In this report, an attempt is made to discuss the issue related to tax implication for conducting business in Australia. The report explains the permanent establishment and whether it is required for operation in Australia. The aim of this report is to issue tax related briefly.
Meaning and role of Permanent establishment in determining tax liability
Determining whether business is operating through Permanent Establishment
The definition of Permanent establishment is provided under subsection 6 (1) of the Income Tax Assessment Act 1936 and this definition is applicable to both the Taxation Administration Act 1953 and the Income Tax Assessment Act 1997. The section 6(1) of the Income Tax Assessment Act 1997 defines permanent establishment as a place or through which an individual is carrying on a business and it includes the following:
- The place in which the agent of the person is carrying on the business;
- It includes place where the person has installed substantial machinery and equipment;
- The place where the person is engaged in the project of construction;
- The place where the person is engaged in selling, manufacturing, assembling, processing or distribution;
However, it should be noted that the following provided below are not included in the definition of the permanent establishment. These are:
- Where the person is conducting the business with agent engaged in normal course of activity of doing business on a commission basis.
- The place maintained only for the purpose of purchasing goods and merchandise.
The concept of permanent establishment is used in both the domestic and international trade. In Australia, it was used firstly in the tax treaty with United Kingdom that was signed in the year 1946. In the Australian Tax treaties, the permanent establishment is defined as the fixed place of business that is used for controlling the operation of the business wholly or partially (Ross et al., 2017). The meaning is consistent with the model Tax convention of OECD countries. In the definition of permanent establishment, the term permanence has been given certain importance so the taxation ruling tries to provide an interpretation on the definition.
The Taxation Ruling TR 2002/5 deals with the interpretation of the meaning of a phrase provided in the definition of the Permanent establishment under section 6(1) of the Income tax Assessment Act 1936. The Para 9 of the Taxation Ruling TR 2002/5 states that concept of the permanent establishment is based on the meaning provided in the Australian Tax treaties. In the definition, the term Permanent establishment is referred to the place in which the person carries on its business activity (Becker et al., 2015). The ruling states that the place should have both the element of permanence like temporal and geographical. The ruling further provides that the permanence is dependent on the particular context of the business and is in the matter of fact or degree. However, the ruling clearly states that the permanence does not means forever. The Para 33 of the ruling provides that if a business continues to operates from a place for more than six month then the place is regarded as the temporarily permanent.
In this case, Taite and Aramis resident of United Kingdom has developed a business plan. In this plan, they have decided to set up a parent company and provide loan to the subsidiary company (Aktaev et al., 2015). The subsidiary company will be engage in the developing and selling of land. The subsidiary company will be engaged in the land development or construction activity. The section 6 (1) (c) of the definition of permanent establishment provided under Income tax Assessment Act 1936 includes place where the person is engaged in construction. Therefore, after analyzing the above situation in the light of relevant section and tax ruling it can be said that Taite and Aramis are required to operate through permanent establishment.
Role of permanent establishment in determining the tax liability
In Australia, the taxable presence of an organization is said to exist if the enterprise derives income from Australia or carry on the activity of the enterprise in Australia. If the enterprise is from the country that has activity in Australia, in that case the activities of the permanent establishment will only be subject to taxation and other business activity of the permanent establishment will not be subject to tax (Avi-Yonah, 2016). The assets that are owned by the permanent establishment in Australia are subject to Australian Capital gain tax if the assets are sold or disposed. That means in this case, for the permanent establishment that is the income made by the subsidiary company will be taxable and the gains that is made from the disposal of capital assets held by the subsidiary company will be taxable.
Tax treatment of Interest expenses
Tax Treatment of Interest expenses prior to the commencement of business
The section 8-1 (1) of the Income Tax Assessment Act 1997 provides that expenses that have been incurred for generating assessable income are allowed as deduction. The section 8-1 (2) of the Income Tax Assessment Act 1997 provides that the expense are not allowed as deduction if:
- The expenses are related to the capital nature;
- The expenses are related to private or domestic nature;
- The expenses are incurred for producing the exempt income;
Therefore, it is clear from the above discussion that if expenses is not carried out for the purpose of producing assessable income then the expense are not allowed as deduction. Therefore, in order to address the issue of interest expenses prior to the commencement is deal in a separate tax ruling (Burns et al., 2016).
