Edited version of your private ruling

Authorisation Number: 1012418035324

Subject: Trust losses and Part IVA

Questions

1. Can the Trust apply current and prior year losses generated from rental activities against dividend income?

Answer:

Yes

2. Will Part IVA apply to the arrangement?

Answer:

No

This ruling applies for the following period

Year ended 30 June 2011

Year ended 30 June 2012

Year ended 30 June 2013

The scheme commenced on

1 July 2010

Relevant facts and circumstances

This ruling is based on the facts stated in the description of the scheme that is set out below. If your circumstances are materially different from these facts, this ruling has no effect and you cannot rely on it. The fact sheet has more information about relying on your private ruling.

The Trust

The Trust is a unit trust.

The Trust has not made a family trust election yet but intends to make a family trust election.

The Trust is a property investment entity.

The Trust has incurred losses each year of operation since its establishment. You submit that it has never made a profit due to the level of commercial debt applicable to the property assets which are negatively geared.

The Trust has not made a distribution in over a number of years and will not make a distribution within two months after the end of the income year to which the ruling applies.

There has been no change in the control structure of the Trust since its establishment. 

Under the Trust Deed a unit holder's interest in a share of the income or capital of the trust is defeasable.

The Company

The Company is a trading entity.

The Company operates out of the premises owned by the Trust

The Company pays market rent for the property owned by the Trust. 

The Company does not have any unpaid present entitlements from trusts. 

The Company does not intend to make an interposed entity election when the Trust becomes a family trust.

The Company is an outsider to the Trust

Proposal

At present the market rent received by Trust from The Company is insufficient to cover the expenses incurred in operating the investment property held by the Trust. 

The Company intends to issue one redeemable preference share to the Trust.

The Company will pay a cash dividend to the Trust on a semi-yearly basis to assist in the liquidity and ongoing viability of the Trust. The cash dividend will be calculated on projected expenses for the Trust in operating the commercial retail premises during a particular period.

The cash dividend will be applied to current and/or prior year losses generated from the Trust's rental activities.

The cash dividend would be calculated on projected expenses for operating the commercial retail premises during a particular period. 

You submit that this will resolve both the cash flow shortage within the Trust and reduce the loan between it and The Company.

Relevant legislative provisions

Income Tax Assessment Act 1936 section 267-20

Income Tax Assessment Act 1936 section 267-30

Income Tax Assessment Act 1936 section 267-35

Income Tax Assessment Act 1936 section 267-45

Income Tax Assessment Act 1936 section 267-75

Income Tax Assessment Act 1936 section 267-B

Income Tax Assessment Act 1936 section 267-C

Income Tax Assessment Act 1936 section 269-50

Income Tax Assessment Act 1936 section 95A(2)

Income Tax Assessment Act 1936 subsection 267-30(2)

Income Tax Assessment Act 1936 subsection 267-40(2)

Income Tax Assessment Act 1936 subsection 267-70(2)

Income Tax Assessment Act 1936 subsection 270-25(1)

Income Tax Assessment Act 1936 subsection 270-25(2)

Income Tax Assessment Act 1936 paragraph 177E(1)(a)

Income Tax Assessment Act 1936 paragraph 177E(1)(d)

Income Tax Assessment Act 1936 section 177F

Income Tax Assessment Act 1936 section 269-60

Income Tax Assessment Act 1936 section 269-85

Income Tax Assessment Act 1936 subsection 272-5(2)

Income Tax Assessment Act 1936 subsection 272-5(2)

Income Tax Assessment Act 1997 subsection 995-1(1)

Reasons for decision

Schedule 2F to the Income Tax Assessment Act 1936 (the ITAA) operates to disallow a deduction for prior year and current year trust losses and other income tax deductions unless certain tests are passed.

Different test must be met depending on whether a trust is fixed or a non-fixed trust.

Fixed or non fixed trust

Subsection 272-5(1) of Schedule 2F to the ITAA 1936 defines a fixed entitlement in a trust:

If, under a trust instrument, a beneficiary has a vested and indefeasible interest in a share of income of the trust that the trust derives from time to time, or of the capital of the trust, the beneficiary has a fixed entitlement to that share of the income or capital.

