Edited version of private advice

Authorisation Number: 1051766409464

Date of advice: 27 October 2020

Ruling

Subject: Sovereign immunity

Question 1

Will Govsub Co be immune from interest withholding tax on interest income derived upon the loan notes that it holds that were issued by AusCo on XX/XX/XXXX under the common law doctrine of sovereign immunity until 30 June 20XX?

Answer

Yes.

Question 2

Is the ordinary and statutory income derived by Govsub Co from the loan notes it holds that were issued by AusCo on XX/XX/XXXX not assessable and not exempt income under section 880-105 of the ITAA 1997 for the period from 1 July 20XX to 30 June 20XX?

Answer

Yes.

This ruling applies for the following period:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

Year ending 30 June 20XX

The scheme commenced on:

XX/XX/20XX

Relevant facts and circumstances

The statutory body of Country A

The statutory body was established under statute in XXXX to own and administer assets of the government of Country A. It is a corporation and a legal person capable of suing and being sued, and has the ability to hold title to movable and immovable property.

The statutory body owns 100% of the shares in a number of entities, including GovCo.

GovCo

GovCo is a company incorporated in Country A and is a resident of Country A for income tax purposes. GovCo is wholly owned by a foreign government statutory body.

GovCo receives its funds from the government of Country A and manages its reserves for long term investment.

The sources of the government's assets managed by GovCo include proceeds from the issuance of bonds, government surpluses, and the sale of government assets.

GovCo owns 100% of the shares in Govsub Co.

Any returns made by GovCo are paid to the government of Country A or reinvested by the broader GovCo group. Any returns of the broader GovCo Group are paid to the government of Country A.

Govsub Co

Govsub Co is a company incorporated in Country A and is a resident of Country A for tax purposes. It is not a resident of Australia for income tax purposes, is not a resident trust estate as defined in Part III of the ITAA 1936, and is not a partnership under section 6 of the ITAA 1936.

Govsub Co's sole business activity is to hold the AusCo loan notes.

Govsub Co does not actively trade in financial assets and liabilities, or operate commercially in financial markets or provide services listed in paragraph 880-130(2)(c) of the ITAA 1997.

Govsub Co's share capital is wholly funded from GovCo.

Any returns made by Govsub Co can only be paid to GovCo.

AusCo loan notes

On XX/XX/XXXX, AusCo, an Australian resident company, issued loan notes totalling $X to investors. Of that amount, $X of the loan notes were issued to Govsub Co. The loan notes were issued as consideration for the purchase by a third party of Govsub Co's equity interest in the AusCo business.

No AusCo loan notes are held by any Country A government entities or members of Govsub Co's sovereign entity group as defined in section 880-20 of the ITAA 1997.

The terms of the AusCo loan notes are:

a)    Unsecured

b)    Fixed interest rate of X%

c)    Subordinated to all other liabilities and obligations of the company

d)    Interest accrues daily and is automatically capitalised (less any withholding tax to be deducted) and added to the outstanding principal amounts of the loan notes. Any accrued interest after being capitalised, will be treated as part of the principal amount of the Notes and bears interest

e)    X year term

f)     Non-transferable without the consent of the issuer

g)    On redemption, the issuer must pay all outstanding amounts of principal and interest to the noteholders.

h)    The provisions of the loan note, including these conditions may be amended by AusCo only with the approval for minor matters of X% of the noteholders in proportion to the face value of their holding as compared to total value on issue, or unanimous approval for major terms which relate to the fundamental terms of the AusCo loan notes, including loan term, interest rate, principal amount, and parties to the loan note agreement.

The AusCo loan notes do not give Govsub Co or any other entity within the sovereign entity group of Govsub Co the right to appoint, or participate in the appointing of persons that exercise the control and direction of AusCo.

The AusCo loan notes do not give Govsub Co or any other entity within the sovereign entity group of Govsub Co any right to participate in the business or decisions relating to the business, or in any decisions that comprise the control and direction of AusCo.

The AusCo loan notes do not give Govsub Co or any other entity within the sovereign entity group of Govsub Co any other influence in AusCo potentially of a kind described in subsection 880-105(6) of the ITAA 1997.

Govsub Co's sovereign entity group own minor indirect participation interests in AusCo that cumulatively satisfy the portfolio test in subsection 880-105(4) of the ITAA 1997.

GovsubCo's sovereign entity group's indirect participation interests in AusCo do not give rise to influence in AusCo potentially of a kind described in subsection 880-105(6) of the ITAA 1997.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 880

Reasons for Decision

All references in the Reasons for Decision are to the ITAA 1997 unless otherwise indicated.

