Edited version of private ruling

Authorisation Number: 1011715494251

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Ruling

Subject: Share trading agreement

Question 1

Does the company's assessable income pursuant to section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997) and allowable deductions pursuant to section 8-1 of the ITAA 1997 include the income and the losses directly attributable to the trading and investment of the shares beneficially owned by Q?

Advice/Answers

No.

Question 2

Pursuant to section 6-5 of the ITAA 1997 does the assessable income of the company include the profit share payable by virtue of the Agreement?

Advice/Answers

Yes.

Question 3

Pursuant to section 6-5 of the ITAA 1997 does the assessable income of the company include the dividend income and franking credits arising from the shares beneficially owned by Q

Advice/Answers

No.

Question 4

Is the interest on the margin loan taken out by the company as part of the share trading business managed by the company an allowable deduction pursuant to section 8-1 of the ITAA 1997?

Advice/Answers

Yes.

This ruling applies for the following periods:

Year ended 30 June 2006

Year ended 30 June 2007

Year ended 30 June 2008

The scheme commences on:

1 July 2005

Relevant facts and circumstances

Q entered into the following arrangements:

· He incorporated the company. With Q and X each holding 50% of the company's issued capital.

· On the same day Q and X entered into an Agreement with the company.

· Pursuant to the agreement Q undertook to provide a share portfolio which Q legally and beneficially owned.

· The shares would remain the beneficial property of Q.

· Q also provided the company with an interest-free loan for its start up costs.

The Agreement set out the terms of management, control and funding of business operations when read with the company's Constitution.

To enhance the operation of it's business operations the company established a margin loan facility secured against the share portfolio provided by Q.

The company confirmed that there has been no change in the beneficial ownership of its shares from the commencement of business operations to the present day.

Reasons for decision

Question 1

Does the company's assessable income pursuant to section 6-5 of the ITAA 1997 and allowable deductions pursuant to section 8-1 of the ITAA 1997 includes the income and the losses directly attributable to the trading and investment of the shares beneficially owned by Q?

Assessable income includes income according to ordinary concepts which pursuant to subsection 6-5(1) of the ITAA 1997 is called an entities ordinary income.

Subsection 6-5(2) of the ITAA 1997 provides that an entities assessable income includes the ordinary income which it derived directly and indirectly from all sources whether in or out of Australia.

Similarly, pursuant to subsection 8-1(1) of the ITAA 1997 an entity can deduct from its assessable income any loss or outgoing to the extent that it is:

1. incurred in gaining or producing its assessable income; or

2. necessarily incurred in carrying on a business for the purpose of gaining or producing it's assessable income.

According to the facts and constituent documents the company's stated purpose is to carry on the business of management of investments in securities and creation of a margin lending account leveraged against the share portfolio pledged as security by Q, but wholly owned by and registered to him. To pursue this business the company bought and sold shares and other securities and received dividends, interest and trust distributions.

The securities were purchased using funds from a margin loan facility the company held and then traded and as the registered owner of those securities. This resulted, according to the company's financial statements, in the realisation of profits and losses which arose from this security trading and related activities.

However, as evidenced by the Agreement between Q, X and the company and by the margin loan agreement these security acquisition, sale and investment activities were to be carried out on behalf of Q, in exchange for a management fee calculated in accordance with the formula stated in the Agreement.

Under long standing principles that exist within Australian and the United Kingdom (UK) law of equity, a person who does not legally own an item of property but is entitled to receive all the benefits of ownership is the equitable or beneficial owner of that property. Therefore when that property produces gains, benefits and / or losses those gains, benefits and / or losses legally accrue to the beneficial owner.

In this case the beneficial owner of the share trading and investment activities is Q on the basis of the evidence provided in the facts.

Therefore the income and losses that are directly attributable to the trading and investment of the shares beneficially owned by Q's behalf are not referable the company and thus neither contributes to the company's assessable income or allowable deductions.

Question 2

Does the assessable income of the company, pursuant to section 6-5 of the ITAA 1997 include the profit share calculated in accordance with clause 13.1 of the Agreement?

As discussed above, the company carried on the business of managing the share trading and investments of a portfolio of securities that was beneficially owned by Q.

Pursuant to the Agreement, the company was entitled to receive a profit share of 100% of the amount a certain value of the share portfolio contributed.

This amount is the net realised profit (after sale of shares but before income taxes) of the share trading, and investment activity of the share portfolio (the profit share).

Taxation Ruling TR 92/3, which sets out the Commissioner's views as to the application of the decision of the Full Court of the High Court of Australia in FC of T v. The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693 (Myer), provides the following at paragraph 31 to 32:

Profits or gains in the ordinary course of business

31. In Myer, the High Court spoke of profits or gains made in the ordinary course of carrying on a business being income. The Court went on to say that, because a business is carried on with a view to profit, such profits or gains are invested with a profit-making purpose and are thereby stamped with the character of income.