The Taxation Ruling TR 2004/4 deals with the deductibility of the expenses related to interest that have been incurred prior to the commencement of interest earning activity and after the income, earning activity has ceased. The Para 6 of the TR 2004/4 provides that deduction of interest expenses is dependent on the result of examination in which the purpose of borrowing and the use of borrowed funds are determined. This examination of determining the deductibility of interest expense are supported by the following case:
- Fletcher & Ors v. FC of T91 ATC 4950; (1991) 22 ATR 613;
- FC of T v. Energy Resources of Australia Limited96 ATC 4536; and
- Steele v. FC of T99 ATC 4242; (1999) 41 ATR 139 (Steele)
It can be seen that the above-mentioned cases supports the examination of interest expenses for deductibility prior to the commencement of the interest expenses. In the case of Kidston Goldmines Limited v. FC of T 91 ATC 4538 at 4545; (1991) 22 ATR 168 at 176 it was held by Hill J that the purpose of the borrowed fund can be determined from the manner in which the borrowed fund is put to use (Rosenbloom et al., 2014). However, in the case of FC of T v. JD Roberts and FC of T v. Smith 92 ATC 4380 at 4388; (1992) it was observed that strict tacking of funds is not always the necessary or appropriate in determining the deductibility of interest expense. The Para 8 of the TR 2004/4 provides that interest expenses cannot be considered capital expenditure because the borrowed funds are utilized for purchasing capital assets. The interest expense is a recurring expenditure so not allowed as deduction.
The Para 9 of the TR 2004/4 provides that interest that have been incurred before deriving any assessable income will be regarded as expenses that have been incurred for producing assessable under the following circumstances:
- The interest is not incurred that is preliminary or too soon for the income earning activity;
- The interest expenses is not for private or domestic purpose;
- The period between the interest expenses and the income earning activity is not long;
- The interest expenses are incurred for producing assessable income and efforts are continuously made in that pursuit.
In this case, it can be seen that the subsidiary company will borrow fund from the parent company and is required to pay interest expenses on that borrowed fund. It is provided that the business will require two years for conducting the business planning phase (Lang et al., 2014). The borrowed fund in this case is utilized for generating assessable income. Therefore, it can be said that the interest expenses in this case will be deductible as the activities are undertaken for generating assessable income.
Interest expenses incurred during the period of land development
The discussion earlier have shown that the section 8-1 of the Income Tax Assessment Act 1997 provides that expenses incurred for generating assessable income are allowed as deduction. In this case, development of land is the revenue generating activity. The funds are borrowed from the parent company are utilized for conducting land development activity (Morse & Deutsch 2016). Therefore, it can be said that the interest expenses for the development of land for the 5 years are allowed as deduction.
Interest expenses after the sale of business
The Para 10 of the TR 2004/4 states that interest expenses that are incurred after the relevant income earning activity has ceased in that case it is apparent that in such cases interest are not incurred for generating income earning activity. The interest expenses are still considered as incurred for generating assessable income if the outgoing was related to the assessable income of the earlier years (Stewart, 2014). This involves use of judgment to determine the relationship between the outgoing and income earning activity. The interest expenses cannot be disallowed from deduction simply because of the following:
- The loan is not a fixed term loan;
- There was a legal entitlement that the taxpayer should repay the loan before maturity;
- The original loan has been refinanced once or more than once;
Therefore, it can be said that if there is sufficient relationship between the interest expense and the income earning activity that has ceased. In that case, the interest expense are allowed as deduction.
