Private ruling: Debt equity rules - effect non-contingent obligation
Date of advice: 24 May 2022
Published: August 2022
Ruling period: Year ending 30 June 20XX | Year ending 30 June 20XX | Year ending 30 June 20XX | Year ending 30 June 20XX | Year ending 30 June 20XX

Ruling: Q1: Do the Income Sub-Class Units in the DGF constitute debt interests for the purposes of Division 974 of the Income Tax Assessment Act 1997 (ITAA 1997)? | A1: No. | Q2: Will the rental income of the DGF to which the Income Fund has been made presently entitled for the income year be included in the assessable income of the Income Fund pursuant to section 97 of the Income Tax Assessment Act 1936 (ITAA 1936)? | A2: Yes. | Q3: Will a share of any net capital gain made by the DGF upon disposal of the Underlying Property to which the Income Fund has been made specifically entitled for a particular year pursuant to section 115-228 of the ITAA 1997 constitute a capital gain of the Income Fund for the year? | A3: Yes.

Relevant facts and circumstances: Background to the ABC Fund The principal activity of the ABC Group is the development of a software platform to be used for the trading of fractional interests in property. ABC Limited is an Australian resident company for tax purposes and listed for trade on the Australian Securities Exchange. ABC Limited is the head company of an income tax consolidated group. ABC Australia Limited (ABC) is a whollyowned subsidiary of ABC Limited, and is a member of the income tax consolidated group. ABC is the operator of the ABC investment platform that is offered through a registered managed investment scheme, the ABC Fund, which allows investors to invest in one or more properties via a syndicate-like, fractional investment structure. The ABC Fund's Responsible Entity and Trustee is M Ltd, a professional trustee firm. The ABC Fund allows Investors to purchase a fractional interest in an Underlying Asset held by a Sub-Fund established by M Ltd. ABC will issue a Supplementary Product Disclosure Statement (SPDS) in respect of each Underlying Asset and place the relevant details for each Underlying Asset on the ABC Website. A campaign process will be undertaken through which an Investor can indicate their interest in investing in an Underlying Asset by placing a bid through a fractional investing platform. If sufficient investor bids in the campaign are received to enable an offer to be made, and the offer is successful, a Sub-Fund will be created to purchase and hold the Underlying Asset. The Constitution facilitates the creation of a distinct trust (i.e. the Sub-Fund) in connection with each Class of Units. Investors will be issued Units in that Sub-Fund in the proportion that their active bid amounts bear to the active bid amounts of all Investors in the Sub-Fund. The holding of Units in the Sub-Fund will not provide exposure to any other investment in the ABC Fund. The Underlying Asset in a Sub-Fund is held by the ABC Fund's Custodian which acts as an agent of the Trustee. The Custodian holds the Underlying Assets on behalf of the Trustee who in turn holds its interests in the Underlying Assets on trust for the Investors in the ABC Fund. An Underlying Asset held in a Sub-Fund that is Property is referred to as the Underlying Property. After Settlement of an Underlying Property, ABC will appoint a licensed real estate agent as the Property Manager for the SubFund. The Property Manager will be responsible for all property management functions typically undertaken by a property manager of a rental property, including procuring tenants, collecting rental payments and managing lease expiries. The Custodian (on behalf of the Trustee) is entitled to all of the benefits and obligations associated with being the owner of the Underlying Asset, including receiving any income. The Custodian (at the direction of the Trustee and as its agent only) pays out the costs associated with the ownership of the Underlying Asset. These costs will be recovered from the Gross Income of the relevant Sub-Fund and a Provisional Amount maintained for the SubFund. The DGF The DGF will be established as a distinct Sub-Fund of the ABC Fund. The trustee of the DGF will be M Ltd. The DGF will: • be an unlisted managed investment scheme; • be a managed investment trust within the meaning of section 275-10 of the ITAA 1997; and • not be a trading trust for the purposes of Division 6C of the ITAA 1936. The DGF will be a Class for the purposes of the Constitution and will have an Underlying Property as its Underlying Asset. The Underlying Property of the DGF will be a residential property for lease to residential tenants. It is intended to provide Investors who, because of ethical or religious circumstances, are not able to receive or pay interest (such as Islamic investors who are seeking