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Ruling

Subject: Unit Trust - Franking of dividends

Question

Will the unit holders in the Unit Trust be qualified persons within the meaning of Division 1A of former Part 111AA of the Income Tax Assessment Act 1936 (ITAA 1936) in respect of any franked income derived by and flowing from the unit trust, in the absence of a family trust election?

Answer

No.

Question

Will the Commissioner exercise the discretion in former subsection 160APHL(14) of the ITAA 1936 to deem the beneficiaries of the trust as having fixed interests in the corpus of the trust?

Answer

No

This ruling applies for the following period

Year ended 30 June 2007
Year ended 30 June 2008
Year ended 30 June 2009
Year ended 30 June 2010
Year ended 30 June 2011
Year ended 30 June 2012

The scheme commenced on

1 July 2006.

Relevant facts

The Unit Trust ('the Trust') was established by Deed some years ago.

All units issued are of an ordinary class with equal entitlements to capital and income of the trust.

No other units of any class have ever been issued by the Trust and there will not be any different classes of units issued at any time in the future.

The Trust is not a widely held trust as defined in section 160APHD of the ITAA 1936.

The Trust has several unit holders who are the initial subscribers for units in the unit trust from the commencement of the trust.

Some units are held by a Discretionary Trust (DT). The remaining units are held equally by a number of related family members.

One of the unit holders is an unrelated person.

The unrelated unit holder has received distributions of income from the trust in equal proportion to that unit holder's unit holding. (All unit holders received the same distribution of income per unit held).

The distributions of income include franking credits as the only assets held by the unit trust are shares in a private company.

The trust is prevented from making a family trust election as the trust has made distributions of income to a person of a different family group.

If the trust is considered a non-fixed trust, the franking credits would be lost to the beneficiaries under the 45 day holding rule.

No units have been redeemed.

New units were issued to the existing unit holders a few years ago under a director's resolution which was made by a sole director.

All existing unit holders were offered the new units in proportion to the units already held and all unit holders made applications to purchase units on this basis.

The units were purchased at $x as this was to raise additional capital to fund the business operation. The business was not profitable and was not considered to have a market value at the date of the issue of these units.

The proportion of units held has remained constant since the commencement of the trust. The unit trust was established for commercial purposes to hold shares in the company and it was the intention of the Trustee and the unit holders from the commencement of the trust that all unit holders have a fixed entitlement in the capital and income of the trust.

No amendments have been made to the trust deed.

The trustee or unit holders have not resolved to form an advisory committee.

Since commencement, the financial accounts and taxation returns have been completed on the basis that the trust is a fixed trust.

The company has paid, and is expected to pay, franked dividends to the Trust, which in turn has made, and expects to make, franked distributions to its unit holders.

Relevant legislative provisions

Section 207-45 of the Income Tax Assessment Act 1997
Section 207-50 of the Income Tax Assessment Act 1997
Section 207-55 of the Income Tax Assessment Act 1997
Section 207-145 of the Income Tax Assessment Act 1997
Section 207-150 of the Income Tax Assessment Act 1997
Section 160APHD of the Income Tax Assessment Act 1936
Section 160APHE of the Income Tax Assessment Act 1936
Section 160APHL of the Income Tax Assessment Act 1936
Section 160APHM of the Income Tax Assessment Act 1936
Section 160APHO of the Income Tax Assessment Act 1936
Section 160APHU of the Income Tax Assessment Act 1936

Reasons for decision

Summary

The Commissioner will not exercise the discretion available to him pursuant to subsection 160APHL(14) to treat the interests of the unit holders as a vested and indefeasible interest. Consequently, the unit holders will not be qualified persons and therefore will not be entitled to a tax offset under Division 207 of the Income Tax Assessment Act 1997 (ITAA 1997) in respect of any franked income derived by the Trust.

Detailed reasons for decision
Subject to the operation of section 207-150 of the ITAA 1997, section 207-45 of the ITAA 1997 provides that an entity to which a franked distribution flows indirectly in an income year is entitled to a tax offset for that income year equal to its share of the franking credit on the distribution.

A franked distribution is taken to flow indirectly to a beneficiary of a trust estate for the purposes of section 207-45 where the three requirements of paragraphs 207-50(3)(a)-(c) are satisfied:

· First, during that income year the distribution must be made or flow indirectly to the trustee of the trust;

· Second, the beneficiary must have a share of the trust's net income for that income year in the relevant sense;

· Third, the beneficiary's share of the distribution as identified in accordance with section 207-55 of the ITAA 1997 must be a positive amount.

It is intended that the Trust will receive franked distributions, that a share of the Trust's net income for the year in which such distributions are received will be included in the assessable income of the unit holders, and that this amount will be a positive amount. As such, the requirements of section 207-50 of the ITAA 1997 will be satisfied.

