Edited version of private advice

Authorisation Number: 1052090256330

Date of advice: 22 February 2022

Ruling

Subject: Financial institution - double taxation convention

Question

Is the taxpayer a 'financial institution' within the meaning of Article 11(3)(b) of the Convention between Australia and XXXX for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income [XXXX] XXXX (DTA)?

Answer

Yes.

This ruling applies for the following periods:

DD MM YYYY to DD MM YYYY

DD MM YYYY to DD MM YYYY

DD MM YYYY to DD MM YYYY

DD MM YYYY to DD MM YYYY

DD MM YYYY to DD MM YYYY

The scheme commenced on:

DD MM YYYY

Relevant facts and circumstances

The taxpayer is incorporated under XXXX domestic law and its headquarters are located in XXXX.

The taxpayer is the head company of a consolidated group. It has wholly-owned subsidiaries in numerous countries outside XXXX. The taxpayer has no subsidiaries in Australia. This ruling is in relation to the taxpayer on a standalone basis.

The taxpayer is not registered or regulated as an authorised deposit taking institution in Australia or as a bank in XXXX.

The taxpayer operates a leasing and financing business in XXXX and other countries.

The taxpayer raises funds from financial institutions, wholesale and retail lenders, and other banks by:

•                     direct financing, such as issuance of commercial paper and bonds, as well as securitisation of receivables; and

•                     indirect financing, including borrowings from banks, financial institutions and life insurance companies.

The taxpayer has a legal obligation to return to the investors and lenders amounts at least equal to the amounts invested and lent. The taxpayer's legal obligations for the arrangements are:

•                     to return the principal with interest on loans and on securities issued under the securitisation of receivables;

•                     to pay the face value on commercial paper that is sold at a discount; and

•                     to pay the face value with interest (coupons) on bonds.

The majority of the taxpayer's debt financing is raised from third parties, with a smaller percentage sourced from related parties on normal commercial terms. All of these related parties provide finance to the general public as financiers.

In addition, a minimal amount of the taxpayer's funding is sourced from equity financing.

The taxpayer offers and enters into finance lease agreements which have an obligation for the customer to pay a rental payment plus interest in instalments. The customer obtains title to the asset at the maturity date pursuant to the agreement.

In addition, the taxpayer offers and enters into hire purchase agreements, instalment sales agreements, loan agreements and consignment of payment agreements.

All of the arrangements (other than the finance lease agreements) have an obligation for the customer to return to the taxpayer at a later date the funds originally lent pursuant to the agreement. The taxpayer will receive payments that include an interest income component from each of the agreements.

More than 50% of the taxpayer's gross profits for the years ended DD MM YYYY, DD MM YYYY and DD MM YYYY are from finance leases, instalment sales and other finance revenue.

Based on the taxpayer's current estimates and profitability forecasts it expects that the gross profit from finance leases, instalment sales and the other finance revenues will remain at over 50% in the years ended DD MM YYYY, DD MM YYYY and DD MM YYYY.

The taxpayer has entered into financing agreements with Australian customers. The taxpayer intends to enter more financing agreements with Australian customers in the future.

Assumptions

1.    Throughout the period to which this ruling applies, the taxpayer will continue to raise finance predominantly from debt financing arrangements and use those funds to carry on a business of providing leasing and financing.

2.    Throughout the period to which this ruling applies, the taxpayer's leasing and financing business will continue to be the main source of its profits.

Relevant legislative provisions

Convention between Australia and XXXX for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income [XXXX] XXXX

Income Tax Assessment Act 1997 Division 974

Income Tax Assessment Act 1997 section 974-135

Reasons for decision

Article 11(3)(b) of the DTA states:

... 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.

Taxation Ruling TR 2005/5 Income tax: ascertaining the right to tax United States (US) and United Kingdom (UK) resident financial institutions under the US and the UK Taxation Conventions in respect of interest income arising in Australia (TR 2005/5) sets out the Commissioner's interpretation of the law in relation to ascertaining if an entity will be classified as a 'financial institution' under Article 11(3)(b) of Australia's double taxation conventions with the US and the UK (collectively, the US and UK Conventions).