In addition, subsection 272-5(2) of the ITAA 1936 states that:

If:

(a) a person holds units in a unit trust; and

(b) the units are redeemable or further units are able to be issued; and

(c) if units in the unit trust are listed for quotation in the official list of an approved stock exchange - the units held by the person will be redeemed, or any further units will be issued, for the price at which other units of the same kind in the unit trust are offered for sale on the approved stock exchange at the time of the redemption or issue; and

(d) if the units are not listed as mentioned in paragraph (c) - the units held bythe person will be redeemed, or any further units will be issued, for a price determined on the basis of the net asset value, according to Australian accounting principles, of the unit trust at the time of the redemption or issue;

then the mere fact that the units are redeemable, or that the further units are able to be issued, does not mean that the person's interest, as a unit holder, in the income or capital of the unit trust is defeasible.

The word 'interest' is a word that is capable of many meanings. In the absence of a definition one must infer its meaning from the context in which it is found (see Gartside v Inland Revenue Commissioner [1968] AC 553 at 602-602 and 617-618 Commissioner of Stamp Duties (Queensland) v Livingston (1964) 112 CLR 12 at 28-29; and CPT Custodian Pty Ltd v Commissioner of State Revenue 2005 HCA 53).

There may be circumstances in which the word 'interest' could be interpreted broadly to include any right or advantage that a person might be able to claim with respect to the income or capital of the trust and/or in respect of the trustee, whether present or future, ascertained or potential. In the context of Schedule 2F, however, it is clear that for an interest to be recognised as a fixed interest it must be a right with respect to a share of the income or of the capital of the trust that is susceptible to measurement. To adopt the words of Lord Wilberforce in Gartside v Inland Revenue the right must have 'the necessary quality of definable extent'.

The term 'vested and indefeasible' is not defined in the taxation legislation However the Explanatory Memorandum (EM) to the Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997 does discuss its ordinary meaning at some length, at paragraphs 13.4 to 13.9.

In Colonial First State Investments Ltd v Commissioner of Taxation [2011] FCA 16 Stone J stated at [97] that in the absence of a definition, and subject to qualification in subsection 272-5(2) of Schedule 2F of the ITAA 1936, the term 'indefeasible' bears its ordinary meaning when applied to an interest, that is that 'the interest cannot be terminated, invalidated or annulled'. The meaning of the term 'vested and indefeasible' (in the context of Schedule 2F to the ITAA 1936) also appears in subsection 95A(2) of the ITAA 1936 and has been considered in that context by the courts - refer to Estate Mortgage Fighting Fund Trust v FC of T 2000 ATC 4525; Walsh Bay Developments Pty Ltd v Commissioner of Taxation (1995) 95 ATC 4378; Dwight v Commissioner of Taxation (1992) 92 ATC 4192; Harmer v FC of T (1991) 173 CLR 264; 91 ATC 5000.

Also relevant are MSP Nominees Pty Ltd v Commissioner of Stamps (SA) (1999) 198 CLR 494; 99 ATC 4937; Queensland Trustees Ltd v Commissioner of Stamp Duties (1952) 88 CLR 54; Glenn v Federal Commissioner of Land Tax (1915) 20 CLR 490.

It is an essential element of subsection 272-5(1) of Schedule 2F to the ITAA 1936 that in order to have a fixed entitlement to a share of income or capital there must be a vested and indefeasible interest 'under a trust instrument'. In all cases, the determining factor in deciding if fixed entitlements exist will be the terms of the trust instrument under which the trust is constituted. Neither the form of the trust nor the labels that are attached to it can determine this question.

As the High Court recently stated in CPT Custodians Pty Ltd v Commissioner of State Revenue (Vic); Commissioner of State Revenue (Vic) v Karingal 2 Holdings Pty Ltd (2005) 224 CLR 98 at [15], in taking this step:

'…a priori assumptions as to the nature of unit trusts under the general law and principles of equity [will] not assist and would be apt to mislead. All depends, as Tamberlin and Hely JJ put it in Kent v SS "Maria Luisa" (No 2), upon the terms of the particular trust. The term "unit trust" is the subject of much exegesis by commentators. However, "unit trust", like "discretionary trust", in the absence of an applicable statutory definition, does not have a constant, fixed normative meaning which dictate the application to particular facts of the [relevant statutory definition]…'

The relevant question is whether the vested and indefeasible interests represent 100% of the income and 100% of the capital of the trust. The fact that a power held by the trustee has not yet been exercised is not relevant when determining if the power results in an interest being defeasible. The exercise of the power determines if an interest has in law been defeased, not if it is defeasible. The real question is whether the power, if exercised, would result in a defeasance of some or all of the unit holder's rights to the income and/or capital of the trust.

