Edited version of private advice

Authorisation Number: 1052351772033

Date of advice: 24 January 2025

Ruling

Subject: Financial institution definition

Question

Is the taxpayer a "financial institution" within the meaning of Article 11(3)(b) of the Convention between Australia and Country A for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income [2008] ATS (DTA)?

Answer

Yes.

This ruling applies for the following periods:

1 April 20XX to 31 March 20XX

1 April 20XX to 31 March 20XX

The scheme commenced on:

1 April 20XX

Relevant facts and circumstances

1.    The taxpayer was incorporated under Country A domestic law and its headquarters are located in Country A.

2.    The taxpayer is the head company of a consolidated group. It has wholly-owned subsidiaries in numerous countries outside Country A. This ruling is in relation to the taxpayer on a standalone basis.

3.    The taxpayer operates a leasing and financing business in Country A and other countries.

4.    The taxpayer does not have a permanent establishment in Australia, under Australian domestic law or the DTA.

5.    The taxpayer procures its funding by raising debt finance in the financial markets on normal commercial terms.

6.    The taxpayer raises funds by:

(a)          direct financing, such as issuance of commercial paper and bonds, as well as securitisation of receivables; and

(b)          indirect financing, including borrowings from banks, financial institutions and life insurance companies.

7.    During the years ended 31 March 20XX and 31 March 20XX, the taxpayer sourced a minor portion of its funding from equity financing.

8.    Approximately X% of the debt raised by the taxpayer is from related parties (on the basis that they have shareholdings in the taxpayer - as at 31 March 20XX), all of whom provide finance to the general public as financiers.

9.    The key activities of the taxpayer's business generating revenue are as follows:

(a)          Finance leases;

(b)          Operating leases;

(c)          Instalment sales;

(d)          Finance revenue (mainly interest from loans); and

(e)          Other revenue (relating to the sale of equipment, distributions from investments, etc.).

10.    The financing activities referred to above relate to:

(a)          Finance leases;

            i.        Under the finance lease arrangements, the taxpayer enters into an agreement to purchase equipment from a customer, and on receipt of the purchase price for the equipment, the taxpayer leases the equipment back to the customer. The customer makes rental payments for the equipment during the lease term (which includes an interest component). Title to the equipment remains vested in the taxpayer until the customer purchases the equipment at the maturity date (or any earlier time in accordance with the lease agreement).

(b)          Instalment sales;

            i.        Under the instalment sales arrangements, the taxpayer enters into a sale agreement with customers to sell products to buyers on a deferred payment basis. Broadly, the purchase price is payable in instalments with interest accruing and being payable on each due date.

(c)          Other financing;

            i.        This primarily relates to loan arrangements, under which the taxpayer provides loans to customers and receives interest and a portion of the principal amount of the loan on each repayment date. In addition, other financing activities include consignment of payments arrangements.

11.  More than 50% of the taxpayer's gross profits for the years ended 31 March 20XX and 31 March 20XX are from spread activities.

12.  Based on the taxpayer's current estimates and profitability forecasts it expects that the gross profit from financing activities will remain at over 50% in the years ended 31 March 20XX and 31 March 20XX.

13.  The taxpayer has entered into financing agreements with Australian customers who are unrelated parties.

Assumptions

1.            Throughout the period to which this ruling applies, the taxpayer will continue to raise finance predominantly from debt financing arrangements and use those funds to carry on a business of providing leasing and financing.

2.            Throughout the period to which this ruling applies, the taxpayer's leasing and financing business will continue to be the main source of its profits.

Relevant legislative provisions

Convention between Australia and country A for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income [2008] ATS 21

Income Tax Assessment Act 1997 Division 974.

Income Tax Assessment Act 1997 Section 974 -135

Reasons for decision

Article 11(3)(b) of the Convention between Australia and Country A for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income [2008] ATS 21 (DTA) states:

... 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 taking deposits at interest and by using those funds in carrying on a business of providing finance.

The Taxation Ruling TR 2005/5 Income tax: ascertaining the right to tax United States (US) and United Kingdom (UK) resident financial institutions under the US and the UK Taxation Conventions in respect of interest income arising in Australia (TR 2005/5) sets out the Commissioner's interpretation of the law in relation to ascertaining if an entity will be classified as a financial institution under Article 11(3)(b) of the US and UK Conventions.

