Edited version of private advice

Authorisation Number: 1052173230258

Date of advice: 28 September 2023

Ruling

Subject: Lease

Question 1

Will the Lessee be entitled to a deduction pursuant to section 240-50 of the Income Tax Assessment Act 1997 (ITAA 1997) for the 'notional interest' calculated under Subdivision 240-E of the ITAA 1997 in relation to the Lease Agreement?

Answer

Yes.

Question 2

Will the Lessee be entitled to claim a deduction under section 40-25 of the ITAA 1997 for the decline in value of the commercial equipment that is subject to the Lease Agreement?

Answer

Yes.

Question 3

Will the Lessee have an obligation to withhold an amount from the 'notional interest' in respect to the rents paid to the Lessors under section 12-245 of Schedule 1 to the Taxation Administration Act 1953 (TAA 1953)?

Answer

No.

Question 4

Will the Lessee have an obligation to withhold an amount from a royalty in respect to the rents paid to the Lessors under section 12-280 of Schedule 1 to the TAA 1953?

Answer

No.

This ruling applies for the following period:

1 July XXXX to 30 June XXXX

The scheme commenced on:

During the year ended 30 June XXXX

Relevant facts and circumstances

The Lessee, a company incorporated in Australia, owns the commercial equipment and enters into a sale and leaseback transaction (Transaction) with foreign resident Lessors.

The Lessee sold the commercial equipment to the Lessors under a Sale Agreement for its market value. Upon acquisition of the commercial equipment the Lessor leases the commercial equipment to the Lessee under the Lease Agreement for the lease term.

The commercial equipment is a 'depreciating asset' under subsection 40-30(1) of the ITAA 1997.

The commercial equipment is used in the Lessee's business for the purpose of producing the Lessee's assessable income.

The Lease Agreement commencing on the Lease Commencement Date is entered into on commercially agreed terms and negotiated on an arm's length basis.

During the term of the lease, the Lessee is required to make semi-annual payments in arrears to the Lessor. The Lessee has advised that the sum of the total rent payments and amounts payable on exercise of the option to purchase the equipment (Purchase Option Amount) exceed the purchase price of the commercial equipment.

The Lease Agreement contains an option for the Lessee to purchase the commercial equipment (Purchase Option) on an agreed date (Purchase Option Date). The Purchase Option Amount payable on the exercise of the purchase option is estimated to be significantly less than the indicated forecast market value of the commercial equipment at the same date.

The Lessee intends to exercise the option to purchase the commercial equipment. It is the common practice of the Lessee to exercise purchase options under similar arrangements.

An election by the Lessee to exercise the Purchase Option under the Lease Agreement is irrevocable.

The Lessors will be entitled to depreciation deductions in the Foreign Country in relation to its expenditure on the commercial equipment (i.e. the purchase price paid for the commercial equipment under the Sale Agreement).

Each Lessor's depreciation reflects its percentage ownership of the commercial equipment.

Each Lessor:

•                     is a company incorporated under the laws of the Foreign Country for the purpose of acquiring and leasing the commercial equipment

•                     is a wholly-owned subsidiary of a company, which is also incorporated under the laws of the Foreign Country

•                     is a resident of, and liable to tax in, the Foreign Country

•                     is not a resident of Australia for the purposes of Australian tax

•                     does not have a place of business in Australia through which the leasing arrangement is wholly or partly carried on

•                     carries on business in the Foreign Country, which is limited to the leasing and any transactions incidental thereto

•                     is responsible for accounting and tax in relation to its business in and is a party to the Lease Agreement and other related agreements

•                     cannot without the prior consent of the Lessee, carry on any business other than the acquisition, owning and leasing of the commercial equipment

•                     has no relationship with the Lessee other than the Transaction

•                     is not owned, controlled or otherwise influenced by the Lessee, and

•                     does not have ownership interests in, control over, or the ability to be able to exert influence over the Lessee.

