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International Tax Agreements Amendment Bill (No. 2) 2002

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2002

 

THE PARLIAMENT OF THE COMMONWEALTH OF AUSTRALIA

 

 

 

HOUSE OF REPRESENTATIVES

 

 

 

International Tax Agreements Amendment Bill ( No . 2) 2002

 

 

 

 

EXPLANATORY MEMORANDUM

 

 

 

 

(Circulated by authority of the

Treasurer, the Hon Peter Costello, MP)



T able of contents

Glossary                                                                                                               1

General outline and financial impact............................................................ 3

Chapter 1           Protocol amending the Convention with Canada........ 13

Chapter 2           Second Protocol (and associated Exchange

of Letters) amending the Agreement with Malaysia.... 31

Chapter 3           US interest amendment.................................................... 43

Chapter 4           Minor technical amendments.......................................... 47

Chapter 5           Regulation impact statements......................................... 49



The following abbreviations and acronyms are used throughout this explanatory memorandum.

Abbreviation

Definition

ASEAN

Association of South East Asian Nations

ATO

Australian Taxation Office

Canadian Convention

Protocol amending the Convention 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

CFC

Controlled foreign corporation

Commissioner

Commissioner of Taxation

DTA

Double taxation agreement

DTC

Double tax convention

ITAA 1936

Income Tax Assessment Act 1936

ITAA 1997

Income Tax Assessment Act 1997

Malaysian Agreement

Second Protocol amending the Agreement 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

OECD

Organisation for Economic Co-Operation and Development

OECD Model

OECD Model Tax Convention on Income and on Capital

The Agreements Act

International Tax Agreements Act 1953

UN Model

United Nations Model Double Taxation Convention between Developed and Developing Countries

US Convention

Convention 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

 



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:

·       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 

·       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 countries’ domestic law and clarifies the taxation position of income flows between them.

Australia’s tax treaties are designed to:

·       prevent double taxation and provide a level of security about the tax rules that will apply to particular international transactions by:

-            allocating taxing rights between the countries over different categories of income;

-            specifying rules to resolve dual claims in relation to the residential status of a taxpayer and the source of income; and

-            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

·       prevent avoidance and evasion of taxes on various forms of income flows between the treaty partners by:

-            providing for the allocation of profits between related parties on an arm’s length basis;

-            generally preserving the application of domestic law rules that are designed to address transfer pricing and other international avoidance practices; and

-            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:

·       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;

·       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

·       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:

·       inserting into subsection 3(1) the definition of the Canadian and Second Malaysian Protocols;

·       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;

·       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;

·       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;

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

·       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

·       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 :

·       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

·       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 :

·       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

·       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 :

·       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 :

·       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:

2002-2003

2003-2004

2004-2005

2005-2006

2006-2007

$1 million

$1 million

$1 million

$1 million

$1 million

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 :  

·       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.

·       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%.

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

·       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 :

·       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).

·       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.

·       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.

·       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.

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

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

·       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.



C hapter 1

Protocol amending the Convention with Canada

What is the Canadian Protocol?

1.1         The Canadian Protocol, once in force, will amend the Convention between Australia and Canada for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income signed on 21 May 1980 (referred to as ‘the Convention’ for the purpose of this chapter).

Why is the Protocol necessary?

1.2         The Protocol is required to amend the existing tax treaty to reflect modern business practice and changes to both countries’ law and tax treaty practice since the Convention was negotiated. The Protocol will facilitate trade and investment between Australia and Canada by reducing withholding taxes in some circumstances and by extending coverage of the Convention to taxes on capital gains.

Main features of the Protocol

1.3         The Protocol between Australia and Canada accords substantially with treaty practice adopted in Australia’s recent tax treaties.

Under the Protocol:

·       The list of taxes covered will be updated to include the resource rent tax imposed by Australia.

·       The definition of Australia will be revised to conform with Australia’s current drafting approach.

·       A definition of international traffic will be included for the purposes of the Alienation of Property Article and the Dependent Personal Services Article of the Convention.

·       The scope of the substantial equipment provision in the permanent establishment definition will be widened. To constitute a permanent establishment, ‘substantial equipment’ need no longer be used for more than 12 months in a Contracting State and need not be used in relation to natural resources.

·       A new Income from Real Property Article will be substituted which accords with current Australian drafting practice and ensures the Article applies to leases and rights to explore for natural resources.

·       A new provision will be inserted to ensure that Australia can tax profits derived by a resident of Canada where those profits are effectively connected with a permanent establishment of a trust in Australia.

·       Taxation of dividends will be substantially revised with a ‘split rate’ limit on dividend withholding tax rates being adopted similar to the formula incorporated in Australia’s most recent treaties. In the case of Australia, a dividend withholding tax rate limit of 5% for franked non-portfolio dividends and 15% for all other dividends will be implemented. Generally a reciprocal reduction in dividend withholding tax rate limits has been achieved.

·       The limitation on the rate of Canadian branch profits taxation rate will be reduced to 5%, consistent with the reduced dividend withholding tax rate limits.

·       The interest withholding tax rate limitation will be reduced from 15% to 10%.

·       The definition of royalties will be expanded in conformity with current Australian tax treaty practice.

·       A comprehensive Alienation of Property Article, in conformity with current Australian tax treaty practice, will be added to the Convention. The new Article clarifies the coverage of capital gains.

·       The treatment of employment income under the Dependent Personal Services Article will be substantially modified -including the deletion of the former monetary thresholds. Existing arrangements for taxation by the State in which employment is exercised will be modified to conform with current Australian and OECD tax treaty practice.

·       The method by which relief from double taxation is provided under the Convention will be revised to reflect current Australian and Canadian tax treaty practice.

·       A provision will be included requiring the consent of both Canada and Australia before the General Agreement on Trade in Services process for dispute resolution is invoked. This will prevent the possibility of a single country unilaterally taking to the Council on Trade in Services a dispute as to whether a measure falls within the scope of the tax agreement .

Detailed explanation of changes made by the Protocol

Article 1 of the Protocol

Amends Article 2 of the Convention - Taxes Covered

1.4         Article 1 of the Protocol updates the taxes covered by the Convention by replacing Article 2 of the Convention. In the case of Australia, the Protocol includes a specific reference to the resource rent tax in respect of offshore petroleum relating to exploration of petroleum resources. Although this tax is considered by Australia to be encompassed by the term ‘Australian income tax’, a specific reference is included to put beyond doubt that it is a tax covered by the Convention.

[New paragraph (1)]

1.5         Under the new paragraph 2, the time specified for the notification of substantial changes in the laws of the respective States has been changed so that such changes need to be notified within a reasonable period of time after such changes. [New paragraph (2)]

Article 2 of the Protocol

Amends Article 3 of the Convention - General Definitions

Definition of Australia

1.6         The definition of Australia in the Convention is revised to conform with current Australian tax treaty practice. The definition is amended to make clear that the treaty definition of Australia includes the Territory of Heard Island and McDonald Islands.

Definition of international traffic

1.7         A definition of ‘international traffic’ is included for the purposes of the Alienation of Property Article and the Dependent Personal Services Article. In the Convention, this term is of relevance only for alienation of ships and aircraft (Article 13(3)) and wages of crew (Article 15(3)).

Removal of the deeming provision

1.8         A redundant provision (Article 3(1)(k)) which deemed words in the singular to include the plural meaning (and vice versa) has been deleted from the Convention in accordance with modern tax treaty practice as this is considered to be implicit.

Undefined terms provision

1.9         Article 3(3) of the Convention, which allows recourse to definitions under domestic law where a term has not been defined in the Convention, is revised to accord with modern tax treaty language.

Article 3 of the Protocol

Amends Article 4 of the Convention - Residence

1.10       Paragraphs 1 and 2 of the Residence Article are revised to conform with the current tax treaty practice of both countries.

Residence of Governments

1.11       Article 4(1) of the Convention is amended to clarify that Governments, political subdivisions, local authorities or any agency or instrumentality of a State, Subdivision or authority are residents of States for the purposes of the Convention.

Exception for persons taxed only on income from sources in the State

1.12       Article 4(2) of the Convention is replaced with a paragraph which provides that a person is not a resident of a Contracting State if that person is liable to tax in that State in respect only of income from sources in that State.

Article 4 of the Protocol

Amends Article 5 of the Convention - Permanent Establishment

1.13       Article 4 of the Protocol expands the ‘substantial equipment provision’ of the Permanent Establishment Article of the Convention by removing the 12-month time threshold and requisite connection with natural resources. However, substantial equipment used in a State in connection with a building site or construction, installation or assembly project is not encompassed by this provision. Such equipment is dealt with under paragraph 2(h) of Article 5 of the Convention.

1.14       Australia’s experience is that the permanent establishment provision in the OECD Model may be inadequate to deal with high value activities involved in the development of natural resources, particularly in offshore regions. For example, mobile equipment used in offshore exploration may not have the necessary geographical fixedness to be considered as permanent establishments under Article 5(1) of the Convention. Also construction of offshore oil drilling platforms can be effected in a relatively short time. Consequently, Australia has made a reservation to the OECD Model which indicates that Australia will seek to treat an enterprise as having a permanent establishment in Australia if substantial equipment is used in Australia by, for or under contract with the enterprise. New Article 5(4)(b) of the Convention reflects that reservation.

1.15       Substantial equipment used in a State ‘in connection with a building site or construction, installation or assembly project’ is expressly excluded from the operation of new Article 5(4)(b). This exclusion ensures that building sites which would not otherwise constitute a permanent establishment are not caught under new Article 5(4)(b) of the Convention.

Article 5 of the Protocol

Amends Article 6 of the Convention - Income from Real Property

1.16       The Protocol substantially revises Article 6 to conform with current Australian tax treaty practice by ensuring the Article covers leases and rights to explore for natural resources, as well as other real property.

