"income tax" included tax on capital gains. This has been an extremely important, and until now, unresolved issue in Australia and other countries. It appears that ...
Treaty Interpretation-whether "income tax" includes tax on capital gains Craig Elliffe1 Introduction Virgin Holdings SA,2 Undershaft (No 1) Ltd,3 and Kinsella4 are concerned with the issue of whether "income tax" included tax on capital gains. This has been an extremely important, and until now, unresolved issue in Australia and other countries. It appears that, with the decisions (both in the Federal Court of Australia) of Virgin Holdings SA, by Edmonds J and Undershaft (No 1) by Lindgren J both being in the taxpayer's favour, and with the decision by the Australian Tax Office not to appeal these decisions, the law is now settled, at least in that jurisdiction.5 The decision in the Irish High Court of Kinsella also appears not to have been appealed to the Irish Supreme Court.6 Should New Zealand decide to introduce additional taxes to “broaden the tax base”7then this issue will become vitally important for the effective implementation of regimes such as a capital gains tax. The reason why this is important is that treaties prescribe that business profits8 are only taxed in New Zealand if the non-resident from the other Contracting State has a permanent establishment here. In the absence of a permanent establishment, New Zealand may have “surrendered” the right to tax such profits or gains to our treaty partners. The importance of these decisions to the Australian revenue base have been somewhat lessened by the significant changes to the taxation of non-residents disposing of Australian assets. These changes were introduced by the Tax Laws Amendment (2006 Measures No 4) Act 2006 which took effect from 12 December 2006. After that date, New Zealand residents who make capital profits in Australia, are subject to tax on their direct and indirect investments in real property (including certain options and rights). In addition business assets held by an Australian permanent establishment of a New Zealand resident are subject to the capital gains tax provisions.9
1
Professor of Tax Law and Policy and Director of the Master of Taxation Studies, University of Auckland. These cases were part of the presentation at the NZICA Tax Conference on 16 and 17 October 2009.
2
Virgin Holdings SA v Commissioner of Taxation [2008] FCA 1503, 11 ITLR 335. Undershaft (No 1) Ltd v Commissioner of Taxation [2009] FCA 41, 11 ITLR 652. 4 Kinsella v Revenue Commissioners [2007] IEHC 250, 10 ITLR 63. 5 In the Decision Impact Statement released by the Australian Taxation Office on 29 July 2009 the Australian Commissioner withdrew his appeal to the Full Federal Court in the Virgin Holdings case and decided not to appeal the Undershaft proceedings. 6 Although the editor's note to the International Tax Law Report series notes that it was an understanding that the case was going to be appealed. 3
7
See the papers produced for the Victoria University Tax Working Group Session Three on 16 September 2009 at: http://www.victoria.ac.nz/sacl/cagtr/twg/session-three.aspx 8 9
Not associated with immovable property. Note5 under the heading “Tax Office View of Decisions”.
Electronic copy available at: http://ssrn.com/abstract=1562343
Of course, for New Zealand residents, the pre-capital gains tax treaty10 was replaced with a renegotiated treaty in 1995.11 That treaty contained the following paragraph in Article 13 (5): Nothing in this Agreement affects the application of a law of a Contracting State relating to the taxation of gains of a capital nature derived from the alienation of any property other than that to which any of the preceding paragraphs of this Article apply.
