Edited version of your written advice

Authorisation Number: 1012927255521

Date of advice: 14 December 2015

Ruling

Subject: Trading Trusts

Question 1

Is the Trust considered to be a 'trading trust' for the purposes of Section 102N of the Income Tax Assessment Act (ITAA) 1936?

Answer

No

Question 2

Is the Trust considered to be a 'public trading trust' for the purposes of Section 102R of the ITAA 1936?

Answer

No

This ruling applies for the following periods:

1 July 2014 to 30 June 2019

The scheme commences on:

1 July 2014

Relevant facts and circumstances

• The Trust was established in 19XX

• The Trust is a unit trust with a sole unit holder

• The applicant is a trustee company with a sole company shareholder

• The company shareholder is an income tax exempt entity

• The Trust is a public unit trust for the purposes of section 102P(2) of the Income Tax Assessment Act (ITAA )1936

• The Trust derives income in the form of interest and dividends in respect of its investments

• The Trust has an investment (Investment) in a company

• Since 20YY the Trust has held % of the investment shares. The balance of the shares is held by unrelated entities. Entity 1 holds % of the shares while Entity 2 holds the residual % of the shares

• The Investment's constitution provides that the ordinary shares confer the right to cast one vote at a general meeting of the Company

• In 20XX the Trust and all shareholders executed a Shareholders' Agreement (Agreement) in relation to the Investment. The Agreement provides that in the case of any inconsistency between the Agreement and the constitution of the Investment, the provisions of the Agreement prevail

• Under the Agreement the Investment must have more than five directors at all times. The Agreement provides that the Trust may appoint less than five directors, Entity 1 may appoint X directors and Entity 3 may appoint Y director

• Each director, under the Agreement, is entitled to exercise one vote at the director meetings. If all directors of the Trust and Entity 1 are not present, then those present are entitled to vote in a manner that the votes of the absent directors are counted

• The Agreement provides that the Chairman of the Board of the Investment will be appointed by Entity 1 while it holds % or more of the of the voting shares in the company

• All decisions of the Board or the shareholders in general meetings are made by Simple Majority Vote. The Agreement states that certain decisions of the Board must be unanimous, or failing this, must be put to the shareholders who must agree by Special Majority Vote

• Under the Agreement the Chairman of the Board of the Investment is appointed by Entity 1 while it holds % or more of the shares in the Investment. If the votes are equal at a Board of Directors meetings the Chairman will have the casting vote in addition to the vote as entitled as a director

• The Trust's only other activity is to hold passive investments in publicly listed companies, term deposits and other financial assets

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 6C

Income Tax Assessment Act 1997 section 50-15

Reasons for decision

Division 6C provides a statutory exception to the Division 6 system of trust taxation. Under Division 6C, a public unit trust which is conducting or engaged in a trading business - that is, anything that is not wholly eligible investment business - will be taxed as a corporation. The main operative provisions are in section 102T.

Subsection 102R(1) provides that for a trust to be a public trading trust in relation to the relevant year of income it must be :

• a unit trust

• a public unit trust

• a trading trust

• a resident unit trust; or must have been a public trading trust in relation to a year of income before the relevant year of income; and

• not a corporate unit trust within the meaning of Division 6B

Paragraph 102N(1)(a)

The Applicant has submitted that the Trust does not carry on a trading business under section 102N(1)(a) of ITAA 1936 and therefore does not meet the definition of a trading trust. It submits the trading business is conducted by the Investment. Further it submits under section 102N(1)(b) the Trust has not controlled or had the ability to directly or indirectly control the affairs or operations of the Investment (as the trading business).

Unit Trust

The Trust is agreed to be a unit trust as its beneficial interest is unitised.

Trading Trust 

Section 102N provides that a unit trust is a 'trading trust' if, at any time during the year of income, it:

• carries on a trading business; or

• controls, or is 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 regard to the meaning of 'trading business', section 102M provides that:

• a 'trading business' is '…a business that does not consist wholly of eligible investment business';

• 'eligible investment business' means one or more of:

• investing in land for the purpose, or primarily for the purpose, of deriving rent; or

• investing or trading in any or all of the following:

• secured or unsecured loans (including deposits with a bank or other financial institution)

• bonds, debentures, stock or other securities

• shares in a company including shares in a foreign hybrid company (as defined in the Income Tax Assessment Act 1997)

• units in a unit trust

• futures contracts

• forward contracts

• interest rate swap contracts

• currency swap contacts

• forward exchange rate contracts

• forward interest rate contracts

• life assurance policies

• a right or option in respect of such a loan, security, share, unit, contract or policy

• any similar financial instruments; or

• investing or trading in financial instruments (not covered by paragraph (b)) that arise under financial arrangements, other than arrangements excepted by section 102MA

('Financial arrangements' is defined in Div 995 of the ITAA 1997 and has the meaning given by sections 230-45 to 230-55 of the ITAA 1997).

