Edited version of private advice

Authorisation Number: 1051629144119

Date of advice: 18 February 2020

Ruling

Subject: Whether a gain made on redemption of Preference Units is assessable

Question 1

Are the proceeds of the redemption of the preference units in the XYZ Trust assessable as a capital gain?

Answer

Yes. The gain will be assessable as a capital gain.

Question 2

Are the preference units a 'security' as defined in subsection 159GP(1) of the ITAA 1936 such that it could be considered a qualifying security or traditional security?

Answer

No

This ruling applies for the following period:

From 1 July 20XX to 30 June 20XY

Relevant facts and circumstances

You owned units, both ordinary and preference units, in the XYZ Trust, which is an unlisted Australian trust that did not carry on a business other than holding investments in other unit trusts that ultimately carry on a business called the 123 group.

The 123 group ownership structure consists of a majority unitholder, WWW group, and several minority holders including you. The relationship between the various parties was governed by a Unitholders Deed.

The 123 group required additional working capital. WWW group was able to pay its share of the additional funds required, but the minority unitholders were not able to pay their share of the required funds such that the percentage ownership ratio is maintained.

WWW group paid their share of the capital raising and also provided the minority unitholders' share as a back to back loan from WWW group.

WWW group provided a loan term sheet to you and other minority unitholders. The term sheet contained very onerous terms. WWW group also provided a promissory note to allow minority unitholders more time to negotiate the loan.

The terms of the promissory note were also very onerous. The WWW group-controlled board resolved to endorse the note.

As a result of the onerous terms and material impacts of defaulting on the promissory notes, and given the short timeframe to provide your share of the additional funding to 123 Group, you as the only minority unitholder in a position to invest additional capital, agreed to invest the required amount via the subscription of preference units in 123 Group.

You commenced litigation against WWW group and won the case. Among other conditions of the settlement of the case, the 123 Group would be sold. A portion of the funds received for selling the operational entity of the group was then used to redeem all owned preference units held by you.

Relevant legislative provisions

Income Tax Assessment Act 1936 subsection 159GP(1)

Income Tax Assessment Act 1997 section 6-5

Income Tax Assessment Act 1997 subsection 104-25(1)

Reasons for decision

Question 1: Are the proceeds of the redemption of the preference units in XYZ Trust assessable as a capital gain?

Summary

Yes. The gain will be assessable as a capital gain.

Detailed reasoning

The gain from the redemption of the preference units may be assessable either as:

·                 ordinary income under section 6-5 of the Income Tax Assessment Act 1997 (ITAA 1997); or

·                 profit from an isolated profit-making venture or transaction; or

·                 as a capital gain.

Section 6-5 of the ITAA 1997 provides that the assessable income of an Australian resident taxpayer includes ordinary income derived directly or indirectly from all sources during the income year. You owned units, both ordinary and preference units, in the XYZ Trust.

Taxation RulingTR 92/3Income tax: whether profits on isolated transactions are income (TR 92/3) states that a profit from an isolated transaction is generally assessable income when both of the following elements are present:

a)               the intention or purpose of the taxpayer (objectively determined) in entering into the transaction was to make a profit or gain; and

b)               the transaction was entered into and the profit made in the course of carrying on a business or in carrying out a business operation or commercial transaction.

Determining the intention or purpose of the taxpayer requires a consideration of the character of the advantage sought by the taxpayer and the circumstances and reasons for the subscription of the preference units.

In this case, your decision to invest in the preference units was mostly, if not wholly, for protecting your capital value in the trust. The onerous consequences in the event of non-payment of the Promissory Note included the immediate suspension of vital rights in your remaining investment in the ordinary units, such as voting rights or right to appoint directors on the board. It was a hostile situation with your directors forced to resign from the board as well as looming litigation. It is unreasonable to think that you would risk more of your capital in an investment that you may have no control over due to your rights being removed or threatened.

