Private ruling: Assessability of Overriding Royalty Payments received by a non-resident entity
Published: April 2015
Date scheme commenced: Company M is a limited liability company established in Country F which has a double tax agreement with Australia.

Ruling: Q1: Is Company M subject to Australian income tax under the provisions of the Income Tax Assessment Act 1936 (ITAA 1936), the Income Tax Assessment Act 1997 (ITAA 1997) and the International Tax Agreements Act 1953 on any amounts payable and ultimately received by the beneficiaries who reside in Country F? | A1: No

Relevant facts and circumstances: Company M is a limited liability company established in Country F which has a double tax agreement with Australia. Company M is treated as a partnership in Country F for tax purposes, and not a company. Company M was assigned the rights to receive an overriding royalty payment from certain mining operations in Australia. The majority of the membership interests of Company M are held by residents of Country F. Membership interests in the Company M carry identical and proportional rights to the income of Company M. The payers of the overriding royalties are Australian tax residents. The private overriding royalty payments made to Company M are calculated by reference to the value and quantity of natural resources extracted in Australia and sold. Company M does not currently hold nor ever held any interest in the properties which are subject to the overriding royalties. Company M does not control nor otherwise influence the quantity of production in respect of any of the relevant properties. The contracts under which the overriding royalties arise do not oblige the relevant Australian miners to pay anything unless the companies produce minerals, nor do the contracts oblige the miners to use their best or even reasonable endeavours to achieve such production. Company M does not have and did not have a presence in Australia during the relevant periods. There is no fixed place of business through which the business of Company M is or was carried on in Australia through an agent or otherwise. The central management and control of Company M is not in Australia. In accordance with subparagraph 6CA(1)(d)(iv) of the Income Tax Assessment Act 1936 (ITAA 1936), no statement was received from the Commissioner prior to 8 April 1986 to the effect that income tax would be levied on 50% of the overriding royalty income.

Relevant legislative provisions: Income Tax Assessment Act 1936 Subsection 6(1) (definition of royalty) | Income Tax Assessment Act 1936 Section 6CA | Income Tax Assessment Act 1936 Section 128B | Income Tax Assessment Act 1936 Section 128D | Income Tax Assessment Act 1997 Section 6-5 | Income Tax Assessment Act 1997 Section 6-10 | International Tax Agreements Act 1953 Section 4 | International Tax Agreements Act 1953 Subsection 4(2) | International Tax Agreements Act 1953 S ection 5 | Taxation Administration Act 1953 (TAA) Section 12-325 of Schedule 1 | Taxation Administration Act 1953 (TAA) Section 15-15 of the TAA

Reasons for decision: Detailed Reasoning - Ordinary Income: Subsection 6-5(3) of the ITAA 1997 provides that the assessable income of a non-resident taxpayer includes ordinary income derived directly or indirectly from all Australian sources during the income year. Company M is a company with no Australian presence and therefore is not a resident of Australia for Australian Income tax purposes. The overriding royalty payments received by Company M constitutes ordinary income in accordance with the decision handed down in Ivanac v DFC of T 95 ATC 4683 (Ivanac), where the court held that the royalty payment received by Ivanac, in relation to ore from the tenements mined, represented ordinary income when derived. | Detailed Reasoning - Taxing rights: In determining liability to Australian tax on income received by a non-resident, it is necessary to consider not only Australian income tax laws, but also relevant tax treaties as governed by the International Tax Agreements Act 1953 (Agreements Act). Each tax treaty is given the force of law domestically under section 5 of the Agreements Act. Section 4 of the Agreements Act incorporates the Assessment Act being the ITAA 1936 and ITAA 1997 such that the Assessment Act is read as one with the Agreements Act. Australia and the Country F are parties to a tax treaty (DTA). | Detailed Reasoning - Application of the DTA: The personal scope article of the DTA states that the DTA applies to persons who are residents of in either or both contracting states. The overriding royalty payments are made by Australian residents. Pursuant to the personal scope article, Company M must be a resident of the Country F, Australia or both for the purposes of the DTA for the DTA to apply to Company M. Company M is treated as a partnership in Country F for tax purposes, and not as a company. The General Definition Article provides that a partnership can be treated as a resident to