Edited version of your written advice

Authorisation Number: 1012683500625

Ruling

Subject: Offshore Banking Unit: Risk Participation Arrangement

Question 1

Is the activity of entering into a risk participation arrangement an 'eligible contract activity' within the meaning of subsection 121D(5) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes

Question 2

Is the activity of entering into a risk participation arrangement a 'guarantee-type activity' within the meaning of paragraph 121D(3)(a) of the ITAA 1936?

Answer

Yes

Question 3

Is the activity of entering into a risk participation arrangement a 'guarantee-type activity' within the meaning of paragraph 121D(3)(b) of the ITAA 1936?

Answer

Yes

This ruling applies for the following periods:

1 July 2013 to 30 June 2015

Relevant facts and circumstances

All legislative references are to the Income Tax Assessment Act 1936 unless specified otherwise.

Company A (CoA) is an international financial services group that provides a range of financial services and products in Australia and overseas. CoA is the head of the consolidated group under section 703-15 of the Income Tax Assessment Act 1997 (ITAA 1997).

CoA is an Offshore Banking Unit (OBU) by notice published in the Gazette.

OBU Sub is an Australian incorporated wholly-owned subsidiary of CoA and is a member of the consolidated tax group.

OBU Sub is gazetted as an OBU under paragraph 128AE(2)(ba) as a wholly owned subsidiary of CoA.

Risk participation is of commercial and strategic importance to CoA, and allows CoA to centrally manage and review its credit risks originated outside Australia.

Risk Participation Arrangement

CoA is undertaking risk participations through OBU Sub, who has entered into separate contractual relationships with some of CoA's offshore branches. As such, OBU Sub is able to assume the credit risk associated with a specified underlying loan or credit asset. There is no legal or contractual relationship between OBU Sub and the third party borrower located offshore (Borrower).

Risk Participation Arrangements (RPAs) can potentially be applied to several credit assets.

Only unfunded risk participations, where the credit risk of the underlying credit asset is accepted without posting cash funds as collateral against a credit event (as defined in the relevant Master Risk Participation Agreement (MRPA)) by the Borrower, will be undertaken by OBU Sub. In return for the assumption of credit risk, the offshore branch pays OBU Sub a fee, which depends on the underlying credit assumed and the percentage of credit risk participation.

Where a RPA is in respect of an undrawn loan facility, a fee will still be payable even though there is no current transfer of credit risk. The amount of the fee will depend on the credit profile of the Borrower, the tenor of the underlying credit asset and the percentage of the credit risk participation in the underlying credit asset.

If a credit event occurs, OBU Sub becomes liable for any credit losses. The RPAs will be cash settled.

Master Risk Participation Agreement

RPAs have been entered into between offshore branches and OBU Sub through the execution of MRPAs. Under the MRPA, OBU Sub agrees to participate up to 100% in the risk under a RPA with the offshore branch on the terms of the MRPA. OBU Sub currently participates in 100% of the credit risk and there is no intention to sell or transfer any credit risk assumed under any risk participation.

The MRPA provides that all dealings between the parties in relation to the MRPA are conducted and undertaken on arm's length commercial terms.

Participation Fee

The Participation Fee is the fee payable to OBU Sub from the offshore branch in return for assuming the credit risk of the underlying credit asset.

The price for a RPA is based on the total facility commitment amount incorporating expected utilisation rates as at the pricing date.

Other matters

• CoA is an Australian resident company for Australian taxation purposes.

• The offshore branches are permanent establishments outside of Australia and the tax consolidated group.

• Any offshore subsidiary of CoA is not an Australian resident company for Australian tax purposes.

• All transactions between the relevant entities (including transactions between Australian resident entities and offshore branches and subsidiaries) will be undertaken at arm's length.

• Appropriate transfer pricing documentation will be drafted to support the arm's length nature of the transaction.

• All transactions will be accurately recorded as transactions in the books of account.

Assumptions

1. At the time OBU Sub enters into a RPA under a MRPA, it is a thing done by the OBU.

2. When the 'thing is done' by the OBU, the OBU meets the OBU requirement in section 121EA.

3. The counterparty to a RPA is an 'offshore person' as set out in section 121E. This includes the offshore branches which constitute 'separate' persons pursuant to section 121EB.

