Will Article 12(2) of the 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 [1983] ATS 16 and Protocol amending the 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 [2003] ATS 14 (the US Convention ) apply to the royalty payments made from AusCo to ForeignCo A, a single member disregarded United States Limited Liability Company (LLC) ultimately owned by ForeignCo B, such that, to the extent that income of ForeignCo B is ultimately subject to US federal income tax as the income of a US resident, AusCo are obliged only to withhold under section 12-300 of Schedule 1 to the Tax Administration Act 1953 (TAA 1953) at a reduced royalty withholding tax rate of 5%?
Yes. This ruling applies for the following period : XXXX to XXXX The scheme commenced on: XXXX
ForeignCo A is a company formed in the US that is a disregarded single member US LLC for US federal income tax purposes. ForeignCo B is a company formed in the US that for tax purposes in the US is treated as a partnership. The immediate partners in ForeignCo B are ForeignCo C and ForeignCo D. ForeignCo C is a company formed in the US and is a tax resident of the US. It is wholly owned (indirectly) by ForeignCo D via ForeignCo F. It is treated as a corporation and taxed in its own right for the purposes of US federal income tax. ForeignCo D is a company formed in the US that for US federal income tax purposes is treated as a partnership (i.e. it is a pass through entity for US tax purposes). Foreign Group Holdings indirectly holds X% of the membership interests in ForeignCo D via ForeignCo E. ForeignCo E is a company formed in the US. ForeignCo E is treated as a domestic corporation for US tax purposes. It is included in the consolidated corporate income tax return of Foreign Group Holdings. ForeignCo E is the direct holding company of Foreign Group Holdings' interest in ForeignCo D. ForeignCo D's business is the sole investment of Foreign Group Holdings (via Foreign Co E).
ForeignCo E is the sole manager of ForeignCo D, and Foreign Group Holdings is the sole manager of ForeignCo E. ForeignCo F is a company formed in the US that is a disregarded single member LLC for US federal income tax purposes. All of its membership interests are owned by ForeignCo D. Foreign Group Holdings is a company formed in the US. It is a US tax resident company. Foreign Group Holdings is the ultimate holding company of the Foreign Group. ForeignCo B and its subsidiaries, including ForeignCo A and other disregarded single member LLCs (ForeignCo B Group), operate an integrated business, principally engaged in the development, production, sales and marketing of products featuring the relevant business operation. ForeignCo B is headquartered in the US. It (indirectly) wholly-owns ForeignCo G which is the operating entity for the relevant business operation. ForeignCo A was established when the relevant business operation expanded overseas. The key sources of income of this entity are the same as those discussed above, but these relate to non-US markets including Australia. The relevant business operation generated circa US$X of gross receipts during FYXX.
None of the above entities are tax resident in Australia. AusCo is a company formed in Australia that is an Australian tax resident. AusCo makes royalty payments to ForeignCo A (the Royalties). ForeignCo A does not receive the royalty income in the capacity as an agent or nominee. It has not entered into any agreements under which it must pass on the royalties received or the benefit of these to another person. There are no arrangements in place under which the royalty income derived by ForeignCo A from AusCo can be streamed to a particular class of shareholder of any of Foreign Group Holdings, ForeignCo E or ForeignCo C (collectively the Residents), or any of the interest holders in any of the entities interposed between the Residents and ForeignCo A in a disproportionate manner. AusCo is not connected to any of the entities referred to above. Taxation of royalty income in the USA of ForeignCo A
Under US Treasury Regulations, Subchapter F, sec. 301.7701-2(a) Business entities; definitions, a business entity with only one owner can be classified as a corporation or is disregarded; if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch or division of the owner. As such, disregarded LLCs of which ForeignCo B is the ultimate sole member are treated for US federal income tax purposes as domestic branches of ForeignCo B and the activities of the LLCs are treated as those of ForeignCo B. As a disregarded entity of ForeignCo B, ForeignCo A is treated as a branch or division of its owner, ForeignCo B, for US federal income tax purposes. Its activities are treated as the activities of its owner ForeignCo B, and the royalty income is reported in ForeignCo B's US Partnership return. As a partnership, ForeignCo B does not pay US federal income tax. Instead, it allocates the proportionate share of its taxable income to ForeignCo C and ForeignCo D.