the extent that the income is subject to tax in the country of residence as the income of a resident either in the hands of the partnership, or in the hands of a partner, or if the income is exempt from tax in the country of residency, it is so exempt solely because it is subject to tax in the other country. Any income subject to tax in Country F in the hands of resident partners of the partnership residing in Country F will be treated as income derived from a Country F resident and therefore the partnership will be a Company F resident to this extent in accordance with the Residency Article of the DTA. The Limitation on Benefits Article of the DTA provides Company M, as a Country F resident, shall be entitled to the benefits of the DTA provided it is a 'qualified person' as defined in that Article. Company M is a 'qualified person' for the purposes of the Limitation on Benefits Article and is entitled to the benefits of the DTA. | Detailed Reasoning - Business Profits Article: As Company M has no fixed place of business in Australia, Company M does not have a permanent establishment in Australia. Accordingly, it is necessary in determining whether the Business Profits Article of the DTA applies to establish if Company M is an enterprise of Country F and if so whether the royalty payments are business profits of that enterprise for the purposes of the Business Profits Article of the DTA. If these conditions are met, the overriding royalty payments will be taxable only in Country F. Paragraph 4 of the Commentary on Article 3 of the OECD Model in referring to the definition of 'enterprise' states: No exhaustive definition of the term 'enterprise' has therefore been attempted in this Article. However, it is provided that the term "enterprise" applies to the carrying on of any business. The case of Thiel v Federal Commissioner of Taxation (1990) 64 ALJR 516; (1990) 94 ALR 647; (1990) 90 ATC 4717; (1990) 21 ATR 531; (1990) 171 CLR 338 (Thiel) sets out the common law meaning of 'enterprise' within the context of the Swiss tax treaty. In Thiel, the judgment of Mason CJ, Brennan and Gaudron JJ of the High Court of Australia stated at 649 - 650 : The meaning of ``enterprise'' can then be ascertained from the Agreement construed in the light of such extrinsic materials as may be relevant…. … However, for the reasons given by McHugh J., it is appropriate to consider the OECD Model Convention and the associated commentaries. Importantly, the commentary on Art. 3 states: "The question whether an activity is performed within the framework of an enterprise or is deemed to constitute in itself an enterprise has always been interpreted according to the provisions of the domestic laws of the Contracting States.'' This statement plainly recognises that an activity, as well as a framework within which activities are engaged in, may constitute an ``enterprise'' for the purposes of the Agreement. Moreover, we agree with Sheppard J. in thinking that an enterprise ``may consist of an activity or activities and be comprised of one or more transactions provided they were entered into for business or commercial purposes'': (1988) 21 F.C.R. 122 at p. 146. Article 7, especially the heading ``Business Profits'', supports the notion that one or more transactions entered into for business or commercial purposes is an enterprise for the purposes of the Agreement. Dawson J stated at 654 -655: …the term ``enterprise'' may cover an entity or framework through which an activity is carried on, for which those concepts are appropriate, as well as an activity itself. The need to acknowledge isolated profit-making activities as well as continuing commercial conduct, both of which can be subsumed under the term ``enterprise'', is recognised by sec. 3(2) of the Income Tax (International Agreements) Act which provides: ``For the purposes of this Act and the Assessment Act, a reference in an agreement to profits of an activity or business shall, in relation to Australian tax, be read, where the context so permits, as a reference to taxable income derived from that activity or business.'' Article 7 is headed ``Business Profits'' and, as that heading indicates, it deals with business profits. But once it is recognised that ``enterprise'' includes an isolated activity as well as a business, business profits cannot be confined to profits (or taxable income) derived from the carrying on of a business but must embrace any profit of a business nature or commercial character. Profit from a single transaction may amount to a business profit rather than something in the nature of a capital gain even if it does not involve the carrying on of a business. Of course, the repetition of a transaction may constitute the carrying on of a business and so confirm its business character, but a single transaction may amount to a business dealing so as to characterise the profit derived from it as a business profit. If it were not so, Art. 7(1) would have the capricious result of