Edited version of private ruling

Authorisation Number: 1011544453962

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Ruling

Subject: Debt and Equity Classification

Question 1

Is the loan between Company X and Company Y (the Loan) classified as a 'debt interest' for the purposes of Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes, the Loan between Company X and Company Y is classified as a 'debt interest' for the purposes of Division 974 of the ITAA 1997.

Question 2

Are the interest payments made by Company X to Company Y in respect of the loan deductible to Company X under section 8-1 of the ITAA 1997?

Answer

Yes, the interest payments made by Company X to Company Y in respect of the loan are deductible to Company X under section 8-1 of the ITAA 1997.

Question 3

Are the indemnification payments made by Company X to Company Y categorised as 'interest under section 128A(1AB) of the ITAA 1936 and therefore subject to withholding by Company X under section 12-245 of the Taxation Administration Act 1953 (TAA 1953)?

Answer

No, the indemnification payments made by Company X to Company Y are not categorised as 'interest under section 128A(1AB) of the ITAA 1936 and therefore, are not subject to withholding by Company X under section 12-245 of the TAA 1953?

Question 4

Are the indemnification payments made by Company X to Company Y deductible to Company X under section 8-1 of the ITAA 1997?

Answer

Yes, the indemnification payments made by Company X to Company Y are deductible to Company X under section 8-1 of the ITAA 1997.

This ruling applies for the following periods:

Period ended 31 December 2010

Period ended 31 December 2011

Period ended 31 December 2012

Period ended 31 December 2013

Period ended 31 December 2014

Period ended 31 December 2015

Period ended 31 December 2016

Period ended 31 December 2017

Period ended 31 December 2018

Period ended 31 December 2019

The scheme commences on:

1 July 2010

Relevant facts and circumstances

Company Z and subsidiaries

Company Z is a resident of Country W and the ultimate holding company of the Group. Company Y is also a resident of Country W and a subsidiary of Company Z.

Company X is an Australian resident company. Of the shares on issue by Company X, the majority are owned by Company Y.

Company X has an operating subsidiary in Australia, Company C. Company C has established subsidiary companies overseas.

Company X and Company C have formed an income tax consolidated group for Australian income tax purposes.

Debt capitalisation by the Australian group

Some years ago, as a result of a downturn in the Australian operations, the level of debt within the Australian group was not supportable. To rationalise the level of intra-group debt owing by Australia, debt owing by Company X of $N to Company Y was capitalised by the issue of shares to Company Y through a debt to equity swap. The shares were of the same class as the shares issued originally.

The debt that was on issue prior to capitalisation originally arose from the advance of loan funds from Company Y to Company X (principal and capitalised interest) as a working capital loan to fund the growth of business in regions under the auspices of the Australian group.

Company X and its subsidiary Company C also came to owe additional amounts of debts to related parties. These debts represent borrowings made for working capital requirements.

The shares issued by Company X to company Y were accepted in full settlement of the Australian debt employed as working capital of the Australian business.

Purpose of the capital reduction program

A significant turn-around in the profitability of the Australian group has resulted in a genuine surplus of share capital for Company X. As a result it was proposed that part of the share capital balance of Company X referable to the debt capitalisation be returned to its shareholders in Country W.

The proposed capital return will be funded by a loan for an amount of $M from Company Y to Company X (the Loan).

The composition of Company X's share capital account prior to the proposed Capital Return is as follows:

Paid in capital: $P

Less: Operating losses: $L

Equity held by Company Y: $E

Terms of the draft Loan Agreement ('Agreement')

The proposed term of the Loan from Company Y to Company X is less than ten years, with interest accruing daily (compounding annually). The interest rate has been set at arm's length rate based on a review of relevant data, including forecast profit and loss and balance sheet information.