Question 1

Will Govsub Co be immune from interest withholding tax on interest income derived upon the loan notes that it holds that were issued by AusCo on XX/XX/XXXX under the common law doctrine of sovereign immunity until 30 June 2019?

Summary

Govsub Co is immune from withholding tax on interest income derived from the AusCo loan notes it holds pursuant to the common law doctrine of sovereign immunity for the period between XX/XX/XXXX and 30 June 2019.

Detailed reasoning

For Australian income tax and withholding tax purposes, it is accepted that the doctrine of sovereign immunity applies to a foreign government or an agency of a foreign government that engages in governmental functions. This approach is consistent with the decision of the British House of Lords in the case I Congreso del Partido [1981] 2 All ER 1064 which held that activities of a trading, commercial or other private law character were not governmental functions.

When determining whether the doctrine of sovereign immunity applies to exempt Australian sourced income and gains from Australian income tax and/or withholding tax, it is necessary to establish the following:

1. That the person making the investment (and therefore deriving the income) is a foreign government or an agency of a foreign government
2. That the monies invested are and will remain government monies, and
3. That the income or gain is being derived from a non-commercial activity.

If these three conditions are satisfied, then the income or gains will not be subject to Australian income tax and/or withholding tax.

Condition 1: A foreign government or agency of a foreign government

For Govsub Co's Australian income to be exempt from tax under the doctrine of sovereign immunity, it must be established that it is part of Country A's government or is a body exercising governmental functions. Govsub Co satisfies these criteria for the following reasons:

·         Govsub Co is a wholly-owned subsidiary of GovCo, which in turn is wholly owned by a statutory body of the government of Country A.

·         The statutory body is charged with owning and administering the assets of the government of Country A.

·         As the statutory body is a foreign government agency, a wholly owned subsidiary of such an agency will likely be considered to be a body exercising governmental functions, being the management of the government of Country A's financial reserves.

The above factors support a finding that Govsub Co is ultimately wholly owned by a part of the government of Country A, satisfying condition 1 with respect to sovereign immunity.

Condition 2: the monies being invested are and will remain government monies

In line with the principle that sovereign immunity applies to foreign states performing only governmental functions, an entity claiming sovereign immunity must establish that the monies being invested are and will remain government monies.

Govsub Co's share capital is funded by share capital provided by GovCo. GovCo receives its funds and share capital ultimately from the government of Country A for long term management and investment.

All distributions of profit by Govsub Co are made to its shareholder GovCo, and ultimately to the government of Country A.

Accordingly, the monies being invested by Govsub Co are, and will remain, government monies, satisfying condition 2 with respect to sovereign immunity.

Condition 3: The income or gain is being derived from a non-commercial activity

As noted in ATO Interpretative Decision ATO ID 2002/45 Sovereign Immunity, whether an operation or activity is a commercial transaction will depend on the facts of each case. As a guide, a commercial transaction is generally considered to be an activity concerned with the trading of goods and services, such as buying, selling, bartering, transportation, and includes the carrying on of a business. A passive investment is more likely to be considered a non-commercial transaction.

In relation to the ownership of shares in a company or other similar equity interests, there will be instances where the extent of the holding gives rise to questions as to whether the interests constitute a passive investment or a commercial investment. Generally, the holding of debt investments is likely to be considered a passive or non-commercial investment. However there may be circumstances where the circumstances indicate that the entity is engaged in the business of money lending.

In all circumstances, consideration will be given to factors relating to the influence or control potentially able to be exercised by the investor (or a related party/associate of the investor) in relation to the investment. This includes (but is not limited to) any potential influence or control in relation to day to day management and key business, strategy and financial decisions.

Govsub Co's holding of AusCo loan notes

Govsub Co owns loan notes issued by AusCo with a face value of $X.

The key terms of the loan notes are:

·         10 year term ending XX/XX/XXXX

·         Interest accrues daily at X% p.a. and capitalises annually, with enough paid to cover any interest withholding tax liability of the lender

·         AusCo may propose changes to the terms of the loan notes. Any changes to the terms of the loan note proposed by AusCo require at least X% of noteholders by face value to vote in favour of the change. Major changes to the terms of the issued loan notes require unanimous consent from the noteholders. The noteholders cannot of themselves change the terms of the loan note

·         Loan notes are subordinated to other debt issued by AusCo.

