Edited version of your written advice

Authorisation Number: 1013138799893

Date of advice: 6 February 2017

Ruling

Subject: Financing and Servicing Agreement

Question 1

Is the Financing and Servicing Agreement (FSA) a 'Division 230 financial arrangement' as defined in section 995-1 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

Yes

Question 2

If the FSA is a 'Division 230 financial arrangement' as defined in section 995-1 of the ITAA 1997, and assuming that no tax-timing elections under Division 230 of the ITAA 1997 are made by the Trust, will the accruals method under Subdivision 230-B of the ITAA 1997 apply to the Trust's losses arising from each Profit Amount to be provided under the FSA?

Answer

Yes

This ruling applies for the following periods:

Year ended 30 June 2016

Year ending 30 June 2017

Year ending 30 June 2018

Year ending 30 June 2019

Year ending 30 June 2020

Relevant facts and circumstances

The Trust:

● is an Australian unit trust;

● is an unregistered managed investment scheme, with an option to become a registered MIS in the future;

● adheres to Shariah compliant financing principles; and

● has been created for the purpose of acquiring a property (the Property).

Financing of the Property

The Trust's acquisition of the Property is to be funded by a combination of equity and debt. The debt component will include on-shore debt financing.

The Shariah board of the Trust requires that any finance advanced to the Trust for the purposes of funding the acquisition of the Property be done so in a form which is Shariah compliant, meaning it must adhere to Islamic financing principles which prohibit the payment of interest (as technically defined under Shariah principles) on debt.

Accordingly, the debt financing of the Property, used to part fund the Trust's acquisition of the Property, has been structured to be Shariah compliant and involves the Trust's participation in a FSA.

The FSA

The Investor agrees to appoint the Trust (as the Investment Manager) to invest the amount funded by debt (the 'debt amount') in the purchase of the Property and to manage the Property on behalf of the Investor in accordance with the Investment Plan and the terms of the FSA.

The Investment Plan provides, inter alia, that:

● the Trust undertakes to invest the debt amount in accordance with this Plan in order to generate an anticipated profit, which shall be sufficient to pay the Profit Amount to the Investor periodically; and

● the Trust must manage the Property as a commercial office building; keep proper records in relation to the Property; and pay the Profit Amount to the Investor.

Subject to the availability of funds, the Investor will promptly pay the debt amount to the Trust. In consideration of the Investor providing the debt amount and entering into the FSA, the Trust must pay to the Investor:

● an amount equivalent to the debt amount (the 'repayment amount'), as well as any other unpaid Secured Moneys, in full on the Termination Date (being 36 months after the date on which the debt amount is provided to the Trust); and

● the Profit Amount on each relevant date.

In respect of each relevant period, the order of priority for the distribution of the Investment Income (defined in the FSA to broadly include rental income and other profits earned in connection with the Property) received by the Trust for that period shall, in the first instance, be 100% to the Investor until and to the extent the Investor has received an amount equal to the Profit Amount.

The Trust acknowledges that a failure to pay the Profit Amount when due shall constitute an Event of Default under the FSA.

The FSA is a scheme which gives rise to a debt interest under Division 974 of the ITAA 1997, and the Profit Amount payable by the Trust under the FSA will be deductible.

Assumptions

1. Division 230 of the ITAA 1997 applies to gains or losses from the financial arrangements of the Trust.

2. The FSA (and associated financing arrangements) is entered into or carried out by the Trust in gaining or producing assessable income of the Trust, being rental income from the Property.

