Edited version of your written advice

Authorisation Number: 1012775458243

Ruling

Subject: 'Interest' under subsection 128A(1AB) of the ITAA 1936

This ruling applies to" Entity X

Question 1:

Will Payment A paid by Entity X to Entity Y under Agreement Z fall within the expanded definition of 'interest' under Australian income tax laws, as either an amount in the nature of interest or an amount in substitution for interest under subsection 128A(1AB) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer:

Yes. Payment A paid by Entity X to Entity Y under Agreement Z will fall within the expanded definition of 'interest' under Australian income tax laws, as either an amount in the nature of interest or an amount in substitution for interest under subsection 128A(1AB) of the ITAA 1936.

Question 2:

Will Payment B paid by Entity X to Entity Y under Agreement Z fall within the expanded definition of 'interest' under Australian income tax laws, as either an amount in the nature of interest or an amount in substitution for interest under subsection 128A(1AB) of the ITAA 1936?

Answer:

Yes. Payment B paid by Entity X to Entity Y under Agreement Z will fall within the expanded definition of 'interest' under Australian income tax laws, as either an amount in the nature of interest or an amount in substitution for interest under subsection 128A(1AB) of the ITAA 1936.

Question 3

Will Payment C paid by Entity X to Entity Y under Agreement Z fall within the expanded definition of 'interest' under Australian income tax laws, as either an amount in the nature of interest or an amount in substitution for interest under subsection 128A(1AB) of the ITAA 1936?

Answer:

Yes. Payment C paid by Entity X to Entity Y under Agreement Z will fall within the expanded definition of 'interest' under Australian income tax laws, as either an amount in the nature of interest or an amount in substitution for interest under subsection 128A(1AB) of the ITAA 1936.

Question 4

For the purposes of section 12-245 of Schedule 1 to the Taxation Administration Act 1953 (TAA 1953), when does Entity X's requirement to withhold from Payment A and Payment B made to Entity Y arise?

Answer:

For the purposes of section 12-245 of Schedule 1 to the TAA 1953, Entity X's requirement to withhold from Payment A and Payment B arises when those payments are 'taken to have been paid' to Entity Y for the purposes of subsection 11-5(1) of the TAA 1953.

Relevant facts and circumstances

Entity Y Group, Country D

Entity Y is incorporated in Country D and is wholly owned by an entity whose principal activities are property development and construction.

Entity X Group, Australia

Entity X forms part of a group also involved in the construction and development of property.

The Project

The Entity Y and Entity X group agreed to jointly commission the design, construction, development, financing, marketing and completion of residential apartments in Australia.

The Project is to be funded by a combination of debt and equity. The Project Land is held by Entity X.

Entity Y has provided funds to Entity X ('Facility M Funds'') under the terms and conditions of Agreement Z.

Agreement Z

The terms and conditions of Agreement Z provide that:

• The Facility M Funds are only to be used to finance the development of the Project and finance Project costs

• In consideration of Entity Y providing the Facility M Funds and entering into Agreement Z,

• Entity X is to pay the Facility M Funds to Entity Y on a specified Maturity Date at the end of N years, under Agreement Z

• Entity X must make a payment termed 'Payment A' to Entity Y at regular intervals of the term of Agreement Z until the Maturity Date

• Payment A is calculated by applying a nominated AUD Bank Bill Swap Interest Rate to the Facility M Funds

• At Maturity Date, Entity X must pay an amount termed 'Payment B' to Entity Y

• Payment B amounts to the difference between:

• stipulated percentage per annum of the Facility M Funds for the term of N years of Agreement Z ('Amount E); and

• the sum of each Payment A made during the term of Agreement Z

• Entity X must make a payment, on demand, to Entity Y, termed 'Payment C' on any amount payable under Agreement Z that remains outstanding

• Payment C is determined by applying a rate that is approved by the Country D banks to each unpaid amount in question

Relevant Legislative Provisions:

Division 11A: Income Tax Assessment Act 1936

Subsection 128A(1AB): Income Tax Assessment Act 1936

Subsection 128B(2): Income Tax Assessment Act 1936

Subsection 128B(5): Income Tax Assessment Act 1936

Section 11-5: Schedule 1 to the Taxation Administration Act 1953

Section 12-245: Schedule 1 to the Taxation Administration Act 1953

Paragraph 230-45(1)(c): Income Tax Assessment Act 1997

Reasons for decision

These reasons for decision accompany the Notice of private ruling for Entity X.

