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1996-97
THE PARLIAMENT OF THE COMMONWEALTH OF AUSTRALIA
HOUSE OF REPRESENTATIVES
TAXATION LAWS AMENDMENT BILL (NO. 2) 1997
SUPPLEMENTARY EXPLANATORY MEMORANDUM
88521 Cat. No. 96 7731 3 ISBN 0644 50272X
Amends the Bill to:
more accurately target certain arrangements which attempt to convert an interest income stream into another income form which it is argued is not 'interest' or 'in the nature of interest'; and
ensure that the interest component of securities is subject to withholding tax where they are sold by non-residents to residents of Australia just before interest becomes payable.
Date of effect: The measures will apply to interest payments made after 7:30 pm Eastern Standard Time on 20 August 1996.
Amendment announced: Not previously announced.
Financial impact: The amendments ensure that the provisions operate as intended. Accordingly, there is no additional financial impact.
Compliance cost impact: These amendments will have no additional cost impact. The measures seek to provide certainty for the Banking and Finance Industry and other taxpayers.
Amends the income tax law to require non-resident borrowing subsidiaries that issue debentures overseas to be resident in the overseas country in which the finance is raised in order to be eligible for the section 128F interest withholding tax exemption.
Date of effect: Applies from 1 January 1996.
Amendment announced: Not previously announced.
Financial impact: Negligible cost to the revenue.
Compliance cost impact: The compliance costs of these amendments will be minimal.
1.1 The amendments contained in item 3 of Schedule 2 of the Bill amend the Income Tax Assessment Act 1936 (the Act) to expand the definition of the term 'interest'. Amendment 1 omits the proposed definition in the Bill and replaces it with a new definition to ensure that the measures have their intended effects.
1.2 The purpose of the amendments is to more accurately target certain avoidance arrangements and to ensure that in the case of traded securities that the accrued interest component is subject to withholding tax only where it is disposed of in connection with a 'washing arrangement'. See paragraphs 1.27 to 1.41. [New subsection 128A(1AB)]
1.3 Amendment 1 replaces the proposed definition of interest in the Bill. In order to avoid confusion and for ease of understanding, the entire definition of interest has been rewritten. However, a brief explanation of the main differences between the Bill's original definition and the proposed new definition is provided below.
1.4 For the purposes of the withholding tax provisions the term 'interest', which is currently defined in subsection 128A(1), includes amounts which are 'interest' within the ordinary meaning of the term and amounts which are 'in the nature of interest'.
1.5 The courts have formulated general principles for determining whether specific amounts fall within the ordinary meaning of interest, such as, 'interest is regarded as flowing from the principal sum' and to be 'compensation to the lender for being kept out of the use and enjoyment of the principal sum'. Interest is also said to be calculated by reference to a period of time and that it accrues on a daily basis.
1.6 The existing definition in subsection 128A(1), being an inclusive definition, ensures that the withholding tax provisions apply to amounts such as discounts on bills which, while in the nature of interest, may not have fallen within the ordinary meaning of interest.
1.7 The proposed amendment to the definition of the term 'interest' contained in the Bill is designed to address certain arrangements which attempt to change the character of the income from interest to something else. The main feature of these arrangements is the purported conversion of an interest income stream into another income form, through a transaction or a series of transactions. It is argued that the effect of the conversion is that withholding tax is not payable. Although these arrangements are considered ineffective the Bill seeks to amend the definition of the term 'interest' to remove any possible doubt that, notwithstanding the purported conversion of the interest income stream, the amounts paid are interest or in the nature of interest.
1.8 The proposed amendments are designed to give effect to the policy intent of the existing withholding tax provisions. Financial products which have never been subject to withholding tax are not intended to be captured by the expanded definition. Examples of transactions which would not generally be considered as falling within the existing withholding tax provisions are forward foreign exchange transactions, forward rate agreements, swaps and reciprocal purchase agreements. Broadly speaking, these transactions do not involve the provision of finance. In the case of swaps, this is consistent with the Australian Taxation Office's long held view which is expressed in Income Tax Ruling IT2050.
1.9 On the other hand, financial products are continually being developed and refined and, accordingly, there may be products developed in the future which, although they incorporate some of the features of an existing product, may fall within the proposed new definition.
1.10 Similarly, an arrangement which converts an interest income stream into another income form would not be excluded from the proposed measures merely because it includes one of the above mentioned transactions.
