Private ruling: Income tax - deductions, capital versus revenue expenditure
Published: October 2013
Ruling period: Year 1, 2 and 3
Date scheme commenced: 2007

Ruling: Q1: Are losses to be made by the taxpayer on the disposal or cancellation of its units in a unit trust of a revenue nature and deductible under section 8-1 of the Income Tax Assessment Act 1997 or any other provision? | A1: Yes

Relevant facts and circumstances: The taxpayer undertakes a number of diversified activities as part of its commercial/business operations. Its investment's income is derived from widely diversified sources, including interest from term deposits and loans, rental income, profits from property developments undertaken directly or indirectly through property partnerships, dividend income from publicly listed shares, trust distribution income from publicly listed managed funds, operating businesses and venture capital type investments. Certain percentage of assets allocated to venture capital type of investments. Venture capital type of investments usually comprise of early stage, high growth business investment opportunities. These investments usually made by the taxpayer as a partner, unit holder or a joint venturer with other third parties, depending on the structure of the new deal which is influenced by various commercial and economic factors and partners preference. The taxpayer is currently invested in various capital type of deals with various partners and directly. Ordinarily, the investment in venture capital type of deal is made through a unit trust and shares in the company. The net profit from the realisation of investments ordinarily returned by the interposed unit trust are on revenue account and on-distributed to the taxpayer. One of the taxpayer's investments is in a special purpose unit trust established for a purpose of providing investors participation in a diversified portfolio of early stage, high growth privately owned business opportunities. Details about the unit trust have been provided.

Relevant legislative provisions: Income Tax Assessment Act 1997, Section 8-1.

Reasons for decision: Summary: The loss that the taxpayer is likely to incur will be deductible under section 8-1 of the Income Tax Assessment Act 1997 ( ITAA 1997). | Detailed Reasoning - Detailed reasoning: The general deduction provision in section 8-1 of the ITAA 1997 allows a deduction for losses and outgoings to the extent to which they: · are incurred in gaining or producing assessable income; or · are necessarily incurred in carrying on a business for the purpose of gaining or producing such income. However, no deduction is allowed under section 8-1 of the ITAA 1997 for expenses to the extent to which they are of a capital, private or domestic nature, or are incurred in gaining or producing exempt income, or are otherwise prevented from being deductible by a specific division of ITAA 1997 or the Income Tax Assessment Act 1936 . For a loss to be incurred in gaining or producing assessable income 'it is both sufficient and necessary that the occasion of the loss…be found in whatever is productive of assessable income, or if none be produced, would be expected to produce assessable income' ( Ronpibon Tin N.L. and Tongkah Compound N.L. v FC of T (1949) 78 CLR 47 at 57; Fletcher & Ors v. FC of T (1991) 173 CLR1; 91 ATC 4950; (1991) 22 ATR 613 at 622). For an outgoing to be deductible under the second limb of section 8-1 as expenditure necessarily incurred in carrying on a business for the purpose of gaining or producing assessable income, it must have the character of a working or operating expense of the entity's business or be an essential part of the cost of its business operations. In John Fairfax & Sons Pty Ltd v. FC of T (1958-9) 101 CLR 30 Menzies J stated (at page 49): … there must, if an outgoing is going to fall within its terms, be found (i) that it was necessarily incurred in carrying on a business; and (ii) that the carrying on of the business was for the purpose of gaining assessable income. The element that I think is necessary to emphasise here is that the outlay must have been incurred in the carrying on of a business, that is, it must be part of the cost of trading operations. In order to determine whether an amount is part of the cost of business operations, one has to 'make both a wide survey and an exact scrutiny of the taxpayer's activities': Western Gold Mines No Liability v Commissioner of Taxation (WA) 59 CLR 729 at 740;1937-1938 4 ATD 453 at 462. In G P International Pipecoaters Pty Ltd v FC of T 90 ATC 4413, the High Court said: To determine whether a receipt is of an income or of a capital nature, various factors may be relevant. Sometimes, the character of receipts will be revealed most clearly by their periodicity, regularity or recurrence; sometimes, by the scope of the transaction, venture or business in or by reason of which money is received and by the recipient's purpose in engaging in the transaction, venture or business. From a general perspective, the ordinary course of business is not limited necessarily to the everyday dealings and can encompass transactions that occur outside the day to day business activities. In Californian Copper Syndicate (Limited and Reduced) v Harris (1904) 5 TC 159, it was held that the sale of mining property in exchange of shares, was in fact 'a sale in the line of the Company's business, resulting in a profit liable to income tax.' Lord Justice-Clerk stated in that case: But it is equally well established that enhanced values obtained from realisation or conversion of securities may be so assessable, where what is done is not merely a realisation or change of investment, but is an act done in what is truly the carrying on or carrying out of a business. Although a mining company, the profits from the sale of property were still considered to be part of their business where it was found the transaction was a 'scheme for profit-making.' The taxpayer undertakes a number of activities as part of its business operations. Its income is derived from a variety of sources. One source of its income is venture capital type investments. The taxpayer is currently investing in various start-up companies directly or as a partner, unit holder or a joint venturer. Ordinarily where the investment is made though a unit trust, it is the unit trust that acquires shares in start up companies and any profit or loss upon realisation of the shares is on revenue account. When the unit trust passes the income on to the unit holders, under the conduit theory, income retains its character when passing from the trustee to beneficiary. The conduit theory was recognised by the decision in Charles v Federal commissioner of Taxation (1954) 90 CLR 958. Therefore income earned on revenue account by the trust will be on revenue when distributed to the unit holders, and income earned on capital account by the trust will be on capital account when distributed to the unit holders. However, it does not necessarily follow that any gain or loss made by the unit holders upon redemption of their units in the interposed trust will have the same character as the loss or gain made by the interposed trust on the redemption of its hares in the start up companies. As stated earlier the character of the gain or loss made upon the redemption of the units in the interposed trust will depend on the nature of the business of the unit holder. Although the taxpayer is not directly investing in the start up companies, the nature of the unit trust is such that the taxpayer's investment in it is consistent with its aim to make a profit from assets with high capital appreciation and a high risk of failure. Hence, it is considered part of its usual business operations. Since such investments are part of its business operations, it can be concluded that any loss on the cancellation of its units will be incurred in the course of carrying on that business. The amount of that loss will be deductible under section 8-1 of the ITAA 1997.