Edited version of your written advice

Authorisation Number: 1012797501327

Ruling

Subject: Payments to non-resident holder of Notes

Question 1

Will the distributions made on the Notes to a non-resident Investor constitute 'interest' for the purposes of the withholding tax provisions in Division 11A of the Income Tax Assessment Act 1936¹?

Answer

Yes

Question 2

Where the distributions do not constitute 'interest' for the purposes of Division 11A, will an Annual Investment Income Report (AIIR) be required pursuant to regulation 56 of the Income Tax Regulations 1936 (ITR 1936) in relation to the distributions?

Answer

No need to answer

This ruling applies for the following periods:

Income Year ending 30 June 2016

Income Year ending 30 June 2017

Income Year ending 30 June 2018

Income Year ending 30 June 2019

Income Year ending 30 June 2020

The scheme commences on:

19 May 2015

Relevant facts and circumstances

A Note is an unsecured note with a term of approximately one year. It is issued by the Issuer to individual Investors who must be both Australian residents for taxation purposes (as defined in subsection 6(1)) when applying for the Note and employees of the Issuer or associates of the Issuer.

Each Note provides exposure to an underlying asset (a reference asset).

A Note entitles the Investor to receive:

• an initial distribution, being a fixed amount calculated as a percentage of the investment amount payable by the Issuer on a date falling approximately one month after the issue date; and

• a final distribution, payable by the Issuer at maturity and comprised of a fixed component calculated as a percentage of the investment amount, and a variable component being a gain (if any) calculated by reference to the performance of the relevant reference asset for that Note.

Depending on the Note chosen, the variable component of the final distribution will provide the Investor with exposure to the performance of a reference asset, subject to a participation rate, and allows the Investor to benefit from increases or falls in the value of that reference asset, up to a cap (if any).

Provided an early termination event has not occurred, the Investor will (in addition to the final distribution) be entitled to receive from the Issuer at maturity an amount equal to their investment amount.

If an early termination event occurs in relation to a Note, the Issuer may declare that the Note will terminate on a date earlier than the maturity date. If the Issuer determines that there will be an early termination in relation to a Note, then the Investor becomes entitled to receive an early termination amount from the Issuer, and the Note will be redeemed. The early termination amount may be more or less than the Investor's investment amount.

Assumptions

1. The term of a Note will begin and end within a single income year.

2. All dealings between the Investors and the Issuer will be at arm's length.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 6(1)

Income Tax Assessment Act 1936 subsection 26C(1)

Income Tax Assessment Act 1936 Division 11A

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

Income Tax Assessment Act 1936 paragraph 128A(1AB)(a)

Income Tax Assessment Act 1936 paragraph 128A(1AB)(b)

Income Tax Assessment Act 1936 paragraph 128A(1AB)(c)

Income Tax Assessment Act 1936 paragraph 128A(1AB)(d)

Income Tax Assessment Act 1936 paragraph 128A(1AB)(e)

Income Tax Assessment Act 1936 subsection 128A(1AD)

Income Tax Assessment Act 1936 subsection 128B(2)

Income Tax Assessment Act 1936 section 160ZZV

Income Tax Assessment Act 1936 section 202A

Income Tax Assessment Act 1936 subsection 202D(1)

Income Tax Assessment Act 1997 subsection 974-75(1)

Income Tax Regulations 1936 regulation 56

Does Part IVA apply to this ruling?

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.

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

Question 1

Broadly and pursuant to subsection 128B(2), a liability to withholding tax arises under Division 11A where a non-resident derives interest income paid to them by a resident.

Subsection 128A(1AB) defines interest for the purposes of Division 11A as follows

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

(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.

This definition of interest is an inclusive definition and expands on the ordinary meaning of the term interest. Accordingly and putting aside any double tax agreement, distributions made on a Note to an Investor who becomes a non-resident subsequent to acquiring their Note will be subject to withholding tax under subsection 128B(2) if the distributions are considered to be interest as per the ordinary meaning of that term, and/or interest in accordance with any part of the expanded statutory definition set out in subsection 128A(1AB).

Ordinary meaning of interest

Whilst the term interest is given specific meaning in a number of provisions of the Income Tax Assessment Act its meaning is not defined for the purposes of the Act generally. The Macquarie Dictionary defines interest as '… payment, or a sum paid, for the use of money borrowed (the principal), or for the forbearance of a debt …'.

Cooper J in Consolidated Fertilizers Ltd v Commissioner of Taxation 92 ATC 4260 (Consolidated Fertilizers), at 4263-4264, provided a detailed description of what 'interest' is and said:

'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.) …'

This concept of interest is supported and expanded on in the following cases

Riches v Westminster Bank Limited [1947] AC 390, where Lord Wright said:

'the essence of interest is that it is a payment which becomes due because the creditor has not had his money at the due date. It may be regarded either as representing the profit he might have made if he had had the use of the money, or conversely the loss he suffered because he had not that use. The general idea is that he is entitled to compensation for the deprivation.'

