Edited version of private advice

Authorisation Number: 1051563371663

Date of advice: 25 September 2019

Ruling

Subject: Application of section 97 in respect of distributions made by head trust to its Australian resident beneficiaries

Question

Will Australian resident beneficiaries who are not under any legal disability, and who are presently entitled to a share of the income of Head Trust be assessed under section 97 of the Income Tax Assessment Act (ITAA 1936) on their share of the net income of Head Trust?

Answer

Yes.

Relevant facts and circumstances

The fund

The fund is established by an Australian independent real estate manager that provides Australian investment opportunities to Australian and international wholesale and institutional investors. The manager holds an Australian Financial Services Licence. It has a disciplined investment strategy, criteria, governance framework and risk parameters.

The fund will comprise two distinct sub-trusts - a passive arm and a trading arm.

The fund will be a 10 year fund with the possibility of extension where approved by investors. Its objective is to invest in or create a portfolio of quality income producing real estate assets. There will be a 3 year investment period from final close. The Fund will be targeting a certain overall internal rate of return ('IRR') or gross equity multiple ('GEM').

The fund will be an unlisted wholesale fund domiciled in Australia and not offered to the public.

Fund investors

Investment in the fund will be sought from the manager's existing investor base and select new investors. The new investors will be privately, specifically and directly approached by the manager as Investment Manager to scope for their interest in participating in the fund.

The expected unitholder composition of Head Trust comprises resident companies (related to the manager), resident complying superannuation funds, resident trusts, non-resident companies, non-resident trusts and non-resident limited partnerships.

The location of non-resident investors is expected to be the foreign countries. At the time of application, there were no discussions with other potential investors which are not resident in an Exchange of Information (EoI) country. Further, it is anticipated that, other than Australian investors, only non-resident investors resident in EoI countries will invest, directly or indirectly, into Head Trust.

The investors in Head Trust will hold 'units' in the trust which represent a proportionate share, measured by reference to a fixed standard, of the income and property of the trust.

Feeder Fund

Non-resident investors have the option to indirectly invest in the fund through a 'Feeder Fund'. The Feeder Fund will take the form of either a company or a foreign corporate limited partnership incorporated or formed in a foreign jurisdiction that is an EoI country.

Where it is a limited partnership, it will be formed in a foreign jurisdiction, under which, by operation of the applicable law (and not by contract or deed), liability of at least one of the partners is limited.

The voting power of the Feeder Fund will not be controlled by Australian resident shareholders.

The purpose of the Feeder Fund is to eliminate the compliance burden for non-resident investors. As such, it will be an administrative business that undertakes administrative functions including, record keeping, and collecting and distributing funds from/to non-resident investors and returns from Head Trust. It will also manage tax compliance, legal compliance, notifications of distribution notices, pay and receive funds etc. The functions will be outsourced to a local third party service provider in the jurisdiction in which it was formed. The service provider will appoint directors, and perform all functions required to be undertaken by the Feeder Fund.

The high level decisions of the Feeder Fund will be made by the directors of the company (most of whom will not be Australian residents), and such decisions will not be exercised in Australia. To the extent that any directors of the Feeder Fund attend meetings from Australia (e.g. by phone or video conference), a majority of the directors of the Feeder Fund will not be attending from Australia. The directors of the Feeder Fund will not merely rubber stamp or mechanically follow decisions of the directors who will attend meetings from Australia, nor those of the Investment Manager or any other person or body in Australia, but will make decisions in the best interests of the Feeder Fund.

If the Feeder Fund takes the form of a corporate limited partnership, the general partner would generally take part in the management of the business of the partnership, however the general partner will not be an Australian resident and will not undertake any decision making in Australia.

Given that the shareholders of the Feeder Fund will be non-residents, it is unlikely that the shareholders' meetings will be held in Australia. The meetings of directors will mainly occur outside of Australia and the associated documents will be recorded and kept outside of Australia.

Declarations of dividends and payments of dividends will occur outside of Australia. The registered office, the company's books and register of shareholders will be kept outside of Australia.

