Edited version of your written advice

Authorisation Number: 1051240565590

Date of advice: 22 June 2017

Ruling

Subject: Covered assets

Question 1

Will the Commissioner confirm that long and short positions taken by Company X as trustee of the Trust Y Fund, as part of making investments, are “covered assets” as defined by subsection 275-105(1) of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

This ruling applies for the following periods

Year ending 30 June 20YY

The scheme commenced on

1 July 20XX

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 Trust Y Fund is an Australian unit trust that aims to achieve consistent absolute returns regardless of market conditions from a portfolio of both long and short large-capitalisation Australian shares (the strategy). The strategy seeks to limit exposure to market risk through the construction of a long/short portfolio via a series of correlated long and short paired positions. The Trust Y Fund achieves these long and short paired positions by identifying correlated pairs.

The Trust Y Fund’s long positions are established by the acquisition of shares on the Australian Securities Exchange (ASX), and are closed by the sale of the shares on the ASX.

Short positions are established by borrowing shares under a Securities Lending Arrangement (SLA) and selling those shares on the ASX. Under the SLA, the Trust Y Fund, the “borrower” of the shares, in fact acquires outright legal title to those shares free of encumbrances. In legal terms the position of the Trust Y Fund as the borrower of the shares under the SLA is in no way different from the owner of shares acquired otherwise than by way of an SLA.

The short positions are typically executed under standardised agreements, and under such agreements, the lender typically charges a fee for the loan and requires that the Trust Y Fund post collateral. The lender also typically reserves the right to recall the securities with a specified period of notice prior to the end of the loan period (typically based on the standard settlement period in the market - three days in Australia).

Short positions are closed by acquiring shares on the ASX and delivering those shares in satisfaction of the Trust Y Fund’s obligations under the SLA.

Some SLA’s undertaken by the Trust Y Fund are for periods in excess of 12 months.

As a result of the overall strategy, the Trust Y Fund is expected to:

● Derive dividend income in relation to its underlying positions held;

● Derive gains and incur losses in respect of the disposal of its long and short positions; and

● Incur expenses in respect of deriving the abovementioned income.

The Trust Y Fund is a managed investment trust (MIT) pursuant to Subdivision 275-A of the ITAA 1997. Specifically:

● The Trust Y Fund is operated and managed by an Australian tax resident company, the Trustee;

● The Trustee is a financial services licensee as defined in the Corporations Act 2001;

● The activities of the Trust Y Fund constitute an eligible investment business pursuant to Division 6C in Part III of the Income Tax Assessment Act 1936 (ITAA 1936);

● The Trust Y Fund’s investment management activities are undertaken in Australia;

● The Trust Y Fund is a Managed Investment Scheme within the meaning of the Corporations Act 2001;

● The Trust Y Fund has at least 25 members in relation to the income year ended 30 June 20YY;

● The Trust Y Fund does not have 20 or fewer members that that have an interest of 75% or more; and

● The Trust Y Fund does not have a foreign resident individual member that has an interest of 10% or more.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 6C

Income Tax Assessment Act 1936 Section 26BC

Income Tax Assessment Act 1936 Subsection 26BC(3)

Income Tax Assessment Act 1936 Subsection 26BC(5)

Income Tax Assessment Act 1936 Subsection 26BC(9)

Income Tax Assessment Act 1997 Section 275-100

Income Tax Assessment Act 1997 Subsection 275-105(1)

Income Tax Assessment Act 1997 Subsection 275-105(2)

Income Tax Assessment Act 1997 Section 275-115

Income Tax Assessment Act 1997 Subdivision 275-A

Income Tax Assessment Act 1997 Subdivision 275-B

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 Section 230-45

Income Tax Assessment Act 1997 Section 230-50

Income Tax Assessment Act 1997 Subdivision 974-B

Income Tax Assessment Act 1997 Section 974-130

Corporations Act 2001

Reasons for decision

Question 1

Summary

The Commissioner will confirm that long and short positions taken by Company X as trustee of the Trust Y Fund, as part of making investments, are “covered assets” as defined by subsection 275-105(1) of the ITAA 1997.

