Denial of interest withholding tax exemption to a US financial institution under Article 11(9)(a) of the United States Convention

Will amounts paid by an Australian resident corporate limited partnership (CLP) to a US resident financial institution, that holds redeemable partnership interests in it, be subject to interest withholding tax pursuant to Article 11(9) of Schedule 2 of the International Tax Agreements Act 1953 (Agreements Act) as amended by Schedule 2A of the US Protocol (the US Convention), on the basis that the amounts paid are referenced to the profits of the Australian CLP?

Yes. Article 11(9) will apply to the US resident financial institution to deny an exemption from interest withholding tax provided to financial institutions, as the payments to it are referenced to the profits of the Australian CLP.

The taxpayer is a US resident company which is classified as a 'financial institution' within the meaning of Article 11(3)(b) of the US Convention.

Under a financing arrangement, the taxpayer will provide funding to an Australian resident CLP. Those funds will ultimately be used to invest in Australian interest bearing deposits, fixed rate loans and other interest bearing assets in return for redeemable limited partnership (RLP) interests issued under a Partnership Deed. These RLP interests will be classified as debt under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997).

As the RLP interests will be classified as debt, returns made on these interests will be covered by Article 11 of the US Convention (the Interest Article). This is due to the operation of section 3(2A) of the Agreements Act and the definition of interest under Article 11(5) which refers to Australian domestic law. Under section 128A(1AB) of the Income Tax Assessment Act 1936 (ITAA 1936) interest is defined as including 'a dividend paid in respect of a non-equity share'. The RLP interests are classified as non-equity shares.

Under the Partnership Deed the taxpayer is entitled to that amount of net income of the Australian CLP that equals the RLP Interest Distribution Amount. The RLP Interest Distribution Amount is calculated by reference to the funds provided by the taxpayer multiplied by the bank bill swap rate (BBSW) less the spread.

In circumstances where the net income does not equal the RLP Interest Distribution Amount, the taxpayer will receive whatever the net income of the Australian CLP is, which may be more or less that the RLP Interest Distribution Amount.

The net income of the Australian CLP is the income generated from its investments in Australian interest bearing deposits, fixed rate loans and other interest bearing assets less expenses incurred in deriving that income.

The accounts and the Partnership Deed do not treat the RLP Interest Distribution Amount as an expense item in determining net income.

Article 11(3) of the US Convention provides an exemption from interest withholding tax for financial institutions where certain conditions are met. However, Article 11(9) enables the source country to tax interest paid to a resident of the other country at a higher rate of 15% if the interest is calculated with reference to profits of the issuer or of one of its associated enterprises.

Article 11(9) relevantly provides that: Notwithstanding the provisions of paragraphs (1), (2), (3) and (4): (a) interest that is paid by a resident of one of the Contracting States and that is determined with reference to the profits of the issuer or of one of its associated enterprises, as defined in sub-paragraph (a) or (b) of paragraph (1) of Article 9 (Associated Enterprises), being interest to which a resident of the other State is beneficially entitled, also may be taxed in the Contracting State in which it arises, and according to the laws of that State, at a rate not exceeding 15 percent of the gross amount of the interest.

Although the rate of interest withholding tax under Article 11(9) may be at a rate not exceeding 15%, the maximum rate that Australia can impose under subsection 128B(5) of the ITAA 1936 cannot be in excess of 10% (per the Income Tax (Dividends and Interest Withholding Tax) Act 1974 ). Accordingly, where Article 11(9) applies the rate of withholding tax will be limited to 10%.

As 'profits of the issuer' is not defined under the Convention, regard may be had to its meaning under Australian domestic tax law (see Article 3(2)).

'Profits' are not specifically defined in the ITAA 1936 or the ITAA 1997, however, in FCT v. Slater Holdings Ltd (No.2) (1984) 156 CLR 447; 15 ATR 1299; 84 ATC 4883 the High Court considered the meaning of the word 'profits' in its context in subsection 44(1) of the ITAA 1936. Gibbs CJ (with whom Mason, Brennan, Deane and Dawson JJ agreed) saw as a starting point in defining the word 'profits' its 'fundamental meaning' given by Fletcher Moulton LJ in Re Spanish Prospecting Company Ltd (1911) 1 Ch. 92 at 98: Profits implies a comparison between the state of a business at two specific dates usually separated by an interval of a year. The fundamental meaning is the amount of gain made by the business during the year. This can only be ascertained by a comparison of the assets of the business at the two dates.

In MacFarlane v. FCT (1986) 13 FCR 356; (1986) 17 ATR 808; 86 ATC 4477 the Full Federal Court of Australia considered the interaction between sections 44 and 108 of the ITAA 1936 and the meaning of 'profits'. Fisher J after outlining the approach taken by Gibbs J in Slater Holdings went on to state (ATC at 4482 - 4483; ATR at 815) that: There are in my opinion a number of indications in the Act which confirm my view that there is no justification for attributing a narrow or accounting meaning to the word 'profits'. I consider that the circumstances here permit the application of the conventional rule.

And later, Fisher J again in relation to the word 'profits' in subsection 44(1) (ATC at 4483; ATR at 815), said that: There is nothing to indicate that the legislature had in mind designating the nature of these profits, i.e., net profits, divisible profits, after tax profits etc.

Paragraph 101 of Taxation Ruling TR 2005/5 also relevantly provides that 'profits', in the context of interpreting the phrase 'substantially deriving its profits', takes on an accounting meaning. Thus profits can be measured according to a range of acceptable accounting indicators of profits, including gross profit, net operating income or operating profit.

Having regard to these authorities, it is considered that the relevant gain made by the Australian CLP between two points in time could relevantly be said to be the excess of the Australian CLPs income over its expenses. Therefore any distribution of this particular amount would be considered a distribution of profit.

Under the operation of the Partnership Deed the taxpayer is entitled to the RLP Interest Distribution Amount. However, where the net income of the Australian CLP is more or less than the RLP Interest Distribution Amount, the taxpayer's distribution is adjusted to reflect the net income of the Australian CLP. Accordingly, the taxpayer's distribution will always be dependent on the net income of the Australian CLP. Moreover, the RLP Interest Distribution Amount is not treated as an expense in the determination of net income.

Accordingly, it is the Commissioner's view that the distribution made to the US financial institution is determined with reference to the profits of the Australian CLP within the meaning of Article 11(9).