Edited version of your written advice

Authorisation Number: 1013118359235

Date of advice: 5 December 2016

Ruling

Subject: Foreign interest withholding tax

Question 1

Will the interest paid by a non-resident taxpayer on the loan obtained from an offshore bank to purchase an Australian rental property be subject to Australian withholding tax under Section 128B of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No.

Question 2

Will the interest paid on the loan from an offshore bank for the purchase of an Australian rental property deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997) against the Australian rental income?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2017

Year ended 30 June 2018

Year ended 30 June 2019

Year ended 30 June 2020

Year ended 30 June 2021

The scheme commences on:

1 July 2016

Relevant facts and circumstances

The taxpayer (the company) is a company incorporated in the X.

The company's sole shareholder is a resident of Y.

The company has purchased an apartment in Australia (the apartment).

The company and its wholly-owned subsidiaries have no other property interests in Australia and are not in the process of purchasing additional properties.

The Foreign Investment Review Board (FIRB) has approved the company's purchase of the apartment.

To finance the purchase of the apartment, the company took out a loan with a foreign bank (the bank).

The loan is subject to monthly repayments.

The company will derive rental income from letting the apartment that will be collected by an independent and bona fide agent (the agent).

The agent will manage the letting of the apartment. Outgoings such as rates, taxes, levies and repairs will be deducted by the agent, with the residual amount remitted to the company as agreed between the agent and the company from time to time.

The company will lodge tax returns in Australia annually as a non-resident.

Relevant legislative provisions

Income Tax Assessment Act 1936, Section 128B.

Income Tax Assessment Act 1936, sub-section 6(1)

Income Tax Assessment Act 1997, Section 995-1

Income Tax Assessment Act 1997, Section 8-1

Income Tax Assessment Act 1997, Section 26-25

Reasons for decision

Question 1

Detailed reasoning

An entity's liability to pay withholding tax is determined by application of the provisions contained in Section 128B LIABILITY TO WITHHOLDING TAX  of Division 11A - Dividends, interest and royalties paid to non-residents and to certain other persons of the Income Tax Assessment Act 1936 (ITAA 1936).

For non-resident taxpayers, subsection 128B (2) of the ITAA 1936 imposes a liability to withholding tax on certain income that consists of interest. Subsection 128B (2) provides that:

A 'person to whom this section applies' is defined earlier in subsection 128B(1A):

The company, a non-resident X company, will incur interest expenses on a loan used to finance the purchase of an Australian apartment. The interest is payable to a non-resident bank.

In accordance with sub-paragraph 128B(2)(b)(ii) of section 128B of the ITAA 1936, this interest will be subject to interest withholding tax only if it is, or is in part, an outgoing incurred by the company in carrying on business in Australia at or through a permanent establishment of the company in Australia.

Whether the company is carrying on a business in Australia at or through a permanent establishment is a question of fact that is determined by applying the facts of the company to the definition of 'permanent establishment' in subsection 6(1) of the ITAA 1936.

Permanent Establishment

Subsection 6(1) defines 'permanent establishment' as follows:

'permanent establishment', in relation to a person (including the Commonwealth, a State or an authority of the Commonwealth or a State), means a place at or through which the person carries on any business and, without limiting the generality of the foregoing, includes:

a)  a place where the person is carrying on business through an agent; …

but does not include:

e)  a place where the person is engaged in business dealings through a bona fide commission agent or broker who, in relation to those dealings, acts in the ordinary course of his or her business as a commission agent or broker and does not receive remuneration otherwise than at a rate customary in relation to dealings of that kind, not being a place where the person otherwise carries on business; …

Hence, 'permanent establishment' is defined to mean 'a place at or through which' a person 'carries on any business' - including a place where a person carries on business through an agent. However, in general, paragraph 6(1)(e) of the ITAA 1936 excludes from the definition of 'permanent establishment' a place where a person is engaged in business dealings through a bona fide commission agent or broker, provided that the agent or broker are acting in the ordinary course of their business.

From the above it can be seen that, whether the company has a permanent establishment in Australia, depends firstly on whether the activities of the company in Australia constitute the carrying on of a business by the company.

Business

'Business' is defined in subsection 995-1(1) of the ITAA 1997 as the ordinary meaning of the word and includes 'any profession, trade, employment, vocation or calling'.

The ATO view of whether a company investing in a real estate property managed by a real estate agent, constitutes the carrying on of a business, is contained in Taxation Ruling IT 2423 'Withholding tax: whether rental income constitutes proceeds of business - permanent establishment - deduction for interest' (IT 2423).

IT 2423 provides that, whether the letting of property amounts to carrying on a business, depends on the circumstances of each case, and notes that if a company's objectives are business objectives that are carried out, then the company is carrying on a business. In addition to this, paragraph 6 of IT 2423 emphasises that active management of the rental property is an essential factor in determining whether a permanent establishment exists. IT 2423 states that:

PREAMBLE

This Ruling considers the liability to interest withholding tax in circumstances where a non-resident of Australia borrows moneys from financial institutions outside Australia for the purchase of properties in Australia from which rental income is derived. Interest payments on the loans might be made either from funds outside Australia or from funds in Australia, i.e. from the rental income derived from the properties.

RULING

2. Sub-paragraph 128B(2)(b)(ii) imposes liability to withholding tax on interest paid to a non-resident by another non-resident where the interest is an outgoing incurred by the other non-resident in carrying on a business in Australia through a permanent establishment in Australia.

