Senate

Explanatory Memorandum

(Circulated by the authority of the Treasurer the Hon Ralph Willis, M.P.)

CHAPTER 11 - TAXATION OF AUSTRALIAN BRANCHES OF FOREIGN BANKS

Overview

11.1 The Bill will insert a new Part IIIB into the Income Tax Assessment Act 1936 (the Act). Part IIIB will include new measures for the taxation of an Australian branch of a foreign bank. It will also apply non-resident interest withholding tax to interest that is treated as being paid by an Australian branch of a foreign bank to the foreign bank. The Bill will also repeal existing section 128M of the Act.

Summary of the amendments

Purpose of the amendments

11.2 The amendments of the income tax law will establish a new regime for the taxation of Australian branches of foreign banks as announced in the former Treasurer's Banking Policy Statement on 18June1993. This new regime will recognise intra-bank loans, derivative transactions and foreign exchange transactions by treating the branch as an entity separate from the foreign bank for the purposes of determining the liability of the foreign bank to tax in Australia. Under the new measures non-resident interest withholding tax will be applied to interest treated as being paid by the branch to the foreign bank. [Clause 112]

Date of effect

11.3 The provision that treats certain foreign banks as Australian entities and Australian residents for withholding tax purposes will be repealed with effect from 18 June 1993.

11.4 The amendment relating to interest withholding tax on intra-bank interest will take effect on the first day of a taxpayer's income year beginning after the date of introduction of the Bill (30 June 1994).

11.5 The amendments allowing a foreign bank branch to receive and transfer both revenue losses and capital losses will apply to assessments in respect of the first year of income following the year of income in which the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 commenced and for all later years of income. The Financial Corporations (Transfer of Assets and Liabilities) Act 1993 commenced on 22 December 1993.

11.6 The other foreign bank branch taxation measures will take effect in respect of a taxpayer's first year of income following the date of introduction of the Bill (30 June 1994). [Clause 116]

Background to the legislation

11.7 In the 1992 One Nation statement the Government announced that it would legislate to allow foreign banks to carry on wholesale banking business in Australia through branches. However, the One Nation statement did not deal with the taxation aspects of foreign banks operating in Australia through branches.

11.8 Following consultation on the taxation issues with the banking industry the Treasurer's Banking Policy Statement of 18 June 1993 set out both the transitional and on-going taxation measures. The transitional measures were designed to assist the transition from subsidiary to branch banking for certain subsidiaries of foreign banks operating in Australia and were enacted in the Financial Corporations (Transfer of Assets and Liabilities) Act 1993 . The on-going measures apply a new taxation regime for foreign banks operating through branches in Australia.

11.9 As a general principle, a foreign bank branch, its head office and other branches are part of the one legal person, the foreign bank. At law, a legal person cannot enter transactions with itself. This is called the single entity approach. For taxation purposes however, it is necessary to determine the taxable income of an Australian branch of a foreign bank. In that respect it is often difficult to ascertain the appropriate allocation of the foreign bank's income and deductions to the Australian branch.

11.10 For example, funding provided by the foreign bank to its Australian branch will generally be provided from the bank's pool of funds which has been formed by the aggregation of deposits and other funds. The pool of funds is used, amongst other things, by a bank to provide loans to customers. It will generally be difficult for the bank to know the precise cost of funds provided to the Australian branch because the foreign bank's pool of funds will have many sources with different costs. Further, the use of an average cost of funds mechanism is seen as being costly, inaccurate and time consuming.

11.11 It is common, however, for the branch of a foreign bank to operate as a separate profit centre and to notionally enter transactions with the foreign bank Accordingly, the new measures will treat the Australian branch and foreign bank as if they were separate entities in order to recognise certain intra-bank transactions for the purpose of determining the taxable income of the Australian branch. Under the new measures interest treated as being paid to the foreign bank by an Australian branch of the bank on an intra-bank loan will be subject to non-resident interest withholding tax.

11.12 A new measure, called the notional equity requirement, will treat part of the branch's overall funding as notionally representing equity funding of the Australian branch operations of the bank. This measure is consistent with existing policy on thin capitalisation. Therefore a part of a branch's interest expense arising from loan funding will not be deductible.

Explanation of the amendments

Definitions of terms used in new Part IIIB

11.13 The definitions for the new measures on the taxation of Australian branches of foreign banks are located in Division 1 of new Part IIIB. [Clause 114 - new section 160ZZV]

Treating an Australian branch as if it were a separate legal person

11.14 The tax liability of a foreign bank on income derived by the Australian branch of the bank will be determined by reference to the Australian branch's taxable income. The provisions of new Division 2 set out the methods for determining certain aspects of the branch's taxable income.

