Edited version of your private ruling

Authorisation Number: 1012481978730

Ruling

Subject: Interest withholding tax

Question 1

Will the Applicant be required to withhold an amount from interest that accrues but is not paid under the arrangement (including compound interest) pursuant to Subdivision 12-F Part 2-5 of Schedule 1 of the Taxation Administration Act 1953?

Answer

Yes.

Relevant facts and circumstances

The Applicant is a wholly owned subsidiary of a non-resident corporation.

The Applicant applied for a private binding ruling relating to interest withholding tax.

The Applicant provided the following information:

· It is the holding company of an Australian income tax consolidated group for the purposes of Part 3-90 of the Income Tax Assessment Act 1997 (ITAA 1997).

· From time to time it borrows monies from non-resident related entities to fund further investment in its business in Australia and is currently contemplating borrowing funds from a related party.

· The Lender will be a non-resident of Australia for taxation purposes and will not operate through a permanent establishment in Australia. It is unlikely to be a financial institution within the meaning used in the International Tax Agreements Act 1953.

· The precise terms of any borrowing will be subject to commercial negotiation with the Lender, however it is contemplated that:

o All funds will be advanced under a facility agreement;

o Funds will be drawn under the facility agreement from time to time as required;

o All advances, repayments of principal, and payments of interest, under the facility agreement, will be denominated in Australian Dollars even if made in another currency;

o The term of the facility will be less than ten years with no funds able to be drawn before the effective date of the agreement and no funds able to be drawn after the nominated maturity date for the agreement;

o The facility will be subject to a maximum aggregate of advances and accrued interest under the facility (Maximum Loan Amount), which at the Lender's sole discretion, may be reduced on or after the first anniversary of the effective date of the facility, but not below the principal and accrued interest outstanding at that time;

o The outstanding balance of advances and accrued interest (Actual Loan Balance) will be calculated quarterly (at the end of each calendar quarter) for the purposes of determining whether the Actual Loan Balance exceeds the Maximum Loan Amount;

o Interest shall accrue daily on the outstanding principal balance at the end of the day plus any accrued but unpaid interest from the previous quarter that is still outstanding at the end of the day;

o Interest under the facility shall be calculated at the AUD overseas bank offered rate for AUD as quoted plus a premium to be agreed (the premium to reflect an arm's length premium);

o The interest premium will be subject to review and adjustment;

o The Applicant will recognise the accruing interest as an expense and a debt owing to the Lender as it accrues;

o All payments of interest by the Applicant will be made free and clear of and without deduction for any present or future taxes, levies, imposts, deductions, charges, or withholding, and all associated liabilities, except taxes imposed on the Lender's income;

o Notwithstanding, if the Applicant is required to deduct taxes from payments, including Withholding Taxes, it will be required to increase the payment as far as is necessary to ensure the Lender receives an amount equal the sum they would receive if no such taxes were payable;

o The Applicant may repay all or part of the principal amount, and may pay accrued but unpaid interest thereon, at any time or from time to time, without penalty;

o The Applicant must repay all or part of the Actual Loan Balance to the extent that the Actual Loan Balance at the end of the quarter exceeds the Maximum Loan Amount under the facility;

o The final repayment of the outstanding principal amount, and accrued but unpaid interest thereon, not previously paid, will be repayable at an agreed maturity date;

o There will be no other fees payable under the facility agreement; and

o Payments to the Lender will be required to be made to an address outside Australia.

In response to a request for further information, the following was provided:

· accrued but unpaid interest will be paid prior to the payment of any principal;

· there may not be a physical disbursement of funds to the lender to discharge the interest debt;

· the term of the facility will be less than 10 years and that any advances and interest thereon will be repaid and/or paid no later than the agreed maturity date;

· accruing interest will be recognised as a liability in the books of account of the borrower - it is now clear that applicable accounting standards may require the taxpayer to book some interest as an additional cost of constructing some assets. 

The Applicant confirmed they would be claiming interest on the loan facility as a tax deduction.

