Private ruling: Financial Institution for the purposes of the Australia-OverseasTaxation Convention
Published: November 2014
Ruling period: 1 July 2014 to 30 June 2018

Ruling: Q1: Does the taxpayer qualify as a 'financial institution' for the purposes of Article 11(3)(b) of the Convention between the Government of Australia and the Government of the Overseas country for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital Gains [2003] ATS 22 (Convention)? | A1: Yes

Relevant facts and circumstances: The taxpayer is a wholly owned (indirect) subsidiary of Bank, and is part of Bank's group of companies. The taxpayer is a resident of the overseas country for Australian and overseas tax purposes. The taxpayer is a financier which is not regulated in the overseas country. It does not carry on a business at or through a permanent establishment in Australia. Financing The taxpayer's funding is principally obtained through loans from Bank. The taxpayer is also financed by equity in the form of fully paid share capital. The intra-group funding arrangements are interest bearing and on commercial terms. Bank is a non-resident financial institution. Its principal activities include the provision of banking, investing, asset management and other financial services to corporate entities and individuals. Bank regularly raises and provides finance to the public as a financier. Business The taxpayer enters into financing arrangements with Australian customers. The revenue split for the taxpayer demonstrates that a substantial proportion of its total revenue is from financing arrangements. The financing arrangements have an obligation for the customer to return to the taxpayer at a later date the funds originally lent pursuant to the agreement. The taxpayer will receive payments that include an interest income component. Assumption The taxpayer is unrelated to, and dealing wholly independently of, the payers from which it derives interest.

Relevant legislative provisions: Convention between the Government of Australia and the Government of the overseas country for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital Gains [2003] ATS 22 Article 11(3)(b) | Income Tax Assessment Act 1997 s ection 974-135

