Focus: Tax disputes involving s25-90 interest deductions
28 March 2011
In brief: The recent Federal Court decision in Noza Holdings Pty Ltd v Commissioner of Taxation involved the Australian Taxation Office's unsuccessful application of the General Anti-Avoidance Rule in Part IVA to a funding structure involving deductions under section 25-90 of the Income Tax Assessment Act 1997. The Commissioner's approach in this case reflects a more general ATO suspicion of such deduction claims, exemplified by the recent release of Draft Taxation Determination TD 2011/D2 in relation to bank lending arrangements involving offshore subsidiaries. Partner Toby Knight (view CV) reports.
How does it affect you?
- The Australian Taxation Office (the ATO) is examining arrangements involving the derivation of non-assessable non-exempt (NANE) section 23AJ foreign dividend income by Australian entities where the relevant investment is funded by interest deductible under section 25-90 of the Income Tax Assessment Act 1997 (Cth) (the 1997 Act). The amended assessments issued to companies in the ITW Group in the Noza Holdings case1, and recent Draft Taxation Determination TD 2011/D2 concerning a hypothetical banking transaction involving the capitalisation of an offshore company to make loans to a foreign resident borrower, are examples of the ATO seeking to apply Part IVA to such structures.
- In Noza Holdings, Justice Gordon held that Part IVA did not apply to the particular arrangements in that case, which funded an acquisition and sale of certain royalty streams. Her Honour held that the dominant purpose of those arrangements was not to obtain a section 25-90 deduction, but rather to obtain certain US state tax benefits and to facilitate the protection of the intellectual property (IP) of the taxpayer's US parent. The case demonstrates how fact dependent the application of Part IVA is, and that a careful consideration of the particular facts and supporting evidence associated with funding structures supporting the derivation of NANE income will always be warranted in response to an ATO review.
- Taxpayers with section 25-90 funding structures likely to excite ATO attention should consider the collation of contemporaneous records and preparation of material evidencing the commercial rationale (and non-Australian tax benefits) for the structure of such cross-border transactions, in anticipation of any tax controversy that may arise.
The Noza Holdings case concerned the consequences of transactions between CSA and AFC, which were Australian subsidiaries of the ITW Group, and CSF and SGTS, which were US subsidiaries of that group.
Noza Holdings was the head company of the Australian multiple-entity consolidated (MEC) group, of which AFC and CSA became subsidiary members.
The ITW Group had investigated ways in which it could improve protection of its customer-based intangibles or IP, as well as migrating that IP from high taxing US states (such as Illinois) to lower taxing states (Delaware).
This involved the licensing and sub-licensing of the intangibles in exchange for the payment of royalties.
A complex restructure involved the transfer of royalty rights to an Australian group company. This was intended to be integrated with the formation of the Australian MEC group and to assist in AFC's IP being allocated a cost base close to its market value.
Following the assignment of royalty rights in various transactions in the US, CSF (a US entity) contributed a demand note to the capital of CSA by way of subscribing for preference shares in CSA (an Australian subsidiary). CSA, in turn, contributed the demand note to the capital of AFC (another Australian group company). AFC then purchased the royalty rights to the IP from CSF, by using the demand note contributed to its equity and also by issuing a purchase money note (ie, by also borrowing money from a related party).
AFC then contributed its royalty rights (purchased from CSF) to SGTS (a US resident company), which company also assumed AFC's obligations under the purchase money note. In return, SGTS issued voting stock and voting preferred stock to AFC.
So, the final structure involved the Noza Holdings MEC group having issued preference shares to CSF (via CSA) and also holding (through AFC) voting and preferred stock in an offshore company (SGTS). The Commissioner accepted that the CSA preference shares were 'debt interests' for the purposes of section 25-90 and Division 974 of the 1997 Act.
Section 23AJ NANE dividends were paid on the preferred stock issued by SGTS to AFC (by the issue of a promissory note for $222.6 million).
