Private ruling: Royalty withholding tax liability and withholding tax avoidance
Published: July 2013
Ruling period: Year ended 30 June 2013
Date scheme commenced: 1 July 2012

Ruling: Q1: Does the Commissioner of Taxation consider either the whole or part of the purchase price for Products from Company A to be a royalty under the Double Tax Agreement (DTA)? | A1: Yes | Q2: Does the Commissioner of Taxation consider either the whole or part of the purchase price for Products from Company A gives rise to royalty withholding tax under subsection 128B(5A) of the Income Tax Assessment Act 1936 (ITAA 1936)? | A4: Answer to Question 3(i) is no - answer not required.

Relevant facts and circumstances: The Applicant applied for a Private Binding Ruling (the Application) on behalf of Company A (non-resident). The Applicant advises that changes have occurred in Company B's manufacturing and supply chain arrangements which affect an Agreement Company A has with Company B in relation to the purchase of Products. The Application seeks a ruling on royalty withholding tax liability and withholding tax avoidance.

Relevant legislative provisions: Income Tax Assessment Act 1936 subsection 6(1). | Income Tax Assessment Act 1936 subsection 128B(2B). | Income Tax Assessment Act 1936 subsection 128B(2C). | Income Tax Assessment Act 1936 subsection 128B(5A). | Income Tax Assessment Act 1936 section 177A. | Income Tax Assessment Act 1936 section 177CA. | Income Tax Assessment Act 1936 section 177D. | Income Tax Assessment Act 1936 subsection 177F(2A). | International Tax Agreements Act 1953 subsection 3(1). | International Tax Agreements Act 1953 subsection 3(8). | International Tax Agreements Act 1953 section 3AAA. | International Tax Agreements Act 1953 section 4. | International Tax Agreements Act 1953 section 11.

Reasons for decision: Detailed Reasoning - Interpretation of the relevant agreement is fundamental to characterisation: Payments made by Company B (resident) to Company A (non-resident) to purchase Products are made under the Agreement. "Products" is defined in the Agreement to include any and all rights in the trade marks and packaging for the brands. Paragraph 3 of Taxation Ruling TR 93/12 states that: The nature of amounts received in respect of … depends on the terms of the particular agreement between the parties, having regard to all the circumstances of the case. In International Business Machines Corporation & Anor v FC of T 2011 ATC 20-256 (the IBM case) the Court considered all the terms of the agreement between the parties to determine whether the payments made under the contract were a royalty. Bennet J said, at paragraph 16: The interpretation of the SLA (the relevant contract) is fundamental to the characterisation of the Payments. | Detailed Reasoning - The relevant royalty definition which applies is the definition in the DTA (and not subsection 6(1) of the ITAA 1936): Section 4 of the International Tax Agreements Act 1953 provides that: 4(1) Subject to subsection (2), the Assessment Act is incorporated and shall be read as one with this Act. 4(2) The provisions of this Act have effect notwithstanding anything inconsistent with those provisions contained in the Assessment Act (….) or in an Act imposing Australian tax. In McDermott Industries (Aust) Pty Ltd v FC of T 2005 ATC 4398 , the Court said, at paragraph 11, that: …Subsection 4(2) provides, subject to exceptions not presently relevant, that it and thus the double taxation agreements scheduled to it both prevail over provisions of the Income Tax Assessment Act 1936…and indeed, the Income Tax Assessment Act 1997. The Court in the IBM case expressed the legal principle as follows (at paragraph 7): It is also not in dispute that the definition of "royalties" in Article 12(4) of the Treaty is given primacy by s4(2) of the International Agreements Act 1953 and it is that definition that applies for the purposes of determining the extent to which the Treaty limits the operation of s128B of the 1936 Act. Accordingly, the question at issue is whether payments made under the Agreement give rise to a royalty as defined in the DTA. | Detailed Reasoning - Definition of royalty in the DTA: The definition of royalties in the DTA corresponds with the definition of royalty in subsection 6(1) of the ITAA 1936. Taxation Ruling IT 2660 states the Commissioner's view on the definition of royalty in subsection 6(1) of the ITAA 1936 and in the various DTAs. Paragraph 11 and the subsequent paragraphs of IT 2660 discuss the extended meaning of royalty in