3. Whether the letting of property amounts to the carrying on of a business will depend on the circumstances of each case, (Californian Copper Syndicate (Limited and Reduced) v. Harris (1904) 5 TC 159). Generally, it is easier for a company that derives income from the letting of property to show that it carries on a business than it is for an individual. If a company's objects are business objects and are, in fact, carried out it carries on business, (IRC v. Westleigh Estates [1924] 1 KB 390 at pp 408, 409 per Sir Ernest Pollock, M.R.). In American Leaf Blending Co. Sdn Bhd v. Director-General of Inland Revenue (Malaysia) [1978] 3 All E.R. 1185 at p 1189 Lord Diplock concluded that it would be difficult to displace the prima facie inference that the gainful use of a company's property in letting it out for rent would constitute the carrying on of a business.

4. More recently in the Federal Court, Pincus J, in Lilydale Pastoral Co. Pty. Ltd. v. FCT 87 ATC 4235; 18 ATR 508, held, in the context of the withholding tax provisions, that the purchase of property to rent out, whether or not after renovating it, and the proprietorship of that property, constitute an undertaking of a business or commercial kind.

The company has no property interests in Australia other than the apartment being purchased. While the letting of a property by itself is prima facie an activity in the nature of investment rather than a business (see paragraph of Goods and Services Tax Determination GSTD 2000/9), Taxation Ruling IT 2423 notes that this presumption changes in the case of a rental property acquired by a company. This is confirmed in paragraphs 16-17 of Taxation Ruling TR 93/32.

The company is carrying on business in Australia through the letting of the apartment.

Bona fide commission agent or broker

The company has advised it will engage the services of a bona fide commission agent, in an arm's length transaction to act as agent for the company's Australian rental property.

Because the agent is a bone fide commission agent acting in the ordinary course of its business, and does not receive remuneration otherwise than at a rate customary in relation to dealings of that kind, paragraph 6(1)(e) of the ITAA 1936 specifically applies to exclude this arrangement and place from the definition of permanent establishment.

In this regard, IT 2423 explains that:

6. Before withholding tax is payable by either a company or an individual it is necessary to show that the non-resident is carrying on business in Australia at or through a permanent establishment of the non-resident in Australia. In this connection the definition of “permanent establishment” in sub-section 6(1) specifically excludes a place where the person is engaged in business dealings through a bona fide commission agent or broker. This means that in the case of rental properties managed by a real estate agent acting as a commission agent it could not generally be said that the non-resident has a permanent establishment in Australia unless there are other factors.

Note also that this is consistent with the Commentary on Article 5: Concerning the Definition of Permanent Establishment in the OECD Model Tax Convention on Income and on Capital as it read on 15 July 2014, which states that:

36. Where an enterprise of a Contracting State carries on business dealings through a broker, general commission agent or any other agent of an independent status, it cannot be taxed in the other Contracting State in respect of those dealings if the agent is acting in the ordinary course of his business (see paragraph 32 above). Although it stands to reason that such an agent, representing a separate enterprise, cannot constitute a permanent establishment of the foreign enterprise, paragraph 6 has been inserted in the Article for the sake of clarity and emphasis.

37. A person will come within the scope of paragraph 6, i.e. he will not constitute a permanent establishment of the enterprise on whose behalf he acts only if:

a) he is independent of the enterprise both legally and economically, and

b) he acts in the ordinary course of his business when acting on behalf of the enterprise.

38. Whether a person is independent of the enterprise represented depends on the extent of the obligations which this person has vis-à-vis the enterprise. Where the person's commercial activities for the enterprise are subject to detailed instructions or to comprehensive control by it, such person cannot be regarded as independent of the enterprise. Another important criterion will be whether the entrepreneurial risk has to be borne by the person or by the enterprise the person represents.

Conclusion

While interest income is derived by a non-resident entity and paid to that entity by a non-resident, the company has no existing permanent establishment in Australia.

The company's purchase and letting of the Australian property, under the conditions described, will not cause a permanent establishment to be created, because it is using a bona fide commission agent to handle the property investment, and there are no other factors that suggest a permanent establishment exists.

Thus, the company will not be carrying on a business at or through a permanent establishment in Australia. Therefore, the withholding tax provisions in section 128B of Division 11A of the ITAA 1936 do not apply - and withholding tax is not payable on interest paid by the company to the foreign bank, on the loan used to finance the purchase of the property by the company.

Question 2

Detailed reasoning

Section 8-1 of the ITAA 1997 allows a deduction for interest to the extent that it is incurred in gaining or producing your assessable income or in carrying on a business for the purpose of gaining or producing your assessable income; except to the extent that the interest is a loss or outgoing of capital, or of a capital nature, or a private or domestic nature, or incurred in relation to gaining or producing exempt income or non-assessable non-exempt income.

Whether interest has been incurred in the course of gaining or producing assessable income generally depends on the use to which the borrowed funds have been put. The 'use' test, established in the High Court of Australia decision in Federal Commissioner of Taxation v. Munro (1926) 38 CLR 153, is the basic test for the deductibility of interest, and looks at the application of the borrowed funds as the main criterion. The interest will be deductible to the extent that the property is used to produce assessable income.

In general, subsection 26-25(1) of the ITAA 1997 specifies that interest is not deductible if the interest withholding tax requirements have not been met. As per the reasons for decision in Question 1, there will be no interest withholding tax requirement for the company under the proposed scheme.

The company has taken out a loan on the property.

The property the company purchased in Australia is intended to be used by the company for the purpose of generating rental income.  The interest expense on the loan from the foreign bank to the company, which was used by the company to finance the purchase of the property, will be incurred in gaining or producing that rental income, thereby satisfying the requirement in section 8-1 of ITAA 1997.

Therefore, the interest paid by the company to the foreign bank, will be deductible against the Australian rental come derived by the company from letting out the Australian property.