Taxation Ruling TR 92/11



Ruling: 7. Four conditions to be satisfied before a Division 13 adjustment can be made 8. Four conditions must be satisfied for an adjustment to be made under Division 13 in relation to interest income on a loan made by a resident company to a non-resident company. (subsections 136AD(1) and (2)) 9. These conditions are that: 10. Correspondingly, in relation to a loan received by a resident company from a non-resident company, an adjustment may be made under Division 13 if: 11. The provisions also apply where: The meaning of the term 'loan' 12. The essential character of a loan is the lender's entitlement to repayment, at some time in the future, of the property lent. The fact that interest is not payable in respect of a supply of funds would not, of itself, lead to the conclusion that the funds are not supplied under a loan agreement. The meaning of the term 'agreement' 13. The term 'agreement' is given a very wide meaning. The expression is sufficiently wide, for example, to include an implied understanding whereby balances due from one company to another are left uncollected by the creditor company over a substantial period of time. (Subsection 136AA(1)) Provision of property under an 'international agreement' 14. Property is treated as provided under an international agreement in relation to a loan if property is provided, for example, by a resident company to a non-resident company for use in an offshore business. The provision of property by a non-resident company to a resident company under a loan agreement will also constitute a supply of property under an international agreement. (section 136AC) 15. The property may be supplied between related parties such as a parent company and a subsidiary or between unrelated companies. Supply of property 16. The term 'supply' is defined in wide terms to include 'provide, grant or confer'. The term 'property' is also given a wide meaning and includes the supply of services. The expression 'supply of property' is therefore wide enough to cover the case where a benefit is 'provided, granted or conferred' by one company to another. Where, for example, one company leaves uncollected credit balances it has with another company, and therefore available for the use of the other company, the creditor company has conferred a benefit on the debtor company. (subsections 136AA(1) and (3)) 17. Representations have been made that: 18. These propositions are not accepted. The definition of the expression 'supply of property' to include a benefit conferred is a clear indication of the legislative intent to give that expression the broadest meaning consistent with the purpose of Division 13. Arm's length dealing 19. The mere fact that two parties to an agreement are associates will not be determinative in concluding that they were not dealing at arm's length. On the other hand, there could be instances where dealings between unrelated parties could be on non-arm's length terms. (Paragraphs 136AD(1)(b), 136AD(2)(b) and 136AD(3)(b).) 20. In the case of a loan to a company, the question whether a particular dealing can be regarded as being on an arm's length basis would be determined by having regard to what terms an arm's length supplier of funds might seek if approached to supply funds to that company under the same circumstances. Arm's length consideration 21. Representations have been made that an adjustment to income should not be made in respect of a loan granted by a resident parent company to a non-resident subsidiary because the parent company receives immediate and adequate compensation in the form of an increase in the value of the shares it holds in the subsidiary. 22. This proposition is not accepted as it would make Division 13 inapplicable to non-arm's length transactions between a parent resident company and a non-resident subsidiary despite the clear purpose of the legislation as set out in the Explanatory Memorandum and the Second Reading Speech. In this connection it is important that the emphasis in paragraphs 136AA(3)(c) and (d) is on the consideration in respect of the particular transaction that falls within the terms of the Division. 23. Where, for example, an arm's length lender would have received a regular interest payment throughout the life of a loan, Australian revenue would lose if assessable income is to be recognised only if and when dividends are actually distributed. Group company transactions 24. We do not accept the view that because interest free finance arrangements are common between members of multinational enterprises, they should be regarded as arm's length arrangements. Nor should it be concluded that a transaction is on arm's length terms simply because it is a transaction that can only be entered into between related parties. The fact that arm's length parties would not have entered into similar agreements will, in most cases, confirm the non-arm's length nature of the dealings between the parties. Non-availability of comparable transactions 25. Representations have also been made that, in the case of some transactions between members of a company group, it would not be possible to arrive at an arm's length consideration. It is stated that this is because similar transactions would not occur between unrelated parties and that Division 13 should not apply in these cases. 