Edited version of private advice

Authorisation Number: 1051632375362

Date of advice: 5 February 2020

Ruling

Subject: International issues ~Sovereign immunity

Division 880 of the Income Tax Assessment Act 1997 ("ITAA 1997")

Question 1

Is the ordinary and statutory income derived by Entity B from its unit holding in Trust A (the Test Entity) not assessable income and not exempt income under section 880-105 of the ITAA 1997?

Answer

Yes.

Question 2

Is any loss incurred by Entity B in respect of interest in the Test Entity not deductible under section 880-110 of the ITAA 1997?

Answer

Yes.

Question 3

Is any capital gain or loss made by Entity B with respect to its investment in the Test Entity disregarded under sections 880-115 and 880-120 of the ITAA 1997?

Answer

Yes.

This ruling applies for the following period:

XXXX to XXXX

The scheme commences on:

XXXX

Relevant facts and circumstances

1.     Entity A is a wholly owned subsidiary of a foreign government department. The foreign government department's objective is to outline financial policy for the State, and to manage financial affairs to achieve State social and economic development plans.

2.     The foreign government department receives the revenues and funds of the State and disperses these funds to other government departments of the State as well as investing surplus funds for the benefit of the people of the State.

3.     Entity A is wholly capitalised and funded by the foreign government department. The funds used for capitalisation and ongoing financing are from the general pool of government finances which are managed by the foreign government department.

4.     Entity A's management is elected by the foreign government department.

5.     Entity A has a wholly owned subsidiary, Entity B. Entity B's management is elected by Entity A. Entity B is wholly capitalised and funded by Entity A from funds allocated to Entity A by the foreign government department.

6.     Entity A and B were incorporated to be corporate investment vehicles of the foreign government department to invest surplus government funds.

The investment - Trust A

7.     The foreign government department, through Entity B, acquired less than 10% of the units in Trust A, an unlisted single asset Fund.

8.     Entity B expects to receive MIT fund payments and capital gains from their investment in Trust A.

9.     Trust A's Constitution states that the initial term of Trust A is X years, which can be extended by an ordinary resolution of the unitholders for a further X years. An ordinary resolution must be passed by unitholders holding at least 50% of the units on issue. The term of the Trust can be further extended by unanimous resolution. Where a unanimous resolution is not passed, the trustee may decide, in its discretion, to provide those unitholders that voted against the resolution an opportunity to exit the investment, and for the trust to continue for a further X year term.

10.  Unitholders can remove the trustee of Trust A if a resolution is supported by unitholders together holding 35% of all units on issue, and the resolution to remove the trustee is supported by at least 50% of all units where the right to vote was exercised. A replacement trustee must be approved by unitholders holding at least 50% of the total units on issue.

11.  Trust A's Constitution can be amended by a special resolution passed by unitholders holding at least 75% of the units on issue.

12.  A clause in Trust A's Constitution states that the Trustee has all the powers in respect of the Trust. The Trustee has full discretion over the over the day to day management, and broader business direction and operation of Trust A. Unitholders have no right or entitlement to interfere with any rights, powers, authorities or discretions of the trustee, interfere, encumber, or force the transfer of any Trust A assets, or otherwise interfere with the trustee's determination of any matter with respect to Trust A's business.

13.  Neither Entity B or any associates of Entity B will be represented on the board of directors of the trustee or the responsible entity of Trust A.

14.  Entity B's less than 10% interest in the Test Entity does not provide it with an entitlement to either directly or indirectly determine the identity of any person who makes decisions that compromise the control and direction of the Test Entities' operations.

15.  Trust A does not have an investment committee and as a consequence, the foreign government department, Entity A nor Entity B will exert actual or potential influence over the operations or investments of Trust A.

16.  Entity B does not have any special rights issued with respect to its unit holding in Trust A.

17.  The foreign government agency's indirect interest in Trust A equates to less than 10% of the equity in Trust A.

18.  No other entity of the State other than Entity B has an interest in Trust A. OSI's less than 10% interest in Trust A represents the State's complete interest.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 880-105

Income Tax Assessment Act 1997 section 880-110

Income Tax Assessment Act 1997 section 880-115

Income Tax Assessment Act 1997 section 880-120

Reasons for decision

All legislative references are to the Income Tax Assessment Act 1997 unless otherwise specified.

Question 1

Is the ordinary and statutory income derived by Entity B from its unit holdings in Trust A ("the Test Entity") not assessable income and not exempt income under section 880-105?