The meaning of 'investing in' is a necessary consideration in ascertaining if an 'eligible investment business' is investing in units in a unit trust.

Investing In

The term 'investing in' is not defined for the purposes of Division 6C. Accordingly, reference is to be made to the ordinary meaning of the term (taking into account any relevant case law).

The Macquarie Dictionary defines 'investing' as:

to put (money) to use, by purchase or expenditure, in something offering profitable returns, especially interest or income

A number of cases have considered the meaning of the word 'invest', including:

Marks and Ors v Roe and Ors (unreported judgement of 28 May 1996) where Mandie J noted that:

As to the meaning of 'invest' and 'investment' in this context, the applicants referred to what was said by PO Lawrence, J in In re Wragg [1919] 2 Ch 58, 64-65 that: 'Without attempting to give an exhaustive definition of the words 'invest' and 'investment', I think that the verb 'to invest' when used in an investment clause may safely be said to include as one of its meanings 'to apply money in the purchase of some property from which interest or profit is expected and which property is purchased in order to be held for the sake of income which it will yield…' .' In re Wragg was a case involving the construction of an investment clause in a trust deed and, even so, His Lordship did not purport to give an exhaustive definition. I think that in ordinary commercial usage the words 'invest' and 'investment' in relation to shares have a connotation of laying out money in their purchase with a purpose of yielding profit (whether that profit arises by way of dividends, capital appreciation or otherwise)

Inland Revenue Commissioners v. Rolls-Royce Ltd [1944] 2 All ER 340, where it was considered by MacNaghten J whether royalties could be said to be 'income derived from investments' for the purposes of the Finance Act 1939, relevantly noting at p341 that:

The word 'investment', though it primarily means the act of investing, is in common use as meaning that which is thereby acquired; and the primary meaning of the transitive verb 'to invest' is to lay out money in the acquisition of some species of property; consequently, letters patent, which are undoubtedly a species of property, may properly be described as an investment

Melville v. Mutual Life and Citizens Assurance Co Ltd (1980) 31 ALR 649, where Lockhart J stated (in interpreting a provision of the Life Insurance Act 1945 preventing the assets of a statutory fund from being invested in any company carrying on life insurance) that (at p653):

'Invest' is not defined in the Act. It is defined by the Shorter Oxford English Dictionary, so far as relevant, as meaning: 'to employ (money) in the purchase of anything from which interest or profit is expected... to make an investment... colloq. to lay out money

Accordingly, the act or action of 'investing' should generally exhibit the following characteristics:

• money is outlaid, applied or employed; and

• interest or profit is expected from the thing on which the money has been outlaid, applied or employed.

Therefore, under section 102N(1)(a) of the ITAA 1936, the Trust is not considered to be a trading business as its portfolio only consists of the shares in the Investment and passive investments in publicly listed companies, term deposits and other financial assets.

Paragraph 102N(1)(b)

Section 102N provides that a unit trust is a trading trust if the trustee controls or is 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. This requires an understanding of what constitutes 'control', and what are the affairs or operations of another person.

Control

Generally, the question of control arises not by virtue of the level of ownership (each Investor Trust generally owns less than % of the Operating Entity), but because of the existence of a power of veto in various constituent documents and other agreements which may be exercised by an investor or an entity acting on behalf of the investor (for example, a director of Operating Entity appointed by the investor).

They are referred to as a 'power of veto' because they allow the investor (or person acting on behalf of the investor) to prevent or block a decision being made by the Operating Entity on a particular topic.

There are a range of different types and sources of these veto powers. Broadly they relate to matters concerning Investor Trust's investment in Operating Entity and matters related to the running of Operating Entity. They generally require the approval of a 'super-majority' of investors or persons acting on behalf of the investors. They tend to be in respect of, or a mixture of:

(a) the actual business functions and activities of the trading business of Operating Entity, or

(b) the governance and management of its business or structure (e.g. board membership, dividend policy)

The key question is if, and when, the existence of such veto powers will be considered sufficient to give the investor trusts 'control' of the Operating Entity.

Specifically, under paragraph 102N(1)(b) of the ITAA 1936, the Trust would only be a trading trust in relation to a year of income, if it was considered to control, or be able to control, directly or indirectly, the affairs or operations of the Investment in respect of the Investment's carrying on of its trading business.

The term 'control' or 'controlled' is not defined for the purposes of Division 6C of Part III of the ITAA 1936. Accordingly, its meaning must be construed by reference to its normal meaning.

'Control' is defined in the Macquarie Dictionary, 2001, rev. 3^rd edn, the Macquarie Library Pty Ltd, NSW:

1) To exercise restraint or direction over; dominate, command

2) To hold in check, curb

Therefore, the concept of 'control' encompasses both the positive aspect of directing or commanding and the negative aspect of restraining. The view that power of veto constitutes control for the purposes of paragraph 102N(1)(b) of the ITAA 1936 is adopted in ATO Interpretative Decision ATO ID 2003/162 Public trading trust - meaning of control and ATO ID 2011/11 Trading trust: meaning of 'control' and 'affairs or operations' of another person.

