Tax Brief. 8 September Withholding Tax on Interest Paid to US and UK Financial Institutions - The ATO's Opening Gambit.

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1 Tax Brief 8 September 2004 Withholding Tax on Interest Paid to US and UK Financial Institutions - The ATO's Opening Gambit On 1 September 2004, the ATO issued its preliminary view in the form of Draft Taxation Ruling TR 2004/D16 of the operation of the relatively new interest withholding tax (IWT) exemption in Australia s double tax conventions (DTCs) with the United Kingdom and the United States. This Draft Ruling is in large part an attempt to clarify (and in so doing, circumscribe) the kinds of companies that will qualify as a financial institution for the purpose of the IWT exemption. The scope of the financial institutions exemption has already been the subject of some dispute between the ATO and local advisors; the Draft Ruling is a first step toward obtaining some clarity at least at this end of the transaction. Moreover, there appears to be some real divergence of views between the ATO and the tax authorities of our treaty partners who, it seems, take a more expansive view of the scope of the exemption. This can be seen for example in the US Treasury s Technical Explanation (5 March 2003) of the Protocol, which is discussed more fully later in this Tax Brief. It remains to be seen whether the ATO view expressed in the Draft Ruling will need revision before it is made final whether as a result of industry consultations, or from correspondence with the other tax authorities, or both. Background The Draft Ruling attempts to provide some guidance on the operation of a provision which appears in both the 2003 Australia-UK DTC and in the Protocol to the Australia-US DTC. The text of the provision is identical in both DTCs. It states that (subject to some other conditions) interest paid by an Australian resident to a UK or US resident may not be taxed in Australia if:... 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

2 markets or by taking deposits at interest and using those funds in carrying on a business of providing finance The impact of the article is that no IWT is payable in Australia where these conditions are met. While the Draft Ruling is written to focus on the identity of the non-resident recipient, the principal implications of the Draft Ruling arise for the Australian payer: The Australian resident payer is relieved of its obligation to withhold tax from the gross payment; As a consequence, the Australian resident is no longer exposed to the risk of penalties and the non-deductibility of its interest expense for failing to withhold Australian IWT; Moreover, as IWT will often be passed back to the Australian borrower under the terms of the relevant facility, accessing this exemption can reduce the Australian entity s cost of funds and the amount it needs to pay the nonresident; and Although the Draft Ruling does not address what is meant by the word interest for the purposes of the IWT exemption, both DTCs have an expansive definition of interest that will be applicable for the IWT exemption. This means that dividends paid on certain types of shares that are treated as debt rather than equity for withholding tax purposes should also qualify for exemption from Australian withholding tax. Draft Ruling The Draft Ruling takes the view that the definition of financial institution creates two groups of companies: Banks which need only be banks to qualify for the exemption, and Other enterprises which have to meet all the additional tests in the article to qualify. Banks The Draft Ruling takes the position that, for the purposes of this article, a bank means a US or UK resident that is granted its principal banking licence in its country of residence being respectively the US or the UK to take deposits and make advances, and satisfies the capital adequacy requirements to operate as a bank in that same place of residence. 2Withholding Tax on Interest Paid to US and UK Financial Institutions - The ATO's Opening G

3 Several interesting implications arise from this interpretation: It seems that only the licence-holding company in a banking group will meet the test. Indeed, one of the Examples in the Draft Ruling excludes from being a financial institution a company which is a wholly-owned subsidiary of a US bank; Companies, even US or UK-resident companies, which operate banks in the US or UK but under banking licences issued by other countries will not be entitled to the IWT exemption; and The ATO interpretation requires that the relevant licence is one which authorises the company to take deposits and make advances and that the company meets the capital adequacy requirements to operate as a bank. These limitations seem designed to limit the scope of the exemption to exclude companies which hold other types of license. The Draft Ruling clearly acknowledges that there will be bank-like institutions that won t qualify as banks under this test because they won t hold the appropriate kind of licence or won t be subject to the appropriate capital adequacy rules, and gives as examples US Savings and Loan institutions and UK Building Societies. Companies holding only dealers licenses or insurers licenses would similarly be disqualified. It is important to note, however, that where a company is not a financial institution because it is not a bank as understood by the ATO, it may nevertheless qualify as a financial institution under the other enterprises portion of the financial institution test. Other Enterprises The more contentious part of the Draft Ruling deals with just how broadly the exemption for interest paid to other enterprises is to be drawn. The Draft Ruling takes the view that there are three discrete elements to the test, all of which have to be satisfied: the company must substantially derive [its] profits from the relevant activities; it is involved in raising debt finance in the financial markets or taking deposits at interest ; and it is using those funds in carrying on a business of providing finance. The Draft Ruling takes the position that these requirements accumulate to create a position, the general tenor of which is that the enterprise must substantially derive its profits from its spread activities, that is their profits must result mainly from the difference between the cost of raising funds and the return from providing finance. 3Withholding Tax on Interest Paid to US and UK Financial Institutions - The ATO's Opening G