While these reasons are not part of the private ruling, we provide them to help you to understand how we reached our decision.

Meaning of the term 'interest'

Section 12-245 of Schedule 1 to the Taxation Administration Act 1953 (TAA 1953) provides that:

'an entity must withhold an amount from interest (within the meaning of Division 11A of Part III of the ITAA 1936) it pays to an entity, or to entities jointly, if:

(a) The recipient or any of the recipients has an address outside Australia according to any record that is in the payer's possession, or is kept or maintained on the payer's behalf, about the transaction to which the interest relates; or

(b) The payer is authorised to pay the interest at a place outside Australia (whether to the recipient or any of the recipients or to anyone else)'.

Interest' is defined in section 128A(1AB) of the ITAA 1936 as follows:

'interest' includes an amount, other than an amount referred to in subsection 26C(1) of the

ITAA 1936:

(a) that is in the nature of interest; or

(b) to the extent that is could reasonably be regarded as having been converted into a form that is in substitution for interest; or but does not include an amount to the extent to which it is a return on an equity interest in a company'.

Subsection 26C(1) of the ITAA 1936 is concerned with gains on disposals of prescribed securities and has no relevance in the present circumstances.

Facility M Funds

Agreement Z enables Entity Y to advance the Facility M Funds to Entity X under particular terms and conditions.

ATO Interpretative Decision (ATO ID) 2006/292 provides that the definition of a loan in the Chitty on Contracts, 1989, 26th edition, at para 3574, indicates that a loan should possess the following elements:

•  a person lends or agrees to lend money to another

•  in consideration of a promise to repay that sum

•  the repayment is at a fixed or determinable future time

•  the repayment can be made with or without interest, and

•  an equivalent amount will be repaid.

In the present circumstances, Agreement Z is a contract of loan of money, whereby Entity Y provides the Facility M Funds to Entity X in consideration of the promise expressed by Entity X to repay that sum at a fixed or determinable future time.

Is income derived under Agreement Z an amount of 'interest'?

Subsection 128A(1AB) of the ITAA 1936 provides an expanded definition of 'interest' for the purposes of Division 11A of the ITAA 1936. It relevantly provides that interest includes an amount that is in the 'nature of interest' or an amount to the extent that it could reasonably be regarded as having been converted into a form that is in 'substitution for interest'.

The word 'interest' is not otherwise defined by the Income Tax Act and it is therefore necessary to have regard to common law to determine whether an amount is, in the first instance, 'interest'.

There are several essential characteristics of 'interest amounts' emerging from some of the decided cases as follows:

In considering its ordinary meaning, interest was described by Rowlatt J in Bennett v. Ogston (HM Inspector of Taxes) (1930) 15 TC 374 at 379, as being 'a payment by time for the use of money'.

It is an amount that is calculated by reference to a principal sum and by reference to time (Federal Wharf Co Ltd v. Deputy Commissioner of Taxation (1930) 44 CLR 24 at 28.

Interest is in essence compensation to a lender for being kept out of the use and enjoyment of the principal sum (Federal Commissioner of Taxation v. The Myer Emporium Ltd (1987) 163 CLR 199; (1987) 18 ATR 693; (1987) 87 ATC 4363).

ATO Interpretative Decision (ATO ID) 2008/153 provides that, per Taxation Rulings TR 93/27 (paragraphs 24-30) and TR 2002/15 (paragraphs 53-56), the following requirements must normally be satisfied for a payment to be treated as interest:

• there must be a sum of money by reference to which the payment is to be ascertained (generally called the principal sum or the principal debt);

• that sum must be a sum which is due to the person entitled to the interest; and

• the payment must be calculated by reference to time.

In the context of interest withholding tax, which is relevant to the present circumstances, the Full Federal Court in Federal Commissioner of Taxation v. Century Yuasa Batteries Pty Ltd (1998) 82 FCR 288; 38 ATR 442; 98 ATC 4380, stated that the ordinary meaning of interest is the 'return, consideration or compensation for the use or retention by one person of a sum of money belonging to, or owed to, another, and that interest must be referable to a principal'. In particular, Cooper J said in relation to the precursor to paragraph 128A(1AB)(a) of the ITAA 1936 that:

...In my view, for a payment to fall within the extended definition under section 128A(1) of the ITAA 1936 in the context of the withholding tax provisions of ITAA it must have the character of a return or profit to the lender for the use of money advanced to the borrower howsoever calculated or ascertained. For example, the difference between the "extended credit price" and the cash price under consideration in Re Rouse; South Australian Gas Co v Official Receiver , in my opinion would fall within the extended definition in s 128A(1) of the ITAA 1936'.

