Edited version of your written advice

Authorisation Number: 1051445068189

Date of advice: 28 February 2019

Ruling

Subject: Income tax - Tax losses - Trust losses - Fixed entitlements

Question 1

Do the unitholders in the Trust have fixed entitlements to all of the income and capital of the Trust under subsection 272-5(1) to Schedule 2F of the Income Tax Assessment Act 1936 (ITAA 1936)?

Answer

No.

Question 2

If not, will the Commissioner exercise the discretion in subsection 272-5(3) to Schedule 2F of the ITAA 1936 to deem the beneficiaries of the Trust as having fixed entitlements to all of the income and capital of the Trust?

Answer

Yes.

This ruling applies for the following periods:

Year ended 30 June 2018

Year ending 30 June 2019

Year ending 30 June 2020

Year ending 30 June 2021

Year ending 30 June 2022

The scheme commences on:

The scheme has commenced

Relevant facts and circumstances

1. This description of facts is based on the following documents. The documents form part of and are to be read with this description. The relevant documents are:

(a) the Private Ruling Application (the ruling application) and attachments;

(b) the three information request from the ATO; and

(c) the three responses from the taxpayer’s representatives.

Overview

2. The Trust is a unit trust established by the Unit Trust Deed (the Deed) dated X May 20XX. The Trust was established with an initial sum of $X00, representing X00 initial ordinary units.

3. The Trust is not:

(a) listed for quotation in the official list of an approved stock exchange;

(b) a registered managed investment scheme (MIS) for the purposes of Chapter 5 of the Corporations Act 2001 (Corporations Act);

(c) an unregistered MIS; or,

(d) a widely held trust.

4. Company A (the Corporate Trustee) is the trustee of the Trust.

5. Company B (Beneficiary A) is the trustee of the Family Trust. Beneficiary A, in its capacity as trustee of the Family Trust, owns 100% of all ordinary and preference units in the Trust.

6. The Family Trust is a family trust for the purposes of section 272-75 of Schedule 2F to the ITAA 1936.

7. The Trust was originally established for the purpose of undertaking a proposed business activity but commenced and carried on an alternative business.

8. The Trust has accrued tax losses of approximately $Xm as at 30 June 20XX.

Unit holdings of the Trust

9. From settlement of the Trust to XX September 20XX, Beneficiary A was the sole unitholder of the Trust (holding X00 units).

10. On XX September 20XX, Beneficiary A transferred X0 units of the Trust to Beneficiary B.

11. From XX September 20XX to XX June 20XX, Beneficiary A and Beneficiary B held units in a X:Y ratio, respectively.

12. Over this period, the Trust incurred tax losses of $XXX,XXX.

13. On XX June 20XX, Beneficiary A bought back the X0 units held by Beneficiary B.

Types of units

14. The Trust currently has two units in circulation: (a) ordinary units (X00), and (b) preference units (X)(PUCs).

15. All units in circulation are held by Beneficiary A.

16. The taxpayer submits that the intention of the parties was that, as far as was legally possible, the preference units would substantively operate as debt amounts owing by the Trust to Beneficiary A.

17. The taxpayer also submits that the capital amounts subscribed for the preference units were fixed in the same manner as principal advanced under a loan (units issued for $1 per unit) and did not include a reference to the net assets of the Trust. Additionally, the income entitlements arising from the preference units were to be calculated in the same manner as an annual ‘interest’ entitlement on an amount advanced (3% above the 90 Bank Bill rate), and paid preferentially to income entitlements paid on the ordinary units.

Other submissions

18. As part of the taxpayer’s ruling application, the taxpayer submits:

(a) The Trust proposed to utilise its tax losses by distributions of income to the Trust from non-fixed trusts which are members of the same family group as the Trust.

(b) No Unitholders’ Agreement is currently in place.

(c) No Unitholders’ Agreement is intended to be implemented.

(d) At the time of the ruling application, no arrangement had been entered into which would result in:

(i) section 272-35 of Schedule 2F to the ITAA 1936 having application;

(ii) the trafficking of the tax benefit of a tax loss, bad debt deduction or debt/equity swap deduction; or,

(iii) fraud or evasion.

19. Since the establishment of the Trust, the Corporate Trustee never exercised any power capable of defeating a beneficiary’s interest to defeat a beneficiary’s interest in the income or capital of the Trust.