As a partnership, ForeignCo D does not pay US federal income tax. Instead, it allocates the proportionate share of its taxable income to ForeignCo E and other members. ForeignCo E reports its share of income in the consolidated US Corporate Income Tax Return of its parent, Foreign Group Holdings. The income tax returns of the relevant entities evidence that: (a) X% of the income of ForeignCo B is being allocated to, and subject to US tax in the hands of ForeignCo C, (b) the remaining X% of the income of ForeignCo B is being allocated to ForeignCo D, and (c) ForeignCo D's income, including its share of ForeignCo B's income, is allocated to its partners, X% of which is included in the taxable income of ForeignCo E for US tax purposes. Other As an LLC, the relationship between ForeignCo B and its members is akin to that of shareholders and a company, with the members not having any interest in the underlying property of the company. The members of the LLC only have a legal right to payment of a distributions per the LLC Agreement, which states that a distribution to members is at the discretion of the Managing Member.
ForeignCo B and its subsidiaries, including ForeignCo A, are effectively managed and viewed by the group as a single entity when determining distributions as they together form a business unit, and each of the entities except for ForeignCo B are disregarded, such that the activities of those entities are treated as those of ForeignCo B. In particular, with respect to distributions, ForeignCo B makes distributions to its members based on the combined cash resources of the ForeignCo B Group. These distributions are then settled by cash moving directly from the bank account of the relevant entity that generated it (including ForeignCo A) to the bank accounts of ForeignCo D and ForeignCo C. Entries are recorded on intercompany accounts between ForeignCo B and the relevant entity that settled the distribution to reflect the cash payments. There are no agreements in place stating that amounts received from AusCo must be distributed to any other entity or entities. Distributions throughout the ForeignCo B Group tend to be driven by the cash requirements of ForeignCo C and ForeignCo D, for example in relation to acquisitions or tax payments.
At the time of the ruling request, there were approximately X full-time employees of the ForeignCo B Group worldwide that manage and operate the relevant business operations. There are no employees based in Australia and the ForeignCo B Group does not carry on a business in Australia.
Section 128B of the Income Tax Assessment Act 1936 Article 12 of the 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 [1983] ATS 16 and Protocol amending the 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 [2003] ATS 14 Section 12-300 of Schedule 1 to the Tax Administration Act 1953
Section 12-280 of Subdivision 12-F of Schedule 1 to the Taxation Administration Act 1953 (TAA) requires that an entity must withhold an amount from a royalty it pays to an entity, or to entities jointly, if the recipient or any of the recipients has an address outside Australia. However, the application of section 12-280 is limited by section 12-300 of Subdivision 12-F of Schedule 1 to the TAA which only requires an Australian entity to withhold if there is a liability to withholding tax in respect of the payment being made. The obligation of an Australian entity to withhold is therefore determined by whether a non-resident is liable to withholding tax under section 128B of the Income Tax Assessment Act 1936 (ITAA 1936). Section 128B(2B) of the ITAA 1936 creates such a liability in respect of royalties where an Australian resident pays those royalties to a non-resident. AusCo makes royalty payments to ForeignCo A, an entity which has an address outside of Australia. Therefore, prima facie AusCo has a withholding tax obligation in respect of the Royalties. Section 15-10(2) of the TAA states that the amount to be withheld is to be worked out under the regulations to the TAA.
Regulation 42 of the Taxation Administration Regulations 2017 refers to both international tax sharing treaty and double tax agreement cases (which, if applicable, prescribe the rate of withholding), otherwise the rate is 30%. Article 12 of the US Convention deals with the taxation of royalties. Under Article 12: (1) 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. (2) Such royalties may be taxed in the Contracting State in which they have their source, and according to the law of that State, but the tax so charged shall not exceed 5 percent of the gross amount of the royalties. ... (6) (a) Royalties shall be treated as income from sources in a Contracting State when the payer is ... a person who is a resident of that State for the purposes of its tax... Article 16 of the US Convention limits a person's entitlement to relief from taxation under the US Convention unless certain conditions are met. As AusCo is a resident of Australia, the Royalties paid by AusCo to ForeignCo A will be sourced in Australia.
Therefore, if a resident of the US for the purposes of the US Convention is beneficially entitled to the royalties and that person satisfies the requirements of Article 16: Limitation of Benefits , the rate of withholding tax on the Royalties will be 5% per Article 12(2). US Convention - application In order for the US Convention to apply, Article 1 of the US Convention states: (1) Except as otherwise provided in this Convention, this Convention shall apply to persons who are residents of one or both of the Contracting States. Resident Article 3(1)(a) of the US Convention defines the term 'person' to include: ...an individual, an estate of a deceased individual, a trust, a partnership, a company and any other body of persons; Article 3(1)(b) of the US Convention defines the term 'company' to mean: ...any body corporate or any entity which is treated as a company or body corporate for tax purposes; Article 4(1)(b) of the US Convention, a resident of the United States includes a person that is: (i) A United States corporation; or....