From the above court cases and the Taxation Rulings it is possible to draw the following conclusions regarding interest:

(a) There is generally a relationship of debtor and creditor;

(b) Interest must be calculated with reference to a sum of money;

(c) Interest is payable for the use of money and is in the nature of compensation for deprivation of use of money; and

(d) Interest accrues over time.

Question 1

Is 'Payment A' payable under Agreement Z an amount in the 'nature of interest' or, an amount paid in 'substitution for interest'?

The description of an item used in any relevant agreement is not conclusive of its character (refer Cliffs International Inc. v. FC of T (1979) 142 CLR 140 at 148; 79 ATC 4059 at 4064; 9 ATR 507 at 512 per Barwick CJ).

In Broken Hill Pty Co Ltd v FC of T [2000] FCA 1431; 2000 45 ATR 507 (Broken Hill case) the Full Federal Court determined that an amount described as 'interest' in a share purchase agreement between the taxpayer and the vendor was an outgoing of capital or capital in nature. Although the 'interest' was calculated as a % per annum on the purchase price of the asset, the court noted that there was no loan to the taxpayer nor had the taxpayer entered into possession of the assets being sold at the date of the contract or at the date from which any amount was payable. The whole of the money payable, both the purchase price and so-called 'interest', were therefore part of the total consideration to be paid for the assets.

'Payment A' payable under Agreement Z is an amount calculated over the term of Agreement Z by multiplying the principal outstandings in respect of the Facility M funds by a nominated rate referable to the AUD Bank Bill Swap Interest Rate.

Agreement Z provides that Payment A, among others, is paid by Entity X in consideration of the provision of the Facility M Funds by Entity Y.

The following conclusions can be drawn from the method of ascertainment of the Payment A:

• Payment A is referable to the Facility M Funds provided by Entity Y to Entity X under the terms of Agreement Z;

• Entity X has an obligation to repay the Facility M Funds, the principal equivalent under Agreement Z, on or before a date specified under agreement Z;

• Payment A is calculated on the Facility M Funds at a stipulated rate;

• Payment A runs from day to day until repayment of the Facility M Funds, its total depending on the term of Agreement Z; and

• Payment A's function, derived from the above conclusions, is to compensate Entity Y for the delay in repayment of the Facility M Funds by Entity X.

In reference to the observation made by the courts in the Broken Hill case, in the present circumstances Payment A is not made to acquire the investment (asset) that is financed.

The economic substance of Agreement Z is the equivalent of a loan arrangement. That is, the principal equivalent under Agreement Z is the value of the Facility M Funds, and the interest equivalent is the aggregate of Payment A amounts made by Entity X during the term of Agreement Z.

Therefore, Payment A is in substance an amount of 'interest' so that for the purposes of subsection 128A(1AB) of the ITAA 1936, it is an amount in the 'nature of interest' or alternatively, an amount paid 'in substitution for interest'.

Question 2

Is 'Payment B' payable under Agreement Z an amount in the 'nature of interest' or, an amount paid in 'substitution for interest'?

Agreement Z provides that Payment B, among other payments, is paid by Entity X in consideration of the provision of the Facility M Funds by Entity Y.

The Facility M Funds is the principal amount provided by Entity Y to Entity X under Agreement Z. Entity X has an obligation to repay the Facility M Funds on or before a date specified under Agreement Z, being the Maturity Date of Agreement Z.

Payment B under Agreement Z is calculated as the difference between 'Amount E' at Maturity Date less the aggregate of Payment A amounts at Maturity Date.

Amount E is derived as a percentage per annum of the Facility M Funds. The aggregate of Payment A amounts is the total of all Payment A amounts made during the term of Agreement Z.

It has been established previously in this report that Payment A is in substance an amount of interest for the purposes of subsection 128A(1AB) of the ITAA 1936.

In a similar vein the true nature of 'Amount E' needs to be examined.

Amount E is calculated:

• by reference to the Facility M Funds drawdown at the end of each year of Agreement Z;

• by reference to time, and accrues from day to day until repayment of the Facility M Funds; and

• at a stipulated rate, applied to the Facility M Funds drawdown in each year of the term of Agreement Z

'Amount E' bears all the hallmarks of an amount of 'interest' as elicited from case law and the relevant Taxation Rulings cited previously in this report. Therefore, Payment B is the difference between an amount of interest described as Amount E, and an amount of interest described as aggregate of Payment A amounts.

