Edited version of private advice

Authorisation Number: 1052075987892

Date of advice: 22 February 2023

Ruling

Subject: Withholding tax exemption - Article 11(3)(b) of the Relevant Convention

Question 1

Will Article 11(3)(b) of the Country A Treaty, prevent taxation in Australia on the interest income paid by Aus Co 1 and Aus Co 2 (collectively known as Aus Co) to Fin Co, a fiscally transparent entity for the purpose of the laws of Country A which is wholly owned by Ultimate Hold Co, under the Syndicated Facility Agreement (SFA) that Fin Co has entered into with Aus Co?

Answer

Yes.

This ruling applies for the following period:

1 July 20XX to 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances Ultimate Hold Co

1.             Ultimate Hold Co is a foreign corporation incorporated and headquartered in Country A that is a resident for Country A taxation purposes.

2.             Ultimate Hold Co has its Common Stock listed and traded on a Country A stock exchange. Ultimate Hold Co only has Common Stock on issue. Ultimate Hold Co is very widely held, with no shareholder holding more than X% of the shares on issue.

3.             Ultimate Hold Co engages in the provision of real estate debt finance by originating, acquiring, financing and managing of commercial mortgage loans and other commercial real estate debt investments.

4.             Ultimate Hold Co is governed by the Ultimate Hold Co Constitution (UHC Constitution).

5.             UHC Constitution states the holders of the Common Stock are entitled to receive dividends when, as, and if authorised by the Board and declared by the Board out of assets legally available for the payment of dividends.

6.             Any distribution of dividends by Ultimate Hold Co is ultimately at the discretion of the Board provided it is in the best interests of Ultimate Hold Co. All distributions are made at the discretion of the Board and depend on a range of factors, including Ultimate Hold Co's taxable income, financial conditions, applicable laws and other factors the Board deems relevant. Ultimate Hold Co is not taxed on its net income to the extent it distributes such income as a dividend to shareholders and intends to pay out its net income as dividends as far as possible.

7.             Ultimate Hold Co is a holding company conducting the majority of its borrowing and lending activities via its wholly owned subsidiaries that are fiscally transparent for Country A income tax purposes. For Country A accounting and tax purposes, the results and operations of the subsidiaries are included with Ultimate Hold Co's accounting and tax information, with tax returns filed and tax (if any) paid by Ultimate Hold Co.

8.             Under Country A tax law, the subsidiaries are treated as domestic branches of Ultimate Hold Co and the activities of the subsidiaries are treated as those of Ultimate Hold Co.

9.             The use of subsidiaries is to quarantine the risk of each loan portfolio and to quarantine the external indebtedness on a portfolio-by-portfolio basis. In addition, the subsidiaries are used by Ultimate Hold Co to 'silo' foreign currencies to allow for foreign currency hedging. Notwithstanding the use of subsidiaries to hold the assets, Ultimate Hold Co and its subsidiaries operate together as a single enterprise engaging in the provision of real estate debt finance.

10.         Ultimate Hold Co is not registered or regulated as an authorised deposit taking institution in Australia.

11.         Ultimate Hold Co is not a bank under the laws of Country A.

Ultimate Hold Co's Spread Activities

12.         Ultimate Hold Co does not (directly or indirectly) own equity in any real estate assets and only makes loans through its subsidiaries. Ultimate Hold Co both directly and indirectly raises debt to finance the operations of its subsidiaries that have made investments in mortgage-backed securities, mortgages and other loans.

13.         Ultimate Hold Co sources finance from the financial market in a variety of ways, including the issuing of equity, notes, convertible notes, secured debt agreements, credit facilities, syndications, and term loans. Ultimate Hold Co also engages in securitisation transactions and asset specific financings to assist it to raise finance for its operations.

14.         Ultimate Hold Co, via its subsidiaries, provides debt finance to entities secured against commercial real estate assets. These investments may be in the form of whole loans, pari passu participations within mortgage loans, or other similar structures. Ultimate Hold Co provides finance on a recurring and regular basis.

