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Ruling

Subject: Derivation of capitalised interest, bad debt deduction and whether unit trust is a fixed trust

Question 1

Can the rulee's income tax returns for certain financial years be amended to omit capitalised interest income that was never received in each financial year?

Answer

No

Question 2

Can the capitalised interest be excluded as assessable income in a certain financial year?

Answer

No

Question 3

Can the capitalised interest be excluded as assessable income for the following financial year?

Answer

Question 4

Is the capitalised interest receivable on loans due to the rulee by a certain person and their associated entities tax deductible to the rulee at the instance when they physically stopped paying interest, when all further interest payments were being capitalised?

Answer

No

Question 5

Is the capitalised interest received in earlier financial years on loans from a certain person due to the rulee tax deductible in the rulee's income tax return for the following financial year, at the instance when the liquidators and receivers were appointed?

Answer

No

Question 6

Is the capitalised interest received in earlier financial years on loans due to the rulee by a certain person, tax deductible in the rulee's income tax return for the following financial year because the person revealed that they did not have the resources to repay the loans?

Answer

No

Question 7

Is the capitalised interest received in earlier financial years on the loans due to the rulee by other persons, tax deductible at the instance when a Commercial List Statement was filed?

Answer

No

Question 8

Is the capitalised interest received in earlier financial years on loans due to the rulee by an entity deductible at the instance when a judgement was entered in favour of the rulee?

Answer

No

Question 9

Is the capitalised interest received in earlier financial years on the loan to other associated entities deductible at the instance when a judgement was entered in favour of the rulee?

Answer

Question 10

Is the capitalised interest received in earlier financial years on loans due to the rulee tax deductible at the instance when the debtors are declared bankrupt by the Court?

Answer

Question 11

Whether the rulee is a fixed trust for the purposes of section 272-65 of Schedule 2F to the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The rulee is a unit trust whose trustee is a company. A trust deed was prepared.

A certain person was a director of the trustee company and was involved in the formation, management and accounting of the rulee.

The unit trust was established for investment purposes. The units were issued to investors associated with the director.

A significant amount of the rulee's funds have been lent to the director and their associated entities on an unsecured basis. Loans were used to acquire assets.

An entity associated with the director prepared all the accounts and income tax returns for the rulee.

The loan agreements between the rulee and the borrowers do not state whether interest is to be calculated monthly, quarterly, or annually and as simple or compound interest.

The financial statements prepared appear to have compounded interest monthly.

Most of the interest due on the loans was capitalised and returned as assessable income in the income tax returns of the rulee up to and including a certain financial year. The profit of the rulee was distributed to the unit holders each year. The unit holders in later years did not receive any cash distributions.

Liquidators were appointed to the Trustee Company and as Receivers and Managers of the rulee trust. The Liquidators undertook various correspondences with all parties from the time of their appointment. It became apparent to the Liquidators in their investigations there was little chance that any amount of interest receivable on the major loans would be recoverable.

A letter of demand was issued to the director for payment of debt.

The rulee also initiated legal recovery against some of the rulee's debtors. A Commercial List Statement was filed against the debtors.

A number of the major debtors have been declared bankrupt.

No special units have been issued to any investors at any time.

There are a small number of unit holders who all held the same proportion of units.

The unit trust deed provided that the trustee shall hold the capital and income of the trust fund upon trust for the registered holders in proportion to the number of units held by them.

Another clause provides that every unit shall confer an interest in the fund in accordance with a certain clause, however, each unit holder will not have an interest in any particular part of the fund or of any investment. The units will be of equal value.

Another clause provides the trustee with power to issue special units and classes of units at their discretion. The rights attributed to the special units will be provided in the certificates and any inconsistent provisions between those in the certificates and the trust deed will be overridden by those in the certificate. A certain clause gives the trustee the power to issue classes of units which refer to interests in specific property only.

Another clause states that a unit holder may not transfer units unless all other registered holders give their consent.

A certain clause gives the trustee absolute discretion to redeem any unit at the request of the registered holder as they consider appropriate by either return of capital or part thereof or cancellation of the units.

