exporter in e-commerce so its position is easy to understand. Without a wide international consensus there is a risk of double-taxation as net importers try to preserve their tax base. No country which levies an income tax forgoes taxing domestic source income, irrespective of who has derived it. In contrast there a number of exceptions and qualification to the general practice of taxing foreign source income. Perhaps this suggests that there is a stronger case for source taxation.

 

Exclusive source-based taxation

 

Earlier it was noted that residence taxation has been justified under the benefit principle. However, Klaus Vogel and Georg Von Schanz amongst others have argued that it the source country, i.e. the place of income-generating activity, which makes the greater contribution to the production of income, and is therefore deserving of a greater share of tax revenue. Schanz argued that where a taxpayer has an ‘economic allegiance’ to both a residence and source state, both countries should receive a share of tax revenue. However, the allegiance to the source-state is the greater allegiance and therefore it should receive the greater share. Schanz proposed that three-quarters of the income be taxed in the source state and only one-quarter in the residence state. Vogel, approving of Schanz’s novel suggestion, takes things a step further and argues that if the state of residence levies a significant quota of indirect taxes, these taxes are sufficient to entirely compensate the residence state for the benefits it provides and therefore exclusive income taxation by the source state would be justified.

 

Vogel and Von Schanz formulated their positions before the advent of electronic commerce. Where trade is less tangible and no presence in the source country is needed to derive income from it, the only contribution of a source country may be its customer base and the telecommunications infrastructure to reach them. Of course this sill is a significant contribution – it would be impossible to earn income without a market to earn it in. Furthermore, as Arvid Skaar and others have noted, there are numerous other benefits that a source country provides, even in the absence of a physical presence. These benefits include a legal system that enforces payment for transactions, protects consumers (which builds necessary trust) and upholds intellectual property rights. The protection of intellectual property rights is especially critical to vendors of intangible products and digitised services. They also include a political and economic system that maintain a stable and competitive business environment (e.g. keeping exchange rates stable and interest rates low) and even an education system which ensures consumers have the required level of competency in computers to purchase their products. 

 

Source-based taxation has also been justified on the grounds that it is consistent with capital-import neutrality. Capital-import neutrality exists when the same taxation scheme applies to all income earned within a given territory, regardless of the where the investor resides. Proponents of capital import neutrality hold that firms, when competing in foreign markets, should not be handicapped (as they would be under capital-export neutrality) because their residence lies in a higher-tax country. Such a situation would be inefficient and, from the perspective of the firm, unfair. The preference for capital-export neutrality mentioned above has been challenged in recent times and on the basis of these challenges source taxation has been put forward as superior. Otto Gandenberger critiqued capital-export neutrality on two grounds. Firstly, if residence taxation is employed and the rate of tax in the residence country is higher than in the source country, an enterprise would face a higher overall tax burden than its competitors and be less likely to finance new investment in the source country. Secondly, Gandenberger argued that the level of taxation in a country is likely to correspond to the level of public goods provided. A country providing fewer public goods will typically have a lower tax rate than one providing more public goods. If true, an enterprise’s decision whether to invest in a lower-taxed country could be affected since it would receive less public goods in the source country than in the country of residence, yet it would still be residence country’s higher tax rate.

 

There are numerous practical obstacles to adopting source as the exclusive basis for taxation. Modern technology makes it easier to trade in a source country without a physical presence, but without such a presence (i.e. something that could operate as a tax withholding agent or as security for the tax liability) it is difficult for the source country to enforce tax rules. Secondly, and as noted above, source taxation benefits e-commerce importing countries to the detriment of exporting countries and therefore an international consensus would be difficult to build. It would also be extremely difficult to reach an agreement regarding how taxing-rights would be apportioned among jurisdictions which claim that income is sourced in their territory. Without such an agreement double taxation could result.

 

This section has evaluated two significantly new approaches to international taxation. Each approach has strong theoretical grounds but also significant problems. Overall, neither approach has clearly established itself as a necessary solution to the difficulties established in parts one and two, or a significant improvement to the current system. Therefore neither can be recommended. Overall, residency and source remain workable, and a new approach is unnecessary.

 

Tax residency for companies – part 2

In part one I wrote about the central management and control test and whether or not it had two requirements. For now let’s assume it does – carrying on a business in Australia and having central management and control in Australia.

Carries on a business in Australia

For the purposes of this test the Commissioner will consider virtually all companies (other than dormant companies) to be carrying on a business. Where that business is carried on depends on what it does. A company with operational activities (e.g. a trading, service, manufacturing or mining business) will be resident in Australia if those activities take place in Australia i.e. if their offices, factories or mines are situated in Australia. Conversely, where a company earns its income through passive investments, the company will be resident in Australia if the investment decisions are made in Australia.

Central management and control

Central management and control does not refer to the day-to-day running of the company but rather to high-level decision making processes. That includes things like reviewing strategic directions, major agreements, significant financial matters and overall performance. Typically (but not always) these powers will be vested in the board of directors of a company. If the directors do in fact manage and control the company then central management and control will generally be located where the directors meet. The Commissioner says that if the majority of board meetings are held in Australia, the central management and control of a company will be taken to be in Australia, unless that situation is artificial or contrived. The courts too have tended to focus on formal acts (which has opened the door for manipulation) though they have sometimes shown a willingness to consider a wider number of factors.

Central management and control will not always be exercised by the board of directors of a company. This can be illustrated by the contrasting cases of Union Construction v Bullock and Esquire Nominees. In Unit Construction the parent company (located in the United Kingdom) effectively took over management of the company from its board of directors. Therefore the court found that central management and control was in the UK, despite the constitution expressly provided that the director’s meetings were not to take place in the United Kingdom. In Esquire Nominees the director’s meetings were held in Norfolk Island but the agenda was prepared in Australia by accountants acting on behalf of the beneficial owners. The Norfolk Island directors would invariably follow the advice of the accountants but the court ruled that central management and control remained with the Norfolk Island directors. Justice Gibb explained that although the accountants were influential, the final decision lay in Norfolk Island and the directors would not agree to any recommendation that was improper or inadvisable.  From this we get the principle that a director can delegate some of his or her decision making power and still retain central management and control, provided they at least review and consider the actions of the delegated decision-maker.

 Voting power test

The final test of corporate residency sayst that a company, not incorporated in Australia, will be resident if it carries on business in Australia and has its voting power controlled by shareholders who a residents of Australia. Two comments are worth mentioning here. Firstly, a shareholder is somebody who appears on the company’s share register (Patcorp Investments). The test therefore does not look through to the ultimate beneficial owner of the shares. Secondly, shareholders with the capacity to control the company’s general meeting but who do not in fact exercise that control, do not control the voting power (Aluminium Corp Ltd).

Finally, just like a natural person, a company can be resident of two or more countries. This was a finding of the Swedish Central railway case. Just like with individuals, Australia’s double taxation agreements (DTAs) typically contain tie-breaker rules designed to allocate a single place of residence for the purpose of the DTA. I will get to double taxation agreements eventually, but before then I will finish with residency of other entities and then move on to discuss where income is sourced. I hope you stick around.

Cheers,

Simon

All advice in this blog is of a general nature. I’ve done my best to make sure it is accurate but I give no guarantees. Make sure you seek professional advice that is specific to your situation.