Edited version of private advice

Authorisation Number: 1052233465680

Date of advice: 12 April 2024

Ruling

Subject: Commercial equipment lease

Question 1

Will the Lessee have a balancing adjustment event under section 40-295 of the Income Tax Assessment Act 1997 (ITAA 1997) for the sale and leaseback of the commercial equipment?

Answer

No.

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 commercial equipment, being the subject of Lease Agreements between the Lessor and the Lessee?

Answer

Yes.

Question 3

Will the Lessee be entitled to a deduction pursuant to section 240-50 of the ITAA 1997 for the 'notional interest' calculated under Subdivision 240-E of the ITAA 1997 in relation to the Lease Agreements?

Answer

Yes.

Question 4

Will the hybrid mismatch rules in Subdivisions 832-C and 832-G of the ITAA 1997 apply to disallow the Lessee 'notional interest' and depreciation deductions relating to the commercial equipment?

Answer

No.

Question 5

Will the Lessee have an obligation to withhold an amount from the 'notional interest' in respect of the rent paid to each Lessor under section 12-245 of Schedule 1 to the Taxation Administration Act 1953 (TAA 1953) for:

(a)          the Managing Partner's share of the 'notional interest'?

(b)          the Regular Partners' share of the 'notional interest'?

Answer

5(a) No.

5(b) Yes.

Question 6

Will the Lessee have an obligation to withhold an amount from a royalty in respect of the rent paid to each Lessor 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 commercial equipment and enters into sale and leaseback transactions (Transactions) with foreign resident Lessors.

The Lessee sold the commercial equipment to the Lessors under Sale Agreements for its market value. Upon the acquisition of the commercial equipment each Lessor leases the commercial equipment to the Lessee under the Lease Agreements 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.

Lease

The Lease Agreements commencing on each Lease Commencement Date are entered into on commercially agreed terms and negotiated on an arm's length basis.

During the term of the leases, the Lessee is required to make semi-annual payments in arrears to each 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) under each lease exceed the purchase price of the commercial equipment.

The Lease Agreements contain 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 options 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 Agreements is irrevocable.

In limited circumstances the Lessee has an ability under each Lease Agreement to acquire the commercial equipment under an early termination purchase arrangement absent it exercising its Purchase Option under each Lease Agreement.

Lessors

Each Lessor is a partnership comprising a Managing Partner and Regular Partners formed under the laws of the Foreign Country.

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

The Partnership Agreement for each Lessor provide that the Managing Partner executes the partnership business-related agreements on behalf of the partnership and all the partners. It also undertakes the administration and management activities associated with the arrangements it enters into itself, including stipulating the terms and conditions of the arrangements as Managing Partner.

The Managing Partner contributed the majority of the equity capital to each of the Lessor partnerships and has the majority partnership share in those partnerships.

The Managing Partner has a history of providing leases with a purchase option to third parties other than as a Managing Partner of each Lessor with the intention of realising a profit. Its history of providing these leases was undertaken in a manner that exhibited system, regularity and continuity for a period of a number of years.

The Managing Partner's lease arrangements with purchase options with other parties have for a number of years been greater than 50% of its business activities although leasing is not its only business.

The Managing Partner's leasing business has predominantly been funded by external debt from banks.

Each Regular Partner was recently established for the purpose of forming each Lessor partnership.

Each Regular Partner has no history of raising debt finance or providing leases with a purchase option, other than as partners of the Lessors. They only made a nominal equity investment in the partnerships and have a nominal partner share in those partnerships.

Each partner of each Lessor:

•         is a company 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

•         has no relationship with the Lessee other than the Transactions

•         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 Lessor partners are wholly owned by companies incorporated under the laws of the Foreign Country.

Loan

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

Each Lessor is the Borrower under each Loan Agreement. Each Lessor is required, amongst other things, to pay interest in arrears on the Loan and have provided security for their obligations under each Loan Agreement.

Under the Partnership Agreement each Lessor partner is liable for the obligations of the Partnership in proportion to their partner share, which includes the Loan. As a result, the Managing Partner of each Lessor has the majority share of the Loan under each Loan Agreement.

