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Ruling

Subject: 2003 United Kingdom Convention and Notes - Withholding Tax Exemption

Question

Is Fin Co eligible for withholding tax exemption on its interest income under Article 11 (3) (b) of the 2003 Australia/United Kingdom Double Tax Convention and Notes (UK Convention)?

Answer

Yes

Facts

Fin Co is a financial entity which is a UK resident.

Fin Co does not have a branch or permanent establishment in Australia.

Reasons for Decision

The 2003 United Kingdom Double Tax Convention and Notes (UK Convention) seeks to avoid double taxation and fiscal evasion for taxpayers with tax payable in both the United Kingdom and Australia. With respect to interest income earned by a United Kingdom resident taxpayer in Australia Article 11 Paragraph 3 of the UK Convention provides the following:

1 Interest arising in a Contracting State and beneficially owned by a resident of the other Contracting State may be taxed in that other State.

2 However, that interest may also be taxed in the Contracting State in which it arises, and according to the law of that State, but the tax so charged shall not exceed 10 per cent of the gross amount of the interest.

3 Notwithstanding paragraph 2, interest arising in a Contracting State and beneficially owned by a resident of the other Contracting State may not be taxed in the first-mentioned State if:

(a) the interest is derived by a Contracting State or by a political or administrative sub-division or a local authority thereof, or by any other body exercising governmental functions in a Contracting State, or by a bank performing central banking functions in a Contracting State; or

(b) the interest is derived by a financial institution which is unrelated to and dealing wholly independently with the payer. For the purposes of this Article, the term "financial institution" means a bank or other enterprise substantially deriving its profits by raising debt finance in the financial markets or by taking deposits at interest and using those funds in carrying on a business of providing finance.

A UK based taxpayer may be liable to pay UK tax on interest income earned in Australia in the UK. However the interest income may be subject to withholding tax of up to 10% of the gross amount of interest in Australia.

Financial institution

Article 11 Subparagraph (3)(b) of the UK Convention contains the definition of a financial institution. There are two categories contained in the definition, banks and other enterprises.

If an entity is not a UK bank then it can attain the status of a financial institution by way of the other enterprises category. The Commissioner has issued TR 2005/5 which sets out the Commissioner's view on the taxation of UK resident financial institutions under the UK Convention and focuses on the definition of financial institution contained in Article 11(3)(b) of the 2003 UK Convention.

Other enterprises

Paragraph 15 of the Ruling states that:

Other enterprises are those residents of the UK that are not classified as banks. This means that these enterprises must substantially derive their profits by raising debt finance in the financial markets or by taking deposits at interest and using those funds in carrying on a business of providing finance. Collectively, these activities are referred to as spread activities in this Ruling. (emphasis added)

An entity which is not a bank can still qualify for interest income exemption provided that entity meets the definition of being an 'other enterprise'. In order to meet that definition the entity must substantially derive its profits from its spread activities.

Substantially derives its profits

Paragraphs 26 & 27 of the Ruling provide that:

26. The term substantially deriving its profits means that the activities of raising debt finance in the financial markets or taking deposits at interest and using those funds in carrying on a business of providing finance, needs to comprise the UK residents main business activity.

 

27. These activities constitute the main business activity of the UK resident if such activity is the main contributor to the overall profit of the UK resident. Profit in this context can be measured according to a range of acceptable accounting indicators, including gross profit, net operating income or operating profit. It can also be measured on the same accounting basis over a reasonable period to ascertain whether the spread activity is consistently the main activity of the enterprise. (emphasis added)

Spread Activities

Accordingly, the spread activities need to be the main business activity of the UK entity if it is to qualify for an exemption from withholding tax under Article 11 of the UK Convention. Paragraph 100 of TR 2005/5 further clarifies how spread activities can be shown to be the main business activity of an entity.

100. This means that while the spread activities need not be the sole activity of the enterprise, it will need to constitute its main activity when compared to any other activity that it undertakes in terms of its contribution to the enterprises overall profits.

101. Profits in this context takes on its accounting meaning. Thus, profits can be measured according to a range of acceptable accounting indicators of profits, including gross profit, net operating income or operating profit.

102. The Commissioner also recognises that the amount of profits that an enterprise generates will fluctuate from year to year. As such, the enterprises profits should be evaluated on the same accounting basis over a reasonable period of time in relation to each business activity to ascertain whether the main source is from its spread activities.

103. For example, a merchant bank that obtains its profits from both fees and from its spread activities will need to demonstrate that the profits from its spread activities are the main contributor to the enterprises profits. It is accepted that in a particular year its spread activities may suffer a downturn in profitability. However, despite the profit result in that particular year, if its main source of profits over time is from its spread activities, it will constitute a financial institution.

Therefore the main source of profits for the entity must come from its spread activities. Profits take on the accounting meaning of the term. These profits are split between spread activities and non spread activities. The profit levels of these activities are compared and should be evaluated over a reasonable period of time and a short period of losses will not necessarily preclude the entity from being exempt from withholding tax on interest income.

Fin Co

In your case Fin Co is a company which is a resident of the UK. Fin Co does not have a permanent establishment in Australia. Fin Co does not act as a corporate treasury for the group for the purposes of paragraph 11 b) of the UK Convention and its transactions are undertaken on a commercial basis.

We are satisfied that Fin Co substantially derives its profits from its spread activities, including the requirement to use those funds in carrying on a business of providing finance, and it will continue to do so for the period of the ruling. Therefore Fin Co is classed as an enterprise to which Paragraph 15 of TR 2005/5 applies. Hence Fin Co would continue to gain an exemption from withholding tax by virtue of being a financial institution under the other enterprises category.

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