Edited version of private advice

Authorisation Number: 1051953428795

Date of advice: 24 February 2022

Ruling

Subject: Sovereign immunity

Question

Is the ordinary and statutory income derived by the Foreign Entity from its Australian investments in state government bonds not assessable income and not exempt income under section 880-105 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes.

This ruling applies for the following periods:

year ended 30 June 20XX

year ended 30 June 20XX

year ending 30 June 20XX

year ending 30 June 20XX

year ending 30 June 20XX

year ending 30 June 20XX

year ending 30 June 20XX

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

The Foreign Entity

The Foreign Entity is an autonomous public entity. It is the Central Bank of the Foreign Country and is governed by the Foreign Country's Law (The Law).

The Foreign Entity's principal mission is to determine and direct the monetary policy aimed at maintaining price stability in order to facilitate economic development within the framework of the Foreign Country's economic and financial policy.

Broadly, the Foreign Entity has the following functions and duties:

a.    set monetary policy

b.    set interest rates

c.     act as the sole issuer of national currency

d.    regulate and supervise the activities of banks and financial institutions and those entities operating within the financial market, foreign exchange markets, and the market for precious stones and metals

e.    manage and maintain international reserves

f.      provide banking services to the Foreign Government

g.    oversee payments systems

h.    establish the balance of payments, and

i.      participate in the management of external debt and claims

The Foreign Entity is the banker for the Foreign Government, agencies of the Foreign Government, domestic banks, foreign central banks, and public financial institutions.

The Foreign Entity may not open accounts for enterprises, including those owned by the State.

The Foreign Entity acts as the agent of the Foreign Government, or other public entities when marketing securities issued by these entities.

The Foreign Entity reports to the Foreign Government on a regular basis on the economic and financial conditions of the Foreign Country, and on the performance of the Foreign Entity.

The Foreign Entity also submits reports to the National Assembly on request.

The Foreign Entity is managed by a Board of Directors, chaired by the Governor.

The Foreign Entity's Governor serves as the chief executive officer of the Foreign Entity.

The Foreign Entity Governor and Deputy Governor are appointed, replaced, and dismissed by a decree on the recommendation of the Foreign Government. All other members of the Board of Directors are appointed, replaced, and dismissed by sub decree.

The Foreign Entity has an amount of capital that is determined by sub decree. All of the capital of the Foreign Entity is subscribed for and held exclusively by the Foreign Government and is not transferable or subject to encumbrance.

Whenever the Foreign Entity's assets on its balance sheet fall below the sum of its liabilities, the Foreign Government transfers its government securities to the Foreign Entity to remedy the deficiency.

The balance of the net income of the Foreign Entity is transferred to the National Budget after various deductions.

The assets, property, income operations and transactions of the Foreign Entity is exempt from all duties and taxes.

Sovereign Entity Group

For the purpose of applying Division 880 of the ITAA 1997, the Foreign Entity is considered to form part of a sovereign entity group as set out in section 880-20 of the ITAA 1997. The Foreign Entity, as the central bank of the Foreign Country, will form part of a sovereign entity group including the Foreign Country and any entities in which the Foreign Government either directly or indirectly holds 100% of the participation interests.

For the purpose of applying subsection 880-105(6) of the ITAA 1997, the Foreign Entity will form part of a sovereign entity group including the Foreign Country and any entities in which the Foreign Government either directly or indirectly holds 50% of the participation interests.

Overview of Australian Investments

The Foreign Entity as part of managing its foreign reserves holds a number of low volatility debt instruments. The Foreign Entity's Australian investments consist of the following types of debt instruments:

a.    Australian government bonds, and

b.    Australian State government bonds.

The Foreign Entity derives interest income from these investments and gains on their disposal.

The Foreign Entity manages the foreign reserves conservatively in order to ensure that the Foreign Country is able to cover any foreign currency net imbalances, maintain confidence in its monetary and exchange policies, and protect the economic well-being of the country in the event of national disaster or external events.

Investment in the Test Entities

Only the Foreign Entity's investments in Australian State government bonds are the subject of this private ruling.

Each of the issuers of the bonds are Australian resident companies (the Test Entities) wholly owned by the respective State Governments.

Neither the Foreign Entity, nor any members of its sovereign entity group, has involvement in the day to day management of the business of any of the Test Entities.

Neither the Foreign Entity, nor any members of its sovereign entity group, has the right to appoint a director to the Board of Directors of any of the Test Entities.

