Private ruling: How proceeds from transfer of units are to be assessed.
Published: April 2012
Ruling period: Year ended 30 June 2011.
Date scheme commenced: Year ended 30 June 2011.

Ruling: Q1: Is the payment received from the transfer of the units in the Unit Trust on capital account, and not on revenue account? | A1: No.

Relevant facts and circumstances: In early 2006, the taxpayer acquired some special units in the unit trust. The taxpayer included the specific details of the trust in an Information Memorandum which had been prepared by the promoter during 2004. Where necessary, parts of this memorandum have been reproduced below. In late 2010, a previous associate of the director of the trustee company approached the taxpayer to purchase the units which were set to mature soon after. At this time, the taxpayer had held the units for a few years. The taxpayer agreed to transfer its units at a price which was just below the estimated "final portfolio distribution". A deposit was paid up front with the balance within a couple of months. The Information Memorandum contained information relating to the trustee, the registrar, the issue price, and it also advised that the special units will not be listed on any stock exchange. The Investment Summary provides the following information in relation to the special units: · the special unit holders will be entitled to fixed distributions quarterly at the end of each three month period from issue date until the repayment date; · the special unit holders will be entitled to a repayment distribution equal to the initial price of each unit on repayment date; · the special unit holders will be entitled to a final distribution approximately 40 days after final maturity; · the special unit holders will be entitled to be paid portfolio distributions from the net profits earned by the trust either on or before final distribution date; · the special unit holders will not be liable to pay any of the portfolio losses themselves; · the special unit itself will be redeemed for nil consideration following the payment of the final distribution; · the special units will operate for a fixed term from date of issue, but can be subject to early termination, or an extension in certain defined circumstances; · the special units have special voting rights outlined in clause 14 of the constitution. The Investment Summary sets out the taxation implications, but it also included a rider stating that investors should seek their own specific advice on the tax implications of the investment. The relevant details from this statement are as follows: - the trust is a resident of Australia for tax purposes, but it will not be liable for income tax as the net income will generally be distributed to the special unit holders; - the quarterly distributions are considered to be assessable income when paid out of the distributable income, but not taxable if the distributable income was nil, however any non taxable amounts reduce the cost base of the special unit; - the repayment distribution is the return of capital and so is not assessable income, however the cost base of the special unit is reduced by that amount; - the portfolio distribution is assessable income as it has been paid out of the net income of the trust; - if the special unit holder sells the special unit, then the sale will be subject to the capital gain rules; - if the special unit holder redeems the special unit, then the redemption will be subject to the capital gain rules.

Relevant legislative provisions: Income Tax Assessment Act 1997 Section 974-1. | Income Tax Assessment Act 1997 Section 974-15. | Income Tax Assessment Act 1997 Section 974-20. | Income Tax Assessment Act 1997 Section 974-5. | Income Tax Assessment Act 1997 Section 6-5. | Income Tax Assessment Act 1997 Section 6-10. | Income Tax Assessment Act 1997 Section 104-10. | Income Tax Assessment Act 1997 Section 104-70. | Income Tax Assessment Act 1997 Section 118-20. | Income Tax Assessment Act 1936 Section 159GP. | Income Tax Assessment Act 1936 Section 159GQ. | Income Tax Assessment Act 1936 Section 97.