Another clause provides that the trustee may at any time at their absolute discretion, with the approval of registered holders given by resolution, may amend, modify or vary the power and provisions contained in the deed.

The liquidator has not capitalised the interest for the financial year in which they were appointed.

The unit trust will be dissolved following the Liquidators completion of their duties.

Question 1 to Question 3- Derivation of capitalised interest

Summary

For the financial years before the liquidator was appointed the interest is considered to be derived at the point it was capitalised in accordance with subsection 6-5(4) of the ITAA 1997.

For the financial year in which the liquidator was appointed, the interest income s not considered assessable income in accordance with subsection 6-5(4) of the ITAA 1997, as the liquidator determined that the interest was not capitalised at the end of that financial year.

Detailed explanation

In Australian taxation law assessable income is derived in accordance with section 6-5 of the ITAA 1997. Section 6-5 provides that a taxpayer's assessable income includes ordinary income derived during the income year. Subsection 6-5(4) of the ITAA 1997 states;

In working out whether you have "derived" an amount of ordinary income, and (if so) when you derived it, you are taken to have received the amount as soon as it is applied or dealt with in any way in your behalf or as you direct.

This is a restatement of the repealed section 19 of the ITAA 1936 which stated;

Income or money shall be deemed to have been derived by a person although it is not actually paid over to him but is reinvested, accumulated, capitalized, carried to any reserve, sinking fund or insurance fund however designated, or otherwise dealt with on his behalf or as he directs.

In accordance with section 1-3 of the ITAA 1997 the interpretation of subsection 6-5(4) of the ITAA 1997 is to be consistent with the interpretation of section 19 of the ITAA 1936.

The concept of derivation is wider than actual receipt. It was held in FCT v Clarke (1927) 40 CLR 246 at p 260 and Tindal v FCT (1946) 72 CLR 608 at p 624 that income is derived when it is "got", "acquired" or "obtained" which means "arises, accruing or coming in by way of income, [and] not necessarily actually received".

Section 19 of ITAA 1936 extends the ordinary meaning of the term derived to situations where income is deemed to be derived although not actually paid over to the taxpayer but is reinvested, accumulated, capitalised, carried to any reserve, sinking fund or insurance fund however designated, or otherwise dealt with on his behalf or as he directs.

The application of section 19 of the ITAA 1936 in the context of the derivation of capitalised interest was considered by the Full High Court in Permanent Trustee Co & Anor v FCT (1940) 6 ATD 5. In that case the taxpayer was a partner in a partnership with W. The taxpayer had lent money to W and to the partnership. On the dissolution of the partnership W owed the taxpayer 8,388 which included interest of 2,535. Under the deed of dissolution W undertook personal liability for the debt and gave security by way of a charge over certain property which was already heavily mortgaged and quite incapable of producing a surplus out of which the amount representing interest could be paid. W was not in a financial position to make any payments towards the debt. The High Court held that in order for an amount to be caught by s19, it must first be found to be income and must have been realised by the taxpayer.

Rich J said at p13

In the present case the interest was by the deed carried to the capital account and in this sense capitalised. But s19 does not say wherever this happens income shall be deemed to be derived but it says it shall be deemed to be derived income on the presumption that it is income and in other respects is derived notwithstanding that there is no actual payment over but a capitalisation or other dealing on behalf of the taxpayer. The object is to prevent the taxpayer from escaping tax though his resources have actually been increased by the accrual of the income and its transformation into some form of capital wealth or its utilisation for some purpose.

But here the facts show that the deceased got nothing except a new obligation to pay in exchange for an existing obligation to pay. He was no nearer getting his money or of transferring it into anything of value. His debtor could neither pay nor secure payment of the debt to him except by charging it on property heavily mortgaged and quite incapable of producing a surplus out of which the amount representing interest could be paid . To see whether income has been derived one must look at realities. Usually payment of interest by cheque involves a receipt of income but payment by valueless cheque does not. For income tax purposes receivability without receipt is nothing, Law of Income Tax (Sir Holdsworth Shaw & Baker), p111. You do not transform interest into an accretion of capital by writing out words on a piece of paper. There must be some reality behind them. Some accretion to corpus. The facts of this case show that there was not an actually realised or realisable profit. All that happened in this case was to change a forlorn hope of interest into a still more forlorn hope of capital.

