Edited version of private ruling

Authorisation Number: 1011601763130

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Ruling

Subject: Interest foregone and assessable income

What this ruling is about

Questions

1. Will the interest foregone be included in the assessable income of an entity?

Answer: Yes.

2. Will any gain on the right to interest foregone be included in the assessable income of an entity?

Answer: Yes.

3. Will Part IVA of the Income Tax Assessment Act 1936 (ITAA 1936) apply to the scheme?

Answer: No.

This ruling applies for the following periods:

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

Year ended 30 June 2014

The scheme commences on:

1 July 2008

Relevant facts and circumstances

The entity is the trustee for investors in respect of rights to the payment of interest and the repayment of principal on investments issued by a company.

Investment terms are generally from 3 months to 5 years. For investments of less than twelve months - interest is payable on the maturity date. For Investments of twelve months or more - interest is paid monthly, quarterly, annually or compounded annually.

During the term of investments an investor would receive:

· A reminder notice approximately 21 days before the maturity date;

· In July, a statement of interest earned to June 30 each year;

· If the investor has requested interest to be paid quarterly, a quarterly and an annual interest statement;

· If the investor has requested interest to be paid monthly or annually, an annual interest statement;

· If the investor has requested interest to be compounded, an annual statement showing interest accrued.

If the investor has requested interest to be compounded, the first interest calculation date is the anniversary of the 15^th day of the month in which the investment was accepted. Interest is calculated from the day of receipt until the first interest calculation date and thereafter interest is compounded annually on the anniversary of the first interest calculation date and credited to the Investor's account. Payment of interest is then made on the maturity date.

In the case where a Receiver or Receiver and Manager is appointed under a Deed, the Deed directs the entity to apply moneys received in priority order. The third priority is money received for the account of investors in respect of interest. The fourth priority is money received for the account of investors in respect of principal.

On a date, Receivers and Managers took control of the company's business affairs and assets and all Investments were frozen. There were a number of investments that had not matured on that date and interest had not been paid.

On a later date investors received an initial distribution on their outstanding claims. In a circular from the Receivers and Managers, investors were notified that the initial distribution included unpaid interest accrued to the date Receivers and Managers took control.

Additionally, on a further later date, some particular investors received a second distribution on their outstanding claims. In a circular from the Receivers and Managers, investors where advised of the second distribution and that the Receivers and Managers intended to treat the distributions as returns of capital.

The entity intends to send a notice or enter into an agreement with the company on investors' behalf under which the entity will agree to forego its and investors' rights to unpaid interest as at the date Receivers and Managers took control of the company.

Once the entity has forgone its right to the accrued interest, all monies will be applied to repay, to the extent possible, the principal owing.

Relevant legislative provisions:

Income Tax Assessment Act 1997 Section 6-1

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 104-145.

Income Tax Assessment Act 1997 Subdivision 106-B

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 116-30

Income Tax Assessment Act 1997 Section 995-1

Income Tax Assessment Act 1936 Division 6

Income Tax Assessment Act 1936 Section 177A

Income Tax Assessment Act 1936 Section 177C

Income Tax Assessment Act 1936 Section177D

Income Tax Assessment Act 1936 Section 177F

Income Tax Assessment Act 1936 Subsection 70B(4)

Reasons for decision

Question 1

The provisions relating to the taxation of trust income are contained in Division 6 of Part III of the ITAA 1936.

Under section 97 of the ITAA 1936 a beneficiary who is presently entitled to a share of the income of the trust estate is assessed on that share of the trust's notional taxable income worked out under section 95. That notional taxable income is referred to as the 'net income' of the trust estate. In coming to that conclusion we have relied on Practice Statement Law Administration PS LA 2010/1 titled, Approach to cases involving Division 6 of Part III of the Income Tax Assessment Act 1936 (PS LA 2010/1).

As far as is relevant in this case the term 'net income' of the trust estate is defined in subsection 95(1) of the ITAA 1936 to mean the total assessable income as if the trustee were a resident taxpayer, less all allowable deductions.

Interest as assessable income

The assessable income of an entity for an income year consists of ordinary income and statutory income in terms of subsection 6-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997).

Subsection 6-5(2) of the ITAA 1997 provides that the assessable income of a resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year.

The expression 'ordinary income' or 'income according to ordinary concepts' is not defined in the legislation; however, its meaning has been widely explored by the Courts. Whether a particular receipt will be regarded as 'ordinary income' in the hands of a particular taxpayer will depend upon the individual circumstances surrounding the receipt. Typically, a receipt will be ordinary income if it is received periodically, recurrently or regularly.

As such, it is a well established principle that interest income is an ordinary income and, prima facie, assessable under section 6-5 of the ITAA 1997.

An amount of interest will only be included in the assessable income of the trust estate, of which the entity is the trustee, for an income year if it has been derived during that year.