Sharia-compliant products) with access to property returns without the use of borrowings. The DGF will be an Australian resident unit trust for income tax purposes with two classes of Units; Income SubClass Units and Growth Sub-Class Units, as facilitated by the Constitution. Units in the DGF will be issued at a price of $1.00 per Unit. Pursuant to the Product Disclosure Document and the SPDS, the Growth Sub-Class Unit Holders will fund a Provisional Amount representing approximately four months' rent of the Underlying Property. No unused portion of the Provisional Amount will be used to form part of the Distributable Amount of the DGF, and will be returned only as a return of capital upon termination of the DGF. Assuming the Underlying Property is tenanted, the DGF will derive rental income. For each Distribution Period (i.e. month), the Distributable Amount of the DGF (equating to the gross rental income derived from the Underlying Property, less expenses and management fees incurred in connection with the Underlying Property) will be apportioned between the Income Sub-Class and Growth Sub-Class Unit Holders and distributed as follows: • 99% to the Income Sub-Class Unit Holders; and • 1% to the Growth Sub-Class Unit Holders. The term of the DGF will be 25 years from the date of the first issue of its Units. The term can be extended by an ordinary resolution of Unit Holders in the DGF, or terminated early at the discretion of the Trustee by providing a minimum of 30 days' notice to all Unit Holders in the DGF. Early termination will only happen where, on the recommendation of ABC, the Trustee determines it is in the best interests of Unit Holders to sell the Underlying Property before the end of the term. Subject to making a decision to sell their Units, Unit Holders will not be able to withdraw their investment in the DGF until the DGF is terminated. On the termination of the DGF the Underlying Property will be realised by the Trustee. There will be no constraints on the selling price of the Underlying Property. If the capital proceeds available from the realisation of the Underlying Property (after the payment of all expenses associated with the winding up of the DGF) is equal to or exceeds the amount invested in the Income Sub-Class by Income Sub-Class Unit Holders, then: • the Income Sub-Class Unit Holders will receive the amount originally invested; and • the balance will be split 0.001% to the Income Sub-Class Unitholders and 99.999% to the Growth SubClass Unitholders. If the proceeds available from the realisation of the Underlying Property (after the payment of all expenses associated with the winding up of the DGF) is less than the amount invested in the Income Sub-Class by the Income Sub-Class Unit Holders, then the Income Sub-Class Unit Holders will receive all of the amount available for distribution. The Income Fund and the Growth Fund The sole holder of the Income Sub-Class Units in the DGF will be the Income Fund, an Australian resident managed fund. Investors in the Income Fund are expected to be wholesale or institutional investors. One holder of the Growth Sub-Class Units in the DGF will be the Growth Fund, an Australian resident managed fund, potential Investors in which will be comprised of individuals and institutional investors. Other investors of the Growth Sub-Class Units are likely to include individuals and trusts. The Income Fund and the Growth Fund will be pooled funds which are expected to invest in the income sub-class and the growth sub-class of different equity mortgage products respectively. The trustee of the Income Fund and the Growth Fund will be M Ltd. Pursuant to the Constitution, the Income Fund will have the right to be granted a real property mortgage over the Underlying Property of the DGF. Assumptions 1. All dealings between any of the parties involved in the DGF, including the Responsible Entity, the Custodian, the Income Fund, the Growth Fund and the tenants of the Underlying Property will be at arm's length. 2. No guarantees or indemnities will be provided by the tenant or any other parties involved in the DGF in respect of the rent payments for the Underlying Property, the Distributable Amount of the DGF, or the sales price of the Underlying Property. 3. Upon the termination and winding up of the DGF, and for the purposes of paragraph 115-228(1)(c) of the ITAA 1997, entitlement of a Sub-Class Unit Holder to the net proceeds from the realisation of the Underlying Property will be recorded, in its character as referable to any capital gain realised, in the accounts or records of the DGF no later than two months after the end of the income year in which the entitlement arises. 4. Division 230 and Division 276 of the ITAA 1997 will not apply to the gains or losses of the DGF, the Income Fund and the Growth Fund.