4 Such an interpretation will obviously limit the scope of the exemption to traditional bank-like institutions. There is no obvious passage in either DTC which supports this requirement of making most of its profit from a spread, rather than by way of fee or by trading, but the ATO repeatedly insists on spread activities at several places in the Draft Ruling. Substantially Derive Profits from Raising Funds and Providing Finance The Draft Ruling takes the position that this part of the test requires that spread activities forms [sic] the resident s main business activity and that this requirement will be satisfied where spread activity is the main contributor, in gross profit terms, to the overall profitability of the resident. The contribution to gross profit must be consistent over a reasonable period. The ATO s requirement is that income from spread activity is the main contributor, not that the income from spread activity exceeds 50% of total income. An Example in the Draft Ruling treats a company as substantially deriving profit from spread activities where the income from the activity is 40% of gross profit. The conclusion depends on the fact that the remaining 60% comes from several other sources, none of which exceeds 40%. Raising Debt Finance in the Financial Markets or Taking Deposits at Interest The Draft Ruling adopts the position that a company will be raising debt finance if it issues instruments which meet the debt test in Australia s domestic income tax law. In broad terms, that test is whether the Australian company has an effectively non-contingent obligation to repay to the non-resident an amount at least equal to the amount it received. The domestic test is seen as appropriate because the economic concept underlying the term [used in the DTC] is analogous to the concept expressed by the debt test. So, the Draft Ruling treats as debt finance : issuing promissory notes, issuing commercial bills, a securities lending arrangement, a repurchase agreement (REPO). The Draft Ruling takes the view that debt finance can be raised in wholesale or retail markets but insists that the funds must be raised on normal commercial terms. The phrase taking deposits at interest is more narrowly defined by the ATO. It takes the view that this test can only be met by institutions which are authorised under domestic law to accept deposits. Contentiously, the Draft Ruling 4Withholding Tax on Interest Paid to US and UK Financial Institutions - The ATO's Opening G

5 specifically distinguishes deposits from mere loans. Hence, if the company must raise its funds by way of deposit rather than other kinds of borrowing, this will have the effect of restricting the test to companies that are authorised deposittaking institutions. The Ruling takes the view that this part of the definition exists primarily for US Savings Loans institutions and UK Building Societies; it specifically rules out the possibility that inter-company loan accounts amount to taking deposits at interest. More importantly, the Draft Ruling takes the view that in either case raising debt finance or accepting deposits the IWT exception only extends to the company which actually undertakes both the fund-raising and lending activity. In other words, where funds are raised in the appropriate manner, but are then on-lent to another group company and then advanced to the Australian company, the IWT exemption does not apply. The group company must raise the debt finance itself or accept its own deposits it cannot acquire the funds from the parent. Using Those Funds in Carrying on a Business of Providing Finance The final element is that the company must be using those funds in carrying on a business of providing finance. The Draft Ruling takes the view that a company can provide finance by way of debt, as equity or by way of equipment leasing; but there are then qualifications: The Draft Ruling says that fee income derived from underwriting activities or from advisory services is not income derived from providing finance ; It also takes the view that the company must be carrying on a business which may exclude some special purpose vehicles set up for a single substantial capital raising; The Draft Ruling says this test also excludes the purchase of shares or bonds by insurance companies they acquire these assets for investment, not in carrying on a business of providing finance to the issuers; and The Draft Ruling takes the view that a company which is engaged in equipment leasing can be carrying on a business of providing finance, but it also says that the payments received by the financier may not be interest for the purpose of the DTC and so will not benefit from the exemption. Other Requirements While the main focus is on the definition of financial institution, the Draft Ruling also touches on, but does not address in detail, three other restrictions which affect this IWT exemption: whether the US or UK financial institution is unrelated to and dealing wholly independently with the [Australian resident] payer ; 5Withholding Tax on Interest Paid to US and UK Financial Institutions - The ATO's Opening G