On 21 September 2022, the Commissioner published Taxation Ruling TR 2005/5DC2[1] (TR 2005/5DC2), a draft consolidation outlining proposed changes to TR 2005/5 to clarify the ATO view on aspects of the second limb of the definition of 'financial institution' as used in the US and UK Conventions. TR 2005/5DC2 is a draft for public comment and where it proposes changes to TR 2005/5, it represents the Commissioner's preliminary view on how a relevant provision could apply.[2]

Article 11(3)(b) of the DTA has the same wording as Article 11(3)(b) in the US and UK Conventions. As such, TR 2005/5DC2 also applies to determine if the taxpayer is a 'financial institution' within the meaning of Article 11(3)(b) of the DTA.[3]

In order to meet the definition of 'financial institution' pursuant to Article 11(3)(b) of the DTA, the taxpayer must be either:

•                     a bank; or

•                     'other enterprise'.

A bank

Paragraph 12 of TR 2005/5DC2 provides that a 'bank' means an entity that is authorised or licensed to carry on a banking business (that is, to take deposits and make advances). The taxpayer is not registered or regulated as an authorised deposit taking institution in Australia or as a bank in XXXX.

Therefore, the taxpayer is not a 'bank' for the purposes of Article 11(3)(b) of the DTA.

Other enterprise

Consequently, in order to be classified as a 'financial institution' for the purposes of Article 11(3)(b) of the DTA, the taxpayer must satisfy the definition of 'other enterprise'.

Paragraph 15 of TR 2005/5DC2 provides that 'other enterprises' are those entities that are not classified as banks. These enterprises must 'substantially derive their profits' by 'raising debt finance in the financial markets' or by 'taking deposits at interest' and 'using those funds in carrying on a business of providing finance'. In TR 2005/5DC2 (at [15]), these activities are collectively referred to as 'spread activities'.

Raising debt finance

In accordance with paragraph 65 of TR 2005/5DC2, when applying the phrase 'raising debt finance in the financial markets', it must be determined whether the type of financing is 'debt' financing.

Paragraphs 67 and 68 of TR 2005/5DC2 state that the approach in Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) to distinguish between debt and equity can be used in determining whether a financing arrangement is 'debt finance' for the purposes of the DTA.[4]

Paragraph 69 of TR 2005/5DC2 provides:

... where it can be concluded that the raising of funds results in an effectively non-contingent obligation, as defined in section 974-135 of the ITAA 1997, to provide an amount at least equal to the amount received, this will constitute 'raising debt finance' for the purposes of the Conventions.

The taxpayer raises finance via borrowings, securitisation of receivables, commercial paper and bonds. The taxpayer also raises a minor percentage of its finance by equity financing.

The taxpayer's legal obligations in relation to the borrowings, securitisation of receivables, commercial paper and bonds are:

•                     to return the principal plus interest on the borrowings and on securities issued under the securitisation of receivables;

•                     to pay the face value on the commercial paper that is sold at a discount; and

•                     to pay the face value plus interest (coupons) on the bonds.

Under the finance via borrowings, commercial paper, bonds and securitisation of receivables, the taxpayer has a legal obligation to return to the investors and lenders amounts at least equal to the amounts invested and lent. As such, the Commissioner accepts that the borrowings, securitisation of receivables, commercial paper and bonds all constitute 'raising debt finance' for the purposes of Article 11(3)(b) of the DTA.

Financial markets

Article 11(3)(b) of the DTA also requires that the 'debt finance' is raised in the 'financial markets'. Paragraph 72 of TR 2005/5DC2 states that the term 'financial markets', in the context of the phrase 'raising debt finance in the financial markets', takes its ordinary commercial meaning which is:

...a facility through which:

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

o        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).

Further, paragraph 73 of TR 2005/5DC2 says 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 taxpayer raises the majority of its debt finance from third party financial institutions, wholesale and retail lenders and other banks. The debt financing from these entities all satisfy the requirement of being raised in financial markets as the entities, being lenders, financial institutions and banks, all regularly offer and provide the relevant debt finance products and form part of the financial markets.

The taxpayer also raises debt finance from related parties.

Paragraphs 74 and 75 of TR 2005/5DC2 provide that if a related party regularly provides finance to the public as a financier, it will form part of the financial markets. As such, a related party borrowing from that entity will qualify as raising debt in the financial markets if such funds are raised on normal commercial terms.

