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Ruling

Subject: Income Tax: Deduction - Capital payment of loan to-Co-operative Company

Question 1

Does the co-operative company (the co-op) fall under the definition for Co-operative companies under sections 117 and 118 of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

Yes

Question 2

Will the principal payments of a State Government loan for income producing capital purchases be an allowable deduction under paragraph 120(1)(c ) of the ITAA 1936 to the co-op in the income year that it is paid?

Answer

Yes

This ruling applies for the following period

Financial year ended 30 June 20VV

Financial year ended 30 June 20WW

Financial year ended 30 June 20XX

Financial year ended 30 June 20YY

Financial year ended 30 June 20ZZ

The scheme commenced on

1 July 20UU

Relevant facts and circumstances

The co-operative company (the co-op) is registered under the Co-operative Act 1997 (Co-op Act).

The co-op currently provides a diverse range of services to the farming community in the local area consisting of:

§ extensive specialist commodities storage capacity for growers

§ controlled atmosphere and refrigerated casual storage for a wide range of products

§ commodities packing and marketing services

§ rural supplies and support services.

The co-op provides services to non-members but is relatively minor and less than X% of the total value of co-op business.

The co-op advised the following as their proposed scheme:

§ to purchase trees and sell those trees to the grower

§ the growers will enter into an agreement whose terms and conditions require the fruit grown from the trees to be stored packed and marketed by co-op for the term of the agreement

§ to enable the co-op to purchase the trees it will seek finance from state government which will be utilised to purchase the trees that from the basis of the agreement

§ the grower having entered into the agreement agrees to certain terms and conditions which include that the grower must market all the produce from the trees to co-op.

The co-op advised that it has to satisfy the following conditions to be eligible for a Treasury Loan with the relevant state:

§ certified invoices are to be forwarded to the relevant rural financial services authority prior to each drawdown with instructions as to the loan repayment period and method of interest payment required.

§ the co-op must obtain a private ruling from the Tax Office prior to loan drawdown to confirm the loan purpose will be eligible in terms of sections 117-120 of the ITAA 1936.

§ existing loan is to be repaid prior to this loan drawdown.

The co-op's rules have been provided.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 117(1).

Income Tax Assessment Act 1936 paragraph 117(1)(b).

Income Tax Assessment Act 1936 section 118.

Income Tax Assessment Act 1936 subsection 120(1).

Income Tax Assessment Act 1936 paragraph 120(1)(c).

Income Tax Assessment Act 1936 subsection 120(3).

Does Part IVA, or any other anti-avoidance provision, apply to this ruling?

Part IVA of the Income Tax Assessment Act 1936 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 fully considered the application of Part IVA to the arrangement you asked us to rule on, or to an associated or wider arrangement of which that arrangement is part.

If you want us to rule on whether Part IVA applies we will first need to obtain and consider all the facts about the arrangement which are relevant to determining whether Part IVA may apply.

For more information on Part IVA, go to our website www.ato.gov.au and enter 'part iva general' in the search box on the top right of the page, then select: Part IVA: the general anti-avoidance rule for income tax.

Reasons for decision

Question 1

Summary

The objects of the co-op fall under the definition of paragraph 117(1)(b) of the ITAA 1936 and it is considered as a Co-operative Company for the purpose of Division 9 of the ITAA 1936.

Further, the facts indicate that not less than Y% of the shareholders are members of the co-op who are able to access the services that provided by the co-op. You confirmed that co-op provides services to non-members but this is relatively minor and incidental.

Accordingly, the co-op satisfies the requirements under paragraph 117(1)(b) of the ITAA 1936 and section 118 of the ITAA 1936 for the purpose of Division 9 of the ITAA 1936.

