Edited version of private advice

Authorisation Number: 1051791264480

Date of advice: 21 December 2020

Subject: Income tax - capital gains tax - capital v revenue classification - asset sale

Question 1

Are the gains derived by the trustee of the fund (the Fund) from the disposal of Preference Shares assessable as ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997)?

Answer

No

This ruling applies for the following period:

Income year ended 30 June 2020

Relevant facts and circumstances

Background

A large group of individual investors travelled to a conference where companies gave presentations on potential investment opportunities in their businesses.

Company A, an unlisted foreign company, was seeking investment from investors of $XM to purchase preference shares with an 8% cumulative dividend to be paid in priority of any dividend paid on ordinary shares. The owner of Company A requested that for the purpose of signing off on the investments it would be best to have one contact person.

The investor group utilised a trust structure to pool their funds to purchase shares in Company A (the Fund). The investor group were known to each other and some were employees (including owners) of the corporate trustee (the trustee).

The Fund was set up as the most efficient, low cost vehicle to pool the investment and have a single contact point as requested by Company A.

The trustee has a business offering clients investment products through several investment funds.

The Fund used by the investor group was not offered as part of the trustee's business and was not actively managed by the trustee. In particular the trustee would not:

•         take any step to buy or sell any shares in Company A without the express authority of each individual member of the investor group to whom the Preference Shares were notionally attributed;

•         seek briefings from Company A or attend management presentations on behalf of the investor group;

•         provide updates to the investor group or conduct any independent analysis of the performance of the investment;

•         make recommendations to the investor group regarding buying or selling Preference Shares in Company A;

•         enter into a management agreement with the investor

The trustee was not entitled to and did not receive any performance or management fees, and was only able to recover some of its direct expenses incurred in administering the Fund.

When any Preference Shares were sold, the trustee would distribute the proceeds of that sale only to the exiting unitholder in exchange for the redemption of the equivalent portion of their units.

The Fund Deed

An existing pro-forma unit trust deed was used to establish the Fund (the pro-forma Deed), as this was most cost-effective. The pro-forma Deed contained terms similar to those used for commercial funds, however many of the terms would not be required in relation to the investment in Company A. The use of a pro-forma Deed was considered more efficient than creating a specific deed to meet the limited needs of the investor group.

Each investor was in control of a parcel of Preference Shares which corresponded to their investment in Company A. In that sense, the trustee's role (for which it was not paid any fee, nor reimbursed for any of its costs) was akin to that of a nominee. In relation to the acquisition and, in particular, the disposal of the Preference Shares, the investor group and trustee acted on the basis that each investor (i.e. each unitholder) was entitled to direct the trustee how to deal with that portion of the Preference Shares which reflected their equivalent interest in the units in the Fund.

The term sheet of the Fund noted that:

• the Fund's purpose was to raise funds for the sole purpose of making an early stage investment into Company A;
• each investor was defined as a "wholesale client" within the meaning of the Corporations Act 2001;
• The Fund would not accept redemptions. Redemption of their units by any single investor was a necessary part of the structure of the Fund - however, such redemption required a sale of that investor's Preference Shares in Company A to have been made by the Fund. The pro-forma Deed dealt comprehensively with the procedure for redemption (described as "withdrawal") of an investor's units.
• There was no management fee payable to the trustee;
• There was no performance fee payable to the trustee;
• The duration of the Fund would exceed X years (no time limit or termination date was set);
• Income distributions (out of any dividends to be paid on the Preference Shares) would usually be paid each year; and
• The "Exit Strategy" for the investment was described as "IPO or Business sale".

The Fund's activities

The applicant asserts that the use of the Fund was to passively facilitate the collective investments in Company A without limiting each individual investor's rights to deal with their Preference Shares. For example, when Company A conducted further capital raising the trustee did not make any of its own enquiries nor conduct research on behalf of the investor group, nor did it make any specific recommendation as to whether to participate in these further opportunities. On each occasion, each investor was given the opportunity to increase their investment by participating in the new capital raising - but this was their individual decision. As no member elected to participate in any of the subsequent capital raisings, the Fund did not acquire any further shares in Company A.

