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Edited version of private ruling
Authorisation Number: 1011558775895
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Ruling
Subject: Income received prior to winding up of an entity
Question 1
Are your distributions received prior to the winding up of the Fund assessable income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?
Answer
Yes.
Question 2
Are your distributions received prior to the winding up of the Fund a non-taxable return of capital?
Answer
No.
Question 3
Is your final distribution from the Fund a non-taxable return of capital?
Answer
Yes.
Question 4
Does the 'hotchpot' amount not included in your final distribution plus your brokerage fee result in a capital gains tax (CGT) loss under section 104-25 of the ITAA 1997?
Answer
Yes.
Question 5
Can you claim a deduction for a foreign exchange loss under section 775-30 of the ITAA 1997?
Answer
Yes.
Relevant facts and circumstances
You acquired units in the (overseas) Fund at a certain exchange rate. You also incurred a telegraphic transfer charge and brokerage fee. From this investment, you received monthly distributions.
Soon after, ASIC acted to wind up the Fund due to it being suspected as a scheme. At a latter time, a court ruled the remaining capital should be distributed among investors pari passu in proportion to their respective contributions, subject to investors bringing into hotchpot the returns paid to them.
You received your final distribution of the total of your original capital, less the amount subject to the hotchpot method and less an amount incurred due to a foreign exchange loss.
Relevant legislative provisions
Income Tax Assessment Act 1997 Section 6-5
Income Tax Assessment Act 1997 Section 104-25
Income Tax Assessment Act 1997 Section 110-35
Income Tax Assessment Act 1997 Section 775-15
Income Tax Assessment Act 1997 Section 775-30
Reasons for decision
Summary
Your distributions received prior to the winding up of the Fund is assessable income because the character of a receipt in the hands of an investor rather than the character of the fund of money out of which it is paid will determine whether or not it is income; because Ponzi schemes do not alter the character of the periodical contractual payments made; and because an income receipt in a prior income year cannot be recharacterised in a later income year.
Your distributions received prior to the winding up of the Fund are not returns of capital because the court did not make such as judgment nor make any comments about taxation law. The court simply ruled on how the final capital distribution to investors should be made.
Your final distribution from the Fund is a non-taxable return of capital because it was simply the return of your original capital. Your original investment was merely your 'profit yielding subject' rather than derived profits.
The 'hotchpot' amount not included in your final distribution is a CGT loss because your investment units were cancelled in the relevant income year and a loss was made.
You can claim a deduction for your foreign exchange loss in the year it was incurred because a forex realisation loss under section 775-30 of the ITAA 1997 occurred during that income year.
Detailed reasoning
Assessability of monthly receipts
Under section 6-5 of the ITAA 1997, an amount is assessable income if it is income according to ordinary concepts. The phrase 'income according to ordinary concepts' is not defined in the taxation legislation but is taken to mean 'income' as it is understood at common law.
In general, whether a receipt of money is income or capital is determined by the character of the receipt in the hands of the taxpayer (Scott v. FCT (1966) 117 CLR 514 at 526; GP International Pipecoaters Pty Ltd v. FCT 90 ATC 4413; (1990) 170 CLR 124 at 136-137).
The periodicity or recurrence of a receipt may evidence the nature of the receipt; with regular periodic receipts more likely to be income than a lump sum payment (FCT v. Dixon (1952) 86 CLR 540).
In summary, based on case law, it can be said that ordinary income includes receipts that:
- are earned
- are expected
- are relied upon, and
- have an element of periodicity, recurrence or regularity.
Where a beneficiary may be beneficially entitled to the capital of a trust estate, payments made out of capital do not necessarily retain their character as such and the payments must be construed in the hands of the taxpayer (see for e.g., Case C57 71 ATC 250; Jackson's Trustees v. Commissioners of Inland Revenue (1942) 25 TC 13; Inchyra (Baron) v. Jennings (1966) 1 Ch 37).
Similarly, the character of a receipt in the hands of an investor, rather than the character of the fund of money out of which it is paid, will determine whether or not it is income (Trustees of H K Brodie v. IR Commissioners (1933) 17 TC 432 at 438).
The fact that capital funds of new investors may be used to pay existing investors their entitlements in an investment scheme will not determine the character of the payment in the hands of a receiving investor. Loans from investors governed by loan agreements are evidence of an intention to create a relationship of debtor and creditor in respect of a principal sum lent. The payments of interest to investors to satisfy an agreed obligation to pay interest have the character of interest in the hands of the recipient.
The above views were applied by the Commissioner in Class Ruling CR 2002/13, which is about investments in the Wattle Group. Here, payments of interest from a fraudulent investment retained the nature of interest. The Wattle Group was an unincorporated investment vehicle operated by Geoffrey Robert Dexter. Investments in the Wattle Group were made by way of unsecured loan, documented in a loan agreement. In most cases, fund 'administrators' promoted the scheme to investors and took a commission, paid by the Wattle Group, on investments they had facilitated. The loan agreements provided the loans would bear interest. Interest was generally said to be at the rate of 50% per annum or 5% per month, payable no later than 30 days after the end of each calendar monthly period. The Wattle Group was wholly dependant on obtaining funds from lenders in order to pay existing lenders their interest entitlements. It appeared only a small fraction of the money lent to Wattle was put to income producing purposes. The Supreme Court of Queensland issued an injunction in March 1998 which restrained the Wattle Group from further trading. Geoffrey Robert Dexter was declared bankrupt on 26 May 1998.
