Edited version of private advice

Authorisation Number: 1051579842620

Date of advice: 25 September 2019

Ruling

Subject: Sale and operating lease transactions

Question 1

Will a balancing adjustment event under section 40-295 of the Income Tax Assessment Act 1997 (ITAA 1997) happen to AusCo when AusCo sells each item of commercial equipment to a Lessor?

Answer

Yes

Question 2

Will each Lease be treated as a hire purchase agreement subject to Division 240 of the ITAA 1997?

Answer

Yes

Question 3

Will AusCo be entitled to deductions pursuant to section 240-50 of the ITAA 1997 for the 'notional interest' calculated under Subdivision 240-E of the ITAA 1997 in relation to each Lease?

Answer

Yes

Question 4

Will AusCo be entitled to deductions under section 40-25 of the ITAA 1997 for the decline in value of each item of commercial equipment that is subject to a Lease?

Answer

Yes

Question 5(a)

Will AusCo be disallowed deductions under Subdivision 832-C of the ITAA 1997 for interest deductions that it is entitled to claim under Division 240 of the ITAA 1997?

Answer

No

Question 5(b)

Will AusCo be disallowed deductions under Subdivision 832-G of the ITAA 1997 for depreciation deductions that it is entitled to claim under Division 40 of the ITAA 1997?

Answer

No

Question 6

Will AusCo have an obligation to withhold an amount from the notional interest in relation to the lease rentals paid to the Lessor under section 12-245 of Schedule 1 to the Tax Administration Act 1953 (TAA)?

Answer

No

Relevant facts and circumstances

Sale and Leaseback

1. AusCo, a company incorporated in Australia, owns and operates four items of commercial equipment and enters into a sale and leaseback transaction in relation to each item.
2. The items of commercial equipment are depreciating assets for the purposes of the capital allowance provisions in ITAA 1997.
3. AusCo has not entered into these transactions via a permanent establishment located outside Australia.
4. Under each transaction, AusCo has:
   1. entered into a Sale and Purchase Agreement (SPA) with a foreign lessor (Lessor) pursuant to which it has sold the commercial equipment to the Lessor (there is a separate Lessor for each transaction);
   2. entered into a lease (the Lease) with the Lessor under which the Lessor (immediately on acquisition of the commercial equipment) has leased the commercial equipment back to AusCo (each Lease is for a term of either 5.75 or 6.75 years); and
   3. the Lessor has granted AusCo a purchase option to acquire the commercial equipment.
5. The price at which AusCo sold each item of commercial equipment to the Lessor (under each SPA) reflected the market value of the commercial equipment.
6. All aspects of the transactions have been and will be entered into on an arm's length basis and the consideration payable reflects the consideration payable between two independent parties.
7. The Lessor will be entitled to depreciation deductions in Foreign Country in relation to its expenditure on the commercial equipment (i.e. the Purchase Price that it pays for each commercial equipment under the SPAs).

Lessor

8. Each Lessor:
   1. is a limited liability company incorporated under the laws of Foreign Country;
   2. will be managed and controlled by directors and other personnel who reside outside Australia;
   3. is a special purpose company formed to participate in the transaction. The Lessor's business is limited to the leasing and any transactions incidental thereto;
   4. is a resident of Foreign Country for tax purposes and is liable to tax in Foreign Country;
   5. is not a resident of Australia for the purposes of Australian tax;
   6. does not have a place of business in Australia through which the leasing is wholly or partly carried on;
   7. does not have a person acting on its behalf in Australia which has the authority to negotiate or conclude contracts on its behalf in connection with the leasing;
   8. is a 'company' and therefore a 'person' under the Definitions Article of the Convention between Australia and Foreign Country (the Convention).
   9. has no relationship with AusCo other than entering into the leasing transactions. Each Lessor, its direct or indirect holding companies and their directors, do not have ownership interests in, control over, or the ability to be able to exert influence over AusCo; and
   10. is owned by Foreign Holding Co. Foreign Holding Co owns 100% of the shares (being ordinary shares) and voting power in the Lessor - the subscription price for the ordinary shares was a nominal amount.
9. Foreign Holding Co is a:
   1. company incorporated under the laws of Foreign Country;
   2. wholly owned subsidiary of Foreign Head Co.
10. Foreign Holding Co will not receive any distributions on its nominal shareholding in the Lessor. The only income that Foreign Holding Co will receive from the Lessor will be fee income that it receives in the first year of the transaction.
11. Foreign Head Co's principal class of shares is listed on a 'recognised stock exchange' for the purposes of the Limitation of Benefits Article of the Convention.
12. Foreign Holding Co and Foreign Head Co are both residents of Foreign Country.
13. The Lessor shall not, without the prior consent of AusCo, carry on any business other than the acquisition, owning and leasing of the commercial equipment.

Lessor - financing

14. The Lessor is funded through a combination of financing provided by third party banks (senior loan financing) and contractual arrangements (the investments) with investors resident in Foreign Country.
15. Relevantly, the Purchase Price paid for the commercial equipment is funded as follows:
    1. approximately 60%-70% through senior loan financing; and
    2. the remaining 30%-40% through the investments.

Rental Payments

16. The Rents are payable on a quarterly basis (in arrears) and are comprised of two amounts, being the A Rent and B Rent. The Rents have been split into these components in order to make it easier for the Lessor to make payments under the Senior Loan - as, in high-level terms, the A Rents reflect the amounts payable to the Banks under the Senior Loan. The B Rent reflects the remaining part of the Rents to be retained by the Lessor from which the Lessor will then meet its other expenses/liabilities (i.e. any fees and expenses payable by the Lessor and any amounts payable to the investors).
17. The Banks under the Senior Loan only have recourse to the A Rents (i.e. they do not have recourse to the B Rents).
18. The Lessor is the legal and beneficial owner of all the Rent that it receives under the Lease.

