Edited version of private advice

Authorisation Number: 1051847661731

Date of advice: 3 June 2021

Ruling

Subject: Mineral payment under a financing agreement

Question 1

Is the Mineral Payment 'natural resource income' as defined in section 6CA of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes

Question 2

X Treaty Article 14?

Answer

Yes

Question 3

Is the Mineral Payment 'interest' as defined in subsection 128A(1AB) of the ITAA 1936?

Answer

No

Question 4

Is the Mineral Payment assessable income of Company S under paragraph 6-5(3)(a) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 5

In respect of the Mineral Payment, is a payment made under a tax gross-up clause or tax indemnity clause worked out 'wholly or partly by reference to the value or quantity of natural resources produced or recovered in Australia' under section 12-325 of Schedule 1 to the Taxation Administration Act 1953 (TAA 1953)?

Answer

No

Question 6

In respect of the Mineral Payment, is a payment made under a tax gross-up or tax indemnity clause of the financing agreement 'interest' as defined in subsection 128A(1AB) of the ITAA 1936?

Answer

No

This ruling applies for the following periods:

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

Year ended 30 June 20XX

The scheme commences on:

Month 20XX

Relevant facts and circumstances

1.            Company A is an Australian tax resident company, and a wholly owned subsidiary of Company B, which is listed on the Australian Securities Exchange.

2.            Company A carries on mining operations in Australia from which XXXXX is produced.

3.            Company S is a limited liability company incorporated in Country X.

4.            Company S is a non-resident of Australia and is a tax resident of Country X.

5.            Company S has a 30 June financial year-end.

6.            Company S does not carry on business in Australia and does not have a permanent establishment or presence in Australia.

7.            A financing agreement was entered into and subsequently updated by the following parties:

•                    Company A as 'borrower';

•                    Company B as the 'parent';

•                    other subsidiaries of Company B, together with Company B as 'guarantors'

•                    Company S as 'original lender';

8.            Under the financing agreement, Company S must subscribe for loan notes, and by way of such subscription make the facilities available to Company A.

9.            Under the financing agreement, interest is payable on outstanding amounts at commercial rates. Outstanding amounts are required to be repaid on maturity.

10.         Under the financing agreement, there are Mineral Payments required in respect of each Facility.

11.         The Mineral Payments are calculated as a percentage of Company A's total quarterly production of refined XXXXX.

12.         The obligation to make the Mineral Payments survives repayment or prepayment of the loan notes.

13.         The financing agreement contains a tax gross-up clause and a tax indemnity clause.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 6

Income Tax Assessment Act 1936 section 6CA

Income Tax Assessment Act 1936 section 128A

Income Tax Assessment Act 1997 section 6-5

International Tax Agreements Act 1953 section 7

Treaty X Article 14

Taxation Administration Act 1953 Schedule 1 section 12-325

Reasons for decision

Question 1

Is the Mineral Payment under the financing agreement 'natural resource income' as defined in section 6CA of ITAA 1936?

Detailed reasoning

Under subsection 6CA(1) of the ITAA 1936, 'natural resource income' means income that:

(a)          is derived by a non-resident; and

(b)          is calculated, in whole or in part, by reference to the value or quantity of natural resources produced, recovered or produced and recovered, in Australia after 7 April 1986; but does not include:

(c)          income that consists of royalty; or

(d)          income where:

(i)            on 7 April 1986, the non-resident had a continuing entitlement to receive the income;

(ii)           the income was derived by the non-resident pursuant to that continuing entitlement;

(iii)         the non-resident was, at 5 o'clock in the afternoon, by standard time in the Australian Capital Territory on 7 April 1986, a resident, within the meaning of a double tax agreement, of a foreign country in respect of which the double tax agreement was in force;

(iv)         before 8 April 1986, the Commissioner had given a statement in writing to the effect that income tax would be levied on 50% of income included in a specified class of income; and

(v)          the income is included in that class of income.

The relevant components of the definition are considered below.

Is the payment 'income'?

The Mineral Payments are income derived by Company S. This is because these amounts are a return received by Company S under the financing agreement in connection with the provision of the financing facility, in addition to interest and other fees payable under the financing agreement. The payments are derived in the ordinary course of Company S's business and are not a return of a capital nature.

Derived by a non-resident

The Mineral Payments are paid by Company A to Company S. As Company S is a non-resident paragraph (a) of the definition is satisfied.

Meaning of 'natural resources'

Subsection 995-1(1) of the ITAA 1997 provides that 'natural resource' means minerals or any other non-living resource of the land, sea-bed or sea. 'Minerals' is not defined and so will take its ordinary meaning (although subsection 40-730(5) provides that 'minerals' includes petroleum).

The Macquarie Dictionary relevantly defines 'minerals' as:

noun 1. a substance obtained by mining; ore.

