Private ruling: Payments of interest
Date of advice: 26 June 2015
Published: June 2015
Ruling period: 1 January XXXX to 31 December XXXX
Date scheme commenced: 1 January XXXX

Ruling: Q1: Is HoldCo, for the purposes of the Convention between the Government of Australia and the Foreign Country for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income [1983] ATS 16 and Protocol [2003] ATS 14 ("Australia/ Foreign Treaty"), a resident of the Foreign Country taken to be deriving and beneficially entitled to payments of interest on loans made by AusCo to FinCo? | A1: Yes. | Q2: Does HoldCo satisfy the requirements of the limitation on benefits provisions (Article 16) of the Australia/ Foreign Treaty? | A2: Yes. | Q3: Does HoldCo constitute a 'financial institution' within the meaning of Article 11(3) of the Australia/Foreign Treaty? | A3: Yes.

Relevant facts and circumstances: Entities FinCo is a limited liability company ("LLC") that was organised and registered in the Foreign Country. FinCo raises funds in its own name through the issue of commercial paper. FinCo is a wholly owned subsidiary of HoldCo which is a corporation that was incorporated and registered in the Foreign Country. HoldCo is wholly owned by UltimateHoldCo which is a corporation that was incorporated and registered in the Foreign Country. UltimateHoldCo is wholly owned by an individual ("Individual Owner") who is a citizen of the Foreign Country. FinCo and HoldCo are controlled and managed from the Foreign Country. Neither FinCo nor HoldCo conducts any business activities in Australia. HoldCo does not engage in any income producing activities other than holding its interests in FinCo. Neither FinCo nor HoldCo will have an office, branch or agent with general authority to enter into contracts on their behalf in Australia. Foreign treatment FinCo has elected to be a 'disregarded entity' for foreign tax purposes. FinCo is not a Foreign corporation for Foreign tax purposes. FinCo does not file income tax returns in the Foreign Country. HoldCo is a corporation that is treated as a resident of the Foreign Country for Foreign tax purposes. HoldCo files a tax return in the Foreign Country inclusive of all of FinCo's income and expense items due to the fact that FinCo is disregarded as an entity separate from HoldCo for tax purposes. UltimateHoldCo is a resident of the Foreign Country for the Foreign tax law purposes. Individual Owner is a resident of the Foreign Country for Foreign tax law purposes. Activities FinCo's gross profits over the last three financial years have substantially been obtained through the issuing of debt instruments and using the funds raised from such issues to provide funding to other entities. The percentage of HoldCo's gross income for a taxable year (excluding arm's length payment for services) that to date has been and going forward will be paid to persons that are residents neither of the Foreign Country nor Australia and deductible for the purposes of Foreign Country's tax law will be less than 50%. Neither FinCo nor HoldCo are registered as a bank or a bank holding company in the Foreign Country. The Foreign federal banking regulations do not apply directly to FinCo or HoldCo. Proposed transaction FinCo intends to issue commercial paper in the Foreign Country through private placements with commercial paper dealers. The commercial paper will be issued on market terms. The commercial paper issue will fund the purchase of Australian Notes by FinCo from AusCo, an Australian tax entity. The Australian Notes will be issued on ordinary market terms. Assumptions For the purposes of this Ruling, the Commissioner is asked to assume the following: • The Australian Notes will constitute 'debt interests' within the meaning of Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997) or that, if they are not 'debt interests', they will not be 'equity interests' for the purposes of that Division. • FinCo will not be paid interest on the Australian Notes in the capacity as agent, nominee, fiduciary or administrator.

Relevant legislative provisions: The Convention between the Government of Australia and the Government of the Foreign Country for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income [1983] ATS 16 and Foreign Protocol (No 1) [2003] ATS 14 Articles 1, 3, 4, 11 and 16. Income Tax Assessment Act 1997 Division 974. Income Tax Assessment Act 1997 section 974-135.