Fund structure

The fund will comprise a head unit trust (Head Trust), which will hold approximately 99% of the units in Sub Trust A and Sub Trust B unit trusts. The remaining interests (approximately 1%) will be held by a special purpose vehicle ('SPV'), which will be a company for the purposes of this ruling. SPV will hold the units at the Sub Trust A and Sub Trust B level as performance fees will be paid to the manager at the head trust level.

The manager will be the Investment Manager for Head Trust, Sub Trust A and Sub Trust B. It will also be the trustee of Head Trust.

The trustees for Sub Trust A, Sub Trust B and all other sub-trusts will be either a special purpose trustee company or a third party trustee. Sub Trust B will have a different trustee to that of Sub Trust A and each of its sister trusts. There will be 2 directors for each trustee, with only one common director between the trustee for Sub Trust B and the trustee/s for Sub Trust A and each of its sister trusts.

The Investment Memorandum for the Fund will clearly state and differentiate the different strategies of Sub Trust A and Sub Trust B.

There will be no arrangements of any kind between Sub Trust A and Sub Trust B, including no loans, leasing or licensing arrangements between the two entities. Sub Trust A will not rely on, nor influence or impact the financial position of Sub Trust and vice versa.

The funds invested are not intended to be recycled and reinvested, in particular with regard to capital invested in Sub Trust A.

Sub Trust A and its sister trusts

Sub Trust A will hold investments of a 'passive' kind and on a long term basis. It will only conduct the business of investing in commercial, industrial and retail assets for the purpose, or primarily for the purpose, of deriving rent.

Multiple trusts may be established in order to hold the investments through wholly (or partly) owned sub-trusts (i.e. Sub Trust A and its 'sister trusts'). There may be sub-trusts that Sub Trust A owns jointly with third parties not related to the fund.

Specifically, Sub Trust A and its sister trusts will seek to acquire properties with the purpose of continuing to lease them, or improve the rental stream through value creation strategies, including leasing vacant or expiring tenancies, lease repositioning, capital expenditure including refurbishment, asset expansion and/or rehabilitation to maximise rental income over the holding period.

Key to this strategy is the obtaining of favourable prices for the assets, and proactively managing leasing strategies once the assets are acquired.

Prior to the acquisition of any asset, a 'Final Investment Proposal' ('FIP') will be issued by the Investment Manager to the Investment Committee for consideration. The FIP will include:

·        Details of the asset to be acquired;

·        The purpose of the acquisition;

·        What value-add strategies (if any) are to be implemented; and

·        The asset's alignment with the investment strategy of Sub Trust A, including intended holding period, projected rental yields etc.

Accompanying the FIP will be a detailed forecast financial model prepared for each asset proposed to be acquired.

Depending on the time of acquisition of the asset within the Fund's lifecycle, the average expected holding period of the assets will be at least six years, which may expand where an extension of the Fund's life occurs beyond the initial 10 year fund life.

Tax advice and sign-off will also be required to confirm whether an asset is eligible/suitable for Sub Trust A. Where it is unclear, a ruling with the ATO will be sought.

Sub Trust B

Sub Trust B will carry on a trading business.

Prior to the acquisition of any asset, a FIP will be issued by the Investment Manager to the Investment Committee for consideration. The FIP will outline details of the asset to be acquired, the purpose for doing so, the value-add strategies (if any) to be implemented and the asset's alignment with the investment strategy of Sub Trust B.

The assets Sub Trust B will invest in will range from commercial, retail and industrial assets in respect of which the anticipated capital gain component will exceed expected rental income to buying, renting and ultimately selling distressed completed residential housing.

Investment Management Services

The manager will enter into separate Investment Management Agreements with Head Trust, Sub Trust A and Sub Trust B. The activities the Investment Manager will be performing as part of their investment management services will be on an entity-by-entity basis. That is, the activities will reflect, distinguish and clearly delineate between the separate investment strategies (as will be outlined in the Investment Memorandum). The Investment Manager will perform their duty in respect of Sub Trust A (and its sister trusts) separately and independently from its duties to Sub Trust B, and within the parameters set by the Investment Management Agreement with each trust.