Definition

1.17        Real property is effectively defined as including:

·       a lease of land and any other interest in or over land (including exploration and mining rights); and

·       royalties and other payments relating to the exploration for or exploitation of mines or quarries or other natural resources or rights in relation thereto.

[New paragraph (2)]

Where income from real property is taxable

1.18       The Protocol retains the general principle of the Convention that income from real property may be taxed in the State in which the property is situated. Thus, income from real property in Australia will be subject to Australian tax laws. [New paragraphs (1) and (3)]

Article 6 of the Protocol

Amends Article 7 of the Convention - Business Profits

1.19       Article 7(6) of the Convention, which sets out the relationship between the Business Profits Article and other provisions in the Convention dealing with business profits, is revised consistently with current international tax treaty practice.

1.20       A new paragraph 8 is added to Article 7 to clarify that Australia can tax business profits derived by a resident of Canada through one or more interposed trusts where the profits are effectively connected with a permanent establishment of the trust in Australia. The clarification of Australia’s source country right to tax trust beneficiaries on their share of business profits effectively connected with an Australian permanent establishment is consistent with Australia’s recent tax treaty practice and subsection 3(11) of the Agreements Act.

Article 7 of the Protocol

Amends Article 8 of the Convention - Shipping and Air Transport

1.21       The Protocol makes a minor modification to the wording of paragraph 4, changing ‘another place’ to ‘a place’. This change ensures that domestic transport includes journeys which return to the port of origin, such as certain cruise ship operations. [New paragraph (4)]

Article 8 of the Protocol

Amends Article 10 of the Convention - Dividends

1.22       The Protocol substantially revises the treatment of dividends. In particular, the Protocol introduces a ‘split rate’ limitation on dividend withholding tax similar to the formula incorporated in Australia’s most recent treaties. The main features of the amended Dividends Article are:

·       a maximum 5% rate of dividend withholding tax for non-portfolio dividends (to the extent they are franked, in the case of Australia; and to the extent they are not paid by Canadian non-resident-owned investment corporations);

·       15% for all other dividends; and

·       reduction of the rate limit on Canadian branch profits taxation rate from 15% to 5%, to conform with the reduced maximum dividend withholding tax rate for non-portfolio dividends.

Rate of tax and exceptions to limitation

1.23       Under paragraph 2(a)(i) of Article 10, the rate of dividend withholding tax which Australia may impose is limited to 5% of the gross amount of the dividends, to the extent to which the dividends have been fully franked in accordance with Australian law, if the recipient is a company which holds directly at least 10% of the voting power of the company paying the dividends. Under Australia’s domestic law, franked dividend payments will remain free of dividend withholding tax.

1.24       Under paragraph 2(a)(ii) of Article 10, the rate of dividend withholding tax which Canada may impose on dividends paid to a company with at least 10% control of the voting power of the company paying the dividends is also limited to 5%, except in the case of dividends paid by a non-resident-owned investment corporation that is a resident of Canada for the purposes of its tax. This exception represents Canadian tax treaty practice.

1.25       Non-resident-owned investment corporations are Canadian corporations owned by non-residents for the purpose of making investments in Canada. They were established to allow non-residents the choice of holding their Canadian investments personally or through a corporation such that either method of ownership would create the same tax result. Tax is initially paid by the non-resident-owned investment corporation at 25%, Canada’s domestic standard withholding tax rate, rather than Canada’s normal corporate tax rate. When a dividend is paid by the non-resident-owned investment corporation to its foreign shareholders, this tax is refunded and replaced by the appropriate rate of withholding tax on the dividend. It should be noted that this concessional regime is being phased out. Canada announced in 2000 that the special status granted to non-resident-owned investment corporations would be repealed for elections made after 27 February 2000. Existing non-resident owned investment corporations will be entitled to retain their status until the end of their last taxation year that begins before 2003.

1.26       The withholding tax rate on these and any other dividends not covered by paragraphs 2(a)(i) and (ii) will continue to be limited to 15% of gross.

1.27       The proviso allows for flexibility if there is a change to either country’s general approach to dividend withholding tax. In such a case the two countries are obliged to consult to make appropriate amendments to this paragraph. [New paragraph (2)]

Definition of dividends

1.28       Consistent with Australia’s current tax treaty practice, the Protocol modernises the definition of ‘dividends’ in paragraph 4 of the Article. The definition is not different in substance to the paragraph replaced. [New paragraph (4)]

Branch profits tax

1.29       In line with Canada’s reservation to the OECD Model, the Convention includes a provision allowing for the imposition of a branch profits tax (paragraph 6 of Article 10). The paragraph is modified to reflect Canada’s more modern tax treaty practice. The limit on Canadian branch profits taxation is reduced from 15% to 5%. [New paragraph (6)]

1.30       Article 10(7) of the Convention, which imposed a limit on Australian branch profits taxes, has been retained but with the limit reduced to 5%. Australia does not currently impose a branch profits tax. [New paragraph (7)]

Article 9 of the Protocol

Amends Article 11 of the Convention - Interest

1.31       The limit on the interest withholding tax rate is reduced from 15% to 10% by the Protocol. [New paragraph (2)]

Article 10 of the Protocol

Amends Article 12 of the Convention - Royalties

1.32       Article 10 of the Protocol amends the Royalties Article of the Convention. The changes exclude payments for the use of source code in a computer software program where the supply or right is granted merely to enable effective operation of the program by the user.

1.33       Payments for the use of spectrum licences are not dealt with in the Royalties Article. These payments remain, however, covered by subsection 3(11A) of the Agreements Act and are taxed as business profits under Article 7 of the Convention.

Definition

1.34       The Protocol extends the royalties definition in respect of broadcasting media to reflect modern technologies. The definition extends to include payments for the use of all means of image or sound reproduction or transmission for use in connection with television. The change clarifies that the source country can tax these payments as royalties. [New subparagraph (3)(e)(ii)]

1.35       Canadian tax treaty practice in relation to computer software, in accordance with its Observation to the Commentary to Article 12 of the OECD Model, is to treat as royalties, payments under contracts that require the source code in the computer software program to be kept confidential. However, new paragraph 7 provides that such payments will not be treated as royalties where the right to use the source code is limited to such use as is necessary to enable the user to operate the software program. In these cases, Article 7 of the Convention will apply. [New paragraph (7)]

1.36       The definition of royalties is amended to specifically include payments for the reception of, or the right to receive, visual images or sounds, or both transmitted to the public by satellite, cable, optic fibre or similar technology. The revised definition accords with Australia’s domestic law definition. It is considered that payments of this kind are implicitly covered in the earlier definition of royalties. However, it was considered important to ensure that they are expressly included in the revised definition. [New subparagraph (8)(a)]

1.37       The revised definition also explicitly includes payments for the use or right to use in connection with television or radio broadcasting, visual images or sounds, or both transmitted by satellite, cable, optic fibre, or similar technology. [New subparagraph (8)(b)]

1.38       Consistent with Australian tax treaty practice, new subparagraphs 3(f) and (8)(c) expressly treat as a royalty, amounts paid or credited in respect of forbearance to grant to third persons, rights to use property covered by the Royalties Article. This is designed to ensure coverage of arrangements along the lines of those considered in Aktiebolaget Volvo v. Federal Commissioner of Taxation (1978) 8 ATR 747; 78 ATC 4316, where, instead of amounts being payable for the exclusive right to use the property, they were made for the undertaking that the right to use the property will not be granted to anyone else, not being subject to tax as a royalty payment under the terms of Article 12. [New subparagraphs (3)(f) and (8)(c)]

Article 11 of the Protocol

Amends Article 13 of the Convention - Alienation of Property

1.39       The Protocol introduces a new Alienation of Property Article. The Protocol replaces the existing Alienation of Property Article with a comprehensive Article that:

·       permits source country taxation of amounts derived from alienation of real property and business property and on amounts derived from the alienation of land rich entities;

·       provides exclusive residence country taxation on profits from the disposal of ships or aircraft operated in international traffic;

·       improves arrangements for taxing gains accrued on certain assets held by departing residents by reducing compliance difficulties and ensuring appropriate relief is provided from double taxation; and

·       provides for capital gains not covered by specific distributive rules to be taxed in accordance with the domestic laws of each country.

1.40       This Article allocates between the respective States taxing rights in relation to income, profits or gains arising from the alienation of real property (as defined in Article 6 of the Convention) and other items of property.

1.41       Income, profits or gains from the alienation of real property may be taxed by the State in which the property is situated. This is in accordance with Australian and international tax treaty practice. [New paragraph (1)]

Source country taxation of amounts derived from alienation of business property

1.42       Paragraph 2 deals with income, profits or gains arising from the alienation of property - other than real property covered by paragraph 1 - forming part of the business property of a permanent establishment of an enterprise or pertaining to a fixed base used for performing independent personal services. It also applies where the permanent establishment itself (alone or with the whole enterprise) or the fixed base itself is alienated. Such income, profits or gains may be taxed in the State in which the permanent establishment or fixed base is situated. This corresponds to the rules for taxation of business profits and income from independent personal services contained in Articles 7 and 14 respectively . [New paragraph (2)]

Exclusive residence country taxation on the disposal of ships or aircraft

1.43       Income, profits or gains from the disposal of ships or aircraft operated in international traffic, or associated property - other than real property covered by paragraph 1 - are taxable only in the State in which the enterprise alienating the ships or aircraft is resident . This rule corresponds to the operation of Article 8 in relation to profits from the international operation of ships or aircraft in international traffic . [New paragraph (3)]

1.44       For the purposes of this Article, the term ‘international traffic’ shall not include any transportation which commences at a place in a country and returns to that place, after travelling through international waters but not visiting another country . [Article 2 of the Protocol]

Shares and other interests in land-rich entities

1.45       Paragraph 4 applies to situations involving the alienation of shares or other interests in companies, and other entities, the value of whose assets is derived principally from real property (as defined in Article 6) which is situated in the other country (again, in the terms of Article 6) . Such income, profits or gains may be taxed by the country in which the real property is situated . This paragraph complements paragraph 1 of this Article and is designed to cover arrangements involving the effective alienation of incorporated real property, or like arrangements.

