Assessability of foreign branch income derived from New Zealand

Is the income derived by the taxpayer from a 'substantial equipment' operating lease agreement with a New Zealand resident company not assessable income and not exempt income under subsection 23AH(2) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Yes. The income derived by the taxpayer from a 'substantial equipment' operating lease agreement with a New Zealand resident company is not assessable income and not exempt income under subsection 23AH(2) of the ITAA 1936.

The taxpayer is an Australian resident company for income tax purposes.

The taxpayer is carrying on a business in the transport industry. The taxpayer's business includes the leasing of substantial equipment that is incidental to its broader business operations in the transport industry.

Under an operating lease agreement, the taxpayer leases substantial equipment to a New Zealand resident company (the lessee) which operates the equipment in New Zealand.

The equipment comes within the meaning of 'substantial equipment' under Article 5(4) of the tax treaty between Australia and New Zealand (New Zealand Agreement) contained under Schedule 4 and Schedule 4A of the International Tax Agreements Act 1953 (Agreements Act).

The taxpayer derives lease income from the lessee under the lease agreement.

The exception under subsection 23AH(5) of the ITAA 1936 does not apply to the taxpayer.

Subsection 6-5(2) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources, whether in or out of Australia, during the income year.

Section 11-55 of the ITAA 1997 lists those provisions dealing with non-assessable non-exempt income. Included in this list is section 23AH of the ITAA 1936 that deals with foreign branch income of Australian companies.

Subsection 23AH(2) of the ITAA 1936 provides that foreign income derived by a resident company in carrying on a business at or through a permanent establishment in a listed or unlisted country is not assessable income and is not exempt income.

The definition of 'foreign income' in subsection 23AH(15) of the ITAA 1936 states for present purposes that the term includes an amount that: • would be assessable income under a provision of the ITAA 1936 or the ITAA 1997, and • is derived from sources in a listed or unlisted country.

The term 'listed country' is defined under subsection 23AH(15) of the ITAA 1936 to have the same meaning as in Part X of the ITAA 1936 and New Zealand is a listed country. The lease income derived from New Zealand would normally be assessable income of the taxpayer under subsection 6-5(2) of the ITAA 1997.

The term 'permanent establishment' in relation to a listed country is defined in subsection 23AH(15) of the ITAA 1936 to have the same meaning as in the tax treaty if Australia has a tax treaty with that country. Therefore it is necessary to consider the New Zealand Agreement contained in the Agreements Act.

Moreover, in determining liability to Australian tax on foreign sourced income, it is necessary to consider not only the income tax laws but also any applicable tax treaty contained in the Agreements Act. Section 4 of the Agreements Act incorporates that Act with the ITAA 1936 and ITAA 1997 so that those Acts are read as one. The Agreements Act effectively overrides the ITAA 1936 and ITAA 1997 where there are inconsistent provisions (except for some limited situations).

Article 5 of the New Zealand Agreement deals with permanent establishment. Article 5(4) of the New Zealand agreement provides, among other things, that: An enterprise shall be deemed to have a permanent establishment in a Contracting State and to carry on business through that permanent establishment if: ..... c .substantial equipment is being used in that State by, for or under contract with the enterprise

In McDermott Industries (Aust) Pty Ltd v. Commissioner of Taxation (2005) 142 FCR 134; 2005 ATC 4398; (2005) 59 ATR 358, the Full Federal Court said referring to similar (but not identical) treaty provisions in the tax treaty between Australia and Singapore: It is a deeming provision and as such probably operates to deem something to be that which otherwise it might not be. That deeming goes beyond there being a deeming of a permanent establishment. It operates as well to deem the enterprise to be carrying on trade or business through the deemed permanent establishment.

Article 5(4) of the New Zealand Agreement applies to the taxpayer as substantial equipment is being used in New Zealand under a contract with the taxpayer. The taxpayer is also deemed to have a permanent establishment in New Zealand and to carry on business through that deemed permanent establishment.

As subsection 23AH(15) of the ITAA 1936 imports the definition of permanent establishment from the relevant tax treaty, a separate test of 'carrying on business at or through a permanent establishment' under the domestic legislation is not required for the purpose of section 23AH of the ITAA 1936 where the tax treaty provision deems that the taxpayer has a permanent establishment and is carrying on a business through that permanent establishment.

Paragraph 2.8 of the Explanatory Memorandum (EM) to the New International Tax Arrangements (Participation Exemption and Other Measures) Bill 2004 states that section 23AH of the ITAA 1936 'will allow all foreign branch income, with the possible exception of passive income, derived by Australian companies to be exempt from Australian tax'. Paragraph 2.21 of the EM states that the section 'provides an exemption to a resident company for most foreign income and gains... derived through a permanent establishment in either a listed or unlisted country'. This legislative intention is reflected in the objects of the section in paragraph 23AH(1)(a) of the ITAA 1936 which states that active foreign branch income derived by a resident company is not assessable income or exempt income of the company. The term 'permanent establishment' incorporates the concept of 'foreign branch' used in the EM and paragraph 23AH(1)(a).

In this case, the taxpayer derives the lease income from the New Zealand resident company, the lessee, in accordance with the terms of the operating lease agreement. The lease income derived by the taxpayer is part and parcel of the taxpayer's broader business. The lessee uses the equipment in New Zealand as part of the lessee's business.

The income is not passive income as it is derived from business carried on through a permanent establishment in a listed country. As the taxpayer is deemed to have a permanent establishment in New Zealand and is deemed to carry on business through that permanent establishment, the foreign branch income will be subject to the operation of section 23AH of the ITAA 1936.

Accordingly, the lease income derived by the taxpayer from a 'substantial equipment' operating lease agreement with a New Zealand resident company is non assessable and non exempt income under subsection 23AH(2) of the ITAA 1936.