26. This argument is not accepted. Where an arm's length consideration cannot be ascertained, the legislation permits the Commissioner to determine an arm's length consideration on the information available. (subsection 136AD(4)) Division 13 adjustments and penalties 27. Representations have been made that Division 13, like Part IVA, is an anti-avoidance provision that carries with it stringent penalties and that the Commissioner should therefore apply it only where there is a clear purpose of tax avoidance. 28. However, as explained earlier, the primary purpose of Division 13 is to redress a situation where Australian revenue is denied its appropriate share of tax because of the non-arm's length nature of some transactions. 29. The proposition that Division 13 should only be applied very selectively, in view of the penalties that attach to an adjustment made under that Division, is not accepted. Penalties will not be taken into account as a factor in determining whether the provisions of Division 13 are to be applied. 30. It must be emphasised that the legislation contains provisions that enable the Commissioner to reduce penalties in the appropriate circumstances. The ATO's guidelines on penalties in relation to adjustments made under Division 13 of the ITAA 1936 are set out in Taxation Ruling TR 98/16. Business purpose 31. An Australian entity may have a business purpose for granting an interest free loan to an offshore subsidiary. However, that in itself is not adequate to take the transaction outside the ambit of Division 13. 32. For example, an Australian parent may grant an interest free loan to an offshore subsidiary to enable it to accumulate profits for reinvestment. Where this is the purpose of the loan, Division 13 would be applied to attribute interest to the Australian parent even though there was a business purpose to the transaction. 33. However, in certain special cases, business purpose may be relevant in the exercise by the Commissioner of the discretion not to apply Division 13 to particular transactions. An example would be the case where the Commissioner decides that it would be appropriate not to apply Division 13 on the basis that a particular contribution of funds may be treated as equivalent to equity (see paragraphs 51-61). Tax saving purpose and effect 34. Where a particular transaction has the effect of shifting profits out of Australia, the provisions of Division 13 could apply to adjust the tax liability having regard to the arm's length consideration. 35. It is not necessary that there be a tax saving purpose to the transaction for Division 13 to apply to it. However, where there is such a purpose, it could be expected that Division 13 would be applied. 36. The scope of Division 13 is not limited to cases where profits that would have arisen to an Australian entity are moved offshore to another entity. It would apply equally to cases where the Australian entity does not receive offshore income that would ordinarily be expected to be received in an arm's length transaction. 37. [Omitted]. 38. [Omitted]. 39. [Omitted]. 40. [Omitted]. 41. As in the case of loans, Division 13 could apply to credit facilities or intercompany credit balances for which the creditor company is not adequately compensated. 42. Representations have been made that a clear distinction should be drawn between: 43. In either case, it is common ground that the non-resident company has to repay the credit balance to the resident company. It is argued, however, that in the second case, there is no supply of property by the resident company under an international agreement. 44. This distinction is not fundamental to the application of Division 13 to attribute income to the resident company in relation to the credit balances it holds with the non-resident company. 45. The term 'agreement' has been given a very wide meaning in Division 13 and would include an implied 'understanding' by a creditor company to leave uncollected for a definite or undefined period credit balances that it holds with the debtor company. Where that understanding is between a resident company and a non-resident company, the understanding will constitute an international agreement. 46. Moreover, 'supply' is defined to include a reference to agreeing to supply. (paragraph 136AA(3)(a)) 47. A supply of property will include, by definition, the supply of services. The definitions of 'supply' and 'services' interact to include as the supply of services the conferment of a benefit by one company on another. The benefit, in this case, would be the facility provided by the resident company to the non-resident of having the use of the credit balances due to the resident company. The practical effect of this facility is such that an arm's length creditor who provides a similar facility would require that consideration be paid. (subsection 136AA(1)) 48. The benefit provided by making available the use of a credit balance without adequate consideration is of the same nature as the benefit provided by granting an interest free loan. In either case, the arm's length interest would be the correct measure of the value of the benefit. 49. In this context, it is relevant that the Report of the OECD Committee on Fiscal Affairs, 1979, Transfer Pricing and Multinational Enterprises, recognises at pages 90-91 that it is normal for tax authorities to impute interest on intercompany indebtedness arising from the non-payment of accounts for periods in excess of that allowed to third parties under normal trade practice. 50. Accordingly, in determining whether Division 13 could apply to enable the Commissioner to make adjustments to the income or expenses of a resident, it would not be necessary to determine whether a credit balance held by a resident company with a non-resident constitutes a 'loan' provided by the resident or indebtedness that arose in any other circumstances. In either case, Division 13 enables an appropriate adjustment to be made having regard to an arm's length consideration. 