Purchase Option

19. Each Lease provides AusCo with an option to purchase the commercial equipment either at the end of the Lease terms (the Final Purchase Option Date) or at a point prior to the end of the Lease terms (the Early Purchase Option Date).
20. The amount payable by AusCo on the Final Purchase Option Date (i.e. the Purchase Option Exercise Price) at the end of the Lease term is set when the Lease is entered into and is determined by reference to, amongst other things, the anticipated future market value of the commercial equipment. Although the Purchase Option Exercise Price on the Early Purchase Option Exercise Date is set by reference to the same factors, it also includes a further amount to reflect the fact that the transaction will cease at an earlier point in time.
21. Any notice of election given by the Lessee shall be irrevocable.
22. The commercial equipment is an integral part of AusCo's business.
23. It would be less expensive for AusCo to exercise its call option to purchase the commercial equipment than to put the commercial equipment into the contractually required conditions in order to return the commercial equipment.
24. The combined Rents and the Option Exercise Prices under each Lease exceed the Purchase Prices.

Contractual arrangement with investors

25. The investments are formally recognised under the commercial laws of Foreign Country.
26. One or more investors contribute money or other assets in the activities of an entrepreneur who is to engage in business with a view to sharing profit with the investors. The business of the investment is conducted by only the entrepreneur. The investors have no right or power to manage the business.The assets of the business are owned by the entrepreneur only. The investors have no right to or interest in the property or individual items of income and expenses of the business. An investor has no responsibility for the obligations of the business and loses only his or her contribution in case the investment produces a loss, unless the agreement for the investment provides otherwise.
27. The Lessor will act as an operator to carry out the business (the leasing business) constituted by the Lease Agreement and the other operative documents.
28. The investors are companies tax resident in Foreign Country.
29. The investors do not have a shareholder interest in the Lessor.As the investors do not purchase shares in the Lessor, they do not receive any of the voting or other rights afforded to shareholders of the Lessor under the law of Foreign Country.
30. Although the investors do not own shares in the Lessor, they are regarded as the equity investors in the Lessor. This characterisation reflects the fact that the investment made by the investors (i.e. the amount paid by the investors under the investment agreement) is an amount paid in order to be entitled to receive the profits and losses of the Lessor.
31. The investors agree to contribute cash or other assets to the Lessor in order to allow the Lessor to operate its leasing business.
32. In return for providing the cash investment, the investors receive a contractual return reflecting a percentage of the profits or loss of the Business.All profits and losses of the Lessor will be received/borne by the investors. The amounts that the investors receive from the Lessor are treated as distributions of profit by the Lessor.Consistent with this treatment, from an accounting perspective, the amounts paid to the investors are treated as distributions of profit (below the line) rather than expenses (above the line).
33. The investors are not expected to deal with the Lessors in connection with a business carried on outside of Foreign Country.

Taxation of investment under the Law of Foreign Country

34. The laws of Foreign Country treats income derived subject to this type of investment as the income of the active operator. The operator then is entitled to a deduction for interest, depreciation and other expenses as well as amounts paid to the investor, who takes such amounts into income as a distribution from the arrangement.
35. In this regard, the Lessor is required to include in its assessable income in Foreign Country all Rent payments payable by AusCo under the Leases. The Lessor is not entitled to a credit, rebate or other tax concession in respect of the Rent for tax payable under a tax law of a country outside Foreign Country (including Australia). The rents will be included on a current basis in the income of the Lessor throughout the term of the Lease.
36. There is no concessional rate of tax in Foreign Country for the Lessor.
37. The character of income in the operator's hands does not pass to the investor.
38. The source of the operator's income in a geographical sense does not pass through to the investor.

Reasons for decision

Legislative references in this Ruling are to provisions of the Income Tax Assessment Act 1936 (ITAA 1936), or to provisions of the ITAA 1997 unless otherwise indicated.

Question 1

Will a balancing adjustment event under section 40-295 of the ITAA 1997 happen to AusCo when AusCo sells each item of commercial equipment to a Lessor?

Summary

AusCo 'stops' holding the commercial equipment under Item 10 on the transfer of title, triggering a balancing adjustment event under subsection 40-295(1) for AusCo.

Detailed reasoning

A balancing adjustment event occurs for a depreciating asset if you stop holding the asset (subsection 40-295(1)). The items of commercial equipment are depreciating assets for the purposes of the capital allowance provisions.

Was AusCo 'holding' the commercial equipment?

Section 40-40 of the ITAA 1997 provides a table used to work out who 'holds' or does not 'hold' a depreciating asset. Under Item 10 of the table, in respect of any depreciating asset, the person who 'holds' the asset is 'the owner, or the legal owner if there is both a legal and equitable owner.' Prior to the sale, AusCo owned the commercial equipment, and therefore 'held' the commercial equipment under Item 10 of the table.

Did AusCo 'stop' holding the commercial equipment?

AusCo is no longer the 'owner' under Item 10 of section 40-40 once the title to the commercial equipment is transferred to the Lessor. Accordingly, AusCo 'stops' holding the commercial equipment under Item 10.

A balancing adjustment event under subsection 40-295(1) is triggered on the transfer of title in the commercial equipment to the Lessor.

Question 2

Will each Lease be treated as a hire purchase agreement subject to Division 240 of the ITAA 1997?

Summary

The Leases are each a hire purchase agreement, and will therefore be subject to Division 240 as per section 240-10 of the ITAA 1997.

Detailed reasoning

A 'hire purchase agreement' is defined in subsection 995-1(1) as follows:

995-1(1)

In this Act, except so far as the contrary intention appears:

hire purchase agreement means:

(a) a contract for the hire of goods where:

(i) the hirer has the right, obligation or contingent obligation to buy the goods; and

Note:

An example of a contingent obligation is a put option.

(ii) the charge that is or may be made for the hire, together with any other amount payable under the contract (including an amount to buy the goods or to exercise an option to do so), exceeds the price of the goods; and

(iii) title in the goods does not pass to the hirer until the option referred to in subparagraph (a)(i) is exercised; or

(b) an agreement for the purchase of goods by instalments where title in the goods does not pass until the final instalment is paid.

Does the hirer have the 'right, obligation or contingent obligation' to buy the goods?

Under the Leases, AusCo is the 'hirer' and has the 'right' to purchase the commercial equipment from the Lessor.

Does the charge for the hire, together with any other amount payable under the contract (including an amount to buy the goods or to exercise an option to do so), exceed the price of the goods?

For each item of commercial equipment, the 'charges' - which include the Rents and the Option Exercise Prices - exceed the Purchase Prices.