Reasons for decision: Summary: Article 11 of the Australia/Foreign Treaty states: (1) Interest arising in one of the Contracting States, being interest to which a resident of the other Contracting State is beneficially entitled, may be taxed in that other State. (2) However, that interest may also be taxed in the Contracting State in which it arises, and according to the law of that State, but the tax so charged shall not exceed 10 percent of the gross amount of the interest. However, Article 11(3) of the Australia/Foreign Treaty states that: (3) Notwithstanding paragraph (2), interest arising in one of the Contracting States to which a resident of the other Contracting State is beneficially entitled may not be taxed in the first-mentioned State if: … (b) the interest is derived by a financial institution which is unrelated to and dealing wholly independently with the payer. For the purposes of this Article, the term "financial institution" means a bank or other enterprise substantially deriving its 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. Article 1(1) of the Australia/Foreign Treaty provides that: Except as otherwise provided in this Convention, this Convention shall apply to persons who are residents of one or both of the Contracting States. Article 4(1)(b)(i) of the Australia/Foreign Treaty states that a person is a resident of the Foreign if the person is a 'Foreign corporation'. FinCo is a disregarded entity for Foreign tax purposes. Accordingly, under Article 4(1)(b)(i) of the Australia/Foreign Treaty, FinCo is not a Foreign corporation. Therefore, under Article 1(1) of the Australia/Foreign Treaty, FinCo is not a resident for the purposes of the Australia/Foreign Treaty. However, HoldCo is a corporation that was incorporated and registered in the Foreign Country and is treated as a resident of the Foreign Country for Foreign tax purposes. Therefore, HoldCo is a Foreign corporation and a resident of the Foreign Country for the purposes of the Australia/Foreign Treaty. | Detailed Reasoning - Interest is derived by HoldCo: ATO Interpretative Decision ATO ID 2013/58 Interest withholding tax: Australian interest income paid to a single owner Foreign limited liability company disregarded as an entity separate from its owner explains that Article 11(3)(b) of the Australia/Foreign Treaty can apply to Australian interest paid to a single owner LLC that is incorporated in the Foreign where it: (a) is a disregarded entity; and (b) substantially derives its 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; and (c) is owned by a US Corporation which is a resident for the purposes of the Australia/FOREIGN Treaty and undertakes no other activities provided all the other requirements in Article 11 are satisfied. However, FinCo, being an LLC, is still a taxable entity for the purposes of Australian tax law even though it is a disregarded entity for Foreign tax law purposes. In dealing with this inherent problem, ATO ID 2013/58 refers to paragraph 6.3 of the 2010 OECD Commentary on Article 1 of the OECD Model Tax Convention which states the following: "…the State of source should take into account, as part of the factual context in which the treaty is to be applied, the way in which an item of income, arising in its jurisdiction is treated in the jurisdiction of the person claiming the benefits of the Convention as a resident." This comment relates to partnerships. However, the principle is also applicable to Foreign LLCs, which under Australian tax law are taxed like companies, while the Foreign Country, for Foreign tax law purposes, disregards the LLC and instead treats the income of the LLC as the income of the owner and imposes tax on the owner accordingly. Thus, in applying the Australia/Foreign Treaty, Australia should take into account the Foreign treatment of the interest paid to the LLC where necessary in order to give effect to the object and purpose of a treaty. Pursuant to ATO ID 2013/58, Australia may give due recognition to the fact that under Foreign tax law, the activities and income of the LLC are treated as the activities and income of the Foreign resident owner. Payments of interest on the Australian Notes in this case will be made by AusCo to FinCo. HoldCo files a tax return in the Foreign Country on the basis that FinCo is a disregarded entity and is owned by HoldCo. As FinCo's activities including income will be treated as that of HoldCo's pursuant to Foreign tax law, for the purposes of the Australia/Foreign Treaty, it can be accepted that the interest income is income to which HoldCo has derived. | Detailed Reasoning - Beneficial entitlement: Article 11 of the Australia/Foreign Treaty only applies to a resident where the interest derived by the resident of the Contracting State is interest to which the resident is beneficially entitled. However, Article 11(3) of the Australia/Foreign Treaty states that, subject to the other requirements of the Australia/Foreign Treaty, interest arising in one of the Contracting States to which a resident of the other Contracting State is beneficially entitled may not be taxed in the first-mentioned State. While the interest is derived by FinCo and in turn HoldCo, it may not however, necessarily follow that HoldCo is beneficially entitled to the interest for the purposes of the Australia/Foreign Treaty. In relation to the beneficial ownership requirement in Article 11 of the Australia/Foreign Treaty, the 2010 OECD Commentary on the Model Tax Convention states: 9. The requirement of beneficial ownership 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 immediately received by a resident of a State with which the State of source had concluded a convention. The term "beneficial owner" is not used in a narrow technical sense, rather, it should be understood in its context and in light of the object and purposes of the Convention, including avoiding double taxation and the prevention of fiscal evasion and avoidance. 