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Tax treaty relief from Australian interest withholding tax for US or UK financial institutions In brief: Partner Diccon Loxton (view CV)and Senior Associate Thomas McAuliffe highlight certain aspects of a new draft Taxation Ruling on withholding tax and discuss the practical implications for Australian borrowers. |
- The new 'Interest' Article
- Which entities will be accepted as 'banks'?
- Other enterprises substantially deriving their profits from spread activities
- Exceptions to the zero withholding rate for 'financial institutions'
- Risk allocation issues
Since Australia entered into revised double tax treaties with the United States and the United Kingdom during the past two years, both lenders resident in those countries and Australian borrowers have been tentatively considering the new 'Interest' Article in each of those treaties. That Article exempts payments of interest to some US and UK lenders from Australian interest withholding tax (IWHT). Some welcome guidance on this issue has been released by the Australian Taxation Office (ATO) in the form of a draft Taxation Ruling (TR 2004/D16).
The new 'Interest' Article
Under Article 11 of each of the double tax treaties between Australia and the US and the UK, Australia may not tax interest arising in Australia that is beneficially owned by a resident of the US or the UK if that interest is derived by a 'financial institution' that is unrelated to and dealing wholly independently with the payer. For the purposes of each treaty, 'financial institution' is defined to mean:
a bank or other enterprise substantially deriving its profits by raising debt finance in the financial markets or by taking deposits at interest and using those funds in carrying on a business of providing finance.
In the draft ruling, the ATO states that it will interpret this definition as comprising two distinct categories of financial institution, being:
- banks; and
- other enterprises substantially deriving their profits from raising debt finance in the financial markets or by taking deposits at interest and using those funds in carrying on a business of providing finance.
Which entities will be accepted as 'banks'?
According to the draft ruling, the ATO will regard as banks entities that are residents of the US or the UK that:
- have been granted their principal licence to operate as a bank in either the US or the UK where they are resident respectively, as distinct from operating in either country as the holder of a foreign banking licence; and
- satisfy the capital adequacy requirements necessary to operate as a bank, as distinct from other categories of deposit-taking institutions, in either the US or the UK.
Where an entity satisfies these requirements, the ATO will accept that it is a 'bank' for the purposes of each treaty, in which case it will not need to satisfy the other elements of the 'financial institution' definition. Subsidiaries of banks, that do not themselves hold a banking licence, will not be regarded by the ATO as banks and will therefore need to satisfy the 'other enterprises' category of financial institution (see below).
Credit unions, building societies and saving and loans institutions that have lower capital adequacy requirements than those required of banks will not be regarded as banks by the ATO. However, those entities may still qualify as financial institutions for the purposes of the treaty where they satisfy the additional requirements applicable to 'other enterprises'.
Other enterprises substantially deriving their profits from spread activities
Where an enterprise does not meet the ATO's criteria for a bank, it may nevertheless qualify as a financial institution for the purposes of the treaties if it substantially derives its profits by raising debt finance in the financial markets, or by taking deposits at interest, and using those funds in carrying on a business of providing finance.
This definition of financial institution comprises numerous elements, each of which is considered in some detail by the draft ruling. The manner in which the ATO has dissected the definition of this category of financial institution, and the examples given in the draft ruling, amplify the need to undertake a careful and detailed analysis of whether protection from IWHT will, in fact, be available under the new 'Interest' Article in each of the treaties.
Exceptions to the zero withholding rate for 'financial institutions'
The draft ruling also discusses the circumstances in which Australia will retain the right to tax interest arising in Australia because:
- the US or UK financial institution is related to, and not dealing wholly independently with, the Australian borrower;
- the interest is effectively connected with an Australian permanent establishment of the US or UK financial institution; or
- the interest is paid as part of an arrangement involving 'back to back' loans.
Risk allocation issues
It will be important for Australian borrowers to appreciate that they bear the primary risk associated with the non-payment of IWHT if it transpires that the US or UK lender is not, in fact, entitled to the zero withholding rate under the relevant treaty, even where there is no gross-up clause.
If an Australian borrower failed to withhold an amount of IWHT payable for interest paid to a US or UK lender, the Australian borrower would be liable for the amount of tax that should have been withheld and remitted to the ATO, together with any late payment interest and, possibly, penalties. Any income tax deductions that the Australian borrower had claimed for the relevant interest expense would also be jeopardised.
Therefore, the losses that an Australian borrower may sustain could be significant. In this regard, it is worth noting that many of the factors on which eligibility for treaty protection rests are matters that will be primarily, if not solely, within the knowledge and control of the lender. Accordingly, Australian borrowers from US or UK lenders who claim to be entitled to the zero withholding rate under the US or UK treaty should require:
- a warranty from the lender that it is entitled to the zero withholding rate under the relevant treaty, together with a representation that it will continue to be so entitled (subject to a change in law);
- an undertaking by the lender to notify the Australian borrower on a timely basis if it ceases to be entitled to the zero withholding rate; and
- an indemnity from the lender for any amounts payable by the Australian borrower to the ATO if that warranty or representation turns out to be incorrect, or if it breaches the undertaking.
Of course, where an Australian borrower undertakes a borrowing by way of an issue of debentures that satisfies the 'public offer test' and other requirements of the section 128F exemption from IWHT, it will not be necessary for the parties to consider whether the US or UK lender is entitled to the zero withholding rate under the relevant treaty. That remains a safer option when available.