Other

The amount of rent payments consisting of equity returns to the Lessor partners for each Lessor will be treated as assessable income in the Foreign Country for each partner and each partner will therefore be subject to tax in the Foreign Country.

From an Australian tax perspective, the Lessee will be paying hire purchase rent to each Lessor, and each Lessor uses the cash received for a number of items (for example, to pay the principal and interest on loans, as well as equity returns to the partners of each Lessor).

The Lessee has confirmed that each partner of each Lessor is entitled to depreciation deductions in the Foreign Country in relation to the commercial equipment, calculated based on the purchase price that each Lessor paid for the commercial equipment under the Sale Agreements.

For Australian accounting purposes the Lessee treats the Lease Agreements as finance leases.

The amount of the 'notional interest' deduction in Australia does not exceed the sum of the amount of rent/leasing income in the Foreign Country that is subject to Foreign Country income tax for the relevant income year for the purpose of section 832-105 of the ITAA 1997.

The Managing Partner and Regular Partners of each Lessor do not have a permanent establishment in Australia in respect of the commercial equipment under the tax treaty between Australia and the Foreign Country (the Convention).

Assumption

The Managing Partner's leasing arrangements that have purchase options will be 50% or more of its business activities such as overall accounting profits, leases and assets at the time of each rent payment the Lessee makes under the Transactions.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 40-25

Income Tax Assessment Act 1997 section 40-295

Income Tax Assessment Act 1997 Subdivision 240-E

Income Tax Assessment Act 1997 section 240-50

Income Tax Assessment Act 1997 Subdivision 832-C

Income Tax Assessment Act 1997 Subdivision 832-G

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.

Question 1

Summary

The Lessee will not have a balancing adjustment event under section 40-295 for the sale and leaseback of the commercial equipment.

Detailed reasoning

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

The Lessee acquired the commercial equipment upon their acquisition. Following their acquisition the Lessee sold the commercial equipment to each Lessor and each Lessor then leased back the commercial equipment to the Lessee. As a result, the Lessee is the legal owner of the commercial equipment on its sale to the Lessor and is the holder of the commercial equipment per item 10 of the table in section 40-40.

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

Any notice given by the Lessee to each Lessor under the Lease Agreements 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 each Lease Agreement on the Purchase Option Date.

It is also customary for the Lessee to exercise its right to purchase the commercial equipment in similar arrangements and there is nothing to suggest this pattern will change.

Each Lease Agreement is a hire purchase agreement as defined in subsection 995-1(1), as discussed in Question 3.

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 taxpayer ('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 each 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 each 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.

Therefore, the Lessee has not stopped 'holding' the commercial equipment from its acquisition date, sale to each Lessor and lease back from the Lessor. Therefore, no balancing adjustment event has occurred under subsection 40-295(1).

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 each Lease Agreement.

Detailed reasoning

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.

As discussed in Question 1, the commercial equipment is a 'depreciating asset' that the Lessee holds from acquisition date, sale to each Lessor and lease back from the Lessor. The Lessee 'held' the commercial equipment subject to each 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).

Furthermore, 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 be entitled to a deduction pursuant to section 240-50 for the 'notional interest' calculated under Subdivision 240-E in relation to each 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.

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

Each 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 under each Lease Agreement 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 each Lessor.

Therefore, each 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.

Each Lessor is party to the relevant Lease Agreement and own the commercial equipment. Accordingly, each Lessor is the 'notional seller' under paragraph 240-17(1)(a).

The Lessee is a party to each 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), each Lessor is 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 each 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 each Lease Agreement, or when the Lessee becomes the 'notional seller' under a later arrangement to which Division 240 applies.

Each Lessor ('notional seller') is taken to have made a loan (notional loan) to the Lessee ('notional buyer') upon entering each Lease Agreement under subsection 240-25(1).

The notional loan is an amount (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 Agreements 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 under each Lease Agreement 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 each Lease Agreement.

Question 4

Summary

Subdivision 832-C does not apply to the deductions that the Lessee is entitled to claim for the 'notional interest' calculated under Subdivision 240-E.

Subdivision 832-G does not apply to the deductions that the Lessee will be entitled to claim for the depreciation of the commercial equipment under Division 40.

Detailed reasoning

The scheme is within scope of Division 832, which applies to income years starting on or after 1 January 2019.