Another example of the same tax treatment is found in the Administrative Appeals Tribunal (AAT) case Re Maber and Deputy Commissioner of Taxation Case [2001] AATA 19 (Maber). Here, the taxpayer invested $70,000 with a mortgage broker and received interest payments on the investment. The taxpayer disputed the interest she received should be treated as income and argued because the mortgage was a sham, she had effectively been defrauded and the payments to her should be treated as a return of capital. R D Fayle, Senior Member held the mortgage was not a sham. Despite the fact that subsequent events prevented a realisation of the objectives as originally intended did not, of itself, make the original mortgage agreement a sham. In the tribunal's opinion the agreement was enforceable and the mortgagees' rights under the agreement were preserved should the mortgagor default. That being the case, the periodic payments under the agreement were and had the character of interest. The fact that the mortgagees were likely to lose all or some of their principal did not alter the character of those periodical contractual payments in the hands of the mortgagees.
In your case, you made an investment in the Fund, from which, for a period of time you received monthly receipts of investment income. This is the same situation as found in the Wattle Group and the case of Maber. Your investment was governed by a valid investment agreement, which is evidence of an intention to create a relationship of debtor and creditor in respect of the principal amount invested. The periodic payments you received were to satisfy an agreed obligation to pay returns. As such, they have the character of income in your hands. It follows these periodic distribution receipts are assessable income under section 6-5 of the ITAA 1997.
The court judgment
The judgment of the court was in response to concerns by the liquidator about the correct method of distributing the surplus funds of each scheme to investors in that scheme. Here, the court ruled the remaining capital be distributed among investors pari passu in proportion to their respective contributions, subject to investors bringing into hotchpot the returns paid to them.
However, the court did not rule here about the character of the returns previously paid to investors. The court simply ruled on the method to be used for the repayment of invested capital. It is notable the court did not mention any taxation Act or legislation in its judgment. Although the judgment of the court included the monthly receipts in quantifying the final distributions of capital, the judgment did not explicitly or implicitly rule on the character of the monthly receipts or change their character.
If you believe you have been disadvantaged by having to pay tax on your monthly returns whereas other investors who did not receive monthly returns paid no tax, then your concerns about inequity rest with the final distributions quantified by the liquidator. Whether or not the liquidator took tax paid into account when quantifying the final distribution of capital does not alter the decision of the court.
Receipts of income cannot be recharacterised
The character of a payment cannot be changed after it is made. This view is supported by AAT Case U35 87 ATC 262, where Senior Member Roach considered a situation where wages paid during the year were altered to constitute a borrowing from the company at the end of the financial year. In this case, the taxpayer was a panel beater employed by a company which he controlled. The financial performance of the company was not very good. This prompted the company's bank manager to suggest to the taxpayer that he should draw against his loan account with the company rather than draw wages, at least until such time as the company returned a profit. The taxpayer checked with his accountant who approved the idea. The accountant told the taxpayer to continue drawing wages as before and that he would fix it at the end of the year.
The Senior Board Member, P.M. Roach, stated that the error the accountants for the taxpayer made was they misunderstood the law, overrating the capacity of accountancy in thinking that accounting entries could retrospectively create events rather than only record events of the past. Senior Member Roach said:
It is also true that members of the company, so far as their own interests alone are concerned, may approve a reorganisation of things already done by the company - although they cannot alter the fact of the things which were done - although not doing so to the extent of creating a new order of priorities to bind a future liquidator.
It was contended that A and PBCO were entitled to carry out those actions without it necessarily following that the amounts recorded as wages actually constituted rewards to A for his personal services . Before such a conclusion could be reached, it would have to be found to flow from the making of some arrangement between A and PBCO which gave a different character to the actions in the tax years 1982 and 1983 to the character the same actions had in the year of income ended 30 June 1981. There is simply no evidence to that effect.
It follows, in your case, the character of monthly distributions received that had the nature of ordinary income cannot be altered during a later year so they possess the nature of capital.
CGT event C2
CGT event C2 in section 104-25 of the ITAA 1997 happens if your ownership of an intangible CGT asset ends in certain ways, including because the asset expires or is redeemed, cancelled, released, discharged, satisfied, abandoned, surrendered or forfeited. The time of the event is when you enter into the contract that results in the asset ending. You make a capital gain if the capital proceeds from the ending are more than the asset's cost base. You make a capital loss if those capital proceeds are less than the asset's reduced cost base.
Also, any costs of brokerage incurred in acquiring or disposing of the CGT asset will form part of the CGT cost base under section 110-35 of the ITAA 1997.
In your case, you incurred a brokerage fee in acquiring your investment units in the Fund, which were subsequently cancelled in a later year as a result of liquidation action. Your entire original investment was redeemed in the final distribution of capital, apart from the amount subject to the hotchpot method. It follows CGT event C2 occurred during the relevant year, from which you made a CGT loss comprising of the brokerage fee and the hotchpot amount.
You may include and/or carry forward this CGT loss in your tax returns and use it to offset any CGT gains that may arise in the current income year or in future income years until extinguished.
Foreign exchange loss
Division 775 of the ITAA 1997 recognises foreign currency gains and losses for income tax purposes by including forex realisation gains in assessable income (section 775-15) and by allowing forex realisation losses as deductions (section 775-30) that are made from forex realisation events.
Forex realisation event 1 is CGT event A1 that happens if you dispose of foreign currency or a right or a part of a right, to receive foreign currency. Although forex realisation event 1 is CGT event A1, the gains or losses will be accounted for as assessable income or income deductions, that is, on revenue account. Also, as CGT event A1, any costs of transfer incurred in a foreign exchange transaction will form part of the CGT cost base under section 110-35 of the ITAA 1997.
In your case, your incurred a forex realisation loss and also incurred a telegraphic transfer charge. It follows section 775-30 of the ITAA 1997 allows you to claim a deduction for these amounts against your ordinary income.
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