Summary

The ordinary and statutory income derived by Entity B from its unit holdings in Trust A is not assessable and not exempt income due to the operation of section 880-105.

Detailed reasoning

Section 880-105 provides that amounts of ordinary and statutory income derived by a sovereign entity are not assessable and not exempt income if certain conditions are met. Those conditions are listed in subsection 880-105(1):

(a) the sovereign entity is covered by section 880-125; and

(b) the amount is a return on any of the following kinds of interest that the sovereign entity holds in another entity (the test entity):

(i) a *membership interest;

(ii) a *debt interest;

(iii) a *non-share equity interest; and

(c) the test entity is:

(i) a company that is an Australian resident at the time (the income time) when the amount becomes ordinary or statutory income of the sovereign entity; or

(ii) a *managed investment trust in relation to the income year in which the income time occurs; and

(d) the *sovereign entity group of which the sovereign entity is a member satisfies the portfolio interest test in subsection (4) in relation to the test entity:

(i) at the income time; and

(ii) throughout any 12 month period that began no earlier than 24 months before that time and ended no later than that time; and

(e) the sovereign entity group of which the sovereign entity is a member does not have influence of a kind described in subsection (6) in relation to the test entity at the income time.

These conditions are considered below.

Entity B is a covered sovereign entity

Section 880-125 states:

A *sovereign entity is covered by this section if it satisfies all of the following requirements:

(a) the entity is funded solely by public monies;

(b) all returns on the entity's investments are public monies;

(c) the entity is not a partnership;

(d) the entity is not any of the following:

(i) a *public non-financial entity;

(ii) a *public financial entity (other than a public financial entity that only carries on central banking activities).

These conditions are considered below.

Entity B is a sovereign entity

For an entity to be covered by section 880-125, it must be a sovereign entity. Section 880-15 defines a sovereign entity to be any of the following:

(a) a body politic of a foreign country, or a part of a foreign country;

(b) a *foreign government agency;

(c) an entity:

(i) in which an entity covered by paragraph (a) or (b) holds a *total participation interest of 100%; and

(ii) that is not an Australian resident; and

(iii) that is not a resident trust estate for the purposes of Division 6 of Part III of the Income Tax Assessment Act 1936.

A 'foreign government agency' is defined in subsection 995-1(1) of the ITAA 1997 as:

(a) the government of a foreign country or of part of a foreign country; or

(b) an authority of the government of a foreign country; or

(c) an authority of the government of part of a foreign country.

Section 960-180 provides that an entity's total participation interest in another entity is the sum of:

(a) the entity's direct participation interest in the other entity at that time; and

(b) the entity's indirect participation interest in the other entity at that time.

The foreign government department is one of the departments of the government of a foreign State and is not a separate entity from the government of the foreign State.

The foreign government department:

·        directs the public financial policy for the foreign State

·        controls and supervises the asset management and government's properties

·        manages and liquidates the funds that devolve upon the foreign state by virtue of laws and court judgments, and

·        manages government investments and issue relevant bylaws, regulations and resolutions.

Entity A was incorporated to facilitate and exercise the governmental functions bestowed upon the foreign government department. The foreign government department holds 100% of the beneficial interest in Entity A as well as being the ultimate parent entity of Entity A.

Entity B was incorporated by Entity A to make and acquire investments for the benefit of the foreign government department.

Entity B's sole shareholder is Entity A, who elects Entity B's management.

Entity B is therefore ultimately wholly owned by the foreign government agency.

Entity B meets the requirements of being a sovereign entity in accordance with section 880-15 as it is an entity owned by a foreign government agency as defined in subsection 880-15(c).

Entity B is funded solely by public monies

The phrase 'public monies' is not defined and as such takes its ordinary meaning. In the context of Division 880, this phrase essentially means monies raised by a foreign government (or part of a foreign government) for a public purpose which form part of the foreign government's (or part of the foreign government's) equivalent to Australia's Consolidated Revenue Fund (Roy Morgan Research Pty Ltd v FC of T & Anor [2011] HCA 35). This would ordinarily include general tax revenue, proceeds from the issue of government bonds, the proceeds of privatisations etc.

Entity B has been wholly capitalised and funded by Entity A. Entity A is wholly capitalised and funded by the foreign government department. The funds used for capitalisation and ongoing financing are from the general pool of the Government finances which are managed by the foreign government department.

