Edited version of your written advice

Authorisation Number: 1013040729898

Date of advice: 23 June 2016

Ruling

Subject: Offshore Banking Units

Question 1

Will Company A entering into a contract that is materially the same as a Guarantee and Risk Participation Agreement (GRPA) under the Master Guarantee and Risk Participation Agreement (MGRPA) constitute an 'OB activity' of Company A within the meaning of subsection 121D(1) of the Income Tax Assessment Act 1936 (ITAA 1936), by virtue of being an 'OB eligible contract activity' as defined in section 121DB of the ITAA 1936?

Answer

Yes.

Question 2

Will Company A entering into a contract that is materially the same as an Indemnity and Risk Participation Agreement (IRPA) under the Master Indemnity and Risk Participation Agreement (MIRPA) constitute an 'OB activity' of Company A within the meaning of subsection 121D(1) of the ITAA 1936, by virtue of being an 'OB eligible contract activity' as defined in section 121DB of the ITAA 1936?

Answer

Yes.

Question 3

Will Company A entering into a contract that is materially the same as a Contract of Insurance (CI) constitute an 'OB activity' of Company A within the meaning of subsection 121D(1) of the ITAA 1936, by virtue of being an 'OB eligible contract activity' as defined in section 121DB of the ITAA 1936?

Answer

Yes.

Question 4

Will Company A entering into a contract that is materially the same as a Non-Payment Insurance Policy (NPIP) constitute an 'OB activity' of Company A within the meaning of subsection 121D(1) of the ITAA 1936, by virtue of being an 'OB eligible contract activity' as defined in section 121DB of the ITAA 1936?

Answer

Yes

Question 5

Where entering into a Contract constitutes an 'OB activity' of Company A within the meaning of subsection 121D(1) of the ITAA 1936, will fees and premiums paid by Company A to a counterparty (or its agent) under the Contract constitute 'exclusive OB deductions' as defined in subsection 121EF(3) of the ITAA 1936?

Answer

Yes.

Question 6

Where entering into a Contract constitutes an 'OB activity' of Company A within the meaning of subsection 121D(1) of the ITAA 1936, will amounts received by Company A under the Contract constitute 'assessable OB income' of Company A as defined in subsection 121EE(2) of the ITAA 1936?

Answer

Yes.

This ruling applies for the following periods

1 July 20VV to 30 June 20YY

The scheme commenced on

20XX

Relevant facts and circumstances

1. Company A is an Australian financial institution.

2. Company A was declared to be an offshore banking unit (OBU) by notice published in the Gazette.

3. Company A undertakes a range of OBU activities. These include providing loans directly to offshore persons, or entering into credit default swaps or other credit risk derivatives with offshore persons.

4. Company A seeks to manage existing and future credit risk exposures by entering into various credit risk contracts (collectively the Contracts) through the OBU such as:

a. GRPA under a MGRPA

b. IRPA under a MIRPA

c. CI, and

d. NPIP.

Company A's OBU will be entering into a Contract with a non-resident party, most likely a financial institution or insurance company. In return for a fee from Company A's OBU, the non-resident party will take on some of the risk of the credit exposure covered by the Contract in question.

5. Company A manages credit risk, and seeks to enter these Contracts for a number of commercial, credit, and portfolio reasons.

6. Each risk participant will be an 'offshore person' under subsection 121E(a) of the ITAA 1936 in the context of entering into the Contracts. Each risk participant to the Contracts will

a. be a non-resident for Australian income tax purposes, and

b. will not be entering into the Contracts in carrying on a business in Australia at or through a permanent establishment of the risk participant in Australia.

7. Company A's activities with respect to entering into a Contract will satisfy the 'OBU' requirement in section 121EA of the ITAA 1936.

8. None of the money used by Company A in relation to entering into the Contracts, or making any payments under the Contracts, will be 'non-OB money' of Company A, as defined in section 121C of the ITAA 1936.