11.15 Under the new measures, the branch will be treated, for certain purposes, as if it were a separate company for determining the liability of a foreign bank to tax. The branch is treated as having been a company since its establishment. Under this legal fiction loans to the branch from the foreign bank and derivative transaction and foreign exchange transactions between the branch and the foreign bank will be treated as if they were made between two separate companies. Consequently loans, derivative and foreign exchange transactions are treated as if they were real transactions for taxation purposes.

11.16 These intra-bank transactions are recognised by virtue of the legal fiction in new section 160ZZW which applies in respect of new 160ZZZ, 160ZZZA, 160ZZZB, 160ZZZC, 160ZZZE and 160ZZZF . The legal fiction also extends to the other provisions of the Act as they operate in relation to those transactions to determine the taxable income of the branch.

11.17 It is intended that section 136AD of the Act is to apply to the notional transactions recognised by new Part IIIB. In order to put this beyond doubt, new subsection 160ZZW(4) confirms that the Australian branch is to be treated as not being an Australian permanent establishment of the foreign bank for the purposes of the transfer pricing provisions in Division 13 of Part III of the Act.

11.18 The separate entity legal fiction also applies to new section 160ZZZJ for the purpose of determining the liability of the foreign bank to interest withholding tax for interest treated as being paid by the Australian branch to the foreign bank. [New section 160ZZW]

Income of the branch to have an Australian source

11.19 The income attributable to the Australian branch of a foreign bank will be treated for the purposes of the income tax law as having an Australian source. This new provision places beyond doubt the source of income connected with the Australian branch of a foreign bank. [New 160ZZX]

11.20 A deduction will be available for foreign tax paid on income attributable to the Australian branch which is treated as having an Australian source under new section 160ZZX. [New section 160ZZY]

Interest expense deductions

Notional borrowing by an Australian branch from the foreign bank (intra-bank loans)

11.21 The Australian branch of a foreign bank is to be treated as having borrowed funds from the foreign bank where the foreign bank has made funds available for use by the branch and the branch's accounting records show those funds as having been provided to the branch by the foreign bank. The loan is treated as being borrowed in the currency in which the funds were provided to the Australian branch. [New section 160ZZZ]

Payment of interest on intra-bank loans

11.22 Interest on intra-bank loans will be treated as being incurred and paid when the accounting records of the branch show that an amount was borrowed by the Australian branch and an amount of interest, for a particular period, is entered in the branch's accounting records as being interest in respect of the borrowing. This acknowledges that, in the case of intra-bank loans, interest may be paid by means of a book entry instead of an actual payment of funds. [New paragraphs 160ZZZA(1)(a) & (b)]

Ceiling rate of interest on intra-bank loans

11.23 In relation to intra-bank loans to the Australian branch, there will be a ceiling rate of interest. The ceiling rate will be the London inter-bank offer rate (LIBOR). This is the rate of interest that a bank in London is willing to lend funds to other banks. LIBOR is quoted by international business information services such as the Reuter Monitor Money Rates Service. There is a LIBOR for most currencies for loan terms of up to one year. [New paragraph 160ZZZA(3)(a)]

11.24 Where intra-bank funds are provided at a rate that is in excess of LIBOR the branch will be denied a deduction for the excess. In other words, the maximum rate of deductible interest on intra-bank loans is LIBOR. [New paragraph 160ZZZA(1)(c)]

11.25 The applicable LIBOR is that which applies in respect of loans in that currency for a term equal to the number of days in the period in respect of which interest is calculated under the loan from time to time. The applicable LIBOR is to be determined at the beginning of each period that interest is reset. Where there is no LIBOR for a term equal to the particular period used for the calculation of interest, the applicable LIBOR will be that which applies in respect of loans for a term of days closest to the reset period. Where the term of the loan is such that there could be two applicable LIBOR's, the applicable LIBOR will be that which applies in respect of loans for the shortest term. [New subsections 160ZZZA(2) & (3)]

Example 1

Assume that an Australian branch of a foreign bank borrows $100m for 2years from its head office located in New York. The interest under the terms of the intra-bank loan are reset every 180 days at the 180 day LIBOR plus 100 basis points, at the beginning of the period. Under new section 160ZZZA the branch will have the 100 basis points of interest excess over LIBOR, as at each 180 day reset, disallowed as a deduction. The remainder of the interest expense will be allowable as a deduction. This deduction will then be subject to the notional equity requirement discussed in paragraphs 11.26 & 11.27.

Notional equity requirement

11.26 Under the notional equity requirement in new section 160ZZZB , a part of the branch's funds are treated as equity under the new rules. To give effect to this policy, part of the Australian branch's debt funding will be treated as equity funding for tax purposes and consequently a deduction for interest on this notional equity component will be denied.