15.         Ultimate Hold Co recognises interest income from its loan receivables portfolio and debt securities over the life of each investment using the effective interest method and records it on an accrual basis, which includes the income from loans issued by its subsidiaries.

16.         The vast majority of Ultimate Hold Co's gross and net income is derived from its spread activities. It consists of primarily interest income.

17.         Ultimate Hold Co does not have a permanent establishment in Australia.

Hold Co

Hold Co is a wholly owned subsidiary of Ultimate Hold Co. It is fiscally transparent for Country A tax purposes and it has other subsidiaries which are also fiscally transparent in Country A. It is currently a holding company for subsidiaries which issue finance in Australian dollars. This enables Hold Co to maintain a currency hedge as Hold Co only holds exposure to a single currency.

18.         The predominant activity of each subsidiary held by Hold Co is to originate loans with borrowers. Each subsidiary is funded with a mix of unrelated third party credit from the debt markets and funds from Ultimate Hold Co. In the case of Fin Co specifically, 100% is provided by Ultimate Hold Co.

19.         Hold Co is governed by the Hold Co Constitution. The relevant clauses of the constitution are as follows:

a.         Hold Co is wholly owned by Ultimate Hold Co.

b.         Ultimate Hold Co, , has the power to do any and all acts necessary or convenient to or for the furtherance of the purpose of the Hold Co Constitution.

c.          Ultimate Hold Co is required to provide sufficient cash and property to enable Hold Co to carry on its business.

d.         At any time Ultimate Hold Co may decide to wind up the affairs of Hold Co and dissolve the company.

e.         All items of income, gain, loss, deductions, and credit for tax purposes is allocated to each member of Hold Co pro rata in accordance with the members percentage interest in Hold Co.

f.           Distributions are made by Hold Co to members at times and in the aggregate amounts agreed upon by the members. As Ultimate Hold Co is the sole member of Hold Co, it has sole and complete discretion as to the quantity and timing of distributions.

Fin Co

20.         Fin Co was incorporated by Ultimate Hold Co and is wholly owned by Hold Co.

21.         Fin Co is the lender in the Syndicated Facility Agreement (SFA) subject to this Ruling.

22.         Fin Co is fiscally transparent for Country A income tax purposes

23.         Fin Co is governed by the Fin Co Constitution. The relevant clauses of the constitution are as follows:

a.         Fin Co is wholly owned by Hold Co

b.         Hold Co has the power to do any and all acts necessary or convenient to or for the furtherance of the purposes of the company.

c.          All items of income, gain, loss, deductions and credit shall be allocated to each member in accordance with their percentage.

d.         Distributions are made to members at the times and in the aggregate amounts agreed by the members. Fin Co is wholly owned by Hold Co, it has sole and complete discretion as to the quantity and timing of distributions. This means that Ultimate Hold Co, ultimately has sole and complete discretion as to the quantity and timing of distributions made by Fin Co as Hold Co is wholly owned by Ultimate Hold Co.

24.         Fin Co makes loans to unrelated Australian resident borrowers.

25.         Fin Co is financed from debt issued by Ultimate Hold Co and other Ultimate Hold Co subsidiaries. Fin Co has not raised any finance directly.

26.         Fin Co has no employees and is managed by the officers of Ultimate Hold Co . All of Fin Co's activities, such as loan origination and monitoring of loans are undertaken by Ultimate Hold Co.

27.         Fin Co intends to, and will be, carrying on a business of providing AUD denominated finance to third parties.

28.         Other than assisting Ultimate Hold Co to manage its portfolio risks, the creation of Fin Co will also help Ultimate Hold Co manage currency risk from a commercial and financial reporting perspective.

29.         All of the income derived by Fin Co will be income derived from its loans and will consist of interest income and fees associated with lending, such as origination and service fees. Fin Co will not undertake any other business or make any other types of investments that will cause it to derive income from anything other than loans.

30.         Fin Co's dominant source of income is from interest and related income.

31.         Fin Co does not have a permanent establishment in Australia.

The SFA

32.         Fin Co has entered into the SFA with Aus Co.

33.         Fin Co is the lender under the SFA. Fin Co, under the SFA, receives Australian sourced interest income paid to it by Aus Co. In addition, Fin Co receives fee income in the form of commitment fees, arrangement fees and facility fees. Over the term of the SFA, Fin Co will be substantially engaged in earning interest income from the provision of finance.

