Edited version of your private ruling

Authorisation Number: 1012503641772

Ruling

Subject: Trust investment loss - exit strategy

Questions and Answers:

1. Is your loss from the sale of the relevant shares deductible under section 8-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

No.

2. Is your loss from the relevant shares a capital loss to be accounted for under the capital gains tax (CGT) provisions in Part 3-1 of the ITAA 1997?

Yes.

This ruling applies for the following period:

Year ended 30 June 2012

The scheme commences on:

1 July 2011

Relevant facts and circumstances

You are the corporate trustee for the trust.

During the year ended 30 June 20XX, you disposed of the shares held in a private research, development and trading company (which is the subject of this private ruling).

During the year ended 30 June 200X, you acquired a minor shareholding in the company, in which the majority shareholder held a large majority of the shares.

Any unconditional takeover by a third party was subject to a 70% acceptance clause.

The company had been operating for over ten years and was reliant on government grants. Historically, the company made large losses each year.

You were its first third party private shareholder. After your investment, the share capital of the company greatly increased.

Throughout the period of investment, the CEO and board of the company believed that, with additional influxes of capital, a real return could be generated for investors via growth in share price and/or the sale of the company assets.

In a meeting, prior to your shareholding in the company, your trustee directors made a conscious decision that a certain percentage of their family net wealth would be invested in high risk, high return investments, i.e., speculative investments.

It was understood that the investment in the company was speculative. The view was the opportunity lay in building the company to a point that would make it attractive as a trade sale for a larger player in the market.

The company business plan for the 200Y year provided investors with an exit strategy from the business, which, however, stated, that it was difficult to define exactly what the exit strategy would be. The exit strategy listed various potential buyers of the company assets, although none of the potential buyers actually approached the company.

This exit strategy was repeatedly mentioned in investor memorandums and presentations issued in later years.

In the later years, after your investment, the company continued to raise needed capital, with the share capital tripling from when you made your investment by 30 June 200Z,

It became evident, to you, over time that the company was unlikely to provide any form of return on the money invested. Throughout the period of investment, you made a decision to continue to support the company through a number of its cashflow crisis', on the understanding that an exit was still possible.

Subsequently, a merger and acquisition specialist was appointed and specifically funded to conduct a process of seeking an exit via a trade sale. However, prior to any trade sale, you made the decision to exit from the investment. It was agreed the founder of the company would purchase your shares.

At the time of acquiring the shares in the company, you also held investments in other high risk, highly speculative start up companies, which were similarly unprofitable.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Income Tax Assessment Act 1997 Section 102-5

Reasons for decision

Trust investments

Taxation Determination TD 2011/21 is about the characterisation of trust income from trustee investments and applies directly to your case, given you are the trustee of an investment trust.

TD 2011/21 follows the general principles established by case law in relation to characterising whether a gain or loss has been made on revenue account or on capital account.

In summary, TD 2011/21 provides the mere fact that a gain or loss from an investment is made by an entity in its capacity as trustee of a trust is not conclusive as to whether the gain or loss is on revenue or capital account for tax purposes.

Paragraph 56 of TD 2011/21 states factors which tend to support a capital account conclusion include:

§ the absence of an investment style which envisages an exit point - for example the trustee adopts a 'buy and hold' style of investment;

§ a low average annual turnover - that is, less than in London Australia where turnover had been in the order of 10%;

§ a lack of regularity in the particular sale activity;

§ a high proportion of those stocks that are sold have been held for a significant number of years (see AGC Investments where 75% of stocks sold was held more than 5 years). However, if a high proportion of the remainder are then also turned over, this tends to support the opposite conclusion;

§ a low level of sales transactions compared with the number of stocks in the portfolio;

§ profits on sale normally only constitute a small percentage of total income;

§ significant percentage of 'aged' stocks remain in the portfolio; and

§ the existence of a family as distinct from a commercial explanation for the dealing.

