October 22, 2018 2018-2101 Australian court rules deemed source provision in Indian DTA creates liability to income tax in Australia Executive summary On 11 October 2018, Australia's Full Federal Court handed down its decision in Satyam Computer Services Limited v Commissioner of Taxation (now an amalgamated entity named Tech Mahindra Limited). The decision, unless successfully challenged in the High Court, provides authority for the Commissioner to apply the deemed source provision in the Indian Double Tax Agreement (DTA), and potentially DTAs more broadly, to create a liability to income tax in Australia absent a domestic tax provision first giving rise to that liability. The decision impacts engineering, software and other companies making outbound payments to India who have an Indian company in the group providing "technical services" (broadly defined) to Australian customers, including Australian affiliate entities. The case involves a DTA with unique features and should not be seen as changing the general approach to the interpretation and application of tax treaties. Impacted cases are very fact specific and businesses need to review their facts to understand their position in light of the Full Federal Court decision. This is particularly so for the engineering sector which tends to exhibit features which may be distinguished from that in Tech Mahindra. Detailed discussion The decision – Interaction between domestic tax law and the Indian DTA The Full Federal Court unanimously held that payments received by the applicant, a resident of India, from its Australian clients that are royalties for the purposes of the Indian DTA (but not under Australian law) are taken to have an Australian source for the purposes of section 6-5 of the Income Tax Assessment Act 1997 (ITAA'97) by application of Article 23 of the Indian DTA and the International Agreements Act (ITAA'53). As a consequence, the payment were considered to be assessable income under Australian law. The Court read the text of Article 23(1) of the Indian DTA as not ambiguous. Its "effect" is given paramountcy by section 4(2) as recognized and affirmed by section 3AA(2) of ITAA'53. The Court further concluded there is nothing in the context, object or purpose of the Indian DTA or ITAA'53 which permits it to be read down to conform with a generalized assertion about the "effect" of tax treaties drawn from outside the text of the Indian DTA. In the Court's view, Article 23 effectively deems income, profits or gains derived by a resident of one country which, under the agreement, may be taxed in the other country, to be income from sources in the latter country for the purposes of the domestic laws of both countries and Article 24 of the Indian DTA. The facts and earlier decisions The applicant is a resident of India for tax purposes and carries on a business providing computer technology services to customers. In the income years ended 30 June 2009, 30 June 2010 and 30 June 2011, the applicant had offices in Sydney and Melbourne through which it provided software products and information technology services to entities in Australia. The services provided by the applicant to entities in Australia were performed partly by employees located in Australia and partly by employees located in India. In a related earlier decision, Tech Mahindra Limited v Federal Commissioner of Taxation (2015) 101 ATR 755; [2015] FCA 1082 (Tech Mahindra), the Court held that the payments received by the applicant for the services provided by the employees located in India (the Indian services) were "royalties" as defined in Article 12(3)(g) of the Indian DTA and Australia was given the right to tax those payments under Article 12(2) of the Indian DTA. That decision was upheld on appeal and an application for special leave to appeal was refused by the High Court. The Court also held that the payments were deemed to have an Australian source by virtue of Article 23 of the Indian DTA and section 4(2) of the ITAA'53 and were therefore taxable as Australian source income under section 6-5(3)(a) of the ITAA'97. That conclusion was not challenged on appeal or considered by the Full Court in Tech Mahindra Limited v Federal Commissioner of Taxation (2016) 250 FCR 287. In this further decision, the applicant challenges that conclusion. Applicant's arguments At issue is whether, where Article 23 applies to an item of income, the item of income is deemed to have an Australian source for the purposes of the law of Australia "relating to its tax." The applicant argued: - While Australia is allocated the right to tax the "royalties" by the Indian DTA, it can only exercise that right if it has the right to impose tax on those amounts under Australia's domestic law and Australia's domestic law does not give Australia that right.
- And while section 4(1) of ITAA'53 operates to incorporate the provisions of the Assessment Acts into that Act, the reverse is not true and the Assessment Acts retain their own identity and are not amended by the Agreements Act. The purpose of Article 23 is not to create a tax liability in circumstances where there is no liability under the domestic law of the Contracting State that has the right to tax.
- The principle is that tax treaties are, and can only be, exclusively relieving: that is, they are only ever "shields not swords" and they do not grant standalone taxing powers and an independent imposition of taxation.
- This involves "a substantial reconstruction of the statutory scheme that assesses and imposes taxation in Australia."
The Full Federal Court rejected all submission points including that treaties only ever are "shields not swords." The judges accepted there was "no standalone taxing power" and "independent imposition of taxation arguments" before adding, "none of these generalisations establish the proposition that Article 23 does not operate according to its terms." Implications The Australian Taxation Office (ATO) in a review will seek to assess fees paid by Australian customers to Indian companies for "technical services" as "income received by an Indian company for providing "technical services" to Australian customers as Australian sourced and subject to tax as ordinary income under Article 12(3)(g) of the India-Australia treaty." The following "technical services" may be considered to fall within the scope of Article 12: - Engineering services (including the subcategories of bioengineering, aeronautical, agricultural, ceramics, chemical, civil, electrical, mechanical, metallurgical and industrial engineering)
- Computer software development and IT services
- Architectural and other services consisting of the development and transfer of a technical plan or design
Any business with an Indian company in the group providing "technical services" to Australian customers, including Australian affiliated entities, must be aware that the ATO will scrutinize these payments and may wish to review and where appropriate restructure these arrangements. The ATO is selecting businesses for risk review/audit based on the International Dealings Schedule to the Income Tax Return where Australian companies use Indian subsidiaries as a shared services support function. The payments to the related party in that case should not necessarily involve the transfer ("making available" for the purposes of the DTA) of intellectual property (IP) (e.g., engineering companies getting drafting done in India) but the ATO may select businesses for audit based merely on the existence of the outbound payment. This case essentially impacts any Australian company using an Indian provider of "technical services" including related parties or third parties. The payment for such services is potentially a "royalty" as defined under the Indian DTA if it involves the required dealing with IP. While there is no withholding tax requirement, the recipient's income can be deemed to be sourced and taxable in Australia. Businesses should therefore review contracts to see if there's a gross up clause that enables Indian service providers to recharge tax back to Australia customers. ——————————————— CONTACTS For additional information with respect to this Alert, please contact the following: Ernst & Young (Australia), Sydney - Sean Monahan
sean.monahan@au.ey.com - Tony Cooper
tony.cooper@au.ey.com - Martin Caplice
martin.caplice@au.ey.com - Alf Capito
alf.capito@au.ey.com
Ernst & Young (Australia), Perth - Andrew Nelson
andrew.nelson@au.ey.com - Mathew Chamberlain
mathew.chamberlain@au.ey.com
Ernst & Young (Australia), Melbourne - Peter Janetzki
peter.janetzki@au.ey.com - Sue Williamson
sue.williamson@au.ey.com
Ernst & Young (Australia), Brisbane - Michael Hennessey
michael.hennessey@au.ey.com
Ernst & Young LLP, Australian Tax Desk, New York - David Burns
david.burns1@ey.com
——————————————— ATTACHMENT PDF version of Tax Alert 2018-2101
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