Starke J said at p 14:

Now it appears to me that, despite the covenant, which on the face of it looks as if the parties had received the sums and had reinvested or capitalised them at interest, the true facts were, although that was the form of the transaction, that it was not the substance, nor the truth of the transaction, and that all the mortgagee did was to take a further security for moneys that were owing to him. That seems to me to come precisely within the reasoning of Lord. MacMillan in the Indian case which is cited in Cross v London & Provincial Trust Ltd (1938) 1 KB at p 798. The essence of the matter is that there was no actually realised or realisable income. In receiving the further charge the mortgagee did not thereby receive payment or the equivalent of payment of the sums assessed. What happened was that the mortgagee received a security for an existing debt. To give security for a debt is not to pay a debt. [Emphasis added].

The question at issue is whether there has been a constructive receipt of the capitalised interest. One of the seminal cases concerning constructive receipt is St Lucia Usines and Estates Co Ltd v Colonial Treasurer of St Lucia [1924] AC 508. The case was an appeal before the Privy Council of a judgement of the Royal Court of St Lucia.

A taxpayer had sold property in St Lucia to a third party. The sale was on the basis that part of the purchase price with interest would be paid in 12 months. The payment was not made and, in the year ended 30 September 1921 (the 1922 financial year) the taxpayer obtained judgement against the defaulting party and received the interest payment. The Colonial Treasurer assessed the interest in the 1921 financial year. The relevant statute (subsection 4(1) of Income Tax Ordinance, 1910, of St Lucia) provides that the income in respect of which income tax is imposed shall include certain income arising or accruing to a person.

Lord Wrenbury stated (at pp 512-513):

The respondent contends that the above interest accrued to the company in the year 1921 because it was payable in that year and none the less because it was not paid in that year. Their Lordships do not agree. The words income arising or accruing are not equivalent to the words Debts arising or accruing. To give them that meaning is to ignore the word income. The words mean money arising or accruing by way of income. There must be a coming in to satisfy the word income.

Comments regarding the reinvestment of interest were also made in Perrot v The Commissioner of Taxation (1922) 23 SR (NSW) 118. Ferguson J said (at p 124):

What that clause* contemplates is the case where the taxpayer, though he has not received the money itself, has had the benefit of it, or of something which is substantially equivalent to it. If he is given credit for the amount, for example, in his bank account, he is in the same position as if he had actually been paid the cash and had deposited it in the bank. So with a re-investment, or accumulation, or any of the other dealings mentioned in the section.

*Section 9 of the Income Tax (Management) Act 1912 (NSW):

Any gains or profits accruing to a taxpayer on the sale by him, during the year of income, of any estate or interest in land, where such estate or interest was bought by him during such year or the four years next prior thereto, where the buying or selling of such estate or interest was not in the course of the business of the taxpayer, shall be deemed to be income derived during the year of income from a source in the State.

Perrot and St Lucia Usines and Estates Co Ltd all provide that income is considered to be received if it is utilised to give something of value to the taxpayer. Income will not be derived from the mere crediting of an amount to an account where there is no prospect of that amount being realised. However, the amount credited will be assessable if it is a realisable sum. In this case, the capitalised amount has been utilised to give something of value to the taxpayer in that the book value of the debt owed to them has increased with the capitalising of the interest. "Receipt" of an amount is not always necessary in order to for it to be derived. For taxpayers who return income on accruals or earnings basis, an amount is derived when it becomes due to the taxpayer, actual receipt is not required.

In the present case, the director confirmed that the books of the rulee were kept on an accruals basis and that the interest on the loans was compounded monthly and capitalised and included as assessable income of the rulee. In this case, as the rulee returns income on an accrual basis, the capitalised interest is considered to be derived when it becomes due, which will be when it is capitalised in the accounts of the rulee, physical receipt of the interest is not necessary.