Relevant legislative provisions

Corporations Act 2001, Chapter 5

Corporations Act 2001, section 601GC

Income Tax Assessment Act 1936, Schedule 2F

Income Tax Assessment Act 1936, section 272-5 of Schedule 2F

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

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

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

Income Tax Assessment Act 1936, subsection 272-35 of Schedule 2F

Income Tax Assessment Act 1936, section 272-75 of Schedule 2F

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

Reasons for decision

Question 1

Do the unitholders in the Unit Trust (the Trust) have fixed entitlements to all of the income and capital of the Trust under subsection 272-5(1) to Schedule 2F of the Income Tax Assessment Act 1936 (ITAA 1936)?

Summary

No. The terms of the Deed do not provide the unitholders of the Trust with vested and indefeasible interests in all of the income and capital of the Trust.

Detailed reasoning

Fixed entitlements

20. A ‘fixed trust’ is defined in section 272-65 of Schedule 2F to the ITAA 1936:

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

21. A ‘fixed entitlement’ is defined in subsection 995-1(1) of the Income Tax Assessment Act 1997 (ITAA 1997):

[A]n entity has a fixed entitlement to a share of the income or capital of a company, partnership or trust if the entity has a fixed entitlement to that share within the meaning of Division 272 in Schedule 2F of the Income Tax Assessment Act 1936.

22. Subsection 272-5(1) of Schedule 2F to the ITAA 1936 provides 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. [emphasis added]

23. Subsection 272-5(2) of Schedule 2F to the ITAA 1936 further provides 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 by the 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.

Meaning of the word ‘interest’

24. ‘Interest’ has a range of meanings. In the absence of a definition, its meaning must be inferred from the context in which the word is found: as highlighted in Gartside v. Inland Revenue Commissioner [1968] AC 553 at 602-603 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 (Vic) (2005) 224 CLR 98.

25. There may be circumstances when ‘interest’ can be interpreted broadly to include any right or advantage that a person may 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.

26. For the purposes of Schedule 2F to the ITAA 1936, in order for an interest to be recognised as a fixed interest, it must be a right with respect to a share of the income or capital of the trust that is susceptible to measurement (ie the right must have ‘the necessary quality of definable extent’: Gartside v. Inland Revenue Commissioner [1968] AC 553).

Meaning of the words ‘vested and indefeasible’

27. The terms ‘vested and indefeasible’ are not defined in the ITAA 1936 or ITAA 1997.

28. The Explanatory Memorandum to the Taxation Laws Amendment (Trust Loss and Other Deductions) Bill 1997 (EM) discusses the nature of a ‘vested interest’:

13.4 A person has a vested interest in something if the person has a present right relating to the thing. Stated simply, a vested interest is one that is bound to take effect in possession at some point in time. A vested interest is to be contrasted with a ‘contingent’ interest which may never fall into possession. If an interest of a beneficiary in income or capital is the subject of a condition precedent, so that an event must occur before the interest becomes vested, the beneficiary does not have a vested interest to the income or capital since such an interest is instead ‘contingent’ upon the event occurring.

13.5 In traditional legal analysis, a person can be said to be either ‘vested in possession’ or ‘vested in interest’. A present interest, i.e. one that is being enjoyed, is said to be ‘vested in possession’; a future interest, i.e. one which gives its holder a present right to a future enjoyment, is said to be a ‘vested interest’. A person is vested in possession where the person has a right to immediate possession or enjoyment of the thing in question. In the definition of fixed entitlement, ‘vested’ includes both vested in possession and vested in interest.

13.6 Because vested interests include future interests, a person can have a vested interest in a thing even though the person’s actual possession and enjoyment of the thing is delayed until sometime in the future.

29. This is reflected in paragraph 13 of the Practical Compliance Guideline PCG 2016/16 Fixed entitlements and fixed trusts (PCG 2016/16).

30. The EM also addresses when a vested interest is indefeasible:

13.7 A vested interest is indefeasible where, in effect, it is not able to be lost. A vested interest is defeasible where it is subject to a condition subsequent that may lead to the entitlement being divested. A condition subsequent is an event that could occur after the interest is vested that would result in the entitlement being defeated, for example, on the occurrence of an event or the exercise of a power. For example, where a beneficiary’s vested interest is able to be taken away by the exercise of a power by the trustee or any other person, the interest will not be a fixed entitlement.

