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Ruling

Subject: Alternative financing and interest withholding tax

Question and answer

Will the 'fee' be considered in the nature of interest or a substitution of interest under subsection 128A(1AB)?

Yes

Will the withholding tax liability be triggered only when the X Trust actually pays the Fee to the Unit Holder?

Yes

This ruling applies for the following period

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

Year ended 30 June 2015

Year ended 30 June 2016

The scheme commenced on

30 June 2011

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The scheme

In or about January 2012, Z approached the Financer seeking finance in respect of the development. The Financer agreed to provide the Loan Facility (the Facility) to Z in respect of the development.

For the purposes of providing the Facility (a facility provided by X Pty Ltd to Z, Financer procured the incorporation of X Pty Ltd and the establishment of the X Unit Trust. X Services Pty Ltd is the sole unit holder in the X Unit Trust.

X Pty Ltd is incorporated in Australia on 1June 2012 and wholly owned by X Services Pty Ltd.

X Services Pty Ltd is a company incorporated in the Country D and wholly owned by Z Ltd.

Z Ltd is a company incorporated in the Country D and is wholly-owned by the Somewhere.

By virtue of the Financer's ownership of the shares in Z Ltd which owns the shares of X Services Pty Ltd which in turn owns the units of the X Unit Trust being the sole shareholder of X Pty Ltd, the Somewhere Financial House is the sole legal and beneficial owner of the assets held by X Pty Ltd.

You advise that where amounts paid to X Pty Ltd are paid as interest, they will be paid onwards to the X Unit Trust as Interest, who will consequently pay the interest amounts to X Services Pty Ltd in the Country D.

X Pty Ltd's participation in the development is governed by the Agreement, which provides

The parties agree that X Pty Ltd will participate in the Project by:

1. providing the Facility on a particular basis; and

2. entering into the Project Documents (where necessary)

Providing the Facility on an particular basis means that the consideration that Z provides for the use of the Facility cannot be (referred to as) "interest". Instead, upon completion and sale of the Development, X (and Z) will receive:

1. an annualised internal rate of return of X% from the net proceeds of sale

2. for any return above the internal rate of return, X Pty Ltd and Z will share that additional return in the ratio of Y% to Z and YY% to X Pty Ltd.

(together, this amount is referred to as a Fee for the activation of loan facility)

The Agreement provides for the payment of the Fee to X Pty Ltd.

In consideration of X Pty Ltd providing the Facility (and entering into the Project Documents), Z must pay X Pty Ltd the Fee

The 'Net Sale Proceeds' of the Project are to be distributed in accordance with an order of priority

The Deed of Loan provides:

Subject to the terms and conditions, the Lender agrees to make available to the Borrower during the Period a loan facility any additional amount that may be required to be made available by the Lender.

Z may utilise the Facility by delivery to X Pty Ltd of a "Utilisation Request"

Z must repay the aggregate principal amount of all outstanding Utilisations in full which is some years after the date of the "First Utilisation":

The key payment obligations of under the Deed of Loan and the Agreement will be secured pursuant to a number of documents.

Relevant legislative provisions

Income Tax Assessment Act 1936

128A(1AB)

128A(2)

128A(3)

128B(2)

128B(2)(b)(i)

128B(3) (ga)

128B(5)

128B(6)

128B(7)

128D

Income Tax Assessment Act 1997

Section 6-5

Reasons for decision

Under section 128B(2) of the ITAA 1936, interest derived by a non-resident is subject to withholding tax, if it is:

(i) paid by a person to whom the section applies (as defined in section 128B(1A)of the ITAA 1936), provided the interest is not wholly incurred by the payer in a business carried on in a country outside Australia at or through a permanent establishment of the payer in that country, or '

(ii) paid by a non-resident or non-residents, provided the interest is wholly or partly incurred by the non-resident payer in carrying on business in Australia at or through a permanent establishment of the payer in this country.

Under subsection 128A(1AB) of the ITAA 1936 interest is defined as follows:

interest includes an amount, other than an amount referred to in subsection 26C(1) of the ITAA 1936:

(a)  that is in the nature of interest; or

(b)  to the extent that it could reasonably be regarded as having been converted into a form that is in substitution for interest; or

(c)  to the extent that it could reasonably be regarded as having been received in exchange for interest in connection with a washing arrangement; or

(d)  that is a dividend paid in respect of a non-equity share; or

(e)  if regulations under the Income Tax Assessment Act 1997 are made having the effect that instruments known as upper tier 2 capital instruments, or a class of instruments of that kind, are debt interests-that is paid on such a debt interest and is not a return of an investment;

but does not include an amount to the extent to which it is a return on an equity interest in a company.

The above definition includes the ordinary meaning of interest. On the ordinary meaning of interest, Hill J in Macquarie Finance Ltd v. FC of T said the following:

Interest has variously been described as a payment made by a borrower for the use of the money borrowed: FC of T v. Century Yuasa Batteries Pty Ltd 98 ATC 4380 at 4383; (1998) 82 FCR 288 at 291 or the price of money which is borrowed: Re Farm Security Act 1944 of the Province of Saskatchewan [1947] SCR 394 cited in FC of T v. Firth 2002 ATC 4346 at 4349-4350; (2002) 120 FCR 450 at 454 or as a recompense to the lender for being kept out of his money: Lomax (Inspector of Taxes) v. Peter Dixon & Co Ltd [1943] 2 All ER 255 (editorial note). What these descriptions make clear is that there must be a borrowing before what is paid can be regarded as interest. At least ordinarily the concept of borrowing presupposes that the lender is entitled to a return of the money lent. However, there may be a question whether a 'borrowing' which is not repayable at all is really a borrowing or whether 'interest' thereon is properly to be regarded as interest.