Does title in the goods not pass to the hirer until the option referred to in subparagraph (a)(i) is exercised?

Title in the commercial equipment does not pass to AusCo until an election to purchase is made by AusCo.

Accordingly, the Leases are each a hire purchase agreement, and will therefore be subject to Division 240 as per section 240-10 of the ITAA 1997.

Question 3

Will AusCo be entitled to deductions pursuant to section 240-50 of the ITAA 1997 for the 'notional interest' calculated under Subdivision 240-E in relation to each Lease?

Summary

AusCo is entitled to deduct the notional interest calculated under Subdivision 240-E of the ITAA 1997.

Detailed reasoning

Where Division 240 of the ITAA 1997 applies to a 'hire purchase agreement,' a notional buyer's entitlement to deductions is outlined in section 240-50 as follows:

240-50(1)

The *notional buyer is only entitled to deduct *notional interest for an income year to the extent that the notional buyer would, apart from this Division, have been entitled to deduct *arrangement payments for that income year if no part of those payments were capital in nature.

240-50(2)

The *notional buyer is entitled to deduct *notional interest for *arrangement payment periods, and parts of arrangement payment periods, in the income year.

Is AusCo a 'notional buyer'?

The effect of Division 240 of the ITAA 1997 applying to an arrangement that is a hire purchase agreement is that a 'notional seller' is taken to have disposed of the property by way of sale to a 'notional buyer,' and the 'notional buyer' is taken to have acquired it at the start of the arrangement (see subsection 240-20(1)). On entering into the arrangement, the 'notional seller' is taken to have made a loan (the notional loan) to the 'notional buyer' (section 240-25).

A 'notional seller' includes a party to the arrangement who owns the relevant property (subsection 240-17(1)). An entity is a 'notional buyer' if it is a party to the arrangement and, under the arrangement, has the right to use the property (subsection 240-17(2)).

AusCo is the 'notional buyer' as AusCo has the right to use and possess the commercial equipment under its lease agreements with each Lessor. Each Lessor is the 'notional seller' as it actually owns the commercial equipment during the arrangement.

To what extent are the arrangement payments deductible?

An 'arrangement payment' is defined in section 240-65 as follows:

240-65

An arrangement payment is an amount that the *notional buyer is required to pay under the *arrangement but does not include:

(a) an amount in the nature of a penalty payable for failure to make a payment on time; or

(b) a *termination amount.

AusCo is required under the lease agreement to pay Rent, and therefore the Rent is an 'arrangement payment.' On the other hand, the Option Exercise Price is a 'termination amount' as defined in paragraph (a) of that term under subsection 995-1(1), and is therefore not an 'arrangement payment.' Apart from Division 240, the Rent would have been deductible under section 8-1, as it is an outgoing incurred by AusCo in its business for the purpose of gaining or producing assessable income.

Accordingly, all of the 'arrangement payments' would have been deductible apart from the operation of Division 240. Therefore, AusCo is entitled to deduct the notional interest calculated under Subdivision 240-E.

Question 4

Will AusCo be entitled to deductions under section 40-25 of the ITAA 1997 for the decline in value of each item of commercial equipment that is subject to a Lease?

Summary

AusCo will be entitled to claim deductions under section 40-25 of the ITAA 1997 for the decline in value of each item of commercial equipment that is subject to a Lease.

Detailed reasoning

Section 40-25 sets out when you can deduct the decline in value of a depreciating asset as follows:

40-25(1)

You can deduct an amount equal to the decline in value for an income year (as worked out under this Division) of a *depreciating asset that you *held for any time during the year.

40-25(2)

You must reduce your deduction by the part of the asset's decline in value that is attributable to your use of the asset, or your having it *installed ready for use, for a purpose other than a *taxable purpose.

Does AusCo 'hold' the commercial equipment subject to the lease agreements under Item 6 of section 40-40?

The 'economic owner,' and not the 'former holder,' of a depreciating asset 'holds' the asset under Item 6 of section 40-40 where:

40-40 - Item 6

A depreciating asset that an entity (the former holder) would, apart from this item, hold under this table (including by another application of this item) where a second entity (also the economic owner):

(a) possesses the asset, or has a right as against the former holder to possess the asset immediately; and

(b) has a right as against the former holder the exercise of which would make the economic owner the holder under any item of this table;

and it is reasonable to expect that the economic owner will become its holder by exercising the right, or that the asset will be disposed of at the direction and for the benefit of the economic owner

For the purposes of Item 6, the Lessor is the 'former holder' and AusCo is the 'economic owner.' AusCo 'possesses' the commercial equipment during the Lease. Further, AusCo has a right under the Lease as against the Lessor to repurchase the commercial equipment, which would make AusCo the owner of the commercial equipment again, and therefore, a 'holder' under Item 10.

For the 'reasonable to expect' element in Item 6 to be satisfied, it must be 'reasonable to conclude' that the notional buyer will acquire the asset: see paragraph 6 of Taxation Ruling TR 2005/20 Income tax: the interaction of deemed ownership under Division 240 of the Income Tax Assessment Act 1997 with the 'holding' rules in Division 40. In making the assessment as to the future, the likelihood that goods will be acquired must be objectively determined. Factors that may be relevant, but not necessarily conclusive, include: (see paragraph 30 in the Explanation Section of TR 2005/20)

·         independent assessments of the expected market value of the goods at the end of the hire period as against the amount required to purchase the goods under the arrangement;

·         the notional buyer's history in deciding to acquire goods under previous hire purchase agreements providing there is nothing to suggest this pattern will change; and

·         any other relevant commercial considerations affecting the notional buyer's decision to acquire the goods.

It is reasonable to conclude that AusCo will acquire the commercial equipment based on the following circumstances:

a)    The Final Purchase Option Price is determined by reference to, amongst other things, the anticipated future market value of the commercial equipment. The Purchase Option Exercise Price on the Early Purchase Option Exercise Date is set by reference to the same factors, but also includes a further amount to reflect the fact that the transaction will cease at an earlier point in time.

b)    The commercial equipment is an integral part of AusCo's business.

c)    If AusCo does not exercise the Purchase Option, then AusCo will be required to return the commercial equipment to the Lessor on expiry of the Lease in accordance with the terms of the relevant Lease. It would be less expensive for AusCo to exercise its call option to purchase the commercial equipment than to put the commercial equipment into the contractually required conditions in order to return the commercial equipment.

d)    Each Lessor is a special purpose company formed to participate in the sale and leaseback transactions.