The Agreement to be entered into between Company Y (lender) and Company X (borrower) provides for:

· the determination of interest payable on the Loan;

· the repayment date for the principal sum and accrued interest;

· the advancement of the principal sum by the lender on the draw down date as provided under the loan agreement;

· the accrual of daily interest, compounded annually, on the outstanding balance;

· the repayment of the outstanding principal sum and any accrued interest by the borrower in the even of default, as declared by the lender; and

· an indemnification clause which requires that the borrower pays an additional amount to indemnify the lender for any withholding the borrower has to make from the interest payments on account of any tax payable by the lender to the relevant tax authority in the borrower's country of residence.

Purpose of the Loan

As stated previously, the proposed capital return by Company X will be funded by a loan from Company Y, thereby replacing part of the share capital with debt capital. This will increase the gearing ratio of the Australian group in the short to medium term. An increase to the gearing ratio of the Australian operations is seen by management as ultimately improving shareholder profitability on the basis that:

· the interest paid by Company X on the loan will enable additional funding to be repatriated to Country W.

· the loan from Company Y to Company X will increase the flexibility of Company X to return surplus cash to Country W in the short to medium term.

· the interest paid by Company X will be income tax deductible, which will improve the after-tax position of payments made by the Australian group to the Country W parent.

Utilisation of funds repatriated to Company Y

Company Y anticipates using the cash received (i.e. from loan repayments, dividends and interest) from the capital return by Company X to retire existing debt within the group in Country W. The repayment of the debt obligations of the group in Country W is part of a global repatriation program of funding from both Australia and other overseas locations.

History of the funding of the Country W and Australian operations

The issue of shares by the consolidated group in Country W took place a number of years before the debt funding of the Australian operations by Company Y.

At the time of the capitalisation of the debts of Country X, the equity that was on issue by the consolidated group in Country W was minor compared to its debt obligations on issue.

Assumptions

a) Company Y does not have a permanent establishment (PE), as defined in the relevant Article of the double tax agreement (DTA) between Australia and Country W, in Australia.

b) All parties to the Capital Return are dealing with each other on arm's length terms and for fair market value and consideration.

c) All payments, receipts, assets and liabilities under the Capital Return are denominated in Australian dollars.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 51(1)

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 974-15

Income Tax Assessment Act 1997 Section 974-20

Income Tax Assessment Act 1997 Section 974-30

Income Tax Assessment Act 1997 Section 974-35

Income Tax Assessment Act 1997 Section 974-130

Income Tax Assessment Act 1997 Section 974-135

Income Tax Assessment Act 1997 Section 974-150

Income Tax Assessment Act 1997 Section 974-160

International Tax Agreements Act 1953

Does Part IVA apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies, the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is a part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

These reasons for decision accompany the Notice of private ruling for Company X.

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

1. Is the Loan between Company X and Company Y classified as a 'debt interest' for the purposes of Division 974 of the ITAA 1997?

Subsection 974-15(1) of the ITAA 1997 provides that a 'scheme' gives rise to a 'debt interest' in relation to an entity if all the requirements of the debt test, as set out in subsection 974-20(1) of the ITAA 1997, are met. These requirements are:

(a) the scheme is a financing arrangement for the entity,

(b) the entity, or a connected entity of the entity, receives, or will receive, a financial benefit or benefits under the scheme,

(c) the entity has an effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time when the financial benefit referred to in paragraph (b) is received,

(d) it is substantially more likely than not that the value provided (worked out under subsection 974-20(2) of the ITAA 1997) will be at least equal to the value received (worked out under subsection 974-20(3) of the ITAA 1997), and

(e) the value provided (worked out under subsection 974-20(2) of the ITAA 1997) and the value received (worked out under subsection 974-20(3) of the ITAA 1997) are not both, nil.

Under subsection 974-150(1) of the ITAA 1997, the term 'scheme' has the meaning given to it in subsection 995-1(1) of the ITAA 1997. Under subsection 995-1(1) of the ITAA 1997, the term 'scheme' is defined to mean 'any arrangement, or any scheme, plan, proposal, action, course of action or course of conduct, whether unilateral or otherwise.'

