House of Representatives

Tax Laws Amendment (2008 Measures No. 5) Bill 2008

Explanatory Memorandum

Circulated By the Authority of the Treasurer, the Hon Wayne Swan Mp

Chapter 5

Managed funds : changes to the eligible investment business rules

Outline of chapter

5.1 Schedule 5 to this Bill amends Division 6C of the Income Tax Assessment Act 1936 (ITAA 1936) to streamline and modernise the eligible investment business rules for managed funds.

5.2 These amendments will:

·
clarify the scope and meaning of investing in land for the purpose of deriving rent;
·
introduce a 25 per cent safe harbour allowance for non-rental, non-trading income from investments in land;
·
expand the range of financial instruments that a managed fund may invest in or trade; and
·
provide a 2 per cent safe harbour allowance at the whole of trust level for non-trading income.

5.3 The introduction of these amendments will make it easier for managed funds, in particular property trusts, to comply with the law by reducing the scope for them to inadvertently breach Division 6C.

5.4 All references to legislative provisions in this chapter are references to the ITAA 1936 unless otherwise stated.

Context of amendments

5.5 Division 6C applies to tax the income of certain 'public unit trusts' and their equity holders like companies and their shareholders if the trust is a 'public trading trust'. A public unit trust is a public trading trust if at any time during an income year it operates, or controls operations of an entity that carries on activity that is not an eligible investment business. An eligible investment business is defined in section 102M of Division 6C as any, or any combination of:

·
investing in land (including the acquisition and development of land) for the purpose or primarily for the purpose of deriving rent; or
·
investing or trading in any, or any combination of, the financial instruments as listed in the definition in section 102M, paragraph (b).

5.6 Consistent with the Government's pre-election commitment, the Assistant Treasurer and Minister for Competition Policy and Consumer Affairs announced in Media Release No. 010 of 22 February 2008 that the Board of Taxation would examine options for the introduction of a specific tax regime for managed funds. The review is also to include an examination of Division 6C. The review is a key part of the Government's commitment to enhance the competitiveness of Australian managed funds. The Government also announced that pending the outcome of the review certain changes would be made in the interim to Division 6C to streamline and clarify the application of the eligible investment business rules.

Summary of new law

5.7 These amendments will clarify the scope and meaning of investing in land for the purpose of deriving rent by ensuring that investing in land, including an interest in land, for the purpose of deriving rent is taken to include investing in fixtures on the land and investing in movable property (ie, chattels) customarily supplied, incidental and relevant to the renting of the land and ancillary to the ownership and utilisation of the land.

5.8 These amendments will introduce a 25 per cent safe harbour allowance for non-rental, non-trading income from investments in land. The allowance for non-rental, non-trading income from land is to operate as a safe harbour in conjunction with the existing rental purpose tests on an overall land portfolio basis. If a trust does not meet this safe harbour, it can assess whether it is investing in land for the purpose, or primarily for the purpose of deriving rent under the existing law (ie, paragraph (a) of the definition of 'eligible investment business' in section 102M).

5.9 These amendments will expand the range of permitted financial instruments that a managed fund may invest in or trade by extending the scope of financial instruments covered by the eligible investment rules to include financial instruments that are not already covered by paragraph (b) of the definition of 'eligible investment business' in section 102M that arise under financial arrangements in the Income Tax Assessment Act 1997 (ITAA 1997), other than certain excepted arrangements. However, as per the note under subsection 102MA(1), nothing in paragraph (c) affects an activity that meets paragraph (a) of the definition of 'eligible investment business' in section 102M.

5.10 These amendments will provide a 2 per cent safe harbour allowance at the whole of trust level for non-trading income to reduce the scope for inadvertent minor breaches of the Division 6C eligible investment business rules. The trustee of a unit trust will not be treated as carrying on a trading business if not more than 2 per cent of the gross revenue of the unit trust in an income year is not from eligible investment business and that income is not from carrying on a business that is not incidental and relevant to the eligible investment business.

5.11 The allowance is to provide for situations where the trustee derives some income that is not income from an eligible business investment and it is not from a separate business activity (ie, income from directors' fees received from positions on company boards, certain guarantee or option fees, or income from an investment in a non-financial arrangement).

5.12 These amendments will apply to the income year of Royal Assent and later income years.

Comparison of key features of new law and current law

New law Current law
Investing in land is taken to include investing in fixtures on land and investing in movable property that is incidental and relevant to the renting of the land, customarily supplied or provided in connection with the renting of the land, and ancillary to the ownership and use of the land. No equivalent.
New law Current law
Financial instruments include additional financial instruments that arise under financial arrangements other than certain excluded arrangements.
Shares in a company are to include shares in certain foreign hybrid companies.
Financial instruments are limited to those listed in Division 6C.
A 25 per cent safe harbour allowance for non-rental income where that income is not from the carrying on of a business that is not ancillary and incidental to the renting of the land or excluded rent (ie, certain profit based rents). No equivalent.
A 2 per cent of gross income safe harbour allowance for non-eligible investment business income. No equivalent.