Relevant legislative provisions: Income Tax Assessment Act 1936 Division 6 of Part III | Income Tax Assessment Act 1936 section 95 | Income Tax Assessment Act 1936 section 97 | Income Tax Assessment Act 1936 subsection 97(1) | Income Tax Assessment Act 1936 subparagraph 97(1)(a)(i) | Income Tax Assessment Act 1936 subparagraph 97(1)(a)(ii) | Income Tax Assessment Act 1936 Division 6C | Income Tax Assessment Act 1936 Division 6E | Income Tax Assessment Act 1997 Subdivision 115-C | Income Tax Assessment Act 1997 paragraph 115-227(a) | Income Tax Assessment Act 1997 section 115-228 | Income Tax Assessment Act 1997 subsection 115-228(1) | Income Tax Assessment Act 1997 paragraph 115-228(1)(a) | Income Tax Assessment Act 1997 paragraph 115-228(1)(b) | Income Tax Assessment Act 1997 paragraph 115-228(1)(c) | Income Tax Assessment Act 1997 Division 230 | Income Tax Assessment Act 1997 section 275-10 | Income Tax Assessment Act 1997 Division 276 | Income Tax Assessment Act 1997 Division 974 | Income Tax Assessment Act 1997 subsection 974-5(1) | Income Tax Assessment Act 1997 subsection 974-15(1) | Income Tax Assessment Act 1997 section 974-20 | Income Tax Assessment Act 1997 subsection 974-20(1) | Income Tax Assessment Act 1997 paragraph 974-20(1)(a) | Income Tax Assessment Act 1997 paragraph 974-20(1)(b) | Income Tax Assessment Act 1997 paragraph 974-20(1)(c) | Income Tax Assessment Act 1997 paragraph 974-20(1)(d) | Income Tax Assessment Act 1997 paragraph 974-20(1)(e) | Income Tax Assessment Act 1997 section 974-130 | Income Tax Assessment Act 1997 subsection 974-130(1) | Income Tax Assessment Act 1997 section 974-135 | Income Tax Assessment Act 1997 subsection 974-135(1) | Income Tax Assessment Act 1997 subsection 974-135(3) | Income Tax Assessment Act 1997 section 974-160

Reasons for decision: Summary: The Income Sub-Class Units do not constitute debt interests for the purposes of Division 974 of the ITAA 1997 [1] . | Detailed Reasoning - Detailed reasoning: The provisions of Division 974 determine whether, for certain income tax purposes, an interest is a 'debt interest' or an 'equity interest'. These provisions do not impose tax, but rather categorise whether an interest is debt or equity based on "economic substance rather than mere legal form" (subsection 974-5(1)). Pursuant to subsection 974-15(1), a scheme gives rise to a debt interest in an entity if the scheme, when it comes into existence, satisfies the debt test in subsection 974-20(1) in relation to the entity. Subsection 974-20(1) provides that a scheme satisfies the debt test in relation to an entity if: (a) the scheme is a *financing arrangement for the entity; and (b) the entity, or a *connected entity of the entity, receives, or will receive, a *financial benefit or benefits under the scheme; and (c) the entity has, or the entity and a connected entity of the entity each has, an *effectively non-contingent obligation under the scheme to provide a financial benefit or benefits to one or more entities after the time when: (i) the financial benefit referred to in paragraph (b) is received if there is only one; or (ii) the first of the financial benefits referred to in paragraph (b) is received if there are more than one; and (d) it is substantially more likely than not that the value provided (worked out under subsection (2)) will be at least equal to the value received (worked out under subsection (3)); and (e) the value provided (worked out under subsection (2)) and the value received (worked out under subsection (3)) are not both nil. The classification of a scheme as giving rise to a debt interest is done from the perspective of the issuer of the interest, in this instance M Ltd as the trustee for the DGF. Paragraph 974-20(1)(a) requires that the scheme is a 'financing arrangement' for the DGF. Subsection 974-130(1) states that a scheme is a financing arrangement for an entity if it is entered into or undertaken: (a) to raise finance for the entity (or a *connected entity of the entity); or (b) to fund another scheme, or a part of another scheme, that is a *financing arrangement under paragraph (a); or (c) to fund a return, or a part of a return, payable under or provided by or under another scheme, or a part of another scheme, that is a financing arrangement under paragraph (a). The DGF (a 'scheme' for the purposes of the Income Tax Assessment Act ) will be undertaken to raise finance used to fund the DGF's acquisition of the Underlying Property. The DGF, as a scheme, will therefore constitute a 'financing arrangement' pursuant to section 974-130, thereby satisfying paragraph 974-20(1)(a). A 'financial benefit' is defined in section 974-160 as anything of economic value and includes property and services. Generally, the financial