Senate

Explanatory Memorandum

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

Chapter 2 - Withholding tax avoidance

Overview

2.1 The proposed amendments in Schedule 2 of the Bill will amend the Income Tax Assessment Act 1936 (the Act) to:

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extend Part IVA so that it can apply to non-resident interest, dividend and royalty withholding tax;

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address avoidance arrangements which attempt to convert an interest income stream into another income form which it has been argued is not 'interest' or 'in the nature of interest';

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impose royalty withholding tax on royalties derived from Australia by a resident of Australia in the course of carrying on business through an offshore permanent establishment;

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impose withholding tax in situations where tax exempt bodies are interposed between an Australian resident payer of interest, dividend or royalties and a non-resident recipient; and

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remove any doubt that withholding tax is payable where dividends are paid out of capital reserves.

Summary of the amendments

Purpose of the amendments

2.2 The purpose of these amendments is to provide a mechanism within the Act to effectively counter withholding tax avoidance arrangements in a general and comprehensive way, to address certain specific tax avoidance arrangements which are currently being entered into and to make it clear that withholding tax is payable where dividends are paid from capital reserves.

Date of effect

2.3 The measures will apply to interest, dividend and royalty payments made after 7.30pm EST on 20 August 1996.

Background to the legislation

What is withholding tax?

2.4 The taxation of Australian sourced interest, dividends and royalties paid or credited to non-residents is subject to the provisions contained in Division 11A of the Act. These provisions provide, in conjunction with the relevant Rates Act, that the non-resident recipient is subject to withholding tax on the gross amount paid or credited. A rate of 10% is imposed in relation to interest and 30 % in the case of dividends and royalties. However, the rates for dividends and royalties are generally reduced if Australia has concluded a Double Tax Agreement with the recipient's country of residence. The obligation for the collection of withholding tax is placed on the person making the payment.

2.5 Although the general intent of Division 11A is to impose tax on non-residents deriving Australian sourced interest, dividend and royalty income, the Division also imposes withholding tax on interest paid to a resident of Australia operating through an offshore permanent establishment (for example, a branch) - subsection 128B(2A).

Collection of withholding tax and additional liabilities

2.6 Under section 221YL of the Act, the payer of interest, dividends or royalties is required to deduct from that payment, an amount of withholding tax which is determined by the percentage specified in the Income Tax Regulations (Regulations 136, 137 and 137A).

2.7 Section 221YQ imposes a liability for the failure by a payer of interest, dividends or royalties to make a deduction as specified under section 221YL. The payer is liable for the amount of withholding tax which was not deducted. However, the payer may claim the amount from the recipient after the withholding tax has been remitted to the Taxation Office. A second liability imposed under this section is an amount of additional tax determined under subsection 128C(3), which imposes a penalty, on the person liable to pay the tax, for the late payment of that tax to the Taxation Office. This amount cannot be reimbursed from the non-resident.

Amendments to Part IVA

Withholding tax and the general anti-avoidance provisions

2.8 Part IVA is a provision intended to prevent tax avoidance. It was introduced in 1981 to replace the previous general anti-avoidance provision (section 260).

2.9 The operation of Part IVA (unlike section 260) is confined to situations which give rise to a tax benefit, in the form of an amount not included in assessable income, or in the form of an amount of deduction from assessable income, gained as a result of a scheme as defined in Part IVA (specifically section 177D).

2.10 The non-resident withholding tax provisions for interest, dividends and royalties stand apart from the provisions of the law that deal with tax by assessment. Part IVA does not apply to schemes to avoid withholding tax.

2.11 Prior to the introduction in 1993 of a final withholding tax for royalties paid to non-residents, royalty income was subject to income tax by the normal assessment method and Part IVA applied.

2.12 In order to protect the non-resident withholding tax base from emerging tax avoidance practices and to provide a mechanism within the Act to effectively counter withholding tax avoidance schemes in a comprehensive way, it has become necessary to expand the effect of Part IVA to include avoidance of withholding tax on an amount of interest, dividends or royalties because of a scheme as defined in Part IVA.

