Edited version of administratively binding advice

Authorisation Number: 1011617174514

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Subject: application of paragraph 102N(1)(b) of the Income Tax Assessment Act 1936

ADVICE:

The trustee of the MIT, by its power of veto over the Shareholder Reserved Matters in conjunction with the matters proposed to be included in the constitution of X Co, has control, or the ability to control, directly or indirectly, the affairs or operations of X Co in respect of the carrying on by X Co of its trading business for the purposes of paragraph 102N(1)(b) of the ITAA 1936.

THE SUBJECT OF THE ADVICE:

The applicant previously sought the Commissioner's advice on the application of paragraph 102N(1)(b) of the Income Tax Assessment Act 1936 ("ITAA1936") to a proposed investment in a property asset by a unit trust (the "MIT'). Subsequently, the applicant advised that as a result of the Commissioner's position stated in a corresponding advice (the earlier "ABA') to that application, the form of the proposed investment will be amended (the "new proposal") such that the list of Shareholder Reserved Matters would be reduced and in addition, certain matters are proposed to be included in the constitution of X Co.

It is intended that the MIT, together with other investors will invest in a property asset via the bidding vehicle comprising a unit trust, the Property Trust, and a company, the X Co. The plan is for the Property Trust to hold investments in the property asset and X Co to conduct all the operations related to the property asset. X Co will lease part or all of the property asset from the Property Trust in return for rent and the Property Trust will not conduct any other activities apart from deriving rent under that lease. It is proposed that X Co will carry on a "trading business" for the purposes of Div 6C of the ITAA 1936.

The rights and obligations of each investor, including the MIT, in respect of the proposed investment of the property asset are set out in the Consortium Terms. Each investor holds an interest of less than 40% in the proposed investment. In accordance with the Consortium Terms, the trustee of the MIT can effectively block the approval threshold being met with respect to all matters listed in the Shareholder Reserved Matters.

This advice applies for the following period:

Year ending 30 June 2011

The arrangement commences during:

The year ending 30 June 2011

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 6C.

Income Tax Assessment Act 1936 section 102M.

Income Tax Assessment Act 1936 section 102N.

Income Tax Assessment Act 1936 subsection 102N(1).

Income Tax Assessment Act 1936 paragraph 102N(1)(b).

Income Tax Assessment Act 1936 Part IVA.

Tax Administration Act 1953 Subdivision 12-H.

Tax Administration Act 1953 section 12-400 of Schedule 1.

Part IVA of the ITAA 1936

Part IVA of the ITAA 1936 ("Part IVA") is a general anti-avoidance rule that can apply in certain circumstances if you or another taxpayer obtains a tax benefit in connection with an arrangement and it can be concluded that the arrangement, or any part of it, was entered into or carried out by any person for the dominant purpose of enabling a tax benefit to be obtained. If Part IVA applies the tax benefit can be cancelled, for example, by disallowing a deduction that was otherwise allowable.

We have not considered the application of Part IVA to the proposed arrangement you asked us to provide advice on, or to an associated or wider arrangement to which that arrangement is part.

If you want us to consider whether Part IVA applies or not, you need to lodge a request and provide us with all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

EXPLANATION: (This does not form part of the Notice of Administratively Binding Advice)

The applicant advised that the MIT, once settled, is intended to satisfy the definition of a "managed investment trust" in section 12-400 of Schedule 1 to the TAA 1953. Recent changes to section 12-400, with effect from 1 July 2010, introduced a restriction to the effect that a trust must not be a "trading trust" under Division 6C of the ITAA 1936 in order to qualify as a "managed investment trust".

Accordingly, the applicant has sought the Commissioner's views on whether the trustee of the MIT, at any time during the relevant income year, would breach section 102N of Division 6C of the ITAA 1936. Subsection 102N(1) provides that a unit trust will be a "trading trust" if, at any time during the year of income, the trustee:

(a) carried on a trading business; or

(b) controlled, or was able to control, directly or indirectly, the affairs or operations of another person in respect of the carrying on by that other person of a trading business.

