Edited version of private advice

Authorisation Number: 1051801057077

Date of advice: 11 February 2021

Ruling

Subject: Base rate entity passive income

Question 1

Are either the payments received or the gain arising in relation to the debts base rate entity passive income of the taxpayer within in the meaning of section 23AB of the Income Tax Rates Act 1986 (ITRA)?

Answer

No.

Question 2

Are either the payments received or the gain arising in relation to the debts included in the aggregated turnover of the taxpayer for the year ended 30 June 2021 for the purposes of section 23AA of the ITRA?

Answer

No.

This ruling applies for the following period:

1 July 20xx to 30 June 20xx

The scheme commences on:

1 July 20xx

Relevant facts and circumstances

The taxpayer is a private company.

In the income years prior to XXXX, the taxpayer was a dormant company.

There is no record of the taxpayer carrying on any activities, owning any assets or earning any income prior to the XXXX income year.

In XXXX, the taxpayer acquired two debts owing by Entity B under two deeds of assignment between the taxpayer and:

•         Entity C, and

•         Entity D.

The taxpayer's debt due by Entity B arises out of the taxpayer taking assignments under two deeds of assignment from Entity C and Entity D of debts due to them by Entity B.

Having regard to the circumstances of Entity B, its related parties at that time and the debts were unsecured, it was generally considered that the debts were worthless. However, the taxpayer was of the view that there was a remote possibility that the debts could become valuable assets in future years.

As such the debts acquired by the taxpayer arose from advances made by Entity C and Entity D to Entity B on an unsecured at call basis subject to interest accruing as in forced from time to time, compounded monthly.

Under the deeds of assignment, the taxpayer paid an amount to obtain the assignment of the debts due by Entity B.

At that time, the debts were acquired when Entity B was insolvent.

Entity B was a finance company within a Group which had been taken over by Entity E which had subsequently collapsed.

Entity C and Entity D were related parties of Entity B.

The taxpayer is not a related party of Entity C or Entity D.

The acquisition of the debts occurred at arm's length.

The liquidator of Entity B and related entities launched a claim against an entity which had refinanced external borrowings of the Group. This litigation extended over many years until a settlement between the liquidator and the entity was reached.

The liquidator for Entity B admitted a proof of debt.

A further dispute occurred between the creditors to the Group as to the manner in which the settlement proceeds should be distributed by the liquidator. The creditors entered into a settlement deed.

Under the settlement deed, a scheme of arrangement for the distribution of proceeds by the liquidator was required to be approved by the Supreme Court which was later approved.

Pursuant to the settlement agreement, the taxpayer received an initial distribution from the liquidator.

The distribution payment as a result of the settlement agreement to the taxpayer was an undissected lump sum amount.

Since the acquisition of the two debts, the taxpayer has not:

•         undertaken any activities other than holding the debts,

•         had any employees, and

•         held any other material assets.

Following the acquisition of the debts and the commencement of the claim by the liquidator, the taxpayer's activities were limited to monitoring any developments in relation to the dispute. Recently, significant time has been required by representatives of the taxpayer in relation to the various legal disputes and agreeing to a settlement of those matters.

The taxpayer has not derived any income or other gains since other than the gain arising from the liquidator's distribution and from the receipt of minor amounts of interest income in recent years.

Relevant legislative provisions

Section 23 of the Income Tax Rates Act 1986

Section 23AA of the Income Tax Rates Act 1986

Section 23AB of the Income Tax Rates Act 1986

Section 26BB of the Income Tax Assessment Act 1936

Subsection 159GP(1) of the Income Tax Assessment Act 1936

Section 102-5 of the Income Tax Assessment Act 1997

Section 118-20 of the Income Tax Assessment Act 1997

Reasons for decision

Question 1

Summary

The payments received or the gain arising in relation to the debts is not base rate entity passive income of the taxpayer within in the meaning of section 23AB of the Income Tax Rates Act 1986 (ITRA).

Detailed reasoning

Section 23 of the ITRA provides the rates of tax payable by a company, other than a company in the capacity of a trustee.

Paragraph 23(2)(a) of the ITRA provides that if a company is a base rate entity for a year of income, the applicable tax rate from 1 July 2020 in respect of its taxable income is 26%.