34.         For the purposes of Country A taxation, the tax rules will apply such that the interest income paid under the SFA to Fin Co will be reflected in Ultimate Hold Co's tax return, and the tax liabilities will be treated as arising to Ultimate Hold Co. Furthermore, the activities of Fin Co are treated in the same manner as a branch or division of Ultimate Hold Co.

Other Relevant Facts

35.         Neither of the Aus Co entities, nor their ultimate owners, are associates (as defined in section 318 of the ITAA 1936) of Ultimate Hold Co or any member of Ultimate Hold Co's corporate group.

36.         The loan entered into by Fin Co is not a back-to-back loan for the purpose of the relevant provision of the Country A Treaty.

37.         Neither Ultimate Hold Co nor its wholly owned subsidiaries operate a permanent establishment in Australia in which the interest from the loan from Fin Co to Aus Co arises for the purpose of the relevant provision of the Country A Treaty.

Assumptions

1.             Fin Co will continue to carry on a business of providing finance by engaging in lending activity and will continue to earn predominantly interest income from these activities.

2.             Throughout the period to which this ruling relates, Fin Co and Hold Co will continue to be fiscally transparent for Country A tax purposes.

3.             Throughout the period to which this ruling applies, Ultimate Hold Co continues to predominantly be in the business of providing real estate debt finance.

Relevant legislative provisions

Section 128B of the Income Tax Assessment Act 1936

Section 6-5(3) of the Income Tax Assessment Act 1997

Section 4(1) International Tax Agreements Act 1953

Subsection 4(2) International Tax Agreements Act 1953

Article 11 of the Relevant Convention

Reasons for decision Issue

Question 1

Will Article 11(3)(b) of the Country A Treaty prevent taxation in Australia on the interest income paid by Aus Co to Fin Co, a fiscally transparent entity for the purpose of Country A's tax law which is wholly owned by Ultimate Hold Co, under the SFA that Fin Co has entered into with Aus Co?

Summary

For the purposes of the Country A Treaty, interest income that is paid to Fin Co by Aus Co under the SFA and included as income of Ultimate Hold Co for Country A tax purposes may not be taxed in Australia under Article 11(3)(b) of the Country A Treaty.

Detailed reasoning

Subsection 6-5(3) of the Income Tax Assessment Act 1997 (ITAA 1997) provides that the assessable income of a non-resident taxpayer includes ordinary income derived directly or indirectly from all Australian sources during the income year.

Additionally, under Australian domestic tax law, income that consists of interest is subject to withholding tax where it is paid by a resident to a non-resident, except where it is wholly incurred by the payer in carrying on business outside Australia at or through a permanent establishment (subsection 128B(2) of the Income Tax Assessment Act 1936 (ITAA 1936)). Under subsection 128A(2) of the ITAA 1936, amounts are deemed to be paid if they have been reinvested, accumulated, capitalised or otherwise dealt with on behalf of the other person or as the other person directs.

When determining whether Australia has a taxing right in respect of income derived in or sourced from Australia by a foreign resident, consideration must also be made to the International Tax Agreements Act 1953 (Agreements Act).

Subsection 4(1) of the Agreements Act incorporates the ITAA 1936 and ITAA 1997 so that those Acts are read as one with the Agreements Act. Subsection 4(2) of the Agreements Act effectively overrides the ITAA 1936 and ITAA 1997 where there are inconsistent provisions (except for some limited situations).

Under Article 11(1) of the Country A Treaty, interest arising in one of the contracting states (Australia in this case) which is beneficially received by a resident of the other contracting state (Country A) may be taxed in that other State (Country A). Under Article 11(2), the interest may also be taxable in Australia, the State in which the interest arises, at a rate not exceeding 10 per cent.