1.46       This is to be the case whether the real property is held directly or indirectly through a chain of interposed entities . While not limited to chains of companies, or even chains of entities only some of which are companies, the example of chains of companies is used to make clear that the corporate veil should be lifted in examining direct or indirect ownership.

1.47       This provision responds to the tax planning opportunities exposed by the decision of the Full Federal Court in the Commissioner of Taxation v. Lamesa Holdings BV (1997) 77 FCR 597 . It is designed to protect Australian taxing rights over income, profits or gains on the alienation or effective alienation of Australian real property (as defined in new Article (6)(2)) despite the presence of interposed bodies corporate or other entities. [New paragraph (4)]

Capital gains not covered by specific distributive rules to be taxed in accordance with the domestic laws of each country

1.48       The Article contains a ‘sweep-up’ provision in relation to capital gains which enables each State to tax, according to its domestic law, any gains of a capital nature derived by its own residents or by a resident of the other State, from the alienation of any property not dealt with in the preceding paragraphs of the Article . It thus preserves the application of Australia’s domestic law relating to the taxation of capital gains in relation to the alienation of such property.

1.49       This paragraph operates independently of Article 21, which contains sweep-up provisions in relation to items of income not dealt with in other Articles of the Convention. [New paragraph (5)]

Taxation of gains accrued on assets held by departing residents

1.50       Changes made by the Protocol help prevent double taxation that may arise when an individual changes residence . Unrealised gains on assets that do not have the necessary connection with Australia are generally taxable under Australia’s domestic law when a person ceases to be a resident of Australia (section 104-160 of ITAA 1997). Double taxation can potentially arise in the new country of residence if that country taxes the gain on the subsequent disposal of the asset and does not provide a credit for the Australian tax.

1.51       New paragraph 6 allows an individual to elect in the new country of residence to be treated as having alienated the asset at the residence change time . The election will be available where the individual changes residence from one State to the other . As a result of that residence change, certain assets may be taken to have been alienated under the laws of the former country of residence such that the individual is taxable in that country on the residence change gain (or loss) that arises . Where the election is made, the property will be taken to have been alienated and reacquired in the new country of residence at the time the individual ceased to be a resident of the country of former residence (according to the taxation laws of that country) . The alignment of the taxing point in both jurisdictions will help ensure appropriate relief is provided in the country that the individual is leaving for foreign tax that may have accrued in the other country.

Example 1.1

An individual departing Australia may, for instance, hold a less than 10% shareholding in an Australian public company. This shareholding will not have the necessary connection with Australia and thus the individual may be taken to have alienated the shares at the residence change time. Double taxation could arise if Canada taxes the pre-residence change component of the gain on a subsequent alienation of the shares.

If the election in paragraph 6 were exercised, the individual would be taken in Canada to have alienated the shareholding immediately before ceasing to be a resident of Australia under Australian tax law. The provisions of the Convention would then operate to ensure appropriate relief is provided from double taxation. Relief may not be required because Canada is unlikely to tax a non-Canadian resident on the disposal of a foreign asset. Canada would be able to tax the post-residence change gain on the subsequent disposal of the shareholding.

1.52       A residence change disposal will generally not give rise to a gain in the other country unless the asset has some connection with that country (e.g. the asset is real property situated in that country). Paragraph 6 will crystallise a gain immediately before an individual changes residence and the country in which the individual is resident at that point in time would generally be required to provide a credit for tax, if any, that arises in the other country . Australia would therefore provide a credit for Canadian tax that may be paid on the deemed disposal of a Canadian asset when an individual ceases to be a resident of Australia, and vice versa for Canada . [New paragraph (6)]

Article 12 of the Protocol

Amends Article 15 of the Convention - Dependent Personal Services

1.53       The Protocol amends the Dependent Personal Services Article to substitute new conditions under which employment income from short-term visits is exempted from tax in the country visited.

Basis of taxation

1.54       Generally, salaries, wages and similar remuneration derived by a resident of one country from an employment exercised in the other country are liable to tax in that other country. However, subject to specified conditions, there is a conventional provision for exemption from tax in the country being visited where visits of only a short-term nature are involved.

Short-term visit exemption

1.55       The Protocol replaces paragraphs 2 and 3 of Article 15, which set out the conditions for the short-term visit exemption, with a new paragraph 2. The new paragraph conforms with current Australian and international tax treaty practice.

1.56       The Protocol removes the existing exemption for remuneration not exceeding specified monetary limits derived during short-term visits. [New paragraph (2)]

Article 13 of the Protocol

Amends Article 22 of the Convention - Source of Income

1.57       The Protocol substitutes a new Source of Income Article. The new Article accords with current Australian tax treaty practice.

Deemed source

1.58       New paragraph 1 of this Article effectively deems income, profits or gains derived by a resident of one country which, under the Convention, may be taxed in the other country to have a source in the latter country for the purposes of the domestic income tax law of that other country . It therefore avoids any difficulties arising under domestic income tax law source rules in respect of, for example, the exercise by Australia of the taxing rights allocated to Australia by the Convention over income derived by residents of Canada. [New paragraph (1)]

Double taxation relief

1.59       New paragraph 2 is designed to ensure that where an item of income, profits or gains is taxable in both countries, double taxation relief will be given by the income recipient’s country of residence (pursuant to Article 23) for tax levied by the other country as prescribed under the Convention. In this way, income derived by a resident of Australia, which is taxable by Canada under the Convention, will be treated as being foreign income for the purposes of the ITAA 1936, including the foreign tax credit provisions of that Act. [New paragraph (2)]

Article 14 of the Protocol

Amends Article 23 of the Convention - Methods of Elimination of Double Taxation

1.60       The Protocol substitutes a new Article on Methods of Elimination of Double Taxation . The new Article:

·       updates the language of the provision to reflect each country’s modern tax treaty practice;

·       introduces provisions for the allowance of underlying tax credit relief in each country; and

·       introduces a new provision which permits Canada to provide exemption with progression.

Underlying tax credit

1.61       The credit will include the allowance of underlying tax credit relief in respect of dividends paid by a Canadian resident company to an Australian resident company which controls directly or indirectly at least 10% of the voting power of the Canadian company.

[New subparagraph (1)(b)]

1.62       Canada will allow underlying tax credit relief in respect of dividends paid by an Australian resident company to a Canadian resident company, controls directly or indirectly at least 10% of the voting power of the Australian company . [New subparagraph (2)(b)]

Exemption with progression

1.63       Australia considers that ‘exemption with progression’ is implicit in its credit provision. However, as Canada formally provides for exemption with progression within its credit rules, this has been explicitly expressed in new subparagraph 2(c) . ‘Exemption with progression’ means that the country of residence may take into account income over which the country of residence does not have a taxing right for the purposes of calculating tax on the income over which it does have taxing rights. [New subparagraph (2)(c)]

Article 15 of the Protocol

Amends Article 24 of the Convention - Mutual Agreement Procedure

1.64       Article 15 of the Protocol inserts a new paragraph 6 into the Mutual Agreement Procedure Article of the Convention.

General Agreement on Trade in Services dispute resolution process

1.65       Paragraph 3 of Article XXII of the General Agreement on Trade in Services provides that a disputed measure that falls within the scope of an ‘international agreement relating to the avoidance of double taxation’ may not be resolved under the dispute resolution mechanisms provided by Articles XXII and XXIII of the General Agreement on Trade in Services.

1.66       If there is a dispute as to whether a measure actually falls within the scope of a tax agreement, however, either country may take the matter to the World Trade Organisation’s Council on Trade in Services for referral to binding arbitration.

1.67       Article 24(6) of the Convention is introduced to require the consent of both Australia and Canada before a dispute as to whether a measure falls within the scope of the tax agreement may be brought before the Council on Trade in Services. [New paragraph (6)]

Article 16 of the Protocol

Inserts new Article 26A - Various Interests of Canadian Residents

1.68       Article 16 of the Protocol clarifies that Canada may tax income of Canadian residents relating to partnerships, trusts or controlled foreign affiliates in which the resident has an interest . The majority of OECD member countries accept that anti-abuse measures, such as the CFC rules, are a necessary means of attaining equity and neutrality of international tax laws . Australia considers that its CFC regime is consistent with the requirements of the Convention, as amended by this Protocol . In particular, Australia considers there is no conflict between the CFC rules and Articles 7 and 10(3) of the Convention . However it is Canadian tax treaty practice to expressly confirm the preservation of the operation of its CFC rules in its double tax treaties.

Article 17 of the Protocol

Entry into Force

1.69       Article 17 provides for the entry into force of the Protocol.

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

1.71       Once it enters into force, the Protocol will apply in Australia in respect of withholding tax on income that is derived by a Canadian resident in relation to income derived on or after 1 January in the calendar year after entry into force. That would be 1 January 2003 if it enters into force during the 2002 calendar year [Article 17 (a)(i) of the Protocol] . For other Australian taxes, the Protocol will apply to income, profits or gains derived by a person in a year of income beginning on or after 1 July in the calendar year next following that in which the Protocol enters into force [Article 17(a)(ii) of the Protocol] . The Protocol would thus apply to these taxes starting from the year of income commencing on or after 1 July 2003 if the Protocol enters into force during the 2002 calendar year.