Paragraph 16 of TD 2011/21 includes the following theoretical example:

Example 3: add-value and exit investment strategy

Z is the trustee of a trust established for a period of 10 years. The trust deed defines the trust's investment strategy by reference to the information memorandum issued to investors. The information memorandum indicates that the trust will acquire a majority shareholding in one or more companies, actively manage those companies to add to their value and then sell the shares at a profit when a specified rate of return has been reached (usually within 3 to 5 years ). The information memorandum states that the trust is speculative, illiquid and a risky investment, and that the principal return to unitholders will be sourced in the profit anticipated upon the sale of the trust's assets. In accordance with the trust's investment strategy, directors are appointed to the companies' boards and acquired companies are actively managed with a view to their value increasing, for example by leverage, restructuring or asset sales. All of the shareholdings in the acquired companies are sold within 5 years, and some within 12 months, of acquisition. Having regard to the information memorandum and the trustee's duties under the trust deed, it is clear that the trust exists for the purpose of generating a return to investors from profit making undertakings involving the acquisition and disposal of the target companies. In these circumstances, the gains and losses on the sale of the shares in the relevant companies would be on revenue account.

Isolated commercial transactions

Taxation Ruling TR 92/3 is about whether profits on isolated transactions are income, i.e., whether an isolated transaction is a "commercial" (rather than capital) transaction. TR 92/3 explains:

7. The relevant intention or purpose of the taxpayer (of making a profit or gain) is not the subjective intention or purpose of the taxpayer. Rather, it is the taxpayer's intention or purpose discerned from an objective consideration of the facts and circumstances of the case.

9. The taxpayer must have the requisite purpose at the time of entering into the relevant transaction or operation. If a transaction or operation involves the sale of property, it is usually, but not always, necessary that the taxpayer has the purpose of profit-making at the time of acquiring the property.

As examples of isolated commercial transactions, TR 92/3 highlights the High Court of Australia cases of Federal Commissioner of Taxation v. The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693 (Myer) and Federal Commissioner of Taxation v. Whitfords Beach Pty Ltd (1982) 150 CLR 355; 82 ATC 4031; 12 ATR 692 (Whitfords Beach).

In the Myer case, the taxpayer lent $80 million to a subsidiary for a period just exceeding 7 years at an interest rate of 12.5% per annum. Three days later, as had always been intended, the taxpayer assigned to a finance company its right to receive the interest payable over the remainder of the loan period. As consideration for the assignment, the finance company paid the taxpayer $45.37 million in a single sum. The Full High Court held the amount was both income according to ordinary concepts and a profit arising from the carrying on or carrying out of a profit-making undertaking or scheme.

In the Whitfords Beach case, the court decided a subdivision of land was done in the course of what was a business venture. In 1954, the taxpayer company acquired land north of Perth to secure, for the original shareholders, access to fishing shacks, which they occupied for a recreational purpose. On 20th December 1967, all the shares in the taxpayer company were bought by three companies, which had not previously been shareholders. The three companies bought the shares only to obtain control of the land, and with the intention that the taxpayer would cause the land to be developed, subdivided and sold at a profit. Gibbs CJ concluded the taxpayer was transformed from a company which held land for the domestic purposes of its shareholders to a company whose purpose was to engage in a commercial venture with a view to profit.

In respect to a characteristic of many isolated commercial transactions, Mason J, in Whitfords Beach, highlighted the activity of improving an asset for resale, where he said at 82 ATC 4047:

However, apart altogether from this factor, the facts previously mentioned show that there was involved more than mere realization of an asset. Deane J. was right in pointing to the circumstance that the asset was divided and improved in the course of a business of dividing and improving the asset….All this amounts to development and improvement of the land to such a marked degree that it is impossible to say that it is mere realization of an asset. We need to bear in mind that the subdivision of broad acres into marketable residential allotments involves much more in the way of planning, development and improvement than was formerly the case.

Paragraph 48 of TR 92/3 mentions, in Myer , the High Court did not set out guidelines as to what constitutes a business operation or commercial transaction, however, it did regard the following instances as being such operations or transactions:

(i) In California Copper Syndicate Ltd v Harris (Surveyor of Taxes) (1904) 5 TC 159, the company acquired copper-bearing land in California but had insufficient funds to mine the copper. The land was sold to another company at a profit in consideration of an allotment of shares in that company. The profit was held to be income in nature because it was always the company's intention to profit from the sale of the land.