subsection 6(1) of the ITAA 1936 and are also relevant in considering the royalty definition in the DTA. The words "to the extent to which" require the apportionment of a payment made partly as a royalty and partly as something else, refer to paragraph 13 of IT 2660. Paragraph 16 of IT 2660 refers specifically to payments described in paragraph (a) of the section 6(1) definition, as follows: Payments of the kinds described in paragraph (a) of the definition do not require a great deal of explanation. The concept of payment "for the use of, or the right to use" covers all forms of exploitation of a right or property short of outright sale of the right or property. As to copyright, a payment for the right to produce, reproduce or exploit a work or other subject matter in which copyright subsists will be a payment for the use of the copyright, whether or not the right is actually used by the person paying the royalty. For example, payments for the right to reproduce audio or video tapes, or laser or compact discs, will come within paragraph (a). Other examples of payments for the use of, or the right to use, copyright would include payments to the owner of a famous painting to produce prints, or payments to the owner to produce books of original literary works. | Detailed Reasoning - Trade marks and intellectual property rights in the Brands conferred on Company B under the Agreement: The Agreement provides Company B a licence of the trade mark and associated intellectual property rights in the Brands necessary for the sole purpose of importing, distributing, marketing and selling the Products. | Detailed Reasoning - Restrictions on the use of the trademarks and intellectual property rights imposed by the Agreement: The Agreement imposes limitations on Company B's use of the trademarks and Brands. Company B's use of the trademarks and Brands for purposes of marketing and advertising is restricted in certain respects and subject to the control of Company A. | Detailed Reasoning - Use of or the rights to use: Company B carries on the business of import and sale of Products. The Products are supplied by Company A under the Agreement. Company B is granted trademarks and Brands under the Agreement. It would not be possible for Company B to carry on its business without the trademarks and Brands. The trademarks and Brands are used in the sense described in paragraph 16 of IT 2660, that is: The concept of payment "for the use of, or the right to use" covers all forms of exploitation of a right or property short of outright sale of the right or property. It is clear that the trade marks and Brands are exploited by Company B in the conduct of their business and are used within the meaning of the definition of royalties in the DTA. | Detailed Reasoning - The strict terms of the agreement provide for payment for the trade marks and Brands: Under the Agreement, Company A sells the Products to Company B. Products are defined in the Agreement to mean Products including any and all rights in the trade marks and packaging for those products. Therefore, on the face of the Agreement, Company B is purchasing the trade marks and brands (packaging) from Company A as well as the Products themselves. Under the Agreement, Company B shall pay make a Payment to Company A as consideration for the Products. As noted above, Products include the trademarks and packaging. It follows that under the strict terms of the Agreement some part of the Payment includes consideration for the trademarks and packaging. | Detailed Reasoning - The extent to which the Payment is a payment for the use of the rights granted: The definition of royalties in the DTA permits and requires apportionment of the consideration between the amount related to the royalties and the amount related to anything else. An apportionment in this case would require coming to an appropriate price for the Products and an appropriate price for the trade marks and intellectual property rights. | Detailed Reasoning - Conclusion: The Commissioner of Taxation considers that part of the purchase price for Products will constitute royalties as defined in the DTA. The quantum of the royalties will, however, depend on the appropriate pricing for Products. | Detailed Reasoning - Liability for royalty withholding tax: A person is liable under subsection 128B(5A) of the ITAA 1936 to pay withholding tax if they derive 'income' that consists of a royalty and the requirements of subsections 128B(2B) or (2C) of the ITAA 1936 are satisfied in relation to that income. Subsection 