Detailed reasoning

Section 117 of the ITAA 1936

Subsection 117(1) of the ITAA 1936 provides that, for a co-operative company to fall within the meaning of Division 9 of the ITAA 1936, it must comply with the following conditions: -

1. its rules must limit the number of shares which may be held by or on behalf of any one shareholder;

2. its rules must prohibit the quotation of its shares for sale or purchase at any stock exchange, or in any other public manner whatever;

3. it must be established for the purpose of carrying on any business having as its primary object or objects one or more of the following:-

a the acquisition of commodities or animals for disposal or distribution among its shareholders;

b the acquisition of commodities or animals from its shareholders for disposal or distribution;

c the storage, marketing, packing or processing of commodities of its shareholders;

d the rendering of services to its shareholders;

e the obtaining of funds from its shareholders for the purpose of making loans to its shareholders to enable them to acquire land or buildings to be used for the purpose of residence or of residence and business.

For subsection 117(1) of the ITAA 1936 to apply, the primary or dominant object of the business must be to serve the shareholders by acquiring their products or rendering some other of the specified services. If the dominant motive is merely to carry on a business for the purpose of making profits which are not divided on a recognised co-operative basis, the company would not be a co-operative company even though there is literal compliance with all the other conditions of Division 9 of the ITAA 1936.

In A & S Ruffy Pty Ltd v FCT (1958) 98 CLR 637; 7 AITR 238, the taxpayer company argued that it satisfied paragraph 117(1)(b) of the ITAA 1936, namely "the acquisition of commodities or animals from its shareholders for disposal or distribution. The company, which manufactured sausage casings, purchased the raw material from its "C" class shareholders, who were wholesale butchers. The High Court held that the acquisition of the runners from shareholders was not a primary object and to say what the primary purpose of a business is may not always be quite easy, but relatively speaking the test it provides may be considered practicable.

On examination of the facts, particularly the rights and benefits of the "C" class shareholders, it was held that the primary object was the manufacture and sale of sausage casings for the purpose of earning profits for the benefit of "A" and "B" class shareholders.

The meaning of subsection 117(1) of the ITAA 1936 was considered by the High Court in Brookton Co-operative Society Ltd v FC of T 81 ATC 4346; (1981) 11ATR 880. In the appeal to the High Court it was held that the primary object of the company was to be established from year to year, and regard was to be had to the whole of the activities surrounding the business undertaken irrespective of the form in which that business undertaking was carried on. Gibbs CJ, Mason and Wilson JJ were of the view that the dominant purpose for which it was established was to hold shares in subsidiary companies which would engage in share trading and dividend stripping, so that the Co-operative and the subsidiaries would benefit, from the point of view of income tax, from the circumstance that the co-operative was a public company. In determining the primary object the real activities of the business must be examined and the primary object must be the sole or dominant purpose. Mason and Wilson JJ added that the intentions of the promoters might also be examined in determining the primary object.

Aickin J had a narrower interpretation. His Honour felt that there could be only one object. Thus, if a company was carrying on a business with an object as outlined in paragraphs 117(1)(a)-(e) of the ITAA 1936 and also for the purpose of carrying on some other business, then it would not gain co-operative status unless the secondary activity had a primary object as outlined in paragraphs 117(1)(a)-(e) of the ITAA 1936. The company was thereby disqualified from such status because the share trading and associated activities were not encompassed within paragraphs 117(1)(a)-(e) of the ITAA 1936. He also stated the intentions of the promoters were irrelevant in determination of the primary object.

In this case the primary activity of the co-op is the acquisition, storage, packing or marketing commodities of the members for disposal or distribution.

The co-op rules limit the number of shares which may be held by, or on behalf of, any one shareholder shall not exceed Z% of the nominal value of the share capital of the co-operative. Also, the shares of the co-operative are prohibited from quotation for sale or purchase at any stock exchange.

Accordingly, the objects of the co-op fall under the definition of paragraph 117(1)(b) of the ITAA 1936 and it is considered as a Co-operative Company for the purpose of Division 9 of the ITAA 1936.

