Income tax: application of section 6CA of the Income Tax Assessment Act 1936 and Australia's tax treaties and the payer's withholding obligations

This Ruling applies to income which is derived by a non-resident and calculated by reference to the value or quantity of natural resources produced and/or sold. For convenience, this Ruling refers to such income as 'override royalties'. [1] Such income is typically paid by the holder of a mining right to an entity that does not have an interest in the right.

The Ruling sets out: • when a payment, that is income, is calculated, in whole or in part, by reference to the value or quantity of natural resources produced in Australia for the purpose of the definition of 'natural resource income' in subsection 6CA(1) of the Income Tax Assessment Act 1936 (ITAA 1936) (see Part A of this Ruling) • how the income from real property articles in Australia's tax treaties apply to override royalties (see Part B of this Ruling), and • the circumstances in which an Australian-resident payer of override royalties is required to withhold an amount from an override royalty payment under section 12-325 of Schedule 1 to the Taxation Administration Act 1953 (Schedule 1 to the TAA) (see Part C of this Ruling).

The Ruling does not address: • the application of Australia's tax treaties, other than the income from real property article • the tax treatment of a grant, assignment or transfer of the right to receive an override royalty payment • whether override royalty payments constitute interest or non-share dividends, or • the tax treatment of common law royalties.

Under paragraph (b) of the definition of 'natural resource income' in subsection 6CA(1) of the ITAA 1936, income is calculated, in whole or in part, by reference to the value or quantity of resources produced [2] where the calculation is based on the level of production.

In working out whether the calculation of a payment is based on the level of production, it is appropriate to have regard to the contractual terms of the relevant override royalty agreement and any related agreements, and the substance of the arrangement.

A direct causal connection between the amount of income and the level of production is not required. As a result, income calculated by reference to a value or measure other than production (such as sales or shipping volume) may be natural resource income. For example, where it is reasonable to conclude: • the income is calculated by reference to sales or shipping volume and the relevant agreement(s), in calculating the income treat all, or substantially all, of the relevant resources produced as having been sold or shipped (whether or not in the same income year) • the difference between production and sales or shipping volumes arises from wastage of part of the resource between production and delivery to the customer, or • due to the nature of the resource or the market, in practice, all, or substantially all, of the relevant resources produced are sold or shipped (whether or not in the same year).

For Co receives payments calculated as 1% of the wellhead value of petroleum produced by Aus Co. The wellhead value equals the sales proceeds less the cost of transportation downstream of the wellhead. As the payment varies with changes in the value of petroleum produced, it is calculated by reference to the value of natural resources produced.

For Co provided Aus Miner Co $50 million. In exchange, Aus Miner Co is required to make payments amounting to 1.5% of the value of gas it recovers (regardless of whether that gas is sold). In the circumstances, the payment is calculated by reference to the value of natural resources produced.

Income is calculated 'in whole' by reference to the value or quantity of resources produced where the income is calculated solely by reference to the value or quantity of the resources produced. Income is calculated 'in part' by reference to the value or quantity of resources produced where the income is the sum of two or more amounts, one of which is calculated by reference to the value or quantity of resources produced, or the income is a single amount which is partly calculated by reference to the value or quantity of resources produced. Where the income is calculated 'in part' by reference to the value or quantity of natural resources produced in Australia, then the whole of the payment will be natural resource income.

Minerals and any other non-living resources of the land, seabed or sea, are 'natural resources' under the definition in subsection 995-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) irrespective of whether those minerals or resources require extensive processing to separate them from other substances or to remove impurities.

The meaning of the phrase 'natural resources produced, recovered or produced and recovered' depends on the nature of the resource.

A natural resource may be produced or recovered, or produced and recovered, by mere extraction or by separation following extraction. Separation includes physical and chemical processes such as crushing, washing, refining and smelting.

Natural resources will be produced in Australia when all of the material processes of production occur in Australia.

In working out whether an override royalty is calculated wholly or partly by reference to the value or quantity of production in Australia , the relevant production is all of the material processes of production which occur until the point at which the override royalty is determined.