(ii) In Ducker v. Rees Roturbo Development Syndicate Ltd [1928] AC 132, a company, engaged in exploiting a particular invention by granting licences under patents, acquired additional patents in relation to the invention and, as always contemplated, sold those patents at a profit.

(iii) In Edwards v. Bairstow [1956] AC 14, a partnership purchased a complete spinning plant with a view to resale at a profit, having no intention of using the plant to derive income from spinning, and later sold the plant at a profit.

In addition, paragraphs 78 to 84 of TR 92/3 include the following theoretical examples:

Example 4

Mr Goldfinger purchased a number of gold bars for $100,000 and, following a sharp rise in the price of gold, sold the gold bars one week later for $110,000. Goldfinger did not carry on a business and had no previous dealings in gold. The profit of $10,000 is income and assessable…. It can be inferred from the objective circumstances (especially the quick sale following a rise in price and the fact that the asset had no immediate use other than as an object of trade) that profit-making was a significant purpose of Goldfinger in acquiring the gold bars. Furthermore, the substantial amounts of money involved and the nature of the asset traded lead to the conclusion that the transaction was commercial in nature.

Example 5

Hungry Ltd, a public company, made a takeover bid for another public company, Morsel Ltd, in which it already held a 15% interest. Shortly after, Ravenous Ltd also made a takeover bid for Morsel. Ravenous' takeover bid was successful and Hungry's failed. Hungry sold to Ravenous the shares it had acquired in Morsel at a large profit. Hungry was a holding company in a group of companies. Many of the entities in the company group had previously been involved in takeovers of other companies. Hungry had not previously been involved in a takeover attempt and had only disposed of shares in the course of restructuring the company group. From the time Hungry began to acquire shares in Morsel the directors of Hungry had hoped to acquire control of Morsel - they were not interested in a 'passive investment'. The contingency plan of the directors in the event that control could not be obtained was to dispose of the shares in Morsel at a profit. The profit on the sale of the shares is income. A substantial, but not dominant, purpose of Hungry in acquiring the shares was to dispose of them at a profit because the contingency plan was to dispose of the shares at a profit. Furthermore, the acquisition and sale of the shares was effected in the course of the taxpayer's business.

Example 6

Conglomerate Ltd, a large public company, made a takeover bid for Awful Ltd, the owner of lands containing a large mineral deposit. Conglomerate intended to obtain control of Awful and expedite the mining of the deposit. The takeover bid was unsuccessful and Awful did not commence mining operations. Conglomerate held its Awful shares for about 2 years before selling the shares at a profit. Assuming that the unsuccessful takeover bid was not made in the ordinary course of Conglomerate's business, the profit on the sale of the shares is not income. The evidence shows that Conglomerate acquired the shares to obtain control of Awful and derive dividends generated by mining activities of that company, not to make a profit from the sale of the shares.

Private equity

Taxation Determination TD 2010/21 provides the profit on the sale of shares in a company group acquired in a leveraged buyout (LBO) can be included in the assessable income of the vendor under subsection 6-5(3) of the ITAA 1997 .

Similar to TD 2011/21, TD 2010/21 provides whether a profit so gained will be ordinary income or a gain of a capital nature will depend on all the circumstances of the particular case. The facts of each case can vary and each case has to be determined on its own merits.

About LBO acquisitions, paragraph 14 of TD 2010/21 explains the Commissioner understands that private equity LBO acquisitions involve:

§ the direct or indirect acquisition of interests (such as shares) in a target entity (such as a company) using investor equity and substantial borrowed amounts (leverage);

§ the holding of those interests for a period during which operational improvements are usually made (such as improving the management and cost structure of the target entity) to increase earnings over the life of the investment and improve the value of the target entity; and

§ the acquisition of those interests with the intention of resale at a profit and the subsequent realisation of a profit

Paragraph TD 2010/21 provides the following theoretical example:

Offshore Co is a Cayman Islands entity. Its equity is primarily owned indirectly by non-Cayman Islands resident investors. Offshore Co acquires an Australian public company in a LBO with the intention of restructuring its activities and re-floating the company on the Australian Securities Exchange within a three year time frame. It will have low or negative returns until the realisation of the investment because of interest costs and management expenses. Offshore Co's profit from this arrangement arises from carrying out a commercial transaction entered into for the purpose of profit-making by sale rather than from a mere realisation of assets. Consequently, the profit constitutes income according to ordinary concepts for the purposes of section 6-5 (see Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income). The characterisation of this gain as constituting ordinary income is not changed because the non-resident investors in Offshore Co may be superannuation funds and managed funds that indirectly hold interests in Offshore Co.

