ATO ID 2008/1: Equity Mortgage Agreements: Division 6C of the Income Tax Assessment Act 1936
Date of decision: 12 October 2007
Year of income: 30 June 2008 30 June 2009 30 June 2010 30 June 2011 30 June 2012
Business line: Public Groups and International

Issue
Are the Equity Mortgage Agreements to be entered into between a Unit Trust and various Home Owners 'other securities' for the purposes of subparagraph 102M(b)(ii) of the Income Tax Assessment Act 1936 (ITAA 1936).

Decision
Yes. The Equity Mortgage Agreements when entered into between a Unit Trust and Home Owners will be 'other securities' for the purposes of subparagraph 102M(b)(ii) of the ITAA 1936.

Facts
The Unit Trust will enter into a number of contracts described as Equity Mortgage Agreements (EMAs) with Home Owners. An EMA involves the issue of a financial instrument by the Home Owner to the Unit Trust and the subsequent redemption of that financial instrument by the Home Owner. Description of the Unit Trust The Unit Trust's assets will consist mainly of the EMAs. The Unit Trust will predominantly derive its net income from activities associated with the EMAs in each income year in which EMAs exist. Description of Home Owners Home Owners will be natural persons who own property or who are in the process of acquiring property that will be their main or principal residence. Description of the Equity Mortgage Agreements (EMAs) The EMA is an instrument issued by a Home Owner (as issuer) to the Unit Trust (as holder) in consideration for the payment of money by the Unit Trust. The Home Owner also grants a registrable mortgage over their property ('the property') to secure all moneys that may become due and payable under the EMA. The Unit Trust does not acquire an ownership interest in the Home Owner's property, nor will it have any right of occupancy. The Home Owner will have the sole right to occupy the property and will have a right to sell the property to a third party at any time during the term of the EMA. The amount to be paid by the Home Owner to the Unit Trust under the terms of the EMA will depend on the notional value of the property at a particular redemption time (or times where applicable if partial redemptions occur) in the future. At the expiry of the agreed term or upon the sale of the property to a third party, the Home Owner must redeem the EMA from the Unit Trust. Any gains or losses for both the Home Owner and the Unit Trust will arise from the change in the market value of the property, as measured between the date the Unit Trust subscribes for the EMA and the date on which the Home Owner redeems it. The value of the property on the date the Home Owner redeems (or partially redeems) the EMA will determine the redemption amount. Under the EMA, the Unit Trust will outlay an initial amount to the Home Owner which will result in the Unit Trust acquiring a specified entitlement to be paid an amount upon redemption (the 'redemption amount') which is expressed as a notional proportion of the then value of the property. That redemption amount will be determined where a Home Owner seeks to redeem the security (in part or in full) under either an Early Repayment (Call) Option or the exercise of a Final Repayment (Put) Option. The redemption amount to be paid by the Home Owner to the Unit Trust will be calculated by reference to a percentage of the property's value as at the date of the contract. This percentage is called the 'Notional Equity Interest' (the 'NEI') in the property. If the Home Owner does not redeem some or all of the EMA, the percentage of the sales proceeds realised on the sale of the property to a third party, or the amount which the Home Owner must pay to the Unit Trust, will be determined by reference to the NEI of the Unit Trust in the property. Requirement to redeem A Home Owner may choose various terms for the maturity of the EMA. If the property remains unsold at the end of the agreed term, the Home Owner must redeem the EMA. The Home Owner must also redeem the EMA in the event of a sale of the Property or if the terms of the EMA are breached. On final redemption, the Home Owner will become indebted to the Unit Trust in respect of an amount due under the EMA. The amount to be paid on redemption of the EMA will change over time and is to be calculated by reference to the appraised market value of the property over that period. On redemption of the EMA, the amount that the Home Owner is required to pay the Unit Trust will become a debt due from the Home Owner if unpaid. Interest will accrue in respect of this debt liability until discharged. Early repayment option A Home Owner may reduce the Unit Trust's entitlement based on the NEI by redeeming part of the EMA through the exercise of an early repayment option. The Home Owner may redeem the EMA (in part or in full) prior to the maturity date. Similarly, any amount(s) which the Home Owner is required to pay the Unit Trust upon early redemption of the EMA will become a debt due to the Unit Trust if unpaid.

