Edited version of private advice

Authorisation Number: 1051735288682

Date of advice: 07 August 2020

Ruling

Subject: Replacement asset roll-over

Question 1

Will expenditure incurred on subscribing for replacement trust units constitute the taxpayer incurring "expenditure in acquiring another CGT asset" under paragraph 124-75(2)(a) of the Income Tax Assessment Act 1997?

Answer

Yes

Question 2

Will the use of the replacement trust units be for the same purpose as, or for a similar purpose to, the purpose for which the taxpayer used the land just before the partial compulsory acquisition of the land for the purposes of subsection 124-75(4) of the ITAA 1997?

Answer

No

This ruling applies for the following periods:

Income year ended 30 June 2020

Income year ended 30 June 2021

The scheme commences on:

1 July 2018

Relevant facts and circumstances

The Background

1.    Several documents provided by the taxpayer form part of the facts in this ruling.

2.    The taxpayer is an Australian resident company that is the trustee of a discretionary trust.

3.    The taxpayer is part of a group of entities which includes trusts that own residential, commercial and industrial real estate, held for a long term for the purposes of earning rental income.

The Original Property

4.    Prior to 1995, the taxpayer acquired a property (the original property) for investment purposes. Specifically, at the time of its purchase, it was intended that:

·         The original property would be developed into an industrial warehouse and leased to a suitable tenant.

·         If rezoning occurs, the original property would be developed into a mixture of commercial and residential units.

·         This property would be held as a long-term investment. However, some of the residential units developed may be sold in order to fund the development.

5.    Following its acquisition by the taxpayer, the original property was leased as commercial premises to a third party and rental income was received.

6.    A portion of the original property was later compulsorily acquired by the Roads and Maritime Services (RMS), a NSW Government agency.

Purchase of Trust Units

7.    Unit Trust A is a member of the same group of entities as the taxpayer.

8.    The taxpayer was the sole unit holder of the Unit Trust A at establishment. The taxpayer is considering the purchase of further trust units Unit Trust A and will continue to be the sole unitholder of the trust.

9.    The funds obtained by Unit Trust A from the taxpayer will be used for the property development outlined below.

Property development

10.  Trust B is also a member of the same group of entities as the taxpayer.

11.  Trust B owns a property (the development property) with two other group members as minority stakeholders who do not have a right to receive any capital proceeds or rental income.

12.  Trust B acquired the development property for investment purposes. It has been leased to various third parties since its acquisition.

13.  The development property is currently a single storey commercial property. Trust B views the development property as 'under-developed', being zoned for a higher density use.

14.  Unit Trust A and Trust B entered into an agreement in relation to the development property. Trust B would enter into a contract with a third party construction company to construct a mezzanine level and office, toilets and new façade on the existing building on the development property and for the environmental works on the property e.g. the removal of hazardous items and the decontamination of the property.

15.  Trust B would pay for the environmental works and Unit Trust A would pay for the construction works. However, Trust B will make all the payments to the third party construction company but will be reimbursed by Unit Trust A for the construction works.

16.  The net revenue received from rent after costs and maintenance will be divided between Trust B and Unit Trust A based on each trust's respective contributions. However, all costs and revenues in relation to the property will be received and paid by Trust B in the first instance.

17.  Similarly, if the property were to be sold by Trust B, the sale proceeds after costs will also be divided between Trust B and Unit Trust A based on each trust's respective contributions.

18.  To secure the rights of Unit Trust A under the development agreement, Trust B would grant a charge over the development property in favour of Unit Trust A. Unit Trust A would register a caveat over the development property.

19.  Trust B entered into a construction agreement with a third party construction company and a mezzanine level and office, toilets and new façade was built on the existing building on the development property. The development property was then leased to a third party at a higher rental rate than that which was charged prior to the development. It is not intended that the development property will be sold; it will continue to be held as an investment property from which rental income will be derived.

