This Case Decision Summary has been withdrawn.

ATO Case Decision

Case Decision Number:

CDS10406

Subject:

Is interest withholding tax payable on accrued interest income which under the loan agreement is capitalised but will never be paid because of the borrower's subsequent inability to pay?

Decision:

Yes, interest withholding tax is payable on the capitalised interest.

Facts:

An Australian resident company obtains a loan from its main shareholder. The shareholder is a non-resident and is not a financial institution. Under the loan agreement the interest accrues daily on the principal outstanding. The accrued interest is compounded monthly in arrears. The compounded interest accrued is capitalised on a monthly basis and forms part of the principal outstanding with further interest accruing on the new balance. This capitalisation is reflected in the borrower's accounts as debits to the interest expense account and credits to the lender’s loan accounts. All outstanding interest and principal is payable at a fixed date in the future.

Due to financial difficulties encountered by the borrower, the lender proposes to waive all of the accrued interest which has been capitalised to date under the loan. The financial statements prepared by the borrower indicate that the borrower is capable of meeting the payment of interest at the time that the obligation to capitalise the interest arises.

The taxpayers contend that where no interest has been paid and never will be paid there is no withholding tax liability.

Reasons for Decision:

Division 11A, Part III (Income Tax Assessment Act 1936 (ITAA 1936)) operates to impose a liability to withholding tax on dividends, interest and royalties paid to non-residents. Though the liability to the tax is imposed on the non-resident, for collection purposes, the tax is generally deducted and paid by the resident paying the income: see Division 4, Part VI (ITAA 1936).

Of current relevance, subsection 128B(2) of Division 11A, Part III (ITAA 1936) imposes a liability for interest withholding tax on interest that is derived by a non-resident and paid to the non-resident by an Australian resident.

The terms derived and paid are respectively defined in subsection 6-5(4) (Income Tax Assessment Act 1997 (ITAA 1997)) and subsection 128A(2) (ITAA 1936).

The capitalisation of the interest under the terms of the loan agreements represents an application or dealing on behalf of the lender or a direction on the part of the lender and thus constitutes a deemed derivation at the time of capitalisation in terms of subsection 6-5(4) (ITAA 1997)). The capitalisation of the interest under the same circumstances also constitutes a deemed payment for the purposes of subsection 128A(2) (ITAA 1936). As such, the capitalising of interest raises a liability for interest withholding tax: see also Taxation Determination TD 93/146. The subsequent waiver of the interest debt does not negate the deemed derivation and payment of interest which has occurred at an earlier point in time.

However, there does exist an exception to the general treatment of capitalised interest mentioned above. The question of derivation in the context of the capitalising of accrued interest was judicially considered in Permanent Trustee Co of New South Wales Ltd v. Federal Commissioner of Taxation, (1940) 6 ATD 5, (1940) 2 AITR 109, and St. Lucia Usines and Estates Co Ltd v. St Lucia (Colonial Treasurer) (1924) AC 508. These cases appear to stand for the proposition that there is no derivation if there is no commercial prospect of income being realised or realisable to the lender. These cases are however distinguishable on their facts. In the circumstance of the present case, the borrower is in the financial position to meet its interest obligations at the time of capitalisation.

In this case, the general treatment applies and interest withholding tax is payable on the capitalised interest.

Legislative References:

Income Tax Assessment Act 1997 subsection 6-5(4).

Income Tax Assessment Act 1936 section 19; subsection 128A(2); subsection 128B(2); subsection 128C(1).

Relevant Cases:

Permanent Trustee Co of New South Wales Ltd v. Federal Commissioner of Taxation (1940) 6 ATD 5, (1940) 2 AITR 109

St. Lucia Usines and Estates Co Ltd v. St Lucia (Colonial Treasurer) (1924) AC 508

Tindal v. Federal Commissioner of Taxation (1946) 72 C.L.R. 608

Rulings/Determinations Cited:

Taxation Determination TD 93/146

Other References:

Explanatory Memorandum to Income Tax Assessment Bill (No. 4) 1967

Case Decision Summary CDS10359

Keywords:

Withholding taxes

Non resident interest withholding tax

Income derived

Interest income

Accrued interest

Date of decision:

02 December 1999

Year of Income/Date of Transaction:

Year ending 30 June 1995 - Year ending 30 June 1999

FOI Number:

I2000406