32. It is not completely clear what the High Court meant in referring to 'profits or gains made in the ordinary course of carrying on a business'. However, we consider that there are two types of profits or gains which come within that description, namely:

(i) a profit or gain arising from a transaction which is itself a part of the ordinary business of a taxpayer (judged by reference to the transactions in which the taxpayer usually engages) - provided that the gross receipts from the transaction lack the character of income ( Commercial and General Acceptance Ltd v. FC of T (1977) 137 CLR 373 at 381; 77 ATC 4375 at 4380; 7 ATR 716 at 722); and

(ii)  a profit or gain arising from a transaction which is an ordinary incident of the business activity of the taxpayer, although not a transaction entered into directly in its main business activity e.g. profits of insurance companies and banks on the sale of investments are generally income ( Chamber of Manufactures Insurance Ltd v. FC of T (1984) 2 FCR 455; 84 ATC 4315; 15 ATR 599 and C of T v. Commercial Banking Co. of Sydney (1927) 27 SR(NSW) 231).

Accordingly, receipts of amounts in the ordinary course or as a natural incident of carrying on the business generally constitute the ordinary business income.

The company's assessable income will include the profit share, being ordinary business income, derived pursuant to section 6-5 of the ITAA 1997 and calculated in accordance with the Agreement.

Question 3

Pursuant to section 6-5 of the ITAA 1997 does the assessable income of the company include the dividend income and franking credits arising from the shares beneficially owned by Q pursuant to section 6-5 of the ITAA 1997?

As discussed in question 1 (above) the securities which the company managed are beneficially owned by Q. Therefore all the gains, benefits and / or losses legally accrue to Q, including all dividends accruing in respect of those shares and their attached franking credits.

Question 4

Is the interest on the margin loan taken out as part of the share trading business managed by the company an allowable deduction pursuant to section 8-1 of the ITAA 1997?

Section 8-1 of the ITAA 1997 allows a deduction for any loss or outgoing to the extent that it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

However, no deduction is allowable under section 8-1 of the ITAA 1997 for outgoings to the extent they are of a capital, private or domestic nature or are incurred in gaining or producing exempt income.

In this case the company used and always intended to use the margin loan as a means to acquire additional securities with which to trade with and therefore realise more trading and investment profits from which it would derive significant management fees pursuant to the Agreement. In fact the use of this particular mechanism was both core to the company's business plan and the management agreement.

The facts show that the company alone was liable to pay any interest or margin calls in the first instance. Q was only liable to pay anything out of the pledged security if the company defaulted under the margin loan agreement.

The above facts from the margin loan agreement clearly show that the company was liable to pay any interest or margin calls in the first instance. Q was only liable to pay anything out of the pledged security if the company Ltd defaulted under the margin loan agreement. Therefore as per TR 97/7 for Q the expense was merely contingent on the unlikely event of a default and no more than pending, threatened or expected. For this reason he cannot be said to have incurred the interest expenses.

Furthermore:

· While the securities purchased with the margin loan were clearly beneficially owned by Q pursuant to the letter from a lender, there was no acknowledgement in any of the documentation provided that Q was ever to be responsible for paying it, unless a default occurred.

· As Taxation Determination TD 93/13 title makes clear, the nature of the security provided has no bearing on the tests for whether the interest on the underlying borrowings is deductible or not.

Based on the above it is accepted that the outgoing was incurred by the company.

However, is the outgoing of a capital nature?

Taxation Ruling TR 2004/4 provides the Commissioner's view on deductions for interest incurred prior to the commencement of, or following the cessation of, relevant income earning activities and considers the implications of the decision of the High Court in Steele v FCT 99 ATC 4242; (1999) 41 ATR 139 (Steele).

TR 2004/4 provides the following at paragraphs 8 and 9:

Can interest be capital?

8. Outgoings of interest are a recurrent expense. The fact that borrowed funds may be used to purchase a capital asset does not mean the interest outgoings are therefore on capital account (see Steele 99 ATC 4242 at 4249; (1999) 41 ATR 139 at 148).

9. It follows from Steele that interest incurred in a period prior to the derivation of relevant assessable income will be 'incurred in gaining or producing the assessable income' in the following circumstances:

· the interest is not incurred 'too soon', is not preliminary to the income earning activities, and is not a prelude to those activities;

· the interest is not private or domestic;

· the period of interest outgoings prior to the derivation of relevant assessable income is not so long, taking into account the kind of income earning activities involved, that the necessary connection between outgoings and assessable income is lost;

· the interest is incurred with one end in view, the gaining or producing of assessable income; and

· continuing efforts are undertaken in pursuit of that end.

Applying TR 2004/4 to the use and purpose of the borrowings as previously detailed, it is not considered that the outgoing is capital in nature.

As the margin loan proceeds were used to purchase shares from which the company would derive a profit share, equal to 100% of the gains derived from that activity, the margin loan interest is wholly allowable as deduction to the company pursuant to section 8-1 of the ITAA 1997.

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