4. CoA satisfies the record keeping requirements of section 262A(1A).

5. For the purposes of subsection 121D(3), all funds provided or received by OBU Sub and the offshore branch under a RPA are not in Australian currency or Australian currency denominated.

6. For the purposes of paragraph 121D(3)(a), the guarantee is in relation to activities that are, or will be, conducted wholly outside of Australia.

7. For the purposes of paragraph 121D(3)(b), the underwriting is in relation to property outside Australia or an event that can only happen outside Australia.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 121C

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

Income Tax Assessment Act 1936 subsection 121D(3)

Income Tax Assessment Act 1936 paragraph 121D(3)(a)

Income Tax Assessment Act 1936 paragraph 121D(3)(b)

Income Tax Assessment Act 1936 subsection 121D(5)

Income Tax Assessment Act 1936 section 121E

Reasons for decision

Question 1

Is the activity of entering into a risk participation arrangement an 'eligible contract activity' within the meaning of subsection 121D(5) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Summary

A Risk Participation Arrangement (as governed by the Master Risk Participation Agreement (MRPA))(RPA) is an 'eligible contract' on the basis that it is a form of a swap and/or an option contract.

Given that the Commissioner is asked to assume that the counterparty to a RPA is an offshore person as set out in section 121E, the entry into the 'eligible contract' is an 'eligible contract activity' within the meaning of subsection 121D(5).

Detailed reasoning

Pursuant to subsection 121D(5), for the purposes of paragraph 121D(1)(d), an 'eligible contract activity' is entering into an 'eligible contract' (other than a loan contract as per section 121D(5)) with an offshore person. Section 121C defines an eligible contract as a futures contract, a forward contract, an options contract, a swap contract, a cap, collar, floor or similar contract or a loan contract.

While there is limited guidance on what an eligible contract is, Taxation Determination TD 93/205 (TD 93/205) states that:

[T]he definition [of eligible contract] has been drafted widely and there is nothing to suggest that only interest rate derivative products and loans of foreign currencies should fall within the definition.

Further, the definition in section 121C explicitly states that an 'eligible contract' includes 'similar contracts'. While it could be argued that the inclusion of 'similar contract' is in reference to a cap, collar or floor contract rather than all the contracts listed in the definition, there is a view that the inclusion of 'similar contracts' supports the proposition that a wide interpretation of eligible contract is appropriate.

Therefore, in order for a RPA to be an 'eligible contract activity' within the meaning of subsection 121D(5), it must satisfy the commercial definition of one of the 'eligible contracts' set out in section 121C.

Risk participation

Risk participation allows a lender to reduce its exposure to a borrower by entering into an agreement with another party who will assume that risk. A significant factor of risk participation is that there is no direct contractual relationship between the sub-participant and the borrower. This remains with the lender (including its existing rights and obligations).¹

Risk participation can be either funded or unfunded. Pursuant to unfunded risk participations (which are the subject of this Ruling), the participant underwrites a proportion of any failure of the borrower to pay, in return for a fee. If the borrower defaults, the participant is required to reimburse the lender.

What is a swap?

The International Swaps and Derivatives Association (ISDA) defines a swap as a bilateral agreement to exchange cash flows at specified intervals (payment dates) during the agreed-upon life of the transaction (maturity or tenor). ²

David Mengle, the head of research at ISDA, has stated in his paper 'Credit Derivatives: An Overview' that a derivative is an agreement that shifts risk from one party to another, with its value derived from the value of an underlying price, rate, index, or financial instrument. ³

ISDA has defined a derivative as 'a risk transfer agreement, the value of which is derived from the value of an underlying asset'. ISDA classifies derivatives into three categories:

1. over-the-counter (OTC) derivatives (sometimes called swap agreements or swaps): customized, bilateral, privately negotiated agreements that transfer risk from one party to the other and are booked directly with each other.

2. listed derivatives or futures: standardized, exchange-traded derivatives, executed over a centralized trading venue and then booked with a central counterparty (a clearing house).

3. cleared derivatives: derivatives that are negotiated bilaterally but are booked with a clearing house.⁴

These classifications demonstrate the ISDA view that all OTC derivatives are swaps.

