House of Representatives

Revised Explanatory Memorandum

(Circulated by authority of the Treasurer, the Hon Peter Costello, MP)

Chapter 1 - Interest withholding tax exemptions

Outline of chapter

1.1 Schedule 1 to this bill explains amendments to Division 11A of Part III of the ITAA 1936 that will remove certain impediments to Australian businesses raising finance and reduce certain compliance costs. The measures will further enhance Australia's development as a centre for financial services in the Asia-Pacific region.

Context of amendments

1.2 The amendments explained in this chapter give effect to three measures announced by the former Assistant Treasurer and the former Minister for Financial Services and Regulation in Press Release No. 42 of 29 August 2001 which relate to:

•

the associates prohibitions contained in section 128F of the ITAA 1936;

•

deemed interest payments under section 128AA of the ITAA 1936 and the interaction with section 128F; and

•

interest paid on nostro accounts.

1.3 Although each of the measures is distinct, they all relate to the imposition of IWT.

What is IWT?

1.4 The taxation of Australian sourced interest paid or credited to non-residents, and residents operating through offshore permanent establishments, is subject to the IWT provisions contained in Division 11A of Part III of the ITAA 1936. These provisions provide, in conjunction with the Income Tax (Dividends, Interest and Royalties) Withholding Tax Act 1974, that the recipient of Australian sourced interest is subject to WHT on the gross amount paid or credited. A rate of 10% of the gross amount of the interest is imposed. The obligation for collecting the IWT is placed on the person making the payment.

The associates tests

What is section 128F?

1.5 Section 128F of the ITAA 1936 provides an exemption from IWT where an Australian resident company or a non-resident company carrying on business at or through a permanent establishment in Australia issues debentures and the issue satisfies requirements of the public offer test contained in subsection 128F(3) or (4). In the absence of the exemption, IWT would be payable on the interest paid to foreign debenture holders.

What are the associates tests

1.6 Under subsection 128F(5) an issue of debentures will fail the public offer test, with consequential loss of eligibility for the exemption, if at the time of issue the company was aware or suspected that the debentures would be acquired by the issuing company's associates other than associates acting in the capacity of a dealer, manager or underwriter. Additionally, subsection 128F(6) denies the exemption if the issuing company was aware or suspects that the interest in respect of the debentures was paid to an associate of the company. For ease of explanation, these prohibitions will be referred to in this chapter as the 'associates tests'.

1.7 Amendments to the ITAA 1936 were made in 1999 to widen the IWT exemption provided under section 128F by removing:

•

the requirement that debentures be issued outside Australia and that interest be paid outside Australia; and

•

the restriction prohibiting the acquisition of debentures by Australian residents.

1.8 These amendments implemented parts of the 'Australia - Regional Financial Centre' component of the Investing for Growth statement announced by the Government on 8 December 1997. Those measures were aimed at making Australia a more attractive regional financial centre by building on Australia's existing advantages to ensure its participation in the increasing global trade in financial services.

1.9 Despite these changes, major Australian issuers are not issuing debentures in Australia because of the perceived risk of breaching the associates tests. This risk primarily arises where the issuer has Australian associates that are fund managers, custodians, nominees or superannuation funds that are independently required to take a weighting in major new Australian debenture issues. In these cases the associates of the issuer hold the debentures for the benefit of another party. Australian issuers indicate that they are continuing to issue into overseas markets rather than to issue domestically and expose themselves to that risk (the risk is much lower in the former case). This is frustrating the Government's policy intention behind the 1999 amendments.

1.10 A similar difficulty arises in relation to offshore issues of debentures. Offshore associates of major Australian issuers which act in the capacity of clearing houses, paying agents, custodians or funds managers also hold the debentures for short periods or in a non-beneficial capacity. There is some concern that these associates will acquire the debentures in an offshore issue and so put at risk the IWT exemption.