The capitalising of the interest was at the discretion of the lender according to the loan agreements. By capitalising the interest the lender has called for that interest. The capitalisation has occurred as directed by the lender. It is acknowledged that these loans were made on a non-arms length basis; however, the funds were invested for commercial purposes. This situation can be distinguished from the Permanent Trustee case because in that case the partner (W) was not in a financial position to pay any of the outstanding amounts (viz. principal sum and capitalised interest) under the deed of dissolution and accordingly the taxpayer was found not to have derived any interest income. As stated by Starke J at p 14 " [t]hat seems to be the truth of this case. The mortgagee capitalised nothing, re-invested nothing, but took further security for sums which he could not realise".

In the present case there is no adequate financial information that has been presented to confirm that the borrower was incapable of meeting the obligations under the loan agreements at the time the interest was being capitalised and included as assessable income in each financial year. Although the director stated that the physically stopped interest paying at a certain date; there were still assets held by the debtors which may have been realised in meeting the debts if they were called for at that time.

The same can be said for the other advances to family, there is no evidence to suggest that there was never an intention to repay the debt on the sale of the respective assets during the period that the interest was capitalised. This capitalisation of interest occurred on an accruals basis with the capitalised interest being derived as interest in each relevant financial year.

For the financial year prior to the liquidators being appointed the capitalised interest will continue to be assessable income in accordance with the practice adopted by the director when preparing the books of the trust. For the financial years prior to the liquidators being appointed the interest is considered to be derived at the point it was capitalised in accordance with subsection 6-5(4) of the ITAA 1997.

For the financial year in which the liquidators were appointed, it is at their determination as to whether they continue to capitalise the interest or whether the practice is stopped. As the controlling mind of the trust has changed the liquidators needed to determine how they were treating the loans and interest when preparing the records of the trust at the end of that financial year. Accordingly, as the liquidator determined that the interest was not capitalised at the end of that financial year accordingly, it is not considered assessable income as require by subsection 6-5(4) of the ITAA 1997.

Question 4 to Question 10 Deductions

Summary

The rulee is not entitled to a deduction for the capitalised interest that will not be recovered in accordance with section 8-1 of the ITAA 1997 or section 25-35 of the ITAA 1997. This is because once the interest is capitalised the rulee is exchanging interest income for a capital investment and this is a capital amount.

Reasoning

The rulee has argued that the non-payment of the capitalised interest has given rise to a bad debt which should be allowed as a deduction under section 25-35 of the ITAA 1997.

Section 25-35 of the ITAA 1997 provides relief for taxpayers assessed on an accruals basis who have included as assessable income an amount in respect of which they will not receive payment. Subsection 25-35(1) of the ITAA 1997 states:

(1) You can deduct a debt (or part of a debt) that you write off as bad in the income year if:

(a) it was included in your assessable income for the income year or for an earlier income year; or

(b) it is in respect of money that you lent in the ordinary course of your business of lending money.

Section 25-35 of the ITAA 1997 relates to a debt included in a taxpayer's assessable income. In other words section 25-35 of the ITAA 1997 relates to a debt which is income. The relevant debt in the current case is the capitalised interest. Once the interest was capitalised in the books of the rulee the amount became part of the capital, exchanging interest income for a capital investment. As the rulee has now lost a capital amount rather than income section 25-35 of the ITAA 1997 has no application.

Section 8-1 of the ITAA 1997

Section 8-1 provides as follows:

8-1(1) You can deduct from your assessable income any loss or outgoing to the extent that:

(a) it is incurred in gaining or producing your assessable income; or

(b) it is necessarily incurred in carrying on a business for the purpose of gaining or producing your assessable income.

8-1(2) However, you cannot deduct a loss or outgoing under this section to the extent that:

(a) it is a loss or outgoing of capital, or of a capital nature; or

(b) it is a loss or outgoing of a private or domestic nature; or

(c) it is incurred in relation to gaining or producing your exempt income or your non-assessable non-exempt income; or

(d) a provision of this Act prevents you from deducting it.

In this case, the loss will be the capitalised interest included as assessable income which will not be recovered.

In looking at the circumstances surrounding this case we are of the view that any loss incurred is on capital account. That is, once the interest was capitalised it was then considered capital in nature. Therefore in accordance with paragraph 8-1(2)(a) of the ITAA 1997 a deduction is not available for the capitalised interest that has not been recovered as it is a loss or outgoing of capital or of a capital nature. The rulee will need to consider the capital gains and capital loss provisions with regard to the capitalised interest that will not be recovered.