128A(1AA) of the ITAA 1936 provides that for the purposes of Division 11A of Part III of the ITAA 1936 and the Act imposing withholding tax the term 'income' includes a royalty. | Detailed Reasoning - Subsections 128(2B) and 2C) of the ITAA 1936: Subsection 128B(2B) of the ITAA 1936 applies to income that consists of a royalty derived by a non-resident that: · is paid by a resident and is not an outgoing wholly incurred by the payer in carrying on business in a foreign country at or through a permanent establishment (PE) in that country (subparagraph 128B(2B)(b)(i) of the ITAA 1936); or · is paid by one or more non-residents and is, or is in part, an outgoing incurred by the non-resident(s) in carrying on business in Australia at or through a PE in Australia (subparagraph 128B(2B)(b)(ii) of the ITAA 1936). Subsection 128B(2C) of the ITAA 1936 applies to income that consists of a royalty derived by a resident in carrying on business in a foreign country at or through a PE in that country that: · is paid by another resident and is not an outgoing wholly incurred by that other person in carrying on business in a foreign country at or through a PE in that country (subparagraph 128B(2C)(b)(i) of the ITAA 1936); or · is paid by one or more non-residents and is, or is in part, an outgoing incurred by the non-resident(s) in carrying on business in Australia at or through a PE in Australia (subparagraph 128B(2C)(b)(ii) of the ITAA 1936). As concluded in Question 1 above, the purchase price for Products from Company A includes a 'royalties' component. As the royalties are paid to Company A (non-resident) by Company B (resident), the 'royalties' component satisfies subsection 128B(2B) of the ITAA 1936 and is not an outgoing wholly incurred by Company B in carrying on business in a foreign country at or through a PE in that foreign country. Therefore, the 'royalties' component of the purchase price for Products is income covered in subparagraph 128B(2B)(b)(i) of the ITAA 1936. | Detailed Reasoning - Liability to pay Royalty withholding tax - Subsection 128B(5A) of the ITAA 1936: Subsection 128B(5A) of the ITAA 1936 provides that: A person who derives income to which this section applies that consists of a royalty is liable to pay income tax upon that income at the rate declared by Parliament in respect of income to which this subsection applies. As explained above, the 'royalties' component of the purchase price for Products is income covered in subparagraph 128B(2B)(b)(i) of the ITAA 1936. Consequently, Company A derives income to which Section 128B of the ITAA 1936 applies. Therefore, pursuant to subsection 128B(5A) of the ITAA 1936 Company A (the person who derives the 'royalty' income) is liable to pay income tax upon that income at the rate declared by Parliament. In conclusion, the Commissioner of Taxation considers the 'royalties' part of the purchase price for Products from Company A gives rise to royalty withholding tax under subsection 128B(5A) of the ITAA 1936. | Detailed Reasoning - Question 3(i): Subsection 177F(2A) of the ITAA 1936 provides that where a tax benefit in the form of the avoidance of withholding tax has been obtained, or would but for that section be obtained, by a taxpayer in connection with a scheme, the Commissioner may determine that the taxpayer is subject to withholding tax under s 128B of the ITAA 1936. The Commissioner can make a determination under subsection 177F(2A) of the ITAA 1936 if the following prerequisites are satisfied: 1. there is a 'scheme' as defined in subsection 177A(1) of the ITAA 1936 2. a taxpayer has obtained a 'tax benefit' in connection with the 'scheme' This requires consideration of whether: (i) a taxpayer has obtained a 'tax benefit' within the meaning of subsection 177CA(2) of the ITAA 1936; (ii) the 'tax benefit' was obtained 'in connection with' the scheme in accordance with section 177D(a) of the ITAA 1936; and (iii) the 'tax benefit' is not an excluded tax benefit by reason of section 177C(2) or (2A) of the ITAA 1936. 