Penalties in relation to Part IVA

2.13 Since 1992, section 226 has been in place to provide for the imposition of the liability for an amount of additional tax by way of penalty where an amount has been subject to a determination by the Commissioner of Taxation under section 177F of Part IVA. The liability for the additional tax falls upon the taxpayer in relation to whom the determination was made. The amount of additional tax is a penalty percentage of the amount of tax which was avoided by the use of a Part IVA scheme. The penalty percentage is either 25% or 50% of the amount of tax avoided, depending upon whether or not the taxpayer has a reasonably arguable case against the application of Part IVA.

Definition of interest

2.14 For the purposes of the withholding tax provisions, the term 'interest', which is currently defined in subsection 128A(1), includes amounts which are 'interest' within the ordinary meaning of the term and amounts which are 'in the nature of interest'.

2.15 The courts have formulated general principles for determining whether specific amounts fall within the ordinary meaning of interest, such as, 'interest is regarded as flowing from the principal sum' and to be 'compensation to the lender for being kept out of the use and enjoyment of the principal sum'. Interest is also said to be calculated by reference to a period of time and that it accrues on a daily basis.

2.16 The existing definition in subsection 128A(1), being an inclusive definition, ensures that the withholding tax provisions apply to amounts such as discounts on bills which, while in the nature of interest, may not have fallen within the ordinary meaning of interest.

2.17 The proposed amendment to the definition of the term 'interest' contained in the Bill is designed to address certain arrangements which attempt to change the character of the income from interest to something else. The main feature of these arrangements is the purported conversion of an interest income stream into another income form, through a transaction or a series of transactions. It is argued that the effect of the conversion is that withholding tax is not payable. Although these arrangements are considered ineffective the Bill seeks to amend the definition of the term 'interest' to remove any possible doubt that, notwithstanding the purported conversion of the interest income stream, the amounts paid are interest or in the nature of interest.

2.18 The proposed amendments are designed to give effect to the policy intent of the existing withholding tax provisions. Financial products which have never been subject to withholding tax are not intended to be captured by the expanded definition. Examples of transactions which would not generally be considered as falling within the existing withholding tax provisions are forward foreign exchange transactions, forward rate agreements, swaps and reciprocal purchase agreements. Broadly speaking, these transactions do not involve the provision of finance. In the case of swaps, this is consistent with the Australian Taxation Office's long held view which is expressed in Income Tax Ruling IT2050.

2.19 On the other hand, financial products are continually being developed and refined and, accordingly, there may be products developed in the future which, although they incorporate some of the features of an existing product, may fall within the proposed new definition.

2.20 Similarly, an arrangement which converts an interest income stream into another income form would not be excluded from the proposed measures merely because it includes one of the above mentioned transactions.

Royalties paid to a resident operating through an offshore permanent establishment

2.21 Subsection 128B(2B) currently provides that there is a liability to royalty withholding tax:

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under subparagraph 128(2B)(b)(i), on a royalty paid by an Australian resident that is not an outgoing wholly incurred in carrying on business outside Australia through an offshore permanent establishment (PE) eg. a branch; and

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under subparagraph 128(2B)(b)(ii), on a royalty paid by a non-resident that is incurred in carrying on business through a PE in Australia.

2.22 The proposed legislation is designed to counter arrangements which attempt to exploit a technical deficiency in the law where royalty withholding tax is not payable in circumstances where royalties, which would be subject to withholding tax if paid directly to a non-resident, are paid to a resident of Australia carrying on business through an offshore PE and the PE in turn pays the royalties to a non-resident. The proposed legislation will impose royalty withholding tax on the Australian resident in these cases. Subsection 128B(2A) together with subsections 128B(8) and 128B(9) deal with similar situations where interest is paid. These provisions were introduced some years ago as an anti-avoidance measure.

