Private ruling: Royalty interest income
Published: May 2013
Ruling period: Year ending 30 June 2013 | Year ending 30 June 2014 | Year ending 30 June 2015 | Year ending 30 June 2016 | Year ending 30 June 2017 | Year ending 30 June 2018
Date scheme commenced: 1 July 2012

Ruling: Q1: For the purposes of subsection 6-5(3) of the Income Tax Assessment Act 1997 (ITAA 1997), will the royalty interest income payable to the Company be ordinary income with an Australian source or ordinary income that a provision includes in assessable income on some basis other than having an Australian source? | A1: Yes. | Q2: For the purposes of subsection 6-10(5) of the ITAA 1997, will the royalty interest income payable to the Company be statutory income with an Australian source or statutory income that a provision includes in assessable income on some basis other than having an Australian source? | A2: No. | Q3: Pursuant to section 4-1 of the ITAA 1997, is income tax payable by the Company on the royalty interest income? | A3: No.

Relevant facts and circumstances: 1. The taxpayer is a company that is a tax resident of the US for US Federal income tax purposes. 2. At least 50% of the company's ordinary shares are held, directly or indirectly, by US citizens. 3. The taxpayer was formerly the registered holder of the permits. 4. The Company assigned its 100% interest in the permits to an unrelated company (Permit Holder) that is an Australian resident for income tax purposes. 5. In consideration for the assignment the taxpayer received a royalty interest in the resources. 6. The royalty interest income is calculated with reference to the value of all resources produced and recovered from the permit areas. 7. In Australia, the Company does not have: · a place of management · a branch · an office · a factory · a workshop · a mine, an oil or gas well, a quarry or any other place of extraction of natural resources · an agricultural, pastoral or forestry property · a building site or construction, assembly or installation project which exists for more than 9 months, or · an installation, drilling rig or ship that, for an aggregate period of at least 6 months in any 24 month period, is used by the Company in Australia for dredging or for or in connection with the exploration or exploitation of natural resources of the sea-bed and subsoil. 8. The Company does not carry on business in Australia through a person who has authority to conclude contracts on behalf of the Company and who habitually exercises that authority in Australia. In addition, the Company has not appointed any agent of independent status. 9. The Company does not maintain substantial equipment for rental or other purposes within Australia (excluding equipment let under a hire-purchase agreement) for a period of more than 12 months. 10. The Company is not engaged in supervisory activities in Australia for more than 9 months in any 24 month period in connection with a building site or construction, assembly or installation project in Australia. 11. The Company does not have goods or merchandise belonging to it that: · were purchase by it in Australia, and not subjected to prior substantial processing outside Australia, or · were produced by it or on its behalf in Australia, and are, after such purchase or production, subjected to substantial processing in Australia by an enterprise where either enterprise participates directly or indirectly in the management, control or capital of the other enterprise, or where the same persons participate directly or indirectly in the management, control or capital of both enterprises.

Relevant legislative provisions: Income Tax Assessment Act 1936 section 6CA. | Income Tax Assessment Act 1997 section 4-1 | Income Tax Assessment Act 1997 section 6-5. | Income Tax Assessment Act 1997 section 6-10. | Income Tax Assessment Act 1997 subsection 995-1(1).