The income from real property articles in Australia's tax treaties will not apply to override royalties in circumstances where subsection 6CA(1) of the ITAA 1936 would not otherwise apply to the override royalty. In relation to override royalties, the scope of the income from real property articles is no wider than section 6CA.

The large majority of Australia's income tax treaties contain an 'Income from real property' article which treats as real property 'a right to receive variable or fixed payments either as consideration for or in respect of the exploitation of, or the right to explore for or exploit, mineral, oil or gas deposits, quarries or other places of extraction or exploitation of natural resources'.

Under that article, payments calculated by reference to the value or quantity of natural resources produced are 'in respect of' the exploitation of natural resources. This means that 'natural resource income' under subsection 6CA(1) of the ITAA 1936 will be income from real property under the majority of treaties.

The Australian treaty with the United States of America (US treaty) [3] is an exception to paragraphs 16 and 17 of this Ruling. [4] Under the US treaty, income from real property includes income from rights to exploit or to explore for natural resources. Recipients of override royalty payments who do not hold the right to exploit or explore for natural resources do not derive income from real property for the purposes of the US treaty.

Aus Co owns a production licence issued by a State Government, entitling it to produce oil and gas from an onshore field. For monetary consideration, Aus Co enters into a deed granting US Co a right to 10% of the value of oil and gas produced from the field. US Co does not obtain any proprietary interest in the production licence. US Co's right to payment is not derived from the real property, being Aus Co's rights to exploit the oil and gas under the production licence. Therefore, the income received by US Co is not income from real property for the purposes of the United States treaty.

An override royalty payment to which subsection 6CA(1) applies is deemed to have an Australian source, and will be included in the recipient's assessable income under paragraph 6-5(3)(a) of the ITAA 1997.

Where subsection 6CA(1) of the ITAA 1936 applies to an override royalty payment, the conditions in subsection 12-325(1) of Schedule 1 to the TAA will be satisfied.

This Ruling applies to years of income commencing both before and after its date of issue. However, this Ruling will not apply to taxpayers to the extent that it conflicts with the terms of a settlement of a dispute agreed to before the date of issue of this Ruling (see paragraphs 75 and 76 of Taxation Ruling TR 2006/10 Public Rulings).

Non-residents that derive natural resource income are subject to Australian income tax on that income as subsection 6CA(3) deems that income to have been derived from a source in Australia for, in the present context, the purposes of section 6-5 and 6-10 of the ITAA 1997. Also, subsection 6CA(2) deems natural resource income to be attributable to sources in Australia for the purposes of Divisions 5 and 6 of Part III of the ITAA 1936.

The definition of natural resource income in subsection 6CA(1) , to the extent that definition is relevant to this Ruling, states: natural resource income means income that: (a) is derived by a non-resident; and (b) is calculated, in whole or in part, by reference to the value or quantity of natural resources produced, recovered or produced and recovered, in Australia after 7 April 1986; ...

Australian courts have said the phrase 'by reference to' covers a wider range of connections than phrases such as 'by reason of', which are limited to connections of a causal nature. [5] Typically, however, a causal connection between the level of production of natural resources and the amount of the override royalty will be sufficient to satisfy the requirement that the payment be calculated by reference to the value or quantity of natural resources produced.

This is consistent with the Explanatory Memorandum to the Taxation Laws Amendment Bill (No.4) 1986 (the EM) which introduced section 6CA into the ITAA 1936, which states (emphasis added): The amendments proposed by this Bill will mean that, subject to the exception outlined below, income that is directly related to the exploitation of Australia's natural resources and that is derived by a non-resident (referred to as "natural resource income") will be subject to full Australian tax. The amendment will apply to payments of natural resource income made after 7 April 1986 and which are based on the level of production and recovery of natural resources after that date.

As outlined in the EM, the intent of the provision is to include income that is directly related to the exploitation of Australia's natural resources. A payment will be directly related to the exploitation of natural resources where the payment is based on the level of production or recovery of natural resources.

