Edited version of private advice

Authorisation Number: 1051869103750

Date of advice: 16 July 2021

Ruling

Subject: CGT event E4 and application of mutuality principle

Question One

Will CGT event E4 in section 104-70 of the Income Tax Assessment Act 1997 ('ITAA 1997') apply to the capital payments paid by Trustee Company to Body Corporate A in respect of its interest in the Unit Trust X?

Answer

Yes

Question Two

Will the mutuality principle apply to the capital payments paid to Body Corporate A so that those receipts are not assessable as statutory income under section 6-10 of the ITAA 1997?

Answer

No

This ruling applies for the following period:

Income Year Ending 30 June 20XY

The scheme commences on:

1 July 20XX

Relevant facts and circumstances

Body Corporate A

Body Corporate A is a strata title body. It was established by legislation.

Unit Trust X

Unit Trust X was established by Deed on XX/XX/XX with units issued to two Body Corporates.

Trustee Company is the trustee of Unit Trust X. Company XY owns 100% of the issued shares in Trustee Company.

Clause a of Unit Trust X Deed provided the following units were allotted:

•         Body Corporate A had xxxx units issued for $1 each (2/3rds)

•         Body Corporate B had xxxx units issued for $1 each (1/3rds)

(Both entities are strata title bodies created by legislation.)

Body Corporate A currently owns xxxx units in Unit Trust X (initial allotments of xxxx and subsequent allotments of xxxx). The initial xxxx units have zero cost base, and the subsequent xxxx units have $X,XXX,XXX cost base and reduced cost base.

Some of the relevant Clauses under the Deed are highlighted.

No redemption of units had occurred to date. However, there were return of capital payments on the initial units and Body Corporate A have recorded those under the original cost base for those initial units.

No other distributions have been paid to unitholders since the formation of Unit Trust X.

Unitholder Agreement and Network Services Agreement

The Unitholder Agreement was entered into between: Trustee Company; Company XY; and the unitholders (being Body Corporate A and Body Corporate B).

The Unitholder Agreement states that Unit Trust X and the Trustee Company have been established for the purposes of constructing and owning a network ('the Project') that connects residences within a large-scale community development, which encompasses Body Corporate A and Body Corporate B.

The Unitholder Agreement regulates their relationship as the shareholder in the Trustee Company, unitholders in Unit Trust X and other matters.

Some of the relevant terms of the Unitholder Agreement are highlighted.

The Network Service Agreement is between Body Corporate A and the Trustee Company and it governs the terms and conditions for Body Corporate A to access the Network.

The Service Agreement states that the Body Corporate A must pay for the services. Body Corporate A and Body Corporate B born these costs in accordance with their respective proportion of usage.

The Project - Network

The Network has been designed to provide modern communication network to the residents.

As per the Service Agreement, Unit Trust X receives contributions from the unitholders for relevant costs. Unit Trust X also receives regular amounts each year via an agreement with a third-party internet provider for the use of the network, along with interest income from bank accounts and term deposits.

Unit Trust X has not paid out any distributions.

No units in Unit Trust X have been redeemed to date. Where return of capital payments on the initial unitholding have been received, Body Corporate A has recorded these amounts in a subaccount under the cost base for those units.

Proposed network sale and capital payment

Body Corporate B would like to remove itself from the operations of the network. Unit Trust X is proposing to sell the network to Body Corporate A, and then it intends to terminate.

The proposed network sale to Body Corporate A is for $X,XXX,XXX cash and is based on an independent valuation obtained. It is expected to occur in the 20XY income year.

Body Corporate A will fund the proposed acquisition from its sinking fund with $XX million balance accumulated for future capital requirements.

Following completion of the network transfer, Unit Trust X will use the cash to pay-out the retained profits and redeem all remaining units on issue.

Relevant legislative provisions

Income Tax Assessment Act 1997 section 6-10

Income Tax Assessment Act 1997 section 104-70

Income Tax Assessment Act 1997 subsection 104-70(1)

Income Tax Assessment Act 1997 subsection 104-70(3)

Income Tax Assessment Act 1997 subsection 104-70(5)

Income Tax Assessment Act 1997 subsection 104-70(6)

Income Tax Assessment Act 1997 subsection 104-70(7)

Income Tax Assessment Act 1997 subsection 104-70(8)

Income Tax Assessment Act 1997 subsection 104-70(9)

Reasons for decision

Question One

Summary

CGT event E4 in section 104-70 of ITAA 1997 will happen to Body Corporate A when Trustee Company pays a capital payment to it in respect of its interest in the Unit Trust X.

