ATO Interpretative Decision

ATO ID 2004/962

Income tax

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Issue

Does the making of financial derivative contracts by a company, which has applied to become an Offshore Banking Unit (OBU), as broker on behalf of offshore persons with other offshore persons qualify as an investment activity for the purposes of subsection 121D(6) of the Income Tax Assessment Act 1936 (ITAA 1936)?

Decision

Yes, if it is successful in obtaining the OBU status and only in circumstances where the broker's client has entered into the financial derivatives contract with an expectation to receive income or make a gain. Accordingly, where the broker is unable to determine such a purpose on the part of its client, the activity is unlikely to qualify.

Facts

The company is an Australian resident company and has applied to the Treasurer to be declared an OBU.

It is proposed that interest rate derivative broking activities be conducted by the OBU. The financial brokerage services encompass the facilitation of foreign currency interest rate based derivative contracts (such as over-the-counter (OTC) foreign currency interest rate swaps and foreign currency interest rate options) as broker for and between non-residents of Australia who are not acting through an Australian permanent establishment. The financial derivative contracts between the offshore parties are documented as standard International Swap Dealers Association (ISDA) agreements. In essence, the broking activities encompass the acting as intermediary between the offshore counterparties entering into financial derivative contracts.

Reasons for Decision

Section 121D of the ITAA 1936 sets out the circumstances in which a transaction entered into by an OBU^[1] is an offshore banking (OB) activity. Only income derived by an OBU from an OB activity is taxed concessionally under Division 9A of the ITAA 1936. For an activity engaged in by an OBU to be an OB activity, three conditions must be satisfied:

(i)

The activity must be:

(a)

borrowing or lending money;

(b)

providing certain types of guarantees;

(c)

trading in certain assets;

(d)

entering into certain contracts;

(e)

making and managing certain investments;

(f)

providing financial advice;

(g)

hedging against certain risks; or

(h)

another activity declared by regulation to be an OB activity;

(ii)

The other party to the transaction must be an offshore person as defined by section 121E of the ITAA 1936, except where the activity is a trading activity within sec 121D(4)(d) or (e) of the ITAA 1936 and

(iii)

The OBU must, at the time of the activity, be either:

(a)

a resident, and the activity is not done in carrying on business outside Australia at or through a permanent establishment of the OBU; or

(b)

a non-resident, and the activity is done in carrying on business in Australia at or through a permanent establishment of the OBU (section 121EA of the ITAA 1936).

Investment activity is defined in subsection 121D(6) of the ITAA 1936 as follows:

For the purposes of paragraph (1)(e), an "investment activity" is making (but not managing), as broker or agent for, or trustee for the benefit of, an offshore person to whom paragraph 121E(a) applies, an investment with an offshore person to whom that paragraph applies, where:

(a)

the currency in which the investment is made is not Australian currency; and

(b)

if the investment involves the purchase of any thing:

(i)

if the thing is a share in a company - the company is a non-resident company; or

(ii)

if the thing is a unit in a unit trust - the unit trust is a non-resident trust; or

(iii)

if the thing is land or a building - the land or building is not in Australia; or

(iv)

in any other case - the thing is located outside Australia.

Investment activity, within the meaning of subsection 121D (6) of the ITAA 1936, means making (as broker, agent or trustee for the benefit of an offshore person) an investment with an offshore person. The investment must be made in non-Australian currency. The investors must be non residents. If the investment involves the purchase of something, it must be something which is not in Australia. The OBU must be acting in the capacity of a broker, agent or trustee in making the investment for the benefit of an offshore person; it must not be acting on its own behalf

According to the facts provided, the company will be conducting financial brokerage services which will include the facilitation of foreign currency interest rate based derivative contracts (OTC foreign currency interest rate swaps and foreign currency interest rate options) as broker for and between non-residents of Australia. These activities encompass the acting as intermediary between the counterparties entering into the derivative contracts which will be denominated in foreign currency. Any Australian currency denominated contracts will be recorded as a non-OBU activity.

The company satisfies the requirements that it must deal in foreign currency and act in the capacity of a broker on behalf of offshore persons, but the question arises whether entering into derivative contracts (the foreign currency interest rate swaps and foreign interest rate options) constitutes investment for the purposes of 121D (6) of the ITAA 1936.

In general, an interest rate swap involves two parties exchanging interest payment streams based on a notional principal over a period of time in the same currency. The interest payment streams are determined by applying a rate of interest to the notional principal and each party's payment is calculated by reference to a different rate of interest. An interest rate option is an option over an instrument such as a bond, giving the buyer, in return for the payment of a premium, the right (but not the obligation) to buy (if a call option) or to sell (if a put option) the given bond at a specified price on or before a specified date.

This means that entering into such arrangements creates contractual rights which constitute a chose in action which in turn is an asset. The company has reached similar conclusions to this point but further contends that the derivatives represent assets and therefore the acquisition of such assets is an investment for subsection 121D (6) of the ITAA 1936 purposes.

The view taken by the ATO is that not all acquisitions of such assets amount to investment. The Macquarie Dictionary, 2001, rev. 3rd edn, The Macquarie Library Pty Ltd, NSW provides the ordinary meaning of the term investment as 'the investing of money or capital in order to secure profitable returns, especially interest or income.'

The definition encompasses the notion that there is an expectation of profit or income. Not all derivative contracts are entered into to receive income or to make a gain since derivatives also serve a risk management function as a hedge or cheaper means of financing for certain transactions undertaken by businesses. If the interest rate derivatives are being used as a risk management technique or as a means of obtaining lower cost of financing by the company's clients then it may be said that the entering into such contracts is not an investment. On the other hand if the interest rate derivative contracts were entered into to manage portfolios; for trading, speculation or creating exposure to a particular position in the market(s) or for arbitrage to take advantage of pricing anomalies in financial markets, it could be argued that there was an expectation of receiving an income or making a gain and such derivatives could amount to investment.

Therefore, in the Tax Office's view, the facilitation of foreign currency interest rate based derivative contracts (OTC foreign currency interest rate swaps and foreign currency interest rate options) as broker may be making an 'investment' for the purposes of 121D (6) of the ITAA 1936 in certain situations. Those situations will depend on the factual circumstances of each client indicating the purpose served by these contracts. That is, entered into to receive income or to manage risk or to reduce cost of capital. It is considered that the intent to receive income or to make profit is a necessary element for the making of an 'investment' with respect to the provisions of 121D (6) of the ITAA 1936.

Amendment History

Year of income:  Year ended 30 June 2004 Year ended 30 June 2005 Year ended 30 June 2006 Year ended 30 June 2007 Year ended 30 June 2008

Legislative References:
Income Tax Assessment Act 1936
   section 121D
   subsection 121D(6)
   section 121EA

Related Public Rulings (including Determinations)
Taxation Determination TD 93/133

Other References:
Explanatory Memorandum to Taxation Laws Amendment Bill (No. 4) 1992
Macquarie Dictionary, 2001, rev. 3rd edn, The Macquarie Library Pty Ltd, NSW

Keywords
International tax
Offshore banking
Offshore banking activities
Offshore banking units

Siebel/TDMS Reference Number:  3589618

Business Line:  Public Groups and International

Date of publication:  10 December 2004
Date reviewed:  12 October 2021

ISSN: 1445-2782