Spender J

Kiefel J
Finn J

Full Federal Court

Judgment date: 27 March 1998

Spender, Kiefel and Finn JJ

This is an appeal from a decision of a single judge of this court (Cooper J) [reported at 97 ATC 4299], who rejected a contention on behalf of the Commissioner of Taxation (``the Commissioner'') that the appellant, Century Yuasa Batteries Pty Ltd (``Century Yuasa Batteries'') was obliged to pay to the Commissioner $123,532.08 on account of interest, withholding tax and late payment penalties in respect of interest payments made to Bank Negara Indonesia 1946 (subsequently known as PT Bank Negara Indonesia (Persero)) (``BNI'').

In essence, Century Yuasa Batteries borrowed from a non-resident, BNI, pursuant to a loan facility agreement dated 14 February 1990. Clause 11 of that agreement required Century Yuasa Batteries to ``gross up'' interest payments made to BNI. The proper characterisation of those payments is the question on the appeal. The contention on behalf of the Commissioner is that those payments are either ``interest'' or ``in the nature of interest'' for the purposes of s 128A(1) of the Income Tax Assessment Act 1936 (Cth) (``the ITA Act'').

While the history of the litigation is not that of a simple objection appeal, by the conduct of the parties below and on the appeal, the question for resolution on the appeal presents as a discrete legal issue.

The relevant factual background appears in the reasons for judgment of the primary judge. Century Yuasa Batteries was at all relevant times a company incorporated in Queensland; BNI was at all relevant times a bank not resident in Australia and carried on business, amongst other places, at a branch office in London. Pursuant to the loan facility agreement of 14 February 1990, BNI granted to Century Yuasa Batteries a credit facility in the amount

ATC 4382

of US$2,000,000, trade finance facilities up to US$3,000,000 and a working capital facility of US$18,000,000. Interest on the advances made pursuant to the credit facility and the working capital facility was payable every three or six months (the period being selected by BNI) at a rate to be calculated in accordance with cl 5.4 of the facility agreement. The ``Loan'' was defined in cl 1.1 of that agreement to mean ``the aggregate principal amount drawn, and for the time being outstanding under the Credit Facility and the Working Capital Facility''. By cl 13.2 of the facility agreement, all payments in respect of the credit facility and the working capital facility, including interest payments, were to be made in Australian dollars on the relevant date to ``NAB Bank Melbourne Account No Indo-006''.

Clause 11 of the facility agreement, which is central to the issue raised on the appeal, provided:

``11. TAXES

All sums payable by the Borrower under this Agreement shall be paid in full without set- off or counterclaim and free and clear of and without any deduction or withholding for or on account of any tax. If the Borrower or any other person is required by any law or regulation to make any deduction or withholding from any payment, the Borrower shall together with such payment pay an additional amount so that the Lender receives free and clear of any tax the full amount which it would have received if no such deduction or withholding had been required. The Borrower shall pay to the relevant taxing or other authority the full amount of the deduction or withholding made by it and promptly forward to the Lender copies of official receipts or other evidence showing that the full amount of any such deduction or withholding has been paid over to the relevant taxation or other authority before the date on which penalties attach thereto.''

There was, in addition to the obligation to make the payment under cl 5.4, a number of other monetary obligations on the respondent imposed by the loan facility agreement: cl 6.5 imposed additional amounts in the event of early repayment; cl 10.2 imposed additional costs (including additional taxes) to a lender by reason of a change of law; cl 11 (already set out), applied to any amount which the borrower was required to deduct from any payment (whether of principal or interest); cl 12.1 concerned commissions or letters of credit under the trade financing facility; cl 12.2 required reimbursement to the lender of the costs, charges and expenses (including legal fees and reasonable travel expenses) incurred in connection with establishing the facility; cl 12.3 related to enforcement costs; and finally cl 12.4 referred to stamp duty and other like taxes. Pursuant to cl 15.3, the appellant was required to give security for all ``principal, interest and other amounts'' payable.