(iii) "any other person...resident in the United States for the purposes of its tax, provided that, in relation to any income derived by a partnership..., such person shall not be treated as a resident of the United States except to the extent that the income is subject to United States tax as the income of a resident, either in its hands or the hands of a partner..." A United States corporation is further defined in Article 3(1)(g)(i) of the US Convention as: a corporation which, under United States law relating to United States tax, is a domestic corporation or an unincorporated entity treated as a domestic corporation, and which is not, under the law of Australia relating to Australian tax, a resident of Australia; Single member LLCs
ForeignCo B is the single owner of a chain of LLCs which includes the recipient of the Royalties, ForeignCo A. All of the LLCs in the chain are limited liability companies formed in the US under State X law. However, the entities are disregarded as entities separate from their owner for US federal income tax purposes. ForeignCo A and the other single member disregarded LLCs therefore do not pay US federal income tax of themselves, but rather are treated as a branch or division of the owner for the purposes of US domestic tax law. Foreign Co A and the other disregarded LLCs are therefore treated as a branch or division of ForeignCo B for US federal income tax purposes. As noted in US Treasury Regulations, Subchapter F, sec 301.7701-2(a); A business entity with only one owner is classified as a corporation or is disregarded; if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch or division of the owner.
As ForeignCo A and the other single member LLCs are disregarded, they are not treated as US Corporations for the purposes of the US Convention and are therefore incapable of being 'residents' under the treaty. This is because the US Convention defines US Corporation with reference to the US domestic tax treatment. Such a view is also supported by ATO Interpretative Decision ATO ID 2010/188: Income tax treaty benefits: United States limited liability company disregarded as an entity separate from its owner (ATO ID 2010/188) which concludes that a disregarded LLC with a single owner is treated as part of the owner and is not itself a resident for the purposes of the US Convention. ForeignCo B ForeignCo B is a limited liability company formed in the US which for US federal income tax purposes is treated as a partnership. ForeignCo B's net income is allocated to each of its members in accordance with their interest in ForeignCo B and the LLC Agreement. Given ForeignCo B is treated in the US as a partnership for US taxation purposes, ForeignCo B is a partnership and therefore a person within the meaning of Article 3(1)(a) of the US Convention.
Whether ForeignCo B is a resident or not is determined by Article 4(1)(b)(iii), which relevantly states that a US resident includes (iii) "any other person....resident in the United States for the purposes of its tax, provided that, in relation to any income derived by a partnership..., such person shall not be treated as a resident of the United States except to the extent that the income is subject to United States tax as the income of a resident, either in its hands or the hands of a partner..." As ForeignCo B is not a US Corporation as defined under Article 3(1)(g)(i) of the US Convention due to it being taxed as a partnership in the US, its residency status is determined by reference to this paragraph being 'any other person'. The Full Federal Court in Federal Commissioner of Taxation v Resource Capital Fund IV LP and Others [2019] FCAFC 51 ( RCF IV ) considered the application of Article 4(1)(b)(iii) of the US Convention in respect to a limited partnership and the majority stated at [70]:
We do not see that "context" necessarily requires one to read a "person" in Art 4(1)(b)(iii) as excluding a partnership. Indeed, the reference to "such person shall not be treated as a resident" in the subparagraph arguably refers back to a "partnership", deceased estate or trust, as does the phrase "in its hands". But we note that Art4(1)(b)(iii) would, in any event, only include a partnership "to the extent that the income is subject to United States tax as the income of a resident, either in its hands or in the hands of a partner or beneficiary, or, if that income is exempt from United States taxes, is exempt other than because such person, partner or beneficiary is not a United States person according to United States law relating to United States tax". And at [71]; ...Edmonds J at first instance formed the view that the definition of a 'resident' in Art 4(1)(b)(iii) imposed a dual requirement to be satisfied, namely that the partnership was a resident of the United States for tax purposes and the income of the partnership had to subject to United States tax. And at [73]:
On appeal, the Full Court of this Court accepted that Resource Capital Fund III LP was not a resident of the United States, but otherwise did not consider the dual requirement test. We respectfully adopt the reasoning and conclusion of Edmonds J on the issue. As confirmed by the majority of the Full Federal Court in RCF IV , the reference to 'any other person' at Article 4(1)(b)(iii) of the US Convention includes a partnership. Edmonds J, when discussing the Article, also suggested that the Article imposed a requirement that such a partnership was 'domestic' to the US and organised under US law. Foreign Co B satisfies this initial condition as an entity created and organised in State X under State X law. Given ForeignCo B is a partnership for the purposes of the US Convention and its net income is allocated to each of its members, it is also relevant to consider the extent to which ForeignCo B's income is subject to United States tax as the income of a resident of the US in the hands of a partner (its members) in determining its residency status.
