Edited version of your written advice

Authorisation Number: 1012927451301

Date of advice: 14 December 2015

Ruling

Subject: Fixed entitlements to income and capital of the trust

Question 1

Will the Members of the Trust have 'fixed entitlements' to all of the income and capital of the Trust as defined in subsection 995-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997) and subsection 272-5(1) of Schedule 2F to the Income Tax Assessment Act 1936 (ITAA 1936) such that the Trust will be a 'fixed trust' under section 272-65 of Schedule 2F to the ITAA 1936 and subsection 995-1(1) of the ITAA 1997?

Answer

No

Question 2

Will the Commissioner exercise the discretion in subsection 272-5(3) of Schedule 2F to the ITAA 1936 to deem the Members of the Trust as having fixed entitlements to all of the income and capital of the Trust such that the Trust will be a fixed trust under section 272-65 of Schedule 2F to the ITAA 1936 and subsection 995-1(1) of the ITAA 1997?

Answer

Yes

Question 3

Is the Trust a 'public trading trust' for the purposes of Division 6C of Part III of the ITAA 1936?

Answer

No

This ruling applies for the following periods:

• Income year ending 30 June 2016

• Income year ending 30 June 2017

• Income year ending 30 June 2018

• Income year ending 30 June 2019

The scheme commenced on:

The scheme has commenced

Relevant facts and circumstances

The Trust is a resident Australian trust for income tax purposes.

The Trust will not be a corporate unit trust within the meaning of Division 6B of Part III of the ITAA 1936 in relation to a year of income.

The Trust is a managed investment scheme (MIS) under section 9 of the Corporations Act 2001, but is not a registered MIS.

There is no provision in the Trust's Constitution to reclassify Member Interests of a particular class to a different class.

Based on the terms of the Trust's Constitution, there exists a single trust relationship, rather than multiple sub-trusts.

The Constitution may be amended by the passing of a Special Members' Resolution, by deed executed by the Trustee.

Investors (known as Members) hold Interests in the Trust. The Interest is an undivided beneficial interest in a particular underlying asset and associated rights in a proportionate share as determined by the Trustee.

The underlying assets of the Trust include loans provided to third party borrowers, and funds (which are provided by Members) held by the Trustee for the future provision of loans.

Members are entitled to receive a proportionate share of income, as defined under the terms of the Trust's Constitution, that is generated from the underlying asset (akin to interest less expenses) and a return of their capital ($1:$1), assuming that the underlying asset has not been written off due to becoming a bad debt.

Relevant legislative provisions

Income Tax Assessment Act 1936 Division 6B of Part III

Income Tax Assessment Act 1936 Division 6C of Part III

Income Tax Assessment Act 1936 section 102M

Income Tax Assessment Act 1936 subparagraph 102M(b)(i)

Income Tax Assessment Act 1936 subsection 102N(1)

Income Tax Assessment Act 1936 subsection 102P(1)

Income Tax Assessment Act 1936 section 102R

Income Tax Assessment Act 1936 paragraph 102R(1)(b)

Income Tax Assessment Act 1936 subparagraph 102R(1)(b)(ii)

Income Tax Assessment Act 1936 Schedule 2F

Income Tax Assessment Act 1936 subsection 272-5(1) of Schedule 2F

Income Tax Assessment Act 1936 subsection 272-5(3) of Schedule 2F

Income Tax Assessment Act 1936 subparagraph 272-5(3)(b)(i) of Schedule 2F

Income Tax Assessment Act 1936 subparagraph 272-5(3)(b)(ii) of Schedule 2F

Income Tax Assessment Act 1936 subparagraph 272-5(3)(b)(iii) of Schedule 2F

Income Tax Assessment Act 1936 section 272-65 of Schedule 2F

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

Corporations Act 2001 section 9

Reasons for decision

Question 1

Fixed entitlement

A 'fixed trust' is defined in section 272-65 of Schedule 2F to the ITAA 1936 (and subsection 995-1(1) of the ITAA 1997):

A trust is a fixed trust if persons have fixed entitlements to all of the income and capital of the trust.