It was accepted by the parties on the appeal that as a consequence of the decision of
David Securities Pty Ltd & Ors v Commonwealth Bank of Australia 92 ATC 4658; (1992) 175 CLR 353, a ``gross up'' clause such as cl 11 was void pursuant to s 261 of the ITA Act. This aspect of the matter was not argued below; it is unnecessary for this court to consider the possible consequence of that concession on the appeal if the court is of the same view as the primary judge, namely, that the payments made pursuant to cl 11 of the loan facility agreement were not ``interest'' or ``in the nature of interest'' as defined in s 128A(1) of the ITA Act.

Division 11A of Pt III of the ITA Act imposes a liability to pay income tax upon a non-resident who derives income in the form of interest paid to the non-resident: ss 128B(1A), 128B(2) and 128B(5). That income tax is called ``withholding tax'': s 6(1) of the ITA Act. Section 128A(1) defines interest as including:

``... an amount in the nature of interest, not being an amount referred to in sub-section 26C(1);''

Division 4 of Pt VI is directed at facilitating the collection of withholding tax. The learned primary judge held that s 221YL(2A), within Div 4 of Pt VI, of the ITA Act applied to payments made by Century Yuasa Batteries to BNI. That subsection applies where interest is payable by a borrower to a non-resident, and the subsection requires the borrower to ``make a deduction from the interest of an amount determined in accordance with the regulations''. Section 221YK(1) defines interest as meaning ``any amount that is or is deemed to consist of interest for the purposes of Division 11A of Part III''. Section 128A(1) is in that Division.

ATC 4383

The parties to the appeal accept that interest is to bear its ordinary meaning, which is the return, consideration or compensation for the use or retention by one person of a sum of money belonging to, or owed to another, and that interest must be referable to a principal. In
FC of T v The Myer Emporium Ltd 87 ATC 4363; (1987) 163 CLR 199, the High Court (Mason ACJ, Wilson, Brennan, Deane and Dawson JJ) said at ATC 4371; CLR 218:

``... Interest is regarded as flowing from the principal sum (
Federal Wharf Co Ltd v DFC of T (1930) 44 CLR 24 at p 28) and to be compensation to the lender for being kept out of the use and enjoyment of the principal sum:
Riches v Westminster Bank Ltd [1947] AC 390 at p 400. A covenant to pay interest on a principal sum may, according to the terms of the lending agreement, be independent of or accessory to a covenant to repay the principal sum or the covenants may be integral parts of a single obligation, but it is of the essence of interest that it be referable to a principal sum: per Rand J in Reference as to the Validity of Section 6 of the Farm Security Act, 1944, of the Province of Saskatchewan [1947] SCR 394 at pp 411-412.''

The contention on behalf of the Commissioner on the appeal is disarmingly simple. It was asserted on behalf of the Commissioner that payments made pursuant to cl 11 are payments of interest or in the nature of interest. It was submitted that cl 11 obliged the borrower to pay ``an additional amount'', so that BNI receives ``the full amount which it would have received if no such deduction or withholding had been required''. The submission is that the full amount which BNI ``would have received'' is the full amount of interest and that consequently there is no reason why the additional payment does not itself have the character of interest. In the alternative, it was submitted that, if the payment is not itself interest, it is ``in the nature of interest''.

The submission on behalf of the Commissioner is that the extension intended by the phrase ``an amount in the nature of interest'' was the inclusion of payments which, ``though not strictly interest'', are properly to be regarded as part of the cost to the borrower, which the lender extracts as the price of the borrowing.

The conclusion of the learned primary judge on this aspect of the matter was as follows [97 ATC at 4315]:

``Clause 11 is not concerned with any additional liability to pay interest over and above the obligation contained in clause 5. Rather, clause 11 seeks to make the applicant as between it and BNI responsible for the payment in Australia of BNI's liability for withholding tax. What the applicant has done is to covenant in clause 5 to pay interest on the principal advanced in accordance with the terms of the clause. What it has further covenanted to do under clause 11 is to pay BNI's withholding tax liability on that interest income.''

