Edited version of private advice

Authorisation Number: 1052278286521

Date of advice: 26 July 2024

Ruling

Subject: Withholding tax - foreign resident

Question

Is the Bank entitled to the benefit of the exemption under Article 11(3)(b) of the Conventionsuch that amounts of interest income payable on bonds issued by an Australian entity to the Bank are not subject to interest withholding tax under section 128B of the Income Tax Assessment Act 1936 ('ITAA 1936')?

Answer

Yes.

This ruling applies for the following periods:

Year ended 1 July 20XX to 30 June 20YY

The scheme commenced on:

1 July 20XX

Relevant facts and circumstances

The Bank

1. The Bank is a company incorporated in the Foreign Country and is a resident of the Foreign Country for tax purposes.
2. The Bank is liable to tax in the Foreign Country.
3. The Bank holds a banking license allowing it to do all common banking activities.

Capital adequacy requirements

4. The Bank is subject to increased capital adequacy requirements.
5. The Bank fully meets current capital adequacy requirements.

Australian Investments

6. The Bank holds bonds in AUD issued by Australian companies.
7. The Bank and the bond issuers are third parties and transacting at arm's length.
8. The bond agreements under which the interest payments will be received by the Bank are not back-to-back loans, nor are they economically equivalent to back-to-back loans.
9. The Bank has no subsidiaries or permanent establishments in Australia.
10. The interest income is paid by Australian residents for the purposes of Australian tax, and all such income is not connected to a permanent establishment, or a fixed base situated outside Australia.

Manager

11. The Bank has engaged an external asset manager ('Manager').
12. The Manager uses brokers to close deals in the Australian bond market with the Bank as the beneficial owner itself (and not for the Bank's customers).
13. The Bank's income which flows from the Australian bonds does not pass through the Manager.

Custodian

14. The Custodian acts as the custodian for the Bank. It is responsible for the correct processing of the Bank's purchases and sales. It also withholds the foreign withholding tax and settles it with the competent authority.
15. The interest income derived from the Australian investments flows through the Custodian. The income is paid to the account of the Bank at the Custodian. The Custodian then informs the Bank about the money that arrived on the account from each issuer and bond. The Bank checks the total amount of money on all accounts and gives the order to transfer the liquidity on the accounts to the Bank's own accounts.
16. The Custodian pays the full interest income received to the Bank. The Bank checks if the amount of interest received through the Custodian is correct and corresponds the Bank's calculations.
17. The Custodian charges the Bank a monthly service fee for custodial services and transactions.
18. The Custodian does not withhold any tax in the Australian market. Withholding tax on dividends and interest income is deducted at source by the Australian (local) custodian before the income is remitted to the Custodian for distribution to the beneficial owners. If, according to the law in the respective country, an income tax is owed by the Bank, the Custodian will deduct the withholding tax before transferring the remaining interest to the Bank's account at the Custodian, who will forward the tax to the respective Government account.
19. The Custodian holds the Bank's titles on account of the Bank.
20. Aside from the Custodian, there are no other entities (including any entities related to the Bank, such as subsidiaries) that are interposed between the Bank and the issuers of any of the Australian investments.

Assumption

1. The interest income from the Australian investments is paid by entities who are Australian residents for the purposes of Australian tax and the Convention.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 128B

The Convention Article 11

Does Part IVA apply to this arrangement?

Part IVA of the Income Tax Assessment Act 1936 contains anti-avoidance rules that can apply in certain circumstances where you or another taxpayer obtains a tax benefit, imputation benefit or diverted profits tax benefit in connection with an arrangement.

If Part IVA applies, the tax benefit or imputation benefit can be cancelled (for example, by disallowing a deduction that was otherwise allowable) or you or another taxpayer could be liable to the diverted profits tax.

We have not fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies, we will need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select 'Part IVA: the general anti-avoidancerule for income tax'.

Reasons for decision

Question 1

Is the Bank entitled to the benefit of the exemption under Article 11(3)(b) of the Convention such that amounts of interest income payable on bonds issued by an Australian entity to the Bank are not subject to interest withholding tax under section 128B of the ITAA 1936?

Summary

For the purposes of the Convention, interest income payable on bonds issued by Australian entities that is derived by the Bank may not be taxed in Australia under Article 11(3)(b) of the Convention, and therefore is not subject to interest withholding tax under section 128B of the ITAA 1936.

Detailed reasoning

The Convention

Subsection 6-5(3) of the Income Tax Assessment Act 1997 ('ITAA 1997') provides that the assessable income of a non-resident taxpayer includes ordinary income derived directly or indirectly from all Australian sources during the income year.