Under the SFA, Fin Co, a non-resident, has made available to Aus Co the amount of AUD $X million. Aus Co is an Australian resident. As such, interest that is paid or deemed to be paid (by capitalisation or otherwise) from Aus Co to Fin Co would prima facie be included in the assessable income of the foreign resident under subsection 6-5(3) of the ITAA 1997 and subject to withholding tax under subsection 128B(2) of the ITAA 1936.

However, Article 11(3) of the Country A Treaty 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.

Therefore, the interest paid by Aus Co to Fin Co under the SFA will not be subject to taxation in Australia in accordance with Article 11(3) of the Country A Treaty if it is established that the interest income was derived by an entity entitled to the benefit of the Country A Treaty that is the beneficial owner of the interest payments and is a 'financial institution' as defined in paragraph Article 11(3)(b).

Resident of Country A

Article 1(1) of the Country A Treaty states:

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

Ultimate Hold Co is a corporation that is a resident of Country A for the purposes of the Country A Treaty. Hold Co is wholly owned by Ultimate Hold Co. In turn, Fin Co is wholly owned by Hold Co.

Fin Co and Hold Co are subsidiaries with a single owner incorporated under Country A law. Fin Co and Hold Co are treated as fiscally transparent entities for Country A income tax purposes. Because they are not themselves subject to taxation in Country A, they are not residents of a contracting state for the purposes of the Country A Treaty.

As Ultimate Hold Co is a Country A corporation which is regarded, it is a resident of Country A under the Country A Treaty. As such, it is entitled to the benefit of the application of the Country A Treaty where those benefits arise in Ultimate Hold Co's circumstances. As neither Fin Co nor Hold Co are entitled to the benefit of the application of the Country A Treaty, with respect to income derived by Fin Co it is only Ultimate Hold Co that may benefit from the application of the Country A Treaty, subject to Ultimate Hold Co satisfying the other applicable requirements in the relevant Articles of the Country A Treaty.

Interest paid to Fin Co is 'derived' by Ultimate Hold Co

In order to be subject to the exemption under Article 11(3) of the Country A Treaty, the relevant interest income must be derived by the relevant treaty resident, in this case being Ultimate Hold Co. The Country A Treaty does not define the term 'derived' and therefore the term has the meaning under domestic law of the Contracting State applying the Convention (in this case, Australia) unless the context otherwise requires: per Article 3(2).

Under Australian domestic tax law, Fin Co, as the non-resident company party to the SFA that is paid the relevant interest, would be considered to be deriving the relevant interest income from Aus Co. As previously noted, however, neither Fin Co nor Hold Co are residents of Country A for the purposes of the Country A Treaty.

The exemption in Article 11(3)(b) concerns "a resident of the other Contracting State" that is beneficially entitled to the interest. The text, context, and purpose of the Country A Treaty indicate Article 11(3)(b) is to be interpreted in a manner that accommodates differences in treatment between the contracting states as to tax residency. That is, Article 11(3)(b) is to be interpreted within the context of Articles 1, 3 and 4, the identified Country A resident the subject of the benefit of Article 11(3)(b), and Country A domestic tax law.

In ATO Interpretative Decision ATO ID 2013/58 Interest withholding tax: Australian interest income paid to a single owner United States limited liability company disregarded as an entity separate from its owner, when considering whether the exemption from interest withholding tax was available to a single owner disregarded LLC that was a financial institution under the US Convention, the Commissioner stated the following with respect to differing tax treatment of single owner LLCs in Australia and the United States:

In dealing with the inherent problem associated with the differing treatment of partnerships in different countries, paragraph 6.3 of the 2010 OECD Commentary on Article 1 of the OECD Model Tax Convention states the following principle:

"...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."

This comment relates to partnerships. However, the principle is also applicable to United States LLCs which, under Australian tax law, are taxed like companies while the United States of America, for United States tax law purposes, disregards the LLC and instead treats the income of the LLC as the income of the owner and imposes tax on the owner accordingly.

Thus in applying the US Convention, Australia should take into account the US treatment of the interest paid to the LLC. Where it is necessary to do so in order to give effect to the object and purpose of a treaty, Australia may give due recognition to the fact that under US tax law, the activities and income of the LLC are treated as the activities and income of the US resident owner.