Mengle, in his paper, goes on to define a credit derivative as 'an agreement designed explicitly to shift credit risk between parties, with its value derived from the credit performance of one or more corporations, sovereign entities, or debt obligations'.⁵

Satyajit Das, author of 'Structured Products: Equity, Commodity & New Markets', defines a credit derivative as 'a class of financial instrument, the value of which is derived from an underlying market value driven by the credit risk of private or government entities other than the counterparties to the credit derivative transaction itself'.⁶ In particular, he states that credit derivatives allow for the trading of credit risk of a particular entity by two parties, which may have no commercial or financial relationship with the entity whose credit risk is being traded.⁷

Gunter Meissner, author of 'Credit Derivatives: Application, Pricing and Risk Management', describes credit derivatives as 'financial instruments designed to transfer credit risk from one counterpart to another. Legal ownership of the reference obligation is usually not transferred. Credit derivatives can have the form of forwards, swaps and options, which may be imbedded in financial assets such as bonds or loans. Credit derivatives allow an investor to reduce or eliminate credit risk to assume credit risk, expecting to profit from it'.⁸

A credit default swap is a specific type of credit derivative. It takes the form of a contractual agreement to transfer the default risk of one or more reference entities from one party to the other.⁹ One party pays a periodic fee to the other party during the term of the credit default swap in return for compensation for default (or similar credit event) by a reference entity, which is not a party to the credit default swap.¹⁰

An interest rate derivative is a straightforward example of a plain vanilla swap. However, TD 93/205 is suggests that the definition of eligible contract should not be limited to interest rate derivative products (without expressing a view as to whether a credit derivative, or more specifically, a credit default swap, is a swap).

This suggests that a credit derivative (or a credit default swap as a form of a credit derivative) could be interpreted as an 'eligible contract' for the purposes of section 121C.

What is an option?

As stated above, a credit derivative could have the form of a forward, a swap or an option.¹¹ As such, it is important to consider whether a RPA, while called a 'swap' by name, is in substance an option.

An option is an agreement that gives the buyer the right (but not the obligation) to buy or sell a specified amount of an underlying asset at an agreed upon price in return for a fee. In contrast, a swap locks in a price and the parties are locked in to symmetric and offsetting payment obligations, which is not necessarily the case with a credit default swap.

Options are generally perceived to be different from insurance as options do not require one party to suffer an actual loss for payment to occur.¹²

As stated by Meissner, a 'default swap can be viewed as a put option on the reference obligation. The default buyer owns this put, allowing him to sell the reference obligation to the default seller in case of default'.¹³ In other words, the asymmetrical obligations of a credit default swap, which give the seller of the credit default swap the obligation to purchase the underlying credit asset only when there is a default on that underlying credit asset, can also lead to the conclusion that a credit default swap is, in substance, a put option on the underlying credit asset.

Are RPAs 'eligible contracts'?

A key characteristic of a RPA that suggests that it is similar to a credit derivative is that it involves OBU Sub assuming the credit risk of an unrelated third party without any financial or contractual relationship with that party. Further, legal ownership of the underlying credit asset is not transferred from the offshore branch to OBU Sub.

Specifically, a RPA is similar to a credit default swap as OBU Sub receives a payment from the offshore branch for swapping the credit risk, payment of which is made for the OBU Sub agreeing to guarantee and underwrite the risk.

As stated above, a credit default swap is a form of a credit derivative. As such, RPAs, having similar attributes to credit default swaps, could be categorised as credit derivatives. Given the Commissioner's view in TD 93/205 that the definition of 'eligible contract' has been drafted widely, a RPA, being similar to a credit derivative, would, for the purposes of section 121C, be an 'eligible contract'.

A RPA also has features that are akin to a put option on a reference obligation. Should a credit event occur with a corresponding demand of payment to OBU Sub by the offshore branch, OBU Sub is obligated to pay an amount in reference to the amount in default. Or, in other words, the Originator (the buyer of the put) has an economic put option against the Participant (the seller of the put) to 'sell' the underlying credit asset (the reference obligation) which is triggered when there is a credit event.

Therefore, should it be considered that a RPA is not a 'swap', it could still be an 'eligible contract' by virtue of being a put option on the underlying credit asset.

Question 2

Is the activity of entering into a risk participation arrangement a 'guarantee-type activity' within the meaning of paragraph 121D(3)(a) of the ITAA 1936?