Article 13 (5) made it clear that the provisions of the treaty would not affect the imposition of capital gains tax on New Zealand residents. This position is true for many of Australia's other significant trading partners.12 Consequently for New Zealand residents investing in Australia, the decision in Virgin Holdings was of relatively little consequence. The decisions13 are significant however on the issue of the interpretation of treaties, and also in particular on whether the term "the Australian income tax" should be given a meaning and scope which is static rather than ambulatory. The decisions may also have a profound consequence on the ability of New Zealand to successfully impose capital gains tax or some other new tax on the residents of our treaty partners. Background to the Virgin Holdings case Virgin Holdings was a Swiss-resident company which owned shares in Australian subsidiaries. In late 2003 there was an initial public offering of Virgin Blue. As a consequence of this successful float the Commissioner issued assessments for A $192,746,072 to Virgin Holdings. These assessments were issued on the basis that Virgin Holdings had made a capital gain which was subject to Australian tax. The Australian Taxation Office had long taken the view that Australian capital gains tax could be imposed on non-residents notwithstanding that the non-residents were resident in a country which had a double taxation agreement with Australia which was concluded prior to the introduction of Australia's capital gains tax. This pre-CGT double tax agreement usually would deny Australia the right to tax the business profits of an entity in circumstances where there was no permanent establishment based in Australia. The position of the Australian Taxation Office was summarised as follows:14 Australia's right to tax gains taxable in Australia exclusively under the capital gains tax regime ... is not limited by pre-CGT treaties. This is because: (a) from Australia's perspective these treaties do not distribute taxing rights over capital gains; and (b) with the exception of the Australia/Austria DTA, under relevant Taxes Covered articles, Australia's tax on capital gains is not a tax to which pre-CGT treaties apply
10
Double Taxation Relief (Australia) Order 1972. Double Taxation Relief (Australia) Order 1995, which is now being replaced by the 2009 convention. 12 The United States of America, the United Kingdom, and Canada for example. 13 Collectively referring to both the Virgin Holdings and the Undershaft decisions. 14 Taxation Ruling 2001/12 issued by the Australian Taxation Office on 19 December 2001. 11
Electronic copy available at: http://ssrn.com/abstract=1562343
Counsel for the Commissioner made three principal submissions.15 First, that the term "the Australian income tax" in article 2 (1) (a) of the Australian-Swiss agreement did not include tax on gains which were taxable under the capital gains tax regime. Nor was it a "substantially similar tax" within the meaning of that term in article 2 (2). Secondly, article 7 (1) of this agreement whilst denying Australia the right to tax the profits of a Swiss enterprise when these related to revenue profits, this did not affect Australia's right to tax capital profits. Thirdly, article 13 (3) of the agreement by reason of its reference to "income from the alienation of capital assets" manifested an intention that it is not to apply to capital gains (which are not income). General principles of interpretation of double tax treaties The starting point in the approach of interpreting the Australian-Swiss double tax agreement was for Edmonds J to reflect what McHugh J had concluded in the Thiel case:16 The [Swiss agreement] is a treaty and is to be interpreted in accordance with the rules of interpretation recognised by international lawyers: Shipping Corporation of India Ltd. v. Gamlen Chemical Co. (A/Asia) Pty. Ltd. (1980) 147 C.L.R. 142, at p. 159. Those rules have now been codified by the Vienna Convention on the Law of Treaties to which Australia, but not Switzerland, is a party. Nevertheless, because the interpretation provisions of the Vienna Convention reflect the customary rules for the interpretation of treaties, it is proper to have regard to the terms of the Convention in interpreting the Agreement, even though Switzerland is not a party to that Convention: Fothergill v. Monarch Airlines Ltd. [1981] A.C. 251, at p. 276 282, 290; The Commonwealth v. Tasmania (the Tasmanian Dam Case) (1983) 158 C.L.R. 1 at 222; [Golder v United Kingdom] (1975) 57 I.L.R. 201, at pp. 213–214.
After setting out in full Articles 31 and 32 of the Vienna Convention, Edmonds J noted that the approach of the High Court of Australia in Thiel's case was as follows:17 Article 31 of the Convention requires a treaty to be interpreted in accordance with the ordinary meaning to be given to its terms “in their context and in the light of its object and purpose”. The context includes the preamble and annexes to the treaty: Art. 31(2). Recourse may also be had to “supplementary means of interpretation, including the preparatory work of the treaty and the circumstances of its conclusion” to confirm the meaning resulting from the application of Art. 31 or to determine the meaning of the treaty when interpretation according to Art. 31 leaves its meaning obscure or ambiguous or leads to a result which is manifestly absurd or unreasonable: Art. 32.