Accordingly, the effect of Item 6 is that AusCo, the economic owner, is taken to 'hold' each item of commercial equipment, while each Lessor, the former holder, is taken not to 'hold' each item of commercial equipment.

Does AusCo 'hold' the commercial equipment under Item 10 of section 40-40 of the ITAA 1997?

AusCo is deemed to 'own' the commercial equipment under subsection 240-20(2) of the ITAA 1997. Division 240 has effect for the purposes of the ITAA 1997 and ITAA 1936, including the capital allowance provisions (section 240-15). However, section 240-115 sets out a number of modifications to the effect of Division 240 for the purposes of the capital allowance provisions. Subsection 240-155(1) states:

240-115(1)

This section sets out special modifications of the effect of this Division that apply in relation to a *hire purchase agreement unless:

(a) the notional buyer would have been the owner or the *quasi-owner of the property if the *arrangement had been a sale of the property; and

(b) it is reasonably likely that the right, obligation or contingent obligation to acquire the property will be exercised by, or in respect of, the notional buyer.

Given that the exercise of the Purchase Option would result in AusCo being the owner of the commercial equipment, AusCo would have been the owner of the commercial equipment if the arrangement had been a sale instead of a hire purchase agreement.

The 'reasonably likely' test under paragraph 240-115(1)(b) is satisfied, because it is to be given the same meaning as the 'reasonable to expect' test under Item 6 of section 40-40: see paragraph 7 of TR 2005/20.

As a result, the modifications in section 240-155 do not apply, and AusCo is taken to be the 'owner' of the commercial equipment under Item 10 of section 40-40 by virtue of subsection 240-20(2).

Conclusion

AusCo will be entitled to claim deductions under section 40-25 of the ITAA 1997 for the decline in value of the commercial equipment that is subject to a Lease to the extent that AusCo does not use the commercial equipment for a purpose other than a taxable purpose.

Question 5(a)

Will AusCo be disallowed deductions under Subdivision 832-C of the ITAA 1997 for interest deductions that it is entitled to claim under Division 240?

Summary

Subdivision 832-C of the ITAA 1997 does not apply to the deductionsthat AusCo will be entitled to claim for the notional interestcalculated under Subdivision 240-E.

Detailed reasoning

We have considered whether the 'interest' deductions are affected by the 'hybrid financial instrument mismatch' rule in Subdivision 832-C. In particular, section 832-180 states:

832-180 Deduction not allowable - Australian primary response

(1) This section applies to an entity if:

(a) apart from this section, the entity would be entitled to a deduction in an income year in respect of a payment; and

(b) the deduction is the *deduction component of a *hybrid financial instrument mismatch to which the payment gives rise.

(2) So much of the deduction as does not exceed the amount of the *hybrid financial instrument mismatch is not allowable as a deduction.

A payment can only give rise to a hybrid financial instrument mismatch if the payment gives rise to a hybrid mismatch under section 832-215 or 832-230 (paragraph 832-200(1)). A payment gives rise to a hybrid mismatch if, among other conditions, the payment gives rise to a deduction/non-inclusion mismatch (paragraph 832-230(1)(a)) or might reasonably be expected to give rise to a deduction/non-inclusion mismatch (paragraph 832-215(1)(b)).

We do not consider that there is a deduction/non-inclusion mismatch, and as a consequence, the payments do not give rise to a hybrid financial instrument mismatch as per paragraph 832-200(1).

Conclusion

Subdivision 832-C of the ITAA 1997 does not apply to the deductionsthat AusCo will be entitled to for the notional interestcalculated under Subdivision 240-E.

Question 5(b)

Will AusCo be disallowed deductions under Subdivision 832-G of the ITAA 1997 for depreciation deductions that it is entitled to claim under Division 40?

Summary

Subdivision 832-G of the ITAA 1997 does not apply to the deductionsthat AusCo will be entitled to for the depreciation of the commercial equipment.

Detailed reasoning

AusCo will be entitled to claim deductions under section 40-25 of the ITAA 1997 for the decline in value of each item of commercial equipment that is subject to a Lease.

The Lessor will be entitled to depreciation deductions in Foreign Country in relation to its expenditure on the commercial equipment (i.e. the Purchase Price that it pays for each item of commercial equipment under the SPAs).

For subdivision 832-G to apply, a deduction/deduction mismatch under section 832-110 must be present.

Per subsection 832-110(1):

832-110(1) A payment gives rise to a deduction/deduction mismatch if the payment, or a part or share of the payment:

(a) gives rise to a *foreign income tax deduction in a foreign country in a *foreign tax period; and

(b) also gives rise to:

(i) a deduction in an income year; or

(ii) a foreign income tax deduction in a foreign country (other than the country mentioned in paragraph (a)).

The scope for the deduction/deduction mismatch condition to be satisfied beyond mere payments is extended under subsection 832-110(4) to apply to certain non-payment deductions as follows:

832-110(4) This section applies in relation to the following amounts in the same way as it applies in relation to a payment:

(a) an amount representing the decline in value of an asset ...;

Having regard to Subdivision 832-G, with which section 832-110 operates, the extension in subsection 832-110(4) can be seen as recognition that the hybrid nature of an entity may facilitate deduction/deduction mismatches for amounts other than just the payments the entity makes. That is, in the same way that a payment made by an entity may give rise to a deduction in more than one jurisdiction, so too may a decline in value amount relating to the holding of an asset by the entity.

In this case, however, any payment made by the entity, AusCo, could give rise to a deduction only in Australia and, likewise, any decline in value amount relating to the holding of an asset by AusCo could give rise to a deduction only in Australia. Any decline in value amount relating to the holding of an asset by an entity in Foreign Country could give rise to a deduction only in Foreign Country. Accordingly, there is no deduction/deduction mismatch in terms of subsection 832-110(4).

This view on section 832-110 is consistent with the operation of provisions of Subdivision 832-G, the only Subdivision of Division 832 for which section 832-110 is relevant.