Paragraph 2A of Taxation Ruling TR 2005/5 states this Ruling also applies to residents of another country with which Australia has a double tax agreement that includes a financial institution interest withholding tax rates exemption or reduction on identical terms as the US or UK Conventions,

The wording in Article 11(3)(b) of the DTA has the same wording as Article 11(3)(b) in the US and UK Conventions. As such, TR 2005/5 is also relevant in determining if the taxpayer is a financial institution within the meaning of Article 11(3)(b) of the DTA.

To meet the definition of financial institution pursuant to Article 11(3)(b) of the DTA, the taxpayer must be either:

•                     a 'bank'; or

•                     'other enterprise'.

A 'bank'

Paragraph 12 of TR 2005/5 provides that for the purposes of the Conventions, a 'bank' means an entity that is authorised or licensed to carry on a banking business (that is to take deposits and make advances). The taxpayer is not registered or regulated as an authorised deposit taking institution in Australia or as a bank in Country A.

Therefore, the taxpayer is not a 'bank' for the purposes of Article 11(3)(b) of the DTA.

'Other enterprise'

Consequently, to be classified as a 'financial institution' for the purposes of Article 11(3)(b) of the DTA, the taxpayer must satisfy the definition of 'other enterprise'.

Paragraph 15 of TR 2005/5 provides that 'other enterprises are those entities that are not classified as banks. This means that these enterprises must 'substantially derive their profits' by 'raising debt finance in the financial markets' or by taking 'deposits at interest' and 'using those funds in carrying on a business of providing finance'. In TR 2005/5 these activities are collectively referred to as 'spread activities'.

Enterprise

The taxpayer is an enterprise under Article 3(1)(g) of the DTA as it is carrying on a business.

Raising debt finance

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

Paragraph 67 and 68 of TR 2005/5 state that the test in Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) can be used in determining whether a financing arrangement is 'debt finance' for the purposes of the DTA.

Paragraph 69 of TR 2005/5 provides:

... 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.

The taxpayer's debt financing comprises of issuing debt instruments (such as commercial paper and bonds, as well as securitisation of receivables) and borrowing from banks, financial institutions and life insurance companies. The taxpayer also raises a minor percentage of its finance by equity financing.

In relation to the debt financing, the taxpayer has a legal obligation to return to the investors and lenders an amount at least equal to the amounts invested and lent, including:

•                     to return principal with interest payments on loans and securities issued under the securitisation of receivables;

•                     to pay the face value with coupons on bonds; and

•                     to pay the face value on commercial paper that is sold at a discount.

The finance via borrowings, commercial paper, bonds and securitisation of receivables all require the taxpayer to return more than the amount received to the lenders and investors. As such, the borrowings, securitisation of receivables, commercial paper and bonds all constitute 'raising debt finance' for the purposes of Article 11(3)(b) of the DTA.

Financial markets

Article 11(3)(b) of the DTA also requires that the 'debt finance' is raised in the 'financial markets'. Paragraph 72 of TR 2005/5 states that the term 'financial markets', in the context of the phrase 'raising debt finance in the financial markets', 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).

Further at paragraph 73 of TR 2005/5 it states:

This definition includes all forms of loan financing through recognised entities that form part of the retail 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.

The taxpayer raises the majority of its borrowings, bonds, commercial paper and funds from securitisation of receivables from third party financial institutions, wholesale and retails lenders and other banks. The debt financing from these entities all satisfies the requirements of being raised in financial markets as the entities, being lenders, financial institutions and banks, all regularly offer and provide the relevant debt finance products and form part of the financial markets.

The taxpayer also raises debt finance from related parties.

Paragraphs 74 and 75 of TR 2005/5 provide:

74. An issue that has arisen is whether the enterprise that raises if debt finance from a related party within a corporate group is considered to be raising 'debt finance in the financial markets'. The key question here is whether the related party forms part of the 'financial markets'. If so, the related party borrowing will still qualify as raising debt finance in the financial markets.

75. For the related party lender to form part of the financial markets it needs to show that it regularly provides finance to the public as a financier. Where the enterprise raises funds from a related party that regularly provides finance to the public as a financier, the enterprise will be taken to have raised its debt finance in the financial markets if it raises such funds on normal commercial terms.