denying relief from double taxation simply because the same transaction was not repeated a sufficient number of times. McHugh J stated at 661 662: It follows from the foregoing discussion that the Art. 3(1)(f) definition of ``enterprise of one of the Contracting States'' covers an isolated activity as well as a framework for making and carrying out decisions in relation to projects and activities. The definition in Art. 3(1)(f) applies, however, only when the context does not otherwise require. … … I do not think that the context requires the rejection of the application of the Art. 3(1)(f) definition to the phrase ``enterprise of one of the Contracting States'' in the first line of Art. 7(1). If the definition in Art. 3(1)(f) is applied to the first limb of Art. 7(1), Art. 7(1) exempts the profits of an isolated activity as well as the profits of a framework for making and carrying out decisions in relation to activities and projects from taxation in Australia unless the enterprise carries on business in Australia through a permanent establishment based in this country. To interpret the words ``the enterprise'' in the ``unless'' clause and the succeeding sentence of Art. 7(1) as meaning a framework for making and carrying out decisions in relation to activities and projects and not an activity does not, however, contradict the Art. 3(1)(f) meaning of the term ``an enterprise'' in the first limb of Art. 7(1). It simply means that the definition does not apply to the term ``the enterprise'' in Art. 7(1) because, in its context, that term refers only to ``an enterprise'' which has derived its profits by using a framework for making and carrying out decisions in relation to activities or projects. Accordingly, profits derived from an isolated activity may constitute the profits of ``an enterprise'' within the meaning of Art. 7. Indeed, it would be surprising if this was not the case. It is difficult to see any revenue or commercial reason for distinguishing between a Swiss resident who earns profits by constructing a number of buildings while he is in Australia for a few months and a Swiss resident who earns profits by constructing a single building while he is in Australia for a few months. To come within Art. 7, however, it is not enough that the carrying on of an enterprise has produced ``profits''. The heading to Art. 7 must be taken into consideration in determining the meaning of that term. Although it is not necessary that the profits referred to in that Article be those of a business, the heading ``Business Profits'' indicates that, to come within Art. 7, the profits of the enterprise must be profits from an adventure in the nature of trade: cf. Minister of National Revenue v. Tara Exploration and Development Co. Ltd. (1972) 28 D.L.R. 135 In summary, the High Court of Australia held that an enterprise can be an activity or the framework through which the activity is carried on and that the profits on an isolated transaction satisfied the definition of 'profits of an enterprise' in Article 7 of the Swiss tax treaty. The term 'profits of an enterprise' in this context was not limited to profits derived from the carrying on of any business but also includes any profit of a business nature or commercial character, or profit from an adventure in the nature of trade. The judges did not contemplate any distinction between passive income or active income. Taxation Ruling TR 2004/15: Income tax: residence of companies not incorporated in Australia - carrying on business in Australia and central management and control states at paragraph 27: Where a company does not carry on major operational activities and the essence of its business is the investment of assets, it carries on business where those high level investment decisions are made Paragraph 43 of TR 2004/15 also states: This means that a company may be carrying on business for the purposes of the second statutory test of residence even if its main activity is the management of its investment assets. Examples of the types of returns a company may receive from the management of its investment assets include rent, dividends, interest and royalties. As a result of entry into the contractual arrangements, Company M was assigned the rights to receive payments under a number of Royalty Deeds from parties in Australia and elsewhere. Company M's activities include managing the rights under the Deeds (and enforcing them, if necessary). The Commissioner considers that Company M is an enterprise or carries on activities as an enterprise for the purposes of the Business Profits Article of the DTA. With regard to paragraph 18 of Taxation Ruling 1997/11: Income tax: am I carrying on a business of primary production? And in particular the indicia of the commercial size and scale of the activities, their repetition and regularity, the Commissioner accepts that the overriding royalties received by Company M constitute business profits of an enterprise of a Country F resident for the