In the present case, the Loan from Company X to Company Y to fund the proposed Capital Return to Company Y would be a 'scheme' pursuant to that definition.

In respect of the requirements of the debt test, as set out in subsection 974-20(1) of the ITAA 1997:

(a) The scheme is a financing arrangement for Company X.

A financing arrangement is a scheme entered into or undertaken to raise finance for the entity (paragraph 974-130(1)(a) of the ITAA 1997).

In the present circumstances, a loan arrangement is entered into between Company X and Company Y to raise finance for Company X. The Loan enables Company X to draw down funds to finance the proposed Capital Return to Company Y.

(b) Company X receives a financial benefit under the scheme.

Financial benefit means anything of economic value, including property and services (in subsection 974-160(1) of the ITAA 1997). A financial benefit will exist even though the transaction that confers the benefit on an entity might also place that entity under an obligation. In applying the definition of a 'financial benefit', the benefits and obligations under a transaction are analysed separately (subsection 974-160(2) of the ITAA 1997).

Under the loan arrangement with Company Y, Company X receives a financial benefit in the form of immediately available funds. Company X is taken to have received a financial benefit because the loan funds have been provided by Company Y to be applied for the benefit of Company X (paragraphs 974-30(2)(a) or 974-30(2)(b) of the ITAA 1997).

(c) Company X has an effectively non-contingent obligation to provide a financial benefit (section 974-135 of the ITAA 1997).

An obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity), other than the ability or willingness of the entity to meet that obligation (subsection 974-135(3) of the ITAA 1997).

When Company X applies the funds made available by Company Y under the loan agreement to undertake a return of capital to Company Y, Company X has an obligation to repay the principal sum (of the loan) and interest to Company Y on or before the repayment date stated in the loan agreement. Therefore, this obligation is not contingent on any event, condition, or situation, other than the ability or willingness of Company X to meet that obligation.

(d) It is substantially more likely than not that the financial benefit to be provided by Company X will be at least equal to the value of the financial benefit received by Company X.

Section 974-35 of the ITAA 1997 sets out the manner in which the value of a financial benefit to be provided or received under the scheme is to be calculated. Paragraph 974-35(1)(a) of the ITAA 1997 provides that the value of a financial benefit to be provided or received is to be calculated in nominal terms, if the performance period ends no later than ten years after the interest arising from the scheme is issued.

In the present circumstances, the loan agreement has fixed the term of the loan for a period of less than of ten years commencing on the Draw Down date. As a result, nominal values are required to be used in determining the value of the financial benefits provided and received in respect of the borrowing (sub-paragraph 974-35(1)(a)(i) of the ITAA 1997).

The total nominal value of the financial benefits to be provided by Company X (being the interest, any fees and principal payment on the borrowing) will exceed the value of the financial benefits received by Company X in respect of the loan.

(e) The value of the benefit provided and received by Company X are both not nil.

The Loan from Company Y to Company X is classified as a 'debt interest' for the purposes of subsection 974-15(1) of the ITAA 1997as it satisfies all the requirements of the debt test contained in subsection 974-20(1) of the ITAA 1997.

Interpretation of section 974-80 (ITAA 1997) in relation to the 'scheme'

Subsections 974-80(1) and 974-80(2) of the ITAA 1997, in combination ensure that, an interest held in a company by a connected entity is itself treated as an equity interest in the company, if:

· the return on that interest will fund a return on an interest issued by the connected entity to another entity (which may not be a company); and

· the interest held by that other entity in the connected entity is in substance equivalent to an equity interest in the company or a connected entity of the company.

In essence, section 974-80 of the ITAA 1997 applies to reclassify an interest that is not an equity interest under the general test in section 974-70 of the ITAA 1997 as an equity interest in certain circumstances.

Having regard to the facts and circumstances surrounding the proposed arrangement (in particular the Capital Return and the Loan), it is considered that at the time the arrangement is entered into, not all of the requisite requirements of section 974-80 of the ITAA 1997 will be satisfied.