It is accepted that the Constitution provides unit holders with a vested interest in the income and capital of the Trust.

However the Trust Deed allows for a unit holder's interest in a share of the income or capital of the trust to be defeased.

Therefore, it is considered reasonable to conclude, in accordance with subsection 272-5(1) of Schedule 2F to the ITAA 1936, that all unit holders (or beneficiaries) do not have fixed entitlements to all of the income and capital of the Trust. The Trust is therefore categorised as a non fixed trust.

Trust Losses

Subdivision 267-B of Schedule 2F to the ITAA 1936 provides that a non-fixed trust, which is not an excepted trust, can only deduct prior year losses if it passes the following tests;

· if applicable, the 50% stake test (subsection 267-40(2) of Schedule 2F to the ITAA 1936)

· the control test (section 267-45 of Schedule 2F to the ITAA 1936)

· if applicable, the pattern of distribution test (subsection 267-30(2) and section 267-35 of Schedule 2F to the ITAA 1936)

The tests are designed to determine whether there has been a continuity of ownership or control at all times from the beginning of the year of income in which the loss was incurred, (the loss year), to the end of the year of income in which the loss is sought to be recouped (the income year). The same tests apply to determine the deductibility of debt deductions and current year losses, except that the pattern of distribution test does not apply for current year loss purposes.

In addition to the above tests, it is necessary for non-fixed trusts to also pass the income injection test contained in Division 270 of Schedule 2F to the ITAA 1936.

Subdivision 267-C of Schedule 2F to the ITAA 1936 provides that a non-fixed trust, which is not an excepted trust, needs to work out its current year net income and loss under Division 268 unless it passes:

· if applicable, the 50% stake test (subsection 267-70(2) of Schedule 2F to the ITAA 1936)

· the control test (section 267-75 of Schedule 2F to the ITAA 1936)

It is therefore necessary to apply the relevant tests for non-fixed trusts to the Trust to determine deductibility of prior year losses and the calculation of current year losses.

As a family trust is an excepted trust, the above tests are not relevant, except the income injection test, when the Trust became a family trust.

1. The 50% Stake Test for non-fixed trusts

When determining the deductibility of prior year losses, if at any time during the relevant period, there are individuals who have more than a 50% stake in the income or capital of the trust, then the 50% stake test in subsection 267-40(2) of Schedule 2F to the ITAA 1936 needs to be passed.

When determining whether the special rule in Division 268 applies to the calculation of current year losses, if at any time during the relevant period, there are individuals who have more than a 50% stake in the income or capital of the trust, the trust must meet the 50% stake test in subsection 267-70(2) of Schedule 2F to the ITAA 1936.

Under section 269-50 of Schedule 2F to the ITAA 1936, to have more than a 50% stake in the income or capital of the trust, an individual must have "fixed entitlements" to more than 50% share of the income or capital of the trust. Pursuant to section 272-5 of Schedule 2F to the ITAA 1936, to have a "fixed entitlement", a beneficiary must have a vested and indefeasible interest in a share of income or capital of the trust.

As the beneficiaries do not have an indefeasible interest to the income nor capital of the Trust this test does not apply

2. The Control Test

When determining the deductibility of prior year losses, under section 267-45 of Schedule 2F to the ITAA 1936, to pass the test, a group must not during the test period (ie from the beginning of the loss year to the end of the income year), begin to control a trust directly or indirectly.

When determining whether the special rule in Division 268 applies to the calculation of current year losses, there is the same requirement under section 267-75 of Schedule 2F to the ITAA 1936.

Subdivision 269-E of Schedule 2F to the ITAA 1936 contains the relevant rules to determine when control exists. The term "control" is defined in subsection 269-95(1) of Schedule 2F to the ITAA 1936. A group is taken to control a non-fixed trust if the group:

· has the power to obtain beneficial enjoyment (directly or indirectly) of income or capital;

· is able (directly or indirectly) to control the application of income or capital;

· is capable of gaining the enjoyment of or control of the application of income or capital;

· is able to influence the trustee;

· is able to remove or appoint the trustees; or

· acquires more than a 50% stake in the income or capital of the trust.

The test period for the control test is:

· Generally the year the relevant deduction was incurred, each intervening income year and the income year for determining the deductibility of prior year losses(Section 267-20 of Schedule 2F to the ITAA).