9. The Contracts will be entered into between Company A and the relevant counterparties on arm's length terms.

MGRPA

10. The key terms of the MGRPA are;

a. The risk participant (being the non-resident party) will agree to participate in up to 100% of the credit risk associated with the specified loans.

b. Company A's OBU will pay a fee to the risk participant, calculated as the risk participant's participation percentage multiplied by Company A's gross remuneration received on the underlying loans and credit agreements, including both drawn and undrawn amounts (adjusted for any transfers of Company A's credit risk exposure for these loans). Company A's gross remuneration from loan and credit agreements includes, but is not limited to, the credit risk margin, participation or syndication fees, arrangement fees, underwriting fees, commitment fees and penalties.

c. The fee will be payable to the risk participant periodically as agreed between the parties.

d. Company A may make a demand under the GRPA for unpaid amounts at any time following a non-payment default by providing a demand notice to the risk participant.

e. Within a specified time period following receipt of the demand notice, the risk participant will pay the amount requested in full to Company A, subject solely to any set-off for unpaid fees that Company A owes to the risk participant.

f. Company A will be required to exercise its obligations reasonably to pursue any recoveries from each borrower or obligors under a loan or credit agreement. The risk participant will be entitled to share pro rata, based on their participation percentage in any amounts recovered from the underlying defaulted loans, net of expenses.

g. In the event that Company A find it is legally impossible, unfeasible or otherwise impracticable for any subrogation of its rights against the obligors, it shall assign to the risk participant all of its rights, claims securities and monies it holds in respect of the covered facility pro rata to the risk participant's participation percentage.

MIRPA

11. The key terms of the MIRPA are;

a. The risk participant will agree to participate in up to 100% of the credit risk associated with specific loans or credit agreements.

b. Company A will pay a fee to the risk participant, calculated as the risk participant participation multiplied by Company A's gross remuneration received on the underlying loans and credit agreements, including both drawn and undrawn amounts, and may be subject to a minimum fee. Company A's remuneration from loans or credit agreements includes, but is not limited to, the credit risk margin, participation or syndication fees, arrangement fees, underwriting fees, commitment fees and work fees.

c. Company A may make a demand under an IRPA for unpaid amounts at any time following a non-payment default (i.e. an obligor's failure to make payment to Company A of any amount which is due and payable under the relevant agreement), by providing a demand notice to the risk participant.

d. Within a specified time period following receipt of a demand notice (or some other time specified in the indemnity), the risk participant must pay the amount requested in full to Company A.

e. Company A will be required to exercise its obligations reasonably to avoid or reduce any amounts unpaid under indemnified loans. The risk participant will be entitled to share pro rata (based on their participation percentage) in any amounts recovered from underlying defaulted loans, net of expenses.

CI

12. The key terms of the CI are;

a. The risk participant will indemnify Company A for the insured percentage (up to 100%) of any unpaid principal amounts due and payable under specified loans or credit agreements, capped at the policy limit.

b. Company A will pay premiums to the risk participant, broadly calculated as the risk participant's insured percentage multiplied by specified rates applied to Company A's exposure on its loans and other credit agreements.

c. Premiums are payable by Company A periodically as specified in a CI, for example semi-annually in advance, commencing 60 days from inception of a CI.

d. Company A may make a claim under a CI where there is non-payment (i.e. an obligor fails to make payment to Company A of principal on an insured loan that is due and payable under the relevant agreement).

e. Any valid claim amount will be due and payable to Company A by the risk participant within a prescribed timeframe, for example on the later of 30 days following the date the risk participant has received reasonable evidence necessary to prove the claim or the waiting period.

f. Company A will be required to exercise its obligations reasonably to pursue any recoveries from obligors. The risk participant will be entitled to share pro rata to their insured percentage in any amounts recovered from loans. Upon payment of a Loss, the insurer is subrogated to Company A's rights under, and subject to the terms of the covered document. Company A must, at the insurer's request, assign to the insurer all the rights relating to that proportion of the loss in respect of which a claim has been paid.

NPIP

13. The key terms of the NPIP are;

a. The risk participant will indemnify Company A for the insured percentage (up to 100%) of any unpaid principal amounts due and payable under specified loans and credit agreements, capped at the Maximum Aggregate Limit of Liability.

b. Company A will pay premiums from time to time to the risk participant, broadly calculated as a specified percentage of Company A's exposure on its loans and credit agreements.

c. Company A may make a claim under the NPIP within a prescribed period, for example, no later than 30 days following the date of default in payment on an insured loan/credit agreement.

d. Any valid claim amount will be due and payable to Company A by the risk participant after the prescribed waiting period.

