Income from Property
(1) Annuities
ITAA97 s10-5; ITAAA36 s27H
Ordinary income may be exerted in many ways, most commonly from personal exertion, from property and from business. Income from property is defined in s6(1) ITAA36 as being all income that is not income from personal exertion.
Income from property is a receipt severed from the property from which it is derived. It is derived and generated without active labour or business input by the owner of the property, and for that reason is often described as “passive income”.
Four common examples of income from property include:
Interest – income derived from the use of money.
Annuities – an income stream generally purchased in return for the transfer of funds or property.
Rent – is the price paid for the right to use another person’s property, whether that property island, machinery, equipment, a motor vehicle or other goods.
Royalties – are generally the amounts paid for the use or exploitation of another person’s property, whether tangible (eg a copper mine) or intangible (eg copyright in a film).
What constitutes an annuity
There is no definition of an annuity in the Act. Annuities are expected periodic payments, which have either been given to or purchased by the recipient.
The essential characteristic of an annuity, particularly if it is a purchased annuity, is that the capital amount paid from the annuity is lost, and what is effect you have received for your capital are contractual rights, in the form of a sense of periodical payments.
The nature of an annuity is income. What you have done is bargained to transfer a capital amount into an income stream; ANZ Savings Bank v Commissioner of Taxation. The difficulty in the area of annuities arises where you dispose of an asset in return for a series of payments. The issue is whether what comes back to you for your capital asset is:
• an annuity;
• a capital sum to be paid in instalments, or
• a capital sum payable in instalments, with interest.
Under a purchased annuity, a taxpayer transfers funds or property to an annuity provider in exchange for a right to an annuity. Annuity transactions are commonly divided into two types:
• Private annuities – which arises from a transaction between the annuity purchaser and a private provider who agrees to provide an annuity for that particular annuitant.
• Institutional annuity – arises from a transaction between the annuity purchaser and an institution such as an insurance company, superannuation fund, or similar financial institution that offers annuities to the public at large as part of its business.
Taxpayers who receive superannuation pensions or ETP annuities that are first payable on or after 1 July 1983 are required to include such payments less any “deductible amount” in their assessable incomes under s27H ITAA36.
Private and institutional annuities can be offered as fixed term annuities, payable for a specified number of years, or as life annuities, payable for the life of the annuitant.
Baron Watson in Foley v Fletcher gave a definition of an “annuity”. This has been adopted by Australian courts:
“annuities mean, that where the annuity may be purchased with money the capital is gone and ceases to exist, and consequently, the person to be charged [tax] is the person receiving the annuity, that is, the year sum, year by year … No capital is taxed there, because the principle has been converted into an annuity, and the annuity is chargeable [to tax].
Treating the entire amount of each payment as ordinary income would, however, lead to a significant injustice in the case of purchased annuities because taxpayers would be assessed on the whole of their return without any recognition of the capital invested to acquire the right to an annuity or of the fact that part of each payment merely represents a return of capital.
In Australian tax law, a formula is used to exclude the capital portion of each annuity payment from assessable income (the “recovery of capital” exclusion). The formula, found in s27H ITAA36, applies to superannuation pensions and annuities that have been purchased by the individual. The effect of s27H is to include only part of each annuity payment in assessable income.
Legislation has long since overturned the judicial rule in party by allowing a taxpayer to reduce the amount of income by allowing for the cost of the annuity (it is not, however, a deduction in the sense of Div 8 of the ITAA97).
The reduction formula, in s27H of the ITAA36, is not based on the actual proportions or estimated proportions of interest in each payment. Instead, the taxpayer is allowed to pro-rate the capital (called the “undeducted purchase price”) over each payment and reduce each annuity payment by an equal amount. In the case of a life annuity, the deductible amount is calculated as if the taxpayer were going to live the exact period estimated by the Commonwealth actuary.
Significance of a “fixed gross sum”
To encourage taxpayers to take superannuation pensions or ETP annuities in preference to lump sum ETPs on retirement, the following tax concessions are provided:
• Rebate - A rebate is available to taxpayers who are at least 55 years of age and receive “rebatable superannuation pensions” or “rebatable ETP annuities”.