Additionally, under Australian domestic tax law, income that consists of interest is subject to withholding tax where it is paid by a resident to a non-resident, except where it is wholly incurred by the payer in carrying on business outside Australia at or through a permanent establishment (subsection 128B(2) of the ITAA 1936). Under subsection 128A(2) of the ITAA 1936, amounts are deemed to be paid if they have been reinvested, accumulated, capitalised or otherwise dealt with on behalf of the other person or as the other person directs.

When determining whether Australia has a taxing right in respect of income derived in or sourced from Australia by a foreign resident, consideration must also be made to the International Tax Agreements Act 1953 ('Agreements Act') and any of Australia's double tax agreements ('DTAs') which have been given the force of law by the Agreements Act.

As outlined in paragraph 5 of Taxation Ruling TR 2001/13 Income tax: Interpreting Australia's Double Tax Agreements ('TR 2001/13'):

5. As well as giving DTAs and the MLI the force of law, the Agreements Act clarifies the status of these agreements with respect to the 'Assessment Act' and the various Acts which impose Australian tax. The effect of subsection 4(1) of the Agreements Act, in particular, is that the DTAs are to be interpreted and read as one with the Assessment Act. While each DTA itself is a treaty, and only the other country party to it can take action on it internationally, the provisions of the DTAs become part of Australian domestic law by legislative action, and are just as legally effective in domestic law as the provisions of the Assessment Act. The provisions of a DTA can therefore be relied on, in their implemented form, by individual taxpayers before Australian courts.

Subsection 4(2) of the Agreements Act deals with possible conflicts by effectively providing that the terms of the DTAs override those of the Assessment Acts (except for the general anti-avoidance provisions in Part IVA of the ITAA 1936, Subdivision 195-C of the ITAA 1997, and Acts imposing Australian tax) in the event of any inconsistency.

The Convention - application to the Bank

The Convention applies to residents of the Contracting States. The Bank satisfies this criterion.

The Convention - application to interest withholding tax

The Convention applies to Australian withholding tax.

Taxation of interest

Under subparagraph 3(b) of Article 11 of the Convention, interest arising in one of the contracting states will not be taxed in the other contracting state if it is derived and beneficially owned by a financial institution. There are several additional factors that also need to be met for the Article to apply.

Interest paid to the Bank will not be subject to taxation in Australia in accordance with subparagraph 3(b) of Article 11 of the Convention if it is established that:

1.    The Bank is a resident under the Convention.

2.    There is interest that arises in Australia and is paid to a resident of the Foreign Country.

3.    The Bank is the beneficial owner of, and derives, the interest.

4.    The Bank is a financial institution which is unrelated to and dealing wholly independently with the payer.

5.    The operation of subparagraph 3(b) of Article 11 of the Convention is not limited by any other paragraph of the Convention.

These requirements are considered below.

1. The Bank is a resident under the Convention.

As outlined above, this criterion is satisfied.

2. There is interest that arises in Australia and is paid to a resident of the Foreign Country.

Interest that arises in Australia

The Bank receives income that will constitute interest.

It is assumed that the interest is paid by Australian residents for the purposes of Australian tax and the Convention, and all such income is not connected to a permanent establishment, or a fixed base situated outside Australia. This requirement is satisfied.

The2017 Commentaries on the OECD Model Tax Convention on Income and on Capital ('2017 OECD Commentaries') provide context around the introduction of the requirement of 'beneficial ownership' and the term 'paid to' as follows:

1. Paragraph 1 lays down the principle that interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in the latter. In doing so, it does not stipulate an exclusive right to tax in favour of the State of residence. The term "paid" has a very wide meaning, since the concept of payment means the fulfilment of the obligation to put funds at the disposal of the creditor in the manner required by contract or by custom.

...

9. The requirement of beneficial owner was introduced in paragraph 2 of Article 11 to clarify the meaning of the words "paid to a resident" as they are used in paragraph 1 of the Article. It makes plain that the State of source is not obliged to give up taxing rights over interest income merely because that income was paid direct to a resident of a State with which the State of source had concluded a convention.

10. ...Where an item of income is paid to a resident of a Contracting State acting in the capacity of agent or nominee it would be inconsistent with the object and purpose of the Convention for the State of source to grant relief or exemption merely on account of the status of the direct recipient of the income as a resident of the other Contracting State...