2.23 A further amendment will be made in order to clarify the circumstances in which royalties can be said to have been incurred in carrying on a business through an offshore PE. The amendment will link the location of the outgoing royalty payment with the location of the income resulting from the use of the property which gave rise to the royalty payment. If a royalty payment is not incurred in gaining income of an offshore PE, for example where the property is used in Australia, the effect of the amendment will be to preclude any argument that the royalty was an outgoing wholly incurred in carrying on business outside Australia, and thus not subject to withholding tax.

2.24 A similar linking provision will be included to cover the case of a non-resident who carries on business in Australia through a PE. In such cases, withholding tax is imposed on royalties paid by that non-resident to another non-resident in circumstances where the property which is the subject of the royalty payments is acquired by the non-resident who carries on business in Australia through a PE for use in that Australian business. This provision will guard against the argument that a royalty paid as an expense of an Australian business is not an outgoing incurred in carrying on a PE of that business in Australia.

2.25 As a deterrent, residents who are subject to withholding tax on royalties derived through an offshore PE will also have the royalties included in their assessable income. The withholding tax paid will not, of course, be deductible in calculating their assessable income.

Interposed tax exempt bodies

2.26 Paragraph 128B(3)(a) provides an exemption from withholding tax in relation to interest, dividend and royalty income derived by non-residents who are exempt from income tax by virtue of paragraphs 23(e), (ea), (f), (g), (h), (j) and (jb) and who are also exempt from income tax in the country in which they reside.

2.27 Some arrangements attempt to interpose withholding tax exempt bodies between an Australian resident payer of interest, dividend or royalty income and a non-resident recipient. A payment, which would be subject to withholding tax if paid directly to a non-resident, is paid to the tax exempt body which in turn makes a payment to a non-resident. This relieves the non-resident from the liability to withholding tax.

2.28 The proposed legislation amends the Act to insert a specific anti-avoidance provision which deems amounts paid through tax exempt interposed entities to have been paid by the resident directly to the non-resident.

Dividends paid out of capital reserves

2.29 The amendment relates to a view that, as the law is currently framed, dividend withholding tax does not apply if a dividend is paid out of a capital reserve. For example, where the dividend consists of bonus shares paid from an asset revaluation reserve. It has been argued, relying on tenuous technical argument, that the withholding tax provisions can only apply if the dividend payment is income according to ordinary concepts.

2.30 Although it is considered that the current law is effective and withholding tax applies to these payments, the proposed legislation will amend the Act to make it perfectly clear that withholding tax is payable where dividends are paid out of capital reserves.

Explanation of the amendments

Amendments to Part IVA

The terms 'taxpayer' and 'payer'

2.31 In these amendments, the 'taxpayer' is the entity to whom payments of interest, dividends or royalties are made. The 'payer' is the entity which makes these payments of interest, dividends or royalties.

The plan of the amendments

2.32 These amendments applying Part IVA in cases of avoidance of the payment of withholding tax parallel the existing provisions of Part IVA.

Outline of the amendments

2.33 New section 177CA will be inserted into Part IVA. This section will extend the operation of Part IVA to arrangements which avoid an amount of withholding tax which would otherwise be levied under section 128B. The amount on which withholding tax is not paid is termed a tax benefit for the purposes of Part IVA.

2.34 New subsections 177F(2A), (2B), (2C), (2D), (2E), (2F) and (2G) will allow the Commissioner to make a determination that an amount of tax benefit is subject to withholding tax and to take necessary action to implement that determination .

2.35 New section 221YQ(1A) will remove any doubt that the provisions of section 221YQ apply to make payable by the payer, the amount of withholding tax calculated on the tax benefit determined under new subsection 177F(2A) , together with the applicable amount of additional tax for late payment of withholding tax.

2.36 New subsection 226(1A) will impose a penalty in the form of an amount of additional tax calculated as a percentage of the amount of withholding tax due on the tax benefit determined under new subsection 177F(2A) . Liability for this penalty initially falls on the taxpayer.

2.37 New section 221YQA will operate to shift the liability for payment of the subsection 226(1A) penalty from the taxpayer to the payer.

