Income tax: can section 160ZZZJ of Part IIIB of the Income Tax Assessment Act 1936 apply to interest entered in the accounting records of an Australian branch of a foreign bank if the interest relates to a borrowing the branch has obtained from a third party?

No. Section 160ZZZJ of the Income Tax Assessment Act 1936 (ITAA 1936) only applies to interest that is entered in the Australian branch's accounting records in respect of a 'notional borrowing' that is taken under Part IIIB of the ITAA 1936 to have been provided by the foreign bank to the Australian branch. A 'notional borrowing' will not be taken to have been provided to the Australian branch if an amount has not been 'made available' by the foreign bank for use by the Australian branch.

A foreign bank carries on business through a permanent establishment in Sydney, Australia. That foreign bank has another branch operating from Hong Kong .

On 1 July 2003, the Australian branch arranged to borrow a sum of money from a third party lender located in Singapore for use in its banking business. However, this loan was booked through the branch operating from Hong Kong. The branch in Hong Kong played no role in raising the funds .

The sum borrowed by the bank is entered in the Australian branch's accounting records as having been provided to the branch by the Hong Kong branch. The amount of 'interest' payable by the Australian branch is entered in the branch's accounting records as interest that is payable to the Hong Kong branch in respect of each six month period .

As the Hong Kong branch played no role in obtaining the loan, the 'amount' recorded in the books will not constitute an amount that has been 'made available' by the Hong Kong branch for use by the Australian branch. In these circumstances Part IIIB of the ITAA 1936 will not deem the notional interest to be interest paid by the Australian branch to the Hong Kong branch and as a consequence there will be no amount to which section 160ZZZJ of the ITAA 1936 can apply. However, as the loan is traceable to the non-resident third party lender, the lender will be liable under section 128B of the ITAA 1936 to pay interest withholding tax on the full amount of any interest derived by it under the loan .

When the final Determination is issued, it is proposed to apply both before and after its date of issue. However, the Determination will not apply to taxpayers to the extent that it conflicts with the terms of settlement of a dispute agreed to before the date of issue of the Determination.

Part IIIB of the ITAA 1936 was introduced to recognise certain intra-bank transactions, including intra-bank loans, for the purpose of determining the taxable income of Australian branches of foreign banks. One of the reasons for introducing Part IIIB was the difficulty foreign banks have knowing the precise cost of funding used by their branches. The difficulty arises because intra-bank funding is generally provided from a pool of funds formed by a bank from an aggregation of deposits and other loans. [1]

Under Part IIIB of the ITAA 1936 interest treated as being paid to a foreign bank by an Australian branch of the bank on an intra-bank loan is subject to non-resident interest withholding tax. [2] A foreign bank cannot elect out of the operation of Part IIIB in so far as it applies withholding tax to amounts that are taken to be interest under Part IIIB. [3]

The method for determining the amount of interest withholding tax payable by a foreign bank in respect of amounts that are deemed to be interest under Part IIIB of the ITAA 1936 is set out in section 160ZZZJ of the ITAA 1936. Where section 160ZZZJ applies, interest withholding tax is calculated on 50% of the interest amounts deemed by Part IIIB to be paid by the Australian branch to the foreign bank.

Part IIIB of the ITAA 1936 is not, however, an exclusive code in relation to withholding tax on interest paid by foreign banks. Section 128B of the ITAA 1936 may impose interest withholding tax on interest paid by a foreign bank and derived by a non-resident where the interest has been incurred by the bank in carrying on business through its Australian branch. [4]

For section 160ZZZJ of the ITAA 1936 to apply, among other things, an amount must be taken by Part IIIB of the ITAA 1936 to be interest paid to, and derived by, a foreign bank by the Australian branch. [5] An amount will be taken to have been paid to, and derived by, the foreign bank where an amount is taken to have been borrowed by the Australian branch from the foreign bank and, subject to a statutory ceiling, [6] an amount is entered in the branch's accounting records as being interest in respect of that borrowing.

An amount will be treated as having been borrowed by the Australian branch from the foreign bank where an 'amount' has been 'made available' by the foreign bank for use by the Australian branch and the amount is recorded in the branch's accounting records as having been provided by the bank to the branch. [7]

The use of the expression 'made available' in section 160ZZZ of the ITAA 1936 means that the real effect of what has taken place must be that another part of the bank has itself placed an amount at the disposal of the Australian branch. [8] Therefore, for example, an Australian branch will not be taken to have borrowed an amount from the foreign bank where it is evident that the Australian branch has itself arranged a borrowing directly from a third party and has simply booked the borrowing through another branch's accounts. Nor will the Australian branch be taken to have borrowed an amount from the foreign bank where another branch has acted at the direction of and on behalf of the Australian branch in arranging a borrowing for the Australian branch from a third party (as distinct from the other branch simply accessing the foreign bank's pool of funds). [9] In such cases any interest paid by the foreign bank and derived by a non-resident in respect of such a borrowing will be liable to withholding tax in accordance with subparagraph 128B(2)(b)(ii) of the ITAA 1936 (subject to the possible operation of subsection 128B(3) of the ITAA 1936). [10]

We invite you to comment on this draft Taxation Determination. Please forward your comments to the contact officer by the due date. (Note: The Tax Office prepares a compendium of comments for the consideration of the relevant Rulings Panel. The Tax Office may use a sanitised version (names and identifying information removed) of the compendium in providing its responses to persons providing comments. Please advise if you do not want your comments included in a sanitised compendium.) Due date: 26 May 2006 Contact officer: Contact officer details have been removed following publication of the final ruling.