Relevant legislative provisions

Income Tax Assessment Act 1936, section 19 (repealed)

Income Tax Assessment Act 1936, Division 11A of Part 111

Income Tax Assessment Act 1936, subsection 128A(1AB)

Income Tax Assessment Act 1936, subsection 128A(2)

Income Tax Assessment Act 1936, section 128B

Income Tax Assessment Act 1936, 128B(1A)

Income Tax Assessment Act 1936, 128B(2)

Income Tax Assessment Act 1936, subparagraph 128B(2)(b)(i)

Income Tax Assessment Act 1936, 128B(5)

Income Tax Assessment Act 1936, Part IVA

Income Tax Assessment Act 1936, subsection 262A(1)

Taxation Administration Act 1953, Division 11 Part 2-5 of Schedule 1

Taxation Administration Act 1953, section 11-5

Taxation Administration Act 1953, subsection 11-5(1)

Taxation Administration Act 1953, subsection 11-5(2)

Taxation Administration Act 1953, Division 12 Part 2-5 of Schedule 1

Taxation Administration Act 1953, Subdivision 12-F Part 2-5 of Schedule 1

Taxation Administration Act 1953, section 12-245

International Tax Agreements Act 1953, Article 11 of Schedule 2

Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974, section 7

Income Tax Assessment Act 1997, section 6-5

Income Tax Assessment Act 1997, subsection 6-5(4)

Income Tax Assessment Act 1997, section 8-1

Income Tax Assessment Act 1997, section 26-25

Income Tax Assessment Act 1997, Part 3-90

Reasons for decision

Obligations of the payer

Division 12 of Schedule 1 to the Taxation Administration Act 1953 (TAA) deals with payments from which amounts must be withheld and Subdivision 12-F is specific to dividend, interest and royalty payments. The relevant provision is:

An entity must withhold an amount from interest (within the meaning of Division 11A of Part III of the Income Tax Assessment Act 1936) it pays to an entity, or to entities jointly, if:

(a) the recipient or any of the recipients has an address outside Australia according to any record that is in the payer's possession, or is kept or maintained on the payer's behalf, about the transaction to which the interest relates; or

(b) the payer is authorised to pay the interest at a place outside Australia (whether to the recipient or any of the recipients or to anyone else).

In regard to the actual withholding, the Australian resident entity's obligation to withhold is prima facie determined by section 12-245 of Schedule 1 to the TAA. Section 12-245 of the TAA imposes an obligation on an Australian resident entity to withhold an amount from interest (within the meaning of Division 11A of the ITAA 1936) it pays to a recipient who has an address outside Australia.

Liability for withholding tax

For the purposes of Division 11A of the ITAA 1936, at section 128A(1AB) 'interest' is defined to include 'an amount …:

(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 …'

A non-resident receiving interest paid by an Australian resident is liable for withholding tax on interest under subsections 128B(2) and 128B(5) of the ITAA 1936. Section 7 of the Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974 states the rate of withholding tax on interest paid to non-residents is 10 percent.

Timing

The obligation to withhold tax arises at a time pursuant to subsection 128A(2) of the ITAA 1936:

For the purposes of this Division, interest or a royalty shall be deemed to have been paid by a person to another person although it is not actually paid over to the other person but is reinvested, accumulated, capitalized, carried to any reserve, sinking fund or insurance fund however designated, or otherwise dealt with on behalf of the other person or as the other person directs.

Constructive payment

As stated above, the obligation to withhold is timed to payment; however 'payment' has an extended meaning pursuant to section 11-5 of Schedule 1 to the TAA:

In working out whether an entity has paid an amount to another entity, and when the payment is made, the amount is taken to have been paid to the other entity when the first entity applies or deals with the amount in any way on the other's behalf or as the other directs.

An amount is taken to be payable by an entity to another entity if the first entity is required to apply or deal with it in any way on the other's behalf or as the other directs.

Interest income

Interest income is regarded as ordinary income and is therefore assessable under section 6-5 of the ITAA 1997. Furthermore, it is assessable when derived by the lender, as the following discussion explains.