1.11. The following amendments have been made to item 3 of the Bill:
new paragraph 128A(1AB)(b) has been amended to more accurately target certain arrangements which attempt to convert an interest income stream into another income form which it is argued is not 'interest' or 'in the nature of interest'. New subparagraphs 128A(1AB)(b)(i) and (ii) have been re-drafted and combined.
new paragraph 128A(1AB)(b) has also been amended to ensure that normal trading of securities on the secondary market, which is not currently subject to withholding tax, is not captured by the expanded definition of the term 'interest' unless the securities are disposed of in connection with a 'washing arrangement' (see paragraphs 1.27 to 1.41). This has been achieved by omitting new subparagraph 128A(1AB)(b)(iii) and inserting new paragraph 128A(1AB)(c).
New subsection 128A(1AF) has been re-drafted to make it clearer and to restate that the interest component of certain transactions fall within the withholding tax regime.
the provisions have been re-numbered to cater for the above amendments.
1.12 The existing definition of interest will be repealed by item 1 and a new definition will be inserted by item 3.
1.13 The new definition in new subsection 128A(1AB) defines interest in a similar way as the existing definition, that is, it includes amounts which are 'in the nature of interest'. However, it will also provide an expanded definition to make it clear that:
amounts which can reasonably be regarded as having been converted into a form that is 'in substitution for' interest are interest for the purposes of withholding tax; and
amounts which can reasonably be regarded as having been received in exchange for interest in connection with a 'washing arrangement' are also interest for the purposes of withholding tax.
1.14 The amendments also restate the common law to make it clear that the interest component of certain transactions fall within both the existing definition of interest and the proposed new definition for the purposes of the withholding tax provisions. [Item 3 - new subsections 128A(1AE) and 128A(1AF)]
1.15 New subsection 128A(1C) provides an example of an amount which is 'in the nature of interest' for the purposes of new paragraph 128A(1AB)(a). [Item 3]
1.16 The provisions imposing withholding tax were inserted by Income Tax Assessment Act (No. 4) 1967. The explanatory memorandum which accompanied that Act stated that an example of an amount in the nature of interest is a discount fee on bills of exchange. The view has been put that, notwithstanding the example given in the explanatory memorandum, some discounts on securities are not amounts in the nature of interest.
1.17 New subsection 128A(1AC) has the effect of deeming, and will put it beyond any possible doubt, that an amount representing a discount on a security is an amount 'in the nature of interest' and is, therefore, interest for the purposes of the withholding tax provisions. [Item 3]
1.18 Similarly, new subsection 128A(1AD) provides an example of an amount that is in substitution for interest for the purposes of new paragraph 128A(1AB)(b). [Item 3]
1.19 New subsection 128A(1AD) has the effect of deeming that lump sum payments made instead of payments of interest are amounts in substitution for accrued interest and are, therefore, interest for the purposes of the withholding tax provisions. [Item 3]
An example of an amount which could reasonably be regarded as having been converted into a form that is 'in substitution for' interest - new paragraph 128A(1AB)(b)
1.20 A resident borrows $1 million at an interest rate of 10% per annum from a non-resident lender. Interest is payable at the end of 12 months.
1.21 Prior to the date upon which interest is payable under the loan agreement, the resident borrower issues a promissory note, with a face value of $100,000, to the non-resident lender to evidence its interest liability at the end of the 12 months.
1.22 Prior to the date upon which interest is payable the non-resident lender negotiates the promissory note to a third party for valuable consideration. The resident borrower pays the third party on presentation of the promissory note.
1.23 Although it is considered that the current law is effective and withholding tax applies to these payments, new subsection 128A(1AB)(b) will make it clear that the payment received through the third party, that is through the negotiation of the promissory note, is interest for the purposes of Division 11A.
An example of a lump sum payment made instead of payments of interest which are 'in substitution for' interest - new subsections 128A(1AB)(b) and 128A(1AD)
1.24 An example of a lump sum payment made instead of payments of interest would include the interest component of a lump sum payment made in relation to a loan where the borrower is unable to meet his or her commitments under the loan.
1.25 For instance, a resident borrows $10 million from a non-resident lender. The resident defaults on the repayments and the non-resident lender agrees to accept a lump sum settlement of $6.4 million. The actual amount outstanding is $6 million principle and $800,000 in accrued interest. However, under the terms of the settlement the non-resident agrees to waive a portion of the outstanding debt.
1.26 In this example the $400,000 lump sum payment made instead of the accrued interest would be subject to withholding tax.