Similarly, Cooper J said in FC of T v. Century Yuasa Batteries Pty Ltd that:

The word 'interest' is a term in ordinary English usage. In the context of the payment of money it means 'compensation for injury "damages"' or 'money paid for the use of money lent (the principal) or for forbearance of a debt, according to a fixed ratio'. The Oxford English Dictionary, 2nd Ed, (1980), Vol VII at 1099), or 'a charge for the use of credit or borrowed money; such a charge expressed as a percentage per time unit of the sum borrowed or used'. (Collins English Dictionary (Australian Edition (1982) at 761).

Thus for the fee to be interest, there must be a borrowing or debt owing and the fee must be to recompense the creditor for being kept out of money.

It is considered that the fee payable to X Pty Ltd by Z is the cost of participating in the loan facility. The principle debt or borrowing is owed to the finance provider, the fee payable to X is payable conditional to the Loan being accessed from the financer to Z. The payment of the fee from Z to X Pty Ltd is defined as:

1. an annualised internal rate of return of X% from the net proceeds of sale

2. for any return above the internal rate of return, X and Z will share that additional return in the ratio of YY% to Z and Y% to X.

The fact the Participants are required to pay Additional Payments to X Pty Ltd and that X Pty Ltd will credit the amounts to its capital does not detract from this being a conclusion. The debt is not ultimately owed to X but to the borrower being the Somewhere Financial House. X Pty Ltd is simply the intermediary instrument through which fee amounts are processed, the ultimate beneficiary of the fee is the borrower being the Somewhere Financial House.

The Additional Amount (fee) also needs to be compensation to the creditor for being kept out of money. Z will share that additional return in the ratio of Y% to Z and YY% to X Pty Ltd.

This represents 'a charge for the use of a credit facility or borrowed money; such a charge expressed as a percentage of the sum borrowed or used' to use the words of Cooper J in Century Yuasa Batteries Thus the Additional Amount is compensation to the Investors for being kept out of the Additional Payment and is interest under its ordinary meaning. Alternately, it is interest within the meaning of subsection 128A(1AB) being 'in the nature of interest'.

The Additional Amount, being interest or in the nature of interest, accrues when an amount of Additional Payment is owed. Such amounts are deemed to be 'derived by' and 'paid to' the Investors under subsection 6-5(4) of ITAA 1997 and subsection 128A(2) of ITAA 1936 respectively even when no amount is actually paid over. So the remaining requirements of subsection 128B(2) of the ITAA 1936 are satisfied and interest withholding tax will be payable in those circumstances.

A non-resident is liable to pay interest withholding tax under s 128B(5) ITAA 1936 and 128B(2)(b)(i) ITAA 1936 where:

Where:
(a) income to which section 128B applies consists of interest and is paid to the person by whom it is derived by a person who, or by persons each of whom, is not a resident; and


(b) the interest is, in part only, an outgoing incurred by the person or persons by whom it is paid in carrying on business in Australia at or through a permanent establishment of that person or those persons in Australia;

income tax is payable under subsection (5) upon so much only of the income as is attributable to so much of the interest as is an outgoing so incurred.

A non-resident beneficiary who is presently entitled to a dividend, interest or a royalty included in a distribution of income from an Australian trust estate is deemed to have derived the income (and may therefore be liable for withholding tax) when the present entitlement arises (sec 128A(3) ITAA1936).

As X Pty Ltd has a sole shareholder being X Unit Trust, whose sole unit holder is X Services Co Limited incorporated in the Country D, which is wholly owned by Z Ltd incorporated in the Country D which is wholly owned by the financer. a company incorporated in Somewhere. The interest is paid to a non-resident (Somewhere Financial House) carrying on a business via its subsidiaries (X Pty Ltd) therefore creating a liability for X Unit Trust when the beneficiary (X Services Pty Limited) is presently entitled.

Taxing point

As X Pty Ltd is a single legal entity, no interest withholding tax is payable in respect of notional interest amounts payable to the offshore establishment in relation to the interbranch funds transfer (that is, the internal "loan").

The interest paid by X Pty Ltd to the Somewhere financial house is attributable to income that is derived by X Pty Ltd otherwise than in carrying on business at or through an offshore entity. For the purposes of section 128B(2)(b)(i) ITAA 1936, the interest is not an outgoing wholly incurred by X Pty Ltd in carrying on business at or through an offshore entity. Consequently, an interest withholding tax liability arises for the foreign entity when X Services Pty Ltd of the Country D becomes presently entitled.

The interest derived by the X Unit Trust is non-assessable non-exempt income under section 128D of the ITAA 1936. Even if X Unit Trust is required to lodge Australian income tax returns for the income years in which it derives interest income from X Pty Ltd, X Unit Trust does not include its non-assessable non-exempt income in its assessable income, as the interest amount is merely derived and not actually paid.

Private ruling applications and Part IVA

Part IVA 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 part.

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