Subdivision 832-C

The 'notional interest' payments made by the Lessee are in respect of a 'notional loan', which satisfies the definition of a 'debt interest' in Australia under Division 974. Therefore, paragraph 832-215(1)(a) is met.

Deduction/non-inclusion mismatch has the meaning given by section 832-105 (subsection 995-1(1)). A payment gives rise to a deduction/non-inclusion mismatch is outlined in subsection 832-105(1).

The deductions for 'notional interest' in relation to the rent payments in Australia meets the requirement of paragraph 832-105(1)(a).

Subject to foreign income tax

The meaning of subject to foreign income tax is contained in section 832-130.

The Lessee has confirmed that:

•         the amount of rent payments consisting of equity returns to the partners is treated as assessable income in Foreign Country by the partners and therefore that amount is subject to tax in the Foreign Country.

•         from an Australian tax perspective, the Lessee is paying hire purchase rent to each Lessor, and each Lessor uses that cash received for a number of items (for example, to pay the principal and interest on loans, as well as equity returns to the partners).

•         the amount of the 'notional interest' deduction in Australia does not exceed the sum of the amount of rent/leasing income in the Foreign Country that is subject to foreign income tax for the relevant income year for the purpose of section 832-105.

Therefore, paragraph 832-105(1)(b) is not met.

Subject to Australian income tax

No part of the rent payments is included in any taxpayer's assessable income in Australia and therefore no part of those payments are 'subject to Australian income tax' under subsection 832-125(1).

Consequently, no amount of the rent payments can count towards subparagraph 832-105(1)(b)(ii) in determining whether paragraph 832-105(1)(b) is satisfied.

A payment can only give rise to a hybrid financial instrument mismatch if the payment gives rise to a hybrid mismatch under section 832-215 or 832-230 (paragraph 832-200(1)(a)).

The arrangement does not involve a 'substitute payment' for the purpose of section 832-230. Consequently, the relevant question is whether the Lessee's interest deductions (allowable under section 240-50) give rise to a hybrid mismatch under section 832-215 (paragraph 832-200(1)(a)).

The 'notional interest' payments (i.e., the arrangement payments that result in the 'notional interest' deductions), made by the Lessee will not give rise to a deduction/non-inclusion mismatch because the deduction for those payments does not exceed the sum of the payments subject to foreign income tax, meaning paragraph 832-105(1)(b) is not met.

Therefore, the Lessee's interest deductions cannot be the deduction component of a deduction/non-inclusion mismatch to which the payment gives rise pursuant to subsection 832-105(1).

Given there is no deduction/non-inclusion mismatch, no 'hybrid mismatch' can arise under section 832-215 and the hybrid requirement under section 832-220 will not be satisfied.

Subdivision 832-G

For the Lessee to be a 'deducting hybrid' in relation to the decline in value of the commercial equipment, both subsection 832-550(a) and subsection 832-550(b) must be satisfied.

Subsection 832-110(1) explains when a payment gives rise to a deduction/deduction (DD) mismatch.

The scope for the DD mismatch is extended under subsection 832-110(4), to ensure that certain non-payment deductions are also captured, including amounts that represent the decline in a depreciating asset.

Consequently, the decline in value of the commercial equipment and the depreciation deduction incurred by the Lessee are within the scope of Division 832 and can be treated as a 'payment' or 'other amount' giving rise to a 'deduction/deduction' given subsection 832-110(4).

As determined in Question 2, the Lessee is entitled to claim deductions because it satisfies the requirement of section 40-25 being the entity that 'hold' the commercial equipment under section 40-40.

The Lessee has also confirmed that each partner of each Lessor is entitled to depreciation deductions in the Foreign Country in relation to the commercial equipment, calculated based on the purchase price that each Lessor paid for the commercial equipment under the Sale Agreements. These foreign deductions would satisfy the requirements to be foreign income tax deductions under section 832-120.

Prima facie there appears to be a DD mismatch. However, subsection 832-110(4) requires a conclusion to be reached on what the outcome would have been if instead the depreciation amount were a payment. In this context if the Lessee were instead making a payment, would a foreign income tax deduction entitlement arise in addition to the Australian deduction entitlement for that payment. In this case and the context of the depreciation deduction the answer would be no, if the depreciation deduction were a payment, it would only be expected to give rise to a single deduction entitlement (that being the one that arises in Australia).