purposes of the Business Profits Article of the DTA. Should no other Article of the DTA deal with the royalties as set out in the Business Profits Article of the DTA, the royalty amounts are and will be taxable only in the Country F pursuant to the Business Profits Article. The relevant Articles considered in turn below are: • Income from real property Article; • Dividends Article; • Interest Article; • Royalties Article; • Alienation of income Article; • Limitation on benefits Article; • Other Income Article; and • Miscellaneous Article. | Detailed Reasoning - Income from Real Property: The overriding royalties income might be considered to constitute income from real property for the purposes of the Income from real property Article, as the income arises from rights to exploit natural resources. However, it is considered that the income is 'from' the contractual rights' in the Royalty Deeds, rather than income 'from' this real property being the underlying right to exploit natural resources. This reflects the decision of the full Federal Court of Australia in SP Investments Pty Limited (as Trustee of the LM Brennan Trust) v FC of T 93 ATC 4170; (1993) 25 ATR 165. In that case, SP Investments Pty Ltd, Perron Investments Pty Ltd and LSP Pty Ltd (LSP) were companies in the Perron Group of companies which were controlled by Mr Perron. In April 1979, LSP became the trustee of the LM Brennan Trust, a discretionary family trust established for the benefit of Mr Perron's family. In its role as trustee, LSP became entitled to a 15% interest in royalties of an amount equal to 2½% of the sale proceeds of iron ore from a venture at Hamersley in Western Australia (the 15% being in an agreement pursuant to which Hamersley Iron Pty Ltd agreed to pay the royalties). Pursuant to deeds dated 25 October 1979 and 30 June 1980, LSP assigned its interest in the royalties to National Mutual Association of Australasia Ltd for a period in excess of seven years in exchange for a lump sum payment. In determining whether the amounts were assessable to the trustee of the LM Brennan Trust, Hill J (with whom O'Loughlin and Burchett JJ agreed) of the Federal Court of Australia stated at 4182 that, to the extent the income may be considered as deriving from property, the relevant property from which the royalty income was assigned was the chose in action under the Royalty Deed rather than the underlying right to exploit natural resources. The income received by Company M is from the contractual rights rather than from the underlying rights to exploit natural resources. As the relevant income is not income from real property for the purposes of the Income from Real Property Article in the DTA, this article does not apply. | Detailed Reasoning - Dividends, Interest, Royalties and Alienation of income Articles.: The payments received by Company M are not dealt with by the Dividends, Interest, Royalties and Alienation of income Articles of the DTA as: • The payments are not connected with shares. As a result, the payments are not income from shares nor income that is subject to the same treatment as income from shares. Therefore the payments do not constitute dividends for the purposes of the Dividends Article in the DTA. • The payments do not constitute interest from government securities or from bonds or debentures, interest from any other form of indebtedness, or income which is subject to the same tax treatment as income from money loaned under Australian law. Therefore the payments do not constitute interest for the purposes of the Interest Article in the DTA. • Although the payments are referred to as 'royalties', the payments are not royalties for the purposes of the Royalties Article, as the payments are not: • In consideration for the use of items mentioned in in this Article which is concerned with intellectual property, films and image and sound reproduction and transmission items or methods, • In consideration for the provision of scientific, technical, industrial or commercial knowledge, or • Income from sale, exchange or other disposition of any property or right referred to above. • As the payments are not from real property, as discussed above, there is no need to consider if the payments are from the alienation or disposition of real property. | Detailed Reasoning - Other income Article: As set out above, the payments received by Company M constitute business profits of Company M's enterprise and are dealt with under the Business Profits Article of the DTA. Therefore, the Other Income Article has no application to the facts of this case. | Detailed Reasoning - Conclusion: The royalties received by Company M constitute business profits of an enterprise of a Country F resident for the purposes of the Business Profits Article of the DTA. As none of the other Articles of the DTA deal with the overriding royalties, the overriding royalties are and will be taxable only in the Country F pursuant to the Business Profits Article of the DTA.