On 22.9.2016, the Full Federal Court has dismissed a taxpayer’s appeal, effectively upholding the judgment of Perry J at first instance (in Tech Mahindra Limited v FCT [2015] FCA 1082).

At first instance, Perry J, held that a company resident in India and registered in Australia, and which carried out IT services for Australian clients both from its permanent establishment (PE) in Australia and by employees located in India, was liable to tax in Australia in respect of part of the income derived from the services provided from India. It did so on the grounds that the payments made in Australia for certain services undertaken in India constituted “royalties” under the Australia-India Double Tax Agreement (DTA) and were deemed to be income derived from Australian sources under the DTA.

In its income tax return for the 2008 income year, the taxpayer included income generated from both the performance of the Indian services, as well as the Australian services to Australian customers. However, the taxpayer later formed the view that the net income derived from the performance of the Indian services was not liable to Australian taxation and accordingly lodged an objection to have this amount excluded from its taxable income (being approximately 1/3rd of its taxable income). The Commissioner disallowed the objection essentially on the grounds that the income derived from the Indian services was liable to Australian taxation under Art 7(1)(b) of the DTA because it was generated by “business activities of the same or a similar kind as those carried on through the taxpayer’s permanent establishment in Australia”. The taxpayer appealed.

Before the Federal Court, the taxpayer argued that even if the relevant amount constituted “royalties” as defined by Article 12 of the DTA, nevertheless Article 12(4) gave priority to Article 7 under which Australia did not have the right to tax the relevant amount as the income was not attributable to other business activities of “the same or a similar kind” as those carried on by the taxpayer through its PE in Australia. The Commissioner disagreed. The Federal Court found for the Commissioner.

The Full Federal Court was of the view that the primary judge was correct on the construction and application of Article 12(4). It said Article 12(4) was to be construed in the context that Article 7(7) gives priority to Article 12 over Article 7. Without Article 12(4), the Court said royalties forming part of the business profits of an enterprise attributable to a PE in the source State would be taxable by the source State but subject to a limit on the amount of tax that may be charged. “No evident object or purpose is indicated, and none was suggested by the [taxpayer], for construing Art 12(4) in a way that would disentitle the source State from the right at all to tax a payment otherwise within the scope of Art 12(2) but outside the scope of Art 7”.

The Court said the payments in question were held to be royalties because they were made as consideration for the services of the kind in Article 12(3)(g), namely: “The rendering of any services (including those of technical or other personnel) which make available technical knowledge, experience, skill, knowhow or processes or consist of the development and transfer of a technical plan or design”.

The Full Federal Court dismissed the taxpayer’s appeal.

(Tech Mahindra Limited v FCT [2016] FCAFC 130, Full Federal Court, Robertson, Davies and Wigney JJ, 22 September 2016.)

[LTN 184, 22/9/16]

FJM Note

This takes a little unravelling [using relevant portions of the Treaty, please, quoted in the extract from the judgement, below].

  • Article 7(1)(a) allowed Australia to tax the Indian company’s profits ‘attributable to’ its Australian ‘permanent establishment’ (and it was common ground that payments for their Australian based services would be taxed on this basis).
  • Article 7(7) gave precedence to more specific subsequent provisions (such as the ‘royalty’ provisions in Article 12).
  • The Taxpayer, therefore argued it could avoid Australian tax, altogether, if it could get itself into the more specific Article (viz: the Royalty Article) and then find a provision precluding that more specific article applying.
  • It was common ground that the Australian payments for the work done in India were ‘know-how’ based ‘royalties’ (Art 12(3)(g)), which got the Taxpayer to ‘first base’ (prima-facie, into the more specific ‘royalties’ Article).
  • The Taxpayer then sought to use Art 12(4) to escape the ‘royalties’ regime (and, it thought, escape Australian tax altogether).
  • Article 12(4) is activated when the royalties were ‘effectively connected’ with an Australian ‘permanent establishment’. The Taxpayer argued that it needed to supply both the Indian and Australian services to perform its contracts with its Australian customers and that the ‘know-how’ payments for Indian services were, in that sense, relevantly ‘effectively connected’ to the Australian ‘permanent establishment’ and therefore escaped Australian tax altogether.
  • The Court(s) disagreed.
  • They held that Art 12(4) worked with Art 7(7) to allocate income that could be taxed by Australia as both a ‘business profit’ and a ‘royalty’. Its effect was to act a ‘gateway’ back to Art 7(1) business profits Australian taxation.
  • The Court’s held that the relevant ‘connection’ with the ‘permanent establishment’ had to be enough to attract Art 7 ‘business profits’ tax in Australia (viz: it was a compendious reference to the factors that made profits ‘attributable to’ an Australian permanent establishment).
  • As it was common ground that the payments for the Indian services were not taxable as ‘business profits’, the Courts held that Art 12(4) was not relevantly engaged and that the payments for Indian services were taxable, in Australia, under the relevant domestic, and Treaty, ‘royalty’ provisions (at a capped amount of the gross payment).
  • [‘Simple’ – as they say in the ‘compare the market’ TV advertisement.]