51. 52. Representations have been made that before Division 13 can be applied to attribute arm's length interest on a loan, it is necessary to determine whether an agreement that is in legal form a loan agreement is, in essence, a contribution to equity. 53. Reference has been made, in this connection, to page 86 of the Report of the OECD Committee on Fiscal Affairs, 1979, Transfer pricing and Multinational Enterprises . The report points out that 'since for tax and other reasons equity contributions may be disguised as loans, a distinction has to be made between the two. Where it is determined that a financial transaction is a contribution to the equity of an enterprise, it follows that no interest is due'. 54. The OECD report acknowledged at page 89 that 'A hard and fast debt-equity rule would, however, not be appropriate for the solution of problems raised by the determination of the nature of a financial transaction'. It is recommended that 'a flexible approach be adopted in which the special conditions of each individual case would be considered'. This was because of the perception that 'financing practices differ too widely from one country to another and, within a given country, between different categories of enterprises'. 55. The question whether a loan, credit facility or credit balance is the equivalent of an equity investment is relevant at the stage where the Commissioner exercises the discretion whether or not to impute an arm's length consideration under Division 13. 56. In a resolution of this issue under Australian income tax law, the starting point would always be that a transaction would be taken to be a loan or a contribution to equity capital depending on the legal relationship that is established between the provider of funds and the recipient. 57. Where the legal relationship established in a transaction is that between a creditor and a debtor, it could generally be expected that Division 13 would be applied to attribute an arm's length consideration. 58. Where the agreement relating to the contribution provides for the payment or accumulation of interest, the agreement could generally be expected to be treated as a loan agreement. 59. In recommending a flexible approach, the OECD at pages 86-89 acknowledges that a number of countries use quite different criteria. It also recognises that, as a practical matter, some countries may be less concerned about the distinction between debt and equity than others. In this regard, the context in which the distinction is required is important. This includes: 60. In the context of applying Australia's transfer pricing rules, the principal factors that will be taken into account in determining whether a particular loan agreement should be treated as equivalent to a contribution to equity are detailed below. 61. While these and other factors will be of relevance, what is important is the total picture that emerges from the transaction. The taxpayer would have to establish that the transaction that bears the legal character of a loan is equivalent to a contribution to equity. 62. Interaction between Division 13 and the tax treaties 63. The 'Associated Enterprises' article of a tax treaty applies in the case of companies to parent and subsidiary companies and companies under common control. It authorises the taxation authority to adjust the profits of associated enterprises for taxation purposes where: 64. The adjustment to profits is made on the basis of the profits that might have been expected to accrue to an enterprise if the associated enterprises were independent enterprises dealing wholly independently with one another. 65. When an adjustment is made under this article by one state to increase the profits of a company resident in that state, the treaty may provide for an adjustment to be made by the other state to the tax charged on the associated company that is a resident of that other state. However, the OECD Commentary points out that an adjustment has to be made in the other state only if it is justified both in principle and as regards the amount. 66. Where Australia increases the profits of a company under this article, the treaty partner country may adjust the tax charged on the associated company by reducing the profits of the associated company that are taxed in the treaty partner country. 67. Some tax treaties provide that where Australia increases the profits of a company (Company A) by an amount under this article, the treaty partner country is to treat the corresponding profits of the associated company (Company B) as sourced in Australia and provide a credit to Company B for the Australian income tax paid on those profits by Company A. An example of this type of adjustment is Article 22 of the Australia/United Kingdom Convention. 68. Subsection 3(2) of the International Tax Agreements Act 1953 provides that a reference in an Agreement to profits of an activity or business shall, in relation to Australian tax, be read, where the context permits, as a reference to taxable income derived from that activity or business. 