1.11 The associates tests will be amended to remove the perceived impediment for companies issuing debentures in Australia and remove the remaining concerns when issuing offshore. This will make it easier for companies to issue IWT-free debentures in Australia and thereby encourage this activity and reduce borrowing costs. It will also facilitate issues offshore. The amendments will further assist in integrating the domestic and offshore corporate debt markets by allowing companies to issue debt on equal terms in both markets.

Deemed interest payments under section 128AA

1.12 The interaction between section 128AA of the ITAA 1936 and section 128F is also frustrating the implementation of the 'Australia - Regional Financial Centre' measures.

1.13 Under section 128AA, where a security is sold and the transfer price of a qualifying security exceeds either the issue price or the reduced issue price of a partially redeemed security the excess is deemed to be interest income which may be subject to IWT. Section 128AA hampers the concessional treatment offered by section 128F when a non-resident on-sells a debenture issued under section 128F to an Australian resident before the debenture's maturity date. The sale triggers section 128AA to impose WHT on part of the payment made to the non-resident for the debenture. In these circumstances the concession provided by section 128F is not available because it is not the issuing company making the payment to the non-resident.

1.14 Restoring the concessional treatment will enhance the liquidity of these securities issued under section 128F and thereby improve access to global capital market funding for Australian businesses. Non-residents who acquire these securities will not be subject to WHT when they sell them and residents who acquire the securities from non-residents before their maturity will be relieved of the compliance costs associated with deducting and remitting WHT.

Interest paid on nostro accounts

What are nostro accounts?

1.15 Broadly speaking, nostro accounts are foreign currency denominated accounts maintained by ADIs with foreign banks for the purpose of settling foreign currency transactions.

1.16 IWT is currently payable on interest paid by financial institutions to an overseas bank if their nostro account held with that bank is overdrawn. The overdraft generally results from a short payment (or no payment) by an overseas counterparty depositing funds into the nostro account. These overdrafts are settled on notification and are not outstanding over considerable amounts of time. The compliance costs imposed on financial institutions in meeting the IWT obligation are very high relative to the amount of tax collected. Exempting interest paid on nostro accounts from IWT will eliminate the compliance costs imposed in meeting the current IWT obligation associated with these accounts.

Summary of new law

1.17 This bill amends the WHT provisions in Division 11A of the ITAA 1936 to:

•

exclude certain associates from the associates prohibitions contained in section 128F;

•

restore the concessional treatment under section 128F to certain securities by exempting gains deemed to be interest under section 128AA from IWT; and

•

exempt interest derived by a non-resident on nostro accounts held by certain financial institutions from IWT.

Comparison of key features of new law and current law

Detailed explanation of new law

The associates tests

1.18 For the purposes of section 128F the term 'associates' has the meaning given by section 318 of the ITAA 1936 with certain modifications. The definition of associates in section 318 is very broad.

1.19 Subsections 128F(5) and (6) rely on this definition to prevent debentures being issued and interest being paid to entities that are associates of the company issuing the debentures. The Government has decided to amend subsections 128F(5) and (6) in order to remove the perceived impediments for companies issuing debentures in Australia and remove the remaining concerns with offshore issues. The amendments make a distinction between associates operating in Australian and those that operate offshore. Broadly speaking, onshore associates are excluded from the associates test. However, offshore associates are only excluded if they acquire the debenture or receive the interest whilst acting in certain capacities.

What is the public offer test?

1.20 There are a number of tests listed in subsections 128F(3) and (4) which are collectively referred to as the 'public offer' test. Companies are required, at the time of issuing debentures, to satisfy at least one of these tests in order to qualify for the section 128F exemption. The purpose of these tests is to ensure that lenders on the capital markets are aware that a company is offering debentures for issue.

Subsection 128F(5)

1.21 As a result of the amendments, the issue of a debenture will not satisfy the public offer test if, at the time of issue, the company knew, or had reasonable grounds to suspect all of the following:

•

the debenture will be acquired by an associate and that the associate is either:

•

a non-resident and the debenture is not acquired in carrying on business at or through a permanent establishment in Australia; or

•

an Australian resident and the debenture is acquired in carrying on business at or through a permanent establishment in a country outside Australia; and

•

the debenture is not acquired by the associate in the capacity of:

•

a dealer, manager or underwriter in relation to the placement of the debenture; or

•

a clearing house, custodian, funds manager or responsible entity of a registered scheme.

