By Anthony Diosdi
The major purpose of an income tax treaty is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Because tax treaties often substantially modify U.S. and foreign tax consequences, the relevant treaty must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction. The U.S. currently has income tax treaties with approximately 58 countries. This article discusses the implications of the United States- Australia Income Tax Treaty.
There are several basic treaty provisions, such as permanent establishment provisions and reduced withholding tax rates, that are common to most of the income tax treaties to which the United States is a party. In many cases, these provisions are patterned after or similar to the United States Model Income Tax Convention, which reflects the traditional baseline negotiating position. However, each tax treaty is separately negotiated and therefore unique. As a consequence, to determine the impact of treaty provisions in any specific situation, the applicable treaty at issue must be analyzed. The United States- Australia Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States- Australia Income Tax Treaty and the implications to individuals attempting to make use of the treaty.
Definition of Resident
The tax exemption and reduction that treaties provide are available only to a resident of one of the treaty countries. Thus, the determination of an individual’s country of residence is important because the United States- Australia Income Tax Treaty only applies to residents of the United States and Australia.
The term “resident of the United States” means: 1) a business entity formed in the United States, or 2) any other person (except a corporation or any entity treated under United States law as a corporation) resident in the United States for purposes of United States tax, but in the case of an estate or trust only to the extent that the income derived by such person is subject to United States tax as the income of a resident. Section 7701(b) of the Internal Revenue Code treats an alien individual as a U.S. resident where such an individual is 1) lawfully admitted for permanent residence, (26 C.F.R. Section 301.7701(b)-1(b)(1)) “Green card test:” An alien is a resident alien with respect to a calendar year if the individual is a lawful permanent resident at any time during the calendar year. A lawful permanent resident is an individual who has been lawfully granted the privilege of residing permanently in the United States as an immigrant in accordance with the immigration laws. Resident status is deemed to continue unless it is rescinded or administratively or judicially determined to have been abandoned.”) (2) meets the substantial presence test, (An individual meets the substantial presence test with respect to any calendar year if i) such individual was present in the United States at least thirty-one days during the calendar year, and ii) the sum of the number of days on which such individual was present in the United States during the current year and the two preceding calendar year (when multiplied by the applicable multiplier: current year – 1, first preceding year – ⅓, second preceding year – ⅙) equals or exceeds 183 days) or iii) makes a first year election.
In contrast to the U.S. law, individuals are residents of Australia if they reside in Australia, and this includes the following: 1) an individual whose domiciled and permanent place of abode is in Australia; and 2) an individual who has actually been in Australia during more than one-half of the year, unless the individual’s usual place of abode is outside Australia and the individual does not intend to reside in Australia. Persons coming to Australia for employment or other reasons may be regarded as residents even if they are in the country for a short term of, say, two or four years. Citizenship and nationality do not determine liability of Australian income tax.
Because the United States and Australia have their own unique definition of residency, a person may qualify as a resident in more than one country. For example, an alien who qualifies as a U.S. resident under the substantial presence test pursuant to U.S. tax law may simultaneously qualify as a resident of Australia under its definition of residency. To resolve this issue, the United States- Australia Income Tax Treaty has included a tie-breaker provision in the treaty. The tie-breaker rules are hierarchical in nature, such that a subordinate rule is considered only if the superordinate rule fails to resolve the issue. Article 4(2) of the United States- Australia Income Tax Treaty provides the following rule for individuals in determining residency:
1) the individual will be a resident in the country in which he maintains his home;
2) if the provisions of (1) do not apply, the individual will be a resident in the State in which he has an habitual abode if he has his permanent home in both Contracting States or in neither of the Contracting States;
3) if the provisions of provisions (1) and (2) do not apply, the individual will be a resident of the State with which his personal and economic relations are closer if he has an habitual abode in both Contracting States or in neither of the Contracting States.
4) if he is a national of both States or neither of them, the competent authorities of the Contracting States shall settle the question by mutual agreement;
For purposes of determining tax residence, in determining an individual’s permanent home, regard shall be given to the place where the individual dwells with his family, and in determining the Contracting State with which an individual’s personal and economic relations are closer, regard shall be given to his citizenship (if he is a citizen of one of the Contracting States).