In the Thiel case, Edmonds J noted that McHugh J18 viewed the supplementary materials referred to in Article 32 of the Vienna convention as being both the 1977 OECD Model Convention and the Commentary to the convention.19
15
Note2 at paragraph 17. Thiel v Federal Comr of Taxation (1990) 171 CLR 338, at 356. 17 Note16 at 356–357, McHugh J. 18 Note16 at page 357. 16
Having ascertained the general principles of interpretation of double tax agreements, Edmonds J then moved on to the first underlying issue. What taxes are covered in the Australian-Swiss agreement? Article 2 of the Australian-Swiss agreement is headed "Taxes covered". In Australia this is defined to mean in paragraph 1:20 The Australian income tax, including the additional tax upon the undistributed amount of the distributable income of a private company and also income tax upon the reduced taxable income of a non-listed company;
Paragraph 2 goes on to provide: This Agreement shall also apply to any identical or substantially similar taxes which are imposed after the date of signature of this Agreement in addition to, or in place of, existing taxes ...
There is no definition of "the Australian income tax" in the agreement. However, Article 3 (2) provides: In the application of this Agreement by one of the Contracting States, any term not otherwise defined shall, unless the context otherwise requires, have the meaning which it has under the laws of that Contracting State relating to the taxes to which this Agreement applies.
Edmonds J looked at the definition of the term "Australian tax" in the various Australian domestic tax legislation enactments, and concluded that at the time of the conclusion of the Swiss agreement, "the term "the Australian income tax" in article 2 (1) (a) of this was agreement meant, under the relevant laws of Australia, income tax as assessed under the ITAA 1936." The Commissioner argued that the reference to “the Australian income tax" should be given a static meaning, and that at the time the Swiss agreement was concluded on the 28th February 1980, the ITAA did not contain the provisions which comprehensively subjected capital gains to income tax by their inclusion in taxable income.
19
The connection between the domestic New Zealand position and the Vienna Convention was directly made in the Court of Appeal decision Commissioner of Inland Revenue v JFP Energy Inc (CA) (1990) 12 NZTC 7,176, when Richardson J noted that when interpreting a DTC in New Zealand, that it was part of a network of international agreements which used international language, and that its purpose was to promote the exchange of goods and services on the movement of capital and persons in international trade by eliminating double taxation. He referred to the Commissioner of Inland Revenue v United Dominions Trust Ltd (1973) 1 NZTC 61, 028), and the High Court of Australia decision in Thiel v FC of T (see note30), and the earlier English decisions Stag line Ltd v Foscolo, Mango and Co Ltd, [1932] AC 328 and Fothergill v Monarch Airlines [1981] AC 251, as authority for the proposition that the OECD Convention rules have an international currency in New Zealand and should be construed on broad principles of general acceptation, having appropriate regard to the Commentary and any travaux preparatoires. 20
The Agreement between Australia and Switzerland for the avoidance of Double Taxation with respect to Taxes on Income [1981] ATS 5.
Not unexpectedly, Virgin Holdings took the view that the correct approach to interpreting the term "the Australian income tax" was ambulatory rather than static. This was supported, by the text of the Swiss agreement itself, in particular article 2 (2), and was consistent with the “context, object and purpose" of the agreement. Reliance was made on the fact that this was an assumption underlying the Model Commentary and it was well supported by various international cases and academic commentators. A number of examples were given that Australian income tax at the time the conclusion of the Swiss agreement had always been more than a tax on "income" so-called but was often a tax on receipts which were capital in nature. Edmonds J took the view that in this particular instance it was not necessary to decide the question of whether the interpretation should be static or ambulatory. This was because in his view the term "the Australian income tax" in article 2 (1) (a) accommodated and encompassed, at the time of the conclusion of the Swiss agreement, the taxation of capital gains.21 He said:22 It is true, that at the time, capital gains were not taxed on the comprehensive basis that came with the introduction of Pt III A into the ITAA 1936, but the income tax assessed under the Act accommodated and encompassed the assessment of capital gains as income, the assessment of capital receipts as income and the assessment of notional amounts as income just as much as it accommodated and encompassed the assessment of income according to ordinary concepts.
He expressed the opinion, while not actually committing himself to this point, that he was firmly of the view that the preferred approach to interpretation should be ambulatory and not static, reflecting23: That was a conclusion reached by the OECD Committee on Fiscal Affairs (1992 OECD Model, Official Commentary on article 3, paragraph 11), which led to the 1995 amendment to article 3 (2) of the Model Convention to adopt, specifically, the ambulatory approach.