In working out whether the calculation of a payment is based on the level of production the Commissioner will have regard to the relevant circumstances, including the conduct of the parties, the relevant agreement(s) and the substantive outcome (meaning its effects from a practical and business point of view). Therefore, payments will be natural resource income where they are calculated by reference to a measure other than production, but the payments are nonetheless based on the level of production.

This is consistent with the purposive approach to legislative interpretation [6] , and ensures that the purpose for the introduction of section 6CA of the ITAA 1936, as outlined in paragraph 26 of this Ruling in the EM, is achieved. Support for the purposive approach is found in Attorney-General (WA) v Marquet [7] where in considering the construction of the provisions of the Electoral Distribution Act 1947 (WA) the majority of the High Court commented that '[t]he evident purpose of the provision should not be defeated by preferring form over substance.'

The terms 'produced' and 'recovered' are not defined in the ITAA 1936 or ITAA 1997. The Shorter Oxford Dictionary [8] defines 'produce' to mean 'Of country, region, process, etc: yield or supply (a commodity etc)'. It defines 'recover' to mean 'Get, obtain, get hold of; collect, gather up'. Whether a particular natural resource has been produced or recovered depends on both the nature of the resource and the relevant processes used.

A natural resource will generally be found in the earth's crust embedded in other substances. The resource will typically be extracted, for example by drilling and blasting, along with those other substances. On extraction, multiple natural resources may have been produced or recovered. This is because a substance extracted may itself be a natural resource and may also contain several different substances that are each natural resources.

Many of Australia's tax treaties contain an article dealing with 'income from real property', although the article may have other headings in particular tax treaties, for example 'income from immovable property' or 'income from land'. In this Ruling, these articles are referred to collectively as 'income from real property' articles.

All income from real property articles in Australia's tax treaties use the terms 'exploitation' or 'exploit' in the context of the exploitation of natural resources. These words are not defined in the tax treaties and Australian domestic tax law nor is there any common law guidance on the meaning of the word in the present context. The Shorter Oxford Dictionary defines 'exploit' as '... verb trans. Work (a mine); make use of (natural resources)...'.

This meaning of exploit aligns with the meaning of natural resources 'recovered' or 'produced' as those terms are used in sections 6CA of the ITAA 1936 and section 12-325 of Schedule 1 to the TAA.

In certain contexts, the exploitation of resources may involve processes or activities that occur after a natural resource is produced. For example, it might include activities related to the marketing or distribution of the natural resource. In the context of the income from real property articles, it is appropriate to confine the word 'exploitation' to mean 'recovered' or 'produced'.

Therefore, in the context of override royalties, the exploitation of natural resources has the same scope as the 'recovery' or 'production' of natural resources.

This interpretation is consistent with the EM and the associated withholding provisions of former Division 3B of the ITAA 1936, which were replaced with section 12-325 of Schedule 1 to the TAA. The EM states that (emphasis added): The amendments proposed by this Bill will mean that ... income that is directly related to the exploitation of Australia's natural resources and that is derived by a non-resident (referred to as "natural resource income") will be subject to full Australian tax.

Article 6 of the Canadian treaty [9] is representative of the majority of income from real property articles.

Under Article 6(1) of the Canadian treaty, Australia may tax income from real property if the real property is situated in Australia. The definition of real property includes at paragraph 6(2)(b: a right to receive variable or fixed payments either as consideration for or in respect of the exploitation of, or the right to explore for or exploit, mineral, oil or gas deposits, quarries or other places of extraction or exploitation of natural resources.

The phrase 'as consideration for' has a wide meaning and must be construed in the context in which it appears.

The phrase implies a direct connection, in that the right to receive the payments is, in whole or part, consideration for the exploitation or the sale of the right to explore for or exploit natural resources.

The phrase 'in respect of' has a very wide meaning [10] and must be construed in the context in which it appears.

The phrase connects two subject matters. There must be 'some discernible and rational link' [11] between the two subject matters, and the connection must be material and not merely coincidental or extraneous. [12] In the context of the relevant income from real property articles, the two subject matters are: • a right to receive payment, and • the exploitation of the relevant natural resource.