10. Relief or exemption in respect of an item of income is granted by the State of source to a resident of the other Contracting State to avoid in whole or in part the double taxation that would otherwise arise from the concurrent taxation of that income by the State of residence. Where an item of income is received by 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 immediate recipient of the income as a resident of the other Contracting State. The immediate recipient in this situation qualifies as a resident but no potential double taxation arises as a consequence of that status since the recipient is not treated as the owner of the income for tax purposes in the State of residence. Similar commentaries are set out in the 2014 OECD Commentary on the Model Tax Convention. In this case, neither FinCo nor HoldCo are required to hold the interest income received on trust, as agents, as nominees, mere fiduciaries or administrators or in any other capacity that limits their rights to apply the income for their own purposes. Thus, it cannot be said that there is a restriction on the ability of FinCo (or HoldCo, to whom the income is attributed) to utilise the interest income for their own purposes. Therefore, it is considered that HoldCo would in this case be 'beneficially entitled' to the interest income for the purposes of applying the Australia/Foreign Treaty. | Detailed Reasoning - Conclusion: For the purposes of the Australia/Foreign Treaty, HoldCo is a resident of the Foreign Country taken to be deriving and beneficially entitled to payments of interest on the Australian Notes made by AusCo to FinCo. | Detailed Reasoning - Question 2: Article 16(1) of the Australia/Foreign Treaty provides: A resident of one of the Contracting States that derives income from the other Contracting State shall not be entitled to the benefits of this Convention otherwise accorded to residents of one of the Contracting States unless such resident is a "qualified person" as defined in paragraph (2). Article 16(2) of the Australia/Foreign Treaty defines 'qualified person' to include: (a) an individual; … (g) a person other than an individual, if (i) on at least half the days of the taxable year persons that are qualified persons by reason of sub-paragraph (a), (b), (c)(i), or (d)(i) of this paragraph own, directly or indirectly, at least 50 percent of the aggregate vote and value of the shares or other beneficial interests in the person; and (ii) less than 50 percent of the person's gross income for the taxable year is paid or accrued, directly or indirectly, to persons who are not residents of either Contracting State in the form of payments that are deductible for purposes of the taxes covered by this Convention in the person's State of residence (but not including arm's length payments in the ordinary course of business for services or tangible property and payments in respect of financial obligations to a bank, provided that where such a bank is not a resident of one of the Contracting States such payment is attributable to a permanent establishment of that bank located in one of the Contracting States); Articles 3(1)(a) and 1(b) of the Australia/Foreign Treaty provides that the term 'person' includes 'a company' which means "any body corporate or any entity which is treated as a company or body corporate for tax purposes". As HoldCo is a corporation for the purposes of the Foreign tax law, it is considered to be 'a person other than an individual' for the purposes of Article 16(2) of the Australia/Foreign Treaty. The test under Article 16(2)(g)(i) of the Australia/Foreign Treaty requires that 50% or more of the aggregate voting power and value of the person be owned directly or indirectly on at least half of the days of the person's taxable year by persons who are themselves qualified persons under Articles 16(2)(a), 16(2)(b), 16(2)(c)(i) or 16(2)(d)(i) of the Australia/Foreign Treaty . HoldCo is and in the future will be, indirectly wholly owned by Individual Owner (through UltimateHoldCo which is directly wholly owned by Individual Owner). Article 16(2)(g)(i) of the Australia/Foreign Treaty is thus satisfied as the Individual Owner is a person that is a qualified person under Article 16(2)(a) of the Australia/Foreign Treaty, who indirectly wholly owns HoldCo. Article 16(2)(g)(ii) of the Australia/Foreign Treaty effectively disqualifies a person that meets the requirement in Article 16(2)(g)(i) of the Australia/Foreign Treaty if 50% or more of the unlisted entity's gross income for the taxable