Detailed reasoning

Under Subdivision 275-B of the ITAA 1997 a managed investment trust is able to make an election on the treatment of certain gains and losses.

Section 275-100 of the ITAA 1997 sets out the requirements for a gain or loss to be affected by this election:

(1) The modifications in subsection (2) apply if:

(a) a CGT event happens at a time involving a CGT asset; and

(b) the CGT asset is owned at that time by an entity that is a managed investment trust in relation to the income year in which the time occurs; and

(c) the CGT event happens because the managed investment trust disposes of, ceases to own or otherwise realises the asset; and

(d) the asset is covered by section 275-105; and

(e) the entity meets the requirement in section 275-110 at the time; and

(f) a choice under section 275-115 covering the entity is in force for the income year in which the time occurs.

(2) These provisions do not apply to the CGT event:

(a) sections 6-5 (about ordinary income), 8-1 (about amounts you can deduct), and 15-15 and 25-40 (about profit-making undertakings or plans);

(b) sections 25A and 52 of the Income Tax Assessment Act 1936 (about profit-making undertakings or schemes);

(c) section 118-20 (about reducing capital gains if amount otherwise assessable);

(d) Division 70 and section 118-25 (about trading stock).

However, the gain or loss must be derived from the event arising from those assets listed in subsection 275-105(1) of the ITAA 1997:

(1) An asset is covered by this section if it is any of the following:

(a) a share in a company (including a share in a foreign hybrid company);

(b) a non-share equity interest in a company;

(c) a unit in a unit trust;

(d) land (including an interest in land);

(e) a right or option to acquire or dispose of an asset of a kind mentioned in paragraph (a), (b), (c) or (d).

Long positions

The Trust Y Fund’s long positions are established by the acquisition of shares on the ASX, and are closed by the sale of the shares on the ASX.

As the Trust Y Fund’s long positions involve the direct acquisition of shares, they will be covered assets for the purposes of section 275-105(1) of the ITAA 1997. The long positions are also not a Division 230 financial arrangement or a debt interest. Therefore, they are not excluded from being a covered asset by subsection 275-105(2) of the ITAA 1997.

Short positions

Short positions are established by borrowing shares under a SLA and selling those shares on the ASX. Short positions are closed by acquiring shares on the ASX and delivering those shares in satisfaction of the Trust Y Fund’s obligations under the SLA.

Section 26BC of the ITAA 1936 sets out the tax treatment (both in terms of income and capital gains) of lenders and borrowers of shares under compliant SLAs.

Subsection 26BC(3) of the ITAA 1936 sets out the requirements that an SLA must meet if section 26BC is to apply to that SLA. Among those requirements is that the period between the original disposal time by the lender to the borrower of the share(s) and the time that the share(s) or identical securities are re-acquired by the lender be less than 12 months (paragraph 26BC(3)(a) of the ITAA 1936). The remarks below will only apply to SLAs that comply with this and the other requirements of subsection 26BC(3).

Regarding borrowers of shares who dispose of those shares to third parties, paragraph 26BC(5)(c) of the ITAA 1936 (for traders of shares who account for gains and assessable income) and paragraph 26BC(9)(a) (for investors who account for gains on disposal as a capital gain) set out rules for share borrowers to account for their gains and losses on disposal of the borrowed share to third parties.

Where a share(s) is acquired under an SLA that does not comply with subsection 26BC(3) of the ITAA 1936, among other things, the roll-overs at subsections 26BC(5) and (6) do not apply to the disposals and acquisitions that take place under the SLA. Each disposal and acquisition of a share(s) is effectively treated under the ordinary rules that apply to the acquisition and disposal of share(s).

Therefore for borrowers of shares, section 26BC of the ITAA 1936 does not change the legal outcome of “borrowing” shares: the borrower of shares under a compliant SLA is treated no differently from any other owner of shares.