1.72       The Protocol will apply in Canada in respect of withholding tax on income that is paid or credited by an Australian resident in relation to income derived on or after 1 January in the calendar year after entry into force. That would be 1 January 2003 if it enters into force during the 2002 calendar year [Article 17 (b)(i) of the Protocol ] . For other Canadian taxes, the Protocol will apply to income, profits or gains derived by a person in a taxation year beginning on or after 1 January in the calendar year next following that in which the Protocol enters into force. The Protocol would thus apply to these taxes starting from the year of income commencing on or after 1 January 2003 if the Protocol enters into force during the 2002 calendar year [Article 17 (b)(ii) of the Protocol] .

 



C hapter 2  

Second Protocol (and associated Exchange of Letters) amending the Agreement with Malaysia

What is the Second Protocol (and associated Exchange of Letters)?

2.1         The Second Protocol and associated Exchange of Letters, once in force, will amend the Agreement between Australia and Malaysia for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income signed on 20 August 1980, as amended by the First Protocol of 2 August 1999 (referred to as ‘the Agreement’ for the purpose of this chapter).

Why is the Second Protocol (and associated Exchange of Letters) necessary?

2.2         Amendments contained in the Second Protocol and associated Exchange of Letters will operate to exclude persons who benefit from the preferential tax treatment under the Labuan offshore business activity regime, and other substantially similar regimes, from receiving treaty benefits. Such amendments are necessary to ensure that Australian revenue is protected from inappropriate claims for treaty benefits by persons enjoying tax privileges under preferential tax regimes which shelter income from taxation.

2.3         The original Agreement between Australia and Malaysia was signed in 1980. The DTA contains tax sparing provisions. Tax sparing refers to the situation where tax forgone (in the form of tax holidays or tax reduction) by a foreign country on the income of an Australian resident taxpayer is deemed to have been paid (i.e. the tax forgone is credited, as if actually paid, under Australia’s foreign tax credit system). The typical circumstances in which this arrangement operates is where tax incentives are offered by developing nations seeking to attract foreign investment. The rationale for tax sparing is that, without special provisions which recognise such incentives, they would be negated to the extent that the tax forgone by the source country would be collected by the resident country.

2.4         Tax sparing arrangements under the original provisions of the Agreement expired on 30 June 1984. The arrangements were later extended for 3 years from 1 July 1984 to 30 June 1987 through an Exchange of Letters and again for another 5 years from 1 July 1987 to 30 June 1992 by an Exchange of Letters made under the First Protocol of 2 August 1999 amending the Agreement.

2.5         Amendments contained in the Second Protocol will operate to provide new tax sparing arrangements (to reflect the changes made to the Malaysian tax incentive legislation) in relation to certain designated development incentives provided by Malaysia for an additional 11 year period, that is, from 1 July 1992 to 30 June 2003, at which time they will permanently expire.

2.6         In addition, the Second Protocol will also update the Agreement to reflect Australia’s current tax treaty practice in relation to a number of existing Articles, including those dealing with Associated Enterprises (Article 9), Dividends (Article 10), Royalties (Article 12) and Other Income (Article 21), reflecting the Government’s commitment to modernising Australia’s tax treaty network.

Main features of the Second Protocol (and associated Exchange of Letters)

2.7         The Second Protocol (and associated Exchange of Letters) will:

·       exclude from receiving DTA benefits, persons who benefit from the Labuan offshore business activity regime (Malaysia’s international offshore financial centre - a low tax regime);

·       insert a new paragraph in the Associated Enterprises Articleto provide for correlative relief where there is an adjustment of profits;

·       replace the Dividends Article with a new article which states that Australia will be limited to a zero rate of dividend withholding tax on franked non-portfolio dividends and 15% on all other dividends. Malaysia will be precluded from imposing dividend withholding taxes;

·       update the definition of royalties to take into account modern communication methods, and to include payments for spectrum licences;

·       replace the existing Article dealing with third country income of dual residents with an Other Income Article which provides for source country taxation of income not otherwise dealt with in the Agreement;

·       ensure that the ‘tax sparing’ provisions of the Agreement reflect changes in the Malaysian tax incentives legislation;

·       extend the operation of the ‘tax sparing’ provisions of the Agreement for a further period of time, that is, until 30 June 2003, at which time they will permanently expire; and

·       insert a provision, in accordance with current Australian tax treaty practice, to deal with disputes which may be brought before the Council for Trade in Services.

Detailed explanation of changes made by the Second Protocol

Article 1 of the Second Protocol

Amends Article 9 of the Agreement - Associated Enterprises

2.8         The Second Protocol will insert a new paragraph in the Associated Enterprises Article of the Agreement to provide for correlative relief where there is an adjustment of profits by the revenue authority of one of the two countries. The Article deals with parent and subsidiary companies and companies under common control, and provides that the profits of such associated enterprises may be taxed on the basis of dealings at arm’s length. Where a reallocation of profits is made so that the profits of an enterprise of one country are adjusted upwards, a form of double taxation would arise if the profits so reallocated continued to be subject to tax in the hands of an associated enterprise in the other country. To avoid this result, the other country is required to make an appropriate compensatory adjustment to the amount of tax charged on the profits involved to relieve any such double taxation. The new paragraph replaces the former relief mechanism in the Methods of Elimination of Double Taxation Article of the Agreement that requires Australia to give a credit to the resident company for the extra tax chargeable on the amount of adjusted profits of the associated foreign company.

Article 2 of the Second Protocol

Substitutes new Article 10 of the Agreement - Dividends

2.9         The Second Protocol will substitute a new Dividends Article into the Agreement to bring it into line with Australia’s current tax treaty practice.

2.10       The Article allows each Contracting State to tax residents who are beneficially entitled to receive a dividend from the other State. Dividends may also be taxed in the country where the company paying the dividends is resident, but the rate of tax that can be imposed is limited (in some cases to nil). [New paragraphs 1&2]

Rate of tax

2.11       Under this Article as it existed prior to this Second Protocol, Australia limited its rate of withholding tax on dividends paid by Australian resident companies, to beneficially entitled Malaysian residents, to 15% of the gross amount of the dividends.

2.12       The Second Protocol will provide that Australia will not tax franked dividends flowing to a Malaysian company which holds directly at least 10% of the voting power in the company paying the dividends. In practice, the tax treatment of franked dividends derived by Malaysian residents remains unchanged, as Australian sourced franked dividends are generally exempt from dividend withholding tax in Australia under current domestic law. Australia will continue to tax at 15%, those dividends that do not meet the nil rate criteria. [New paragraph 2 (a) (i) and (ii)]

2.13       Article 10 of the existing Agreement does not allow Malaysia to impose dividend withholding tax. However it provides that, in the event of Malaysia subsequently introducing such a tax, the rate of dividend withholding tax would not exceed 15%. The new Article 10 will continue to preclude Malaysia from imposing dividend withholding tax, but provides, in accordance with Australia’s treaty practice, 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 to the source country taxing rights provided under paragraph 2. [New paragraphs 2 and 3]

Substantially similar provisions

2.14       New paragraph 4 deals with the definition of the term ‘dividends’, and new paragraph 5 deals with dividends derived by a permanent establishment. The new paragraph 7 provides that dividends paid by a company which is a resident of Malaysia will include dividends paid by a company which is a resident of Singapore that has declared itself to be a resident of Malaysia for the purpose of those dividends. The new paragraph 7 also states that dividends paid by a company that is resident of Malaysia, which for the purpose of those dividends has declared itself to be a resident of Singapore, shall not be covered by this article. These new paragraphs reflect recent treaty language and are not different in substance to the paragraphs replaced.

Preclusion of extra-territorial application

2.15       The extra-territorial application by either country of taxing rights over dividend income will be precluded by providing, broadly, that a country (the first country) will not tax dividends paid by a company which is a resident of the other country, unless:

·       the person beneficially entitled to the dividends is a resident of the first country; or

·       the shareholding in respect of which the dividends are paid is effectively connected with a permanent establishment in that first country.

2.16       An example of the effect of this paragraph is that Australia may not tax dividends paid out of profits derived from Australian sources, if they are paid by a Malaysian company to a Malaysian resident shareholder, unless the shareholding is effectively connected with a permanent establishment situated in Australia.

2.17       However, the exemption does not apply where the dividend paying company is a resident of both Australia and Malaysia. This provision ensures that Australia retains the right to tax dividends paid to a person resident outside of both countries by a company which is a resident of Australia under its domestic law, notwithstanding that the company is deemed to be a resident of Malaysia for the purposes of the tax treaty under the dual resident tie-breaker test for companies contained in Article 4 of the Agreement. [ New paragraph 6]

Article 3 of the Second Protocol

Amends Article 12 of the Agreement - Royalties

2.18       The Second Protocol will amend the definition of royalties to take into account modern communications methods as reflected in Australian domestic law. A provision has also been included in the Second Protocol that deems radiofrequency spectrum licence payments to be royalties for the purposes of the Agreement. This is in accordance with Treasurer’s Press Release No. 26 of 11 March 1998 concerning revised taxation treatment to be afforded to spectrum licences. [ New paragraph 6(d) and (e)]

2.19       The Royalties Article has also been amended to delete :

·       the current exemption from Malaysian tax of approved industrial royalties; and

·       the current exclusion from Malaysian tax of royalties that, as film rentals, are subject to cinematograph film-hire duty in Malaysia.

Article 4 of the Second Protocol

Substitutes new Article 21 of the Agreement - Other Income (previously Income of Dual Resident)

2.20       The existing Article dealing with third country income of dual residents will be replaced with a more comprehensive Other Income Article which provides rules for the taxation of income not otherwise dealt with in the Agreement.

2.21       The new Article allocates taxing rights between the two countries on items of income not dealt with in the preceding Articles of the Agreement. The scope of the Article is not confined to such items of income arising in one of the countries - it extends also to income from sources in a third country.