The income tax returns of ForeignCo B demonstrate that it is a US tax partnership and confirms the partners who are subject to US tax as residents on their share of the income of ForeignCo B. The income tax returns evidence that X% of the income of ForeignCo B is being allocated to, and subject to US tax in the hands of, ForeignCo C. ForeignCo C is a company formed in the USA and is a US tax resident which is treated as a corporation and taxed in its own right for the purposes of US federal income tax. ForeignCo C therefore satisfies the definition of a United States corporation in Article 3(1)(g)(i) of the US Convention and is therefore a resident in accordance with Article 4(1)(b)(i) of the US Convention for the purposes of the US Convention.
The remaining X% of the income of ForeignCo B is being allocated to ForeignCo D. ForeignCo D, like ForeignCo B is a limited liability company formed in the US that for tax purposes is treated as a partnership (a pass through entity for US tax purposes). Like ForeignCo B, ForeignCo D is not itself subject to US income tax on its income, instead ForeignCo D's income, including its share of ForeignCo B's income, is allocated to its partners, X% of which is included in the taxable income of ForeignCo E for US tax purposes. Similar to ForeignCo C, ForeignCo E is a company formed in the USA and is a US tax resident that is treated as a corporation and taxed in its own right for the purposes of US federal income tax. ForeignCo E therefore satisfies the definition of a US Corporation and is a resident in accordance with Article 4(1)(b)(i) of the US Convention. As ForeignCo D is itself an LLC taxed as a partnership, and therefore is not subject to US income tax on its share of ForeignCo B's income, a relevant consideration is whether Article 4(1)(b)(iii) of the US Convention allows an "indirect partner" of ForeignCo B to satisfy the condition ".....
the income is subject to United States tax as the income of a resident, either in its hands or in the hands of a partner.....". The Commissioner's accepted approach to treaty interpretation has been explained in TR 2001/13 Income tax: Interpreting Australia's Double Tax Agreements at paragraphs 90 to 94 (TR 2001/13). Of particular relevance, paragraph 92 of TR 2001/13 outlines the general principles that can be drawn from the approach taken by Australian courts in respect to the interpretation of DTA's, and includes: reflecting the need for negotiating compromises, treaties are usually less precise than domestic legislation. Consequently, treaty interpretation should be based on a view that treaties cannot be applied with the 'taut logical precision' that might be appropriate for statues. International instruments should therefore be interpreted more 'liberally' than domestic legislation
Paragraph 92 of TR 2001/13 also notes that the Vienna Convention rules apply to tax treaties, including Article 31 of the Vienna Convention which requires a 'holistic' approach to treaty interpretation, where simultaneous consideration should be given to the 'ordinary meaning' of the relevant words, their 'context', and the 'object and purpose' of the treaty they form part of. In respect to the "subject to tax requirement" in Art 4(1)(b)(iii) of the US Convention Edmonds J explains in Resource Capital Fund III LP v Commissioner of Taxation [2013] FCA 363 ( RCF III ) that it was inserted to close a loophole in the 1953 Convention where partnerships (fiscally transparent) were simply required to be US residents to obtain treaty benefits. Paragraph 43 of the judgment in RCF III states:
43. Under Art II(1)(g) of the 1953 Convention, a partnership created or organised in or under the laws of the US (a US domestic partnership) was a resident of the US for the purposes of the 1953 Convention whether or not the partners were liable to US tax on the income of the partnership. If the partners in the US domestic partnership were foreign companies (i.e., incorporated outside the United States) and the partnership income was not effectively connected with the conduct of a trade or business carried on in the US, neither the partnership (because it was fiscally transparent) nor the partners would be liable to US tax on the partnership income, but because the partnership was a resident of the US for the purposes of the 1953 Convention, it was entitled to the benefits of the 1953 Convention vis-à-vis Australian source income. The negotiators of the Convention were conscious of this anomaly when drafting Art 4(1)(b)(iii); thus, under the Convention, even a US domestic partnership will only be a resident of the US for the purposes of the Convention to the extent that the income of the partnership is subject to US tax in the hands of a partner or, if that income is exempt from US tax, is exempt other than because such partner is not a US person according to US law relating to US tax.
The intention of Article 3(1)(a) and Article 4(1)(b)(iii) of the US Convention is to provide residency status and treaty benefits to a partnership. The "partial residency clause" condition in Article 4(1)(b)(iii) of the US Convention was added to ensure that US tax was paid on partnership's income as a condition to obtaining treaty benefits, and that residents from other jurisdictions were not able to access the benefits of the US Convention through the use of a US interposed entity. From a policy perspective, there does not appear to be any basis for an additional requirement that a direct partner needs to be the payer of the US tax. Given this policy context (and the absence of conflicting context), Article 4(1)(b)(iii) of the US Convention should be interpreted to qualify a US domestic/organised partnership as a resident to the extent the income is subject to US tax in a US resident's hands, even if this requires tracing through interposed US partnerships to identify a relevant US resident paying US federal income tax on that basis.
