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Ruling

Subject: Residual Income Units in Trusts

Question 1

Are the residual income units in the relevant trusts (Income Units) "assets" for the purposes of Division 705 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Are the Income Units "reset cost base assets" for the purposes of section 705-35 of the ITAA 1997?

Answer

Yes

Question 3

Is the taxpayer entitled to deduct a net loss arising on redemption of the Income Units under section 8-1 of the ITAA 1997, in the income year in which the Income Units are redeemed?

Answer

No

Question 4

Will the tax cost setting amount attributed to the Income Units as reset cost base assets be treated in accordance with subsection 701-55(6) of the ITAA 1997?

Answer

No

This ruling applies for the following periods:

Year ended 31 December 2005

Year ended 31 December 2006

Year ended 31 December 2007

Year ended 31 December 2008

Year ended 31 December 2009

The scheme commences on:

On or after 1 December 2004

Relevant facts and circumstances

Background

1. A Co was a member of an income tax consolidated group (henceforth referred to as the A Group).

2. B Co acquired A Co and subsequently B Co and all of its wholly owned subsidiaries (including the A Group) joined the Taxpayer Consolidated Group.

3. At the time B Co acquired A Co, A Co held Residual Income Units in a number of trusts.

4. The A Group has only ever held income units in the trusts while the capital units were held by unrelated third parties.

5. The A Group envisaged that it would hold the Income Units until the trusts were wound up or terminated.

6. The trusts have all been wound up. The balance of any trust fund has been distributed to the Taxpayer Consolidated Group as holder of the Income Units after appropriate allocation to the holder of the capital units.

7. On termination of the trust the residual income unitholder was entitled to receive the entire beneficial interest of the trust (comprising the remaining income and the amount originally contributed) other than the amount payable to the holder of the residual capital unit, being the residual capital unit issue price of $X. In effect, the residual income unitholder should have received back its initial contribution and any surplus income on termination of the trust.

Allocable Cost Amount (ACA) Process

8. As a result of A Co joining the Taxpayer Consolidated Group, the taxpayer undertook the process of setting the tax cost of the joining entity's assets pursuant to Sub-division 705-D of the ITAA 1997.

9. In accordance with Sub-division 705-D of the ITAA 1997, the Income Units were allocated a portion of the ACA in proportion to their market value. The Income Units were independently valued at the joining time and given a market value based on the net present value of future cash flows.

10. The taxpayer asserts that the ACA for the joining entity has not been reduced by an amount in respect of the Income Units under any of the steps in the table in section 705-60 of the ITAA 1997.

Other Matters

11. The taxpayer is a resident of Australia for Australian tax purposes.

12. It is the 'pre-rules' enacted by Part 1 of Schedule 3 of Tax Laws Amendment (2012 Measures No 2) Act 2012 that apply for the relevant income years in respect of the Income Units.

Relevant legislative provisions

Income Tax Assessment Act 1936 Section 95

Income Tax Assessment Act 1936 Section 97

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Division 70

Income Tax Assessment Act 1997 Part 3-90

Income Tax Assessment Act 1997 Subsection 701-55(5)

Income Tax Assessment Act 1997 Subsection 701-55(6)

Income Tax Assessment Act 1997 Division 705

Income Tax Assessment Act 1997 Sub-division 705-D

Income Tax Assessment Act 1997 Subsection 705-25(5)

Income Tax Assessment Act 1997 Paragraph 705-25(5)(b)

Income Tax Assessment Act 1997 Section 705-35

Income Tax Assessment Act 1997 Subsection 705-35(1)

Income Tax Assessment Act 1997 Subsection 705-35(2)

Income Tax Assessment Act 1997 Section 705-60

Income Tax Assessment Act 1997 Subsection 713-515(1)

Income Tax Assessment Act 1997 Subsection 713-705(2)

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

Reasons for decision

Unless otherwise indicated references to legislative provisions are to the Income Tax Assessment Act 1997 (ITAA 1997).

Question 1

1. Division 705 sets out the tax cost setting rules for the assets of an entity that becomes a subsidiary member of a consolidated group. However the term "asset" is not defined in Part 3-90 and therefore takes its ordinary commercial or business meaning.

2. Taxation Ruling TR 2004/13 addresses the question of what is an asset for the purposes of the tax cost setting rules in Part 3-90. An asset for the purpose of the tax cost setting rules is anything recognised in commerce and business as having economic value to the joining entity at the joining time for which a purchaser of its membership interests would be willing to pay.

3. The Explanatory Memorandum to the New Business Tax System (Consolidation) Bill (No. 1) 2002 states at paragraph 5.19:

An asset, for the purposes of the cost setting rules, is anything of economic value which is brought into a consolidated group by an entity that becomes a subsidiary member of the group.