[Schedule 1, items 6, 8 and 9, subsection 128F(5) and definition of 'registered scheme' and 'responsible entity' in subsection 128F(9)]

1.22 In effect, this will mean that a company will be able to issue a debenture to the following associates without failing the public offer test:

•

an Australian resident that does not acquire the debenture in carrying on business at or through a permanent establishment in a country outside Australia;

•

an Australian resident that acquires the debenture in carrying on business at or through a permanent establishment in a country outside Australia if the debenture is acquired in the capacity of:

•

a dealer, manager or underwriter in relation to the placement of the debenture; or

•

a clearing house, custodian, funds manager or responsible entity of a registered scheme;

•

a non-resident that acquires the debenture in carrying on business at or through a permanent establishment in Australia; and

•

a non-resident that acquires the debenture in carrying on business outside Australia if the debenture is acquired in the capacity of:

•

a dealer, manager or underwriter in relation to the placement of the debenture; or

•

a clearing house, custodian or funds manager.

Subsection 128F(6)

1.23 The exemption will not apply to interest paid by a company if, at the time of the payment, the company knows, or has reasonable grounds to suspect all of the following:

•

the recipient of the interest is an associate and the associate is either:

-

a non-resident and the payment is not received in respect of a debenture that was acquired in carrying on business at or through a permanent establishment in Australia; or

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* an Australian resident and the payment was received in respect of a debenture that was acquired in carrying on business at or through a permanent establishment in a country outside Australia; and

•

the associate does not receive the payment in the capacity of a clearing house, paying agent, custodian, funds manager or responsible entity of a registered scheme.

[Schedule 1, items 7 to 9, subsection 128F(6) and definition of 'registered scheme' and 'responsible entity' in subsection 128F(9)]

1.24 As a result of the amendments, interest payments to the following associates will be eligible for the exemption if the issue of the debenture otherwise satisfies the requirements of section 128F:

•

an Australian resident that does not acquire the debenture in carrying on business at or through a permanent establishment in a country outside Australia;

•

an Australian resident that acquires the debenture in carrying on business at or through a permanent establishment in a country outside Australia if the interest is received in the capacity of a clearing house, paying agent, custodian, funds manager or responsible entity of a registered scheme;

•

a non-resident that acquires the debenture in carrying on business at or through a permanent establishment in Australia; and

•

a non-resident that acquires the debenture in carrying on business outside Australia if the interest is received in the capacity of a clearing house, paying agent, custodian or funds manager.

Paying agent

1.25 It is not uncommon for an issuer of debentures to appoint another entity to make payments to debenture holders on its behalf. Paying agents acting in that capacity do not acquire the debentures. Rather, they receive the interest payments from the issuer which they then distribute to the debenture holders. For this reason, interest payments made to paying agents operating offshore will retain the exemption [Schedule 1, item 7, subsection 128F(6)]. However, the issue of a debenture to an offshore paying agent will not satisfy the public offer test because acting in that capacity does not require the paying agent to acquire the debentures [Schedule 1, item 6, subsection 128F(5)].

Deemed interest payments under section 128AA

1.26 This bill amends section 128F in order restore the concessional treatment to amounts that are deemed interest under section 128AA where the deemed interest is paid on a debenture which complies with the section 128F requirements. Specifically, the section 128F exemption will also apply where:

•

income derived on the sale of a debenture is deemed to be interest under section 128AA; and

•

at the time of issue the debenture satisfied the public offer test in section 128F.