• Pension RBL - Taxpayers who take at least 50% of their retirement benefits in the form of “complying pensions or annuities” which meet the pension and annuity RBL standards prescribed in the SISR are allowed to measure their benefits against the “pension RBL”, this allows them to receive a greater amount of concessionally taxed benefits.
• Tax exemption - Superannuation funds that have commenced to pay a pension are exempt from tax on income derived from assets used to pay the pension.
In the case of payments relating to assets acquired before the introduction of CGT, the entire proceeds of each payment may be tax-free. This result is quite different from the tax treatment of annuity payments, which may be assessable in full if the taxpayer is unable to ascertain an undeducted purchase price. Although the correct characterization of the transaction appears to be an instalment sale can be difficult, the tax consequences may be significant.
Egerton-Warburton & Ors v DFCT (1934)
Facts: the taxpayer was a farmer who sold his farm to his sons. Payment for the farm was to be $1,200 pa for the duration of his life, and after this death payment of $1,000 pa for his wife for the rest of her life and a lump sum to his daughters and grandchildren.
Issue: whether the taxpayer was assessable on the $1,200 pa or were they capital receipts for the sale of the property. The Commissioner argued it was an annuity and therefore assessable.
Held: The High Court said the payments were an annuity, of an income nature. They said what the taxpayer had bargained for was an income stream, and rejected the argument that it was capital, because they said, there was no definite price being paid for the property. (This is important in working out if it is an annuity – if the amount is open-ended, taxpayer has a problem). Court said he had not sold the farm, he had used the farm to purchase an annuity, ie uncertain what you get back.
In ascertaining a payment’s true nature, Rich, Dixon and McTiernan JJ pointed out in Egerton-Warburton & Ors v DFC of T that in each case it is necessary to determine whether the taxpayer has sold property in return for:
(i) an annuity – in which case the annuity will be taxable;
(ii) a capital sum to be pain in instalments, as in Foley v Fletcher – in which case the payments are capital, not ordinary income, or
what looks like an annuity, but is in fact payment of a capital sum spread over a period together with interest – in which case the interest, but not the capital investments, will be taxable (Secretary of State in Council of India v Scoble & Ors).
In endeavouring to distinguish between annuities and instalments of capital, the courts have often placed considerable weight on whether or not the parties’ agreement stipulates a “fixed gross sum” as the foundation of the agreed price. In Egerton-Warburton & Ors v DFC of T the High Court held that since there was no fixed gross sum or definite purchase price – because the total amount payable would vary depending upon how long the taxpayer lived – the £1,200 payment received each year for the duration of the taxpayer’s life was not an instalment of a capital price, but rather an assessable annuity payment.
Just v FCT (1949)
Facts: a third party created a “rent charge” over certain premises, entitling Just to receive 90% of the rent for the premises.
Held: In the High Court, Webb J indicated that if the £17,500 stipulated in the parties’ agreement had been the purchase price of the land rather than merely its value for stamp duty purposes, he might have characterized the payment as instalments of the purchase price plus interest on the balance outstanding. However, in the absence of a fixed gross sum, his Honour held the amount to be assessable income: the substance of the transaction was that “the Just’s had bargained to have not a capital sum but an income.”
The whole of an annuity is income, but s27H is a statutory provision which excludes what is called “the deductible amount”. It is a bad use of terminology, it is not deductible, is actually part of the gross amount of the payment which is not included in your assessable amount.
IRC v Ramsay [1935]
Facts: Ramsay purchased a dental practice for £15,000, the contract providing that the agreed price was to be met by the purchaser paying a £5,000 lump sum immediately, plus an annual payment for each of the next 10 years equal to 25% of that year’s net profits from the practice. This was so even if the sums paid might total more than the balance of £10,000. Ramsay argued that the 10 payments of 25% were annual payments in the nature of income, which he would therefore be entitled to deduct from his total income in calculating his liability to surtax.