The term 'fixed entitlement' is defined in subsection 272-5(1) of Schedule 2F to the ITAA 1936 which states that:

'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.'

The Explanatory Memorandum to the Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997 states the following in relation to the question of 'What is a fixed entitlement to income or capital of a trust?'

13.3 A person (the beneficiary) will have a fixed entitlement to either income or capital of a trust (whichever is applicable) where the beneficiary has a vested and indefeasible interest in a share of the income of the trust that the trust derives from time to time (i.e. current and future income), or a share of capital of the trust [subsection 272-5(1)]. The share that the person has an interest in is expressed as a percentage of the total income or capital (whichever is applicable) of the trust. [Emphasis added]

The expression 'vested and indefeasible interest' is not defined in the ITAA 1936 or the ITAA 1997. However in ATO ID 2002/676 the Commissioner explains the broad meaning of vested and indefeasible interest. The same view is also contained in the Explanatory Memorandum to A New Tax System (Closely Held Trusts) Bill 1999:

Where the trustee exercises a power to accumulate income or capital of the trust in accordance with the trust deed, the accumulation does not result in a beneficiary's interest being taken away or defeased as long as the beneficiary nevertheless remains entitled at some future time to enjoy his or her share of the income or capital which has been accumulated.

In Colonial First State Investments Ltd v FCT (2011) 192 FCR 298; 201 ATC 20-235 at 97, the Federal Court defined an indefeasible interest under subsection 272-5(1) of Schedule 2F to the ITAA 1936 as having "its ordinary meaning when applied to an interest, that is that the interest cannot be terminated, invalidated or annulled."

Trust Instrument

The determining factor in deciding if a fixed entitlement exists under subsection 272-5(1) of Schedule 2F to the ITAA 1936 will be the terms of the trust instrument under which the trust is constituted.

In the context of subsection 272-5(1) of Schedule 2F to the ITAA 1936, determining whether a beneficiary has a 'vested and indefeasible' interest in a trust requires examination of the terms of the trust's deed upon which the relevant trust property is held, including individual clauses, and whether a beneficiary's interest in a share of the income or capital is defeasible by virtue of any of the powers contained in the trust instrument (see CPT Custodian Pty Ltd v Commissioner of State Revenue; Commissioner of State Revenue v Karingal 2 Holdings Pty Ltd [2005] HCA 53).

Application of the law

Under subsection 272-5(1) of Schedule 2F to the ITAA 1936 a person will be taken to have a fixed entitlement to a share of the income or capital of a trust if they have a vested and indefeasible interest under the trust instrument.

Under the Constitution, the Members of the Trust may not be considered to have a vested and indefeasible interest in all of the income and capital of the fund as the Constitution contains defeasible powers which enable the amendment of the Constitution under certain circumstances. [See Colonial First State Investments Ltd v Commissioner of Taxation [2011] FCA 16; 2011 ATC 20-235 at [106]]

Conclusion

Given that the Member's (beneficiaries) Interests can be defeased, the Members do not have fixed entitlements to all of the income and capital of the Trust.

Question 2

Under subsection 272-5(3) of Schedule 2F to the ITAA 1936 the Commissioner has the discretion to deem certain beneficiaries to have fixed entitlement to the income or capital of a trust:

272-5(3) Deemed fixed entitlement

If:

(a) a beneficiary with an interest in a share of income that the trust derives from time to time, or of the capital of a trust, does not have a fixed entitlement to the share; and

(b) the Commissioner considers that the beneficiary should be treated as having the fixed entitlement, having regard to:

(i) the circumstances in which the entitlement is capable of not vesting or the defeasance can happen; and

(ii) the likelihood of the entitlement not vesting or the defeasance happening; and

(iii) the nature of the trust;

the beneficiary has the fixed entitlement.

