This case concerns the tax treatment of payments made by the trustee of a unit trust on the redemption of units; in particular whether redeeming unitholders would be assessed on trust capital gains apportioned to them.
The taxpayer, Colonial First State Investments Limited (Colonial), is the trustee and Responsible Entity of a retail unit trust (the Retail Fund).
In its capacity as trustee of the Retail Fund, Colonial invested in units in a wholesale unit trust known as the Commonwealth Property Fund 6 (the Wholesale Fund).
To comply with s 601FC(1)(i) of the Corporations Act 2001, the units for both Funds were held by a Citicorp Nominees Pty Ltd (as a Custodian) on behalf of Colonial.
Colonial sought a private ruling from the ATO as to the tax consequences of proposed amendments to the constitution of the Wholesale Fund, seeking to alleviate what it perceives as unfairness in the tax burdens imposed on unitholders by its current practices in allocating payments to redeeming unitholders.
The proposed amendments to the Wholesale Fund Constitution pertain to Clause 12, which entitled a redeeming unitholder to a ‘redemption amount’ on making a redemption application.
Through the exercise of its power of appointment, Colonial would direct short term capital gains to investors who held their investment for less than 12 months and long term capital gains to investors who held their investment for more than 12 months.
It was intended that an allocation of capital gains in this manner would constitute a present entitlement to income of the trust estate for the purposes of s 97 of the Income Tax Assessment Act 1936 (ITAA 1936).
Such allocations were intended to result in the tax on capital gains made by the trustee of the Wholesale Fund in disposing of assets for the purposes of paying out redeeming unitholders being borne by those unitholders (rather than the liability being spread amongst the unitholders remaining at the end of the income year).
The proposed amendments sought to confer on the Responsible Entity of the Wholesale Fund an absolute discretion to appropriate the redemption amount from three accounts:
- An account representing the corpus of the Wholesale Fund (Corpus Account).
- An account to which has been credited the Wholesale Fund’s short term capital gains (i.e. those calculated for tax purposes which did not qualify for the CGT discount) – (Short Term Capital Gain Account).
- An account to which has been credited the Wholesale Fund’s long term capital gains (i.e. those calculated for tax purposes which qualified for the CGT discount) – (Long Term Capital Gain Account).
The proposed amendments also provided:
- The Responsible Entity (i.e. Colonial) may decide to which accounts of the Trust a Redemption Amount should be debited after the end of the financial year during which the entitlement to that Redemption Amount arises and will notify each Redeeming Holder accordingly.
Clause 32– Concerned the distribution of income, and provided that “each Holder registered at midnight on the last day of each tax year, is presently entitled to a share of Distributable Income for that year not previously distributed in the proportion of the number of Units held to all Units then in issue in the Trust”.
- Distributable income was defined to be the amount the trustee had to distribute to ensure the lowest amount of tax payable.
Clause 32 also gave the trustee the power to elect to any amount (capital gains or income) to be distributed from the Trust to the Holders, and to decide which part of a redemption amount should be treated as a distribution from the capital gains tax and corpus accounts (respectively).
Summary of judgment:
Consider a situation where the Gain part appropriated from the Short Term Capital Gain Accoutn to payment of the Redemption Amount was equal to the excess of the Redemption Amount over the Subscription Amount.
Question 1(a) – Whether the capital gains part is included in the assessable income taken into the calculation of the net income of the trust estate of the Retail Fund, as being that part of the net income of the Wholesale Fund to which Colonial is, in consequence of the redemption and the operation of clause 12 of the amended Constitution, presently entitled for the purposes of s 97 of the 1936 Act.
Colonial is not presently entitled to the funds from which the Gain part was sourced at the time those funds were derived by the trustee and therefore Colonial’s assessable income does not include an amount under s 97(1). Similarly, the Gain part of the Redemption Amount is not a distribution of income of the trust estate.
In coming to this conclusion, the Court analysed s 97 of the ITAA 1936 as follows:
Colonial was a beneficiary of the Wholesale Fund for the purposes of s 97 of the ITAA 1936.