31. ‘Vested and indefeasible’, for the purposes of Schedule 2F to the ITAA 1936, has not been judicially considered, other than in the limited context of amending the constitution of a registered MIS under section 601GC of the Corporations Act: see Colonial First State Investments Ltd v. Commissioner of Taxation [2011] FCA 16; (2011) 192 FCR 298; 81 ATR 772; ATC 20-235.

‘Trust instrument’

32. 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 or indefeasible interest ‘under a trust instrument’.

33. The determining factor in deciding whether 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.

34. For the purposes of subsection 272-5(1) of Schedule 2F to the ITAA 1936, the Commissioner accepts that a ‘trust instrument’ includes:

…a deed or constitution as supported by documentation such as a Product Disclosure Statement, Investment Memorandum or other document that modifies or supplements the terms of the trust set out in the deed or constitution.

Applying the law to your circumstances

The ‘trust instrument’

35. Relevantly here, the ‘trust instrument’ is comprised of the terms of the Deed.

36. Under the Deed, the terms of a “Unitholders’ Agreement” prevails in the event that terms of the Deed or Constitution conflict with the terms of the Unitholders’ Agreement.

37. The Commissioner notes that there is no Unitholders’ Agreement currently in place.

Clauses in the ‘trust instrument’ which may indicate vested interests

38. The Commissioner accepts that the Deed provides beneficiaries with a vested interest in the income and capital of the Trust.

39. The Commissioner also accepts that the PUCs provide Beneficiary A with a vested interest in the income of the Trust.

Clauses in the ‘trust instrument’ which may contain defeasible powers

40. Pursuant to paragraph 16 of PCG 2016/16, the Deed contains clauses which may cause a beneficiary’s interest to be defeated.

41. The Commissioner also notes the existence of the PUCs, which entitle unitholders to a priority distribution of income. Specifically:

(a) Capital amounts subscribed for units were fixed in the same manner as principal advanced under a loan.

(b) PUCs were issued for $1 per unit.

(c) PUCs are not subject to any increase with reference to the net asset value of the Trust.

42. The PUCs will not satisfy the savings rule.

43. Therefore, it can be concluded that all beneficiaries (being unitholders of the Trust) do not have fixed entitlements to all of the income and capital of the Trust.

Impact of a Unitholders’ Agreement

44. The Deed provides that, in the event of there are conflicting terms between either (a) the Unitholders’ Agreement and the Deed, or (b) the Unitholders’ Agreement and the Constitution, the terms of the Unitholders’ Agreement will prevail.

45. While there is no Unitholders’ Agreement currently in place, one could be introduced that contains terms relating to a beneficiary’s entitlement to the income or capital of the Trust. If these terms conflicted with the terms of the Deed, the terms of the Unitholders’ Agreement would prevail. As a result, the introduction of a Unitholders’ Agreement could result in the entitlement of a beneficiary to the income or capital of the Trust being defeated if the terms of the Unitholders’ Agreement had the effect of defeating a beneficiary’s entitlement to income or capital of the Trust.

Conclusion

46. The terms of the ‘trust instrument’ do not provide the unitholders of the Trust with vested and indefeasible interests in all of the income and capital of the Trust.

47. As a result, the unitholders of the Trust do not have fixed entitlements to all of the income and capital of the Trust for the purposes of subsection 272-5(1) of Schedule 2F to the ITAA 1936.

Question 2

If not, will the Commissioner exercise the discretion in subsection 272-5(3) to Schedule 2F of the ITAA 1936 to deem the beneficiaries of the Trust as having fixed entitlements to all of the income and capital of the Trust?

Summary

Yes. The Commissioner will exercise his discretion in subsection 272-5(3) of Schedule 2F to the ITAA 1936, subject to the assumptions outlined above, to deem the beneficiaries of the Trust as having fixed entitlements to all of the income and capital of the Trust.

Detailed reasoning

Commissioner’s discretion

48. As highlighted above, the beneficiaries of the Trust do not have a fixed entitlement in accordance with subsection 272-5(1) of Schedule 2F to the ITAA 1936. This is because the beneficiaries do not have a vested and indefeasible interest in all of the income and capital of the Trust.