Otherwise, paragraph 23(1)(b) of the ITRA states the rate of tax payable is 30%.

Base rate entity

Section 23AA of the ITRA defines the term base rate entity. It provides that an entity is a base rate entity for a year of income if:

(a)  no more than 80% of its assessable income for the year of income is base rate entity passive income; and

(b)  its aggregated turnover for the year of income, worked out as at the end of that year, is less than $50 million for the 2019 income year and later income years.

Eligibility for the lower corporate tax rate depends on an entity's base rate entity passive income (BREPI) and aggregated turnover in an income year.

Base rate entity passive income

Section 23AB of the ITRA defines the term BREPI. Subsection 23AB(1) provides that BREPI is assessable income that is:

(a)  a distribution (within the meaning of the Income Tax Assessment Act 1997) by a corporate tax entity (within the meaning of that Act), other than a non-portfolio dividend (within the meaning of section 317 of the Assessment Act);

(b)  an amount of franking credit (within the meaning of the Income Tax Assessment Act 1997) on such a distribution;

(c)   a non-share dividend (within the meaning of the Income Tax Assessment Act 1997) by a company;

(d)  interest (or a payment in the nature of interest), royalties and rent;

(e)  a gain on a qualifying security (within the meaning of Division 16E of Part III of the Assessment Act);

(f)    a net capital gain (within the meaning of the Income Tax Assessment Act 1997); or

(g)  an amount included in the assessable income of a partner in a partnership or of a beneficiary of a trust, to the extent that the amount is referable directly or indirectly to another amount that is BREPI.

For the payment arising from the debts paid under the settlement agreement to be BREPI, it must be one of the seven types of assessable income listed in the definition of BREPI contained in section 23AB of the ITRA, as set out above.

The only type of payment that is relevant from the types of income listed in section 23AB of the ITRA is paragraph 23AB(1)(d) in relation to interest.

Law Companion Ruling LCR 2019/5 Base rate entities and base rate entity passive income provides guidance on the meaning of the types of assessable income that are BREPI.

LCR 2019/5 considers the Treasury Laws Amendment (Enterprise Tax Plan Base

Rate Entities) Act 2018 which amends the law to limit access to the lower corporate tax rate. From the 2017-18 income year a corporate tax entity must be a 'base rate entity' to be taxed at the lower rate.

Under the new law, a corporate tax entity will be taxed at the lower corporate tax rate if it is a base rate entity. A corporate entity will be a base rate entity if:

•         no more than 80% of its assessable income is BREPI, and

•         its aggregated turnover is less than the relevant threshold ($50 million from the 2018-19 income year). A corporate tax entity's aggregated turnover is the sum of their ordinary income and the ordinary income of any entity that is connected with or an affiliate of the corporate tax entity, where that ordinary income is derived in the ordinary course of carrying on a business.

Eligibility for the lower corporate tax rate depends on an entity's BREPI and aggregated turnover in an income year.

Taxation Ruling TR 95/35 Income tax: capital gains: treatment of compensation receipts (TR 95/35) provides the Commissioner's view in relation to a person who receives an amount as compensation as well as whether the amount should be included in the assessable income of the recipient.

Paragraph 18 of TR 95/36 states that if the amount of compensation received is an undissected lump sum, the whole amount is treated as being consideration received for the disposal of the right to seek compensation.

Interest

LCR 2019/5 provides guidance what is interest for the purposes of BREPI.

10. Interest (or payments in the nature of interest) is BREPI, except in the circumstances outlined in Table 1 of this Ruling.
11. Interest means 'the return, consideration, or compensation for the use or retention by one person of a sum of money belonging to, or owed to, another, and that interest must be referable to a principal'.
12. Payments in the nature of interest must have the character of return or profit to the lender for the use of money belonging to, or owed to another. Whether a payment has this character turns on its substance, no matter how it is calculated. For example, payments are not in the nature of interest if they are payable under a clause in a contract that requires a borrower to pay a lender's costs and liabilities a lender incurs to establish a loan, or under an indemnification clause to pay amounts of tax payable on interest received.