Held: The UK Court of Appeal unanimously held that the 10 annual payments were not annuities, but were instalments of the balance of purchase price outstanding. Their Lordships were influenced by the presence and dominant role of the fixed gross sum of £15,000 stipulated in the contract as the purchase price. The provision for instalments of varying amounts which in the aggregate might amount to either more or less than £10,000 simply meant that Ramsay might in the end have to pay a total sale price of more or less than £15,000.
Ramsay’s case can thus be characterized as one in which the parties had agreed that the obligation to pay a specified purchase price could be satisfied by payment of a lump sum plus a series of variable instalments which were expected in the aggregate to approximate £15,000, but might in fact total more or less. That is, the operation of the agreement was governed by a fixed gross sum, even though the purchase price itself was not precisely fixed.
(2) Royalties
ITAA97 ss 10-5, 15-20; ITAA ss6, 6C
INCOME TAX ASSESSMENT ACT 1936 - SECT 6
Interpretation
"royalty or royalties" includes any amount paid or credited, however described or computed, and whether the payment or credit is periodical or not, to the extent to which it is paid or credited, as the case may be, as consideration for:
(a) the use of, or the right to use, any copyright, patent, design or model, plan, secret formula or process, trademark, or other like property or right;
(b) the use of, or the right to use, any industrial, commercial or scientific equipment;
(c) the supply of scientific, technical, industrial or commercial knowledge or information;
(d) the supply of any assistance that is ancillary and subsidiary to, and is furnished as a means of enabling the application or enjoyment of, any such property or right as is mentioned in paragraph (a), any such equipment as is mentioned in paragraph (b) or any such knowledge or information as is mentioned in paragraph (c);
(da) the reception of, or the right to receive, visual images or sounds, or both, transmitted to the public by:
(i) satellite; or
(ii) cable, optic fibre or similar technology;
(db) the use in connection with television broadcasting or radio broadcasting, or the right to use in connection with television broadcasting or radio broadcasting, visual images or sounds, or both, transmitted by:
(i) satellite; or
(ii) cable, optic fibre or similar technology;
(dc) the use of, or the right to use, some or all of the part of the spectrum (within the meaning of the Radiocommunications Act 1992 ) specified in a spectrum licence issued under that Act;
(e) the use of, or the right to use:
(i) motion picture films;
(ii) films or video tapes for use in connexion with television; or
(iii) tapes for use in connexion with radio broadcasting; or
(f) a total or partial forbearance in respect of:
(i) the use of, or the granting of the right to use, any such property or right as is mentioned in paragraph (a) or any such equipment as is mentioned in paragraph (b);
(ii) the supply of any such knowledge or information as is mentioned in paragraph (c) or of any such assistance as is mentioned in paragraph (d);
(iia) the reception of, or the granting of the right to receive, any such visual images or sounds as are mentioned in paragraph (da);
(iib) the use of, or the granting of the right to use, any such visual images or sounds as are mentioned in paragraph (db);
(iic) the use of, or the granting of the right to use, some or all of such part of the spectrum specified in a spectrum licence as is mentioned in paragraph (dc); or
(iii) the use of, or the granting of the right to use, any such property as is mentioned in paragraph (e)
INCOME TAX ASSESSMENT ACT 1936 - SECT 6C
Source of royalty income derived by a non-resident
(1) This section applies to income that is derived on or after 1 July 1968 by a non resident and consists of royalty that:
(a) is paid or credited to the non resident by the Commonwealth, by a State, by an authority of the Commonwealth or of a State or by a person who is, or by persons at least one of whom is, a resident and is not an outgoing wholly incurred by the Commonwealth, the State, the authority or that person or those persons in carrying on business in a country outside Australia at or through a permanent establishment of the Commonwealth, the State, the authority or that person or those persons in that country; or
(b) is paid or credited to the non resident by a person who is, or by persons each of whom is, a non resident and is, or is in part, an outgoing incurred by that person or those persons in carrying on business in Australia at or through a permanent establishment of that person or those persons in Australia.
(1A) For the purposes of Division 5 and Division 6 of Part III, but subject to subsections (3) and (4), income to which this section applies shall be deemed to be attributable to sources in Australia.