Detailed explanation of new law

Eligible investment business : investments in land for the purpose, or primarily for the purpose, of deriving rent

5.13 Under the current law there is some uncertainty about the scope of the term investing in land . These amendments clarify the meaning of investment in land by introducing into the law specific references to:

·
fixtures on land [Schedule 5, item 7, section 102M] ; and
·
moveable property that is incidental and relevant to the renting of the land, customarily supplied or provided in connection with the renting of the land, and ancillary to the ownership and use of the land [Schedule 5, item 8, subsection 102MB(1)] .

Example 5.1 A public unit trust invests in land used as a shopping centre. The property includes some fittings and moveable furnishings in the common areas that are for use by centre customers. The investment in the fittings and moveable property are included as part of the investment in land.

Safe harbour allowance for non-rental, non-trading income from investments in land

5.14 A public unit trust is not characterised as a public trading trust in relation to investing in land so long as the public unit trust is investing in land for the purpose, or primarily for the purpose, of deriving rent. While this test allows a degree of flexibility in its application, for certain taxpayers it may not necessarily provide the level of certainty they require.

5.15 In order to provide taxpayers with increased certainty while retaining the flexibility of the existing test, these amendments introduce a safe harbour allowance for non-rental, non-trading income from land. The allowance is to operate on an overall land portfolio basis in conjunction with the existing rental purpose tests.

5.16 The safe harbour allowance for the rental purpose test in relation to investments in land is taken to be satisfied if:

·
at least 75 per cent of the gross revenue from eligible investments in land is rent that is not excluded rent; and
·
none of the remaining non-rental gross revenue is excluded rent or is from carrying on a business that is not incidental and relevant to the renting of the land.

5.17 In working out the gross revenue for the purposes of the rent and other income safe harbour test:

·
capital gains and capital losses arising from disposals or other realisations of the ownership of land (including an interest in land) held for purposes of deriving rent are to be disregarded;
·
rent for the land includes payments for provision of services that are incidental and relevant to the renting of the land and ancillary to the ownership and use of the land [Schedule 5, item 8, subsection 102MB(3)] ; and
·
revenue must not include rent based on profits or receipts under an arrangement that is designed (to be objectively determined) to result in all, or substantially all, of what would otherwise be profits being transferred to another party to the arrangement [Schedule 5, item 5, section 102M] .

The words 'or other realisations' in the first dot point cover cases akin to a disposal. An example would be where a statutory lease is in effect transferred to another entity. They would not extend to cases such as granting a sublease for a premium, except if it gives rise to a disposal of the land.

Example 5.2 A public unit trust earns $250 million in gross revenue in an income year from its investments in land. Each of the trust's investments has a purpose of deriving rent. The revenue comprises:

Rent of the properties $200m
Billboards and advertising on the properties $25m
Mobile phone towers on the properties $25m
Excluded rent Nil
The trust would satisfy the 25 per cent safe harbour test as 80 per cent of its gross revenue from the properties is rent and the remaining revenue is not from carrying on a business that is not incidental and relevant to the renting of the land.

Example 5.3 A public unit trust owns and rents out a shopping centre that includes a car park for shopping centre customers. To deter use by non-customers long-stay users are charged fees. The revenue from car parking fees would be incidental to the rental of the land and would be non-rental income for the purposes of the safe harbour rule. The income from the car park is not from carrying on a business that is not incidental and relevant to the renting of the land.

Example 5.4 A public unit trust acquires land and buildings which comprise of office accommodation for rent and parking for the tenants. The trust subsequently decides not to make the parking available primarily for tenants but to run a car parking operation on the property. The income from the car parking operation would not fall within the 25 per cent safe harbour as it is income from carrying on a business that is not incidental and relevant to the renting of the land. The trust would be carrying on a trading business.

Eligible investment business : financial instruments

5.18 Since the introduction of Division 6C in 1985 the number and variety of financial instruments available for investment has increased significantly. In recognition of this change, these amendments amend the list of financial instruments in section 102M to include financial instruments that arise under 'financial arrangements' as defined in the ITAA 1997 other than certain excepted arrangements. [Schedule 5, item 4, section 102M]

5.19 This amendment is to include certain financial instruments not already included in the existing list of financial instruments in the definition of 'eligible investment business'. The meaning of a financial instrument is discussed in the Australian Accounting Standards AASB 132 Financial Instruments : Disclosure and Presentation and AASB 139 Financial Instruments : Recognition and Measurement .

