Edited version of private advice

Authorisation Number: 1012646471463

Ruling

Subject: Offshore Banking Unit: Proposed offshore equity financing business

Question 1

Does the provision of Cash Collateral by the taxpayer to an "offshore person" (as defined in section 121E of the Income Tax Assessment Act 1936 (ITAA 1936)) under a cash-driven securities lending arrangement (SLA) entered into with that offshore person constitute "borrowing or lending activity" as defined in subsection 121D(2) of the ITAA 1936?

Answer

Yes

Question 2

Do payments made by the taxpayer under clauses 7.2 and 7.3 of the Global Master Securities Lending Agreement (GMSLA) and clause 5(1)(a) of the Australian Master Securities Lending Agreement (AMSLA) in respect of Cash Collateral provided by the taxpayer to an "offshore person" (as defined in section 121E of the ITAA 1936 under a cash-driven SLA constitute "assessable OB Income," as defined in subsection 121EE(2) of the ITAA 1936, where none of the money lent, invested or otherwise used in carrying on the activity is non-OB money of the taxpayer?

Answer

Yes

Question 3

Does dividend income that the taxpayer receives on the borrowed securities under a cash-driven SLA with an "offshore person" (as defined in section 121E of the ITAA 1936) constitute "assessable OB income" under subsection 121EE(2) of the ITAA 1936, as income derived "from" or "because of" OB activities?

Answer

Yes

Question 4

Does a manufactured dividend payment made by the taxpayer under a cash-driven SLA with an "offshore person" (as defined in section 121E of the ITAA 1936 constitute an "exclusive OB deduction" under subsection 121EF(3) of the ITAA 1936?

Answer

Yes

This ruling applies for the following periods:

Year ending XX/XX/XXXX

The scheme commences on:

XX/XX/XXXX

Relevant facts and circumstances

1. The taxpayer is an Australian resident company and a financial institution engaged in retail and wholesale banking activities in Australia and overseas. The taxpayer is an 'offshore banking unit' (OBU) under subsection 128AE(2) of the ITAA 1936.

2. The taxpayer will provide cash to offshore persons under "cash-driven" Security Lending Agreements (SLA). The SLA will be an over-the-counter arrangement and will be documented under either a standardised Global Master Securities Lending Agreement (GMSLA) or a standardised Australian Master Securities Lending Agreement (AMSLA) between the taxpayer and the relevant counterparty. The counterparty will be an offshore person as defined in section 121E of the ITAA 1936.

3. The counterparty will have the obligation to return the cash at the end of the arrangement, in addition to a monthly payment at an agreed rate on the amount of cash provided.

4. Under the arrangements, the taxpayer will receive securities (e.g. shares mostly in foreign companies) from the counterparty and will hold those securities as security against the cash provided to the counterparty, i.e. the taxpayer will not trade or deal with the securities held except in an event of default. The taxpayer will have an obligation to return those securities to the counterparty at the end of the arrangement.

5. The transactions will be funded by the taxpayer from one or more source(s) of money which is not 'non-OB money' and meets the requirements of section 121EE of the ITAA 1936.

6. The term of a transaction will be no longer than 12 months and may be less than 24 hours for example in the provision of overnight financing.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 121A

Income Tax Assessment Act 1936 section 121C

Income Tax Assessment Act 1936 paragraph 121B(2)(a)

Income Tax Assessment Act 1936 section 121D

Income Tax Assessment Act 1936 subsection 121D(1)

Income Tax Assessment Act 1936 paragraph 121D(1)(a)

Income Tax Assessment Act 1936 subsection 121D(2)

Income Tax Assessment Act 1936 paragraph 121D(2)(b)

Income Tax Assessment Act 1936 section 121E

Income Tax Assessment Act 1936 paragraph 121E(b)

Income Tax Assessment Act 1936 section 121EA

Income Tax Assessment Act 1936 paragraph 121EA(a)

Income Tax Assessment Act 1936 paragraph 121EA(b)

Income Tax Assessment Act 1936 paragraph 121EB(1)(c)