- The interposition of the custodian did not prevent Colonial from being a beneficiary – Citigroup was holding the units of the Wholesale Fund on sub-trust for Colonial.
- The legal arrangements pursuant to which Colonial, as trustee of the Retail Fund, had appointed Citicorp as the custodian, meant that while Citicorp was the conduit through which the payment must flow to Colonial, it was Colonial not Citicorp to whom the Redemption Amount must be paid.
- As a unitholder of the Wholesale Fund, Colonial was “entitled to enforce the trustee’s obligation to administer the trust according to its terms” (Kafataris v Deputy Commissioner of Taxation (2008) 172 FCR 242 at ).
Colonial was not ‘presently entitled’ within the meaning of s 97(1) of the ITAA 1936, according to the test in Harmer v Federal Commissioner of Taxation (1991) 173 CLR 264:
- The beneficiary has an interest in the income which is both vested in interest and vested in possession; and
- The beneficiary has 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.
In Harmer, the Court also noted that this question “must be answered as at the time when the interest was derived… during the tax years”.
Having regard to the manner in which, and the time at which, any part of the Redemption Amount is allocated to one or other of the relevant accounts (See Clause 12), and the fact that the allocation is at the discretion of the Responsible Entity, it is impossible to satisfy the Harmer requirement that the present entitlement arise within the relevant tax year.
The capital gains (‘Gain part’), both short and long term, did not form part of the income of the Wholesale Fund trust estate under s 97.
- Refer to Clause 32
- The provision for the distribution to registered unitholders of income previously not distributed in the relevant year has no operation with respect to redemptions or the composition of a Redemption Amount.
- On its proper construction, the Wholesale Fund Constitution did not have a provision equivalent to those in Bamford and Cajkusic, which had the effect of treating capital receipts as income of the trust estate.
The ‘Gain part’ could not be included in the assessable income of the redeeming unitholder as the redeeming unitholder’s ‘share’ of the s 95 net income of the Wholesale Fund.
- Confirmed that share in ‘share of the net income’ in s 97 is a proportion, not an amount.
- Even if the effect of a redemption had been to make a redeeming unitholder presently entitled to income from which the gain part of the redemption payment was sourced, it would not follow that the gain part was the amount that was included in the assessable income of the redeeming unitholder under section 97.
Question 1(b) – Whether the ‘gain part’ is treated, by reason of Subdivision 115-C of the ITAA 199), as a capital gain to be taken into account in calculating the assessable income of the redeeming unit holder.
The Gain part is a particular amount, being the excess of the Redemption Amount over the Subscription Amount, and is not a distribution of income to the trust estate.
In contrast, the amount of the net income of the Wholesale Fund which is taken into the assessable income of the Retail Fund would be calculated with respect to the share (or proportion) of distributable income of the Wholesale Fund to which Colonial is presently entitled.
Consequently, Subdivision 115-C of the ITAA 1997 would require an enquiry into how much of the proportionate share of the net income of the fund assessed to the unitholder was attributable to a capital gain made by the fund.
Question 1(c) and (d) – Whether a redeeming unitholder makes a capital gain from CGT event C2 happening upon redemption of the units.
A CGT Event C2 is the redemption of an intangible CGT Asset, which in this case is the unit in the Wholesale Fund.
Pursuant to (1)(b), a trust amount attributable to the Wholesale Fund’s net capital gain could not be included in the assessable income of either the Wholesale Fund or the Retail Fund. Additionally, if such an amount were so included it would not equate to the Gain part which is an amount not a proportion.
On redemption of a unit the unitholder receives a Redemption Amount (Clause 12). The entirety of that amount, not just the Gain part, represents the capital proceeds from the CGT C2 Event that occurred when the unitholder’s ownership of the unit (an intangible CGT asset) ended.
Accordingly, a capital gain is made ‘to the extent that the capital proceeds… exceed the subscription amount’ by the Gain part.
