Private ruling: Controlled foreign companies tainted income
Date of advice: 29 October 2015
Published: October 2015
Ruling period: Year ended 30 June 2015 | Year ending 30 June 2016 | Year ending 30 June 2017 | Year ending 30 June 2018 | Year ending 30 June 2019
Date scheme commenced: 1 July 20VV

Ruling: Q1: Whether rental income derived by Company C from legacy operating leases during the statutory accounting period ended 30 June 20XX and from legacy and new operating leases in future periods is "tainted royalty income" for the purposes of Part X of the Income Tax Assessment Act 1936 (ITAA 1936)? | A1: Yes. | Q2: Whether income derived by Company C from hire purchase transactions during the statutory accounting period ended 30 June 20YY and future periods is "tainted interest income" for the purpose of calculating "gross tainted turnover" for the tainted income ratio under the 'active income test', and for the purpose of calculating Company C's notional assessable income? | A2: Yes.

Relevant facts and circumstances: Company A is an Australian resident company. Company A owns a % of Company B, a foreign resident company. Company A is an attributable taxpayer under Subdivision C of Part X of the ITAA 1936 in relation to Company C, a foreign resident company, as Company A owns a % of the issued share capital in Company C. Z is an unlisted country for the purposes of the ITAA 1936. The remaining % of the issued share capital in Company C is owned by various entities owned by Company N, also a Z resident company. Company C was incorporated before 1 July 20VV and commenced business on 1 July 20VV. On or around 1 July 20VV, Company C established permanent establishments (or branches) in several other countries through which local business is conducted. The joint ventures (JV) Prior to 1 July 20VV, Company B carried on a leasing JV with Company N. Prior to 1 July 20VV, Company C incorporated a % owned subsidiary, Company D, a W resident company. On 1 July 20VV, Company B transferred a lease intangible representing the right to an % share in any secondary term profits of 'legacy' leases (refer below) from its JV with Company N to Company D. Company D will continue to hold the lease rights to the 'legacy' portfolio until those leases expire, and will receive an % profit share to mirror the old JV arrangement. Also on 1 July 20VV, various entities from the Company N group made 'in specie contributions' of their % share of 'legacy' lease rights to Company C in return for their % shareholding in Company C. An amount of % of the legacy portfolio profits belongs to Company N and will be paid out by Company D as a dividend. As each legacy lease reaches its secondary term (refer below), Company N transfers the asset ownership to Company C (rather than Company D) and Company C derives the rental income throughout the secondary term and eventually disposes of the asset. Business and leasing services of Company C Company C's business comprises of leasing equipment to the public in a foreign country. The offices located in Z and several other countries are all fully staffed and carry out various business activities, including marketing and promotion, signing up customers and managing lease portfolios. Company C provides equipment leasing as part of an end to end fleet management service to its customers. Prior to the lease, Company C assists with the planning, sourcing, procurement and deployment of the customer's IT equipment, via including services that include vendor selection, price benchmarking, asset tagging, equipment configuration and staged delivery. Company C also provides customers with a suite of online tools that they can use to manage their internal workflows for ordering, approval and deployment. During the lease, customers can manage their fleet of assets using Company C services for tracking the location, age and replacement cycle. Invoices can be configured for customer accounting (e.g. cost centres, department or location). Company C also provides financial reporting that customers can use for their statutory disclosures, and can provide logistics for the maintenance and repair of the customer fleet. If necessary, at the end of the lease, Company C provides services for the disposal of the equipment; collection and preparation for subsequent resale on the used market (e.g. dismantling and disc wiping) or ecological disposal and recycling if the assets cannot be resold. Terms and conditions Each lease may have a primary and secondary term. The primary term is the contractual term of the lease. During the primary term, Company N owns the asset and is the lessor and Company C and its branches act merely as billing/collection agents and derive administrative fees as consideration for these services. At the end of the lease (primary) term, if the customer chooses to continue leasing the asset, Company N novates the lease to Company C in consideration for Company C paying the residual value of the asset under the lease. Title in the underlying asset is transferred to Company C and Company C becomes the lessor during the secondary term either on a month by month basis or a fixed period at the option of the customer. At the end of the secondary term, the customer is asked if they would like to purchase or return the asset. If the asset is returned to Company C, it is sold by a third party on Company C's behalf and Company C will receive the disposal proceeds less commission and sale costs. Such leases are typically not hire purchase agreements as defined for Australian income tax purposes (i.e. neither Company N nor Company C grants the lessee an option to purchase the asset nor does the lessee automatically become the owner of the asset following the final lease payment at the end of the secondary term). However, some leases entered into in several countries may be assigned to Company C during the year ending 30 June 20YY that may be hire purchase agreements as defined for Australian income tax purposes as they contain options for the lessee to purchase the leased equipment at the expiry of the lease. In summary, Company C head office (or its branches) have or will earn rental income from a mix of 'legacy' leases and new leases entered into since 1 July 20VV. During the year ended 30 June 20XX, Company C and its branches earned rental income from secondary term 'legacy' leases. None of these 'legacy' leases contained purchase options and should therefore not be characterised as hire purchase contracts for Australian tax purposes. From 1 July 20YY, rental income may be derived from both new and legacy operating leases and hire purchase agreements. Assumption The decisions in this ruling are dependent on the assumption that, during the ruling periods, Company C does not pass the active income test in subsection 432(1) of the ITAA 1936, specifically paragraph (f).