Income Tax Assessment Act 1936 section 121EE

Income Tax Assessment Act 1936 subsection 121EE(2)

Income Tax Assessment Act 1936 paragraph 121EE(2)(a)

Income Tax Assessment Act 1936 subsection 121EE(3A)

Income Tax Assessment Act 1936 section 121EF

Income Tax Assessment Act 1936 subsection 121EF(2)

Income Tax Assessment Act 1936 subsection 121EF(3)

Income Tax Assessment Act 1936 subsection 121EF(7)

Income Tax Assessment Act 1936 section 128AE

Income Tax Assessment Act 1936 subsection 128AE(2)

Income Tax Assessment Act 1936 Division 9A

Income Tax Assessment Act 1997 section 6-1

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 Part 3-1

Reasons for decision

Question 1

Detailed reasoning

All legislative references are to the ITAA 1936, unless otherwise stated.

Section 121A states that the object of Division 9A is to provide for concessional taxation, at the rate of 10%, of the offshore banking (OB) income of an offshore banking unit (OBU). The meaning of an OBU is given in section 128AE. The taxpayer has been accepted and declared to be an OBU in accordance with subsection 128AE(2).

The most important of the main concepts used in Division 9A and set out in paragraph 121B(2)(a) are the following three primary requirements for the purposes of the OBU provisions:

• 'OBU activity' (section 121D);

• 'offshore person' (section 121E) and

• 'OBU requirement' (section 121EA).

OBU requirement

For present purposes paragraph 121EA(a) provides that in order for a thing done by a resident OBU to be an OB activity, it is necessary that, when the thing is done and the OBU is a resident the thing is not done in carrying on business in a country outside Australia at or through a permanent establishment of the OBU. Based on the facts, paragraph 121EA(a) would be satisfied in this case.

OB Activity & Offshore Person

Subsection 121D(1) provides that each of the things done by an OBU, (as set out in paragraphs (a) to (h)), is an 'OB activity' provided the requirement in either paragraph 121EA(a) or (b) is met. Paragraph 121D(1)(a) provides that a borrowing or lending as described in subsection 121D(2) is an OB activity.

An examination of 'borrowing' is not relevant for the purposes of this ruling. The question is whether the proposed activity of the taxpayer, via its OBU, in the provision of Cash Collateral to a counterparty is treated as 'lending money' under paragraph 121D(2)(b) and therefore qualifies as an OB activity under paragraph 121D(1)(a).

Paragraph 121D(2)(b)

The agreements (GMSLA or AMSLA) together with the facts for this ruling are that the taxpayer will provide the counterparty (the offshore person) with Cash Collateral against the transfer of non-specific securities being provided to the taxpayer. Legal title to the securities passes to the taxpayer but the lender of the securities retains economic exposure to the securities and the securities will be returned to them by the taxpayer at the end of the arrangement. The parties agree on a rate to be paid to the taxpayer on the Cash Collateral (see GMSLA clauses 7.2 and 7.3). The counterparty is also obliged to return the Cash Collateral to the taxpayer either on demand or on a specific agreed date and at that time the taxpayer is obliged to return the securities to the counterparty (see GMSLA clause 8). The counterparty is an offshore person for the purposes of paragraph 121D(2)(b).

Paragraph 121D(2)(b) provides that for the purposes of paragraph 121D(1)(a), a lending activity is lending money to an offshore person where, if that person is a person to whom paragraph 121E(b) applies and is not an OBU, the money is not Australian currency.

Therefore, paragraph 121D(2)(b) requires the following three conditions to be met in order for a thing done by an OBU to be a lending activity which would satisfy paragraph 121D(1)(a) and constitute an OB activity.

1. The activity must be the lending of money;

2. The lending must be to an offshore person; and

3. If the offshore person is a person to whom paragraph 121E(b) applies and is not an OBU, the money is not Australian currency.