Extract from Full Federal Court decision

INTRODUCTION

  1. This appeal concerns Article 7 (the business profits rule) and Article 12 (the royalties provision) of the Agreement between the Government of Australia and the Government of the Republic of India for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income, concluded 25 July 1991, [1991] ATS 49 (entered into force 30 December 1991) (“the Indian Treaty”).
  2. The Appellant is a resident of India, which carries on business in Australia through a permanent establishment. In the income year in issue, the Appellant performed services for its Australian customers both in Australia and in India.

The Appellant (Taxpayer) did not dispute that Article 7(1)(a) of the Indian Treaty [business profits derived through a permanent establishment in Australia] gave Australia the right to tax the income that the Appellant received in respect of the services performed in Australia, but in issue was whether Australia had any taxing rights in respect of the income from the services performed by the Appellant in India (“the Indian services”).

The respondent (Commissioner) contended that:

  • the payments in respect of the Indian services were “royalties” as defined in Art 12(3) [‘know-how’ payments] and taxable in Australia under Art 12(2) [at the capped percentage of gross] and,
  • in the alternative, that the net profits from the Indian services were liable to Australian tax under Article 7(1)(b) of the Indian Treaty[sales ‘of the same or similar kind’ to those from the permanent establish establishment].

The Appellant in turn contended that:

  • the payments were not “royalties” as defined in Art 12(3) but,
  • if royalties, Art 12(4) [royalties provisions not engaged if royalty consideration was ‘effectively connected with’ the permanent establishment] was engaged and gave priority to Art 7, so that whether Australia had the right to tax those payments depended on whether the criteria in Art 7(1) were met which, it was submitted, they were not [however, the Taxpayer overlooked Art 7(1)(b) taxing sales of ‘the same or similar kind’ as those carried out through the permanent establishment].

It was common ground that the profits referable to the Indian services were not attributable to the Appellant’s permanent establishment in Australia and that Australia did not have taxing rights in respect of those profits under Art 7(1)(a).

  1. The primary judge held that certain categories of payments referrable to the Indian services were “royalties” within the meaning of that term as defined in Art 12(3)(g) and

held also that Art 12(4) was not engaged, so that Australia had the right to tax those payments under Art 12(2) of the Indian Treaty.

The Appellant has appealed the decision of the primary judge that Art 12(4) was not engaged but not the finding that certain categories of payments referrable to the Indian services were “royalties” within the meaning of that term as defined in Art 12(3)(g).

For the reasons that follow we agree with the primary judge that Art 12(4) of the Indian Treaty was not engaged.

THE INDIAN TREATY

  1. The Indian Treaty is set out in Schedule 35 to the International Tax Agreements Act 1953 (Cth), and incorporated into Australian domestic law pursuant to s 11Z of that Act.
  2. Article 7 of the Indian Treaty relevantly provides:

Business Profits
(1) The profits of an enterprise of one of the Contracting States shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to:

(a)      that permanent establishment; or

(b)     sales within that other Contracting States of goods or merchandise of the same or a similar kind as those sold, or other business activities of the same or a similar kind as those carried on, through that permanent establishment.

…
(3) In the determination of the profits of a permanent establishment, there shall be allowed as deductions…expenses of the enterprise…
…
(7) Where profits include items of income, which are dealt with separately in other Articles of this Agreement, then the provisions of those Articles shall not be affected by the provisions of this Article.

  1. Article 12 relevantly provides:

Royalties
(1) Royalties arising in one of the Contracting States, being royalties to which a resident of the other Contracting State is beneficially entitled, may be taxed in that other State.
(2) Such royalties may also be taxed in the Contracting State in which they arise, and according to the law of that State, but the tax so charged shall not exceed:

…

(b)     in the case of other royalties:

(i)      during the first five years of income for which this agreement has effect:

…

  1. in all other cases: 20% of the gross amount of the royalties; and

(ii)     during all subsequent years of income: 15% of the gross amount of royalties.