As such, Entity B is funded solely by public monies.

All returns on Entity B's investments are public monies

Entity B is wholly owned by Entity A, which in turn is beneficially wholly owned by the foreign government department, a part of the State. As such, the State is the beneficial owner of all the capital invested, and all income derived from that capital by Entity B. Surplus income derived by Entity B is distributed to Entity A and subsequently to the foreign government department for use by the State. The moneys therefore will remain government moneys.

Entity B is not a partnership

Entity B is a sole proprietor company with limited liability and is not a partnership. As such, it passes this condition.

Entity B is not a public non-financial entity or public financial entity

Subsection 880-130(1) defines the term public non-financial entity:

An entity is a public non-financial entity if its principal activity is either or both of the following:

(a) producing or trading non-financial goods;

(b) providing services that are not financial services.

Subsection 880-130(2) defines the term public financial entity:

An entity is a public financial entity if any of the following requirements are satisfied:

(a) it trades in financial assets and liabilities;

(b) it operates commercially in the financial markets;

(c) its principal activities include providing any of the following financial services:

(i) financial intermediary services, including deposit-taking and insurance services;

(ii) financial auxiliary services, including brokerage, foreign exchange and investment management services;

(iii) capital financial institution services, including financial services in relation to assets or liabilities that are not available on open financial markets.

It is noted that subparagraph 880-125(d)(ii) excludes public financial entities that only carry on central banking activities from being excluded as a covered sovereign entity.

Entity B was incorporated by Entity A to make and acquire investments for the benefit of the foreign government department. The plan administered by Entity B is considered a function of the State, that is, to invest the funds of the State in a manner benefitting the obligations of the foreign government department. Entity B does not produce or trade non-financial goods and does not provide services that are not financial services. Entity B does not actively trade in financial assets and liabilities, operate commercially in financial markets or provide services listed in paragraph 880-130(2)(c).

As such, Entity B is not a public non-financial entity, nor a public financial entity and passes the condition in 880-125(d).

As Entity B satisfies each of the requirements in paragraphs 880-125(a) through (d) it is considered a sovereign entity that is covered by section 880-125 for the purposes of paragraph 880-105(1)(a).

Entity B's return is received on a relevant interest in the Test Entities

For an amount of ordinary income or statutory income of a sovereign entity to satisfy paragraph 880-105(1)(b), it must be a 'return on' a membership interest, debt interest or non-share equity interest held by the sovereign entity in the test entities.

As detailed in paragraph 4.37 of the Explanatory Memorandum to the Making Sure Foreign Investors Pay Their Fair Share of Tax in Australia and Other Measures) Act 2019 ('the EM'), a 'return on' a membership interest for the purposes of paragraph 880-105(1)(b) will include:

1. dividends - including non-share dividends and dividends that pass through a managed investment trust (MIT)
2. interest - including interest that passes through a MIT
3. fund payments made by a MIT (other than fund payments that are attributable to non-concessional MIT income), and
4. revenue gains made on the disposal of an interest in the test entity - including revenue gains that pass through a MIT.

The Test Entity, Trust A, is an unlisted, closed-ended, single asset property fund, which provides investors with the opportunity to invest in a special purpose trust (Holding Trust), which in turn holds a 50% interest in an A-grade office building in an Australian city.

The Test Entity has been managed as a MIT and will continue to be managed as a MIT for Australian tax purposes.

Entity B's investment in the Test Entity is through a subscription of units (which meet the requirements of being a membership interest as defined by the interaction of sections 960-135and 960-130) and Entity B receives MIT fund payments and capital gains from their investment in the Test Entity.

As such, Entity B will receive amounts which satisfy the requirements of paragraph 880-105(1)(b).

Entity B's income is received from Australian resident companies or managed investment trusts

For an amount of ordinary income or statutory income of a sovereign entity to satisfy paragraph 880-105(1)(c), it must be received from an entity that is either:

       i.          a company that is an Australian resident at the time (the income time) when the amount becomes ordinary or statutory income of the sovereign entity; or

      ii.          a *managed investment trust in relation to the income year in which the income time occurs.

The Test Entity, Trust A, is a managed investment trust for Australian income tax purposes and it is intended for the Test Entity to continue to be managed in a manner to qualify as a managed investment trust.

As such, Entity B's income is received from an entity which satisfies the requirements of paragraph 880-105(1)(c).