Having regard to the extent to which the royalty income of ForeignCo B that is subsequently allocated to ForeignCo D, is subject to US tax in the hands of a US resident it is relevant to look at the status of ForeignCo E. As outlined above, as a US partnership that is not subject to US income tax on its income, ForeignCo D allocates X% (including X% of ForeignCo B's royalty income) of its income to its US partner, ForeignCo E. ForeignCo E is a company formed in the US that since XXXX, has been treated as a domestic corporation for US tax purposes. The income of ForeignCo E, including its share of the royalty income, is included in the consolidated corporate income tax return of Foreign Group Holdings. ForeignCo E therefore satisfies the definition of a United States Corporation in Article 3(1)(g) of the US Convention and is a resident of the US under Article 4(1)(b)(i) for the purposes of the US Convention. Therefore, ForeignCo B is a resident of the US for the purposes of the US Convention in accordance with Article 4(b)(iii) of the US Convention to the extent that its income is subject to US income tax in the hands of ForeignCo C and ForeignCo E.
The US Convention will therefore apply to ForeignCo B as it is a person that is a resident of the US within the meaning of the US Convention. US Convention - application to taxes Article 2 of the US Convention confirms that the US Convention applies to Australian income tax. Section 128B of the ITAA 1936imposes liability to withholding tax on royalty income derived by non-residents. As such, withholding tax payable in respect to royalties paid to non-residents is considered to be an Australian income tax and is covered by the US Convention. Royalty income Article 12 of the US Convention is the relevant provision in relation to royalty income. The provision relevantly states: (1) 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. (2) Such royalties may be taxed in the Contracting State in which they have their sources, and according to the law of that State, but the tax so charged shall not exceed 5 percent of the gross amount of the royalties.
(3) Paragraph (2) shall not apply if the person beneficially entitled to the royalties, being a resident of one of the Contracting States, has a permanent establishment in the other Contracting State or performs independent personal services in that other State from a fixed base situated therein, and the property or rights giving rise to the royalties are effectively connected with such permanent establishment or fixed base. In such a case, the provisions of Article 7 (Business profits) or Article 14 (Independent personal services), as the case may be, shall apply. ...
(5) Where, owing to a special relationship between the payer and the person beneficially entitled to the royalties or between both of them and some other person, the amount of the royalties paid or credited, having regard to what they are paid or credited for, exceeds the amount which might have been expected to have been agreed upon by the payer and the person so entitled in the absence of such relationship, the provisions of this Article shall apply only to the last-mentioned amount. In that case, the excess part of the amount of the royalties paid or credited shall remain taxable according to the law of each Contracting State, but subject to the other provisions of this Convention. For Article 12 of the US Convention to apply to the royalties paid by AusCo to ForeignCo A, to the effect that the tax charged in Australia on the royalties shall not exceed 5 percent of the gross amount of the royalties, the following must be satisfied: • There are royalties paid from a source in Australia. • A resident of the US is beneficially entitled to the royalties. Royalties paid from a source in Australia
The term 'royalty' is defined at paragraph 4 of Article 12 of the US Convention as follows: (4) The term "royalty" in this Article 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; ... Paragraph 6 of Article 12 of the US Convention states:
(6) (a) Royalties shall be treated as income from sources in a Contracting State when the payer is that State itself or a political subdivision or local authority of that State or a person who is a resident of that State for the purposes of its tax. Where, however, the person paying the royalties, whether he is a resident of one of the Contracting States or not, has in one of the Contracting States or outside both Contracting States a permanent establishment or fixed base in connection with which the liability to pay the royalties was incurred, and the royalties are borne by the permanent establishment or fixed base, then the royalties shall be deemed to have their source in the State in which the permanent establishment or fixed base is situated. (b) Where sub-paragraph (a) does not operate to treat royalties as being from sources in one of the Contracting States, and the royalties relate to use or the right to use in one of the Contracting States of any property or right described in paragraph (4), the royalties shall be treated as income from sources in that State. AusCo pays royalty income to ForeignCo A.
AusCo is a company formed in Australia that is an Australian tax resident. AusCo is therefore a 'person' within the meaning of Article 3(1)(a) of the US Convention and a 'resident of Australia' within the meaning of Article 4(1)(i) of the US Convention. Therefore, the amounts paid from AusCo to ForeignCo A are royalties paid from a source in Australia. Resident of the US is beneficially entitled to the royalties While the royalties are paid to ForeignCo A, it may not necessarily follow that there are US residents that are beneficially entitled to the royalties for the purposes of the US Convention. The term 'beneficially entitled' is not defined in the US Convention. Paragraph 2 of Article 3 of the US Convention provides the following: As regards the application of this Convention by one of the Contracting States, any term not defined herein shall, unless the context otherwise requires, have the meaning which it has under the laws of that State relating to the taxes to which this Convention applies.