Summary

Having satisfied all the requirements for paragraph 121D(3)(a), by entering into a RPA under the MRPA, OBU Sub is undertaking a 'guarantee-type activity' within the meaning of paragraph 121D(3)(a).

Detailed reasoning

Paragraph 121D(3)(a) provides that a guarantee-type activity is providing a guarantee or letter of credit to an offshore person in relation to activities that are, or will be, conducted wholly outside Australia, where, if the offshore person is a related person, any money payable under the guarantee, letter, underwriting, loan or bond is not Australian currency.

The Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 2) 1994 (EM) states at paragraph 19.8 that:

[G]uarantee-type activities involve fee income for providing a guarantee or letter of credit, syndicating a loan, providing a performance bond or underwriting a risk.

Therefore, in order for the activity of entering into a RPA to be a 'guarantee-type activity', OBU Sub must receive fee income and the following requirements must be satisfied:

1. that the RPA is a guarantee or a letter of credit;

2. that the guarantee is provided to an offshore person;

3. that the guarantee is provided in relation to activities that are, or will be, conducted wholly outside Australia; and

4. where the offshore person is a related person, any money payable under the guarantee is not Australian currency.

Is the RPA a guarantee?

The word 'guarantee' is not defined in section 995-1 of the ITAA 1997 or section 6(1) of the ITAA 1936. It therefore takes its ordinary meaning.

The Commissioner has stated at paragraph 2 of Taxation Determination TD 93/129 (TD 93/129) that:

[T]he meaning of guarantee-type activities is to be interpreted widely. The Explanatory Memorandum states that 'activities which fall within the normal meaning of a guarantee … would also constitute 'guarantee-type activities'. All of the activities listed guarantee performance of a contract. In Lord Halsbury's Laws of England, 'guarantee' is defined as 'an accessory contract whereby the promisor undertakes to be answerable to the promisee for the debt, default or miscarriage of another person whose primary liability to the promisee must exist or be contemplated'. Activities which fall within this broad definition are to be treated as 'guarantee-type activities'.

The Macquarie Dictionary defines 'guarantee' as:

[A] warrant, pledge, or promise accepting responsibility for the discharging of another's liabilities, as the payment of a debt.

In Mallesons Stephen Jaques, Australian Finance Law, 2003, Fifth Edition, Law Book Company, at page 240, the authors state that:

A risk sub-participation will provide that, rather than the sub-participant funding the lender, the sub-participant will underwrite, in return for a fee, a proportion of any failure of the borrower to pay. … Risk sub-participations are often structured as guarantees or indemnities.

Under a RPA, OBU Sub has entered into a contractual relationship with the offshore branch through the execution of the MRPA to assume the risk of the underlying credit asset.

Pursuant to the MRPA, upon the occurrence of a credit event, OBU Sub is obligated to pay to the offshore branch, on demand, an amount.

Therefore, as OBU Sub is economically contracting to accept the responsibility to discharge the Borrower's debt in the event of that entity not discharging its obligations to the offshore branch, the rights and obligations of the offshore branch and OBU Sub are the same rights and obligations under a guarantee.

Therefore the first requirement in paragraph 121D(3)(a) is satisfied and a RPA could be construed to be a guarantee.

Has the guarantee been provided to an offshore person?

CoA has asked the Commissioner to assume that the counterparty to the RPA is an 'offshore person' within the meaning of section 121E.

Therefore the second requirement in paragraph 121D(3)(a) is satisfied.

Has the guarantee been provided in relation to activities that are, or will be, conducted wholly outside Australia?

CoA has asked the Commissioner to assume that the guarantee is in relation to activities that are, or will be, conducted wholly outside Australia within the meaning of paragraph 121D(3)(a).

Therefore the third requirement in paragraph 121D(3)(a) is satisfied.

Where the offshore person is a related person, is any money payable under the guarantee Australian currency?

CoA has asked the Commissioner to assume that amounts payable under the guarantee are not Australian currency within the meaning of subsection 121D(3).

Therefore the fourth requirement is satisfied.

Question 3

Is the activity of entering into a risk participation arrangement a 'guarantee-type activity' within the meaning of paragraph 121D(3)(b) of the ITAA 1936?