We will now discuss the operative articles of the United States- Australia Income Tax Treaty.
A central tax issue for any company exporting its goods or services is whether it is subject to taxation by the importing country. Most countries assert jurisdiction over all of the income derived from sources within their borders, regardless of the citizenship or residence of the person receiving that income. Such an extreme approach has its limits, however. For example, if the exporter’s marketing activities within the importing country are de minimis, the administrative costs of collecting the tax on those activities may exceed the related tax revenues. These concerns have led countries to include permanent establishment provisions in their income tax treaties.
Under a permanent establishment provision, the business profits of a resident of one treaty country are exempt from taxation by the other treaty country unless those profits are attributable to a permanent establishment located within the host country. Article 7 of the United States- Australia Income Tax Treaty states that profits are taxable only in the Contracting State where the enterprise is situated “unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein,” in which case the other Contracting State may tax the business profits “but only so much of them as [are] attributable to the permanent establishment.” The concept of permanent establishment is a key term to this and any bilateral tax treaty. Article 5 of the United States- Australia Income Tax treaty defines permanent establishment as a “fixed place of business” – including a place of management; a branch, an office, a factory, mine, a workshop; a mine, agricultural or forestry property, a building site or construction, or installation.
The term “permanent establishment” does not include: 1) the use of facilities solely for the purpose of storage, display, or delivery of goods or merchandise belonging to the enterprise; 2) the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display, or delivery; 3) the maintenance of a stock or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise; 4) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or for collecting information, for the enterprise; 5) the maintenance of a fixed place of business solely for the purpose of advertising, for the supply of information, for scientific research; and 6) the maintenance of a building site or construction, assembly or installation project which does not exist for more than 9 months.
If a resident of one treaty country has a permanent establishment in the other treaty country, the importing country may tax the taxpayer’s business profits, but only to the extent those business profits are attributable to the permanent establishment.
Article 9 of the United States- Australia Income Tax Treaty incorporates into the treaty the arm’s-length principle reflected in the transfer pricing provisions of Internal Revenue Code Section 482. Article 9 provides that when related enterprises engaged in a transaction are related and the enterprises engage in a transaction on terms that are not arm’s length, the Contracting States may make appropriate adjustments to the taxable income and tax liability of such related enterprises to reflect what the income and tax of these enterprises with respect to the transaction would have been had there been an arm’s-length relationship between them.
Independent Personal Services
Treaty provisions covering personal services compensation are similar to the permanent establishment clauses covering business profits in that they create a higher threshold of activity for host country taxation. Generally, when an employee who is a resident of one treaty country derives income from services performed in the other treaty country, that income is usually taxable by the host country. However, in certain cases, this income may be exempt from taxation by the host country. Under Article 14 of the United States- Australia Income Tax Treaty, a contracting State may tax the income from personal services of a nonresident individual if: 1) the individual is present in that State for a period or periods aggregating more than 183 days in the taxable year of income of that other State; or 2) the individual has a fixed base regularly available to him for the purposes of performing his activities.
Dependent Personal Services
Under Article 15 of the treaty, a Contracting State may not tax employment income derived by a nonresident to the extent the employee services are performed in the Contracting State: 1) the employee is present in the Contracting State less than 183 days during a taxable year; 2) the remuneration is paid by, or on behalf of, an employer or company who is not a resident of the other State; and 3) the remuneration is not deductible in determining taxable profits of a permanent establishment, a fixed base or a trade or business which the employer or company has in the other State.
Under Article 6 of the United States- Australia Income Tax Treaty, the Source State can impose a gross withholding tax of 15 percent on all types of cross-border dividends. However, in certain cases, the 15 percent rate is reduced to 5 percent. The 5 percent rate is available to beneficial owners of a corporation if they own 10 percent or more of the payer’s voting stock for at least 12 months before the dividend is declared.
Finally, the United States- Australia Income Tax Treaty provides that dividends from regulated investment companies (“RICs”) and real estate investment trusts (“REITs”) do not qualify for the 5 percent dividend rates. RIC dividends are taxed at taxed at 15 percent if: 1) the beneficial owner is an individual owning no more than 10 percent of the REIT; or 2) the dividends are paid with respect to a publicly traded class of stock and the beneficial owner is a person owning no more than 5 percent of any class of REITs stock.