11.27 Under the notional equity requirement a branch's total interest deduction is reduced by 4 per cent. To apply this measure the branch must determine its interest deduction under subsection 51(1) of the Act. This new rule is subject to the ceiling rate of interest, under new section 160ZZZA, which is discussed in paragraphs 11.23-11.25. This measure does not apply to the offshore banking unit (OBU) operations of a branch. [New section 160ZZZB]

Example 2

Assume that the Australian branch of a foreign bank is entitled to an interest deduction of $200m. Assume further that this interest expense is comprised of interest paid to resident third party lenders of $50m and interest paid to its London head office of $150m at LIBOR. The notional equity requirement in new section 160ZZZB will disallow 4 per cent of the branch's total interest expense that would otherwise have been an allowable deduction. Under the notional equity requirement, $8m is disallowed as a deduction, reducing the branch's deduction to $192m.

Derivative products traded between an Australian branch and the foreign bank

11.28 Derivative products are financial instruments used for the purposes of eliminating or reducing risk from interest rate or currency exposure, exploiting comparative advantages or for profit-making. Such products in relation to interest or currency may include swaps, futures, options and forward contracts.

11.29 Derivative product transactions between an Australian branch and the foreign bank, reflected in the accounting records of the branch, will be recognised for Australian taxation purposes. The time of either payment or receipt under an intra-bank derivative product transaction will be when the branch's accounts are either debited or credited. [New 160ZZZE]

Foreign exchange transactions between an Australian branch and the foreign bank

11.30 A foreign exchange transaction is a transaction in which one currency is exchanged for another.

11.31 Foreign exchange transactions between an Australian branch and the foreign bank, reflected in the accounting records of the branch, will be recognised for Australian taxation purposes. The time of either payment or receipt under an intra-bank foreign exchange transaction will be when the branch's accounts are either debited or credited. [New subsection 160ZZZF]

Offshore banking units

11.32 An OBU is defined in section 128AE of the Act to mean a legal person in relation to whom a declaration is in force under that section. OBUs are entitled to certain interest withholding tax and income tax concessions. Entities eligible to be an OBU are licensed banks or foreign exchange dealers. A foreign bank with an Australian branch may be approved by the Treasurer to operate an OBU provided that the OBU keeps separate accounts.

11.33 Where a foreign bank carries on OB activities within its Australian branch, the Act will treat the branch as if it were an OBU for the purposes of the Act. [New section 160ZZZC]

Thin capitalisation

11.34 Thin capitalisation is a term that refers to companies that are funded by an excessive amount of debt or borrowings and very little share or equity capital. This means that a thinly capitalised company is primarily financed by borrowings rather than equity capital of shareholders. The thin capitalisation rules of the income tax law, contained in Division 16F of Part III of the Act, are an anti-avoidance measure and impose a "foreign debt" to "foreign equity" ratio on loans to Australian companies from related non-resident parties. If the set ratio of 6:1 for financial institutions and 3:1 for other taxpayers is exceeded, a corresponding proportion of the taxpayer's interest expense is disallowed.

11.35 The thin capitalisation rules will not apply to a foreign bank operating a branch banking business in Australia through a permanent establishment. This effect is achieved by not treating the foreign bank as a "foreign investor". Consequently the Australian branch of a foreign bank may borrow funds from related non-resident parties without any thin capitalisation consequences. [New section 160ZZZD]

11.36 The notional equity requirement, discussed at paragraphs 11.26 & 11.27 will replace the thin capitalisation rules for foreign bank branches.

Transfer of group losses between an Australian branch of a foreign bank and Australian subsidiaries of the foreign bank

Background

11.37 Under section 80G, a company which is part of a wholly owned group, may transfer a loss to another resident company of the group. The transferor and transferee companies must have the same beneficial ownership in the year of income in which the loss is incurred, the income year in which the loss is transferred, and the intervening period. Following the transfer the loss is treated as the loss of the transferee.

11.38 Similar provisions apply to capital losses. Section 160ZP of the Act allows a resident company incurring a capital loss to transfer that loss to another company in the group that has an accrued net capital gain.

11.39 As the foreign bank is a non-resident for tax purposes, these rules preclude it from being able to transfer or receive losses.