Also, the value of your ordinary units would have been drastically eroded if the additional investment was not made by you.

The redemption of the preference units was triggered by a clause in the deed which obliged the trustee to redeem the units when the Trust's assets were ultimately disposed of.

As the gain incurred by the taxpayer on redemption of the units in the Trust was made from the sale of trust corpus, it is acceptable that the gain incurred is more appropriately characterised on capital account.

Under subsection 104-25(1)(a) of the ITAA 1997, a Capital Gains Tax (CGT) event C2 happens if the ownership of an intangible CGT asset ends by the asset being redeemed or cancelled. CGT event C2 will happen when the preference units held by the taxpayer are redeemed by the Trustee.

The time of CGT event C2 will be when the Trustee redeemed the taxpayer's units (paragraph 104-25(2)(b)).

Therefore, based on the reasons above, we believe that you, in receiving an amount on redemption of the preference units, received an amount that was capital in nature and CGT event C2 has taken place.

Question 2:

Are the preference units a 'security' as defined in subsection 159GP(1) of the Income Tax Assessment Act 1936 (ITAA 1936) such that it could be considered a qualifying security or traditional security?

A unit in a unit trust cannot be a traditional security or a qualifying security unless it first satisfies the definition of 'security' in subsection 159GP(1) of Division 16E of the ITAA 1936.

Subsection 159GP(1) states that a 'security' means:

a)               stock, a bond, debenture, certificate of entitlement, bill of exchange, promissory note or other security;

b)               a deposit at bank or other financial institution;

c)               a secured or unsecured loan; or

d)               any other contract, whether or not in writing, under which a person is liable to pay an amount or amounts, whether or not the liability is secured.

Under this definition, a unit in a private unit trust will not be a listed item in paragraph (a) nor does it fall within either paragraph (b), (c) or (d) of the definition of security. Accordingly, it must be considered whether the units come within the general term 'or other security' to fall within paragraph 159GP(1)(a).

Taxation Ruling TR 96/14 Income tax: traditional securities (TR 96/14), paragraph 29 addresses the term "or other security":

29. ...it is our view that the term 'or other security' in the context in which it is used only encompasses instruments that evidence an obligation on the part of the issuer or drawer to pay an amount to the holder or acceptor, whether during the term of the instrument or at its maturity. We have drawn this conclusion because each of the listed instruments in paragraph (a) evidences such an obligation. These types of securities will generally be recognised as debt instruments.

TR 96/14 at paragraph 36 provides:

The rights and interests of a unit holder will generally be determined by the provisions of the relevant unit trust deed under which the unit is issued. We expect that in most cases a unit holder will have an undivided interest in the property of the trust fund which may be expressed as a ratio of units held to total units issued. The units are thus a measure of a unit holder's interest in property. In the light of that characterisation and the discussion in paragraphs 24 to 29 above, we do not believe that a unit in a public unit trust is, of itself, a security of the sort specified by paragraph (a).

It is our view that a unit in a public unit trust does not fall within the meaning of the term 'or other security' in paragraph (a) unless there are instruments that evidence an obligation on the part of the issuer or drawer to pay an amount to the holder or acceptor, whether during the term of the instrument or at its maturity. The obligation here would generally be recognised as a debt instrument, or a loan.

Taxation Ruling TR 2010/3Income tax: Division 7A loans: trust entitlements (TR 2010/3) cites the case of Federal Commissioner of Taxation v. Radilo Enterprises Pty Ltd (1997) 34 ATR 635 as authority for what constitutes a loan according to the ordinary meaning of the word:

A loan involves an obligation on the borrower to repay the sum borrowed. The matter is put this way by Dr Pannam:

A loan of money may be defined, in general terms, as a simple contract whereby one person ('the lender') pays or agrees to pay a sum of money in consideration of a promise by another person ('the borrower') to repay the money upon demand or at a fixed date. The promise of repayment may or may not be coupled with a promise to pay interest on the money so paid. The essence of the transaction is the promise of repayment. As Lowe J put it in a judgment delivered on behalf of himself and Gavan Duffy and Martin JJ: ''Lend' in its ordinary meaning in our view imports an obligation on the borrower to repay'.... Repayment is the ingredient which links together the definitions of 'loan' to be found in the Oxford English Dictionary, the various legal dictionaries and the text books. In essence then a loan is a payment of money to or for someone on the condition that it will be repaid.