As such, the definition of the term 'beneficially entitled' or 'beneficial owner' in relation to royalties sourced from Australia shall be guided by the context of its use in the US Convention or, without such context, by the laws of Australia for the purposes of taxation. ATO Interpretive Decision ATO ID 2011/13 Income Tax Interest withholding tax: interest arising in Australia paid to a New Zealand Limited Partnership - 'beneficially owned' (ATO ID 2011/13)provides guidance in relation to the use of relevant context for interpreting Australian tax treaties and is therefore instructive in considering the application of the US Convention. ATO ID 2011/13 states the following: Relevant context for the purposes of interpreting an Australian tax treaty includes the Commentaries on the OECD Model Tax Convention on Income and on Capital (the OECD Commentary). Paragraph 104 of Taxation Ruling TR 2001 / 13 states that the OECD Commentary provides important guidance on interpretation and application of the OECD Model Tax Convention and will often need to be considered as a matter of practice, in interpreting tax treaties, at least where the wording is ambiguous.
The OECD Commentary explains broadly that a person is the 'beneficial owner' to income for the purposes of the dividend, interest and royalty (DIR) Articles where that person demonstrates that in substance they have [it has] the practical rights and capacity to enjoy the income for their [its] own benefit. The 2017 OECD Commentary on Article 12 at paragraphs 4 - 4.3 states: 4. The requirement of beneficial ownership was introduced in paragraph 1 of Article 12 to clarify how the Article applies in relation to payments made to intermediaries. It makes plain that the State of source is not obliged to give up taxing rights over royalty income merely because that income was paid direct to a resident of a State with which the State of source had concluded a convention. The term "beneficial owner" is therefore not used in a narrow technical sense (such as the meaning that it has under the trust law of many common law countries), rather, it should be understood in its context and in light of the object and purposes of the Convention, including avoiding double taxation and the prevention of fiscal evasion and avoidance.
4.1 Relief or exemption in respect of an item of income is granted by the State of source to a resident of the other Contracting State to avoid in whole or in part the double taxation that would otherwise arise from the concurrent taxation of that income by the State of residence. Where an item of income is paid to a resident of a Contracting State acting in the capacity of agent or nominee it would be inconsistent with the object and purpose of the Convention for the State of source to grant relief or exemption merely on account of the status of the direct recipient of the income as a resident of the other Contracting State. The direct recipient of the income in this situation qualifies as a resident but no potential double taxation arises as a consequence of that status since the recipient is not treated as the owner of the income for tax purposes in the State of residence.
4.2 It would be equally inconsistent with the object and purpose of the Convention for the State of source to grant relief or exemption where a resident of a Contracting State, otherwise than through an agency or nominee relationship, simply acts as a conduit for another person who in fact receives the benefit of the income concerned. For these reasons, the report from the Committee on Fiscal Affairs entitled "Double Taxation Conventions and the Use of Conduit Companies" concludes that a conduit company cannot normally be regarded as the beneficial owner if, though the formal owner, it has, as a practical matter, very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties.
4.3 In these various examples (agent, nominee, conduit company acting as a fiduciary or administrator), the direct recipient of the royalties is not the "beneficial owner" because that recipient's right to use and enjoy the royalties is constrained by a contractual or legal obligation to pass on the payment received to another person. Such an obligation will normally derive from relevant legal documents but may also be found to exist on the basis of facts and circumstances showing that, in substance, the recipient clearly does not have the right to use and enjoy the royalties unconstrained by a contractual or legal obligation to pass on the payment received to another person... Where the recipient of royalties does have the right to use and enjoy the royalties unconstrained by a contractual or legal obligation to pass on the payment received to another person, the recipient is the "beneficial owner" of these royalties. It should also be noted that Article 12 refers to the beneficial owner of royalties as opposed to the owner of the right or property in respect of which the royalties are paid, which may be different in some cases.
The OECD concept of 'beneficial entitlement' applied in the OECD Commentary considers the right to use and enjoy the royalties unconstrained by a contractual obligation to pass on the payment received to another person as a relevant determinate factor of beneficial ownership/entitlement rather than solely focusing on whether an entity is subject to income tax on the income, whilst acknowledging that the latter may be relevant when considering the broader purpose and objective of a Convention, to avoid double taxation and prevent avoidance. Single member LLC's As previously outlined, in ATO ID 2010/188 the Commissioner accepted that single member LLCs are disregarded for the purposes of applying the US Convention, in accordance with the residence country (US) treatment. In the US, under US Treasury Regulations, Subchapter F, sec 301.7701-2(a); A business entity with only one owner is classified as a corporation or is disregarded; if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch or division of the owner.