All of the related party debt financing sourced by the taxpayer was provided on normal commercial terms by lenders that regularly provide finance to the general public as financiers. As such, those related party lenders form part of the financial markets and accordingly, the debt finance that the taxpayer raises from those related parties qualifies as raising debt in the financial markets.

Therefore, all of the taxpayer's debt finance is raised in the financial markets.

Carrying on a business

The activities of providing finance must be undertaken in such a manner that the entity is considered to be carrying on a business.

Where a company aims to make, and has a prospect of, profit, it is presumed that the company intends to, and does in fact, carry on a business.[5]

However, it is also necessary to determine if this presumption arises, and if so if it is rebutted, by considering a range of indicia of carrying on a business, including:[6]

•                     whether the person intends to carry on a business;

•                     the nature of the activities, particularly whether they have a profit-making purpose;

•                     whether the activities are:

o        repeated and regular;

o        organised in a business-like manner, including the keeping of books, records and the use of a system;

•                     the size and scale of the activities including the amount of capital employed in them; and

•                     whether the activity is better described as a hobby, or recreation.

In each case it will be a question of fact whether an entity can be said to be carrying on a business and the conclusion requires weighing all the relevant indicators.[7]

Applying each of the indicators to the facts in this case:

•                     The scale of the taxpayer's activities shown in the capital raised, the fact it conducts dealings in numerous countries and the revenues and gross profit earned show an intention to carry on a business.

•                     The taxpayer's activities are commercial in nature and have a profit-making purpose, as evidenced by the significant profits made.

•                     The taxpayer has a longstanding history of operating and providing financing activities.

•                     The taxpayer publishes financial statements each year.

•                     The commercial nature of the activities undertaken by the taxpayer are such that they are properly described as a business, rather than a hobby or recreation.

In view of the above factors, it can be said that the taxpayer is carrying on a business for the purposes of Article 11(3)(b) of the DTA.

Business of providing finance

Paragraph 89 of TR 2005/5DC2 states that the term 'providing finance' is not qualified by stating whether this must be undertaken through debt or equity. Paragraph 89 of TR 2005/5DC2 goes onto refer to the ordinary meaning of the term 'finance', which is:

...to supply with means of payment; provide capital for; obtain or furnish credit for.

Paragraph 90 of TR 2005/5DC2 continues by saying:

The Commissioner considers that the non-resident may provide both debt finance and equity finance. Accordingly, the 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 the funds or assets in the future.

Further, paragraph 92 of TR 2005/5DC2 states that leasing of an asset under a finance lease constitutes the provision of finance where there is an obligation to return the asset(s) at a later date.

The taxpayer uses the funds it obtains through debt financing to:

•                     lease equipment under finance lease arrangements where the taxpayer purchases equipment from a customer and leases it back to the customer who is then required to pay a rental payment plus interest in instalments. The customer obtains title to the equipment at the maturity date pursuant to the lease agreement;

•                     offer instalment sales arrangements for products where the customer is required to repay the purchase price in instalments plus interest;

•                     make loans to third parties and related parties, which require the repayment of the principal plus interest;

•                     offer hire purchase agreements where the taxpayer sells equipment to customers on a hire purchase basis and receives quarterly repayments (each of which comprise a principal and interest component); and

•                     enter into consignment of payment agreements as consignee where the consignor repays the payment amount plus interest to the taxpayer.

As the instalment sales agreements, hire purchase agreements, loans and consignment of payment agreements all have an obligation for the recipient to return the funds to the taxpayer (plus interest), they entail providing finance as described in paragraph 90 of TR 2005/5DC2. Further, the finance lease agreements require the taxpayer to return the equipment to the lessee at the maturity date. As such, the finance lease agreements constitute the provision of finance as set out at paragraph 92 of TR 2005/5DC2.

Using the funds in carrying on a business of providing finance

Article 11(3)(b) of the DTA also requires that the funds raised by debt finance must be used to carry on the business of providing finance. The requirement of 'using those funds' will be satisfied when the activities of raising the debt finance and carrying on a business of providing finance are undertaken concurrently.[8]

The taxpayer raises debt finance and carries on the business of providing financing activities concurrently. Hence, the taxpayer satisfies the requirement of using funds raised from debt finance in carrying on the business of providing finance.

