“Loose” tax treaty language given meaning in Australian permanent establishment case

Global Publication September 2016

The Full Federal Court recently considered the double tax agreement between India and Australia (DTA) in Tech Mahindra Limited v Commissioner of Taxation [2016] FCAFC 130.  Tech Mahindra Limited (the taxpayer) argued that it was possible that royalties paid from Australia to India could escape Australian taxation altogether under the terms of the DTA.  The Court held in favour of the Commissioner of Taxation, with the result that the royalties were subject to withholding tax.

The taxpayer was an Indian tax resident company, which had a permanent establishment (PE) in Australia.  The taxpayer provided services to Australian customers both from its Australian PE and from its home jurisdiction, India.  The issue was whether any “royalties” paid by Australian customers to the taxpayer in India were subject to royalty withholding tax.  

The normal position is that royalties paid to a foreign resident are subject to withholding tax, unless the royalties are attributable to a PE.  The taxpayer sought to disrupt this position by saying that the payments were “effectively connected” with its Australian PE (so that royalty withholding tax did not apply), but were not a result of activities carried on through the PE.  If the taxpayer had been successful, that would mean that Australia would have no taxing rights over the royalties paid by Australian customers to the taxpayer’s base in India.

The taxpayer based its argument on the language of Article 12(4).  Article 12(4) applies to remove a payment from the royalty withholding tax provisions if the property, right or services in respect of which the royalties are paid are “effectively connected” with a PE.  If Article 12(4) of the DTA applies, payments are not subject to royalty withholding tax but are instead taxed as business profits under Article 7.  

The Court considered the “loose” language in the DTA having regard to the purpose of the DTA, including how the DTA allocated taxing rights to income among Australia and India.  The Court concluded that Article 12(4) is intended to give priority to Article 7 (business profits).  Article 12(4) was not intended to remove Australia’s right to tax the royalty altogether, but rather to determine whether the royalty should be taxed as a royalty (subject to withholding tax) or as part of the profits of the PE.  Accordingly, Article 12 applied to the taxpayer, and royalty withholding tax was imposed on the royalties paid by Australian customers to the taxpayer.

The case confirms that the language used in the DTA will be given a meaning that is consistent with the broader purpose of double tax treaties, being to allocate taxing rights among countries.

The Court’s analysis is particularly relevant in the current OECD BEPS environment, where countries are jostling for taxation rights.  Tech Mahindra shows that there can be significant ambiguity in interpreting Australia’s tax treaties, and the Court’s decision will help guide Australia’s response to the BEPS project.

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