Federal Commissioner of Taxation v Myer Emporium Ltd (1987) 71 ALR 28 (Myer Emporium), where their honours, at 38, referred to interest as

'flowing from the principal sum (Federal Wharf Co. Ltd. v. D.F.C. of T (1930) 44 C.L.R. 24 at p. 28) and to be compensation to the lender for being kept out of the use and enjoyment of the principal sum: Riches v. Westminster Bank Limited (1947) AC 390 at p. 400.'

FC of T v Radilo Enterprises Pty Ltd 97 ATC 4151 where their honours, at 4157, said:

'The common meaning of interest is the money which accrues from day to day, calculated according to a fixed ratio of a sum lent, agreed to be paid under a contract of loan. But the word has a wider meaning which may include the compensation or damages to be paid to a person denied the use of a sum to which that person is, or becomes, entitled. Cardinal to either meaning is that interest be referable to a principal in money or an obligation to pay money. (See: Halsbury's Laws (4th Ed), Vol 32 para 106; Consolidated Fertilizers Ltd v DFC of T 92 ATC 4260; (1992) 107 ALR 456 per Cooper J at ATC 4263; ALR 461-462.)

Federal Commissioner of Taxation v Century Yuasa Batteries Pty Ltd (1998) 82 FCR 288 where, in the context of interest withholding tax, the Full Federal Court referred to Myer Emporium and stated, at 291, that the ordinary meaning of interest:

'… 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.'

Steele v Federal Commissioner of Taxation 99 ATC 4242, where their honours said, at 148, that:

'… interest is ordinarily a recurrent or periodic payment which secures, not an enduring advantage, but, rather, the use of borrowed money during the term of the loan.'

and

Macquarie Finance Ltd v. FC of T (2004) 210 ALR 508, where Hill J said the following on the ordinary meaning of interest

'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.'

These cases, together with paragraphs 24 to 30 of Taxation Ruling TR 93/27² and paragraphs 53 to 56 of Taxation Ruling TR 2002/15³, identify the presence of the following factors in properly characterising a payment as interest

• an indebtedness to which the payment is ascertained, i.e. a debtor-creditor relationship; and

• a sum of money (the principal) by reference to which the payment is calculated.

Debtor-creditor relationship

A loan requires the existence of a debtor-creditor relationship underpinned by the obligation to repay the principal sum lent (paragraph 61 of TR 2002/15), and to do so at the end of a temporary period or on demand (paragraph 88 of TR 2002/16⁴).

A debtor-creditor relationship between the Issuer and the Investor exists under the terms of a Note on the basis that the Issuer has a present obligation from the time the Note is issued to pay to the Investor at maturity an amount equivalent to the principal sum invested in the Note (the investment amount) by the Investor. Although there is no explicit obligation for the Issuer to repay the investment amount, the Issuer effectively has this obligation by virtue of its obligation to pay an amount equal to the investment amount. This obligation to pay exists so long as the Note is in existence.

If an early termination event occurs in relation to a Note, the Issuer may declare a date earlier than the maturity date for that Note to be the early termination date of that Note. The Investor will thereupon become entitled to an early termination amount in respect of that Note.

The effect of the occurrence of an early termination event and the declaration by the Issuer of an early termination date of a Note is:

• firstly, to bring the maturity date of the Note forward to the early termination date; and

• secondly, to render the Issuer liable to pay an early termination amount to the Investor.

The Issuer and the Investor maintain a debtor-creditor relationship until the Note is terminated - whether this is upon the elapse of the maturity date or by reason of an early termination event occurring and the Issuer choosing afterwards to declare an early termination date.

The impact of an early termination event occurring and the Issuer choosing an early termination date is on the date that the obligations under the Note fall due and on the value of those obligations. The Issuer and Investor are and remain debtor and creditor throughout the duration of the Note, however long that may be.

Calculated by reference to the principal

For distributions payable by the Issuer under a Note to be interest, there must be a borrowing or debt owing and, in the words of Cooper J in Consolidated Fertilizers, the distributions must represent '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' or 'money paid for the use of money lent'.

The initial distribution is expressed to be payable by the Issuer as a fixed percentage of the investment amount and is therefore calculated by reference to that amount. This represents a charge for the use of credit or borrowed money, expressed as a percentage per time unit of the sum borrowed or used and, the usual characteristic of an amount of interest, is considered to be compensation to the Investor for being kept out of the investment amount.

The final distribution consists of two components.

The fixed component is also expressed to be payable by the Issuer as a fixed percentage of the investment amount and therefore calculated by reference to that amount.

The variable component is a gain (if any) expressed to be payable by the Issuer as a variable percentage of the investment amount and is therefore also calculated by reference to the investment amount. Although the variable percentage used to calculate the variable component of the final distribution (which cannot be a loss) is based on the performance of the relevant reference asset rather than by reference to a variable upon which interest is more commonly calculated, the variable component forms part of the reward paid to the Investor for the temporary use of the investment amount over a specified period of time.

Conclusion

It follows that, in the context of a Note and the terms under which amounts are payable, the initial distribution and the final distribution are amounts of 'interest' as that term is ordinarily understood.