Tax benefit

2.38 New subsection 177CA(1) will specify a particular amount (of interest, dividends or royalties paid to the taxpayer) to which section 177CA is to apply. Such an amount will have both of the following characteristics:

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as a result of the entering into or the carrying out of a scheme, the taxpayer is not liable to pay withholding tax on the amount. (The existing definition of 'scheme' contained in section 177A(1) applies to this subsection); and

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there is a reasonable expectation that, if the scheme had not been entered into or carried out, then a liability to the taxpayer for withholding tax on that amount, would have arisen. [Item 12]

2.39 Where there is a ' new subsection 177CA(1) amount' new subsection 177CA(2) will apply to designate that amount to be a tax benefit. New subsection 177CA(2) further specifies that the tax benefit is taken to have been obtained by the taxpayer. [Item 12]

2.40 New section 177CA will apply to payments made after 7.30 pm, Eastern Standard Time on 20 August 1996 (whether or not the arrangement was entered into before that date). [Item 19]

Schemes to which Part IVA applies

2.41 Section 177D outlines certain criteria which must be satisfied before the scheme is one to which Part IVA applies. The proposed legislation makes no amendments to section 177D. Its provisions therefore apply without alteration to new section 177CA in the same way as to section 177C.

Determination in relation to a tax benefit

2.42 Where an amount of tax benefit has been identified by the application of new section 177CA , and section 177D has been applied to determine that the scheme which produced that benefit is a Part IVA scheme, new subsection 177F(2A) will apply to that tax benefit as follows:

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it is open to the Commissioner to determine that the taxpayer is liable to withholding tax (by the operation of section 128B) on that amount or such part of that amount as the Commissioner may decide (the determination); and

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where the Commissioner does determine that there is such an amount, the Commissioner must take such action considered necessary to give effect to that determination. [Item 13]

2.43 New subsection 177F(2B) will mandate that where the Commissioner makes a determination, advice of such determination must be given in writing. [Item 13]

2.44 New subsection 177F(2C) will require that the written notice of the determination specified in new subsection 177F(2B) be given to both the taxpayer and the payer. [Item 13]

2.45 New subsection 177F(2D) will allow the inclusion of more than one determination in a single written notice. This provision is included to allow for the fact that a liability for withholding tax arises under section 128B on the basis of each payment of interest, dividends or royalties and the withholding tax becomes due and payable on a monthly basis (under subsection 128C(1)), rather than on an annual basis as is the case with taxes which are assessed. This provision, therefore, allows the inclusion in a single written notice of more than one determination of a monthly withholding tax liability. [Item 13]

2.46 New subsection 177F(2E) will specify that a determination is not rendered invalid if the notice, required by new subsection 177F(2C) , is not issued to both or either of the taxpayer and the payer [item 13] . This provision is necessary as it is possible the Tax Office may not have the taxpayer's address.

2.47 New subsection 177F(2F) will specify that where a determination is made the amount is deemed to have been subject to withholding tax at all times. This will allow penalties to be imposed on the amount from the time the original liability would have arisen. [Item 13]

2.48 New subsection 177F(2G) will allow the taxpayer to object to a subsection 177F(2A) determination. This right to object does not extend to the payer. [Item 13]

2.49 Item 14 will insert a reference to new subsection 177F(2A) in subsection 177F(3) to authorise the Commissioner, in cases where she or he has made a determination, to make a compensating adjustment in favour of either the taxpayer against whom the determination has been made, or any other taxpayer, if the Commissioner is of the opinion that the person concerned has suffered a taxation disadvantage as a result of the scheme and that it is fair and reasonable that the adjustment be made. The Commissioner again is empowered to take whatever action is necessary to give full and proper reconstructive effect to the determination.

