Edited version of your written advice

Authorisation Number: 1051447841777

Date of advice: 20 November 2018

Ruling

Subject: Financing and servicing agreement

Question 1

Is the Financing and Servicing Agreement (FSA) a scheme which gives rise to a ‘debt interest’ under Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

Is the FSA a ‘Division 230 financial arrangement’ as defined in section 995-1 of the ITAA 1997?

Answer

Yes

Question 3

Will the Profit Amount payable by the Trust under the FSA be deductible to the Trust under subsection 230-15(2) of the ITAA 1997?

Answer

Yes

This ruling applies for the following periods:

Income tax year ended 30 June 20XX

Income tax year ending 30 June 20XX

Income tax year ending 30 June 20XX

Income tax year ending 30 June 20XX

Relevant facts and circumstances

The Trust:

● is an Australian unit trust;

● is a registered managed investment scheme;

● adheres to Shariah compliant financing principles; and

● has been created for the purpose of acquiring property.

Financing of the property

The Trust’s acquisition of property is funded by a combination of equity and debt. The debt component includes on-shore debt financing.

The Shariah board of the Trust requires that any finance advanced for the purposes of funding the acquisition of property be done so in a form which is Shariah compliant, meaning it must adhere to Islamic financing principles which prohibit the payment of interest (as technically defined under Shariah principles) on debt.

Accordingly, the debt financing of property is structured to be Shariah compliant and involves the Trust’s participation in a FSA.

The FSA

The Investor agrees to appoint the Trust to invest the amount funded by debt (the ‘debt amount’) in the purchase of property and to manage it on behalf of the Investor in accordance with the Investment Plan and the terms of the FSA.

The Investment Plan provides, inter alia, that:

● the Trust undertakes to invest the debt amount in accordance with this Plan in order to generate an anticipated profit which shall be sufficient to pay the Profit Amount to the Investor periodically; and

● the Trust must manage the property; keep proper records in relation to the property; and pay the Profit Amount to the Investor.

Subject to the availability of funds, the Investor will promptly pay the debt amount to the Trust. In consideration of the Investor providing the debt amount and entering into the FSA, the Trust must pay the Investor:

● an amount equivalent to the debt amount (the ‘repayment amount’), as well as any other unpaid Secured Moneys, in full on the Final Termination Date (being 36 months after the date on which the debt amount is provided to the Trust); and

● the Profit Amount on each relevant date.

In respect of each relevant period, the order of priority for the distribution of the Investment Income (defined in the FSA to broadly include all income and other profits earned in connection with the property) received by the Trust for that period shall, in the first instance, be 100% to the Investor until and to the extent the Investor has received an amount equal to the Profit Amount.

The Trust acknowledges that a failure to pay the Profit Amount when due shall constitute an Event of Default under the FSA.

Assumptions

1. Division 230 of the ITAA 1997 applies to gains or losses from the financial arrangements of the Trust.

2. The FSA (and associated financing arrangements) is entered into or carried out by the Trust in gaining or producing assessable income of the Trust.

3. All dealings between and/or amongst any of the Trust and any other parties to be involved will be at arm’s length.

4. The Trust will not hold, or invest in, any assets other than property during the term of the FSA.

Relevant legislative provisions

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 subsection 230-15(2)

Income Tax Assessment Act 1997 section 230-45

Income Tax Assessment Act 1997 subsection 230-45(1)

Income Tax Assessment Act 1997 paragraph 230-45(1)(d)

Income Tax Assessment Act 1997 paragraph 230-45(1)(e)

Income Tax Assessment Act 1997 paragraph 230-45(1)(f)

Income Tax Assessment Act 1997 subsection 230-45(2)

Income Tax Assessment Act 1997 Subdivision 230-B

Income Tax Assessment Act 1997 Subdivision 230-H

Income Tax Assessment Act 1997 Division 974

Income Tax Assessment Act 1997 subsection 974-5(1)

Income Tax Assessment Act 1997 subsection 974-15(1)

Income Tax Assessment Act 1997 subsection 974-20(1)