Summary

Having satisfied all the requirements for paragraph 121D(3)(b), by entering into a RPA under the MRPA, OBU Sub is undertaking a 'guarantee-type activity' within the meaning of paragraph 121D(3)(b).

Detailed reasoning

Paragraph 121D(3)(b) provides that a guarantee-type activity is underwriting a risk for an offshore person in respect of property outside Australia or an event that can only happen outside Australia, where, if the offshore person is a related person, any money payable under the guarantee, letter, underwriting, loan or bond is not Australian currency.

As stated above, the EM states at paragraph 19.8 that:

[G]uarantee-type activities involve fee income for providing a guarantee or letter of credit, syndicating a loan, providing a performance bond or underwriting a risk [emphasis added].

Therefore, in order for a RPA to be a guarantee-type activity for underwriting a risk, OBU Sub must receive fee income and the following requirements must be satisfied:

1. that the RPA is underwriting a risk

2. that the underwriting is for an offshore person

3. that the underwriting is in respect of property outside Australia or an event that can only happen outside Australia, and

4. that if the offshore person is a related person, any money payable under the underwriting is not Australian currency.

Is the RPA the underwriting of a risk?

The words 'underwriting' or 'risk' are not defined in section 995-1 of the ITAA 1997 or section 6(1) of the ITAA 1936. They therefore take their ordinary meaning.

The definition of 'underwrite' in the Macquarie Dictionary includes:

[T]o agree to meet the expense of; undertake to finance.

Or, with respect to insurance:

a. to write one's name at the end of (a policy of insurance), thereby becoming liable in case of certain losses specified therein.

b. to insure.

c. to assume liability to the extent of (a certain sum) by way of insurance.

Further, the Macquarie Dictionary defines 'risk' as:

[E]xposure to the chance of injury or loss; a hazard or dangerous chance.

And in the case of insurance, as:

a. the hazard or chance of loss.

b. the degree of probability of such loss.

c. the amount which the insurance company may lose.

d. a person or thing with reference to the risk involved in insuring them.

e. the type of loss, as life, fire, theft, etc., against which insurance policies are drawn.

The Commissioner has stated at paragraph 2 of TD 93/129 that the meaning of guarantee-type activities is to be interpreted widely.

A RPA effectively enables a participant to assume the liability of a third-party borrower in the event of a credit event, which could be interpreted as being by way of insurance for the offshore branch.

Therefore the first requirement in paragraph 121D(3)(b) is satisfied.

Is the underwriting for an offshore person?

CoA has asked the Commissioner to assume that the counterparty to the RPA is an 'offshore person' within the meaning of section 121E.

Therefore the second requirement in paragraph 121D(3)(b) is satisfied.

Is the underwriting in respect of property outside Australia or an event that can only happen outside Australia?

CoA has asked the Commissioner to assume that the underwriting is in respect of property outside Australia or an event that can only happen outside Australia within the meaning of paragraph 121D(3)(b).

Therefore the third requirement in paragraph 121D(3)(b) is satisfied.

Where the offshore person is a related person, is any money payable under the underwriting Australian currency?

CoA has asked the Commissioner to assume that amounts payable under the underwriting are not Australian currency within the meaning of subsection 121D(3).

Therefore the fourth requirement is satisfied.

¹ Mallesons Stephen Jaques, Australian Finance Law, 2003, Fifth edition, Law Book Company, p 240.

² http://www.isda.org/educat/faqs.html.

³ Mengle, David 'Credit Derivatives: An Overview' Federal Reserve Bank of Atlanta Economic Review, Fourth Quarter December 2007, p 1.

⁴ http://www.isda.org/educat/faqs.html.

⁵ Ibid.

⁶ Das, Satyajit, 'Structured Products Volume 2: Equity; Commodity; Credit & New Markets', 3^rd ed revised, 2006 John Wiley & Sons (Asia) Pte Ltd, Singapore, p 669.

⁷ Ibid, p 670.

⁸ Meissner, G, 'Credit Derivatives Application, Pricing and Risk Management', 2005, Blackwell Publishing, Carlton, p 1.

⁹ Mengle, David, above n 3, p 1.

¹⁰ http://www.isda.org/educat/faqs.html.

¹¹ Meissner, G, above n 8 p 1.

¹² http://www.isda.org/educat/faqs.html.

¹³ Meissner, G, above n 8, p 15.