According to the Explanatory Memorandum to the Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997 (at paragraph 13.13), the discretion is:

… intended to provide for special circumstances where there is a low likelihood of a beneficiary's vested interest being taken away or defeated and, having regard to the scheme of the trust loss provisions to prevent the transfer of the tax benefit of losses and other deductions incurred by trusts, it would be unreasonable to treat the beneficiary's interest as not constituting a fixed entitlement.

After having regard to the factors in subparagraphs 272-5(3)(b)(i), (ii) and (iii) of Schedule 2F to the ITAA 1936 and the submissions of the applicant, it is considered that the facts warrant the exercising of the Commissioner's discretion to deem the Members to have fixed entitlements to the income and capital of the Trust.

Question 3

The trustee of a public trading trust is assessed and liable to pay tax on the net income of the public trading trust at the company tax rate (section 102S of the ITAA 1936).

Paragraph 102R(1)(b) of the ITAA 1936 provides that a unit trust is a public trading trust in relation to a relevant year of income if:

(i) the unit trust is a public unit trust in relation to the relevant year of income;

(ii) the unit trust is a trading trust in relation to the relevant year of income;

(iii) either of the following conditions is satisfied:

(A) the unit trust is a resident unit trust in relation to the relevant year of income;

(B) the unit trust was a public trading trust in relation to a year of income preceding the relevant year of income; and

(iv) the unit trust is not a corporate unit trust within the meaning of Division 6B in relation to the relevant year of income.

Is the Trust a unit trust?

For the purposes of determining whether a trust is a public trading trust as defined in section 102R of the ITAA 1936, that trust must be a unit trust. There is no legislative definition of a 'unit trust' for the purposes of Division 6C of Part III of the ITAA 1936. However, interpretative guidance is provided by ATO Interpretative Decision ATO ID 2010/57 Income Tax Entity specific matters: trusts - whether a Managed Investment Scheme is a Unit Trust for the purposes of Division 6C of Part III of the Income Tax Assessment Act 1936 (ATOID 2010/57).

ATO ID 2010/57 considered a trust (a managed investment scheme) in which each individual beneficial interest in the trust was expressed as a fraction of the beneficial interest of all such interests collectively in the whole beneficial interest, and in respect of which redemption of any individual unit in the trust was provided for in very limited circumstances. It was concluded that the trust was a unit trust because the beneficial interest in the trust was held in units, the common reference to fractions of the whole of an identified interest. ATOID 2010/57 states:

The joint judgment of the High Court in CPT Custodians Pty Limited v. Commissioner of State Revenue [2005] HCA 53 at paragraph 15 stated, '"unit trust", like "discretionary trust", in the absence of an applicable statutory definition, does not have a constant, fixed normative meaning'.

There is however a consistent approach to what constitutes a unit trust which can be found in authoritative works. This definition reiterates the concept that the beneficial interest of the trust is held in 'units'. Units are expressed and defined as part of the whole beneficial interest of the trust (or in some circumstances of the whole beneficial interest of a particular kind). Other than this 'unit trusts' are, like all other trusts, subject to the terms of the impressed or stated trust and to the application of the law of trusts…

…

Accordingly, where beneficiaries are made entitled to a share of a beneficial interest under a trust, such as an interest in the income and capital, or in either one of these, and which entitlement is measured by reference to a fixed standard of measurement howsoever described (for example a percentage or a fraction or a fixed formula), then whether or not the deed itself labels the interests 'units' the beneficial interest have been unitised and the trust would be a 'unit trust' for the purpose of considering the application of Division 6C of the ITAA 1936. As one example where the phrase 'pro-rata' is used in specifying the relative interests of beneficiaries then this will mean the interest of the beneficiary of the trust will be identified as a proportion of, or share of, the whole of a beneficial interest (or class of interest) and in most occasions of this nature the holder of the beneficial interest will be a unit holder and the trust will be a unit trust.

In relation to the Trust, the Trust is not settled as a "unit trust". Each Member's Interest in the property of the Trust is not divided into parcels of rights, each of which reflect proportionately the net value of the property of the Trust as a whole. Nor is each Member's Interest in the property of the Trust represented by a share of the total net value of the property of the Trust as a whole. It is therefore not intended that each Member will have a beneficial interest in all of the Trust's property having regard to their proportionate contribution to the trust funds.

