Edited version of your written advice

Authorisation Number: 1012716599730

Ruling

Subject: Bonds - Capital or revenue; CGT and TOFA.

Issue 1

Question 1

Are the bonds sold by the trustee of The Trust (the trustee) in the 20XX income year 'traditional securities' for the purposes of sections 26BB and 70B of the Income Tax Assessment Act 1936 (ITAA 1936)?

In determining whether the bonds constitute "traditional securities", it is necessary to first consider whether the bonds are a "security" for the purposes of section 26BB of the ITAA 1936.

Security

Subsection 26BB(1) defines a 'security' to have the same meaning as in Division 16E of the ITAA 1936. Subsection 159GP(1) within Division 16E defines a "security" to mean:

(a) stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security;

(b) a deposit at bank or other financial institution;

(c) a secured or unsecured loan; or

(d) any other contract, whether or not in writing, under which a person is liable to pay an amount or amounts, whether or not the liability is secured.

The trustee acquired bonds which require the issuer to repay the issue value of the bonds on redemption at maturity. Accordingly it is considered that the bonds constitute securities by reason of paragraph 159GP(1)(a) of the ITAA 1936.

Traditional security

The term 'traditional security' is defined under subsection 26BB(1) of the ITAA 1936 to mean a security held by a taxpayer that:

(a) is or was acquired by the taxpayer after 10 May 1989;

(b) either:

(i) does not have an eligible return; or

(ii) has an eligible return, where:

(A) the precise amount of the eligible return is able to be ascertained at the time of issue of the security; and

(B) that amount is not greater than 1.5% of the amount calculated in accordance with the formula:

Payments x Term

where:

Payments is the amount of the payment or of the sum of the payments (excluding any periodic interest) liable to be made under the security when held by any person; and

Term is the number (including any fraction) of years in the term of the security;

(c) is not a prescribed security within the meaning of section 26C of the ITAA 1936; and

(d) is not trading stock of the taxpayer.

In order to constitute 'traditional securities', the bonds must satisfy the remaining criteria listed under subsection 26BB(1) of the ITAA 1936. Paragraph 26BB(1)(a) is satisfied as the bonds were acquired after 10 May 1989.

The criteria described at paragraph 26BB(1)(b) is reliant on whether the security has an eligible return or not. An 'eligible return' is defined in subsection 159GP(3) of the ITAA 1936. A security will be taken to have an eligible return subject to this definition when it is reasonably likely at the time of its issue, having regard to the terms of the security, for the sum of all payments to be made under it (other than periodic interest payments) to exceed the security's issue price.

'Periodic interest' has the same meaning as in Division 16E (in subsection 159GP(6) of the ITAA 1936). Basically, it is any interest that is paid not more than one year after it commences to accrue. The interest may be payable by virtue of a coupon rate attached to the security, or the amounts and the timing of payment may be specified in the terms of the security. The coupons for each of the bonds the trustee holds are paid quarterly, half yearly or annually and thus meet the definition of periodic interest in subsection 159GP(6).

Subparagraph 26BB(1)(b)(ii) requires the precise amount of the eligible return to be capable of calculation when the security is issued and for that amount to be not greater than 1.5% of the payments liable to be made under the terms of the security (excluding periodic interest) x the years in the term of the security.

As the bonds issue value is the same as their redemption value, the precise amount of the eligible return when the security was issued is zero and is incapable of exceeding 1.5% of the payment to be made by the bond issuer on maturity, whatever the term of the security may be. The value of this type of bond lies in the return from periodic interest.

The R1 bonds were redeemed for a lower value from the issuer than that determined at their issue date and did not exceed an eligible return of 1.5%. It is reasonable to assume that when the R1 bonds issued the eligible return was expected to be zero.

Whilst the trustee has made a profit on selling all but its R1 bonds on the secondary market of greater than 1.5% of the issue value of the bonds, the profit made is by a payment from an entity other than the bond issuer and therefore cannot be considered a payment as defined for the purposes of sub subparagraph 26BB(1)(b)(ii)(B). Therefore the trustee does not have an eligible return of greater than 1.5%.

Furthermore, the precise amount of the eligible return must be capable of calculation when the security is issued. The terms of the trustee's bonds are such that the issue value is the same as the redemption value. When the securities issued, the precise amount of any return was zero. As there is no excess amount, there is no eligible return. Subparagraph 26BB(1)(b)(i) will apply. Therefore the securities will not be regarded as 'qualifying securities' (ie those securities with an eligible return) by virtue of subsection 159GP(1) of the ITAA 1936.

