Edited version of private advice

Authorisation Number: 1051804079011

Date of advice: 15 February 2021

Ruling

Subject: International issues - Sovereign immunity

Question 1

Is the ordinary and statutory income derived by the Foreign Entity from its investment in shares in the Test Entity not assessable income and not exempt income under section 880-105 of the ITAA 1997?

Answer

No.

Question 2

Is any loss incurred by the Foreign Entity in respect of interests in the Test Entity not deductible under section 880-110 of the ITAA 1997?

Answer

No.

Question 3

Is any capital gain or loss made by the Foreign Entity with respect to its investments in the Test Entity disregarded under sections 880-115 and 880-120 of the ITAA 1997?

Answer

No.

This ruling applies for the following periods

1 July XXXX to 30 June XXXX

The scheme commences on

1 July XXXX

Relevant facts and circumstances

The Foreign Entity

1.    The Foreign Entity is a statutory body of the Foreign Government, established and governed by a set of rules (the Rules).

2.    The Foreign Entity develops and implements a public housing programme which seeks to achieve the Foreign Government's policy objective to meet the housing needs of low-income families which cannot afford private accommodation.

3.    The equity of the Foreign Entity is solely contributed by the government of the Foreign Government.

4.    The Foreign Entity's Financial Statements are consolidated to the Financial Statements of the Foreign Government.

5.    The Foreign Entity's principal activity is to plan, build, manage and maintain different types of public housing services, including rental housing, interim housing and transit centres.

6.    In addition to its principal activities, the Foreign Entity also provides services along with the development of public housing, including operating a rent assistance scheme and providing non-domestic facilities within public housing estates such as welfare and community facilities, retail facilities and parking spaces.

7.    The Foreign Entity appoints several fund managers to acquire investments in Australia on their behalf.

8.    Through their fund manager, the Foreign Entity holds shares in the Test Entity.

9.    Under the Rules, the Foreign Entity is effectively under the management and control of the Foreign Government.

The Foreign Entity's Investments in Australia

10.  The aim of the Foreign Entity's investment strategy and guidelines is to ensure there is sufficient liquidity to meet the operational needs of the Foreign Entity, and to put the rest of the Foreign Entity funds into longer term investments in a prudent and diversified manner to enhance long term returns.

11.  The Foreign Entity's Investments in Australia are managed by fund managers that are appointed by the Foreign Entity. The fund managers have the discretion to purchase and sell investments in accordance with the investment guidelines, while the Foreign Entity has the discretion to inject or withdraw the Foreign Entity's funds from the fund managers.

12.  There is no indication that the funds invested in Australia by the Foreign Entity or the income from the investments in Australia is able to be applied for the benefit of any entity other than the Foreign Entity.

13.  The investments in Australia by the Foreign Entity's fund managers on behalf of the Foreign Entity are part of the Foreign Entity's diversified global portfolio for longer term investment.

14.  The Foreign Entity expects to derive interest income and dividend income from its investments in Australia. The Foreign Entity may also make capital gains or capital losses from the investments.

15.  The current investment the Foreign Entity holds in Australia are shares in the Test Entity.

The Foreign Entity's investment in the Test Entity

16.  As at 31 December 2020, the Foreign Entity owns approximately 0.08% of the shares in the Test Entity.

17.  The Foreign Entity expects to derive dividend income from its shares in the Test Entity. The Foreign Entity may also make capital gains or capital losses from this investment.

18.  Dividends received by the Foreign Entity in respect to its investment in the Test Entity are currently fully franked.

19.  The Foreign Entity will form part of a sovereign entity group including the Foreign Government and any entities in which the Foreign Government either directly or indirectly holds 100% of the participation interests.

20.  To the best of the Foreign Entity's knowledge, there is no indication that the foreign Entity and all members of its sovereign entity group hold collectively 10% or more of the total participation interest in the Test Entity with reference to the current investment guidelines that the maximum investment exposure to the shares of any one company generally shall not exceed 0.5% of the market capitalisation of the stock.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 880-105

Income Tax Assessment Act 1997 section 880-110

Income Tax Assessment Act 1997 section 880-115

Income Tax Assessment Act 1997 section 880-120

Reasons for decision

All legislative references are to the ITAA 1997 unless otherwise specified.

Question 1

Is the ordinary and statutory income derived by the Foreign Entity from the Test Entity not assessable income and not exempt income under section 880-105 of the ITAA 1997 for the period 1 July XXXX to 30 June XXXX?

Summary

All of the conditions listed in subsection 880-105(1) have not been satisfied in relation to the Foreign Entity's investments in the Test Entity. Therefore, section 880-105 will not apply.

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.

The Foreign Entity 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.

The Foreign Entity 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.

A 'foreign government agency' is defined in subsection 995-1(1) of the ITAA 1997 as:

(a) the government of a foreign country or of part of a foreign country; or

(b) an authority of the government of a foreign country; or

(c) an authority of the government of part of a foreign country.