Govsub Co has no influence over AusCo as a result of being issued the loan notes. The powers of the loan note holders are limited to voting on changes to the terms of the notes, and enforcement action.

The issue of AusCo loan notes to Govsub Co is a legacy of its prior investment into the equity of AusCo. On selling its interest in AusCo, Govsub Co was provided the loan notes as consideration. Based on this background, it is unlikely that the holding of the loan notes, being the sole business activity and investment of Govsub Co, would mean that it is in the business of money lending. A better interpretation is that Govsub Co is in the business of investment, and specifically the holding of a single investment, being the loan notes.

As such, during this period Govsub Co did not hold a level of potential influence and control in relation to key business, strategy and financial decisions of AusCo.

In addition, when considered as a whole, the Government of Country A's investments into AusCo did not provide Country A with the ability to potentially influence, participate in, or control key business, strategic, and financial decisions of AusCo.

Based upon the above factors in relation to Govsub Co's investment, it is considered that these investments are of a non-commercial nature and condition 3 is satisfied with respect to sovereign immunity.

Conclusion

Govsub Co is immune from withholding tax on all income derived from its holding of the AusCo loan notes issued on XX/XX/XXXX from the date of issue to 30 June 20XX pursuant to the common law doctrine of sovereign immunity.

Question 2

Is the ordinary and statutory income derived by Govsub Co from the loan notes it holds that were issued by AusCo on XX/XX/XXXX not assessable and not exempt income under section 880-105 of the ITAA 1997 for the period from 1 July 20XX to 30 June 20XX?

Summary

All of the conditions listed in subsection 880-105(1) have been satisfied in relation to Govsub Co's investment in the AusCo loan notes. As such, section 880-105 will apply to the effect that amounts of ordinary and statutory income derived by Govsub Co from its investments in the AusCo loan notes are not assessable and not exempt income for the period from 1 July 20XX to 30 June 20XX.

Detailed reasoning

Section 880-105 provides that amounts of ordinary and statutory income derived by a sovereign entity are not assessable and not exempt income if certain conditions are met. Those conditions are listed in subsection 880-105(1):

(a) the sovereign entity is covered by section 880-125; and

(b) the amount is a return on any of the following kinds of interest that the sovereign entity holds in another entity (the test entity):

(i) a *membership interest;

(ii) a *debt interest;

(iii) a *non-share equity interest; and

(c) the test entity is:

(i) a company that is an Australian resident at the time (the income time) when the amount becomes ordinary or statutory income of the sovereign entity; or

(ii) a *managed investment trust in relation to the income year in which the income time occurs; and

(d) the *sovereign entity group of which the sovereign entity is a member satisfies the portfolio interest test in subsection (4) in relation to the test entity:

(i) at the income time; and

(ii) throughout any 12 month period that began no earlier than 24 months before that time and ended no later than that time; and

(e) the sovereign entity group of which the sovereign entity is a member does not have influence of a kind described in subsection (6) in relation to the test entity at the income time.

These conditions are considered below.

Govsub Co is a covered sovereign entity

Section 880-125 states:

A *sovereign entity is covered by this section if it satisfies all of the following requirements:

(a) the entity is funded solely by public monies;

(b) all returns on the entity's investments are public monies;

(c) the entity is not a partnership;

(d) the entity is not any of the following:

(i) a *public non-financial entity;

(ii) a *public financial entity (other than a public financial entity that only carries on central banking activities).

These conditions are considered below.

Govsub Co is a sovereign entity

For an entity to be covered by section 880-125, it must be a sovereign entity. Section 880-15 defines a sovereign entity to be any of the following:

(a) a body politic of a foreign country, or a part of a foreign country;

(b) a *foreign government agency;

(c) an entity:

(i) in which an entity covered by paragraph (a) or (b) holds a *total participation interest of 100%; and

(ii) that is not an Australian resident; and

(iii) that is not a resident trust estate for the purposes of Division 6 of Part III of the Income Tax Assessment Act 1936.

Section 960-180 provides that an entity's total participation interest in another entity is the sum of:

(a) the entity's direct participation interest in the other entity at that time; and

(b) the entity's indirect participation interest in the other entity at that time.

Country A's government is a foreign government and has incorporated a statutory body that wholly owns and holds the assets of Country A's government for the purposes of investment.

Through its 100% ownership of GovCo, which then wholly-owns Govsub Co, the government of Country A has a total participation interest of 100% in Govsub Co.

Govsub Co is not an Australian resident and is not a resident trust estate for the purposes of Division 6 of Part III of the Income Tax Assessment Act 1936.