Paragraph 26BB(1)(c) excludes prescribed securities as defined by subsection 26C(4) of the ITAA 1936. The trustee's bonds are interest bearing securities that do not meet the definition of a prescribed security.

The trustee obtained the bonds as an investment because it believed the net yield based on the purchase price, the redemption price at maturity and coupon payments (less any fees) would constitute an acceptable revenue stream. Its bonds were not acquired or disposed of as trading stock. Paragraph 26BB(1)(d) does not apply.

The bonds are securities that satisfy the definition of a 'traditional security' within the meaning of subsection 26BB(1) of the ITAA 1936. Subsection 70B(1) of the ITAA 1936 provides for expressions used in section 26BB to also be used in section 70B of the ITAA 1936. Section 26BB provides for the gains on disposal or redemption of traditional securities to be assessable income and section 70B provides for losses on the disposal or redemption for traditional securities to be deductions.

The bonds sold by the trustee in the 20XX income year are 'traditional securities' for the purposes of sections 26BB and 70B of the ITAA 1936.

Question 2

Are the gains on disposal of the bonds sold by the trustee in the 20XX income year gains from financial arrangements to which Division 230 of the ITAA 1997 apply?

Division 230 of the ITAA 1997 is about the tax treatment of gains and losses from financial arrangements and applies in priority to other taxation rules unless specifically provided for otherwise. Subsection 230-5(1) includes financial arrangements if the taxpayer has one or more cash settlable legal or equitable rights and/or obligations to receive or provide a financial benefit. The trustee, X Pty Ltd, holds traditional securities on trust that may be redeemed for their issue value or traded on a secondary market. The securities are financial arrangements.

However subsection 230-5(2) of the ITAA 1997 broadly identifies arrangements which may be excluded from the scope of the division if further conditions in section 230-455 of the ITAA 1997 are met. In order to qualify for the exclusion, subparagraph 230-5(2)(a)(v) requires an entity to be in a financial arrangement where the arrangement is not a qualifying security. The trustee is in financial arrangements on behalf of The Trust that are not qualifying securities. Certain income and asset conditions described in subparagraph 230-5(2)(a)(iv) are also required to be met in order to qualify for the exclusion. Section 230-455 of the ITAA 1997 further refines those conditions that will exclude an entity from Division 230. Subsection 230-455(4) sets the income and asset conditions to be met by an entity as:

• financial assets of less than $100 million

• assets of less than $300 million and

• an aggregated turnover of less than $100 million.

Where the entity meets the above conditions in the preceding year and has not made an irrevocable election to have this division apply to its financial arrangements then Division 230 will not apply to those arrangements.

Section 328-115 of the ITAA 1997 defines the 'aggregated turnover' of a taxpayer as including the total ordinary income earned during a year of business by the taxpayer and any entity that is either 'connected with', or an 'affiliate' of the taxpayer, less any amounts derived from dealings between the taxpayer and connected entities or affiliates.

Subsection 328-125(1) states that an entity is connected with another entity if:

(a) either entity controls the other entity in a way described in this section; or

(b) both entities are controlled in a way described in this section by the same third entity

Subsections 328-125(3)-(5) of the ITAA 1997 describe when an entity will be regarded as having direct control of a discretionary trust.

Subsection 328-125(3) states that an entity will control a discretionary trust if a trustee of the trust acts, or could reasonably be expected to act, in accordance with the directions or wishes of the entity, its affiliates, or the entity together with its affiliates.

The deed of settlement for The Trust appointed D as the guardian and appointor of the trust. Furthermore, D is a director of the corporate trustee and has held enduring power of attorney over the trustee and all its affairs for ten years. Therefore we consider that the trustee would be reasonably expected to act in accordance with the directions given by D. As such, D is considered to have control of The Trust by virtue of subsection 328-125(3) of ITAA 1997. It follows that as X Pty Ltd is also the corporate trustee of XYZ Trust, D also has direct control of XYZ Trust.

As an individual, D is neither an exempt entity nor a deductible gift recipient. Therefore subsection 328-125(5) of the ITAA 1997 will not apply to deny him control of The Trust or XYZ Trust.

As D controls The Trust, The Trust is connected with D by the operation of paragraph 328-125(1)(a) of the ITAA 1997, and XYZ Trust is connected with The Trust by the operation of paragraph 328-125(1)(b) of the ITAA 1997.

Paragraph 328-125(2)(b) of the ITAA 1997 states that an entity controls a company if they own, or have the right to acquire the ownership of, equity interests in the company that carry between them the right to exercise, or control the exercise of, at least 40% of the voting power in the company. As Y Pty Ltd and Z Pty Ltd are wholly owned by D, this control test is satisfied. Y Pty Ltd,Z Pty Ltd and The Trust are all controlled by the same entity, D. Paragraph 328-125(1)(b) of the ITAA 1997 therefore applies to deem that The Trust is connected to both Y Pty Ltd and Z Pty Ltd.