Other comments - Capital gains event C2

Section 102-5 of the ITAA 1997 includes in your assessable income, your net capital gain for the income year. You make a capital gain or capital loss if and only if a capital gains tax (CGT) event happens to a CGT asset.

Subsection 108-5(1) of the ITAA 1997 defines a CGT asset to be any kind of property, or a legal or equitable right that is not property. One of the examples given in the notes to section 108-5 of the ITAA 1997 is debts owed to you. An unpaid loan would be considered to be a debt that is owing to you.

Therefore, a debt, or right to repayment, is an asset for CGT purposes.

However, subsection 108-20(1) of the ITAA 1997 states that in working out a taxpayers net capital gain or loss for an income year, any capital loss made from a personal use asset is disregarded.

Paragraph 108-20(2)(d) of the ITAA 1997 defines personal use assets to include a debt owed to the taxpayer that arose other than in the course of gaining or producing their assessable income or from them carrying on a business.

In your situation, the debt arose out of monies lent from which the trust expected to produce assessable interest income.

Therefore, the debt owed would not be a personal use asset and accordingly may give rise to a capital loss.

CGT event C2 in section 104-25 of the ITAA 1997 discusses what happens when your ownership of an intangible CGT asset ends. Subsection 104-25(1) of the ITAA 1997 explains that CGT event C2 occurs when the intangible asset ends by being redeemed, cancelled, surrendered or through other similar endings.

The mere writing off of a debt by a taxpayer is insufficient to meet requirements of subsection 104-25(1) of the ITAA 1997. In respect of a borrower who has become bankrupt the debt will continue to exist until such time as the bankrupt borrower is discharged from bankruptcy. The discharge operates to release the bankrupt from all provable debts. Until discharge no CGT event has occurred (refer to ATO Interpretive Decision 2003/215).

For an asset such as a debt or a loan, the requirements of subsection 104-25 of the ITAA 1997 would also be met if you would no longer be entitled to seek payment of any outstanding amount or sue for its repayment. Also a debt may be extinguished by forgiveness under a deed of release.  A debt will not be extinguished if it is merely forgiven or abandoned without any legal impediment imposed on its collection.

Question 11 Fixed Trust

Summary

The terms of the trust instrument do not provide the beneficiaries with vested and indefeasible interests in the income and capital of the trust. Accordingly, the rulee is not a fixed trust in accordance with section 272-65 of the ITAA 1936.

Detailed reasoning

A 'fixed trust' is defined in similar terms in subsection 995-1(1) of the ITAA 1997 and section 272-65 of Schedule 2F to the ITAA 1936. The latter definition provides that:

A trust is a fixed trust if persons have fixed entitlements to all of the income and capital of the trust.

The definition of 'fixed entitlement' in subsection 995-1(1) of the ITAA 1997 provides:

… an entity has a fixed entitlement to a share of the income or capital of a trust if the entity has a fixed entitlement to that share within the meaning of Division 272 in Schedule 2F to the Income Tax Assessment Act 1936.'

Subsection 272-5(1) of Schedule 2F to the ITAA 1936 defines a fixed entitlement in a trust:
If, under a trust instrument, a beneficiary has a vested and indefeasible interest in a share of income of the trust that the trust derives from time to time, or of the capital of the trust, the beneficiary has a fixed entitlement to that share of the income or capital.

In addition, subsection 272-5(2) states that:

If:

(a) a person holds units in a unit trust; and

(b) the units are redeemable or further units are able to be issued; and

(c) if units in the unit trust are listed for quotation in the official list of an approved stock exchange - the units held by the person will be redeemed, or any further units will be issued, for the price at which other units of the same kind in the unit trust are offered for sale on the approved stock exchange at the time of the redemption or issue; and

(d) if the units are not listed as mentioned in paragraph (c) - the units held by the person will be redeemed, or any further units will be issued, for a price determined on the basis of the net asset value, according to Australian accounting principles, of the unit trust at the time of the redemption or issue;

then the mere fact that the units are redeemable, or that the further units are able to be issued, does not mean that the person's interest, as a unit holder, in the income or capital of the unit trust is defeasible.