Penalties

2.50 New subsection 221YQ(1A) will be inserted into section 221YQ to avoid doubt that that section will operate in relation to a determination. Thus, the payer, having not made a deduction in relation to withholding tax, will become liable to pay the amount of withholding tax due to the Commissioner (paragraph 221YQ(1)(a)). Further, the payer will be liable to pay to the Commissioner an amount of additional tax calculated in accordance with subsection 128C(3), by way of penalty for late payment of withholding tax (paragraph 221YQ(1)(b)). [Item 15]

2.51 New section 226(1A) will provide for the calculation of additional tax by way of penalty applicable to the amount of withholding tax calculated by the Commissioner as a result of his or her determination. The amount of additional tax is calculated by the application of the 'penalty percentage' specified in subsection 226(2) to the amount of withholding tax liability of the taxpayer as determined under the proposed amendments to Part IVA. [Item 17]

2.52 The provisions of subsection 226(2) will apply to new subsection 226(1A) in the same way as they apply to subsection 226(1). The penalty percentage of the amount of withholding tax calculated is 25% if there is a reasonably arguable case that Part IVA does not apply to the transactions under scrutiny (paragraph 226(2)(b)). If there is no such reasonably arguable case, then the applicable percentage is 50% (paragraph 226(2)(a)). [Items 17 and 18]

2.53 The term 'reasonably arguable' is defined in section 222C. This provision is not amended by the proposed legislation.

2.54 New subsection 221YQA(1) will operate to transfer liability for the amount of penalty imposed under new subsection 226(1A) to the payer. [Item 16]

2.55 New subsection 221YQA(2) will allow the payer to recover from the taxpayer, the amount paid to the Commissioner by way of penalty under new subsection 221YQA(1) . [Item 16]

2.56 New subsection 221YQA(3) will specify that where a payment has been made by the payer under new subsection 221YQA(1) ,a credit of that amount is available against the taxpayer's liability under new section 226(1A) . [Item 16]

2.57 New subsection 221YQA(4) will provide that after an amount of penalty has been paid to the Commissioner, if that amount or part of that amount, is remitted by the Commissioner, a refund of the remitted amount is to be paid to the payer of the penalty. Further, any amount of credit allowed to the taxpayer under new subsection 221YQA(3) is to be reduced by the amount of any penalty remitted by the Commissioner. [Item 16]

Definition of interest

2.58 The existing definition of interest will be repealed by item 1 and a new definition will be inserted by item 3 .

2.59 The new definition in new subsection 128A(1AB) defines interest in a similar way as the existing definition, that is, it includes amounts which are 'in the nature of interest' . However, itwill also provide an expanded definition to make it clear that:

•

amounts which can reasonably be regarded as having been converted into a form that is 'in substitution for' interest are interest for the purposes of withholding tax; and

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amounts which can reasonably be regarded as having been received in exchange for interest in connection with a 'washing arrangement' are also interest for the purposes of withholding tax.

2.60 The amendments also restate the common law to make it clear that the interest component of certain transactions fall within both the existing definition of interest and the proposed new definition for the purposes of the withholding tax provisions. [Item 3 - new subsections 128A(1AE) and 128A(1AF)]

In the nature of interest

2.61 New subsection 128A(1C) provides an example of an amount which is 'in the nature of interest' for the purposes of new paragraph 128A(1AB)(a) . [Item 3]

2.62 The provisions imposing withholding tax were inserted by Income Tax Assessment Act (No. 4) 1967. The explanatory memorandum which accompanied that Act stated that an example of an amount in the nature of interest is a discount fee on bills of exchange. The view has been put that, notwithstanding the example given in the explanatory memorandum, some discounts on securities are not amounts in the nature of interest.

2.63 New subsection 128A(1AC) has the effect of deeming, and will put it beyond any possible doubt, that an amount representing a discount on a security is an amount 'in the nature of interest' and is, therefore, interest for the purposes of the withholding tax provisions. [Item 3]

In substitution for interest

2.64 Similarly, new subsection 128A(1AD) provides an example of an amount that is in substitution for interest for the purposes of new paragraph 128A(1AB)(b) . [Item 3]

2.65 New subsection 128A(1AD) has the effect of deeming that lump sum payments made instead of payments of interest are amounts in substitution for accrued interest and are, therefore, interest for the purposes of the withholding tax provisions. [Item 3]

An example of an amount which could reasonably be regarded as having been converted into a form that is 'in substitution for' interest - new paragraph 128A(1AB)(b)

2.66 A resident borrows $1 million at an interest rate of 10% per annum from a non-resident lender. Interest is payable at the end of 12 months.