(2) For the purposes of sections 6 5 and 6 10 of the Income Tax Assessment Act 1997 , but subject to subsections (3) and (4), income to which this section applies shall be deemed to have been derived from a source in Australia.
(3) Where:
(a) income to which this section applies is paid or credited to the non resident by whom it is derived by the Commonwealth, by a State, by an authority of the Commonwealth or of a State or by a person who is, or by persons at least one of whom is, a resident; and
(b) the royalty of which the income consists is, in part, an outgoing incurred by the Commonwealth, the State, the authority or that person or those persons in carrying on business in a country outside Australia at or through a permanent establishment of the Commonwealth, the State, the authority or that person or those persons in that country;
subsection (2) has effect in relation to so much only of the income as is attributable to so much of the royalty as is not an outgoing so incurred.
(4) Where:
(a) income to which this section applies is paid or credited to the non resident by whom it is derived by a person who, or by persons each of whom, is a non resident; and
(b) the royalty of which the income consists is, in part only, an outgoing incurred by the person or persons by whom it is paid or credited in carrying on business in Australia at or through a permanent establishment of that person or those persons in Australia;
subsection (2) has effect in relation to so much only of the income as is attributable to so much of the royalty as is an outgoing so incurred.
(5) In subsection (6), a reference to a relevant person is a reference to the Commonwealth, a State, an authority of the Commonwealth or of a State or a person who is, or persons at least 1 of whom is, a resident.
(6) For the purposes of paragraphs (1)(a) and (3)(b), where:
(a) royalty is paid or credited, after the commencement of this subsection, to a non resident by a relevant person carrying on business in a country outside Australia; and
(b) the royalty or a part of the royalty:
(i) is incurred by the relevant person in gaining or producing income that is derived by the relevant person otherwise than in carrying on business in a country outside Australia at or through a permanent establishment of the relevant person in that country or is incurred by the relevant person for the purpose of gaining or producing income to be so derived; or
(ii) is incurred by the relevant person in carrying on business for the purpose of gaining or producing income and is reasonably attributable to income that is derived, or may be derived, by the relevant person otherwise than in so carrying on business at or through a permanent establishment of the relevant person in a country outside Australia;
the royalty or the part of the royalty, as the case may be, is not an outgoing incurred by the relevant person in carrying on business in a country outside Australia at or through a permanent establishment of the relevant person in that country.
(7) For the purposes of paragraphs (1)(b) and (4)(b), where:
(a) royalty is paid or credited, after the commencement of this subsection, to a non resident by another person or other persons (in this subsection referred to as the payer ), being:
(i) another person who is carrying on business in Australia and is a non resident; or
(ii) other persons who are carrying on business in Australia and each of whom is a non resident; and
(b) the royalty or a part of the royalty:
(i) is incurred by the payer in gaining or producing income that is derived by the payer in carrying on business in Australia at or through a permanent establishment of the payer in Australia or is incurred by the payer for the purpose of gaining or producing income to be so derived; or
(ii) is incurred by the payer in carrying on a business for the purpose of gaining or producing income and is reasonably attributable to income that is derived, or may be derived, by the payer in so carrying on business at or through a permanent establishment of the payer in Australia;
the royalty or the part of the royalty, as the case may be, is an outgoing incurred by the payer in carrying on business in Australia at or through a permanent establishment of the payer in Australia.
Common law royalties are:
• payments which the grantor for monopolies, such as patents and copyrights, receive under licences;
• payments which the owner of soil obtains in respect of the tranting of a right to another person to take some special thing forming part of or attached to the land, eg timber, minerals.
Characteristics of a royalty payment at common law:
• it is paid for the right to exercise a beneficial privilege;
• it is usually paid as and when the right to the beneficial privilege is exercised.
• The payments for the exercise of the right are calculated by reference to the benefit derived from the exercise of the right, eg, payments based on quantity of timber taken or articles produced under licence eg a patent.
The property in this case is the land or the patent. You give permission for someone to use your property. The property remains intact, you just allow someone to use it, so receipt is of an income nature. If the payment is not based on the use of your property it is not income at common law eg if you grant someone the exclusive right to use your patent for 20 years, it is capital.