2.22       Broadly, such income derived by a resident of one country is to be taxed only in the country of residence unless it is derived from sources in the other country, in which case the income may also be taxed in that other country. Where this occurs, the country of residence of the recipient of the income would be obliged by Article 23 ( Methods of Elimination of Double Taxation ) to provide double taxation relief. [New paragraphs 1 and 3]

2.23       With the exception of income from land as defined in paragraph 2 of Article 6, this Article does not cover income derived by a resident of one of the contracting states where that income is effectively connected with a permanent establishment situated in the other contracting state. In such a case, Article 7 ( Business Income or Profits ) shall apply. [New paragraph 2]

Article 5 of the Second Protocol

Amends Article 23 of the Agreement - Methods of Elimination of Double Taxation

2.24       The Second Protocol will make a number of amendments to Article 23 of the Agreement.

Correlative relief

2.25       The relief mechanism in paragraph 4 of the existing Article which requires Australia to give a credit to the resident company for the extra tax chargeable on the amount of adjusted profits of the associated foreign company will be deleted and replaced by a new paragraph in the Associated Enterprises Article.

Malaysian incentives laws specified

2.26       New paragraph 4 defines the term ‘Malaysian tax forgone’ for the purposes of the tax sparing credit and ensures that the provision reflects changes in the Malaysian tax incentives legislation.

Activities excluded from tax sparing

2.27       Under the new paragraph 5, tax forgone on income derived from certain sectors is excluded from the tax sparing provisions. A general anti-avoidance provision is also included.

Finance sector

2.28       New subparagraph 5(a) excludes income from banking, insurance, consulting, accounting, auditing or similar services from the scope of tax sparing. These exclusions reflect the fact that, under Malaysian tax incentive laws, most of the finance sector is not eligible for tax incentives.

Ships and aircraft

2.29       New subparagraph 5(b) excludes income from shipping and aircraft operations from tax sparing - except where operations are carried on within Malaysia. Tax sparing concessions relating to income from highly mobile assets such as ships and aircraft is susceptible to exploitation and so has been specifically excluded.

General anti-avoidance provision

2.30       New subparagraph 5(c) is designed to prevent abuse of tax sparing, under schemes where Malaysia-based intermediaries are used as conduits for flows of income, profits or gains, or where property is located in Malaysia. If the scheme is entered into to avoid Australian tax through the exploitation of the Australian foreign tax credit provisions (which includes tax sparing under the Agreement) or to confer a benefit on a resident of a third country, then under this subparagraph, Malaysian tax forgone is not deemed to be paid and thus tax sparing is not available.

2.31       The reference in this provision to a scheme having the purpose of using Malaysia as a location of property would not apply to genuine loans nor to the provision of assets effectively connected with the carrying on of a business.

Deemed tax paid

2.32       New paragraph 6 provides that for the purposes of the tax sparing credit, Malaysian tax forgone as defined in new paragraph 4 and which is not of a type referred to in new paragraph 5 is to be treated as Malaysian tax paid.

Tax sparing period

2.33       The operation of the tax sparing provisions in the Agreement expired on 30 June 1992. The Second Protocol will extend the operation of tax sparing in the Agreement until 30 June 2003, at which time they will expire permanently. [New paragraph 7]

Article 6 of the Second Protocol

Amends Article 24 of the Agreement - Mutual Agreement Procedure

General Agreement on Trade in Services dispute resolution process

2.34       The Second Protocol will insert a new provision for the purposes of the General Agreement on Trade in Services, in accordance with current Australian treaty practice, to deal with disputes which may be brought before the Council for Trade in Services.

2.35       Paragraph 3 of Article XXII of the World Trade Organisation General Agreement on Trade in Services provides that a disputed measure that falls within the scope of an ‘international agreement relating to the avoidance of double taxation’ may not be resolved under the dispute resolution mechanisms provided by Articles XXII and XXIII of the General Agreement on Trade in Services.

2.36       If there is a dispute as to whether a measure actually falls within the scope of a tax agreement, however, either country may take the matter to the World Trade Organisation’s Council on Trade in Services for referral to binding arbitration.

2.37       New paragraph 5 of the Agreement will require the consent of both Australia and Malaysia before a dispute as to whether a measure falls within the scope of the DTA may be brought before the Council on Trade in Services. This is seen as the most effective way of dealing with such disputes, and avoids difficult questions as to when a disputed issue falls within the dispute resolution mechanism of the Agreement or of the General Agreement on Trade in Services.

2.38       This provision is based, in all essential respects, on an OECD Model Commentary recommendation, and is common in recent international treaty practice.

Article 7 of the Second Protocol

Amends Article 27 of the Agreement - Limitation of Relief

2.39       The Second Protocol will insert two new paragraphs in Article 27 that will operate to deny the benefits of the Agreement in certain circumstances identified in an Exchange of Letters between Australia and Malaysia.

2.40       When the Second Protocol was signed on 28 July 2002, an associated Exchange of Letters were also signed on the same day. The Second Protocol and the Exchange of Letters will exclude from receiving DTA benefits, persons who benefit from the preferential tax treatment under the Labuan offshore business activity regime (specifically, activity under the Labuan Offshore Business Activity Tax Act 1990 , as amended) and other substantially similar regimes . [New paragraphs 2 and 3 and Exchange of Letters]

Article 8 of the Second Protocol

Date of entry into force

2.41       This Article provides for the entry into force of the Second Protocol. The Second Protocol will enter into force when the notifications between the two countries that the procedures necessary to give it the force of law in the respective countries have been completed.

2.42       Once it enters into force, the Second Protocol will form an integral part of the Agreement. In Australia, enactment of the legislation giving the force of law in Australia to the Second Protocol along with tabling the Second Protocol are prerequisites to the exchange of diplomatic notes.

2.43       Legislation is not required for the Exchange of Letters. In accordance with section 4A of the Agreements Act, the Exchange of Letters, once they enter into force (at the same time as entry into force of the Second Protocol) will be published in the Gazette.

Retrospective application - tax sparing provisions

2.44       Under subparagraph (a)(i) of this Article, the Second Protocol will, on entry into force, have effect for the purposes of the tax sparing provisions of Article 5 of the Second Protocol, in respect of tax on income of any year of income beginning on or after 1 July 1992 in Australia and in respect of Malaysian tax for any year of assessment beginning on or after 1 January 1993.

2.45       Australian taxpayers who have received the benefit of the relevant Malaysian tax sparing concessions during the years referred to in the above paragraph, may request a foreign tax credit determination or amended determination from the Commissioner of Taxation once the Second Protocol enters into force, to claim the relevant Malaysian tax forgone as a foreign tax credit.

Retrospective application - underlying tax credit

2.46       Subparagraphs (a)(i) and (b)(i) of this Article will also operate so that the Second Protocol will have effect, on its entry into force, for the purposes of underlying tax credit relief in respect of tax on income of the 1992-1993 and subsequent years of income in the case of Australia and in respect of tax for any year of assessment beginning on or after 1 January 1993 in the case of Malaysia.

2.47       In the case of Australia, the domestic underlying tax credit provision would be applicable in any event.

Other income

2.48       In respect of other income, the Second Protocol will have effect in Australia in relation to income of any year of income beginning on or after 1 July in the calendar year next following that in which the Second Protocol enters into force. It will have effect in respect of Malaysian tax for any year of assessment beginning on or after 1 January in the calendar year next following the calendar year in which the Second Protocol enters into force.

 



C hapter 3

US interest amendment

Overview

3.1         Schedule 3 to 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.

 



C hapter 4

Minor technical amendments

Minor technical amendments

4.1                   Schedule 3 to this bill makes a number of technical corrections to the Agreements Act.

4.2                   The first amendment alters the current definition of the ‘Greek agreement’ in the Agreements Act. Under the drafting convention in force when the Greek airline profits agreement was implemented, this agreement was described as the ‘Greek agreement’ because no comprehensive DTA with Greece existed. However the definition will be amended to read ‘the Greek airline profits agreement’ to avoid giving the impression that the agreement is a comprehensive DTA. This change will make the description consistent with other airline profits agreements enacted in that legislation.

4.3                   The second amendment corrects a typographical error in the Romanian Agreement. 

4.4         The third amendment corrects a typographical error in the Vietnam Agreement.

 



C hapter 5

Regulation impact statements

PROTOCOL TO UPDATE AUSTRALIA’S DOUBLE TAX CONVENTION WITH CANADA

Specification of policy objective

5.1         Two key objectives of the existing Australia-Canada DTC (the 1980 DTC) are to:

·       promote closer economic cooperation between Australia and Canada by eliminating possible barriers to trade and investment caused by the overlapping taxing jurisdictions of the two countries. The existing DTC provides a reasonable element of legal and fiscal certainty within which cross-border trade and investment can be carried on; and

·       create a framework through which the tax administrations of Australia and Canada can prevent international fiscal evasion.

5.2         The prime objective in updating the 1980 DTC is to make a significant advance in providing a competitive tax treaty network for companies located in Australia by reducing the rate of dividend withholding tax on Canadian-based subsidiaries and branches of Australian companies. Important secondary goals are to prevent double taxation of capital gains derived by Canadian residents on the disposal of interests in Australian entities while retaining Australian taxing rights, and to reduce maximum interest withholding tax rates. In other respects, revision of the DTC will align it more closely with developments in taxation law and administration since 1980 and with the modern DTC policies of the two countries.

Background

Ralph Review of Business Taxation

5.3         The Government agreed in its Stage 2 response to the Ralph Report’s Review of Business Taxation recommendations that priority be given to renegotiating Australia’s aging DTCs with major trading partners (in particular, with the United States of America, the United Kingdom and Japan) and that Australian investment offshore would significantly benefit from a lowering of dividend withholding tax on non-portfolio dividends (i.e. dividends paid on 10% or greater shareholdings) under such DTCs.

5.4         The proposed Protocol was substantially negotiated prior to the Ralph Report recommendations, but accords with them. Canada is, as noted below, a significant trading partner, and in the top ten of destinations for Australian investment overseas.