The Foreign Entity was established under the Rules and fulfils the purpose of developing and implementing the policy objectives of the Foreign Government in relation to meeting the housing needs of low income-families which cannot afford private accommodation.

The ability provided by the Rules for the Foreign Government to direct how the Foreign Entity conducts its activities, either wholly, or in part, indicates the degree to which the Foreign Entity is required to operate solely to achieve its designated purpose of managing the Foreign Government's satisfaction of the housing needs of low income families. Effectively, the Foreign Government can control the operation of the Foreign Entity at all times.

The granting of power to act as an agent for the Foreign Government in certain circumstances under the Rules adds weight to the argument that the operations of the Foreign Entity are directed towards achieving some purpose set out by the Foreign Government.

As such, the Foreign Entity meets the requirements of being a sovereign entity in accordance with section 880-15 as it is a foreign government agency as defined in subsection 995-1(1).

The Foreign Entity 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.

The equity of the Foreign Entity is solely contributed by the Foreign Government.

As such, the Foreign Entity is funded solely by public monies.

All returns on the Foreign Entity's investments are public monies

There is no indication that the funds invested in Australia by the Foreign Entity or the income from the investments in those funds in Australia is able to be applied for the benefit of any entity other than the Foreign Entity. As such, the monies that are the subject of the scheme will remain monies of the Foreign Entity.

Therefore, all returns on the Foreign Entity's investments are public monies.

The Foreign Entity is not a partnership

The Foreign Entity is a statutory body established under the Rules and is not a partnership. As such, it passes this condition.

The Foreign Entity is not a public non-financial entity or public financial entity

Public financial entity

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.

The Foreign Entity does not actively trade in financial assets and liabilities, operate commercially in financial markets or provide services listed in paragraph 880-130(2)(c).

Therefore, the Foreign Entity is not a public financial entity.

Public non-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.

The term 'principal' is not defined and, as such, takes its ordinary meaning having regard to the purpose and context to which it appears. The Macquarie Dictionary defines 'principal' as '1. First or highest in rank, importance, value, etc.; chief; foremost...'.

Law Companion Ruling LCR 2020/3 - The superannuation fund for foreign residents withholding tax exemption and sovereign immunity (LCR 2020/3)addresses the term 'principal activity' and states at paragraph 75 that 'the principal activity of an entity, for the purposes of subsection 880-130(1), is therefore its chief or foremost activity'.

The terms 'non-financial goods' and 'services that are not financial services' in subsection 880-130(1) are also not defined, so should be given their ordinary meaning having regard to their context and purpose.

Subsection 880-130(2) provides a definition for a 'public financial entity' and identifies 'financial services' to include the following:

(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.

The Macquarie Dictionary defines 'service' as '1. an act of helpful activity;...3. the providing of, or a provider of, a public need, such as communications, transport, etc.'; further it defines the verbs 'serviced' and 'servicing' as '31. ...to provide housing, amenities, etc.'.

The Explanatory Memorandum to the Making Sure Foreign Investors Pay Their Fair Share of Tax in Australia and Other Measures) Act 2019 ('the EM') provides the following:

4.27 Public non-financial entities include entities such as airline corporations, postal authorities, state water corporations and port authorities. They also include public non-profit institutions engaging in market production (such as hospitals, schools, or colleges) if they are separate institutional units and charge economically significant prices.

The EM indicates that 'public non-financial entities' include public non-profit institutions engaging in market production if they are separate institutional units and charge economically significant prices. Subsection 880-130 does not however, import the notion of charging economically significant prices, nor does it distinguish between non-profit institutions and institutions that operate for profit. This is consistent with LCR 2020/3 which outlines examples of public non-financial entities without differentiating between profit and non-profit institutions, nor indicating that economically significant prices need to be charged. The examples are outlined at paragraph 76 as follows:

Whether an entity is producing or trading non-financial goods and/or providing services that are not financial services is a question of fact. Common examples of public non-financial entities include:

•   airline corporations

•   postal authorities

•   state water corporations

•   port authorities

•   hospitals

•   schools

•   colleges

•   state electricity corporations, and

•   state mining corporation

Therefore, the relevant enquiry is whether the entity is producing or trading non-financial goods and/or providing services that are not financial services as their chief or foremost activity.

The Foreign Entity is a statutory body established under the Rules. It develops and implements a public housing programme which seeks to achieve the Foreign Government's policy objective to meet the housing needs of low-income families which cannot afford private accommodation.

Although the Foreign Entity performs a range of activities, including the construction and development of shopping centres and administering a rental assistance scheme, its principal activity is to plan, build, manage and maintain different types of public housing services.

Based on the relevant facts, it is reasonable to conclude that the Foreign Entity is providing services that are not financial services. As such, the Foreign Entity is a public non-financial entity for the purposes of the condition outlined at paragraph 880-125(d).