49. As a result, the Trustee may request that the Commissioner exercise his discretion under subsection 272-5(3) of Schedule 2F for the ITAA 1936 to deem the beneficiaries’ interests as being vested and indefeasible: pursuant to paragraphs 25 and 26 of PCG 2016/16.

50. Subsection 272-5(3) of Schedule 2F to the ITAA 1936 provides:

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.

51. Each element of the discretion will now be considered.

Paragraph 272-5(3)(a)

52. The beneficiaries of the Trust have a vested interest in the income and capital of the Trust, as outlined above.

53. Further, as provided in paragraph 25 of PCG 2016/16, the Trust is not a discretionary trust or a trust with default income or capital beneficiaries; that is, no beneficial interest in the income or capital of the Trust is capable of being defeated, partly or wholly, by virtue of a power of appointment of income or capital by the trustee.

54. However, the beneficiaries of the Trust do not have an indefeasible interest in the income and capital of the Trust.

Paragraph 272-5(3)(b)(i)

55. The circumstances in which the defeasance of an interest can happen have been discussed above. This includes defeasance arising from:

(a) clauses in the Deed,

(b) terms of the PUCs, and

(c) the introduction of a Unitholders’ Agreement with conflicting terms.

Paragraph 272-5(3)(b)(ii)

56. The likelihood of the defeasance happening is outlined as follows:

(a) Clause A: In relation to this clause, the Commissioner notes:

(i) From X May 20XX to XX September 20XX, Beneficiary A was the sole unitholder of the Trust.

(ii) On XX September 20XX, Beneficiary A transferred X0 units of the Trust to Beneficiary B.

(iii) From XX September 20XX to XX June 20XX, Beneficiary A and Beneficiary B held units in a X:Y ratio, respectively.

(iv) On XX June 20XX, Beneficiary A bought back the X0 units from Beneficiary B.

(v) No changes to the unitholdings or proportions have occurred since.

(vi) The ruling includes the following assumption:

(A) The trustee will not exercise a power capable of defeating a beneficiary’s interest to defeat a beneficiary’s interest in the income or capital of the Trust.

(B) The respective proportions of the unitholders will not be adjusted under the Deed.

(b) Clause B, Clause C and Clause D: In relation to these clauses, the Commissioner notes:

(i) The Corporate Trustee can issue further units, including of different classes (like the existing preference units), as well as reclassify units.

(ii) Any reclassification of units or classes of units which adversely affects the respective unitholders must have the consent of all of those affected unitholders.

(iii) The combined effect of these clauses could enable the Corporate Trustee to stream income or capital (or greater proportions of income or capital) to particular unitholders, with the effect that other unitholders (if the number of unitholders increased) will not receive income or capital to which they would otherwise be entitled. This constitutes a defeasible power.

(iv) At the time of the ruling, Beneficiary A is the only unitholder. Beneficiary A holds two classes of units (ordinary units and preference units).

(v) The ruling includes the following assumptions:

(A) No units in the Trust will be transferred.

(B) No further Ordinary Units will be issued.

(C) Preference Units will only be issued to Beneficiary A and on a basis that will satisfy subsection 272-5(5) of Schedule 2F to the ITAA 1936.

(D) No further Classified Units will be issued.

(E) The trustee will not exercise the power under the Deed to reclassify the rights attaching to any units already in existence.

(c) Clause E: In relation to this clause, the Commissioner notes:

(i) Units redeemed under this clause will satisfy the savings rule.

(ii) Additionally, the ruling will contain the following general assumption:

(A) The trustee will not exercise a power capable of defeating a beneficiary’s interest to defeat a beneficiary’s interest in the income or capital of the Trust.

(d) Clause F: In relation to this clause, the Commissioner notes:

(i) This clause could be used in conjunction with other clauses to stream income or capital (or greater proportions of income or capital) to particular unitholders, with the effect that other unitholders would not receive income or capital to which they would otherwise be entitled. This constitutes a defeasible power.

(ii) There is no evidence before the Commissioner that would suggest that such income or capital streaming has occurred. Further, at the time of this ruling, Beneficiary A is the sole unitholder.

(iii) The ruling includes the following assumption:

(A) The trustee will not exercise a power capable of defeating a beneficiary’s interest to defeat a beneficiary’s interest in the income or capital of the Trust.