Paragraph 18 of TD 2010/21 mentions, in respect to a non-resident of Australia, if the profit made on the disposal of the Australian target assets is not ordinary income, a capital gain or capital loss from the disposal of the assets would usually be disregarded for Australian income tax purposes if made by a non-resident of Australia (under section 855-10 of the ITAA 1997).

Venture capital

The Macquarie Dictionary, [Multimedia], version 5.0.0, 1/10/01 defines the term 'venture capital' as:

….money invested in high-risk, newly established companies in the expectation that the returns will justify the risks taken…

In 2002, a venture capital regime was introduced into the Australian taxation legislation to provide an incentive for foreign investors from specified countries to invest in the Australian venture capital industry and to provide a source of equity capital for relative high risk and expanding businesses who find it difficult to attract investment through normal commercial mechanisms. For the 2007-08 year and later income years, the venture capital regime was expanded to provide tax concessions for Australian residents and foreign residents investing in early stage venture capital activities through a new investment vehicle called an early stage venture capital limited partnership (ESVCLP).

The venture capital tax concession is jointly administered by the Australian Taxation Office under the ITAA 1997 and the Income Tax Assessment Act 1936 and by Innovation Australia (the Board) under the Venture Capital Act 2002.

The primary legislative references for the 2002 venture capital tax concession include:

§ Subdivision 118-F of the ITAA 1997 

§ Sections 26-68, 51-52 and 51-54 of the ITAA 1997, and

§ the Venture Capital Act 2002.

In summary, the purpose of the venture capital concessions is to exempt from income tax the capital gains and losses arising in relation to an eligible venture capital investment, if the required conditions are met.

Also related to venture capital is CGT event K9 under section 104-255 of the ITAA 1997. Here, an individual venture capital manager's entitlement to a payment of carried interest is a CGT event. The manager makes a capital gain at the time an entitlement to receive a payment arises. The capital gain is a discount capital gain if the carried interest arises under a partnership agreement that was entered into at least 12 months before the CGT event happened and the other requirements for the discount are met.

Speculators

Gain and losses from share market activities can be accounted for in three ways:

1. As ordinary income, from carrying on a business of share trading, under sections 6-5 and 8-1 of the ITAA 1997.

2. As capital gains and losses, from investment activity, under the CGT provisions in Part 3-1 of the ITAA 1997.

3. As capital gains and losses, from speculation, under the CGT provisions in Part 3-1 of the ITAA 1997. (In general, section 25-40 of the ITAA 1997 prevents speculative share losses from being deducted on revenue account.)

The distinction between a 'share trader' (carrying on a business of share trading), a 'shares investor' and a 'shares speculator' has been established in many court and Tribunal cases

In Case X86 90 ATC 621; AAT Case 6297 (1990) 21 ATR 3747 and Case 15/2004 2004 ATC 301; [2004] AATA 1293, 58 ATR 1059, the taxpayers were deemed to be speculators because they used their limited capital to make individual forays in particular stocks with a view to resale. As speculators, it was held their share market losses were to be accounted for on capital account. Respective excerpts from the decisions in these cases are as follows:

The Tribunal accepts the applicant's evidence in this case that his intention was at all times to maximise his profits from the sale of his share acquisitions. This does not however inevitably lead to the conclusion that he was engaged in a business of share dealing and accordingly that he was a share trader. It is necessary to consider not only the applicant's subjective intent, but also the objective surrounding circumstances. The applicant invested $100,000 in the share market. His resources were limited, so he did not employ sophisticated share-trading techniques in the management of his share acquisitions. He did not however operate to any particular plan apart from his goal of maximising profits. There were no contingency plans in place should conditions in the share market deteriorate, as they did, dramatically, in October 1987. This is evidenced by the fact that although opportunities for sale at a modest profit presented themselves to the applicant he preferred to hold on to his shares in the hope of much larger gains.