6 whether the interest is effectively connected with a permanent establishment that the non-resident company maintains in Australia; and whether the interest is paid under a back-to-back arrangement. The Draft Ruling says that two companies will be unrelated if there is no significant ownership or control relationship between them. The Draft Ruling states that, As such, the test is aligned with the approach adopted in section 128F that excludes from the exemption debentures acquired by an associate. Accordingly, it should be possible in some instances for redeemable preference shares and other equity-based instruments that are treated as debt for Australian tax purposes to qualify for the IWT exemption provided the parties do not become associates for the purposes of s. 128F. The parties can be dealing wholly independently if they undertake a transaction which is on open market commercial terms and was concluded on an arm s length basis. However, the Draft Ruling also says the conclusion ultimately depends on the facts of each particular case. Where the interest is effectively connected with a permanent establishment that the non-resident company maintains in Australia, the interest is not liable to IWT but is taxed as ordinary income of the Australian branch. The Draft Ruling says that if the interest is paid to the local branch it will be treated as taxable in Australia. Importantly, the Draft Ruling also confirms that if the funds are advanced to the Australian entity from a branch of the US or UK financial institution in a third country, the exemption can still apply. However, the Draft Ruling does not attempt to identify the level of activity which might occur in the Australian branch that would connect interest with the local branch. With regard to back-to-back loan arrangements, the Draft Ruling says simply, It will be necessary to determine whether back to back loans exist on a case by case basis due to the range of arrangements which may arise. Implications The clear purpose of the Draft Ruling is to read down the identity of the kinds of companies that are able to access the IWT exemption. We mentioned above that the US takes a much more expansive view of the scope of the exemption. The US Treasury s Technical Explanation says that, in its view, a financial institution is, an entity that issues debt in financial markets and uses that debt, directly or indirectly, to lend money or purchase debt obligations. Investment banks, brokers and commercial finance companies (but not captive 6Withholding Tax on Interest Paid to US and UK Financial Institutions - The ATO's Opening G

7 financing companies) are covered by this exemption provided that they obtain their funds by borrowing from the public. The ATO appears to agree with the requirement that these companies must obtain their funds by borrowing from the public but squarely takes issue with other parts of the passage. The Draft Ruling says that investment banks, brokers and commercial finance companies will only be classified as financial institutions if they substantially derive their profits from their spread activities. It is clear that there will be many financial institutions that will not qualify for the benefit of the exemption under the terms of the current Draft. First, it is inevitable that the ATO, Treasury and the Government will come under renewed pressure to find a solution to the obvious commercial reality that large multinational banks and other financial institutions typically operate as a single commercial group but through a range of subsidiaries. Representations were made to the Senate Economics and Legislation Committee when it was reviewing the relevant articles to the effect that the exemption should extend to wholly-owned subsidiaries of financial institutions. Unfortunately, the suggestion was not taken up and the burden will now fall on the ATO to interpret the articles in a manner which ensures that Australian borrowers can obtain the benefit of reduced borrowing costs on an appropriate range of financial transactions offered by US and UK financial institutions. Secondly, it is clear that are many financial institutions in a colloquial sense that will not qualify under the terms of the current Draft merchant banks, fund managers, dealers and brokers, insurance companies and even some commercial finance companies may not qualify. Thirdly, the Draft Ruling does not deal with the practical implementation of the exemption what steps must the Australian resident entity take to be adequately assured that the non-resident is entitled to the benefit of the exemption? The Ruling is open for comment until 15 October, We understand that the ATO, in consultation with Treasury, is already giving further consideration to how the IWT exemption might apply to corporate groups the Draft Ruling may not be the last word on this issue. Indeed, the ATO s In-box is likely to be very full, very soon. 7Withholding Tax on Interest Paid to US and UK Financial Institutions - The ATO's Opening G

8 For further information, please contact Sydney Ernest Chang Mark Ferrier Mark.Ferrier@gf.com.au Tony Frost Tony.Frost@gf.com.au Paul King Paul.King@gf.com.au Jane Michie Jane.Michie@gf.com.au G&F document ID _15.docx These notes are in summary form designed to alert clients to tax developments of general interest. They are not comprehensive, they are not offered as advice and should not be used to formulate business or other fiscal decisions. Liability limited by a scheme approved under Professional Standards Legislation Greenwoods & Freehills Pty Limited (ABN ) Sydney ANZ Tower, 161 Castlereagh Street, Sydney NSW 2000 Australia Ph , Fax Melbourne 101 Collins Street, Melbourne VIC 3000, Australia Ph Fax Perth QV.1 Building, 250 St Georges Terrace, Perth WA 6000, Australia Ph Fax Withholding Tax on Interest Paid to US and UK Financial Institutions - The ATO's Opening G