Taxation Ruling TR 98/1 Income tax: determination of income; receipts versus earnings (TR 98/1) sets out the Commissioner's guidelines on the cash or accruals methods for the treatment of income. In the case of interest or investment income, the general principle is that it is only derived, or arises, when it is received or credited (paragraph 47). As TR 98/1 states, (also at paragraph 47):

… exceptions to the general rule include (but are not limited to):

· interest from a business of money lending carried on by the taxpayer;

· interest derived by a financial institution (Taxation Ruling TR 93/27); unless from a 'non-accrual loan' (Taxation Ruling TR 94/32);

· interest from the everyday provision of credit as part of business activities (Taxation Ruling IT 2227);

· interest derived by taxpayers, whose other income is calculated on an accruals basis, who invest in fixed or variable interest securities cum interest (Taxation Ruling TR 93/28); and

· interest from deposits made in the ordinary course of carrying on a business, where the business income is properly assessable on the earnings basis, may be derived on a due and receivable basis. An example of this would be a large trading business that actively manages its funds on deposits.

As already stated, interest reinvested, accumulated, capitalised or otherwise dealt with on the other's behalf or as the other directs is said to be constructively received and therefore assessable.

An overarching principle regarding the Commissioner's guidelines on the cash or accruals methods for the treatment of income, is as follows (paragraphs 58 and 59 of TR 98/1):

Books of account

58. The ITAA does not prescribe the books of account that a taxpayer carrying on a business must keep. All that is required is that the records kept ' ... record and explain all transactions and other acts': subsection 262A(1) of the ITAA 1936.

59. However, where the books of account are kept, the way they are kept is relevant but not determinative to the question of when income has been derived. The question is still whether the accounting method used produces the correct reflex of income for the relevant year.

Derived

The term 'derived' is explained in subsection 6-5(4) of the ITAA 1997 to mean when income is received or applied or dealt with in any way at the person's direction, as follows:

6-5(4)

In working out whether you have derived an amount of ^*ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way on your behalf or as you direct..

Australian courts have long held that income assessable on an accruals basis is derived when a recoverable debt is created such that the taxpayer is not obliged to take any further steps before becoming entitled to payment (Farnsworth v. FC of T (1949) 78 CLR 504; (1949) 9 ATD 33; Henderson v. FC of T (1970) 119 CLR 612; 70 ATC 4016; (1970) 1 ATR 596; Federal Commissioner of Taxation v. Australian Gas Light Co. 83 ATC 4800; (1983) 15 ATR 105).

An exception to the position that income is derived when a recoverable debt arises is where amounts are received in advance of goods being supplied or services being provided (Arthur Murray (NSW) Pty Ltd v. FC of T (1965) 114 CLR 314; (1965) 14 ATD 98). In that case it was held that the fees received were not income while the possibility remained that the whole fee, or a portion of it, would have to be repaid.

In TR 98/1 the Commissioner provides the following explanation of 'derived':

26. For many taxpayers the income they derive in a year is the income received in that year: Brent v. FC of T. For other taxpayers the income they derive in a year is the income earned in that year: Henderson's case.

As to how income is accounted for, which in turn has implications for timing, the Commissioner provides the following, also in TR 98/1:

Method of accounting

27. A taxpayer determines when income is derived by adopting a method of accounting for income. When accounting for income, for tax purposes, a taxpayer must adopt the method of accounting that, in the circumstances, is appropriate. A method of accounting is appropriate if it gives a 'substantially correct reflex' of that income. This is the principle established in Carden's case.

28. Whether a method gives a 'substantially correct reflex' and therefore is appropriate is a conclusion to be made from all circumstances relevant to the taxpayer and the income. It is necessary, according to Dixon J in Carden's case, to:

'... discover what gains have during the period of account come home to the taxpayer in a realized or immediately realizable form.'

29. Appropriateness of the accounting method used by a taxpayer is the sole test for determining which method of accounting should be used: Henderson's case; Brent's case; and Barratt's case.

30. Only one method of accounting is appropriate to any one item of income; there is no choice available.

In Federal Commissioner of Taxation v. Australian Guarantee Corp. Ltd 84 ATC 4642 (Australian Guarantee Corp.) Beaumont J stated:

Although the bare statement that interest is, or will be, 'earned' is not itself determinative of the time at which or the period during which the interest will be derived, ordinarily, where interest is accruing from day to day, it is, I think, appropriate to describe that interest as being 'earned' on such a daily basis in point of time, even if not payable until a later date. Further, in my opinion, the period in which interest is accruing due may properly be regarded as the period in which interest is thus being earned.

