United States Convention: whether packing machines are 'substantial equipment'

Are packing machines 'substantial equipment' for the purposes of Article 5(4)(b) of Schedule 2 of the International Tax Agreements Act 1953 (the US Convention)?

No. The packing machines are not 'substantial equipment' for the purposes of Article 5(4)(b) of the US Convention.

The taxpayer is a non-resident for Australian income tax purposes and is a resident enterprise of the United States under the US Convention.

The taxpayer leases packing machines and associated equipment to Australian resident lessees who use the equipment in Australia.

The taxpayer leases approximately 45 packing machines and 220 attachments to approximately 25 to 30 Australian lessees.

The 'attachments' are associated but separate units of equipment forming an integral part of the overall packing machine.

A packing machine has the approximate dimensions of 4 x 3 x 3 metres, and an 'attachment' to the packing machine has approximate dimensions of 75 x 100 x 30 centimetres.

The replacement cost of a packing machine is approximately USD 25,000 and the replacement cost of an 'attachment' is approximately USD 2,000.

Article 5(4)(b) of the US Convention deems a US enterprise to have a permanent establishment in Australia if the US enterprise maintains 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.

The term substantial equipment is not defined in the US Convention. Paragraphs 105 to 108 of Taxation Ruling TR 2006/D8, however, explain the meaning of 'equipment' in Article 5(4)(b) of the US Convention and in particular that the term will include items of machinery. Therefore, the packing machines and attachments are clearly items of 'equipment'.

Paragraph 109 of TR 2006/D8 states that the relevant meanings of 'substantial' in the Macquarie Dictionary , 2001, 5 th edn, The Macquarie Library Pty Ltd, NSW are: • of ample or considerable amount, quantity or size • of real worth or value • of or relating to the essence of a thing; essential, material, or important.

Paragraph 112 of TR 2006/D8 states that whether equipment is 'substantial' is a question of fact and degree to be determined: • on balance, according to the facts and circumstances of each particular case; and • in an absolute sense, that is, when viewed independently; not in comparison with something else; or • in a relative sense; that is, by comparing it to something else.

Accordingly, based on the ordinary meaning of the term, the relevant case law ( McDermott Industries (Aust) Pty Ltd v. Commissioner of Taxation (2005) 142 FCR 134; 2005 ATC 4398; (2005) 59 ATR 358 ( McDermott ); Tillmanns Butcheries Pty Ltd v. Australian Meat Industry Employees' Union (1979) 42 FLR 331; Case H106 (1957) 8 TBRD 484; (1957) 7 CTBR (NS) Case 98 ( Case H106 )), and the guidance at paragraphs 1.61 to 1.64 of the Explanatory Memorandum to the International Tax Agreements Amendment Bill 2003 incorporating the 2003 Convention between Australia and the United Kingdom of Great Britain and Northern Ireland (the 2003 UK Convention), the Commissioner considers that the following factors are relevant in determining whether equipment is 'substantial': • size • quantity - where part of a unified process • value • importance - in the sense of whether the equipment plays a core role in the income producing activity.

The common characteristic of the examples of substantial equipment in McDermott and at paragraph 1.63 of the Explanatory Memorandum to the 2003 UK Convention is the size of the equipment. The Commissioner therefore considers that size is the key factor and has greater weight in determining whether equipment is 'substantial'. If an item of equipment is sufficiently large in size, it will be 'substantial' in an absolute sense. In such instances, this factor alone will be decisive and further consideration of any of the other factors is not necessary.

As the nature of the 'substantial equipment' test in paragraph 112 of TR 2006/D8 is one of fact and degree, determined on balance according to individual facts and circumstances, the Commissioner considers that the factors listed above, other than size, are not of themselves determinative. Each of these factors needs to be considered with the others, having regard to all the facts and circumstances of the particular case. This is consistent with the analysis in Case H106 , where the Board of Review used more than one of the factors stated above to find that the equipment in question in that case was substantial.

Where there are a number of items of equipment that are not large enough individually to be substantial in an absolute sense, the Commissioner considers that the size of the items collectively and the quantity can only be considered if the items of equipment are part of a unified process. This arises from the context in which the term 'substantial' appears in the provision; that is, it is part of the expression 'substantial equipment' as opposed to 'a substantial amount of equipment'.

Value is a relevant factor in determining if equipment is substantial on two levels; firstly, in the sense of its cost (as per the ordinary meaning of the term) and, secondly, in the sense of its value creating potential. In relation to the latter, paragraph 1.62 of the Explanatory Memorandum to the 2003 UK Convention refers to high value activities involved in the development of natural resources.

Equipment may be so valuable that it may be considered substantial in an absolute sense. For example, in Number 630 v. Minister of National Revenue (1959) 59 DTC 300, tunnelling equipment costing $600,000 was considered to be substantial equipment purely on the basis of its cost alone. However, it is not possible to set a precise monetary threshold in relation to cost that will be appropriate for all cases.

Importance as a relevant factor is reflected in Case H106 where Mr Fletcher, the Chairman of the Board: The meaning of 'substantial' is relative and in the case where the machinery required is not extensive, and the whole is involved, it is 'substantial'.

The statement above from Case H106 , the ordinary meaning of the term 'substantial', and the context in which the term is used, indicate that the sense in which importance is relevant is where the equipment is core to the enterprise conducting its income producing or value creating activity, or to it creating its product in a particular country.

The dimensions of an individual packing machine and an associated attachment are each not large enough in size to be considered substantial in an absolute sense.

As a packing machine and an attachment operate as part of the one unified process in the overall packing process undertaken by each Australian lessee, the two individual machines can be considered collectively to determine if they are substantial. The collective size of a packing machine and attachment is not, however, large enough to be considered substantial in an absolute sense.

In considering the two machines collectively, their replacement cost would be USD 27,000. On the second aspect of value, it is unlikely that this packing industry would be considered a high profit creating industry.

As the Australian lessees also undertake other activities which involve a number of other types of processing equipment in their business, it is considered these packing machines are not 'core' pieces of equipment.

No one individual factor in this particular case is decisive and, on balance, the factors present are insufficient to conclude that this equipment is 'substantial' equipment for the purposes of the US Convention.