The majority of the funding for the Lessor's acquisition of the commercial equipment was a Loan provided by a number of banks on the Lease Commencement Date.

The Lessors are the Borrowers under the Loan Agreement, and their obligations are joint and several.

The Lessors/Borrowers are required, amongst other things, to pay interest in arrears on the Loan and have provided security for their obligations under the Loan Agreement. The Lessors have an effectively non-contingent obligation to repay the loan with interest.

The remainder of the Lessors' funding was obtained via contractual arrangements between the Lessors with foreign resident investors. Under the contractual arrangement the foreign investors are entitled only to an agreed share of the profit or loss made by each Lessor in relation to the lease arrangement.

The income of each Lessor consists of rent received and/or sale proceeds of the commercial equipment under the Lease Agreement.

The major asset of each Lessor is each Lessor's interest in the commercial equipment and the major liability of each Lessor is their respective share of the Loan.

The Lessors are required to include all rent payments payable by the Lessee under the Lease Agreement in their assessable income in the Foreign Country. The Lessors are then entitled to a deduction for interest, depreciation and other expenses as well as amounts paid to the Investors, who take such amounts into income as a distribution from the arrangement.

The receipts of the foreign investors under the contractual arrangements are residual cash (income minus the expenses and repayment of loan) during the income year. The outgoings are initial investment as equity for the investment and additional investment if needed during the transaction period. Each Lessor distributes the difference between income and expenses to the investor as profit (as taxable revenue)/loss (as tax-deductible expense), which is recorded at the investor's income year.

For Australian accounting purposes the Lessee treats the Lease Agreement as a finance lease.

The Lessor beneficially owns the 'notional interest' for the purposes of the tax treaty between Australia and the Foreign Country (the Convention).

The amount consisting of the 'notional interest' is taxed in the hands of the Lessors and does not retain its character and source as it passes through the Lessors' arrangement.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 40-25

Income Tax Assessment Act 1997 subdivision 240-E

Income Tax Assessment Act 1997 section 240-50

Taxation Administration Act 1953 Schedule 1 section 12-245

Taxation Administration Act 1953 Schedule 1 section 12-280

Reasons for decision

All legislative references below are to the ITAA 1997, unless otherwise indicated, and * denotes a term defined in subsection 995-1(1) of the ITAA 1997.

Question 1

Summary

The Lessee will be entitled to a deduction pursuant to section 240-50 for the 'notional interest' calculated under Subdivision 240-E in relation to the Lease Agreement.

Detailed reasoning

Division 240 deals with 'hire purchase agreements' (as defined in subsection 995-1(1)) entered into after 27 February 1998.

Section 240-10 provides that a 'hire purchase agreement' is treated as a notional sale and notional loan.

The Lease Agreement is an 'arrangement' as the term is defined in subsection 995-1(1).

The Lease Agreement is a contract under which the Lessee hires the commercial equipment and has the right to purchase the commercial equipment (the Purchase Option) on the Purchase Option Date. The Lessee has advised that the sum of the total rent plus the Purchase Option Amount exceeds the cost of the commercial equipment. Furthermore, title to the commercial equipment will not pass to the Lessee until the Purchase Option is exercised. If the Lessee does not exercise the option and the lease expires, title will remain with the Lessors.

Therefore, the Lease Agreement is a 'hire purchase agreement' as defined in subsection 995-1(1) as it satisfies the requirements of paragraph (a) of the definition.

The Lessors are parties to the Lease Agreement and own the commercial equipment. Accordingly, the Lessors are the 'notional sellers' under paragraph 240-17(1)(a).

The Lessee is a party to the Lease Agreement and has the right to use the commercial equipment under the agreement. Thus, the Lessee is the 'notional buyer' under subsection 240-17(2).

Under subsection 240-20(1), the Lessors are taken to have sold the commercial equipment to the Lessee and the Lessee is taken to have acquired the commercial equipment at the start of the Lease Agreement, being the Lease Commencement Date. Under subsection 240-20(2), the Lessee is taken to own the commercial equipment as the 'notional buyer' until the end of the Lease Agreement, or when the Lessee becomes the 'notional seller' under a later arrangement to which Division 240 applies.