How DTCs operate

5.5         Australian tax treaties are usually based on the OECD Model with some influences from the UN Model. In addition, countries propose variations to these Models to reflect their particular economic interests and legal circumstances.

5.6         DTCs reduce or eliminate double taxation caused by the overlapping taxing jurisdictions because treaty partners agree (in certain situations) to limit taxing rights over various types of income. The respective countries also agree on methods of reducing double taxation where both countries have a right to tax.

5.7         Australia seeks an appropriate balance between source and residence country taxing rights. Generally the allocation of taxing rights under Australia’s DTCs is similar to international practice as set out in the OECD Model, but (consistent with our practice) there are a number of instances where it leans more towards source country taxing rights and the UN Model.

5.8         In addition, DTCs provide an agreed basis for determining whether the income returned or expenses claimed on related party dealings by members of a multinational group operating in both countries can be regarded as acceptable. DTCs are therefore an important tool in dealing with international profit shifting.

5.9         To prevent fiscal evasion, DTCs normally include an exchange of information facility. The two tax administrations can also use the mutual agreement procedures to develop a common interpretation and resolve differences of application of the DTC. There is also provision for residents of either country to instigate a mutual agreement procedure.

The 1980 Canada DTC

5.10       The Australia-Canada DTC was signed on 21 May 1980 and came into effect in 1981. Negotiations to update the DTC were held in 1996 and 1998, and some remaining issues have recently been settled by correspondence.

Australia’s Trade and Investment Relationship with Canada [1]

5.11       Investment ties between Australia and Canada are substantial. The stock of Australian investment in Canada was valued at $2.8 billion in mid-1999, our 10th largest. Investment in Canada is chiefly in the mining, transportation and packaging sectors including through such major companies as TNT, Mayne Nickless and Western Mining. In 1998, BHP opened the billion-dollar Ekati diamond mine in the Northwest Territories. Canadian interests also have substantial investments in Australia, principally in mining and energy, food processing, computer software and media and communications. Canadian investment in Australia stood at A$1.75 billion in mid-1999, our 14th largest source of foreign investment.

5.12       Canada is Australia’s 16 th largest trading partner (A$3.6 billion) and 16 th largest market for merchandise exports. Australian exports to Canada were worth $1.8 billion in the year 2000-2001. Australia’s principal exports are alumina, sugar and beef. Primary products as a proportion of total trade represent around 80%. A number of processed primary products, including wine and cereal preparations, have performed well in the Canadian market.

Canadian tax treaty practices

5.13       As at August 2001, Canada had entered into 71 bilateral tax agreements (with approximately eight more finalised but not yet in force) and is engaged in negotiations with approximately 22 countries. In general, Canada adheres to the OECD Model.

Canadian tax system/rates (as modified by the 1980 DTC)

5.14       Under the unamended 1980 DTC, Canada’s domestic withholding tax rates for dividend and interest payments to non-residents (currently 25% for each in the absence of the DTC), are limited to 15%. The DTC restricts withholding tax rates on royalty payments (currently 25% under Canadian law, subject to a lower DTC rate) to 10%.

5.15       An Australian resident’s business profits will only be taxable in Canada if the Australian resident has a permanent establishment in Canada and those business profits are attributable to that permanent establishment, following the OECD Model. In the absence of the 1980 DTC, such business profits would be subject to Canada’s domestic income tax if the taxpayer is an individual (currently between 17-29% plus provincial tax) and Canada’s branch tax where applicable (currently 25%).

5.16       The 1980 DTC also provides that Australian residents receiving income from professional services will only be taxable in Australia (and therefore will not be subject to Canada’s domestic individual tax) unless they have a fixed base in Canada. Australian residents deriving professional services income through their fixed bases in Canada may be taxed in Canada on that income at Canada’s domestic individual rates.

5.17       The 1980 DTC also provides that employees are generally only taxable in the country where the services are performed, although Australian employees on certain short visits to Canada will be exempt in relation to their employment income in Canada.

Amendments anticipated as a result of revising the 1980 DTC

5.18       One of the most significant changes resulting from revising the 1980 DTC would be the adoption of a split rate dividend withholding tax. The practical result of implementing a change of this kind, is that certain non-portfolio dividends (those which are also fully franked, in the case of dividends flowing from Australia to Canada) would be taxed at a maximum rate of 5% as opposed to the current DTC rate of 15%. While each country would be allowed to impose a branch profits tax, the limit would be reduced to 5%, rather than the 15% allowed under the 1980 DTC. Only Canada currently has such a tax, which would be levied at 25% without a DTC reduction.

5.19       Other changes to be made in the proposed revision of the 1980 DTC include:

·       making definitional changes to reflect current practices. Specifically, the definitions of ‘Australia’ and ‘residence’ as well as the meaning of ‘substantial equipment’ permanent establishments;

·       revising the Income from Real Property Article to conform to modern Australian drafting practice, ensuring the Article will cover leases and exploration for natural resources;

·       inserting a new provision dealing with interposed trusts in relation to permanent establishments, consistent with Australia tax treaty practice;

·       reducing the interest withholding tax rate limitation from 15% to Australia’s usual treaty rate of 10%;

·       expanding the definition of royalty in conformity with current Australian tax treaty practice to expressly include technological advances in relation to satellite and cable broadcasting as well as reproduction techniques in connection with television, in order to remove any doubt as to whether they are covered by the current definition;

·       clarifying the operation of the royalties provision in the case of use of software;

·       revising the Alienation of Property Article in line with current Australian tax treaty practice, including ensuring that the coverage extends to real property owned through corporate or other entities, and helping to avoid double taxation when a resident of one of the Contracting States departs to become a resident of the other;

·       modifying the treatment of employment income in the Dependent Personal Services Article by removing the current monetary limits;

·       updating the Source Article to reflect current Australian tax treaty practice;

·       provision of credits for underlying taxes on a reciprocal basis;

·       a provision clarifying the relationship of the amended DTC with the General Agreement on Trade in Services , in accordance with current Australian (and wider OECD) treaty practice; and

·       A provision required by Canadian tax treaty practice to confirm that the amended DTC does not prevent the operation of certain Canadian legislation applying to interests of Canadian residents .

Identification of implementation option(s)

5.20       The implementation options for achieving the policy objectives are:

·       no further action - rely on the existing DTC;

·       negotiate an amending Protocol to the 1980 DTC; or

·       renegotiate the 1980 DTC in its entirety.

Option 1:  No further action - rely on the existing DTC

5.21       The implementation of this option requires no further action on the part of the ATO or any other organisation. The policy objectives would not be achieved.

Option 2:  Negotiate an amending Protocol to the 1980 DTC.

5.22       The proposed Protocol would update the DTC to:

·       reduce the rate of dividend withholding tax on Canadian-based subsidiaries and branches of Australian companies;

·       reduce the rate at which Canada could impose branch profits tax from 15% to 5%;

·       prevent the double taxation of capital gains derived by Canadian residents on the disposal of Australian entities, while retaining Australian source country taxing rights;

·       reduce maximum interest withholding tax rates; and

·       achieve the other policy outcomes noted above.

5.23       Implementation of this option is achieved by negotiating only those Articles of the 1980 DTC which are considered to be pivotal to achieving the policy objectives of the revision. This limits the scope of negotiations, potentially avoiding contentious areas, resulting in shorter negotiations.

Option 3:  Renegotiate the 1980 DTC in its entirety

5.24       Renegotiation of the 1980 DTC in its entirety would allow for a general overhaul of the 1980 DTC to ensure that its original objectives are being adequately met. Every area of the 1980 DTC would be examined and negotiated. Under this option, a lengthier period of negotiations would be required, with little more being achieved in terms of achieving the policy objectives.

Assessment of impacts (costs and benefits) of option

Impact group identification

5.25       A revised DTC is likely to impact on Australian residents who derive amounts from Canada and on Canadian residents who derive amounts from Australia, particularly the former. The extent of this impact will depend in particular on the advantage taken of the reduced rates in repatriating dividends back to Australia from Canada.

5.26       The main groups initially affected by a reduction in the rate of Canadian dividend withholding tax and from comprehensively covering the taxation of capital gains in the DTC are likely to be the at least 38 major Australian companies with investments in Canada and publicly listed Canadian companies with investments in Australia. Persons affected by changes in investment flows between the countries would also be impacted. Any Australian banks lending to Canadian residents should also benefit from reduced Canadian interest withholding taxes. The small number of mining companies operating between the two countries may be affected by the changes to the ‘substantial equipment’ provisions.

5.27       The ATO will need to administer the changes to the DTC and Government policy in relation to taxation of Canadian residents could be constrained by changes to treaty obligations, but as those changes closely accord with our other modern DTCs, that is not likely to be significant.

5.28       Australian employees working in Canada and vice versa may also be impacted by the amendments to the Dependent Personal Services Article, but the changes are not likely to have any significant impact, since the monetary limits under which the country where the work is performed may currently not tax the income, and which the Protocol would remove, are very low in current conditions.

Assessment of costs

Option 1:  No further action - rely on existing DTC

5.29       As this option represents a continuance of the current position, it would be expected that the administration and compliance costs of this option would be minimal. Because the current treaty is not in line with international best practice, there may in fact be a slight increase in the administration costs of retaining the 1980 DTC, however, due to issues arising from the interpretation and application of the outdated provisions contained in the DTC. There is a clear cost to those investing in Canada as the terms of the 1980 DTC disadvantage Australian investors in Canada in comparison to those from many other countries.

Option 2:  Negotiate an amending Protocol to the 1980 DTC

5.30       Revision of the 1980 DTC is not expected to result in increased administration or compliance costs for the ATO. In fact, the modernisation of the terms of the DTC could be expected to lead to a reduction in costs. An example is that the removal of the money limits in the Dependent Personal Services Article allows the ATO to apply the same general approach to the application of this Article as in most of our DTCs, and is not required to address updating the monetary limits (which was provided for as a possibility in the 1980 DTC but never occurred). Similar issues arise in the many other areas where the DTC is being aligned with modern tax treaties practice. A major example is the clear coverage of capital gains generally. This avoids the risk of double taxation of such gains, which may have some compliance costs from the ATO perspective, such as engaging in a mutual agreement procedure.