The relevant point for this question is that in each case the share borrower is in each situation treated as the owner of the share before the share is disposed of.

Subsection 275-105(2) of the ITAA 1997 provides that an asset is not a covered asset for the purposes of section 275-105 if it is a Division 230 financial arrangement or a debt interest.

A debt interest for the purposes of Subdivision 974-B of the ITAA 1997 necessitates that the scheme in question be a financing arrangement pursuant to section 974-130 of the ITAA 1997. Relevantly, SLA’s under section 26BC of the ITAA 1936 are specifically excluded from being a financing arrangement (paragraph 974-130(4)(b) of the ITAA 1997). Therefore, the Trust Y Fund’s short positions that are SLA’s under section 26BC of the ITAA 1936 will not be debt interests in accordance with section 974-130 of the ITAA 1997.

In respect of those SLAs that are not compliant with section 26BC of the ITAA1936, those may be “financial arrangements” pursuant to section 974-130 if they are undertaken to “raise finance for the entity” pursuant to paragraph 974-130(1)(a) of the ITAA1997.

In his discussion of the phrase “raise finance”, Justice Edmonds of the Federal Court remarked in Blank v. FCoT 2014 ATC 20-442 at paragraph 70:

“70. Equally, the amount of capital raised by the issue of shares will not, of itself, be determinative of whether the arrangement is entered into or undertaken to raise finance for the company issuing the shares. But para (a) of the definition of "financing arrangement" requires the scheme to be entered into or undertaken "to raise finance for the entity", not just capital.”

“Raising finance” is clearly intended to refer to the process of gaining money or money equivalent for the use of the entity.

SLAs are undertaken by the Trust Y Fund as part of process to create a positon in the market to profit from changes in relative prices of shares in its portfolio. This is not an undertaking that “raises finance” for the Trust Y Fund.

Section 230-50 of the ITAA1997 provides that:

(1) You also have a financial arrangement if you have an equity interest. The equity

interest constitutes the financial arrangement.

(1) You also have a financial arrangement if:

(a) you have, under an arrangement:

(i) a legal or equitable right to receive something that is a financial arrangement under this section; or

(ii) a legal or equitable obligation to provide something that is a financial

arrangement under this section; or

(iii) a combination of one or more such rights and/or obligations; and

(b) the right, obligation or combination does not constitute, or form part of, a

financial arrangement under subsection 230-45(1).

The right, obligation or combination referred to in paragraph (a) constitutes the financial arrangement.

The Explanatory Memorandum to Tax Laws Amendment (Taxation of Financial Arrangements) Bill 2008 (TOFA EM) explains that “…these rules operate only for the purpose of assisting in working out any gain or loss from the financial arrangement and are not intended to broaden what constitutes the financial arrangement as determined under section 230-45 or 230-50 [of the ITAA 1997]”.

Accordingly, the Division 230 financial arrangement exclusion should be limited to securities where gains and losses are taxed under Division 230 of the ITAA 1997. For the reasons noted above, this will not extend to short positions adopted by the Trust Y Fund in relation to its SLA’s.

Section 26BC of the ITAA 1936 will not apply to SLA’s for short positions undertaken by the Trust Y Fund for periods in excess of 12 months. However, as these short positions exceed 12 months in duration, CGT will be the primary code for calculating gains or losses on those assets, and therefore, they will be covered assets for the purposes of section 275-105 of the ITAA 1997.

Summary

Having satisfied the conditions above, long and short positions taken by the Trust Y Fund, as part of making investments, are covered assets as defined by subsection 275-105(1) of the ITAA 1997. Therefore, the Trust Y Fund is eligible to make a choice under section 275-115 of the ITAA 1997. The consequences of making a choice are set out in section 275-100 of the ITAA 1997; that is, CGT will be the primary code for calculating gains and losses.

The Capital Account Election may be made by the Trust Y Fund on lodgement of its income tax return for the income year ended 30 June 20YY on the basis that this is the income year in which the taxpayer first became a MIT.

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