e. Company A will be required to exercise its obligations reasonably to avoid or reduce any amounts that are due and payable but remain unpaid under an insured loan. The risk participant will be entitled to share pro rata to their insured percentage in any amounts recovered from an insured loan net of expenses. Upon the payment of any compensation by the insurer, the insurer shall be subrogated (to the proportionate extent of the payment of a claim relative to Company A's total loss on the covered credit agreement) to, and if requested, Company A shall (to the extent it is legally permissible to do so) assign or transfer to the insurer, to the extent of the insured loss, Company A's rights of recovery.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 121C

Income Tax Assessment Act 1936 subsection 121D(1)

Income Tax Assessment Act 1936 section 121DB

Income Tax Assessment Act 1936 section 121E

Income Tax Assessment Act 1936 subsection 121EE(2)

Income Tax Assessment Act 1936 subsection 121EF(2)

Income Tax Assessment Act 1936 subsection 121EF(3)

Income Tax Assessment Act 1997 subsection 20-20(2)

Income Tax Assessment Act 1997 paragraph 25-35(1)(b)

Reasons for decision

Question 1

Will Company A entering into a contract that is materially the same as a GRPA under the MGRPA constitute an 'OB activity' of Company A within the meaning of subsection 121D(1) of the ITAA 1936, by virtue of being an 'OB eligible contract activity' as defined in section 121DB of the ITAA 1936?

Detailed reasoning

Division 9A of Part III of the ITAA 1936 allows certain income of an OBU to be given concessional tax treatment. The types of income treated this way must be derived from 'OB activities.' A list of OB activities is provided in subsection 121D(1) of the ITAA 1936 and includes:

(a) a borrowing or lending activity described in subsection (2); or

(b) a guarantee-type activity described in subsection (3); or

(c) a trading activity described in subsection (4) (subject to subsection (4A)) or

(d) an OB eligible contract activity (see section 121DB); or

(e) an investment activity described in subsection (6), (6A) or (6B); or

(f) an OB advisory activity (see section 121DC); or

(g) a hedging activity described in subsection (8); or

(ga) an OB leasing activity (see section 121DD); or

(h) any other activity involving an offshore person, being an activity declared by regulations for the purposes of this paragraph to be an OB activity.

Of particular relevance is paragraph (d) OB eligible contract activity.

OB eligible contract activity is defined in section 121DB of the ITAA 1936 as:

An OB eligible contract activity is entering into an eligible contract (other than a loan contract that is not a securities lending or repurchase arrangement) with:

(a) an offshore person; or

(b) if the eligible contract is a non-deliverable forward foreign currency contract - any person.

Each risk participant will be an 'offshore person' under subsection 121E(a) of the ITAA 1936 in the context of entering into the Contracts. Each risk participant to the Contracts will:

a. be a non-resident for Australian income tax purposes, and

b. will not be entering into the Contracts in carrying on a business in Australia at or through a permanent establishment of the risk participant in Australia.

Eligible contract

An eligible contract for OB activities purposes is defined in section 121C of the ITAA 1936 as:

(a) any of the following:

(i) a futures contract;


(ii) a forward contract;


(iii) an options contract;


(iv) a swap contract;


(v) a cap, collar, floor or similar contract; or

(b) a loan contract; or

(c) a securities lending or repurchase arrangement; or

(d) a non-deliverable forward foreign currency contract.

The Commissioner has issued Taxation Determination TD 93/205 Income tax: Offshore Banking Units (OBU) - does trading in, or entering into commodity derivatives such as commodity futures, forwards, options and swaps constitute offshore banking (OB) activity for the purposes of section 121D? in which he expressed the view that 'eligible contract' has been drafted widely and should be interpreted broadly and extend beyond including only interest rate derivative products and loans of foreign currencies.

For the GRPA to be an eligible contract, it must satisfy the commercial definition of one of the contracts above. Of particular relevance is the inclusion of a 'swap' contract in the list.

Swap Contract

A 'swap' is defined by the International Swaps and Derivatives Association (ISDA) as:

A swap is a bilateral agreement to exchange cash flows at specified intervals (payment dates) during the agreed-upon life of the transaction (maturity or tenor).

A swap is a form of a derivative, which is also defined by the ISDA as:

A derivative is a risk transfer agreement, the value of which is derived from the value of an underlying asset. The underlying asset could be an interest rate, a physical commodity, a company's equity shares, an equity index, a currency or virtually any other tradable instrument upon which parties can agree.