Accordingly, section 974-80 of the ITAA 1997 will not apply to treat the Loan from Company Y to Company X as an equity interest in Company X for the purposes of Division 974 of the ITAA 1997, for the reasons provided below.

Subsection 974-80(1) of the ITAA 1997

In the present circumstances, sub-section 974-80(1) will apply to the 'scheme', if the loan from Company Y to Company X (the Loan) is part of a scheme (or a series of schemes) designed to operate such that the return to Company Y by Company X is to be used by Company Y to fund (directly or indirectly) a return to another person (the ultimate recipient).

The Loan satisfies paragraphs 974-80(1)(a) to 974-80(1)(ca) of the ITAA 1997 in that, the Loan is an interest that carries a right to a fixed return, it is held by a connected entity (Company Y), it is otherwise not an equity interest and it is a financing arrangement.

For paragraph 974-80(1)(d) of the ITAA 1997 to apply, it needs to be established from the surrounding facts and circumstances of the scheme, that there exists a link between (i) a financial instrument that was issued by Company Y and (ii) the funding of the investment by Company Y in Company X.

However, based on the information provided in the ruling application, the Loan does not satisfy paragraph 974-80(1)(d) of the ITAA 1997 as explained below.

Overall funding of Australian operations

It is not possible to make any direct (or indirect) link between the issue of the various debt and equity obligations of the Company Z consolidated group in Country W to the funding by Company Y and Company Z of the Australian operations. In particular, there is no link between the time that debt and equity interests were issued by the Company Z consolidated group and the time that Company Y and Company Z funded the Australian operations by contributing capital and making loans.

For example, based on the information provided in the ruling application, the issue of shares by Company Z took place many years prior to the debt funding of the Australian group by Company Y and Company Z.

At the time of the funding of the Australian group by Company Y a number of years ago, the equity on issue by the Company Z consolidated group was relatively minor compared to the debt obligations on issue by the Company Z consolidated group.

Even in circumstances where a direct (or indirect) link between the debt and equity funding of the operations in Country W can be made to the debt funding of the Australian operations, such a link would no longer exist as at the date of the proposed capital return.

Funding of the capital return

As described previously, the Loan from Company Y to Company X is made in return for the repatriation of an equivalent amount of capital invested by Company Y in Company X. In that respect, the Loan is not a funding transaction from Company Y (the connected entity) to Company X.

Additionally, the capital that is being returned to Company Y can be traced back to the debt owed by Company X to Company Y (refer to capitalisation of debt discussed previously in this report). As such, it could be argued that the Loan is simply a re-statement of part of the original debt of the Australian operations that was in place prior to the debt capitalisation.

For the above reasons, it is considered that the Loan is not part of a scheme (or a series of schemes) designed to operate such that the return to Company Y by Company X is to be used by Company Y to fund (directly or indirectly) a return to another person (the ultimate recipient) for the purposes of subsection 974-80(1)(d) of the ITAA 1997. .

Subsection 974-80(2) of the ITAA 1997

For the equity override provision to operate to deem the Loan to be an equity interest, subsection 974-80(2) of the ITAA 1997 must also be satisfied.

Subparagraphs 974-80(2)(a) to 974-80(2)(c) of the ITAA 1997 require that the return to the ultimate recipient:

· be contingent on the economic performance of Company X, Company Y or Company Z (subsection 974-80(2)(a)(i)-974-80(2)(a)(iii) of the ITAA 1997); or

· be at the discretion of Company X, Company Y or Company Z (subsection 974-80(2)(b)(i)-974-80(2)(a)(ii)) of the ITAA 1997; or

· give the ultimate recipient the right to be issued with an equity interest, or an interest that may convert into an equity interest, in Company X, Company Y or Company Z (subsection 974-80(2)(c)(i)-974-80(2)(c)(ii) of the ITAA 1997).

Based on the information provided, the Loan could not be said to be ultimately sourced from the shares on issue by the Company Z consolidated group. This is due to the significant interval between the time when shares were issued by the Company Z consolidated group and the time that Company Y and Company Z debt funded the Australian operations.