Thus, when interpreting the meaning of derived under the Country A Treaty, the text, context and purpose indicate due regard should be given to the Country A tax treatment, including how it identifies the relevant tax treaty resident, the fact that Country A for tax purposes treats the activities of Fin Co, including the entering into of the SFA, as having been done by Ultimate Hold Co for tax purposes, and treats the interest paid to Fin Co ultimately as interest paid to Ultimate Hold Co, on the basis that Fin Co is treated as a branch or division of Ultimate Hold Co.

With respect to this transaction, payments of interest made by Aus Co, an Australian resident, will be made to Fin Co. Under both Country A taxation law and the respective clauses of the Fin Co Constitution, Fin Co is intended to be and is a fiscally transparent entity, allocates all income and expenses to Hold Co , and distributes funds at the sole discretion of Hold Co. Similarly, under Country A taxation law and the Hold Co Constitution, Hold Co is intended to be and is a fiscally transparent entity, allocates all income and expenses to Ultimate Hold Co, and distributes funds to and at the sole discretion of Ultimate Hold Co. This process of allocating all income and expenses of Hold Co to Ultimate Hold Co necessarily includes allocating all income and expenses of Fin Co to Ultimate Hold Co.

When considering these broader circumstances of Ultimate Hold Co, Hold Co and Fin Co as well as the OECD Commentary and the Commissioner's approach in ATOID 2013/58, it is accepted that for the purposes of the Country A Treaty, Ultimate Hold Co is treated as having derived the relevant interest income for the purposes of applying Article 11(3)(b) of the Country A Treaty.

Beneficial entitlement

Article 11(3) of the Country A Treaty only applies to effectively exempt a resident of a Contracting State from tax in respect of interest income arising in the other Contracting State if the resident is beneficially entitled to the interest income and satisfies Article 11(3)(a) or (b).

The concept of beneficial ownership in Article 11 of the Country A Treaty is based on the Model Tax Convention of the OECD. The 2017 OECD Commentary on the Model Tax Convention states:

10.1      It would be equally inconsistent with the object and purpose of the Convention for the State of source to grant relief or exemption where a resident of a Contracting State, otherwise than through an agency or nominee relationship, simply acts as a conduit for another person who in fact receives the benefit of the income concerned. For these reasons, the report from the Committee on Fiscal Affairs entitled "Double Taxation Conventions and the Use of Conduit Companies" concludes that a conduit company cannot normally be regarded as the beneficial owner if, though the formal owner, it has, as a practical matter, very narrow powers which render it, in relation to the income concerned, a mere fiduciary or administrator acting on account of the interested parties.

10.2      In these various examples (agent, nominee, conduit company acting as a fiduciary or administrator), the direct recipient of the interest is not the "beneficial owner" because that recipient's right to use and enjoy the interest is constrained by a contractual or legal obligation to pass on the payment received to another person. Such an obligation will normally derive from relevant legal documents but may also be found to exist on the basis of facts and circumstances showing that, in substance, the recipient clearly does not have the right to use and enjoy the interest unconstrained by a contractual or legal obligation to pass on the payment received to another person. This type of obligation would not include contractual or legal obligations that are not dependent on the receipt of the payment by the direct recipient such as an obligation that is not dependent on the receipt of the payment and which the direct recipient has as a debtor or as a party to financial transactions, or typical distribution obligations of pension schemes and of collective investment vehicles entitled to treaty benefits under the principles of paragraphs 22 to 48 of the Commentary on Article 1. Where the recipient of interest does have the right to use and enjoy the interest unconstrained by a contractual or legal obligation to pass on the payment received to another person, the recipient is the "beneficial owner" of that interest. It should also be noted that Article 11 refers to the beneficial owner of interest as opposed to the owner of the debt-claim with respect to which the interest is paid, which may be different in some cases.

Accordingly, it is necessary to consider not only the contractual or legal obligations on the recipient to pass on the interest payment to another person, but whether the facts and circumstances show that, 'in substance, the recipient clearly does not have the right to use and enjoy the interest unconstrained by a contractual or legal obligation to pass on the payment received to another person'.

Are Fin Co or Hold Co 'beneficially entitled' to the interest?