This construction is also consistent with Recommendation 6 of the OECD Action 2 Report on which Subdivision 832-G is based.[1]

Accordingly, subdivision 832-G does not apply to the deductions that AusCo will be entitled to under Division 40 for the decline in value for an income year of the commercial equipment.

Question 6

Will AusCo have an obligation to withhold an amount from the notional interest in relation to the lease rentals paid to the Lessor under section 12-245 of Schedule 1 to the TAA?

Summary

Subdivision 12-F of Schedule 1 to the TAA does not require AusCo to withhold from the notional interest, as no withholding tax is payable in respect of that amount (section 12-300 of Schedule 1 to the TAA).

Detailed reasoning

Subdivision 12-F of Schedule 1 to the TAA

An entity is not required to withhold an amount from interest under subdivision 12-F of schedule 1 to the TAA if no withholding tax is payable in respect of the interest. In particular, section 12-300 of schedule 1 to the TAA says that subdivision 12-F does not require an entity to withhold an amount if no withholding tax is payable in respect of that amount.

Interest Withholding Tax under Subsection 128B(2)

Section 128B deals with withholding tax liability. Relevantly, subsection 128B(2) provides:

Subject to subsection (3), this section also applies to income that:

(a) is derived, on or after 1 January 1968, by a non-resident; and

(b) consists of interest that:

(i) is paid to the non-resident by a person to whom this section applies and is not an outgoing wholly incurred by that person in carrying on business in a country outside Australia at or through a permanent establishment of that person in that country; or

(ii) is paid to the non-resident by a person who, or by persons each of whom, is not a resident and is, or is in part, an outgoing incurred by that person or those persons in carrying on business in Australia at or through a permanent establishment of that person or those persons in Australia.

For the purposes of withholding tax, subsection 128AC(5) deems the portion of an 'attributable agreement payment' in relation to a 'hire purchase agreement,' as does not exceed the 'notional interest,' to be income that consists of interest.

'Hire-purchase agreement,' for the purposes of section 128AC, is undefined. Even though it is a defined term in subsection 995-1(1), subsection 995-1(2) states that so far as a provision of the ITAA 1997 gives an expression a particular meaning, the provision does not also have effect for the purposes of the ITAA 1936, except as provided in the ITAA 1936 (see also paragraph 70 of Taxation Ruling TR 98/21 Income tax: withholding tax implications of cross border leasing arrangements).

TR 98/21 provides guidance as to the definition of hire-purchase agreement for the purposes of section 128AC. It states that a hire-purchase agreement has two basic ingredients: the paramount purpose of purchasing, and the financing element of hire-purchase (purchasing by deferred payment).

Paragraphs 7 to 8 of TR 98/21 state:

7. Where it is clear from the outset that the purchase or repurchase of the equipment is paramount, payments made under a cross border equipment leasing transaction are not subject to equipment royalty withholding tax under subsection 128B(5A) of the Act. The paramount purpose of a transaction is to be decided by having regard to all the surrounding circumstances and commercial consequences of the transaction (such as the passing of the incidents of ownership and economic risks to the lessee and other matters). Where an instalment payment under a hire-purchase agreement in respect of the type of arrangements covered by this Ruling contains an implicit interest component, that interest component is subject to interest withholding tax in accordance with section 128AC.

8. Conversely, where the main object of the transaction in the context of cross border leases is hire, even where the hirer has an option to purchase the equipment, royalty withholding tax under subsection 128B(5A) applies...

Factors considered relevant to the question of whether the paramount purpose of the transaction is one of purchase are: (paragraph 31 of TR 98/21)

(1) Whether the lessee has a call option or equivalent over the equipment.

(2) Whether the lessor has a put option or equivalent over the equipment.

(3) When any purchase option is exercisable and whether the exercise is effectively irrevocable.

(4) Whether the equipment is specially adapted to the special requirements of the lessee.

(5) Whether the equipment is likely to have any value to another person on the expiration of the lease if the lease is not for the life of the equipment.

(6) Whether the lease term is for the life of equipment so that the equipment is likely to have no or an insignificant market value at the end of the lease.

(7) Which party bears the financial risks associated with the funding of the equipment.

(8) Whether there are security arrangements in relation to payments under the lease and what is their nature.

(9) How the residual value (if any) is calculated.

(10) Whether an up front payment or payments satisfies the payment obligations of the lessee and whether such payment is effectively irrevocable.

In this case, having considered the factors in paragraph 31 of TR 98/21, it is concluded that the paramount purpose is of purchasing. In particular:

a)    AusCo has an option to repurchase each item of commercial equipment on the Final Purchase Option Date or the Early Purchase Option Date;

b)    Any notice of election given by AusCo shall be irrevocable;

c)    The Final Purchase Option Price is determined by reference to, amongst other things, the anticipated future market value of the commercial equipment. The Purchase Option Exercise Price on the Early Purchase Option Exercise Date is set by reference to the same factors, but also includes a further amount to reflect the fact that the transaction will cease at an earlier point in time;

d)    The Leases are not for the life of the commercial equipment;

e)    The commercial equipment are an integral part of AusCo's business;

f)     It would be less expensive for AusCo to exercise its call option to purchase the commercial equipment than to put the commercial equipment into the contractually required conditions in order to return the commercial equipment.

The next question then is whether the transaction has a financing element which attracts interest withholding tax under section 128C (paragraph 63 of TR 98/21). If there is no financing element, then there is no interest withholding tax under that section.

For a financing element to be present, there needs to be a passage of time before all the necessary payments under the lease are made (paragraph 81 of TR 98/21). In the absence of such deferred payments, we consider that the lease is in substance a repurchase of the equipment without any element of financing of the repurchase. However, if there is a financing element, section 128AC would apply.

In the present case, the Rents are effectively 'deferred payments' as they are payable on a quarterly basis (in arrears) rather than upfront. Accordingly, the Leases have a financing element.

The elements of a 'hire-purchase agreement' are satisfied. Subsection 128AC(5) therefore deems a portion of the 'attributable agreement payment' to be income that consists of interest. An 'attributable agreement payment' means so much of any payment made or liable to be made under the agreement as represents consideration for the use, sale or disposal of the relevant agreement property (subsection 128AC(1)). In this case, AusCo is liable to pay the Rent under the Leases and so these payments are 'attributable agreement payments.'