Therefore, the most arguable position is that the Loan to be entered between Company X and Company Y was ultimately sourced from the debt obligations on issue by the Company Z consolidated group (notwithstanding that part of the Country W debt would need to remain outstanding at the time the Loan was issued for it to be possible to trace a return made on the Loan to the returns made in relation to the Country W debt obligations).

Without analysing the terms of each of the debt obligations that the Company Z consolidated group had on issue (to the extent any still remain on issue), it is considered that the returns on the debt obligations were not contingent on economic performance, were not at the discretion of any party, and did not give the ultimate recipient the right to be issued with an equity interest.

Therefore, it is concluded that subsection 974-80(2) of the ITAA 1997 is not satisfied as none of the elements at subparagraphs 974-80(2)(a)-974-80(2)(c) of the ITAA 1997 are satisfied.

As subparagraph 974-80(1)(d) is not satisfied and none of subparagraphs 974-80(2)(a) - 974-80(2)(c) of the ITAA 1997 are satisfied, the "equity override provision" will not apply to deem the Loan to be an "equity interest".

2. Are interest payments made by Company X to Company in respect of the loan deductible to Company X under section 8-1 of the ITAA 1997?

Of relevance in the present circumstances is the test in the second limb of section 8-1 of the ITAA 1997 which requires that, to be deductible, an outgoing must be necessarily incurred in carrying on a business for the purpose of producing assessable income. In other words, the outgoing in question must have the necessary connection with the operations or activities of the taxpayer's business which more directly gain or produce assessable income.

In the present circumstances Company X will incur interest expenses in respect of a loan from Company Y to fund the proposed capital return to Company Y.

Refinancing principle

In Federal Commissioner of Taxation v. JD Roberts and Smith (1992) 37 FCR 240; 92 ATC 4380; 23 ATR 494 (1992) (Roberts' case), the Full Federal Court considered whether interest on a loan used to repay working capital of a partnership originally borrowed from another source (refinancing) is deductible under section 51(1) of the ITAA 1936, including where the working capital was advanced by a partner in the partnership.

The Court found that the refinancing takes on the same character as the original borrowing and gives to the interest the character of a deductible working expense, provided that, the amount of refinance replaces the original partnership capital employed in the business of the partnership.

Taxation Ruling TR 95/25 outlines the implications flowing from the Roberts' case and provides further clarification in respect of the application of the 'refinancing principle' to partnerships and companies.

In reference to the Roberts' case, TR 95/25 explains at paragraphs 6 to 9 that, the refinancing principle applies only where a partnership borrows to refund capital invested by the partners or where one form of borrowing replaces another. In this regard, capital invested by partners refers to contributions to capital, advances by the partners such as a loan, or a share of any accumulated and undistributed realised profits, which the partners are entitled to withdraw.

On this basis, TR 95/25 makes it clear that, interest on borrowings to replace partnership capital which is represented by unrealised capital or revenue losses, asset revaluations and internally generated goodwill will not be deductible to the partnership.

Further, where a partnership dissipates contributed partnership capital as a result of making operating or capital losses, only the remaining part of the original partnership capital can be returned to the partners (paragraph 36 of TR 95/25).

Under the reasoning in the Roberts' case, the refinancing principle can apply to a borrowing by a company where the borrowing is used to fund a repayment of share capital to the shareholders with a view to the reduction or extinguishment of the share capital account. Where the borrowing replaces share capital that was employed as capital or working capital in the company's business, the interest incurred on the borrowing is considered to be relevant to the gaining of assessable income of the company (paragraphs 12and 13 TR 95/25).

At paragraphs 38 and 39, TR 95/25 clarifies that all the aspects of the refinancing principle in relation to partnerships, including the limitation on interest deductibility, as discussed previously, also applies to companies.

