Distributions treated as interest - are they 'determined with reference to profits' under Article 11(9)(a) of the United States Convention

Where the taxpayer, a United States (US) resident company, receives distributions treated as interest from an Australian resident corporate limited partnership (the CLP) in which the taxpayer has a redeemable limited partnership interest, is the interest paid by the CLP to the taxpayer 'determined with reference to the profits of the issuer' for the purposes of Article 11(9) of Schedule 2 of the International Tax Agreements Act 1953 (Agreements Act) as amended by Schedule 2A of the Agreements Act (the US Convention)?

Yes. The amounts that are treated as interest and paid by the CLP to the taxpayer, a US resident company that holds redeemable partnership interests in it, will be amounts that are 'determined with reference to the profits' of the CLP pursuant to Article 11(9) of the US Convention.

The taxpayer is a US resident company and a 'financial institution' for the purposes of Article 11(3)(b) of the US Convention.

Under a financing arrangement, the taxpayer provided funding to an Australian resident corporate limited partnership (CLP1) in return for a redeemable limited partnership interest (RLPI) in CLP1 issued under its partnership deed. Those funds have ultimately been used by another Australian resident CLP (CLP2) of which CLP1 has a general partnership interest. (The taxpayer also has a limited partnership interest in CLP2 issued under a separate partnership deed). CLP2 invests in floating interest bearing deposits, fixed rate loans and other interest bearing assets.

The taxpayer's RLPI in CLP1 is classified as debt for the purposes of Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997).

The after-tax income of CLP2 is to be distributed CLP1 on its general partnership interest (and to the taxpayer on its limited partnership interest). The first-mentioned Australian resident CLP1 will in turn make distributions to the taxpayer on its RLPI in CLP1 and to another entity not relevant for present purposes.

The partnership deed of the CLP1 provides that the taxpayer (the holder of the RLPI in CLP1) is primarily entitled to the portion of the adjusted net income of CLP1 equal to the RLPI distribution amount for each distribution period, the period for determining entitlement to receive distributions.

The RLPI distribution amount for each distribution period is calculated by applying the agreed rate (the 90 day Bank Bill Swap Rate less a fixed margin or spread) to the capital contributed by the taxpayer under its RLPI in CLP1; that is, the capital contributed multiplied by the agreed rate. The adjusted net income of CLP1 is CLP1's net income excluding amounts in respect of certain realised gains or losses on particular assets.

In addition, where the adjusted net income of CLP1 for a distribution period exceeds the aggregate of the amounts to which the partners are primarily entitled; the taxpayer is also entitled to such excess as reflects the proportion of its primary entitlement relative to the total primary entitlements. Where the amount to which the partners are primarily entitled is greater than the adjusted net income for a distribution period, each entitled partner receives the amount of the adjusted net income that is in the proportion to the amount the taxpayer is primarily entitled to relative to the total.

Article 11(9) of the US Convention 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.

Central to the operation of Article 11(9) of the US Convention in this case is the meaning of 'interest that ... is determined with reference to the profits of the issuer'.

Subsection 3(2) of the Agreements Act states that a reference to profits of an activity or business is a reference to taxable income derived from that activity or business. The Explanatory Memorandum to the Agreements Act states that the purpose of subsection 3(2) of the Agreements Act is to permit references to profits in the agreements to be construed as references to taxable income and that the provision is required because the Australian law imposes tax upon taxable income and not upon profits as such. Subsection 995-1(1) of the ITAA 1997 refers to section 4-15 of the ITAA 1997 for the definition of taxable income, being assessable income less deductions.

The reference to profits in subsection 3(2) of the Agreements Act is qualified to where the context in the Agreements Act so permits. Taxation Ruling TR 2001/12 states at paragraph 114: ...the ATO considers the purpose of subsection 3(2) of the Agreements Act is not to define the term profits as used in the treaties. The legislative history and related explanatory material demonstrate this subsection is strictly a mechanism to implement a treaty term which is foreign to Australia's taxation laws within the technical language of Australia's domestic legislation - rather than as an aid in defining a tax treaty term. Confirming this purpose, subsection 3(2) is drafted to apply 'in relation to Australian tax' - not in relation to the agreement.

As subsection 3(2) of the Agreements Act does not assist in defining the term 'profits' for the purposes of the agreements and as the term 'profits' is not otherwise defined in the Agreements Act or the US Convention, regard may be had to its meaning under Australian domestic tax law unless the context otherwise requires (see Article 3(2) of the US Convention).