The word 'interest' is a word that is capable of many meanings. In the absence of a definition one must infer its meaning from the context in which it is found (see Gartside v Inland Revenue Commissioner [1968] AC 553 at 602-602 and 617-618 Commissioner of Stamp Duties (Queensland) v Livingston (1964) 112 CLR 12 at 28-29; and CPT Custodian Pty Ltd v Commissioner of State Revenue 2005 HCA 53).

There may be circumstances in which the word 'interest' could be interpreted broadly to include any right or advantage that a person might be able to claim with respect to the income or capital of the trust and/ or in respect of the trustee, whether present or future, ascertained or potential. In the context of Schedule 2F, however, it is clear that for an interest to be recognised as a fixed interest it must be a right with respect to a share of the income or of the capital of the trust that is susceptible to measurement. To adopt the words of Lord Wilberforce in Gartside v Inland Revenue the right must have 'the necessary quality of definable extent'.

The term 'vested and indefeasible' is not defined in the taxation legislation and to date there is no precedential 'ATO view' which defines or clarifies the term. However the Explanatory Memorandum (EM) to the Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997 does discuss its ordinary meaning at some length, at paragraphs 13.4 to 13.9.

In Colonial First State Investments Ltd v Commissioner of Taxation [2011] FCA 16 Stone J stated at [97] that in the absence of a definition, and subject to qualification in subsection 272-5(2) of Schedule 2F, the term 'indefeasible' bears its ordinary meaning when applied to an interest, that is that 'the interest cannot be terminated, invalidated or annulled'. The meaning of the term 'vested and indefeasible' (in the context of Schedule 2F to the ITAA 1936) also appears in subsection 95A(2) of the ITAA 1936 and has been considered in that context by the courts - refer to Estate Mortgage Fighting Fund Trust v FC of T 2000 ATC 4525; Walsh Bay Developments Pty Ltd v Commissioner of Taxation (1995) 95 ATC 4378; Dwight v Commissioner of Taxation (1992) 92 ATC 4192; Harmer v FC of T (1991) 173 CLR 264; 91 ATC 5000.

Also relevant are MSP Nominees Pty Ltd v Commissioner of Stamps (SA) (1999) 198 CLR 494; 99 ATC 4937; Queensland Trustees Ltd v Commissioner of Stamp Duties (1952) 88 CLR 54; Glenn v Federal Commissioner of Land Tax (1915) 20 CLR 490.

It is an essential element of subsection 272-5(1) of Schedule 2F to the ITAA 1936 that in order to have a fixed entitlement to a share of income or capital there must be a vested or indefeasible interest "under a trust instrument". In all cases, the determining factor in deciding if fixed entitlements exist will be the terms of the trust instrument under which the trust is constituted. Neither the form of the trust nor the labels that are attached to it can determine this question.

The first step in determining whether a Registered Holder has a vested and indefeasible interest in a share of the income or capital of a trust is to ascertain the terms of the trust upon which the relevant trust property is held. As the High Court stated in CPT Custodians Pty Ltd v Commissioner of State Revenue (Vic); Commissioner of State Revenue (Vic) v Karingal 2 Holdings Pty Ltd (2005) 224 CLR 98 at [15], in taking this step:

… a priori assumptions as to the nature of unit trusts under the general law and principles of equity [will] not assist and would be apt to mislead. All depends, as Tamberlin and Hely JJ put it in Kent v SS "Maria Luisa" (No 2), upon the terms of the particular trust. The term "unit trust" is the subject of much exegesis by commentators. However, "unit trust", like "discretionary trust", in the absence of an applicable statutory definition, does not have a constant, fixed normative meaning which dictate the application to particular facts of the [relevant statutory definition] …

There will be some circumstances in which a trust instrument must be read subject to the operation of a particular legal rule, whether by common law, statute or statutes. See, for example, the provisions of Chapter 5C of the Corporations Act 2001 which, if inconsistent with the constitution of a registered managed investment scheme, can have the effect of altering or modifying the scheme's constitution. It is possible for a constitution to be altered or modified by operation of law irrespective of whether the trust instrument itself expressly recognises the relevant common law rule or statute, and the entitlements of a beneficiary under the trust instrument are those as so altered or modified by operation of law.