Detailed reasoning

Subsection 104-70(1) of the ITAA 1997 provides that CGT event E4 happens if:

(a)  the trustee of a trust makes a payment to you in respect of your unit or your interest in the trust (except for CGT event A1, C2, E1, E2, E6 or E7 happening in relation to it); and

(b)  some or all of the payment (the non-assessable part) is not included in your assessable income.

Subsection 104-70(3) of the ITAA 1997 states that the time of the event is:

(a)  just before the end of the income year in which the trustee makes the payment; or

(b)  if another *CGT event (except CGT event E4) happens in relation to the unit or interest or part of it after the trustee makes the payment but before the end of that income year - just before the time of that other CGT event.

Unit Trust X will be making a non-assessable payment to Body Corporate A in respect of its X units in the 20XY income year.

The initial X units that Body Corporate A owns have zero cost base, and the subsequent X units have $X,XXX,XXX cost base and reduced cost base.

The exceptions in subsections 104-70(7), (8) and (9) of the ITAA 1997 do not apply in this case.

Body Corporate A will make a capital gain if the sum of the amounts of the non-assessable parts of the payments made by Trustee Company in respect of the X unit is more than its cost base (subsection 104-70(5) of the ITAA 1997).

However, if the sum is not more than the cost base, then the cost base and reduced cost base is reduced by that sum (subsection 104-70(6) of the ITAA 1997).

Question Two

Summary

The mutuality principle does not apply to the capital payments paid to Body Corporate A.

Detailed reasoning

A receipt will not be income if it is subject to the principle of mutuality. In The Bohemians Club v The Acting Federal Commissioner of Taxation [1918] 24 CLR 334 (Bohemians Club), Griffith CJ stated at 337-338:

A man is not the source of his own income, though in another sense his exertions may be so described. A man's income consists of moneys derived from sources outside himself. Contributions made by a person for expenditure in his business or otherwise for his own benefit cannot be regarded as his income unless the Legislature expressly so declares.

The above comments of Griffith CJ have formed the basis of the principle of mutuality as it applies in Australia. As such, a receipt by a taxpayer will not have the quality of ordinary income if the mutuality principle applies to it.

However, section 6-10 of the ITAA 1997 provides that assessable income includes statutory income. These amounts are included in assessable income as specified by specific legislative provisions despite not being ordinary income. Where an amount is specified as statutory income the principle of mutuality cannot operate to make the amount non-assessable. The principle of mutuality only operates to prevent mutual receipts being assessed as ordinary income.

The essence of the mutuality principle is that you cannot derive any gain and, therefore, income from dealings with yourself. The mutuality principle provides that where a number of people associate for a common purpose and contribute to a common fund in which they are all interested, any surplus of those contributions remaining after the fund has been applied to the common purpose is not income or profit.

The mutuality principle was described by McTiernan J in Revesby Credit Union Cooperative Ltd v Federal Commissioner of Taxation (1965) 112 CLR 564 (Revesby Credit Union) at 574-575:

The principle of mutuality seems to me to be settled. Where a number of people contribute to a fund created and controlled by them for a common purpose any surplus paid to the contributors after the use of the fund for the common purpose is not income but is to be regarded as a mere repayment of the contributor's own money...Incorporation of the fund is not relevant...What is required is that the fund must have been created for the common purpose and owned or controlled wholly by the contributors. If it is owned or controlled by anyone else the principle cannot apply...Furthermore any contributions to the fund derived from sources other than the contributors' payments, such as interest from the investment of part of the fund, or income from a business activity conducted by the members, cannot be taken into account in computing the surplus...Also the cases establish that the principle cannot apply unless at any given point in time the contributors to the fund are identical with the beneficiaries of the distribution of the surplus.

A number of authorities have established the application of the mutuality principle in Australia. They include Bohemians Club (1918) 24 CLR 334, Revesby Credit Union 112 CLR 564, Social Credit Savings & Loan Society Ltd v Federal Commissioner of Taxation 125 CLR 560, Sydney Water Board Employees Credit Union Ltd v FC of T (1973) 73 ATC 4129, Royal Automobile Club of Victoria (RACV) v Federal Commissioner of Taxation 73 ATC 4153, and FC of T v Australian Music Traders Association (1990) 90 ATC 4536.