69. Paragraph 1 of each of the associated enterprises articles refers to conditions 'operative between the two enterprises in their commercial or financial relations which differ from those which might be expected to operate between independent enterprises dealing at arm's length with one another'. This indicates clearly that the adjustment to profits would include an adjustment to attribute an arm's length consideration for loans that are not on arm's length terms. It would also include an adjustment to profits to deny or reduce a deduction for the payment of excessive interest. 70. In the case of a transaction between a resident company and a subsidiary that is a resident of a treaty partner country, the Commissioner may apply either the provisions of Division 13 or the treaty provisions. However, where the application of Division 13 would produce a result that is inconsistent with the treaty provisions, the treaty provisions will prevail. 71. This conclusion flows from the fact that section 4 of the International Tax Agreements Act 1953 provides that the ITAA 1936 is incorporated and shall be read as one with that Act. This is subject only to the provisions of the International Tax Agreements Act 1953 having effect notwithstanding anything contained in the ITAA 1936 (other than Part IVA) or in an Act imposing Australian tax. 72. It is generally unlikely that the application of Division 13 would produce a result that is inconsistent with the treaty provisions. This is because the treaties as well as Division 13 adopt arm's length considerations as the basis on which adjustments are made. 73. The argument has been made that, in determining whether interest is to be attributed to a parent company on an arm's length basis in relation to a loan granted to a subsidiary, it is necessary in the case of treaty countries to take into account potential or actual dividend flows from the subsidiary to the parent. 74. This argument is not accepted. 75. The OECD Commentary on Article 9, Associated Enterprises, of the OECD Model Convention itself envisages that adjustments may be of two types: 76. It is clear that the Article provides for adjustments to: 77. The Article, therefore, envisages adjustments to the primary profits without taking into account potential dividend distributions out of those profits. 78. This approach is consistent with the well established principle that the taxable income of a company is calculated separately for each income year. 79. The approach is also consistent with the making of adjustments under Article 9 to profits to avoid the adverse consequences to revenue that would flow from a deferral, indefinite or otherwise, of the payment of dividends. 80. 81. Division 13 has application to non-arm's length arrangements where: 82. The comparison in either case is that between: 83. All the relevant facts and circumstances will be taken into account in determining the arm's length consideration in relation to a loan. These would include: 84. The comparable uncontrolled pricing method will usually be the preferred method for determining the arm's length consideration. 85. Interest rates applicable to arm's length Eurocurrency term loans to corporate borrowers are usually calculated using the London Inter Bank Offered Rate (LIBOR) as the basic rate plus a margin that reflects the credit standing of the borrower. 86. The Singapore Inter Bank Offered Rate (SIBOR) is the usual reference rate for Asian currency loan facilities. This is again a basic rate and a margin may be added to reflect the credit standing of the borrower. 87. For Australian dollar loans, an analysis of the facts of a particular case will be required to determine which market interest rate is the appropriate reference rate. 88. The OECD publishes financial statistics of member countries, including prime rates and rates applicable to short and long term bank loans. These lending indicators offer some guidance on whether an interest rate is, on first analysis, likely to fall within an acceptable range of arm's length rates. However, these rates will not be determinative and a full analysis of the circumstances of the agreement will be required to compute the arm's length consideration in respect of the agreement. 89. A taxpayer may have borrowed funds from an independent third party specifically to on-lend to the party to the international agreement on interest free or low interest terms. In this case, the interest rate chargeable by the third party on the borrowed funds will be relevant to the calculation of the arm's length terms. However, adjustments to the interest rate may be required to reflect the other factors listed at paragraph 83. 90. Deferral or non-payment of interest may be considered arm's length where interest had been paid in the past and because of financial difficulties of the borrower circumstances arose where arm's length lenders would, in the circumstances, have deferred or forgone the payment of interest. This would be expected to relate to a desire on the part of the lender to preserve repayment of the principal. Non-payment of interest in these circumstances could be demonstrated to be in accordance with the arm's length principle where, for example, other arm's length lenders have deferred receipt of interest. 91. The application of Division 13 is not automatic and requires the exercise of the Commissioner's discretion provided under that Division. 92. In keeping with the legislative purpose of Division 13, it could be expected that the Commissioner's discretion would normally be exercised to attribute income to a resident company if a non-arm's length agreement has resulted in a shifting of income from Australia, regardless of the motive or purpose of the agreement. 