11. Subject to other conditions imposed by the Article and the other provisions of the Convention, the limitation of tax in the State of source remains available when an intermediary, such as an agent or nominee located in a Contracting State or in a third State, is interposed between the beneficiary and the payer but the beneficial owner is a resident of the other Contracting State (the text of the Model was amended in 1995 and in 2014 to clarify this point, which has been the consistent position of all member countries).

The direct recipient of the interest paid by the Australian resident bond issuers is the Custodian.

However, it is evident from the 2017 OECD Commentaries that the main focus of the term 'paid...to' in Article 11 of the Convention requires an enquiry into the status of the 'beneficial owner' of the interest income and not the status of the intermediary who is the direct recipient of the payment.

As the Bank is the beneficial owner of the interest (see analysis and conclusion on this point below), the interest income will be taken to be paid to the Bank when it is paid to the Custodian.

Therefore, this condition is satisfied.

3. The Bank is the beneficial owner of, and derives, the interest.

Beneficial owner

The term 'beneficial owner' is not defined in the Convention.

The 2017 OECD Commentaries on Article 11 state:

9.1 Since the term "beneficial owner" was added to address potential difficulties arising from the use of the words "paid to a resident" in paragraph 1, it was intended to be interpreted in this context and not to refer to any technical meaning that it could have had under the domestic law of a specific country (in fact, when it was added to the paragraph, the term did not have a precise meaning in the law of many countries). The term "beneficial owner" is therefore not used in a narrow technical sense (such as the meaning that it has under the trust law of many common law countries), rather, it should be understood in its context, in particular in relation to the words "paid to a resident", and in light of the object and purposes of the Convention, including avoiding double taxation and the prevention of fiscal evasion and avoidance.

Paragraph 10.2 of the 2017 OECD Commentaries informs that the 'beneficial owner' can be found through identifying the entity which has the unconstrained right to use and enjoy the interest income:

10.2 In these various examples (agent, nominee, conduit company acting as a fiduciary or administrator), the direct recipient of the interest is not the "beneficial owner" because that recipient's right to use and enjoy the interest is constrained by a contractual or legal obligation to pass on the payment received to another person. Such an obligation will normally derive from relevant legal documents but may also be found to exist on the basis of facts and circumstances showing that, in substance, the recipient clearly does not have the right to use and enjoy the interest unconstrained by a contractual or legal obligation to pass on the payment received to another person...

The Bank invests in the Australian bonds in its own name and for its own accounts. The Bank's right to use and enjoy the interest income is not constrained by a contractual obligation to pass the payment on to another party.

In contrast, the Custodian acts only as intermediary and the Custodian's right to use and enjoy this interest income is constrained by an obligation to pass the interest payment in its entirety to the Bank, which occurs when the interest is received by the Custodian. The Custodian is the legal owner of the Australian investments, however, this arrangement is a part of its role and responsibilities as a custodian, with all assets being held for the account of the Bank. The Custodian is remunerated for its custodial services separately to the interest payments that it receives on behalf of the Bank.

The roles and responsibilities of the Custodian are similar to those of other intermediaries highlighted in paragraph 10.2 of the 2017 OECD Commentaries above (e.g. an agent or nominee).

Therefore, the Bank is the 'beneficial owner' of the interest income paid by the Australian resident entities for the purposes of the Convention. The income is also considered to have been 'paid to' the Bank.

Therefore, this condition is satisfied.

The Bank derives the interest

Under Australian domestic tax law, the Bank, as the non-resident company that is paid the relevant interest, would be considered to be deriving the relevant interest income from the Australian resident payers.

The term 'derive' is not defined in the Convention or the 2017 OECD Commentaries.

Under Australian taxation law, where interest income is initially received by a manager and/or custodian prior to it being paid to the beneficial owner, the beneficial owner will be deemed to have derived the income at the time it became presently entitled to the income where a trust relationship exists (refer to section 128A(3) of the ITAA 1936).

Guidance provided by the Courts on when a trust relationship exists was outlined in ATO Interpretive Decision ATO ID 2008/61 Income Tax: Withholding Tax Exemption: interest and dividends paid by an Australian resident and received by a Dutch Stichting as unitholder in an Irish Common Contractual Fund ('ATO ID 2008/61'), which notes that:

Justice French in Harmer & Ors v. FC of T 89 ATC 5180; (1989) 20 ATR 1461 stated that a trust 'is notably a definition of a relationship by reference to obligations'. His Honour went on to state that the four essential elements of a trust are:

1.    the trustee who holds a legal or equitable interest in the trust property

2.    the trust property which must be property capable of being held on trust and which includes a chose in action

3.    one or more beneficiaries other than the trustee, and

4.    a personal obligation on the trustee to deal with the trust property for the benefit of the beneficiaries, which obligation is also annexed to the property.

