Debt and Equity Financing: rate of withholding tax on a return on a debt interest under Division 974

Is the taxpayer, a non-resident company, liable for withholding tax on Australian-sourced dividends at a rate of 10% if the dividends constitute a return on a debt interest?

Yes. The taxpayer is liable for withholding tax at a rate of 10%, on Australian-sourced dividends that constitute a return on a debt interest.

The taxpayer is a non-resident company. During 2002, the taxpayer company received dividends on redeemable preference shares (RPS) from a resident company.

The terms of the RPS are such that the shares give rise to a debt interest under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997).

Liability to non-resident withholding tax on interest and dividends is determined by Division 11A of Part III of the Income Tax Assessment Act 1936 (ITAA 1936).

Section 128B of the ITAA 1936 deals with liability to withholding tax. Subsections 128B(2) and 128B(5) provide that subject to certain exceptions listed in subsection 128B(3), a non-resident is liable to withholding tax on income consisting of interest that is paid to the non-resident by a resident person and is not an outgoing solely incurred by that person in carrying on business in a country outside Australia at or through a permanent establishment of that person in that country.

For the purposes of Division 11A of the ITAA 1936, 'interest' is defined to include 'an amount...that is a dividend paid in respect of a non-equity share' (paragraph 128A(1AB)(d)).

The term 'non-equity share' is defined as a share that is not an equity interest in the company. As the RPS issued by the resident company constitute a debt interest under Division 974 of the ITAA 1997, they are not an equity interest (paragraph 974-70(1)(b)). The RPS are non-equity shares for income tax purposes.

Therefore, RPS dividends will be income derived by a non-resident that consists of interest to which section 128B applies of the ITAA 1936. The taxpayer company is therefore liable to pay tax on the dividends at the rate which applies to interest income under subsection 128B(5) of the ITAA 1936. Paragraph 7(b) of the Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974 provides that this rate is 10%.

The taxpayer company's liability under these income tax provisions is not affected by any articles in the applicable Double Tax Agreement.