Income Tax Assessment Act 1997 paragraph 974-20(1)(a)

Income Tax Assessment Act 1997 paragraph 974-20(1)(b)

Income Tax Assessment Act 1997 paragraph 974-20(1)(c)

Income Tax Assessment Act 1997 paragraph 974-20(1)(d)

Income Tax Assessment Act 1997 paragraph 974-20(1)(e)

Income Tax Assessment Act 1997 section 974-35

Income Tax Assessment Act 1997 section 974-130

Income Tax Assessment Act 1997 section 974-135

Income Tax Assessment Act 1997 section 974-160

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

Summary

The FSA is a scheme which gives rise to a debt interest under Division 974 of the ITAA 1997.

Detailed reasoning

The provisions of Division 974 determine whether, for certain income tax purposes, an interest is a ‘debt interest’ or an ‘equity interest’ for tax purposes. These provisions do not impose tax, but rather categorise whether an interest is debt or equity based on “economic substance rather than mere legal form” (subsection 974-5(1)).

A scheme gives rise to a debt interest in an entity if the scheme, when it comes into existence, satisfies the debt test in subsection 974-20(1) in relation to the entity (subsection 974-15(1)).

Subsection 974-20(1) provides that a scheme satisfies the debt test in relation to an entity if:

(a) the scheme is a *financing arrangement for the entity; and

(b) the entity, or a *connected entity of the entity, receives, or will receive, a *financial benefit or benefits under the scheme; and

(c) the entity has, or the entity and a connected entity of the entity each has, an *effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time when:

(i) the financial benefit referred to in paragraph (b) is received if there is only one; or

(ii) the first of the financial benefits referred to in paragraph (b) is received if there are more than one; and

(d) it is substantially more likely than not that the value provided (worked out under subsection (2)) will be at least equal to the value received (worked out under subsection (3)); and

(e) the value provided (worked out under subsection (2)) and the value received (worked out under subsection (3)) are not both nil.

The classification of a scheme as giving rise to a debt interest is done from the perspective of the issuer of the interest, in this instance the Trust.

Addressing each component of subsection 974-20(1) separately:

● the FSA (a ‘scheme’ for the purposes of the Income Tax Assessment Act) has been entered into by the Trust to raise finance used to fund (partly) its acquisition of property, and therefore will be a ‘financing arrangement’ for the Trust pursuant to section 974-130, thereby satisfying paragraph 974-20(1)(a);

● the debt amount received by the Trust under the FSA from the Investor will constitute a ‘financial benefit’ pursuant to section 974-160, thereby satisfying paragraph 974-20(1)(b);

● subsequent to the receipt of the debt amount from the Investor, the Trust will have an ‘effectively non-contingent obligation’, as per section 974-135, to provide a financial benefit under the FSA in the form of the repayment amount and the Profit Amounts, thereby satisfying paragraph 974-20(1)(c);

● it is substantially more likely than not that:

● the value of the repayment amount to be provided by the Trust to the Investor under the FSA (in nominal terms pursuant to section 974-35) will at least equal the value of the debt amount received by the Trust from the Investor under the FSA; and

● the aggregate value of all the effectively non-contingent financial benefits (in nominal terms) to be provided by the Trust to the Investor under the FSA (including the Profit Amounts) will, to the extent of the Profit Amounts paid, exceed the value of the debt amount received by the Trust from the Investor under the FSA, thereby satisfying paragraph 974-20(1)(d); and

● neither the value of the financial benefit received by the Trust, nor the value of the financial benefits provided by the Trust under the FSA will be nil, thereby satisfying

● paragraph 974-20(1)(e)).

As each of the requirements of the debt test in subsection 974-20(1) are satisfied, the FSA gives rise to a debt interest in the Trust.

Question 2

Summary

The FSA is a ‘Division 230 financial arrangement’ as defined in section 995-1.

Detailed reasoning

Generally, an entity will have a ‘financial arrangement’ if they have under an arrangement, a cash settlable legal or equitable right to receive a financial benefit, a cash settlable legal or equitable obligation to provide such benefit, or a combination of one or more such rights and/or obligations, and paragraphs 230-45(1)(d) to (f) do not apply (subsection 230-45(1)).

