When it comes to the alienation of property, it is usually standard practice to give the taxing rights to the state which, under the DTA, is entitled to tax both the property and income derived from it.
Article 13 provides rules for the taxation of certain gains derived by a resident of a Contracting State. In general, the Article makes provision for the following:
- gains from the alienation of real property may be taxed where the real property is located;
- gains derived from the alienation of ships or aircraft or related property may be taxed only by the State of which the enterprise is a resident, except to the extent that the enterprise has been allowed depreciation of the property in computing taxable income in the other State; and
- gains from the alienation of property referred to in paragraph 4 (c) of Article 12 (Royalties) are taxable under Article 12.
Gains with respect to any other property are covered by Article 21 (Income Not Expressly Mentioned), which provides that gains effectively connected with a permanent establishment are taxable where the permanent establishment is located, in accordance with Article 7 (Business Profits), and that other gains may be taxed by both the State of source of the gain and the State of residence of the owner. Double taxation is avoided under the provisions of Article 22 (Relief from Double Taxation).
INTERPRETING ARTICLE 13 OF THE DTA – ALIENATION OF PROPERTY
Article 13(1) states that income or gains derived by a resident of one country from the alienation of real property in the other country may be taxed in that other country.
For example, if a US resident derived income or gains from the disposal of real property located in Australia, that income or gain may be taxed in Australia.
The meaning of the phrase ‘income or gains’ was clarified by the Protocol. Article 2(1)(b) (Taxes Covered) was amended to include a specific reference to Australian capital gains tax to ensure that capital gains are within the scope of the DTA.
Article 13(2) defines the term ‘real property’.
For purposes of the US, Article 13(2)(a) provides that the term ‘real property situated in the other Contracting State’ includes a ‘United States real property interest and real property referred to in Article 6 which is situated in the United States’.
Accordingly, the US retains its full taxing rights under its domestic law.
For purposes of Australia Art 13(2)(b) provides that real property includes the following:
- real property referred to in Article 6;
- shares or comparable interests in a company, the assets of which consist of wholly or principally of real property situated in Australia, and
- an interest in a partnership, trust or estate of a deceased individual, the assets of which consist wholly or principally of real property situated in Australia.
Article 6 includes within the definition of real property a leasehold interest in land and rights to exploit or to explore for natural resources.
Shares or comparable interests in a company, the assets of which consist wholly or principally of real property, and an interest in a partnership, trust or deceased estate are also deemed to be real property in terms of Article 13(2)(b)(ii) and 13(2)(b)(iii).
Article 13(3) states that income or gains arising from the alienation of property (other than real property covered by Article 13(1)) forming part of the business assets of a permanent establishment of an enterprise or pertaining to a fixed base used for performing independent personal services may be taxed in that other state.
This article also applies where the permanent establishment itself (alone or with the whole enterprise) or the fixed base is alienated and corresponds to the rules for the taxation of business profits and income from independent services in Article 7 and Article 14 respectively.
Article 13(4) makes provision for exclusive taxing rights of income and capital gains by the residence country from the alienation of ships, aircraft or containers operated or used in international traffic. It is also important to note, that this applies even if the income is attributable to a permanent establishment maintained by the enterprise in the other Contracting State.
Article 13(5) applies to the taxation of deemed disposals when ceasing your tax residency in a contracting state. This is also referred to as an exit tax. This article states that where an individual, has a deemed disposal event in their residence state due to ceasing residency, they can elect to be treated for the purposes of the taxation laws of the other state as having alienated and re -acquired the property for an amount equal to its fair market value at that time.
This rule has two significant consequences –
- Firstly, if the individual is subject to tax in the other Contracting State on the gain from the deemed sale of the asset a foreign tax credit for tax on the deemed sale will be available pursuant to Article 22.
- Secondly, the deemed sale and repurchase will result in the individual resident in the other Contracting State having a “stepped up” cost base equal to the fair market value of the property.
Article 13(6) states that where a resident of one state elects to defer taxation on income or gains relating to property that would otherwise be taxed in that state (upon ceasing to be a resident) only the state where they subsequently become a resident can tax the deferred gain.
Article 13(7) makes provision for any other capital gains not covered by Article 13. These capital gains are to be taxed in accordance with the domestic laws of each country.
Article 13(8) lastly clarifies the taxation of real property which consists of shares in a company or interests in a partnership, estate or trust as referred to in Article 13(2)(b) is deemed to be situated in Australia.
There have been numerous disputes regarding the application of this Article and reference to case law is extremely important. Especially in relation to limited partnerships and or indirect ownership through a chain of companies of Australian real property.
Make sure you understand how Article 13 can impact your potential liquidity event when planning to dispose of your business.
We strongly recommend seeking professional advice when it comes to this Article and our team of International Tax specialists at Asena Advisors, will guide you on how to approach and interpret Article 13.