1.27 The term 'washing arrangement' is defined in new paragraph 128A(1AB)(c) to mean an arrangement under which title to a security is transferred to a resident shortly before an interest payment is made pursuant to the security and the sole or dominant purpose of the arrangement is to reduce the amount of withholding tax payable.
1.28 A simple example of a washing arrangement is shown at paragraphs 1.35 to 1.41.
Outline of a typical washing arrangement
1.29 Washing arrangements are used by non-resident businesses investing in securities issued by resident companies or governments. Prior to the time that the interest payment is due (coupon day), the non-resident sells the security to an unrelated resident third party at market prices. The price incorporates the forthcoming interest payment. Just after the coupon date the non-resident purchases the same security on the open market. It is immaterial whether or not a right to reacquire that security is obtained (by options, forward purchases or the like) by the non-resident.
1.30 The re-purchase price of the resident participant in the scheme is lower than the sale price because of the intervening interest payment. The scheme, in effect, allows the non-resident to convert interest income into business profits. If the non-resident is from a country with which Australia has a double tax agreement (DTA) and does not have a permanent establishment (eg. a branch) in Australia, the non-resident's profit on the transaction is not taxable in Australia.
Dominant purpose
1.31 The definition of 'washing arrangement' contemplates situations where the arrangement is undertaken with more than one purpose in mind. New paragraph 128A(1AB)(c) requires that where more than one purpose exists for entering into the arrangement, the purpose of reducing the amount of withholding tax payable must be the dominant purpose.
1.32 The words 'dominant purpose' are not defined in the proposed legislation. However, these words have been the subject of judicial consideration in the context of Part IVA of the Act. It has been held that 'in its ordinary meaning dominant indicates that purpose which was the ruling, prevailing, or most influential purpose'.
1.33 Whether a person has entered into an arrangement for the sole or dominant purpose of reducing the amount of withholding tax payable will be a question of fact to be determined objectively from the surrounding circumstances.
1.34 Accordingly, an arrangement will be considered to fall within new paragraph 128A(1AB)(c) if the 'ruling, prevailing, or most influential purpose' for entering into the arrangement was, on an objective view, to reduce the amount of withholding tax payable. This will be the case notwithstanding that there may be a commercial reason or reasons for entering into the arrangement.
A simple example of a washing arrangement
1.35 Assume the following facts:
A non-resident investor, from a country with which Australia has a DTA, purchases bonds with the intention of selling the bonds before interest is paid in order to avoid the withholding tax payable on the interest income. The non-resident does not have a permanent establishment in Australia.
The purchase price of the bonds is $10 million and interest, at a rate of 10% per annum, is payable yearly by coupons.
The underlying value of the security does not change.
The first coupon is due on the 31 March 1998.
1.36 The non-resident sells the bonds in March 1998 to a resident for $10.95 million. The Australian resident purchaser receives interest income of $1 million on 31 March 1998 and sells the security on 1 April 1998 for $10 million to a non-resident. On 1 April 1998 the non-resident repurchases the same type of bonds in the market for $10 million.
1.37 This process may be repeated several times or only undertaken once.
Effect of the arrangement
1.38 By selling the bonds the non-resident has derived $950,000 which has been converted from interest income into business profits which, by virtue of the DTA, are not taxable in Australia. If the non-resident had held the bonds at coupon date, the interest income of $1 million would have been subjected to interest withholding tax of $100,000.
1.39 The resident has derived gross income of $11 million (interest income of $1 million and proceeds from the sale of $10 million). The resident will have an allowable deduction of $10.95 million against this income. The taxable income is $50,000 and using the company rate of tax (36%), the tax payable is $18,000.
1.40 The net loss to the Australian revenue as a result of the washing arrangement is $82,000, that is, $100,000 (withholding tax that would have been payable because the interest is $1 million and the withholding tax is 10 per cent) less $18,000 (actual tax paid).
1.41 The proposed amendment will ensure that the accrued interest component received from the resident purchaser will be subject to withholding tax. In this example, the accrued interest component was $950,000.
1.42 Section 128B currently provides that there is a liability to interest withholding tax:
1. under subparagraph 128B(2)(b)(i), on interest paid by an Australian resident that is not an outgoing wholly incurred in carrying on business outside Australia through an offshore permanent establishment (PE) eg. a branch;
2. under subparagraph 128B(2)(b)(ii), on interest paid by a non-resident that is incurred in carrying on business through a PE in Australia; and
3. under subsection 128B(2A) on interest paid to an Australian resident carrying on business through an offshore PE and the interest is paid by either an Australian resident falling within point 1 above or a non-resident falling within point 2 above.