2.any of a class of substances occurring in nature, usually comprising inorganic substances (as quartz, feldspar, etc.) of definite chemical composition and definite crystal structure, but sometimes taken to include aggregations of these substances (more correctly called rocks) and also certain natural products of organic origin, as asphalt, coal, etc.

The XXXXX produced by Company A falls within the ordinary meaning of 'minerals' and in addition is also a 'non-living resource of the land' and so is a natural resource for the purposes of the definition in section 6CA.

Calculated, in whole or in part, by reference to the value or quantity of natural resources produced, recovered or produced and recovered, in Australia

It is considered that the Mineral Payment made under the financing agreement is calculated by reference to the value of XXXXX (being a natural resource) produced or recovered in Australia.

The gross revenue received from the sale of refined XXXXX is a measure of the value of the XXXXX produced and the Mineral Payment is calculated by reference to this value.

Paragraph 4 of Tax Ruling TR 2020/5 Income tax: application of section 6CA of the Income Tax Assessment Act 1936 and Australia's tax treaties and the payer's withholding obligations (TR 2020/5) provides that:

...income is calculated, in whole or in part, by reference to the value or quantity of resources produced where the calculation is based on the level of production. (emphasis added)

The Mineral Payments are 'based on' the level of production of XXXXX as payment is calculated with reference to the total XXXXX produced in a quarter.

In Australia

The definition requires that the relevant natural resources be produced or recovered in Australia. The ATO position, outlined at paragraph 13 of TR 2020/5, is that a natural resource will be produced or recovered in Australia when all the material processes of production and/or recovery occur in Australia. As all the extraction/recovery and refining of the XXXXX from the tenements occurs in Australia, this element of the definition is satisfied.

Are the payments royalties?

Paragraph (c) of the definition of 'natural resource income' excludes 'income that consists of royalty'. The Mineral Payments are not royalties as defined in subsection 6(1) of the ITAA 1936 as they are not made in consideration for any of the matters referred to in that definition. The payments also do not fall within the definition of royalties as defined in Article 10 of the X Treaty.

Other exclusions

None of the exclusions in paragraph (d) of the definition of 'natural resource income' are relevant to the Mineral Payments, and so will not apply.

Conclusion

As all the elements of the definition of Natural Resource Income are satisfied and none of the exclusions apply, the Mineral Payments are 'natural resource income' of Company S.

Question 2

Are the Mineral Payments under the financing agreement 'income from real property' under Article 4A of the X Treaty?

Summary

The Mineral Payments are 'income from real property' under Article 4A of the X Treaty, as the payments are made 'in respect of' the exploitation of mineral deposits, or other places of extraction or exploitation of natural resources.

Detailed reasoning

Under Article 4A(2) of the X Treaty, the definition of 'real property' relevantly includes:

b)            a right to receive variable or fixed payments either as consideration for the exploitation of or the right to explore for or exploit, or in respect of the exploitation of, mineral, oil or gas deposits, quarries or other places of extraction or exploitation of natural resources.

For a payment to be considered to be 'in respect of' the exploitation of natural resources there must be 'some discernible and rational link' (Technical Products Pty Ltd v State Government Insurance Office [1989] HCA 24, per Brennan, Deane and Gaudron JJ) between the right to receive the payment and the exploitation of the relevant natural resource (paragraph 43 of TR 2020/5). It is considered that where a payment such as the Mineral Payments are calculated by reference to the value or quantity of natural resources produced in Australia, such payments will be 'in respect of' the exploitation of the relevant natural resource (paragraph 17 of TR 2020/5).

The Mineral Payments are variable payments, that are received by Company S, 'in respect of' the exploitation of a natural resource, being XXXXX. Company S's right to receive the Mineral Payments pursuant to the financing agreement therefore constitutes 'real property' for the purposes of the X Treaty.

Under Article 4A(1), income from real property may be taxed in the Contracting State in which the real property is situated.

Article 4A(3) provides:

Any interest or right referred to in paragraph (2) shall be regarded as situated where the land, mineral, oil or gas deposits, quarries or natural resources, as the case may be, are situated or where the exploration may take place.

In respect of Mineral Payments, that place is Australia.

Consequently, the Mineral Payments constitute 'income from real property' which may be taxed in Australia.

Question 3

Is the Mineral Payment 'interest' under the financing agreement as defined in subsection 128A(1AB) of the ITAA 1936?

Summary

The Mineral Payment under the financing agreement is not 'interest' as defined in subsection 128A(1AB) of the ITAA 1936.