3. All dealings between and/or amongst any of the Trust and the other parties to be involved will be at arm's length.

4. The Trust will not hold, or invest in, any assets other than the Property during the term of the FSA.

Relevant legislative provisions

Income Tax Assessment Act 1936 Part IVA

Income Tax Assessment Act 1997 Division 230

Income Tax Assessment Act 1997 subsection 230-15(2)

Income Tax Assessment Act 1997 section 230-45

Income Tax Assessment Act 1997 subsection 230-45(1)

Income Tax Assessment Act 1997 paragraph 230-45(1)(d)

Income Tax Assessment Act 1997 paragraph 230-45(1)(e)

Income Tax Assessment Act 1997 paragraph 230-45(1)(f)

Income Tax Assessment Act 1997 subsection 230-45(2)

Income Tax Assessment Act 1997 Subdivision 230-B

Income Tax Assessment Act 1997 subsection 230-100(3)

Income Tax Assessment Act 1997 section 230-110

Income Tax Assessment Act 1997 section 230-115

Income Tax Assessment Act 1997 subsection 230-115(2)

Income Tax Assessment Act 1997 subsection 230-115(3)

Income Tax Assessment Act 1997 subsection 230-130(3)

Income Tax Assessment Act 1997 subsection 230-175(3)

Income Tax Assessment Act 1997 subsection 230-175(4)

Income Tax Assessment Act 1997 Division 820

Income Tax Assessment Act 1997 Division 974

Income Tax Assessment Act 1997 section 974-160

Income Tax Assessment Act 1997 section 995-1

Reasons for decision

Question 1

Summary

The FSA is a 'Division 230 financial arrangement' as defined in section 995-1.

Detailed reasoning

Generally, an entity will have a 'financial arrangement' if they have under an arrangement, a cash settlable legal or equitable right to receive a financial benefit, a cash settlable legal or equitable obligation to provide such benefit, or a combination of one or more such rights and/or obligations, and paragraphs 230-45(1)(d) to (f) do not apply (subsection 230-45(1)).

Paragraphs 230-45(1)(d) to (f) state:

(d)  you also have under the arrangement one or more legal or equitable rights to receive something and/or one or more legal or equitable obligations to provide something; and

(e)  for one or more of the rights and/or obligations covered by paragraph (d):

(i)  the thing that you have the right to receive, or the obligation to provide, is not a financial benefit; or

(ii)  the right or obligation is not cash settlable; and

(f)  the one or more rights and/or obligations covered by paragraph (e) are not insignificant in comparison with the right, obligation or combination covered by paragraph (a), (b) or (c).

The term 'financial benefit' is defined in section 974-160 as anything having economic value and includes property and services.

Whether a right to receive or obligation to provide a financial benefit is cash settlable is specified in subsection 230-45(2) to include, inter alia, a benefit that is money, a right you intend to satisfy or settle by receiving money, or an obligation that you intend to satisfy or settle by providing money.

Under the terms of the FSA (i.e. the 'arrangement' for the purposes of section 230-45), the Trust will have a cash settlable right to receive a financial benefit from the Investor in the form of the debt amount, and cash settlable obligations to provide financial benefits to the Investor in the form of the repayment amount and the periodic Profit Amounts.

Under the terms of the FSA, the Trust will also have an obligation to manage the Property as a commercial office building. Whilst the obligation to provide for the management of the Property is neither a financial benefit nor cash settlable, it is (in the context of the purpose of the FSA and the intention of the parties to the FSA - i.e. to arrange debt financing in a manner which adheres to Islamic financing principles and is thus Shariah compliant) insignificant in comparison with the Trust's cash settlable right to receive a financial benefit and cash settlable obligations to provide financial benefits under the FSA.

As such, paragraphs 230-45(d) to (f) do not apply and the FSA will constitute a financial arrangement pursuant to section 230-45.

Section 995-1 defines a 'Division 230 financial arrangement' as a financial arrangement to which Division 230 applies in relation to your gains and losses from the arrangement.

Pursuant to assumption 1 of this ruling that Division 230 applies to gains and losses from the financial arrangements of the Trust, and on the basis that the FSA will constitute a financial arrangement, Division 230 will apply in relation to gains or losses of the Trust from the FSA. The FSA will therefore be a Division 230 financial arrangement as defined in section 995-1.