Nature of security lending arrangement

In Beconwood Securities Pty Ltd v Australia and New Zealand Banking Group Limited FCA 594 (Beconwood) Finkelstein J considered the substance of securities lending arrangements (SLAs). The dispute was focused on whether or not an equity of redemption can exist after the outright transfer of title that occurs in SLAs, at paragraph 4-5 he outlined that:

4 'securities lending refers to the practice by which securities are transferred from one party (the lender) to another party (the borrower), with the borrower contractually obliged to redeliver to the lender at a later time securities which are equivalent in number and type'.

5 The modern securities lending market can, broadly speaking, be divided into two markets, one that is defined by the motive of the borrower (the "securities driven" market) and the other by the motive of the lender (the "cash driven" market). In the first category, which is the more common type of transaction, a borrower seeks access to specific securities, usually to cover exposure to a short position. In the second category, a lender of securities seeks access to cash, often for purposes of equity financing at interest rates which are better than the uncollateralised borrowing rate.

In Beconwood, Finkelstein J considered the nature of the GMSLA and AMSLA, the same agreements the subject of this ruling:

44 The SLA is derived from AMSLA which in turn is derived from OSLA. Both OSLA's successor GMSLA and AMSLA are in widespread use in markets (both cash driven and securities driven) in which the participants give or take an outright transfer of securities in exchange for a promise that the borrower will deliver equivalent securities or that the redelivery obligation will be set off against the duty to return collateral in the event of default.

The GMSLA and AMSLA agreements ('the Agreements") are standard security lending arrangements, and the taxpayer seeks to engage in cash driven securities lending. However, putting the nomenclature aside, the arrangement is not lending in the usual legal sense. As explained in Beconwood by Finkelstein J, in his analysis of the GMSLA and AMSLA agreements:

14 The term "securities lending" under these agreements is factually incorrect. The transaction that is referred to as "lending" is in terms an outright disposal of the securities lent, linked to a subsequent acquisition of equivalent securities. In other words the agreements provide that title to the securities on loan, as well as to any collateral that is received by the lender, passes from one party to the other. On the other hand, the economic benefits of ownership are "manufactured" back to the lender by the terms of the securities loan agreements.

Consistent with this analysis, in the taxpayer's cash driven securities lending, the taxpayer acquires clear and absolute title both legal and beneficial, to the borrowed shares: clause 4.2 GMSLA, clause 1.4(b) AMSLA. The taxpayer is required to make manufactured payments, net of tax, to its Lender: clauses 4.4 and 6 of the GMSLA, clause 4.2 of the AMSLA. These payments are intended to be the equivalent of receipts the Lender would be entitled to, had it not transferred its legal and beneficial interest in the shares borrowed to the taxpayer.

To remove any confusion the name securities lending may create between the parties to the agreement, the definitions section of the GMSLA defines Market Terminology, at clause 2.3, as (and similar for the AMSLA at clause 1.4(b)):

"Notwithstanding the use of expressions such as "borrow", "lend", "Collateral", "Margin" etc. which are used to reflect terminology used in the market for transactions of the kind provided for in this Agreement, title to Securities "borrowed" or "lent" and "Collateral" provided in accordance with this Agreement shall pass from one Party to another as provided for in this Agreement, the Party obtaining such title being obliged to deliver Equivalent Securities or Equivalent Collateral as the case may be."

The present arrangement for the purposes of this ruling has all the features of the contract examined in Beconwood. The end result of that case was that the substance of the agreement could not be extended to the conclusion that it was a mortgage or charge, and inevitably it could not be a borrowing or lending instrument. This was essentially because the SLA requires the sale of the securities to the provider of the cash collateral, and it is the sale that defeats the characterisation of the SLA as a loan: Beconwood paras 46-50:

50 In light of the foregoing, the argument that the SLA can be characterised as a mortgage is simply unsustainable. It breaks down at many points. First of all, by the express terms of the SLA, unencumbered title in both lent securities and collateral passes on delivery. Secondly, when the transaction comes to an end there is no obligation to hand back in specie the securities initially lent. Nor is there an obligation to return the collateral actually provided. The obligation falling on the borrower is to deliver the same number and type of securities. The same is true as regards the collateral. Third, there are the netting and set off provisions that come into effect on default. This is the means by which the parties mitigate credit risk, converting redelivery obligations into payment obligations. The provisions are particularly important because they confirm that the parties did not intend there to be any equitable property rights retained over lent securities or collateral following their delivery, for if such rights existed, they could not simply be converted by contract to monetary obligations. Equity does not allow the redemption to be "clogged": Kreglinger v New Patagonia Meat and Cold Storage Co Ltd AC 25, 61; E I Sykes and S Walker, The Law of Securities (5th ed, 1993) at 70.