Reasons for decision: Detailed Reasoning - Detailed reasoning: For the purposes of subsection 6-10(5) of the ITAA 1997, will the royalty interest income payable to the Company be statutory income with an Australian source or statutory income that a provision includes in assessable income on some basis other than having an Australian source? The Company is a non-resident of Australia for Australian income tax purposes. The royalty interest is considered to be ordinary income (see Ivanac v. Commissioner of Taxation (1995) 60 FCR 417; (1995) 32 ATR 288; 95 ATC 4683). It is therefore necessary to determine whether the royalty interest income is derived from an Australian source. As the royalty interest income is connected with a natural resource (being a 'natural resource' as defined in subsection 995-1(1) of the ITAA 1997), consideration must be given to the application of subsection 6CA(1) of the Income Tax Assessment Act 1936 (ITAA 1936). 'Natural resource income' is defined in subsection 6CA(1) of the ITAA 1936 to mean income that is: (a) derived by a non-resident, and (b) is calculated, in whole or in part, by reference to the value or quantity of natural resources produced, recovered or produced and recovered, in Australia after 7 April 1986 but does not include: (c) income that consists of a royalty, or (d) income where: (i) on 7 April 1986, the non-resident had a continuing entitlement to receive the income (ii) the income was derived by the non-resident pursuant to that continuing entitlement (iii) the non-resident was, at 5 o'clock in the afternoon, by standard time in the Australian Capital Territory on 7 April 1986, a resident, within the meaning of a double tax agreement, of a foreign country in respect of which the double tax agreement was in force (iv) before 8 April 1986, the Commissioner had given a statement in writing to the effect that income tax would be levied on 50% of income included in a specified class of income, and (v) the income is included in that class of income. Paragraph (a) of the definition of 'natural resource income' in subsection 6CA(1) of the ITAA 1936 is satisfied as the Company is a non-resident. The royalty interest income that will be payable to the Company is calculated by reference to the value of all resources produced and recovered from the exploration permit title areas. Accordingly, the royalty interest income satisfies paragraph 6CA(1)(b) of the definition of 'natural resource income' in subsection 6CA(1) of the ITAA 1936. The negative limbs contained in paragraphs (c) and (d) of the definition of 'natural resource income' in subsection 6CA(1) of the ITAA 1936 also require consideration. Paragraph (c) of the definition of 'natural resource income' in subsection 6CA(1) of the ITAA 1936 excludes income that consists of a royalty. 'Royalty' or 'royalties' are defined in subsection 6(1) of the ITAA 1936. The definition provides a list of items that are specifically included in the definition of 'royalty' or 'royalties'. The royalty interest income does not fall within the specifically listed items in the definition of 'royalty' or 'royalties' in subsection 6(1) of the ITAA 1936. Consequently, although the royalty interest income does not fall within any of the specifically listed items in the definition of 'royalty' or 'royalties' in subsection 6(1) of the ITAA 1936, consideration needs to be given as to whether the royalty interest income falls within the common law meaning of royalties. The case of McCauley v. Federal Commissioner of Taxation (1944) 69 CLR 235; (1944) 7 ATD 427; [1944] ALR 306 considered the term 'royalty' in the context of natural resources. Latham CJ stated that: In my opinion the word "royalty" is properly used for the purpose of describing payments made by a person for the right to enter upon land for the purpose of cutting timber of which he becomes the owner, where those payments are made in relation to the quantity of timber cut or removed. Thus I am of opinion that the moneys received by McCauley were royalties and accordingly were part of his assessable income. The Commissioner's views on the definition of 'royalty' and 'royalties' are contained in Taxation Ruling IT 2660. Paragraph 10 of IT 2660 identifies a common law royalty, or a royalty within the ordinary meaning of the term as having the following characteristics: · whether the payment is in return for the right to exercise a beneficial privilege (e.g. to remove minerals or natural resources) · whether the payment is made to the person who owns the right to confer that beneficial right or privilege · whether the consideration payable is determined on the basis of the amount of use made of the right acquired, and · whether the consideration is paid as and when the right acquired is exercised. The Company disposed of its right, title and interest in the exploration permit to the Permit Holder through the Heads of Agreement. When considering the key characteristics as outlined in paragraph 10 of IT 2660, it is apparent that payments made by the Permit Holder are not in return for the right to exercise a beneficial privilege or right. The facts provided also demonstrate that the Company no longer holds the right and so a payment made by the Permit Holder is not to 'a person who owns the right'. Therefore, the income received by the Company is not considered to be a 'royalty' or 'royalties' under common law. Given that the royalty interest income is not a 'royalty' or 'royalties' as defined, paragraph (c) of the definition of 'natural resource income' in subsection 6CA(1) of the ITAA 1936 is not satisfied. Paragraph (d) of the definition of 'natural resource income' in subsection 6CA(1) of the ITAA 1936 is not relevant as the Company had no continuing entitlement to receive income on 7 April 1986. Accordingly, the royalty interest income satisfies the definition of 'natural resource income' in subsection 6CA(1) of the ITAA 1936. Subsection 6CA(3) of the ITAA 1936 states that for the purposes of section 6-5 of the ITAA 1997, natural resource income shall be deemed to have been derived from a source in Australia. The royalty interest income is ordinary income derived