Deemed Source of Income: Expanding Australia’s Domestic Tax Base

The acceleration of the globalisation of Australia’s economy and increasing use of digital technology in business and trade has put pressure on governments to efficiently and effectively tackle tax avoidance.

However, in the international environment, there are differing systems and concepts of law and tax operating across the globe. Those differences can cause uncertainty and have unintended consequences meaning that a taxpayer is subject to tax in more than one country, or conversely, lead to double non-taxation.

In order to address these issues and allocate taxing rights, many countries enter into double taxation agreements (DTAs). Under a DTA, two countries (contracting states) agree to allocate taxing rights based on either the source of income or the residency of the taxpayer. Significantly, a DTA can vary the operation of the common law, which in non-DTA cases plays a significant role in determining tax liabilities that are based on the source of income and the residency of a taxpayer.

Examples of taxing points which are typically regulated by DTAs include the provision of services within a particular country, the payment of interest or royalties out of a country, the period of presence in a country that determines tax residency, and the extent of a business presence that will constitute a permanent establishment and allow the host country to tax that part of a business.

Australia’s deemed source rule

One provision which is found in many of Australia’s DTAs, and which is intended to address the potential for double non-taxation, is Australia’s deemed source rule.

Australia’s deemed source rule provides that income, profits or gains derived by a resident of a contracting state which may be taxed in the other contracting state shall for the purposes of the tax law of that other contracting state be deemed to arise from sources in that other contracting state. The deemed source rule is an ‘Australian specialty’ as there is no equivalent provision in the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention on Income and on Capital.

Historically, it was Australia’s practice to negotiate the inclusion of a source of income rule in its tax treaties. Australia considers the rule necessary for a couple of reasons.

Firstly, there is no absolute rule to determine the source of income in Australian tax law. Under the common law approach to determining the source of income, it is difficult to determine with certainty that Australia will be able to tax the various types of income derived by non-residents. Therefore, the purpose of the source of income provision is to provide source taxing rules to compensate for potential deficiencies in the domestic source rules, which might otherwise prevent Australia from effectively exercising taxing rights negotiated in its favour in the DTA. Following the High Court’s decision in Commissioner of Taxation (Cth) v Mitchum (1965), Australia was concerned that, even where there is an applicable DTA in place that grants taxing rights, payments may not have an Australian source according to the domestic source rules. Thus, the source of income provision ensures that Australia can exercise the taxing rights allocated to it by the DTA, even where domestic law rules may otherwise call for a different outcome.

Secondly, in light of the text of the source of income article and the history of how source of income has been determined in Australia, the purpose of the deemed source rule is clear: to perfect the taxing rights to which the DTA refers by ensuring that, for the purposes of Australian tax law, such income has a source in Australia. Thereby, it avoids the potential for double non-taxation and ensures that treaty relief to prevent double taxation is appropriately available. In effect, the Commissioner may collect tax in a DTA case when, in the absence of the DTA, there would be no tax. Therefore, the source of income article in an Australian DTA may operate with a ‘sword-like’ effect in practice.

A shield or a sword?

The decision of Satyam Computer Services Ltd v Federal Commissioner of Taxation (2018) put to rest a long and widely debated interpretation issue in Australia: do Australia’s DTAs operate as a shield or a sword?

The case of Satyam is an example of the unique operation of the source of income article in Australia’s DTA, and shows that it can be more than a shield. By virtue of the source of income article, the position in Australia is that a DTA can create tax outcomes over and above what would result under the domestic law, thus operating as a sword. In effect, the domestic tax base can be expanded by a DTA provision. Absent the deemed source provision in the Australia-India DTA, it is very likely that Satyam would not otherwise be liable to tax in Australia. The history of the shield or sword debate and the implications of the Satyam case are explored further in my paper ‘Double Taxation Agreements: Shields or Swords?’ (2020).

Therefore, the deemed source rule that Australia has employed in its treaty practice reflects the tax sharing that has been agreed by Australia and its treaty partner. To this extent, it is totally consistent with that DTA and no question of treaty override arises. Its purpose is to give effect to the DTA as it operates within Australia’s system of law and according to the terms of the DTA itself.

Post Satyam

Australia’s most recent DTA entered with Israel does not contain a source of income provision. The Australian Government has made amendments to Australia’s domestic tax law to ‘provide that certain income covered by a tax treaty is deemed to have an Australian source’. The Treasury Laws Amendment (International Tax Agreements) Bill 2019 received Royal Assent on 28 November 2019 and brought into effect the new section 764-10 of the Income Tax Assessment Act 1997, which provides that income, profits or gains derived by a person are taken to be derived from an Australian source if the person is a resident of a foreign country for the purposes of an international tax agreement and the effect of the agreement is that the income, profits or gains may be taxed in Australia. The provision applies prospectively in relation to Australian DTAs entered into on or after 28 March 2019. This approach will mean that Australia will no longer need to secure agreement to include its specific source rule when negotiating a tax treaty. The introduction of Division 764 appears to be part of a broader project by Treasury to tidy up and rewrite Australia’s source rules into the Income Tax Assessment Act 1997.

Some disagree with the policy underlying the source of income provision and argue that it is not a sensible policy to insist on placing the deemed source rules in the DTA and then limit its operation by domestic law. Whether one agrees or disagrees with the policy, the operation of Australia’s source of income rule is clear following the Satyam case. The effect is that tax may be collected in a case where in the absence of the DTA there would be no tax. The new section 764-10 removes any doubt (on a prospective basis) that Australia’s treaty specific source rules can trigger a tax liability for a foreign resident that would not otherwise exist.

 

Further reading: Tranzillo, Joseph, “Double Taxation Agreements: Shields or Swords?” (2020) 49 AT Rev 186.