Detailed reasoning

Subsection 128A(1AB) of the ITAA 1936 defines interest for the purposes of Division 11A of the ITAA1936 as including an amount:

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

(b)          to the extent that it could reasonably be regarded as having been converted into a form that is in substitution for interest; or

(c)          to the extent that it could reasonably be regarded as having been received in exchange for interest in connection with a washing arrangement; or

(d)          that is a dividend paid in respect of a non-equity share; or

(e)          if regulations under the Income Tax Assessment Act 1997 are made having the effect that instruments known as upper tier 2 capital instruments, or a class of instruments of that kind, are debt interests - that is paid on such a debt interest and is not a return of an investment;

but does not include an amount to the extent to which it is a return on an equity interest in a company.

The term 'interest' is not defined for the purposes of Division 11A of the ITAA 1936, it is therefore necessary to have regard to the meaning of 'interest' at common law.

Ordinary meaning of interest

Interest is in essence compensation to a lender for being kept out of the use and enjoyment of the principal sum (Federal Commissioner of Taxation v. The Myer Emporium Ltd (1987) 163 CLR 199). It is an amount that is calculated by reference to a principal sum and by reference to time (Federal Wharf Co Ltd v. Deputy Commissioner of Taxation (1930) 44 CLR 24 at 28; per Cooper J in Century Yuasa Batteries Pty Ltd v. Federal Commissioner of Taxation (1997) 73 FCR 528 (Century Yuasa Batteries)).

The Mineral Payments under the financing agreement are not calculated by reference to the principal loan sum outstanding under the financing agreement or the time it is outstanding.

Further, the Mineral Payments are amounts payable in addition to interest under the loan. Those payments are payable even if the loan under the financing agreement has already been repaid or prepaid early by Company A. The obligation to make the Mineral Payments survives the repayment or prepayment of the loan.

Therefore, the Mineral Payments are not interest within the ordinary meaning of the term, even though they are payable to Company S under the financing agreement in connection with a loan.

Paragraph 128A(1AB)(a)

Under paragraph 128A(1AB)(a) of the ITAA 1936, the definition of 'interest' is extended to include an amount 'that is in the nature of interest'. In Century Yuasa Batteries, Cooper J held that:

In my view, for a payment to fall within the extended definition under s 128A(1) in the context of the withholding tax provisions of the ITAA it must have the character of a return or profit to the lender for the use of money advanced to the borrower howsoever calculated or ascertained.

While the Mineral Payments do constitute a return to the lenders, the payments are not considered to be a return 'for the use of money advanced'. This is because the loan under the financing agreement has a commercial rate of interest that is payable to the lenders on the outstanding balance, which constitutes the return to the lenders 'for the use of money advanced'. The Mineral Payments required under the financing agreement are required to be made regardless of whether Company A still has use of any money advanced, the Mineral Payments stand alone and are required to be made regardless of whether the loan is still outstanding.

Consequently, paragraph 128A(1AB)(a) of the ITAA 1936 does not apply to the Mineral Payments.

Paragraph 128A(1AB)(b)

Under paragraph 128A(1AB)(b) of the ITAA 1936, the definition of 'interest' includes an amount 'to the extent that it could reasonably be regarded as having been converted into a form that is in substitution for interest'.

The Mineral Payments will not fall within paragraph 128A(1AB)(b) as there is no conversion of what would have been 'interest' under the financing agreement into the form of the Mineral Payments.

The example of an amount in substitution for interest given in subsection 128A(1AD) of the ITAA 1936 is a lump sum payment made instead of payments of interest. The Mineral Payments are clearly distinguishable from a lump sum payment that is made instead of periodic payments of interest. Interest on the borrowing is not converted into any other form but is fully covered by the interest rate of 8% payable under the financing agreement.

Therefore, paragraph 128A(1AB)(b) of the ITAA 1936 does not apply to the Mineral Payments.

Paragraphs 128A(1AB)(c), (d), and (e)

None of paragraphs (c), (d) or (e) of the extended definition of interest under subsection 128A(1AB) of the ITAA 1936 are relevant to the Mineral Payments.

Question 4

Are the Mineral Payments assessable income of Company S under subsection 6-5(3)(a) of the ITAA 1997?

Summary

The Mineral Payments are assessable income of Company S under section 6-5(3)(a) of ITAA 1997.

Detailed reasoning

Under paragraph 6-5(3)(a) of the ITAA 1997, the assessable income of a foreign resident includes the ordinary income derived directly or indirectly from all Australian sources during the income year.

Under subsection 6CA(3) of the ITAA 1936, for the purpose of section 6-5 of the ITAA 1997, natural resource income shall be deemed to have been derived from a source in Australia. Accordingly, the Mineral Payments made to Company S have an Australian source.

Section 128D of the ITAA 1936 provides that certain types of income under section 128B are non-assessable non-exempt income. The types of income that are considered to be non-assessable non-exempt income under section 128B include types of interest, dividends and royalties. Therefore, sections 128B and 128D do not apply to the Mineral Payments, because they are not 'interest' under subsection 128A(1AB) of the ITAA 1936 (or dividends or royalties).