It is acknowledged that the payment distributed by the liquidator is less than the amount admitted as proof of debt. Therefore, the payment could be considered a return of the original principal amount.

The settlement agreement specified an amount to be paid to the taxpayer. It did not specify what the amounts represented an interest component or a repayment of the loan capital component.

If any part of the payment received was included as an amount of interest, then that part of the payment would be interest for the purposes of paragraph 23AB(1)(d) of the ITRA.

However, it is accepted that the amount representing interest component (if any) would not exceed 80% of the taxpayer's assessable income for that income year.

Net capital gain

LCR 2019/5 provides guidance what is interest for the purposes of BREPI.

16. A net capital gain for an income year is calculated using the method described in subsection 102-5(1) of the ITAA 1997. Broadly, it is calculated by subtracting the total of capital losses made in the income year and carried forward net capital losses, from the total of capital gains made in an income year. This is then adjusted for any small business concessions to which the taxpayer is entitled.

However, paragraph 118-20(1)(a) of the ITAA 1997 states that a capital gain you make from a CGT event is reduced if, because of the event, a provision of this Act (outside of this Part) includes an amount (for any income year) in your assessable income or exempt income.

In this case, the Commissioner considers the payment from the settlement agreement in relation to the debts is assessable income to the taxpayer pursuant to subsection 26BB(2) of the ITAA 1936. Therefore, any capital gain that would otherwise arise will be reduced to nil under section 118-20 of the ITAA 1997.

Statutory income includes gain from traditional securities

Section 26BB of the ITAA 1936 considers whether a gain on disposal or redemption of traditional securities is assessable income of the taxpayer.

Subsection 26BB(2) of the ITAA 1936 provides that where a taxpayer disposes of a traditional security or a traditional security of a taxpayer is redeemed, the amount of any gain on the disposal or redemption of a traditional security shall be included in the assessable income in the year that the disposal or redemption takes place.

The term 'Traditional security' is defined in subsection 26BB(1) of the ITAA 1936 as a 'security' that:

•         is or was acquired after 10 May 1989

•         does not have an 'eligible return', or where it does have an eligible return, it must not exceed the prescribed level, and

•         is not trading stock of the taxpayer.

The definition of traditional security incorporates a number of terms that are defined as having the same meaning as in Division 16E. Subsection 159GP(1) of the ITAA 1936 provides the following definitions:

security means:

(a) stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security;

(b) a deposit with a bank or other financial institution;

(c) a secured or unsecured loan; or

(d) any other contract, whether or not in writing, under which a person is liable to pay an amount or amounts, whether or not the liability is secured.

redemption, in relation to a security, means the discharging of all liability to pay any amount or amounts under the security representing a return of the issue price of the security.

Subsection 159GP(3) of the ITAA 1936 states:

For the purposes of this Division, there shall be taken to be an eligible return in relation to a security if at the time when the security is issued it is reasonably likely, by reason that the security was issued at a discount, bears deferred interest or is capital indexed or for any other reason, having regard to the terms of the security, for the sum of all payments (other than periodic interest payments) under the security to exceed the issue price of the security, and the amount of the eligible return is the amount of the excess.

Taxation Ruling TR 96/14 Income tax: traditional securities considers a number of interpretative matters in relation to section 26BB of the ITAA 1936 which deals with traditional securities.

Subparagraph 4(i) of TR 96/14 states:

paragraph (a) of the definition of 'security' in subsection 159GP(1) of the Act includes securities which are generally recognised as debt instruments. Having regard to paragraphs (a), (b) and (c) of the definition, only those contracts that have debt like obligations will usually fall under paragraph (d) of the definition;

In this case, the debts pursuant to the settlement agreement will be a traditional security as defined in subsection 26BB(1) of the ITAA 1936. The debts:

•         are 'securities' as defined in subsection 159GP(1)

•         they were acquired after 10 May 1989

•         do not have an eligible return as defined in subsection 159GP(3), and

•         are not trading stock.

The amount paid to the taxpayer by the liquidator partly or wholly represents a return of the issue price of the debts. The payment was a redemption of part of the securities.

As provided for in subsection 26BB(2) of the ITAA 1936, where a traditional security is disposed or redeemed, any gain on the disposal or redemption is included in assessable income.