As such, Govsub Co meets the requirements of being a sovereign entity in accordance with subsection 880-15(c) as it is an entity in which the government of Country A holds a total participation interest of 100%.

Govsub Co is funded solely by public monies

The phrase 'public monies' is not defined and as such takes its ordinary meaning. In the context of Division 880, this phrase essentially means monies raised by a foreign government (or part of a foreign government) for a public purpose which form part of the foreign government's (or part of the foreign government's) equivalent to Australia's Consolidated Revenue Fund (Roy Morgan Research Pty Ltd v FC of T & Anor [2011] HCA 35). This would ordinarily include general tax revenue, proceeds from the issue of government bonds, the proceeds of privatisations etc.

A statutory body created by the government of Country A holds and administers assets of the government of Country A. This body is entirely government funded. The statutory body in turn established and capitalised GovCo, which in turn capitalised and provided the funds to Govsub Co which have facilitated its ownership of the AusCo loan notes.

As such, Govsub Co is funded solely by public monies.

All returns on Govsub Co's investments are public monies

Although Govsub Co may retain its earnings, to the extent that it pays distributions these distributions are to its sole shareholder GovCo, which in turn reinvests the funds or pay distributions to the statutory body which holds and administers the government reserves on behalf of the government of Country A. The returns on these reserves are the property of Country A.

As such, all returns on Govsub Co's investments will ultimately be paid to the government of Country A, making them public monies.

Govsub Co is not a partnership

Govsub Co is a company incorporated in Country A.It is not a partnership under subsection 6(1) of the ITAA 1936. Govsub Co therefore satisfies this requirement.

Govsub Co is not a public non-financial entity or public financial entity

Subsection 880-130(1) defines the term public non-financial entity:

An entity is a public non-financial entity if its principal activity is either or both of the following:

(a) producing or trading non-financial goods;

(b) providing services that are not financial services.

Subsection 880-130(2) defines the term public financial entity:

An entity is a public financial entity if any of the following requirements are satisfied:

(a) it trades in financial assets and liabilities;

(b) it operates commercially in the financial markets;

(c) its principal activities include providing any of the following financial services:

(i) financial intermediary services, including deposit-taking and insurance services;

(ii) financial auxiliary services, including brokerage, foreign exchange and investment management services;

(iii) capital financial institution services, including financial services in relation to assets or liabilities that are not available on open financial markets.

It is noted that subparagraph 880-125(d)(ii) excludes public financial entities that only carry on central banking activities from being excluded as a covered sovereign entity.

Govsub Co is a special purpose vehicle whose sole business activity is the holding of the AusCo notes. It does not have any other investments. Govsub Co therefore does not produce or trade non-financial goods and does not provide services that are not financial services. Govsub Co does not actively trade in financial assets and liabilities, operate commercially in financial markets or provide services listed in paragraph 880-130(2)(c).

As such, Govsub Co does not meet either definition of being a public non-financial or financial entity, satisfying the condition in 880-125(d).

As Govsub Co satisfies each of the requirements in paragraphs 880-125(a) through (d) it is a sovereign entity that is covered by section 880-125 for the purposes of paragraph 880-105(1)(a).

Govsub Co's return is received on a relevant interest in the Test Entities

For an amount of ordinary income or statutory income of a sovereign entity to satisfy paragraph 880-105(1)(b), it must be a 'return on' a membership interest, debt interest or non-share equity interest held by the sovereign entity in the test entities.

AusCo, being the test entity, is a company which has issued loan notes, a debt interest, to investors including Govsub Co. Govsub Co receives interest income as a return on this debt interest.

As such, Govsub Co will receive amounts which satisfy the requirements of paragraph 880-105(1)(b).

Govsub Co's income is received from Australian resident companies or managed investment trusts

For an amount of ordinary income or statutory income of a sovereign entity to satisfy paragraph 880-105(1)(c), it must be received from an entity that is either:

(i) a company that is an Australian resident at the time (the income time) when the amount becomes ordinary or statutory income of the sovereign entity; or

(ii) a *managed investment trust in relation to the income year in which the income time occurs.

AusCo, as the issuer of the loan notes, pays interest to Govsub Co. AusCo is an Australian resident company.

As such, Govsub Co receives income from an entity which satisfies the requirements of paragraph 880-105(1)(c).

Govsub Co's sovereign entity group satisfies the portfolio interest test

For an amount of ordinary income or statutory income of a sovereign entity to satisfy paragraph 880-105(1)(d), the sovereign entity and the sovereign entity group to which it belongs must satisfy the portfolio interest test in relation to the test entity/ies at both the income time and throughout any 12 month period that began no earlier than 24 months before that time and ended no later than that time.