Section 118 of the ITAA 1936

Where a company is a co-op within section 117 of the ITAA 1936 because of its primary objects, section 118 of the ITAA 1936 deems a co-op company not a co-operative company for an income year if:

If, in the ordinary course of business of a company in the year of income, the value of commodities and animals disposed of to, or acquired from, its shareholders by the company, or the amounts of its receipts from the storage, marketing, packing and processing of commodities of its shareholders, or from the rendering of services to them, or the amount lent to it by them, is less than 90% of the total value of commodities and animals disposed of or acquired by the company, or of its receipts from the storage, marketing, packing and processing of commodities, or from the rendering of services, or of the total amount lent by it, that company shall in respect of that year be deemed not to be a co-operative company.

Thus in general terms, so long as 90% of the value of the company's total activity is with its shareholders, then the company can still be a co-operative company. There is no prohibition on activity being conducted with third parties so long as the value of that activity is less than 10% of the company's total activity.

In Renmark Fruitgrowers Co-operated Ltd v FC of T 69 ATC 4135 the company, a co-operative whose main business was always the processing and packing of its shareholders' fruit, also had from its inception purchased commodities for sale to its shareholders. By the year under review, the latter activity accounted for more than 60% of total receipts. The processing and packing was almost exclusively done for shareholders, but the sales to non-shareholders accounted for about 22% of all sales in the merchandising business. Held, the company was not a co-operative as it failed to meet the 90% test of section 118 of the ITAA 1936 in relation to its merchandising activities. The primary object or objects of a company's business are to be determined each year and merchandising was by the year under review a primary object of the company's business.

In Case J88 (1958) 9 TBRD, a co-operative operating a butter factory was held not to qualify as a co-operative under section 118 of the ITAA 1936, although it purchased more than 90% of its cream supplies from shareholders. This was because in order to induce, in the face of stiff competition from other butter factories, new settlers to sell their cream supplies to it and in order to increase membership, it offered milking machinery and hardware for sale also to non-members and sales to non-members which accounted for more than 10% of all sales of such goods.

On the other hand, Case T1 (1967)18 TBRD a company whose primary object was the sale of dairy produce, more than 90% of its supplies received from members, was held to be a co-operative though it also derived a small proportion of its gross income from storage of produce of non-members, loans to non-members and milk treatment charges foe metropolitan supplies, and in regard to these operations it did not satisfy the 90% test.

In your case the facts indicate that not less than Z% of the shareholders are members of the co-op who are able to access the services that provided by the co-op. You have confirmed that co-op provides services to non-members but this is relatively minor and incidental.

Accordingly, the co-op satisfies the requirements under paragraph 117(1)(b) of the ITAA 1936 and section 118 of the ITAA 1936 for the purpose of Division 9 of the ITAA 1936.

Question 2

Summary

The co-op stated that more than Z% of the services are provided to its members. The co-op further stated that 100% of the capital has been contributed by the co-ops members.

Therefore, the co-op will be eligible to claim deduction for the principal payment of the Treasury loan that will be obtained for the purchase of assets for income producing purposes under paragraph 120(1)(c) of the ITAA 1936 provided that members holding at least Z% of the paid up capital have in fact done business with the co-op in that year. Any repayment in excess of the total assessable income of that year in which they are made would not be an allowable deduction.

Detailed reasoning

Where an organisation satisfies the requirements of section 117 and section 118 of the ITAA 1936, and obtains the status of a co-operative company for income tax purposes, it becomes eligible for a range of deductions not usually available to other types of companies. These deductions relate to various forms of distributions to shareholders and in certain cases deductions for repayments of principal of government loans.

In the case of a co-operative company within the meaning of Division 9 of the ITAA 1936, subsection 120(1) of the ITAA 1936 allows a deduction for so much of its assessable income as:

(a) is distributed among its shareholders as rebates or bonuses based on business done by shareholders with the company;

(b) is distributed among its shareholders as interest or dividends on shares; or

shall be an allowable deduction:

Provided that the deduction under paragraph (c) shall not be allowed unless shares representing not less than Z% of the value of the company are held by persons who supply the company with the commodities or animals which the company requires for the purposes of its business.