It is considered that Payment B has the character of compensation or consideration payable in respect of keeping Entity Y out of the use and enjoyment of the Facility M Funds until the Maturity date.

Accordingly, Payment B is an amount that is in the 'nature of interest or alternatively, an amount paid 'in substitution for interest' for the purposes of subsection 128A(1AB) of the ITAA 1936.

Question 3

Is a 'Payment C' payable under Agreement Z an amount in the 'nature of interest' or, an amount paid in 'substitution for interest'?

Payment C is payable by Entity X to Entity Y in respect of a payment under Agreement Z that remains unpaid on the due date. Payment C will accrue on a daily basis.

Payment C is calculated by applying a rate per annum, as approved by Country D banks, to an unpaid amount, for each day the amount remains unpaid.

It needs to be considered whether a Payment C amount paid by the resident borrower and derived by the non-resident lender, constitutes interest.

Each Payment C amount is a percentage per unit of time calculated by reference to a sum of money (namely unpaid amounts under Agreement Z). Payment C is therefore payable as consideration or compensation for amounts in relation to which a liability to repay exists, and which Entity Y can require to be paid either on demand or at a fixed date.

Furthermore, every Payment C amount is a charge for keeping Entity Y out of the use and enjoyment of an amount payable on a specified date under the terms of Agreement Z.

Accordingly, Payment C is in substance an amount of interest for the purposes of the expanded definition of interest in paragraphs 128A(1AB)(a) and (b) of the ITAA 1936 so that it is an amount 'in the nature of interest' or an amount paid in 'substitution for interest'.

Question 4

When does the requirement to withhold from Payment A and Payment B arise?

Section 12-245 of the TAA 1953 requires a person to withhold amounts from payments of interest to a non-resident. Subsection 11-5(1) of Schedule 1 to the TAA 1953 deems an amount to have been paid when the paying entity applies or deals with the amount in any way on the payee's behalf or as the payee directs ( Taxation Determination TD 93/146 and TD 93/146A- Addendum).

In the present circumstances, Payment A and Payment B amounts are considered to be amounts of 'interest' for the purposes of subsection 128A(1AB) of the ITAA 1936. Further, Payment A and Payment B amounts are made to Entity Y, a resident of Country D for income tax purposes.

Entity X has therefore an obligation to withhold from each Payment A and Payment B amount at the time those amounts are taken to have been paid to Entity Y. Pursuant to subsection 11-5 (1) of the TAA 1953, Entity X is taken to have made a Payment A or a Payment B to Entity Y if Entity X applies or deals with a Payment A or Payment B amount in any way on behalf of Entity Y or as directed by Entity Y.

Further issues considered

• Taxation of Financial Arrangements (TOFA) rules.

Where a contract of loan of money is also a 'financial arrangement' for the purposes of Division 230 of the ITAA 1997, the gains or losses on the loan are brought to account or allowable as a deduction under Division 230 of the ITAA 1997.; see Explanatory Memorandum to Tax Laws Amendment (Taxation of Financial Arrangements) Act 2009 at paragraph 11.30 of Chapter 11 'Interaction and consequential amendments (other than consolidation) (Explanatory Memorandum).

Agreement Z is considered to be a 'financial arrangement' in terms of paragraph 230-45(1)(c) of the ITAA 1997.

However, as stated in paragraph 11.32 of the Explanatory Memorandum:

'Where a financial arrangement is held (as an asset) by a foreign resident, any gain or part thereof from the financial arrangement that is income (e.g. interest) to which section 128B of the ITAA 1936 applies is not to be assessable under Division 230. Those gains are to be subject to withholding tax as per Division 11A of Part III of the ITAA 1936'.

In the present circumstances, the arrangement under agreement Z would be reflected as an asset in the accounts of Entity Y, a Country D resident for income tax purposes. Therefore, any income derived under Agreement Z to which section 128B of the ITAA 1936 applies, is not subject to the TOFA rules in Division 230 of the ITAA 1997.

As established earlier in this report, the income derived under agreement Z, namely, Payment A and Payment B, is in substance an amount of 'interest' to which the withholding tax provisions in Division 11A would apply, specifically sections 128B(2) and 128B(5) of the ITAA 1936. Therefore, income derived by Entity Y under Agreement Z is not subject to Division 230 of the ITAA 1997.