Edited version of your written advice

Authorisation Number: 1051499583593

Date of advice: 1 April 2019

Ruling

Subject: Financial institutions for the purposes of the Australia and the Relevant taxation convention

Question

Will Article 11(3)(b) of the Convention between the Government of Australia and the Relevant State for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income [1983] ATS 16 and Protocol [2003] ATS 14 (Relevant Convention), apply to interest derived by the taxpayer in relation to the Proposed Transactions as described below?

Answer

Yes

This ruling applies for the following periods:

30 June 2019

30 June 2020

30 June 2021

30 June 2022

30 June 2023

30 June 2024

30 June 2025

The scheme commences on:

March 2019

Relevant facts and circumstances

The taxpayer is part of a global group of companies with a core business focuses on originating, acquiring, financing and managing commercial mortgage loans and other commercial real estate debt investments. The taxpayer is a resident of the X for Australian and the X tax purposes.

Investment approach

The taxpayer’s target assets include the following types of loans and other investments with respect to its core business:

● Whole mortgage loans

● B-Notes

● Mezzanine loans

● CMBS

● Corporate bank debt

● Equity

● Corporate bonds

● Non-Agency RMBS

● Residential mortgage loans

● Net leases

● Agency RMBS

Business segments

The taxpayer has several reportable business segments as detailed below:

1. Real estate lending

Real estate lending is the taxpayer’s primary business since its inception.

2. Real estate investing and servicing

This segment includes a variety of business lines focuses on commercial mortgage-backed securities (CMBS) and commercial real estate investments; special servicing operations; and a commercial mortgage conduit platform.

3. Property

Recently, the taxpayer commenced investing in real estate assets to complement its other businesses.

Proposed Transactions in Australia

The taxpayer is currently in the process of underwriting a construction loan for the development of a housing development in Australia.

The taxpayer’s investments in Australia will consist of commercial mortgage/mezzanine financing. The return on these investments will therefore primarily consist of interest income, as well as any fee income (such as commitment and arrangement fees).

The taxpayer does not plan to directly invest in any real estate assets in Australia.

In relation to their proposed lending activities in Australia, the taxpayer will establish one or more wholly owned X limited liability companies (LLCs) as the lender(s). These LLCs are required because the taxpayer uses various repo facilities and other borrowings that necessitate the creation of separate LLCs to hold pledged assets.

The LLCs will provide debt finance to Australian resident borrowers. As single member companies, the LLCs will be disregarded for X federal income tax purposes, such that interest income will be treated as derived by the taxpayer.

The LLCs may provide loans to independent third party Australian borrowers with a co-lending vehicle (Co-lender) that is managed by the taxpayer’s parent company. The LLCs and the Co-lender will operate independently of each other.

Source of funding

The taxpayer’s funding is principally obtained through a variety of financing, including:

′ Repurchase agreements

′ Secured property financings

′ Bank credit facilities

′ Loan sales, syndications and securitisations

′ Unsecured senior notes

′ Federal home loan bank (FHLB) financing.

Net income

The majority of the taxpayer’s net income for the last three years is derived from its spread activities. Even if the lending segment is considered in isolation, it continues to contribute the majority of net income earned by the taxpayer.

Even as the taxpayer has diversified and grown its business since its inception (and in particular in respect of its decision to make equity investments in real estate), its core lending business still generates the greater part of its net income.

Other matters

The taxpayer is a resident of the X for income tax purposes, and is subject to X federal income tax on its income and profits.

Neither the taxpayer nor the LLCs will carry on any business in Australia at or through a permanent establishment.

The Proposed Transactions will be entered into by the LLCs on arm’s length terms and at fair market value.

The taxpayer and the LLCs will not be entering into any back-to-back loans or other arrangements in respect of the Proposed Transactions for the purposes of Article 11(4)(a) of the Relevant Convention.

Relevant legislative provisions

The Convention between the Government of Australia and the Government of the X for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income [1983] ATS 16 and X Protocol (No 1) [2003] ATS 14

Income Tax Assessment Act 1997 section 974-135

Reasons for decision

Article 11(3) of the Relevant Convention states:

(3) Notwithstanding paragraph (2), interest arising in one of the Contracting States to which a resident of the other Contracting State is beneficially entitled may not be taxed in the first-mentioned State if:

…

(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.

Resident of the US

Article 1(1) of the Relevant Convention provides that:

Except as otherwise provided in this Convention, this Convention shall apply to persons who are residents of one or both of the Contracting States.

The taxpayer is a corporation that is a resident of the X for the purposes of the Relevant Convention.