Future investment in Unit Trust A

20.  In the future, other entities in the taxpayer's group may subscribe for additional units in Unit Trust A. Unit Trust A will use the funds acquired from the issue of units to make various property-related investments. To that end, the intention for Unit Trust A is to become an investment vehicle for members of the group to efficiently pool funds and make property investments.

Relevant legislative provisions

Section 108-5 of the ITAA 1997

Section 124-75 of the ITAA 1997

Treasury Laws Amendment (2017 Enterprise Incentives No 1) Act 2019

Reasons for decision

Question 1

Summary

Yes, the expenditure incurred by the taxpayer in subscribing for replacement trust units will constitute expenditure in acquiring another CGT asset for the purposes of paragraph 124-75(2)(a) of the ITAA 1997.

Detailed reasoning

Subdivision 124-B of the ITAA 1997 outlines the requirements for a replacement asset roll-over where an original asset has been compulsorily acquired, lost or destroyed.

The taxpayer satisfies the terms of paragraph 124-70(1)(a) of the ITAA 1997 as a part of a CGT asset it owned, being the original property, was partially compulsorily acquired by RMS, an Australian government agency.

The taxpayer received money by way of compensation for the compulsory acquisition: subsection 124-75(1).

The issue is whether it satisfies the requirement under subsection 124-75(2), which provides as follows:

124-75(2):

You must:

(a) incur expenditure in *acquiring another *CGT asset (except a *depreciating asset whose decline in value is worked out under Division 40 or deductions for which are calculated under Division 328); or

(b) if part of the original asset is lost or destroyed - incur expenditure of a capital nature in repairing or restoring it.

The definition of a CGT asset is prescribed under section 108-5. The subsection states as follows:

'108-5(1)

A CGT asset is:

(a) any kind of property; or

(b) a legal or equitable right that is not property

108-5(2)

To avoid doubt, these are CGT assets:

(a) part of, or an interest in, an asset referred to in subsection (1);

(b) goodwill or an interest in it;

(c) an interest in an asset of a partnership;

(d) an interest in a partnership that is not covered by paragraph (c).

Note 1:

Examples of CGT assets are:

o   land and building

o   shares in a company and units in a unit trust

o   options

o   debts owed to you

o   a right to enforce a contractual obligation

o   foreign currency

As clarified in the example provided in Note 1 to the section, CGT assets include units in a unit trust.

Therefore, consideration paid by the taxpayer as part of its subscription for trust units will constitute expenditure incurred in acquiring another CGT asset for the purposes of paragraph 124-75(2)(a) of the ITAA 1997.

Question 2

Summary

The use of the replacement trust units will not be for the same purpose as, or for a similar purpose to, the purpose for which the taxpayer used the original property just before the partial compulsory acquisition for the purposes of subsection 124-75(4) of the ITAA 1997.

Detailed reasoning

Subsection 124-75(4) provides as follows:

If just before the event happened the original asset:

(a) was used in your *business; or

(b) was *installed ready for use in your business; or

(c) was in the process of being *installed ready for use in your business;

the other asset must be used in the business, or be installed ready for use in the business, for a reasonable time after you *acquired it.

Otherwise, you must use the other asset (for a reasonable time after you *acquired it) for the same purpose as, or for a similar purpose to, the purpose for which you used the original asset just before the event happened.

Taxation Determination TD 2000/42 Income tax: capital gains: what is the scope of the words 'use

the other asset ... for the same purpose ... or for a similar purpose' in subsection 124-75(4) of the Income Tax Assessment Act 1997 in relation to a replacement asset? (TD 2000/42) provides general guidance on the application of the requirement in subsection 124-75(4) in its outline of the following principles:

'..1. The words 'use the other asset ... for the same purpose ... or for a similar purpose' should be read in their context in subsection 124-75(4) of the Income Tax Assessment Act 1997.

2. Whether a CGT asset is used for the same or a similar purpose as another asset is a question of fact and degree....'

The following analysis may be divided into 3 parts:

1)    The first part requires a consideration of the purpose for which the 'original asset' was used;

2)    The second considers the purpose for which the 'other asset' is used.