Interest under subsection 128A(1AB)

The Explanatory Memorandum to the Taxation Laws Amendment Act (No. 2) 1997 explains the introduction of subsection 128A(1AB) and states at paragraph 2.17 that the definition of the term interest is designed to ensure that certain income is interest for the purposes of the withholding tax provisions, despite arrangements which attempt to change the character of the income from interest to another form of income.

In the nature of interest

Paragraph 128A(1AB)(a) is intended to broaden the application of the withholding tax provisions beyond amounts which are interest as such, and aims at amounts that are in substance interest but which may not otherwise fall within the ordinary meaning of interest. To be in the nature of interest an amount must have the character of compensation or consideration payable in respect of keeping a person out of the use and enjoyment of a principal sum (ATO ID 2010/133).

In substance, a Note is characteristic of a loan under which the Issuer (as the 'borrower' or 'debtor') has an obligation at maturity to repay (or pay) an amount equivalent to that advanced by the Investor.

Under the terms of a Note the Investor is certain to receive a positive return. That positive return is either capped or is a relatively fixed amount.

The limited opportunity for gains, as offered to the Investor under a Note in the form of the distributions payable thereunder, is characteristic of a return on a loan or debt. Similarly, a return that is always positive but has limited possibility of gain or loss is characteristic of a variable interest rate loan.

The use of an index to calculate the variable component of the final distribution may give the Note the colour of a derivative transaction, but the essential character of the relationship is that of a loan of money with a reward (which cannot be a loss) payable by the Issuer for the temporary use of the investment amount.

It follows that the distributions are amounts that are effectively referable to a principal in money or an obligation to pay money. These sums are characteristic of an amount in the nature of interest as they have the character of compensation or consideration payable to the Investor for being kept out of the use and enjoyment of the investment amount. As such the distributions, if they are not 'interest' strictly so called, are in the 'nature of interest' as described at paragraph 128A(1AB)(a).

In substitution for interest

The words 'converted into a form that is in substitution for interest' under paragraph 128A(1AB)(b) entails postulating on reasonable grounds that the amount is payable instead of interest. This requires that the amount is in substance and effect the same as the interest for which it was substituted, and means that it must have been possible for interest, in the ordinary sense of the word, to have been paid (ATO ID 2009/154). Subsection 128A(1AD) provides an example of an amount that is in substitution for interest, that being a lump sum payment made instead of payments of interest.

As (for reasons discussed above in relation to paragraph 128A(1AB)(a)) a Note is considered to be characteristic of a loan or other form of debt, it is also considered possible for amounts properly regarded as interest to have been paid in relation to that Note.

The distributions made to the Investor under a Note are, in substance and effect, the same as interest to the extent that they are referable to a debt or principal amount and payable by the Issuer in substitution for the payment of interest. The sum total of the distributions payable to the Investor by the Issuer over the term of a Note equates to a rate that could reasonably be regarded as interest.

Paragraphs (c), (d) and (e)

The distributions are not considered to be interest pursuant to any of the statutory extensions set out in paragraphs (c), (d) or (e) of the definition in subsection 128A(1AB).

For completeness and relevant to specific elements of the definition of 'interest' in
subsection 128A(1AB)

• the distributions are not amounts referred to in subsection 26C(1); and

• a Note does not satisfy the equity test in subsection 974-75(1) of the Income Tax Assessment Act 1997 in relation to a company and the distributions therefore cannot constitute an amount which is a return on an equity interest in a company.

Conclusion

It is considered that the distributions are amounts of interest, or in the 'nature of interest' or amounts 'in substitution for interest' and therefore 'interest' within the meaning of
subsection 128A(1AB).

As the distributions made on a Note to a non-resident Investor will constitute interest as defined under subsection 128A(1AB), those distributions should be subject to withholding tax under Division 11A.

Question 2

Regulation 56 of the ITR 1936 relates to AIIRs and states that:

'A person who at any time during a financial year is an investment body that accepted any investments mentioned in section 202D of the Act must give to the Commissioner a written report relating to those investments'.

Relevantly, the investments listed in the table at subsection 202D(1) include interest-bearing accounts with a financial institution and interest-bearing deposits (other than deposits to the credit of an account) with a financial institution.

The term 'interest- bearing account' is defined in section 202A to relevantly include any facility by which a financial institution accepts deposits of money to the credit of a person and 'pays or credits interest, or amounts in the nature of interest, on the balance standing to the credit of the person from time to time'.

The term 'interest- bearing deposit' is defined in section 202A to mean a deposit of money with a financial institution, in consideration of which the financial institution 'pays or credits interest, or amounts in the nature of interest, to a person'.

For the purposes of these definitions and pursuant to section 160ZZV, interest has the same meaning as in Division 11A.

¹ All legislative references in this ruling are to the Income Tax Assessment Act 1936 unless otherwise indicated.

² Income tax: basis of assessment of interest derived and incurred by financial institutions.

³ Income tax: deductibility of payments incurred on moneys raised through the issue of perpetual notes.

⁴ Income tax: the taxation consequences for taxpayers issuing certain stapled securities.

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