The LLCs are companies with a single owner incorporated under X law. They are disregarded as entities separate from its owner for X federal tax purposes. The LLCs therefore do not pay X tax themselves. Rather, they are treated as part of the owner for the purposes of X domestic tax law.

Article 4(1)(b)(i) of the Relevant Convention states that a person is a resident of the X if the person is a 'X corporation'. Article 3(1)(g)(i) of the Relevant Convention defines the term 'X corporation' as:

... a corporation which, under the Relevant law relating to X tax, is a domestic corporation or an unincorporated entity treated as a domestic corporation, and which is not, under the law of Australia relating to Australian tax, a resident of Australia;

Treasury Regulations, Subchapter F, sec. 301.7701-2(a) provides:

A business entity with only one owner is classified as a corporation or is disregarded; if the entity is disregarded, its activities are treated in the same manner as a sole proprietorship, branch or division of the owner.

As the LLC is disregarded, it is not a corporation for the purposes of X tax law nor, a 'X corporation' for the purposes of Article 4(1)(b)(i) of the Relevant Convention. The LLC is not a resident under Article 4(1)(b)(i).

Article 4(1)(b)(iii) of the Relevant Convention includes as a resident:

Any other person (except a corporation or unincorporated entity treated as a corporation for X tax purposes) resident in the X for the purposes of its tax...

As it is the single owner who is a resident of the X for the purposes of its tax, not the LLC. The LLC is not a resident under Article 4(1)(b)(iii) and is not, therefore, a resident of the X for the purposes of the Relevant Convention.

Interest paid to LLCs is ‘derived’ by the taxpayer

Article 11(3)(b) of the Relevant Convention can apply to Australian interest paid to a single owner LLC that is incorporated in the X where it:

- is a disregarded entity; and

- substantially derives 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; and

- is owned by a X Corporation which is a resident for the purposes of the Australia/XA Treaty and undertakes no other activities

provided all the other requirements in Article 11 are satisfied.

Paragraph 6.3 of the OECD Commentary on Article 1 of the 2017 OECD Model Tax Convention which states the following:

“…the State of source should take into account, as part of the factual context in which the treaty is to be applied, the way in which an item of income, arising in its jurisdiction is treated in the jurisdiction of the person claiming the benefits of the Convention as a resident.”

Thus, in applying the Relevant Convention, Australia should take into account the X treatment of the interest paid to the LLCs where necessary in order to give effect to the object and purpose of the treaty. Australia may give due recognition to the fact that under X tax law, the activities and income of the LLCs are treated as the activities and income of their X resident owner – the taxpayer.

Payments of interest on the Proposed Transactions in this case will be made by the Australian customers to the LLCs. The taxpayer files a tax return in the X on the basis that the LLCs are disregarded entities and are owned by the taxpayer. As the LLCs’ activities including their income will be treated as that of the taxpayer ’s pursuant to X tax law, for the purposes of the Relevant Convention, it is accepted that the interest income is derived by the taxpayer.

Therefore the taxpayer must satisfy the definition of a financial institution within Article 11(3)(b) of the Relevant Convention in order to claim exemption from interest withholding tax in relation to the Proposed Transactions.

For the purposes of Article 11(3)(b) of the Relevant Convention, the definition of ‘financial institution’ is:

…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.

The taxpayer is not a bank. It will satisfy the definition of a financial institution if it falls into the ‘other enterprise’ limb of the definition.

Paragraph 15 of Taxation Ruling TR 2005/5 Income tax: ascertaining the right to tax United States (US) and United Kingdom (UK) resident financial institutions under the US and the UK Taxation Conventions in respect of interest income arising in Australia provides that ‘other enterprises’ are “those residents of the United States of America…that are not classified as banks”. 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’. In TR 2005/5, these activities are collectively referred to as ‘spread activities’.

Raising debt finance

Paragraph 65 of TR 2005/5 requires that when applying the phrase ‘raising debt finance in the financial markets’, it must be determined whether the type of financing is ‘debt’ financing.

Paragraphs 67 and 68 of TR 2005/5 state that the test in Division 974 of the ITAA 1997 can be used in determining whether the financing arrangement is ‘debt finance’ for the purposes of the Relevant Convention.

Paragraph 69 of TR 2005/5 provides:

…Therefore, where it can be concluded that the raising of funds results in an effectively non-contingent obligation, as defined in section 974-135 of the ITAA 1997, to provide an amount at least equal to the amount received, this will constitute ‘raising debt finance’ for the purposes of the Conventions.

While the taxpayer uses a variety of sources of financing, the bulk of its financing is derived from the sources as listed above. It is accepted that, based on their descriptions and the information on financial liabilities contained in the taxpayer’s annual report, they are sources of debt finances.