Interest on borrowed funds will be fully deductible provided the amount of 'capital' attributable to the borrower at the time of borrowing is equal to or greater than the amount borrowed. If the amount of capital attributable to the borrower is less than the amount borrowed it will be necessary to apportion the interest expense.

In the present case, Company X is borrowing an amount of $M from Company Y to fund a return of share capital to Company Y (shareholder) as part of a share capital reduction program.

The surplus in the share capital account of Company X is the direct result of the capitalisation of around $N of Company X's debt at a time when the business was recording consistent losses and unable to support its debt.

The $N of debt originally arose from the advance of loan funds from Company Y to Company X (principal and capitalised interest) as a working capital loan to fund business growth in the regions managed by Company X.

Company X and its subsidiary, Company C, also came to owe additional amounts of debts to related parties. These debts represent borrowings made for working capital requirements in respect of payments for related party purchases and other expenses.

The shares issued by Company X to Company Y were accepted in full settlement of the Australian debt employed as working capital of the Company X business.

The composition of the share capital account of Company X based on its Balance Sheet prior to the Capital Return is as follows:

Paid in capital: $P

Less: Operating losses: $L

Equity held by

Company Y & Company Z $E

The balance in the share capital account of Company X of $E represents a source of funding from Company Y to Company X in the nature of contributed capital and working capital loans employed in the business of Company X. The amount does not include unrealised profits and has appropriately taken into account operating losses of the relevant period.

Therefore, for the purposes of the 'refinancing principle' drawn from Roberts' case, the amount in the share capital account of Company X represents Company Y's investment in the business of Company X.

Accordingly, the borrowing by Company X of $M would allow for the provision of funds to Company Y in circumstances where that provision is a repayment of an equivalent amount of funds invested in the business by Company Y. Consequently, the borrowed funds in their entirety have the essential connection with the income producing activities of Company X.

The interest incurred on the borrowing of $M is therefore deductible to Company X under section 8-1 of the ITAA 1997.

3. Are the indemnification payments made by Company X to Company Y categorised as 'interest under section 128A(1AB) of the ITAA 1936 and therefore subject to withholding by Company X under section 12-245 of the TAA 1953?

The 'interest article' of the tax treaty between Australia and Country W provides that, interest arising in Australia and derived by a Country W resident is subject to tax in Australia.

Subsections 128B(2) and 128B(5) of the ITAA 1936 in combination provide that, a non-resident is liable to withholding tax on interest that is paid to the non-resident by a resident of Australia, unless, the interest is derived by the non-resident in carrying on a business in Australia through a permanent establishment (PE) in Australia.

Section 12-245 of the TAA 1953 imposes an obligation on a resident to withhold tax on interest it pays to a recipient who has an address outside Australia.

As Company Y is a Country W resident and assumed to not carry on a business in Australia through a PE, it is subject to interest withholding tax on interest payments received from Company X in respect of the Loan.

In Commissioner of Taxation v. Century Yuasa Batteries Pty Ltd (1998) 82 FCR 288; 98 ATC 4380; (1998) 38 ATR 442 ('CYB case'), the Full Federal Court ruled on a matter concerning 'indemnification payments' in relation to Australian interest withholding tax. In that case the Australian borrower 'grossed up' the payments of interest it made to the non-resident lender to ensure that, after any deduction for interest withholding taxes the lender received the full amount of interest it would otherwise have received under the loan agreement.

The issue under consideration in the CYB case was whether the amounts by which interest was grossed-up (indemnification payments) could properly be said to be 'interest' or 'in the nature of interest' within the meaning of the then IWT definition of 'interest' in subsection 128A(1) of the ITAA 1936.

The parties accepted that the term 'interest' bore its ordinary meaning which, the Court interpreted, 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.

Accordingly, the Court ruled that the amounts by which the interest payments were grossed-up did not fit the description of interest and that the amounts were 'neither interest nor in the nature of interest but were an indemnity against the non-resident's [the lender's] liability for Australian income tax'.