Even where the indirect flow through rules are satisfied, a beneficiary of a trust to whom a franked distribution flows indirectly is only entitled to the tax offset under 207-45 of the ITAA 1997 if they are a qualified person for the purposes of Division 1A of former Part IIIAA of the ITAA 1936 in relation to the distribution (refer paragraph 207-150(1)(a) of the ITAA 1997).

By virtue of sections 207-145 and 207-150 of the ITAA 1997 as well as Taxation Determination TD 2007/11, it is clear that regard must be had to the rules in Division 1A of former Part IIIAA of the ITAA 1936 in determining whether a person is a qualified person and hence able to derive the benefit of franking credits attached to distribution made directly or indirectly to the entity. The purpose of the Division is to ensure that the benefits of the franking credits on distributions paid on shares are only available to the true economic owners of the shares, that is, those persons who are sufficiently exposed to the risks of loss and opportunities for gain associated with ownership of the shares (see paragraphs 4.6 and 4.7 of the Explanatory Memorandum that accompanied Taxation Law Amendment Act (No. 2) of 1999 which introduced the Division).

Importantly, irrespective of whether or not a trust is a widely held trust as defined, a beneficiary of the trust cannot be a qualified person in relation to a franked distribution which has indirectly flowed to them through the trust unless the trustee of the trust is themselves a qualified person in relation to the distribution (subsection 160APHU(1) of the ITAA 1936).

As such, unit holders cannot be qualified persons in relation to franked distributions flowing indirectly to them as beneficiary of the Trust unless the Trustee is also a qualified person in relation to the distributions, that is the Trustee satisfies the holding period rules and, where relevant, related payment rules of section 160APHO of the ITAA 1936 in respect of the franked distributions.

As the Trust does not satisfy any of the criteria under the definition of widely held trust in section 160APHD of the ITAA 1936, it is not a widely held trust for the purposes of Division 1A.

By reason of paragraph 160APHO(1)(a) and subparagraph 160APHO(2)(b)(i) of the ITAA 1936, where a taxpayer who holds an interest in shares (not being preference shares) on which a dividend has been paid, and neither the taxpayer nor the associate of the taxpayer has made, is under an obligation to make or is likely to make a related payment in respect to the dividend, the taxpayer will be a qualified person in respect of the dividend if, during the primary qualification period, they held their interest in the shares for a continuous period of not less than 45 days.

Under subsection 160APHG(3) of the ITAA 1936, the beneficiaries of a trust that is not a widely held trust are deemed to have acquired, held or disposed of an interest in shares when the trustee acquires, holds or disposes of those shares.

The primary qualification period in relation to an interest in a share (not being a preference share) is defined in section 160APHD of the ITAA 1936 as the period beginning on the day after the day the taxpayer acquired their interest and ends on the 45^th day after the day on which the interest became ex-dividend. In relation to a beneficiary of a non-widely held trust, under subsection 160APHE(1) of the ITAA 1936 an interest in a share becomes ex-dividend on the day after the last day on which the acquisition by a person of the share will entitle the person to receive the dividend.

In accordance with subsection 160APHO(3) of the ITAA 1936, in calculating the number of days for which unit holders continuously held an interest in a share held by the Trust, any days on which unit holders had 'materially diminished' risks of loss or opportunities for gain in respect of the interest are to be excluded (although this exclusion is not taken to break the continuity of the period for which the interest was held).

Subsection 160APHM(2) provides that a taxpayer is taken to have "materially diminished" risks of loss or opportunities for gain on a particular day in respect of an interest held by the taxpayer in a share if their net position on that day in relation to the interest has less than 30% of those risks and opportunities. Subsection 160APHM(3) of the ITAA 1936 states that a taxpayer's net position for this purpose is worked out using the financial concept of delta.

Section 160APHL of the ITAA 1936 will apply as the shares were acquired after 31 December 1997. Subsection 160APHL(7) of the ITAA 1936 attributes a delta of +1 to the interest in the shares held by a beneficiary of a non-widely held trust as determined under subsection 160APHL(5) of the ITAA 1936.

Unless there is a family trust election in place (or exceptions relating to deceased estates or employee share schemes are satisfied), subsection 160APHL(10) of the ITAA 1936 attributes additional positions to the beneficiary. It gives rise to a short position equal to the beneficiary's long position determined under subsection 160APHL(7) of the ITAA 1936 and a long position equal to so much of the taxpayer's interest in the trust holding as is a fixed interest. For the purposes of subsection 160APHL(10), the beneficiary's interest in the trust holding will be taken to be a fixed interest to the extent that the interest represents a vested and indefeasible interest in so much of the corpus of the trust as is comprised by the trust holding.

