ATO Interpretative Decision

ATO ID 2010/128

Income Tax

Issue

Whether a unit trust is investing in land for the purpose, or primarily for the purpose of rent under Division 6C of the Income Tax Assessment Act 1936 (ITAA 1936) notwithstanding realisation gains made during the term of the investment.

Decision

Yes, the unit trust will still be investing in land for the purpose, or primarily for the purpose of rent under Division 6C of the ITAA 1936.

Facts

A corporation has created an investment for specific investors with a minimum commitment obligation of $XX million each. The investment will be conducted through a unit trust which will also be a managed investment scheme regulated under the Corporations Law 2001.

The unit trust will have a life of Y years, with an option to extend the trust for a further period in specific circumstances. At the end of the investment term, the trustee will wind-up the unit trust and realise the investment properties and derive realisation gains.

The capital of the settled trust is from the investor's subscription for units, and applied by the trustee for the acquisition of the investment portfolio.

The trustee's mandate is to acquire quality commercial office and retail shopping properties within a specific investment strategy. The trustee must comply with the 'investment period' where the acquisition of the investment properties must be within the first 12 months of the trust. For example, the characteristics for the investment properties require long-term quality tenants underpinned by secure income streams, leases that provide for fixed rental increases and potential increases in capital values.

The investors expect an 'Equity Multiple' in excess of 1.5 times the amount of their initial invested capital (comprising a return of investment, net operating profit and realisation profit). The trustee has forecasted an Equity Multiple of 1.84 times the initial investment. The trustee has forecasted that nominal profits from rent over the term of the investment to constitute 91% of the investment returns if capital values of the invested properties remain stable. If capital values increase, this percentage changes to 61% of the return being derived from rent.

Furthermore, the trustee has forecasted an 'Internal Rate of Return' (IRR) from the use of investor capital of 13% to 15% per annum. This overall rate is dependant on rental income from the acquired investment properties of at least 9.5% with the remainder constituted by a return of 3.5% to 5.5% from appreciation of capital values.

Reasons for Decision

Where a public unit trust is engaged in activities that is a 'trading business' it will be a 'trading trust' and therefore a 'public trading trust' under Division 6C of the ITAA 1936 and treated as a company for income tax purposes.

Pursuant to paragraph 102N(1)(a) of the ITAA 1936, a unit trust is a 'trading trust' if at any time in relation to a year of income, the trustee of the unit trust '...carried on a trading business'.

Section 102M of the ITAA 1936 defines that phrase to mean a '...business that does not consist wholly of eligible investment business'. The section in turn defines 'eligible investment business' to mean inter alia one or more of:

(a)

investing in land for the purpose, or primarily for the purpose, or deriving rent; or

(b)

investing or trading in any or all of the following:...

The ordinary meaning of the word 'primarily' as used within the section is taken to be 'principally' or 'chief' and can be interpreted to mean 'predominant' in the context of appraising whether an asset has been used for a 'predominant' purpose: Speedo Knitting Mills Pty Ltd v. Commonwealth of Australia [1981] 37 ALR 417 per Justice Woodward at pages 428-429. The test applied is whether the characterisation of the investment in land is predominantly for the purpose of deriving income from rent.

The trustee's forecast of the investment return to the investors from the acquired properties that will be held almost continuously for the duration of the trust, is based on a high degree of the rental income being more certain. This is because the rent, rather than any realisation gains is critical to enable the trustee to meet the forecasted return to the investors.

This is expressed by reference to the forecasted IRR and the equity multiple expected by the trustee and also the investors. The high degree of certainty of expected rent is consistent with a predominant purpose of the trustee investing in land to derive income from rent: cf. London Australia Investment Co. Ltd v. Federal Commissioner of Taxation (1977) 138 CLR 106; (1977) 7 ATR 757; 77 ATC 4398, per Justice Gibbs at CLR 117.

That purpose is also confirmed by the investment strategy of the trustee in acquiring retail and office properties which will indicate the source and character of the forecast return on investment, that is, largely rental income (for example a fixed year term, single use of capital, no switching of investment by the trustee).

Moreover, the character and certainty of the investment return is an outcome of the investment structure. Objectively appraised, the structure of the investment is predominantly designed, principally and in-chief to derive rental income for the trustee from the investments in land.

Therefore, the expectation of any gains on the disposal of the investments by the trustee as one of the purposes of this transaction is limited such that the trustee will not be conducting a 'trading business' during the relevant years of income, and will not be a 'trading trust' for the purpose of subsection 102N(1) of the ITAA 1936.

Year of income:  Year ended 30 June 2009

Legislative References:
Income Tax Assessment Act 1936
   section 102N
   section 102M

Case References:
Speedo Knitting Mills Pty Ltd v Commonwealth of Australia
   [1981] 37 ALR 417

Keywords
Income
Public trading trusts
Trust income

Siebel/TDMS Reference Number:  1-1RY5V16

Business Line:  Public Groups and International

Date of publication:  11 June 2010

ISSN: 1445-2782