ISDA states that derivatives fall into three categories; over the counter derivatives (OTC derivatives), standardized exchange-traded derivatives and cleared derivatives. Of relevance are OTC derivatives, which

are customised, bilateral agreements that transfer risk from one party to the other. OTC derivatives, which are sometimes called swap agreements or swaps, are negotiated privately between the two parties and then booked directly with each other.

A swap contract and an OTC derivative therefore broadly have the same definition.

A specific type of credit derivative is the credit default swap. 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. 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.

Are the GRPAs swap contracts, and therefore 'eligible contracts?'

From an economic viewpoint, a GRPA is similar to a credit default swap. This is because Company A pays a regular fee or premium to the relevant risk participant for 'swapping the credit risk'. The risk participant in exchange for a fee or premium agrees to take on the credit risk of the underlying loan. In the event that the borrower fails to make payment to Company A of any amount which is due and payable under the covered agreement, the risk participant makes a payment for the unpaid amount.

GRPAs, having similar attributes to credit default swaps, and can be categorised as credit derivatives. Considering the Commissioner's view that 'eligible contract' has been drafted widely and should be interpreted broadly, a GRPA, being similar to a credit derivative, would be a swap contract, satisfying the definition of OB eligible contract activity under section 121DB of the ITAA 1936.

Question 2

Will Company A entering into a contract that is materially the same as an IRPA under the MIRPA constitute an 'OB activity' of Company A within the meaning of subsection 121D(1) of the ITAA 1936, by virtue of being an 'OB eligible contract activity' as defined in section 121DB of the ITAA 1936?

Detailed reasoning

Although referred to as an IRPA, the terms of the agreement are, in all aspects relevant to this ruling, the same as the GRPA. The economic substance of the agreement is substantially the same, with the risk participant being paid a fee or premium in exchange for taking on a percentage of the credit risk of the covered asset. The only difference of note is the terminology used.

As a result, the same analysis as set out above for the GRPA applies to the IRPA. That is:

• The IRPA is on materially the same terms as the GRPA. As such, the IRPA is an 'eligible contract' on the basis that it is a swap contract.

• Each risk participant will be an 'offshore person' under subsection 121E(a) of the ITAA 1936 in the context of entering into the Contracts.

Therefore Company A entering into the IRPA (an eligible contract), with the offshore person will qualify as an OB eligible contract activity under section 121DB.

Question 3

Will Company A entering into a contract that is materially the same as a CI constitute an 'OB activity' of Company A within the meaning of subsection 121D(1) of the ITAA 1936, by virtue of being an 'OB eligible contract activity' as defined in section 121DB of the ITAA 1936?

Detailed reasoning

Although referred to as a CI, the terms of the agreement are, in all aspects relevant to this ruling, the same as both the GRPA and IRPA. The economic substance of the agreement is substantially the same with the insurer (risk participant) being paid a fee or premium in exchange for taking on a percentage of the credit risk of the insured loan or credit facility. Again, the primary difference is the terminology used.

The terminology used for the CI is that of insurance as these contracts have been prepared so that Company A can limit its credit exposure by entering into agreements not just with other non-resident financial institutions, but also with non-resident insurance and reinsurance companies. This is to increase the potential pool of non-resident counterparties with which Company A can transact to manage its OBU credit exposures.

The CI falls within the definition of a credit default swap, and thus a 'swap' or 'option' contract for the same reasons as the GRPA and IRPA. As each risk participant will be an 'offshore person' under subsection 121E(a) of the ITAA 1936 in the context of entering into the Contracts, then Company A when entering into the CI will be conducting an OB eligible contract activity and therefore an OB activity under subsection 121D(1) of the ITAA 1936.

Question 4

Will Company A entering into a contract that is materially the same as a NPIP constitute an 'OB activity' of Company A within the meaning of subsection 121D(1) of the ITAA 1936, by virtue of being an 'OB eligible contract activity' as defined in section 121DB of the ITAA 1936?

Detailed reasoning

The NPIP is materially the same as the CI. For the same reasons outlined with respect to the other Contracts being 'eligible contracts', the NPIP is also an 'eligible contract'.

As each risk participant will be an 'offshore person' under subsection 121E(a) of the ITAA 1936 in the context of entering into the Contracts, then the entering into of the NPIP will be an OB eligible contract activity and therefore an OB activity under subsection 121D(1) of the ITAA 1936.