A non-resident (the Lessor) directly derives income that consists of interest paid by a resident (AusCo). The income consisting of interest is not an outgoing that AusCo has incurred in connection with a foreign permanent establishment.

Thus, the interest component of the hire-purchase agreement is prima facie subject to interest withholding tax under subsection 128B(2).

Application of the Convention

However, in determining the liability to tax on Australian sourced income that a foreign resident receives, it is necessary to also consider any applicable tax treaty.

Australia's taxation rights are affected by tax treaties that it enters into with other countries. Subsection 4(2) of the International Tax Agreements Act 1953 (ITAA 1953), which implements these treaties, states that the provisions of this Act have effect notwithstanding anything inconsistent with those provisions contained in the Assessment Act (other than Part IVA) or in an Act imposing Australian tax.

The Convention applies to persons who are residents of one or both of the Contracting States. As per the Facts above, each Lessor is a company and therefore is a 'person' for the purposes of the Convention. Further, each Lessor is a 'resident' of one of the 'Contracting States.'

Therefore, the Convention applies to each Lessor.

The Interest Article of the Convention

The Interest Article of the Convention states:

1. Interest arising in a Contracting State and beneficially owned by a resident of the other Contracting State may be taxed in that other Contracting State.

2. However, such interest may also be taxed in the Contracting State in which it arises and according to the law of that Contracting State, but the tax so charged shall not exceed 10 per cent of the gross amount of the interest.

3. Notwithstanding the provisions of paragraph 2, interest arising in a Contracting State and beneficially owned by a resident of the other Contracting State shall not be taxed in the first-mentioned Contracting State if:

b) the interest is derived by a financial institution which is unrelated to and dealing wholly independently with the payer. For the purpose of this Article, the term "financial institution" means a bank or other enterprise substantially deriving its profits by raising debt finance in the financial markets or taking deposits at interest and by using those funds in carrying on a business of providing finance; or

4. Notwithstanding the provisions of paragraph 3, interest referred to in subparagraph b) of that paragraph may be taxed in the Contracting State in which it arises at a rate not exceeding 10 per cent of the gross amount of the interest if the interest is paid as part of an arrangement involving back-to-back loans or other arrangement that is economically equivalent and intended to have a similar effect to an arrangement involving back-to-back loans.

6. The provisions of paragraphs 1 and 2, subparagraph b) of paragraph 3 and paragraph 4 shall not apply if the beneficial owner of the interest, being a resident of a Contracting State, carries on business in the other Contracting State in which the interest arises through a permanent establishment situated therein and the debt-claims or other rights in respect of which the interest is paid is effectively connected with such permanent establishment. In such case the provisions of Article 7 shall apply.

Does the notional interest calculated under section 128AC amount to 'interest' for the purposes of the Interest Article?

'Interest' is income from debt-claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor's profits, and in particular, all other income that is subjected to the same taxation treatment as income from money lent by the tax law of the Contracting State in which the income arises.

Section 128AC treats part of the periodic returns paid by AusCo to the Lessor as 'notional interest.' Notional interest is subject to the same tax treatment under Australian domestic law as income from money lent, as notional interest is deemed to be 'income that consists of interest' under subsection 128B(2) (see subsection 128AC(5)). Accordingly, the notional interest is 'interest' for the purpose of the Interest Article.

Does the interest 'arise' in Australia?

Interest shall be deemed to arise in a Contracting State when the payer is a resident of that Contracting State for the purposes of its tax.

AusCo is resident and incorporated in Australia, and is the payer of the amounts that consist of the notional interest. Accordingly, the interest 'arises' in Australia.

Does each Lessor 'beneficially own' the interest?

The Lessor is the legal and beneficial owner of all the Rent (including the notional interest) that it receives under the Lease.

Is each Lessor a 'financial institution' under the Interest Article of the Convention?

A 'financial institution' is defined in the Interest Article as 'a bank or other enterprise substantially deriving its profits by raising debt finance in the financial markets or taking deposits at interest and by using those funds in carrying on a business of providing finance.' The Lessor is not a bank and so must meet the characteristics of the 'other enterprise'. Additionally, the Lessor does not take deposits at interest and therefore this aspect does not apply to it.

'Enterprise' applies to the carrying on of any business (the Definitions Article of the Convention). The elements that the Lessor has to satisfy for the purposes of the Interest Article will be examined in the following order:

a)    'Raising debt finance in the financial markets'

b)    'In carrying on a business of providing finance'

c)    'Using those funds'

d)    'Profits'

e)    'Substantially derived' from spread activities

Raising Debt Finance in the Financial Markets

The term 'debt finance' is not defined in the Convention, nor is it a term that is specifically defined in Australia's tax law.

In respect of interest income arising in Australia, paragraph 17 of TR 2005/5 states that the meaning of the term 'debt finance' has regard to the approach applied in Division 974 of analysing the economic substance of the rights and obligations arising under a financing arrangement rather than the mere legal form. This recognises that the basic indicator of the economic character of debt is the non-contingent nature of the returns.

The Lessor will raise 70% of the purchase price through traditional debt sourced from third party banks on commercial arm's length terms. Under the Loan Agreement, the Lessor has, in substance or effect, an obligation to repay the debt (with interest) that is not contingent on any event, condition or situation, other than the ability or willingness of the Lessor to meet the obligation.

The debt finance must also be raised in financial markets. Paragraph 18 of TR 2005/5 states that the term 'financial markets' in the expression 'raising debt finance in the financial markets' takes on its ordinary commercial meaning. It means a facility through which:

·         offers to acquire or dispose of debt finance products are regularly made or accepted (including offering loans); or

·         offers and invitations are regularly made to acquire or dispose of debt finance products that are intended to result or may reasonably be expected to result in the making (or acceptance) of offers to acquire or dispose of such debt finance products (including offering loans).

Paragraph 73 of TR 2005/5 states that the definition of 'financial markets' includes all forms of loan financing through recognised entities that form part of the retail financial market (that is, depository institutions and finance companies). It also includes the raising of debt finance in the wholesale financial markets through which debt finance products such as notes and bonds are issued.