The repayments of part of the debts are expected to discharge all liability to pay an amount equal to the repayment, being a return of the loaned amount (i.e. the issue price of the security), therefore the repayments are redemptions of traditional securities for the purposes of section 26BB of the ITAA 1936.

Subsection 26BB(2) of the ITAA 1936 will include the gain on any redemption as assessable income in the year of income in which the redemption takes place. Therefore, as the payment represents a repayment of the debt, the taxpayer would include in its assessable income any gain made on the redemption.

Accordingly, this payment is not considered to be BREPI as per paragraph 23AB(1)(f) of the ITRA.

A gain on a qualifying security

A qualifying security is broadly a security issued after 16 December 1984 for a period that is reasonably likely to exceed 12 months, under terms whereby it is reasonably likely that the security will produce receipts (other than of periodic interest) which are in excess of the issue price of the security (section 159GP of the ITAA 1936).

The payment from the liquidator to the taxpayer as a result of the settlement deed does not meet the definition of a gain on a qualifying security. Accordingly, this payment is not considered to be BREPI as per paragraph 23AB(1)(e) of the ITRA.

A distribution by a corporate tax entity (other than a non-portfolio dividend)

A distribution by a corporate tax entity pursuant to section 960-120 of the ITAA 1997 includes:

(a)  if from a company, a dividend, or something that is taken to be a dividend;

(b)  if from a corporate limited partnership, a distribution made by a partnership to a partner in the partnership, other than a distribution, or part thereof, that is attributable to profits or gains in an income year the partnership was not a corporate limited partnership;

(c)   if from a public trading trust, a unit trust dividend, as defined in section 102M of the ITAA 1936.

The payment from the liquidator to the taxpayer as a result of the settlement deed does not meet the definition of a distribution by a corporate tax entity, and consequently, it is not such a distribution nor is it franking credits on such a distribution. Accordingly, this payment is not considered to be BREPI as per paragraph 23AB(1)(a) of the ITRA.

A non-share dividend by a company

A non-share dividend means all non-share distributions, except for where the amount is debited against the company's non-share capital account or the company's share capital account (pursuant to section 974-120 of the ITAA 1997).

The payment from the liquidator to the taxpayer as a result of the settlement deed is not derived because of a non-share equity interest they hold in in a company. Accordingly, this payment is not considered to be BREPI as per paragraph 23AB(1)(c) of the ITRA.

Royalties

Royalties include any amount paid or credited as consideration for, amongst others, the use of, or the right to use, any industrial, commercial or scientific equipment (paragraph 14 of LCR 2019/5).

The payment from the liquidator to the taxpayer is not royalties. That is because such consideration is not for the use of, or the right to use, any industrial, commercial or scientific equipment. Accordingly, this payment is not considered to be BREPI as per paragraph 23AB(1)(d) of the ITRA.

Rent

Rent is the consideration payable by a tenant to a landlord for the exclusive possession and use of land or premises (paragraph 15 of LCR 2019/5).

The payment from the liquidator to the taxpayer is not rent. That is because it does not arise from the right to exclusive possession and use of land or premises. Accordingly, this payment is not considered to be BREPI as per paragraph 23AB(1)(d) of the ITRA.

Share of income from trust or partnership

If a company is assessed on a share of net income from a trust, or their individual interest in the net income of a partnership, it will have BREPI to the extent that the amount included in its assessable income under Divisions 5 or 6 of Part III of the ITAA 1936 is referable to BREPI of the trust or partnership (paragraph 17 of LCR 2019/5).

The payment from the liquidator to the taxpayer is not an amount that would be included in the assessable income of a partner or a beneficiary that is referable to an amount that is otherwise BREPI. That is because the taxpayer is not carrying on a business in partnership. Accordingly, this payment is not considered to be BREPI as per paragraph 23AB(1)(g) of the ITRA.

Conclusion

Assessable income is only base rate entity passive income if it is one of the types of income listed in section 23AB of the ITRA.

As the payment from the liquidator represents the gain on redemption of a traditional security, it will not result in a capital gain (due to section 118-20 of the ITAA 1997). Furthermore, the payment is not one of the types of income listed in section 23AB of the ITRA. Consequently, the settlement payment is not base rate entity passive income.