While royalties are normally calculated by reference to actual exploitation or usage (e.g an amount per book sold), a direct connection between the payment and the exploitation or usage is not essential so long as the payment is calculated indirectly by reference to the exploitation or usage. E.g. a lump sum payment may be a royalty where it is a pre-estimate of the anticipated amount of further use.
McCauley’s case and Stanton’s case provide a distinction between a common law royalty and a non-royalty payment.
McCauley v FCT (1944)
Facts: Taxpayer was a dairy farmer. He owned land on which trees were growing. Taxpayer was approached by a sawmiller, and entered into an agreement with him. The sawmiller agreed to pay him for the right to cut and remove the timber, at a rate of 3/- for every 100 yards cut.
Issue: what was the nature of the receipt?
Held: The High Court held the receipts were royalties, and hence of an income nature. The Court said the payments were made by the person for the grant of a right to enter upon the land and cut timber and was made based on the quantity of timber cut.
Stanton v FCT (1955)
Facts: Taxpayer was a grazier who had some timber on his land. He entered into an agreement with a sawmiller, who agreed to pay him a lump sum amount based on the amount of timber standing on the land. The amount payable was payable quarterly, and became due independently of whether the timber was cut and removed or not.
Issue: Was taxpayer assessable on those payments?
Held: High Court said no, it was not a royalty payment.
Why the difference? Economically and commercially it was the same transaction, but structured differently. In the second case, what in effect was happening was that the grazier was selling the timber for a lump sum, and whether the purchaser came and cut it or not was a matter for him. In MCCAULEY’S CASE, the payment was for the exercise of the right to cut the timber, not for the timber itself, ie payment for each time they did it.
In Stanton v FC of T, the High Court identified the essence of a royalty as follows:
“In other words it is inherent in the conception expressed by the word that the payments should be made in respect of the particular exercise of the right to take the substance and therefore should be calculated either in respect of the quantity or value taken or the occasions upon which the right is exercised.”
The nature of the right to cut timber is part of your proprietary rights as an owner of land. The money is not for the timber, it is for the right to cut and remove the timber. At the end of the agreed period, the right reverts to the owner. The right may have diminished in value, to zero if no timber left, but the owner has not disposed of his right.
Why this is an unfair result is that the right has diminished in value. With a building, eg, you would have been able to claim depreciation, as the value of your asset decreases – but no so in regard to diminishing of the value of your rights here.
Section 15-20 ITAA97 expressly contemplates that there will be payments which constitute “royalties” under the ordinary meaning of the word which will not be characterized as ordinary income. The purpose of s15-20 is to include these amounts in assessable income as statutory income. If an amount is a royalty under the statutory definition but not the ordinary meaning of royalty and is not ordinary income, it cannot be assessed under s6-5 or under s15-20 ITAA97. It may, however, be assessable as a capital gain.
If an amount is a royalty under the statutory definition but not the ordinary meaning of royalty and is not ordinary income, it cannot be assessed under s6-5 or under s15-20 ITAA97. It may, however, be assessable as a capital gain.
Australia has entered into international tax treaties with most of its principal trading partners and under the treaties Australia has foregone its rights to tax residents of the treaty countries on many types of income sourced in Australia where the non-resident does not operate in Australia through a permanent establishment. One type of income derived by residents of treaty countries over which Australia has retained taxing rights is royalty income and the primary purpose of the definition is to characterize ordinary that is analogous to royalty income as royalty income so Australia can exercise its taxing rights under the international tax treaties. The statutory definition works in conjunction with s6C ITAA36 to ensure payments from Australia that fall within the statutory definition of royalty will have an Australian source.
One example of ordinary income that is characterised as a royalty by the statutory definition is a payment for the use of know-how where the payer does not actually acquire a right to intellectual property or know- how. This is illustrated in –
FCT v Sherritt Gordon Mines (1977)
Facts: Sherritt agreed to supply technical assistance to Western Mining Corporation Ltd. In consideration of this assistance, Western Mining agreed to pay Sherritt an “aggregate sum expressed as a percentage of the Aggregate Sales Value of the nickel and by-products produced … by the practice of the Sherritt System”.