The Lessors ('notional sellers') are taken to have made a loan (notional loan) to the Lessee ('notional buyer') upon entering the Lease Agreement under subsection 240-25(1).

The notional loan is an amount (the notional loan principal) equal to consideration for the sale of the property less any amount paid or credited by the 'notional seller', as having been paid by the 'notional buyer' to the 'notional seller', at or before the start of the arrangement, for the cost of the property (subsection 240-25(3)). The notional loan is subject to the payment of interest (subsection 240-25(4)).

The Lessee is required under the Lease Agreement to make semi-annual rent payments, which are 'arrangement payments' as defined in section 240-65. The Purchase Option Amount for the commercial equipment payable on the exercise of the Purchase Option is a 'termination amount' as defined in paragraph (a) of that term under subsection 995-1(1), being an amount payable for the acquisition of property at the end of the arrangement. Therefore, the Purchase Option Amount is not an 'arrangement payment' under paragraph 240-65(b).

The term 'notional interest' is defined in subsection 995-1(1) to have the meaning given by section 240-60 and it is calculated in accordance with subsection 240-60(1).

The Lessee, as the 'notional buyer', is only entitled to deduct 'notional interest' to the extent that it would, apart from Division 240, have been entitled to deduct 'arrangement payments' if no part of those payments were capital in nature per subsection 240-50(1).

Apart from Division 240, the rent payments would have been deductible to the Lessee under section 8-1, being outgoings incurred in carrying on the Lessee's business for the purpose of gaining or producing its assessable income.

Therefore, the Lessee is entitled to deduct 'notional interest', as calculated under Subdivision 240-E, under subsection 240-50(1) in relation to the Lease Agreement.

Question 2

Summary

The Lessee will be entitled to claim a deduction under section 40-25 for the decline in value of the commercial equipment that is subject to the Lease Agreement.

Detailed reasoning

The commercial equipment is a 'depreciating asset' under subsection 40-30(1).

The Lessee will be able to deduct an amount equal to the decline in value of the commercial equipment for an income year (as worked out under Division 40) under subsection 40-25(1) if the Lessee 'held' the commercial equipment for any time during the year.

The Lessee 'held' the commercial equipment subject to the Lease Agreement for a 'taxable purpose', being the production of assessable income, so subsection 40-25(2) would not apply to reduce the deduction available to the Lessee under subsection 40-25(1).

Under the Lease Agreement, the Lessee will have possession of the commercial equipment for the duration of the lease, commencing on the Lease Commencement Date. The Lessee also has a Purchase Option under the Lease Agreement which allows the Lessee the right to purchase the commercial equipment on the Purchase Option Date.

Any notice given by the Lessee to the Lessors under the Lease Agreement electing to purchase the commercial equipment is irrevocable and shall oblige the Lessee to purchase the commercial equipment on the Purchase Option Date.

The Lessee has advised that it intends to exercise the Purchase Option under the Lease Agreement on the Purchase Option Date.

It is also customary for the Lessee to exercise its right to purchase commercial equipment, during and at the end of hire purchase type arrangements, and there is nothing to suggest that this pattern will change in respect of the commercial equipment.

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 states that:

...a notional buyer who is taken to be the owner of goods under subsection 240-20(2) will not be the holder of the goods for the purposes of Division 40, unless it is reasonable to conclude that the notional buyer will acquire the asset, or that the asset will be disposed of at the direction, and for the benefit of, the notional buyer.

In the Lessee's circumstances it is reasonable, for the reasons discussed above, to conclude that the Lessee, as 'notional buyer', would acquire the commercial equipment by exercising the Purchase Option under the Lease Agreement.

Accordingly, the Lessee is the economic owner of the commercial equipment and is a holder of the commercial equipment under item 6 of the table in section 40-40.