Subsection 328-125(4) of the ITAA 1997 states that an entity controls a discretionary trust if at least 40% of the income or capital of the trust is paid or applied to the entity and/or the entity's affiliates in the four years preceding the relevant income year. D's spouse and descendants derive passive income from The Trust. None of these family members derive income from operating a business either as individuals or in concert with others. Accordingly, they are not considered to be affiliates of D, Y Pty Ltd, Z Pty, XYZ Trust, or of each other for the purposes of section 328-130 of the ITAA 1997. Therefore, when considering the trust distributions for the relevant financial years, his/her spouse and descendants are not considered to control The Trust based on the test in subsection 328-125(4) of the ITAA 1997.

D's parents will have direct control of The Trust if they satisfy the requirements of either subsection 328-125(3) or 328-125(4).

Whilst her/his parents together hold all the shares in the corporate trustee, neither parent has exercised any control over the trustee since D received enduring power of attorney over the trustee some years ago. At the same time her/his parents resigned as directors of the trustee. In addition, D stated that X Pty Ltd acts in accordance with her/his directions or wishes, and not in accordance with the directions or wishes of either or both of her/his parents. Therefore it is considered that neither parent is an affiliate of D. As such, neither parent controls The Trust pursuant to subsection 328-125(3) of the ITAA 1997.

Her/his parents have never received distributions from The Trust. Therefore neither of them controls The Trust by virtue of subsection 328-125(4).

Subsection 328-130(2) of the ITAA 1997 explains that an individual or a company is not your affiliate merely because of the nature of the business relationship you and the individual or company share. An example given in the subsection is that of directors of the same company, or the company and a director of that company. A is the other director of the trustee company. Other than a one-off business transaction in the past between D's company and A's enterprise, A's business affairs are independent of D's business affairs. He is not an affiliate of D merely because of the business relationship he shares with D as a co-director. In the absence of any other current business relationships, it cannot be concluded that A is an affiliate of D.

For the purposes of subparagraph 230-455(4)(a)(ii) of the ITAA 1997, the aggregated turnover of the trustee will include the annual turnover for the preceding income year of D, Y Pty Ltd, Z Pty, XYZ Trust. The Trust's Profit and Loss for the 20XX income year and the 20XX income tax returns for all of the entities show that the aggregated turnover for the preceding year was less than $100 million. Subparagraph 230-455(4)(a)(ii) is satisfied.

The trustee's Balance Sheet for the 2012 income year show that the trust has financial assets of less than $100 million and assets of less than $300 million. Subparagraphs 230-455(4)(b)(ii) and 230-455(4)(c)(ii) of the ITAA 1997 are satisfied.

Therefore we conclude that section 230-455 of the ITAA 1997 applies to exclude the gains from the disposal of the bonds in the 20XX year, from being recognized as gains from financial arrangements to which the rules in Division 230 of the ITAA 1997 apply.

Question 3

Are the gains on disposal of the bonds sold by the trustee in the 20XX income year assessable pursuant to section 6-10 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Section 6-10 of the ITAA 1997 includes amounts that are statutory income in the trustee's assessable income for an income year. Subsection 6-10(1) refers the taxpayer to section 10-5 of the ITAA 1997 for a list of provisions from both the ITAA 1936 and the ITAA 1997 which act to include amounts that are not ordinary income in the trustee's assessable income. That list includes section 26BB of the ITAA 1936 that provides for gains on the disposal or redemption of traditional securities under the heading of 'investments'. Subsection 26BB(2) states that:

Where a taxpayer disposes of a traditional security or a traditional security of a taxpayer is redeemed, the amount of any gain on the disposal or redemption shall be included in the assessable income of the taxpayer of the year of income in which the disposal or redemption takes place.

Paragraph 4(ix) of Taxation Ruling TR 96/14 Income tax: traditional securities provides more detail on the calculation of a gain under subsection 26BB(2) of the ITAA 1936. It describes the amount of the assessable gain as the excess of the consideration received on disposal or redemption over the acquisition costs and any other incidental costs associated with the acquisition and disposal of the security (such as the trustee's brokerage fees). It will not include the periodic interest paid.

However subsections 26BB(4) and 26BB(5) of the ITAA 1936 exempt traditional securities that are exchanged or converted to ordinary shares, from being included in assessable income in the year in which the disposal or redemption takes place. In such circumstances, the gain is deferred until the shares are disposed of. The trustee has advised that none of its bonds were converted to shares.