The result of this is that a DD mismatch is unable to arise under section 832-110 even though the partners of each Lessor and the Lessee are entitled to a decline in value (depreciation) deduction in their respective countries for the same asset.

Given a DD mismatch under section 832-110 cannot be satisfied a deducting hybrid mismatch cannot arise under section 832-545.

Question 5

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 rents paid to each Lessor that are beneficially owned by the Managing Partner.

The Lessee will 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 each Lessor that are beneficially owned by the Regular Partners.

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 each 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 each Lease Agreement.

In accordance with paragraph 7 of TR 98/21, rent payments made by the Lessee under each Lease Agreement, being a 'hire purchase agreement' as discussed in Question 3, 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, at first instance 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 partners of the Lessor partnerships are companies and are therefore 'persons' under the Convention.

Each Lessor, as a partnership under the laws of the Foreign Country, should also be a person pursuant to Convention as a partnership should be considered 'any other body of persons' (paragraph 1.18 of the Explanatory Memorandum to the International Tax Agreements Amendment Bill (No. 1) 2008). When interpreting treaty terms, regard may be given to Explanatory Memoranda for the enabling Bills when Australia's DTAs are implemented domestically (paragraphs 116 to 117A of Taxation Ruling TR 2001/13 Income tax: Interpreting Australia's Double Tax Agreements).

Based on the information provided, the Managing Partner and the Regular Partners are residents of the Foreign Country on the basis they are persons who are liable to tax in the Foreign Country. However, each Lessor is a partnership that is not liable to tax in the Foreign Country. As such, each Lessor is not a resident of the Foreign Country for the purposes of the Convention.

To the extent the income, profits or gains derived by the Lessors from Australia are treated as the income, profits or gains of the beneficiaries, members or participants of the Lessors under Foreign Country's tax law, the Convention provides that those items of income, profits or gains shall be eligible for the benefits of the Convention as if they were directly derived by the Lessors' beneficiaries, members or participants who are resident of the Foreign Country and to the extent that such beneficiaries, members or participants are residents of the Foreign Country and satisfy any other conditions specified in the Convention.

The 'notional interest' derived by the Lessors are treated as the income of the partners, being the Managing Partner and the Regular Partners, for the purposes of the Foreign Country tax law. On that basis, the Convention therefore provides that the 'notional interest' income can be treated as being directly derived by the Managing Partner and the Regular Partners, as beneficiaries, members or participants of the Lessors, and shall be eligible for benefits under the Convention to the extent the Managing Partners and Regular Partners are residents of the Foreign Country and satisfy any other conditions specified in the Convention. That is, the Lessors, as Foreign Country partnerships, can be looked through for the purposes of applying the Convention.

As noted above, the Managing Partner and Regular Partners are residents of the Foreign Country for the purposes of the Convention. Additionally, in order to determine whether the 'notional interest' is eligible for any benefits under the Convention, any other conditions that need to be satisfied would need to be considered having regard to Managing Partner and the Regular Partners.

Interest

Subsection 240-35(1) includes 'notional interest' in the 'notional seller's' assessable income. As the 'notional interest' under each 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' of the Lessee. Accordingly, the interest 'arises' in Australia.

Based on the information provided, the Managing Partner and the Regular Partners of each Lessor are considered to be the beneficial owners of the 'notional interest'.

The Managing Partner and Regular Partners of each Lessor do not have a permanent establishment in Australia in respect of the commercial equipment under the Convention.

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 provided 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'.

It is therefore necessary to consider whether the partners of each Lessor are 'financial institutions'. As the partners of each Lessor are not banks they will not be liable to withholding tax on the 'notional interest' under the Lease Agreements only if they are each 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 partner is an 'enterprise' under the Convention as each is carrying on a business as discussed below.

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).