Given single member LLCs are disregarded for the purposes of applying the US Convention and its activities treated as that of the owner, it is the single member owner that is the relevant entity for the purposes of applying the US Convention. In the case of the single member LLCs within the ForeignCo B Group, it is ForeignCo B which is the first entity that is not a single member disregarded entity. ForeignCo B is treated as a partnership for US tax purposes and is a resident. As such, the question is whether ForeignCo B is beneficially entitled to the Royalties for the purposes of the US Convention. ForeignCo B right to enjoy the royalty income When considering ForeignCo B's circumstances, it demonstrates characteristics of being the beneficial owner of the royalty income. The following factors are relevant in determining whether ForeignCo B is beneficially entitled to the royalty income: (a) ForeignCo B is a legal form company. The relationship between an LLC and its members is akin to that of shareholders and a company, with the members not having any interest in the underlying property of the company.
(b) The members of the LLC only have a legal right to payment of a distribution per the LLC Agreement, which states that a distribution to members is at the discretion of the Managing Member. It is only at this moment that a member is entitled to a distribution and the enjoyment of the underlying income. (c) Generally, the distributions that the Managing Member makes tend to be driven by the cash requirements of its members, including to cover the tax liability that arises for the ultimate partners due to the allocation of its profits for US domestic tax purposes. (d) From a commercial perspective, ForeignCo B is fundamentally the head of the ForeignCo B Group of the Foreign Group. It is a separate business unit to the other parts of the Foreign Group. The ForeignCo B Group business unit considers its requirements in totality before making decisions as to distributions.
(e) ForeignCo B is the first entity in the ownership chain that is recognised by the US Convention as being a resident of a Contracting State. As outlined, the US position is that ForeignCo B's single member disregarded LLC entities are ignored for US income tax purposes, and are not recognised as residents under the US Convention. Similarly, in ATO ID 2010/188 the Commissioner has accepted the view that such entities are not residents for US Convention purposes, and accepts that the single member resident is the relevant entity that is entitled to treaty benefits with respect to income derived by a single member disregarded LLC. (f) For US federal income tax purposes, ForeignCo B is a partnership. As such, it is not taxed on the income it earns. Rather its partners (or in this case, due to ForeignCo D also being a partnership, its ultimate partners) are for income tax purposes allocated their share of ForeignCo B's net income and taxed on their share. However, to whom the amount is allocated for tax purposes in the country of residence is but part of the analysis and is not itself decisive.
As ForeignCo B in substance has the practical rights and capacity to enjoy the royalty income for its own benefit (and more broadly the ForeignCo B Group), rather than having a contractual obligation to distribute the royalty income to its members, it is beneficially entitled to the royalty income. As demonstrated above, ForeignCo B is also a resident of the US for the purposes of the US Convention. Therefore a resident of the US is beneficially entitled to the royalties. Other provisions of Article 12 of the US Convention Paragraphs 3 and 5 of Article 12 of the US Convention operate to limit the application of Article 12 of the US Convention in certain circumstances. These paragraphs do not apply for the following reasons: ForeignCo B does not have a permanent establishment in Australia nor does it perform independent personal services in Australia. There is no special relationship between AusCo and ForeignCo B. Conclusion
Given ForeignCo B is beneficially entitled to the royalty income and a tax resident of the US for the purposes of the US Convention, AusCo will only be obliged to withhold from Royalties paid to ForeignCo A a withholding tax amount of 5% to the extent the income of ForeignCo B is subject to US income tax in the hands of US residents, and subject to whether ForeignCo B satisfies the requirements in Article 16 Limitation on benefits. Article 16 - Limitation on benefits Under Article 16(1) of the US Convention, a resident of the US that derives income from Australia is not entitled to the benefits under the US Convention unless the person is a "qualified person" or satisfies another paragraph of Article 16. ForeignCo B does not satisfy the definition of a qualified person in Article 16(2) of the US Convention. Whether it is entitled to treaty benefits is determined by reference to the remaining paragraphs in the Article. Relevantly, Article 16(3) of the US Convention states:
(a) A resident of one of the Contracting States will be entitled to the benefits of the Convention with respect to an item of income derived from the other State, regardless of whether the resident is a qualified person, if the resident is engaged in the active conduct of a trade or business in the first-mentioned State (other than the business of making or managing investments for the resident's own account, unless these activities are banking, insurance or securities activities carried on by a bank, insurance company or a registered, licensed or authorized securities dealer), and the income derived from the other Contracting State is derived in connection with, or is incidental to, that trade or business.