47. The essential element of an ordinary loan is obligation to repay a borrowed amount. The fact that a debt exists is not, of itself, sufficient to characterise an arrangement as a loan. For example, in Prime Wheat Association Ltd v. Chief Commissioner of Stamp Duties (Prime Wheat Association) Gleeson CJ acknowledged that a share sale agreement which provided for payment by instalments over a 20 year period was a debt and the provision of financial accommodation, but as there was only 'payment' and not 'repayment', there was no loan. Similarly, the Full Federal Court found that the sale and lease-back arrangement in Eastern Nitrogen Ltd v. Commissioner of Taxation was a financing arrangement for financial accommodation, but without the obligation to repay a sum advanced, it was not a loan.

48. Once there is an arrangement for the repayment of an amount advanced, there is an ordinary loan irrespective of whether the rights in respect of that arrangement arise under contract or in equity. Moreover, there is no requirement that an ordinary loan be in writing.

On the basis of the above, it is clear that an obligation to repay a borrowed amount forms an integral and indispensable characteristic of a loan in terms of the ordinary meaning of the word.

The terms and clauses of the Subscription Deed of the preference units are inconsistent with the ordinary definition of a loan. Accordingly, where the subscription in the preference units does not have the characteristics of a loan, it follows that the redemption amount cannot be 'in substitution' for interest.

In further considering whether any part of the redemption amount is assessable under ordinary concepts, consideration has been given to the character of the receipt received by the taxpayer.

It is also noted that the Trust did not carry on a business and has historically only held investments in a number of underlying unit trusts. The redemption was triggered by the sale of the operational entities in the group, being trust corpus. With no underlying investments, the Trustee sought to return the capital to the unitholders. Furthermore, the Trustee was obligated under the Subscription Deed to redeem the units when the Trust's assets were ultimately disposed.

In the Charles case, the Full High Court held that an amount received by the appellant, to the extent that it was not a distribution of assessable income received by the trustees, was not part of his assessable income. Profits arising on the sale of securities, distributions in the winding-up of a company in which the trustees held shares and the sale of rights in respect of shares held by the trustees were accretions to capital and not assessable income derived by the trustees.

It was further stated in Charles Case at 609 that:

a unit held under this trust deed is fundamentally different from a share in a company. A share confers upon the holder no legal or equitable interest in the assets of the company; it is a separate piece of property ... But a unit in the trust deed before us confers a proprietary interest in all of the property which for the time being is subject to the trusts of the deed.

The preference units held by you were ultimately redeemed out of funds received by the Trust when the Trust was ultimately wound up. It is therefore argued that the funds in the hands of the Trustee were capital in nature and the amount paid to you has retained this character.

We believe that the preference units that you subscribed to were an equity instrument, and not a debt instrument or a loan. As detailed above, your subscription in the preference units does not have the characteristics of a loan and as such does not have sufficient debt like obligations to be a contract to which paragraph (d) of the definition of security in subsection 159GP(1) of the ITAA 1936 applies, nor does it fall within paragraphs (a), (b), (c) or (d) of that definition. On this basis, it is considered that the preference units do not meet the definition of security under subsection 159GP(1) of the ITAA 1936.

Where the preference units do not meet the definition of security under subsection 159GP(1) of the ITAA 1936, the units cannot be a qualifying security for the purposes of Division 16E of the ITAA 1936, nor a traditional security for the purposes of sections 26BB and 70B of the ITAA 1936.

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