Paragraphs 230-45(1)(d) to (f) state:

(d) you also have under the arrangement one or more legal or equitable rights to receive something and/or one or more legal or equitable obligations to provide something; and

(e) for one or more of the rights and/or obligations covered by paragraph (d):

(i) the thing that you have the right to receive, or the obligation to provide, is not a financial benefit; or

(ii) the right or obligation is not cash settlable; and

(f) the one or more rights and/or obligations covered by paragraph (e) are not insignificant in comparison with the right, obligation or combination covered by paragraph (a), (b) or (c).

The term ‘financial benefit’ is defined in section 974-160 as anything having economic value and includes property and services.

Whether a right to receive or obligation to provide a financial benefit is cash settlable is specified in subsection 230-45(2) to include, inter alia, a benefit that is money, a right you intend to satisfy or settle by receiving money, or an obligation that you intend to satisfy or settle by providing money.

Under the terms of the FSA (i.e. the ‘arrangement’ for the purposes of section 230-45), the Trust will have a cash settlable right to receive a financial benefit from the Investor in the form of the debt amount, and cash settlable obligations to provide financial benefits to the Investor in the form of the repayment amount and the periodic Profit Amounts.

Under the terms of the FSA, the Trust will also have an obligation to manage each property. Whilst this obligation is neither a financial benefit nor cash settlable, it is (in the context of the purpose of the FSA and the intention of the parties to the FSA – that is, to arrange debt financing in a manner which adheres to Islamic financing principles and is thus Shariah compliant) insignificant in comparison with the Trust’s cash settlable right to receive a financial benefit and cash settlable obligations to provide financial benefits under the FSA.

As such, paragraphs 230-45(d) to (f) do not apply and the FSA will constitute a financial arrangement pursuant to section 230-45.

Section 995-1 defines a ‘Division 230 financial arrangement’ as a financial arrangement to which Division 230 applies in relation to your gains and losses from the arrangement.

Pursuant to assumption 1 of this ruling that Division 230 applies to gains and losses from the financial arrangements of the Trust, and on the basis that the FSA will constitute a financial arrangement, Division 230 will apply in relation to gains or losses of the Trust from the FSA. The FSA will therefore be a Division 230 financial arrangement as defined in section 995-1.

Question 3

Summary

The Profit Amount payable by the Trust under the FSA will be deductible under subsection 230-15(2).

Detailed reasoning

The classification of an interest as a debt interest under Division 974 has certain taxation consequences. In particular, returns paid on a debt interest may be deductible, but not frankable.

Where the debt interest is a financial arrangement for the purposes of Division 230, and that Division applies to the issuer’s gains and losses from financial arrangements, losses on that debt interest are (subject to specific exceptions under Subdivision 230-H) allowable as a deduction under subsection 230-15(2) to the extent that they are made in gaining or producing assessable income or are necessarily made in carrying on a business for the purpose of gaining or producing assessable income.

The Profit Amount payable by the Trust under the FSA in consideration of money advanced to the Trust under the FSA (i.e. the debt amount) is, in substance, considered analogous to interest payable on money borrowed. Therefore, like interest, the essential character of the Profit Amount is a question of fact to be determined by reference to the objective circumstances of the use to which the advanced funds are put by the Trust.

Under the terms of the FSA, the Trust was advanced the debt amount from the Investor to part fund the Trust’s acquisition of a property.

As the Profit Amount payable is in respect of the debt amount to be used to acquire a property, being an asset that is expected to produce assessable income in the form of rental income, the Profit Amount will be incidental and relevant in gaining or producing the Trust’s assessable income and/or incidental and relevant in carrying on a business for the purpose of gaining or producing the Trust’s assessable income.

Therefore, the Profit Amount is incurred by the Trust in gaining or producing the Trust’s assessable income and/or necessarily incurred by the Trust in carrying on a business for the purpose of gaining or producing the Trust’s assessable income, and gives rise to a deductible loss under subsection 230-15(2).

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