Edited version of private ruling

Authorisation Number: 1011620085488

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Ruling

Subject: Income tax - assessable income, interest forgone

Question 1

Will the interest forgone be included in the assessable income of an entity?

Answer

No

Question 2

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

Answer

Yes.

Question 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:

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.

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 particular 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 two later dates investors received initial distributions on their outstanding claims. These payments are not the subject of this ruling and will not be considered.

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.

Any unpaid interest that is forgone as a result of this proposed arrangement is the subject of this ruling.

Assumption

The interest that will be forgone is interest that has not yet been paid.

Relevant legislative provisions

Income Tax Assessment Act 1997 Subsection 995-1(1)

Income Tax Assessment Act 1997 Subsection 6-1(1)

Income Tax Assessment Act 1997 Section 6-5

Income Tax Assessment Act 1997 Section 102-5

Income Tax Assessment Act 1997 Section 108-5

Income Tax Assessment Act 1997 Section 104-25

Income Tax Assessment Act 1997 Section 116-30

Income Tax Assessment Act 1936 Part IVA

Reasons for decision

Question 1

Summary

The interest that will be forgone under the proposed arrangement will not be included in the assessable income of the entity as the interest will not be derived by the entity.

Detailed reasoning

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.

The amount of interest will only be included in the assessable income of the trust estate, of which the entity is the trustee for the 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 (1971) 125 CLR 418 at pp 427-428 stated that:

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 sets out the Commissioner's policy on derivation of income. In relation to investment income, paragraph 47 of the Taxation Ruling TR 98/1 sets out the general principle that interest is only derived when it is received or credit and the exceptions to this.

The entity in its capacity as trustee for investors in respect of rights to the payment of interest and the repayment of principal on investments is not carrying on a business. As such, according to paragraph 47 of the Taxation Ruling TR98/1, the general principle of income derivation in relation to interest applies, that is, interest is only derived when it is received or credited.

The entity has the capacity to forgo interest rights on interest that it has not yet received.

On the date that receivers and managers took control of the company's business affairs and assets interest had accrued that was not yet payable. As no further interest will be paid, the forgone interest will not be derived by the entity as trustee for the investors..

Question 2

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) of the ITAA 1936.

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.

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 of the ITAA 1997 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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