Each Lessor 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 18 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' per paragraph 17 of TR 2005/5. Under the Partnership Agreement for each Lessor each Lessor partner is liable for the obligations of the Partnership in proportion to their partner share so it would follow that the Managing Partner and the Regular Partners have in substance or effect, an obligation to repay the loan (with interest) that is not contingent on any event, condition or situation, other than the ability or willingness to meet the obligation. Therefore, the requirement of 'raising debt finance in the financial markets' for the purposes of the Convention is satisfied for the Managing Partner and the Regular Partners of each Lessor.

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 each Lease Agreement, each Lessor is leasing the Lessee the commercial equipment in return for semi-annual rent payments. The Lessee has an option under each Lease Agreement 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 each Lease Agreement.

The Lessee intends to exercise the options 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). The Lessor Partnership Agreements provide that the Managing Partner executes the partnership business-related agreements on behalf of the Partnership and all the partners. In view of this, the actions of leasing the commercial equipment by the Managing Partner on behalf of each Lessor to the Lessee can be imputed to each of the partners such that they 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).

The funds must be used in carrying on a business of providing finance as per the ordinary meaning or understanding of that term, it is not enough for an entity to be providing finance and to be carrying on a business.

In determining what is 'the carrying on a business of providing finance' care must be taken to ensure it is read with regard to the context of the statutory provision (as per Certain Lloyd's [2009] HCA 56 (Lloyds Case) at [23-26]), in this case the Convention.

Moneylending and business of banking are examples of carrying on a business of providing finance. As such they share characteristics with other activities that are forms of carrying on a business of providing finance.

Relevantly, the following cases concerning moneylending and the business of banking provide indicators for the business of providing finance being carried on. They include:

•         A business of moneylending involves the notion of system, repetition and continuity such that there must be more than occasional loans (Edgelow v. MacElwee [1918] 1 KB 205).

•         A moneylender must also hold themselves out as a lender to every eligible borrower (Litchfield v. Dreyfus [1906] 1 KB 584).

•         A business of banking involves profit-making by putting out money to increase it, generally through obtaining interest (Commercial Banking Company of Sydney Ltd v. Federal Commissioner of Taxation [1950] HCA 15; (1950) 81 CLR 263).

•         The lending of money is the essence of a business of banking and if that aspect ceased, the nature of the business would change (FC of T v. Australian Mutual Provident Society (1953) 88 CLR 450).

•         A single transaction by a person who receives a deposit of money and promises to repay is not a banking transaction; the person must hold themselves out as a banker and the public acknowledge them as such (Bank of NSW v. Commonwealth [1948] HCA 7; (1948) 76 CLR 1).

The indicia in paragraph 95B of TR 2005/5 is considered below and whether each partner is 'carrying on a business of providing finance'.

The Managing Partner of each Lessor is considered to be carrying on a business of providing finance as indicated by:

•         its history of raising debt finance for its leasing business other than as a Managing Partner of the Lessors

•         having a history of providing leases with a purchase option to third parties other than as a Managing Partner of each Lessor with the intention of realising a profit. Its history of providing the finance leases was undertaken in a manner that exhibited system, regularity and continuity for a period of a number of years

•         while its leasing business is not its only business, based on the information provided in respect of the profits and assets as compared to its other business/es, it is apparent that its leasing business is more than merely ancillary or incidental

•         having contributed the majority of the equity capital to each of the Lessor partnerships and has the majority interest in those partnerships

•         based on the terms of each Partnership Agreement it, as Managing Partner, executing documents to conduct the Partnership Business and is responsible for the conduct of the business, and

•         undertaking the administration and management activities associated with the arrangements it enters into itself, including stipulating the terms and conditions of the arrangements as Managing Partner.

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'. The Managing Partner's leasing business is funded predominantly by external debt from banks. Similarly, its partner share of each Loan, being debt raised in the financial markets by each Lessor, forms the majority of the funding for the acquisition and leaseback of the commercial equipment. The debt was raised at around the same time as the entry into each Lease Agreement such that it is considered to be concurrently using the debt finance raised in carrying on a business. Therefore, the Managing Partner is using the debt finance raised in carrying on its business of providing finance.

The Regular Partners of each Lessor are not considered to be carrying on a business of providing finance as indicated by:

•         Each has no history, or intention, of raising debt finance other than as partners of the Lessors.

•         Each has no history, or intention, of providing leases with a purchase option other than as partners of the Lessors.