Held: The High Court held by majority that the payments were not royalties. The majority reached this conclusion because, under the agree, the payments were not made in consideration of the grant of a right. (p227 ATL) The Court dismissed the appeal for the following reasons:
(i) The substantial, if not sole, consideration for the payments made by Western, was not the grant of a right but the provision of technical assistance and information, and that the amounts payable were not royalties at general law (royalties according to the ordinary sense of that term.
(ii) The extended definition of the term “royalty” in s6(1) of the ITAA 36 as amended is designed to add to or supplement the ordinary meaning of the term by including payments falling within the definition of “royalties” in art 10(5) of the First Schedule to the Income Tax (International Agreements) Act 1953 as amended (UK Agreement).
(iii) Article 10(5) of the UK Agreement applies only to payments made by an Australian resident to a United Kingdom resident or vice versa, and does not apply to payments made by an Australian resident to a Canadian resident.
Royalties paid or credited to non-residents that are outgoings of an Australian business are deemed to have an Australian source.
Royalties are ordinary income, but covered by statute 10-5, “royalties” s15-20. If you receive an amount as or by way of royalty which is a royalty at common law (disregarding the meaning of “royalty in s995-1(1)), then it is caught by this section if it is not otherwise assessable as ordinary income, ie if you find a royalty which is capital at common law then it will be assessable. However, a royalty at common law would be income. In effect s15-20 is redundant.
Extended definition of “royalty”
The wide ordinary meaning of royalty is expanded further by the definition in s6(1) ITAA36.
Taxpayers may receive amounts that are analogous to or similar to royalties but which fall outside the ordinary meaning of that term. It is possible to identify the principal tests used by the courts to make the distinction:
1. If the taxpayer is an individual in the business of creating income-generating property rights, as would be the case with say, an author, the sale of copyright for a lump sum would normally give rise to an income, albeit not a royalty, receipt. However, if the person disposing of rights is no longer in the profession that gave rise to the rights, the lump sum may constitute a capital receipt, assessable only under the CGT provisions.
2. In the case of an entity that makes an outright sale of rights, the character of the consideration received will depend on the nature of the taxpayer’s business.
3. Where a taxpayer sells intangible rights such as patents or know-how of secret processes on an instalment basis, the character of the instalment receipts may depend on whether the sale was an absolute assignment of ownership or merely for a limited period.
4. When characterizing receipts for the exploitation of real property that look similar to royalty payments, courts will look to see if the payment is for actual use or exploitation of an asset or is compensation for the effects of use of exploitation.
5. Where a taxpayer provides intellectual property rights for a lump sum plus royalties, the character of the lump sum portion of consideration may turn on whether subsequent royalties are based on actual usage or are based on flat annual amounts regardless of usage.
6. Where a licensing agreement provides for the payment of royalties for the use of intellectual property and a separate lump sum (which might be paid in instalments) for the licensor agreeing not to compete in the jurisdictions covered by the licence agreement, the payment for non-competition may be a capital receipt, assessable only under the capital gains provisions (Murray v Imperial Chemical Industries Ltd).
Where a taxpayer sells “know-how” for a lump sum, the payment is likely to be an income receipt if the provision is seen as an integral part of the taxpayer’s business, and a capital receipt if the provision of know-how is outside the normal course of business for the taxpayer.
The difficulty inherent in the process of distinguishing the purpose of payments and their consequent income or capital characterization is well illustrated in the judgment of Lord Denning MR in -
Murray v Imperial Chemical Industries Ltd [1967]
Facts: In the 1950’s Imperial Chemicals were exploiting a new fibrous material which they called Terylene. It was manufactured at Wilton, but they could not make enough to meet the world demand. So they granted exclusive licences to foreign companies in various countries. They covenanted to “keep out” of that country and in return, they received considerable sums of money from the overseas companies.