by a non-resident. The royalty interest income is deemed to have an Australian source by virtue of subsection 6CA(3) of the ITAA 1936. The royalty interest income is therefore assessable income under section 6-5(3) of the ITAA 1997. | Detailed Reasoning - Question 2: For the purposes of subsection 6-10(5) of the ITAA 1997, will the royalty interest income payable to the Company be statutory income with an Australian source or statutory income that a provision includes in assessable income on some basis other than having an Australian source? | Detailed Reasoning - Detailed reasoning: Section 6-10 of the ITAA 1997 provides that a taxpayer's assessable income includes statutory income amounts that are not ordinary income but are included in assessable income by another provision. As the royalty interest income is ordinary income with an Australian source that is assessable under subsection 6-5(3)(a) of the ITAA 1997, section 6-10 of the ITAA 1997 does not apply as that provision is only relevant to statutory income that are not ordinary income. | Detailed Reasoning - Question 3: Pursuant to section 4-1 of the ITAA 1997, is income tax payable by the Company on the royalty interest income? | Detailed Reasoning - Detailed reasoning: Section 4-1 of the ITAA 1997 states that income tax is payable for each year by each individual and company, and by some other entities. In determining the liability to Australian income tax on income received by a non-resident, it is necessary to consider not only Australian income tax laws but also the tax treaties that are governed by the International Tax Agreements Act 1953 (Agreements Act). Section 4 of the Agreements Act incorporates that Act with the ITAA 1997 so that those Acts are read as one. The Agreements Act effectively overrides the ITAA 1997 where there are inconsistent provisions (except in some limited situations). Australia and the United States of America have a tax treaty entitled 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 (USA Convention). To determine how the USA Convention applies to the royalty interest income, the following Articles require consideration: · Article 6 (income from real property) · Article 7 (business profits) · Article 12 (royalties) · Article 13 (alienation of property), and · Article 21 (other income). | Detailed Reasoning - Article 6 of the USA Convention: Article 6 of the USA Convention considers which country has taxing rights over income from real property. Income from real property may be taxed by the Contracting State in which the real property is situated. The term 'income from real property' is not defined for the purposes of the USA Convention. However, in accordance with Article 3(2) of the USA Convention, the term has its ordinary meaning under Australian domestic law. Therefore, Australian income tax laws must be applied to determine whether the Company has received income from real property. For the purposes of the USA Convention, rights to exploit, or to explore for natural resources shall be regarded as real property situated where the natural resources are situated or sought. 'Exploration' is defined in subsection 40-730(4) of the ITAA 1997 to include: · geological mapping, geophysical surveys, systematic search for areas containing minerals (except petroleum) or quarry materials, and search by drilling or other means for such minerals or materials within those areas; and search for ore within, or near, an ore-body or search for quarry materials by drives, shafts, cross-cuts, winzes, rises and drilling when considering what is 'exploration' for mining in general, and quarrying · geological, geophysical and geochemical surveys; and exploration drilling and appraisal drilling when considering what is 'exploration' for petroleum mining · feasibility studies to evaluate the economic feasibility of mining minerals or quarry materials once they have been discovered, and · obtaining mining, quarrying or prospecting information associated with the search for, and evaluation of, areas containing minerals or quarry materials. 'Natural resource' is defined in subsection 995-1(1) of the ITAA 1997 to mean minerals or any other non-living resource of the land, sea-bed or sea. That section also defines minerals to have the meaning given by section 40-730 of the ITAA 1997. The agreement between the Company and the Permit Holder provides how the royalty interest is to be calculated. The exploration permits grant the holder the right to explore for resources in the area included under the permits. As such, it is considered that the permits, and any subsequent leases and licences, represent a right to explore for natural resources and are considered to be 'real property' for the purposes of Article 6 of the USA Convention. Given that the title has been deemed to be 'real property' for the purposes of Article 6 of USA Convention, it must be determined whether the royalty interest income was received by the Company as 'income from' that 'real property'. The word 'from' is defined by the Macquarie Dictionary , 2009, rev. 5 th edn, The Macquarie Library Pty Ltd, NSW to mean 'a particle specifying a starting point, and hence used to express removal or separation in space, time, order, etc., discrimination or distinction, source or origin, instrumentality, and cause or reason'. This definition does not provide any light as to the proximity required for the income to be 'from' real property as required by Article 6 of the USA Convention. Given that the term 'income from' as used above does not give any indication as to whether that term requires the income to be derived from that property directly (in this case from the chose in action), or indirectly (in this case from the title), it is necessary to apply principles drawn from common law to determine how the term 'income from real property' should be applied. In SP Investments Pty Limited (as Trustee of the LM Brennan Trust) v. Federal Commissioner of Taxation (1993) 41 FCR 282; 93 ATC 4170; (1993) 25 ATR 165 the taxpayers, SP Investments Pty Ltd and Perron Investments Pty Ltd, were two companies in the Perron Group which were controlled by Mr Perron. Another company