Refinancing on deductibility of interest expenses
The business model of the business is to purchase the shares of the company at a considerable value at a later period after selling those shares to incompetent tender applicants. This business model involves requirement of borrowed fund for purchase of those shares. The company plans to purchase those share with borrowed fund by refinancing the loans of the company. The Para 4 of the Taxation Ruling 95/25 states that fund borrowed for repayment of capital is allowed as deduction under section 51(1) of the Income Tax Assessment Act 1997 (Brauner & Pistone, 2015). Therefore, it can be said that interest expenses that are incurred for refinancing are allowed as deduction.
Deductibility of Expected loss after repurchase
The expenses that helps generating assessable income are allowed as deduction. The loss incurred from the repurchase of shares are not related to activity that generates assessable income. Hence, they are not allowed as deduction (Sawyer, 2017).
CGT Implication of land
In the context of property transactions, the taxing regime of the country provides three possibilities as far as the taxability of such transactions are concerned. These possibilities are discussed below to let the readers understand the taxability associated with such property transactions (Brooks & Krever, 2015).
In case of property disposal, land or other property, the seller will be liable to pay capital gain tax on the amount of gain from such disposal. In this case, the property is a capital asset to the seller and the sale is not in the ordinary course of business of the seller. Under such circumstances the seller will be liable to pay CGT tax on the amount of capital gain resulted from the disposal of such property (Sprague, 2014).
In case the property is considered as trading stock of the trader and the property sold is in the ordinary course of business of the seller then the seller will be liable to pay tax on the amount of revenue arising from the ordinary course of business. In this case, the tax payer will not be liable to pay capital gain tax as the asset is not a capital asset rather is a trading stock and the sale is in ordinary course of business of the seller (James et al., 2015).
In case the sale of property is under a profit-making scheme then the seller will be liable to pay tax on the amount of profit made by him from the sale of such property. No capital gain tax is needed to be paid by the seller under such circumstance.
Taking into consideration the fact that Taite Moneybags and his business colleague Aramis Lots money treat the land as a trading stock thus, in case of sale of such stock they are not liable to pay capital gain tax on the sale of the subsidiary. Thus, since the land is trading stock for the subsidiary they are exempt from CGT on the sale of the subsidiary (Eisenbeiss, 2016).
Risk Associated with the Strategy
There are numerous risks associated with the business plan made by Taite Moneybags and his business colleague Aramis Lotsamoney and they should know about these risks before taking any decisions to implement the proposed business plan (Daurer & Krever, 2014). Let us dissect the business plan first for the readers to help them understand the numerous risks associated with the proposed business plan.
Taite Moneybags and his business colleague Aramis Lotsamoney have decided to set up a parent company to borrow money by using the company structure. The parent company then will lend the borrowed money at 100% commercial rate to its 100% owned subsidiary. After the initial planning phase of 2 years the subsidiary will operate for a period of 5 years after which the subsidiary shall be sold. During the 5 year of operation period the subsidiary will buy and develop land for subdivision and sale. According to the plan the subsidiary will be sold after the 7 years period and the sale will generate huge loss due to the interest expenses (Gianni, 2014).
The whole business plan has been made to avoid payment of tax using the loopholes in our tax structure. The fact that that the formation of a parent company to borrow funds and then to subsequently lent the money to a 100% subsidiary at 100% commercial rate which will use the funds to buy and develop land (Picciotto, 2015). The fact that the land after acquisition and development will be sold as trading asset is another way to avoid payment of capital gain tax. Further by incurring huge loss at the time of sale of the subsidiary after the period of 7 years. It is only to use the loss to off-set the tax liability to be aroused subsequent to the sale of the land is another way to use the loopholes in the income tax structure of the country to avoid payment of income tax. The whole objective of the business plan is to offset tax liability by utilizing the losses to be incurred at the time of sale of the subsidiary as well as by avoiding the payment of capital gain tax. The land to be used as trading asset of the subsidiary after the acquisition and development of the same (Hearson & Kangave, 2016).
Based on the above discussion it can be said that the business is required to operate as permanent establishment. The income and capital gain of the business will be taxable in Australia. The risk associated with the business model is high.
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