2.67 Prior to the date upon which interest is payable under the loan agreement, the resident borrower issues a promissory note, with a face value of $100,000, to the non-resident lender to evidence its interest liability at the end of the 12 months.

2.68 Prior to the date upon which interest is payable the non-resident lender negotiates the promissory note to a third party for valuable consideration. The resident borrower pays the third party on presentation of the promissory note.

2.69 Although it is considered that the current law is effective and withholding tax applies to these payments, new subsection 128A(1AB)(b) will make it clear that the payment received through the third party, that is through the negotiation of the promissory note, is interest for the purposes of Division 11A.

An example of a lump sum payment made instead of payments of interest which are 'in substitution for' interest - new subsections 128A(1AB)(b) and 128A(1AD)

2.70 An example of a lump sum payment made instead of payments of interest would include the interest component of a lump sum payment made in relation to a loan where the borrower is unable to meet his or her commitments under the loan.

2.71 For instance, a resident borrows $10 million from a non-resident lender. The resident defaults on the repayments and the non-resident lender agrees to accept a lump sum settlement of $6.4 million. The actual amount outstanding is $6 million principle and $800,000 in accrued interest. However, under the terms of the settlement the non-resident agrees to waive a portion of the outstanding debt.

2.72 In this example the $400,000 lump sum payment made instead of the accrued interest would be subject to withholding tax.

Washing arrangements

2.73 The term 'washing arrangement' is defined in new paragraph 128A(1AB)(c) to mean an arrangement under which title to a security is transferred to a resident shortly before an interest payment is made pursuant to the security and the sole or dominant purpose of the arrangement is to reduce the amount of withholding tax payable.

2.74 A simple example of a washing arrangement is shown at paragraphs 2.81-87.

Outline of a typical washing arrangement

2.75 Washing arrangements are used by non-resident businesses investing in securities issued by resident companies or governments. Prior to the time that the interest payment is due (coupon day), the non-resident sells the security to an unrelated resident third party at market prices. The price incorporates the forthcoming interest payment. Just after the coupon date the non-resident purchases the same security on the open market. It is immaterial whether or not a right to reacquire that security is obtained (by options, forward purchases or the like) by the non-resident.

2.76 The re-purchase price of the resident participant in the scheme is lower than the sale price because of the intervening interest payment. The scheme, in effect, allows the non-resident to convert interest income into business profits. If the non-resident is from a country with which Australia has a double tax agreement (DTA) and does not have a permanent establishment (eg. a branch) in Australia, the non-resident's profit on the transaction is not taxable in Australia.

Dominant purpose

2.77 The definition of 'washing arrangement' contemplates situations where the arrangement is undertaken with more than one purpose in mind. New paragraph 128A(1AB)(c) requires that where more than one purpose exists for entering into the arrangement, the purpose of reducing the amount of withholding tax payable must be the dominant purpose.

2.78 The words 'dominant purpose' are not defined in the proposed legislation. However, these words have been the subject of judicial consideration in the context of Part IVA of the Act. It has been held that 'in its ordinary meaning dominant indicates that purpose which was the ruling, prevailing, or most influential purpose'.

2.79 Whether a person has entered into an arrangement for the sole or dominant purpose of reducing the amount of withholding tax payable will be a question of fact to be determined objectively from the surrounding circumstances.

2.80 Accordingly, an arrangement will be considered to fall within new paragraph 128A(1AB)(c) if the 'ruling, prevailing, or most influential purpose' for entering into the arrangement was, on an objective view, to reduce the amount of withholding tax payable. This will be the case notwithstanding that there may be a commercial reason or reasons for entering into the arrangement.