AFC subsequently paid a dividend to CSA (by endorsing the same SGTS promissory note), and CSA then paid a dividend of $222.6 million on the preference shares it had issued to CSF (by endorsing the same promissory note). It was for this dividend that the section 25-90 deduction was claimed, which the ATO attacked under Part IVA.
Justice Gordon found:
- The taxpayer was entitled to a deduction under section 25-90 of the 1997 Act for $170.9 million of the dividends of $222.66 million declared by CSA to CSF (the remaining amount was held to be non deductible as of a capital nature).
- Part IVA did not apply to deny that section 25-90 deduction.
- Part IVA also did not apply to permit the Commissioner to deem the taxpayer to be liable to dividend withholding tax (as there had been no dividend withholding tax avoidance by bringing the payment of the dividend on the CSA preference shares forward, so as to pay it prior to the amendment of the International Tax Agreement Act 1953 (Cth) to apply the debt/equity rules to dividends).
In Draft Taxation Determination TD 2011/D2 (which was issued after Justice Gordon's decision in Noza Holdings), the ATO concedes that the application of Part IVA to any particular arrangement depends on a careful weighing of all of the relevant circumstances.
The determination describes a rudimentary fact situation where an Australian resident company (AusCo) that is a subsidiary of an authorised deposit-taking institution borrows from an external source to acquire 100 per cent of the shares in a non-Australian resident company (OffshoreCo). OffshoreCo then lends that money to a non Australian resident company (ForCo) that is unrelated to AusCo. ForCo has previously borrowed from AusCo to fund its business activities, but now borrows from the interposed OffshoreCo. ForCo is indifferent to whether it makes the interest payment to AusCo or to OffshoreCo.
The features of the transaction include that:
- both the directors and the shareholders of OffshoreCo can require the ordinary shares in OffshoreCo to be cancelled at any time, with their fair market value returned to AusCo;
- OffshoreCo does not have any employees, although its directors are located in its country of incorporation;
- ForCo's relationship with OffshoreCo grew out of activities conducted by employees of AusCo (who conducted the risk assessment and consequent pricing of the loan);
- interest paid to OffshoreCo is not subject to withholding tax in ForCo's country of tax residence;
- interest derived by OffshoreCo in respect of its loan to ForCo is not subject to income tax in OffshoreCo's country of tax residence;
- dividends paid by Offshore Co to AusCo are not subject to withholding tax in OffshoreCo's country of tax residence; and
- dividends on the shares held in OffshoreCo are payable at the discretion of the directors in OffshoreCo, but are paid in the same amount and immediately after the interest is received from ForCo.
In its draft Taxation Determination, the ATO states that Part IVA will apply to this arrangement, on the basis that this is a scheme to convert assessable interest income into NANE dividends. If unsuccessful in that application of Part IVA, then the Commissioner would, we presume, have no basis for objecting to the allowance of deductions for the funding costs.
In TD 2011/D2, the ATO has constructed a 'straw man' fact scenario to demonstrate features of section 25-90 funding structures that it finds objectionable. The actual facts of particular cases in the banking industry, or of investment and funding structures entered into by corporates, are likely to be more nuanced and detailed, and need to be understood in their proper commercial setting.
Justice Gordon's decision in Noza Holdings is on appeal and any decision on appeal will need to be analysed. However, the decision at first instance emphasises that, given a detailed examination of the particular facts, Part IVA may not apply to defeat a taxpayer's ability to utilise a funding structure that provides a section 25-90 deduction where it occurs within an appropriate commercial setting.
Taxpayers that have claimed interest expense deductions under section 25-90 should be conducting internal risk reviews in anticipation of ATO audit activity.
- Toby KnightPartner,
Ph: +61 3 9613 8590
- Katrina ParkynPartner,
Ph: +61 7 3334 3323
- Larry MagidPartner,
Ph: +61 2 9230 4918