5.31       The negotiation of an amending Protocol (involving one round of formal negotiations in Australia) and the subsequent enactment of any resulting amendments has been at a cost of approximately $46,000. Most of these costs have been borne by the ATO, although other agencies, such as Treasury and the Department of Foreign Affairs and Trade would bear some of these costs. There would also be an unquantified cost in terms of Parliamentary time and drafting resources in enacting any amendments to the 1980 DTC, though these would not be large, based on similar agreements in the past.

5.32       There is already a small unquantified ‘maintenance’ cost to the ATO associated with the administration of the 1980 DTC in terms of dealing with enquiries, mutual agreement procedures and Advance Pricing Agreements, OECD representation, etc. Any changes to the 1980 DTC would result in further minor implementation costs to the ATO.

5.33       A revised DTC is not expected to result in increased compliance costs for taxpayers. The closer alignment with more recent treaty practice would probably reduce them. The reduced dividend and interest withholding rates, will for example, give those investing in Canada greater freedom in structuring their investments and repatriating dividends and interest. Likewise the clear coverage of capital gains means that the difficult issues of the applicable law in such cases, and the issue of how double taxation of such gains can be avoided, brings the situation into line with most of our DTCs and with most tax treaties, which address capital gains tax where it is levied and seek to avoid double taxation on the gains.

5.34       The removal of the monetary amounts under which employment in a country during a visit of less than 183 days would not be taxed would possibly disadvantage some taxpayers, however the figures are so low ($Can 3,000; $Aus 2,600) since they have never been increased under the 1980 DTC that this is likely to have little or no practical impact.

5.35       There might be some reduction in Australian Government revenue from taxation of Canadian investments and other business activities in Australia, but in view of the enhanced anti-avoidance aspects of the DTC, and that the dividend and interest reductions only reflect Australian domestic law reductions already applying, any reduction is likely to be minimal.

5.36       On the other hand, further limitation of Canadian taxation rights in circumstances where Australia may have given credit for Canadian taxation may lead to increased Australian tax revenue. The main areas in this respect are the imposition of Canadian royalty withholding taxes and interest withholding taxes. Canadian withholding taxes are generally imposed at a 25% rate subject to the reduction by a DTC. By reducing the maximum rate of dividend withholding tax from 15% to 5% in most cases and of interest withholding tax from 15% to 10% the amount of tax effectively paid by Australian residents to the Canadian revenue is likely to be reduced. As both the unamended 1980 DTC and the treaty in its amended form require Australia to give a tax credit for such taxes paid on dividends and interest flowing from Canada to an Australian resident, the lower withholding tax rates would reduce the amount of such required credit in cases where the Australian resident was able to use the credit. The effect is likely to be somewhat balanced by the increased likelihood of repatriation under the lower rates. As to dividends flowing from Australia to Canada and interest flowing in the same direction, the lower rates only reflect our domestic law anyway, so the situation of Canadian investors in Australia is not affected.

5.37       It should also be recognised that DTCs generally limit the flexibility of treaty countries’ policy in relation to cross-border taxation. However, given the existence of the 1980 DTC , and the fact that most changes align the DTC to Australia’s recent treaty practice, the effect of revising the DTC, in terms of reduced policy flexibility, will only be very marginal.

Option 3:  Renegotiate the 1980 DTC in its entirety

5.38       The costs associated with this option are generally the same as for Option 2, with the exception that the actual administrative costs associated with meeting for negotiations may be greater if some of the issues become difficult to agree on. Although occasionally an agreed text can be settled in a single week of negotiations, substantial renegotiation of an existing DTC often takes at least 2 rounds of negotiations. There may also be additional unquantified costs in terms of Parliamentary time and drafting resources in enacting additional amendments to the 1980 DTC. Based on the experience of previous DTCs, that is only likely to be minimal.

Assessment of benefits

Option 1:  No further action - rely on existing DTC

5.39       This option represents the status quo . By adopting this option there would be no need for further action and resources could be devoted to other issues.

Option 2:  Negotiate an amending Protocol to the 1980 DTC

5.40       It is anticipated that the proposed amending Protocol would result in the clarification of the operation of the DTC and bring it into line with current domestic law and treaty practice. Consequently, such a revision would further assist the development of trade and economic cooperation between Australia and Canada, and would be likely to reduce the administration and compliance costs of the ATO and the Canadian tax authority.

5.41       Specifically, it is expected that revision of the 1980 DTC would result in the reduction of Canadian taxation on dividends and interest and therefore be of direct benefit to Australian investors in Canada. The cost of Australian investment in doing business in Canada and the international competitiveness of those seeking to lend to Canadian enterprises would be enhanced by those lower rates, and there would be greater freedom as to how such activities are structured, which should itself reduce the costs of such enterprises.

5.42       In the broader sense, DTCs play a role in ‘growing’ investment and trade between countries. As indicated above, reducing the cost of our residents doing business abroad and promoting international investment would increase the returns on Australian capital and maximise gross national product, so that the Australian tax revenue would be increased.

5.43       These benefits are expressed in broad terms. This is because the ATO has not been able to precisely define the costs and benefits to the revenue of DTCs. The specific reasons why it has not been possible to forecast the costs and benefits of a DTA in more than a general sense include:

·       the range of income covered by a DTA;

·       the time period for which a DTA will operate (usually 15 or more years);

·       the difficulty of obtaining adequate data;

·       the fact that domestic tax rules may already provide relief for foreign taxes;

·       the relationship with increased trade and investment flows; and

·       the prospective nature of such flows as well as the time lag which will be involved in ‘growing’ trade and investment.

5.44       This has been a difficulty internationally. A 1991 OECD study [2] indicates, however, that there is a slight improvement in the required rate of return on the cost of capital when there is a DTC in existence as compared to where there is no DTC. The OECD study concluded that “it is possible to be relatively positive about the effects of the current network of double tax treaties, since they both lower the average required return and they reduce the variance in required returns between alternative locations” [3] .

5.45       In 1993-1994, the OECD considered the feasibility of a study specifically assessing the impact of DTAs on investment flows between countries, but it was concluded that no further work could usefully be done by it on the subject at that time. The main reason was that it found almost no empirical work has been undertaken in this area, largely because of the difficulty of obtaining adequate data.

5.46       By extending taxing rights in relation to the Permanent Establishments Article and the Income from Real Property Article, in line with the changes proposed to be made as a consequence of revision of the 1980 DTC to include the exploration of natural resources, it is anticipated that the Australian revenue may benefit, due to the size of Canadian activity in the area.

Option 3:  Renegotiate the 1980 DTC in its entirety

5.47       This option offers the same benefits as Option 2. In addition, it allows for a more general updating of the 1980 DTC, which in turn provides for the text of the resulting DTC to be in one document with consistent language.

Consultation

5.48       Information has been provided to the States and Territories through the Commonwealth-State Standing Committee on Treaties’ Schedule of Treaty Action.

5.49       The amending Protocol has been be considered by the ATO’s Tax Treaties Advisory Panel of industry representatives and tax practitioners. That Panel has been notified of developments in the renegotiation since 1998 and has been supportive of the package of proposed changes. The Protocol will be considered by the Parliamentary Joint Standing Committee on Treaties prior to treaty action, and that Protocol is likely to provide for public consultation in its hearings.

Conclusion and recommended option

5.50       Revision of the 1980 DTC is desirable to ensure that the objectives of the 1980 DTC are advanced and reflected in the modern business and taxation environment. Based upon a cost benefit analysis, Option 2 is considered to be the preferable option for implementing the revision. Negotiating an amending Protocol will maximise the objectives of revision whilst limiting costs. Such an amending Protocol can be viewed as a necessary part of the general maintenance work associated with Australia’s existing DTC network.

5.51       By modernising the 1980 DTC to reflect international best practice, ease and efficiency of the administration of the treaty will be enhanced, thereby reducing both administration costs as well as compliance costs. Proposed reduction of dividend and interest withholding taxes payable by Australian investors in Canada, and those lending to Canadian entities, will benefit such investors. It will also specifically address the taxation of Australian capital gains, rendering that issue more certain.

5.52       The Treasury and the ATO would monitor the amending Protocol, as part of the whole taxation system, on an ongoing basis. In addition, the ATO has consultative arrangements in place to obtain feedback from professional and small business associations and through other taxpayer consultation forums.

Second Protocol and Exchange of Letters amending the Australia-Malaysia Double Taxation Agreement

Specification of policy objectives

5.53       The three key objectives of the Second Protocol and Exchange of Letters amending the Australia-Malaysia DTA (the Second Protocol) are to:

·       ensure that the ‘tax sparing’ provisions of the existing DTA reflect changes in the Malaysian tax incentives legislation;

·       extend ‘tax sparing’ relief for a further period of time

(i.e. until 30 June 2003); and

·       exclude from receiving DTA benefits, persons who benefit from the Labuan offshore business activity regime (Malaysia’s international offshore financial centre - a low tax regime).

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

Background

5.55       The Australia-Malaysia DTA was signed in 1980. Tax sparing arrangements under the original provisions of that DTA expired on 30 June 1984. The tax sparing arrangements were extended for 3 years, from 1 July 1984 to 30 June 1987 through an Exchange of Letters and again for another 5 years from 1 July 1987 to 30 June 1992 by a Protocol amending the DTA signed on 2 August 1999. That Protocol entered into force on 27 June 2000.