Issue: The question was whether an amount of £400,000 payable for the “keep out” covenant by annual instalments was a trading receipt and taxable as part of the income of the taxpayer company or whether it was a capital receipt which is not taxable.
Held: Lord Denning noted that the “keep-out” covenant was ancillary to the grant of a licence. The receipts by the taxpayer company bear the same character – capital or income – no matter whether the “keep-out” covenant is co-extensive with the licence or somewhat wider than it. When the taxpayer company granted this licence they were disposing of a capital asset. There is no difference in this regard between an assignment of patent rights and grant of an exclusive licence for the period of the patent. It is the disposal of a capital asset. If a man disposes of patent rights outright (viz., by an assignment of his patent, or by the grant of an exclusive licence), and receives in return royalties calculated by reference to the actual user, the royalties are clearly revenue receipts. If and in so far as he disposes of them for annual payments over the period, which can fairly be regarded as compensation for the user during the period, then those also are revenue receipts. If and in so far as he disposes of the patent rights outright for a lump sum, which is arrived at by reference to some anticipated quantum of user, it will normally be income in the hands of the recipient … If an in so far as he disposes of them outright for a lump sum which ahs no reference to anticipated user, it will normally be capital. … It is different when a man does not dispose of his patent rights, but retains them and grants a non-exclusive licence. He does not then dispose of a capital asset. He retains the asset and he uses it to bring in money for him. … Similarly a lump sum for “know-how” may be a revenue receipt. The capital asset remains with the owner. All he does is put it to use. The royalties in this case for the master CPA patents and the royalties for the ancillary patents of the taxpayer company were revenue receipts.
Deemed source of interest payments
A statutory source rule applies in determining whether royalties have an Australian source (s6C). This is a one-sided source rule that does not apply for the purpose of the foreign tax credit.
Section 6C applies an origin-based source rule in relation to royalties. It applies to income which is derived by a non-resident and consists of a royalty that is paid or credited to the non-resident by:
(a) a resident, other than where the royalty is an outgoing wholly incurred in carrying on a business at or through a permanent establishment outside Australia, or
(b) a non-resident, where the royalty is an outgoing incurred in carrying on business at or through a permanent establishment in Australia.
Where s6C applies, the royalty is deemed to be derived from a source in Australia for the purposes of s6-5 and 6-10 ITAA97 and s23(r) and 255 ITAA36.
(3) Interest
INCOME TAX ASSESSMENT ACT 1997 - SECT 6.5
Income according to ordinary concepts (ordinary income)
(1) Your assessable income includes income according to ordinary concepts, which is called ordinary income .
Note: Some of the provisions about assessable income listed in section 10 5 may affect the treatment of ordinary income.
(2) If you are an Australian resident, your assessable income includes the * ordinary income you * derived directly or indirectly from all sources, whether in or out of Australia, during the income year.
(3) If you are a foreign resident, your assessable income includes:
(a) the * ordinary income you * derived directly or indirectly from all * Australian sources during the income year; and
(b) other * ordinary income that a provision includes in your assessable income for the income year on some basis other than having an * Australian source.
(4) In working out whether you have derived an amount of * ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct
Nature of interest payments
The nature of interest is income. Interest is simply compensation for yield based on time for someone being able to use your money. It does not matter what you call something – if it is the nature of interest it will be assessable.
Interest is commonly thought of as the price of money which is borrowed. It is the “return or consideration or compensation for the use or retention by one person of a sum of money belonging to, in a colloquial sense, or owed to another”. “Interest relates to a sum borrowed or agreed to be borrowed. Without a borrowing (or agreement to borrow) there can be no interest.
Interest may be payable as “simple” interest or “compound” interest. Simple interest is payable on a regular basis (often annually or semi-annually), while compound interest is payable upon redemption of the loan, when the loan principle is repaid.
Disguised interest payments
A common technique used to adjust the rate of return is to lend funds subject to a loan discount or premium. Under a loan discount arrangement, the borrower receives a discounted loan principle, meaning the loan agreement obliges the borrower to repay a principal greater than the amount actually borrowed.