Reasons for decision: Summary: The investment in the special units is considered to be a debt instrument. The investment in the special units is also considered to be a qualifying security. As a result, the profit on sale is considered to be assessable income under ordinary concepts. The amount to be included as assessable income is the amount above the initial unit allocation price, plus the cost base reductions as the capital component of the units has been reduced by the capital returns (the quarterly distribution previously not subject to tax). Alternatively, if it is not income under ordinary concepts, the difference between the issue price reduced by the previous returns and the sale price will be on revenue account and so will be included as assessable income. | Detailed Reasoning - Detailed reasoning: Section 974-1 of the Income Tax Assessment Act 1997 (ITAA 1997) looks at the issue of debt interests and equity interests. Basically a debt interest is deductible, and an equity interest is frankable, which very roughly equates to a debt interest being on revenue account and equity interest being on capital account. Section 974-15 of the ITAA 1997 defines a debt interest to be a scheme that satisfies the debt test. Section 974-20 of the ITAA 1997 defines the debt test. These requirements include that the scheme must be a financing arrangement, financial benefits must be payable under the arrangement, it is substantially more than likely that the financial benefit will at least equal the original amount. Sub-section 974-5(4) of the ITAA 1997 states that if the arrangement could be considered to be both a debt instrument and an equity instrument, then it will be a debt instrument. Section 6-5 of the ITAA 1997 includes ordinary income and statutory income as assessable income. Taxation Ruling TR 92/3 considers when transactions can be considered as assessable income. Section 6-10 of the ITAA 1997 includes statutory income as part of assessable income. Section 159GP of the Income Tax Assessment Act 1936 (ITAA 1936) defines the terms 'qualifying security' and 'eligible return'. Section 159GQ of the ITAA 1936 includes the eligible return from a qualifying security as assessable income. Section 104-10 of the ITAA 1997 covers CGT event A1, and this event applies if a CGT asset is disposed of by one entity to another entity. Section 118-20 of the ITAA 1997 reduces the capital gain you make if another provision of the Act includes an amount as assessable income. A. Debt/equity rules In this case, the taxpayer invested in a number of special units in the Unit Trust. These units have not been issued in the normal manner as a unit in a unit trust (that is, like an ordinary unit in a widely held property unit trust), in that they have a set lifespan from issue date, at which time they become effectively worthless. However, a short extension is possible. The special units are not to be traded on any exchange, and the transfer rules are quite restrictive. The payments made from the Unit Trust to the special unit holders are also relevant here. The first group of payments are the quarterly distributions at a set percentage rate. The second payment takes place at the end of the lifespan, when the special unit holder will receive the amount invested back in cash. If the Unit Trust made a profit during the period, then the special unit holder would be entitled to the third payment, which is their share of that profit based on their share of the overall unit holding. The definition of the debt test is a follows: · There must be a scheme; · The scheme must be a financing arrangement; · There must be a financial benefit received; · The issuing entity must have an effectively non-contingent obligation to provide a future financial benefit; and · It must be substantially more likely than not that the value of the financial benefit to be provided will be at least equal to or exceed the financial benefit received. A scheme is widely defined to include almost any arrangement, so this arrangement fits within the definition of a scheme. This scheme was set up as a financing arrangement for the promoter. The scheme guaranteed a minimum quarterly return to the special unit holder on the amount invested, which is the quarterly distributions plus the guaranteed return of the sum invested at the end of the lifespan (the repayment distribution). There was also the possibility of a greater return if the trust had additional profits available (the portfolio distributions). The last requirement is that the scheme was more likely than not to have returns that would greatly exceed the sum invested. This scheme does provide for guaranteed repayments in excess of the sum invested, so that requirement is satisfied. Also, once the repayment distribution has been made, the special unit itself is effectively worthless, so the value was not in the special unit itself, but it was in the financing arrangement. The result is that the scheme as outlined satisfies the definition of a debt interest under sections 974-15 and 974-20 of the ITAA 1997. With the exception of the portfolio distributions, the guaranteed payment every quarter, and the eventual repayment of the entire sum at the end of the lifespan, means that the financing arrangement here is similar to a bank term deposit with the interest being paid to the holder quarterly, and the principal amount paid back at the end of the six years, so that also indicates that it should be considered to be a debt instrument. | Detailed Reasoning - Section 6-5.: The next step is that given that the special units are considered to be debt instruments, how the amounts received from the sale of these units are to be treated