Question 2

Summary

The payment from the liquidator to the taxpayer in relation to the debts are not included in the aggregated turnover calculations of the taxpayer for the year ended 30 June 20xx for the purposes of section 23AA of the ITRA.

Detailed reasoning

Section 23AA of the ITRA defines the term base rate entity. It provides that an entity is a base rate entity for a year of income if:

(a)  no more than 80% of its assessable income for the year of income is base rate entity passive income; and

(b)  its aggregated turnover (with the meaning of the ITAA 1997) for the year of income, worked out as at the end of that year, is less than $50 million for the 2019 income year and later income years.

The meaning of 'aggregated turnover' is defined in section 328-115 of the ITAA 1997. Subsection 328-115(1) states:

Your aggregated turnover for an income year is the sum of the relevant annual turnovers (see subsection (2)) excluding any amounts covered by subsection (3).

Subsection 328-115(2) of the ITAA 1997 states that the relevant annual turnovers includes your annual turnover and the annual turnovers of your connected entities and affiliates.

LCR 2019/5 considers in part the aggregated turnover test for a corporate entity to determine if they meet the requirements of a base rate entity.

A corporate entity will be a base rate entity if:

•         no more than 80% of its assessable income is BREPI, and

•         its aggregated turnover is less than the relevant threshold ($50 million from the 2018-19 income year). A corporate tax entity's aggregated turnover is the sum of their ordinary income and the ordinary income of any entity that is connected with or an affiliate of the corporate tax entity, where that ordinary income is derived in the ordinary course of carrying on a business.

Unlike the aggregated turnover test, a corporate tax entity does not include the BREPI or assessable income of any connected entity or affiliate when determining whether it meets the 80% BREPI test. In other words, it is only the BREPI and assessable income of the corporate tax entity that is relevant when determining whether 80% or more of its assessable income is BREPI. The BREPI and assessable income of any connected entity or affiliate is not relevant for this purpose.

The meaning of annual turnover is defined in subsection 328-120(1) of the ITAA 1997 as:

An entity's annual turnover for an income year is the total *ordinary income that the entity *derives in the income year in the ordinary course of carrying on a business.

Ordinary income is defined in section 6-5 of the ITAA 1997 to include income according to ordinary concepts.

The term'ordinary income' is defined in section 6-5 of the ITAA 1997 as income according to ordinary concepts. An entity's annual turnover therefore includes all income according to ordinary concepts derived in the ordinary course of carrying on a business.

The 'ordinary course of business' covers the usual transactions, customs and practices of a certain business; a term for activities that are necessary, normal and incidental to the business; common practice.

The Commissioner holds the view that principles have been established that income derived in the ordinary course of carrying on a business includes amounts arising from a transaction which is an ordinary incident of the business activity of the taxpayer, although not a transaction entered into directly in its main business activity (Chamber of Manufactures Insurance Ltd v. FC of T (1984) 2 FCR 455; 84 ATC 4315; 15 ATR 599 and C of T v. Commercial Banking Co. of Sydney (1927) 27 SR(NSW) 231). See Taxation Ruling TR 92/3 Income tax: whether profits on isolated transactions are income, at paragraph 31, for an explanation of the Commissioner's view on profits or gains in the ordinary course of business. You must however also be carrying on a business for an entity to have an annual turnover.

The term 'business' is defined in subsection 995-1(1) of the ITAA 1997 to include any profession, trade, employment, vocation or calling, but does not include occupation as an employee.

The term 'carrying on a business' is not defined in Division 328 of the ITAA 1997 nor is it defined elsewhere in the ITAA 1997. It therefore takes its ordinary meaning. This approach is confirmed in the Explanatory Memorandum to the Tax Laws Amendment (Small Business) Act 2007, which introduced the small business $2 million turnover test and as an alternative to the Maximum Net Assets Value $6 million test. At paragraph 2.15, it is stated:

What does 'in the ordinary course of carrying on a business' mean?

........

2.15 In general, income is derived in the ordinary course of carrying on a business if the income is of a kind that is regularly or customarily derived by the entity in the course of carrying on its business, arising out of no special circumstance or event. Similarly, the income is derived in the ordinary course of carrying on a business if the income although not regularly derived, is a direct result of the normal activities of the business.