According to the Technical Explanation, the term dividends includes income from shares, or other corporate rights that are not treated as debt under the law of the source State, that participate in the profits of the company. The term also includes income that is subject to the same tax treatment as income from shares by the law of a source State. Thus, a constructive dividend that results from a non-arm’s length transaction between a corporation and a third party is a dividend. The term dividends also includes amounts treated as a sale or redemption of shares or a transfer of shares in a reorganization.
Branch Profits Tax
The U.S. imposes a 30 percent branch profits tax on the “dividends equivalent amount” of a foreign corporation engaged in a trade or business in the U.S., where the “dividend equivalent amount” is roughly equal to the taxable income of the branch, less income of the branch, less income tax paid by the branch and less amounts retained in U.S. operations. Under the United States- Australia Income Tax Treaty, the branch profits tax will not be imposed, however, if certain requirements are met. The branch profits tax imposed shall not exceed the withholding rate of 5 percent if the company is a qualified person by it being a publicly-traded company, a subsidiary of a publicly-traded company or a company is granted treaty benefits by the competent authorities.
Article 7 of the United States- Australia Income Tax Treaty does not have a withholding tax rate on interest paid. Article 7(1) generally grants to the State of residence the non-exclusive right to tax interest to which its residents are beneficially entitled and arises in the other Contracting State. The term “beneficial owner” is not defined in the treaty or the treaty’s Technical Explanations, and is, therefore, defined as under the internal law of the country imposing tax (i.e., source country).
Article 7(4) contains an exception to the zero percent withholding rules. This exception permits source State taxation (at a 10 percent maximum rate applicable to interest) if the interest is paid as part of an arrangement involving back-to-back loans or their economic equivalent. The term “back-to-back loans” encompasses securities issued at a discount, or certain swap arrangements.
The term interest includes income from a debt obligation carrying the right to participate in profits. The term does not include dividends or late payments.
Article 8 of the United States- Australia Income Tax Treaty reduces source-state withholding tax royalties paid to 5 percent. The term “royalties” in Article 8 means a payment or credits of any kind to the extent to which they are in consideration for the use of: 1) copyright, patent, design or model, plan, secret formula or process, trademark or other like property or right; 2) motion picture films; 3) films or video tapes for the use in connection with television or tapes; or 4) the supply of scientific, technical, industrial, or commercial knowledge or information owned by any person.
Gains from the Alienation of Property
With a few exceptions, Article 13 of the United States- Australia Income Tax Treaty provides for exclusive resident state taxation of gains from the alienation of property. An exception to this general rule are gains from the sale of real property and gains from the sale of shares or other interests in certain real property holding companies. In these cases, gains may be taxed in the country where the property is located and by the owner’s home country.
Cross-Border Pensions, Superannuation Funds, 401K, IRAs, and 403(b) Plans
One of the biggest fears Australian nationals have that become U.S. residents is how the U.S. will tax their Australian retirement accounts. This fear is justified because U.S. tax laws are not compatible with Australian retirement accounts and as a result, Australian retirement accounts such as Superannuation Funds can be subject to the dreaded PFIC tax computations. Fortunately, in certain cases, the United States- Australian Income Tax Treaty may exclude Superannuation Funds from U.S. federal taxation.
Article 18 of the United States- Australia Income Tax Treaty addresses the taxation of cross-border pensions and annuities. Subject to the provisions of Article 19, pensions and other similar remuneration paid to an individual who is a resident of one Contracting State in connection of past employment shall be taxable only in that State. The term “pensions and other similar remuneration,” as used in this Article means periodic payment made by reason of retirement or death, in consideration of services rendered, or by way of compensation paid after retirement for injuries received in connection for past employment. Annuities paid to an individual who is a resident of one of the Contracting States shall be taxable only in that State. The term “annuities,” as used in Article 18, means stated sums paid periodically at stated times during the life, or during a specific ascertainable number of years, under an obligation to make the payments in return for adequate and full consideration (other than services rendered or to be rendered).