4. At joining time the Income Units, with expected net future cash flows in the form of the surplus income, have economic value. The surplus income is distributed to the unitholder of the Income Units and the taxpayer has included the surplus income as assessable income in its income tax return. The Income Units are recognised as assets under the ITAA 1936 and ITAA 1997, for instance they are CGT assets. It is accepted that the Income Units will have value in business and commerce to the joining entity and to the consolidated group.

5. Accordingly, the Income Units are assets for the purposes of Division 705.

Question 2

6. Subsection 705-35(1) explains that a reset cost base asset is an asset that is neither a retained cost base asset nor an excluded asset (defined under subsection 705-35(2) to mean an asset in respect of which the joined group's allocable cost amount (ACA) for the joining entity is required to be reduced).

7. Subsection 995-1(1) states that the term "retained cost base asset" has the meaning given by subsections 705-25(5), 713-515(1) and 713-705(2).

8. As A Co is neither a life insurance company nor a general insurance company it is not necessary to consider the special rules in 713-515(1) and 713-705(2).

9. As the Income Units are not Australian currency, units in a cash management trust, unbilled income assets or rights for services performed it is necessary to consider paragraph 705-25(5)(b).

10. Taxation Ruling TR 2005/10 explains that the expression "a right to receive a specified amount of Australian currency" in paragraph 705-25(5)(b) is a reference to "an indefeasible, present right to the actual or constructive receipt of a fixed, nominal amount of Australian currency" (see paragraph 9 and 20 of TR 2005/10).

11. Paragraph 25 of TR 2005/10 states that an indefeasible, present right does not exist where the "actual right… is liable to be defeated or terminated by the operation of a condition subsequent or conditional limitation".

12. TR 2005/10 does not explain what the expression "condition subsequent" means. However, the meaning of that expression is defined in The CCH Macquarie Concise Dictionary of Modern Law (Sydney: CCH Australia Limited, 1988) as "an event the occurrence of which deprives a previous act of its effect".

13. Paragraph 30 of TR 2005/10 provides guidance on the expression "specified amount", stating that it is a "fixed, nominal amount… that can be definitively arrived at by the use of a formula, rather than an expressly stipulated dollar amount, provided that it is not a self adjusting formula that could result in differing amounts to which there is a right to receive after the date of the agreement".

14. Distributions to unitholders via their holding of Income Units is contingent on there being excess income. Further, whilst the amount of surplus income is calculated with reference to a formula, the amount is not fixed and the fluctuations in the interest rate may result in no amounts ever being distributed.

15. The taxpayer asserts that the joining entity's ACA for the Income Units is not reduced by an amount under any of the steps in the table in section 705-60 and thus are not considered to be excluded assets.

16. Accordingly, the Income Units are reset cost base assets as they are neither retained cost base assets under subsection 705-25(5) nor excluded assets under subsection 705-35(2).

Question 3

17. Section 8-1 allows a deduction for any loss or outgoing to the extent that it is incurred in gaining or producing assessable income, or it is necessarily incurred in carrying on a business for the purposes of gaining or producing assessable income. However a deduction is not allowed to the extent that the loss or outgoing is capital or of a capital nature.

18. Ordinarily, it would be A Co who actually incurred the outgoing who would be entitled to the deduction under section 8-1. However, the effect of the consolidation provisions in Part 3-90 is that a loss incurred by A Co is taken to have been incurred by the head company (in this case the taxpayer) for the purposes of determining whether the taxpayer is allowed a deduction for the loss under section 8-1.

Is the net loss resulting from the redemption of Income Units a loss that is deductible under Section 8-1?

19. The net loss that is under consideration in this private ruling is the loss that arose from the redemption of the Income Units when the trusts were wound up.

20. If the Income Units are revenue assets but not trading stock, it follows that if the redemption of those Income Units results in a net loss, that loss is deductible under section 8-1: see paragraph 67 of Taxation Ruling TR 96/4.

Are the Income Units trading stock?

21. On the facts provided, A Co did not buy the Income Units for the purpose of selling for a profit. The Income Units were held until they were redeemed on winding up of the relevant trusts. Accordingly, the Income Units are clearly not trading stock. Hence, the acquisition cost of the Income Units would not be deductible under the provisions in Division 70.

Are the Income Units revenue assets?

22. To determine whether an asset is on revenue account or capital account, it is necessary to examine whether the asset is a structural asset, which forms part of the "profit yielding subject" of the business, or a revenue asset, that is not part of the structure of the process of income derivation (R.W. Parsons, Income Taxation in Australia, The Law Book Company, 1985).