Base investment management fees for funds under management or services provided will be paid by Sub Trust A and Sub Trust B respectively.

Subject to the overall performance of the fund, a performance fee will be paid by Head Trust to the manager.

Governance

The fund's compliance with the parameters that will be contained within the Information Memorandum is ensured by way of two committees - the Investment Committee and the Investor Consultation Committee. At least two fully independent members are appointed to the Investment Committee with the other two members of the Investment Committee being members of the manager's Board.

The Investment Committee is responsible for the approval of all significant investment and governance decisions and is independent from the manager's Board. Consistent with industry practice, all acquisition, disposal and other material decisions will require unanimous approval from the Investment Committee.

The Investor Consultation Committee is comprised of investor representatives and is responsible for communicating and consulting with the Investment Committee on any matter referred to them by the Investment Committee. No related party transaction or investment outside the Investment Strategy and criteria may be entered into without first being referred to the Investor Consultation Committee for discussion. In the event that an investment opportunity is outside the Investment Strategy and criteria, specific approval needs to be sought and obtained from the Investment Committee and, ultimately Investors through the Investor Consultation Committee.

The Investment Committee and Investor Consultation Committee (where required) for Sub Trust A (and its sister trusts) and Sub Trust B, will meet and act only in the interests of the respective trusts.

There will be separate agendas, meetings, resolutions and records maintained in respect of each trust.

Neither Sub Trust A nor Sub Trust B will have the ability to appoint members to the Investment Committee. Further, Sub Trust A, the trustee for Sub Trust A, the Investment Manager in its capacity as Investment Manager of Sub Trust A, the Investment Committee and Investor Consultation Committee in their capacities as committees for Sub Trust A, will not have the ability to veto any decisions in respect of Sub Trust B (and vice versa).

Assumption

·        All trusts established as part of the fund will be unit trusts.

·        While there is no certainty as to the investor composition at the date of this ruling, the anticipated investor profile of Head Trust is currently as follows:

˗   The four resident superannuation funds are complying superannuation funds or a pooled superannuation trust that has at least one member that is a complying superannuation fund, a fund that has at least 50 members.

˗   The non-resident trust is recognised under a foreign law as being used for collective investment by pooling the contributions of its members as consideration to acquire rights to benefits produced by the entity and has at least 50 members, and the contributing members do not have day-to-day control over the entity's operation.

˗   At least 95% of the membership interests in the limited partnership are owned by entities mentioned in subsection 275-20(4)(a)-(ia), or by entities that are wholly-owned by those entities; and the remaining membership interests (if any) in the limited partnership are owned by a general partner of the limited partnership that habitually exercises the management power of the limited partnership.

·        The trustees for all unit trusts in the Head Trust chain of trusts are Australian resident entities for income tax purposes.

·        The Investment Manager is an Australian resident entity and conducts all its investment management activities in relation to the fund in Australia.

·        While the Investment Manager operates or manages Sub Trust A, it will be a financial services licensee (within the meaning of section 761A of the Corporations Act 2001) that holds an Australian financial services licence, which licence covers it providing financial services (within the meaning of section 766A of that Act) to wholesale clients (within the meaning of section 761G of that Act).

·        Sub Trust A and each of its sub-trusts will be a managed investment scheme ('MIS') under section 9 of the Corporations Act 2001.

·        Sub Trust A is an unregistered wholesale trust and is not required to be registered in accordance with section 601ED of the Corporations Act 2001 because of subsection 601ED(2) of that Act.

·        Head Trust and SPV had not become members of Sub Trust A because a financial service was provided to, or acquired by, the members as a retail client (within the meaning of sections 761G and 761GA of the Corporations Act 2001).

·        Sub Trust A will carry on a business that consists wholly of eligible investment business.

·        Sub Trust A and Sub Trust B will only invest in real estate situated in Australia and will only derive Australian sourced income.

·        Head Trust is not eligible to elect into the Attribution MIT ('AMIT') regime.