benefit received by the issuer of the interest (or a connected entity of the issuer) under the scheme, for the purposes of paragraph 974-20(1)(b), will be the issue price specified in the terms of the financing arrangement. The financial benefit to be received could be a single amount or involve a number of instalments over time. Each Investor's active bid amount received by the DGF and applied to acquire the Underlying Property constitutes a 'financial benefit' pursuant to section 974-160 received by the DGF, thereby satisfying paragraph 974-20(1)(b). Paragraph 974-20(1)(c) requires DGF (or DGF together with a connected entity) to have an 'effectively noncontingent obligation' under the scheme to provide one or more financial benefits after its receipt of the first active bid amount. An 'effectively non-contingent obligation' has the meaning given by section 974-135. Subsection 974-135(1) provides that whether an effectively non-contingent obligation exists is determined having regard to the terms, conditions and pricing of the financing arrangement. The obligation must be non-contingent in substance as opposed to being non-contingent only in form. Subsection 974-135(3) provides that an obligation is non-contingent if it is not contingent on any event, condition or situation (including the economic performance of the entity having the obligation or a connected entity of that entity) other than the ability or willingness of that entity or connected entity to meet the obligation. After its receipt of the first active bid amount, the DGF will have an obligation to provide Unit Holders with financial benefits in the form of: • their Distribution Entitlement for each Distribution Period during the term of the DGF; and • a distribution of any capital on the termination of the DGF and the realisation of the Underlying Property. The DGF's obligation to pay the Distribution Entitlement for each Distribution Period cannot be met with funds constituting the Provisional Amount and will be contingent on a number of factors, including whether the Underlying Property is tenanted (or the extent to which it is tenanted), the payment of rent by the tenants, and the receipt of rental payments in excess of the costs of managing the Underlying Property. The DGF's obligation to pay the Distribution Entitlement for each Distribution Period is therefore not an effectively non-contingent obligation under section 974-135. The DGF's obligation to pay a distribution of any capital on termination will be contingent on the Underlying Property's sale, and therefore will not be an effectively non-contingent obligation under section 974-135. As none of the DGF's obligations to provide Income Sub-Class Unit Holders with financial benefits are effectively non-contingent obligations, paragraph 974-20(1)(c) is not satisfied, and the Income Sub-Class Units do not constitute interests that satisfy the debt test under section 974-20. [2] | Summary: Upon being made presently entitled to a share of the rental income of the DGF, the Income Fund will be assessed under section 97 of the ITAA 1936 on its share of that income. | Detailed Reasoning - Detailed reasoning: The net income of a trust estate for a particular year is calculated in accordance with section 95 of the ITAA 1936. Broadly, it is the amount that would have been the trustee's taxable income if it were assumed that the trustee was a resident taxpayer. The net income is assessed to the trustee or to beneficiaries of the trust in accordance with the rules set out in Division 6 of Part III of the ITAA 1936. Subsection 97(1) of Division 6 of Part III of the ITAA 1936 sets out when amounts are included in the assessable income of a beneficiary that is an Australian resident not under a legal disability. It provides: | Detailed Reasoning - 97 Beneficiary not under any legal disability: (1) [Assessable and exempt income of beneficiary] Subject to Division 6D, where a beneficiary of a trust estate who is not under a legal disability is presently entitled to a share of the income of the trust estate: (a) the assessable income of the beneficiary shall include: (i) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was a resident; and (ii) so much of that share of the net income of the trust estate as is attributable to a period when the beneficiary was not a resident and is also attributable to sources in Australia; and ... Accordingly, subsection 97(1) of the ITAA 1936 provides that in circumstances where a beneficiary that is a resident not under a legal disability has been made presently entitled to a share of the income of the trust estate, the beneficiary includes their share of the net income of the trust estate in their assessable income. Paragraph 12 of Taxation Ruling TR 2012/D1 [3] provides that the income of the trust estate for section 97 of the ITAA 1936 purposes is the 'distributable income': | Detailed Reasoning - Amount beneficiary can be made presently entitled to: 12. In the context of Division 6, the 'income of the trust estate', is not a reference to the gross income of a trust estate, but rather a reference to the net amount of income to which a beneficiary could be made presently entitled or accumulated. That is, it is a reference to the income available for distribution to beneficiaries or accumulation by the trustee, commonly referred to as 'distributable income'. As confirmed in paragraph 13 of Taxation Determination TD 2018/9 [4] , a beneficiary is only presently entitled to income if they have: (a) an interest in the income which is both vested in interest and vested in possession; and (b) a present legal right to demand and receive payment of the income, whether or not the precise entitlement can be ascertained before the end of the relevant year of income and whether or not the trustee has the funds available for immediate payment. [5] The 'income of the trust estate' in section 97 of the ITAA 1936 may be different to the 'net income of the trust estate'. The latter is defined in section 95 as follows: net income , in relation to a trust estate, means the total assessable income of the trust estate calculated under this Act as if the trustee were a taxpayer in respect of that income and were a resident, less all allowable deductions, except deductions under Division 393 of the Income Tax Assessment Act 1997 (Farm management deposits) and except also, in respect of any beneficiary who has no beneficial interest in the corpus of the trust estate, or in respect of any life tenant, the deductions allowable under Division 36 of the Income Tax Assessment Act 1997 in respect of such of the tax losses of previous years as are required to be met out of corpus. The term 'share', as used in subparagraphs 97(1)(a)(i) and (ii) of the ITAA 1936, means 'proportion' such that once the share of the income of the trust estate to which the beneficiary is presently entitled is determined, the beneficiary is assessed on that same percentage share of the trust's net income as defined in section 95 of the ITAA 1936. The Constitution enables M Ltd (as the Responsible Entity) to determine the income of the DGF and the Distributable Amount in each Distribution Period. M Ltd will determine the Income of the DGF. Generally, the Income of the DGF will reflect the rental income received, net of all relevant costs and expenses. For each Distribution Period, M Ltd will calculate the Distributable Amount and each Unit Holder's Distribution Entitlement, and distribute each Unit Holder's Distribution Entitlement. The Constitution provides that persons who are Unit Holders on the last day of the Distribution Period will have an absolute vested and indefeasible interest in the Unit Holder's Distribution Entitlement for that Distribution Period, subject to the rights, restrictions and obligations attaching to the particular Unit, Class or Sub-Class. The Constitution, in conjunction with the SPDS, specifies how the Distributable Amount is to be apportioned between the Income Sub-Class and Growth Sub-Class Unit Holders. It provides that 99% will be distributed to the Income Class Unit Holders, and 1% will be distributed to the Growth-Sub Class Unit Holders. The Income Fund is an Australian resident beneficiary of the DGF that is not under a legal disability. Accordingly, once the Income Fund is made presently entitled to a share of the income of the DGF (that income being comprised of the net rental income of the DGF), it will be assessed under section 97 of the ITAA 1936 on its share of the net income of the DGF (and that assessable income will be included in the calculation of the net income of the Income Fund pursuant to section 95 of the ITAA 1936). | Summary: A share of any net capital gain made by the DGF upon disposal of the Underlying Property to which the Income Fund is made specifically entitled for a particular year pursuant to section 115-228 will constitute a capital gain of the Income Fund for the year. | Detailed Reasoning - Detailed reasoning: Where the net income of a trust estate includes a capital gain, Subdivision 115-C operates simultaneously with Division 6 of the ITAA 1936, such that the taxation of a trust's capital gains is dealt with under the former and effectively taken out of the latter pursuant to Division 6E of the ITAA 1936. Subdivision 115-C sets out the rules for calculating a beneficiary's net capital gain if they are entitled to a distribution from a trust that includes a net capital gain. For Subdivision 115-C to apply, the beneficiary must be specifically