ATO ID 2004/848: Deductibility of an amount to a resident taxpayer who has not deducted withholding tax on an amount paid to a non-resident
Date of decision: 23 December 2003
Year of income: Year ended 30 June 2001 Year ended 30 June 2002
Business line: Public Groups and International

Issue
Does section 26-25 of the Income Tax Assessment Act 1997 (ITAA 1997) apply to deny a deduction otherwise available under section 8-1 of the ITAA 1997 in respect of 'interest' payments made by the taxpayer to a non-resident entity?

Decision
No. Section 26-25 of the ITAA 1997 will not apply to deny a deduction otherwise available under section 8-1 of the ITAA 1997 in respect of 'interest' payments made by the taxpayer as the payments made to the non-resident are not interest as defined under Division 11A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936).

Facts
The taxpayer entered into an agreement to appoint the non-resident as their exclusive marketer and distributor for their products. The key terms of the agreement are summarised as follows: The non-resident receives a commission from the taxpayer for sales made under the agreement and carries the credit risks by guaranteeing payments for products sold to its clients. On receiving the Bill of Lading, the non-resident pays a percentage of the value of the products in the shipment to the taxpayer as the 'Provisional Payment'. The remainder of the purchase price is paid at the time the non-resident receives monies from its clients. However, the non-resident must make payment in full to the taxpayer in respect of any outstanding monies from any sales to its clients which are beyond the general sales terms between the non-resident and its clients. For each shipment a 'notional account' will be maintained by the non-resident on behalf of the taxpayer. The 'Provisional Payments' are subject to adjustments in accordance with the agreement. The non-resident earns 'interest' from the taxpayer where there is a debit balance in the 'notional account'. The use of 'notional account' enables the non-resident to derive further income (in addition to its commission income) and provides some protection against currency fluctuations and changes in commodity prices whilst the goods are in transit. Simple 'interest' is calculated daily on the outstanding debit balance of the 'notional account' maintained until the shipment is finalised. Title to the products passes to the non-resident upon its receipt of the Bill of Lading.

Reasons for decision
Summary: Section 26-25 of the ITAA 1997 denies a deduction under section 8-1 of the ITAA 1997 for interest (interest within the meaning of Division 11A of Part III of the ITAA 1936), where the taxpayer is required to withhold an amount from the interest in accordance with section 12-245 of the Taxation Administration Act 1953 (TAA) and the taxpayer either fails to withhold the amount or fails to comply with certain other requirements. Section 12-245 of the TAA provides that an entity must withhold an amount from interest (within the meaning of Division 11A of Part III of the ITAA 1936) it pays to a non-resident entity. Generally, interest is an amount paid for the use of borrowed funds. The term interest, at least with respect to its ordinary meaning, is not specifically defined in Division 11A of Part III of the ITAA 1936. It is accordingly necessary to look elsewhere for that meaning of the term. However, subsection 128A(1A) of the ITAA 1936 extends the ordinary meaning of interest and includes amounts that are in the nature of interest (paragraph 128(1A)(a)). The Macquarie Dictionary, 2001, rev. 3rd edn, The Macquarie Library Pty Ltd, NSW defines interest as 'a payment, or a sum paid, for the use of money borrowed (the principal), or for the forbearance of a debt'. Similarly, the Australian Oxford Dictionary, 1999, Oxford University Press, Melbourne defines interest as 'money paid for use of money lent, or for not requiring repayment of debt'. There are several decided cases where the courts reveal a number of essential characteristics of interest. With reference to the decisions from these cases, it is possible to establish that an amount is interest if: (Re Euro Hotel (Belgravia) Ltd (1975) 51 TC 293, Riches v. Westminster Bank Limited [1947] AC 390 at 400; [1947] 1 All ER 469, Bennett v. Ogston (1930) 15 TC 374, Willingale (HM Inspector of Taxes) v. International Commercial Bank Limited (1978) 52 TC 242; [1978] 2 WLR 452, Chow Yoong Hong v. Choong Fah Rubber Manufactory [1961] 3 All 1163; [1962] AC 209) In this case it is necessary to decide whether these four conditions exist in order to establish that the amount in question is interest. | Detailed Reasoning - Is there a relationship of debtor and creditor?: There are no clauses in the agreement which imply that the taxpayer must pay the debit balance of the notional amount to the non-resident at any time or that the non-resident has any right to return the goods to recover monies. The non-resident is not a 'lender', nor is the taxpayer a creditor of the non-resident in respect of the debit balance of the notional amount. The non-resident pays for the products it acquires from the taxpayer in accordance with a complicated formula which ultimately allows the non-resident to make a profit which is calculated as a percentage of the ultimate sale price for on-selling the product plus a small profit calculated as 'interest' plus a fee for taking the credit risk in selling to the ultimate buyer. | Detailed Reasoning - Is the 'interest' calculated with reference to a sum of money?: It is clear from the method used to calculate the 'interest' set out in the contract that it is calculated with reference to a sum of money. | Detailed Reasoning - Is the 'interest' payable for the use of money and in the nature of compensation for deprivation of use of money?: It cannot be said that the 'interest charge' is payable for the use of money and in the nature of compensation for the deprivation of the use of money. The 'interest' is nothing more than a unit of calculation used to calculate the final price. | Detailed Reasoning - Does the 'interest' accrue over time?: The 'interest' in respect of each shipment which is the subject of the ruling is calculated by charging simple interest daily on any debit amount in the notional account. Clearly it does accrue over time. However, because there is no relationship of debtor and creditor and because the 'interest' is not payable for the use of money, nor is it in the nature of compensation for deprivation of use of money, the 'interest' in question is not interest in the ordinary meaning of the word. | Detailed Reasoning - Is the 'interest' in the nature of interest?: Paragraph 128A(1AB)(a) of the ITAA 1936 provides that the term interest includes amounts that are "in the nature of interest". This paragraph is directed at bringing into the interest withholding net amounts that are called something other than interest but are in fact interest. As the amount in question is not in fact interest, subsection 128A(1AB) of the ITAA 1936 has no application in the present case. | Detailed Reasoning - Effect of any relevant double taxation agreement: There is a double taxation agreement between Australia and the relevant country of the non-resident in this case. However, as the payments in question also fail to qualify as 'interest' for the purposes of the Article covering interest within that agreement, it has no additional bearing on this case. | Detailed Reasoning - Conclusion: As the 'interest' payments made under the agreement are not interest within the meaning of Division 11A of Part III of the ITAA 1936, the taxpayer has no obligation, under section 12-245 of the TAA, to withhold amounts from 'interest' payments it paid to the non-resident. As a result, section 26-25 of the ITAA 1997 will not apply to deny a deduction otherwise available under section 8-1 of the ITAA 1997.

Legislative references: Income Tax Assessment Act 1936 subsection 128A(1AB) subsection 128A(1AC) subsection 128A(1AD) section 128B subsection 128B(2)
Case references: Riches v. Westminster Bank Limited [1947] 1 All ER 469 [1947] 1 AC 390
Other references: The Macquarie Dictionary, 2001, rev. 3rd edn, The Macquarie Library Pty Ltd, NSW The Australian Oxford Dictionary, 1999, Oxford University Press, Melbourne
Subject references: Double tax agreements Non resident interest withholding tax