Article 18 of the treaty is extremely important to anyone who is a beneficiary of an Australian Superannuation Fund. A Superannuation Fund is any plan, fund, or scheme which provides retirement income. Under the Internal Revenue Code, most foreign retirement plans are not considered “qualified plans” under Internal Revenue Code Section 401(a), which means the accounts generally do not qualify for tax-deferral treatment. Instead, these accounts are governed by Internal Revenue Code Section 402(b) as a foreign trust. Thus, under Section 402(b) of the Internal Revenue Code, workers holding foreign retirement accounts may receive much harsher U.S. federal tax treatment than that of other deferred compensation plans.
In the case of Australian Superannuation Funds, these plans can be treated as either a foreign grantor trust or an annuity depending on whether the assets obtained in the funds or accounts are preserved or non-preserved. In certain cases, there may also be mixed or hybrid treatment of the funds where a portion of the Superannuation Fund can be treated as an annuity and a portion of the Superannuation Funds can be treated as a foreign grantor trust. As a general rule, gains recognized from a foreign grantor trust are taxable in the U.S. Sometimes, foreign grantor trust can trigger the harsh passive foreign investment company (“PFIC”) or throwback interest tax regime. If some or all of a Superannuation Fund or Funds can be characterized as an annuity for U.S. tax purposes under the United States- Australian Income Tax Treaty, it may be possible exclude some or all of the Superannuation Fund from U.S. taxation. This is even the case if the beneficiary of the Superannuation Fund has become a U.S. resident for tax purposes.
In our experience, Australian nationals are not only concerned about the U.S. taxation of Superannuation Funds, they are also concerned about the taxation U.S. taxation of domestic retirement accounts such as Individual Retirement Accounts (“IRAs”), 401(k) plans, or 403(b) plans.The way the United States- Australian Income Tax Treaty is drafted provides Australian nonresidents that work in the United States planning opportunities to reduce U.S. income tax consequences or eliminate U.S. federal tax associated with IRA, 403(b) or 401(k) contributions after they depart the United States. For example, let’s assume that Tom is an Australian national that came to the U.S. on an E-3 Visa for a short-term assignment. While working in the U.S., Tom contributed money to an IRA. Tom has returned to Australia and would like to withdraw money from his U.S. based IRA. However, Tom is concerned about the U.S. 20 percent withholding tax and the 10 percent early withdrawal penalty.
Since Tom is a citizen of Australia, he may utilize the United States- Australia Income Tax Treaty to avoid the 20 percent withholding tax and the early withdrawal penalty. This is because under Article 18, Paragraph 1, of the United States- Australia Income Tax Treaty, “pensions and other similar remuneration” paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State.” The Technical Explanations to the treaty further explain that “paragraph 1 provides that pensions derived and beneficially owned by a resident of one of the Contracting States in consideration of past employment….shall be taxable only in the State [of residency].” This means that under the applicable provisions of the United States- Australia Income Tax Treaty, the country of residence has the sole taxing rights over pension distributions.
The terms “pensions and other remuneration” is not defined in the United States- Australia Income Tax Treaty. However, the OECD defines the word “pension” under the ordinary meaning of the word which covers periodic and non-periodic payments. The OECD also provides that a lump-sum payment in lieu of periodic pension payments that is made on or after cessation of employment may fall within the definition of Article 18. See OECD 2014 Commentary, Art 18. Thus, although Article 18 of the United States- Australia Income Tax Treaty makes a reference to “periodic payments,” the word “periodic” does not preclude Tom from excluding a lump sum IRA distribution from U.S. federal income tax. Even though the OECD or Article 18 of the United States- Australia Income Tax Treaty does not mention the term IRA, the Internal Revenue Service (“IRS”) has clarified that IRAs can be defined as pensions for articles in U.S. income tax treaties. See PLR 200209026. Since Tom is a resident of Australia, he can utilize the United States- Australia Income Tax Treaty to avoid U.S. federal tax on the distribution from his IRA.
Article 22 of the United States- Australian Income Tax Treaty applies to “other income.” This article applies to income not otherwise dealt with in other articles of the treaty. Examples of the types of income that fall under Article 22 are income received from covenants not to compete, punitive damage awards, gambling income, and income received from certain financial instruments.