Consequently, the Mineral Payments are ordinary income and assessable income of Company S under paragraph 6-5(3)(a) of the ITAA 1997.

Question 5

In respect of the Mineral Payments under the financing agreement, is a payment made under the 'tax gross-up' or 'tax indemnity' clauses of the financing agreement worked out 'wholly or partly by reference to the value or quantity of natural resources produced or recovered in Australia' under section 12-325 of Schedule 1 to the TAA 1953?

Summary

In respect of the Mineral Payments under the financing agreement, a payment made under the 'tax gross-up' or 'tax indemnity' clauses of the financing agreement is not worked out 'wholly or partly by reference to the value or quantity of natural resources produced or recovered in Australia' under section 12-325 of Schedule 1 to the TAA 1953.

Detailed reasoning

Under subsection 12-325(1) of Schedule 1 to the TAA 1953, an entity must withhold an amount from a payment it makes to a foreign resident if the payment is worked out wholly or partly by reference to the value or quantity of natural resources produced or recovered in Australia.

Under subsection 12-325(2) of Schedule 1 to the TAA 1953, the amount to be withheld is:

(a)          the amount notified by the Commissioner under section 12-330; or

(b)          the amount worked out under a certificate in force under section 12-335 that covers the payment; as appropriate.

As determined in Question 1 above, an additional payment under the financing agreement is 'natural resource income' as defined in section 6CA of the ITAA 1936. Therefore, there is an obligation to withhold an amount from the Mineral Payments under section 12-325 of Schedule 1 to the TAA 1953. An amount withheld under subsection 12-325(1) of Schedule 1 to theTAA 1953 would be considered a tax deduction under the financing agreement.

Therefore, Company A would have an obligation to pay an additional amount equal to the tax deduction under the tax gross-up clause. Alternatively, if no tax deduction is required to be made, Company A may have an obligation to pay an additional amount under the tax indemnity payment clause of the financing agreement. The tax indemnity payment would be equal to the Australian tax payable by Company S that is attributable to the Mineral Payments for the income year (if any).

As the withholding rate under subdivision 12-G of Schedule 1 to the TAA 1953 is determined for a gross payment, it may be reduced to a percentage lower than the income tax rate applicable to the foreign resident Company S. That is, the tax gross-up payment or a tax indemnity payment need to appropriately take into account:

•                    the income tax rate applicable to the foreign resident; and

•                    allowable deductions of the foreign resident in calculating its taxable income - in the case of a tax gross-up payment, these may need to be estimated.

As explained above in the answer to question 1, an amount will be calculated by reference to the value or quantity of resources produced where the calculation is based on the level of production. Any tax gross-up payment or tax indemnity payment will not be based on the level of production of XXXXX, as the value or quantity of XXXXX produced is not a component of the calculation (unlike the Mineral Payments themselves). Rather:

•                    in the case of a tax indemnity payment, it is determined by reference to an amount of Australian tax payable by Company S in respect of its taxable income that is determined under the income tax legislation; and

•                    in the case of a tax gross-up payment, it is determined by reference to a rate set by the Commissioner.

Therefore, there is no amount required to be withheld by Company A from a payment of a tax gross-up payment or a tax indemnity payment to Company S.

Question 6

In respect of the Mineral Payments under the financing agreement, is a payment made under the 'tax gross-up' or 'tax indemnity' clauses of the financing agreement 'interest' as defined in subsection 128A(1AB) of the ITAA 1936?

Summary

In respect of the Mineral Payments under the financing agreement, a payment made under the 'tax gross-up' or 'tax indemnity' clauses of the financing agreement is not 'interest' as defined in subsection 128A(1AB) of the ITAA 1936?

Detailed reasoning

Under Subdivision 12-F of Schedule 1 to the TAA 1953, an entity may have an obligation to withhold an amount from 'interest' as defined in subsection 128A(1AB) of the ITAA 1936.

As explained in the answer to question 3, the Mineral Payments are not 'interest' as defined in subsection 128A(1AB) of the ITAA 1936, therefore any tax gross-up payment or tax indemnity payment under the financing agreement in relation to a tax deduction or a tax liability in respect of a Mineral Payment cannot constitute 'interest' as defined in subsection 128A(1AB).

For completeness, even if the Mineral Payments were 'interest' as defined in subsection 128A(1AB) of the ITAA 1936, the decision of Full Federal Court in Century Yuasa Batteries would apply and any tax gross-up payment or tax indemnity payment under the financing agreement in relation to a tax deduction or a tax liability would not be 'interest' as defined in subsection 128A(1AB).

Consequently, no amount is required to be withheld by Company A from a payment of a tax gross-up payment or tax indemnity payment under Subdivision 12-F of Schedule 1 to the TAA 1953.