Substantially deriving its profits

With respect to the requirement of 'substantially deriving its profits' from carrying on the business of spread activities, the Commissioner is of the view that the use of the word 'substantially' requires the main source of the entity's profits to be derived from its spread activities.[9] TR 2005/5 says the spread activities need to constitute the entity's main activity when compared to any other activity that it undertakes in terms of its contribution to the entity's overall profits.[10]

The Commissioner's preliminary view in TR 2005/5DC2 is that the 'spread activities' will constitute the main business activity if, when compared with all the other activities carried on by the enterprise, they are the main contributor to the enterprise's overall profits.[11] The Commissioner takes the preliminary view that where the spread activities are the source of more than 50% of the overall accounting profits, it is a strong indicator that the enterprise substantially derives its profits from the spread activities.[12]

Paragraph 101 of TR 2005/5DC2 provides that 'profits' in this context takes on its accounting meaning. Thus, 'profits' can be measured according to a range of acceptable accounting indicators of profits, including gross profit, net operating income or operating profit.

The audited accounts for the taxpayer for the years ended DD MM YYYY, DD MM YYYY and DD MM YYYY show the taxpayer's gross profits from spread activities were more than 50% of its total profit in each of those years. Accordingly, the Commissioner accepts that the taxpayer substantially derives its profits from its spread activities.[13]

Further, the profitability forecasts for the taxpayer show it is expected the profit from spread activities will continue to be more than 50% of its total profit in the years ended DD MM YYYY through to DD MM YYYY.

Provided these spread activities do not materially change and remain the main source of the taxpayer's profits, the taxpayer is considered to be substantially deriving profits by raising debt finance in the financial markets and using those funds in carrying on a business of providing finance.

Conclusion

As the taxpayer is an enterprise substantially deriving its profits by raising debt finance in the financial markets and using those funds in carrying on a business of providing finance, the taxpayer satisfies the 'financial institution' definition in Article 11(3)(b) of the DTA.

[1] Full title: Taxation Ruling TR 2005/5DC2 Income tax: ascertaining the right to tax United States (US) and United Kingdom (UK) resident financial institutions under the US and the UK Taxation Conventions in respect of interest income arising in Australia.

[2] Any reference in these reasons for decision to TR 2005/5DC2 which represents a proposed change to TR 2005/5 will be noted to highlight that it is the Commissioner's preliminary view on that issue. All other references to TR 2005/5DC2 represent the Commissioner's settled view as stated in TR 2005/5.

[3] TR 2005/5DC2, [2A] - this paragraph is a proposed addition to TR 2005/5. Prior to this proposed change, the Commissioner has referred to TR 2005/5 as guidance on how similar provisions in other tax treaties have been interpreted.

[4] As it is consistent with the context of the US and UK Conventions (and, in this case, the DTA) to utilise the economic principle underpinning Division 974 of the ITAA 1997 in interpreting the term 'debt finance' (TR 2005/5DC2, [69]).

[5] Inland Revenue Commissioners v Westleigh Estates Co Ltd [1924] 1 KB 390 (Westleigh) and American Leaf Blending Co Sdn Bhd v Director-General of Inland Revenue [1979] AC 676 (American Leaf),both referred to at [19] of Taxation Ruling TR 2019/1 Income tax: when does a company carry on a business? (TR 2019/1).

[6] TR 2019/1, [21]. An addition at paragraph 95C of TR 2005/5DC2 states that the approaches in TR 2019/1 and Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production (TR 97/11) are considered applicable in the context of determining whether an entity is carrying on the business of providing finance. Given the nature and scale of the taxpayer's activities, the Commissioner did not view it as necessary to consider TR 97/11 in this case.

[7] TR 2019/1, [18].

[8] TR 2005/5DC2, [88].

[9] TR 2005/5DC2, [99].

[10] TR 2005/5, [100].

[11] TR 2005/5DC2, [100A] - this paragraph is a proposed addition to TR 2005/5.

[12] TR 2005/5DC2, [100B] - this paragraph is a proposed addition to TR 2005/5.

[13] For completeness, the Commissioner considers the requirement in TR 2005/5 at [100] to be satisfied as well as the proposed requirements in TR 2005/5DC2 at [100A] and [100B] to be satisfied.