in the group was LSP Pty Ltd. In April 1979, LSP became the trustee of the LM Brennan Trust, a discretionary family trust established for the benefit of the family of Mr Perron. By virtue of its trusteeship, LSP became entitled to a 15% interest in an agreement under which Hamersley Iron Pty Ltd agreed to pay, by way of royalties, an amount equal to 2½% of the sale proceeds of iron ore from a venture at Hamersley in Western Australia. By two deeds dated 25 October 1979 and 30 June 1980, LSP assigned its right, title, interest and benefit in the royalty agreement to National Mutual Association of Australasia Ltd for a period in excess of seven years for a lump sum payment. In determining whether the amounts were assessable to the trustee of the LM Brennan Trust, Hill J noted that the property from which the royalty income that had been assigned was the chose in action, to the extent that the income could be referred to as deriving from property at all. Hill J went on to state that in the relevant sense, the present income was not income derived from property. When the Company assigned the exploration permit to the Permit Holder, the Company no longer owned that property. The contractual rights which the Company acquired in consideration for the assignment of the real property are not real property under the definition of the USA Convention. The real property definition in the USA Convention does not extend to include such contractual rights as being real property, in contrast to real property Articles in other Australian tax treaties. The Company's rights to income from the Permit Holder are contractual. To say that the income is from its ownership of real property would ignore what is the direct cause for the payment, and ignores that the Company does not own the exploration permit. The income is connected with the Company's ownership of the permit, but only in as much as the income is connected with the ending of that ownership. The receipt of income being received from the contractual obligations and not the exploration permit that represents real property is further supported by the contractual obligations on the Permit Holder to ensure that any transferee of the exploration permit or subsequent mining right is also assigned the obligations of making the royalty payment to the Company. The limited rights of the Company as a result of any transfer of the exploration permit or subsequent mining right highlights the limitation of their 'rights'. That is, the rights held by the Company are not in the 'real property', should the Permit Holder transfer the exploration permit or subsequent mining right, and not assign the obligations to pay the overriding royalty, the Company would only have contractual remedies against the Permit Holder. The Company would have no rights against the transferee, because they have no interest in the exploration permit or subsequent mining right. This serves to highlight the different character of the rights as not being from real property. As such, it is considered that the royalty interest income is not income from real property for the purposes of Article 6 of the USA Convention. | Detailed Reasoning - Article 7 of the USA Convention: Article 7 of the USA Convention provides the extent to which business profits of an enterprise can be taxed in a Contracting State. Essentially, the business 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 business profits of the enterprise may be taxed in the other State but only so much of them that are attributable to that permanent establishment. Paragraph 2 of Article 5 of the USA Convention provides the meaning of the term 'permanent establishment' for the purposes of the USA Convention. It is stated that the term means a fixed place of business through which the business of an enterprise is wholly or partly carried on. The term includes: (a) a place of management (b) a branch (c) an office (d) a factory (e) a workshop (f) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources (g) an agricultural, pastoral or forestry property (h) a building site or construction, assembly or installation project which exists for more than 9 months, and (i) an installation, drilling rig or ship that, for an aggregate period of at least 6 months in any 24 month period, is used by an enterprise of one of the Contracting States in the other Contracting State for dredging or for or in connection with the exploration or exploitation of natural resources of the sea-bed and subsoil. Based on the facts and circumstances, the Company does not have a permanent establishment in Australia for the purposes of Article 5 of the USA Convention. Accordingly, while royalty interest income may constitute business profits, no income is attributable to an Australian permanent establishment that would be subject to Australian income tax. To the extent that the Company does not have a permanent establishment in Australia, the United States of America would retain taxing rights to this income under Article 7 of the USA Convention. | Detailed Reasoning - Article 12 of the USA Convention: Article 12(1) of the USA Convention provides that royalties from sources 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. Article 12(4) of the USA Convention defines the 'royalties' to which Article 12 of the USA Convention applies. The term 'royalties' means: (a) payments or credits of any kind to the extent to which they are consideration for the use of or the right to use any: (i) copyright, patent, design or model, plan, secret formula or process, trademark or other like property or right; (ii) motion picture films; or (iii) films or audio or video tapes or disks, or any other means of image or sound reproduction or transmission for use in connection with television, radio or other broadcasting; (b) payments or credits of any kind to the extent to which they are consideration for: (i) the supply of scientific, technical, industrial or commercial knowledge or information owned by any person; (ii) the supply of any assistance of an ancillary and subsidiary nature furnished as a means of enabling the application or enjoyment of knowledge or information referred to