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Ruling

Subject: Financial institution - Article 11 of the UK Convention

Question

Does the applicant satisfy the definition of financial institution contained in Article 11(3)(b) of Schedule 1 to the International Tax Agreements Act 1953 (UK Convention)?

Answers

Yes.

Relevant facts

X, a UK resident company, borrows money from Y, its parent company, on normal commercial terms.

X is contemplating providing finance to Australian customers with the money so borrowed.

X's principal activities are the provision of finance to the public.

X is not a bank as recognised in the UK.

Y regularly provides finance to the public as a financier.

Relevant legislative provisions

International Tax Agreements Act 1953 Article 11 of Schedule 1

Reasons for decision

Article 11(3)(b) of the UK Convention relevantly provides the definition of financial institution to be:

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.

In order to be a financial institution, the UK resident needs to be either:

(a) a bank; or

(b) 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.

1. Financial Institution

X is not a bank. As such, in order for it to be considered to be a financial institution, it must therefore be an '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'.

The definition itself has a number of phrases that themselves need to be defined.

(i) Raising debt-finance in the financial markets or by taking deposits at interest

X does not take deposits at interest. As such, it needs to meet the condition, inter alia, of raising debt finance in the financial markets,

In the context of debt finance there is no definition in the UK Convention nor is the term used in Australia's tax laws. Paragraph 68 of 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) states that:

the approach used in Division 974 to distinguish between debt and equity, based on the economic substance of the rights and obligations in question, should be applied to the meaning to be given to 'debt finance' in the Conventions.

Further, paragraph 69 of TR 2005/5 states that:

The Commissioner does not require the US or UK resident to satisfy all of the requirements of Division 974 (for example, there is no requirement that the scheme is a financing arrangement under section 974-130). Rather it is consistent with the context of the Conventions to utilise the economic principle underpinning that Division in interpreting this term. 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.

A traditional loan arrangement would therefore constitute 'raising debt finance' due to an effectively non-contingent obligation of the borrower to repay at least the amount lent.

X raises debt finance from Y, a related party. The related party finance is interest bearing and is on normal commercial terms. These loans are non-contingent on any factor barring the applicant's ability to make the relevant payments. In essence, they would be effectively non-contingent obligations as defined in section 974-135 of the ITAA 1997. As a result the related party finance would be regarded as debt finance.

The meaning of debt finance also needs to be considered in the context of the expression financial markets. Paragraph 72 of TR 2005/5 states that:

The term 'financial markets' in the composite expression 'raising debt finance in the financial markets' takes on 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).

However, where the debt finance is raised through a related party within a corporate group, the related party must form part of the financial markets to be considered raised in the financial markets. Paragraph 75 of TR 2005/5 relevantly states:

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 debt in the financial markets if it raises such funds on normal commercial terms.

As stated, X obtains its debt finance from Y. As Y regularly provides finance to the public as a financier, the debt finance raised by X from Y will be considered to be debt finance raised in the financial markets as it has been advanced to it on normal commercial terms.

(ii) Using those funds in carrying on a business of providing finance

The second part of the requirement to satisfy 'other enterprise' is that the applicant uses the debt finance raised in the financial markets in carrying on a business of providing finance.

Paragraph 88 of TR 2005/5 states that:

The Convention requires 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 the 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.

The term 'providing finance', as it appears in Article 11(3)(b) of the UK Convention, is not specifically defined in the UK Convention. As such, it takes on its domestic law meaning (Article 3(3) of the UK Convention). The term 'providing finance' within the meaning of Article 11(3)(b) of the UK Convention is considered in TR 2005/5, which states at paragraph 90:

that 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 91 of TR 2005/5 states that:

the definition of 'providing finance' is broader than the traditional lending of funds.

It is considered that X is carrying on a business of providing finance.

(iii) Substantially deriving its profits

The last requirement is that they substantially derive their profits from raising that debt finance and carrying on a business of providing finance.

Paragraph 99 of TR 2005/5 states that:

The relevant term 'substantially' when used in conjunction with 'deriving profits' requires that the main source of the enterprises profits be derived from its business of undertaking 'spread activities'.

Spread activities are defined in paragraph 63 of TR 2005/5 to be the activities of raising debt finance in the financial markets or taking deposits at interest and using those funds in carrying on a business of providing finance. X has stated that it does not take deposits.

Paragraph 100 of TR 2005/5 states 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 any other activity it undertakes in terms of its contribution to the enterprises overall profits.

In relation to profits, paragraph 101 of TR 2005/5 states:

The enterprises profits should be evaluated on the same accounting basis over a reasonable period of time in relation to each business activity to ascertain whether the main source is from its 'spread activities'.

X's profits are derived from using the borrowed funds from the related party to provide finance to Australian customers. As such, it is considered that this condition is satisfied.

Conclusion

It follows therefore that X substantially derives its profits from spread activities. Accordingly, X has substantially derived profits by raising debt finance in the financial markets and using those funds to carry on a business of providing finance.

As a result X has satisfied the requirements to be categorised as an 'other enterprise' and is therefore a financial institution as defined in the UK Convention.