Furthermore Company A would communicate directly to certain investors and not necessarily to the trustee.

No information was provided to the investors prior to 30 June 2020 as to the specific intention of Company A to declare and distribute dividends on the Preference Shares. Company A was not cash-flow positive in the early years of its growth phase and the terms of their Preference Shares provide for the right to the dividend of 8% to accumulate each year if unpaid. However, the lack of short-term cash-flow available (during the growth phase of the company) did not adversely affect the accumulating 8% right.

The Fund made only the single purchase of Preference Shares in Company A. Those Preference Shares have been held continuously by the Fund until the time that an individual investor/unitholder elected to cause the Fund to sell their portion of the Preference Shares.

No fees were payable in relation to the purchase of the Preference Shares. Legal fees, custody fees and brokerage fees were paid in connection with the sale of the Preference Shares.

Brokerage fees were incurred when a broker (on behalf of a prospective purchaser) approached the Fund and the broker required agreement for a commission to be paid before identifying the prospective purchaser. The fee to the broker was paid by the Fund out of the proceeds of the sale of the Preference Shares and shared pro-rata by the underlying investors who sold their shares. Each underlying investor determined whether they wanted to dispose of their shares and only the investors who elected to sell their shares bore the costs of the brokerage fee.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 paragraph 8-1(1)(a)

Reasons for Decision

Summary

The gains derived by the trustee in its capacity as trustee of the Fund did not arise as part of a business operation or commercial transaction, but from a mere realisation of the Preference Shares. The gain should therefore be treated on capital account.

Detailed reasoning

Taxation Determination TD 2011/21: Income tax: does it follow merely from the fact that an investment has been made by a trustee that any gain or loss from the investment will be on capital account for tax purposes? (TD 2011/21) provides that the mere fact that a gain or loss from an investment is made by an entity in its capacity as trustee of a trust is not conclusive as to whether the gain or loss is on revenue or capital account for tax purposes.

Paragraph 3 of TD 2011/21 states that the nature of the trust and the terms and content of the trustee's duties are important considerations in the characterisation process, however they are not necessarily determinative.

At paragraph 4, TD 2011/21 provides a number of factors which may also assist in determining whether a gain or loss is on revenue or capital account, being:

•         the nature and scale of the trustee's investment and other activities;

•         the investment style employed in respect of the trust assets;

•         the nature of the trust assets;

•         the length of time individual investments are held, the regularity in sale activity involving the trust assets;

•         the average annual turnover of the trust assets;

•         the percentage of total income which the gains represent; and

•         the nature of any connection between the trustee and other parties to the dealings.

TD 2011/21, at paragraph 54, states:

54. The nature of the trust and the terms and content of the trustee's duties must be determined having regard to all relevant circumstances, including the events surrounding the establishment of the trust, the trust instrument and associated information such as a prospectus. It may also be relevant, as discussed in Orr v. Wendt & Ors [2005] WASCA 199 (at paragraph 46), to examine:

• whether there are different classes of beneficiaries with competing interests;

• the nature of the assets comprising the trust fund;

• the professional expertise of the trustee and its advisors; and

• the personal circumstances of the relevant beneficiaries (for example, whether they are investors or family members of the settlor, if they are investors what expectations they have about returns from the trust, and if they are family members whether they depend on trust distributions for their livelihood).

The character of a gain or loss made by a trustee on disposing of an investment must be determined having regard to all of the relevant facts and circumstances. If, on the facts, a disposal of an investment by a trustee amounts to no more than a mere realisation or change of investment, the gain or loss will be on capital account.

However if, on an assessment of all the facts, including the nature of the trust and the content of the trustee's duties, the disposal of the investment is a normal operation in the course of carrying on a business of investment, any gain will be income according to ordinary concepts and any loss deductible (London Australia Investment Co Ltd v. Federal Commissioner of Taxation (1977) 138 CLR 106; 77 ATC 4398; (1977) 7 ATR 757). Furthermore, a disposal will be on revenue account if no provision of the income tax law specifically treats it as being on capital account and, after a wide survey and exact scrutiny of all of the relevant factors, it is determined that the gain or loss was from:

• an extraordinary operation by reference to the ordinary course of that business but one entered into with the intention of making a profit or gain; or

• a one-off or isolated transaction where the investment was acquired in a business operation or commercial transaction for the purpose of profit-making.