[Schedule 1, item 5, subsection 128F(1B)]

No associates test requirement when interest is paid

1.27 Importantly, although the issue of the debenture must have satisfied the associates test in subsection 128F(5) at the time of issue, there is no associates test applied when an amount deemed to be interest under section 128AA is paid. [Schedule 1, item 5, subsection 128F(1B)]

Interest paid on nostro accounts

1.28 Paragraph 128B(3)(gc) will exempt income that consists of interest derived on a nostro account by a non-resident from IWT. [Schedule 1, item 4, paragraph 128B(3)(gc)]

1.29 To qualify for the exemption the interest must be derived on a 'nostro account'. The term 'nostro account' is defined to mean an account:

•

that an ADI or non-ADI financial institution holds with a foreign bank and maintains for the sole purpose of settling international transactions; and

•

which is operated by the ADI or non-ADI financial institution on the basis that;

•

amounts deposited in the account are held in the account for no more than 10 days; and

•

any overdrafts on the account are repaid within 10 days.

[Schedule 1, item 3, definition of 'nostro account' in subsection 128A(1)]

1.30 An 'ADI' is a body corporate that is an authorised deposit-taking institution for the purposes of the Banking Act 1959 [Schedule 1, item 1, definition of 'ADI' in subsection 128A(1)]. A non-ADI financial institution is a registered entity within the meaning of the Financial Sector (Collection of Data) Act 2001 , included as a Money Market Corporation in a list kept under that Act. This means that the exemption will be limited to merchant banks and similarly classified financial institutions that carry on the business of providing finance on a commercial basis, predominantly to unrelated parties [Schedule 1, item 2A, definition of 'non-ADI financial institution' in subsection 128A(1)]. These entities include Australian banking entities, foreign bank branches and merchant banks that carry on a general business of providing finance on a commercial basis. A 'foreign bank' is defined to mean a non-resident company that carries on banking business. There is no requirement for the foreign bank to be an ADI for the purposes of the Banking Act 1959 [Schedule 1, item 2, definition of 'foreign bank' in subsection 128A(1)]. Accordingly, interest paid by these financial institutions on nostro accounts held with foreign banks will qualify for the exemption.

Application and transitional provisions

1.31 The amendments to section 128F to exclude certain associates will apply to:

•

issues of debentures by a company on or after 29 August 2001; and

•

interest paid on or after 29 August 2001 by a company in respect of a debenture that satisfied the public offer test when it was issued. [Schedule 1, subitems 10(3) and (4)]

1.32 The amendments to restore the concessional treatment under section 128F to certain debentures caught by section 128AA will apply to the amount of the transfer price of a debenture that is, on or after 29 August 2001, deemed by section 128AA to be interest. [Schedule 1, subitem 10(2)]

1.33 The exemption for interest derived on nostro accounts in paragraph 128B(3)(gc) will apply to interest income derived on or after 29 August 2001. [Schedule 1, subitem 10(1)]

REGULATION IMPACT STATEMENT

Policy objective

1.34 The policy objective of these measures is to enhance Australia's development as a centre for financial services in the Asia-Pacific region. The proposed amendments will assist in improving Australia's capital markets by removing certain impediments to Australian businesses raising finance and by reducing and eliminating certain compliance costs.

Implementation options

1.35 Legislative amendments are necessary to implement the measures which were announced by former Assistant Treasurer and former Minister for Financial Services and Regulations in Press Release No. 42 of 29 August 2001. The amendments reflect the initiatives announced in that Press Release.

1.36 This bill amends the WHT provisions in Division 11A of the ITAA 1936 to:

•

exclude certain associates from the associates prohibitions contained in section 128F;

•

restore the concessional treatment under section 128F to certain securities by exempting from IWT gains deemed to be interest under section 128AA; and

•

exempt from IWT interest derived by a non-resident on nostro accounts held by banks and financial institutions which provide finance on a commercial basis.

Assessment of impacts

Impact group identification

1.37 The proposed amendments will affect larger Australian businesses that issue debentures under section 128F, their associates and entities who acquire those debentures. They will also impact on banks and financial institutions which provide finance on a commercial basis and maintain nostro accounts with foreign banks.

