The Economic Cooperation and Trade Agreement (ECTA) recently signed between India and Australia includes a commitment from Australia to amend its domestic tax law to “…stop the taxation of offshore income of Indian firms providing technical services to Australia”. Once ratified by the Australian Parliament, the agreement would greatly benefit Indian IT companies that have been impacted by a ruling by the Federal Court of Australia in 2018 which had interpreted the Articles of the India-Australia Tax Treaty and upheld the levy of tax by the Australian Tax Office (ATO) on income from certain offshore technical services provided by Indian companies to their clients in Australia.

In India, the Income Tax Act , 1961, provides [through section 90 (2)] that a taxpayer who is eligible to access a tax treaty will have the provisions of the Act apply to it only to the extent that the domestic tax provision is more beneficial — else treaty provisions will apply.

However, in Australia, tax treaties are imported into the domestic tax differently — first by incorporating the treaty in the Australian International Tax Agreements Act 1953 and then by virtue of the Act’s provisions, all treaty provisions are imported into Australia’s domestic income-tax law to be applicable to a taxpayer who is a resident of the treaty country. There is no mention, unlike India’s income tax law, that only the beneficial provisions of the treaty would be applicable.

Accordingly, the India-Australia Tax Treaty ( For the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income [1991]) is included in Schedule 35 to the Australian International Tax Agreements Act and by virtue of the provisions of this Act, the treaty provisions are incorporated into Australia’s Income Tax Assessment Act.

Tech Mahindra case

In the case of Tech Mahindra, the taxpayer had a permanent establishment (PE) in Australia as well as offshore staff located in India. For completing contracts with Australian clients, the company used services of its staff located in Australia as well as those located in India.

In Tech Mahindra Limited v Commissioner of Taxation [2015] FCA 1982, the Australian Court concluded that a portion of the payments made to Tech Mahindra for services rendered under its contracts, satisfied the definition of ‘royalties’ under Article 12(3)(g) of the tax treaty. The taxpayer’s contention was that offshore services classified as royalty (under Article 12) could only be taxed in Australia if they were effectively connected to the taxpayer’s PE in Australia under Article 7 of the tax treaty.

Article 7 gives Australia the right to tax the business income attributable to the taxpayer’s PE in Australia; since these offshore services were not undertaken by its Australian PE, the taxpayer argued that consequently this royalty income would not be taxable in Australia.

The Court did not accept the taxpayer’s contention. It held that Article 12, read with Article 23 of the tax treaty, gave an independent ‘deemed source’ right to tax royalty income and, accordingly, the taxpayer was liable to pay taxes in Australia on this royalty income emanating from offshore services.

Under Australia’s domestic tax law only that income of a non-resident taxpayer is taxable which arises from sources in Australia. Tech Mahindra was providing services to Australian clients partly performed by its employees located in Australia and partly by employees in India. The source of income emanating from offshore services rendered from India would not be regarded as taxable in Australia, under its domestic tax law since the services are performed outside Australia.

However, as a result of the ruling of the Full Federal Court of Australia, consideration received by the taxpayer for providing IT services to clients in Australia through staff located in India, though not taxable under the domestic tax law of Australia, would still be taxable in Australia by virtue of treaty provisions. Hence, the treaty-based source rule effectively created a new taxation right for Australia beyond its normal domestic law provisions.

Indian companies, especially in the IT services space, have been grappling with the consequences of this ruling for the past five years — litigation, higher taxes in Australia, issues regarding availability of foreign tax credit and adverse impact on their businesses for rendering services.

Representations were made to the Indian government to resolve this issue. Consequently, Australia’s commitment under the ECTA to resolve this issue through changes to its domestic laws is a welcome development for India-based IT service providers who power the bulk of India’s global service exports.

The writer is Partner, Deloitte India

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