The term 'derived' is not defined by the legislation. The Courts, however, have provided guidance to the meaning of 'derived'. Gibbs J in Brent v. FC of T 71 ATC 4195; (1971) 125 CLR 418 at pp 427-428. states:

The Act does not define the word "derived" and does not establish a method to be adopted as a general rule to determine the amount of income derived by a taxpayer... It has become well established that unless the Act makes some specific provision on the point the amount of income derived is to be determined by the application of ordinary business and commercial principles and that the method of accounting to be adopted is that which "is calculated to give a substantially correct reflex of the taxpayer's true income" (The Commissioner of Taxes (South Australia) v The Executor, Trustee and Agency Company of South Australia Limited (Carden's Case) (1938) 63 CLR 108 at pp152-4).

Taxation Ruling TR 98/1 titled Income tax: determination of income; receipts versus earnings (TR 98/1) sets out the Commissioner's policy on derivation of income.

In relation to investment income, paragraph 47 of TR 98/1 states:

Interest

The general principle is that interest is only derived, or arises, when it is received or credited. This general rule is subject to the overall principle that the appropriate method is that giving a substantially correct reflex of income. So exceptions to the general rule include (but are not limited to):

a. interest from a business of money lending carried on by the taxpayer;

b. interest derived by a financial institution (Taxation Ruling TR 93/27); unless from a 'non-accrual loan' (Taxation Ruling TR 94/32);

c. interest from the everyday provision of credit as part of business activities (Taxation Ruling IT 2227);

d. interest derived by taxpayers, whose other income is calculated on an accruals basis, who invest in fixed or variable interest securities cum interest (Taxation Ruling TR 93/28); and

e. interest from deposits made in the ordinary course of carrying on a business, where the business income is properly assessable on the earnings basis, may be derived on a due and receivable basis. An example of this would be a large trading business that actively manages its funds on deposits.

The entity holds the investments on trust for the investors and in its capacity as trustee is not carrying on a business. As such, according to paragraph 47 of TR98/1, the general principle of income derivation in relation to interest applies, i.e. interest is only derived when it is received or credited.

In this case the investors had received an initial distribution on their investments after Receivers and Managers took control of the company's business affairs and assets and all Investments were frozen and additionally, some particular investors received a second distribution.

Distributions on winding up

The Archer Brothers principle arose from the High Court case of Archer Bros Pty Ltd (In Vol Liq) v. FC of T (1953) 10 ATD 192; (1953) 90 CLR 140 and was discussed in Taxation Determination TD 95/10 titled Income tax: what is the significance of the Archer Brothers principle in the context of liquidation distributions? (TD 95/10) where, at paragraph 2 it states:

The principle is that if a liquidator appropriates (or sources) a particular fund of profit or income in making a distribution (or part of a distribution), that appropriation ordinarily determines the character of the distributed amount for the purposes of section 47 and other provisions of the Income Tax Assessment Act 1936 (the Act).

Further to this, paragraph 4 of TD 95/10 states that the principle applies if:

(i) the company accounts have been kept so that a liquidator can clearly identify a specific profit or fund in making a distribution; and

(ii) it is clear from either the accounts or statements of distribution that the liquidator has appropriated the specific profit or fund in making the distribution.

In this case the distributions from the Receivers and Managers were appropriated from funds of the company and the investors' interests in those funds were the rights to receive payments of interest and repayment of principal in respect of their Investments.

The initial and second distributions included interest and having been received, was derived for the purposes of section 6-5 of the ITAA 1997 and accordingly should be included in the assessable income of the trust estate.

Amounts that have the character of interest derived as income cannot be re-characterised as capital by the entity in an agreement to forego the amounts as interest. In coming to this conclusion we have relied on paragraphs 22 and 23 of PS LA 2010/1.

The entity has the capacity to forgo its and investors' rights to interest unpaid or otherwise dealt with on investors' behalf after the date it agrees to forego, and either amends the Deed or holds a meeting in accordance with the Deed, in respect of future amounts of accrued interest not yet paid or otherwise dealt with on investors' behalf.

Question 2

Cancellation of the entity's right to interest as trustee for the investors under the scheme

Assessable income includes any net capital gain for the income year in terms of section 102-5 of the ITAA 1997.

A right to receive interest is a contractual right enforceable under the contract, and as such, it is an intangible capital gain tax (CGT) asset in terms of section 108-5 of the ITAA 1997.

Subsection 104-25 (1) of the ITAA 1997 states that a CGT event C2 happens if a taxpayer's ownership of an intangible CGT asset ends by the asset:

(a) being redeemed or cancelled; or

(b) being released, discharged or satisfied; or

(c) expiring; or

(d) being abandoned, surrendered or forfeited; or

(e) if the asset is an option - being exercised; or

(f) if the asset is a convertible interest - being converted.

Subsection 104-25 (2) of the ITAA 1997 states that the time of the event is:

(a) when you enter into the contract that results in the asset ending; or

(b) if there is no contract - when the asset ends.

In this case, the entity, as trustee for the investors, intends to enter into an agreement to forgo its and investors' right to interest not received as at the date Receivers and Managers took control of the company.

A CGT event C2 will occur at the time when the entity enters into the contract to forgo its and investors' right to interest on the investments is executed.