Based on the terms of the Constitution each Member's Interest entitles the Member to a proportionate share of the income (less fees) generated by the particular underlying assets and the rights connected to the particular asset.

A Member's Interest in the Trust will differ from Member to Member and generally what happens with one underlying asset will have no impact on Members who do not have an interest in that asset.

On this basis, the Trust is not considered to be a unit trust for the purposes of Division 6C of Part III of the ITAA 1936 and, in turn, is not a public trading trust for the purposes of that Division.

Is the Trust a trading trust?

A unit trust is a trading trust if at any time during the relevant year of income, the trustee carries on a 'trading business' 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: subsection 102N(1) of the ITAA 1936.

A 'trading business' is defined to mean 'a business that does not consist wholly of eligible investment business' (section 102M of the ITAA 1936). 'Eligible investment business' is defined in section 102M of the ITAA 1936 to mean one or more of:

(a) investing in land for the purpose, or primarily for the purpose, of deriving rent; or

(b) investing or trading in any or all of the following:

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

(ii) bonds, debentures, stock or other securities;

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

(iv) units in a unit trust;

(v) futures contracts;

(vi) forward contracts;

(vii) interest rate swap contracts;

(viii) currency swap contracts;

(ix) forward exchange rate contracts;

(x) forward interest rate contracts;

(xi) life assurance policies;

(xii) a right or option in respect of such a loan, security, share, unit, contract or policy;

(xiii) any similar financial instruments; or

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

The terms 'investing' and 'trading' are not defined under the Income Tax Assessment Act. Macquarie Dictionary (online) provides the ordinary meaning of these terms as follows

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

Trading: (verb) to give in return; exchange; barter

to exchange: to trade seats with a person.

to carry on trade.

to make an exchange.

There are a number of cases that have considered the meaning of the verb 'invest'. Mandie J of the Supreme Court of Victoria in Marks and Ors v. Roe and Ors [1996] VicSC 239 (28 May 1996) (unreported judgment) stated the following in relation to the meaning of 'invest':

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 arise by way of dividends, capital appreciation or otherwise). (emphasis added)

Similarly, Macnaghten J in Inland Revenue Commissioners v. Rolls-Royce Ltd [1944] 2 All ER 340 considered whether royalties could be said to be 'income derived from investments' for the purposes of the Finance Act 1939. In that case, the issue arose in relation to royalties which had been received by Rolls-Royce Ltd from the licences it had granted to manufacture certain products of which it was the registered proprietor. At page 341 his Honour explained 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. (emphasis added)

Furthermore, Lockhart J in Melville v. Mutual Life and Citizens Assurance Co Ltd (1980) 31 ALR 649 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, stated at page 653:

'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'. (emphasis added)

The principle that is evident from the above cases is that within the context of finance, the act or action of 'investing' generally should exhibit the following by the investor:

• money is outlaid, applied or employed; and

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

Therefore, for the purposes of establishing whether the Trustee is carrying on an eligible investment business in the form of investing in loans (as per subparagraph (b)(i) of the definition of eligible investment business), it is necessary to examine whether the Trustee will be required to outlay, employ, apply or put to use any money and whether any profit is expected from that money.

The Trustee will outlay moneys to advance loans to third parties (the borrowers) in return for interest and fees. The sole activity of the Trustee is to invest in Loans for the purpose of deriving income.

The activity of the Trustee of investing in loans will satisfy the definition of 'eligible investment business' within section 102M of the ITAA 1936. As the Trustee does not engage in any other activity, it is not regarded as carrying on a trading business for the purpose of Division 6C of Part III of the ITAA 1936.

On the basis of the above, even if the Trust were considered to be a unit trust, it does not satisfy subparagraph 102R(1)(b)(ii) of the ITAA 1936 and does not constitute a public trading trust for the purpose of Division 6C of Part III of the ITAA 1936.