Neither the Foreign Entity, nor any members of its sovereign entity group, holds the right to representation on any investor representative or advisory committee (or similar) of the Test Entities.

Neither the Foreign Entity, nor any members of its sovereign entity group, has the ability to direct or influence the operation of the Test Entities outside of the ordinary rights conferred by any debt interest held.

Voting rights, if any, of debt interests in each investment held by the Foreign Entity, and any members of its sovereign entity group, do not exceed the proportion of debt interests held by the Foreign Entity and any members of its sovereign entity group.

The Foreign Entity's interests in the Test Entities, and the interests of any members of its sovereign entity group, do not provide it or them with an entitlement to either directly or indirectly determine the identity of any person who make decisions that comprise the control and direction of the Test Entities' operations.

The Foreign Entity's interests, when combined with the other interests held within its sovereign entity group, do not provide an entitlement to either directly or indirectly determine the identity of any person who make decisions that comprise the control and direction of the Test Entities' operations.

No person involved in the control and direction of the Test Entities' operations is accustomed or obliged to act in accordance with the directions, instructions or wishes of the Foreign Entity or members of the Foreign Entity's sovereign entity group.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 128B

Income Tax Assessment Act 1997 section 880-105

Income Tax Assessment Act 1997 section 880-110

Income Tax Assessment Act 1997 section 880-115

Income Tax Assessment Act 1997 section 880-120

Income Tax Assessment Act 1997 section 880-125

Reasons for decision

Section 880-105 of the ITAA 1997 provides that amounts of ordinary and statutory income derived by a sovereign entity are not assessable and not exempt income if certain conditions are met. Those conditions are listed in subsection 880-105(1):

(a) the sovereign entity is covered by section 880-125; and

(b) the amount is a return on any of the following kinds of interest that the sovereign entity holds in another entity (the test entity):

(i) a *membership interest;

(ii) a *debt interest;

(iii) a *non-share equity interest; and

(c) the test entity is:

(i) a company that is an Australian resident at the time (the income time) when the amount becomes ordinary or statutory income of the sovereign entity; or

(ii) a *managed investment trust in relation to the income year in which the income time occurs; and

(d) the *sovereign entity group of which the sovereign entity is a member satisfies the portfolio interest test in subsection (4) in relation to the test entity:

(i) at the income time; and

(ii) throughout any 12-month period that began no earlier than 24 months before that time and ended no later than that time; and

(e) the sovereign entity group of which the sovereign entity is a member does not have influence of a kind described in subsection (6) in relation to the test entity at the income time.

These conditions are considered below.

The Foreign Entity is a covered sovereign entity

Section 880-125 of the ITAA 1997 states:

A *sovereign entity is covered by this section if it satisfies all of the following requirements:

(a) the entity is funded solely by public monies;

(b) all returns on the entity's investments are public monies;

(c) the entity is not a partnership;

(d) the entity is not any of the following:

(i) a *public non-financial entity;

(ii) a *public financial entity (other than a public financial entity that only carries on central banking activities).

These conditions are considered below.

The Foreign Entity is a sovereign entity

For an entity to be covered by section 880-125 of the ITAA 1997, it must be a sovereign entity. Section 880-15 of the ITAA 1997 defines a sovereign entity to be any of the following:

(a) a body politic of a foreign country, or a part of a foreign country;

(b) a *foreign government agency;

(c) an entity:

(i) in which an entity covered by paragraph (a) or (b) holds a *total participation interest of 100%; and

(ii) that is not an Australian resident; and

(iii) that is not a resident trust estate for the purposes of Division 6 of Part III of the Income Tax Assessment Act 1936.

A 'foreign government agency' is defined in subsection 995-1(1) of the ITAA 1997 as:

(a) the government of a foreign country or of part of a foreign country; or

(b) an authority of the government of a foreign country; or

(c) an authority of the government of part of a foreign country.

The Foreign Entity is the Central Bank of the Foreign Country. Its ownership, purpose, functions, governance and global status are consistent with being a foreign government agency.

All of the Foreign Entity's capital is subscribed for and held exclusively by the Foreign Government and is not transferable or subject to encumbrance. The balance of net income of the Foreign Entity is also transferred to the National Budget of the Foreign Country. The Foreign Entity is effectively owned by the Foreign Government as the Foreign Government has all rights to its capital and income. Further, where the Foreign Entity's assets on its balance sheet falls below the sum of its liabilities, the Foreign Government transfers its government securities to the Foreign Entity to remedy the deficiency. In that respect, the Foreign Entity is effectively guaranteed or indemnified by the Foreign Government.