A right to receive payments under an override royalty agreement essentially arises from the exploitation of the natural resources and this aptly demonstrates the discernible and rational link to exploitation. The exploitation is the very thing that crystallises the foreign resident's right to receive the payment. The connection in this situation is material and is not merely coincidental or extraneous.

The task is to characterise the nature of the right and its link to exploitation. It is not to analyse the relationship between the parties, nor the reasons for, nor the transactions which gave rise to, the right to receive the payments.

For example, a right to receive income may be granted for the provision of finance, or in satisfaction of some other liability, however, the right to receive the payment is still 'in respect of' the exploitation of natural resources if the payment is calculated by reference to the value or quantity of natural resources produced.

This interpretation is consistent with the Explanatory Memorandum to the International Tax Agreements Amendment Bill 1999 which introduced the first Amending protocol to the Malaysian treaty into Australian law. That Explanatory Memorandum explains that the income from real property article applies to payments which are natural resource income for Australian tax purposes: 2.25 The inclusion of the words 'or in respect of' in relation to natural resources are intended to ensure that Australia may tax payments which are 'natural resource income' for Australian tax purposes. 2.26 Natural resource income includes payments which, unlike royalties, are based on a contractual arrangement and not on the holding of any proprietary right in the natural resources concerned. The inclusion of the words 'or in respect of' therefore ensures that the definition of land includes not only payments in consideration for the right to exploit or to explore for natural resources, but also payments in relation to those resources where there is no proprietary right to explore/exploit the resources concerned.

There is no requirement for the foreign-resident recipient to have, or to have had, a proprietary interest in the underlying rights to explore for or exploit natural resources, or to have or to have had any role in exploiting natural resources.

For present purposes, the US treaty provides that income from real property includes income from 'rights to exploit or to explore for natural resources ... '.

Under the US treaty, an override royalty payment is not income from real property where the recipient does not hold the right to exploit or explore for natural resources.

The words 'worked out wholly or partly by reference to the value or quantity of natural resources produced or recovered in Australia' in subsection 12-325(1) of Schedule 1 to the TAA have the same meaning as 'calculated, in whole or in part, by reference to the value or quantity of natural resources produced, recovered or produced and recovered, in Australia' in paragraph (b) of the definition of 'natural resource income' in subsection 6CA(1) of the ITAA 1936.

Accordingly, the views set out in Part A of this Ruling in relation to paragraph (b) of the definition of 'natural resource income' in subsection 6CA(1) of the ITAA 1936 also apply to the withholding rules in section 12-325 of Schedule 1 to the TAA.

The following is a detailed contents list for this Ruling: Paragraph Summary - what this Ruling is about 1 Ruling 4 Part A - Override royalties and 'natural resource income' 4 Calculated, in whole or in part, by reference to the value or quantity of natural resources produced 4 Example 1 - override royalty varies with changes in value of production 7 Example 2 - override royalty calculated by reference to all resources produced (whether or not sold) 8 Meaning of 'natural resources', 'produced' and 'recovered' 10 'In Australia' 13 Part B - Tax treaties 15 Scope of the income from real property articles 15 General position for tax treaties 16 United States treaty 18 Example 3 - override royalty not derived from rights to exploit natural resources 19 Assessability of override royalty payments 20 Part C - Withholding on natural resource income 21 Date of effect 22 Appendix 1 - Explanation 23 Section 6CA overview 23 Part A - Override royalties and 'natural resource income' 25 Calculated, in whole or in part, by reference to the value or quantity of natural resources produced 25 Meaning of 'natural resources', 'produced' and 'recovered' 30 Part B - Tax treaties 32 'Exploitation' of natural resources 33 General position for tax treaties 38 'As consideration for' the exploitation of natural resources 40 'In respect of' the exploitation of natural resources 42 United States treaty 49 Part C - Withholding on natural resource income 51 Appendix 2 - Detailed contents list 53