Question 5

Where entering into a Contract constitutes an 'OB activity' of Company A within the meaning of subsection 121D(1) of the ITAA 1936, will fees and premiums paid by Company A to a counterparty (or its agent) under the Contract constitute 'exclusive OB deductions' as defined in subsection 121EF(3) of the ITAA 1936?

Detailed reasoning

Subsection 121EF(2) of the ITAA 1936 provides that an allowable OB deduction is any of the following kinds of allowable deduction

a) An exclusive OB deduction;

b) A general OB deduction; and

c) An apportionable OB deduction.

An exclusive OB deduction is defined in subsection 121EF(3) as;

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.

Company A entering into the Contracts constitutes an 'OB activity'. Any amounts paid under the Contracts to Company A by a counterparty will be assessable OB income as per the reasoning below in question 6. The fees and premiums paid by Company A to a counterparty under the Contracts will be 'exclusive OB deductions.' This is because the fees and premiums are outgoings incurred exclusively in relation to the assessable OB income that Company A may derive under the Contracts in the event of a non-payment default and pay-out by the risk participant.

The fees and premiums paid by Company A to a counterparty or its agent under the Contracts are therefore exclusive OB deductions as defined in subsection 121EF(3) of the ITAA 1936.

Question 6

Where entering into a Contract constitutes an 'OB activity' of Company A within the meaning of subsection 121D(1) of the ITAA 1936, will amounts received by Company A under the Contract constitute 'assessable OB income' of Company A as defined in subsection 121EE(2) of the ITAA 1936?

Detailed reasoning

Subsection 121EE of the ITAA 1936 provides the definition of 'assessable OB income':

The assessable OB income of an OBU is so much of the OBU's OB income of the year of income as is assessable income.

Subsection 121EDA(1) of the ITAA 1936 provides the definition of 'OB income':

Subject to subsections (2) to (5), the OB income of an OBU of a year of income is so much of the OBU's ordinary income and statutory income 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 statutory income because of such activities.

Subsection 121EDA(3) of the ITAA 1936 states that:

Subsection (1) does not apply to the extent that the money lent, invested, or otherwise used in carrying on the OB activities is non-OB money of the OBU.

Essentially, OB income is ordinary or statutory income derived from OB activities.

The amounts that Company A will receive under the Contracts are receipts from the risk participant in the event of a default on the underlying credit obligation and pay-out by the Contract risk participant.

The amounts received under the Contracts will constitute assessable statutory income of Company A under subsection 20-20(2) of the Income Tax Assessment Act 1997 (ITAA 1997). Subsection 20-20(2) of the ITAA 1997 provides:

An amount you have received as a *recoupment of a loss or outgoing is assessable income if

a) you received the amount by way of insurance or indemnity; and

b) you can deduct an amount for the loss or outgoing for the *current year, or you have deducted or can deduct an amount for it for an earlier income year under any provision of this Act.

The amounts are received under the Contracts to recoup Company A's losses where a borrower defaults. The amounts are received by way of indemnity or insurance as per the Contracts.

As the borrower has defaulted and recovery processes have been exhausted, the losses are bad debts, which are in respect of money that Company A lent in the ordinary course of its business of lending money. The losses are therefore deductible under paragraph 25-35(1)(b) of the ITAA 1997

The amounts paid by the risk participant to Company A to recoup those losses are therefore assessable income to Company A under subsection 20-20(2) of the ITAA 1997.

In order to be OB income, the amounts must be derived by Company A from OB activities or are included in Company A's statutory income because of OB activities as per subsection 121EDA(3) of the ITAA 1936.

The Contracts constitute OB eligible contract activity and therefore OB activity. Assessable receipts received under the Contracts would clearly be derived from the OB activity of entering into OB eligible contract activities. The amounts are payable to Company A pursuant to the terms of the Contracts.

Finally, subsection 121EDA(3) of the ITAA 1936 does not apply as none of the money used by Company A in relation to entering into the Contacts or making any payments under the Contracts will be 'non OB-money' of Company A as defined in section 121C of the ITAA 1936.

The amounts therefore received by Company A under the Contracts constitutes assessable OB income in accordance with subsection 121EE(2) of the ITAA 1936.