The Lessor will obtain the 70% funding through third party banks, and will therefore meet the requirement of 'raising debt finance in the financial markets' for the purposes of the Interest Article.

As some of the funding is through 'raising debt in the financial markets,' this element of the 'financial institutions' exemption is satisfied.

Providing Finance

The Convention does not specify what the term 'providing finance' means. Paragraph 22 of TR 2005/5 states that the term providing finance takes its ordinary meaning and in the Macquarie Dictionary, 2009, rev. 5th edn, The Macquarie Library Pty Ltd, NSW, 'finance' is defined as 'to supply with means of payment; provide capital for; obtain or furnish credit for'.

The meaning of 'finance' in the phrase 'providing finance' is broader than 'debt finance'. A provision of finance entails the supply or provision of funds or assets with an obligation (either contingent or non-contingent) on the recipient to return those funds or assets in the future. Furthermore, the leasing of an asset under a finance lease, or the lending of a security under a security lending arrangement may also constitute the provision of finance under the Convention where there is an obligation to return those assets or securities at a later date (paragraph 92 of TR 2005/5).

Under the Lease, the Lessor is supplying AusCo with the commercial equipment in return for periodic lease payments and, if the purchase option is exercised, a lump sum payment, or if the option is not exercised, the return of the commercial equipment. Accordingly, the Lessor is 'providing finance.'

Carrying on of a Business

The term 'carrying on a business' is not defined in the Convention. 'Business' includes the performance of professional services and of other activities of an independent character (the Definitions Article of the Convention). However, the definition is only inclusive. The Definitions Article provides that, as regards the application of this Convention at any time by a Contracting State, an undefined term shall, unless the context otherwise requires, have the meaning that it has at that time under the law of that Contracting State concerning the taxes to which the Convention applies.

Under Australian domestic law, there is no precise test for whether a person is carrying on a business.

Paragraph 95 of TR 2005/5 states whether an enterprise is 'carrying on a business of providing finance' is a question of fact and would need to be considered in the light of the general principles relevant to this question.

The Commissioner's views on the concept of carrying on a business for companies within the meaning of section 328-110 and section 23 of the Income Tax Rates Act 1986 (ITRA 1986) is contained in Taxation Ruling TR 2019/1 Income tax: when does a company carry on a business?. Paragraph 10 of TR 2019/1 is instructive in the current context.

Companies are typically formed for the purpose of carrying on a business (Inland Revenue Commissioners v. Westleigh Estates Company Ltd; South Behar Railway Company Ltd; Eccentric Club Ltd [1924] 1 KB 390) (Westleigh) and American Leaf Blending Co. Sdn Bhd v. Director-General of Inland Revenue (Malaysia) [1978] 3 All ER 1185 (American Leaf)).

In Westleigh, Pollock MR at [1924] 1 K.B. 390, 408-409 stated:

...as a general rule in cases of a company registered with the appendix "Limited" there would be a strong presumption that it was intended to, and did carry on a trade or business, yet, in my judgment, that presumption can be rebutted, and is so, where the facts are such, as in this case, as to negative both the aim and the prospect of gain.

In holding that a company was carrying on a business, Diplock LJ in American Leaf at [1978] 3 All ER 1185 stated:

In the case of a private individual it may well be that the mere receipt of rents from property that he owns raises no presumption that he is carrying on a business. In contrast, in the case of a company incorporated for the purpose of making profits for its shareholders any gainful use to which it puts any of its assets prima facie amounts to the carrying on of a business. Where the gainful use to which a company's property is put is letting it out for rent, their Lordships do not find it easy to envisage circumstances that are likely to arise in practice which would displace the prima facie inference that in doing so it was carrying on a business.

Each Lessor is a limited liability company incorporated under the laws of Foreign Country and established for the purpose of leasing the commercial equipment to AusCo. A presumption that each Lessor is carrying on a business will likely arise provided the Lessors were formed for the purpose of profit. AusCo has confirmed that the investors are equity investors in the Lessor, and that the amounts that the investors receive from the Lessor are distributions of profit by the Lessor rather than expenses of the Lessor. AusCo has also confirmed that the Leasing Business will make profits, albeit not in the earlier years of the Lease.

Further, the activities of the Lessor have a significant commercial purpose and character. The sale and leaseback of the commercial equipment and financing are entered into on arm's length terms. Each leased equipment is a significant commercial asset of AusCo.

Due to the commercial structure under which the Lease is arranged and the fact that it involves the acquiring and exploitation of valuable rights for profit the Commissioner considers each Lessor is carrying on a business.

Carrying on a business 'of' providing finance

It has been established that each Lessor, as the test entity, is 'providing finance' and 'carrying on a business.'

The composite expression 'carrying on a business of providing finance' requires us to consider the scope of the Lessor's business and whether that business includes the provision of finance. Paragraph 25 of TR 2005/5 states that the activities of providing finance must be undertaken 'in such a manner' that a resident is considered to be carrying on a business.

The Lessor conducts spread (finance) activities and derives a profit on the margin of those activities. The Lessor shall not, without the prior consent of the Lessee, carry on any business other than the acquisition, owning and leasing of the commercial equipment.

As the Lessor's profit is derived from the margin of the spread activities, and the Lessor is restricted from carrying on other activities, we consider that the Lessor is carrying on a business 'of' providing finance.

Using those funds

Where the Lessor is carrying on a business of providing finance, the funds from the raising of debt finance must be 'used' in the carrying on of that business (paragraph 88 of TR 2005/5). Each Lessor is using the debt finance it raises in the financial markets for its business of providing finance, as it is applying the funds towards 70% of the purchase price of the commercial equipment that is subject to the Lease.

Does the Lessor derive 'profits'?

'Profits' in this context can be measured according to a range of acceptable accounting indicators, including gross profit, net operating income or operating profit (paragraph 27 of TR 2005/5). It should also be measured on the same accounting basis over a reasonable period to ascertain whether the spread activity is consistently the main activity of the enterprise.

As noted earlier, the Lessor derives 'profits' (albeit not in the earlier years of the Leases), being the profits made on the margin on the spread activities. Having established this, the total profits earned by the Lessor must be compared against the profits that are attributable to the spread activities to determine whether the total profits are 'substantially derived' from those spread activities.