year is paid or accrued (directly or indirectly) to a person or persons who are not residents of either the Foreign Country or Australia, in the form of payments deductible for tax purposes in the payer's state of residence. FinCo is disregarded for Foreign tax purposes and its income will be treated as income of HoldCo. Additionally HoldCo also files Foreign tax returns that reflect the activities of FinCo. As the percentage of HoldCo's gross income for a taxable year that, excluding arm's length payment for services, has been paid to persons that are residents neither of the Foreign Country nor Australia and deductible for the purposes of the Foreign tax law is and in the future will be less than 50%, Article 16(2)(g)(ii) is satisfied. | Detailed Reasoning - Conclusion: Based on the facts provided by HoldCo, HoldCo satisfies the requirements to be a 'qualified person' under Article 16(2) of the Australia/Foreign Treaty. | Detailed Reasoning - Question 3: Paragraph 38 of Taxation Ruling TR 2005/5 Income tax: ascertaining the right to tax (Foreign) and United Kingdom (UK) resident financial institutions under the foreign and the UK Taxation Conventions in respect of interest income arising in Australia provides that, for the purposes of Article 11(3)(b) of the Australia/Foreign Treaty, the definition of 'financial institution' is: …a bank or other enterprise substantially deriving its 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. In other words, in order for HoldCo to meet the definition of financial institution pursuant to Article 11(3)(b) of the Australia/Foreign Treaty, HoldCo must be a bank or other enterprise as defined in Article 11(3)(b) of the Australia/Foreign Treaty. As discussed above, in the case of Foreign disregarded entities, it is accepted that the activities of the disregarded entity will be treated as part of those of the single owner. In this case, HoldCo does not conduct any other activities other than holding its interests in FinCo. Accordingly, HoldCo will satisfy the financial institution requirement if FinCo satisfies the financial institution requirement. A bank Paragraph 12 of TR 2005/5 provides that a 'bank' means a Foreign Country resident that is authorised or licensed to carry on a banking business in the Foreign. FinCo is not registered or regulated as an authorised deposit taking institution in Australia or as a bank in the Foreign Country. Therefore, FinCo is not a 'bank' for the purposes of Article 11(3)(b) of the Australia/Foreign Treaty. | Detailed Reasoning - Other enterprise: Consequently, in order to be classified as a 'financial institution' for the purposes of Article 11(3)(b) of the Australia/Foreign Treaty, FinCo must satisfy the definition of 'other enterprise'. Paragraph 15 of TR 2005/5 provides that 'other enterprises' are "those residents of the Foreign Country…that are not classified as banks". 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'. In TR 2005/5, these activities are collectively referred to as 'spread activities'. | Detailed Reasoning - Raising debt finance: Paragraph 65 of TR 2005/5 requires that when applying the phrase 'raising debt finance in the financial markets', it must be determined whether the type of financing is 'debt' financing. Paragraphs 67 and 68 of TR 2005/5 state that the test in Division 974 of the ITAA 1997 can be used in determining whether the financing arrangement is 'debt finance' for the purposes of the Australia/Foreign Treaty. Paragraph 69 of TR 2005/5 provides: …Therefore, where it can be concluded that the raising of funds results in an effectively non-contingent obligation, as defined in section 974-135 of the ITAA 1997, to provide an amount at least equal to the amount received, this will constitute 'raising debt finance' for the purposes of the Conventions. FinCo is obligated to pay interest and capital on the commercial paper issued greater than the value of the notes regardless of economic performance. This obligation constitutes an effectively non-contingent obligation on FinCo as defined in section 974-135 of the ITAA 1997. Thus the commercial paper would be debt finance. Therefore, when FinCo raises funds via the issue of commercial paper, this constitutes 'raising debt finance' for the purposes of Article 11(3)(b) of the Australia/Foreign Treaty. | Detailed Reasoning - Financial markets: According to paragraph 72 of TR 2005/5, the meaning of 'debt finance' also needs to be viewed in the context of it being raised in the 'financial markets'. The term 'financial markets', in the context of the phrase 'raising debt finance in the financial markets', takes its ordinary commercial meaning which is: a facility through which: • offers to acquire or dispose of debt finance products are regularly made or accepted (including offering loans); or • offers and invitations are regularly made to acquire or dispose of debt finance products that are intended to result or may reasonably be expected to result in the making (or acceptance) of offers to acquire or dispose of such debt finance products (including offering loans). FinCo intends to issue commercial paper in the Foreign Country through private placements with commercial paper dealers. The commercial paper will be issued on market