A simple example of a washing arrangement

2.81 Assume the following facts:

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A non-resident investor, from a country with which Australia has a DTA, purchases bonds with the intention of selling the bonds before interest is paid in order to avoid the withholding tax payable on the interest income. The non-resident does not have a permanent establishment in Australia.

•

The purchase price of the bonds is $10 million and interest, at a rate of 10% per annum, is payable yearly by coupons.

•

The underlying value of the security does not change.

•

The first coupon is due on the 31 March 1998.

2.82 The non-resident sells the bonds in March 1998 to a resident for $10.95 million. The Australian resident purchaser receives interest income of $1 million on 31 March 1998 and sells the security on 1 April 1998 for $10 million to a non-resident. On 1 April 1998 the non-resident repurchases the same type of bonds in the market for $10 million.

2.83 This process may be repeated several times or only undertaken once.

Effect of the arrangement

2.84 By selling the bonds the non-resident has derived $950,000 which has been converted from interest income into business profits which, by virtue of the DTA, are not taxable in Australia. If the non-resident had held the bonds at coupon date, the interest income of $1 million would have been subjected to interest withholding tax of $100,000.

2.85 The resident has derived gross income of $11 million (interest income of $1 million and proceeds from the sale of $10 million). The resident will have an allowable deduction of $10.95 million against this income. The taxable income is $50,000 and using the company rate of tax (36%), the tax payable is $18,000.

2.86 The net loss to the Australian revenue as a result of the washing arrangement is $82,000, that is, $100,000 (withholding tax that would have been payable because the interest is $1 million and the withholding tax is 10 per cent) less $18,000 (actual tax paid).

2.87 The proposed amendment will ensure that the accrued interest component received from the resident purchaser will be subject to withholding tax. In this example, the accrued interest component was $950,000.

Restatement of the law

2.88 Section 128B currently provides that there is a liability to interest withholding tax:

1.

under subparagraph 128B(2)(b)(i), on interest paid by an Australian resident that is not an outgoing wholly incurred in carrying on business outside Australia through an offshore permanent establishment (PE) eg. a branch;

2.

under subparagraph 128B(2)(b)(ii), on interest paid by a non-resident that is incurred in carrying on business through a PE in Australia; and

3.

under subsection 128B(2A) on interest paid to an Australian resident carrying on business through an offshore PE and the interest is paid by either an Australian resident falling within point 1 above or a non-resident falling within point 2 above.

2.89 New subsection 128A(1AE) restatesthe common law to make it clear that where a lender, that is an entity to whom subsection 128B(2) applies, assigns a loan, or the right to interest under a loan, to a non-resident or to an Australian resident carrying on business through an offshore PE, any payments from the borrower to the assignee that would have been interest but for the assignment are interest for the purposes of the withholding tax provisions. [Item 3]

2.90 A similar provision is inserted by item 3 which merely restates the common law and will operate in relation to the acquisition of securities. The amendment relates to a view that, in certain circumstances, where securities are purchased on a cum interest basis, interest withholding tax does not apply to payments made after the sale because no debtor/creditor relationship exists between the issuer of the security and the purchaser. The Australian Taxation Office's long held view is that withholding tax applies to these payments at present; the proposed legislation will make it perfectly clear. That is, where a non-resident, or an Australian resident carrying on business through an offshore PE, acquires a security or the right to receive interest under the security any payments from the issuer of the security to the non-resident or Australian resident holder mentioned above, that would have been interest but for the acquisition, are payments of interest subject to withholding tax. [New subsection 128A(1AF)]

Miscellaneous amendments

2.91 Items 4, 10 and 11 will make consequential amendments as a result of the amendment described above by omitting references to subsection 128A(1) in paragraph 128AB(4)(b) and sections 159GZA and 159GZY and substituting references to new subsection 128A(1AB) . These amendments will incorporate the new definition of interest into those provisions.