As the Foreign Entity does not satisfy each of the requirements in paragraphs 880-125(a) through (d) it is not considered a sovereign entity that is covered by section 880-125 for the purposes of paragraph 880-105(1)(a).

The Foreign Entity's return is received on a relevant interest in the Test Entity

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.

As detailed in paragraph 4.37 of the EM a 'return on' a membership interest for the purposes of paragraph 880-105(1)(b) will include:

1. dividends - including non-share dividends and dividends that pass through a managed investment trust (MIT)
2. interest - including interest that passes through a MIT
3. fund payments made by a MIT (other than fund payments that are attributable to non-concessional MIT income), and
4. revenue gains made on the disposal of an interest in the test entity - including revenue gains that pass through a MIT.

The Test Entity is a company in which the Foreign Entity holds shares (which meet the requirements of being membership interests as defined by the interaction of sections 960-135 and 960-130) and pay to the Foreign Entity fully franked dividends.

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

The Foreign Entity's income is received from an Australian resident company or managed investment trust

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.

The Test Entity is a company that is an Australian resident. It is expected that the Test Entity will continue to be an Australian resident at the time the ordinary and statutory income is derived by the Foreign Entity.

As such, the Foreign Entity's income is received from an entity which satisfies the requirements of paragraph 880-105(1)(c).

The Foreign Entity'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.

The Foreign Entity will form part of a sovereign entity group including the Foreign Government and any entities in which the Foreign Government either directly or indirectly holds 100% of the participation interests. To the best of the Foreign Entity's knowledge, the Foreign Entity and all members of its sovereign entity group hold collectively less than 10% of the total participation interest in the Test Entity.

As such, the Foreign Entity's interest in the Test Entity satisfies the requirements of paragraph 880-105(d).

The Foreign Entity's sovereign entity group does not have influence of a kind described in subsection (6) in relation to the Test Entity at the income time

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.

As no other members of the Foreign Entity's sovereign entity group (including any entity directly or indirectly owned by the Foreign Government) hold interests in the Test Entity the influence considerations are limited to the influence held by the Foreign Entity.

The Foreign Entity's approximate 0.08% interest in the Test Entity does not provide it with an entitlement to either directly or indirectly determine the identity of any person who make decisions that compromise the control and direction of the Test Entities operations.

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.

No person involved in the control and direction of the Test Entities operations is accustomed or obliged to act in accordance with the directions, instructions or wishes of the Foreign Entity.

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

Conclusion

As all of the conditions listed in subsection 880-105(1) have not been satisfied, section 880-105 will not apply.

Question 2

Is any loss incurred by the Foreign Entity in respect of interests in the Test Entity not deductible under section 880-110 of the ITAA 1997?

Detailed Reasoning

Section 880-110 provides that a sovereign entity cannot deduct an amount if:

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

(b) the amount is a loss in respect of any of the following kinds of interest that the sovereign entity holds in another entity:

(i) a membership interest;

...

(c) the requirements in paragraphs 880-105(1)(c), (d) and (e) would be satisfied, on the assumptions that:

(i) the amount were ordinary income or statutory income; and

(ii) the amount became ordinary income or statutory income of the sovereign entity at the time it arose; and

(iii) references in those paragraphs to the test entity were references to the other entity mentioned in paragraph (b) of this section.

As established in Question 1, the Foreign Entity is not a sovereign entity covered by section 880-125, and therefore does not meet the requirements of section 880-110.

As such, the Foreign Entity can deduct an amount if it is a loss in respect of its ownership interests in the Test Entity.

Question 3

Is any capital gain or loss made by the Foreign Entity with respect to its investments in the Test Entity disregarded under sections 880-115 and 880-120 of the ITAA 1997?

Detailed Reasoning

Section 880-115 provides that a sovereign entity disregards a capital gain from a CGT event that happens in relation to a CGT asset if:

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

(b) the CGT asset is a membership interest, non-share equity interest or debt interest in another entity; and

(c) the requirements in paragraphs 880-105(1)(c), (d) and (e) would be satisfied, on the assumptions that:

(i) the capital gain were an amount of ordinary income or statutory income; and

(ii) the amount mentioned in subparagraph (i) became ordinary income or statutory income of the sovereign entity immediately before the time the CGT event happened; and

(iii) references in those paragraphs to the test entity were references to the other entity mentioned in paragraph (b) of this section.

Section 880-120 provides that a sovereign entity disregards a capital loss from a CGT event if, on the assumption that the loss were a capital gain, the capital gain would be disregarded because of section 880-115.

As established in Question 1, the Foreign Entity is not a sovereign entity covered by section 880-125, and therefore does not meet the requirements of section 880-115.

As such, the Foreign Entity will not be required to disregard any capital gain or loss made in respect of its ownership interests in the Test Entity.

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