In their request, the applicant advised that the trustee of the MIT is not expected to carry on a "trading business" pursuant to paragraph 102N(1)(a) of the ITAA 1936 and thus the Commissioner's considerations are to be confined to paragraph 102N(1)(b) of Division 6C.

In the earlier ABA, the Commissioner examined the position of the trustee in relation to paragraph 102N(1)(b) of the ITAA 1936 and concluded that it was appropriate to consider the terms used in the provision and the context within which the provision was intended to operate. In that regard, it was considered helpful to revisit Parliament's intention in enacting paragraph 102N(1)(b), discerned from the Explanatory Memorandum to Taxation Laws Amendment Bill (No. 4) 1985 which commented as follows:

Paragraph (b) of section 102N is a safeguarding provision against arrangements to circumvent the operation of Division 6C by having activities that would constitute a trading business of a public unit trust carried on by an associated entity. By taking income from the associate in the form of eligible investment income, the trust could otherwise ensure that the relevant trust did not qualify as a trading business and so avoid the operation of Division 6C.

Under paragraph 102N(1)(b) of the ITAA 1936, Division 6C is mobilised if the trustee of the MIT either "controlled", or is "able to control", the affairs or operations of another person; in this instance, X Co. The word "control" in the context of Division 6C was explored in the earlier ABA and was considered to exist in circumstances where the trustee of the MIT, via their percentage of voting power in X Co, could effectively block a resolution put to the shareholders by the Board of Directors. The Consortium Terms, under which the trustee of the MIT holds the power, presently exercisable, to restrain the Board of Directors from undertaking an action listed as a Shareholder Reserved Matter is a form of "control" in the negative sense.

Paragraph 102N(1)(b) of the ITAA 1936 requires that the trustee of the trust controlled, or was able to control, directly or indirectly, the "affairs" or "operations" of another person. The concept of "affairs" or "operations" as qualified by the phrase "in respect of the carrying on by that other person of a trading business" was also explored in the earlier ABA. As "affairs" or "operations" are not defined in the Tax Act, the Commissioner considered that they should take their natural meaning refined by their context. On ordinary concepts, the "affairs" of a person are held to include their business and internal affairs and in the context of a company, Winn J in R v. Board of Trade, ex parte St Martin Preserving Co Ltd, said:

… the phrase "affairs of the company" comprises all its business affairs, interests or transactions, all its investment or other property interests, all its profits and losses, and its goodwill.

"Operations", on the other hand, is defined in the Australian Oxford Dictionary in the singular as (i) an action, or process or method of working or operating; (ii) an active process, a discharge of a function; and (iii) a piece of work, especially one in series. Thus, in the earlier ABA "operations" was acknowledged as a reference to the day to day business of the company rather than its business structure. Therein it was also concluded that the concept of "affairs" may include "operations".

Discussion

In the earlier ABA, it was concluded that the trustee's power of veto over matters that go to the structure, scope and management of X Co's business effectively usurped the discretion of the Board of Directors in relation thereto such that the requirements of paragraph 102N(1)(b) were satisfied. A seemingly self-evident point that might also have been made in the earlier ABA was that the trustee's power of veto enabled it to forestall certain strategic changes agreed to by the other shareholders in combination. In this way the trustee could effectively ensure that the business of X Co remained essentially unchanged from its inception as sublessee of the property asset.

In relation to the new proposal, the applicant suggests that the matters which remain Shareholder Reserved Matters should be viewed as "of a fundamental nature only and consistent with the minority protection rights that a shareholder would be entitled under Australian Corporations Law". However, the pertinent issue is not whether the trustee can exercise control through the Shareholder Reserved Matters but, simply, whether it can exercise control over the "affairs" and "operations" of X Co. This is essentially a practical matter of fact, the mechanism of the control notwithstanding.