All of the related parties from which the taxpayer sources debt finance regularly provide finance to the general public as financiers, so form part of the financial markets. Hence, the debt finance that the taxpayer raises from those related parties still qualifies as raising debt in the financial markets.

Therefore, all of the taxpayer's debt finance is raised in the financial markets.

Using the funds in carrying on a business

The taxpayer must use the funds (from the debt finance it raises in the financial markets) in carrying on a business of providing finance.

TR 2005/5 summarises the criteria as follows:

95. ... Whether an enterprise is 'carrying on a business of providing finance' is a question of fact and would need to be considered in the light of the general principles relevant to this question ...

...

95B. ... A range of indicia are relevant in determining whether a business is carried on including:

•                    whether the person intends to carry on a business;

•                    the nature of the activities, particularly whether they have a profit-making purpose;

•                    whether the activities are:

-                    repeated regular;

-                    organised in a business-like manner, including the keeping of books, records and the use of a system;

•                    the size and scale of the activities including the amount of capital employed in them; and

•                    whether the activity is better described as a hobby, or recreation.

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.

Whether the person intends to carry on a business

The taxpayer operates a leasing and financing business both locally in Country A and overseas. The revenues and gross profit earned show an intention to carry on a business.

The nature of the activities, particularly whether they have a profit-making purpose

The taxpayer's corporate existence is driven by profit. The taxpayer has gross profits for at least the last five financial years from issuing debt instruments and the use of the funds raised from such issues to provide funding to other entities.

Whether the activities are repeated and regular

The taxpayer's financing activities have been ongoing and recurring.

Whether the activities are organised in a business-like manner, including the keeping of books, records and the use of a system

The taxpayer carries on its activities in a business-like manner for the making of profit as it has a clear growth vision and strategy to enhance its profitability. The taxpayer also publishes audited financial statements each year.

The size and scale of the activities including the amount of capital employed in them

The taxpayer's activities are of a large size and scale as it has a global presence. The taxpayer raises significant amounts of capital to provide finance in large volume. The scale of the provision of finance indicates its significant commercial character and purpose. Further, the taxpayer intends to engage in its activities for the long-term as evidenced by its stated commercial objectives.

Whether the activity is better described as a hobby, or recreation

The activities of the taxpayer are a business and not a hobby or recreation.

Conclusion

In view of the above factors, it can be said that the taxpayer is carrying on a business for the purposes of Article 11(3)(b) of the DTA.

Business of providing finance

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

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

Paragraph 90 of TR 2005/5 provides:

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.

Further, at paragraph 92 it states that leasing of an asset under a finance lease constitutes finance where there is an obligation to return the asset(s) at a later date.

The taxpayer's core business activities comprise the following:

•                     finance leases, where the taxpayer purchases equipment from a customer and leases it back to the customer who is then required to pay a rental payment plus interest in instalments. The customer obtains title to the equipment at the maturity date (or earlier if the 'early buyout option' is exercised pursuant to the lease agreement);

•                     instalment sales, where the customer is required to repay the purchase price in instalments plus interest;

•                     financing (mainly loans to third parties and related parties) which require the repayment of the principal plus interest;

•                     hire purchase agreements, where the taxpayer sells equipment to customers on a hire purchase basis and receives quarterly repayments (each of which comprise a principal and interest component);

•                     consignment of payment agreements, where the consignor repays the payment amount plus interest to the taxpayer as consignee;

•                     operating leases; and

•                     other activities relating to the sale of equipment, distributions from investments, etc.

As the instalment sales agreements, hire purchase agreements, loans and consignment of payment agreements all have an obligation for the recipient to return the funds to the taxpayer (plus interest), they all entail providing finance as described in paragraph 90 of TR 2005/5. Further, the finance lease agreements provided by the taxpayer have an obligation for the taxpayer to return the equipment to the lessee at the maturity date or upon exercise of the early buyout option. As such, the finance lease agreements constitute finance as set out of paragraph 92 of TR 2005/5.

The taxpayer undertakes these financing activities in the manner as set out above such that the taxpayer satisfies the requirement of carrying on a business of providing finance.