The important question is whether the vested and indefeasible interests represent 100% of the income and 100% of the capital of the trust. The fact that a power held by the trustee or manager has not yet been exercised is not relevant when determining if the power results in an interest being defeasible. The exercise of the power determines if an interest has in law been defeased, not if it is defeasible. The real question is whether the power, if exercised, would result in a defeasance of some or all of the unit holder's rights to the income and/or capital of the trust.

Specifically

For the purposes of subsection 272-5(1) of Schedule 2F to the ITAA 1936, the trust instrument consists of the Deed of Settlement for the unit trust. It is accepted that the Deed provides unit holders with a vested interest in the income and capital of the trust.

The Deed of the unit trust contains certain clauses by which a Registered Holder's interest in a share of the income or capital of the trust may be defeased. Therefore, it is considered reasonable to conclude, in accordance with subsection 272-5(1) of Schedule 2F to the ITAA 1936, that all Registered Holders do not have fixed entitlements to all of the income and capital of the unit trust.

Clauses which may contain defeasible powers

Special unit

A certain clause provides the trustee with the power to issue units and classes of units at the discretion of the trustee. The terms of those units prevail over the provisions of the deed if there is any inconsistency between the two.

The issue of any units or classes of units could defease the interest of existing Registered Holders.

Alteration of the trust deed

A certain clause permits the trustee to vary the powers and provisions of the deed without any specified restriction other than the need for approval of all the Registered Holders. There is no caveat which would protect the existing interests of the Registered Holders so, depending on the terms of the resolution put to the meeting, the interests in the income and capital of the existing Holders could be defeased.

Commissioner's discretion

Summary

On the facts of this case the Commissioner considers that it is not reasonable to exercise his discretion to treat the beneficiaries as having fixed entitlements to a share of the income and capital of the trust.

Detailed reasoning

Subsection 272-5(3) of Schedule 2F to the ITAA 1936 contains a discretion whereby, in cases where beneficiaries do not have a fixed entitlement, the Commissioner may, for the purposes of the Act, treat such beneficiaries as having a fixed entitlement where it is reasonable to do so based upon the factors prescribed in paragraph 272-5(3)(b). Paragraph 272-5(3)(b) stipulates that the Commissioner may treat a beneficiary as having a fixed entitlement (in cases where in fact beneficiaries do not have a fixed entitlement) having regard to:

(i) the circumstances in which the entitlement is capable of not vesting or the defeasance can happen; and

(ii) the likelihood of the entitlement not vesting or the defeasance happening; and

(iii) the nature of the trust.

The interpretation of section 272-5 of Schedule 2F to the ITAA 1936 (the meaning of vested and indefeasible) was raised at the March 2006 meeting of the National Taxation Liaison Group (NTLG), and referred to the newly formed Trust Consultation Sub-group for discussion. At their meeting on 28 November 2006, the ATO advised that:

In applying the discretion, the ATO would have regard to what the Office understands was the policy that underlay the provisions at the time they were enacted. The Commissioner would also have to apply the statutory tests having regard to the terms of the particular trust deeds and all the surrounding circumstances.

(see section 30.15 of the Minutes of NTLG meeting - 7 Dec 2006) http://www.ato.gov.au/taxprofessionals/content.asp?doc=/content/00092226.htm&page=68&H68

In the absence of any precedential guidelines, taxpayers seeking access to the Commissioner's discretion will be dealt with according to the relevant facts on a case by case basis. In the case of trusts which are managed investment schemes, it is also appropriate that consideration is given to any potential impacts that the Corporations Act 2001 (as noted above), the regulatory powers of the Australian Securities and Investments Commission (ASIC), and the actions of the Australian Securities Exchange (ASX) may have on the administration of the trust and the entitlements of beneficiaries.

In view of the conclusion above that Registered Holders in the unit trust do not have vested and indefeasible interests, pursuant to subsection 272-5(1) of Schedule 2F to the ITAA 1936, subsection 272-5(3) may be considered.