Profits arising from an isolated business or commercial transaction will be ordinary income if the taxpayer's purpose or intention in entering into the transaction is to make a profit, even though the transaction may not be part of the ordinary activities of the taxpayer's business (FC of T v. Myer Emporium Ltd 1987 163 CLR 199; 87 ATC 4363; 18 ATR 693 (Myer Emporium)).

Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income (TR 92/3) considers the principles outlined in the Myer Emporium case and provides guidance in determining whether profits from isolated transactions are assessable under section 6-5 of the ITAA 1997 as ordinary income.

In TR 92/3, the term 'isolated transactions' refers to:

• those transactions outside the ordinary course of business of a taxpayer carrying on a business; and
• those transactions entered into by non-business taxpayers.

It is not necessary that the intention or purpose of profit-making be the sole or dominant intention or purpose for entering into the transaction. It is sufficient if profit-making is a significant purpose.

If a taxpayer makes a profit from a transaction or operation, that profit is income (assessed under section 6-5 of the ITAA 1997) if the transaction or operation is not in the course of the taxpayer's business but:

• the intention or purpose of the taxpayer in entering into the profit-making transaction or operation was to make a profit or gain; and
• the transaction or operation was entered into, and the profit was made, in carrying out a business operation or commercial transaction.

Whether an isolated transaction is business or commercial in character will depend on the circumstances of each case. TR 92/3 lists the following factors to be considered:

(a)  the nature of the entity undertaking the operation or transaction;

(b)  the nature and scale of other activities undertaken by the taxpayer;

(c)   the amount of money involved in the operation or transaction and the magnitude of the profit sought or obtained;

(d)  the nature, scale and complexity of the operation or transaction;

(e)  the manner in which the operation or transaction was entered into or carried out;

(f)    the nature of any connection between the relevant taxpayer and any other party to the operation or transaction;

(g)  if the transaction involves the acquisition and disposal of property, the nature of that property; and

(h)  the timing of the transaction or the various steps in the transaction.

A recent Full Federal Court decision in Greig v Commissioner of Taxation [2020] FCAFC 25 (Greig case) considered whether a taxpayer who was employed as a full-time senior executive and not otherwise carrying on a business during the relevant period acquired shares in an Australian Securities Exchange (ASX)-listed company as part of a 'business operation or commercial transaction'. A majority of the Full Court concluded that the taxpayer did. Therefore, given the taxpayer also had a profit-making intention in acquiring those shares (which was not in dispute), the principle in Myer Emporium was engaged. As a result, the losses and outgoings made by the taxpayer from the compulsory transfer of those shares were deductible under paragraph 8-1(1)(a) of the ITAA 1997.

The facts of the Greig case were summarised in the ATO Decision impact statement (DIS) to that case:

The taxpayer was a senior executive for a global group of companies providing construction, project management and engineering services to clients, including those in the mining and resources industry. The case related to the taxpayer's acquisitions of shares in the former ASX-listed company, Nexus Energy Limited (Nexus). The taxpayer was familiar with Nexus because of his knowledge of the mining and resources sector. He considered there was value in the shares beyond that reflected in their share price, and reasonable prospects of him making a profit by selling the shares in the short-term. In particular, the taxpayer was of the view that Nexus' interest in a gas field off the north-west coast of Western Australia was undervalued. The taxpayer acquired a large number of Nexus shares over 64 transactions spanning approximately two years between 2012 and 2014, with an intention of making a profit from their sale prior to his retirement within four to five years.