Reasons for decision

As Head Trust will not be a public trading trust for the purposes of Division 6C of the ITAA 1936, it will not be taxed like a company. Instead, the net income of the trust estate will be subject to tax in accordance with the rules in Division 6 of the ITAA 1936.

Division 6 of the ITAA 1936 sets out the basic income tax treatment of the net income of a trust estate, subject to the modifications contained in Division 6E of the ITAA 1936 (where relevant), with Subdivision 115-C providing the corresponding taxation treatment for that part of the net income of the trust estate that comprises capital gains.

The general position is that, except as provided in the income tax Act, a trustee shall not be liable as trustee to pay income tax upon the income of the trust estate pursuant to section 96 in Division 6 of the ITAA 1936.

In circumstances where an Australian resident beneficiary is presently entitled to a share of the income of a trust estate and is not under any legal disability, section 97 of Division 6 of the ITAA 1936 includes in that beneficiary's assessable income their share of the net income of the trust estate. The provision states:

Section 97 Beneficiary not under any legal disability

97(1) Subject to Division 6D, where a beneficiary of a trust estate who is not under any legal disability is presently entitled to a share of the income of the trust estate:

(a) the assessable income of the beneficiary shall include:

(i) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident; and

(ii) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was not a resident and is also attributable to sources in Australia; and...

Accordingly, Australian resident beneficiaries of Head Trust, who are not under any legal disability and who are presently entitled to a share of the income of Head Trust, will be assessed under section 97 of the ITAA 1936 on their share of the net income of Head Trust.

For completeness and clarity, the following applies:

·        The expression 'income of the trust estate' in section 97 of the ITAA 1936 refers to the distributable income of the trust as determined according to trust law and in accordance with the relevant trust deed. The amount may be different to the 'net income of the trust estate', which is defined in section 95 as follows:

net income, in relation to a trust estate, means the total assessable income of the trust estate calculated under this Act as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions, except deductions under Division 393 of the Income Tax Assessment Act 1997 (Farm management deposits) and except also, in respect of any beneficiary who has no beneficial interest in the corpus of the trust estate, or in respect of any life tenant, the deductions allowable under Division 36 of the Income Tax Assessment Act 1997 in respect of such of the tax losses of previous years as are required to be met out of corpus.

·        The term 'share', as used in subparagraphs 97(1)(a)(i) and (ii), means 'proportion' such that once the share of the distributable income of the trust to which the beneficiary is presently entitled is determined, the beneficiary is assessed on that same percentage share of the trust's net income as defined in section 95 of the ITAA 1936.

·        Where the net income of a trust estate includes a capital gain, Subdivision 115-C operates simultaneously with Division 6, such that the taxation of a trust's capital gains is dealt with under the former and effectively taken out of the latter.

As the income received by Head Trust, and which is then distributed to Head Trust beneficiaries, will comprise distributions from Sub Trust A and Sub Trust B, which in turn will be in the form of Australian sourced income including rent, interest income and capital or revenue gains, the following also applies:

·        Generally, the provisions in the tax law assume, or provide for, amounts (such as capital gains, franked distributions and interest income) to have the same character in the hands of a beneficiary as they had in the hands of a trustee.

·        For instance, in relation to interest income of a trust, subsection 6B(2) of the ITAA 1936 provides a tracing mechanism whereby income derived by a person as a beneficiary in a trust estate is deemed to be an amount attributable to interest income where the income arises from interest income derived by the trustee of a trust estate. Section 6B(2) of the ITAA 1936 relevantly states:

Section 6B Income beneficiary derived

6B(2) [Income attributable to interest income]

For the purposes of this Act, an amount of income derived by a person, being income other than interest income, shall be deemed to be income attributable to interest income:

(a) if the person derived the amount of income by reason of being beneficially entitled to an amount representing interest income; or

(b) if the person derived the amount of income as a beneficiary in a trust estate and the amount of income can be attributed, directly or indirectly, to interest income or to an amount that is deemed, by any application or successive applications of this subsection, to be an amount of income attributable to interest income.