Relevant legislative provisions: Acts Interpretation Act 1901 section 15AB, | Income Tax Assessment Act 1936 Division 8, | Income Tax Assessment Act 1936 Part X, | Income Tax Assessment Act 1936 subsection 6(1), | Income Tax Assessment Act 1936 section 317, | Income Tax Assessment Act 1936 subsection 317(1), | Income Tax Assessment Act 1936 section 384, | Income Tax Assessment Act 1936 section 385, | Income Tax Assessment Act 1936 section 386, | Income Tax Assessment Act 1936 subsection 432(1), | Income Tax Assessment Act 1936 section 435, | Income Tax Assessment Act 1936 section 441, and | Income Tax Assessment Act 1936 subsection 446(1).

Reasons for decision: Summary: The rental income (royalties) derived by Company C from • legacy operating leases during the statutory accounting period ended 30 June 20XX, and • legacy and new operating leases for future periods, is "tainted royalty income" for the purposes of Part X of the Income Tax Assessment Act 1936 (ITAA 1936) as the equipment that is the subject of the royalties, did not originate with Company C, and is not altered in a way that its market value is substantially enhanced. | Detailed Reasoning - Detailed reasoning: Section 6(1) of the Income Tax Assessment Act 1936 (ITAA 1936) provides that 'royalty' or 'royalties' includes amounts paid or credited, to the extent to which it is paid or credited, as consideration for the use of, or the right to use, any industrial, commercial or scientific equipment. Taxation Ruling IT 2660 Income tax: definition of royalties , at paragraph 3, provides that the definition in subsection 6(1) of the ITAA 1936 will apply for all purposes of the ITAA 1936. Paragraph 18 of IT 2660 explains that in this context, the word 'equipment' does not have a narrow meaning, and includes such things as machinery and apparatus. A payment for the rental of confectionary wrapping plant would be a royalty, as would a payment for the hire of a computer. The treatment of income from the leasing of industrial, commercial or scientific equipment as 'royalties' has an extensive history in Australian and international taxation as discussed in Taxation Ruling TR 98/21 Income tax: withholding tax implications of cross border leasing arrangements (paragraphs 15-38) . Equipment leasing has been discussed in various court cases, which led to changes in the definition, but without any suggestion that they impinge upon the meaning intended by the paragraph relating to equipment leasing (TR 98/21, paragraphs 23). Subsection 317(1) in Part X of the ITAA 1936 contains the definition of the term 'tainted royalty income'. The subsection defines the term to mean royalties derived by a company, except where all of the following conditions are satisfied: (a) the royalties are derived in the course of the conduct of a business carried on by the company (b) the entity liable to pay the royalties was not an associate of the company (as defined under subsection 318(2)) (c) either of the following paragraphs applies: (i) the matter or thing in respect to which the royalty income was derived originated with the company (ii) where it did not, the company has substantially developed, altered or improved that matter or thing with the result that its market value was substantially enhanced. Under section 15AB of the Acts Interpretation Act 1901 consideration may be given to use extrinsic material such as the Explanatory Memorandum to the legislation introducing the definition of "tainted royalty income" to confirm the meaning of the phrase. Section 317 of the ITAA 1936 was introduced in the Taxation Laws Amendment (Foreign Income) Bill 1990 . The Explanatory Memorandum for the Bill regarding section 317 states that: Section 317 contains definitions of terms that have general use in Part X. Each defined term is to have the given meaning unless the contrary intention appears. "tainted royalty income" is defined for the purpose of determining passive income in section 446 and is to mean all but certain specified royalties. The exception is for royalties received from unrelated persons in the course of a business carried on by the company in which the company produces or substantially develops or improves the property, information, etc. in respect of which the royalty is paid. The exception would not apply to any royalty received on property, etc. which was acquired by the company and licensed for use by others without any other input from the company [Emphasis added]. In this instance, when a legacy lease reaches the end of its primary term, and if the customer, an unrelated party, chooses to continue leasing the asset: • Company N novates the lease to Company C in consideration for Company C paying the residual value of the asset under the lease, • Title in the underlying asset is transferred to Company C and Company C becomes the lessor during the secondary term, • Company C derives rental income throughout the second term of the lease, and eventually disposes of the asset. Accordingly, the equipment is acquired by Company C from Company N. Although the rental income (royalties) is received from unrelated parties and in the active conduct of a trade or business, the thing (equipment) which is the subject matter of the royalties did not originate with Company C, nor is the equipment altered such that its market value is substantially enhanced. Therefore, the rental income derived by Company C from legacy operating leases during the statutory accounting period ended 30 June 20XX, and from legacy and new operating leases for future periods is "tainted royalty income" for the purposes of Part X of the ITAA 1936. | Summary: Under section 441 of the ITAA 1936 hire-purchase income is treated as interest for the purpose of Part X. As such, Company C's hire-purchase income is 'tainted interest income' for the purposes of: • calculating gross tainted turnover for the tainted