(3)     The term “royalties” in this Article means payments or credits, whether periodical or not, and however described or computed, to the extent to which they are made as consideration for:

…

(g)      the rendering of any services (including those of technical or other personnel) which make available technical knowledge, experience, skill, know-how or processes or consist of the development and transfer of a technical plan or design…

…

(4) The provisions of paragraphs (1) and (2) shall not apply if the person beneficially entitled to the royalties, being a resident of one of the Contracting States, carries on business in the other Contracting State, in which the royalties arise, through a permanent establishment situated therein, or performs in that other State independent of personal services from a fixed base situated therein, and the property, right or services in respect of which the royalties are paid or credited are effectively connected with such permanent establishment or fixed base. In such a case, the provisions of Article 7 … shall apply.
…
(emphasis added)

  1. Whether Art 12(4) applied thus depends upon whether the Indian services in respect of which the royalties were paid to the Appellant were “effectively connected with” its permanent establishment in Australia.

DECISION BELOW

  1. Before the primary judge, the Appellant argued that Article 12(4) was engaged because the Indian services in respect of which the royalties were paid were “effectively connected” to its permanent establishment.

First it was said that the Appellant’s contractual arrangements with the Australian customers defined both the scope of the services to be provided to the customers, and the Appellant’s entitlement to be paid for those services, and the contractual rights which gave rise to the payments thus served to effect the purpose of the permanent establishment in that they provided the essential foundation for the business activities carried on by the Appellant in Australia through the permanent establishment.

Secondly, it was submitted that the Indian services were performed in concert with the services performed through the permanent establishment, such that it was only the Indian services in combination with the Australian services that together satisfied the contractual obligations to the Australian customers. The close relationship was said to have the consequence that the Indian services were effectively connected with the permanent establishment.

  1. The Commissioner argued that Art 12(4) is co-extensive with Art 7(1)(a) and that the relevant “property, right or services in respect of which the royalties are paid” are “effectively connected with [the permanent establishment]” where the profits from such services are “attributable to [the] permanent establishment”.

[He] argued that Article 12(4) gave priority to Article 7 where the criteria in Article 7(1)(a) were met so as to give Australia the right to tax the royalties as part of the profits of the permanent establishment, instead of at the capped rate under Art 12.

  1. The primary judge accepted the Commissioner’s construction.

First her Honour reasoned that the purpose of Art 12(4) was “manifestly” to entitle the source State where the royalties arise to impose tax on those “royalties” at the potentially more generous rates permitted under Art 7(1), rather than the capped rate under Art 12(2), where there is an effective connection between the payments and the permanent establishment in the source State through which the non-resident carries on business.

Secondly her Honour accepted that the words “effectively connected” with the permanent establishment are intended to encapsulate in a shorthand way the different tests of connection under Art 7(1)(a) (and Article 14) which were regarded as sufficient justification for permitting a Contracting State to tax profits of an entity notwithstanding that it is not a resident of that State.

Thirdly, her Honour considered that the Appellant’s construction left the concept of “effectively connected” undefined.

Fourthly, her Honour considered that the Commissioner’s construction was consistent with the decision in McDermott Industries (Aust) Pty Ltd v Commissioner of Taxation (2005) 142 FCR 134; [2005] FCAFC 67 which considered Art 10 of the double taxation agreement between Australia and Singapore (equivalent to Art 12 of the Indian Treaty).

  1. The primary judge also held that if however the Appellant’s construction was the correct construction, then the profits from the Indian services in the relevant year were not liable to tax by Australia under Art 7.

…

CONSIDERATION

…

  1. The essential competing difference in construction between the parties is whether Art 12(4) is simply a gateway to Art 7 so that whether the source State will have taxing rights under Art 7 will depend on whether the royalties “assimilated” to business profits are, relevantly, attributable to the permanent establishment in the source State through which enterprise carries on business. On the construction argued by the Appellant, a royalty may fall outside of the scope of the source State’s right to tax by virtue of Art 12(4), if Art 7 does not give taxing rights to the source State in respect of that royalty. The context and evident purpose of Art 12(4) does not give support for that construction [and does support the Commissioner’s contention].

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Category: Tax Month - September 2016

Author: John Morgan

John Morgan is a tax specialist lawyer of more than three decades experience now practicing at the Victorian Bar - w: www.FJMtax.com e: f.john.morgan@vicbar.com.au