3. having regard to the eight matters listed in section 177D(b) of the ITAA 1936, it would be concluded that a person who entered into or carried out the scheme did so for the dominant purpose of enabling the relevant taxpayer to obtain a tax benefit in connection with the scheme. | Detailed Reasoning - Section 177A(1) of ITAA 1936 - Scheme: 'Scheme' is defined in section 177A(1) of the ITAA 1936 to mean: (a) any agreement, arrangement, understanding, promise or undertaking, whether express or implied and whether or not enforceable, or intended to be enforceable, by legal proceedings; and (b) any scheme, plan, proposal, action, course of action or course of conduct. For the purposes of determining the existence of a 'tax benefit' under section 177CA of the ITAA 1936, the 'Scheme' involved a number of steps/events that resulted in the change in manufacturing and supply chain arrangements of Company B: | Detailed Reasoning - Section 177CA of the ITAA 1936 - Withholding Tax Avoidance: Section 177CA of the ITAA 1936 provides: (1) [Application] This section applies in relation to a particular amount if a taxpayer is not liable to pay withholding tax on an amount where that taxpayer would have, or could reasonably be expected to have, been liable to pay withholding tax on the amount if a scheme had not been entered into or carried out. (2) [Tax Benefit] For the purposes of this Part, if this section applies in relation to an amount , the taxpayer is taken to have obtained a tax benefit in connection with the scheme of an amount equal to the amount mentioned in subsection (1). (Emphasis added) A 'tax benefit' will only be obtained by a taxpayer in connection with a 'scheme' if the requirements of section 177CA of the ITAA 1936 are satisfied. To identify a 'tax benefit' in subsection 177CA(2) of the ITAA 1936, it is necessary to consider what the taxpayer might reasonably be expected to have done had the scheme not been entered into. (the Counterfactual) This inquiry requires a comparison between: 1. the consequences of the scheme in question; and 2. the consequences of what would have occurred had the scheme not been carried out, the counterfactual. As to the circumstances which might "reasonably be expected" to have occurred within the meaning of section 177C of the ITAA 1936, it was stated in FCT v Peabody (1994) 181 CLR 359 at 385 that: A reasonable expectation requires more than a possibility. It involves a prediction as to events which would have taken place if the relevant scheme had not been entered into or carried out and the prediction must be sufficiently reliable for it to be regarded as reasonable. In FCT v Lenzo (2008) 167 FCR 255 at [137] Sackville J (Heerey and Siopis JJ agreeing), after referring to Peabody , said that section 177C of the ITAA 1936: '... contemplates a reasonable prediction as to events that would have taken place had the scheme not been entered into'. | Detailed Reasoning - 1. Consequence of the 'Scheme' in question: The Scheme will affect Company B's royalty withholding tax obligation. Company B only has obligation to withhold both before and after the Scheme. It does not have a liability to pay the withholding tax. To determine the 'tax benefit' for the purpose of section 177CA of the ITAA 1936, a comparison between the Scheme and the counterfactual (that is what the taxpayer might reasonably be expected to have done had the scheme not been entered into) is required. | Detailed Reasoning - 2. The Counterfactual: The Applicant submitted, and the Commissioner accepts that the relevant 'counterfactual' would have achieved some (or all) of the Objectives. | Detailed Reasoning - Tax Consequence under the counterfactual: Under the counterfactual, the Applicant submits that royalties (and its associated royalties withholding tax) would still be paid. | Detailed Reasoning - Exclusions: The exclusions listed in subsections 177C(2) and 177C(2A) of the ITAA 1936 are not applicable to the Scheme. | Detailed Reasoning - Conclusion to Tax Benefit (subsection 177CA(2) of the ITAA 1936): By comparing the tax outcome under the Scheme and the tax outcome under the counterfactual, no Australian withholding tax benefit can be identified from the implementation of the Scheme. Under the counterfactual Company A may be required to pay withholding tax. This is because we have ruled that there is a royalty payment from Company B to Company A under the Agreement. As the Agreement between Company B and Company A is unaffected by the Scheme or the counterfactual, there is no tax benefit to which 177CA could apply. | Detailed Reasoning - Question 3(ii): The answer to Question 3(i) is No. Therefore, section 177D of the ITAA 1936 is not required to be considered.

Does the Commissioner of Taxation consider that a tax benefit arises under section 177CA of the ITAA 1936 in respect of the arrangement described in this ruling? | If the answer to Question 3(i) is yes, does the Commissioner of Taxation consider that section 177D of the ITAA 1936 applies in respect of the tax benefit arising under section 177CA of the ITAA 1936?