income ratio when determining whether the company passes the active income test, and • calculating Company C's notional assessable income should the active income test be breached for the relevant statutory accounting period. | Detailed Reasoning - 'Gross tainted turnover': Section 435 of the ITAA 1936 explains 'gross tainted turnover' for the purposes of Part X and states: '… the 'gross tainted turnover' of a company of a statutory accounting period is so much of the gross turnover of the company of the statutory accounting period as consists of: (a) passive income of the company of the statutory accounting period; or (b) tainted sales income of the company of the statutory accounting period; or (c) tainted services income of the company of the statutory accounting period.' Subsection 446(1) of the ITAA 1936 defines 'passive income' to include 'tainted interest income'. Subsection 317(1) defines 'tainted interest income' which, among other things, means 'interest or a payment in the nature of interest'. In relation to hire-purchase income, section 441 in Part X of the ITAA 1936 provides: ' [Hire-purchase transaction deemed a loan] For the purpose of this Part, in determining whether a company passes the active income test: (a) … (b) income derived under the transaction is to be treated as interest. As provided in the facts, Company C will derive income during the year ending 30 June 20YY and future periods from agreements defined as hire-purchase transactions for Australian income tax purposes, as they contain options for the lessee to purchase the leased equipment at the expiry of the lease. Under section 441 of the ITAA 1936, this income is treated as interest for the purpose of Part X of the ITAA 1936, and is included in "gross tainted turnover" when determining whether the Company C passes the active income test. | Detailed Reasoning - Calculating notional assessable income: Under Division 7 in Part X of the ITAA 1936, an amount is included in a controlled foreign company's (CFC) notional assessable income only if it is an amount to which either section 384 (in respect of a CFC resident in an unlisted country) or section 385 (in respect of a CFC resident in a listed country) of the ITAA 1936 applies. In this instance, Company C is a resident of Z, which is an unlisted country for the purpose of Part X of the ITAA 1936, and section 384 of the ITAA 1936 applies. Paragraph 384(2)(a) of the ITAA 1936 provides that, where an eligible CFC does not pass the active income test in subsection 432(1), the CFC's 'notional assessable income' includes: '… amounts that would be included in its notional assessable income for the eligible period under this Act as modified by Subdivisions B to E [of Division 7] if the only income or other amounts derived by it during the period, and any earlier statutory accounting period, were adjusted tainted income. Section 386 of the ITAA 1936 defines 'adjusted tainted income' to include 'passive income'. 'Passive income' is defined in subsection 446(1) to include 'tainted interest income' derived by the company in the statutory accounting period. Subsection 317(1) defines 'tainted interest income' which means, among other things, 'interest or a payment in the nature of interest'. In relation to hire-purchase income, section 441 in Part X of the ITAA 1936, further states: [Hire-purchase transaction deemed a loan] For the purpose of this Part, in determining whether a company passes the active income test: (a) … (b) income derived under the transaction is to be treated as interest. The Commissioner's view in relation to hire purchase income is provided in the Foreign income return form guide (the Guide) (available on the ATO web site www.ato.gov.au), which explains measures relating to the taxation of foreign income derived by, or attributed to, Australian residents. In Chapter 1, Part 2, section 1, under the heading of Interest income, the Guide states: 'Passive income includes tainted interest income, which is all interest income except for interest derived through an offshore banking unit. It also specifically includes: • amounts in the nature of interest (for example, discounts) • income earned from hire purchase and other property financing transactions • …' Further, the Guide discusses 'adjusted tainted income' in relation to calculating attributable income and at Chapter 2, Part 3, section 1 under the heading 'What is adjusted tainted income?' explains: 'Adjusted tainted income is based on the definition of tainted income used for the active income test. Broadly, it comprises amounts that are either passive income, tainted sales income or tainted services income. The main difference in the definition of tainted income for the active income test and the definition for working out attributable income is that net gains are included in determining the active income test, whereas the entire consideration on disposal of an asset is included when working out attributable income.' Although the treatment of hire-purchase income as 'interest' under section 441 of the ITAA 1936 specifically refers to the treatment being applied in determining whether a company passes the active income test, it is the Commissioner's view that the section applies for the purposes of the whole of Part X, applying a consistent treatment of hire-purchase income throughout the Part, including calculating a CFC's notional assessable income. As provided in the facts, during the year ending 30 June 20YY and future periods Company C will derive income from agreements defined as hire-purchase transactions for Australian income tax purposes. Hire purchase income is treated as interest for the purpose of Part X of the ITAA 1936, and is "tainted interest income" for the purpose of calculating NFTAB's notional assessable income should the active income test be breached for the relevant statutory accounting period.