Therefore, the relationship between the manager, custodian and the unitholder constitutes a trust relationship. Accordingly, the income received by the manager and/or custodian of the CCF is income of a trust estate for the purposes of subsection 128A(3) of the ITAA 1936.

Under the terms of the deed, income of the CCF accrues to the unitholder as it arises. Accordingly, the Stichting would have a present legal right to demand and receive payment of the income and therefore, would be presently entitled to the interest and dividend income received by the CCF.

These four elements of a trust are present in the relationship between the Bank and Custodian:

1. the Custodian holds legal title to the bonds
2. the bonds are property which is capable of being held on trust
3. the Bank is beneficially entitled to the bonds and the income arising from those bonds
4. the Custodian operates under an obligation to deal with the bonds and interest income for the benefit of the Bank.

Based upon the above rights and obligations, a trust relationship exists between the Bank and Custodian.

The Bank accrues income from the Australian investments as it arises and therefore has a present legal right to demand and receive payment of the income and therefore, is presently entitled to the income when it is received by the Custodian.

Pursuant to subsection 128A(3) of the ITAA 1936, as the Bank is presently entitled to the interest income at the time it is paid, this is also the time that the Bank derives the interest income.

Therefore, this condition is satisfied.

4. The Bank is a financial institution which is unrelated to and dealing wholly independently with the payer.

Does TR 2005/5 apply?

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 the US and UK Conventions.

Consistent with the Commissioner's approach in TR 2005/5, the interest earned from the Australian bonds will not be subject to withholding tax in accordance with Article 11(3) of the Convention if it can be shown that the Bank is a financial institution.

A financial institution is defined in Article 11(3)(b) of the Convention as either:

•         a bank, or

•         other enterprise.

Bank

Paragraphs 12 to 14 of TR 2005/5 states that:

12. For the purposes of the Conventions, the Commissioner considers that a bank means a US or UK resident that is authorised or licensed to carry on a banking business (that is, to take deposits and make advances) in the US or the UK and satisfies the capital adequacy requirements to be classified as a bank, as distinct from other categories of deposit taking institutions.

13. Where a US or UK resident satisfies these requirements, it will constitute a financial institution and does not need to satisfy the other elements of the definition of what is a financial institution.

14. The Commissioner considers that UK residents that appear on the list of banks published by the UK Prudential Regulation Authority will constitute a bank for the purposes of Article 11(3)(b) of the UK Convention.

The Bank holds a banking license as a bank allowing it to do all common banking activities. The Bank is subject to increased capital adequacy requirements which it fully satisfies.

Based on the facts and circumstances, the Commissioner considers that the Bank satisfies the definition of a 'financial institution' under subparagraph (3)(b) of Article 11 of the Convention.

Unrelated to and dealing wholly independently with the payer of the interest

Paragraphs 30-31 of TR 2005/5 provide that:

30. The term 'unrelated' means that there is no ownership or control based relationship between the payer of the interest and the financial institution, under which one party is able to exert sufficient influence over the activities of the other party. In this regard, the term 'sufficient influence' takes its meaning from section 318 of the ITAA 1936. Essentially, an entity will be sufficiently influenced by another entity where that entity has 'influence, because of obligation or custom, over a company or its directors to direct the actions of the company either directly or through interposed entities'.

31. In determining whether the parties will be regarded as dealing wholly independently with each other, an arm's length test is applied to ascertain whether the transaction has taken place on normal, open market, commercial terms. In relation to the arm's length requirements, paragraphs 4, 23 and 24 of Taxation Ruling TR 2002/2 Income tax: meaning of "Arm's Length" for the purpose of subsection 47A(7) of the Income Tax Assessment Act 1936 (ITAA 1936) dividend deeming provisions provide guidance.

The Bank and the bond issuers are third parties and transacting at arm's length. Therefore it is considered that the Bank is unrelated to and dealing wholly independent of the Australian bond issuers.

5. The operation of subparagraph 3(b) of Article 11 of the Convention is not limited by any other paragraph of the Convention.

No other paragraph within Article 11 of the Convention operates to limit subparagraph 3(b) of Article 11 of the Convention.

Conclusion

Therefore, subparagraph (3)(b) of Article 11 of the Convention will apply to the interest income paid to the Bank from the Australian bond issuers, such that the interest shall not be taxed in Australia. This will result in the Bank being exempt from withholding tax on such interest income.