5.56       Tax sparing refers to the situation where tax forgone (e.g. in the form of tax holidays or tax reductions) by a foreign country on the income of an Australian resident taxpayer is deemed to have been paid (i.e. the tax forgone is credited as if actually paid, under Australia’s foreign tax credit system). The typical circumstances in which this arrangement operates is where tax incentives are offered by developing nations seeking to attract foreign investment. The rationale for tax sparing is that, without special provisions which recognise such incentives, they would be negated to the extent that the tax forgone by the source country would be collected by Australia.

5.57       Malaysia had requested an extension to the tax sparing arrangements in the DTA, as amended by the First Protocol, beyond 30 June 1992. Malaysia had been advised on several occasions of Australia’s general reluctance to grant further tax sparing incentives under Australia’s DTAs (a position announced in the Government’s 1997 Budget statement) and that Australia would allow existing incentives to generally lapse on expiry.

5.58       However the Australian Government had considered Malaysia’s request for a further extension of the tax sparing arrangements beyond 30 June 1992 and had approved further negotiations between officials in relation to the matter. The Australian Government’s approval was given only on the basis that those further negotiations would also deal with the Australian proposal to exclude from treaty benefits of persons who benefit from the Labuan offshore business activity regime.

5.59       ATO officials and their Malaysian counterparts met in Canberra on 9-10 May 2001, resulting in a draft Second Protocol being initialled at officials’ level. The officials reached agreement on all issues, with the exception of the date of expiry of the tax sparing provisions. The two sides agreed to seek approval from their respective Governments and to advise each other of the outcome by correspondence. Both Governments have now agreed to the 30 June 2003 expiry date for the tax sparing provisions in the DTA.

Identification of implementation option(s)

5.60       A Second Protocol between Australia and Malaysia is the only way to achieve bilateral agreement in relation to all the above objectives.

5.61       The Second Protocol will also update the existing DTA in a number of respects to bring it into line with Australia’s current tax treaty practice including:

·       Dividends - 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 and 15% limit for all others. In practice, the tax treatment of franked dividends derived by Malaysian residents remain unchanged as generally Australian sourced franked dividends are exempt from tax in Australia under current law. Although Malaysia currently does not impose dividend withholding tax, the existing DTA provides that, in the event of Malaysia subsequently introducing such a tax, the rate of dividend withholding tax would not exceed 15%. The draft amendment continues to preclude Malaysia from imposing dividend withholding tax, but provides, in accordance with our treaty practice, 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 to that paragraph;

·       Royalties - the definition of ‘royalties’ was amended to take into account modern communications methods, and to include payments for spectrum licences;

·       Associated Enterprises - a new paragraph was included to provide for correlative relief where there is an adjustment of profits. Where a reallocation of profits is made so that the profits of an enterprise of one country are adjusted upwards, a form of double taxation would arise if the profits so reallocated continued to be subject to tax in the hands of an associated enterprise in the other country. To avoid this result, the other country is required to make an appropriate compensatory adjustment to the amount of tax charged on the profits involved to relieve any such double taxation;

·       Other Income - the existing provision dealing with third country income of dual residents was 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; and

·       General Agreement on Trade in Services - a provision was included, in accordance with current Australian treaty practice, to deal with disputes which may be brought before the Council for Trade in Services.

Assessment of impacts (costs and benefits)

Impact group identification

5.62       The Second Protocol is likely to impact on Australian residents doing business with Malaysia. The ATO will need to administer the changes to the DTA.

Australia’s Investment and Trade Relationship with Malaysia [4]

5.63       Malaysia’s rapid economic development, location and active participation in our immediate region, and its long-standing relationship with Australia in many spheres, makes Malaysia an important bilateral partner.

5.64       The bilateral relationship is diverse, with active and cooperative relations across a broad range of sectors. These include trade and investment, defence, education, tourism, sports cooperation, science and technology, narcotic control, aviation and newly emerging areas such as electronic commerce and cooperation on rural firefighting capacities.

5.65       In 2000, Australian exports to Malaysia totalled $A2,363 million (major items being copper, milk and cream, non-monetary gold, aluminium, medicaments, wheat and sugar). In the same year Australian exports of services to Malaysia totalled $A866 million. In 2000, Australian imports from Malaysia totalled $A4,266 million (major items being computers, crude petroleum, telecommunications equipment, integrated circuits and furniture). In the same year, Australian imports of services from Malaysia totalled $A841 million. In 2000, Australia was Malaysia’s 12 th largest trading partner whilst Malaysia was Australia’s second largest trading partner in ASEAN and our 10 th largest trading partner overall.

5.66       In 1999-2000, Australian investment in Malaysia totalled $A389 million. In 2000, Australian investment in Malaysia in the manufacturing sector totalled $A70 million. Investments from Australia for the period 1999 to 30 June 2001 in the manufacturing sector were mainly concentrated in machinery manufacturing, fabricated metal products, chemicals and chemical products. There are 115 non-manufacturing Australian companies registered with AUSTRADE, Kuala Lumpur concentrated mainly in information technology, import or distribution, building and construction, engineering, education and management services.

5.67       In 2000, Malaysian investment in Australia totalled $A1,731 million. Malaysia is the second largest ASEAN investor, after Singapore, in Australia. There are 56 companies with Malaysian interest operating in Australia, concentrated mainly in food, tourism, hospitality, property investment and manufacturing.

Assessment of costs

5.68       The Second Protocol is not expected to result in increased administration costs for the ATO because the Second Protocol further clarifies the taxing rights of Australia and Malaysia under the existing DTA.

5.69       The Second Protocol is unlikely to result in increased compliance costs for business because no extra burden to comply is placed on them by it.

5.70       It is not possible to quantify with any degree of precision the tax likely to be forgone by the Australian Revenue in providing tax sparing credits for the Malaysian tax incentives. Much is dependent on the amount of the income subject to tax sparing, the amount of the Malaysian tax reduction or exemption applicable in respect of the particular income, the nature of the investment income, the legal structures used by Australians to make these investments, their need to remit or reinvest the income and their ability to utilise the tax spared foreign tax credits. The presently available information and statistics are of little help in this regard.

5.71       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. The revenue cost of extending the tax sparing provisions to 30 June 2003 is therefore likely to be insignificant.

5.72       A further complication relates to the fact that the tax sparing provisions of the Second Protocol relate only to tax sparing granted by Malaysia for years of income up to and including the Australian year ended 30 June 2003. The amount of likely revenue forgone will to some extent be subject to taxpayers making a claim for amendment of tax assessments issued several years ago. The taxpayers that are likely to do this cannot be determined with any great certainty.

5.73       Subject to the above qualifications, an annual cost to Australian revenue of around $A1-2 million is estimated, with the greatest cost likely to occur towards the end of the period covered by the tax sparing provisions (i.e. 30 June 2003).

5.74       It is relevant that the tax sparing measures in the proposed Second Protocol were found necessary during negotiations to secure its agreement to other measures in the Second Protocol. These include updating the existing DTA to reflect Australia’s current treaty practice in a number of areas and in particular to the carve-out of the Labuan preferential tax regime.

Assessment of benefits

5.75       The Second 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. Treaty benefits such as reduced withholding taxes are to be denied in relation to income or profits derived from such activities. These activities generally do not require a substantial presence in the other treaty partner country, are preferentially taxed in that country and the information concerning that income or profits is granted greater than usual confidentiality by that country. The exclusion from DTA benefits of persons who benefit from the Labuan offshore business activity will ensure that the DTA is not subject to abuse.

5.76       Clarification of which Malaysian tax laws qualify for tax sparing will reduce compliance costs for Australian investors seeking to take advantage of the tax sparing provisions.

Consultation

5.77       Information on the Second Protocol has been provided to the States and Territories through the Commonwealth-State Standing Committee on Treaties’ Schedule of Treaty Action.

5.78       The ATO’s Tax Treaties Advisory Committee of industry representatives and tax practitioners have been consulted.

5.79       The Second Protocol will also be considered by the Parliamentary Joint Standing Committee on Treaties which provides for public consultation in its hearings.

5.80       The Treasury and the ATO monitor DTAs, as part of the whole taxation system, on an ongoing basis. In addition, the ATO has consultative arrangements to obtain feedback from professional and small business associations and through other taxpayer consultation fora.

Conclusion

5.81       A Second Protocol between Australia and Malaysia is the only way to achieve bilateral agreement in relation to all the policy objectives.

5.82       The Second Protocol ensures that the ‘tax sparing’ provisions of the existing DTA reflect changes in the Malaysian tax incentives legislation, extends the operation of the tax sparing provisions to 30 June 2003, deletes existing tax sparing provisions relating to passive income,  includes an anti-avoidance rule to limit tax sparing concessions to active income, excludes from treaty benefits persons who benefit from the Labuan offshore business activity regime, and updates the DTA to reflect Australia’s current treaty practice in relation to a number of existing Articles, including those dealing with Associated Enterprises , Dividends , Royalties and Other Income .

5.83       The Second Protocol represents a satisfactory outcome for Australia, especially in relation to the exclusion of Malaysia’s tax haven of Labuan, which was one of our main objectives in the negotiations. Having regard to the benefits that will accrue to Australia from agreeing to the Second Protocol, there is a good case for accepting the proposed 30 June 2003 expiry date for tax sparing. 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, relates to activities that have already been undertaken. The revenue cost of extending the tax sparing provisions to 30 June 2003 is therefore not likely to be significant. Furthermore, since the proposed expiry date is not later than that specified in the Australia-Vietnam DTA (the last expiring tax sparing provisions in our current DTA network, due to expire on 30 June 2003), agreeing to the extension of tax sparing in this Second Protocol should not provide an undesirable precedent for other countries which may seek tax sparing from Australia.

 

 



 




[1] Source:  Department of Foreign Affairs and Trade, September 2001.

[2] See OECD, Taxing Profits in a Global Economy: Domestic and International Issues , Paris 1991. p.143.

[3] At p 144 .

[4] Source:  Department of Foreign Affairs and Trade.