Section 26BC

However, to the extent Beconwood militates against securities lending being lending or borrowing, the context of that decision was not taxation. Part III of ITAA 1936 at Section 26BC lists the requirements for the liability to taxation and assessable income from securities lending arrangements, and as such the taxation laws recognise securities lending arrangements as lending and borrowing activities. Section 26BC was introduced by the Taxation Laws Amendment Act (No. 2) 1990. Of particular relevance in the Explanatory Memorandum to the Bill is the following (at page 24):

All lenders give, and all borrowers require, either actual title to securities or such signed transfers and the like as are necessary to be able to give title to third parties. This means that lending arrangements will generally be treated as sales and repurchases of securities. Nevertheless, the securities industry describes and treats these arrangements as loans, because in the longer term such arrangements do not alter a lender's portfolio.

Clause 7 will insert a new section 26BC in the Principal Act. Section 26BC will deal with arrangements where a taxpayer enters into an agreement to dispose of securities to another taxpayer on condition that at some later time the borrower returns the same or identical securities.

Meaning of 'lending money' in Division 9A

The term 'lending money' for the purposes of Division 9A is not defined in the ITAA 1936, however section 121C provides that:

'Lend' includes provide finance by the purchase of a security.

For this purpose the term 'security' is defined in section 121C to mean:

a bond, debenture, debt interest, bill of exchange, promissory note, or other security or similar interest

It is considered however that the meaning of 'other security or similar interest' does not encompass equity interests e.g. ordinary shares. There must, at the very least, be an obligation on the counterparty or issuer of the interest to return the amount of the Cash Collateral for it to constitute a lending of money.

Notwithstanding this, the fact that Division 9A provides for the conception of lending money to include the provision of finance by the purchase of securities it is indicative that non-traditional means of lending money may be included in eligible OB activities for the purposes of Division 9A.

The Explanatory Memorandum (EM) for the Taxation Laws Amendment Act (No.4) 1992 which introduced Division 9A of the ITAA 1936 provides no further assistance on the meaning of lending money and merely states:

Lending Money

Lending in any currency to non-residents (excluding Australian branches of non-residents) and other OBUs, and in non-AUD to overseas branches of Australian residents;

When construing the GMSLA and AMSLA Agreements in the context of "cash-driven" arrangements and the facts outlined for this ruling, the provision of the Cash Collateral to the counterparty by the taxpayer, against the transfer of securities being provided to the taxpayer (to be held by the taxpayer as security for the Cash Collateral and not traded) along with a subsequent obligation of the counterparty to return the Cash Collateral to the taxpayer including an agreed rate payable on the Cash Collateral, would constitute lending by the taxpayer of money to an offshore person, which would satisfy all the conditions in paragraph 121D(2)(b) and would therefore constitute an OB activity for the purposes of paragraph 121D(1)(a).

The meaning of business of lending money in the context of Income tax arose in FC of T v BHP Billiton Finance Ltd (2010) 76 ATR 472, (2010) 182 FCR 526. In this case the Full Court said a lending activity must have the character of generating profit for the party involved in the lending, that is there must be some return and risk to the lender.

Profit was held to be the overall profit, as it would be recorded in the profit and loss account. In the BHP case, the plurality agreed that the continuous borrowing and lending of money over several years, where the rate of interest at which the money was lent was higher than the amount at which it was borrowed led to the conclusion the activity was lending: 2010 ATC 10784.

The amounts to be generated by clause 7 of the GMSLA answer the description.