Entity B's sovereign entity group satisfies the portfolio interest test

For an amount of ordinary income or statutory income of a sovereign entity to satisfy paragraph 880-105(1)(d), the sovereign entity and the sovereign entity group to which it belongs must satisfy the portfolio interest test in relation to the test entity/ies at both the income time and throughout any 12 month period that began no earlier than 24 months before that time and ended no later than that time.

The portfolio interest test is outlined in subsection 880-105(4), which states:

A *sovereign entity group satisfies the portfolio interest test in this subsection in relation to the test entity at a time if, at that time, the sum of the *total participation interests that each *member of the group holds in the test entity:

(a)   is less than 10%; and

(b)   would be less than 10% if, in working out the *direct participation interest that any entity holds in a company:

                                     i.          an *equity holder were treated as a shareholder; and

                                    ii.          the total amount contributed to the company in respect of *non-share equity interests were included in the total paid-up share capital of the company.

Section 880-20 provides the definition of sovereign entity group. Broadly, sovereign entities of the same foreign government will be members of the same sovereign entity group and sovereign entities of the same part of a foreign government will be members of the same sovereign entity group.

The foreign government department has invested in Australia through Entity B. As such, Entity B's interest in the Test Entity is the only interest of the foreign government department (and Entity A) in the Test Entity.

No other entity of the State other than Entity B has an interest in the Test Entity.

Entity B's interest and, therefore, the collective interest held in the Test Entity of its sovereign entity group, is less than 10%.

As such, Entity B's interest in the Test Entity satisfies the requirements of paragraph 880-105(d).

Entity B's sovereign entity group does not have influence of a kind described in subsection (6)

For an amount of ordinary income or statutory income of a sovereign entity to satisfy paragraph 880-105(1)(e), at the income time the sovereign entity group to which the sovereign entity belongs must not have influence over the test entity of a kind described in subsection 880-105(6).

Subsection 880-105(6) states:

A *sovereign entity group has influence of a kind described in this subsection in relation to the test entity at a time if any of the following requirements are satisfied at that time:

a)     a *member of the group:

(i) is directly or indirectly able to determine; or

(ii) in acting in concert with others, is directly or indirectly able to determine;

the identity of at least one of the persons who, individually or together with others, make (or might reasonably be expected to make) the decisions that comprise the control and direction of the test entity's operations;

b)     at least one of those persons is accustomed or obliged to act, or might reasonably be expected to act, in accordance with the directions, instructions or wishes of a member of the group (whether those directions, instructions or wishes are expressed directly or indirectly, or through the member acting in concert with others).

As such, there are two distinct sub-tests within the influence test.

Sub-test 1 of the influence test, as contained in paragraph 880-105(6)(a), assesses whether the sovereign entity group is able to determine the identity of at least one of the persons who, individually or together with others, makes or is reasonably expected to make, decisions comprising the control and direction of the test entity's operations. This includes situations where the sovereign entity group is able to act in concert with others to determine the identity of a relevant decision-maker in the test entity.

Sub-test 1 also extends to situations where the sovereign entity group, in its own right, holds the ability to approve or veto decisions which go to the control or direction of the test entity.

As no other members of Entity B's sovereign entity group (including any entity directly or indirectly owned by the State) hold interests in the Test Entity the influence considerations are limited to the influence held by Entity B.

Trust A's Constitution details the restrictions placed on the unitholders of Trust A. A unitholder has no right or entitlement to, and must not:

(a)         Interfere with any rights, powers, authorities or discretions of the Trustee under this Constitution

(b)         Exercise a right, power or privilege in respect of the Assets or lodge a caveat or other notice affecting or encumbering the assets or otherwise claim any interest in the Assets

(c)         Require any Assets be transferred to that unitholder, or

(d)         Give any directions to the Trustee if it would require the Trustee to do or omit to do anything which may result in the exercise of any discretion expressly conferred on the Trustee by this Constitution or the determination of any matter which requires the approval of the Trustee under this Constitution.

Trust A's Constitution states that the initial term of the Trust is XX years, which can be extended by an ordinary resolution of the unitholders for a further two years. An ordinary resolution must be passed by unitholders holding at least 50% of the units on issue. The term of the Trust can be further extended by unanimous resolution. Where a unanimous resolution is not passed, the trustee may decide, in its discretion, to provide those unitholders that voted against the resolution an opportunity to exit the investment, and for the trust to continue for a further XX year term.