Reasons for decision
Summary: Section 102M of the ITAA 1936 defines the operative terms for the interpretation and application of Division 6C of the ITAA 1936 in respect to the income of certain public unit trusts. Division 6C treats certain trusts described as 'public trading trusts' as companies, by taxing the trustees of such trusts at the company rate. A trust is a 'public trading trust' within Division 6C of the ITAA 1936 if it satisfies four requirements (section 102R of the ITAA 1936): In this case, the Unit Trust will satisfy the requirements outlined in (1), (3) and (4). | Detailed Reasoning - Trading Trust: A unit trust is a 'trading trust' pursuant to section 102N of the ITAA 1936 if: The Unit Trust does not satisfy requirement (2) so it remains to be considered whether the Unit Trust conducts a 'trading business'. A 'trading business' is any business that does not consist wholly of 'eligible investment business' which is defined within section 102M of the ITAA 1936 to mean either or both of: (emphasis added): If the activities of the Unit Trust consist wholly of an 'eligible investment business', then it will not be conducting a 'trading business' and will not be subject to Division 6C of the ITAA 1936. | Detailed Reasoning - Eligible investment business: The meaning given to the phrases 'eligible investment business' and 'trading business' is assisted by the Explanatory Memorandum to Taxation Laws Amendment Bill (No. 4) 1985 (the 'EM') which introduced Division 6C into the ITAA 1936. 'Eligible investment business' is a term used in the definition of 'trading business' for the purpose of specifying the type of activities that can be conducted by a trustee of a unit trust without causing the trust to be taken to be a 'trading trust' for the purposes of Division 6C.of the ITAA 1936. For this purpose, an 'eligible investment business' means an activity consisting of either or both of - The term 'trading business' is also defined in section 102M of the ITAA 1936 to mean any business other than 'eligible investment business'. By the operation of this section, and in conjunction with those definitions, a unit trust will be a 'trading trust' in a year of income if it carries on any activity other than the business of investing in land or in an interest in land for rental purposes, or of investing or trading in shares, bonds, securities and such like, or a business consisting of a combination of those activities. Furthermore, the EM states a unit trust which generally satisfies the tests to be treated other than as a trading trust, because it is predominantly carrying on an eligible investment business, will not be taken to be a trading trust merely because it receives income from activities incidental to its main purpose that do not constitute the carrying on of a business. Where a public unit trust conducts activities that are merely incidental to its predominant activity/activities (consisting of activities that meet the 'eligible investment business' definition), this will not, of itself, cause the public unit trust to be considered a 'trading trust'. This interpretation is adopted in Taxation Determination TD 98/4. However, if those activities are more than merely incidental to the eligible investment business activities of the public unit trust and so are activities of the public unit trust in their own right then no such concession is afforded: see ATO ID 2003/73. | Detailed Reasoning - Whether the mortgage is an investment in land: Under the EMA, the Unit Trust does not acquire any legal or equitable ownership interest in the estate of land which is the real property of the Home Owner. However, the amount to be repaid by the Home Owner to the Unit Trust as a redemption payment is calculated on the Unit Trust's notional interest in that real property. In the context of investing in land, section 102M of Division 6C of the ITAA 1936 defines 'land' to 'include an interest in land'. The verb 'include' indicates a legislative intention for the word 'land' to have a wide construction, including situations where somewhat less than full legal title is acquired. In addition to the ordinary meaning of that phrase, a Legal Dictionary meaning of 'interest in land' is: Any legal or equitable estate in land, or restriction on the use of the land, or any other right, charge, power, or privilege over or in connection with land... More technically, a property right in land that is not an estate... In respect of the registrable mortgage granted to the Unit Trust in respect of the real property a Legal Dictionary meaning of 'mortgage' is: A lender's interest in land, secured over the land of the borrower, including a charge on property for the purpose of securing money or money's worth Prima