Until very recently, non-resident entities without a presence in Australia which made certain offtake agreements for the supply of natural resources could be confident they would not be taxed in Australia. That could change, however, if the Australian Tax Office's attempt to tax them succeeds.
The ATO's Interpretative Decision
ATOID 2006/306 seems to come from a renewed interest in transfer pricing provisions and the ATO's attempt to generate more tax revenue from non-residents who have a commercial relationship with Australia.
ATOID 2006/306 takes an aggressive approach in trying to deem non-residents who enter into certain offtake agreements to have a permanent establishment ("PE") in Australia.
If a corporate non resident is deemed to have a PE in Australia, the non-resident will be subject to Australian tax (currently 30 percent) on any taxable income it derives from activities relating to the PE, instead of just being subject to tax in its country of residence.
Implications and recommendations
Although Interpretive Decisions issued by the ATO are not given the force of law and are only based on a specific set of facts, they nonetheless reflect the ATO's view on a particular issue. Therefore, there is a real risk that a non-resident who has entered into or will enter into an offtake agreement for the acquisition of natural resources or processed products may be deemed to have a PE in Australia, at least until a court finds otherwise.
Accordingly, non-residents in these circumstances should review their current or proposed arrangements, and in particular consider:
- is the non-resident dealing with a related entity which is an Australian entity? If it is, it is able to directly control the Australian resident's operations?
- is any substantial equipment required to be used?
- do the terms of the offtake agreement or the nature of the relationship between the non-resident and Australian entity allow the non resident to own, physically possess or control the substantial equipment?
- under the specific PE deeming provisions in any DTA between Australia and the non resident's country of origin, is the substantial equipment required to be used in Australia or to be used in the exploitation of natural resources; and
- does the offtake agreement relate to the exploitation of natural resources?
What is a "permanent establishment"?
The key decision on whether a non resident has a permanent establishment in Australia - and the ATO's main justification for its current position is McDermott Industries (Aus) Pty Ltd v Commissioner of Taxation (2005) 142 FCR 134.
The case considered the PE provisions of the Australia/Singapore Double Tax Agreement ("ASDTA") which contained a deeming provision. This said that a non-resident entity is deemed to have a PE in Australia when substantial plant and equipment in Australia is being used or installed "by, for or under contract" with the non-resident.
The Singaporean entity in McDermott had no office, employees or other operations in Australia and only leased barges which it owned to an Australian company which used them in Australian waters. The Federal Court held that this amounted to a PE in Australia because:
- the barges were "substantial equipment"; and
- the nature of the leasing arrangements was such that the barges were either being used by the Singaporean entity in Australia itself or by the Australian entity "by, for or under contract" with the Singaporean entity.
Therefore, the lease payments that the Singaporean entity received were subject to normal Australian income tax, rather than the lower rate of Australian withholding tax under ASDTA.
What do DTAs say?
In McDermott, the ASDTA contained a provision that a PE can be deemed if the substantial equipment is used in Australia. Under other double tax agreements ("DTAs") which Australian has entered into, such as those with the US, UK, Japan, Germany and Italy, a deemed PE is harder to establish because the substantial equipment must be used "by, for or under contract" for the exploration or exploitation of natural resources, and in some cases for a 12 month period.
It is important to note that the term "exploitation of natural resources" is not defined in any DTA. Based on our experience, the exploitation of resources is limited to when the natural resource is removed from its natural source. It does not extend to when a natural resource is in such a form that it can be used as a direct input in a production process.
The ATO tries to extend McDermott in relation to natural resources and PEs
Relying on McDermott and its application to the substantial equipment provisions contained in various DTAs, the ATO has now concluded in ATOID 2006/306 that a non-resident satisfies the relevant PE requirements where it has an offtake agreement with a related party which uses substantial equipment owned by a related party to produce the Product. In this case a natural resource was an input into the Production Process . There are two main problems with this.
First, and critically, the non-resident does not own nor appears to be in a position to control the "substantial equipment" (unlike in McDermott). The ATO, without any substantial analysis, magically deems that because the entities are "related", and the non-resident is supplied with all the product produced, the non-resident satisfies the "by, for or under contract" criteria as contained in the relevant DTA.
Secondly, the ATO does not discuss the meaning of "exploitation of resources". As outlined above, we think that the exploitation of resources ceases when the natural resource is "won from the ground" and not, as the ATO thinks, when it is used an input into a production process.
Therefore, in our view, the principles contained in ATO ID 2006/306 represents a significant - and unjustified - departure from the principles contained in McDermott and the relevant DTA.
Draft ruling TR 2006/D8 on the treatment of shipping and aircraft leasing profits of US and UK entities states that the relevant DTA may apply in circumstances where the US resident entity does not own the substantial equipment but "physically possesses the equipment under licence, lease or bailment etc with another enterprise". This draft ruling also highlights the ATO's new approach in trying to tax non residents by extending the application of McDermott's.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.