Subsection 120(3) of the ITAA 1936 makes it clear that subsection 120(1)(c) of the ITAA 1936 applies to loans taken out for the purpose of acquiring assets from government or non-government sources.

In order to qualify for a deduction under paragraph 120(1)(c) of the ITAA 1936, shares representing at least Z% of the company's paid up capital must be held by members who supply the company with the commodities or animals which the company requires for the purposes of its business.

This Z% shareholding requirement is especially important for a co-op whose members are involved in rural industries. It may be that, because of seasonal conditions, a significant number of members do not do any business with the co-op in a particular year. In order to sustain a claim for a deduction under paragraph 120(1)(c) of the ITAA 1936, it is necessary to ensure that members holding at least 90% of the paid up capital have in fact conducted business with the co-op in that year.

There is some merit in the argument that the purpose test posited by paragraph 120(1)(c) of the ITAA 1936 incorporates business which is related to a principal object of the co-operative company within the meaning of section 117 of the ITAA 1936. Hence, assets acquired in furtherance of one of those objects would satisfy the requirements of paragraph 120(1)(c) of the ITAA 1936.

In Ardmona Fruit Products Co-operative Co Ltd v FC of T (1952) 86 CLR 530; 5 AITR 342 (Ardmona's case) the court held that the deduction is allowed for moneys that are applied towards the repayment of the loan. Hence, the application of moneys must actually reduce or discharge the debt.

Another point at issue in Ardmona's case was whether, for a deduction to be allowed under paragraph 120(1)(c) of the ITAA 1936, the application must occur within the year in respect of which the deduction is claimed. The directors' report of the co-operative involved stated that £38,000 of the co-operative's earnings for the year had been applied towards repayment of a loan. This was also reflected in the profit and loss appropriation account. However, only £22,000 was in fact paid to the Victorian Government during the relevant year with the balance being paid in the following year. The Commissioner allowed a deduction of only £22,000.

The High Court found that £16,000 repaid after the close of the relevant year was not an application within the meaning of paragraph 120(1)(c) of the ITAA 1936 and also not allowable as a deduction for that year. The resolution of the board of directors (and proceedings at the subsequent general meeting) was not sufficient to be an application of the £16,000.

The Court rejected the co-operative argument that the appropriation it made was sufficient because the application would naturally be made after the close of the financial year when the results of the trading were known, and that it would be sufficient if the appropriation was made and notified to the respondent either in the original return of income or in an amended return at any time prior to assessment.

The Court concluded that assessable income has to be applied for or towards repayment of the debt and money could not be applied for or towards repayment of a debt unless the debt was in some way discharged or reduced.

The decision in Ardmona's Case also indicates that, for a deduction to be allowed under paragraph 120(1)(c) of the ITAA 1936, the application of the money must occur within the year in respect of which the deduction is claimed.

Therefore, deduction is allowable for the amount of repayment made during the financial year. Any repayments in excess of the total assessable income of the year in which they are made would not be an allowable deduction.

The co-op satisfies the requirements of paragraph 117(1)(b) of the ITAA 1936 and section 118 of the ITAA 1936 to be eligible for the concession under Division 9 of the ITAA 1936.

The co-op stated that more than Z% of the services are provided to its members. The co-op further stated that 100% of the capital has been contributed by the co-ops members.

Therefore, the co-op will be eligible to claim deduction for the principal payment of the Treasury loan that will be obtained for the purchase of assets for income producing purposes under paragraph 120(1)(c) of the ITAA 1936 provided that members holding at least Z% of the paid up capital have in fact done business with the co-op in that year. Any repayment in excess of the total assessable income of that year in which they are made would not be an allowable deduction.