Whether the capital gains tax is a "substantially similar tax" to "the Australian income tax"? Given the conclusion that Edmonds J had reached with respect to article 2(1), the arguments on article 2 (2) in the Virgin Holdings case were somewhat academic. Counsel for the Commissioner had argued that the introduction of a broad-based capital gains tax was a monumental change. He quoted the then Treasurer, the Honourable Paul Keating MP, who when introducing the capital gains tax Bill declared: "This legislation will enact a fundamental reform to the Australian Taxation System".24
21
Interestingly, Edmonds J notes that his conclusion is supported by an observation which was not raised by either side's counsel. This was that had the transactions been entered into at the time of the conclusion of the Swiss agreement (February 1980), a larger assessment (then the $192 million) would have occurred under section 26 AAA of the ITAA 1936. Although this provision had been repealed by the time these transactions were entered into in 2003, at the date of concluding the treaty gains from shares sold within 12 months of their acquisition were assessed under the ITAA. 22 Note2 at paragraph 44. 23 Note2 at paragraph 43. 24 Note2 at paragraph 51.
Virgin Holdings' position was supported by the views expressed by Klaus Vogel and other commentators that capital gains tax " ... will, for treaty purposes normally have to be considered as being at least similar to income tax".25 Reference was also made to the Irish High Court case of Kinsella where Kelly J had considered a similar problem in the context of the Irish-Italian double tax agreement. In that case Ireland had like Australia introduced a capital gains tax after the IrelandItalian treaty came into force. In the Irish High Court, Kelly J took the view:26 CGT is, in my view, a substantially similar tax to the Italian taxes listed in article 2.3 and of course specifically covered in article 12. I do not however rest my decision upon that proposition. Rather do I take the view that CGT is a substantially similar tax to the Irish taxes which are mentioned in article 2.3. I do so for the following reasons. As I've already pointed out CGT is a tax on gains or profits rather than a tax on capital wealth. Although introduced in 1975 it is now dealt with by the 1997 Act. That Act contains all the provisions related to other direct taxes such as corporation tax and income tax. The rules for computing CGT are included in that legislation. True it is that capital gains are taxed in a different way from other forms of income but the tax legislation regards the two as being very closely related.
After considering both sides of the argument, Edmonds J took the view that, on the assumption that capital gains tax was not within the term "the Australian income tax", (and he had already concluded that it was), he would have held that a tax on capital gains was "substantially similar" to "the Australian income tax". Were the capital gains within the scope of the business profits article (Article 7 of the AustralianSwiss agreement)? The Commissioner's position was that article 7 which refers to "the profits of an enterprise" only related to revenue profits, and not capital gains.27 Consequently, Australia had the right to tax capital profits, notwithstanding that Virgin Holdings did not have a permanent establishment in Australia. Virgin Holdings' position was that article 7 deals with both capital gains and revenue profits, and consequently, they believed that they would not be subject to tax in Australia unless they carried on business in Australia "through a permanent establishment situated therein". His Honour, Edmonds J, felt this question had been answered by the High Court of Australia in Thiel, in particular in the joint judgement of Mason CJ, Brennan and Gaudron JJ:28
25
Vogel et al, Klaus Vogel on Double Taxation Conventions (3rd edn, 1997) (Kluwer Law International) at 157.
26
Note4 at pages 75 to 77.
27
The full text of article 7 of the Australian-Swiss treaty is as follows: "1. The profits of an enterprise of one of the Contracting States should be taxable only in that State unless the enterprise carries on business in the other Contracting State to a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed at other State, but only so much of them as is attributable to that permanent establishment ..." 28 Note16 at pages 344-345.
Once an activity is held to constitute an enterprise, the heading "Business Profits" in article 7 imports no additional limitation. Ex hypothesi, the activity is undertaken to some business or commercial purpose.
Given the approach of the High Court of Australia in reading the term "profit" in a very broad way, Edmonds J felt he could not limit article 7 to just revenue gains, and consequently held that capitals were included in the term “profits” and that article 7 (1 ) of the Swiss agreement denied Australia the right to tax the amount of question. Does article 13 allow assessment? Article 13 of the Australian-Swiss treaty is headed “Alienation of property” and provides:29 1. Income or gains from the alienation of real property or of a direct interest in or over land, or the right to exploit, or to explore for, a natural resource may be taxed in the Contracting State in which the real property, the land or the natural resource is situated. 2 ... 3. Subject to the provisions of paragraphs 1 and 2, income from the alienation of capital assets of an enterprise of one of the Contracting States should be taxable only in that Contracting State, but, where those assets form part of the business property of a permanent establishment situated in the other Contracting State, such income may be taxed in that other State.