If the Purchase Option under the Lease Agreement is exercised, the Lessee would become the legal owner of the commercial equipment under item 10 of the table in section 40-40.

The modifications in section 240-115 relating to the capital allowance provisions do not apply as it is considered that the requirements in subsection 240-115(1) are satisfied in the Lessee's circumstances.

The Lessee is therefore entitled to deduct an amount equal to the decline in value of the commercial equipment as worked out under Division 40 under subsection 40-25(1).

Question 3

Summary

The Lessee will not have an obligation under section 12-245 of Schedule 1 to the TAA 1953 to withhold an amount from 'notional interest' in respect to the rent paid to the Lessors.

Detailed reasoning

Broadly, section 12-245 of Schedule 1 to the TAA 1953 requires an entity to withhold an amount from interest, within the meaning of Division 11A of Part III of the ITAA 1936, it pays to a recipient that has an address outside Australia. However, withholding is not required by an entity under section 12-300 of Schedule 1 to the TAA 1953 if no withholding tax is payable on the interest by the recipient.

Is 'notional interest' under the Lease Agreement subject to interest withholding tax?

Paragraph 7 of Taxation Ruling TR 98/21 Income tax: withholding tax implications of cross border leasing arrangements states:

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.

Based on the factors in paragraph 31 of TR 98/21, it is considered that the Lessee's purchase or repurchase of the commercial equipment is a paramount purpose under the Lease Agreement.

In accordance with paragraph 7 of TR 98/21, rent payments made by the Lessee under the Lease Agreement, being a 'hire purchase agreement' as discussed in Question 1, are not subject to equipment royalty withholding tax under subsection 128B(5A) of the ITAA 1936 and the interest components paid under the agreement ('notional interest') are subject to interest withholding tax in accordance with section 128AC of the ITAA 1936. Therefore, each Lessor is liable to interest withholding tax under subsection 128B(2) of the ITAA 1936. Accordingly, the Lessee is required to withhold an amount from the 'notional interest' paid to the Lessors under section 12-245 of Schedule 1 to the TAA 1953 unless the Lessors are not liable to interest withholding tax due to the operation of a relevant double tax agreement (DTA).

Convention

Australia's taxing rights are affected by any DTAs Australia has entered into with other countries and which has been given force of law in Australia, including the Convention.

The Convention applies to 'persons' who are residents of one or both of the Contracting States. The term 'person' includes an individual, a company and any other body of persons as defined in the Convention.

The Lessee and each of the Lessors are companies and are therefore 'persons' under the Convention.

On the basis that the Lessors are liable to tax in the Foreign Country and the Lessee is an Australian resident company for Australian tax purposes, the Lessors are residents of the Foreign Country and the Lessee is a resident of Australia pursuant to the Convention. Therefore, it is relevant to consider the Convention.

Interest

Subsection 240-35(1) includes 'notional interest' in the 'notional seller's' assessable income. As the 'notional interest' under the Lease Agreement is treated as income under Australian tax law, it is considered 'interest' under the Convention. The Lessee is a resident of Australia and pays the 'notional interest'. The 'notional interest' is not derived from a foreign 'permanent establishment' (PE) of the Lessee. Accordingly, the interest 'arises' in Australia.

The Lessors are required to include all rent payments payable by the Lessee under the Lease Agreement in their assessable income in the Foreign Country. The Lessors are then entitled to a deduction for interest, depreciation and other expenses as well as amounts paid to the foreign resident investors, who take such amounts into income as a distribution from the arrangement.

As the amount consisting of the 'notional interest' is taxed in the hands of the Lessors and does not retain its character and source as it passes through the Lessors' arrangement, the Lessor is 'treated' under the Foreign Country's law as the entity that 'derives' the amounts consisting of the 'notional interest'.

The Lessors do not hold the 'notional interest' on trust for any other entity, and more broadly, that the Lessors are beneficially entitled to all payments made under the Lease Agreement such that they are the beneficial owners of the 'notional interest'.