•         Each only made a nominal equity investment in the partnerships. Additionally, their share of the leases provided to the Lessee relative to the Managing Partner is of insignificant value and is not consistent with an entity carrying on a business of providing leases with a purchase option.

•         Each provides finance to a single recipient, the Lessee, as partner of each Lessor. Based on the information provided, each Regular Partner would not present itself independently to the general public as providing finance through leases with a purchase option (as opposed to the Managing Partner).

•         Each was recently established, for the purpose of enabling the Managing Partner to create partnerships for the lease arrangements. Further, even if there is an intention to enter into further partnerships with the Managing Partner, the entering into of the partnerships is in itself, not sufficient to conclude that there is repetition or regularity in the activities which are relevant in considering whether there is a business of providing finance as the activities relating to the investment in the partnerships are not considered akin to the activities of a business providing financing.

•         Based on the terms of each Partnership Agreement, each Regular Partner does not execute documents to conduct the Partnership Business and is not involved, or able to be involved, in conducting the business, including activities such as stipulating the terms of the Lease Agreements.

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.

The Managing Partner's primary business activities are leasing arrangements with purchase options, which constitute the provision of finance per paragraph 92 of TR 2005/5, and which is assumed to continue over the period of the Ruling.

The Managing Partner's lease arrangements with a purchase option have for a number of years been greater than 50% of its activities. Further, this Ruling is made on the basis that the Managing Partner's leasing arrangements that have purchase options will generate more than 50% of its overall accounting profits at the time of each rent payment the Lessee makes.

The Regular Partners conduct no other business activities outside their role as Regular Partners of each Lessor such that the leases with a purchase option for the commercial equipment is their only business activity and consequently the only source of profits. Consequently, each Regular Partner is 'substantially deriving its profits' by raising debt finance and using those funds in providing finance through leasing arrangements with a purchase option, being each Lease Agreement, satisfying paragraph 100B of TR 2005/5.

Unrelated and wholly independent

The Convention also requires that each Lessor partner 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 Lessor partners and the Lessee. The Lessee is an Australian resident company. The Lessor partners are wholly owned by companies incorporated under the laws of the Foreign Country. Accordingly, neither the Lessee nor the Lessor partners 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 each 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 or the Lessor partners in a way that would amount to participation in the control of the Lessor partners. As such, each Lessor partner 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 and therefore the Lessor partners (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'.

In relation to the Transactions, it is considered that there is no 'back to back' loan or other arrangement to that effect. Therefore, the interest arising in Australia that is beneficially owned by the Lessor partners is not paid as part of an arrangement involving 'back to back' loans for the purposes of the Convention.

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 Lessor partners is a resident of the Foreign Country and derives income from Australia while carrying on a business in that country. The type of business being carried on is not one that is excluded under the Convention. Each Lessor partner derives income from the rent payments under the Lease Agreements, which include a 'notional interest' amount, in connection with its business of providing finance.

As it has been established that the Managing Partner of each Lessor also satisfies the other conditions set out under the Convention, it is eligible for the treaty benefits.

However, as the Regular Partners of each Lessor do not satisfy all the relevant conditions of the Convention as discussed above they will not be eligible for treaty benefits.

Conclusion

In view of the above discussion, the Managing Partner of each Lessor is a 'financial institution' for the purposes of the Convention as it falls within the meaning of that term, and it is assumed that the Managing Partner satisfies the definition at the time of each rent payment the Lessee makes under the Transactions.

Thus, the 'notional interest' derived by the Managing Partner of 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 International Tax Agreements Act 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 rent paid to each Lessor that is beneficially owned by the Managing Partner.

As the Regular Partners are not 'financial institutions' for the purposes of the Convention, the 'notional interest' derived by them is not exempt from interest withholding tax and the Lessee will 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 that is paid to each Lessor that is beneficially owned by the Regular Partners.

Question 6

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 each Lessor.

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 each Lease Agreement that the purchase or repurchase of the commercial equipment by the Lessee from the Lessors is a paramount purpose of the lease arrangements per paragraph 7 of TR 98/21 (see Questions 1 & 5). Therefore, rent payments made under the Lease Agreements 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 Agreements.

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.