'Profits' are not defined in the Income Tax Assessment Act 1936 or the ITAA 1997. In Thiel v. Federal Commissioner of Taxation (1990) 171 CLR 338; 90 ATC 4717; (1990) 21 ATR 531 (Thiel), where the central question was the interpretation to be given to the term in the Swiss Agreement corresponding to 'business profits of an enterprise' in Article 7 of the US Convention, Mason, Brennan and Gaudron JJ held: Article 3(2) provides no assistance in ascertaining the meaning of the words ''enterprise'' or ''profits'' because these words have no particular or established meaning under the laws relating to Australian income tax which is relevant to the outcome of the question for decision. That question must be resolved by reference to the Agreement itself and any extrinsic materials which may properly be considered.

The same can be said for the question at issue in this case.

In the context of interpreting the phrase 'substantially deriving its profits' in Article 11(3)(b) of the US Convention to determine if an enterprise other than a bank is a financial institution, paragraph 101 of Taxation Ruling TR 2005/5 states that '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.

Given the link between Article 11(9) and Article 11(3)(b) of the US Convention in the chapeau to Article 11(9) and in the absence of any extrinsic material substantiating that a different interpretation of the term 'profits' applies for the purposes of Article 11(9), the 'profits of the issuer' in Article 11(9) are the profits of CLP1 across the range of generally acceptable indicators of profits ascertained according to generally accepted accounting principles.

Accordingly, 'profits' in Article 11(9) of the US Convention is a reference to profits in the broad sense. It is not restricted to one particular measure of the term. To construe the term more narrowly to one particular measure leads to manifest absurdity of result. In this regard, the profits would not necessarily be ascertainable without knowing the distribution amount treated as interest and the distribution amount treated as interest is not able to be determined without knowledge of the amount of adjusted net income. 'Determined with reference to profits'

The phrase 'determined with reference to profits' is not defined in the US Protocol, the US Convention, Australian domestic tax law or Australian common law. There is no provision in the OECD Model Tax Convention corresponding to Article 11(9) of the OECD Model.

The US Department of Treasury Technical Explanation of the Protocol between the US and Australia refers to Article 7 of the Protocol which replaces Article 11 (Interest) of the US Convention and states that paragraph (9) provides two anti-abuse exceptions to paragraphs (1), (2), (3) and (4) and that sub-paragraph (a) applies to so-called 'contingent interest'. The same is said in the Technical Explanation to the United States Model Income Tax Convention of September 20, 1996, as regards Article 11(5) of that Model and in the explanation of the Protocol prepared by the United States Congress Joint Committee on Taxation dated March 3, 2003.

Article 11(9) of the US Convention is focussed on interest which, for present purposes, includes the distribution amounts treated as interest under Division 974 of the ITAA 1997 and Article 11(5) of the US Convention, paid by a resident of one contracting State to a resident of another that is determined by reference to the profits of the issuer or associated enterprise. Except to the extent that Article 11(9) is an integrity measure, the above references are of limited assistance in ascertaining meaning of the term in its bilateral treaty context as against its context for the purposes of the United States. The reference to Article 11(5) of the US Convention is to a differently worded provision and 'contingent interest' in the latter reference is explained by way of restatement of the wording of the provision.

Paragraph 2.54 of the Explanatory Memorandum to International Tax Amendment Bill (No. 1) 2002 substitutes the word 'calculated' for 'determined' and states that the source country taxing right that applies on the application of Article 7(9) equates with the rate that generally applies to dividends.

The phrase 'with reference to' has meanings in the Macquarie Dictionary, 2001, rev. 3rd edn, The Macquarie Library Pty Ltd, NSW of 'concerning; with regard to'.

For the above reasons and from the ordinary meaning of the words in the treaty, 'interest ... determined by reference to the profits of the issuer' in Article 11(9) of the US Convention means that the amount of the distributions are calculated or ascertained having regard to the profits in the broad sense of the issuer.

In the present case, the term 'adjusted net income' is included in the formula in the partnership deed for the calculation of the distribution amounts. Also, where the net income does not equal the RLP Interest Distribution Amount, the amount the taxpayer will receive is the RLP Interest Distribution amount adjusted according to whether the adjusted net income of CLP1 is more or less than the RLP Interest Distribution Amount. From the terms of the partnership deed, the determination of the distribution amount is contingent upon the amount of profits of the issuer.

In this way, the partnership deed refers to, or has regard to, the profits of CLP1 in calculating the entire distribution amount to be paid to the taxpayer. This and the wording of Article 11(9) of the US Convention itself indicate that apportionment is not possible. Furthermore, given the terms of the partnership deed, any treatment of the distribution amount in accounting records as an expense is not determinative or relevant to the question at issue.

Accordingly, the distribution made to the US financial institution is determined with reference to the profits of CLP1 within the meaning of Article 11(9) of the US Convention.