3)    The third considers a comparison of the purpose for which the original asset and the other asset is used.

Original asset - purpose

The compulsorily acquired land was held by the taxpayer as a long-term investment from which rent was derived.

It is noted that a development of the original property was also contemplated by the taxpayer; in particular, it was intended that property would at first instance be developed into an industrial warehouse, whereupon it would be leased to a suitable tenant; and thereafter, given a suitable opportunity, to be developed into a mixture of commercial and residential units for lease to third parties.

In this regard, the potential development of the original property did not comprise a purpose in itself but rather aided or advanced the primary purpose for which the property was (and continues to be) held - that is, for the derivation of rental income.

Other asset - purpose

The next matter to consider is the purpose for which the Unit Trust A units are to be used by the taxpayer.

It is noted that under the proposal:

·         The 'other asset' is not real property, but units in a unit trust.

·         The income derived by the taxpayer from the units is the return stemming from its entitlements as a unit holder of the Unit Trust A.

·         More specifically, the source of such income is derived, not from lease agreements entered into with third party tenants in respect of real property owned by the taxpayer, but from the terms of the Unit Trust A's trust deed, under which the taxpayer as a unitholder is conferred a beneficial interest in the trust fund. This includes a right to 'Distributable Income', which is payable only upon the exercise of the trustee's discretion.

Prima facie the broad purpose for which the units are to be 'used' by the taxpayer might be described as the derivation of trust income, or trust capital, or both.

Comparison: same or different purpose?

That both assets are appropriated for the broader purpose of earning income in general is not itself sufficient to satisfy the terms of subsection 124-75(4), which requires a consideration of how the asset is put to use for the earning of that income; that is, the provision requires that regard be had to the specific 'use' of the asset by the taxpayer.

As mentioned above, the use of the units, from the perspective of the taxpayer, is for the purpose of deriving trust income or trust capital (1) however it arises and (2) when it becomes payable pursuant to the exercise of the trustee's discretion. The entitlement arises from the taxpayer's beneficial interest in the trust fund as a unitholder.

This is fundamentally different from the taxpayer's use, as registered proprietor, of the partially compulsorily acquired land. The land was specifically acquired and held, together with the rest of the original land, for the purpose of (1) leasing to third party tenants; and (2) earning rental income. Any development contemplated in respect of the land was for the primary objective of obtaining or increasing this income. At the outset therefore it would appear that the purpose for which the partially compulsorily acquired land was used is different from the purpose for which the units are 'used'.

This approach is consistent with that taken by the Commissioner in TD 2000/42. Examples 1 and 3 in paragraphs 3 and 5 respectively consider scenarios involving real property acquired for rental purposes:

'...3. Steve owned machinery for use in his manufacturing business. The machinery is destroyed by a fire. He replaces the machinery with a rental property. The rental property is not used for the same or a similar purpose to the purpose for which the machinery was used.....

5. Marina owns a house near the sea which she has always rented out. The house has, for capital gains purposes, been treated as an asset separate from the land on which it is situated - the land having been acquired in 1980 - because of the operation of Subdivision 108-D. The house is destroyed by a cyclone and she has the choice of either:

(a) acquiring a city unit for rental purposes; or

(b) rebuilding the house to use as her main residence.

For the purposes of Subdivision 124-B, the use of the city unit will fall within the scope of the same or similar purpose test. The use of the new building as a main residence will not. ...'

As per example 1, the use of property for the derivation of rental income is separate and distinct from the use of an asset as machinery in a manufacturing business; both earn income, but each is used for different purposes in the earning of that income. Subsection 124-75(4) requires that the use of the asset be for the same or a similar purpose: as per example 3, if the original property is used for rental purposes, the replacement asset must also be rental property.

In the present case, while the partially acquired land was appropriated to earn rental income, the same cannot be said for the Unit Trust A units. The trust units are not rental property from which rental income is derived.