Using those funds in carrying on a business of providing finance

Article 11(3)(b) of the DTA also requires that the funds raised by debt finance must be used to carry on the business of providing finance. The requirement of 'using those funds' will be satisfied when the activities of raising the debt finance and carrying on a business of providing finance are undertaken concurrently.

Paragraphs 88 and 95 of TR 2005/5 state:

88. The Conventions require that the funds raised by debt finance or by taking deposits must be used to carry on a business of providing finance. This indicates that there must be a connection between the provision of finance and the raising of funds in the required manner. The requirement of using those funds will be satisfied where these activities are undertaken concurrently in carrying on a business. (emphasis added)

...

95. The definition also requires the enterprise to use these funds 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 the light of the general principles relevant to this question.

The funds must be used in carrying on a business of providing finance as per the ordinary meaning or understanding of that term, it is not enough for an entity to be providing finance and to be carrying on a business.

The taxpayer's balance sheet and profit and loss accounts show that in the years ended 31 March 20XX and 31 March 20XX the debt finance and the financing activity revenues were raised concurrently. Further, approximately X% of the taxpayer's finance is raised via debt finance and approximately X% of its gross profit is related to financing activities. Therefore, as this occurs concurrently and given the quantum of the debt finance raised and the financing activities carried on by the taxpayer, it is reasonable to conclude that the taxpayer is using the debt finance obtained to provide finance. As such, the taxpayer satisfies the requirement of 'using those funds in carrying on a business of providing finance'.

Substantially deriving its profits

The taxpayer must substantially derive its profit from the business of providing finance (referred to in TR 2005/5 as 'spread activities'). This test is described in paragraphs 99 to 101 of TR 2005/5, as follows:

99. In considering these cases, the Commissioner is of the view that when the word 'substantially' is used in the context of an enterprise substantially deriving its profits from its 'spread activities' it is also used in a relative sense. The relevant term 'substantially' when used in conjunction with 'deriving profits', requires that the main source of the enterprise's profits be derived from its business of undertaking 'spread activities'.

100. This means that while the 'spread activities' need not be the sole activity of the enterprise, it will need to constitute its main activity when compared to all other activities combined that it undertakes in terms of its contribution to the enterprise's overall profits.

100A. The 'spread activities' will constitute the main business activity if, when compared with all the other activities carried on by the enterprise, they are the main contributor to the enterprises' overall profits. This involves determination of the extent to which the 'spread activities' are the source or generator of the enterprise's overall profits.

100B. Whether an enterprise substantially derives its profits from the 'spread activities' is not by its nature a bright-line test. The question of whether the spread activities are the main contributor to the enterprise's profits requires consideration of the relationship between the spread activities and the enterprise's profits. This includes the extent to which underlying economic factors impact of the profitability of the spread activities over a reasonable period of time. However, where the spread activities are the source of 50% or more of the overall accounting profits, this is a strong indicator that the enterprise substantially derives its profits from the spread activities (refer to paragraph 103 of this Ruling in regard to situations where an enterprise is deriving less than 50% of its profits from spread activities).

...

101. 'Profits' in this context takes on its accounting meaning. Thus, 'profits' can be measured according to a range of acceptable accounting indicators of profits, including gross profit, net operating income or operating profit. The calculation of operating income or operating profit should take into account direct expenses and overhead costs in accordance with accounting principles.

The audited accounts for the taxpayer for the years ended 31 March 20XX and 20XX show the taxpayer's gross profits from spread activities in those years were X% of its total profit. As the profits are more than 50%, the taxpayer satisfies the requirement in TR 2005/5 for its profits to have been substantially generated from its spread activities.

Further, the profitability forecasts for the taxpayer show it is expected the profit from spread activities will continue to be more than 50% of its total profit in the years ended 31 March 20XX and 20XX.

Provided these spread activities do not materially change and remain the main source of the taxpayer's profits, the taxpayer is considered to be substantially deriving profits by raising debt finance in the financial markets and using those funds in carrying on a business of providing finance.

Conclusion

As the taxpayer is an enterprise substantially deriving its profits by raising debt finance in the financial markets and using those funds in carrying on a business of providing finance, the taxpayer satisfies the 'financial institution' definition in Article 11(3)(b) of the DTA.

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