93. The application of Division 13 is not automatic and requires the exercise of the Commissioner's discretion provided under that Division. (paragraphs 136AD(1)(d), (2)(d) and (3)(d)) 94. The Explanatory Memorandum states that the discretionary power was vested with the Commissioner to enable him 'to have regard to whether the use of non-arm's length prices has resulted in a shifting of taxable income from Australia'. 95. Taxable income is shifted from Australia if: 96. The application of Division 13 is not limited to agreements that have a dominant tax avoidance purpose. This legislative intent is reflected in the Second Reading Speech on Income Tax Amendment Bill 1982. It was stated that: 97. The Commissioner's discretion would, in keeping with the legislative intent, normally be exercised to attribute income to a resident company if a non-arm's length agreement has resulted in a shifting of income from Australia regardless of the motive or purpose of the agreement. 98. An example of an instance where the Commissioner's discretion would be applied so that no adjustment would be made under Division 13 relates to the cases where the Commissioner decides that it is appropriate not to apply Division 13 to attribute interest income on the basis that the contribution made should be treated as equivalent to equity. Commissioner of Taxation 1 October 1992 Previously released in draft form as EDR 81




What this Ruling is about | Part A: the circumstances in which Division 13 may be applied to impute interest income or to deny deductions for excessive interest expense in relation to loans | Part B: the treatment of credit facilities or inter-company credit balances for which the creditor company is not adequately compensated | Part C: the issues to be taken into account in determining whether an agreement that is in legal form a loan is to be treated as equivalent to a contribution to equity | Part D: circumstances in which adjustments may be made under the Associated Enterprises articles of Australia's tax treaties | Part E: the manner in which arm's length interest will be calculated to determine whether a particular transaction is at arm's length and to attribute an arm's length consideration | Part F: the exercise of the Commissioner's discretion to apply Division | Preamble: This Ruling, to the extent that it is capable of being a 'public ruling' in terms of Part IVAAA of the Taxation Administration Act 1953, is a public ruling for the purposes of that Part. Taxation Ruling TR 92/1 explains when a Ruling is a public ruling and how it is binding on the Commissioner. [ Note: This is a consolidated version of this document. Refer to the ATO Legal Database (http://law.ato.gov.au) to check its currency and to view the details of all changes.] | 2. The Ruling provides guidelines to be applied to the cases discussed and should not be read as a comprehensive document covering all aspects of the application of Division 13 to loans, credit facilities and intercompany credit balances. In providing these guidelines, there is no intention of laying down any conditions to restrict officers in the exercise of any discretion. Each case must be decided on its merits. | 3. The Ruling is stated in relation to companies. The same principles will apply in relation to other entities such as individuals and trusts. | 4. The Ruling does not deal with the special issues arising from the interaction between Division 13 and the calculation of the income of controlled foreign companies and certain non-resident trusts under the accruals tax measures introduced with effect from the 1990-91 income year. Some of these issues were dealt with in Taxation Determination TD 92/103. TD 92/103 was withdrawn with effect for statutory accounting periods of controlled foreign companies commencing after 30 June 1997 following changes made by the Taxation Laws Amendment (Foreign Income Measures) Act 1997 including the insertion of paragraph 400(aa) into the ITAA 1936. [1] | 5. The Ruling does not also deal with financial arrangements within one legal entity (such as between the head office and a branch of the same company), nor does it deal with adjustments to take into account the secondary effects resulting from adjustments to profits. | Date of effect: 6. This Ruling is not concerned with a change in interpretation. Consequently, it applies (subject to any limitations imposed by statute) for years of income commencing both before and after the date on which it is issued. | "the fact that tax saving is not a key purpose of a particular arrangement or transaction is no reason why we, as a nation, should not be in a position to counteract any loss to the Australian revenue inherent in it".


Related rulings: TR 98/16 TD 92/103
Legislative references: ITAA 1936 Div 13 ITAA 1936 136AA(1) ITAA 1936 136AA(3) ITAA 1936 136AA(3)(a) ITAA 1936 136AA(3)(c) ITAA 1936 136AA(3)(d) ITAA 1936 136AC ITAA 1936 136AD ITAA 1936 136AD(1) ITAA 1936 136AD(1)(b) ITAA 1936 136AD(2) ITAA 1936 136AD(2)(b) ITAA 1936 136AD(3) ITAA 1936 136AD(3)(b) ITAA 1936 136AD(4) ITAA 1936 Pt IVA ITAA 1936 400(aa) International Tax Agreements Act 1953 3(2) International Tax Agreements Act 1953 Sch 1 Art 22 Taxation Laws Amendment (Foreign Income Measures) Act 1997
Subject references: arm's length consideration arm's length interest arm's length transactions Article 9 associated enterprises comparable uncontrolled pricing credit facilities equity investment excessive interest impute interest interest free loans intercompany credit balances international agreements international transactions loan agreements loans multinational enterprises supply of property transfer pricing