The Foreign Entity's purpose and functions are consistent with a foreign agency executing governmental functions and responsibilities. Its primary purpose is to, in consultation with the Foreign Government, determine, develop, implement and evaluate monetary policy objectives in order to facilitate economic development. This includes setting interest rates, maintaining the international reserves, and issuing currency. It also functions as a regulatory body for the banking, financial, and securities sectors of the Foreign Country, a clear government function.

The Foreign Entity's governance is also consistent with it being an agency of a foreign government. It is an autonomous public entity created by statute. Its leadership, including the Governor and Deputy Governor, are appointed, replaced and dismissed by decree on the recommendation of the Foreign Government. The Foreign Entity's Board of Directors consists of representatives from the Foreign Government. The Foreign Entity is directly accountable to and is supervised by the Foreign Government. It is required to provide reports to the Foreign Government on the Foreign Entity's performance, its annual budget, the nation's economic and financial policy, and the implementation of monetary and exchange policies.

Finally, the Foreign Entity's global standing is consistent with that of a government agency. The Foreign Entity, as the Central Bank, opens accounts on behalf of other foreign central banks and public international financial institutions, including the WorldBank and the International Monetary Fund. It deals directly with these international agencies, and acts as the government's agent for the marketing of securities issued by the Foreign Government or other government agencies.

As such, the Foreign Entity meets the requirements of being a sovereign entity in accordance with section 880-15 of the ITAA 1997 as it is a foreign government agency as defined in subsection 995-1(1) of the ITAA 1997.

The Foreign Entity is funded solely by public monies

The phrase 'public monies' is not defined and as such takes its ordinary meaning. In the context of Division 880 of the ITAA 1997, this phrase essentially means monies raised by a foreign government (or part of a foreign government) for a public purpose which form part of the foreign government's (or part of the foreign government's) equivalent to Australia's Consolidated Revenue Fund (Roy Morgan Research Pty Ltd v FC of T & Anor [2011] HCA 35). This would ordinarily include general tax revenue, proceeds from the issue of government bonds, the proceeds of privatisations etc.

The Foreign Entity has an amount of capital that is determined by sub decree. All of the capital of the Foreign Entity is subscribed for and held exclusively by the Foreign Government and is not transferable or subject to encumbrance. Whenever the Foreign Entity's assets on its balance sheet falls below the sum of its liabilities, the Foreign Government transfers its government securities to the Foreign Entity to remedy the deficiency. In that respect, the Foreign Entity is effectively guaranteed or indemnified by the Foreign Government.

Furthermore, the monies invested by the Foreign Entity are government monies, and therefore public monies. The monies invested are from a mix of sources including government deposits, international reserves, government agency deposits, accumulation of reserve monies from previous years, and deposits made by commercial banks to the Foreign Entity in its role as the regulatory body of the banking and financial sector in the Foreign Country.

Therefore, the Foreign Entity satisfies this requirement.

All returns on the Foreign Entity's investments are public monies

The monies being invested by the Foreign Entity will also remain public monies. The Foreign Entity will use the income generated from this investment to manage and maintain the reserves, and pay its operating expenses.

Any remaining net income, as defined in The Law, is then transferred to the Foreign Government's National Budget for government spending. The Foreign Government is the final beneficiary of the income generated by the Foreign Entity.

Accordingly, the monies that are invested by the Foreign Entity are and will remain public monies.

Therefore, the Foreign Entity satisfies this requirement.

The Foreign Entity is not a partnership

The Foreign Entity, as the Central Bank of the Foreign Country, is an autonomous public entity created by statute and is not a partnership.

Therefore, the Foreign Entity satisfies this requirement.

The Foreign Entity is not a public non-financial entity or public financial entity

Subsection 880-130(1) of the ITAA 1997 defines the term public non-financial entity:

An entity is a public non-financial entity if its principal activity is either or both of the following:

(a) producing or trading non-financial goods;

(b) providing services that are not financial services.

The Foreign Entity does not produce or trade non-financial goods and does not provide non-financial services. Therefore, the Foreign Entity is not a public non-financial entity.

Subsection 880-130(2) of the ITAA 1997 defines the term public financial entity:

An entity is a public financial entity if any of the following requirements are satisfied:

(a) it trades in financial assets and liabilities;

(b) it operates commercially in the financial markets;

(c) its principal activities include providing any of the following financial services:

(i) financial intermediary services, including deposit-taking and insurance services;

(ii) financial auxiliary services, including brokerage, foreign exchange and investment management services;

(iii) capital financial institution services, including financial services in relation to assets or liabilities that are not available on open financial markets.

