Issue
Is a lump sum amount (the Make Whole Amount), payable to non-resident Note holders by the Administrator of an Australian resident company under the terms of the Note Purchase Agreement, subject to withholding tax under section 128B of the Income Tax Assessment Act 1936 (ITAA 1936)?
Decision
Yes. The Make Whole Amount, payable to non-resident Note holders by the Administrator of an Australian resident company under the terms of the Note Purchase Agreement, is subject to withholding tax under section 128B of the ITAA 1936.
Facts
The taxpayer is an Australian resident company that is currently under administration.
The taxpayer issued Notes to foreign investors under a Note Purchase Agreement (the Agreement).
The appointment of Joint and Several Administrators to the taxpayer company constituted an Event of Default under the terms of the Agreement.
Upon the occurrence of the abovementioned Event of Default, all the Notes became immediately due and payable on that date. Consequently, the entire unpaid principal amount, all accrued and unpaid interest thereon and an additional lump sum amount (the Make Whole Amount) became due and payable immediately in accordance with the terms of the Agreement.
Essentially, the Make Whole Amount is a lump sum equal to the excess of the discounted value of the remaining interest payments payable during the remaining term of the Notes on the outstanding principal amount.
The Agreement provides that in the event Notes are prepaid or are accelerated as a result of an Event of Default, the additional lump sum amount is intended as compensation to the Note holders for the deprivation of such right under such circumstances.
The Agreement also provides that any overdue payment (including any overdue prepayment) of principal, any overdue payment of interest and any overdue payment of any additional lump sum amount owing in respect of the Notes shall bear interest at the Default Rate payable when interest payments on said Notes are payable.
Reasons for Decision
Income that is derived by a non-resident and consists of interest that is paid by a person who is a resident, is subject to withholding tax under subparagraph 128B(2)(b)(i) of the ITAA 1936.
Subsection 128A(1AB) of the ITAA 1936 defines interest to include, among other things, an amount: • that is in the nature of interest; or • to the extent that it could reasonably be regarded as having been converted into a form that is in substitution for interest.
As the term 'interest' is not comprehensively defined for the purposes of Division 11A of the ITAA 1936, it is therefore necessary to have regard to the nature of interest at common law.
Interest is in essence compensation to a lender for being kept out of the use and enjoyment of the principal sum ( Federal Commissioner of Taxation v. The Myer Emporium Ltd (1987) 163 CLR 199; (1987) 18 ATR 693; (1987) 87 ATC 4363). It is an amount that is calculated by reference to a principal sum and by reference to time ( Federal Wharf Co Ltd v. Deputy Commissioner of Taxation (1930) 44 CLR 24 at 28; per Cooper J in Century Yuasa Batteries Pty Ltd v. Federal Commissioner of Taxation (1997) 73 FCR 528; 97 ATC 4299; (1997) 35 ATR 394).
Taxation Rulings TR 93/27 (paragraphs 24-30) and TR 2002/15 (paragraphs 53-56), which provide guidance on the nature of interest, state that the following requirements must normally be satisfied for a payment to be treated as interest: • there must be a sum of money by reference to which the payment is to be ascertained (which might loosely be called the principal sum or the principal debt) • that sum must be a sum which is due to the person entitled to the interest; and • the payment must be calculated by reference to time.
The Full Federal Court in Federal Commissioner of Taxation v. Century Yuasa Batteries Pty Ltd (1998) 82 FCR 288; 98 ATC 4380; (1998) 38 ATR 442 held that an amount is not in the nature of interest if it was not calculated by reference to a principal sum. The Court also said an amount is in the nature of interest if it in essence fits the description of the ordinary meaning of interest but is not called interest. An example is the discount on a security (see subsection 128A(1AC) of the ITAA 1936).
Subsection 128A(1AD) of the ITAA 1936 provides an example of an amount that is in substitution for interest. That subsection 'has the effect of deeming that lump sum payments made instead of payments of interest are amounts in substitution for accrued interest and are, therefore, interest for the purposes of the withholding tax provisions' (paragraph 2.65 of Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 2) 1997).
The Make Whole Amount payable to foreign Note holders by the Administrator of the Australian resident company under the terms the Agreement is in the nature of interest or in substitution for interest for the purposes of subsection 128A(1AB) of the ITAA 1936 as: • it is calculated by reference to the outstanding principal amount • the amount is due to the lender under the terms of the Agreement; and • the amount is calculated by reference to the time the Notes would have been in place if there was no Event of Default.
Although the Make Whole Amount is not called or characterised as 'interest' under the terms of the Agreement, it comes within the extended meaning of interest for the purposes of subsection 128A(1AB) of the ITAA 1936 as it is an amount that is calculated by reference to a principal sum and by reference to time.
Accordingly, the Make Whole Amount payable to foreign Note holders by the Administrator of the Australian resident company is subject to withholding tax under section 128B of the ITAA 1936.