for income tax purposes. Firstly, it is noted that there have been some capital repayments due to some of the quarterly distributions being paid from the capital account, so this means that the remaining capital to be returned is less than the original price paid for the special units. The taxpayer has advised that the lifespan has almost expired, at which time the repayment distribution and portfolio distributions would be made. The repayment distribution would be the same as the original price paid. Once the repayment distribution was paid, the special units are effectively worthless, so no value would be attributable to the units themselves. Also, there will only be one quarterly distribution remaining to be paid, so that will not be a significant amount, as each quarterly payment was based on a set percentage of the special unit holding. However the transfer price advised is well in excess of the repayment distribution and the remaining quarterly distribution. Given that the facts indicate that the special units have no value once the repayment distribution is made, and the one remaining quarterly distribution will only be a few percent of the repayment distribution, the value of the units, which is well in excess of these amounts, must be for the expected portfolio distribution which would be made at the end of the lifespan. If the portfolio distribution was actually paid at the end of the lifespan, it would have been paid as an assessable trust distribution under section 97 of the ITAA 1936. The next issue to consider is whether section 6-5 of the ITAA 1997 can apply to the entire investment. In considering that, the first important fact is that special units were purchased, and not normal trust units. These special units came with a few different conditions than the ordinary units in the trust. Firstly, the units were not permanent. They were only issued for a set lifespan, at which time the investment sum would be paid back to the investor, and then the units would be worthless. This would indicate that these units were not issued for their capital return, unlike any normal units. Also, there were major restrictions on trading these special units, which is also unlike the normal units. It was virtually a guaranteed investment, in that an amount would be paid quarterly (akin to interest), and there was also a possibility of additional distributions at the end of the lifespan. This is not the case with ordinary units in a unit trust, which do not have a guaranteed rate of return (or in some cases in the last few years, any return at all), and with ordinary units there is also no guarantee of the capital value either, as that value would go up and down with the market. These special units are a totally different investment to purchasing normal units in a unit trust. Therefore the tax treatment of these special units can be distinguished from the tax treatment of ordinary units. The taxpayer invested in these special units, and the terms of the arrangement ensured that he was paid a quarterly return on this investment (akin to interest), and the taxpayer was guaranteed his money back at the end of the lifespan. Therefore it could be argued that given the relatively short term nature of the investment, the taxpayer entered the investment with the intention of making a profit on that investment over the lifespan, although the absolute amount of the profit was not known at the time of making the investment, given the contingency of the final payment being based on the profit made by the trust during the lifespan. Given that the special units are considered to be a debt instrument, the investment had a virtually guaranteed profit at the end of the lifespan, and the value of the investment is not in the unit itself, but in the redeemable nature of the investment, then it is considered that the investment was entered into with the intention of making a profit. Taxation Ruling TR 92/3 looks at the issue of single investments, and the ruling does consider that a single transaction can result in a return that is assessable income under section 6-5 of the ITAA 1997 (actually its predecessor sub-section 25(1) of the Income Tax Assessment Act 1936 ). This is provided that the investment was entered into with the intention of making a profit. The ruling sets out the application of the decision of the Full High Court in FC of T v. The Myer Emporium Ltd (1987) 163 CLR 199; 87 ATC 4363; 18 ATR 693. In that case, the taxpayer made an interest bearing loan to a related entity. A few days later, the taxpayer assigned the right to receive future interest income in return for a lump sum payment. The High Court held that the lump sum amount received was income for the following reasons: · the amount in issue was a profit from a transaction which was entered into with the purpose of making a profit; and · the taxpayer sold a mere right to interest for a lump sum, that lump sum being received in exchange for, and as the present value of, the future interest it would have received, so the taxpayer simply converted future income into present income. This case is similar to the Myer case as the taxpayer is selling a future income stream (a future section 97 distribution) for a lump sum receipt. Therefore the treatment of this case should therefore be similar to the decision made by the High Court, given that the special units are considered to be a debt instrument like the interest bearing loan in the Myer case. The end result is that the profit component (the amount received that is greater than the capital originally invested into the special units) would therefore be included as assessable income under section 6-5 of the ITAA 1997. The