entitled to an amount of a capital gain made by the trust. Section 115-228 sets out the requirements of when a beneficiary will be regarded as specifically entitled to a trust's capital gain. Pursuant to paragraphs (a) and (b) of subsection 115-228(1), for a beneficiary to be specifically entitled to a capital gain the beneficiary must receive, or reasonably expect to receive, an amount equal to their share of the net financial benefit that is referable to the capital gain. A beneficiary's entitlement can be expressed as a dollar amount, a share of the trust gain or distribution, or using a known formula provided it refers to the capital gain. Pursuant to paragraph 115-228(1)(c), for a beneficiary to have a specific entitlement to a capital gain the beneficiary's entitlement to the amount must be recorded in its character as referable to the capital gain. This record must be contained in the accounts or records of the trust, such as the trust deed, trust accounts, resolutions and distribution statements, including schedules and notes attached to, or intended to be read with, these documents. A record for tax purposes only does not create specific entitlement. A resolution to distribute a specified amount of trust income, a percentage of the trust income or the balance of the trust income does not create a specific entitlement if there is no reference to a capital gain. However, if the capital gain is clearly referred to in another document, such as the trust accounts, the recording requirement may be satisfied. When a beneficiary is specifically entitled to a capital gain, the beneficiary is assessed on the capital gain, with all the associated tax consequences in respect of that distribution applying. The Constitution enables M Ltd (as the Responsible Entity) to determine whether any amount is to be treated as being on income or capital account for a year, and to distribute capital of the DGF to the Unit Holders. The Constitution, in conjunction with the SPDS, specifies how the (capital) proceeds from the realisation of the Underlying Property will be distributed upon the termination and winding-up of the DGF (after the payment of all of the expenses associated with winding up the DGF). That is: • where the net proceeds are less than the amount invested in the Income Sub-Class by the Income Fund, then the Income Fund will receive all of the amount available for distribution; and • where the net proceeds are equal to or exceed the amount invested in the Income Sub-Class by the Income Fund, then the Income Fund will receive the amount originally invested and the balance will be split 0.001% to the Income Fund and 99.999% to the Growth Fund and other Growth Sub-Class Unitholders. M Ltd will determine in writing the net financial benefit referrable to the capital gain, i.e. the proceeds from the realisation of the Underlying Property reduced by the payment of all expenses associated with winding up the DGF, and will distribute that net financial benefit in accordance with the above capital distribution entitlements. Accordingly, where a capital gain is realised on the disposal of the Underlying Property: • the requirements in paragraphs 115-228(1)(a) and (b) will be satisfied, as the Income Fund will reasonably expect to receive an amount equal to its share of the net financial benefit that is referrable to the capital gain; and • the requirement in paragraph 115-228(1)(c) will be satisfied, as the Income Fund's entitlement to the share of the net financial benefit from the disposal of the Underlying Property will be recorded, in its character as referrable to the capital gain, in the accounts or records of the DGF no later than two months after the end of the relevant income year. As the conditions in subsection 115-228(1) will be satisfied if a capital gain is made on the disposal of the Underlying Property by the DGF, the Income Fund will be specifically entitled to an amount of that capital gain and will have a share of the capital gain equal to that amount pursuant to paragraph 115-227(a). [1] All subsequent legislative references in this document are to the ITAA 1997, unless otherwise stipulated. [2] As the condition at paragraph 974-20(1)(c) will not be satisfied, the conditions are paragraphs 974-20(1)(d) and (e) are not considered for the purposes of this Ruling. [3] Income tax: meaning of 'income of the trust estate' in Division 6 of Part III of the Income Tax Assessment Act 1936 and related provisions . [4] Income tax: deductibility of interest expenses incurred by a beneficiary of a discretionary trust on borrowings on-lent interest-free to the trustee . [5] FCT v. Bamford [2010] HCA 10 at [37]; 75 ATR 1; 2010 ATC 20-170; Harmer v. FCT (1991) 173 CLR 264 at [271]; 22 ATR 726; 91 ATC 5000.