Changes to an exemption for the liability to pay interest withholding tax

By Mark Friezer and Felicity Slater.

Key Points:
A proposed amendment to the Income Tax Assessment Act 1936 will widen the availability of an exemption from liability to pay withholding tax, currently applicable to interest payments under debentures, to include interest payments under widely offered "debt interests." This will affect the way banking and finance transactions are documented and will allow for greater flexibility in the range of instruments that can be used. Other recent changes include a new interest withholding tax exemption for unit trusts, and clarification to the interest exemptions in the US and UK tax treaties.

Extension of 128F to debt interests

Current exemption

There are a number of exemptions to the requirement to pay interest withholding tax, including an exemption given by section 128F, which is intended to enhance the ability of Australian borrowers to raise capital overseas. Under section 128F, interest paid under a debenture is exempt from interest withholding tax if the issue of the debenture satisfies a "public offer" test.

A debenture, at common law, is generally considered to involve an acknowledgement by a company of an indebtedness, with an obligation to repay, whether or not including a charge over property to secure repayment. Debentures are defined in the tax law to include debenture stock, bonds, notes, and any other securities of a company (whether constituting a charge on the assets of the company or not), as well as promissory notes or bills of exchange.

Proposed change to the exemption

As part of Australia's review of international taxation, a proposed change (contained in the New International Tax Arrangements (Managed Funds and Other Measures) Bill 2004) is being considered to extend the exemption in section 128F to interest paid under widely offered "debt interests" as well as under debentures.

The bill lapsed on 31 August 2004 as a consequence of the announcement of the Federal election. However, with the Government being returned to office, we expect that the bill will be introduced in the next sitting of Parliament. The measures are proposed to have effect prospectively from the date of royal assent.

Debt interests are defined in Division 974 of the Income Tax Assessment Act 1997. A "debt interest" arises in an entity if a scheme entered into by the entity is a financing arrangement, and the entity (or an entity connected with it) will receive a financial benefit under the scheme. The entity needs to have a non-contingent obligation under the scheme to provide an amount at least equal to the amount received. A scheme giving rise to a "debt interest" is generally economically equivalent to a loan. So legal form equity, such as redeemable preference shares can, depending on their terms, fall within the definition of a "debt interest".

Consequences of the change

The consequence of the proposed amendment is that a wider range of instruments will be available for use, without losing the benefit of the exemption. The exemption in section 128F will now cover:

• conventional debentures;
  
• debt interests (including, for example, facility agreements and interests in the form of shares, such as redeemable preference shares); and
  
• debentures that pay interest but do not fall within the proposed definition of "debt interest" (for example, those that are equity interests). No further change to the treatment of interest paid on a debenture is intended by the amendments.

This will mean that lenders and borrowers will have greater flexibility in structuring transactions, including issues of hybrid securities and syndicated facility agreements.

Other changes

Exemption for unit trusts

A new exemption from interest withholding tax for debentures issued by certain unit trusts was granted under the New International Tax Arrangements Act 2004. The new provisions largely mirror the existing exemption for debentures in section 128F. The impact of the legislation, which applies to debentures issued on or after 23 June 2004, will be that unit trusts will not need to establish a special purpose company in order to issue widely offered debt instruments. This measure is of particular benefit to the managed funds industry.

The new exemption applies to public unit trusts, or where all of the issued units are held by two or more eligible unit holders. A public unit trust is a trust where at any time of the income year:

• any of the units in the unit trust were listed for quotation in the official list of a stock exchange in Australia or elsewhere;
  
• any of the units in the unit trust were offered to the public; or
  
• the units in the unit trust were held by not fewer than 50 persons.

An eligible unit holder is defined to include public unit trusts, complying superannuation funds with more than 50 members, trustees of pooled superannuation funds, complying approved deposit funds, life insurance companies, public companies, and other unit trusts in which all issued units are held by two or more eligible unit holders.

Tax treaty exemption for interest

Under the tax treaties with the US and the UK, Australia has no right to tax in respect of interest paid to US or UK residents if:

• the US or UK resident is a "financial institution", is beneficially entitled to or beneficially owns the interest, and is unrelated to the payer of the interest; and
• the interest in Australia is not effectively connected with a permanent establishment of the US or UK resident in Australia, and is not paid as part of an arrangement involving back to back loans.

A Draft Ruling from the Tax Office (TR 2004/D16) explains the Tax Office view of how a US or UK resident qualifies as a "financial institution." The Draft Ruling seeks to clarify the distinction drawn in the treaties between financial institutions as either "banks" or "other enterprises."

According to the Tax Office, a "bank" is a US or UK resident that has a banking licence in its country of residence to take deposits and make advances, and satisfies the adequacy requirements to operate as a bank. Credit unions, building societies and saving and loans institutions, that have lower capital adequacy requirements than banks will not satisfy the meaning of the term "bank," but may be considered to be a financial institution where they satisfy the requirements for "other enterprises."

"Other enterprises" is taken to mean those enterprises that 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. The profits of the enterprise must mainly result from the difference between the cost of raising funds and the return from providing finance.

The term "raising debt finance" is not defined, but the Commissioner relies on similar concepts as those in Division 974 for distinguishing debt from equity. The Draft Ruling proposes that an arrangement does not need to give rise to a "debt interest" under Division 974 for it to constitute "raising debt finance," but that an arrangement that satisfies the Division 974 test would clearly constitute "raising debt finance."

The Draft Ruling recognises that modern financing transactions take a number of forms besides traditional loan transactions, so for instance finance leasing and securities lending are given as examples of transactions which would be considered to be the provision of finance. Interestingly there was no comment in the Draft Ruling on the position of securitisation vehicles. It may be expected that further clarification could be forthcoming when the ruling issues its final form.

The Draft Ruling suggests that where the fund-raising activity is undertaken by an associated entity within a corporate group that on-lends the funds to the enterprise, the enterprise may not qualify as a "financial institution." This means, in the Commissioner's view, that in-house finance companies will not be able to benefit under the relevant treaty. Non-margin business such as activities which generate fee income would also not constitute the provision of finance.

The requirement in the treaties that the US or UK resident be unrelated to the Australian payer is considered to be satisfied by showing that there is no ownership or control-based relationship between the payer of the interest and the financial institution, under which one party is able to exert influence over the activities of the other party.

There are some examples given of situations where back to back loans will be taken to exist, however the Draft Ruling suggests that this issue is highly dependant on particular facts and circumstances and will be considered on a case by case basis.

For further information, please contact Mark Friezer and Felicity Slater.