The 'notional interest' is therefore subject to withholding tax, which is limited to 10% per the Convention unless it is exempt under another article of the Convention.

Financial institution

The Convention provides that 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 providing certain conditions are met.

Specifically, 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 the interest is derived by a 'financial institution' which is unrelated to and dealing wholly independently with the payer.

The term 'financial institution' is defined in the Convention to mean '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'.

As the Lessors are not banks they will not be liable to withholding tax on the 'notional interest' under the Lease Agreement only if each Lessor is an '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 is applicable in the current circumstances.

Relevantly, paragraph 15 of TR 2005/5 states:

'Other enterprises' are those residents of the US or UK that are not classified as banks. This means that 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'. Collectively, these activities are referred to as 'spread activities' in this Ruling.

Enterprise

Each Lessor is an 'enterprise' under the Convention as each is carrying on a business.

Raising debt finance in the financial markets

The terms 'debt finance' and 'financial markets' are not defined in the Convention, nor specifically defined in Australia's tax law.

Paragraph 17 of TR 2005/5 states:

The meaning of the term 'debt finance' has regard to the approach applied in Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) 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 the debt is the non-contingent nature of the returns....

The term 'financial markets' takes on its ordinary commercial meaning (paragraph 18 of TR 2005/5).

The Lessors raised the majority of the purchase price of the commercial equipment through traditional debt sourced from third party banks on commercial arm's length terms i.e., 'in the financial markets' (paragraph 65 of TR 2005/5). Under the Loan Agreement, the Lessors have, in substance or effect, an obligation to repay the total debt (with interest) that is not contingent on any event, condition or situation, other than the ability or willingness of the Lessors to meet the obligation, which amounts to 'debt finance'. The requirement of 'raising debt finance in the financial markets' for the purposes of the Convention is satisfied.

Providing finance

The term 'providing finance' takes on its ordinary meaning and in the Macquarie Dictionary is defined as 'to supply with means of payment; provide capital for; obtain or furnish credit for' (paragraph 22 of TR 2005/5).

Under the Lease Agreement, the Lessors are leasing the Lessee the commercial equipment in return for semi-annual rent payments. The Lessee has an option to acquire the commercial equipment under the Purchase Option for a lump sum payment and, in limited circumstances, an ability to acquire the commercial equipment under an early termination purchase arrangement absent it exercising its Purchase Option. If the Purchase Option is not exercised the Lessee is required to return the commercial equipment to the Lessors at the end of the Lease Agreement.

The Lessee intends to exercise the option to purchase the commercial equipment. Thus, the lease of the commercial equipment by the Lessors to the Lessee constitutes the provision of finance such that the Lessors are 'providing finance' (paragraph 92 of TR 2005/5).

Using those funds in carrying on a business of providing finance

Whether an 'enterprise' is 'carrying on a business of providing finance' is a question of fact that needs to be considered in the light of the relevant general principles (paragraph 95 of TR 2005/5).

Considering the indicia in paragraph 95B of TR 2005/5 each Lessor is 'carrying on a business of providing finance', being the leasing of the commercial equipment per paragraph 92 of TR 2005/5, as indicated by:

•                     Each Lessor company is incorporated under the laws of a Foreign Country for the purpose of acquiring and leasing the commercial equipment, being a significant commercial asset, to the Lessee

•                     Each Lessor derives rent under the Lease Agreement and has a share of the sale proceeds from the sale of the commercial equipment if the Lessee exercises its Purchase Option and thus has a profit-making purpose (American Leaf Blending Co Sdn Bhd v Director-General of Inland Revenue [1979] AC 67)

•                     Each Lessor is funded by equity and debt financing. The debt financing, however, is each Lessor's major source of funding for its business

•                     Each Lessor's activities as lessor under the Lease Agreement constitute the whole of each Lessor's business as each Lessor carry on no other activities; and

•                     Each Lessor is organised in a business-like manner for example, each Lessor is responsible for accounting and tax in relation to its business and is a party to the Lease Agreement and other related agreements.