Pursuant to Australian Guarantee Corp., the daily accruals method is considered as an appropriate basis of determining when interest income is earned. Similarly, the ATO view on the appropriate method for the derivation of interest income by financial institutions is set out in Taxation Ruling TR 93/27 Income tax: basis of assessment of interest derived and incurred by financial institutions (TR 93/27). TR 93/27 states that the accounting accrual method gives a 'substantially correct reflex' of a securitisation vehicle's interest income, and generally provides an indicative view for this ruling.

Deduction

In TD 93/99 Income tax: deductibility of royalties where withholding tax has not been remitted to the Tax Office, the so-called 'deduction rule', applicable for the withholding of royalties paid to non-residents is set out. This determination has application to interest payments as well, as a payer of a royalty (or interest) to a non-resident is precluded from obtaining a deduction for the payment until the withholding tax is paid.

Furthermore, the principles governing the deductibility of interest or compound interest are the same. The principles governing ordinary interest can only be applied if a genuine loan exists. If the Commissioner considers that the loan arrangement does not exist because of a lack of substantiation then the amounts purported to be paid or otherwise dealt with as an interest expense under an arrangement are not an interest expense and they are disallowed pursuant to section 8-1 of the ITAA 1997.

ATO ID 2004/848 Income Tax Deductability of an amount to a resident taxpayer who has not deducted withholding tax on an amount paid to a non-resident (ATO ID 2004/848) as titled, deals with the issue of deductability of the tax expense of interest payments to a non-resident. In the circumstances of ATO ID 2004/848 the interest is found not to meet the definition under Division 11A of Part III of the ITAA 1936, nevertheless the commentary, under the sub-heading, Reasons for Decision, on section 26-25 of the ITAA 1997, is apt for the purposes of this ruling, as follows:

Section 26-25 of the ITAA 1997 denies a deduction under section 8-1 of the ITAA 1997 for interest (interest within the meaning of Division 11A of Part III of the ITAA 1936), where the taxpayer is required to withhold an amount from the interest in accordance with section 12-245 of the Taxation Administration Act 1953 (TAA) and the taxpayer either fails to withhold the amount or fails to comply with certain other requirements.

Section 12-245 of the TAA provides that an entity must withhold an amount from interest (within the meaning of Division 11A of Part III of the ITAA 1936) it pays to a non-resident entity.

Application to the facts

In this case, the Lender is to provide a loan facility to the Applicant. There will be a formal agreement for the loan facility, the purpose of which is to enable the Applicant to further fund business operations in Australia.

As part of the agreement, interest will accrue daily and be calculated quarterly for the term of the loan, but there may not be a physical disbursement of funds to the lender to discharge the interest debt. The Applicant has indicated interest will arise and be paid under the facility. Also, the Applicant has indicated that both it and the Lender will account for the interest.

In view of the above it is apparent that applicable accounting standards and the Commissioner's guidelines on the cash or accruals methods for the treatment of income (discussed above) should be used by both the Applicant and the Lender such that there will be recognition and accounting of the interest on the loan facility, as it accrues daily and is calculated quarterly.

Despite the uncertainty of the means and transactions by which the Applicant will make payment of interest to the Lender, the arrangement under the agreement is for interest to accrue daily and to be calculated quarterly, and to be claimed as a tax deduction by the Applicant.

The Applicant's and the Lender's intentions to account for the interest, as well as the Applicant's intention to claim interest expenses for tax purposes highlights that interest will be due and payable. Also, it reiterates that the interest income will be derived by the non-resident.

Also, pursuant to section 11-5 of Schedule 1 to the TAA 1953 the interest will be constructively paid to the Lender and will be included in the latter's assessable income in the year it is derived.

Conclusion

On the facts provided in this application there is an obligation on the Applicant to withhold interest pursuant to Sub-Division 12-F of Schedule 1 to the TAA 1953.

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