During the period in which the taxpayer acquired and held Nexus shares, he regularly monitored their price and ASX announcements either directly or through his professional adviser, conducted research into the company's prospects by reading relevant financial press articles and research reports by investment banks and stockbrokers, and attended company meetings and presentations. During this period, the taxpayer played a key role in influencing a majority of the company's shareholders to reject a takeover proposal from Seven Group Holdings Ltd. However, when the company was placed into voluntary administration, the taxpayer was unsuccessful in legal proceedings (with some other shareholders) to oppose a deed of company administration (DOCA) that proposed the compulsory acquisition of his shares for no consideration. The Supreme Court of New South Wales approved the proposed DOCA in December 2014, which resulted in the taxpayer making share losses of approximately $11.85 million. The taxpayer also incurred associated legal fees of $507,198.

Aside from shares in Nexus, the taxpayer invested millions of dollars in the share market using both professional advice and his own business knowledge and experience. The taxpayer had treated his other considerable share investments (acquired in over 200 separate parcels, totalling approximately $26 million, of which approximately 180 parcels were sold, and the majority held for only short periods of time) as being held on capital account. However, only the tax treatment of the Nexus shares was in dispute in this case.

The DIS discusses the Full Court's application of the Myer Emporium principles, noting that:

•         Profit-making purpose is not sufficient by itself to engage the Myer Emporium principle and will not of itself give a transaction a business-like or commercial character - at [31], [141] and [225]. However, such a purpose is relevant to how the activities of the taxpayer are characterised in determining whether there is a business operation or commercial transaction - at [31], [141-142] and [224-225].

•         In determining whether there is a business operation or commercial transaction, '...it is necessary to make both a wide survey and an exact scrutiny of the taxpayer's activities' and emphasis should not be put on one or more features of a transaction to the exclusion of others - at [27] and [212].

•         Whether a transaction is on revenue account or capital account will depend on an objective assessment of the facts - at [96] and [242(3)]. While a taxpayer's subjective intention may form part of the wide survey and exact scrutiny of a taxpayer's activities, it should be treated with caution - at [212] and [214]. However, evidence about a taxpayer's personal characterisation of the transaction as being either on revenue account or capital account may go to the credit of the taxpayer's evidence or be relevant to penalties - at [242(3)].

•         Activities entered into after an acquisition of shares will generally not be relevant in determining whether the shares were acquired in a business operation or commercial transaction. However, where shares are acquired progressively over time, the taxpayer's activities over that period may be relevant as part of the wide and exact scrutiny of the taxpayer's activities, particularly where the transaction is not an isolated one - at [30], [242(1)] and [245(4)].

•         Where a taxpayer acquires shares to sell at a profit rather than to hold as a long-term investment and to receive dividends over time, the taxpayer waiting to sell the shares so as to realise the profit sought will not be fatal to a characterisation of the transaction as being on revenue account - at [246].

In Taxation Ruling - TR 97/11 Income Tax: am I carrying on a business of primary production? (TR 97/11), the Commissioner sets out indicators which support the view that a person is carrying on a business. These indicators are similar to those in TR 92/3 and paragraphs 13, 15 and 16 provide:

13. The courts have held that the following indicators are relevant:

•         whether the activity has a significant commercial purpose or character; this indicator comprises many aspects of the other indicators (see paragraphs 28 to 38);

•         whether the taxpayer has more than just an intention to engage in business (see paragraphs 39 to 46);

•         whether the taxpayer has a purpose of profit as well as a prospect of profit from the activity (see paragraphs 47 to 54);

•         whether there is repetition and regularity of the activity (see paragraphs 55 to 62);

•         whether the activity is of the same kind and carried on in a similar manner to that of the ordinary trade in that line of business (see paragraphs 63 to 67);

•         whether the activity is planned, organised and carried on in a businesslike manner such that it is directed at making a profit (see paragraphs 68 to 76);

•         the size, scale and permanency of the activity (see paragraphs 77 to 85); and

•         whether the activity is better described as a hobby, a form of recreation or a sporting activity (see paragraphs 86 to 93).

...

15. We stress that no one indicator is decisive ( Evans v. FC of T 89 ATC 4540; (1989) 20 ATR 922), and there is often a significant overlap of these indicators. For example, an intention to make a profit will often motivate a person to carry out the activity in a systematic and organised way, so that the costs are kept down and the production and the price obtained for the produce are increased.