23. Paragraph 7 of TR 96/4 states:

…a 'revenue asset' refers to 'an asset' whose realisation is inherent in, or incidental to, the carrying on of a business'…It is to be distinguished from a "structural asset", which forms part of the "profit yielding subject" of the business': see R W Parsons, Income Taxation In Australia, the Law Book Company Limited, 1985, at 155.

24. A revenue asset covers assets in which a business deals or which is otherwise turned over in the carrying on of the business such as investments of a life insurance company or banking company: see Colonial Mutual Life Assurance Society Ltd v. Federal Commissioner of Taxation (1946) 73 CLR 604 (Colonial), or the investments of the taxpayer in London Australia Investment Company Limited v. Federal Commissioner of Taxation (1977) 138 CLR 106; 7 ATR 757; 77 ATC 4398 (London Australia).

25. In Colonial, the object of the Society are the assurance of lives, the granting of annuities and endowments and all other cognate business and to do all such other things as are incidental or conducive to the attainment of the above objects. The operation of the Society include the issue of policies of assurance of various descriptions, the grant of annuities and endowments and the investment of its funds which it derives from premiums paid to it and returns from its investments. The investments were varied or switched from time to time in order to increase the effective interest yield to the Society. It was a normal operation or step in the carrying on of its business.

26. London Australia has been referred to as authority for the view that an overall purpose to profit is an essential element in the context of business in the business gains principle.

In London Australia, the taxpayer was an investment company whose principal objective was to invest in Australian securities for the purpose of producing dividend income which it could distribute to its shareholders. In buying shares the company was influenced by their "growth potential", i.e. the expectation that they would produce a greater dividend yield. The company never bought shares for the purpose of profit-making by sale, or with the intention of selling, or simply because their market value was likely to increase. The company bought shares to hold as an investment to yield dividends. If the shares increased in value, but the dividend rate did not correspondingly increase, the dividend yield would fall and the company would then be likely to sell the shares.

27. By a 2-1 majority, Gibbs J. and Jacobs J. found in favour of the Commissioner (Barwick C.J. dissenting) and held that the profit on the sale of the securities was to be treated as income.

28. In reaching his conclusion, Gibbs J. stated that when a taxpayer sells one of its investments, the question whether the profit on the sales should be treated as capital or income is to be answered by applying the tests stated in Californian Copper Syndicate (Limited and Reduced) v. Harris (1904) 5 T.C. 159. The principle was stated as follows in Colonial at p. 614:

Prima facie the depreciation in or accretion to the capital value of a security between the date of purchase and that of realization is a loss of or accretion to capital and is therefore a capital loss or gain and does not form part of the assessable income…But in the words of the Lord Justice Clerk in Californian Copper Syndicate v. Harris which have been so often quoted, 'it is equally well established that enhanced values obtained from realization or conversion of securities may be so assessable, where what is done is not merely a realization or change of investment, but an act done in what is truly the carrying on, or carrying out, of a business.

29. Based on the information provided, the Income Units are not revenue assets and it follows that if the redemption of those Income Units results in a net loss, that loss not is deductible under section 8-1.

Are the Income Units held on capital account?

30. Paragraph 7 of TR 96/4 states

In this Ruling a 'revenue asset' refers to 'an asset whose realisation is inherent in, or incidental to, the carrying on of a business'... It is to be distinguished from a "structural asset", which forms part of the "profit yielding subject" of the business': see R W Parsons, Income Taxation In Australia, The Law Book Company Limited, 1985, at 155.

31. Based on the information provided, the Income Units would form part of the "profit yielding structure" and hence, are structural or capital assets of A Co.

IT 2512

32. Taxation Ruling IT 2512 states that at paragraph 19:

Investments of funds by banks, insurance companies and financial intermediaries in financing unit trust arrangements is as much a part of their respective businesses as is the sale of investments, the profits from which were held to be taxable.

33. In IT 2512 the financiers are guaranteed a rate of return on their investment, the rate being calculated in much the same fashion as interest on a loan would be (see paragraph 3 of IT 2512). From the financier's point of view, the investment may be regarded commercially as a substitute for the provision of loan funds upon which interest would be receivable.

34. In contrast, the yield derived by the Taxpayer Consolidated Group from holding the Income Units is a residual amount after taking into account expenses of the trusts. Unlike the financing unit trust in IT 2512, the rate of return on the Income Unit can not be guaranteed. Hence, IT 2512 does not apply to the facts in this case.

Conclusion

35. As the Income Units are not revenue assets and are capital in nature, the net loss arising on redemption the Income Units is not deductible under section 8-1.

Question 4

36. As the Income Units are capital assets and subsection 701-55(5) applies in relation to them, subsection 701-55(6) does not apply.

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