Subsection 104-25(3) of the ITAA 1997 provides that the occurrence of a CGT event C2 will result in a capital gain when the capital proceeds from the asset ending are more than its cost base or a capital loss is made if the capital proceeds are less than the reduced cost base of the assets.

Whether a capital gain or capital loss is made from CGT event C2 happening to the CGT asset will depend on the calculation of the cost base of that CGT asset and the capital proceeds from the CGT event.

There was no consideration for the right to receive interest at the time the investors acquired the investments. Therefore the cost base of the CGT asset is nil.

If the capital proceeds received from the CGT event C2 happening to an asset are less than the market value of the asset, those proceeds are replaced with the market value of the asset as at the time of the event (subsection 116-30(2) of the ITAA 1997). The market value is worked out as if the event had not occurred and was never proposed to occur (subsection 116-30(3A) of the ITAA 1997).

It is likely that there will be no consideration paid to the entity for the surrender of its and investors' right to interest on the investments. As such, the entity will be taken to have received the market value of nil for the CGT asset and there will be no amount to be included in the calculation of the assessable income of the trust estate, of which the entity is the trustee.

However, if there is any consideration received for the surrender of its and investors' right to interest on the investments then there will be a gain or loss on the right to interest forgone and is to be factored into the calculation of the assessable income of the trust estate, of which the entity is the trustee.

Question 3

Part IVA of the ITAA 1936 (Part IVA) contains a number of anti-avoidance provisions. These provisions give the Commissioner the discretion to cancel a tax benefit that has been obtained, or would, but for section 177F of the ITAA 1936, be obtained, by the taxpayer in connection with a scheme to which Part IVA applies. This discretion is found in subsection 177F(1).

Before the Commissioner can exercise the discretion in subsection 177F(1) of the ITAA 1936, the requirements of Part IVA must be satisfied. These requirements are that:

(i) a 'tax benefit', as identified in section 177C, was or would, but for subsection 177F(1), have been obtained;

(ii) the tax benefit was or would have been obtained in connection with a 'scheme' as defined in section 177A; and

(iii) having regard to section 177D, the scheme is one to which Part IVA applies.

In this case, the entity intends to agree to forego interest accrued but unpaid as at the date Receivers and Managers took control of the company.

A 'tax benefit' as that term is defined in section 177C of the ITAA 1936 would arise where an amount that otherwise would be interest income is foregone and is received as principal.

The breadth of what may constitute a scheme therefore reflects the objective nature of the inquiry to be made under Part IVA. The scheme ultimately matters only in the context of whether there is a tax benefit obtained by the taxpayer in connection with the scheme for which the conclusion in paragraph 177D (b) of the ITAA 1936 can be reached. For the purposes of Part IVA, the proposed agreement to forego an amount of accrued interest not yet paid or otherwise dealt with on Investors' behalf and amendment of the Deed is a scheme.

It has been concluded above at Question 1 that amounts as initial and second distributions includes amounts of interest as income and should be included in the assessable income of the trust estate and the entity cannot re-characterise interest income derived as capital by an agreement to forego the amounts as interest and/or later amend the Deed or hold a meeting in accordance with the Deed.

There is no 'tax benefit' for the purposes of section 177C of the ITAA 1936 of those amounts being included in the assessable income of the trust estate and therefore Part IVA needs no further consideration in respect of those amounts.

The entity has the capacity to forgo its and investors' rights to interest that is not received or otherwise dealt with on investors' behalf after the date it agrees to forego, and amends the Deed, in respect of future amounts of accrued interest not yet paid or otherwise dealt with on investors' behalf.

There is a 'tax benefit' for the purposes of section 177C of the ITAA 1936 of those amounts because they would have otherwise been included in the assessable income of the trust estate.

It is a long standing commercial practice and accepted in many of the provision within both the ITAA 1997 and ITAA 1936 that in the process of liquidating company assets, many of the normal provisions of the ITAA no longer apply (e.g. subsection 70B (4) of the ITAA 1936, and section 104-145 and subdivision 106-B of the ITAA 1997).

An element that must be considered for Part IVA to apply is whether a taxpayer has entered into, or carried out a scheme or part thereof, for the dominant purpose of obtaining a tax benefit having regard to eight specified objective factors in paragraph 177D(b) of the ITAA 1936, it would be concluded that a person who entered into or carried out the scheme, or any part of it, did so for the dominant purpose of enabling the taxpayer to obtain a tax benefit.

In respect of the entity and its and investors' rights to amounts that it has not received or is otherwise dealt with on investors' behalf, and from the eight specified objective factors referred to in paragraph 177D(b) of the ITAA 1936, the dominant purpose of entering into the scheme to receive those amounts as principal and not interest is not to gain a tax benefit but is for the purpose to execute a legal and commercial agreement available to the entity.

Therefore the Commissioner will not seek to apply Part IVA of the ITAA 1936 to deny, in part or in full distributions that are received after the proposed agreement is made and governing Deed is amended or a meeting is held in accordance with the Deed.

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