2.16 Ordinary income may be derived in the ordinary course of carrying on a business even if it is not the main type of ordinary income derived by the entity. Similarly, the income does not need to account for a significant part of the entity's overall receipts. It is sufficient that the ordinary income is of a kind derived regularly or customarily in the carrying on of a business. [Emphasis added]

There is no single test to determine whether a business is being carried, through court cases a number of indicators have developed that are relevant to determining whether activities constitute the carrying on of a business. Taxation Ruling TR 97/11 Income Tax: am I carrying on a business of primary production? at paragraph 13, lists the indicators the courts have held are relevant to determining if a business is being carried on. This includes:

•         the nature of the activities, particularly whether they have a profit-making purpose;

•         whether the person intends to carry on a business;

•         whether the activities are:

•         repeated and regular

•         organised in a business-like manner, including the keeping of books, records and the use of a system;

•         the amount of capital employed in those activities; and

•         whether the activity is better described as a hobby, or recreation.

Taxation Ruling TR 2019/1 Income tax: when does a company carry on a business? (TR 2019/1) sets out the Commissioner's views on when a company carries on a business within in the meaning of the small business entity in section 23 of the ITRA (for the 2016 and 2017 income years and section 328-110 of the ITAA 1997.

Paragraph 12 of the TR 2019/1 states that the guidance relevant to identifying whether an individual is carrying on a business is contained in TR 97/11.

Paragraphs 59, 60 and 61 of the TR 2019/1 states:

59. Whether a company is carrying on a business within the meaning of section 23 of the ITRA 1986, as it applied in the 2015-16 and 2016-17 income years, or section 328-110 of the ITAA 1997, ultimately depends on an analysis of and the overall impression of the company's activities. However, where a limited (including a proprietary limited) or NL company is established and maintained to make a profit for its shareholders, and invests its assets in gainful activities that have both a purpose and prospect of profit, it will normally be carrying on a business in a general sense. If so, it carries on a business within the meaning of section 23 of the ITRA 1986, as it applied in the 2015-16 and 2016-17 income years, and section 328-110 of the ITAA 1997. This is so even if the company's activities are relatively limited, and its activities consist of passively receiving rent or returns on its investments and distributing them to its shareholders.

60. A limited (including a proprietary limited) or NL company engaged in gainful activities may be able to establish that it is not carrying on a business in limited circumstances. The most common situations are where it can be shown, on the facts, that the company has no purpose or prospect of profit, and its activities lack a commercial character.

61. If it is concluded that a company carries on a business in a general sense, it is still necessary to determine the scope and nature of that business when determining the taxation consequences of its activities and transactions. This includes whether an amount it receives is income or capital in nature, or whether losses are revenue or capital in nature. These are separate questions that must be considered on the facts of each case.

In this case, the Commissioner has considered the types of factors that would normally be present in the business/commercial transaction that the taxpayer has entered. The payment received by the taxpayer, being the gain arising on the liquidator's distribution as a result of a court settlement is not derived in the ordinary course of carrying on a business.

The Commissioner believes that the factors of the transaction and payment are not within the ordinary course of the taxpayer's business. The factors that the Commissioner believes indicate this are:

•         The receipt of funds from the liquidator to the taxpayer as a result of settlement is a repayment of a debt held for a period close to xx years. This is an extremely long time to wait to recover from the assignment of a debt and indicates that at the beginning of the transaction the gain that has been made would not have been a main motive for entering the transaction. The circumstances of receipt of the payment is not what would normally be expected for a business of this kind.

•         It was not when the debt was acquired anticipated that the debt would be recovered.

•         The recovery is more akin to a windfall gain for the entity. While it is income in nature it is not something that was expected or has resulted from efforts of the business.

•         That there is no repetition or pattern that suggests that the taxpayer is carrying on a broader business or commercial venture of this nature.

Conclusion

As the payment received by the taxpayer is not received in the ordinary course of carrying on a business, the payment is not included in the annual turnover calculations pursuant to subsection 328-115(1) of the ITAA 1997 and section 23AA of the ITRA.