Subparagraph 880-125(d)(ii) of the ITAA 1997 excludes public financial entities that only carry on central banking activities from being excluded as a covered sovereign entity.

Paragraph 79 of the Law Companion Ruling LCR 2020/3 The superannuation fund for foreign residents withholding tax exemption and sovereign immunity (LCR 2020/3) lists common examples of public financial entities which includes banks and deposit taking corporations.

As the Foreign Entity is the Central Bank of the Foreign Country and is created by statute as an autonomous public entity, it is a public financial entity. For the Foreign Entity to be excluded from subparagraph 880-125(d)(ii) of the ITAA 1997 it must be established that the Foreign Entity, as a public financial entity, only carries on central banking activities.

Paragraph 81 of LCR 2020/3 lists the following inclusive list as 'central banking activities':

•         monetary policy development

•         issuing national currency

•         acting as custodian of international reserves, and

•         providing banking services to government.

The principal mission of the Foreign Entity is to, in consultation with the Foreign Government of the Foreign Country, determine, develop, implement and evaluate monetary policy objectives in order to facilitate economic development. The Foreign Entity's activities in pursuit of this mission include:

•         set monetary policy

•         set interest rates

•         act as the sole issuer of national currency

•         regulate and supervise the activities of banks and financial institutions and those entities operating within the financial market, foreign exchange markets, and the market for precious stones and metals

•         manage and maintain international reserves

•         provide banking services to the Government

•         oversee payments systems

•         establish the balance of payments, and

•         participate in the management of external debt and claims

The above activities are consistent with the Foreign Entity being a public financial entity that only carries on central banking activities. As such, the Foreign Entity satisfies the condition in paragraph 880-125(d) of the ITAA 1997.

As the Foreign Entity satisfies each of the requirements in paragraphs 880-125(a) through (d) it is a sovereign entity that is covered by section 880-125 for the purposes of section 880-105 of the ITAA 1997.

The Foreign Entity's return is received on a relevant interest in the Test Entities

For an amount of ordinary income or statutory income of a sovereign entity to satisfy paragraph 880-105(1)(b) of the ITAA 1997, it must be a 'return on' a membership interest, debt interest or non-share equity interest held by the sovereign entity in the test entities.

As detailed in paragraph 4.37 of the Explanatory Memorandum to the Making Sure Foreign Investors Pay Their Fair Share of Tax in Australia and Other Measures) Act 2019 ('the EM'), a 'return on' a membership interest, debt interest or non-share equity interest for the purposes of paragraph 880-105(1)(b) will include:

1.            dividends - including non-share dividends and dividends that pass through a managed investment trust (MIT)

2.            interest - including interest that passes through a MIT

3.            fund payments made by a MIT (other than fund payments that are attributable to non-concessional MIT income), and

4.            revenue gains made on the disposal of an interest in the test entity - including revenue gains that pass through a MIT.

The Foreign Entity's investment in Australian State government bonds are debt interests from which the Foreign Entity earns returns in the form of interest, or gains on their disposal.

As such, the Foreign Entity will receive amounts which satisfy the requirements of paragraph 880-105(1)(b) of the ITAA 1997.

The Foreign Entity's income is received from Australian resident companies or MITs

For an amount of ordinary income or statutory income of a sovereign entity to satisfy paragraph 880-105(1)(c) of the ITAA 1997, it must be received from an entity that is either:

(i) a company that is an Australian resident at the time (the income time) when the amount becomes ordinary or statutory income of the sovereign entity; or

(ii) a *managed investment trust in relation to the income year in which the income time occurs.

The Test Entities that the Foreign Entity holds debt-interests in are companies that are Australian residents. Each of the Test Entities are expected to continue to be Australian resident companies at the time the interest income is derived by the Foreign Entity.

As such, the Foreign Entity's income is received from an entity which satisfies the requirements of paragraph 880-105(1)(c) of the ITAA 1997.

The Foreign Entity's sovereign entity group satisfies the portfolio interest test

For an amount of ordinary income or statutory income of a sovereign entity to satisfy paragraph 880-105(1)(d) of the ITAA 1997, the sovereign entity and the sovereign entity group to which it belongs must satisfy the portfolio interest test in relation to the test entity at both the income time and throughout any 12 month period that began no earlier than 24 months before that time and ended no later than that time.