Counsel for the Commissioner argued that Article 13 (3) of the Swiss agreement does not apply to deny Australia the right to tax the gain because Article 13 (3) was intended to apply only in respect of gains arising from the alienation of capital assets which are income. Because this was a net capital gain it was not subject to the protection of the article. The position of Virgin Holdings is that articles 7 is a complete answer to the Commissioner's claim to assess it, but that in the alternative article 13 (3) also precludes the claim. In his Honour's view:30 The word "income" in the phrase ‘income from the alienation of capital assets of an enterprise’ cannot be confined to ‘income according to ordinary concepts’, otherwise there would be no work for the provision. It is difficult to envisage a situation where the alienation of a capital asset of an enterprise gave rise to ‘income according to ordinary concepts’, but if it did, article 7 would normally apply save, perhaps, where the alienation was, or was part of, the closing of the enterprise; but it would be even less likely to give rise to ‘income according to ordinary concepts’.
Consequently, Edmonds J held, that Australia had no right to tax the amount of A $192 million under article 7 (1). But in the alternative, if he was wrong on this point, then he would hold that article 13 (3) was applicable to deny Australia taxing rights.
29 30
Note20. Note2 at paragraph 79.
Reflection on the cases from a New Zealand perspective The first point to note is that the approach to interpretation taken by Edmonds J in Virgin Holdings, and by Lindgren J in Undershaft is consistent with principles of interpretation relevant to public international law in a broader context. In New Zealand, the writer believes our courts would take exactly the same approach, particularly since the Court of Appeal's decision in the JFP Energy case, where Richardson J adopted the approach of the High Court of Australia in Thiel.31 The consequence of this is that the articles of the Vienna Convention have application.32 Article 31 requires a treaty to be interpreted in accordance with the ordinary meaning to be given to its terms "in their context and in the light of its object and purpose".33 These cases, again consistent with the approach in Thiel and JFP Energy, make use of the OECD Model Commentary to assist in interpreting the meaning of the treaty. New Zealand's treaties, mostly,34 like the Australian treaties referred to in these cases, depart from the OECD Model. They omit the first two paragraphs,35 and begin with paragraph 3 and finish with paragraph 4 of the Model. The consequence of this is that in New Zealand treaties, the “Taxes Covered” article typically begins with a list of taxes which are specified in the treaty. There is also an extension that makes it clear (usually in paragraph 2-which accords with paragraph 4 of the Model) that the treaty will apply to "substantially similar taxes". With the list of taxes being so prescriptive in most of New Zealand’s treaties, this opens up the argument (like Virgin Holdings) as to whether the “taxes Covered” article should be interpreted in a static or fixed manner (being literally the taxes in force at the date of signing the agreement), or whether an ambulatory approach should be taken so that the list of taxes is seen as somewhat generic. The approach of Edmonds J was to regard the list as a generic list, and because the Income Tax Assessment Act 1936 had long recognised as income various forms of capital profits, he had no concerns that a capital gains tax introduced after the signing of the treaty would nonetheless be subject to the treaty (the first argument in Virgin Holdings). He also, although the point is obiter, strongly supported an ambulatory approach to interpretation consistent with the 1995 amendment to article 3 (2) of the model Convention. 31
Note19 New Zealand is a signatory (signed April 29, 1970 with effect from August 4, 1971).The text of the Vienna Convention is available at: http://fletcher.tufts.edu/multi/texts/BH538.txt 33 Note16 at pages 356-357 per McHugh J. 34 But not always, see for instance the Double Taxation Relief (Austria) Order 2007 as an example.
32
35
The OECD model is as follows for the first two paragraphs: Article 2-Taxes Covered
1. This Convention shall apply to taxes on income and on capital imposed on behalf of a Contracting State or of its political subdivisions or local authorities, irrespective of the manner in which they are levied. 2. There shall be regarded as taxes on income and on capital all taxes imposed on total income, on total capital, or on elements of income or of capital, including taxes on gains from the alienation of movable or immovable property, taxes on the total amounts of wages or salaries paid by enterprises, as well as taxes on capital appreciation.