1.38 These entities will need to be aware of these measures in order to receive the benefits.

Analysis of costs / benefits

1.39 The proposed amendments will not create any new obligations or requirements for the entities impacted. The amendments will have the following benefits.

The associates tests

1.40 Prior to the 'Investing for Growth' statement in 1997, section 128F provided an exemption from IWT where a company issued debentures offshore and the issue satisfied certain requirements. Legislative changes enacted in 1999 as a result of the 'Investing for Growth' statement allow for comparable issues in Australia to be IWT-free.

1.41 Major Australian issuers are not issuing debentures in Australia because of the perceived risk of breaching certain restrictions in section 128F which do not allow debentures to be issued to or interest to be paid to associates. This risk primarily arises where the issuer has Australian subsidiaries that are fund managers, custodians, nominees or superannuation funds that are independently required to take a weighting in major new Australian debenture issues. In these cases the subsidiaries hold the debentures in a non-beneficial capacity.

1.42 Australian issuers indicate that they are continuing to issue into overseas markets rather than to issue domestically and expose themselves to that risk. This is frustrating the Government's policy intention behind the 1999 amendments.

1.43 Similarly, associates of major Australian issuers that are offshore which act in the capacity of clearing houses, paying agents, custodians and funds managers also hold the debentures for short periods or in a non-beneficial capacity. There is some concern that these associates will acquire the debentures in an offshore issue and so put at risk the IWT exemption.

1.44 The amendments to the associates prohibitions will remove the perceived impediment for companies issuing debentures in Australia. This will make it easier for companies to issue IWT-free debentures in Australia and thereby encourage this activity and reduce borrowing costs. It will also facilitate issues offshore. The amendments will further assist in integrating the domestic and offshore corporate debt markets.

Deemed interest payments under section 128AA

1.45 Under section 128AA where the transfer price of a qualifying security exceeds either the issue price or the reduced issue price of a partially redeemed security the excess is deemed to be interest income which may be subject to IWT. Section 128AA hampers the concessional treatment offered by section 128F when a non-resident on-sells a debenture issued under section 128F to an Australian resident before the debenture's maturity date. The sale triggers section 128AA to impose WHT on part of the payment made to the non-resident for the debenture. In these circumstances, the concession provided by section 128F is not available because it is not the issuing company making the payment to the non-resident.

1.46 Restoring the concessional treatment will enhance the liquidity of these securities issued under section 128F and thereby improve access to global capital market funding for Australian businesses. Non-residents who acquire these securities will not be subject to WHT and residents who acquire the securities from non-residents before their maturity will be relieved of the compliance costs associated with deducting and remitting WHT.

Interest paid on nostro accounts

1.47 IWT is currently payable on interest paid by financial institutions (i.e. Australian ADIs, Australian branches of foreign banks and financial institutions that carry on a general business of providing finance on a commercial basis) to an overseas bank if their nostro account (clearing account) held with that bank is overdrawn. The overdraft generally results from a short payment (or no payment) by an overseas counterparty depositing funds into the nostro account. The compliance costs imposed on financial institutions in meeting this IWT obligation are very high relative to the amount of tax collected. Exempting interest paid on nostro accounts from IWT will eliminate the compliance costs imposed in meeting the current IWT obligation associated with these accounts.

Impact on the ATO

1.48 There will be no systems changes for the ATO. Some ATO information publications may need to be modified to include references to the measures. There will also be a need for ATO staff to be trained on the amendments. However, these should have minimal cost impacts on administration and will be absorbed as part of business as usual.

Impact on revenue

1.49 The revenue cost of these measures is estimated to be $10 million per annum.

Consultation

1.50 Financial industry representatives have been consulted extensively over a number of years and have actively assisted in developing these initiatives.

Conclusion

1.51 These proposals will enhance Australia's development as a centre for financial services in the region by removing tax impediments and reducing and eliminating certain compliance costs. The legislation will take effect from 29 August 2001 as foreshadowed in Press Release No. 42 announcing the measures.