In this case, the unit holder will have a long position with a delta of +1 under subsection 160APHL(7) of the ITAA 1936 and a short position with a delta of -1 under subsection 160APHL(10) of the ITAA 1936. In the absence of any other long positions, this will leave the unit holder with a net position of zero and a materially diminished risk of loss or opportunity for gain in accordance with subsection 160APHM(2) of the ITAA 1936. However, a long position will arise in respect of the unit holder's interest in the trust holding as is a fixed interest to the extent that the interest is constituted by an indefeasible vested interest in so much of the corpus of the trust as is comprised by the trust holding.

In the present circumstances where the trustee may at its discretion issue further units at a price determined by the trustee, the interest will under subsection 160APHL(12) of the ITAA 1936 be taken to be defeasible if the issue of new units has the effect of materially reducing the value of the relevant interest. However, where the issue is conducted in accordance with subsection 160APHL(13) of the ITAA 1936, no material reduction in the value of the interest will be taken to have occurred and the interest will not be taken to be defeasible. However, as the trustee is at liberty to determine the issue price of any new units that may be issued, subsection 160APHL(13) of the ITAA 1936 will not apply should the trustee determine the issue price of the units in contravention of the requirements of subsection 160APHL(13) of the ITAA 1936. Consequently, the unit holder will have no additional long position and therefore will not be a qualified person in relation to the dividend paid on the shares.

Exercise of Commissioner's discretion under section 160APHL(14).

In circumstances where a beneficiary does not have a vested and indefeasible interest in the corpus of a trust, the Commissioner may, dependant upon the relevant circumstances, exercise the discretion available to him under subsection 160APHL(14) of the ITAA 1936 to treat the interest as being vested and indefeasible. In exercising this discretion, the Commissioner is required to consider a range of factors in determining if an interest, despite the fact that it does not represent a vested and indefeasible interest, ought to be treated as such.

Subsection 160APHL(14) of the ITAA 1936 states:

160APHL(14) Commissioner may determine an interest to be vested and indefeasible.

If:

(a) the taxpayer has an interest in so much of the corpus of the trust as is comprised by the trust holding; and

(b) apart from this subsection, the interest would not be a vested or indefeasible interest; and

(c) the Commissioner considers that the interest should be treated as being vested and indefeasible, having regard to:

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

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

(iii) the nature of the trust; and

(iv) any other matter the Commissioner thinks relevant;

the Commissioner may determine that the interest is to be taken to be vested and indefeasible.

In the present context, it is considered particularly relevant to focus on the factors provided in subparagraph (c) as regard the Trust.

160APHL(14)(c)(i)

The circumstances in which the unit holdings of the Trust are capable of not vesting or a defeasance can happen as demonstrated by some clauses in the Trust Deed.

160APHL(14)(c)(ii)

At no time since the establishment of the Trust, has the trustee ever exercised its powers to vary any class of units or issue any new class of units.

Therefore the defeasance of the unit holders interest in the Trust is unlikely but for certain clauses of the Trust Deed. Even if the trustee has never managed the trust in such a way as to deprive any beneficiary of his or her entitlement, the power does exist.

160APHL(14)(c)(iii)

The Trust is a closely held trust.

160APHL(14)(c)(iv)

The Explanatory Memorandum which accompanied the introduction of section 160APHL of the ITAA 1936 provides the following as an example of when the exercise of the Commissioner's discretion under subsection 160APHL(14) of the ITAA 1936 may be appropriate:

4.82 Even if an interest is not fixed and indefeasible, the Commissioner may, in appropriate circumstances, deem it to be so. For example, it may be appropriate to exercise this discretion, if necessary, in relation beneficiaries of certain hardship trusts (eg. trusts established under workers compensation legislation).

[Item 8, new subsections 160APHL(14 and (15)]

Using this example as a basis for the exercise of this discretion, the circumstances in this case are not the type of circumstances envisaged by the introduction of the discretion under subsection 160APHL(14) of the ITAA 1936.

It is considered that the ultimate owners of the Trusts interests in any given year, with one unit holder being a discretionary family trust, are not sufficiently certain and identifiable in any given year to satisfy the prerequisite requirements of Division 1A of former Part IIIAA of the ITAA 1936.

Having considered the above factors it is considered that defeasance of the interest in the Trust is possible by virtue of the Trust Deed and whilst this may be unlikely, as far as the immediate unit holders are concerned, the circumstances of this case are not of the type for which the exercise of this discretion was intended to be applied.

Therefore, having considered the relevant circumstances, the Commissioner will not exercise the discretion available to him pursuant to subsection 160APHL(14) to treat the interests of the unit holders as a vested and indefeasible interest. Consequently, the unit holders will not be qualified persons and therefore will not be entitled to a tax offset under Division 207 of the ITAA 1997 in respect of any franked income derived by the Trust.

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