Question 2

Detailed reasoning

The term 'assessable OB income' is defined in subsection 121EE(2).

121EE(2) Assessable OB income

Subject to subsection (3A), the assessable OB income of an OBU is so much of the OBU's assessable income (other than amounts included under Part 3-1 of the Income Tax Assessment Act 1997) of the year of income as is:

(a) derived from OB activities of the OBU or the part of the OBU to which paragraph 121EB(1)(c) applies; or

(b) included in the assessable income because of such activities;

except to the extent that the money lent, invested or otherwise used in carrying on the activities is non-OB money of the OBU.

In order for the payment received by the taxpayer under clauses 7.2 and 7.3 of the GMSLA and clause 5(1)(a) of the AMSLA (the Payments) to qualify as 'assessable OB income' the following conditions need to be satisfied:

1. The Payments are assessable income of the OBU;

2. The Payments were either:

(i) derived by the OBU from 'OB activities' or

(ii) included in the OBU's assessable income because of OB activities.

3. The amount is not included under Part 3-1 of the Income Tax Assessment Act 1997 (ITAA 1997) and

4. In respect of which the money is lent, invested or otherwise used by the OBU in carrying on the OB activities does not constitute 'non-OB' money of the OBU.

Each requirement will be considered in relation to the Payments.

Are the Payments assessable income of the OBU?

Assessable income is defined in section 6-1 of the ITAA 1997 to consist of ordinary income and statutory income. However, an amount of ordinary income or statutory income will not be assessable income if the amount is made exempt or is otherwise excluded from assessable income.

Ordinary income is defined to mean income according to ordinary concepts (section 6-5 of the ITAA 1997). The legislation does not provide specific guidance on what is meant by 'income according to ordinary concepts', hence guidance is provided by case law.

Whether or not a particular amount is income according to ordinary concepts depends on the nature and character of the receipt in the hands of the taxpayer.

Ordinary income has generally been held by the Courts to include three categories, namely, income from rendering personal services, income from property and income from carrying on a business.

In Federal Commissioner of Taxation v Myer Emporium Ltd (1987) 163 CLR 199, it was held that an isolated business or commercial transaction would be ordinary income if the taxpayer's purpose or intention in entering into the transaction was to make a profit, notwithstanding that the transaction was not part of the taxpayers daily business.

In Federal Commissioner of Taxation v Montgomery 99 ATC 4749, it was held that the receipt of the inducement payments was an ordinary incident of a transaction in the ordinary course of the taxpayer's business not withstanding that it was an extraordinary and unusual part of that business activity.

The taxpayer is engaged in, amongst other things, extensive retail and wholesale banking activities in Australia and overseas.

The Payments received by the taxpayer on the Cash Collateral, as per the Agreements are received in the ordinary course of the taxpayer's business and therefore represents ordinary income according to general principles.

Are the Payments derived by the OBU "derived from" OB activities or are the Payments included in the OBU's assessable income "because of" OB activities?

The term 'OB activities' as per paragraph 121EE(2)(a) is defined in section 121D. Only income that is derived by an OBU from OB activities receives concessional treatment under Division 9A. For an activity engaged in by an OBU to be an OB activity.

As discussed in Question 1, the provision of the Cash Collateral in the factual circumstances outlined for this ruling qualifies as an OB activity as lending money. Therefore, the Payments received by the taxpayer on the Cash Collateral is "because of", if not in fact "derived from" an OB activity.

Are the Payments included under Part 3-1 of the ITAA 1997?

Part 3-1 of the ITAA 1997 outlines the capital gains and losses provisions.

As the Payments are included in the assessable income as revenue type gains, they will not be included under Part 3-1.

Is the money used by the taxpayer in carrying on the lending activities 'non-OB money' of the taxpayer?