Royalties paid to a resident operating through an offshore permanent establishment

2.92 Item 6 proposes that new subsection 128B(2C) be inserted in section 128B. New subsection 128B(2C) will impose a liability to royalty withholding tax where an Australian resident derives royalty income in carrying on business through an offshore permanent establishment (PE) eg. a branch and the royalty is paid:

•

by an Australian resident where the payment is not an outgoing wholly incurred in carrying on business through an offshore PE; or

•

by a non-resident where the payment is an outgoing incurred in carrying on business through a PE in Australia.

2.93 New subsection 128B(9A) will be inserted by item 7 to clarify, for the purposes of subparagraph 128(2B)(b)(i) and new subparagraph 128(2C)(b)(i) the circumstances in which royalties can be said to have been incurred by an Australian resident in carrying on a business through an offshore PE. New subsection 128B(9A) is similar to subsection 128B(8) which currently applies to interest. A royalty will be deemed not to be an outgoing incurred in carrying on business through an offshore PE where:

•

the royalty is incurred by the Australian resident in gaining or producing income or for the purpose of gaining or producing income that is derived otherwise than in carrying on business through the offshore PE; or

•

the royalty is incurred by the Australian resident in carrying on business for the purpose of gaining or producing income but the royalty is not reasonably attributable to income derived in carrying on business through the offshore PE.

2.94 This amendment will link the location of the outgoing royalty with the location of the income resulting from the use of the property which gave rise to the royalty payment.

2.95 New subsection 128B(9B) will be inserted by item 7 to clarify, for the purposes of subparagraph 128(2B)(b)(ii) and new subparagraph 128(2C)(b)(ii) , the circumstances in which royalties can be said to have been incurred by a non-resident in carrying on a business through a PE in Australia. New subsection 128B(9B) is similar to subsection 128B(9) which currently applies to interest. A royalty will be deemed to be an outgoing incurred in carrying on business through a PE in Australia where:

•

the royalty is incurred by the non-resident in gaining or producing income or for the purpose of gaining or producing income that is derived in carrying on business through the PE in Australia; or

•

the royalty is incurred by the non-resident in carrying on business for the purpose of gaining or producing income and the royalty is reasonably attributable to income derived in carrying on business through the PE in Australia.

2.96 This amendment will also link the location of the outgoing royalty with the location of the income resulting from the use of the property which gave rise to the royalty payment.

2.97 Item 8 amends subsection 128B(11) to provide that the withholding tax payable by a resident as a result of new subsection 128B(2C) is in addition to any ordinary income tax that may be payable on the royalty income, and that the withholding tax paid is not deductible in calculating that other income tax.

2.98 Section 128D will be amended, as a companion measure to that proposed by item 8 , to ensure that a resident who is subject to withholding tax on royalties derived through an offshore PE by virtue of new subsection 128B(2C) will also have the royalty income included in assessable income. [Item 9]

Interposed tax exempt bodies

2.99 New section 128AF will be inserted to deem amounts paid through tax exempt interposed entities to have been paid by the resident directly to the non-resident. New section 128AF will apply when:

•

a payment of dividends, interest or royalties is received by a non-resident through one or more interposed companies, partnerships, trusts or other persons; and

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one or more of the interposed entities is exempt from income tax at the time at which the payment was received by the non-resident. [Item 5]

Dividends paid out of capital reserves

2.100 The definition of income in subsection 128A(1AA) will be amended by item 2 to include dividends. The amendment will make it clear that withholding tax is payable where dividends are paid out of capital reserves.

Application

2.101 The amendments proposed by this Schedule apply in relation to apply to interest, dividend and royalty payments made after 7.30pm EST on 20 August 1996. [Item 19]

Transitional provisions - regulations

2.102 Item 20 will insert a transitional provision which will allow a regulation to be made which takes effect from a date before the notification of the regulations. The regulation will prescribe, for the purposes of section 221YL, the amount of withholding tax to be deducted from royalty payments which are caught by virtue of new subsection 128B(2C) .