(e) Clause G: In relation to this clause, the Commissioner notes:

(i) The Deed has not been amended;

(ii) There is no existing proposal to amend the Deed;

(iii) The Deed requires more than 95% of unitholders to consent to amendments to the Deed before those amendments are effective.

(iv) The Deed also requires that, if a proposed amendment prejudicially affects the rights of beneficiaries to the income or capital of the Trust, the trustee obtains the consent of all of the affected beneficiaries.

(v) The ruling includes the following assumptions:

(A) The trustee will not exercise a power capable of defeating a beneficiary’s interest to defeat a beneficiary’s interest in the income or capital of the trust.

(B) The trust instrument will not be amended under the Deed in a way so as to vary, modify or change the rights of existing unitholders.

57. The Commissioner is of the view that it is unlikely that a defeasance of unitholders’ interests will occur as a result of the existence of the powers contained in the Deed.

Paragraph 272-5(3)(b)(iii)

58. The nature of the trust is as follows:

(a) The Trust is not a registered or unregistered MIS.

(b) The Trust is held by the Family Trust.

(c) The Trust was originally established for the purpose of undertaking a proposed medical centre but commenced and carried on a business as a fitness centre.

Schedule 2F to the ITAA 1936 and tax losses

59. The concept of a ‘fixed entitlement’ was originally introduced in the context of the trust loss measures and should primarily be interpreted in that context (in the absence of any express provision or explanatory guidance that indicates a different context is relevant). The trust loss measures are an important integrity measure, removing a structural flaw in the tax system. The concept of a ‘fixed entitlement’ is fundamental to the structure and effectiveness of the trust loss measures.

60. At paragraph 13.13 of the EM:

This provision 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.

61. This passage indicates that when looking at the facts of a case, in the context of the criteria listed in subsection 272-5(3) of Schedule 2F to the ITAA 1936, unless the context of the provision for which fixed entitlement is required provides otherwise, the Commissioner should always have regard to whether the absence of a fixed entitlement, in these circumstances, could result in the trafficking (or transfer) of the tax benefit of any tax losses.

62. The Commissioner notes:

(a) The Trust has accrued tax losses of approximately $Xm (the tax losses).

(b) The Trust proposes to utilise its tax losses by distributions of income to the Trust from non-fixed trusts which are members of the same family group as the Trust.

(c) At the time of the ruling application, no arrangement had been entered into which would result in:

(i) section 272-35 of Schedule 2F to the ITAA 1936 having application;

(ii) the trafficking of the tax benefit of a tax loss, bad debt deduction or debt/equity swap deduction; or,

(iii) fraud or evasion.

(d) For this ruling, the following assumptions have been included:

(i) An arrangement will not be entered into which would result in:

(A) section 272-35 of Schedule 2F to the ITAA 1936 having application;

(B) the trafficking of the tax benefit of a tax loss, bad debt deduction or debt/equity swap deduction; or,

(C) fraud or evasion.

63. On this basis, it is reasonable for the Commissioner to conclude that the transfer of the tax benefit of the tax loss deductions does not constitute a material risk.

Conclusion

64. As highlighted in the answer to Question 1, the terms of the ‘trust instrument’ do not provide the unitholders of the Trust with vested and indefeasible interests in all of the income and capital of the Trust.

65. As a result, the unitholders of the Trust do not have fixed entitlements to all of the income and capital of the Trust for the purposes of subsection 272-5(1) of Schedule 2F to the ITAA 1936.

66. However, pursuant to paragraph 272-5(3)(b) of Schedule 2F to the ITAA 1936, and after having regard to the requirements of subparagraphs 272-5(3)(b)(i) to (iii) and submissions from the taxpayer, the Commissioner considers it appropriate that the beneficiaries of the Trust should be treated as having fixed entitlements to all of the income and capital of the Trust for the relevant income years.

67. In summary, as:

(a) The Corporate Trustee will not exercise a power capable of defeating a beneficiary’s interest to defeat a beneficiary’s interest in the income or capital of the trust;

(b) The likelihood of defeasance is low;

(c) There is little likelihood of the tax benefit of the Trust being transferred;

the Commissioner will exercise his discretion under subsection 272-5(3) of Schedule 2F to the ITAA 1936 to treat all beneficiaries of the Trust as having fixed entitlements to their share of the income and capital of the Trust for the relevant income years.