Therefore any gains made when the trustee disposed of its bonds in the 20XX income year will be statutory income to the trustee pursuant to subsection 26BB(2) of the ITAA 1936 and assessable income in that year by virtue of section 6-10 of the ITAA 1997.

Issue 2

Question 1

Are the gains on the disposal of the bonds sold by the trustee in the 20XX income year a CGT A1 event pursuant to section 104-10 of the ITAA 1997?

A capital gain or loss may be made if a CGT event happens to a CGT asset. Subsection 108-5(1) of the ITAA 1997 describes a CGT asset as any kind of property or a legal or equitable right that is not property. The trustee's bonds are a CGT asset.

Subsections 104-10(1) and (2) of the ITAA 1997 state that a CGT event A1 occurs when the trustee disposes of a CGT asset and ownership passes from the trustee to another entity because the trustee enters into the contract for the disposal of the asset. The trustee's sale of the bonds on the secondary market to other entities created a disposal of assets. Section 102-5 of the ITAA 1997 includes in the trustee's assessable income for an income year any net capital gain from its sale of bonds on the secondary market.

Two statutory provisions (section 26BB of the ITAA 1936 and section 102-5 on the ITAA 1997) include the gains on the bonds the trustee made in the 20XX income year as assessable income. Section 6-25 of the ITAA 1997 states that where two or more provisions include an amount in assessable income in respect of the same amount (whether for the same income year or different income years), then the amount can only be included once in the trustee's assessable income. Section 118-20 of the ITAA 1997 contains the CGT anti-overlap provisions that operate to reduce the capital gain by the amount that will be included in the trustee's assessable income. As already explained in question 1, the full amount of the profit the trustee made when it sold bonds on the secondary market is assessable income pursuant to section 26BB of the ITAA 1936. Any capital gain is reduced to zero as it will not exceed the amount to be included in the trustee's assessable income by virtue of section 26BB of the ITAA 1936.

Section 26BB of the ITAA 1936 includes the full gain on the sale of the bonds in the trustee's assessable income for the 20XX income year.

Question 2

Does the accrued interest that forms part of the purchase and sale price of the securities form part of the capital gain?

The application of section 118-20 of the ITAA 1997 will act to prevent the accrued interest that forms part of the purchase and sale price of the securities from forming part of any capital gain.

The common law rule is that interest accrues de die in diem (day by day). Accordingly interest accrues on a daily basis on fixed and variable interest securities where the terms and conditions of their issue do not disturb the common law rule.

The bonds the trustee acquired, provided it with a revenue stream on a quarterly, half yearly or annual basis according to the terms of its securities. The interest accrued on a day by day basis and was paid to the trustee at the end of each coupon period.

Taxation Ruling TR 93/28 Income tax: basis of assessment of income derived from securities purchased and sold cum interest provides the Commissioner's view on accrued interest in paragraph 5.

Where securities are transferred cum interest during an interest coupon period a purchaser does not acquire the right to interest (future income) separate from the source of that income. The consideration given by a purchaser is an outlay of a single indivisible sum. The amount referable to the accrued interest component of a fixed or variable interest security should not be treated by the purchaser as a deduction from, or reduction to, interest derived, nor as an adjustment to the purchase price.

The heading of 'accrued interest paid' on the trustee's spread sheet, refers to the amount the trustee paid to compensate a bond vendor for the number of days the vendor held the bond during the particular coupon period, during which the bond was sold to the trustee. Conversely the 'accrued interest earned' that was paid to the trustee when it sold the coupon during a coupon period, refers to the trustee's share of the interest for that bond coupon period. In the buying and selling of the bonds, the amount of accrued interest forms part of the overall purchase or sale price. It is these overall amounts that are used when calculating the gain or loss on the disposal of traditional securities. Therefore section 118-20 of the ITAA 1997 will prevent the accrued interest from forming part of any capital gain. The gains on the disposals of the securities in the 20XX income year are assessable pursuant to sections 10-5 and 6-10 of the ITAA 1997.

Question 3

Will the capital gain from the disposal of the bonds sold by the trustee in the 20XX income year be a discount capital gain pursuant to Division 115 of the ITAA 1997?

For reasons already explained, section 118-20 of the ITAA 1997 will act to prevent any potential discounted capital gain from being treated other than as assessable income subject to section 26BB of the ITAA 1936. Therefore there will be no discount capital gain pursuant to Division 115 of the ITAA 1997.

Copyright notice

© Australian Taxation Office for the Commonwealth of Australia

You are free to copy, adapt, modify, transmit and distribute material on this website as you wish (but not in any way that suggests the ATO or the Commonwealth endorses you or any of your services or products).