An Australian court ruled recently that payments made by Australian clients to an Indian company — which are considered royalties under the Australia-India tax treaty but not under Australian tax law — are taxable as Australian-source income.
In the case at issue, Satyam Computer Services Ltd. was resident in India for tax purposes but also had offices in Sydney and Melbourne, Australia, from which it provided software products and information technology services to Australian customers during fiscal 2009, 2010, and 2011. The company’s services to Australian customers were performed by employees located in both Australia and India.
The issue before the full Federal Court was referred as a special case May 2 by a Federal Court judge.
Paul McNab, a partner at PwC, said a “special case stated” is a procedure used when the facts of a case are not in dispute and both the parties to the litigation and the Federal Court judge agree that there is an issue of law in need of a ruling.
In its October 11 ruling in Satyam Computer Services Ltd. v. Commissioner of Taxation (120181 FCAFC), the full Federal Court referred to its earlier decision in Tech Mahindra Ltd. v Federal Commissioner of Taxation ((2016) 250 FCR 287), in which it upheld a ruling by Federal Court Justice Melissa Perry that payments received by a taxpayer for services provided in 2008 by employees located in India were royalties as defined in article 12(3)(g) of the 1991 Australia-India tax treaty. (Tech Mahindra merged with Satyam in 2013.) The full Federal Court ruled in the 2016 decision that Australia had the right to tax those payments under article 12(2) of the tax treaty between the two countries. The High Court refused to take up the issue for fiscal 2008 on appeal.
In the Tech Mahindra case, Perry had also determined that the payments were deemed to have an Australian source by virtue of article 23 and section 4(2) of the International Tax Agreements Act 1953, which meant that they were taxable as Australian-source income under section 6-5(3)(a) of the Income Tax Assessment Act 1997 (ITAA 1997). While the determination in the Tech Mahindra case for the company’s 2008 tax year was not brought up on appeal, Satyam challenged the conclusion for the years 2009 through 2011.
Graeme Cooper, a professor of tax law at the University of Sydney, said that because the High Court refused to accept Tech Mahindra’s appeal for fiscal 2008, the issue cannot be litigated further for that year. “It looks like the [Australian Taxation Office (ATO)] is now going after the taxpayer for 2009, 2010, and 2011, and the taxpayer is resisting those actions,” he said. “Each year is a new assessment and each assessment can be litigated afresh, although the chances of winning on exactly the same facts drops to almost zero.”
Cooper said it appears that a single judge of the Federal Court determined that the main issue between Satyam and the ATO is the impact of Australia’s deemed source rule. “So the judge has [effectively] said, ‘I am going to send that question off to the full [Federal] Court before I proceed further because if the full court decides that matter, then the taxpayer’s whole case collapses,’” Cooper said.
Christopher Wallis, a lawyer with CGW Tax, said that because the issue of whether payments received for the services of employees in India were deemed to be Australian-source income under section 6-5(3)(a) of the ITAA 1997 had been decided in the 2016 Tech Mahindra decision, a single judge in the Federal Court would be bound to apply that ruling to the same set of facts unless it was determined that the decision was manifestly wrong. “So rather than run the matter before a single judge, knowing what any decision of that single judge must be and that the decision would be appealed anyway, the single judge on May 2 was asked to state a case for the full court,” Wallis said.
In a client note, Greenwoods & Herbert Smith Freehills Pty Ltd. said the issue revolves around article 23(1) of the Australia-India tax treaty, which states:
Income, profits or gains derived by a resident of one of the Contracting States which, under any one or more of articles 6 to 8, articles 10 to 20, and article 22 may be taxed in the other Contracting State, shall for the purposes of the law of that other State relating to its tax be deemed to be income from sources in that other State.”
The firm said article 12(3) of the treaty includes a broad definition of royalties that extends beyond the definition used for withholding tax purposes under Australian law, which means that the services performed by Satyam’s employees in India fell within the treaty definition but not the narrower one for purposes of domestic law royalty withholding tax.
“It was agreed that the payments were ordinary income within section 6-5 of the [ITAA] 1997 and (implicitly at least) that the payments would not be sourced in Australia under domestic law, apart from the treaty, but the treaty allowed Australia to tax them under article 12(5) as they were paid by Australian residents,” the consulting firm said. “The question was whether the rule quoted above, having been implemented into Australian law by the International Tax Agreements Act, meant that the services were sourced in Australia for the purposes of section 6-5(3)(a) of the 1997 Act and hence, [resulted in] assessable income of the Indian resident taxpayer.”
