Australia: McDermott Case: Not So Smooth Sailing

Last Updated: 25 March 2008
Article by Stephen Adrian

The decision handed down in McDermott Industries (Aus) Pty Ltd v FC of T 2005 ATC 4398 ("McDermott") has created a storm of uncertainties for tax structuring of ship chartering arrangements. In taking a view contrary to that contained in the commentary to the OECD1 model convention, the McDermott decision took the industry by surprise. Essentially, the key issue is whether a non-resident lessor without any physical presence in Australia can have a permanent establishment (PE) in Australia, if it leases a vessel in Australia.

At the outset, it is worthwhile explaining the difference between a bareboat chartering arrangement and a time charter. The term "bareboat charter" generally refers to a hire/lease of a vessel without master and crew. This is to be distinguished from a time charter arrangement which is a hire of a vessel together with the master and crew. The technical operation and navigation of the vessel remain the responsibility of the shipowner under a time charter.

In McDermott, the Court considered article 4(3)(b) (the "Substantial Equipment Clause") of the Australian/Singapore double tax agreement ("DTA"). This article defines a PE to include the use of substantial equipment, in Australia, for or under contract with the Singaporean resident. The Court held that a bareboat charter of a vessel by a Singaporean resident to an Australian entity gave rise to an Australian PE for the Singaporean resident. This came as a shock as prior to McDermott, the general view was that the mere leasing of an asset in Australia without any physical presence in Australia does not give rise to a PE. The lease payment was generally considered to constitute an equipment lease royalty and be taxed under the royalty withholding tax regime. Understandably, this put past and contemplated arrangements into limbo. Accordingly, the series of taxation rulings issued by the Commissioner just before the New Year have been received with welcome, albeit a cautious one.

This publication will focus on the Taxation Ruling TR 2007/10 (the "Ruling"). The arrangement contemplated by the Ruling involves a chain of bareboat leases i.e. a non-resident head lessor ("NRHL") bareboat charters to a non-resident sub lessor ("NRSL"), who in turn bareboat charters to an Australian tax resident lessee ("RL"). This is depicted below.

The main question in the minds of most practitioners is whether, by virtue of the McDermott decision, both the NRHL and the NRSL have PEs in Australia.

Readers should note the Ruling does not apply to a time charter arrangement which is regarded as a provision of services by the Australian Taxation Office ("ATO").

Taxation Ruling TR 2007/10 ("The Ruling")

Whilst the Court in McDermott ruled in the context of the Australian/Singapore DTA, the Ruling has a broader scope as it covers the following scenarios:

  1. The NRHL is from a non-treaty country;
  2. The NRHL is from a treaty country (except US, UK and Norway) and the PE definition in relation to the use of substantial equipment is similar to that contained in the Australian/Singapore DTA2; and
  3. The NRHL is from the US, UK or Norway.

The Relevant Contract For Use

In the ATO's view, the Substantial Equipment Clause (whether it is for item 1 or item 2 above) will not give rise to a PE for the NRHL if it does not have any other presence in Australia. The NRSL however, will have an Australian PE. In the ATO's view, the vessel is being used under the contract between the NRSL and the RL but it is not being used in Australia by the NRSL under the lease with the NRHL.

Whilst the decision in McDermott has been interpreted to be capable of causing the NRHL to have an Australian PE, the view taken by the Commissioner is a more practical one. Given that this is a Public Ruling, taxpayers will be able to rely on this interpretation. As a conservative measure, it is recommended that the contract between the NRHL and NRSL be signed outside Australia and the contract not confine the use of the vessel to Australia only.

1. NRHL From A Non-Treaty Country

If the NRHL is from a non-treaty country, the ATO will refer to the domestic law / PE definition to determine whether the NRHL has a PE in Australia. In the ATO's view, the domestic Substantial Equipment clause broadly operates in the same way as the Substantial Equipment clause contained in the relevant DTAs.

