February 7th, 2008

Bilateral trade currently worth $50 billion between Australia and Japan will be boosted from a new Japan-Australia double tax agreement (DTA) which was signed in Tokyo last Thursday according to Deloitte Tax Partner, Terry Rooney.

“The new Japan-Australia DTA, which could take partial effect from as early as 1 January 2009, will replace the existing tax treaty which was signed in 1969, bringing it up to date with commercial practices and in line with the current OECD model treaty,” Mr Rooney said.

“The withholding tax rules changes reflect the modern approach to low withholdings previously negotiated with other major trading partners of Australia’s such as the US & UK.

“The changes will impact all companies with significant investments in the other country, notably Japanese commodity trading and resources companies, consumer electronics companies, meat exporters and financial services organisations,” added Ms Yuko Kearns a Deloitte Tax Principal in the Japanese Services Group.

“Financial institutions and any companies that have unfranked dividends payable to Japan will benefit from these changes as withholding tax will be reduced to nil for many companies.

“Tightening the definition of ‘permanent establishment’ will impact mining exploration and construction projects for infrastructure and mining.  Japanese businesses now have clear guidance that such ventures will require an Australian tax return if the venture lasts more than 90 days in any 12 month period.”

Mr Rooney said another significant and welcome change was the introduction of a seven year time limit on transfer pricing adjustments.

“Most importantly, the introduction of a time limit brings the rules closer to the domestic legislation covering powers of amendment in both countries,” Mr Rooney said.

“Australian subsidiaries of Japanese companies have probably been the subject of more transfer pricing inquiries and adjustments than any other single country so we expect affected Japanese companies to be relieved that there is at least certainty around the inquiry period following this change.”

Key changes

Withholding tax

The key change in the new agreement is the significant reduction in the withholding tax rates on dividend, interest and royalty payments. Although such withholding taxes may be creditable in some circumstances by Australian taxpayers, the withholding tax on non-portfolio dividends is generally not creditable.

Foreign tax credits

New tax rules effective in Australia from 1 July this year prevent any carry forward of foreign tax credits which cannot be used under the foreign income tax offset limit.  This means the reduction of the withholding rates will be welcome news to many Australian taxpayers with operations in Japan.

Dividend withholding tax

The treaty limit on the dividend withholding tax will be reduced from 15% to nil in certain circumstances.

Where the corporate shareholder directly holds at least 80% of the voting power of the company paying the dividends, subject to certain specific conditions, no tax will be payable.

The rate is reduced to 5% where the direct shareholding is at least 10%, and is 10 % in most other cases, including, for individual shareholders.

Property industry

The dividend withholding tax rate is not reduced from the existing 15% in relation to:
• distributions by an Australian real estate investment trust, and
• distributions by a Japanese company that is entitled to a deduction for dividend paid to its beneficiaries in computing its own taxable income in Japan, where more than 50% of its assets consist of real property situated in Japan.

The use of silent or ‘sleeping partnerships’ as methods for Australian investment into Japanese real estate remains viable.

Interest withholding tax

Interest withholding tax levied by the source country will be reduced from the current 10% to nil where the interests are derived by a financial institution or a body performing governmental functions resident in the other country.

The nil rate is subject to some safeguard measures to counter tax avoidance arrangements such as back-to-back loans.

Royalty tax

The general limit on royalty withholding tax under the DTA will be reduced from 10% in the existing treaty to 5%.  Rental of equipment will not be subject to the royalty withholding provision as it was in the existing treaty. 

Leasing

Equipment leasing will either not be taxed at all or will be subject to net income tax if the leasing income is attributable to a permanent establishment in the other country.

Transfer pricing

A significant win for businesses, particularly Japanese companies, is the seven year time limit introduced in relation to transfer pricing adjustments.

The seven year limit should provide increased certainty and allow businesses to better quantify and manage potential transfer pricing risks.

However, the time limit will not apply in the case of fraud or wilful default, or where the inability to initiate the inquiry is due to the actions or inactions of the relevant entity.

Dispute resolution between tax authorities

The provision dealing with the process by which the tax authorities are to resolve a situation of double tax, or differences in the interpretation of the agreement, is also expanded in the new DTA.

Improving the provision dealing with disputes between authorities should provide further comfort to business, especially given the aggressive stance that the tax authorities in both Australia and Japan have taken in recent years, particularly in relation to transfer pricing and use of intangible assets.

Permanent establishments and the resources sector

In an anti-avoidance measure, there is now a requirement for businesses to take into account any activities carried on in that other country by associated entities that are connected with their own activities there. These activities will now be used to determine the aggregate number of days a business has a presence in that country counted toward ‘permanent establishment’ (PE) status.

Businesses that are relying on the temporary nature of their operations in the other country to not create a permanent establishment would need to be aware of this new safeguard provision.

This new measure is likely to close off one of the structuring options for short term foreign operations between Australia and Japan.

Japanese businesses investing in the Australian mining and energy industry will have a PE in Australia if they carry on activities in relation to their exploration or exploitation ventures for more than 90 days in any 12 months period.

Next steps

The new DTA will need to be approved by the respective Governments, and if the new DTA legislation enters into force before 31 December 2008, it will apply:
• generally for withholding tax in Japan and Australia on income derived on or after 1 January 2009
• to Australian tax on income that is not withheld at source, on or after 1 July 2009, and
• to Japanese tax on income that is not withheld at source, on or after 1 January 2009.