In this case, whilst there is a reduction in matters included as Shareholder Reserved Matters, other key matters (included in the original list of Shareholder Reserved Matters) are to be retained indirectly through their rewording and transposition to X Co's constitution proper which, like the Shareholder Reserved Matters, also requires certain voting threshold to vary.

A consequence of including the matters as proposed in the X Co constitution is that they can be controlled, negatively, by the trustee of the MIT given that any material amendment to X Co's constitution is a Shareholder Reserved Matter over which the trustee has the power of veto. The matters proposed to be included in the X Co constitution can be identified closely with items now removed from the original Shareholder Reserved Matters, which were acknowledged in the earlier ABA as significant as they enabled the trustee to resist changes to the structure, scope and management of X Co's business.

The matters to be included in the X Co constitution are matters which one would ordinarily regard as contributing to a significant degree to the "affairs", and arguably also the "operations", of X Co. Furthermore, the Shareholder Reserved Matters to be retained in the new proposal were considered in the earlier ABA to constitute the "affairs" of X Co. The applicant has explained that matters that are to be included in X Co's constitution to ensure compliance with the property lease. However, it is the inclusion of matters in the constitution that bears on the control issue, not the purpose for their inclusion, which in any event may be redundant given that X Co, as sublessee, will be bound by the terms of the property lease.

For the purposes of paragraph 102N(1)(b) of the ITAA 1936 the question remains whether, in fact, the effect of the new proposal is a means by which a shareholder, in this case the trustee of the MIT, can control, directly or indirectly, the "affairs" or "operations" of X Co in respect of the carrying on by X Co of a trading business. In this regard, it is appropriate to recall the words of Lockhart J in Re The News Corporation Ltd and Others, where he stated that "questions of control, whether through voting power or financial interests, are to be determined by practical and commercial considerations rather than highly refined legalistic tests."

Whilst it is acknowledged there is no impediment to the inclusion of these matters in the constitution of X Co when incorporated, it must also be acknowledged that their variation requires a majority vote of shareholder voting power, which, under the new proposal, is a requirement preserved in the Shareholder Reserved Matters. Speaking practically, this combination of factors would result in decisions in respect of the "affairs" of the company being deferred to each consortium member with a certain voting interest, which would include, of course, the trustee of the MIT.

In essence, the matters to be included in the X Co constitution are such as to enable the trustee of the MIT through its veto power to maintain the essential business intact from its inception, avoid undertaking any business not associated with the property lease and to fetter the Board's discretion in regard to the retention of profits. The trustee might seek to protect its investment in the property asset but it does so in a way which entrenches its control over the sorts of decisions that might be expected to be made at Board level. In short, contrary to the applicant's suggestion, the trustee's control over the corporate business extends well beyond mere "minority protection rights".

Conclusion

In reaching a conclusion on the matter, it is to be recalled that paragraph 102N(1)(b) is a safeguarding provision designed to deal with situations where trustees might seek to avoid the operation of Division 6C by bifurcating what is otherwise a trading business and alienating their trading income so as to receive only passive income yet still retain control of the trading business through another person.

From the analysis above, it would seem that the new proposal is essentially one of varying the means by which each shareholder can exercise its negative control over any fundamental changes to the structure, scope and management of X Co's business from matters in the original list of Shareholder Reserved Matters to new provisions to be included in X Co's constitution proper. But, the result in terms of paragraph 102N(1)(b) of the ITAA 1936 is the same.

Under the new proposal, the matters over which the trustee of the MIT has the power of veto are extensive and significant and they encompass matters which pertain to X Co's corporate business structure, future direction and ongoing corporate governance. The practical effect of having control of, or the ability to control, those matters is that X Co cannot act independently of the trustee of the MIT. In these circumstances, paragraph 102N(1)(b) of the ITAA 1936 would apply, whereupon the MIT would qualify as a "trading trust" for the purposes of Division 6C.