We agree with this conclusion.

The learned primary judge said that the repayment of the moneys referred to in cll 6.5, 10.2, 11, 12.1, 12.2, 12.3 and 12.4 do not have the character of a return or profit to the lender for the use of money advanced to the borrower, howsoever calculated or ascertained. The learned primary judge said of these amounts, which include the amounts payable under cl 11 [ 97 ATC at 4315-4316]:

``... They are not calculated by reference to the principal sum advanced and are not in the nature of an additional return or profit to BNI on the money advanced over and above the interest calculated and payable under clauses 5 and 17. The additional amounts relate to costs, expenses, charges and liabilities for taxes and other statutory fees and imposts for which BNI is or may become liable. The clauses dealing with the additional amounts transfer as between the applicant and BNI the liability to pay these amounts to the applicant. The purpose of the clauses was not to enable BNI to earn an additional profit or return on the loan over and above that which it was entitled to under the facility agreement; the purpose, as appears for example in clause 10.2(b), was to ensure that the effective rate of interest earned under clauses 5 and 17 was not reduced by BNI having to pay or bear these additional costs. The purpose was achieved by requiring the applicant to make the payment to the third party or to indemnify BNI for any cost, charge or similar expense incurred by it which fell within the operation of the relevant clauses. That the additional payments were a cost to the applicant of

ATC 4384

obtaining the use of the funds does not convert the payments to `interest' in the hands of the lender where they are referable to costs and liabilities incurred by the lender as a consequence of the loan transaction itself coming into existence and being given effect to by the parties to it. Such payments are not referable to a principal in money being the loan advance actually paid over and do not have the character of a return or profit to the lender on making the loan. They stand apart from the interest paid, although, the fact of their payment undoubtedly enabled BNI to better enjoy the interest earned.''

We have set out these reasons of the primary judge because we respectfully agree with them. In our view the amounts paid to the lender under cl 11 of the loan facility agreement were neither interest nor in the nature of interest but were an indemnity against BNI's liability for income tax.

David Securities Pty Ltd & Ors v Commonwealth Bank of Australia 92 ATC 4658 at 4663; (1992) 175 CLR 353 at 366, Mason CJ, Deane, Toohey, Gaudron and McHugh JJ said:

``... While the statutory obligation to pay the withholding tax still lay upon the Bank, cl 8(b) had the effect of obliging the appellants to bear the financial burden represented by the withholding tax. In these circumstances, it seems entirely apposite to conclude that the clause had `the purpose or effect of imposing on the mortgagor the obligation of paying income tax'.''

In the circumstances of the present case, payments made pursuant to cl 11 are not properly to be characterised as interest or in the nature of interest but as payments of income tax. In
Torrens Aloha Pty Ltd v Citibank NA 96 ATC 4214; (1996) 65 FCR 39, Hill J at ATC 4220; FCR 47C said by way of obiter:

``... Since the grossed up amount payable under a void clause would not properly have been interest, it can be seen that a relatively small amount of withholding tax would also have been paid by mistake. However, this would be recoverable not from the respondent but, if at all, from the Commissioner of Taxation who is not a party. It may safely be disregarded.''

It was submitted on behalf of the Commissioner that this obiter observation by Hill J should not be followed. For the respondent, however, it was submitted that since, following David Securities (supra), cl 11 of the facility agreement was absolutely void, any additional amount that may have been paid was therefore not payable under the mortgage, but rather was an amount paid voluntarily or under a mistake of law and therefore should not be characterised as in the nature of interest. This argument was not put to the learned primary judge, and in the light of our concurrence with the reasons of the primary judge, it is unnecessary to express a concluded view on this further argument.

For these reasons the appeal should be dismissed with costs, to be taxed if not agreed.


The appeal be dismissed with costs, to be taxed if not agreed.

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