Question 2

Summary

The accruals method under Subdivision 230-B will apply to the Trust's losses arising from each Profit Amount to be provided under the FSA.

Detailed reasoning

Where a gain or loss from a financial arrangement arises from a financial benefit that is to be received or provided under that arrangement and is sufficiently certain before or at the time when the arrangement starts and before the benefit is to be received or provided, or becomes sufficiently certain after the time when the arrangement starts and before the benefit is to be received or provided, the accruals method under Subdivision 230-B applies to the gain or loss
(subsection 230-100(3)).

A sufficiently certain gain or loss from a financial arrangement at a particular time is one that is of a particular amount or at least a particular amount, with regard only to financial benefits that are sufficiently certain to be received and provided (sections 230-110 and 230-115).

A financial benefit that is to be received or provided is treated as sufficiently certain if:

(a) it is reasonably expected that the financial benefit will be received or provided (assuming that the financial arrangement will continue to be had for the rest of its life); and

(b) at least some of the amount or value of the benefit is, at that time, fixed or determinable with reasonable accuracy (subsection 230-115(2)).

The expression 'reasonably expected' is not defined for the purposes of the ITAA 1997 but has been considered in various tax law cases.

In Peabody v. Commissioner of Taxation (1993) 40 FCR 531; 93 ATC 4104; (1993) 25 ATR 32, Hill J found that the expression 'reasonable expectation', in the context of the anti-avoidance rules contained in Part IVA of the Income Tax Assessment Act 1936, was also intended to receive its ordinary meaning. His Honour held at FCR 541; ATC 4112; ATR 40 that:

… the expectation must be one which is reasonable and not one which is unreasonable, irrational or absurd…..The word 'expectation' requires that the hypothesis be one which proceeds beyond the level of a mere possibility to become that which is the expected outcome.

On appeal, the Full High Court in Federal Commissioner of Taxation v. Peabody (1994) 181 CLR 359 at 385; 94 ATC 4663 at 4671; (1994) 28 ATR 344 at 353, also noted that a reasonable expectation requires more than a possibility - and therefore, involves a prediction that must be sufficiently reliable for it to be regarded as reasonable.

Adapting the language of Hill J and the Full High Court in the Peabody decisions referred to above, it follows that for something to be 'reasonably expected' there must be a sufficiently reliable prediction (rather than one which is a mere possibility) or at least an expectation or prediction that can be justified in the sense that it is based on a ground or a cause and is not unreasonable, irrational or absurd. In the context of accruals tax treatment, there must be a firm expectation that the financial benefit will be provided or received.

An assessment of 'reasonable expectation' requires an assessment of the circumstances surrounding the financial arrangement particularly with reference to the factors in
subsection 230-115(3):

(i) the terms and conditions of the financial arrangement; and

(ii) accepted pricing and valuation techniques; and

(iii) the economic and commercial substance and effect of the financial arrangement; and

(iv) the contingencies that attach to other financial benefits that are to be provided or received under the arrangement;

Having regard to the terms of the FSA, each Profit Amount which the Trust is obligated to provide to the Investor on a periodic basis (for each relevant period) over the term of the FSA will be reasonably expected and will be fixed or determinable with reasonable accuracy at a time before the Profit Amount is provided.

It follows that the Trust will be sufficiently certain to provide each Profit Amount to the Investor, and the amount of those financial benefits will, for the purposes of section 230-110, constitute a sufficiently certain particular loss of the Trust to which the accruals method will apply.

The period over which the loss is to be spread in accordance with subsection 230-130(3) is the period to which the loss relates. Running balancing adjustments must be made by the Trust in accordance with subsections 230-175(3) and 230-175(4) respectively if a Profit Amount provided or to be provided is less or more than the amount estimated.

Losses made from a financial arrangement are deductible under subsection 230-15(2) to the extent that they're made in gaining or producing assessable income or are necessarily made in carrying on a business for the purpose of gaining or producing assessable income.