... he was, a speculator in mining and oil exploration shares who, having had only very modest and infrequent share transactions before the onset of Australia's minerals boom, during the period of the boom, indulged in quite considerable stock market speculations and did so with remarkable success. Those speculations were, I think, viewed by him as, and indeed had the character of, individual forays in particular stocks which he bought with a view to resale. To regard such shares as trading stock…is to give both them and the whole of the taxpayer's speculative activities a colour which they never bore.

Application of law in your case

In your private ruling application, you made reference to concepts such as "private equity", "venture capital" and "high risk speculation" to support your case for a revenue deduction. As shown in the principles cited above, transactions arising from "venture capital" and "high risk speculation" are not inherently revenue in nature. To the contrary, they are inherently capital in nature, unless the particular circumstances deem them otherwise. As for "private equity", your situation was not a leveraged buyout transaction (the topic of TD 2010/21).

In your case, the principles explained in TD 2011/21 are directly relevant. Here, the factors listed in TD 2011/21 support a capital account conclusion applies to your investments in general, including in the relevant company, namely: (i) the absence of an investment style which envisages an exit point, where you, as trustee, adopted a 'buy and hold' style of investment; (ii) a high proportion of stocks that are sold having been held for a significant number of years; and (iii) a significant percentage of 'aged' stocks remain in the portfolio.

Example 3, in TD 2011/21, is about an 'add-value and exit investment strategy', which falls on revenue account, where the trust acquires a majority shareholding in one or more companies, actively manages those companies to add to their value and then sell the shares at a profit, when a specified rate of return has been reached. In your case, your shareholding is distinguished from this example, since you did not acquire a majority shareholding and, thus, were not in a position to activity manage the company, to add to its value and manage control over your exit time.

Instead, you only provided equity finance as a small minority shareholder to a loss making company, with the highly speculative goal the company could develop some assets and/or improve their current operations to give you a return on your investment. In short, contrary to example 3 in TD 2011/21, your relationship with the company was as a passive investor rather than as actively managing the company.

Further, the company plan for the 200Y year and later investment presentations show an exit point was unable to be tangibly defined. Instead, the information about an exit point appeared speculative and hopeful; merely listing general market participants that the company envisaged could be possible buyers (rather than, for example, potential buyers that actually approached the company).

Contrary to example 5 in TR 92/3, there is no evidence in the company documents provided that there was any tangible and identifiable takeover interest in the company at the time you made your initial investment.

In your private ruling application, you emphasised there was an exit strategy in relation to your shareholding. As stated above, we consider your investment style had an absence of the kind of exit point referred to in TD 2011/21 characteristic of an isolated commercial transaction.

In summary, our overall impressions of your situation are as follows:

(i) The impression of, at the time of your investment, there was no evidence of any takeover or asset acquisition interest in the company or its assets.

(ii) Although we acknowledge the speculative nature of your venture capital investment, the impression of your acquisition at a 27 times revenue multiple would reduce your probability of exiting at a profit. In other words, this purchase valuation supports our ultimate view that your transaction was not a 'commercial' or 'business' transaction, but, instead, a 'speculative' transaction.

(iii) The impression that the exit strategy of the company was speculative and generalised, where the company, seeking a trade sale of their assets, approached numerous companies, resulting in far less expressions of interest and far less preliminary due diligences but, after a number of years, no ultimate successful trade sale.

(iv) The impression that the exit strategy described in your private ruling facts was the corporate exit strategy of the company rather than your individual exit strategy; that you were unable to define an exit strategy independent of a company exit strategy.

(v) The impression that you, being a minority shareholder, had no control or ability to implement an exit strategy in relation to the sale of the company business assets.

(vi) The impression of, as a minority shareholder, your only reasonable exit point was to sell your shares, as an ordinary passive shareholder.

(vii) The impression of, as the company was a private, loss making and largely a product development company (in terms of its dependence on government grants), your minority shareholdings were relatively illiquid, could not be disposed of on a public exchange and probably could only be sold to another, and, possibly not easily available, highly speculative investor. (Ultimately, you sold your shares to the company founder.)

