Interest Withholding Tax Exemption: United States limited liability company

Is the taxpayer, a limited liability company (LLC) incorporated in the United States (US), exempt from interest withholding tax under Article 11(3)(a) of the Australia - US Double Taxation Convention on interest derived in Australia which flowed through the LLC to a US pension fund?

No. The LLC in the US is not exempt from interest withholding tax in Australia.

The LLC is a company incorporated under US state law. It has elected to be treated as a 'partnership' for US federal tax purposes.

The LLC is a fiscally transparent entity and is exempt from income tax in the US.

The LLC is treated as a company for the purpose of Australian domestic law.

The LLC distributes all of its income to a US pension fund. The pension fund was set up by a US local government body for the purpose of providing retirement, survivor and disability benefits to the local government employees.

The pension fund is exempt from tax in the US under US law.

The LLC derives interest income from Australia.

Interest withholding tax is payable on interest derived by non-residents under subsection 128B(2) of the Income Tax Assessment Act 1936 (ITAA 1936). Section 7 of the Income Tax (Dividends, Interest and Royalties Withholding Tax) Act 1974 sets the rates of withholding tax on payments to which subsection 128B(2) of the ITAA 1936 applies. The rate of withholding tax on interest paid to non-residents is 10%.

This liability to Australian withholding tax is subject to any applicable tax treaty provisions contained in the International Tax Agreements Act 1953 (Agreements Act).

In determining liability to Australian tax on income received by a non resident, it is necessary to consider not only the income tax laws but any applicable tax treaty contained in the Agreements Act.

Section 4 of the Agreements Act incorporates that Act with the ITAA 1936 and the Income Tax Assessment Act 1997 (ITAA 1997) so that those Acts are read as one. The Agreements Act effectively overrides the ITAA 1936 and ITAA 1997 where there are inconsistent provisions (except for some limited provisions).

The tax treaty between Australia and the US (the US Convention) and the protocol amending the US Convention (the United States Protocol) contained in schedules 2 and 2A respectively of the Agreements Act operate to avoid double taxation of income received by Australian and US residents.

Article 4(1)(b)(iii) of the US Convention treats the LLC as a US resident for treaty purposes where the income it receives is subject to US income tax in the hands of a partner or, in this case, where the income it receives is exempt from US tax other than because the partner is not a US person under US law.

Article 11(3)(a) of the US Convention provides that Australia may not tax interest derived by the US or by a political or administrative sub-division or a local authority or by any other body exercising governmental functions in the US, or by a bank performing central banking functions in the US.

Based on the wording of Article 11(3)(a) of the US Convention, Australia would examine the LLC to determine whether the treaty benefit conferred by Article 11(3)(a) is to be provided. Taxation Ruling TR 2001/13 discusses the Commissioner's views about interpreting tax treaties. Paragraph 104 of TR 2001/13 provides that the OECD Model Tax Convention and Commentary will often need to be considered in interpreting tax treaties.

In relation to the treatment of partnerships, paragraph 6.3 of the OECD Commentary on Article 1 states the general principle that: ...the State of source should take into account, as part of the factual context in which the Convention is to be applied, the way in which an item of income, arising in its jurisdiction, is treated in the jurisdiction of the person claiming the benefits of the Convention as a resident.

The interest derived by the LLC flows through to the pension fund. Notwithstanding that the pension fund has a specific exemption from US income tax, the pension fund is still recognised as a person in the US. Accordingly, it is necessary to determine whether the pension fund, rather than the LLC or the pension funds, is 'any other body exercising governmental functions' for the purposes of Article 11(3)(a) of the US Convention. This is the case even though the LLC is a resident under Article 4(1)(b)(iii) of the US Convention and Australia treats the LLC as a company.

Where the pension fund is a body exercising governmental functions, Australia is prevented from taxing interest that it paid to the LLC.

In relation to Article 11(3)(a) of the US Convention, the phrase 'any other body exercising governmental functions' is not defined. Article 3(2) of the US Convention provides that any term not defined shall, unless the context otherwise requires, have the meaning it has under the law relating to taxes of the country applying the US Convention.

Australian domestic tax law does not statutorily define what governmental functions are. Paragraph 68 of Taxation Ruling TR 2005/8 indicates that case law is not conclusive in providing a definitive domestic law meaning of that term in its tax treaty context.

Taxation Ruling TR 2005/8 interprets the terms 'governmental functions' and 'in discharge of governmental functions' in the Government Service Article (Article 19) of the US Convention. However, the meaning given to these terms in the Ruling reflects the context in which those terms are used; that of a person being paid wages etc., by government 'for labour or personal services as an employee'. Furthermore, the interpretation was reached on the basis of subsequent practice adopted by Australia in interpreting Article 19 of the US Convention.

The phrase 'any other body exercising governmental functions' in Article 11(3)(a) of the US Convention is not used in Article 19 of the US Convention and there has been no practice of Australia adopting an interpretation of the term 'governmental functions' in the context of Article 11 of the US Convention.

Accordingly, for the above reasons, case law and TR 2005/8 is considered to be of little or no assistance in interpreting the phrase 'any other body exercising governmental functions' in Article 11 of the US Convention, particularly in the context in which the term is used.

In determining the meaning for Article 11 of the US Convention purposes, it is necessary to examine the words of the provision itself ( Thiel v. Federal Commissioner of Taxation (1990) 171 CLR 338; 90 ATC 4717; (1990) 21 ATR 531). The provision also provides an exemption to the US, other political or administrative sub-divisions in the US and a bank performing central banking functions. The term 'any other body exercising governmental functions' in Article 11(3)(a) of the US Convention in concert with the other terms specified in the Article indicates that the exemption is limited to those bodies that are identifiable as being government or that are a statutory authority (that is, an entity of public character created by the laws of a Contracting State in which no other person other than the State itself, or a subdivision thereof, has an interest).

Despite the pension fund being set up by a local government to benefit government employees, the fund itself is not identifiable as a body of government in the US nor set up to benefit only a body of government. Accordingly, Article 11(3)(a) of the US Convention will not apply.

As there is no inconsistency between the application of the Article 11(3)(a) of the US Convention and subsection 128B(2) of the ITAA 1936, interest derived by the LLC is still subject to interest withholding tax.

The LLC is therefore not exempt from interest withholding tax for interest income derived in Australia. Note: The Treasurer issued a press release No. 094 on 4 November 2005 advising that new legislation will be introduced to clarify the current practice of exempting foreign governments and their investment bodies from interest and dividend withholding taxes.