Fin Co and Hold Co are wholly owned subsidiaries of Ultimate Hold Co and are fiscally transparent entities for Country A tax purposes. Fin Co has entered into the SFA with Aus Co from which it is paid interest income. Under clause 11 of both the Fin Co Constitution and the Hold Co Constitution, Fin Co and Hold Co each allocates their income and expenses pro-rata to their membership. This means that all income and expenses are allocated to Ultimate Hold Co.

Additionally, under both the Fin Co Constitution and the Hold Co Constitution, each of these entities distributes its income at the sole discretion of Ultimate Hold Co. Ultimate Hold Co uses this discretion under the Fin Co and Hold Co Constitutions to regularly obtain distributions from its subsidiaries. Finally, given that both Fin Co and Hold Co are fiscally transparent entities for country A tax purposes, their income will be reported by Ultimate Hold Co for Country A tax purposes in Ultimate Hold Co's income tax return under the Country A tax rules.

As discussed above, Article 11(3)(b) applies to "a resident of the other Contracting State", here a Country A resident, and thus the Country A tax treatment should be given due regard in considering whether Article 11(3)(b) applies. The Country A tax treatment is that the activities and income of Fin Co and Hold Co are that of Ultimate Hold Co. Furthermore, the tax liabilities of Fin Co and Hold Co are the tax liabilities of Ultimate Hold Co.

Based on these contractual and legal obligations, as well as the broader facts and circumstances outlined above (notably the Country A tax treatment of the Fin Co and Hold Co), the Commissioner's view is that neither Fin Co nor Hold Co are beneficially entitled to the income. Neither Fin Co or Hold Co have the right to use and enjoy the interest unconstrained by a contractual or legal obligation to pass on the payment to another person.

Is Ultimate Hold Co 'beneficially entitled' to the interest?

Given Ultimate Hold Co is not taxed on its net income to the extent it distribute such income as a dividend to shareholders, and intends to distribute such income as a dividend to its shareholders as far as possible, it is necessary to consider whether it is under any legal constraint or obligation to distribute the interest it receives from Hold Co to its investors.

It is the Board of Ultimate Hold Co that decides whether it is in the best interest of Ultimate Hold Co to make dividend payments to its shareholders. There is no obligation under the UHC Constitution to seek approval or agreement of the shareholders when making that decision.

Furthermore, Ultimate Hold Co is a company listed on a stock exchange. Accordingly, the interest income earned under the SFA is not paid to Ultimate Hold Co shareholders. Rather, it is reported by Ultimate Hold Co for Country A taxation purposes and is then netted off and distributed to shareholders as a dividend. Thus, Ultimate Hold Co shareholders do not receive the interest income from Aus Co. In other words, there is no character flow-through of the interest income, which are distributed as dividends, and the shareholders do not have any non-contingent entitlement to distributions from Ultimate Hold Co.

It is also worth noting that Ultimate Hold Co is significantly widely held and listed on the stock exchange. Thus, no single investor in Ultimate Hold Co has the power to conclusively influence decisions including the decision to distribute dividends and funds.

Also, the UHC Constitution states the holders of the Common Stock are entitled to receive dividends when, as, and if authorised by the Board and declared by the Board out of assets legally available for the payment of dividends. Given the discretion of the Board to pay dividends out of legally available assets, and the fact that investors are entitled only to a payment of dividends in their capacity as shareholders, it supports a conclusion that, with respect to the interest income received, it is Ultimate Hold Co that has the right to use and enjoy the income.

On this basis the Commissioner considers that Ultimate Hold Co would in this case be 'beneficially entitled' to the interest income for the purposes of applying the Country A Treaty.

Financial Institution

Consistent with the Commissioner's approach in Taxation Ruling TR 2005/5DC2 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, the interest earned under the SFA will not be subject to withholding tax in accordance with Article 11(3) of the Country A Treaty if it can be shown that the resident that is the beneficial owner of the interest payments is a financial institution. A financial institution is defined in Article 11(3) of the Country A Treaty as either:

•         a bank, or

•         another enterprise that 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.