Financial markets

Paragraph 72 of TR 2005/5 states that the meaning of ‘debt finance’ needs to be viewed in the context of it being raised in the ‘financial markets’. The term ‘financial markets’, in this context takes its ordinary commercial meaning which is:

a facility through which:

● offers to acquire or dispose of debt finance products are regularly made or accepted (including offering loans), or

● offers and invitations are regularly made to acquire or dispose of debt finance products that are intended to result or may reasonably be expected to result in the making (or acceptance) of offers to acquire or dispose of such debt finance products (including offering loans).

This definition includes all forms of loan financing through recognised entities that form part of the financial market (that is, depository institutions and finance companies). It also includes the raising of debt finance in the wholesale financial markets through which debt finance products such as notes and bonds are issued.

Based on the taxpayer’s annual report, it is clear that the taxpayer raises debt finance in the financial markets as they finance their acquisition of their target assets through:

● sources of private and government sponsored financing, including long and short-term repurchase agreements, warehouse and bank credit facilities, and mortgage loans on equity interests in commercial real estate properties

● loan sales, syndications, and/or securitisations, and

● public or private offerings of their equity and/or debt securities.

Using the funds in carrying on a business of providing finance

Paragraph 88 of TR 2005/5 states that the Relevant Convention requires that funds raised by debt finance must be ‘used’ to carry on a business of providing finance.

Paragraph 89 of TR 2005/5 states that the word ‘finance’ in ‘providing finance’ takes its ordinary meaning which is:

to supply with means of payment; provide capital for; obtain or furnish credit for.

Further, paragraph 90 of TR 2005/5 states:

The Commissioner considers that the non-resident may provide both debt finance and equity finance. Accordingly, the provision of finance entails the supply or provision of funds or assets with an obligation (either contingent or non-contingent) on the recipient to return the funds or assets in the future.

TR 2005/5 provides that the following are examples of providing finance:

● providing cash collateral under a securities lending arrangement;

● purchase of securities under a repurchase agreement; and

● purchase of redeemable preference shares.

TR 2005/5 also considers that the leasing of an asset under a finance lease, or the lending of a security under a security lending arrangement may also constitute the provision of finance where there is an obligation to return those assets or securities at a later date.

Purchasing established loans or debt instruments (receivables) from an originating entity or other holder, under a securitisation arrangement is considered providing finance. In the particular facts of ATO ID 2005/260, the taxpayer substantially derived its profits by issuing commercial paper to investors in the financial markets and using those funds to purchase receivables from an originating entity or other holder under a securitisation arrangement and to make loans or purchase debt instruments as the primary lender.

The taxpayer has three key business segments, being real estate lending, real estate investing and servicing, and investment in property. It has recently added a further segment, being infrastructure lending.

Other than its property segment (which is equity investing to derive rental income), the taxpayer’s other segments are predominantly to provide finance from which it derives interest income. The investments which give rise to interest income are regarded as being part of business carried on by the taxpayer of providing finance.

The taxpayer will be regarded as providing finance in cases both where it is the originating party and where it purchases receivables from an originating party.

Based on the facts, and given the nature of the activities conducted by the taxpayer, it can be concluded that the taxpayer is carrying on a business of providing finance for the purposes of Article 11(3)(b) of the Relevant Convention.

Substantially deriving its profits

Paragraph 99 of TR 2005/5 states that the spread activities need only to be the main activity (not the sole activity) of the enterprise in terms of its contribution to overall profits.

The Commissioner considers that the word substantially, when used in the context of an enterprise that substantially derives its profits from spread activities, is used in a relative sense. This means that the spread activities of an enterprise should be its main activity.

The term “profits” in this context takes its accounting meaning, and is therefore measured according to a range of acceptable accounting indicators of profits, including:

● Gross profit

● Net operating income, or

● Operating profit.

The majority of the taxpayer’s net income for the last three years is derived from its spread activities. Even if the lending segment is considered in isolation, it continues to contribute the majority of net income earned by the taxpayer.

Even as the taxpayer has diversified and grown its business since its inception (and in particular in respect of its decision to make equity investments in real estate), its core lending business still generates the greater part of its net income.

As such, the taxpayer is ‘substantially deriving its profits’ from raising debt finance in the financial markets and using those funds in carrying on a business of providing finance for the purposes of Article 11(3)(b) of the Relevant Convention.

Based on the above, the taxpayer is a ‘financial institution’ for the purposes of Article 11(3)(b) of the Relevant Convention as it meets the requirements set out in that Article under the definition of ‘financial institution’.

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