Loss transfers between the Australian branch of a foreign bank and Australian subsidiaries of the bank

11.40 New Part IIIB will allow loss transfers between the Australian branch of a foreign bank and Australian subsidiaries of the bank. This will be achieved by treating an Australian branch of a foreign bank as if it were both a resident of Australia and a subsidiary of the foreign bank for the purposes of section 80G of the Act. [New 160ZZZG]

11.41 An Australian branch of a foreign bank and Australian subsidiaries of the bank will also be allowed to transfer and receive capital losses. This will be achieved by treating the Australian branch as if it were both a resident of Australia and a subsidiary of the foreign bank for the purposes of section 160ZP. [New section 160ZZZH]

Certain transactions by foreign bank to be disregarded

11.42 In determining the taxable income of the Australian branch of a foreign bank, any costs of the foreign bank in relation to fund raising, derivative transactions and foreign exchange transactions other than those incurred through its Australian branch will be disregarded. New Part IIIB provides the only mechanism for attributing the costs of such transactions to the branch. [New section 160ZZZI]

Withholding tax on interest paid by an Australian branch of a foreign bank to the foreign bank

11.43 The new withholding tax measures will give effect to the Treasurer's announcement in the Banking Policy Statement that foreign bank branches will pay interest withholding tax on 50 per cent of their intra-bank interest. Interest withholding tax will be applied to interest that is treated as being paid by the Australian branch of the bank to the foreign bank. The interest withholding tax will be applied to amounts allowed as interest deductions under Divisions 1 and 2 of new Part IIIB of the Act (see paragraphs 11.21-11.27). Thus where a branch is treated as paying interest to the foreign bank, an obligation is placed on the bank to deduct withholding tax. These measures will not apply to interest on borrowings by OBUs which are exempt from interest withholding tax under section 128GB of the Act (OBU interest).

11.44 Interest withholding tax will be applied where the following conditions are satisfied. Firstly, an amount must be treated under new subsection 160ZZZA(1) as interest paid and derived by the foreign bank. As stated in paragraphs 11.21-11.25, intra-bank interest is recognised under subsection 160ZZZA(1) through the legal fiction of treating the branch and foreign bank as if they are separate legal entities. Secondly, section 128B of the Act must apply to that amount, or part of that amount, which is called the "taxable amount". Where these requirements are satisfied the provisions of new subsection 160ZZZJ(2) apply. [New subsection 160ZZZJ(1)]

11.45 The amount of intra-bank interest which is subject to interest withholding tax under section 128B of the Act is worked out using the formula:

taxable amount less notional equity requirement/2


Under this formula the amount of the notional equity requirement (defined in new subsection 160ZZZJ(2), see paragraphs 11.26 & 11.27) is subtracted from the taxable amount (defined in new subsection 160ZZZJ(1)). The result is that the intra-bank interest for which the branch has been allowed a deduction, other than OBU interest, will be subject to interest withholding tax. This amount is then divided in half. [New subsection 160ZZZJ(2)]

11.46 The features of the new withholding tax are:

•

The term "notional equity requirement" is defined in new subsection 160ZZZJ(2) to mean 4 per cent of the taxable amount. The notional equity requirement amount, which is not allowed as a deduction to the branch, is not subject to interest withholding tax.

•

In accordance with section 128C of the Act, an amount of interest withholding tax is required to be paid at the expiration of 21 days after the end of the month in which the interest is treated as having been paid. [New subsection 160ZZZJ(3)]

•

At year end, when the branch's accounts are finalised certain discrepancies may be disclosed which have resulted in either the payment of insufficient or excess withholding tax. In this situation the discrepancy must be corrected by either a refund of withholding tax or the branch being required to pay additional withholding tax. [New subsection 160ZZZJ(4)]

Example 3

Using the assumptions in Example 2 (paragraph 11.27), the Australian branch of the bank paid interest to its head office of $150m at LIBOR. Under the notional equity requirement in new section 160ZZZB, 4 per cent of this interest expense will be disallowed as a deduction. This will reduce the branch's deduction for intra-bank interest to $144m.

New section 160ZZZJ sets out the method for determining the interest withholding tax payable by the branch. The "taxable amount" under new paragraph 160ZZZJ(1)(b) is $150m, ie the intra-bank interest. The "notional equity requirement" under new subsection 160ZZZJ(2) is $6m, ie 4 per cent of the taxable amount. Under the formula in new subsection 160ZZZJ(2) the interest withholding tax payable will be calculated as follows:

$150m-$6m/2 = $72m


The intra-bank interest that will be subject to interest withholding tax at a rate of 10 per cent will be $72m and the branch will be required to pay interest withholding tax of $7.2m.

Record keeping requirements

11.47 Foreign banks will be required under new subsection 262A(1B) to keep separate identifiable records in respect of money used in the activities of the Australian branch. This will require the bank to keep separate books of account for the branch and to keep the funds of the branch separate from those of the bank. [Clause 115]

Repeal of section 128M of the Act

11.48 As announced in the Treasurer's Banking Policy Statement , section 128M of the Act will be repealed with effect from 18 June 1993, the date of the statement. Section 128M treats certain Australian branches of foreign banks as Australian entities and Australian residents for the purposes of the section 128F interest withholding tax exemption. [Clause113]