(b) If the resident or any of its associated enterprises carries on a trade or business activity in the other Contracting State which gives rise to an item of income, sub-paragraph (a) of this paragraph shall apply to such item only if the trade or business activity in the first-mentioned State is substantial in relation to the trade or business activity in the other State. Whether a trade or business activity is substantial for purposes of this paragraph will be determined based on all the facts and circumstances.
(c) In determining whether a person is "engaged in the active conduct of a trade or business" in a Contracting State under sub-paragraph (a) of this paragraph, activities conducted by a partnership in which that person is a partner and activities conducted by persons connected to such person shall be deemed to be conducted by such person. A person shall be connected to another if one possesses at least 50 percent of the beneficial interest in the other (or, in the case of a company, at least 50 percent of the aggregate vote and value of the company's shares or of the beneficial equity interest in the company) or another person possesses, directly or indirectly, at least 50 percent of the beneficial interest (or, in the case of a company, at least 50 percent of the aggregate vote and value of the company's shares or of the beneficial equity interest in the company) in each person. In any case, a person shall be considered to be connected to another if, based on all the relevant facts and circumstances, one has control of the other or both are under the control of the same person or persons.
Article 16(3)(a) of the US Convention firstly requires that a resident of the US or Australia must be engaged in the active conduct of a trade or business in their state of residence. However, a business of making or managing investments for the resident's own personal account is not regarded as an active trade or business unless these activities are banking, insurance or securities activities carried on by a bank, insurance company or a registered, licensed or authorised securities dealer. Secondly, the income derived in the other Contracting State must be derived in connection with or incidental to the trade or business conducted in the state of residence. Article 16(3)(b) of the US Convention states where a person or an associate carries on a trade or business in the other Contracting State which gives rise to an item of income, the trade or business carried on in the state of residence must be substantial in relation to the activity in the state of source of the income. Article 16(3)(c) of the US Convention states that in determining whether a person is engaged in the active conduct of a trade or business then the following will be deemed to be part of that activity:
Partnership activities provided the person is a partner, and Activities of connected persons. The three circumstances in which a person will be connected to another person are, firstly, if either person possesses at least 50% of the: Beneficial interest of the other; Aggregate vote and value of a company's shares; or Beneficial equity interests of the company. Secondly, if another person possesses directly or indirectly, at least 50% of the: Beneficial interest; Aggregate vote and value of a company's shares; or Beneficial equity interest in the company in each person. Thirdly, a person is connected to another person if the relevant facts and circumstances indicate that: One has control of the other; or Both are under the control of the same person or persons. The activities of all entities in the structure should be taken into account in determining if ForeignCo B is engaged in the active conduct of a trade or business. This is because all are members of the same corporate group, and with respect to each entity, Foreign Group Holdings holds directly or indirectly greater than 50% of the equity interests, meaning they are all connected entities for the purposes of this Article.
Therefore, all of the activities of the entities within the group can be taken into account in determining whether the Residents are "engaged in the active conduct of a trade or business" from which the royalties paid by AusCo to ForeignCo A are derived. Trade from which the royalty income is derived AusCo pays royalties to ForeignCo A. ForeignCo B and its subsidiaries operate an integrated business, principally engaged in the development, production, sales and marketing of products featuring the relevant business. The relevant business generated circa US$X of gross receipts during FYXX. The royalties paid by AusCo to ForeignCo A fall within a key source of income of ForeignCo B and its subsidiaries. At the time of the ruling request, there were approximately X full-time employees of the ForeignCo B Group worldwide that manage and operate the relevant business. Approximately X are employed by ForeignCo G and are located in the US. There are no employees based in Australia and the ForeignCo B Group does not carry on a business in Australia.
As demonstrated by the above, ForeignCo B and its subsidiaries have X employees carrying on an active business in the US in relation to the relevant business which is, generating the royalty income received from AusCo. Finally, it is noted that the same analysis applies to ForeignCo C and ForeignCo E as the residents ultimately taxed on the Royalties in the US. As connected entities of ForeignCo B, they will, for the same reasons outlined with respect to ForeignCo B, be treated as satisfying the requirement under Article 16(3) of the US Convention. For completeness, there are no arrangements in place under which the royalty income derived by ForeignCo A from AusCo can be streamed to a particular class of shareholder of any of the Residents, or any of the interest holders in any of the entities interposed between the Residents and ForeignCo A in a disproportionate manner. Therefore Article 16(4) of the US Convention is not relevant. On this basis, ForeignCo B is considered to be engaged in the active conduct of trade or business in the US and the royalty income is derived in respect of that trade or business, thus satisfying the requirements of Article 16(3) of the US Convention.
Conclusion ForeignCo B (to the extent it is a resident for the purposes of the US Convention) is entitled to access the benefits of the US Convention with respect of the royalty income derived by ForeignCo A from AusCo in Australia.