Like Australia prior to the introduction of a comprehensive capital gains tax in 1986, New Zealand also taxes various forms of capital gains as income. Should New Zealand ever decide to introduce a capital gains tax, the consequences and issues arising in Virgin Holdings may be of huge relevance. To observe the obvious, if New Zealand courts followed the Australian approach, and there is no reason to think that they would not based on current case law, the current treaty network would substantially remove New Zealand’s right to tax non-residents of treaty partners on capital profits arising on the sale of personal property, but not immovable property, where the non-resident does not a permanent establishment here in New Zealand.36 One possible point of difference which was identified by Lindgren J in Undershaft (but not discussed in Virgin Holdings) may not be so consistent. This is due to the fact that the Australian domestic definition of "income tax" in section 6 (1) of the ITAA is defined to mean "income tax ... imposed as such by any Act, as assessed under the [ITAA 1936] or under that Act as amended at any time" (emphasis added). In Lindgren J's opinion the fact that the domestic definition had an express ambulatory meaning made the inclusion of capital gains easier within the term “the Commonwealth income tax". Such an approach would not be so easy under New Zealand's legislation with the definition of income tax lending itself to a more static interpretation.37 However, whether capital gains tax was viewed as "the income tax" in New Zealand or not, and in the writer's view it would most likely be regarded as within that term, it is almost certain that it would fall within the term of a "substantially similar tax" and consequently would fall within the terms of the treaty. Indeed had the first argument in Virgin Holdings failed, it is hard to see that Edmonds J would not have clearly held that a capital gains were a "substantially similar tax" to income tax, particularly since at the time of the signing of the agreement short term capital profits (those resulting from the sale of property within 12 months) were already expressly taxed (under section 26AAA of the ITAA 1936). As Kelly J held in the Kinsella decision CGT is a tax on gains or profits, which although it is calculated in a different way from income tax, is still “substantially similar”. He contrasted capital gains tax as being different from a tax on capital wealth which by implication he would not regard as being substantially similar to income tax. One interesting aspect arising from this discussion is whether New Zealand's tax treaty network would apply to the introduction of a new tax, say, for instance, a land tax. Such a possibility is currently being considered by the Victoria University Tax Working Group. If the same approach was taken in New Zealand, as in the Kinsella decision, it is possible that a judge would not consider a 36
In some cases and argument such as that in Virgin Holdings would be unnecessary as some treaties such as the Double Taxation Relief (Austria) Order 2007 very clearly and obviously include capital gains under the “Taxes Covered” article. 37 Section YA of the Income Tax Act 2007 defines income tax as being tax imposed under section BB 1 which goes on to refer to tax “ ... payable to the Crown under this Act and the Tax Administration Act 1994.” There is no ambulatory extension to the definition.
land tax to be "substantially similar" to income tax. This is because it applies to capital wealth rather than being a tax on gains or profits.38 Such a conclusion may be desirable in order to ensure the successful taxation of non-residents in respect of their investments in New Zealand land. The reason for this is that the current treaty network of New Zealand may not work very well with land tax unless there was some careful consideration given to integrating the domestic law into the New Zealand treaty network. But if land tax were a substantially similar tax to income tax,39 Article 6 will become the key article in the taxation of immovable property. Article 6 however deals with "income derived" by a resident of a Contracting State from immovable property in the other Contracting State. It would seem possible to argue that a land tax does not apply to any "income derived".40 Virgin Holdings illustrates the necessity to have regard to New Zealand's existing commitments to our treaty partners under public international law when considering the effective introduction of new forms of taxation.
38
This conclusion is somewhat reinforced by the observation in the Land Tax background paper prepared for the Tax Working Group (session 3) by the Policy Advice Division of Inland Revenue which under the heading “8. Coherence” on page 16 states “Land tax sits entirely outside existing tax structures. It makes no contribution one way or the other to a coherent tax system.” 39 A conclusion that is unlikely. 40 Articles 7 and 13 seem to work equally poorly.