The Explanatory Memorandum to the Bill introducing the Country A Treaty explains the purpose of Article 11(3)(b) as follows:

The exemption for interest paid to financial institutions reflects that the current 10% rate on gross interest can be excessive given their cost of funds.

Paragraphs 7.1 and 7.7 of the Commentary on Article 11 of the OECD Model Tax Convention expand on the reason for including an Article such as Article 11(3)(b) to prevent taxation by the source country. In short, source country taxation on the interest derived by a financial institution is likely to constitute an obstacle to international trade, because source country taxation is generally based on gross interest and does not take into account borrowing costs.

Paragraph 36 of TR 2005/5DC2 states:

It is the US or UK resident that is beneficially entitled to the interest that must meet the requirements of the Article. The term 'resident' in Article 11 derives its meaning from Articles 1, 3 and 4 of the Conventions. The effect of the definition of 'resident' in the Conventions in the case of corporate groups is that it refers to a particular company within the company group. As a corporate group is not a resident for the purposes of Article 11, the attributes of that Article cannot apply to it. Rather, it is the particular company that is beneficially entitled to the interest that must meet the requirements of Article 11(3), including the requirement to be a financial institution.

ATO ID 2013/58 states that in applying the Country A Treaty, as part of the factual matrix, Australia should take into account the Country A treatment of the interest paid, and where appropriate to give effect to the object and purpose of the treaty, give due recognition to the fact that under Country A tax law, the activities and income of the entity are treated as the activities and income of the Country A resident owner.

As such, Ultimate Hold Co is the Country A resident for the purposes of the treaty that needs to satisfy the requirement in the Article to be a financial institution. The Country A tax treatment of treating the activities and income of Ultimate Hold Co's wholly owned subsidiaries is relevant for these purposes where it is consistent with the text, context and purpose of the treaty, namely, to provide an interest withholding tax exemption for entities whose business substantially consists of 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.

A bank

Paragraph 12 of TR 2005/5DC2 provides that a 'bank' means a Country A resident that is authorised or licensed to carry on a banking business in Country A.

Ultimate Hold Co is not registered or regulated as an authorised deposit taking institution in Australia or as a bank in Country A. Therefore, Ultimate Hold Co is not a bank for the purposes of Article 11(3)(b) of the Country A Treaty.

Other enterprise

As Ultimate Hold Co is not a bank, in order for it to be a financial institution for the purposes of Article 11(3)(b) of the Country A Treaty, it must relevantly be an enterprise that 'substantially derives its profits' by 'raising debt finance in the financial markets' and 'using those funds in carrying on a business of providing finance'. In TR 2005/5DC2, these activities are collectively referred to as 'spread activities'. Relevantly, the Commissioner provides his view as to what constitutes a 'financial institution' for the purposes of Article 11(3)(b) in TR 2005/5DC2.

Raising debt finance

Paragraph 65 of TR 2005/5DC2 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 2005/5DC2 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 Country A Treaty.

Paragraph 69 of TR 2005/5DC2 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.

Ultimate Hold Co is a corporation in Country A that focuses on providing mortgage loans secured over real estate assets located throughout the world, including Australia. Ultimate Hold Co and its subsidiaries obtain capital to provide these loans from a range of activities, including public offers of equity and debt securities, secured debt agreements, securitisations, asset specific financings, senior secured term loans, convertible notes, and public and private secured and unsecured debt issuances.

The above sources of finance have been applied by Ultimate Hold Co to finance its investments and loans made by various subsidiaries, including Fin Co. These sources of finance for Ultimate Hold Co involve effectively non-contingent obligations to provide an amount at least equal to the amount received, and in all circumstances with interest.

The Commissioner therefore accepts that Ultimate Hold Co raises debt finance for the purposes of Article 11(3)(b) of the Country A Treaty.

Financial markets

The Commissioner, at paragraph 72 of TR 2005/5DC2, 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. It means 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.

Ultimate Hold Co has raised debt finance from various third parties which it used to make mortgage investments. The debt finance has been raised primarily through the financial markets, with a significant amount being raised through a number of secured credit facilities Ultimate Hold Co has entered into with global banks. The remainder has come from the creation of a securitisation, the public offering of debt securities to the markets, and a number of asset specific financings.