Limitation on Benefits
Because tax treaties provide lower tax rates on dividends, interest, royalty income, and retirement accounts, individuals and multinational corporations may attempt to utilize treaties even though they are not residents of either country of the treaty at issue. This practice is known as “treaty shopping.” The United States- Australia Income Tax Treaty contains detailed rules intended to limit its benefits to persons entitled to such benefits by reason of their residence in a Contracting State. The rules are specifically intended to eliminate “treaty shopping” whereby, for example, a third-country resident could establish an entity in a Contracting State and utilize the provisions of the treaty to repatriate funds under favorable terms. To eliminate this potential abuse, the full benefits of the treaty are available to only a specified class of persons, limited treaty benefits are provided to an additional class of persons, and a facts and circumstances test provides discretion to make the treaty provisions available to others.
The limitation on benefits provision of Article 2 covers benefits under all articles of the treaty. The provision allows the full benefits of the treaty to individuals, qualified government entities, charities, and pension plans at least 50 percent of whose beneficiaries, members, or participants are individuals of whose beneficiaries, members, or participants are individual residents in either country. Companies that satisfy a “publicly traded” test can qualify for benefits, as can any resident not otherwise eligible for benefits that satisfies an “ownership base erosion” test or an “active trade or business” test. The competent authority of the source country may also grant benefits to persons not otherwise entitled to them.
The publicly traded test allows treaty benefits to a company if all shares in the class or classes of shares representing more than 50 percent of the voting power and value of the company are regularly traded on a “recognized stock exchange.” A “recognized stock exchange” for this purpose means NASDAQ and any stock exchange with the SEC as a national securities exchange for purposes of the Securities Exchange Act of 1934, and any stock exchange constituted and organized under Italian law. According to the Technical Explanation, with respect to the United States and pursuant to existing provisions of the Internal Revenue Code, a class of shares will generally be treated as “regularly traded” if: 1) trades in the class of shares are made in more than de minimis quantities on at least 60 days during the taxable year; and 2) the aggregate number of shares in the class traded during the year is at least 10 percent of the average number of shares outstanding during the year. A company will also qualify if it is owned directly or indirectly by five or fewer companies meeting the publicly traded test, as long as each intermediate owner is entitled to benefits.
The “ownership base erosion” test consists of two prongs. Under the first, persons qualifying for benefits as individuals, qualified governmental entities, charities, pension plans, or publicly traded companies must own, directly or indirectly, at least 50 percent of each class of shares or other beneficial interest in the entity on at least half the days in the taxable year. In the case of indirect ownership, each indirect owner must be entitled to treaty benefits under any of the aforementioned tests or under the ownership base erosion test. Under the second prong, the percentage of the entity’s gross income for the taxable year that can be paid or accrued, directly or indirectly, to persons who are not residents of either country in the form of payments that are deductible for income tax purposes in the entity’s country of residence must be less than 50 percent of gross income, unless the payments are to permanent establishments in either country.
The “active trade or business” test is available to entities not otherwise qualifying for treaty benefits with respect to certain items of income. The entity must be engaged in the active trade or business in its country of residence in the active conduct of a trade or business in its country of residence, the income in question and with respect to which treaty benefits are claimed must be connected with or incidental to such trade or business, and the trade or business must be substantial in relation to the activity generating the income in the source country. For purposes of determining whether a trade or business in the residence country is “substantial,” the treaty provides a safe harbor test based on a comparison of assets, gross income, and payroll expense expenses in each of the countries.
If a resident of the United States or Australia is not otherwise entitled to benefits of the United States- Italy Income Tax Treaty, the competent authority of the state from which benefits are claimed may grant benefits to such a resident at its discretion.
Disclosure of Treaty-Based Return Positions
Any taxpayer that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. See IRC Section 6114. A tax return position is considered to be in conflict with the Internal Revenue Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.
The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:
1. The name and employer identification number of both the recipient and payor of the income at issue;
2. The type of treaty benefited item and its amount;
3. The facts and an explanation supporting the return position taken;
4. The specific treaty provisions on which the taxpayer bases its claims;
5. The Internal Revenue Code provision exempted or reduced; and
6. An explanation of any applicable limitations on benefits provisions.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.