in sub-paragraph (b)(i) or of any other property or right to which this Article applies; or (iii) a total or partial forbearance in respect of the use or supply of any property or right described in this paragraph; or (c) income derived from the sale, exchange or other disposition of any property or right described in this paragraph to the extent to which the amounts realized on such sale, exchange or other disposition are contingent on the productivity, use or further disposition of such property or right. The rights held by the Company are in connection with the recovery of the resource. Rights in connection to the recovery of the resource fall outside the exhaustive definition of royalties provided Article 12(4) of the USA Convention. As such, the royalty interest income is not a 'royalty' as defined in Article 12 of the USA Convention. | Detailed Reasoning - Article 13 of the USA Convention: Article 13(1) of the USA Convention provides that income or gains derived by a resident of one of the Contracting States from the alienation or disposition of real property situated in the other Contracting State may be taxed in that other State. Article 13(2) of the USA Convention states that for the purposes of the Article, the term 'real property', in the case of Australia, shall have the meaning which it has under the laws in force from time to time in Australia and, without limiting the foregoing, includes real property referred to in Article 6 of the USA Convention. As previously determined, the exploration permit that the Company disposed of to the Permit Holder is considered real property under Article 6 of the USA Convention. As such, income or gains derived by the Company from the disposal of the exploration permit would be taxable in Australia pursuant to Article 13 of the USA Convention. The disposal of the exploration permit represents a capital gains tax (CGT) event A1 happening under section 104-10 of the ITAA 1997. A capital gain is made as a result of a CGT event A1 happening where the capital proceeds from the CGT event are greater than the cost base of the CGT asset. Section 116-20 of the ITAA 1997 provides that for the capital proceeds from a CGT event are the total of the money you have received, or are entitled to receive, in respect of the event happening, and the market value of any other property you have received, or are entitled to receive, in respect of the event happening (worked out as at the time of the event). Draft Taxation Ruling TR 2007/D10 considers the capital tax consequences of earnout arrangements. A standard earnout arrangement is described for the purposes of TR 2007/D10 to be any transaction in which an income-earning asset is sold for consideration that includes the creation of an 'earnout right' in the seller of the asset. An earnout right is defined as a right to an amount calculated by reference to the earnings generated by the asset for a defined period following the sale. Although the royalty interest income entitlement does not have a defined period, it is considered that the royalty interest income is akin to an earnout right as described in TR 2007/D10. As such, it is considered that TR 2007/D10 is applicable. Paragraphs 12 to 14 of TR 2007/D10 state that an earnout right is not a right to receive money for the purposes of calculating the capital proceeds from a CGT event A1. Rather, an earnout right is property received by the seller in respect of disposing of the original asset. As such, the capital proceeds from the CGT event A1 include the market value of the earnout right at the time of the CGT event A1, not any subsequent payments made in satisfaction of the earnout right following the CGT event A1 happening. The royalty interest income following the disposal of the exploration permits to the Permit Holder represents payments in satisfaction of the earnout rights acquired. In accordance with TR 2007/D10 these amounts are not taken into account when determining the capital proceeds from the disposal by the Company of the exploration permits. Therefore, the royalty interest income is not considered income or gains derived from the alienation or disposal of real property. Accordingly, Article 13 of the USA Convention does not apply to the amounts to make them taxable in Australia. | Detailed Reasoning - Article 21 of the USA Convention: Article 21 of the USA Convention deals with other income not covered by the other Articles in the USA Convention. Article 21(1) of the USA Convention provides the following: Items of income of a resident of one of the Contracting States which are not expressly mentioned in the foregoing Articles of this Convention shall be taxable only in that State. On the basis that the Company carries on an enterprise and any amounts derived in respect of the royalty interest income constitute business profits of the Company, Article 7 of the USA Convention would apply to the royalty interest income. Therefore, Article 21 of the USA Convention would not apply as that Article is intended to capture other income that is not dealt with in other Articles of the USA Convention. | Detailed Reasoning - Conclusion: The payments to the Company are ordinary income derived by a non-resident. The royalty interest income is deemed to have an Australian source under section 6CA of the ITAA 1936 because it satisfies all of the conditions of being 'natural resources income' as defined in that provision. On the basis that royalty interest income constitutes business profits of an enterprise pursuant to Article 7 of the USA Convention; that income is not subject to Australian income tax as the Company does not have a permanent establishment in Australia. Accordingly, section 4 of the Agreements Act will apply to override the ITAA 1997 and consequently, Australian income tax will not be payable on that royalty interest income under section 4-1 of the ITAA 1997.

Question 1: For the purposes of subsection 6-5(3) of ITAA 1997, will the royalty interest income payable to the Company be ordinary income with an Australian source or ordinary income that a provision includes in assessable income on some basis other than having an Australian source?