Edited version of private ruling

Authorisation Number: 1011546172300

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Ruling

Subject: Indemnification Payments

Question 1

Do the indemnification payments made by Company X to Company Y in relation to Company Y's interest withholding tax obligations under subsections 128B(2) and 128B(5) of the Income Tax Assessment Act 1936 (ITAA 1936), fall within the definition of 'interest' as defined in subsection 128A(1AB) of the ITAA 1936?

Answer

No, the indemnification payments made by Company X to Company Y in relation to Company Y's interest withholding tax obligations under subsections 128B(2) and 128B(5) of the ITAA 1936, do not fall within the definition of 'interest' as defined in subsection 128A(1AB) of the ITAA 1936.

Question 2

Are the indemnification payments made by Company X to Company Y in respect of the Australian withholding tax liability of Company Y, subject to Australian income tax under the Country Z Convention?

Answer

No, the indemnification payments made by Company X to Company Y in respect of the Australian withholding tax liability of Company Y, are not subject to Australian income tax under the Country Z Convention.

This ruling applies for the following period:

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 Y is a Country Z resident company for income tax purposes.

Company X is an unlisted Australian resident company. Company Y owns the majority of the shares on issue by Company X.

Company X proposes to make a return of capital to Company Y which will be funded by a loan for $M from Company Y (the Loan).

Relevant terms of the draft Loan Agreement (Agreement)

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

· the determination of interest payable on the Loan;

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

· 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.

Assumption

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

Relevant legislative provisions

Income Tax Assessment Act 1936 Subsection 128A(1)

Income Tax Assessment Act 1936 Subsection 128A(1AB)

Income Tax Assessment Act 1936 Subsection 128B(2)

Income Tax Assessment Act 1936 Subsection 128B(5)

Income Tax Assessment Act 1997 Section 6-5(3)

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 Y.

1. Do the indemnification payments made by Company X to Company Y in relation to Company Y's interest withholding tax obligations under subsections 128B(2) and 128B(5) of the ITAA 1936, fall within the definition of 'interest' as defined in subsection 128A(1AB) of the ITAA 1936?

The 'interest article' of the Country Z Convention provides that interest arising in Australia and derived by a Country Z 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. This is subject to subparagraph 128B(3)(h)(ii) of the ITAA 1936 which exempts from withholding tax interest derived by a non-resident from carrying on a business in Australia through a permanent establishment (PE).

It has been assumed for the purposes of this ruling that Company Y does not carry on a business in Australia through a PE and accordingly, interest withholding tax (IWT) is payable by Company Y under section 128B(5) of the ITAA 1936 on the interest payments made by 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 in summary that, if the borrower or any other person is required by law to make any deduction or withholding 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 Z 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 Z convention will not apply to tax the indemnification payments received by Company Y, in Australia.

2. Are the indemnification payments made by Company X to Company Y, subject to Australian income tax under the 'business profits' Article of the Country Z Convention?

As a non-resident of Australia for income tax purposes, Company Y is subject to Australian income tax under subsection 6-5(3) of the Income Tax Assessment Act 1997 (ITAA 1997) on income derived directly or indirectly from all Australian sources during the income year.

However, in determining the liability of Company Y, a Country Z resident, to Australian income tax, it is necessary to also consider the provisions of the 'business profits' Article of the Country Z Convention.

Character of the indemnification payments

Although, 'indemnification payments' are not interest income, the Commissioner views these payments as fitting the description of 'income' of the lender as reflected in the reasoning contained in paragraphs 16 to 29 of TR 2002/4, summarised below.

A profit or gain made by a taxpayer from a transaction entered into otherwise than in the ordinary course of carrying on the taxpayer's business is considered as income if the transaction was entered into with the intention of making a profit or gain (FC of T v. Myer Emporium 87 ATC 4363; (1987) 18 ATR 693).

The Full Federal Court recognised in the CYB case that the purpose of the indemnification payments 'was to ensure that the effective rate of interest earned was not reduced by [the lender] having to pay or bear these additional costs (being taxes payable in the State of which the borrower is a resident).'

Indemnification payments that are regular periodic payments made by the borrower to the lender can be considered as 'an addition to the earnings or income of the lender'. Accordingly, the payments acquire the character of 'income' in their own right.

Consequently, the indemnification amounts paid by Company X to Company Y in respect of the Loan are considered to be profits arising from a transaction which is an ordinary incident of the business activity of Company Y, although not a transaction entered into directly in its main business activity.

The indemnification amounts are derived by Company Y from sources in Australia, based on the information provided in the ruling application and are therefore assessable income of Company Y under subsection 6-5(3) of the ITAA 1997.

Taxation of business profits under the Country Z Convention

The 'business profits' Article of the Country Z Convention governs the taxation of business profits derived by a resident of one State from sources in the other State.

The 'business profits' Article of the Country Z Convention states the basic principle which is that the profits of an enterprise of one State may be taxed in the other State only if the enterprise carries on business in that other State through a permanent establishment (PE).

In the present circumstances, it is assumed that Company Y does not carry on business in Australia through a PE in Australia. Accordingly, the business profits of Company Y, in the nature of indemnification payments derived from sources in Australia, are not subject to tax in Australia under the 'business profits' Article of the Country Z Convention.

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