(viii) Since you were the first major third party private (equity) financier of the company, the impression that your transaction did not have the features of an isolated commercial transaction where funds were used to purchase an asset that had no use other than as the subject of trade. Instead, the impression gained is your funds were used in a financing arrangement, i.e., to purchase a small (non-controlling) equity interest in a private company, where your funds could be used and ultimately consumed as working capital by that private company rather than being specifically used to enhance an identifiable asset that could be sold.

(ix) The impression the company remained highly dependent on further financing (capital raisings) to implement its strategies, further inhibiting your ability to exit. As stated in your private ruling application: "Throughout the period of investment, the CEO and board of the company believed that, with additional influxes of capital, a real return could be generated for investors via growth in share price and/or the sale of the company assets".

(x) This impression, that you could not profitably exit your investment without further company financing from other investors, is demonstrated by the growth in the share capital of the company, from a modest amount prior to your share purchase, to a signifigantly larger amount at 30 June 200X which then tripled by 30 June 200Z.

(xi) In summary, the impression gained is you made an investment in what was essentially an unprofitable, cash poor and largely government funded research and development orientated company that required financing from you and other investors to speculatively improve their existing assets or develop new (unproven) assets and to maintain their sales operations.

It follows your absence of: (i) a readily definable and saleable asset; (ii) a readily implementable exit strategy, within your control; and (iii) whilst not essential, the absence of any asset you could take direct action to improve and add value to; are salient features that distinguish your case from examples of the notable isolated commercial transactions, such as Myer, Whitfords Beach and Offshore Co, cited in the Tax Office interpretative positions.

In those cases, the defining of the particular stages of the transaction, the improvement of the value of the investment and the envisaging of an exit point was largely within the control of the taxpayer.

In the case of Myer, once the taxpayer established the loan with their subsidiary, they were able to place the loan on the market for sale. The creation, development, improvement and/or marketing of the loan asset was within the control of Myer and thus was an asset that had the primary features of a subject of trade.

In Whitfords Beach, as a property subdivision, the stages of planning, development, improvement and sale were clearly defined and within the control of the investor. The very nature of a subdivision was the creation of individual assets that have the primary features of subjects of trade.

Similarly, in the theoretical example of Offshore Co, being a leveraged buyout, once the existing business asset purchased was restructured, it could be placed on the market for sale.

Although a profit from sale is naturally dependent on general market conditions, the capacity to purchase, add value to, repackage and/or exit the investment falls largely within the control of the taxpayer.

For more simple isolated commercial transactions, such as the theoretical example of Mr Goldfinger in TR 92/3, the investor purchases an asset that is readily saleable in a market were trading is common place. By taking a quick and available profit, the transaction may be deemed an isolated commercial transaction, dependent on the circumstances.

However, as previously stated, in your case, you only provided equity finance, as a small minority shareholder to a loss making company, which could be used as working capital, with the highly speculative goal the company could develop some assets and/or improve their current operations to give you a return on your investment.

In short, we regard your transaction had the salient features of speculative investing. This speculative investing is of the same genre found in your other investments mentioned in the ruling facts. This speculative investing was the fulfilment of the stated conscious decision of your trustee directors that a certain portion of their family net wealth would be invested in high risk high return investments, i.e., speculative investments.

As 'speculative' investments or transactions (rather than 'business' or 'commercial' transactions), the tax treatment falls on capital account, as ruled in AAT Case 6297 and Case 15/2004.

In conclusion, following the principles in TD 2011/21, we consider your trust to have both a highly speculative and highly passive investment style, which, characteristically, under the history of tax law, is capital in nature. We consider your transaction did not hold any compelling attributes to characterise it differently from your other passive investments. We consider your transaction similar to your other investments, which are/were primarily in speculative high risk start up companies that operate in high risk and quickly changing industries. If these companies did not perform, then exiting at a profit, or even being able to exit at all, was difficult or impossible.

Our conclusion is supported by the absence of any sale or dividend income in your income tax returns for the years ended 30 June 200V and 20YY and by the poor reported financial performance of your investee companies. This supports the primary indicators in TD 2011/21, of a significant percentage of 'aged' stocks remaining in a portfolio and the absence of envisageable exit points.