The control of a company may operate at both the shareholder and director level. Shareholders exercise control by means of majority voting rights as well as negative control. Mahoney JA in North Sydney Brick & Tile Co Ltd v. Darvall & Anor (1986) 10 ACLR 837 at 844 commented on a shareholder's negative control:

The part that a shareholder plays in the restrictions imposed by these articles is, in a sense, negative rather than positive: they empower him to prevent … but do not authorise him to permit … But a power to prevent, in this sense, may constitute a power to control within the section

The respective roles played by shareholders and directors were summarised by Stephen, Mason and Wilson JJ in FCT v. Commonwealth Aluminium Corporation Ltd (1980) 143 CLR 646 at pp 659-60:

… Important decisions, whether involving questions of policy or not, are invariably taken by the directors who are ultimately responsible to the company in general meeting for the conduct of the business operations. The shareholders, through their power to control the company in general meeting and perhaps through their power to elect directors, may be said to control the company, but as a general rule they do not exercise de facto control of the company's business

The words 'able to control' require a present ability to control, whether or not that ability is exercised, but does not include a power by some means or other to obtain the ability to control if that power is not exercised. In WP Keighery Pty Ltd v FC of T (1959) 100 CLR 66 at pp 86-87, Dixon CJ, Kitto and Taylor JJ said:

But to describe a company as capable of being controlled by a person or group of persons is to attribute to that person or group a presently existing power of control. 'Capable of being controlled' in this context cannot be interpreted so widely as to be satisfied whenever a possibility of obtaining control over a company exists by reason of something in its constitution or its special circumstances … The truth is that 'capable of being controlled' connotes the existence of either one person whose enforceable and immediately exercisable rights enable him to control, or a number of persons whose enforceable and immediately exercisable rights enable them, if they act in concert, to control

The affairs or operations of another person

The effect of the words 'directly or indirectly' imply that although the trustee may not, in fact, control or be able to control the affairs or operations of another person, they do so or may do so through their control of an interposed entity (British American Tobacco Co Ltd v. Inland Revenue Commissioners (1943) AC 335). In this case, there is no interposed entity between the Trust and the Investment.

The terms 'affairs' and 'operations' are not defined in the legislation. The Macquarie Dictionary, relevantly, defines 'operation' as follows:

• A course of productive or industrial activity

• A particular course or process

• A business transaction, especially one of a speculative nature or on a large scale

Therefore, the meaning of 'operations' is quite narrow. We regard it as a reference to the day-to-day business of the company.

The term 'affairs' has a much broader meaning. Winn J in R v. Board of Trade, ex parte St Martin Preserving Co Ltd [1964] 2 All ER 561 AT 568, 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

For the purposes of Division 6C of Part III of the ITAA 1936, it is reasonable to adopt this broad meaning, given the context within which the provision is intended to operate, as evidenced from the Explanatory Memorandum to the Taxation Laws Amendment Bill (No. 4) 1985 (which introduced Division 6C):

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 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

This broad meaning of 'affairs' is adopted in ATO Interpretation Decision ATO ID 2011/11. In ATO ID 2011/11, it was held that 'affairs or operation' encompass structure, scope and management of the company. However, the relevant affairs and operations to which paragraph 102N(1)(b) are concerned are those that go to the trading business actually being carried on.

The Trust holds % of the shareholding in the Investment and is entitled to appoint two of the six directors. The remainder of the shareholding is held by two unrelated entities. The Chairman is appointed by the majority shareholder, Entity 1. The Chairman holds a casting vote if shareholder votes are tied. The Trust is not in the position to appoint a Chairman under the Agreement unless it increases its shareholding. The Trust may vote with the majority shareholder, Entity 1, to achieve a majority vote however it cannot achieve a majority when it votes with Entity 2.

The Trust cannot achieve a majority vote or affect the outcome of a vote unless it collaborates with another Investment shareholder or increases its shareholding. Based on the facts provided, the Trust does not have positive or negative control over the Investment in respect of the carrying on by the Investment of its trading business. Therefore, section 102N(1)(b) of the ITAA 1936 will not apply to the Trust as a result of its investment in the entity.

Public Trading Trust

Division 6C of the ITAA 1936 considers the tax liability of certain public trading trusts. Subsection 102R(1) of Division 6C provides that a trust is a public trading trust in a relevant year of income if it is:

• a unit trust; and

• a public unit trust; and

• a trading trust; and

• a resident unit trust.

It must also not be considered to be a corporate unit trust within the meaning of Division 6B of the ITAA 1936.

Accordingly, as the Trust is not a trading trust it is not possible for it to be a public trading trust in terms of section 102R(1) of Division 6C of the ITAA 1936.