The portfolio interest test is outlined in subsection 880-105(4), which states:

A *sovereign entity group satisfies the portfolio interest test in this subsection in relation to the test entity at a time if, at that time, the sum of the *total participation interests that each *member of the group holds in the test entity:

(a) is less than 10%; and

(b) would be less than 10% if, in working out the *direct participation interest that any entity holds in a company:

(i) an *equity holder were treated as a shareholder; and

(ii) the total amount contributed to the company in respect of *non-share equity interests were included in the total paid-up share capital of the company.

Section 880-20 provides the definition of sovereign entity group. Broadly, sovereign entities of the same foreign government will be members of the same sovereign entity group and sovereign entities of the same part of a foreign government will be members of the same sovereign entity group.

Govsub Co holds no direct or indirect participation interests in AusCo. Cumulatively, members of GovsubCo's sovereign entity group have an indirect participation interest in AusCo of less than 10%. As such, GovsubCo's sovereign entity group satisfies paragraph 880-105(1)(d).

Govsub Co's sovereign entity group does not have influence of a kind described in subsection (6)

For an amount of ordinary income or statutory income of a sovereign entity to satisfy paragraph 880-105(1)(e), at the income time the sovereign entity group to which the sovereign entity belongs must not have influence over the test entity of a kind described in subsection 880-105(6).

Subsection 880-105(6) states:

A *sovereign entity group has influence of a kind described in this subsection in relation to the test entity at a time if any of the following requirements are satisfied at that time:

(a) a *member of the group:

(i) is directly or indirectly able to determine; or

(ii) in acting in concert with others, is directly or indirectly able to determine;

the identity of at least one of the persons who, individually or together with others, make (or might reasonably be expected to make) the decisions that comprise the control and direction of the test entity's operations;

(b) at least one of those persons is accustomed or obliged to act, or might reasonably be expected to act, in accordance with the directions, instructions or wishes of a member of the group (whether those directions, instructions or wishes are expressed directly or indirectly, or through the member acting in concert with others).

As such, there are two distinct sub-tests within the influence test.

Sub-test 1 of the influence test, as contained in paragraph 880-105(6)(a), assesses whether the sovereign entity group is able to determine the identity of at least one of the persons who, individually or together with others, makes or is reasonably expected to make, decisions comprising the control and direction of the test entity's operations. This includes situations where the sovereign entity group is able to act in concert with others to determine the identity of a relevant decision-maker in the test entity.

Sub-test 1 also extends to situations where the sovereign entity group, in its own right, holds the ability to approve or veto decisions which go to the control or direction of the test entity.

Sub-test 2 of the influence test, as contained in paragraph 880-105(6)(b), assesses whether at least one of the relevant decision-making persons of the test entity is accustomed or obliged to act, or might reasonably be expected to act, in accordance with the directions, instructions or wishes of the sovereign entity group.

The holding of X% of the AusCo loan notes on issue do not give Govsub Co, directly or indirectly, or acting in concert with others, any ability to appoint, control or influence any person that has the ability to participate in or influence decisions that comprise the control and direction of AusCo. There are no rights to appoint AusCo's directors, or management, or any other person in a decision making capability within AusCo attached to the loan notes held by Govsub Co. Additionally the loan notes issued to Govsub Co do not give it any voting rights similar to those that are held by the equity shareholders of Govsub Co. Govsub Co has no ability to influence or otherwise participate in AusCo decision-making, or the appointment of persons that do have this capability.

No relevant decision making person in AusCo is accustomed or obliged to act, or might reasonably be expected to act, in accordance with the directions, instructions or wishes of Govsub Co or any other entity within its sovereign entity group.

In addition, Govsub Co's sovereign entity group, through its indirect participation interests in AusCo, do not have any ability to appoint, control or influence any person that has the ability to participate in or influence decisions that comprise the control and direction of AusCo.

Based upon the above, the sovereign entity group of Govsub Co does not have influence of a kind described in subsection 880-105(6) and will, therefore, satisfy the requirements of paragraph 880-105(1)(f).

Conclusion

As all of the conditions listed in subsection 880-105(1) have been satisfied, section 880-105 will apply to the effect that amounts of interest income derived by Govsub Co from its investments in the AusCo loan notes issued on XX/XX/XXXX are not assessable and not exempt income for the period from 1 July 20XX to 30 June 20XX.

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