The principle of mutuality has the following characteristics:

•         persons (contributors) make contributions out of their own moneys to a common fund (which they create, own, control and all have an interest in) for a common purpose (which may also be for their personal benefit as participators) and that purpose is not undertaken for profit,

•         complete identity as a class between the contributors and the participators,

•         contributions are based on an estimate of expected expenses of the common purpose (mutual liabilities), and are made on the stipulation that any surplus (the unused or unexpected amount) will be, sooner or later, returned/repaid to the contributors (in their capacity as contributors) in some form or other, and

•         a reasonable relationship between what a person contributes and what the person may be expected or entitled to receive in respect of the common fund.

Application to your circumstances

It is necessary to consider whether mutuality could apply to the capital payments received by Body Corporate A.

If the capital payments received by Unit Trust X from Body Corporate A could be considered to be contributions to a common fund, to which the principle of mutuality would apply: (i) the return of capital by Unit Trust X to Corporate A would not be ordinary income primarily on the basis that it is a return of capital (corpus of the trust); and (ii) any non-capital amount returned would not be in the nature of ordinary income due to the operation of the principle of mutuality.

However, if capital payments made by Unit Trust X to Body Corporate A amount to statutory income, the principle of mutuality does not operate to make those capital receipts non assessable. The principle of mutuality only applies such that a mutual receipt will not have the quality of ordinary income.

Further the establishment of the Unit Trust X demonstrates an intention to create a trust relationship. The purchase of the units in the Unit Trust X by Body Corporate A shows an intention for the funds it contributes to the unit trust to be governed under the terms of the trust deed. There is not an agreement between Body Corporate A and Body Corporate B to create a common fund for common purpose in the required sense. Therefore, the funds held by the unit trust are subject to the terms of the trust and there is no application of the principle of mutuality.

The Unit Trust X has the beneficial ownership divided into a number of units, and these units were allotted to Body Corporate A (with 2/3rds interest) and Body Corporate B (with 1/3rd interest). Body Corporate A paid to acquire the X units, and under the terms of the Deed and the Unitholder Agreement - its interests in the capital and income of the trust are unitised.

For instance, Clauses a and b of the Unitholder Agreement govern how and when surplus and capital payment should be paid out to the unitholders. Additionally, Clause c allows unit holders to deal with their units (i.e. sell, transfer, assign or otherwise dispose).

Furthermore, Clause b of the Deed deals with the termination of the trust. Effectively, the trustee shall divide the proceeds of the sale and conversion less all relevant costs among the unit holders in proportion to the total amount paid up on the number of units.

Accordingly, there is no existence of a common fund controlled by contributors in this case. Body Corporate A's entitlements under Unit Trust X are worked out by reference to its ownership of units. This arrangement is a relationship established under the trust deed (i.e. between trustee and unitholders), and the trust principles apply to this arrangement.

It is accepted that Unit Trust X was established for the purposes of conducting the Project, which was to construct a network that connect residences within a large-scale community development. Furthermore, the usage of the Network encompassed mainly from Body Corporate A and Body Corporate B.

However, the activity carried out by Unit Trust X and the fee received in connection with the activity were not mutual in nature. Firstly, Body Corporate A acquired X units, which are contributions to corpus. Secondly, Body Corporate A 's obligation to pay under the Service Agreement is not a fee payable by members into a common fund. That is, it is not an agreement between the contributors, Body Corporate A and Body Corporate B, to create a common fund for a common purpose. Instead, Unit Trust X, which is not a contributor, has contracted with its unit holders and Body Corporate A's contractual payments are obligations that afforded it benefits (i.e. for the use of the Network and in accordance with its respective proportion of usage).

Unit Trust X also receives regular amounts each year via an agreement with a third-party provider for the use of the network, along with interest income from bank accounts and term deposits. So, no fees or payments in this arrangement could be identified as member contributions and/or are mutual receipts.

In contrast, the terms of the Agreement (e.g. Clause d) acknowledge that the Project's operation/s is for profit, and the surplus can be paid out by way of a profit distribution (i.e. only after the initial capital invested has been returned). Therefore, any capital payment received by Body Corporate A in respect of its X units will be assessable, and will not be subject to the principle of mutuality.