· The income year for determining whether the special rule in Division 268 applies to the calculation of current year losses.

Based on your submission that there has been no change in the control structure of the Trust since its establishment, there would have been no change in the control of the Trust. Consequently, the control test under section 267-45 of Schedule 2F to the ITAA is passed.

3. Pattern of distribution test.

Under subsection 267-30 of Schedule 2F to the ITAA 1936, a trust must pass the Pattern of Distribution test if a trust distributed income and/or capital:

· in the income year or within two months after it ends; and

· in at least one of the six earlier income years.

The Pattern of Distribution test (POD) requirements are listed in Subdivision 269-D (sections 269-60 to 269-85 of Schedule 2F to the ITAA 1936).Based on your submission that no distributions have been made in the last six years and the Trust will not make a distribution within two months after the end of the income year to which the ruling applies, the Pattern of Distribution test does not apply.

4. Income injection test

The income injection test applies where:

· the trust has a deduction in the income year being examined

· there is a scheme under which:

(i) the trust derives an amount of assessable income

(ii) an outsider to the trust provides a benefit, directly or indirectly, to the trustee or a beneficiary or to an associate of the trustee or beneficiary; and

(iii) a return benefit is provided to the outsider, and

· it is reasonable to conclude that the assessable income has been derived, or the benefits have been provided, wholly or partly (but not merely incidentally) because the deduction is allowable.

Under subsection 270-25(1) of Schedule 2F to the ITAA 1936, an outsider to a family trust is a person other than;

(a) the trustee ; or

(b) a person with a fixed entitlement to a share of the income or capital of the trust; or

(c) the individual specified in the trusts family trust election; or

(d) a member of the individuals family; or

(e) a company, partnership or trust that made an interposed entity election to be included in the individuals family group and the election was in force (including before it was made) when the scheme commenced; or

(f) a fixed trust, company or partnership where, at all times while the scheme was being carried out:

(i) the individual specified in the trusts family trust election; or

(ii) one or more members of the individuals family; or

(iii) the trustees of one or more family trusts, provided the individual is specified in the family trust election of each of those family trusts; or

any combination of the above, had fixed entitlements directly or indirectly, and for their own benefit, to all of the income and capital of the entity.

Under subsection 270-25(2) of Schedule 2F to the ITAA 1936, an outsider to a non-family trust is a person other than;

(a) the trustee ; or

(b) a person with a fixed entitlement to a share of the income or capital of the trust.

From the facts given,

· A deduction (the prior year and current year tax losses) is allowable to the Trust for the relevant income years covered by the ruling, and

· the Trust has derived and will derive an amount of assessable income in the relevant income years, and

· The Company is an outsider to the Trust as it is not the trustee of the trust and it does not intend to make an interposed entity election when the Trust becomes a family trust; and

· under the proposal, The Company, as an outsider to the Trust, will directly provide a benefit to the trustee, to a beneficiary in the trust, or an associate of either the trustee or a beneficiary by paying dividends to the Trust.

However, similar to the example in paragraph 10.32 of the EM, as the dividend income from the outsider will be accumulated, the trustee or the beneficiaries of the Trust have not provided a benefit to The Company in return for the benefit provided by The Company. Furthermore, as the beneficiaries do not have a fixed entitlement to the capital or income of the Trust, it could not be said that a benefit has been provided to the beneficiaries, who are also associates of The Company.

On the basis of the information provided, the income injection test does not apply and the Trust would not be prevented from claiming a deduction for tax losses because of the income injection test.

The Trust is therefore able to apply current and prior year losses generated from rental activities against dividend income.

Part IVA

Part IVA of the ITAA 1936 is a general anti-avoidance provision that can apply in certain circumstances. Part IVA gives the Commissioner the power to cancel a 'tax benefit' (or part of a 'tax benefit') that has been obtained, or would, but for section 177F of the ITAA 1936, be obtained, by a taxpayer in connection with a scheme to which Part IVA applies.

Section 177D of Part IVA of the ITAA 1936 sets out the schemes to which Part IVA applies. If a scheme meets the conditions in paragraphs 177E(1)(a) to 177E(1)(d) of the ITAA 1936, then that scheme shall be taken to be a scheme to which Part IVA applies and the amount of the tax benefit is determined according to section 177E.

Based on the facts provided, the proposal is not a scheme to which Part IVA applies, either under section 177D or 177E of the ITAA 1936. Therefore, Part IVA will not apply to this arrangement.