component relating to the repayment distribution is not assessable under section 6-5 of the ITAA 1997 as it is a capital receipt (being a return of capital). However, the facts indicate that the taxpayer has already effectively received some of the original capital contributions back, as not all of the previous amounts received were actually taxable trust distributions to the taxpayer, and in that circumstance, the trust deed indicates that any payments that could not be considered as being paid from the income of the trust were paid out from the trust capital, which then reduced the amount of capital contributions made by the taxpayer. The taxation law requires that any repayments of capital by a unit trust to a unit holder should be reflected as a reduction in the CGT cost base [see CGT event E4 in section 104-70 of the ITAA 1997]. Provided that there were no other cost base reductions, the amount of the non-assessable payments made by the trustee to the taxpayer would be equal to the cost base reductions. If that is the case, the amount of trust capital that has not been returned would be equal to the current CGT cost base for the units. This means that the amount that is being included as assessable income under section 6-5 of the ITAA 1997 includes the following amounts: - the expected portfolio distribution; - the amount of the repayment distribution that exceeds the remaining capital value after the previous capital returns are taken into account. The second part effectively covers the previous quarterly distributions that were not included as assessable income under section 97 of the ITAA 1936. The overall effect is that the taxpayer was not assessed on the total that was originally paid for the special units. The amount of the returns made to the taxpayer above the original investment has been assessed under either section 97 of the ITAA 1936 or section 6-5 of the ITAA 1997. | Detailed Reasoning - Division 16E: Section 159GP of the ITAA 1936 defines a security to include stock, bonds, debentures, promissory notes, bill of exchange, or other similar securities. A unit in a unit trust is similar to stock, so the special units would be included. Section 159GP of the ITAA 1936 defines a qualifying security to be a security issued after 16 December 1994 which has an eligible return. However there are a few exceptions which do not apply here. Section 159GQ of the ITAA 1936 requires the taxpayer to include any positive amounts in their assessable income. There will be an eligible return in relation to a security if it is reasonably likely that the sum of all payments (other than periodic interest payments) made in relation to that security will exceed the issue price of the security. Periodic interest payments are payments made more than once a year. Therefore, in order to calculate out whether there is a positive return on the security, the quarterly payments will need to be excluded in determining whether there would be a positive return. The test is whether it is reasonably likely that the sum of the payments would exceed the sum invested. The scheme was to provide for three sources of payments. The first are the quarterly payments, which are excluded from the calculation. The second was the repayment distribution which is the sum invested. However, if there were any quarterly distributions that could not be paid out of profits, then some of the capital invested would be returned. If this did occur, then there would be a positive return. The third type of payment is the portfolio distribution, which would be payable if the unit trust made a profit during the period of time that the taxpayer owned the special units. Given that the unit trust was under the umbrella of the promoter, it could be argued that the third payment was reasonably likely to occur during the lifespan of the special units. If it was reasonably likely that either the third payment would take place, or one or part of one of the quarterly distributions would not be paid out of profits (which could easily occur in the first quarter of ownership), then the conditions relating to whether there would be an eligible return would be satisfied. If this is the case, then the difference between the amounts received (other than the quarterly distributions), and the cost of the special units (less any amounts previously returned) would be included as assessable income by the operation of section 159GQ of the ITAA 1936. Section 6-10 of the ITAA 1997 specifically includes statutory income (like the amounts included under section 159GQ of the ITAA 1936) as assessable income. Capital Gains . Section 104-10 of the ITAA 1997 provides the basic rules for the application of CGT event A1. These are that the item must be a CGT asset, and it must have been disposed of by one entity to another entity. The definition of CGT asset is very wide and would include the redeemable preference units. Therefore the transfer of the units would be covered by CGT event A1. Section 118-20 of the ITAA 1997 allows for a reduction in the net capital gain if an amount has already been included as assessable income elsewhere. As stated above, the amount received from the investment in excess of the original investment has been included as assessable income under either section 6-5 of the ITAA 1997, or section 97 of the ITAA 1936. Therefore, the capital gain is an excluded capital gain under section 118-20. However, if the capital gain were not excluded, the capital gain is the difference between the sale price and the remaining cost base, which may then be subject to a discount as the special units were held for a period exceeding 12 months.

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