However, pursuant to the Court’s conclusion in (1)(a), s 97 does not operate to include the Gain part in the calculation of Colonial’s net income. As such, the capital gain arising from the CGT C2 Event is not reduced by the Gain part.
Consider a situation where Colonial retains its units but one or more units are redeemed by other unitholders.
Question 5(a) – (c) – Whether the remaining unitholders were entitled to that part of the net income of the Wholesale Fund not distributed to redeeming unitholders
For the reasons given in (1)(a), any unitholder other than the applicant will not be presently entitled:
- The Gain part is not necessarily sourced from income.
- Even if the unitholders were presently entitled to income from which the Gain part is sourced, it does not follow that the amount of the Gain part will be included in s 95 net income upon which the unitholder will be assessed.
Under s 97 trust beneficiaries who are presently entitled to a share or proportion of the income of the trust estate have included in their assessable income the same share or proportion of the net income of the trust estate. It does not follow from this that the amount or part of the net income can be equated to the amount or part of the trust income that has not been distributed (i.e. ss 95 net income of a trust estate and s 97 income of a trust estate are subject matters which do not correspond).
- There are “a range of amounts” that may be included in s 95 income but which “are not capable of being recognized for accounting purposes, let alone founding an entitlement: e.g. franking credits, attributed foreign investment income, amounts included by operation of Pt IVA of the 1936 Act or deemed capital gains included by operation of the market substitution rule”.
Question 5(d) – Whether Division 102 and subdivision 115-C of the ITAA 1997 operates to provide an allowable deduction equal to that share included in assessable income under s 97
The combined effect of these provisions is to allow a beneficiary to reduce attributed capital gains by its capital losses and unapplied net capital losses (if any) and to apply any applicable discount.
To the extent that a redeeming unitholder would be taken to make a capital gain under Subdivision 115-C of the ITAA 1997, they would be entitled to a deduction under subsection 115-215(6) of the ITAA 1997 to offset the corresponding amount assessed under section 97.
Division 102 and subdivision 115-C of the ITAA 1997 operates to provide an allowable deduction equal to that share included in assessable income under s 97.
Question 6 – Pursuant to the contemplated amendments being made, would the Wholesale Fund be a fixed trust under s 272-65 in Sch 2F of the 1936 Act, and as such, would Colonial have a fixed entitlement to a share of income or capital of the Wholesale Fund under s 272-5?
Considered the meaning of ‘defeasible’ in relation to unit trusts (s 272(5)(2)) and held that unless subsection (2)(d) was satisfied (i.e. price of units when redeemed or issued must be determine on the basis of the net asset value according to Australian Accounting Principles), the beneficiaries would not have a fixed entitlement.
Clause 43 of the Constitution permitted Colonial to make any modification, addition or deletion to constitution. Consequently, it appeared capable of defeating any of the unitholders’ interests in the income and capital of the Wholesale Fund. However, it was necessary to consider the operation of s 601GC(1)(b) of Corporations Act 2001, which permits a responsible entity to change its Constitution only if “the responsible entity reasonably considers the change will not adversely affect members’ rights”. The Court did not make a definitive conclusion on this issue.
Instead, the Court considered s 601GC(1)(a) of the Corporations Act 2001 and concluded that the interests of unitholders in income and capital of the Wholesale Fund could be defeated by the unitholders exercising the powers granted to them under this provision.
Consequently, the Wholesale Fund was not a ‘fixed trust for the purposes of s 272-65 of Sch 2F, as the interests of the unitholders in income and capital of the trust were defeasible.
* Note – Questions 2-4 involved the re-examination of Question 1 considering different factual scenarios. The Court, in coming to the same conclusions held that the factual differences were immaterial.
The Court applied the test in Harmer in determining that Colonial was not presently entitled to the funds from which the Gain part was sourced at the time those funds were derived by the trustee and therefore its assessable income does not include an amount under s 97(1).
On a unitholder level, this case indicates that it is increasingly difficult to establish that a unit trust is a fixed trust for taxation purposes.