Australian financial institution (AFI) subsidiary: Part X of the ITAA 1936

Is the sole or principal business of an AFI subsidiary that enters into certain transactions with members of the same wholly owned group, a financial intermediary business for the purposes of subsection 449(1) and 450(1) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Yes. The sole or principal business of the AFI subsidiary that enters into certain transactions with members of the same wholly owned group is a financial intermediary business for the purposes of subsection 449(1) and 450(1) of the ITAA 1936.

The AFI subsidiary is a member of a wholly owned group of an Australian bank.

The AFI subsidiary does not carry on a banking business, it is a special purpose vehicle set up as part of a larger arrangement.

The AFI subsidiary entered into three transactions with two other subsidiary's of the Australian bank whereby it provided a loan and acquired a discounted note.

The AFI subsidiary also acquired bonds under a repurchase agreement (repo) from one of the subsidiaries. This subsidiary acquired the bonds from an entity external to the group (the borrower).

The loan and the repo represent a substantial majority of the total funds invested by the AFI subsidiary.

Sections 449 and 450 of the ITAA 1936 provide that certain types of income will be excluded from a company's passive income provided that at the time the income was derived, the company was an AFI subsidiary whose sole or principal business was financial intermediary business.

Financial intermediary business

Section 317 of the ITAA 1936 defines 'financial intermediary business' to mean 'banking business or a business whose income is principally derived from the lending of money'.

The AFI subsidiary does not carry on a banking business, therefore the question is whether the AFI subsidiary is in a business whose income is principally derived from the lending of money.

Business

The word 'business' is defined in subsection 6(1) of the ITAA 1936 to 'include any profession, trade, employment, vocation or calling, but does not include occupation as an employee'.

In FC of T v. Bivona Pty Limited 89 ATC 4183; (1989) 20 ATR 282, an appeal against the decision in Case U140 87 ATC 808; AAT Case 97 (1987) 18 ATR 3676 and confirmed by the Full Federal Court Commissioner of Taxation v. Bivona Pty Ltd (1990) 21 FCR 562; 90 ATC 4168; (1990) 21 ATR 151, it was decided that, prima facie , in lending money at interest, the respondent was carrying on a business. The fact that a taxpayer lent money, not generally to the public, but only to other companies in a group of which it was a member and that only a small profit was derived from money lending activities, did not prevent the taxpayer from being found to be involved principally in the business of lending money.

Burchett J also pointed out that the relative inactivity that may be involved when a business has only one client is no bar to the conclusion that a business is being carried on.

Taxation Ruling TR 92/18 Income Tax: Bad Debts, at paragraphs 43 to 44, discusses the question of whether a taxpayer is carrying on the business of lending money within the context of paragraph 63(1)(b) of the ITAA 1936. It states that the question of whether a taxpayer is carrying on the business of lending money is necessarily a question of fact. The frequently quoted statement of Farwell J in Litchfield v. Dreyfus [1906] 1 KB 584 at 589 that: Speaking generally, a man who carries on a money- lending business is one who is ready and willing to lend to all and sundry, provided that they are from his point of view eligible

should not restrict the meaning of 'money-lender' for taxation purposes. The Ruling also states at paragraph 46 that for the purposes of paragraph 63(1)(b) of the ITAA 1936 it would be sufficient if the taxpayer lends money to certain classes of borrowers provided the taxpayer does so in a businesslike manner with a view to yielding a profit from it.

It is considered that even though the bulk of the AFI subsidiary's transactions are with one borrower in the same group of companies, this does not prevent it from being in a business at the time the income from the above transactions was derived. Other factors taken into account are that the transactions are undertaken in a business like manner (documentation and security are provided) with a view to yielding a profit ( Case 39/95 95 ATC 347; AAT Case 10,274 (1995) 31 ATR 1034).

Is the AFI subsidiary 'lending money'?

In relation to the repo, it is a sale and repurchase agreement reflecting the transfer of the right, title and interest in the bonds. The legal rights conferred by the agreement effect the sale of securities and not the lending of money.

Even though the repo itself is not a loan, the mere purchase of the securities by the AFI subsidiary may be taken to be a loan to the borrower by virtue of section 442 of the ITAA 1936.

Paragraph 442(a) of the ITAA 1936 applies where a company assumes the rights of a lender under a loan and operates to treat the company as having provided the loan to the borrower. Where the assumption was made in the course of carrying on a particular business, paragraph 442(b) of the ITAA 1936 treats interest derived by the company assuming the rights of the lender as if it had been derived from a loan made in the course of carrying on that business.

In this case, the AFI subsidiary assumes the rights of a lender under a loan when it purchases the bonds under the repo. Therefore, section 442 of the ITAA 1936 treats the AFI subsidiary as having made loans to the borrower.

Accordingly, where an AFI subsidiary principally derives its income from the purchase of bonds or other similar securities that acknowledge an underlying loan of money that company will satisfy section 317 of the ITAA 1936 definition of 'financial intermediary business'. However, this would not be the case where securities are issued on contractual terms which do not create present debtor-creditor relationship or which entitle the holder to consideration (the true nature of which is not interest) for the making of the capital contribution.

The issue of the discounted note is not considered to be a loan (refer to KD Morris & Sons Pty Ltd(in liq) v. Bank of Queensland Ltd (1980) 146 CLR 165 and Case 23/96 96 ATC 278).

Is the AFI subsidiary's income 'principally' derived from the lending of money?

In Federal Commissioner of Taxation v. FH Faulding & Co Ltd (1950) 83 CLR 594; (1950) 9 ATD 201, the High Court considered that 'principally' has the same meaning as 'mainly' and that whether this was referring to a quantitative measure or some other measure was determined by the context in which it was used.

As two of the three transactions relate to the lending of money and represent a substantial majority of the total funds invested by the AFI subsidiary, the AFI subsidiary's income is 'principally' derived from the lending of money.

It is concluded that the activities of the AFI subsidiary amount to a business whose income is principally derived from the lending of money. Therefore, at the time the income was derived, the AFI subsidiary's sole or principal business was financial intermediary business for the purposes of section 449 and 450 of the ITAA 1936.