Wallis said Satyam did not dispute that the income derived from the services of employees working in India, which is taxable as royalty income in Australia under article 12 of the tax treaty, is ordinary income for the purposes of Australian tax law. The taxpayer claimed, however, that article 23 of the Australia-India tax treaty and the International Tax Agreements Act do not have the effect of deeming the amounts received for the services of those employees to be income from Australian sources for the purposes of section 6-5 of the ITAA 1997, and therefore do not result in those amounts being included in its assessable income for Australian tax purposes.
Satyam said that while Australia has the right to tax the royalties under the Australia-India tax treaty, it can only exercise that right if it has the right to impose tax on those amounts under Australia’s domestic law. The company argued that no such right exists under Australian domestic law. “That argument has a strong basis,” Wallis said. “Most advisers construe treaties as allocating taxing rights that exist.”
Article Not Merely Enabling
In its decision, the full Federal Court rejected Satyam’s argument that article 23 of the Australia-India tax treaty is merely enabling. “In our view, the language of article 23 should be given effect according to its terms, and the context, object, and purpose of the [Australia-India tax treaty] does not warrant a different construction being given to the meaning of article 23, which otherwise is sufficiently clear in its terms,” it said.
The court said the section in article 23(1) stating “. . . shall for the purposes of the law of that other State relating to its tax be deemed to be income from sources in that other State” operates to deem an item of income that one of the contracting states has the right to tax to be from sources in that contracting state “for the purposes of” the law of that state “relating to its tax.” Section 6-5(3)(a) of the ITAA 1997 is part of the law of Australia “relating to its tax,” the court said. “The effect of article 23 therefore, is that the payments in question are deemed to have an Australian source for the purposes of [section] 6-5(3)(a).”
The court also rejected the taxpayer’s claim that there is no Australian law imposing tax on the income derived from the services provided by Satyam’s employees working in India. “That income is included in the applicant’s assessable income under [section] 6-5(3)(a) of the ITAA 1997 because it is income from an Australian source by reason of the combined operation of article 23 of the [Australia-India tax treaty], [sections] 4 and 5 of the Agreements Act, and [section] 6-5(3)(a) of the ITAA 1997,” the court said. “As the amounts form part of the applicant’s assessable income, such amounts are an integer in the calculation of the applicant’s taxable income under [sections] 4-15(1) of the ITAA 1997 and therefore, [are] part of the amount on which income tax must be paid by reason of [section] 4-10 of the ITAA 1997 and [section] 5 of the Income Tax Act 1986.”
The full Federal Court similarly rebuffed the taxpayer’s position that the ATO’s claim was contrary to the approach taken by courts in India, which Satyam said have ruled that a provision of a double tax agreement cannot establish a tax liability if the liability is not otherwise imposed under local law. The court said the ATO had not argued that the Australia-India tax treaty imposed a tax liability separate and independent from the operation of Australia’s domestic law. “The construction urged by the [ATO], which the court accepts, does not give rise to an inconsistent interpretation of the provisions of the [Australia-India tax treaty],” the court said. “This is because it is not the interpretation of the [Australia-India tax treaty] which would produce that inconsistency, if there be one, but the effect of Australia’s domestic law in [sections] 4 and 5 of the Agreements Act which would produce that result.”
The court also said the ATO’s position did not give rise to the possibility of double taxation.
Wide-Ranging Implications
Wallis said Perry considered the interpretation of treaties in the 2016 Tech Mahindra case. “That [her] comments were not appealed first time around is telling in itself,” Wallis said. “It is the amount at stake not only in this case, but [also] in the entire services outsourcing industry that is at stake. [It is] perhaps a late realization for many.”
Petter Madden, a partner at KPMG LLP, said the court’s decision didn’t come as a surprise. “[It] finally puts to bed the arguments that Australia’s double tax agreements can only act as a shield and never a sword,” he said.
In a client note, KPMG said the ruling has wide-ranging implications beyond the specific issue addressed by the court. “[It] highlights the risks of adopting filing positions based on long-standing practices and optimistic tax advice without thoroughly analyzing the relevant law,” KPMG said.
Wallis said that while the full Federal Court’s decision depends on “quirks” in the Australian legislation, the ruling is significant because it provides a means for the ATO to tax the income of technology companies generating income in Australia but not paying Australian tax. “One could expect other countries to be studying the decision and their treaties with the leading technology service provider countries — India, the U.S.A., and China — very closely,” Wallis said.
McNab said Satyam has the right to appeal to the High Court. “I suspect that the process will leave the taxpayer with little enthusiasm for such an appeal, but we will have to see,” he said.