1.43 New subsection 128A(1AE) restates the common law to make it clear that where a lender, that is an entity to whom subsection 128B(2) applies, assigns a loan, or the right to interest under a loan, to a non-resident or to an Australian resident carrying on business through an offshore PE, any payments from the borrower to the assignee that would have been interest but for the assignment are interest for the purposes of the withholding tax provisions. [Item 3]
1.44 A similar provision is inserted by item 3 which merely restates the common law and will operate in relation to the acquisition of securities. The amendment relates to a view that, in certain circumstances, where securities are purchased on a cum interest basis, interest withholding tax does not apply to payments made after the sale because no debtor/creditor relationship exists between the issuer of the security and the purchaser. The Australian Taxation Office's long held view is that withholding tax applies to these payments at present; the proposed legislation will make it perfectly clear. That is, where a non-resident, or an Australian resident carrying on business through an offshore PE, acquires a security or the right to receive interest under the security any payments from the issuer of the security to the non-resident or Australian resident holder mentioned above, that would have been interest but for the acquisition, are payments of interest subject to withholding tax. [New subsection 128A(1AF)]
1.45 Items 4, 10 and 11 will make consequential amendments as a result of the amendment described above by omitting references to subsection 128A(1) in paragraph 128AB(4)(b) and sections 159GZA and 159GZY and substituting references to new subsection 128A(1AB). These amendments will incorporate the new definition of interest into those provisions.
2.1 This chapter describes the changes proposed by amendments 2, 3 and 4 and replaces paragraph 5.59 of the Explanatory Memorandum in relation to foreign bank branches.
2.2 The amendments will amend the Income Tax Assessment Act 1936 (the Act) to require non-resident borrowing subsidiaries that issue debentures overseas to be resident in the overseas country in which the debentures are issued in order for the interest on the debentures to be eligible for the section 128F interest withholding tax exemption.
2.3 The Treasurer announced on 16 December 1996 in Press Release No 129, titled 'Implementation of certain international tax measures', that the Government had decided to extend the proposed new section 128F to include overseas borrowing subsidiaries which are wholly owned by Australian resident companies and which are resident in countries to be listed in the income tax regulations. The sole business of the borrowing subsidiary must be the raising of finance for its parent. This change was announced to commence on 1 January 1996, the same date as the other amendments to section 128F.
2.4 Amendment 2 clarifies for the purposes of the proposed paragraph 128F(8)(a) that a qualifying borrowing subsidiary cannot be a resident of Australia.
2.5 Amendment 3 inserts paragraph (ca) in proposed subsection 128F(8), in order to require that in addition to meeting the subparagraph (c) test of issuing debentures in a foreign country specified in the regulations, the borrowing subsidiary must be treated as resident in that country for the purposes of its tax law at the time the debentures are issued.
2.6 Amendment 4 inserts in the definitions contained in proposed paragraph 128F(9) a definition of 'tax law' of a country other than Australia. The definition is relevant for the purposes of the proposed paragraph 128F(ca) and corresponds with the meaning of 'tax law' for the purposes of Part X of the Act in relation to a listed country.
2.7 The following paragraphs replace paragraph 5.59 of the Explanatory Memorandum to clarify the background to the legislation being amended by the Bill. The replacement paragraphs more fully explain that the meaning of the term 'interest' for the purposes of Part IIIB was expanded because as a result of proposed section 128F (Part 2 of Schedule 5 of the Bill) a foreign bank branch can obtain finance from a related Australian company.
2.8 The replacement paragraphs are:
'Australian branches of foreign banks have the option of being taxed under Part IIIB of the Act or they may opt to be taxed under the general law subject to any relevant double tax treaty. In accordance with Part IIIB the thin capitalisation rules do not apply to a branch and instead, 4 per cent of a branch's interest deduction (which is treated as notional equity - the notional equity rule) is disallowed.
Foreign bank branches are ineligible for the section 128F exemption from IWT. However, foreign banks operating in Australia through branches are entitled to have an associated Australian company raise funds overseas under the section 128F exemption. The proposed section 128F does not have an end use test and these Australian companies will be entitled to provide funds to the Australian branches of the foreign banks.
