Controlled foreign companies: financial intermediary business

Does income derived from the 'lending of money' for the purposes of paragraph (b) of the definition of 'financial intermediary business' in section 317 of the Income Tax Assessment Act 1936 (the ITAA 1936) include a profit or gain derived by an Australian financial institution (AFI) subsidiary from the sale of loans prior to maturity or a fee received from the seller on acquisition of loans from third parties?

No. The amount of profit or gain derived by an AFI subsidiary from the sale of loans prior to maturity and a fee received from the seller on the acquisition of loans from third parties will not constitute income derived from the 'lending of money' within the meaning of paragraph (b) of the definition of 'financial intermediary business' in section 317 of the ITAA 1936.

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

The subsidiary is a controlled foreign company (CFC) as defined in sections 317 and 340 of the ITAA 1936.

The subsidiary is an AFI subsidiary as defined in sections 317 and 326 of the ITAA 1936.

The AFI subsidiary does not carry on a banking business however it will advance loans to offshore entities.

The AFI subsidiary will sell some of the loans it has advanced prior to maturity on a regular basis to provide a pool of circulating capital.

The AFI subsidiary will also acquire loans from third parties resulting in the AFI subsidiary assuming the rights of a lender under a loan within the meaning of section 342 of the ITAA 1936.

The AFI subsidiary will receive a fee from the original lender on the successful acquisition of the third party loans.

Paragraph (b) of the definition of 'financial intermediary business' in section 317 of the ITAA 1936 requires that income of the relevant business of the CFC be principally 'income...derived from the lending of money'. This requires, at the least, that the income that is principally derived has a 'sufficiently proximate relationship' ( Kidston Goldmines Limited v. Federal Commissioner of Taxation (1991) 30 FCR 77; 91 ATC 4538; (1991) 22 ATR 168 ( Kidston Goldmines ), per Hill J) to the furnishing of loan funds by the relevant CFC. Income from the lending of money is income from property and necessarily takes its character from, and has its source in, the loans by the lender. This can be contrasted with income from a business operation, such as a mining operation the subject of the decision in Kidston Goldmines , which is not produced from property but from the various transactions and activities that are together productive of the income.

In contrast to income from profit making operations or a business, 'income...from...lending' is income which is necessarily derived from the loan transaction itself. This is reflected in the inherent income character of interest as income from property.

The profit from making loans is a characterising, but not exclusive, feature of the business of banking. Thus, in referring in Commercial Banking Co. of Sydney Limited v. Federal Commissioner of Taxation (1950) 81 CLR 263; (1950) 9 ATD 112; (1950) 4 AITR 406 to 'putting out...money so as to increase it' and thus to profit substantially by way of interest, Dixon J was necessarily referring to making profit from lending itself.

A profit from the sale of property, including a profit from the sale of a lender's rights under a loan, will not be income of the seller for income tax purposes unless it is part of, or incidental to, the seller's business operations or comprises profit from a profit making venture (isolated or not) in accordance with the principles set out in Federal Commissioner of Taxation v. Myer Emporium Limited (1987) 163 CLR 199; 87 ATC 4363; (1987) 18 ATR 693. Thus, the character of a profit from sale of a loan, whether or not assessable in the hands of the seller for income tax purposes, is fundamentally different from the character of income from the property in the loan that is sold. A profit on sale necessarily takes its character from, and has its source in, the sale (and the business or venture which is pursued by the sale); not in what is sold.

This difference in character is reflected in the calculation of the profit or loss on sale that is assessable or deductible, respectively, for income tax purposes. This calculation is the difference between the cost of acquisition and the sale proceeds, which has no necessary connection to the quantum or nature of the income from the property itself.

The same analogy can be drawn on any 'fee' earned for acquiring loans from third parties in that the fee is not income from lending. Any fee received from the seller of the loans is separate from, and does not affect, the amount owing under those loans.

The special rules relating to AFI subsidiaries in Subdivision F of Part X of the ITAA 1936 are considered to support the above interpretation of paragraph (b) of the definition in section 317 of the ITAA 1936 of 'financial intermediary business'.

These special rules provide concessional treatment within the CFC rules for the various separately identifiable activities such as trading in financial instruments considered part of the normal business activities of an AFI subsidiary which is a 'financial intermediary'. This is outlined in the discussion of the financial intermediation concession in Taxation of Foreign Source Income: An Information Paper April 1989 (the 1989 Information Paper) and the drafting of the special rules.

The 1989 Information Paper states that: Financial Intermediary Income 4.38 Given the classification of interest as passive income, most types of income derived by foreign companies engaged in financial intermediation (e.g., banks) would be regarded on this basis as tainted income. But financial intermediation is undeniably a genuine business activity and an exclusion for interest derived in the active conduct of such a business is warranted. 4.39 The income of a financial institution can be divided broadly into the following categories: (a) interest on loans, and income from fees for services provided, to: (i) unrelated persons who are not Australian residents (ii) Australian residents; and (iii) non-Australian related parties (b) income from deposits (c) income from equities and securities (d) rental and leasing income (e) capital gains; and (f) other income. 4.40 In terms of this categorisation: (a) interest on loans to unrelated persons who are not Australian residents will be classified as active income (b) interest income from loans to Australian residents will be classified as other tainted income (c) interest income from loans to related parties is readily shifted and will be classified as other tainted income (d) income from fees for services rendered to unrelated persons who are not Australian residents will be classified as active income (e) income from dealing in foreign exchange, fixed interest securities and other financial instruments with unrelated non-Australian clients will also be classified as active income; and (f) all other categories of income will be classified as passive or other tainted income according to the general rules that apply to those categories of income.

The 1989 Information Paper does not suggest that income from the broad categories will constitute income from lending within the meaning of paragraph (b) in section 317 of the ITAA 1936 of the financial intermediary business definition. For example, rental and leasing income would not constitute income from lending of money.

Also the special rules contained in section 450 of the ITAA 1936 distinguishes between income from the lending of money and the other broad categories of income derived by an AFI subsidiary, for example, income from the disposal or trading of a tainted financial asset

The key to understanding section 450 of the ITAA 1936 is that the sole or principal business must be a financial intermediary business before the income from 'trading activities' is afforded concessional treatment.

Furthermore, the 1989 Information Paper and the words contained in section 450 of the ITAA 1936 disclose the relevant distinction between a business which produces income that is principally derived from lending of money and the separately identifiable business of trading or regular disposal of loans commonly associated with a financial institution.

It is concluded that a profit or gain derived by an AFI subsidiary from the sale of loans prior to maturity and a fee received from the seller on acquisition of loans from third parties does not come within the ambit of income derived from the 'lending of money' for the purposes of paragraph (b) of the definition of 'financial intermediary business' in section 317 of the ITAA 1936.