facie, a mortgage may be considered to be an 'interest in land' in applying paragraph 102M(a) of the ITAA 1936, which provides as follows: The Unit Trust will not derive any rent under the EMA or otherwise under the arrangement, so if the Unit Trust is to invest in land as an activity in its own right the Unit Trust would have a 'trading business' and so its investment activity would not consist wholly of 'eligible investment business'. Notwithstanding the Unit Trust's holding of the EMAs, the grant of the mortgage by the Home Owner represents an incidental activity that merely acts as securing the payment obligations that may arise under the EMA. The mortgage is considered to complement the primary activity of the Unit Trust which is holding EMAs in order to obtain payments producing expected gains upon their redemption, but not to amount to a primary activity in its own right. Accordingly, the presence of a mortgage in the EMA to secure those payments will not, of itself, cause the Unit Trust to be considered to be conducting a 'trading business' of investing in land other than primarily for the purpose of deriving rent. | Detailed Reasoning - Whether an EMA falls within 'other security' for the purposes of subparagraph 102M(b)(ii) of the ITAA 1936: The word 'security' (or specifically the term 'other securities') is not defined within Division 6C of the ITAA 1936, and therefore is to be given its ordinary meaning. | Detailed Reasoning - Ordinary meaning of 'security': Paragraph 102M(b)(ii) of the ITAA 1936 states in full bonds, debentures, stock or other securities. The Commissioner's view of the ordinary meaning of 'security' may be found in the interpretation of the statutory definition of 'security' in paragraph 159GP(1)(a) of the ITAA 1936. That paragraph provides: "security" means: - (a) stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security;... Subparagraph 102M(b)(ii) of the ITAA 1936 is not dissimilar to paragraph 159GP(1)(a) of the ITAA 1936 except that the list of securities identified in paragraph 159GP(1)(a) includes all the securities in subparagraph 102M(b)(ii). The Commissioner's views in this regard are set out in Taxation Ruling TR 96/14. Specifically, the Commissioner has ruled that in respect to paragraph 159GP(1)(a) of the ITAA 1936 the definition of 'security': With respect to the EMA, a fundamental and mandatory financial element will exist - the imposition of a present existing liability upon the Home Owner at the time of entering into the EMA to make a future payment to the Unit Trust. The amount to be paid will be determined at that future time and will be calculated according to agreed procedures and formulae contained in the EMA. This can be contrasted to the obligation to repay a loan or advance and to pay interest and costs in relation to the loan or advance. The fact that the precise amount is not initially known or cannot be calculated until the maturity date, because it is dependent on variables only known and determined at that date, does not change the reasoning. As the EMA will not result in the Unit Trust acquiring an ownership interest in land and is more akin to a financial instrument which evidences and secures an obligation on the part of the Home Owner (issuer) to pay an amount to the Unit Trust (holder) during the term of the instrument or at maturity, confirms that the EMA will also satisfy the definition of 'security' within paragraph 159GP(1)(a) of the ITAA 1936. The fact that the amount to be ultimately paid is referenced to a notional value of the Unit Trust's interest in the Home Owner's property does not alter the reasoning. The EMA is a 'security' because it will secure a claim by the Unit Trust for an amount which is determined on redemption of the EMA and the payment of which will be secured by the mortgage granted by Home Owner's to the Unit Trust. Accordingly, it is considered the EMA will meet the normal definition of a security, being an instrument which evidences and secures an obligation on the part of the issuer (the Home Owner) to pay an amount to the holder (Unit Trust) during the term of the instrument or at its maturity. Therefore, the EMA will be a security encompassed within the phrase 'other securities' for the purposes of subparagraph 102M(b)(ii) of the ITAA 1936.

Legislative references: Income Tax Assessment Act 1936 section 102M section 102N section 102R subsection 159GP(1)
Related public rulings and determinations: Taxation Determination TD 98/4 | Taxation Ruling TR 96/14
Other references: Explanatory Memorandum to Taxation Law Amendment Bill (No. 4) 1985 Butterworths Concise Australian Legal Dictionary (2nd Ed).
Subject references: Eligible investment business Public trading trusts Securities Trading trusts