Excepted arrangements

Leasing or property arrangements

5.20 Most leasing arrangements will not be financial arrangements, as under such an arrangement the taxpayer will not have insignificant non-cash settlable rights or obligations (the lessee's right to use the relevant property being leased, and the lessor's obligation to allow, and be deprived of, such use). However, to the extent that particular leasing arrangements do satisfy the definition of a 'financial arrangement', the leasing or property arrangement exception will apply to exclude a right or obligation arising under:

·
a luxury car lease under Division 42A in Schedule 2E to the ITAA 1936 [Schedule 5, item 8, paragraph 102MA(2)(a)] ;
·
arrangements to which Division 240 of the ITAA 1997 apply [Schedule 5, item 8, paragraph 102MA(2)(b)] ;
·
a financial arrangement in the form of a loan that is taken to exist by subsection 250-155(1) of the ITAA 1997 [Schedule 5, item 8, paragraph 102MA(2)(c)] ; or
·
an arrangement that:

-
is a licence to use an asset [Schedule 5, item 8, paragraphs 102MA(2)(d) and (e)] ;
-
in substance or effect, depends on the use of a specific asset, and gives a right to control the use of that specific asset [Schedule 5, item 8, paragraphs 102MA(2)(d) and (e)] ; or
-
where that asset is goods or a personal chattel (other than money or a money equivalent), real property, or intellectual property [Schedule 5, item 8, paragraphs 102MA(2)(d) and (e)] .

5.21 A luxury car lease within the meaning of Division 42A of Schedule 2E to the ITAA 1936 excludes hire purchase agreements and short-term hiring arrangements. The leases that are subject to this Division are taxed as a notional sale (generally for the cost of the vehicle) and a loan transaction.

5.22 Division 240 of the ITAA 1997 operates to tax some arrangements (such as hire purchase agreements), as a sale of property combined with a loan by the notional seller to the notional buyer to finance the purchase price. Among other things, this Division determines the notional interest on this notional loan and how it is treated for tax purposes.

5.23 The third category under this exclusion broadly covers licences and leases over goods (other than money or a money equivalent), real property, and intellectual property.

5.24 Goods, personal chattels and real and intellectual property take their ordinary meaning, and so in a broad sense cover personal property (other than money or a money equivalent), land, and interests in land and rights in respect of creative and intellectual effort (including copyright, registered designs, patents and trademarks).

Interest in a partnership or a trust estate

5.25 A right that is carried by an interest in a partnership or a trust (or a corresponding obligation) will be subject to an exception if there is an interest or interests in the partnership or the trust estate, or the interest is an equity interest in the partnership or the trust. The reference to an equity interest in the context of a partnership or a trust takes its meaning from section 820-930 of the ITAA 1997. [Schedule 5, item 8, subsection 102MA(3)]

5.26 The exception also applies to a right that is carried by an interest in a trust estate (or a corresponding obligation) where that trust is managed by a funds manager or a custodian, or a responsible entity of a registered scheme. [Schedule 5, item 8, paragraph 102MA(3)(c)]

5.27 What is meant by the reference to a funds manager and a custodian takes on its ordinary commercial meaning. A responsible entity of a registered scheme draws its meaning from the Corporations Act 2001 (Corporations Act). It is the company named in the Australian Securities and Investments Commission's record of the scheme's registration as the responsible entity or temporary responsible entity of a managed investment scheme registered under section 601EB of the Corporations Act. In a general sense, a managed investment scheme as defined under the Corporations Act covers (subject to certain exceptions) a scheme where the contribution made by members to acquire interests in the scheme are pooled and used to produce benefits for members, where the members do not have day-to-day control of the operation of the scheme (see section 9 of the Corporations Act).

General insurance policies

5.28 A right or obligation under a general insurance policy is subject to an exception, except where the policy is a derivative financial arrangement and the taxpayer is not a general insurance company as defined by the ITAA 1997. [Schedule 5, item 8, subsection 102MA(4)]

5.29 This exception ensures that eligible investment business does not include rights and obligations under those general insurance policies that are subject to taxation under Division 321 of Schedule 2J to the ITAA 1936.

5.30 A general insurance policy is defined in subsection 995-1(1) of the ITAA 1997 to mean a policy of insurance that is not a life insurance policy or an annuity instrument. The term policy of insurance is not defined and is intended to take its ordinary meaning. It may include a policy of reinsurance. Examples of general insurance policies include fire, theft, injury, accidental damage, negligence, storm and professional indemnity insurance.

5.31 The activities of a general insurance business can be split into underwriting and investment activities. Rights or obligations from underwriting activities of a general insurance company will usually be the subject of this exception and would therefore be excluded.