Consideration of the factors in subsection 272-5(3) of Schedule 2F ITAA 1936

Paragraph 272-5(3)(a):

The trust deed provides the unit holders of the unit trust with vested interests in:

· a share of the income that the Trust derives from time to time, pursuant to Recital and clauses of the trust deed; and

· in a share of the capital of the Trust, pursuant to clauses of the trust deed.

Subparagraph 272-5(3)(b)(i):

The following comments are made in relation to the circumstances in which the entitlement is considered unlikely to vest or be defeased (as outlined in the above discussion on particular clauses in the Trust deed).

At all times since settlement the trustee had the power to issue units and classes of units at its discretion without the need for approval by the existing Registered Holders. As a closely-held trust, it would be a simple matter for this to be arranged. Even though the power was not used, that does not alter the fact it was available and so the trust was non-fixed.

While it appears the deed hasn't been amended since settlement, the wide power and the closely-held nature of the trust would enable this to happen if needed. Even though the approval of all the Registered Holders is required, this does not necessarily prevent the defeasance of existing entitlements.

Subparagraph 272-5(3)(b)(ii):

The likelihood of the entitlement not vesting or the defeasance happening in respect of the clauses in the Trust Deed (outlined above) are as follows:

In a closely-held trust environment without any external supervision, it is very likely the defeasance could happen should the financial circumstances of the trustee or the ventures in which the trust investments have been placed require this.

Subparagraph 272-5(3)(b)(iii) - the nature of the trust:

The trust is a unitised trust and is closely held and is therefore not subject to regulation imposed by the Corporations Act 2001 or other bodies. As such, it can be influenced by the decisions of the individuals behind the establishment of the trusts who are also involved in the investment policy and the activities funded by those investments.

In this regard clause 12 of the deed provides that sections 14A, 14B and 14C of the Trustee Act 1925 (NSW) do not apply to the deed. Those sections deal with the power of investment and include the 'prudent person' test.

The rulee states that it is '… unclear to the Taxpayers whether the Unit Holders have a vested and indefeasible interest in their share of the income and capital of the Trust … albeit it is the intention of the Trustees that the trust is in fact a Fixed Trust.'

Schedule 2F to the ITAA 1936 and tax losses

The concept of a 'fixed entitlement' was originally introduced in the context of the trust loss measures and should primarily be interpreted in that context. The trust loss measures are an important integrity measure, removing a structural flaw in the tax system. The concept of a 'fixed entitlement' is fundamental to the structure and effectiveness of the trust loss measures.

The Explanatory Memorandum to the trust loss measures states (at paragraph 13.13) in respect of the Commissioner's power in subsection 272-5(3) that:

This provision is intended to provide for special circumstances where there is a low likelihood of a beneficiary's vested interest being taken away or defeated and, having regard to the scheme of the trust loss provisions to prevent the transfer of the tax benefit of losses and other deductions incurred by trusts, it would be unreasonable to treat the beneficiary's interest as not constituting a fixed entitlement

This passage seems to indicate that when looking at the facts of a case in the context of the criteria listed in subsection 272-5(3) regard should always be had to whether the absence of a fixed entitlement in these circumstances could result in the transfer of the benefit of the tax loss.

As stated above, for the purposes of subsection 272-5(1), the unit holders in the unit trust do not have a fixed entitlement to a share of the income and capital of the trust.

Further, after having regard to the factors in subparagraphs 272-5(3)(b)(i), (ii) and (iii) and the submissions of the rulee, it is considered that the facts of the current case do not warrant the exercising of the Commissioner's discretion to deem unit holders to have fixed entitlements.

In summary, as:

· the trust deed contains powers that may defease the unit holder's interest in a share of the income or capital; and

· the unit trust is a 'closely held' trust which is not subject to any fiduciary controls above those that apply generally to a trustee,

· the rulee has been unable to establish a reasonable case that special circumstances exist for the Commissioner to exercise the discretion pursuant to subsection 272-5(3) to treat the interests of the unit holders in the income and capital of the unit trust as fixed entitlements.

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