Interest, meanwhile, is charged on the notional loan principle, not on the discounted loan principal. Under a loan premium arrangement, the borrower is provided with the notional principal for the loan, but is required to repay a premium on top of the notional principal when the loan is redeemed or paid off. In the interim, interest is charged on the notional loan principal, not the amount to be repaid.
The key factor considered by courts when characterizing a discount or premium is whether the borrower was charged the normal rate of interest that would otherwise be levied on such a loan or whether the interest rate was below the benchmark rate at the time. This is best illustrated by –
Lomax v Peter Dixon and Son [1943]
Facts: The taxpayer was a company that had lent funds to a business in Finland just before WWII. Finland was considered a high risk jurisdiction and to compensate, English lenders to Finnish borrowers required a much higher rate of return than the ordinary rate charged equivalent borrowers in the UK.
Held: The House of Lord concluded that this was the appropriate benchmark rate against which the taxpayer’s loan should be measured and accordingly accepted the taxpayers argument that the discount and premium were matters of capital addressing the risk of non-payment of principal.
In determining whether a premium or discount contains an element of interest, the courts have often been guided by the propositions set out by Lord Greene in Lomax, namely:
(i) even though a loan is made at or above the reasonable commercial rate of interest applicable to a sound security, there is no presumption that any associated premium or discount is to be characterized as interest (although where no interest as such is payable, a premium will “normally, if not always” be interest), and
(ii) the true nature of the discount or premium must be ascertained from all the circumstances of the case, and the courts will look particularly at such matters as:
a. the term of the loan
b. the rate of interest (if any) expressly stipulated under the contract, and
the nature of the capital risk of non-repayment, and the extent to which the parties took that risk into account in negotiating the terms of the contract.
It is important to remember in Lomax that it was a manufacturing company. The situation would have been different if it was a bank. If it had have been a bank, it would have been assessable, not because the amount was in the nature of interest, but because banks carry on business to be rewarded, in part, in taking risks in lending money ie banks are in the business of being compensated for taking risk. The premium and discount would have been assessable simply as being a receipt in the course of carrying on their business.
Deemed source of interest payments
As a matter of policy, if the economic activity giving rise to the interest occurs in Australia, then the interest should be given an Australian source. However, this approach was expressly rejected in Commr of IR v Philips Gloeilampenfabrieken. It was held that the source of interest income is the place where the credit is provided, and this means either the place of contracting or the place where the funds are advanced.
In FC of T v Spotless Services Ltd, the Full Federal Court gave considerable weight to the place where the contract was made and the place where the loan funds were advanced in determining the source of interest income.
Interest (except interest paid outside Australia to a non-resident on debentures issued outside Australia by a company) on money secured by a mortgage of any property in Australia is deemed to have an Australian source (s25(2) ITAA36).
(4) Lease and rental income
ITAA97 ss6-5, 10-5
Nature of lease/rental payments
Where property (whether land, machinery, equipment, a motor vehicle, or other goods) is leased by a lessor to a lessee, the price paid for the right to use that property is rent and is assessable income at common law. Rent is the payment which a tenant contracts to pay the landlord for the use of premises (or goods). Rent by its very nature is ordinary income.
In determining whether or not a payment is rent, it is the reality or substance of the matter, rather than the label given by the parties to the transaction which is decisive.
Provided a receipt is really rent, the manner of its payment is irrelevant. Thus rent may be paid in a lump sum; or by the landlord crediting rent due against money which he had borrowed from the tenant.
Premiums
In the contexts of rents, a premium is usually an amount paid by a potential lessee to induce the lessor to grant or assign the lease of particular premises to that lessee. A premium received as consideration for the grant or assignment of a lease will usually be capital in character. However, a premium may be assessable as ordinary income where the taxpayer’s business includes the receipt of such premiums or where the premium is really a disguised payment of additional or advance rent.
When you grant a person a lease, you give that person an interest in the property, a proprietary interest in the property. You may receive a premium for granting that interest, i.e. for actually selling a piece of your property, and is in the nature of capital, i.e. you are a landlord, not a developer. The rent is for allowing you to use that property and that is in the nature of income.