Reasons for decision: Summary: Article 11(3) of the Convention between the Government of Australia and the Government of the overseas country for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income and on Capital Gains [2003] ATS 22 (Convention) provides that: (3) … interest arising in a Contracting State and beneficially owned by a resident of the other Contracting State 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. Based on the above, in order for the taxpayer to be considered a 'financial institution' for the purposes of Article 11(3)(b) of the Convention, the following requirements must be met: • the taxpayer is raising debt finance in the financial markets or by taking deposits at interest; • the taxpayer is using those funds in carrying on a business of providing finance; and • the taxpayer is substantially deriving its profits by doing the above. | Detailed Reasoning - Raising debt finance in the financial markets or taking deposits at interest: The taxpayer is not a regulated entity authorised to take deposits. Therefore in order for the taxpayer to be a 'financial institution' for the purposes of Article 11(3)(b) of the Convention, it must raise debt finance in the financial markets. | Detailed Reasoning - Debt finance: In Taxation Ruling 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 in Australia (TR 2005/5), the Commissioner sets out the requirements to satisfy the definition of 'financial institution' for the purposes of Article 11 of the Convention. It is clear from TR 2005/5 that the use of the term 'debt finance' in paragraph 3(b) of Article 11 of the Convention requires a particular type of financing. 'Debt finance' is not defined in the Convention, nor is it a term defined in the Income Tax Assessment Act 1936 or the Income Tax Assessment Act 1997 (ITAA 1997). However, the Commissioner states at paragraph 17 of TR 2005/5 that: [A] US or UK resident is raising debt finance where the funds obtained result in an 'effectively non-contingent obligation' to return an amount at least equal to the amount received. The term 'effectively non-contingent obligation takes on its meaning from section 974-135 of the ITAA 1997. Section 974-135 of the ITAA 1997 states that: (1) There is an effectively non-contingent obligation to take an action under a *scheme if, having regard to the pricing, terms and conditions of the scheme, there is in substance or effect a non-contingent obligation … to take that action. … (3) An obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a *connected entity of that entity), other than the ability or willingness of that entity or connected entity to meet the obligation. The financing arrangements between Bank and the taxpayer are interest bearing and on commercial terms, with the interest rates being applied being calculated on an arm's length basis. The taxpayer has an 'effectively non-contingent obligation' to repay Bank. As such, the taxpayer is raising 'debt finance' from Bank for the purposes of Article 11(3)(b) of the Convention. | Detailed Reasoning - Financial markets: Article 11(3)(b) of the Convention requires that the taxpayer's 'debt finance' be raised in the 'financial markets', which takes on its ordinary commercial meaning. At paragraph 72 of TR 2005/5, the Commissioner states that 'financial markets' means 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). However, an issue that arises is whether raising debt finance from a related party within a group is considered as raising 'debt finance in financial markets'. The Commissioner states at paragraph 75 of TR 2005/5 that: For the related party lender to form part of the financial markets it needs to show that it regularly provides finance to the public as a financier. Where the enterprise raises funds from a related party that regularly provides finance to the public as a financier, the enterprise will be taken to have raised its debt finance in the financial markets if it raises such funds on normal commercial terms. Bank is a financial institution and regularly raises and provides finance to the public as a financier. As the finance obtained from Bank by the taxpayer is on normal commercial terms, the finance raised by the taxpayer from Bank is 'debt finance raised in the financial markets'. | Detailed Reasoning - Using those funds in carrying on a business of providing finance: In order for the taxpayer to satisfy the definition of 'financial institution', it is not sufficient that it merely raise debt finance in the financial markets. Paragraph 3(b) of Article 11 of the Convention requires that the funds raised by the taxpayer from Bank be used to carry on a business of 'providing finance'. The Commissioner states at paragraph 88 of TR 2005/5 that the "requirement of using those funds will be satisfied where these activities are undertaken concurrently in carrying on a business". Given that the finance obtained by the taxpayer from Bank occurs at the same time that the taxpayer is providing finance to its customers, the requirement of 'using those funds' will be satisfied. | Detailed Reasoning - Providing finance: The definition of 'providing finance' is broader than lending of funds. It 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 (paragraphs 90-91 of TR 2005/5). The Commissioner states at paragraph 92 of TR 2005/5 that: [T]he leasing of an asset under a finance lease, or the lending of a security under a security lending arrangement may also constitute the provision of finance under the Convention where there is an obligation to return those assets or securities at a later date. However, these financing transactions must generate payments in the form of interest under Article 11(5) of the Convention, which defines interest as "income from debt-claims of every kind" but does not include dividends per Article 10 of the Convention. The financing arrangements have an obligation for the borrower to return to the taxpayer at a later date the funds originally lent pursuant to the agreement. Under the financing arrangements, the taxpayer will receive payments that include an interest income component. As such, the financing activities undertaken by the taxpayer are 'providing finance' for the purposes of Article 11(3)(b) of the Convention. | Detailed Reasoning - Carrying on a business: The definition of 'financial institution' also requires that the taxpayer be 'carrying on a business' of providing finance. The courts have held that a range of factors or indicators are relevant in determining whether a business is carried on. At paragraph 95 of TR 2005/5 the Commissioner states that these factors, which are considered in Taxation Ruling TR 97/11 Income tax: am I carrying on a business of primary production? (TR 97/11), should be relied upon in determining whether the enterprise is "carrying on a business" of providing finance. Paragraph 13 of TR 97/11 contains the relevant indicators, which 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 a purpose of profit as well as a prospect of profit from the activity; • whether there is repetition and regularity of the activity; • whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business; • whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at making a profit; • the size, scale and permanency of the activity; and • whether the activity is better described as a hobby, a form of recreation or a sporting activity. The Commissioner states at paragraph 16 of TR 97/11 that the indicators must be considered in combination and as a whole. Based on a consideration of the indicators listed above, the taxpayer is 'carrying on a business' of providing finance. | Detailed Reasoning - Substantially deriving its profits: In order for an enterprise to be a 'financial institution', it must be 'substantially deriving its profits' from raising debt finance in the financial markets and using those funds in carrying on a business of providing finance. The Commissioner is of the view (at paragraph 99 of TR 2005/5) that: [W]hen the word 'substantially' is used in the context of an enterprise substantially deriving its profits from 'spread activities', it is also used in a relative sense. The relevant term 'substantially' when used in conjunction with 'deriving profits', requires that the main source of the enterprise's profits be derived from its business of undertaking 'spread activities'. Or, in other words, while these activities do not need to be the taxpayer's sole activity, they need to constitute its main activity when compared to any other activity that it undertakes. In the relevant income year, a substantial proportion of the taxpayer's revenue was attributable to financing arrangements. Further, all of the taxpayer's debt funding is obtained from Bank on interest-bearing loans made on normal commercial terms. As such, the taxpayer is 'substantially deriving its profits' from raising debt finance in the financial markets and using those funds in carrying on a business of providing finance for the purposes of Article 11(3)(b) of the Convention. Based on the above, the taxpayer is a 'financial institution' for the purposes of Article 11(3)(b) of the Convention as it meets the requirements set out in that Article under the definition of 'financial institution'.