The portfolio interest test is outlined in subsection 880-105(4) of the ITAA 1997, which states:

A *sovereign entity group satisfies the portfolio interest test in this subsection in relation to the test entity at a time if, at that time, the sum of the *total participation interests that each *member of the group holds in the test entity:

(a)  is less than 10%; and

(b)  would be less than 10% if, in working out the *direct participation interest that any entity holds in a company:

(i) an *equity holder were treated as a shareholder; and

(ii) the total amount contributed to the company in respect of *non-share equity interests were included in the total paid-up share capital of the company.

Section 880-20 of the ITAA 1997 provides the definition of sovereign entity group. Broadly, sovereign entities of the same foreign government will be members of the same sovereign entity group and sovereign entities of the same part of a foreign government will be members of the same sovereign entity group.

The Foreign Entity does not hold a membership interest in any of the Test Entities and therefore satisfies the portfolio interest test.

The Foreign Entity is part of the sovereign entity group of the Foreign Country. As the Test Entities are Australian State government entities, no other member of the Foreign Entity's sovereign entity group would hold a membership interest in the Test Entities.

As such, the requirements of paragraph 880-105(d) of the ITAA 1997 are satisfied.

The Foreign Entity's sovereign entity group does not have influence of a kind described in subsection (6) in relation to the Test Entities at the income time

For an amount of ordinary income or statutory income of a sovereign entity to satisfy paragraph 880-105(1)(e) of the ITAA 1997, at the income time the sovereign entity group to which the sovereign entity belongs must not have influence over the test entity of a kind described in subsection 880-105(6) of the ITAA 1997.

Subsection 880-105(6) of the ITAA 1997 states:

A *sovereign entity group has influence of a kind described in this subsection in relation to the test entity at a time if any of the following requirements are satisfied at that time:

(a) a *member of the group:

(i) is directly or indirectly able to determine; or

(ii) in acting in concert with others, is directly or indirectly able to determine;

the identity of at least one of the persons who, individually or together with others, make (or might reasonably be expected to make) the decisions that comprise the control and direction of the test entity's operations;

(b) at least one of those persons is accustomed or obliged to act, or might reasonably be expected to act, in accordance with the directions, instructions or wishes of a member of the group (whether those directions, instructions or wishes are expressed directly or indirectly, or through the member acting in concert with others).

In determining whether a sovereign entity group has the requisite level of influence, subsection 880-105(7) requires that any breaches of the terms of a debt interest by any entity be ignored.

As such, there are two distinct sub-tests within the influence test.

Sub-test 1 is contained in paragraph 880-105(6)(a) of the ITAA 1997 and assesses whether the sovereign entity group is able to directly or indirectly determine the identity of at least one of the persons who, individually or together with others make (or might reasonably be expected to make) the decisions that comprise the control and direction of the test entity's operations. This includes situations where the sovereign entity group is able to act in concert with others to determine the identity of a relevant decision-maker in the test entity.

Sub-test 1 also extends to situations where the sovereign entity group, in its own right, holds the ability to approve or veto decisions which go to the control or direction of the test entity.

The Foreign Entity's interests in the Test Entities do not provide it with an entitlement to either directly or indirectly determine the identity of any person who makes decisions that comprise the control and direction of the Test Entities' operations. Furthermore, the Foreign Entity's interests, when combined with those of its sovereign entity group, do not provide its sovereign entity group with an entitlement to either directly or indirectly determine the identity of any person who makes decisions that comprise the control and direction of the Test Entities' operations.

Sub-test 2 of the influence test, as contained in paragraph 880-105(6)(b) of the ITAA 1997, assesses whether at least one of the relevant decision-making persons of the test entity is accustomed or obliged to act, or might reasonably be expected to act, in accordance with the directions, instructions or wishes of the sovereign entity group.

No person involved in the control and direction of Test Entities' operations is accustomed or obliged to act, or might reasonably be expected to act, in accordance with the directions, instructions or wishes of the Foreign Entity or members of the Foreign Entity's sovereign entity group.

Based on the above, neither the Foreign Entity nor any member of its sovereign entity group has influence of a kind described in subsection 880-105(6) of the ITAA 1997 and therefore satisfies the requirements of paragraph 880-105(1)(f) of the ITAA 1997.

Conclusion

As all of the conditions listed in subsection 880-105(1) of the ITAA 1997 have been satisfied, section 880-105 of the ITAA 1997 will apply such that amounts of ordinary and statutory income derived by the Foreign Entity from its debt interests in Australian state government entities are not assessable and not exempt income.