Paragraph 88 of the TR 2005/5 states that the requirement of 'using those funds' will be satisfied where these activities are undertaken concurrently in 'carrying on a business'. As the Lessors' debt financing was obtained at the time the Lease Agreement commenced each Lessor is considered to be concurrently using the debt finance raised in carrying on a business. Therefore, each Lessor is using the debt finance raised in carrying on its business of providing finance.

Substantially deriving its profits

Paragraph 26 of TR 2005/5 states that 'substantially deriving its profits' means that the entity's main business activity is the raising of debt finance in the financial markets or taking deposits at interest and using those funds in carrying on a business of providing finance. These activities constitute the main business activity if such activity is the main contributor of the overall profit.

Most funds which financed the acquisition of the commercial equipment were obtained through the Lessors raising debt finance and the Lessors conduct no other business activities outside the lease. Consequently, as the majority of the funding is provided by debt finance, it is considered that each Lessor is 'substantially deriving its profits' by raising debt finance as those funds are used in the Lessor's business of providing finance through the Lease Agreement (paragraph 100B of TR 2005/5).

Each Lessor is therefore a 'financial institution' for the purposes of the Convention.

Unrelated and wholly independent

The Convention also requires that each Lessor must be unrelated to and dealing wholly independently with the Lessee in order for the exemption to apply.

The Protocol to the Convention states 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.

There is, and will be, no common ownership between the Lessors and the Lessee. The Lessee is an Australian resident company and the Lessors are wholly owned by companies incorporated under the laws of the Foreign Country. Accordingly, neither the Lessee nor the Lessors will be in any position to exert sufficient influence over one another through either ownership or control and should therefore be considered unrelated persons for these purposes (paragraph 112 of TR 2005/5).

The contractual undertaking given by the Lessors under the Lease Agreement is to protect the Lessee's commercial interest in the commercial equipment. From the Lessee's perspective, the Lessee does not want the Lessors to enter other arrangements which could potentially put the commercial equipment at risk or subject to liability and disrupt the Lessee's operations, without the Lessee's knowledge or consent. However, this restriction does not amount to influence by the Lessee over the Lessors in a way that would amount to participation in the control of the Lessors. As such, each Lessor is not a company that is accustomed or under an obligation (whether formal or informal) or has or might reasonably be expected, to act in accordance with the directions, instructions or wishes of the Lessee.

The arrangements between the parties were entered into on commercially agreed terms which were negotiated on an arm's length basis. The Lessee is therefore regarded as dealing wholly independently with each Lessor (paragraph 117 of TR 2005/5).

Back-to-back loans

The Convention 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 rent payments from the Lessee to the Lessors under the Lease Agreement do not equate to the payments by the Lessor to the Lenders on the Loan, as the rents also fund the foreign resident investors' return under their contracts with the Lessors. In view of this and having regard to the overall circumstances of the Transaction no 'back-to-back loan' or other arrangement to that effect is considered to be present. Therefore, the 'notional interest' arising in Australia that is beneficially owned by the Lessors is not paid as part of an arrangement involving 'back-to-back' loans' for the purposes of the Convention.

Interest arising through a PE

The Convention specifies that the withholding tax exemption will not apply where 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 PE situated therein and the debt-claims or other rights in respect of which the interest is paid is effectively connected with such PE.

PE is defined in the Convention and is deemed to exist where an 'enterprise' of a Contracting State operates 'substantial equipment' in the other Contracting State (other than as provided in subparagraph (b)) for a period or periods exceeding in the aggregate 183 days in any 12 month period. 'Substantial equipment' is generally understood to include the commercial equipment (paragraph 25 of Taxation Ruling TR 2007/10 Income tax: the treatment of shipping and aircraft leasing profits of United States and United Kingdom enterprises under the deemed substantial equipment permanent establishment provision of the respective Taxation Conventions).