The above broadly means that only the NRSL will have an Australian PE. Therefore, charter payments made to the NRHL by the NRSL pursuant to a bareboat charter arrangement will be subject to Australian royalty withholding tax ("RWT") provided that (a) the NRSL has, is using or is installing substantial equipment in Australia and (b) the NRSL is carrying on a business through its deemed Australian PE. 

The second limb is of interest as the ATO's position is that the NRSL having a PE by itself does not trigger a RWT obligation.  It must also be the case that the NRSL is conducting its business through the PE.  The Ruling notes that if the NRSL receives only payments from the RL and the contract is negotiated and signed overseas,  and routine and maintenance checks are not done in Australia, the NRSL is not taken to be carrying on a business through its deemed Australian PE.  Hence, in that instance, the payment to the NRHL will not be subject to Australian RWT. The reader should also question whether the same outcome is achieved if the contract for maintenance is signed outside Australia with a non-resident supplier.

In relation to the Substantial Equipment clause contained in the domestic law, it is the Commissioner's view that the NRSL need not to be carrying on a business to give rise to a PE. A non-resident will have an Australian PE under the domestic tax provision where the non-resident has, is using or is installing the substantial equipment in Australia.

2. NRHL From A Treaty Country (Except US, UK And Norway)

Australian RWT will, prima facie, apply to the bareboat charter payments; where (a) the DTA has a clause similar to the deeming PE substantial equipment clause in the Singapore-Australia DTA and (b) the NRSL is carrying on a business through its deemed Australian PE.

However, the Australian RWT provisions will not apply where:

  • the NRHL is making the lease supply via an actual Australian PE; or
  • the NRSL is not carrying on a business through the deemed Australian PE. 

If either of the above is satisfied, the ATO is of the view that a determination must be made as to whether the deemed source rule in the respective DTA will be triggered. In such a case, Australia will tax the profits made by the NRHL on an assessment basis. This means that the wording of each relevant DTA will need to be closely scrutinised to determine the Australian tax outcome of the relevant arrangement. We note that there may be some technical arguments against the ATO's interpretation of the deemed sourced rule and we are currently seeking clarification from the ATO in relation to this matter.

3. NRHL From US, UK Or Norway

The differentiating factor in these DTAs is that they do not define the payment for the use of commercial, industrial and scientific equipment to constitute royalties. Accordingly, the charter payments made to a NRHL which is a resident of the US, UK or Norway will not be subject to Australian RWT.

Potentially, the above means that payments made to the NRHL from the NRSL may not be subject to any Australian tax. 

Hire Purchase Arrangement

The Ruling also covers hire purchase arrangement3.  Readers should note that in TD 2007/31 ("the Determination"), the ATO is of the view that a hire-purchase agreement of substantial equipment in Australia does not constitute an Australian PE under the Singapore-Australia DTA for the purposes of Article 4(3)(b) of that DTA. The rationale for this approach is that a hire purchase agreement is considered to be a notional disposal4 by the Singaporean lessor and therefore the asset is not considered as being used under contract in Australia.  The Ruling is broadly in line with the determination i.e. no royalty withholding tax should apply to hire purchase arrangements.  However, interest withholding tax may apply to the actual/deemed interest component.


We recommend that care should be taken when entering into bareboat leasing arrangements and proper structuring be put in place to avoid any adverse Australian tax consequences. Although this Ruling deals with the tax ramifications for a NRHL, one should note that where the NRSL does not meet its withholding obligation when there is Australian RWT, the NRSL will not be entitled to deduct any expenses in relation to that payment. This means that the royalty payments will not be factored in when calculating the taxable income of the NRSL Australian PE.

Annexed to this article is a comparative table outlining the application of the deemed PE substantial equipment, royalty and deemed source rule provisions in respect of the different Australian tax treaties.


1. Organisation for economic co-operation and development

2. Refer to TD 2007/31 to see a list of DTAs containing comparative Article clause.

3. A hire purchase arrangement is basically a lease arrangement where the lessee has the right, obligation to buy the ship where the total lease payments and any residual amount paid to acquire the ship exceeds the purchase price of the ship.

4. Interpretation should be sought from domestic law since the DTA does not provide any guidance on hire purchase agreement.

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.

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