Therefore, it is evident that Ultimate Hold Co raises debt finance in the financial markets as they source their finance from a range of security offerings to the public, securitisation arrangements, and from key financial institutions that constitute the financial markets.

It is, therefore, accepted by the Commissioner that Ultimate Hold Co 'raises debt finance in the financial markets' as required to satisfy the definition of a financial institution in Article 11(3)(b) of the Country A Treaty.

Using the funds in carrying on a business of providing finance

Paragraph 88 of TR 2005/5DC2 states that the definition of a financial institution in the Country A Treaty requires that the debt finance raised by the relevant entity must be the funds 'used' to carry on a business of providing finance.

Paragraph 89 of TR 2005/5DC2 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.

Paragraph 90 of TR 2005/5DC2 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.

Paragraph 95 of TR 2005/5DC2 also requires that the enterprise uses the funds it raises in 'carrying on a business' of providing finance. Whether an enterprise is carrying on a business of providing finance is a question of fact and would need to be considered in light of the general principles relevant to this question. The courts have held that a range of factors or indicators are relevant in determining whether a business is carried on. Some of these factors are discussed in Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? and include:

•         whether the activity has a significant commercial purpose or character

•         whether the taxpayer has more than just an intention to engage in business

•         whether the taxpayer has an intention to make a profit and the prospect of making a profit

•         the recurring nature of transactions, and

•         whether the activity is planned, carried on and organised in a business-like manner.

In each case it will be a question of fact whether an entity can be said to be carrying on a business and the conclusion requires weighing all the relevant indicators.

Ultimate Hold Co as a standalone entity is a holding company that raises the necessary capital for the group. Its income on a standalone basis largely consists of distributions from its subsidiaries.

Ultimate Hold Co lends to third parties via loans made by its subsidiaries. Ultimate Hold Co's business of providing commercial loans is undertaken by it and its subsidiaries as a single enterprise, with the subsidiaries used primarily to segregate loan portfolios. Ultimate Hold Co reports the interest income from the loans made by its various subsidiaries in its annual reports.

Given the nature of the Ultimate Hold Co business as a whole, it would appear appropriate to consider the Country A tax treatment of the subsidiaries and the fact that for Country A tax purposes, their activities and income are considered to be those of Ultimate Hold Co.

This suggests that with due regard to the Country A tax treatment, Ultimate Hold Co is using debt finance raised in the financial markets to carry on a business of providing finance.

Further Fin Co, and Hold Co, do not undertake activities inconsistent with that of a financial institution which provide further support for giving due regard for Country A tax treatment. As such, the policy behind Article 11(3) of the Country A Treaty, to provide relief from tax for entities engaging in 'spread activities' where a source tax on gross interest fails to take into account borrowing costs, is not subverted.

Based on all of the above factors, the Commissioner accepts that Ultimate Hold Co is carrying on a business of providing finance for the purposes of the financial institution definition.

Substantially deriving its profits

Paragraph 99 of TR 2005/5DC2 states that to meet the definition of a financial institution under the Country A Treaty, the spread activities need to be the main activity (not the sole activity) of the enterprise in terms of its contribution to overall profits, however so measured.

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.

Paragraph 100 of TR 2005/5DC2 provides that 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 Ultimate Hold Co's net income is derived from its spread activities. As such, Ultimate Hold Co 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 Country A Treaty.

Conclusion

As Ultimate Hold Co is an enterprise that substantially derives its profits by raising debt finance in the financial markets and uses those funds in carrying on a business of providing finance, Ultimate Hold Co satisfies the 'financial institution' definition in Article 11(3)(b) of the Country A Treaty.

As such, with respect to the interest income paid by Aus Co to Fin Co under the SFA which Ultimate Hold Co is treated as deriving and beneficially entitled to for the purposes of Country A tax law and the Country A Treaty, Article 11(3) of the Country A Treaty applies to prevent taxation on that interest income in Australia, in particular under the withholding tax provisions contained in section 128B of the ITAA 1936.

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