However, the provision of 'substantial equipment' under a lease agreement that is solely for the provision of the equipment, is not taken to be operation of 'substantial equipment' and therefore not a PE per the Protocol to the Convention. As such, the Lessors do not have a PE in Australia in respect of the commercial equipment and therefore the interest does not arise through a PE in Australia.

Limitation on Benefits

The Convention sets out to limit certain benefits granted under the treaty to 'qualified persons' as defined therein. Notwithstanding that a 'resident of a Contracting State' may not be a 'qualified person', that resident shall be entitled to the benefits granted under the Convention if it is carrying on a business in the first-mentioned Contracting State (other than the business of making or managing investments for the resident's own account, unless the business is banking, insurance or securities business carried on by a bank, insurance company or securities dealer) and the income, profits or gains derived from the other Contracting State are derived in connection with, or are incidental to, that business and it satisfies the other conditions in the Convention.

Each of the Lessors is a resident of the Foreign Country and derives income from Australia while carrying on a business in that country. Whilst the Lessors are not 'qualified persons', the type of business being carried on is not one that is excluded under the Convention. Each Lessor derives income from the rent payments under the Lease Agreement, which include a 'notional interest' amount, in connection with its business of providing finance. As it has been established that each Lessor also satisfies the other conditions set out under the Convention, each of the Lessors is eligible for the treaty benefits.

Conclusion

In view of the above discussion, each Lessor is a 'financial institution' for the purposes of the Convention as they fall within the meaning of that term. Thus, the 'notional interest' derived by each Lessor is exempt from interest withholding tax and this exemption prevails over the domestic law (subsection 128B(2) of the ITAA 1936) per subsection 4(2) of the ITAA 1953.

Accordingly, the Lessee will not have an obligation under section 12-245 of Schedule 1 to the TAA 1953 to withhold an amount from 'notional interest' in respect to the rents paid to the Lessors.

Question 4

Summary

The Lessee will not have an obligation under section 12-280 of Schedule 1 to the TAA 1953 to withhold an amount from royalty in respect to the rents paid to the Lessors.

Detailed reasoning

Broadly, section 12-280 of Schedule 1 to the TAA 1953 requires an entity to withhold an amount from a royalty it pays to a recipient that has an address outside Australia. However, withholding is not required by an entity under section 12-300 of Schedule 1 to the TAA 1953 where no withholding tax is payable on a royalty.

A 'royalty' is defined in subsection 6(1) of the ITAA 1936 to relevantly include any amount paid or credited, however described or computed, and whether the payment or credit is periodical or not, to the extent to which it is paid or credited, as the case may be, as consideration for the use of, or the right to use, any industrial, commercial or scientific equipment.

The terms 'industrial', 'commercial', 'scientific' or 'equipment' are not defined in the Income Tax Assessment Acts. However, TR 98/21 provides guidance on the meaning of these terms. The commercial equipment is considered commercial equipment per paragraph 37 of TR 98/21 for the purposes of the definition of royalty in subsection 6(1) of the ITAA 1936.

Subsection 128B(5A) in Division 11A of Part III of the ITAA 1936 imposes a withholding tax liability on a non-resident who derives royalty income which is paid by a person who is a resident of Australia.

In the Lessee's circumstances, it is clear from the outset of the Lease Agreement that the purchase or repurchase of the commercial equipment by the Lessee from the Lessors is a paramount purpose of the lease arrangement per paragraph 7 of TR 98/21 (see Question 3). Therefore, rent payments made under the Lease Agreement will not be subject to royalty withholding tax under subsection 128B(5A) of the ITAA 1936.

It is clear from the Convention that payments for industrial, commercial or scientific equipment are not included in the definition of royalties such that the Convention does not capture payments made under the Lease Agreement.

Therefore, the Lessee will not be required to withhold an amount from the rents paid to each of the Lessors under section 12-280 of Schedule 1 to the TAA 1953.