A broader view

The Commissioner is asked, however, to consider whether there is nevertheless a similarity in the purposes for which the assets are used as a matter of practicality; that is, to adopt a substance-over-form approach in his determination. That is, the taxpayer would earn rental income indirectly through Unit Trust A and its purpose of acquiring the units would be the same or similar to their purpose for holding the original land. In relation to the development agreement, Unit Trust A will share in the net rental income and net property returns upon sale that Trust B will receive.

This broader approach has not been sanctioned by any authority or written guidance on the issue. Upon a consideration of the submissions, it is the Commissioner's view nonetheless that, the trust units fail the 'same or similar purpose' test, even as a matter of substance. This view is held for several reasons, outlined below.

·         The nature of the interest in units

A unitholder in the Unit Trust A is conferred a beneficial interest in the trust fund, including a right to 'Distributable Income' payable upon the exercise of the trustee's discretion.

Each unit confers an equal undivided interest in the trust fund as a whole, but it is material that no unit confers an interest in a particular asset.

Under the terms of the Unit Trust A's deed, which form part of the facts in this ruling, income may be earned by the trust from various sources; the application of trust funds is not restricted, for example, merely to purposes relating to the earning of rental income. The Trustee is given very broad powers e.g. the trustee can carry on any business, borrow or raise money, incur obligations or liabilities, advance or lend money, make investments of any kind.

The investment and business activities of the Unit Trust A is not thereby restricted to property investment for the earning of rental income. It follows that an investment in the fund is not an investment in rental property.

·         The nexus between the taxpayer and the development property.

The development property is owned by Trust B and not Unit Trust A.

It is material in this respect that the taxpayer is, in fact, several times removed from direct ownership of the development property. Specifically:

·         The taxpayer is not the registered proprietor of the development property. It is a merely a unitholder in Unit Trust A.

·         The Unit Trust A is not, itself, the registered proprietor of the property.

·         The property is owned by a separate entity, being Trust B.

While a charge has been granted over the development property in favour of Unit Trust A, the development agreement does not convey or assign any portion of the legal title in the development property to Unit Trust A (or to the taxpayer, being even further removed from such ownership). As considered further below, the taxpayer has no power of sale over the development property.

·         Nature of the investment by, and returns to, Unit Trust A

The development agreement is an advance of money to Trust B to fund its construction costs, in return for which Unit Trust A is conferred an amount calculated by reference to either revenue derived by Trust B from the property or proceeds upon disposal of the property. The use of such funds by Unit Trust A is consistent with a trustee's power to lend money.

The fact that the return from the advance of such money is calculated by reference to revenue derived by Trust B does not imbue the return with the character of 'rent' in the hands of Unit Trust A. In this regard:

·         Trust B will receive and pay all revenues and costs under the development agreement. Trust B will then make relevant on payments to Unit Trust A under the development agreement.

·         Consequently, Trust B is the entity that receives rent from the lease of the development property (being the party with whom the relevant tenant contracts), but its subsequent payments to Unit Trust A are made pursuant to the separate legal obligation arising from the development agreement, which provides a return to the unit trust of a different character - ie. consideration for its contribution to the building costs.

It is also relevant that Trust B's payment obligation may, alternatively, be satisfied from the sale of the property. This is a matter in respect of which Trust B has the sole discretion. The discretion is not one that is afforded to Unit Trust A. Such control is even further removed from the taxpayer as a unitholder of Unit Trust A.

In other words, where the taxpayer had the power of sale in respect of its use of the original land, it has no similar discretion in respect of the development property. This is yet another material distinction in the nature of the interest acquired by the taxpayer in its unitholding and in the purpose for which such units are 'used'.

Therefore, under the proposed arrangement, the units in Unit Trust A will not be acquired for the same purpose as or for a similar purpose to the purpose for which taxpayer used the original property just before their partial compulsory acquisition for the purposes of subsection 124-75(4) of the ITAA 1997.