In Taxation Ruling TR 2002/4 the Commissioner accepts the Court's decision in the circumstances of the CYB case and takes the view that payments which fit the description of the indemnification payments in the CYB case are not 'interest' or amounts in the nature of interest.

In the present circumstances, the indemnification clause, provides that, if the borrower or any other person is required by law to make any deduction or withholding for or on account of tax, the borrower shall, together with such payment, pay an additional amount so that the lender receives the full amount it would have received if no such deduction or withholding had been made.

The indemnification clause is worded in a similar manner to clause 11 of the facility agreement in the CYB case, which was central to the decision in the CYB case.

Subsequent to the decision in the CYB case, subsection 128A(1) of the ITAA 1936 was replaced by subsection 128A(1AB) of the ITAA 1936 introduced by the Taxation Laws Amendment Act (No. 2) 1997. Currently, subsection 128A(1AB) contains the definition of 'interest' for the purposes of the withholding tax provisions in respect of non-residents.

Subsection 128A(1AB) of the ITAA 1936 defines interest among other things, to include an amount that is in the nature of interest or that could be reasonably regarded as having been converted into a form that is in substitution for interest.

The additional payments received by Company Y under the indemnification clause are not calculated by reference to the principal sum, being the loan advanced to Company X and do not have the character of a return to Company Y in respect of the loan. They clearly stand apart from the interest paid on the loan although they are a cost to Company X as a consequence of the loan. In particular, the payments are made to compensate Company Y for the IWT payable by Company Y to the Australian Taxation Office.

Accordingly for the purposes of the definition of interest in section 128A(1AB) of the ITAA 1936, the additional payments (indemnification payments) received by Company Y are not in the nature of interest. Further, the payments cannot be regarded as having been converted into a form that is in substitution of interest.

As explained at paragraph 33 of TR 2002/4, for the purposes of applying Australia's tax treaties, in this case the Country W Convention, the term 'interest' has the meaning it has under the laws of Australia, and therefore the definition contained in subsection 128A(1AB) of the ITAA 1936. The Federal Court decided in the CYB case that the definition of interest in subsection 128A(1AB) did not include a tax indemnification amount.

Consequently, the 'interest article' of the Country W convention will not apply to tax the indemnification payments received by Company Y in Australia.

Therefore, Company X is not required to withhold from the indemnification payments made to Company Y, under section 12-245 of the TAA 1953.

4. Are the indemnification payments made by Company X to Company Y deductible to Company X under section 8-1 of the ITAA 1997?

The deductibility of an outgoing under section 8-1 of the ITAA 1997 depends upon satisfying the words of that section, that is, in the circumstances of Company X, being able to show that the outgoing is necessarily incurred in the carrying on of a business for producing assessable income of the taxpayer. An additional requirement in section 8-1 is that the outgoing is not capital, or of a capital, private or domestic nature.

As discussed elsewhere in this report, under the indemnification clause, Company X is required to make an 'indemnification payment' in addition to the periodic interest payable on the Loan. This is to ensure that the effective rate of interest earned by Company Y is not reduced by having to bear additional costs towards Australian withholding taxes payable on the interest derived by Company Y from Australian sources.

In Taxation Ruling TR 2002/4 the Commissioner considers the indemnification amount as an additional payment made by the borrower for the use of the money borrowed, for the relevant period. At paragraph 42, TR 2002/4 further explains that the indemnification amount is payable in respect of each period of the loan that the amount of interest originally contracted for is payable. The payment is repeated each quarter or half year during the course of the loan and is therefore a cost to the borrower of obtaining the use of the money loaned in each of those periods.

Accordingly, the indemnification payment is a payment of a revenue nature and like interest on a loan is deductible if the loan funds are employed to derive assessable income of a taxpayer's business.

In the circumstances of Company X, the Loan from Company Y serves to return an amount of share capital originally invested by Company Y and utilised in the business of Company X. As a cost of securing the use of the borrowed money, the indemnification payments made my Company X to Company Y are deductible to Company X under section 8-1 of the ITAA 1997.

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