16. The indicators must be considered in combination and as a whole. Whether a business is being carried on depends on the 'large or general impression gained' ( Martin v. FC of T (1953) 90 CLR 470 at 474; 5 AITR 548 at 551) from looking at all the indicators, and whether these factors provide the operations with a 'commercial flavour' ( Ferguson v. FC of T (1979) 37 FLR 310 at 325; 79 ATC 4261 at 4271; (1979) 9 ATR 873 at 884). However, the weighting to be given to each indicator may vary from case to case.

Application to the facts and circumstances

The transactions entered into by the trustee in relation to the Preference Shares were not part of the ordinary business of the trustee, nor were they extraordinary transactions by reference to the ordinary course of any business being undertaken by the Fund specifically. Whilst the sale of the Preference Shares did result in a profit (gain) on behalf of the investor group, this factor alone does not point towards the gain being on revenue account when the following factors are also considered.

• The Fund was used as a vehicle to pool the investor group's investment into Company A. The Preference Shares were acquired in a single isolated purchase on one occasion and no further shares were acquired, as no member of the investor group decided to purchase further Preference Shares.
• The Fund was set up to only hold the Preference Shares on behalf of the investor group and the Fund made no further investments in Company A or any other entity.
• The Fund was set up as a result of a group of investors who were known to each other being interested in investing in Company A, and was also set up due to the request from the owner of Company A to only have one investor rather than a group of investors.
• The Fund was not offered to any other client of the trustee and was not listed as a Fund on the trustee's website. The investor group included employees of the trustee who were known to each other and had previously made other investments together.
• The trustee did not provide any investment information to the investor group, nor was the trustee required to provide an investments plan. The trustee's willingness to take on this role was solely because a number of the investor group were associated with the trustee.
• The trustee was not entitled to, and did not receive, any performance or management fees, and was only able to recover some of its direct expenses incurred in administering the Fund. The trustee's relationship with the investor group as trustee was uncommercial and a non-arm's length transaction.
• The investor group were not clients of the trustee as they did not pay the trustee any fees for being trustee of the Fund.
• The trustee did not actively seek to provide a return on the units held by the investor group or to actively manage the Preference Shares. No steps were taken to enhance the value of the Preference Shares.
• The trustee did not trade in the Preference Shares. Each member of the investor group provided their own individual instructions to the trustee as to whether and when they would buy or sell the Preference Shares allocated to them.
• Each sale occurred at the request of an investor (or several investors) and was not initiated or recommended by the trustee.
• Each investor was responsible for the costs associated with the sale of Preference Shares and such costs were offset against their sale of Preference Shares.
• Emails from Company A were not sent directly to the trustee but rather directly to some of the investors individually.
• The activities of the Fund were that of a passive investor.

This case can be distinguished from the Greig case based on the following factors:

•         The trustee did not take any steps to increase the value of the Preference Shares whereas Mr Greig engaged lawyers to challenge the scheme of arrangement in Court, in an attempt to increase the value of his Nexus shares.

•         The Preference Shares were acquired in a single transaction and the trustee did not engage in any further investing activity on behalf of the Fund. Mr Greig, on the other hand, made 64 separate purchases of Nexus shares and engaged in 208 separate acquisitions and 180 disposals of other listed shares during the relevant years.

•         The Preference Shares carried an 8% cumulative dividend yield (although Company A has not yet paid any dividends on them). By comparison, Mr Greig's shares in Nexus did not carry any fixed dividend and Mr Greig did not acquire the shares for the purpose of obtaining a dividend yield.

•         The Fund did not engage any professional advisor. Instead it relied on the individual group members to inform it whether and when they wished to sell their Preference Shares.

Having regard to the factors listed above it is considered that the gain on disposal of the Preference Shares did not arise as part of a business operation or commercial transaction within the meaning of the Myer Emporium principle, but from a mere realisation of those Preference Shares. The gain should therefore be treated on capital account.