If Australian branches obtain finance from associated companies by way of discounted debentures, such as promissory notes or bills of exchange, the notional equity rule may be avoided. Accordingly, to prevent the proposed new section 128F being used to circumvent the notional equity rule the term 'interest', for the purposes of Part IIIB of the Act, will be defined as having the same meaning as in the IWT provisions of the income tax law. This amendment will also prevent the notional equity rule being avoided by Australian branches of foreign banks financing their operation through non-interest borrowings. [New section 160ZZV]
This measure will apply from the time the Bill receives Royal Assent. For example, if the Bill receives Royal Assent on 31 December 1997 then for the year of income ending 30 June 1998 the former meaning of interest will apply for the purposes of Part IIIB from 1 July 1997 to 31 December 1997 and the new definition for the period from 1 January 1997 to 30 June 1998.
The definition of the term 'interest' for the purposes of Division 11A is being amended in this Bill. For a discussion of the amended definition of interest see Chapter 2. [Item 19]'
The following table and commentary replaces the table and the following commentary at the top of page 76. This change is necessary as the table did not include the accrual amount ($838.69) for the accrual period from 15 June to 14 July 1997. In the table, where rentals are payable in advance the accrual amount for each period is shown on the line immediately following the relevant payment.
|
Date
|
Lease payment
|
Finance charge
|
Capital reduction
|
Notional loan principal outstanding
|
|
15-Dec-96
|
$2,090.15
|
$0.00
|
$2,090.15
|
$117,909.85
|
|
15-Jan-97
|
$2,090.15
|
$894.15
|
$1,196.00
|
$116,713.85
|
|
15-Feb-97
|
$2,090.15
|
$885.08
|
$1,205.07
|
$115,508.78
|
|
15-Mar-97
|
$2,090.15
|
$875.94
|
$1,214.21
|
$114,294.57
|
|
15-Apr-97
|
$2,090.15
|
$866.73
|
$1,223.42
|
$113,071.15
|
|
15-May-97
|
$2,090.15
|
$857.46
|
$1,232.69
|
$111,838.46
|
|
15-Jun-97
|
$2,090.15
|
$848.11
|
$1,242.04
|
$110,596.42
|
|
15-Jul-97
|
$2,090.15
|
$838.69
|
$1,251.46
|
$109,344.96
|
The accrual amount for the June/July accrual period of $838.69 may be apportioned as follows for the income year of 1996-97:
$838.69 x 16/30* = $447.30
* There are 16 days in the month of June 1997 that the payment made on 15 June 1997 refers to.
$447.30 would form part of the lessee's allowable deductions and the lessor's assessable income in the 1996-97 income year. Therefore, the total accrual amount that will be allowable to the lessee and assessable to the lessor, in the 1996-97 income year, would be $5,674.77.
4.1 The following changes are made to Chapter 1 of the Explanatory Memorandum to clarify the background to the legislation being amended by the Bill. The background discusses how, under the current law, unrecouped net capital losses are reincurred in each subsequent year of income. For corporate taxpayers reincurrence is subject to recoupment tests being satisfied in each of those years.
4.2 Previous paragraphs 1.8 and 1.12 of the Explanatory Memorandum stated that where the year of incurrence of the loss and the year of recoupment of the loss have a break between them, corporate taxpayers only have to satisfy the recoupment tests in the year of recoupment and the immediately preceding year. This could have been interpreted as saying that corporate taxpayers do not have to satisfy the recoupment tests in each year in order for a net capital loss to be carried forward.
4.3 The reworded paragraphs will make it clear that the recoupment tests for corporate taxpayers must also have been met each year in order for a net capital loss to be carried forward to the next succeeding year.
4.4 Paragraph 1.8 is replaced by:
'However, these tests do not achieve their intended purpose where the year the loss was incurred and the year of recoupment are not consecutive years. Where there is a break between the two years, the effect of the above anomaly is that the company only has to satisfy the recoupment tests by comparing the year of recoupment and the immediately preceding year. This is because until recouped or transferred, net capital losses are reincurred in each subsequent year, provided the recoupment tests are met in each of those years.'
4.5 Paragraph 1.12 is replaced by:
'To illustrate, where a capital loss is transferred in a year of income after the loss was incurred, the amount of a transferred net capital loss is deemed to be a capital loss incurred by the transferee company in the gain year. This means that the transferee company does not have to satisfy the recoupment tests in a year other than the gain year. In contrast, the transferor company does have to satisfy the recoupment tests and in the gain year is required to do so by comparing the gain year and the immediately preceding year. (The amendments in the Bill seeking to prevent the annual reincurrence of net capital losses would effectively require the recoupment tests to be satisfied by both the transferor and transferee companies by comparing the loss year and the gain year.)'.