The term 'non-OB money' is defined in section 121C of the ITAA 1936:

non-OB money , in relation to an OBU, means money of the OBU other than:

(a) money received by the OBU in carrying on an OB activity; or

(b) OBU resident-owner money of the OBU; or

(c) money paid to the OBU by a non-resident (other than in carrying on business in Australia at or through a permanent establishment of the non-resident) by way of subscription for, or a call on, shares in the OBU;

(an example of non-OB money being money borrowed from a resident whose lending of the money does not occur in carrying on business in a country outside Australia at or through a permanent establishment of the resident).

As this ruling is made on the factual basis that none of the money used by the taxpayer in carrying out the lending activity is 'non-OB money', as defined in section 121C, the Payments received by the taxpayer qualifies as 'assessable OB income', as per subsection 121EE(2).

For completeness, it is noted that if more than 10% of the OBU's assessable OB income is attributable to the use of non-OB money, then none of the income from OB activities qualifies for concessional treatment (section 121EH).

Question 3

Detailed reasoning

As outlined in the discussion for Question 2, in order for the dividend income that the taxpayer receives on the borrowed securities to qualify as 'assessable OB income' the following conditions need to be satisfied:

1. The dividend income is assessable income of the OBU;

2. The dividend income was either (i) derived by the OBU from 'OB activities' or (ii)

3. included in the OBU's assessable income because of OB activities;

4. The amount is not included under Part 3-1 of the ITAA 1997; and

5. In respect of which the money is lent, invested or otherwise used by the OBU in carrying on the OB activities does not constitute 'non-OB' money of the OBU.

These conditions will be satisfied as dividends are generally regarded as ordinary income and included in the assessable income as revenue gains and are not generally included in assessable income as capital gains. Further, as the taxpayer will only acquire and hold borrowed securities as security for the Cash Collateral lent, that is the securities will be acquired and held as an integral part of the OB lending activity and will not be acquired or held by the taxpayer for trading or any other purpose, any dividends that are received by the taxpayer on borrowed securities will be a result of making the Cash Collateral loan to the counterparty and will therefore be included in the taxpayer's assessable income "because of", if not in fact derived "from", an OB activity.

As this ruling is made on the factual basis that none of the money used by the taxpayer in carrying out the lending activity is 'non-OB money', as defined in s.121C, the dividends received by the taxpayer qualifies as 'assessable OB income', as per subsection 121EE(2).

For completeness, it is noted that if more than 10% of the OBU's assessable OB income is attributable to the use of non-OB money, then none of the income from OB activities qualifies for concessional treatment (section 121EH).

Question 4

Detailed reasoning

The categories of allowable OB deductions of an OBU in relation to a year of income are set out in subsection 121EF(2):

An allowable OB deduction is any of the following 3 kinds of allowable deduction:

(a) an exclusive OB deduction;

(b) a general OB deduction;

(c) an apportionable OB deduction.

Subsection 121EF(3) provides:

An exclusive OB deduction is any deduction (other than a loss deduction) allowable from the OBU's assessable income of the year of income that relates exclusively to assessable OB income.

The term 'loss deduction' is defined at subsection 121EF(7);

A loss is any allowable deduction under Division 36 of the Income Tax Assessment Act 1997.

Division 36 of the ITAA 1997 deals with carry-forward tax losses of earlier years.

A manufactured dividend payment (if one is required to be made under the Arrangements because of the receipt of dividends from holding the borrowed securities: refer to GMSLA clause 6.2) will be a deduction allowable from the taxpayer's assessable income on the basis that it is incurred in gaining or producing the taxpayer's assessable income from a cash-driven SLA. A manufactured dividend payment will not be an allowable deduction to the extent that income is derived from an SLA arrangement that is not included in the assessable income (for example if section 43A of the ITAA 1936 operates or if some other provision operates to exclude income from an SLA from being included in the taxpayer's assessable income). A manufactured dividend payment is not a 'loss deduction' (as defined in s121EF(7)). A manufactured dividend payment will be an "exclusive OB deduction" provided that, if it is deductible, it relates exclusively to assessable OB income of the taxpayer. As a manufactured dividend payment, if any, would be required to be made under the terms of a particular SLA, it would relate exclusively to that SLA and incurred in gaining the assessable income from the SLA.