'Substantially derived'

The Lessor need only substantially derive its profits in the way prescribed by the Interest Article.

Paragraph 26 of TR 2005/5 states that the term 'substantially deriving its profits' means that the activities of raising debt finance in the financial markets...and using those funds in the carrying on a business of providing finance, needs to comprise the treaty resident's main business activity. The Convention states that it is understood that an enterprise shall derive its profits substantially by a certain activity, where the activity constitutes its main activity when compared to any other activity that it undertakes in terms of its contribution to the enterprise's overall profits.

The 'activity' for the purposes of Item 14(b) are the 'spread activities' - that is, the activity of raising debt finance with the third party banks and using the resulting funds in carrying on a business of providing finance. Item 14(b) requires us to look at the 'contribution [of that activity] to the enterprise's overall profits' in determining whether that activity constitutes the enterprise's 'main activity' in a relative sense.

Given that the majority of funds which are proposed to finance the acquisition of the commercial equipment will be obtained through raising debt finance, it is considered reasonable to conclude that raising debt finance and using the funds to provide finance is the main contributor to the Lessor's overall profits. Consequently, the Lessor is 'substantially deriving its profits' by raising debt finance and using the funds raised to provide finance.

Conclusion

As a result, the Lessor is a 'financial institution' for the purposes of the Interest Article as it falls within the meaning of that term.

Is each Lessor unrelated to and dealing wholly independently with AusCo?

Unrelated

The Convention states that it is understood that a financial institution shall be unrelated to a payer of the interest where, in considering the level of participation in the ownership or control of either the financial institution or the payer by the other party, neither party is able to exert sufficient influence over the other party.

In this regard, the term 'sufficient influence' takes its meaning from section 318 (paragraph 30 of TR 2005/5). Subsection 318(6) states that a company is sufficiently influenced by an entity or entities if the company, or its directors, are accustomed or under an obligation, or might reasonably be expected, to act in accordance with the directions, instructions or wishes of the entity or entities (whether those directions, instructions or wishes are, or might reasonably be expected to be, communicated directly or through interposed entities).

Each Lessor has no relationship with AusCo other than entering into the leasing transactions. Each Lessor, its direct or indirect holding companies and their directors, do not have ownership interests in, control over, or the ability to be able to exert influence over AusCo

Dealing Wholly Independently

Even if AusCo and the Lessor are unrelated to each other, it is still necessary that the parties are dealing with each other wholly independently.

In determining whether the parties will be regarded as dealing wholly independently with each other, an arm's length test is applied to ascertain whether the transaction has taken place on normal, open market, commercial terms (paragraph 30 of TR 2005/5). AusCo has confirmed that each Lease has been entered into on arm's length terms. On this basis, AusCo will be regarded as dealing wholly independently with each Lessor.

Do the Leases form part of a 'back-to-back' arrangement referred to in the Interest Article?

The Interest Article provides that interest may be taxed in Australia if the interest arises in Australia and is paid as part of an arrangement involving back-to-back loans or other arrangement that is economically equivalent and intended to have a similar effect to back-to-back loans.

The aim of this rule is to prevent related party and other debt being structured through a financial institution to gain access to the withholding tax exemption (paragraph 126 of TR 2005/5).

We do not regard that the Loan and the Lease together amount to an 'arrangement involving back-back loans' or 'other arrangement that is economically equivalent and intended to have a similar effect to an arrangement involving back-to-back loans.' The Loans were obtained from the third party banks (i.e. the financial markets) and were entered into on an entirely arm's length basis. The purposes of the Loans were to partly fund the acquisition of the commercial equipment.

We also do not regard that the investments and the Lease together fall within this rule. Rather, in return for providing the cash investment, the investors receive a contractual return reflecting a percentage of the profits or loss of the Leasing Business.

Accordingly, we do not consider that the interest that each Lessor derives is paid as part of an arrangement involving back-to-back loans or a similar or equivalent arrangement.

Does Article 23 (Limitation on Benefits) apply?

The Lessor will only be entitled to the above benefits if it is a 'qualified person' under the Convention.

Under the Limitation of Benefit Article, a 'qualified person' includes:

·         a company (including a company participating in a dual listed company arrangement), if its principal class of shares is listed or registered on a recognised stock exchange specified in clause (i) or (ii) of subparagraph d) of paragraph 6 and is regularly traded on one or more recognised stock exchanges; (Article 23(2)(c))

·         a person other than an individual, if residents of either Contracting State that are qualified persons by reason of the provisions of subparagraphs a) to f) of this paragraph own, directly or indirectly, at least 50 per cent of the aggregate vote and value of the shares of the person, or at least 50 per cent of the beneficial interests in the person. (Article 23(2)(g))

Foreign Head Co will be a qualified person under the Article on the basis that its principal class of shares are listed and regularly traded on a recognised stock exchange. As Foreign Head Co is a qualified person, resident in Foreign Company and indirectly owns more than 50% of the vote and value of the shares in each Lessor, each Lessor is also a qualified person.

Conclusion

The notional interest paid by AusCo shall not be taxed in Australia, as it is derived by a 'financial institution' (being each Lessor) under the Interest Article of the Convention. The ITAA 1997 and ITAA 1936 are incorporated and shall be read as one with the ITAA 1953 (subsection 4(1) of the ITAA 1953) and the provision of the ITAA 1953 has effect despite anything inconsistent in the ITAA 1997 and ITAA 1936 (other than Part IVA) (subsection 4(2) of the ITAA 1953). Accordingly, withholding tax on the notional interest will not be imposed under subsection 128B(2). Subdivision 12-F of Schedule 1 to the TAA does not require AusCo to withhold from the notional interest, as no withholding tax is payable in respect of that amount (section 12-300 of Schedule 1 to the TAA).

[1] In applying the provisions in Division 832 of the ITAA 1997, where appropriate, regard should be had to the commentary in the OECD Action 2 Report and the OECD Branch Mismatch Arrangements Report (paragraph 1.19 of the Explanatory Memorandum to the Treasury Laws Amendment (Tax Integrity and Other Measures No. 2) Bill 2018).