terms. The issue of the commercial paper by FinCo should be considered to be conducted in a 'financial market' for the purposes of Article 11(3)(b) of the Australia/Foreign Treaty in these circumstances. | Detailed Reasoning - Using the funds in carrying on a business of providing finance: Paragraph 88 of TR 2005/5 states that the Australia/Foreign Treaty requires that funds raised by debt finance must be 'used' to carry on a business of providing finance. Paragraph 89 of TR 2005/5 states that the word 'finance' in 'providing finance' takes its ordinary meaning which is: to supply with means of payment; provide capital for; obtain or furnish credit for. Paragraph 90 of TR 2005/5 continues by saying: The Commissioner considers that the non-resident may provide both debt finance and equity finance. Accordingly, the provision of finance entails the supply or provision of funds or assets with an obligation (either contingent or non-contingent) on the recipient to return the funds or assets in the future. FinCo uses the funds it obtains through commercial paper issues to provide finance. Similarly, FinCo intends to use the funds obtained from the proposed commercial paper issue to purchase the Australian Notes from AusCo on ordinary market terms. Based on the facts, it is reasonable to conclude that FinCo is providing finance for the purposes of Article 11(3)(b) of the Australia/Foreign Treaty. | Detailed Reasoning - Carrying on a business: The activities of providing finance must also be undertaken in such a manner that the resident is considered to be carrying on a business. As the Commissioner recognises at paragraph 95 of Taxation Ruling TR 2005/5, the courts have held that a range of factors or indicators are relevant in determining whether a business is carried on. Some of these factors are discussed in Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? and include: • whether the activity has a significant commercial purpose or character • whether the taxpayer has more than just an intention to engage in business • whether the taxpayer has an intention to make a profit and the prospect of making a profit • the recurring nature of transactions • whether the activity is planned, carried on and organised in a business-like manner. In each case it will be a question of fact whether an entity can be said to be carrying on a business and the conclusion requires weighing all the relevant indicators. Applying each of the indicators to the facts in this case: • FinCo has raised significant amounts of capital which is of a significant commercial character and purpose. • FinCo's financing activities represent more than a mere intention to carry on a business. The duration and scale of its activities also support this factor. • FinCo has gross profits from its spread activities for at least the last three financial years which were obtained through the issuing of debt instruments and using the funds raised from such issues to provide funding to other entities. Paragraph 27 of TR 2005/5 provides that gross profits constitute acceptable accounting indicators for 'profit' in the context of spread profits for the purposes of Article 11(3)(b) of the Australia/Foreign Treaty. • The financing activities of FinCo are recurring. As stated above, for at least the last three financial years, FinCo has been engaged in the issuing of commercial paper and using those funds raised to provide funding to other entities. • The manner in which FinCo conducts its activities demonstrates that the activities of FinCo are planned, carried on and organised in a business-like manner. In view of the above factors, given the nature of the activities conducted by FinCo, it can be said that FinCo is carrying on a business of providing finance for the purposes of Article 11(3)(b) of the Australia/Foreign Treaty. | Detailed Reasoning - Substantially deriving its profits: Paragraph 99 of TR 2005/5 states that the spread activities need only to be the main activity (not the sole activity) of the enterprise in terms of its contribution to overall profits. Paragraph 100 of TR 2005/5 provides that 'profits' includes, among other things, gross profits. FinCo's gross profits have been substantially generated from its spread activities. These assets generate income in the form of interest within the meaning of Article 11(5) of the Australia/Foreign Treaty. These activities have been carried on by FinCo for several years and on a significant scale. Provided these spread activities do not materially change and remain FinCo's main profit generator, FinCo is considered to be substantially deriving profits by raising debt finance in the financial markets and using those funds in carrying on a business of providing finance. | Detailed Reasoning - Conclusion: As FinCo is an enterprise substantially deriving its profits by raising debt finance in the financial markets and using those funds in carrying on a business of providing finance, FinCo satisfies the 'financial institution' definition in Article 11(3)(b) of the Australia/Foreign Treaty. As FinCo's activities are treated as the activities of HoldCo as the owner, HoldCo also constitutes a 'financial institution' within the meaning of Article 11(3) of the Australia/Foreign Treaty.