5.32 The exception does not affect the public unit trust's ability to invest or trade in life assurance policies under paragraph (b) of the definition of 'eligible investment business' in section 102M, paragraph (b) of the ITAA 1936. Nor does it preclude the trust insuring its rental properties, which is an activity that is incidental to investing in land for the purpose of deriving rent.

Certain guarantees and indemnities

5.33 A right or obligation under a guarantee or indemnity will be subject to an exception unless:

·
the guarantee or indemnity is of a financial arrangement that is a derivative financial arrangement for any income year [Schedule 5, item 8, paragraph 102MA(5)(a)] ; or
·
the actual guarantee or indemnity is given or entered into in relation to a financial arrangement [Schedule 5, item 8, paragraph 102MA(5)(b)] .

5.34 What is meant by a guarantee or an indemnity takes on its ordinary meaning to include a promise to answer for the debt or default of another, or to make good a loss suffered by a third party.

Example 5.5 A public unit trust provides a guarantee in respect of performance of a loan agreement that is a financial arrangement. Such a guarantee would not be an excepted arrangement.

Superannuation and pension income

5.35 A right to receive, or an obligation to provide, financial benefits will be subject to an exception if that right or obligation arises from a person's membership of a superannuation or a pension scheme. This may include a right of a dependant of a member to receive financial benefits (or the corresponding obligation to provide financial benefits to that dependant). It may also include a right or obligation arising from an interest in a complying or non-complying superannuation fund, a pooled superannuation trust or an approved deposit fund. [Schedule 5, item 8, subsection 102MA(6)]

Retirement village residence contracts

5.36 A right or obligation arising under a contract that gives rise to a right to occupy 'residential premises' in a 'retirement village' is the subject of an exception. [Schedule 5, item 8, subsection 102MA(7)]

5.37 These terms take their meaning from section 195-1 of the A New Tax System (Goods and Services) Act 1999 (GST Act). That definition provides that a residential premises in a retirement village exists if:

·
the premises are occupied by one or more persons as a main residence;
·
accommodation in the premises is intended to be for persons who are at least the age of 55 years or older; and
·
the premises include communal facilities for use by the residents of the premises; but excludes:

-
premises used, or intended to be used, for the provision of residential care (within the meaning of the Aged Care Act 1997 ) by an 'approved provider' (within the meaning of that Act); and
-
'commercial residential premises' as defined in section 195-1 of the GST Act.

Retirement village services contracts

5.38 A right or obligation arising under a contract under which a retirement village resident is provided with general or personal services in the retirement village is the subject of an exception. [Schedule 5, item 8, paragraph 102MA(7)(b)]

A trading business

5.39 Division 6C applies to tax the income of certain public unit trusts like companies if the trust is a public trading trust. A public unit trust is a public trading trust if it does not carry on an eligible investment business. Under the current law even minor breaches of the eligible investment business rules therefore have significant consequences for a public unit trust.

5.40 These amendments introduce an allowance designed to reduce the scope for inadvertent minor breaches of the Division 6C eligible investment business rules, which would otherwise trigger company taxation for a trust. This allowance is to provide for situations where the trustee derives some income that is not income from an eligible business investment and it is not from a separate business activity (eg, income from directors' fees received from positions on company boards, certain guarantee or option fees, or income from an investment in a non-financial arrangement). This allowance does not affect the operation of the control test in section 102N. That is, it does not allow the trustee of the trust to own or control entities carrying on active trading businesses.

5.41 Under these amendments an entity will be taken not to carry on a trading business in a year, if no more than 2 per cent of the gross revenue of the unit trust for the income year was income from other than eligible investment business, provided none of the revenue was not income from carrying on a business that is not incidental and relevant to the eligible investment business. [Schedule 5, item 8, section 102MC]

Example 5.6 In an income year a public unit trust earned $100 million gross revenue from eligible investment business and earned gross revenue from directors' fees of $1 million and $0.5 million gross non-trading revenue from non-eligible investment business and no other revenue was earned. The unit trust will not be taken to be carrying on a trading business in that income year.

Application and transitional provisions

5.42 These amendments apply from the income year of Royal Assent.

5.43 The 25 per cent safe harbour allowance for non-rental, non-trading income from land investment and the 2 per cent safe harbour allowance for revenue from activities other than eligible investment business income do not apply for the income year of Royal Assent if the trustee of the unit trust chooses that those provisions are not to apply to that income year. This provision is intended to deal with situations where the safe harbour rules would convert a public trading trust into a Division 6 trust and the trust wished to continue to be taxed like a company under Division 6C. [Schedule 5, items 9 and 10]


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