US-AU DTA: Article 7 – Business Profits
Covid has changed the way business is done globally. Two of the most common changes are
– Remote working (Employee sitting in Australia could be working for an employer in the US); and
– The increase in e-commerce businesses and being able to grow and expand these businesses globally without actually leaving the house.
That being said, have you ever as an employer considered what the potential tax implications could be for the company by having employees working remotely?
And does your e-commerce business create a permanent establishment in another country perhaps?
Make sure you have taken proper steps to mitigate any unnecessary tax implications due to the ‘new norm’.
Article 7 is one of the more complex and technical articles in the DTA as it has various components to consider. However, I will try and provide a brief summary of its interpretation.
The first overriding principle of double taxation treaties is that a company resident in one country will not be taxed on its business income in the other State unless it carries on that business in the other country through a Permanent Establishment (PE) situated in that country.
The second principle is that the taxation right of the State where the PE is situated does not extend to income that is not attributable to the PE. The interpretation of these principles has differed from country to country. Some countries have pursued a principle of general force of attraction, which means that all income such as other business profits, dividends, interest and royalties arising from sources in their territory was fully taxable in that country if the beneficiary had a PE there, even though such income was clearly not attributable to that PE.
In this week’s blog we will have a look at Article 7 of the US/AUS DTA and highlight some key aspects.
INTERPRETING ARTICLE 7 OF THE DTA – BUSINESS PROFITS
Article 7 sets out the limits of the source state’s taxing rights in relation to business profits. If an enterprise resident in a contracting state has a Permanent Establishment (PE) in the other state through which it carries on business it can be taxable in that other state, as well as the state of residence. The tax is limited in the source state to no more than the profits attributable to the PE.
Article 7(1) states the basic principle which is that the profits of an Australian enterprise may be taxed in the US only if it carries on business in the US through a permanent establishment and vice versa. In the case of an Australian enterprise, the US can only tax the profits of the enterprise to the extent that they are attributable to the permanent establishment.
It should be noted that dual-resident corporations are excluded from the term “enterprise of one of the Contracting States” by reason of the definition of an Australian or a US corporation contained in Article 3(1)(g) and the definition of residence contained in Article 4. Such dual-resident corporations are treated as a resident of neither country for convention purposes, and therefor denied the benefit of this article and other provisions in the convention.
The phrase ‘business profits of an enterprise’ is critical to the operation of Article 7.
The term ‘profits’ is not defined in the agreement and the question arises as to whether it includes profits which are ordinarily regarded as capital in nature or which are not derived from the carrying on of a business.
Article 3(2) of the DTA provides that, unless the context otherwise requires, a reference to profits of a business is a reference to the taxable income of the business. As capital gains are included in taxable income, the section arguably supports the view that Article 7 applies to capital gains.
The 2006 U.S. Model Treaty Technical Explanation attempts to define business profits more generally in Article 7(1), providing that business profits are ‘income derived from any trade or business’.
Article 7(2), which is subject to Article 7(3), provides that the profits to be attributed to a permanent establishment are those, which it might be expected to make if it were an independent enterprise engaged in similar activities under similar conditions. The profits must reflect arm’s length prices. For example, the profits of a branch must be calculated as if it were a separate entity distinct from its head office and on the basis that the branch was dealing wholly independently with its head office.
The practical application of Article 7(2) is not as straightforward as it seems. Quite often, a functional analysis needs to be done to ensure that arm’s length principles are applied properly. This includes the proper characterization of the transaction and the commercial risks undertaken by the enterprise.
Article 7(3) states that expenses that are reasonably connected with the profits of the permanent establishment and would have been deductible if the permanent establishment were an independent entity are deductible. Further, these expenses are deductible whether incurred in the Contracting State in which the permanent establishment is situated or elsewhere including executive and general administrative expenses.
Article 7(4) states that no profits are to be attributed to a permanent establishment by reason of mere purchase by that permanent establishment of goods or merchandise for that enterprise.
Article 7(5) states that unless there is a good and sufficient reason to the contrary, the same method of determining the business profits attributable to a permanent establishment shall be used each year.
Article 7(6) states that where business profits include items of income dealt with in other articles of the Convention the provisions of those other articles override the provisions of this Article.
Categories of income not specifically included in the definition of business profits are subject to the “overlap” rule of Article 7(6), which provides that a treaty article that governs a specific category of income (for example, the article pertaining to interest or dividends) takes precedence over the business profits article. If the item of income is attributable to a permanent establishment, it may ultimately be taxed under the business profits article anyway, because many of the treaty articles addressing specific categories of income (such as dividends and interest) provide that if the income is attributable to a permanent establishment, it is subject to taxation under the business profits article.
Article 7(7) allows the ATO and IRS to apply any of its domestic laws to determine a person’s tax liability where the information required to make an appropriate attribution of profits to a permanent establishment is inadequate.
Article 7(8) provides that nothing in Article 7 prevents each country from applying its domestic law to tax insurance business income provided that such law remains the same (or is modified in only minor respects) since the date the Convention was signed. or will tax the net income of a US trade or business.
Article 7(9) applies where a fiscally transparent entity, such as a trust, has a permanent establishment in a Contracting State and a resident of the other Contracting State is beneficially entitled to a share of the business profits (beneficial owner).
Where the above requirement is satisfied then the beneficial owner is treated as carrying on a business through the permanent establishment in the Contracting State and therefore its share of the business profits of the fiscally transparent entity are taxable due to Article 7(1).
For example, if a trust with a US beneficiary carries on a business in Australia through its trustee, and that trustee’s actions rise to the level of a permanent establishment then the US beneficiary will be treated as having a permanent establishment in Australia. This has the consequence that the profits of the trust attributable to the US beneficiary will be treated as business profits subject to Australian tax.
Article 7(9) was introduced at the request of Australia because the trustees of a trust, as the legal owner of the trust property, might be regarded as the only person having a permanent establishment.
This article is probably one of the more difficult articles to comprehend in the DTA. For purposes of this blog, it’s important to know that a source country can’t attribute any business profits in terms of Article 7 if there is no permanent establishment in that source country.