Trust A's Constitution outlines when a trustee can be removed. The trustee may be removed if a resolution is supported by unitholders together holding 35% of all units on issue, and the resolution to remove the trustee is supported by at least 50% of all units where the right to vote was exercised. A replacement trustee must be approved by unitholders holding at least 50% of the total units on issue.

Trust A's Constitution states that the Constitution can be amended by a special resolution passed by unitholders holding at least 75% of the units on issue.

Trust A's Constitution states that the Trustee has all the powers in respect of the Trust, these include but are not limited to acquire and invest in any property, manage and administer the Assets and make any necessary decisions. The Trustee has full discretion over the day to day management, and broader business direction and operation of Trust A.

Entity B's less than 10% interest in the Test Entity does not provide it with an entitlement to either directly or indirectly determine the identity of any person who makes decisions that compromise the control and direction of the Test Entities' operations.

Sub-test 2 of the influence test, as contained in paragraph 880-105(6)(b), assesses whether at least one of the relevant decision-making persons of the test entity is accustomed or obliged to act, or might reasonably be expected to act, in accordance with the directions, instructions or wishes of the sovereign entity group.

The Test Entity does not have an investment committee and as a consequence, the foreign government department, Entity A, nor Entity B will exert actual or potential influence over the operations or investments of the Test Entity.

No person involved in the control and direction of the Test Entity operations is accustomed or obliged to act in accordance with the directions, instructions or wishes of Entity B.

Based upon the above, the sovereign entity group of Entity B does not have influence of a kind described in subsection 880-105(6) and, therefore, satisfies the requirements of paragraph 880-105(1)(f).

Conclusion

As all of the conditions listed in subsection 880-105(1) have been satisfied, section 880-105 will apply such that amounts of ordinary and statutory income derived by Entity B from its investments in the Test Entity are not assessable and not exempt income.

Question 2

Is any loss incurred by Entity B in respect of interests in the Test Entity not deductible under section 880-110?

Detailed Reasoning

Section 880-110 provides that a sovereign entity cannot deduct an amount if:

(a) the sovereign entity is covered by section 880-125; and

(b) the amount is a loss in respect of any of the following kinds of interest that the sovereign entity holds in another entity:

(i) a membership interest;

...

(c) the requirements in paragraphs 880-105(1)(c), (d) and (e) would be satisfied, on the assumptions that:

(i) the amount were ordinary income or statutory income; and

(ii) the amount became ordinary income or statutory income of the sovereign entity at the time it arose; and

(iii) references in those paragraphs to the test entity were references to the other entity mentioned in paragraph (b) of this section.

As established in Question 1, Entity B:

(a)   is covered by section 880-125

(b)         holds membership interests in the Test Entity, and

(c)         satisfies the requirements in paragraphs 880-105(1)(c), (d) and (e) in relation to ordinary or statutory income that it will derive from the Test Entity.

As such, Entity B cannot deduct an amount if it is a loss in respect of its ownership interests in the Test Entity.

Question 3

Is any capital gain or loss made by Entity B with respect to its investments in the Test Entity disregarded under sections 880-115 and 880-120?

Detailed Reasoning

Section 880-115 provides that a sovereign entity disregards a capital gain from a CGT event that happens in relation to a CGT asset if:

(a) the sovereign entity is covered by section 880-125; and

(b) the CGT asset is a membership interest, non-share equity interest or debt interest in another entity; and

(c) the requirements in paragraphs 880-105(1)(c), (d) and (e) would be satisfied, on the assumptions that:

(i) the capital gain were an amount of ordinary income or statutory income; and

(ii) the amount mentioned in subparagraph (i) became ordinary income or statutory income of the sovereign entity immediately before the time the CGT event happened; and

(iii) references in those paragraphs to the test entity were references to the other entity mentioned in paragraph (b) of this section.

Section 880-120 provides that a sovereign entity disregards a capital loss from a CGT event if, on the assumption that the loss were a capital gain, the capital gain would be disregarded because of section 880-115.

As established in Question 1, Entity B:

(a)       is covered by section 880-125

(b)         holds membership interests in the Test Entity, and

(c)         satisfies the requirements in paragraphs 880-105(1)(c), (d) and (e) in relation to ordinary or statutory income that it will derive from the Test Entity.

As such, Entity B will be required to disregard any capital gain or loss made in respect of its ownership interests in the Test Entity.

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